Top Accounting Issues for 2014 CPE Course - CCH

Top Accounting Issues for 2014 | CPE CoursE

BONUSCPE CoursE! Earn CPE Credit and stay on top

of key Accounting issues. Go to

CCHGroup.com/PrintCPE

http://www.cchgroup.com/webapp/wcs/stores/servlet/content_LP_printcpe?cm_mmc=TC-Print%2bCPE%2bWebpage%2bBook-Jun12-_-AD-_-Reader%2bAd-_-Print%2bCPE%2bLP

CCH Editorial Staff Publication

Top Accounting Issues for 2014 | CPE CoursE

ii

Contributors

Contributing Editors ............................................. Steven C Fustolo, CPA James F. Green, CPA

Technical Review .................................................. Sharon R. Brooks, CPA Nitaya Powell, CPA

Production Coordinator ...............................................Mariela de la TorreProduction ......................................................................... Lynn J. BrownLayout and Design ...............................................................Laila Gaidulis

This publication is designed to provide accurate and authoritative informa-tion in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

© 2013 CCH. All rights reserved.4025 W. Peterson Ave.Chicago, IL 60646-6085800 344 3734CCHGroup.com

No claim is made to original government works; however, within this Prod-uct or Publication, the following are subject to CCH’s copyright: (1) the gathering, compilation, and arrangement of such government materials; (2) the magnetic translation and digital conversion of data, if applicable; (3) the historical, statutory and other notes and references; and (4) the commentary and other materials.

iii

toP ACCountInG IssuEs for 2014 CPE CoursE

Introduction

CCH’s Top Accounting Issues for 2014 CPE Course helps CPAs stay abreast of the most significant new accounting standards and important projects. It does so by identifying the events of the past year that have developed into hot issues and reviewing the opportunities and pitfalls presented by these changes. The topics reviewed in this course were selected because of their impact on financial reporting and because of the role they play in under-standing the accounting landscape in the year ahead.

Module 1 of this course reviews ongoing issues.Chapter 1 reviews the rules for testing impairment of goodwill and in-

tangible assets with indefinite lives, including the new qualitative assessment option found in ASU 2012-02 and ASU 2011-08.

Chapter 2 introduces you to the framework set out in generally accepted accounting principles (GAAP) for measuring an item at its fair value.

Chapter 3 discusses the current developments in the establishment of a set of GAAP rules for private, non-public companies.

Module 2 of this course reviews financial statement reporting.Chapter 4 discusses ASU 2011-09, which expands the required disclo-

sures for employers that participate in multiemployer pension plans and multiemployer other postretirement benefit plans.

Chapter 5 discusses the changes that would be made to accounting for leases based on the exposure draft, and the effects those changes may have.

Chapter 6 discusses several issues that have been addressed by the AICPA, including those related to extraordinary items and involuntary conversions.

Chapter 7 discusses several practice issues including those arising from imputing goodwill on personal financial statements, the disclosure of policies not applicable to the current year, immaterial GAAP departures, presentation of income tax items, and OCBOA financial statements.

Module 3 of this course reviews current developments.Chapter 8 discusses ASU 2013-04: Liabilities (Topic 405): Obligations

Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation is Fixed at the Reporting Date. It examines require-ments of the ASU including the scope, disclosures, and transition rules. Numerous examples are included.

Chapter 9 discusses several ongoing issues in accounting and reporting including the proposed liquidation basis of accounting, going concern as-sessment by management, politically motivated disclosures, and the effects of post office changes on working capital.

Finally, Chapter 10 discusses several Accounting Standards Updates (ASUs) issued in 2012 and 2013, including ASU 2013-05 regarding foreign

iv

currency matters, ASU 2013-02 concerning comprehensive income, ASU 2013-01 concerning disclosures about offsetting assets and liabilities, and ASU 2012-05 dealing with not-for-profit cash flow statements.

Study Questions. Throughout the course you will find Study Questions to help you test your knowledge, and comments that are vital to understanding a particular strategy or idea. Answers to the Study Questions with feedback on both correct and incorrect responses are provided in a special section beginning on page 215.

Index. To assist you in your later reference and research, a detailed topical index has been included for this course beginning on page 229.

Quizzer. This course is divided into three Modules. Take your time and review all course Modules. When you feel confident that you thoroughly understand the material, turn to the CPE Quizzer. Complete one, or all, Module Quizzers for continuing professional education credit.

Go to CCHGroup.com/PrintCPE to complete your CPE Quizzers online for immediate results and no Express Grading Fee. Further information is provided in the CPE Quizzer Instructions on page 239.

September 2013


v

CCH’S PLEDGE TO QUALITY

Thank you for choosing this CCH Continuing Education product. We will continue to produce high quality products that challenge your intellect and give you the best option for your Continuing Education requirements. Should you have a concern about this or any other CCH CPE product, please call our Customer Service Department at 1-800-248-3248.

COUrSE ObjECTIvES

This course provides an overview of important accounting developments. At the completion of this course, the reader will be able to:

Indicate how intangible assets with indefinite lives should be accounted forDescribe events or circumstances that may warrant an entity performing an interim goodwill impairment testDiscuss the two-step test for goodwill impairmentList the disclosures required for goodwill impairment lossesIdentify the objectives of GAAP’s fair value measurement frameworkExplain the hierarchy of inputs to fair value measurementsIdentify the basic disclosures required by ASC 820Indicate the reasons why a set of GAAP rules for private, non-public companies is neededDiscuss the AICPA’s FRF for SMEsExplain the differences between multiemployer plans, single-employer plans, and multiple-employer plansDiscuss the requirements of ASU 2011-09Describe the Pension Protection Act color zones used to evaluate the funded status of pension plans Discuss the changes that will be made under the proposed lease standardExplain how the lessee calculates the liability for a lease under the new standardState how existing leases will be handled when the new statement is adoptedExplain how the new standard may affect book/tax differences, EBITA, and debt-equity ratiosDiscuss how to classify terrorist acts or acts of God on the statement of operationsIndicate how an involuntary conversion is treated under GAAPExplain how business interruption insurance recoveries should be displayed in the statement of operationsDescribe how assets should be presented on personal financial statementsExplain how immaterial departures from GAAP should be handled

vi

Discuss how certain items should be recorded on income tax basis financial statementsIndicate how a reporting entity measures an obligation under ASU 2013-04Describe how a liability for a guarantor is measured under ASC 460State the transition rules and effective date of ASU 2013-04Discuss the major proposed guidance for the liquidation basis of accountingList some of the new disclosures required under the Dodd-Frank ActState the possible accounting impacts from the change in the U.S. Post Office delivery policyIndicate the accounting rules concerning the sale of an investment in a foreign entityDescribe how the effect of reclassifications of accumulated comprehensive income on the line items in the income statement should be presentedExplain how certain donations to not-for-profit entities should be classified on the statement of cash flows

one complimentary copy of this course is provided with certain copies of CCH publications.Additional copies of this course may be downloaded from CCHGroup.com/PrintCPE or ordered by calling 1-800-248-3248 (ask for product 10024493-0001).


vii


Contents

MoDuLE 1: onGoInG IssuEs

1 Intangible Assets with Indefinite Lives—Impairment Test rulesLearning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1Existing GAAP for Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3GAAP CHANGE: Optional Qualitative Assessment

Made by ASU 2011-08 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9Other changes made by ASU 2011-08 . . . . . . . . . . . . . . . . . . . . . . . . . . 12Transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14Examples Illustrating the Application of

the Qualitative Assessment of ASU 2011-08 . . . . . . . . . . . . . . . . . . . 15Changes Made to Impairment of

Intangible Assets with Indefinite Lives . . . . . . . . . . . . . . . . . . . . . . . . 20Deferred Income Taxes—Impairments . . . . . . . . . . . . . . . . . . . . . . . . . . 25Financial Statement Display of Impairments . . . . . . . . . . . . . . . . . . . . . 26Disclosures of Impairments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27Avoiding Impairment Losses Under GAAP . . . . . . . . . . . . . . . . . . . . . . . 29

2 Fair value MeasurementsLearning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35The Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35The Fair Value Concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37Valuation Approaches and Related Inputs . . . . . . . . . . . . . . . . . . . . . . . . 46The Hierarchy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51Measuring Certain Items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

3 big GAAP–Little GAAPLearning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63Prior attempts at little GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65FASB and AICPA Simultaneously Jump on

the Little-GAAP Bandwagon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66FASB’s PCC Comes to Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69AICPA’s FRF for SMEs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69AICPA’s Exposure Draft for FRF for SMEs . . . . . . . . . . . . . . . . . . . . . . 70The Multiple Framework Options for Non-Public Entities . . . . . . . . . . 75

viii

MoDuLE 2: fInAnCIAL stAtEMEnt rEPortInG

4 Multiemployer Plan Disclosures Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77Comparison of U .S . GAAP with IFRS . . . . . . . . . . . . . . . . . . . . . . . . . . 79Requirements of ASU 2011-09 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80Unfunded Pension Plans and the Loaded Pistol . . . . . . . . . . . . . . . . . . . 90

5 Changes Coming With Lease AccountingLearning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97The SEC Pushes Toward Changes in Lease Accounting . . . . . . . . . . . . . 98FASB-IASB Lease Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99Method Used Under the Proposed Standard . . . . . . . . . . . . . . . . . . . . . 100Lessee Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101Lessor Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103Lease Term Used by Lessee and Lessor . . . . . . . . . . . . . . . . . . . . . . . . . 104Lease Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105Reassessment of Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106Reassessment of the Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108Contract Modifications or Changes in Circumstances

After the Date of Inception of the Lease . . . . . . . . . . . . . . . . . . . . . . 108Short-term Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108Sale and Leaseback Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109Presentation and Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109Transition—Existing Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113Effective date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113The Impact of Changes to Lease Accounting . . . . . . . . . . . . . . . . . . . . 113Other Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136Dealing with Financial Covenants . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

6 AICPA Technical Practice Aids— Extraordinary Items and Involuntary ConversionsLearning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139TIS Section 5400, Extraordinary and Unusual Items . . . . . . . . . . . . . . 139 .05 Accounting and Disclosures: Guidance for Losses From

Natural Nongovernmental Entities . . . . . . . . . . . . . . . . . . . . . . . . . . 139Involuntary Conversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

7 Accounting Practice IssuesLearning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153Imputing Goodwill on Personal Financial Statements . . . . . . . . . . . . . . 153Disclosures of Policies Not Applicable

to the Current Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156GAAP Departure Not Material . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161OCBOA (Income Tax Basis Financial Statements)—

Practice Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

ix

MoDuLE 3: otHEr CurrEnt DEvELoPMEnts

8 ASU 2013-04: joint and Several Liability Arrangements with Fixed ObligationsLearning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174Additional Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

9 Selected Accounting and reporting DevelopmentsLearning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185Proposed Liquidation Basis of Accounting . . . . . . . . . . . . . . . . . . . . . . 185Going Concern Assessment by Management . . . . . . . . . . . . . . . . . . . . 189The Politics of Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192Impact of Post Office Changes on Working Capital . . . . . . . . . . . . . . . . .197

Selected ASUs 2012–2013Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201ASU 2013-05: Foreign Currency Matters (Topic 830) . . . . . . . . . . . . . 201ASU 2013-02: Comprehensive Income (Topic 220) . . . . . . . . . . . . . . 205ASU No . 2013-01: Balance Sheet (Topic 210) . . . . . . . . . . . . . . . . . . . 209ASU No . 2012-05: Statement of Cash Flows (Topic 230)

Not-for-Profit Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210Summary of ASUs – 2009 to 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

Answers to Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229CPE Quizzer Instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239CPE Quizzer: Module 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241CPE Quizzer: Module 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249CPE Quizzer: Module 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257Module 1: Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261Module 2: Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265Module 3: Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269

10

1

MoDuLE 1: onGoInG IssuEs — CHAPtEr 1

Intangible Assets with Indefinite Lives— Impairment Test rules

This chapter reviews the rules for testing impairment of goodwill and intan-gible assets with indefinite lives, including the new qualitative assessment option found in ASU 2012-02 and ASU 2011-08.

LEArnInG ObjECTIvES

upon completion of this chapter, the reader will be able to:

Indicate how intangible assets with indefinite lives should be accounted forstate at what level the test for impairment of goodwill is performedDescribe events or circumstances that may warrant an entity performing an interim goodwill impairment testDiscuss the two-step test for goodwill impairmentExplain how the rules for the qualitative assessment of goodwill impairment apply when there is a carrying amount that is zero or negativestate how deferred tax assets and liabilities should be handled in the testing of goodwill of a reporting unitList the disclosures required for goodwill impairment losses

bACkGrOUnD

With the current state of affairs in the U.S. economy, there are many public and non-public companies that have significant impairments of long-lived assets (equipment and real estate), goodwill, and intangible assets with indefi-nite lives. GAAP requires that companies test their goodwill and long-lived assets with indefinite lives annually for impairment, while long-lived asset (equipment and real estate) and intangibles with finite lives must test for impairment only if there is a reason to do so.

A typical acquisition includes the recording at fair value of long-lived tangible assets (equipment and real estate), long-lived intangibles with in-definite lives (such as licenses, tradenames and trademarks), intangibles with finite lives (such as patents), and, finally, goodwill.

ASC 805, Business Combinations (formerly FAS 141R), requires that in a business combination, an acquirer must record at fair value all assets, li-ability and any non-controlling interests in the acquiree. ASC 805 requires that intangible assets other than goodwill be recognized apart from goodwill if they meet certain criteria. ASC 805 further requires that goodwill be initially recognized as an asset in the financial statements, as the excess of

TO P AC C O U N T I N G I S S U E S F O R 2 0 1 4 C P E C O U R S E2

the cost of an acquired entity over the net of the amounts assigned to assets and liabilities assumed.

Once the underlying assets of an acquisition are recorded at their fair value, the rules as to whether or not to depreciate or amortize those assets and how and when to test for impairment writedown come into play.

The authority for testing impairment of long-lived assets, intangibles, and goodwill is found in a series of FASB statements that were issued in the early 2000s, and that drastically changed the way in which such assets were tested for impairment.

The following two tables summarize the authority for accounting for impairment of various assets:

Statement Applies to

Intangibles: Goodwill and Other (AsC 350) (formerly fAs 142), as amended by Asu 2010-28 and Asu 2011-08

n Goodwill n Intangible assets with indefinite lives

Impairments (AsC 360) (formerly fAs 144) n Long-lived assets (equipment, real estate, etc.)n Intangible assets with finite lives

Accounting for Impairments of Assets

Type of assetAuthority for impairment

Accounting treatment

Impairment test approval

InTAnGIbLE ASSETS:

Goodwill AsC 350(formerly fAs 142)

not amortized tested annually for impairment

Intangibles with indefinite lives (trade names, etc.)

AsC 350(formerly fAs 142)


Intangibles with finite lives (patents, agreements not to compete, etc.)


Amortized tested for impairment only if there is an indica-tion that an impairment might exist

TAnGIbLE ASSETS:

Long-lived tangible assets (equipment and real estate)


Depreciated tested for impairment only if there is an indica-tion that an impairment might exist

Because fair value is the basis for measuring impairment, ASC 820, Fair Value Measurement (formerly FAS 157) provides guidance by defining fair value and requiring an entity to follow ASC 820 anytime fair value is measured, such as in the case of ASC 350 (formerly FAS 142)and ASC 360 (formerly FAS 144).

In 2011 and 2012, the FASB issued two new accounting standards updates (ASUs) to offer an optional qualitative assessment of impairment:

ASU 2011-08, Intangibles—Goodwill and Other (Topic 350), Testing Goodwill for Impairment, permits use of an optional qualitative assess-ment of goodwill impairment.

Module 1 — Chapter 1 — Intang ib le assets w i th Indef in i te l ives—Impai rment test ru les 3

ASU 2012-02, Intangibles—Goodwill and Other (Topic 350) Testing Indefinite-Lived Intangible Assets for Impairment, permits use of an op-tional qualitative assessment for intangible assets with indefinite lives.

Both of these qualitative assessments are the subject of this chapter.

ExISTInG GAAP FOr GOODWILL

Before reviewing the optional qualitative assessment available for goodwill, let’s review the general rules related to recording goodwill and testing it for impairment.

ASC 805, Business Combinations, defines goodwill as:

… an asset representing the future economic benefits arising from other assets acquired in a business combination that are not indi-vidually identified and separately recognized.

ASC 350, Intangibles: Goodwill and Other, provides the rules for accounting for goodwill after a portion of the acquisition price is allocated to goodwill by ASC 805, Business Combinations.

rules for Testing Goodwill for Impairment Under ASC 350Goodwill should not be amortized but should be tested for impairment at least annually. The test shall be performed at the reporting unit level.

A reporting unit is defined as an operating segment or one level below an operating segment.

nOTE

for most non-public entities, the entity has one reporting unit so that goodwill is tested at the entity level.

The annual impairment test may be performed any time during the fiscal year, provided the test is performed at the same time each year. Different reporting units may be tested for impairment at different times.

nOTE

Goodwill should be tested for impairment on an interim basis (between annual tests) if an event occurs or circumstances change that would make it more likely than not (more than 50 percent chance) that the fair value of the reporting unit would be below the carrying amount.


Factors that may require an entity to test for impairment on an interim basis (between annual tests) include the following:

Macroeconomic conditions such as:Deterioration in general economic conditions Limitations on accessing capital Fluctuations in foreign exchange ratesOther developments in equity and credit markets

Industry and market considerations such as:Deterioration in the environment in which an entity operates Increased competitive environment Decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers) Change in the market for an entity’s products or services, or a regula-tory or political development

Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flowsOverall financial performance such as:

Negative or declining cash flowsDecline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods

Other relevant entity-specific events such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigationEvents affecting a reporting unit such as:

A change in the composition or carrying amount of its net assets A more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit Testing for recoverability of a significant asset group within a re-porting unit Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit

If applicable, a sustained decrease in share price (consider in both absolute terms and relative to peers)Other relevant events and circumstances that affect the fair value or car-rying amount in determining whether to perform the first step of the goodwill impairment test

Because goodwill is tested for impairment under ASC 350, Intangibles: Good-will and Other, it should not be tested for impairment with other long-lived assets under ASC 360, Property, Plant, and Equipment.

If an asset group is tested for impairment under ASC 350, the ASC 360 impairment test of those assets shall be performed before the goodwill im-pairment test. Any impairment loss incurred on the test of the assets under ASC 360 should be recognized before the goodwill test is performed.


ExAMPLE

reporting unit X consists of various tangible and intangible assets, including goodwill. X is performing an impairment test of all of its assets under AsC 360. X also must perform its annual test for impairment of goodwill.

X should first perform its test for impairment of all of its tangible and intangible assets under AsC 360. If there is an impairment of those assets, they should be written down and an impairment loss recorded prior to including those assets in the test for impairment of goodwill under AsC 350. the written down assets would be used to test for goodwill impairment.

reporting Unit versus Entity Level AssessmentGAAP requires that goodwill be tested for impairment at the reporting unit level based on the assumption that many entities have several reporting units within one entity. A reporting unit is defined as an operating segment or one level below an operating segment.

As it relates to most closely held businesses, such entities typically have only one reporting unit, which is the entity as a whole. In such situations, goodwill is tested for impairment at the entity level (e.g., one reporting unit).For purposes of this chapter and the various examples that are included, the author assumes that the entity has one reporting unit. Thus, in all examples, goodwill is tested at the entity level.

GAAP’s Current Two-Step Test for Goodwill ImpairmentAn entity is required to make an annual test of goodwill for impairment. The test is done separately for each reporting unit and may result in goodwill assigned to one unit being written down, while goodwill for another unit not being written down for impairment. Again, for most closely held businesses, there is only one reporting unit, which is the entity itself.

The standard test for impairment of goodwill consists of applying two formulas as follows:

First Step: Identify a Potential Goodwill Impairment Second Step: Measure the Impairment

First Step: Identify a Potential Goodwill Impairment

A potential goodwill impairment exists if the fair value of the entity’s stock-holders’ equity is less than the carrying amount of the entity’s stockholders’ equity using the following formula:

fair value of the entity’s stockholders’ equityLess: Carrying amount of entity’s stockholders’ equityEquals: negative amount — there is a potential impairment — go to second step and measure the impairment


If fair value is less than the carrying amount of the entity’s stockholders’ equity, there is a potential impairment and the second step is performed. If fair value is not less than the carrying amount, there is no potential impair-ment and the second step is not performed.

Second Step: Measure the Impairment Loss

If fair value is less than the carrying amount of the entity’s stockholders’ equity, there is a potential impairment and the second step is performed as follows:

fair value of the entity’s stockholders’ equityLess: fair value of entity’s individual assets and liabilities (excluding goodwill)Equals: Implied goodwill valueLess: Carrying amount of goodwillEquals: Impairment loss

If the second step is not completed before the financial statements are issued and a goodwill impairment loss is probable and can be reasonably estimated, the best estimate of that loss should be recognized in those financial state-ments. Any adjustment to that estimated loss upon the completion of the loss measurement shall be recognized in the subsequent reporting period.

The aggregate amount of goodwill impairment losses must be presented as a separate line item in the income statement before the subtotal—income from continued operations (or a similar caption) unless a goodwill impair-ment loss is associated with a discontinued operation. A goodwill impair-ment loss associated with a discontinued operation must be included on a net-of-tax basis within the results of discontinued operations.

After the impairment loss is recognized, the adjusted carrying amount of goodwill becomes its new cost basis.

Once goodwill is written down, the writedown may not be restored. This fact emphasizes the importance of the timing of the impairment test-ing. For example, an entity may incur a goodwill writedown and loss due solely to the fact that the test is performed during a weak economic cycle when the entity’s fair value is in decline. Subsequently, when the entity’s fair value recovers, it is not able to restore the previously written down goodwill.


ExAMPLE 1

Company X is performing its annual test of goodwill impairment at December 31, 20XX.

Facts:

fair value of Company X’s stockholders’ equity $1,000,000Carrying amount of X’s stockholders’ equity 850,000fair value of X’s individual assets and liabilities (exclusive of goodwill) 800,000Carrying amount (book value) of goodwill 500,000

First Step: Identify a Potential Impairment

fair value of X’s stockholders’ equity (sE) $1,000,000Less: Carrying amount of sE 850,000Equals: Positive amount- no impairment $150,000

Conclusion: Because the fair value of X’s stockholders’ equity exceeds its carrying amount, there is no impairment and the second step does not have to be performed.

ExAMPLE 2

same facts as Example 1 except that the amounts have changed to the following:

fair value of X’s stockholders’ equity $1,000,000Carrying amount of X’s stockholder’s equity 1,100,000fair value of X’s individual assets and liabilities (exclusive of goodwill) 800,000Carrying amount (book value) of goodwill 500,000

First Step: Identify a Potential Impairment:

fair value of X’s sE $1,000,000 Less: Carrying amount of X’s sE 1,100,000 Equals: Negative amount- go to second step $(100,000)

Second Step: Measure the Impairment Loss:

fair value of X’s sE $1,000,000Less: fair value of X’s individual assets and liabilities (exclusive of goodwill) 800,000Implied goodwill value $200,000Less: Carrying amount of goodwill 500,000Equals: Impairment loss $(300,000)

Entry:

Goodwill Impairment loss 300,000 Goodwill 300,000


the impairment loss is presented on the statement of income in the following manner:

Company X Statement of Income

For the Year Ended December 31, 20XX

net sales $xxCost of sales xxGross profit xxoperating expenses xxImpairment loss on goodwill (300,000)net income before income taxes xxIncome taxes xxnet income $xx

Is it possible to have an impairment in the first step yet have no writedown of goodwill in second step? Yes. A company could have a negative amount in the first step. When the second step is performed, the implied goodwill value may be greater than the carrying amount of the goodwill. This result could be due to the fact that the company has goodwill with a low carrying amount. Example 2A illustrates this point.

ExAMPLE 2A

same facts as Example 2 except that the amounts have changed to the following:

fair value of X’s stockholders’ equity $1,000,000Carrying amount of X’s stockholder’s equity 1,100,000fair value of X’s individual assets and liabilities (exclusive of goodwill) 800,000Carrying amount (book value) of goodwill 150,000


fair value of X’s stockholders’ equity $1,000,000 Less: Carrying amount of X’s stockholders’ equity 1,100,000Equals: Negative amount- go to second step $(100,000)


fair value of X’s sE $1,000,000Less: fair value of X’s individual assets and liabilities (exclusive of goodwill) 800,000Implied goodwill value $200,000Less: Carrying amount of goodwill 150,000Equals: Impairment loss $ 0Entry: nonE


In Example 2A, even though there is a potential impairment in the first step, when performing the second step, there is no impairment loss as im-plied goodwill of $200,000 is greater than the $150,000 carrying amount of goodwill.

STUDY QUESTIOnS

1. X is performing an impairment test of all of its assets including goodwill. Which of the following is the correct order in which X should test the impairment of its tangible and intangible assets other than goodwill, and its test of goodwill impairment?

a. Goodwill should be tested for impairment first and adjusted, and then the test for impairment of all other tangible and intangible assets should be done.

b. Goodwill and all other tangible and intangible assets should be combined and tested for impairment simultaneously under AsC 360.

c. All tangible and intangible assets other than goodwill should be tested and adjusted before the goodwill impairment test is performed.

d. Goodwill and all intangible assets should be tested together separate from the test of tangible assets.

2. once goodwill is written down, the writedown __________.

a. May be written back up to the original costb. May be written back up without limitc. May not be restoredd. May be restored only if there are certain factors that warrant a restoration

3. Which of the following is correct?

a. It is possible to have an impairment in the first step, yet have no writedown of goodwill in the second step.

b. If there is an impairment in the first step, there will automatically be a write-down of goodwill in the second step.

c. If there is an impairment in the first step, there will be no writedown of goodwill in the second step.

d. If there is an impairment in the first step, there could be a writeup of good-will in the second step.

GAAP CHAnGE: OPTIOnAL QUALITATIvE ASSESSMEnT MADE bY ASU 2011-08

In September 2011, the FASB issued ASU 2011-08, Intangibles—Goodwill and Other (Topic 350), Testing Goodwill for Impairment.

Prior to the issuance of ASU 2011-08, the only method available to per-form the annual impairment test of goodwill was to use the two-step formula found in ASC 350. That test requires, at a minimum, that an entity perform the first step by comparing the fair value of the entity’s stockholders’ equity


to the carrying amount of its stockholders’ equity. What this has meant is that in performing its annual test of goodwill, an entity has had to compute fair value (in step 1) which can be tedious, costly and time consuming. Companies complained to the FASB that they needed a simpler method by which to screen a company to determine whether there was a potential impairment of goodwill.

In response to requests by companies to simplify the annual test for goodwill impairment, in September 2011, the FASB issued another document, ASU 2011-08, Intangibles—Goodwill and Other (Topic 350), Testing Goodwill for Impairment, to allow (but not require) use of a qualitative assessment to test impairment of goodwill. This optional qualitative assessment, which is now in effect, may be performed prior to performing the first step in the two-step approach and may alleviate an entity having to perform either the first or second step.

rules for the Qualitative Assessment Found in ASU 2011-08 An entity has the option to first make a qualitative assessment to determine whether it is necessary to perform the two-step goodwill impairment test.

If, based on the qualitative assessment, it is not more likely than not (not more than 50 percent probability) that the fair value of the entity’s stockholder’s equity) is less than the carrying amount of its stockholders’ equity, the entity may bypass the two-step test for impairment as there is no impairment.

If, based on the qualitative assessment, it is more likely than not (more than 50 percent probability) that the fair value of the entity’s stockhold-ers’ equity is less than its carrying amount, the entity must perform the first step of the two-step impairment test and then, if necessary, perform the second step.

The optional qualitative assessment is mandatory for an entity that has a zero or negative carrying amount of stockholders’ equity. (See rules below.)

nOTE

Asu 2011-08’s qualitative assessment is an optional approach in lieu of the standard two-step quantitative test for impairment of goodwill. Because the qualitative assess-ment is optional, an entity has the choice not to perform the qualitative assessment and, instead, perform the two-step goodwill (quantitative) impairment test. An entity may resume performing the qualitative assessment in any subsequent period.

In making the qualitative assessment, an entity may assess qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of the stockholders’ equity is less than the carrying amount of stockholders’ equity.


Examples of such qualitative factors (events and circumstances) include the following:

Macroeconomic conditions such as:Deterioration in general economic conditions Limitations on accessing capital Fluctuations in foreign exchange ratesOther developments in equity and credit markets

Industry and market considerations such as:Deterioration in the environment in which an entity operates Increased competitive environment Decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers) Change in the market for an entity’s products or services, or a regula-tory or political development

Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flowsOverall financial performance such as:

Negative or declining cash flowsDecline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periodsSeveral periods of net operating losses

Other relevant entity-specific events such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigationEvents affecting a reporting unit such as:

A change in the composition or carrying amount of its net assets A more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit Testing for recoverability of a significant asset group within a report-ing unit Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit

If applicable, a sustained decrease in share price (consider in both absolute terms and relative to peers).Other relevant events and circumstances that affect the fair value or car-rying amount in determining whether to perform the first step of the goodwill impairment test.

An entity shall consider the extent to which each of the qualitative factors (events and circumstances) could affect the comparison of an entity’s fair value with its carrying amount considering the following guidelines:

An entity should place more weight on the factors that most affect the entity’s fair value or the carrying amount of its net assets. An entity should


consider positive and mitigating factors that may affect its determination of whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity has a recent fair value calculation, it also should include as a factor in its consideration the difference between the fair value and the carrying amount in reaching its conclusion about whether to perform the first step of the goodwill impairment test.An entity shall evaluate, on the basis of the weight of evidence, the sig-nificance of all identified factors in the context of determining whether it is more likely than not that the fair value is less than its carrying amount.

nOTE

none of the individual examples of factors are intended to represent standalone events or circumstances that necessarily require an entity to perform the first step of the good-will impairment test. the existence of positive and mitigating factors is not intended to represent a rebuttable presumption that an entity should not perform the first step of the goodwill impairment test.

OTHEr CHAnGES MADE bY ASU 2011-08

Carryforward ruleASU 2011-08 also eliminates use of the special goodwill impairment test carryforward rule that was included in the originally issued ASC 350. Under that rule, ASC 350 offered a special relief provision under which, if certain criteria were met, an entity was able to test for impairment in the first year and carryforward the test to each successive year without up-dating it. ASU 2011-08 amends ASC 350 to officially remove the special carryforward rule.

Disclosures ClarificationASU 2011-08 further provides a clarification with respect to disclosures involving goodwill impairment. It states that the quantitative disclosures about significant unobservable inputs used in fair value measurements cat-egorized within Level 3 of the fair value hierarchy are not required for fair value measurements related to the financial accounting and reporting for goodwill after its initial recognition in a business combination.

Qualitative Assessment for Carrying Amount of Zero or negativeASU 2011-08’s qualitative assessment is mandatory for an entity that has a stockholders’ equity carrying amount of zero or negative. The term “carrying amount” means the book value of an entity’s total stockhold-ers’ equity. Thus, an entity with a carrying amount (book value) of its


total stockholders’ equity of zero or negative must perform a qualitative assessment of goodwill. In such a situation, using the original two-step impairment test is not an option.

The first step in the two-step impairment test is bypassed in lieu of the qualitative assessment.

If, based on the qualitative assessment, it is not more likely than not (not more than 50 percent probability) that the fair value of the entity’s stockholders’ equity is less than its carrying amount, the entity may bypass the two-step test for impairment as there is no impairment.

If, based on the qualitative assessment, it is more likely than not (more than 50 percent probability) that the fair value of the entity’s stockholders’ equity is less than its carrying amount, there is an impairment and the entity must per-form the second step of the two-step impairment test (Step 1 is not performed).

nOTE

In evaluating whether it is more likely than not that the goodwill of an entity with zero or neg-ative stockholders’ equity is impaired, an entity also should take into consideration whether there are significant differences between the carrying amount and the estimated fair value of its assets and liabilities, and the existence of significant unrecognized intangible assets.

ObSErvATIOn

the mandatory qualitative assessment rule for a carrying amount of zero or negative was created because companies were manipulating the previous rules for testing impairment of goodwill.

ExAMPLE 2

Company X has the following information. the entity is a single reporting unit so that goodwill is tested at the entity level.

fair value of X’s stockholders’ equity $0Carrying amount of X’s stockholder’s equity (100,000,000)

under the rules in effect prior to the required qualitative assessment, X would perform the first step as follows:

fair value of X’s stockholders’ equity $0Less: Carrying amount of X’s stockholders’ equity (deficit) (100,000,000)NO IMPAIRMENT POSITIVE

Prior to the mandated use of the qualitative assessment for an entity with a zero or negative carrying amount of stockholders’ equity, in the above


example, Company X would avoid having to record an impairment loss because the fair value of X’s stockholders’ equity (zero) was greater than its negative carrying amount ($(100 million)). Yet, with such a large negative carrying amount, it is likely that the company would have an impairment if the second step was performed. Note further that because fair value can never be less than zero, fair value always exceeds a negative carrying amount so that an entity with a negative carrying amount (deficit stockholders’ equity) would never have an impairment in the first step and would not measure an impairment in the second step.

ASU 2011-08 resolved this situation by requiring an entity with either a zero or negative stockholders’ equity to perform a qualitative assessment (look at qualitative factors) in lieu of performing the first step of the impair-ment test. If, after performing the qualitative assessment, it is more likely than not (more than 50 percent likelihood) that a goodwill impairment ex-ists (fair value of stockholders’ equity is less than its carrying amount), then the entity goes directly to the second step to measure the impairment. The first step is bypassed.

Without the issuance of ASU 2011-08, companies with significant amounts of goodwill and deficits in stockholders’ equity were able to avoid writedowns of goodwill under the impairment rules. Now that loophole has been closed with ASU 2011-08.

TrAnSITIOn

Use of the qualitative assessment found in Accounting Standards Update No. 2011-08, Intangibles— Goodwill and Other (Topic 350): Testing Goodwill for Impairment shall be applied prospectively for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Earlier application is permitted.

Earlier application also is permitted for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if the entity’s financial statements for the most recent annual or interim period have not yet been issued or, for non-public entities, have not yet been made available for issuance.


EXaMPLES ILLuStratInG tHE aPPLICatIon oF tHE QuaLItatIvE aSSESSMEnt oF aSu 2011-08

Example 1: Qualitative AssessmentCompany X is performing its annual test of goodwill impairment at Decem-ber 31, 20XX. Company X has one reporting unit so that goodwill is tested at the entity level. X has goodwill with a carrying amount of $500,000. X does not want to waste time testing goodwill using the two-step approach, which requires that X measure fair value.

X chooses to perform a qualitative assessment of whether there may be an impairment. In making the assessment, X should evaluate various qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of X’s stockholders’ equity is less than its carrying amount.

Following is a chart in which X evaluates certain qualitative factors:

Qualitative factor Does it exist in Company x?

Macroeconomic conditions such as deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets?

no

Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development?

no

STEP 2: MEASUrE IMPAIrMEnT

fMv of sE

– fMv-A/L (excl GW)

= Implied GW

Implied GW

– Carrying amount of GW

= Loss

Entry: Loss Goodwill

Goodwill Test for Impairment— Inclusive of the Qualitative Assessment Under ASU 2011-08

nO IMPAIrMEnT

YES

QUALITATIvE ASSESSMEnTDoes the qualitative assessment indicate that it is more likely than not that the fair value of the entity’s stockholders’ equity is less than the carrying amount of stockholders’ equity taking into account qualitative factors such as:n Macro-conditions n Industry and market

considerations n Cost factors n overall financial

performancen other negative factors

YES IMPAIrMEnT

(Go directly to STEP 2)

nO

YES IMPAIrMEnT(Perform STEP 2)

STEP 1: Is the fair value of the entity’s stockholders’ equity less than the carrying amount of stockholders’ equity?

nO(Perform STEP 1)

Is the carrying amount of the entity’s stockholders’ equity zero or negative?



Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flows?

some increases in raw materi-als costs that do not have a significant negative effect on earnings and cash flow

overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings com-pared with actual and projected results of relevant prior periods?

no. Company is profitable although sales are flat, but not declining.

other relevant entity-specific events such as changes in manage-ment, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation?

no

Events affecting a reporting unit such as a change in the composi-tion or carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit?

no

If applicable, is there a sustained decrease in share price (consider in both absolute terms and relative to peers)?

not applicable. X is a closely held company that does not trade shares of its stock.

other relevant events and circumstances that affect the fair value or carrying amount in determining whether to perform the first step of the goodwill impairment test?

nothing significant

Conclusion: Although the list of qualitative factors may not be all-inclusive, when considered in its entirety, the results of the assessment indicate that it is not more likely than not (not more than 50 percent probability) that the fair value of X’s stockholders’ equity is less than the carrying amount of X’s stockholders’ equity.

Therefore, there is no impairment of X’s goodwill and the two-step impairment test does not have to be performed. The best news is that by using the qualitative assessment, X does not have to deal with the two-step fair value test which is based on measuring fair value.

Example 2: Qualitative AssessmentSame facts as Example 1, but the qualitative assessment encompasses the following information.


Macroeconomic conditions such as deterioration in general eco-nomic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets?

Yes. X is having trouble refinanc-ing its existing debt due to recur-ring losses and insufficient equity.

Industry and market considerations such as deterioration in the environment in which an entity operates, an increased competi-tive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development?

Yes. Competition from China and south America has resulted in a deterioration of sales over the past two years and a reduction in backlog of sales going forward.



Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flows?

Yes. there have been steady increases in raw materials costs and the inability to pass along the additional cost by increasing sales prices.

overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings com-pared with actual and projected results of relevant prior periods?

Yes. the company has had sev-eral years of recurring losses that has resulted in tight cash flow.

other relevant entity-specific events such as changes in man-agement, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation?

no

Events affecting a reporting unit such as a change in the composition or carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit?

no

If applicable, a sustained decrease in share price (consider in both absolute terms and relative to peers)?

not applicable. X is a closely held company that does not trade shares of its stock.

other relevant events and circumstances that affect the fair value or carrying amount in determining whether to perform the first step of the goodwill impairment test?

nothing significant

Conclusion: Although not all of the qualitative factors in Example 2 are negative, there are enough of them that suggest that it is more likely than not (more than 50 percent probability) that the fair value of X’s stockhold-ers’ equity is less than its carrying amount. Therefore, X should perform the two-step test for goodwill impairment. That means that X now has to deal with measuring fair value of X in the first step of the two-step test, and possibly the second step, if applicable.

Assume the following additional information is used in performing the two-step goodwill impairment test:

fair value of X’s stockholders’ equity $1,000,000Carrying amount of X’s stockholders’ equity 1,100,000fair value of individual assets and liabilities of X (exclusive of goodwill) 800,000Carrying amount (book value) of goodwill 500,000


fair value of X’s stockholders’ equity $1,000,000Less: Carrying amount of X’s stockholders’ equity 1,100,000Equals: Negative amount $(100,000)POTENTIAL IMPAIRMENT—go to second step



fair value of X’s stockholder’s equity $1,000,000Less: fair value of individual assets and liabilities of X (exclusive of goodwill) 800,000Implied goodwill value $200,000Less: Carrying amount of goodwill 500,000Equals: Impairment loss $(300,000)

Entry:


ObSErvATIOn

By introducing an optional qualitative assessment as a precursor to performing the two-step goodwill impairment test, many otherwise profitable companies can avoid having to deal with the laborious task of measuring fair value as required in the first step of the impairment test and, if necessary, the second step. Previously, many companies wasted time and cost by performing the first step (comparing fair value to carrying amount) only to conclude that the fair value far exceeded the carrying amount resulting in no impair-ment and no need to perform the second step.

of course, whenever qualitative information is introduced into GAAP, there is the potential for abuse. After all, it would not be difficult for an entity to manipulate the qualitative information to reach whichever conclusion it desires particularly when some, but not all, of the qualitative factors point in a negative direction.

Example 3: Qualitative Assessment—Carrying Amount is Zero or negativeCompany X is performing its annual test of goodwill impairment at De-cember 31, 20XX. X has one reporting unit so that the test is performed at the entity level:

fair value of X’s stockholders’ equity $1,200,000Carrying amount of X’s stockholders’ equity (700,000)fair value of X’s individual assets and liabilities (exclusive of goodwill) 900,000Carrying amount (book value) of goodwill 300,000

During the year, Company X incurred several adverse qualitative factors as follows:

X is limited to access to additional financing due to the general economic conditions.X was sued by a competitor for patent infringement involving X’s key product.X lost its top salesperson resulting in a significant reduction in sales.


A new competitor has entered the market with sizeable resources.X has had several years of significant net losses and declining cash flows.

Conclusion: ASU 2011-08 states that if an entity has a carrying amount of its stockholders equity of zero or negative, the entity must perform the qualitative assessment of goodwill impairment. If, after performing the qualitative assess-ment, it is more likely than not (more than 50 percent likelihood) that the fair value of the entity’s stockholders’ equity is less than its carrying amount, then there is a potential impairment and the entity should go directly to the second step and measure the impairment.

In this example, the carrying amount is less than zero ($700,000). Fur-ther, the adverse qualitative factors listed above support the fact that it is more likely than not that a goodwill impairment exists. Therefore, there is a potential impairment and the second step should be performed to measure a goodwill impairment as follows:


fair value of X’s stockholders’ equity $1,000,000Less: fair value of X’s individual assets and liabilities (exclusive of goodwill) 900,000Implied goodwill value $100,000Less: Carrying amount of goodwill 300,000Equals: Impairment loss $(200,000)

Entry:


Example 3A: Carrying Amount is Zero or negative

Company X is performing its annual test of goodwill impairment at De-cember 31, 20XX.

fair value of X’s stockholders’ equity $1,200,000Carrying amount of X’s stockholders’ equity (700,000)fair value of X’s individual assets and liabilities (exclusive of goodwill) 900,000Carrying amount (book value) of goodwill 300,000

During the year, Company X had no significant adverse qualitative factors.

Conclusion: ASU 2011-08 states that if an entity has a carrying amount of its stockholders’ equity is zero or negative, a qualitative assessment of goodwill impairment is required.


If, based on the qualitative assessment, it is not more likely than not (not more than 50 percent probability) that the fair value of the entity’s stockholders’ equity is less than its carrying amount, the entity may bypass the two-step test for impairment as there is no impairment.

In this example, the carrying amount is less than zero ($700,000) so that a qualitative assessment is required.

Based on the assessment, there are no significant adverse qualitative fac-tors that would indicate that it is more likely than not that the fair value of X is less than X’s carrying amount. Thus, there is no potential impairment and there should be no test for impairment.

STUDY QUESTIOnS

4. An entity is performing a qualitative assessment of impairment of its goodwill. the entity concludes that it is more likely than not that the fair value of the entity’s stock-holders’ equity is not less than its carrying amount. Which of the following is correct?

a. the entity must perform the first step of the two-step impairment test.b. the entity may bypass the first step and go directly to the second step.c. the entity may bypass the two-step test for impairment.d. the entity must perform both steps of the two-step impairment test.

5. Which of the following is a change made to the goodwill impairment rules by Asu 2011-08?

a. the Asu eliminates use of the special goodwill impairment test carryforward rule.

b. the Asu adds a new special goodwill impairment test carryforward rule.c. the Asu does not affect the special goodwill impairment test carryforward

rule.d. the Asu adds a new safe harbor rule for goodwill impairment.

6. In making the qualitative assessment, a qualitative factor to consider includes which of the following?

a. stable foreign exchange ratesb. Abundance of capitalc. A change in key personneld. A decrease in the competitive environment

CHanGES MaDE to IMPaIrMEnt oF IntanGIbLE aSSEtS wItH InDEFInItE LIvES

backgroundIn July 2012, the FASB issued Accounting Standards Update (ASU) 2012-02 entitled, Intangibles—Goodwill and Other (Topic 350) Testing Indefinite-Lived Intangible Assets for Impairment. The overall objective of the ASU is


to permit (but not require) that an optional qualitative assessment of impair-ment be permitted for intangible assets with indefinite lives, similar to the qualitative assessment permitted for goodwill by ASU 2011-08.

Going back to the chart previously discussed in this chapter, intan-gible assets and goodwill are segregated into four categories under GAAP as follows:

Accounting for Impairments of Assets

Type of assetAuthority for impairment

Accounting treatment

Impairment test approval

Goodwill AsC 350(formerly fAs 142)


Intangibles with indefinite lives (trade names, etc.)



Long-lived tangible assets (equipment and real estate)


Depreciated tested for impairment only if there is an indication that an impairment might exist

Intangibles with finite lives (patents, etc.)


Amortized tested for impairment only if there is an indication that an impairment might exist

An intangible asset with an indefinite life should not be amortized until its life is determined to be no longer indefinite. An intangible asset is deemed to have an indefinite life if there is no legal, regulatory, contractual, com-petitive, economic, or other factors that limit the useful life of an intangible asset. That is, there is no limit placed on the end of the asset’s useful life to the reporting entity.

Examples of intangible assets that might have indefinite lives include:Certain trademarks and tradenamesCertain licenses such as liquor and broadcast licensesTaxi medallions FranchisesAirport routes

A company is required to follow certain rules in ASC 350 in testing an intangible with an indefinite life for impairment. Unlike goodwill, the impairment test for an intangible asset with an indefinite life consists of a single step as follows:

formula for Annual Impairment test- Indefinite-lived intangible:

fair value of intangible assetLess: Carrying amount of intangible assetEquals: Impairment loss

If an impairment loss is recognized, the written-down carrying amount of the intangible shall be the asset’s new basis for subsequent impairment tests. The reversal of previously recognized impairment losses is prohibited.


ExAMPLE

In 20X1, Joe’s Manhattan taxi service purchases a competitor’s business that includes 30 taxi licenses (medallions). out of the total purchase price of $10 million, $7 million is assigned to the 30 taxi licenses based on the fair value in the marketplace. the licenses have an indefinite life and are renewed annually by paying a small renewal fee.

Conclusion: the $7 million of cost allocated to the intangible asset (licenses) should not be amortized until the useful economic life becomes finite. However, each year the Company should test the licenses for impairment by comparing the $7 million carrying amount to the fair value in the market.

Assume that on December 31, 20X1, the fair value of the licenses is $5 million. the licenses should be written down to fair value as follows:

fair value of licenses $5,000,000 Less: Carrying amount of licenses 7,000,000 Equals: Impairment loss $(2,000,000)

Entry: December 31, 20X1:

Loss 2,000,000 Licenses 2,000,000

Change the facts: Assume on January 1, 20X2, the local government changes the law and states that all licenses will become null and void at the end of 20X8.

Conclusion: At this point, the useful economic life is now finite, with seven years remain-ing. the revised carrying amount of $5 million should be amortized over the seven-year period (20X2 through 20X8) on a straight-line basis, unless another systematic and rational method is used.

Changes Made by ASU 2012-02ASU 2012-02 makes the following changes to the impairment test rules for intangible assets with indefinite lives.

An intangible asset (other than goodwill) that is not subject to amorti-zation (indefinite-lived) shall be tested for impairment annually, and more frequently if events or changes in circumstances indicate that the asset might be impaired.

For an intangible asset that is not subject to amortization for impairment, an entity may first perform a qualitative assessment to determine whether it is necessary to calculate the fair value of an indefinite-lived intangible asset.

An entity has an unconditional option to bypass that qualitative assess-ment for any indefinite-lived intangible asset in any period and proceed directly to performing the quantitative impairment test (e.g., compare fair value to carrying amount).

An entity may resume performing the qualitative assessment in any subsequent period.


Performing the Qualitative AssessmentIf an entity elects to perform a qualitative assessment, it shall first assess qualita-tive factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that an indefinite-lived intangible asset is impaired.

An entity shall assess all relevant events and circumstances that may affect the significant inputs used in determining the fair value of the indefinite-lived intangible asset. In conducting this qualitative assessment, an entity should consider the examples of events and circumstances included in the following list, which is not all inclusive:

Macroeconomic conditions such as deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign ex-change rates, or other developments in equity and credit markets Industry and market considerations such as deterioration in the environ-ment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flows Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periodsOther relevant entity-specific events such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigationLegal, regulatory, contractual, political, business, or other factors, in-cluding asset-specific factors that could affect significant inputs used to determine the fair value of the indefinite-lived intangible asset.

An entity shall consider the extent to which each of the adverse events and circumstances identified could affect the fair value of an indefinite-lived intangible asset.

nOTE

An entity also should consider positive and mitigating events and circumstances that may affect its determination of whether it is more likely than not that the indefinite-lived intangible asset is impaired. If an entity has made a recent fair value calculation for an indefinite-lived intangible asset, it also should include as a factor in its consideration the difference between that fair value and the current carrying amount in reaching its conclusion about whether it is more likely than not that the indefinite-lived intangible asset is impaired. An entity also shall consider whether there have been any changes to the carrying amount of the indefinite-lived intangible asset in determining whether it is more likely than not that the intangible asset is impaired.


An entity shall evaluate, on the basis of the weight of the evidence, the significance of all identified events and circumstances in the context of determining whether it is more likely than not that the indefinite-lived intangible asset is impaired.

nOTE

none of the individual examples of events and circumstances are intended to represent standalone events or circumstances that necessarily require an entity to calculate the fair value of an intangible asset. Also, the existence of positive and mitigating events and circumstances is not intended to represent a rebuttable presumption that an entity should not calculate the fair value of an indefinite-lived intangible asset.

If, after assessing the totality of events and circumstances and their potential effect on significant inputs to the fair value determination, an entity deter-mines that it is not more likely than not that the indefinite-lived intangible asset is impaired, then calculating the fair value of the asset and performing the impairment test is unnecessary.

If, after assessing the totality of events and circumstances and their po-tential effect on significant inputs to the fair value determination, an entity determines that it is more likely than not that the indefinite-lived intangible asset is impaired, then the entity shall calculate the fair value of the intangible asset and perform the impairment test.

formula for Annual Impairment test- Indefinite-lived intangible:

fair value of intangible assetLess: Carrying amount of intangible assetEquals: Impairment loss

The impairment test for an indefinite-lived intangible asset shall consist of a comparison of the fair value of the asset with its carrying amount. If the carrying amount of an intangible asset exceeds its fair value, the entity shall recognize an impairment loss in an amount equal to that excess.

After the impairment loss is recognized, the adjusted carrying amount of the intangible asset shall be its new accounting basis. Subsequent reversal of a previously recognized impairment loss is prohibited.

Effective Date The amendments made by ASU 2012-02 are effective for annual and in-terim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012.


STUDY QUESTIOn

7. under the qualitative assessment for impairment of an indefinite-lived intangible asset, if, after performing the qualitative assessment, it is more likely than not that the asset is impaired, which of the following occurs?

a. there is no impairment test because it is unnecessary.b. the entity shall calculate the fair value of the intangible asset and perform

the impairment test.c. the entity shall perform the two-step quantitative impairment test similar

to the one performed for goodwill.d. Additional qualitative procedures are performed.

DEFErrED InCOME TAxES—IMPAIrMEnTS

When there is an impairment of goodwill or an intangible asset with an indefinite life, the result is that the asset is written down for book purposes, but not for tax purposes. The impairment loss represents a temporary dif-ference that leads to the recording of a deferred income tax asset.

Assume that on December 31, 20X10, there is an impairment writedown of goodwill in the amount of $100,000 for book purposes. The deferred tax asset would be computed as follows:

at December 31, 20X10:

Goodwill book basis $450,00020X10 impairment writedown (100,000)revised book basis 350,000tax basis 150,000revised temporary difference (200,000)temporary difference before writedown (300,000)reversal of temporary difference 100,000tax rate 40%DIt provision adjustment- 20X10 $40,000

Entry: 20X10

Impairment loss 100,000Goodwill 100,000Deferred income tax asset 40,000Income tax expense- deferred 40,000

The deferred tax asset reverses through future depreciation or through the ultimate sale of the asset.


Are Deferred Tax Assets and Liabilities Included as recognized Assets or Liabilities in Testing for Goodwill of a reporting Unit?Yes. All assets and liabilities assigned to a unit are included for purposes of the test. Assume that a test for impairment is being done for a reporting unit. The deferred tax assets are included in the value of the recognized assets of the unit such as in the case of the example that follows:

fair value of recognized assets:reporting

unit a

Assets excluding goodwill $400total assets 900Liabilities: Accounts payable (100) Accrued expenses (150)Deferred income taxes (200)net assets $850

Assume that the fair value of Unit A is $1,000.The implied value of goodwill would be as follows:

fair value of unit A $1,000fair value of recognized assets and liabilities (excluding goodwill)* 850Implied goodwill 150Carrying amount of goodwill 80Impairment loss $70

* Includes deferred tax liability.

In the above example, the deferred tax liability of $200 is included in the net assets of Unit A in computing the impairment loss on goodwill.

FInAnCIAL STATEMEnT DISPLAY OF IMPAIrMEnTS

ASC 350 provides that all impairment losses should be presented in the financial statements as part of income from continuing operations or a similar caption:

Impairment losses related to goodwill should be aggregated and presented as a separate line item from impairment losses related to indefinite-lived intangibles. Impairment losses associated with a discontinued operation should be included (on a net-of-tax basis) within the results of discontinued operations.


For a not-for-profit organization, the loss is presented in income from con-tinuing operations in the statement of activities.

Illustration of Financial Statement Presentation:

net sales $xxCost of sales xxGross profit on sales xxselling, general, and administrative expenses xxImpairment losses related to indefinite-lived intangible assets xxGoodwill impairment losses xxIncome from operations xxother income (expense) xxIncome before income taxes xxIncome tax expense xxnet income $xx

How Should Impairment Losses be Presented in the Statement of Cash Flows?An impairment loss related to goodwill or an indefinite-lived intangible asset is a non-cash item that should be shown as an adjustment (addback) in the operating section of the statement of cash flows:

ExAMPLE

Assume an impairment loss of $100,000 on goodwill.

net income $XXAdjustments to reconcile net income to cash from operating activities:Depreciation and amortization XXDeferred income taxes XXGoodwill impairment loss 100,000Increase in accounts receivable XXDecrease in inventories XXIncrease in accounts payable XXIncrease in accrued expenses XXnet cash from operating activities $XX

DISCLOSUrES OF IMPAIrMEnTS

ASC 350 requires the following disclosures for impairment losses involving goodwill and intangible assets with indefinite lives:

Goodwill: The aggregate amount of impairment losses recognizedGoodwill impairment losses: For each goodwill impairment loss recog-nized, the following shall be disclosed in the notes that include the period in which the impairment loss is recognized:


A description of the facts and circumstances leading to the impairmentThe amount of the impairment loss and the method of determin-ing the fair value of the associated reporting unit (whether based on quoted market prices, prices of comparable businesses, a present value or other valuation technique, or a combination thereof )If a recognized impairment loss is an estimate that has not yet been finalized, that fact and the reasons thereof and, in subsequent periods, the nature and amount of any significant adjustments made to the initial estimate of the impairment loss

ExAMPLE 1: Footnote and Presentation

Consistent with the broad philosophical direction of the risk Assessment standards,

At December 31, 20X2, Company A’s financial statements look like this:

Company a balance Sheet

December 31, 20X2 ($000s)

Current assets: Current liabilities:Cash $xx Accounts payable $xxAccounts receivable xx Accrued expenses xxInventory xx Current portion of debt xxother current assets xx other current liabilities xx total current assets xx total current liabilities xxProperty, plant and equipment, net xx Long-term debt xxGoodwill xx stockholder’s equity xxother intangibles assets, net xx

total assets $xx total liabilities and equity $xx

Company a Statement of Income

For the Year Ended December 31, 20X2

sales $xxCost of sales xxGross profit on sales xxselling, general and administrative expenses xxImpairment losses related to indefinite lived intangible assets (1,000)Goodwill impairment losses (2,000)Income from operations xxIncome tax expense xxIncome before discontinued operations xx Discontinued operations (net of $xx tax benefit) xxExtraordinary items (net of $xx tax benefit) xxnet income $xx


the following disclosures are required by AsC 350.

Disclosures in 20X2:

SuMMarY oF SIGnIFICant aCCountInG PoLICIES:

Impairment losses:

Impairment losses related to goodwill and intangible assets with indefinite lives are recorded in the statement of income as part of income from operations.

notE X: IMPaIrMEnt LoSSES:

In 20X2, the Company recorded an impairment loss in the amount of $2,000 related to the writedown of goodwill associated with its web broadcasting unit. the unit’s pri-mary revenue is derived from offering video and audio streaming services to businesses throughout the united states and European markets. the broadcasting unit has incurred three consecutive years of operating losses as a result of increased competition and a lag in anticipated cost efficiencies from new technologies. the fair value of the web broadcast-ing unit was estimated using the expected present value of future cash flows. the $2,000 impairment loss is presented as a separate line item in the statement of income as part of income from operations.

In addition, the Company recorded an impairment loss of $1,000 related to the writedown to fair value of certain web broadcast trademarks of its streaming business.

(Publicly held companies only)

the impairment loss is included in the Widget Manufacturing segment which is more fully disclosed in note 10.

AvOIDInG IMPAIrMEnT LOSSES UnDEr GAAP

There are three ways to avoid having to record impairment losses under GAAP:

1. Use OCBOA- income tax basis accrual financial statements2. Ignore ASC 350 based on the argument that its effect is not material3. Ignore ASC 350 and reference a GAAP departure exception in the report

Use OCbOA - Income Tax basis Accrual Financial StatementsOne way to avoid having to deal with ASC 350 issues is to use OCBOA- income tax basis financial statements. By doing so, goodwill and intangibles are amortized over 15 years under Section 197 of the Internal Revenue Code, thereby avoiding the test of impairment altogether. If OCBOA financial statements are used, those GAAP disclosures that are applicable to OCBOA


financial statements must still be made. Interpretation 14 of Statement of Auditing Standards (SAS) 62 requires that if OCBOA financial statements are issued, all relevant disclosures that are similar to those required by GAAP must be made.

Ignore ASC 350 based on the Argument that its Effect is not MaterialA second way to avoid ASC 350 is to not implement it at all based on the argument that avoidance has an immaterial impact on the financial state-ments. There are numerous small businesses that have an immaterial, even de minimis amount of goodwill and intangible assets on their balance sheets. Are such companies required to implement ASC 350 when the result would not be material?

ObSErvATIOn

the author believes that if a company has an immaterial amount of goodwill on its bal-ance sheet that is has been amortizing, the company could continue to amortize these assets despite the fact that it violates AsC 350. this argument is supported by the fact that if the company continues to amortize goodwill, the result is not material. that is, the small amount of amortization and the understated goodwill are not material as a percentage of net income and total assets, respectively. the author does recommend that the accountant’s or auditor’s working papers include an explanation that he or she is aware of the fact that AsC 350 should be adopted, but that the effect of its adoption and continued application would be immaterial to the financial statements.

Ignore ASC 350 and reference a GAAP Departure Exception in the reportA third option is for the company to simply violate GAAP by ignoring ASC 350. If the impact of continuing to amortize goodwill is material, there is a GAAP departure which requires an exception in the accountant’s or audi-tor’s report.


Examples

Accountant’s Compilation report

Board of DirectorsXYZ Company

We have compiled the accompanying balance sheet of XYZ Company as of December 31, 20XX, and the related statements of income, retained earnings, and cash flows for the year then ended. We have not audited or reviewed the accompanying financial statements and, accordingly, do not express an opinion or provide any assurance about whether the financial statements are in accordance with accounting principles generally accepted in the united states of America.

Management is responsible for the preparation and fair presentation of the financial state-ments in accordance with accounting principles generally accepted in the united states of America and for designing, implementing, and maintaining internal control relevant to the preparation and fair presentation of the financial statements.

our responsibility is to conduct the compilation in accordance with statements on stan-dards for Accounting and review services issued by the American Institute of Certified Public Accountants. the objective of a compilation is to assist management in presenting financial information in the form of financial statements without undertaking to obtain or provide any assurance that there are no material modifications that should be made to the financial statements. During our compilation, we did become aware of a departure from accounting principles generally accepted in the United States of America that is (are) described in the following paragraph.

Accounting principles generally accepted in the United States of America require that goodwill not be amortized and be tested annually for impairment. Management has informed us that the Company continues to amortize goodwill and has not conducted the annual impairment test. The effects of these departures from accounting principles generally accepted in the United States of America have not been determined. [Or, The effects of these departures would have been to increase goodwill by $xx and xx, respectively, retained earnings by $xx, and net income by $xx.]

James J. fox & Company Burlington, Massachusetts

Date:


Independent Accountant’s review report

Board of DirectorsXYZ Company

We have reviewed the accompanying balance sheet of XYZ Company as of December 31, 20XX, and the related statements of income, retained earnings, and cash flows for the year then ended. A review includes primarily applying analytical procedures to management’s financial data and making inquiries of company management. A review is substantially less in scope than an audit, the objective of which is the expression of an opinion regard-ing the financial statements as a whole. Accordingly, we do not express such an opinion.

Management is responsible for the presentation of the financial statements in accordance with accounting principles generally accepted in the united states of America and for designing, implementing, and maintaining internal control relevant to the preparation and fair presentation of the financial statements.

our responsibility is to conduct the review in accordance with statements on standards for Accounting and review services issued by the American Institute of Certified Public Accountants. those standards require us to perform procedures to obtain limited assurance that there are no material modifications that should be made to the financial statements. We believe that the results of our procedures provide a reasonable basis for our report.

Based on our review, with the exception of the matter described in the following paragraph, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with accounting principles generally accepted in the united states of America.

As disclosed in Note X to the financial statements, accounting principles generally accepted in the United States of America require that goodwill not be amortized and be tested annually for impairment. Management has informed us that the Company continues to amortize goodwill and has not conducted the annual impairment test. The effects of these departures from accounting principles generally accepted in the United States of America have not been determined. [Or, the effects of these departures would have been to increase goodwill by $xx and xx, respectively, retained earnings by $xx, and net income by $xx.]


Date:


Independent Auditor’s report

Board of DirectorsXYZ Companynowhere, Massachusetts

We have audited the accompanying financial statements of XYZ Company, which com-prise the balance sheet as of December 31, 20XX, and the related statements of income, retained earnings, and cash flows for the year then ended, and the related notes to the financial statements.

Management’s Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the united states of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error.

Auditor’s Responsibility

our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the united states of America. those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. the procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified audit opinion.

Basis for Qualified Opinion

As disclosed in Note X, in connection with goodwill, the company has recorded amortization expense and has not tested these assets for impairment. In our opinion, goodwill should not be amortized and should be tested annually for impairment in accordance with accounting principles generally accepted in the United States of America. The effects of these departures from accounting principles generally accepted in the United States of America have not been determined. [If the financial statements were corrected for that departure from accounting principles generally accepted in the United States of America, goodwill would have increased by $xx and net income and retained earnings would have increased by $xx.]


Qualified Opinion

In our opinion, except for the effects of the matters described in the Basis for Quali-fied Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of XYZ Company as of December 31, 20XX, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the united states of America.


Date:

STUDY QUESTIOnS

8. Company X has an impairment writedown of goodwill and intangibles with indefi-nite lives in the amount of $200,000. X’s federal and state tax rate is 40 percent. Which of the following is the correct deferred income tax result?

a. X should record a deferred income tax liability in the amount of $80,000.b. X should record a deferred income tax asset in the amount of $80,000.c. X should not record any deferred income tax related to this transaction

because the writedown will also be recorded on the tax return.d. X should record both a deferred income tax asset and liability in the amount

of $80,000 each.

9. If there is an impairment loss, the loss should be presented ___________.

a. In the income statement before the subtotal income from continued opera-tions

b. In the statement of comprehensive income as an element of other compre-hensive income, net of the tax effect

c. In the income statement as a separate line item, net of the tax effectd. In the income statement, in the other income section

35


Fair value Measurements

LEArnInG ObjECTIvES


Identify the objectives of GAAP’s fair value measurement frameworkExplain the concept of fair value and cite associated definitionsList major categories of valuation approaches and related inputsExplain the hierarchy of inputs to fair value measurementsIdentify the basic disclosures required by AsC 820

THE FrAMEWOrk

This chapter introduces you to the framework set out in generally accepted accounting principles (GAAP) for measuring an item at its fair value. That framework is set out in FASB Accounting Standards Codification® Topic 820, Fair Value Measurements.

The fair value measurement framework:Sets out the concept of fair valueDiscusses valuation approaches (and related inputs) on which fair value measurement may be basedPrioritizes inputs (and, by that, measurements) into a hierarchy based on their relative strength

Like GAAP, this chapter distinguishes between valuation and measure-ment. Valuation—the act of making judgments about the value of an item—is an activity broader than financial reporting. Measurement—the act of assigning a single value to an item for financial reporting purposes—involves valuation but ultimately requires the selection of a single amount to be recognized.

There are various bases used for measurement under generally accepted accounting principles. Over the last 20 years, fair value measurements have increased—especially for financial instruments, derivative instru-ments, and various disclosures). But, although fair value has often been painted as one side of a dichotomy between historic prices and current prices (or “historical cost versus fair value”), the reality is more complex. Two examples follow.

The initial measurement and subsequent measurement of items under generally accepted accounting principles are not consistently based on any one measurement attribute. Some initial recognition is based on the


price of the transaction whether or not that price fits the concept of fair value under the framework discussed in this chapter. For example, an entity that issues certain guarantees measures its liability initially as the premium received rather than at fair value. (460-10-30-2(a)) Similarly, subsequent measurement often adjusts previously recorded amounts for some aspect of market conditions current at the measurement date.A subsequent measurement that uses current prices doesn’t necessarily involve a one-to-one correspondence between the current price of the actual item being measured and what is reported. That may be because the unit of account recognized under GAAP and the unit of account for which current prices are available may be different. For example, mea-surement of a collateral-dependent receivable may report the receivable at the fair value of the collateral. (310-10-35-22)

The fair value measurement framework set out in GAAP as FASB Account-ing Standards Codification® Topic 820, Fair Value Measurements, doesn’t say when to measure at fair value but how to measure fair value if GAAP other than Topic 820 requires (or permits) a fair value measurement:

Upon initial recognition of the item (initial measurement)After initial recognition (subsequent measurement)For disclosure purposes (disclosure)

Included are fair value measurements that are part of the disclosure basis or another basis of measurement. For example, measurement of certain receiv-ables under generally accepted accounting principles considers fair value less costs to sell; the required fair value measurement that is part of “fair value less costs to sell” is subject to the framework.

ObSErvATIOn

Before applying the fair value measurement framework to an item, it is important to confirm both that the objective in applicable GAAP is actually fair value and that topic 820 applies.

some measurements used in revenue recognition involving software and multiple-element arrangements may seem similar to, but are not, fair value measurements and, so, are not subject to the topic 820 framework. (820-10-15-2)

further, there are various circumstances in which GAAP gives an “out” to fair value mea-surement of an item under different rationales. for example, GAAP allows the transaction price (rather than fair value) to be used to initially recognize certain guarantees. (460-10-30-2(a)) the fair value measurement framework doesn’t apply in those circumstances. (for a list of the exceptions, see 820-10-15-3.)

M o d u l e 1 — C h a p t e r 2 — Fa i r Va l u e M e a s u re m e n t s 37

finally, topic 820 doesn’t actually apply pervasively or consistently to all fair value mea-surements required and permitted by GAAP. specifically, the fair value measurement framework in topic 820 doesn’t apply to fair value measurements involving a lease (other than in a business combination) or a share-based payment transaction. (820-10-15-2) rather GAAP for those items provides another “fair value” definition and accompanying guidance on fair value measurements of those items.

Topic 820 reflects efforts between the Financial Accounting Standards Board and the International Accounting Standards Board (IASB) to conform fair value measurement guidance under U.S. GAAP and International Financial Reporting Standards (IFRSs). In addition to nonsubstantive editorial differ-ences, several differences remain involving:

Accounting by an investment companyFair value measurement of a demand deposit by a depository institutionInteraction of fair value measurement with other disclosure and presentation guidance (for example, the implications when netting is permitted by other guidance)Disclosure differences for certain nonpublic entities.

Those differences are discussed in greater detail in the FASB’s Account-ing Standards Update 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs” (May 2011).

STUDY QUESTIOn

1. Which of the following is a true statement about the fair value measurement framework set out in topic 820 of the fAsB Accounting standards Codification®?

a. the framework specifies when an asset, liability, or other item has to be measured at fair value.

b. the framework establishes how to measure fair value if other GAAP guid-ance allows or requires a fair value measurement under the framework.

c. the framework sets forth a set of best practices for valuation.d. the framework is fundamentally inconsistent with how fair value is mea-

sured under International financial reporting standards (Ifrss).

THE FAIr vALUE COnCEPT

The concept of a fair value measurement under the framework is broader than just the definition of fair value. Rather, you will learn in this chapter that the fair value concept envisions a hypothetical transaction in a context involving the attributes of the item bought or sold, the markets in which


the transaction could take place, the knowledge and motivation of the par-ties, and other relevant information. As this chapter addresses each aspect of the concept, keep in mind that it is the accumulation of the definitions and assumptions that drives the fair value measurement.

Core Definition of Fair valueTo measure an item at fair value under GAAP, the reporting entity considers a hypothetical transaction from the perspective of a party that holds the item (if an asset) or owes the item (if a liability). The hypothetical transaction “occurs” at the measurement date.

Fair Value—The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (Master Glossary term “Fair Value”; 820-10-20)

The core definition of fair value includes two other defined terms: orderly transaction and market participant.

A transaction is orderly when it isn’t forced on the parties and involves time for the exchange of information.

Orderly Transaction—A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale). (Master Glossary term “Orderly Transaction”; 820-10-20; 820-10-35-54I and 54J)

GAAP uses the term market participant to denote a buyer (or seller) that is: (Master Glossary term “Market Participant”; 820-10-20; 820-10-35-5; 820-10-35-9)

Party to a transaction in the principal (or most advantageous) marketIndependent of the other party to the transactionKnowledgeable about the item and transactionAble to enter into the transactionWilling to enter into the transaction

The idea that a market participant is willing to enter into a transaction empha-sizes that the party is not being forced into the transaction or otherwise com-pelled to buy or sell. (Master Glossary term “Market Participant”; 820-10-20)

The knowledge a market participant has about an item and transaction comes from all available information, which would include information


that party could get by performing the customary due diligence for such a transaction. (Master Glossary term “Market Participant”; 820-10-20) That knowledge is based on market conditions current at the measurement date and includes the attributes of the item such as where it is located and any restriction on its use or sale. (820-10-35-2B; 820-10-35-3)

ObSErvATIOn

this chapter uses the word “item” to refer to what is being measured at fair value. Most of the GAAP on fair value measurements refers to “asset or liability.” In fact, the item (unit of account) being measured might be an asset, a liability, a group of assets, a group of liabilities, a group of assets and liabilities, the net position of a group of assets and liabilities, a business comprising both assets and liabilities, a reporting unit, and so on. More on unit of account later in the chapter. In the meantime, keep in mind that “item” is shorthand and that the actual unit of account matters. (820-10-35-2C through 2E)

ExAMPLE 1

rEStrICtIon on SaLE oF EQuItY InStruMEnt

You just learned that a market participant considers all information about an item and its attributes, including any restriction on the use or sale of the item. one example GAAP gives of the effects of a restriction involves measurement of the fair value of a financial asset.

specifically, say an entity holds an equity instrument that, under united states securities and Exchange Commission (sEC) rules, the entity can sell only to another qualified investor. GAAP views the restriction as a characteristic of the item that has to be considered in measuring the item’s fair value. (820-10-55-52)

With respect to a restricted equity instrument, the entity could first look to the quoted price of an unrestricted equity instrument of the same issuer. If that other instrument is otherwise identical but for the restriction, fair value could be estimated based on the quoted price adjusted for the amount a buyer would demand due to the restriction. (820-10-55-52)

Among other relevant factors (both qualitative and quantitative) the entity would need to consider in determining the amount of adjustment are: (820-10-55-52)

the nature of the restrictionthe duration of the restrictionthe potential buyers given the restriction

ultimately, the measurement of the adjustment amount is grounded in the question: “What would a market participant do?”


GAAP defines market participant to exclude a related party. For example, a buyer and a seller that are market participants in a given transaction cannot meet the GAAP definition of related parties for the hypothetical transaction to represent fair value. (Master Glossary term “Market Par-ticipant”; 820-10-20)

Related Party—With respect to one party, a second party that is: An affiliate of the first partyAn equity method investee of the first party (or a second party that would be an equity method investee absent the first party’s election under GAAP to measure the investment at fair value [see the Fair Value Option Subsection of Section 825-10-15])A trust for the benefit of the first party’s employees (for example, a pen-sion trust or profit-sharing trust)A principal owner of the first party (or an immediate family member of that principal owner)A member of management of the first party (or an immediate family member of that member of management)A party with which the first party may deal when either party controls or can significantly influence the management or operating policies of the other such that one of the parties could be prevented form fully pursuing its own separate interestsA party that can significantly influence the management or operating policies of either of the partiesA party that has an ownership interest in one of the parties and can significantly influence the other party such that one of the parties could be prevented form fully pursuing its own separate interests. (Master Glossary entry “Related Parties”)

For additional guidance on related parties, see FASB Accounting Standards Codification® Topic 850, Related Party Disclosures.

STUDY QUESTIOn

2. Which of the following is not an important aspect of the fair value concept?

a. the transaction isn’t forced on the parties and involves time for the ex-change of information.

b. the price reflects an actual transaction that has been completed.c. the independent parties are willing and able to enter into the transaction.d. the price is as of the date fair value is being measured.


Principal Market versus Most Advantageous MarketAn item may be bought or sold in more than one market. Which market should an entity look to for a price? GAAP requires that an entity look to the market with the greatest volume and level of activity for the item (the principal market) to which the entity has access at the measurement date. (Master Glossary term “Principal Market”; 820-10-20; 820-10-35-6)

Principal Market—The market with the greatest volume and level of activity for the asset or liability. (Master Glossary term “Principal Market”; 820-10-20)

If no one market fits the definition of a principal market, then GAAP requires that the entity look at all the markets to which it has access at the measurement date and determine which market will give the entity the most advantageous price (the most advantageous market). (Master Glossary term “Most Advantageous Market”; 820-10-20)

Most Advantageous Market—The market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transportation costs. (Master Glossary term “Most Advantageous Market”; 820-10-20)

An entity can presume that the market in which it would buy or sell an item is the market to which it should look in measuring fair value unless there is information available to the contrary. (820-10-35-5A) An entity has to assess its situation further if, for example:

The entity uses more than one market.A market other than the one the entity uses meets the definition of a principal market.

The concept of the principal (or most advantageous) market is specific to the reporting entity. That is, it is limited to the markets to which the reporting entity has access at the measurement date (820-10-35-6A). As a result, dif-ferent entities will identify different markets as the principal market or most advantageous market for different hypothetical transactions.


ExAMPLE 2

MuLtIPLE MarkEtS

Let’s consider an example based on the one set out in 820-10-55-43 through 55-45A.

Entity needs to measure the fair value of a nonfinancial asset (a commodity) it holds. As of the measurement date, Entity has access to two markets – Market A and Market B. to access each market, Entity has to transport the nonfinancial asset to market. Entity has the following information for a hypothetical transaction as of the measurement date.

Market a Market bPrice $26 $25transportation costs (2) (2) $24 $23

Because Entity sells nonfinancial assets in both markets (that is, more than one market), it can’t look to one market as the presumed market for its hypothetical transaction. (820-10-35-5A) rather, Entity has to identify its principal market or, if no principal market exists, the most advantageous market.

Scenario 1: Market a is the Principal Market

If Market A is the market with the “greatest volume and level of activity for the asset” (that is, the principal market), then Entity would measure the fair value of the nonfinancial asset at $24. In other words, fair value is the price in the principal market (Market A) of $26 adjusted for transportation costs of $2 (or $26 minus $2 equals $24). transportation cost is an attribute of Entity’s nonfinancial asset (a commodity that must be transported to market) and, thus, the price in that market is adjusted for the transportation cost. (820-10-35-9C)

Scenario 2: no Principal Market

If Entity can’t consider either market its principal market, then it has to determine which is the most advantageous market. the most advantageous market is the market that “maximizes the amount that would be received to sell the asset…after taking into account transaction costs and transportation costs.” Entity has the following additional information about transaction costs for a hypothetical transaction as of the measurement date.

Market a Market bPrice $26 $25transportation costs (2) (2) $24 $23

transaction costs (3) (1) $21 $22

the net amount received in the hypothetical transaction in Market B is greater than the net amount for Market A. that is, Market B maximizes the amount that would be received after transaction and transportation costs and, thus, Market B is Entity’s most advantageous market for sale of the nonfinancial asset.


transaction costs enter into the determination of which market is the most advantageous but don’t otherwise affect the measurement of fair value because—unlike transportation—GAAP does not consider them to be an attribute of the nonfinancial asset being measured. (820-10-35-9B)

Entity would measure the fair value of the nonfinancial asset at $23. In other words, the price in the most advantageous market (Market B) of $25 adjusted for transportation costs of $2 (or $25 minus $2 equals $23).

(820-10-55-43 through 55-45A)

Transaction Costs versus Transportation CostsIn the preceding example, you learned how transaction costs are relevant to determining which of the multiple markets is the most advantageous market. You also learned that, if location is an attribute of an asset (such as a commodity), the market price is adjusted for the cost to transport the item to that market. That is, if location is a characteristic of an asset, then transportation cost is part of the amount being measured.

As you learned earlier, when an item is measured at fair value, the market participant concept requires the entity to consider all of the item’s characteristics. A transaction cost is not an attribute of an asset or a liability (the item) and, therefore, is not part of the amount being measured. (820-10-35-9B)

How does GAAP define those costs?

Transaction Costs—The costs to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability that are directly attributable to the disposal of the asset or the transfer of the liability and meet both of the following criteria:a. They result directly from and are essential to that transaction. b. They would not have been incurred by the entity had the de-

cision to sell the asset or transfer the liability not been made (similar to costs to sell, as defined in paragraph 360-10-35-38).

GAAP distinguishes a transportation cost from a transaction cost. (820-10-35-9B)

Transportation Costs—The costs that would be incurred to transport an asset from its current location to its principal (or most advantageous) market.

Again, if the location of the asset is a characteristic—for example, if the asset is a commodity that must be transported to market—then transportation cost is part of amount being measured. (820-10-35-9C)


The Exit PriceYou have learned that an important point in understanding GAAP’s concept of fair value is to understand that the price used to measure an item depends on context and perspective; that is, you have learned about the concepts of an orderly transaction, a market participant, and a principal (or most advantageous) market.

Another important concept under GAAP’s fair value measurement framework is that the price an entity pays to acquire an asset (an entry price) is not the same as the price the entity receives to sell that asset (an exit price). Similarly, the price an entity receives to incur a liability (an entry price) is not the same as the price the entity would pay to transfer that liability (an exit price). (820-10-30-2)

Entry Price—The price paid to acquire an asset or received to assume a liability in an exchange transaction. (Master Glossary term “Entry Price”; 820-10-20)

Exit Price—The price that would be received to sell an asset or paid to transfer a liability. (Master Glossary term “Exit Price”; 820-10-20)

GAAP focuses on the exit price because that objective “embodies current expectations about the future inflows associated with the asset and the future outflows associated with the liability from the perspective of market participants.” (FASB Statement No. 157, Fair Value Measurements, paragraph C26)

nOTE

Paragraph C26 of fAsB statement no. 157 was not codified because it describes the basis for the fAsB’s conclusions and is of historical interest only.

When an item is measured at fair value under GAAP, the reporting entity considers a hypothetical transaction from the perspective of a party that holds the item (if an asset) or owes the item (if a liability). That is, fair value is the price the party would receive to sell that asset (an exit price) or to transfer that liability (an exit price) in the hypothetical transaction.

Because GAAP focuses on an exit price, the transaction price at the time an item is initially measured may or may not represent fair value (820-10-30-3). If an item is initially measured at fair value but the transaction price differs from fair value, the entity has to recognize a gain or loss in earnings unless the GAAP requiring the fair value measurement explicitly states otherwise. (820-10-30-6)


What causes a transaction price to differ from fair value (the exit price)? By definition, fair value is not the transaction price if the transaction price reflects: (820-10-30-3A)

A transaction between related parties.A transaction made under duress or forced (for example, if the seller is having financial difficulty).Transaction costs.A transaction in a market other than the principal (or most advantageous) market.More than one item (a unit of account issue).

In the last circumstance, the unit of account represented by the exit price may be just one component of the transaction, with the other components measured separately. This can happen with a business combination, for example. (820-10-30-3A)

PrACTICE POInTEr

Although GAAP excludes related parties from the concept of market participants, an entity can use the price in a related-party transaction as an input to a fair value measurement if the entity “has evidence that the transaction was entered into at market terms.” (Master Glossary term “Market Participants”; 820-10-20)

STUDY QUESTIOnS

3. Which of the following is a true statement about markets and fair value measurement?

a. the most advantageous market is the market with the greatest volume and level of activity for an item.

b. A transaction cost is relevant both in identifying the most advantageous market and determining the price in that market.

c. Assuming an item has to be transported to market, the related transporta-tion cost is relevant only to determining the price in the principal market.

d. If an entity only has access to one market at the measurement date, the principal market versus most advantageous market distinction is irrelevant.

4. Which of the following defines the term “exit price”?

a. the price in the nearest local market for the quantity normally sold, less the estimated cost of the sale.

b. the price paid to acquire an asset or received to assume a liability in an exchange transaction.

c. the price that would be received to sell an asset or paid to transfer a liability.d. the price that must be paid upon exercise of an option.


vALUATIOn APPrOACHES AnD rELATED InPUTS

To measure fair value, GAAP requires that the entity use a valuation approach: (820-10-35-25)

That is appropriate in the circumstancesFor which sufficient inputs are availableThat maximizes the use of relevant observable inputsThat minimizes the use of unobservable inputs

GAAP identifies three widely used approaches to valuation:The cost approach, which focuses on the cost of replacing the item’s service capacityA market approach, which uses a market transaction for a similar (or identical) itemAn income approach, which centers on the current, discounted amount of market-based expectations of future flows.

GAAP acknowledges that a fair value measurement might involve the use of more than one of these valuation approaches; for example, if the item being measured is a reporting unit (820-10-35-24A). If more than one valuation approach is used, the entity has to evaluate the reasonableness of the range of values generated and select the point within that range that is the most representative in the circumstances. (820-10-35-24B)

PrACTICE POInTEr

What if an entity changes its valuation technique or the way it applies that technique? for example, say an entity uses more than one approach but then changes the weight it gives to the various approaches? Any change in valuation approach (or its application) is a change in accounting estimate and the entity has to treat it at as such. Guidance on a change in accounting estimate is provided in topic 250, Accounting Changes and Error Corrections; however, the disclosure requirements in that topic do not apply. (820-10-35-26; 250-10-45-17; 250-10-50-5)

GAAP provides additional guidance on valuation in the case of a significant decrease in the volume or level of activity for an item in relation to normal market activity. (820-10-35-54C through 35-54H)

ObSErvATIOn

GAAP uses the words “technique” and “approach” interchangeably to refer to a way in which an entity estimates values for an item. for consistency, this chapter uses the word “approach.”


Cost ApproachThe cost approach focuses valuation on the cost of replacing the item’s service capacity. Another term used to describe the cost approach is “current replacement cost.”

Underlying the cost approach is the assumption that the buyer would not pay more than the amount to replace the service capacity of the existing asset (820-10-55-3E). A price determined using the cost approach under GAAP is grounded in the cost a buyer would pay to acquire an asset with comparable utility. That amount includes costs of transportation, installation, and customization of the asset to be acquired (820-10-55-3E). That amount has to be adjusted for obsolescence, such as: (820-10-55-37(b))

Physical wear and tear (physical obsolescence)Improvements in technology (technological obsolescence)A market decline in the demand for similar machines (economic obsolescence)

ObSErvATIOn

Considerations about physical, technological, and economic obsolescence go beyond GAAP-basis or tax-basis depreciation. GAAP depreciation allocates the historical cost of a nonfinancial asset. tax-basis depreciation looks to specified service lives. (820-10-55-3E)

PrACTICE POInTEr

If an asset is used in combination with another asset or liability, the cost approach assumes the buyer has the complementary asset or liability. the resulting price (the exit price) would not exceed either of the following: (820-10-55-38A)

the cost the buyer would pay to acquire an asset with comparable utility (as previ-ously discussed)the economic benefit the buyer would get from using the asset.

Market ApproachA market approach uses a market transaction for a similar (or identical) item. For example, for a nonfinancial asset like a machine, the market approach looks to multiple quoted prices for the identical (or similar) item, taking into considering its condition as well as any customization, configuration, or installation needed. GAAP notes that selecting an appropriate amount within the range of estimates requires judgment about all of the qualitative and quantitative factors involved. (820-10-55-3B)

Market approaches include matrix pricing. Used most often to value a fixed-income security, matrix pricing is basically a guessing game in which


a matrix of prices of various fixed-income securities is laid out using their credit, maturity, and interest rate characteristics. The goal is to estimate the price of another given fixed-income security based on its similarity to the securities whose characteristics have been set out in the matrix. (820-10-55-3C)

Income ApproachAn income approach centers on current, discounted amount of market-based expectations of future flows. Determining the discounted present value of a series of future cash flows is a common income approach.

Among income approaches acknowledged in GAAP are: (820-10-55-3F)Discount-rate-adjustment methods, which discount contractual, promised, or most likely cash flows using a risk-adjusted discount rate. (Master Glossary term “Discount Rate Adjustment Technique”; 820-10-20)Expected cash flows (or expected present value) methods, which center on the probability-weighted average of possible future cash flows. (Master Glossary term “Expected Cash Flows”; 820-10-20)Option-pricing models, which consider components of the value of an option (for example, time value and intrinsic value). (820-10-55-3G)Multi-period, excess earnings methods, which look to the future flows associated with an intangible asset, adjusting them for amounts attributable to investments (for example, in capital assets) that support the intangible asset. (820-10-55-3G)

ObSErvATIOn

GAAP identifies two expected cash flow methods:

“Method 1” uses risk-adjusted expected cash flows and a risk-free rate. (820-10-55-15)“Method 2” uses expected cash flows not adjusted for risk and a risk-adjusted dis-count rate. (820-10-55-16)

What distinguishes the discount rates under Method 2 and a discount-rate adjustment method? In the latter, the discount rate is a rate of return relating to conditional cash flows; in the former, the discount rate is an expected rate of return relating to the expected cash flows. for further reading, see 820-10-55-13 through 55-20.

GAAP doesn’t prescribe the use of a specific income approach. Rather, an entity has to consider the facts when identifying its valuation approach. (820-10-55-4)

GAAP does set out some minimum criteria for an income approach. If an entity wants to measure the fair value of an item using a present value


method (that is, an income approach), that measurement must capture a market participant’s expectations in the hypothetical transaction. Those expectations must include all of the following: (820-10-55-5; 820-10-55-6(b); 820-10-55-6(c))

The estimated future cash flows for the itemThe uncertainty inherent in the cash flows (that is, possible variations in the amount and timing)A risk premium for uncertainty inherent in the cash flowsThe time value of money (represented by a risk free interest rate)The risk the obligor won’t perform (if a liability)

The risk-free interest rate is defined as:

[T]he rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows and pose neither uncertainty in timing nor risk of default to the holder. (820-10-55-5)

The discount rate has to reflect the “underlying economic factors of the currency in which the cash flows are denominated.” (820-10-55-56(e)) For amounts denominated in nominal U.S. dollars, the yield curve for U.S. Treasury securities is the risk-free interest rate. (820-10-55-5)

When a liability is being measured using a present value method, the reporting entity has to consider the risk that an obligor won’t perform, even if the obligor on the item is the reporting entity itself. That nonperformance risk is distinguished from the risk premium for other uncertainty inherent in the cash flows. (820-10-55-5)

PrACTICE POInTEr

When using an income approach, it’s important that cash flows and the discount rate are consistent. It’s also important to not count a risk twice.

Inconsistency between cash flows and the discount rate can crop up when dealing with taxes or inflation, for example. When discounting after-tax cash flows, for example, the entity should use an after-tax discount rate. When discounting nominal cash flows, the entity should use the nominal risk-free interest rate so that both the cash flows and the discount rate include the effect of inflation. (820-10-55-6(c))

When discounting expected cash flows, an entity shouldn’t count default risk twice by using a discount rate that also takes default risk into account. Discounting contractual cash flows using a discount rate that incorporates default risk counts that risk only one. Discounting expected cash flows using a discount rate that does not incorporate default risk counts that risk only once. (820-10-55-6(d))


InputsGAAP uses the term input to refer to an assumption used to price an item. An entity has to consider the risks inherent in the particular valuation approach it uses as well as the risks inherent in the entity’s inputs to that approach. (Master Glossary term “Inputs”; 820-10-20)

Inputs—The assumptions that market participants would use when pricing the asset or liability, including assumptions about risk, such as the following: a. The risk inherent in a particular valuation approach used to measure

fair value (such as a pricing model) b. The risk inherent in the inputs to the valuation approach.

Inputs may be observable or unobservable. (Master Glossary term “Inputs”; 820-10-20)

An input may be observable or unobservable. GAAP requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs. (820-10-35-16AA and 820-10-35-36)

An observable input reflects market data and what a market participant would use when pricing the item. For example, an observable input reflects publicly available information about an actual event or transaction. (Master Glossary terms “Inputs” and “Observable Inputs”; 820-10-20) As will be discussed later in the chapter, the fair value hierarchy segregates observable inputs into two categories: Level 1 and Level 2.

Observable Inputs—Inputs that are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability. (Master Glossary term “Observable Inputs”; 820-10-20)

An unobservable input reflects the best information available to a market participant in pricing an item when there is no market data. (Master Glossary term “Unobservable Inputs”) The fair value hierarchy treats unobservable inputs as Level 3 inputs.

Unobservable Inputs—Inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability. (Master Glossary term “Unobservable Inputs”; 820-10-20)


GAAP requires that an entity maximize the use of observable inputs and minimize the use of unobservable inputs. (820-10-35-16AA and 820-10-35-36)

PLAnnInG POInTEr

What about an input that is a price quoted by a third party?

GAAP explicitly permits an entity to use a price quoted by a broker or a pricing service as an input if the price is consistent with the fair value concept. (820-10-35-54K) that is, the quoted price has to reflect an orderly transaction and the assumptions of a market participant (820-10-35-54L). the weight given to a quoted price depends in part on its nature; a price in a binding offer would be given more weight than an indicative price. (820-10-35-54M)

In the next part of this chapter, you will learn how GAAP organizes inputs into a hierarchy.

STUDY QUESTIOn

5. Which of the following is a true statement about valuation approaches and related inputs?

a. An entity must maximize the use of unobservable inputs and minimize the use of observable inputs.

b. GAAP doesn’t limit the types of income approaches or set minimum criteria for an income approach.

c. the cost approach focuses valuation on the cost of replacing the item’s service capacity and must consider obsolescence.

d. If an entity considers a range of estimates under a market approach to valu-ation, GAAP requires that the entity focus on quantitative factors.

THE HIErArCHY

GAAP sets out a hierarchy based on the relative strength of inputs to a fair value measurement. That hierarchy emphasizes observable inputs over unobservable inputs. The fair value hierarchy segregates observable inputs into two categories: Level 1 and Level 2. Unobservable inputs are considered Level 3 inputs.

The three-level hierarchy drives the entity’s fair value measurements and related disclosures. Fair value amounts track the lowest level of input involved in their measurement. That is, an amount using inputs from more than one of the three levels is characterized by the lowest-level input. The nature and significance of an adjustment to an input also affects the ultimate position of that input in the hierarchy. (820-10-35-38A; 820-10-35-51)

How an entity measures fair value of an item may change over time. Which level the final measurement falls under can change. For example,


a restriction on sale of a security might expire, allowing an entity to use a Level 1 measurement of an observable market price without adjustment. An entity has to adopt, disclose, and consistently apply a policy about how it will identify when a “transfer” has happened between any of the three levels (whether into or out of any particular level). (820-10-50-2C)

Level 1 InputsA Level 1 input is a quoted price; specifically, a price for an identical item quoted in an active market to which the entity has access at the measurement date. (Master Glossary term “Level 1 Inputs”; 820-10-20)

Level 1 Inputs—Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. (Master Glossary term “Level 1 Inputs”; 820-10-20)

Active Market—A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis. (Master Glossary term “Active Market”; 820-10-20)

GAAP views a Level 1 input as “the most reliable evidence of fair value.” If a Level 1 input is available, an entity has to use it without making an adjustment to the quoted price. (820-10-35-41)

ObSErvATIOn

one exception to use of a quoted price without adjustment is if the entity thinks that the quoted price is not fair value because of information “after the close of the market but before the measurement date.” such information might come from an announcement by the issuer, a trade in a broker market, or a principal-to-principal transaction. (820-10-35-41C(b))

GAAP does not allow an entity to adjust a quoted price for the size of its holding of an item. For example, say an entity has such a large holding of a particular debt security that the market’s normal daily trading volume isn’t big enough to absorb a sale of that holding without affecting the price. Even in that circumstance, the entity has to apply the unadjusted quoted price to measure the value of its holding—that is, the total price for the hypotheti-cal sale of the holding is the product of the number of items in the holding multiplied by the unadjusted quoted price. GAAP doesn’t permit an adjust-ment (often referred to as a “blockage factor”). (820-10-35-44)

A Level 1 input is a quoted price for the identical item of the same unit of account. For example, a Level 1 input for measurement of single share is


the quoted price for an identical single share.GAAP highlights two circumstances in which a quoted price is not for

an identical item of the same unit of account. In those circumstances, use of a quoted price is adjusted, causing the measurement to fall lower in the fair value hierarchy. (820-10-35-41C) Those circumstances follow.

If the entity thinks it would be difficult to get all the quoted market prices individually for a large number of similar items (for example, a large number of debt securities that are similar rather than identical), it can use an alternative method that falls lower in the hierarchy. (820-10-35-41C(a)) If the item being measured is a liability of the entity (or an item reported in the entity’s shareholders’ equity), then a quoted price for that item held as an asset would be adjusted if the asset is a different unit of account. (820-10-35-16D and 820-10-35-41C(c))

An example of the latter circumstance is a debt security with a third party credit enhancement. That is, a debt security that is a liability of the entity packaged with a third-party credit enhancement. The unit of account for an entity holding the debt security as an asset includes the third-party credit enhancement. The unit of account that the issuer of the debt security uses for measuring and disclosing the fair value measurement of the debt security excludes the third-party credit enhancement. (825-10-25-13) As a result, the debt security is not identical to the liability of the entity as issuer because of the addition of the third-party credit enhancement. Therefore the quoted price is not a Level 1 input when the entity that is the issuer measures the liability at fair value because the items are not identical.

ObSErvATIOn

An entity has to disclose the existence of any inseparable third-party credit enhancement in a liability it issues and measures at fair value. (820-10-50-4A)

If a debt security being measured is a liability of the reporting entity, but the debt security held as an asset can’t be sold by the holder, then the items are not identical and the quoted asset price would need to be adjusted for use in measuring the liability. (820-10-35-16D(a)) In other words, the restriction on the item as an asset is not part of the measurement of the item as a liability.

Level 2 InputsAny observable input that doesn’t meet the definition of a Level 1 input is considered level 2 input. (Master Glossary term “Level 2 Inputs”; 820-10-20; 820-10-55-21) This is true whether the input is observable directly or indirectly. (820-10-35-47)


Level 2 Inputs—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. (Master Glossary term “Level 2 Inputs”; 820-10-20)

Remember that a Level 1 input is a quoted price for an identical item in an active market to which the entity has access at the measurement date. (Master Glossary term “Level 1 Inputs”; 820-10-20)

A quoted price fails to meet the definition of a Level 1 input and, thus, is a Level 2 input if: (820-10-35-48)

The price quoted isn’t for an identical item. The market in which the price is quoted isn’t active.

For example, each of the following is an example of a Level 2 input: (820-10-35-48)

A quoted price for an identical item in a market to which the entity has access at the measurement date, but the market isn’t an active market. A quoted price for a similar (rather than identical item) in an active market to which the entity has access at the measurement date.A quoted price for a similar (rather than identical item) in a market to which the entity has access at the measurement date and the market isn’t an active market.

Also, an input that is observable but is not a quoted price is a Level 2 input. Such observable inputs include: (820-10-35-48)

An interest rate (or yield curve) observable at commonly quoted intervalsAn implied volatilityA credit spreadAnother input corroborated by or derived principally from observable market data through correlation or other means. (Master Glossary term “Market-Corroborated Inputs”; 820-10-20)

Level 3 Inputs

A Level 3 input is an unobservable input. (Master Glossary term “Level 3 Inputs”; 820-10-20) The fact that the input is unobservable doesn’t give the entity an “out” from having to apply all aspects of the fair value concept. That is, an entity using a Level 3 input has to develop that input in the context of an exit price in an orderly transaction with a market participant under current market conditions. (820-10-35-53 through 35-54A; 820-10-55-22)

Level 3 Inputs—Unobservable inputs for the asset or liability. (Master Glossary term “Level 3 Inputs”; 820-10-20)


MEASUrInG CErTAIn ITEMS

Fair value of a nonfinancial AssetBecause a nonfinancial asset may have many uses, fair value focuses on the use of the asset that maximizes the asset’s value—its highest and best use. (Master Glossary term “Highest and Best Use; 820-10-20; 820-10-35-10A) This is true even if the entity uses the nonfinancial asset in another way, including if the entity avoids the highest and best use for competitive reasons. (820-10-35-10C and 10D)

Highest and Best Use—The use of a nonfinancial asset by market participants that would maximize the value of the asset or the group of assets and liabilities (for example, a business) within which the asset would be used. (Master Glossary term “Highest and Best Use; 820-10-20)

In considering highest and best use, an entity has to consider what is: (820-10-35-10B)

Physically possible—for example, based on the asset’s location or physical size.Legally permissible—for example, given legal restrictions such as zoning regulations.Financially feasible—for example, whether it would generate a sufficient return on the investment.

Note that those factors are not mutually exclusive. For example, there may be a legally permissible use that is not physically possible. Or a use that is both physically possible and legally permissible may not be financially feasible.

Given the considerations, the highest and best use of a nonfinancial asset might be its use, for example: (820-10-35-10E)

On a standalone basisWith other nonfinancial assets as a groupWith other assets and liabilities as part of a business

Whichever of those contexts provides the highest and best use is the context in which the nonfinancial asset should be measured. For example, if the highest and best use is in the context of use of the nonfinancial asset in a business, the fair value of the asset should be measured assuming the other party has access to or already holds the complementary liabilities and assets needed to support the highest and best use of the nonfinancial asset in a business. (820-10-35-10E)

The context used for highest and best use does not, however, change the unit of account for measurement purposes. That is, if other GAAP


requires measurement of a standalone asset, even though highest and best use provides a context of, for example, a business, the item being measured is the standalone asset. (820-10-35-11A)

ExAMPLE 3

HIGHESt anD bESt uSE oF LanD

An entity owns land that was developed for use as a factory site. GAAP allows the entity to presume that industrial use as a factory site is the highest and best use unless there is evidence to the contrary.

for example, say that nearby land has been developed for residential use. the entity determines that zoning and other considerations would lead a buyer (a market participant) to consider the potential use of the current industrial site as a residential site. In those circumstances, the entity would consider the value of the land:

As an industrial site for industrial use; that is, in combination with other applicable assets and liabilities such as a factory.As vacant land for residential use; that is, with any necessary demolition or other costs needed to convert the land to a vacant site for residential construction.

Whichever value is higher would be used in estimating the asset’s fair value.

(820-10-55-30 through 55-31)

ObSErvATIOn

If the highest and best use for the item is not the way the entity currently uses the item, the entity must disclose so and explain why. (820-10-50-2(h))

Fair value of a LiabilityGAAP requires an entity assume all of the following when measuring the fair value of a liability: (820-10-35-16(b); 820-10-35-3; 820-10-35-18B through 35-18C; Master Glossary term “Fair Value”; 820-10-20)

The liability is transferred to a market participant at the measurement date in an orderly transaction under current market conditions (including nonperformance risk).The transferee is required to fulfill the obligation.The liability is not extinguished at the measurement date.The liability will remain outstanding. There is no input or adjustment of inputs for a restriction on the transfer.

These assumptions are particularly important if there is no quoted price for a similar liability held as an asset. (820-10-35-16H through 35-16L)


The reference to nonperformance risk encompasses, but may be broader than, credit standing (credit risk). (820-10-35-17; Master Glossary term “Nonperformance Risk”; 820-10-20) Other factors (beyond credit standing) include: (820-10-35-18)

Whether the liability is financial or nonfinancial (the latter involving delivery of goods or a service)The existence of any credit enhancement that is part of the unit of account of the item.

A credit enhancement that isn’t part of the unit of account (for example, a third-party credit enhancement packaged with the liability shouldn’t be considered in measuring performance risk. (825-10-25-13; 820-10-35-18A)

Fair value of an Instrument in EquityGAAP requires an entity assume all of the following when measuring the fair value of an instrument classified in the entity’s own shareholders’ equity: (820-10-35-16(c); 820-10-35-3; 820-10-35-18B through 35-18C; Master Glossary term “Fair Value”; 820-10-20)

The instrument is transferred to a market participant at the measurement date in an orderly transaction under current market conditions.The instrument will remain outstanding. The transferee obtains the rights associated with the instrument.The transferee undertakes the responsibilities associated with the instrument.The instrument is not extinguished at the measurement date (for example, it is not cancelled at the measurement date).There is no input or adjustment of inputs for a restriction on the transfer.

These assumptions are particularly important if there is no quoted price for a similar equity instrument held as an asset. (820-10-35-16H through 35-16L)

An example of an instrument that would be measured using these assumptions is an equity interest issued as consideration in a business combination. (820-10-35-16(c))

Practical Expedient: Financial Portfolio Managed as a net ExposureSometimes an entity manages a portfolio of financial assets and financial liabilities as a net exposure to a particular risk—for example, to changes in prices, interest rates, foreign currency exchange rates, or the counterparty’s creditworthiness.

An entity can use a practical expedient for measuring a portfolio that is managed and reported internally on that basis, if it adopts, discloses, and consistently applies that approach. (820-10-35-18E; 820-10-35-18G; 820-10-50-2D) Specifically, it can measure the net exposure using the price of the net exposure. (820-10-35-18D)


Measurement using this practical expedient applies only if the fair value measurement framework applies. (820-10-35-18E(c)) Because the unit of account for recognition and presentation purposes may differ from the unit of account for measurement purposes, an entity that elects this practical expedient has to make related allocations and disclosures about those al-locations. (820-10-35-18F through 820-10-35-18L)

Practical Expedient: Investment in an Investment CompanyAs a practical expedient, GAAP allows an entity with an investment in an investment company to measure that investment using the unadjusted, reported net asset value instead of fair value. (820-10-15-4; 820-10-35-59 through 35-62) Use of that practical expedient requires additional disclosures. (820-10-50-6A)

An entity is required to make additional disclosures if the entity elects to measure an investment in an investment company using the net asset value. (820-10-15-4; 820-10-35-59 through 35-62; 820-10-50-6A)

STUDY QUESTIOn

6. Which of the following is not an assumption an entity should make when mea-suring either a liability or an equity instrument classified in the entity’s own shareholders equity?

a. there is no input (or adjustment of an input) for a restriction on the transfer.b. the item is not extinguished as of the measurement date.c. the instrument is transferred to a related party with the capacity to fulfill

the obligations under the item.d. the transaction is an orderly transaction under market conditions current at

the measurement date.

DISCLOSUrES

In this part of the chapter, you will review the disclosure objectives and requirements involving fair value measurements.

As noted before, Section 820-10-50 sets out GAAP’s detailed requirements for disclosure about fair value measurements under the framework.

ObSErvATIOn

for examples that illustrate the required disclosures, see 820-10-55-99 through 55-107.

The overall disclosure objectives are to help financial statement users un-derstand both: (820-10-50-1)

The valuation approach (and related inputs) for subsequent fair value measurements of items reported in the statement of financial position. (820-10-50-1(a))


The effects on earnings (or changes in net assets) or other comprehensive income, of recurring fair value measurements using Level 3 (unobservable) inputs. (820-10-40-1(b))

It’s important to keep the disclosure objectives in mind when deciding how best to fulfill the detailed disclosure requirements. Like many disclosures under generally accepted accounting principles, there is a balance to be struck. Too little detail can obscure the necessary information and, by that, fall short of the objectives. Too much detail can overwhelm the reader and similarly miss the disclosure objectives. For that reason, the entity has to make judgments about all of the following in order to meet the disclosure objectives: (820-10-50-1A)

The level of detail needed to satisfy the disclosure requirementsHow much emphasis to place on each requirementHow much to aggregate or disaggregate the informationWhether users of financial statements need more information to evaluate the quantitative information disclosed.

An entity has to present all of the quantitative information it discloses as tables. That requirement to use a tabular format affects how an entity strikes the balance between detail and understandability. (820-10-50-8)

Level of DetailAn entity’s disclosures about fair value have to disaggregate information, at a minimum, by each class of assets or class of liabilities subsequently measured at fair value. (820-10-50-2B) An entity has to determine those classes based on both of the following: (820-10-50-2B)

The attributes of the asset (liability) (that is, its nature, characteristics, and risks)The level of the fair value measurement.

Often, a balance sheet line item will include more than one class. However the entity determines the classes, it must provide enough information that a user can reconcile the disclosure information to the balance sheet line item. Sometimes generally accepted accounting principles outside Topic 820 will specify a class of an asset (liability) based on its attributes. An entity can use that other asset (liability) classification scheme if it is based on the item’s nature, characteristics, and risks and otherwise fulfills the Topic 820 disclosure objectives. (820-10-50-2B)

In addition to distinguishing between levels in the fair value hierarchy, some of the disclosure requirements distinguish a fair value measurement that happens at the end of each reporting period (recurring) from one that happens only under particular circumstances (nonrecurring). (820-10-50-2(a))


An example of a recurring fair value measurement is measurement of a derivative instrument at fair value at the end of each reporting period. (Topic 815, Derivatives and Hedging, 815-10-35-1) An example of a nonrecurring fair value measurement is a write-down of a long-lived asset to fair value less costs to sell. (Topic 360, Property, Plant, and Equipment, Section 360-10-35)

Disclosures for All Fair value MeasurementsLet’s first review minimum disclosure requirements that apply to fair value measurements in each class of assets or class of liabilities the entity has identified.

For all fair value measurements (whether recurring or not) an entity has to disclose:

The fair value measurement at the end of the reporting period (820-10-50-2(a))The level of the fair value hierarchy within which the fair value measurement is categorized (Level 1, 2, or 3) (820-10-50-2(b))

For every asset or liability held at the end of the reporting period for which the fair value measurement transferred between Level1 or Level 2, the entity (unless it is a nonpublic entity) has to disclose all of the following: (820-10-50-2(bb); 820-10-50-C2; 820-10-50-2F)

How the entity identifies when a transfer has occurredThe reason for the transferTransfers into Level 1Transfers into Level 2Transfers out of Level 1Transfers out of Level 2

ObSErvATIOn

for each class of assets or liabilities involving derivative instruments, the entity has to provide the disclosures required by 820-10-50-2(a) through (bb) on a gross basis. (820-10-50-3(a))

For any Level 2 or Level 3 fair value measurement (whether recurring or not), the entity has to describe: (820-10-50-2(bbb))

The valuation technique usedThe inputs usedAny change in valuation technique and the reason for the change


PrACTICE POInTEr

some generally accepted accounting principles require an entity to make a fair value measurement only so the entity can disclose the fair value amount. that is, the entity isn’t required to subsequently measure the item at fair value in the balance sheet, but merely to disclose the item’s fair value. In that circumstance, the entity (unless it is a public entity) has to disclose only:

the level of the fair value measurement (820-10-50-2(b))the information in 820-10-50-2(bbb), except for the quantitative disclosures about significant unobservable inputsIf the item is a nonfinancial asset that is not being used for its highest its best use, an explanation of why (825-10-50-2(h)

none of the other section 820-10-50 disclosure requirements apply to a fair value measurement that is made only for disclosure purposes. (820-10-50-2E; 820-10-50-2f)

Disclosures for Level 3 Fair value Measurements OnlyLet’s review additional minimum disclosures that apply only to Level 3 fair value measurements in each class of assets or class of liabilities the entity has identified.

For any Level 3 fair value measurement (whether recurring or not), the entity has to describe its valuation process; for example, how it determines what valuation method to use, what the valuation method is, how it analyzes changes in fair value measurements, and so on. (820-10-50-2(f ); 820-10-55-105) The entity also has to disclose quantitative information about any significant unobservable input used in any Level 3 fair value measurement (whether recurring or not). (820-10-50-2(bbb))

ObSErvATIOn

As you learned before, an entity might use an unobservable input such a third-party price without adjustment. If that unobservable input is significant, the entity has to provide “reasonably available” quantitative information about the input, but doesn’t have to create quantitative information that it hasn’t developed. the same is true if the unobservable input is a price of a prior transaction. (820-10-50-2(bbb))

For recurring Level 3 fair value measurements, an entity has to disclose reconciliation between opening and closing balances. Each of the following reconciling amounts has to be shown separately: (820-10-50-2(c))

Total gains (losses) recognized in period earningsTotal gains (losses) recognized in period other comprehensive incomePeriod purchasesPeriod salesPeriod issuesPeriod settlements


Period transfers into recurring Level 3 fair value measurementsPeriod transfers out of recurring Level 3 fair value measurements

PrACTICE POInTEr

for each class of assets or liabilities involving derivative instruments, the entity can present the reconciliation on either a gross or net basis. (820-10-50-3(b))

The entity must complement the reconciliation with the following related qualitative information: (820-10-50-2(c))

The line item in which the total gains (losses) are recognized in period earningsThe line item in which the total gains (losses) are recognized in period other comprehensive incomeThe reasons for any transfer into (out of ) recurring Level 3 fair value measurementsHow the entity identifies when a transfer between two levels of fair value measurements has occurred. (820-10-50-2C)

The entity must also disclose that portion of the total gains (losses) recognized in period earnings that is attributable only to those assets and liabilities the entity holds at the end of the reporting period. The entity has to disclose the line item in which that portion of the total gains (losses) is recognized. (820-10-50-2(d))

If a recurring Level 3 fair value measurement would be significantly higher or lower upon changing a related unobservable input (for example, one disclosed under 820-10-50-2(bbb)), the entity (unless it is a nonpublic entity) has to describe that sensitivity. If two or more unobservable inputs interact in the recurring Level 3 fair value measurement, the entity has to describe that interaction and how it might magnify or mitigate the effects of changes in the unobservable inputs. (820-10-50-2(g); 820-10-50-2F)

STUDY QUESTIOn

7. Which of the following is a false statement about required disclosures about fair value measurements?

a. one primary disclosure objective is to identify valuation approaches for fair value measurements and related inputs.

b. Changes in how an entity measures fair value are not of real importance.c. one primary disclosure objective is to identify the effect that Level 3 mea-

surements have on earnings, other comprehensive income, or changes in net assets.

d. Each entity has to make its own judgments about the extent of detail disclosed.

63


big GaaP–Little GaaP

This chapter discusses the current developments in the establishment of a set of GAAP rules for private, non-public companies.

LEArnInG ObjECTIvES


Indicate the reasons why a set of GAAP rules for private, non-public companies is neededDiscuss the AICPA’s financial reporting framework for private small-and medium-sized entities (frf for sMEs)Describe the attributes and use of International financial reporting standards (Ifrs) for sMEs

InTrODUCTIOn

In 2013, there is finally progress toward creating a little GAAP alternative for non-public companies. After all, it has only taken close to 40 years to get to the point where practitioners and their clients are fed up with the extensive growth of GAAP, much of which is useless to the users of non-public company financial statements.

bACkGrOUnD

For years there has been discussion about establishing two sets of GAAP rules; one for private (non-public) companies, and the other for SEC companies. Yet, each time the discussion has fallen into oblivion with no real support from the AICPA and FASB.

The Big-GAAP, Little-GAAP issue has been around since 1974 and still has not been resolved. There is a long history of various attempts to develop two sets of rules for GAAP, one for private companies, and the other for public companies. For purposes of this discussion, the term “Big-GAAP” refers to GAAP for public companies, while “Little GAAP” refers to a modified and simplified version of GAAP applicable to private (non-public) companies.

Because the continued start and stop of the Big GAAP-Little GAAP debate has yielded little fruit, non-public companies and their accountants have had to apply the same standards used by IBM and Microsoft to Joe’s Pizza Shop and Mary’s Office Supply Store.


Nevertheless, the Big GAAP-Little GAAP movement has received new impetus over the past few years due to several reasons:

In the past decade, the FASB has issued several extremely controversial FASB statements and interpretations that are costly and difficult for non-public entities to implement, and not meaningful to the third-party users they serve.The Sarbanes-Oxley Act of 2002 mandated that the FASB’s funding come primarily from SEC registrants, thereby suggesting that the FASB’s focus has been and will continue to be on issues important to public entities.The FASB and International Accounting Standards Board (IASB) in Eu-rope continue to work on an international standards convergence project that may ultimately result in one set of international GAAP standards. Changes will be required to existing U.S. GAAP standards and many of those changes will not be important to non-public entities.Presently, accountants from smaller CPA firms and from non-public companies are not serving as FASB staff or board members, which results in no small business representation or perspective within the FASB.On the auditing side, the role of the Auditing Standards Board (ASB) has diminished to issuing auditing standards for non-public entities only. The Public Company Accounting Oversight Board (PCAOB) is now the standard-setter for SEC auditors. Thus, the AICPA’s ASB and the AICPA, in general, have closer focus on the needs of non-public company audits.

In the past few years, there has been sharp criticism pointed toward the FASB in its issuance of several extremely controversial statements that are difficult to implement for smaller, closely held companies including:

Consolidation of Variable Interest Entities (ASC 810) (formerly FIN 46R): Requires entities (large and small) to consolidate their operating entities with their off-balance-sheet real estate leasing entities, if certain conditions are metAccounting for Uncertainty in Income Tax (An Interpretation of FAS 109) (ASC 740) (formerly FIN 48): Clarifies the accounting for uncertainty in tax posi-tions related to income taxes recognized in an entity’s financial statements

In addition, layers of mindless disclosures have been added to GAAP over the past decade, many of which are targeted at larger publicly held entities. Yet, the FASB has not exempted non-public entities from the application of those disclosures. In general, there have been few instances in which the FASB has is-sued standards that exempt private companies. A few of those instances include:

ASC 260 (formerly FAS 128: Earnings Per Share)ASC 280 (formerly FAS 131: Disclosures about Segments of an Enterprise and Related Information)ASC 825 (formerly FAS 107: Disclosure About Fair Value of Financial Instruments)

M o d u l e 1 — C h a p t e r 3 — B i g G a a p– l i t t l e G a a p 65

In fact, the extent to which the FASB has carved out GAAP exclusions for private companies is limited to delaying the effective date of a new standard and, in very limited cases, exempting private companies from one or two disclosures. Otherwise, private companies have had to adopt the same standards that public companies do. Consequently, accountants and their clients have defaulted to using several techniques to avoid the burdensome task of having to comply with recently issued difficult and irrelevant accounting standards, including:

Using OCBOA (income tax basis financial statements)Including a GAAP exception in the accountant’s/auditor’s reportIgnoring the new GAAP standards by arguing their effect is not material

However, some third parties have not been receptive to using OCBOA finan-cial statements, and issuing a GAAP exception could be a red flag. Simply ignoring the new GAAP standards has its obvious problems.

Adding to the difficulty has been the FASB’s unwillingness to focus on the needs of private companies. Prior to the issuance of Sarbanes-Oxley in 2002, the FASB received most its funding from the SEC’s Fortune 500 com-panies. After the Sarbanes-Oxley Act, essentially all of the FASB’s funding is financed by SEC companies as mandated by Sarbanes-Oxley, so that the FASB’s emphasis is in serving the public company arena. Consequently, the needs of non-public entities have been ignored.

PrIOr ATTEMPTS AT LITTLE GAAP

Over the past 40 years, there have been 12 studies and reports on some version of Big-GAAP, Little-GAAP conducted by committees on behalf of the FASB and AICPA. No viable action was taken on any of the study’s recommendations.

In October 2004, an AICPA Task Force issued a report entitled, 2004 Private Company Financial Reporting Study. That report was followed by a May 2005 AICPA Council passage of a resolution endorsing an effort to explore potential changes to GAAP for private companies. Findings from the 2004 report concluded that GAAP for private companies should be developed based on concepts and accounting that are appropriate for the distinctly different needs of constituents of financial reporting. Nothing happened.

In June 2006, the FASB and AICPA issued a joint proposal entitled, Enhancing the Financial Accounting and Reporting Standard-Setting Process for Private Companies. The Proposal had, as its primary basis, a mechanism by which the FASB can be more reflective of the needs of non-public entities during FASB’s deliberation process. Ultimately, the proposal resulted in the creation of a Private Company Financial Reporting Committee (PCFRC) to provide recommendations that would help the FASB determine whether there should be differences in prospective and existing accounting standards for private companies.


Although the FASB was supposed to listen to the PCFRC’s input on modifying new GAAP statements for the needs of private companies, the results have been flat. Instead of making modifications or exceptions for private companies, the extent to which the FASB has actually taken action for private companies has been to delay the effective date of new FASB state-ments for non-public entities and, in limited cases, eliminated some of the disclosures in those statements. No meaningful actions have been taken to exempt private companies from recently issued FASB statements.

Then there was the Blue Ribbon Panel! In December 2009, a group of organizations led by the AICPA, the Financial Accounting Foundation (FAF) (the parent organization of the FASB), and other organizations established a Blue Ribbon Panel to address accounting standards of private companies. The Panel was comprised of 18 members, all senior leaders including lenders, investors, owners, accountants, and auditors. The Panel also invited regula-tors and other stakeholders to participate (but not vote) in the discussions of the Panel.

Although this effort appeared to be more “déjà vu” and redundant with the actions of other panels and committees, the Panel issued a report in January 2011 to the FAF. That report made drastic recommendations as to how to resolve the accounting standards challenges for private companies.

Unlike previous panels and committees, the Panel recommended that in the near term, a little-GAAP system should:

Retain existing GAAP with carve-out exceptions and modifications for private companies that better respond to the needs of the private com-pany sector rather than move toward a separate, self-contained GAAP for private companies or a wholesale reorganization of GAAPCreate a new separate private company standards board (consisting of five to seven members) to help ensure that appropriate and sufficient exceptions and modifications are made for private companies, for both new and existing standards.Empower the new board to approve all GAAP exceptions and modifica-tions for private companies with the power to override the FASB.

FASb AnD AICPA SIMULTAnEOUSLY jUMP On THE LITTLE-GAAP bAnDWAGOn

Prior to May 23, 2012, it had taken more than 40 years for there to be a legitimate alternative to regular (big) GAAP. During that time, practitioners and their non-public company clients have used a variety of alternatives to avoid the traditional complex GAAP that had evolved.

On May 23, 2012, a rather profound series of events happened. After more than 40 years of the profession seeking a little-GAAP alternative, both the FASB and AICPA simultaneously announced their own independent proposals for a little-GAAP alternative for non-public companies as follows:


FASB’s new PCC was created to issue GAAP exceptions and modifica-tions for private companies.AICPA created its new Financial Reporting Framework for Small and Medium Sized Entities (FRF for SMEs).

FASb’s Private Company Council (PCC)More specifically, on May 23, 2012, the FASB’s FAF Board of Trustees announced that it was establishing a new body to improve the process of setting accounting standards for private companies, referred to as the Private Company Council (PCC). According to the FAF, the PCC will have the fol-lowing principal responsibilities:

Based on criteria mutually developed and agreed to with the FASB, the PCC will determine whether exceptions or modifications to existing non-governmental U.S. GAAP are necessary to address the needs of users of private company financial statements. The PCC will identify, deliberate, and vote on any proposed changes, which will be subject to endorsement by the FASB and submitted for public comment before being incorporated into GAAP. The PCC also will serve as the primary advisory body to the FASB on the appropriate treatment for private companies for items under active consideration on the FASB’s technical agenda.

Key elements of the PCC responsibilities and operating procedures include: Agenda Setting: The PCC and the FASB will mutually agree on criteria for determining whether and when exceptions or modifications to GAAP are warranted for private companies. Using the criteria, the PCC will determine which elements of existing GAAP to consider for possible exceptions or modifications by a vote of two-thirds of all sitting mem-bers, in consultation with the FASB and with input from stakeholders.FASb Endorsement Process: If endorsed by a simple majority of FASB members, the proposed exceptions or modifications to GAAP will be exposed for public comment. At the conclusion of the comment process, the PCC will redeliberate the proposed exceptions or modifications and forward them to the FASB, which will make a final decision on endorse-ment (not ratification), generally within 60 days. Membership and Terms: The PCC will consist of nine to 12 members, including a Chair, all of whom will be selected and appointed by the FAF Board of Trustees.

The PCC Chair will not be a FASB member. Membership of the PCC will include a variety of users, preparers, and practitioners with substantial experience working with private companies. Members will be appointed for a three-year term and may be reappointed for an additional term of two years. Membership tenure may be staggered to establish an orderly rotation.


The PCC Chair and members will serve without remuneration but will be reimbursed for expenses.

FASb Liaison and Staff Support: A FASB member will be assigned as a liaison to the PCC. FASB technical and administrative staff will be as-signed to support and work closely with the PCC. Dedicated full-time employees will be supplemented with FASB staff with specific expertise, depending on the issues under consideration.Meetings: During its first three years of operation, the PCC will hold at least five meetings each year, with additional meetings if determined neces-sary by the PCC Chair. All FASB members will be expected to attend and participate in deliberative meetings of the PCC, but closed educational and administrative meetings may be held with or without the FASB.Oversight: The FAF Board of Trustees will create a special-purpose com-mittee of Trustees, the Private Company Review Committee (Review Committee), which will have primary oversight responsibilities for the PCC. The Review Committee will hold both the PCC and the FASB ac-countable for achieving the objective of ensuring adequate consideration of private-company issues in the standard-setting process. FAF Trustees’ Three-Year Assessment: The PCC will provide quarterly writ-ten reports to the FAF Board of Trustees. The FAF Trustees will conduct an overall assessment of the PCC following its first three years of operation to determine whether its mission is being met and whether further changes to the standard-setting process for private companies are warranted.

STUDY QUESTIOnS

1. Why has the Big GAAP-Little GAAP movement received new impetus over the past few years?

a. Many changes that will be required by the single set of international GAAP standards will be important to non-public entities.

b. recent controversial fAsB statements and interpretations are costly and dif-ficult for non-public entities to implement.

c. the sarbanes-oxley Act mandates that the fAsB’s funding come from non-public entities.

d. there is no large business representation or perspective on the fAsB.

2. Which of the following is one of the controversial statements that are difficult to implement for smaller, closely held companies?

a. Consolidation of variable Interest Entitiesb. Disclosure about fair value of financial Instrumentsc. Earnings per shared. segment reporting


FASb’s PCC COMES TO LIFE

In 2012, the FAF nominated 10 individuals to the new PCC board. On December 6, 2012, the PCC held its first meeting during which time the FASB staff presented to the PCC several key issues that concern constituents of private companies. They are:

Consolidation of Variable Interest Entities (ASC Topic 810) (formerly FIN 46(R) and FAS167): which involves the consolidation of variable interest entities (VIEs), with particular concern for the consolidation of a related party real estate lessor into the financial statements of the operating company lesseeAccounting for “plain vanilla” interest rate swaps, which are used to convert variable interest rates on loans to fixed interest rates, and vice versa, as referenced in ASC Topic 815, Derivatives and Hedging (for-merly FAS 133)Accounting for Uncertain Tax Positions (ASC Topic 740, Income Taxes) (formerly FIN 48): which requires measurement, disclosure, and report-ing of uncertain tax positionsRecognizing and measuring various intangible assets (other than goodwill) acquired in business combinations, including providing Level 3 fair value measurements and disclosures associated with them, as referenced in ASC Topic 805, Business Combinations, and ASC Topic 350, Intangibles-Goodwill and Other (formerly FAS 141(R) and FAS 142, respectively).

On February 12, 2013, the PCC held its second meeting, at which time the FASB staff presented four issue papers on the above noted topics. At that meeting, the PCC directed the FASB staff to prepare research papers on two additional topics: stock-based compensation and development stage enterprises. The PCC also provided input on current FASB projects, includ-ing revenue recognition, going concern, and the Emerging Issues Task Force project on pushdown of new basis accounting.

In 2013, the test will be how quickly the PCC will be able to move to create recommendations for private company exemptions and exceptions for endorsement by the FASB board.

AICPA’s FrF FOr SMEs

As a counter-punch to the FASB taking control over the non-public company issue through the newly established PCC, the AICPA took its own action to deal with the needs of non-public companies.

On May 23, 2012, the AICPA announced that it was developing a finan-cial reporting framework for private small-and medium-sized entities (FRF for SMEs) that do not need U.S. GAAP financial statements. According to the AICPA, the AICPA’s FRF for SMEs framework is less complicated


and a less costly alternative system of accounting to U.S. GAAP for private companies that do not need U.S. GAAP financial statements.

Barry Melancon, President of the AICPA stated:

In addition to advocating for appropriate differences in U.S. GAAP to recognize the unique circumstances of the private company environment, we will be launching a complementary OCBOA fi-nancial reporting framework. The enhanced and simplified financial reporting framework will be a cost beneficial solution for smaller privately held entities that do not need to comply with U.S. GAAP.

AICPA’s ExPOSUrE DrAFT FOr FrF FOr SMEs

In November 2012, the AICPA issued an exposure draft on its framework for FRF for SMEs, entitled, Proposed Financial Reporting Framework for Small- and Medium-Sized Entities. The exposure draft, with its 252 pages, represented the proposed entire codification of FRF for SMEs, and was exposed for public comment.

The FRF for SMEs represents one additional financial reporting frame-work consisting of a set of criteria used to determine measurement, recog-nition, presentation, and disclosure of all material items appearing in the financial statements.

According to the AICPA, the FRF for SMEs is a self-contained special-purpose framework intended for use by privately held small-to-medium-sized entities (SMEs) in preparing their financial statements. The FRF for SMEs draws upon a blend of traditional methods of accounting with some accrual income tax methods.

One key point that appears to be of great concern to practitioners is that the FRF for SMEs is a non-authoritative framework. Although the framework was exposed for public comment, the FRF for SMEs will not be approved, disapproved, or otherwise acted upon by any senior technical committee of the AICPA or the FASB and will have no official or authoritative status. Therefore, a large question is whether third-party users will accept a non-authoritative framework, particularly if the AICPA does not get behind educating third-party users about it.

Is the FrF for SMEs a Special Purpose Framework Under Auditing Standards?Yes, the provisions of AU-C Section 800, Special Considerations—Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks (AICPA, Professional Standards) will apply to financial state-ments prepared under the FRF for SMEs. AU-C section 800 states that if


special purpose framework financial statements include items that are the same or similar to those in GAAP financial statements, similar informative disclosures are required. The AICPA has stated that it believes the FRF for SMEs consists of disclosures that are similar informative disclosures to GAAP.

What Are Some of the Differences between FrF for SMEs and Traditional GAAP?Following is a listing of some of the key recognition, measurement, and disclosure standards found in the FRF for SMEs:

General provisions: The framework is built upon a foundation of reliable and comprehensive accounting principles:

Historical cost is the primary measurement basis. Disclosures are reduced, while still providing users with the relevant information they need. Familiar and traditional accounting methods are employed. Adjustments needed to reconcile tax return income with book income are reduced. The framework is a principles-based framework, usable across industries by incorporated and unincorporated entities. The framework contains less complicated, leaner, relevant financial reporting principles for SMEs. Only financial statement matters that are typically encountered by SMEs are addressed in the framework.

Specific rules:Historical cost is used.Inventories are measured at lower of cost or market, using FIFO, LIFO, or weighted average cost, except for items that are not ordinarily inter-changeable, and goods or services produced and segregated for specific projects, which should be assigned by using specific identification of their individual costs.Fixed assets:

Same rules as existing GAAP Depreciation based on useful lives of assetsStill does not allow Internal Revenue Code Sec. 179/bonus depreciation

Lease accounting: Recorded as a capital or operating lease based on whether substantially all of the risks and benefits of ownership transferExisting five-year disclosures of lease payments remain in effect

Financial instruments: Cost is used except for available-for-sale securities for which fair value is used.


Only the following is disclosed for derivatives:The face or contract amount (or notional principal amount, if there is no face or contract amount)The nature and terms, including a discussion of the credit and market risk and the cash requirements of those derivativesA description of the entity’s objectives for holding the derivativesThe net settlement amount of the derivative at the statement of financial position date

Equity method: follows existing GAAP and is used if there is significant influence presumed at 20-50 percent ownership.Percent-of-completion or completed-contract methods are retained.Consolidations:

There is no consolidation of variable interest entities (VIEs).Consolidation occurs only if more than 50 percent ownershipParent-only financial statements are available where the subsidiary could be recorded using the equity method instead of consolidating.

Income taxes: The company has the choice of either:Recording deferred income taxesRecording only the current tax provision without deferred income taxes

Goodwill: should be amortized generally over the same period as that used for federal income tax purposes or, if not amortized for federal income tax purposes, then a period of 15 years.

No impairment test is required.Push down accounting is allowed when there is a stock redemption or stock purchase.FRF for SMEs does not apply to non-profit organizations.The FRF for SMEs framework will be “stable” as changes will be made only every three to four years.

Status of FrF for SMEsThe FRF for SMEs exposure draft had a comment deadline of January 31, 2013. It was released on June 10, 2013.

ObSErvATIOn

In reviewing the comment letters submitted, the author noted a strong opposition by the state licensing boards to the fact that the framework is non-authoritative and that third parties might not accept a non-authoritative framework. Moreover, there is no indication that the AICPA is going to help promote the use of frf for sMEs with third parties, such as bankers. thus, if third parties do not understand frf for sMEs, they may be reluctant to accept its use in lieu of GAAP.


(Q&A Published by the AICPA in October 2012) Will Lenders/Financial Institutions Accept Financial Statements Prepared Under the FrF for SMEs? AICPA Response: Owner-managers and their CPA practitioners will need to consult with lenders and other key external stakeholders about the use of the FRF for SMEs. With substantial relevance and cost-benefit factors, the AICPA believes that the lending community will accept financial state-ments prepared under the FRF for SMEs. Lenders are often very flexible in accommodating various financial frameworks for smaller entities.

Why Wouldn’t a Practitioner Simply Use Income Tax basis Financial Statements Instead of the FrF for SMEs?In looking at FRF for SMEs and the fact that it will be a non-authoritative framework with no AICPA promotion of its use, one has to ask why a practitioner would not suggest to his or her client to use income tax basis accrual financial statements instead of FRF for SMEs. Both frameworks are considered a special-purpose framework and not GAAP. FRF for SMEs looks very similar to GAAP 30 years ago before the FASB issued many of the recent complex and controversial standards. However, one might conclude that once there is a deviation from U.S. GAAP, income tax basis financial statements might be more easily accepted by banks. Moreover, income tax basis financial statements are probably a more meaningful special-purpose framework because it is based on income tax reporting, a framework that is understandable to a non-public company client.

Why doesn’t a U.S. Private Company Simply Adopt the European version of IFrS for SMEs?Europe’s IASB has been ahead of the United States on the little-GAAP issue, with its own IFRS for SMEs (small and medium-sized entities) for their private companies. IFRS for SMEs is not to be confused with the AICPAs FRF for SMEs. The IFRS for SMEs is an abbreviated standard that has been adopted by numerous countries. According to the IASB, more than 68 jurisdictions have either adopted IFRS for SMEs or have committed to adopt it over the next three years. U.S. companies can adopt it presently but few companies have done so.

The key difference between the IFRS for SMEs as compared with full international standards under IFRSs is that the IFRS for SMEs is much less complex due to the simpler reporting needs of most small and medium-sized entities. The IASB’s only restriction is that listed companies (public com-panies) and financial institutions should not use it. Similarly, U.S. public companies are permitted to use the IFRS but should not use IFRS for SMEs.


Consider the following attributes found in the IFRS for SMEs: There are only 230 pages of material in the IFRS for SMEs as compared with thousands of pages in the full set of IFRS.It is organized by topic within 35 sections.Topics that are not relevant to small and medium-sized private compa-nies have been omitted and many principles have been simplified. (e.g., Amortization of goodwill and the accounting for investments have been simplified from the approach under IFRS.)The IFRS for SMEs only allows use of the easiest option among a choice of accounting policies available under IFRS.There are significantly fewer disclosures required (roughly 300 versus 3,000) as compared with the full IFRS.The standard has been written in a clear and easily translatable language. To further reduce the burden for SMEs, revisions to the IFRS for SMEs are limited to once every three years.

According to a document published by the IASB, more than 95 percent of all companies worldwide are eligible to use IFRS for SMEs. There are only 45,000 public companies worldwide (listed on the 52 largest stock exchanges) that must use full IFRS or U.S. GAAP. All other companies, which are pri-marily private companies, are eligible to use the IFRS for SMEs

Europe and the United States have approximately 53 million private companies:

Europe has 33 million (U.K. alone has 4.5 million).United States has 20 million.

nOTE

there is a discrepancy between the number of private companies in the united states as identified in the IAsB report and the Blue ribbon Panel report. the IAsB states that there are 20 million private companies in the united states while the Blue ribbon report states there are 28 million.

Can U.S. Private Companies Adopt the IASb’s IFrS for SMEs?Although public companies, in general, should not use IFRS for SMEs, U.S. private companies are permitted (but not required) to adopt the IFRS for SMEs.

If IFRS for SMEs were to be used by U.S. private companies, there is a question as to whether U.S. third-party users (banks, etc.) will understand it or even permit it. Most loan documents in the United States, for example, state that financial statements must be prepared in accordance with U.S. GAAP. Changing that requirement to IFRS for SMEs is likely to be difficult, if not impossible, as banks and other third parties are reluctant to accept an accounting standard that they do not understand.


Why Didn’t the AICPA Simply Adopt the IASb’s IFrS for SMEs Instead of Creating its Own FrF for SMEs?It would seem that the AICPA and FASB could have endorsed and supported the existing IFRS for SMEs instead of adopting its own FRF for SMEs. After all, the codification of IFRS for SMEs was already written and approved for use by U.S. private companies. In its October 2012 Q&A, the AICPA offered the following question and answer:

(Q&A published by the AICPA in October 2012) Question: Why not promote the use of IFrS for SMEs rather than develop a new framework? AICPA Response: The International Accounting Standards Board has been recognized by the AICPA as an international accounting standard-setting body and, as a result, the IFRS for SMEs may be an alternative for those SMEs needing GAAP financial statements. Although there will be some similarities between the FRF for SMEs and the IFRS for SMEs, the AICPA believes that the FRF for SMEs will be more understandable and more useful at this time because it is specifically written for U.S. entities. Additionally, the FRF for SMEs will reduce differences between the FRF for SMEs and the U.S. tax code. For example, last in, first out inventory is not permitted by the IFRS for SMEs whereas it will be permitted by the FRF for SMEs.

THE MULTIPLE FrAMEWOrk OPTIOnS FOr nOn-PUbLIC EnTITIESWith the advent of the FASB’s PCC and the AICPA’s FRF for SMEs, U.S. non-public companies will ultimately have many special-purpose frameworks from which to choose. Consider the list of reporting alternatives for U.S. non-public entities:

Types of Frameworks Available (or Pending) For U.S. non-Public Entities

Framework Comments

u.s. GAAP n In effect but getting more complexn Generally accepted by all third parties

u.s. GAAP with GAAP exceptions

n Can be used but practitioner is limited as to the extent to which GAAP exceptions can be used

Income-tax-basis financial statements

n Popular special-purpose framework effective for profitable, non-public businesses

n Many third parties accept its use.

fAsB’s Private Company Council framework

n Goal is to create exceptions and exclusions to existing GAAP for non-public entities.

n Authoritative and endorsed by the fAsB

AICPA’s financial reporting framework for small- to Medium-sized Entities (frf for sMEs)

n simpler version of u.s. GAAPn non-authoritativen Concerns about whether third parties will accept its use

IAsB’s Ifrs for sMEs n Can be used by u.s. non-public entitiesn u.s. accountants and third-party users are not familiar with its

application.


STUDY QUESTIOn

3. Which of the following is an accounting principle under the AICPA’s frf for sMEs?

a. fair value is used instead of historical cost.b. tax return depreciation is used.c. Deferred income taxes is still required.d. Goodwill is amortized over 15 years if not amortized for federal income tax

purposes.

CPE nOTE: When you have completed your study and review of chapters 1–3, which comprise Module 1, you may wish to take the Quizzer for this Module.

Go to CCHGroup.com/PrintCPE to take this Quizzer online.


77

MoDuLE 2: fInAnCIAL stAtEMEnt rEPortInG — CHAPtEr 4

Multiemployer Plan Disclosures

LEArnInG ObjECTIvES


Explain the differences between multiemployer plans, single-employer plans, and multiple-employer plansDiscuss the requirements of Asu 2011-09recite the findings of the Credit suisse study regarding the funding of pension plansDescribe the Pension Protection Act color zones used to evaluate the funded status of pension plans Discuss the role of the Pension Benefit Guarantee Corporation

InTrODUCTIOn

U.S. GAAP for multiemployer pension plans is found in ASC Subtopic 715-80, Multiemployer Plans, which, prior to the application of ASU 2011-09, required individual employers to make disclosures limited primarily to disclosing the historical contributions made to the plans.

ASU 2011-09: Compensation—Retirement Benefits—Multiemployer Plans (Subtopic 715-80) Disclosures about an Employer’s Participation in a Multiemployer Plan, was issued in September 2011. The objective of this Accounting Standards Update (ASU) is to expand the required disclosures for employers that participate in multiemployer pension plans and multi-employer other postretirement benefit plans.

For employers that participate in multiemployer pension plans, the amendments in this ASU require an employer to provide additional quantita-tive and qualitative disclosures to provide users with more detailed informa-tion about an employer’s involvement in multiemployer plans.

bACkGrOUnD

It is common for employers of defined benefit pension plans and other postretirement benefit plans to provide benefits to their employers through multiemployer plans. In general, such plans allow individual employers to pool investment assets with other employers, and reduce administrative costs, particularly with respect to a group of individually smaller employers who seek the economies of scale that a larger multiemployer plan can afford them. Another group that uses multiemployer pension plans is companies with union contracts.


Contrary to multiemployer plans, single-employer plans may not have the benefits of pooling investment assets and driving administrative costs down, but they offer other benefits such as being able to maintain separate accounts for each employer so that each employer’s contributions benefit only the employees of that contributing employer.

One particular difference between multiemployer and single-employer plans is that multiemployer plans may lack some of the transparency of single-employer plans for several reasons:

Such plans may be part of collective-bargaining agreements.It may be difficult for individual employers and employees to obtain timely information about the multiemployer plan, particularly if such information is not published. The regulatory environment of such plans may vary across industries and restrict access to certain information about the plans.

Although a multiemployer pension plan is a defined benefit plan, on each employer’s individual financial statements, U.S. GAAP treats the plan as if it were a defined contribution plan. In doing so, GAAP requires that an employer recognize its required contribution to the plan as pension or other postretirement benefit cost for the period and recognize a liability for any contributions due at the reporting date. The actuarial present value computa-tions and extensive disclosures required of a typical single-employer defined benefit plan are not applicable when the plan is a multiemployer one.

There are also several unique characteristics of a multiemployer plan, some of which may expose one employer to the risks of other employers within the plan as follows:

Assets contributed by one employer for its own employees may be used to provide benefits to employees of other participating employers as those assets are not specifically earmarked only for its employees. If a participating employer fails to make its required contributions, the unfunded obligations of the plan may be borne by the remaining par-ticipating employers. If an employer chooses to stop participating in a multiemployer plan, the withdrawing company may be required to pay to the plan a final payment (the withdrawal liability).

Financial statement users have continued to have concerns that U.S. GAAP has failed to provide sufficient transparency about a particular employer’s participation in a multiemployer pension plan. Because the risk of exposure for any one particular employer within a multiemployer plan could expand beyond that employer’s obligations to its employees, users of financial state-ments have requested that the FASB require additional disclosures to increase awareness of the commitments and risks involved with participating in multiemployer pension plans. In response, the FASB issued ASU 2011-09

M o d u l e 2 — C h a p t e r 4 — M u l t i e m p l oy e r p l a n d i s c l o s u re s 79

to require additional disclosures about an employer’s participation in mul-tiemployer pension plans and other post-retirement plans such as those that provide retirees with health and life insurance benefits.

According to the FASB, in developing the ASU, it had several goals which were to help users:

Assess the potential future cash flow implications relating to an employer’s participation in multiemployer pension plans Assess the financial health of all of the significant multiemployer plans in which the employer participates Access additional information about the multiemployer plan that is available outside the financial statements

Some of the key changes made by ASU 2011-09 are:It applies to non-governmental, multiemployer pension plans and other post-retirement plans, but does not apply to single-employer plans. The amendments require additional separate disclosures for multiemploy-er pension plans and multiemployer other postretirement benefit plans.The ASU amendments require an employer to provide additional quantita-tive and qualitative disclosures, including more detailed information about an employer’s involvement in multiemployer pension plans, including:

The significant multiemployer plans in which an employer partici-pates, including the plan names and identifying number so that a user can obtain additional information about the multiemployer planThe level of an employer’s participation in the significant multiem-ployer plansThe financial health of the significant multiemployer plans The nature of the employer commitments to the planOther information that includes a description of the extent to which the employer could be responsible for the obligations of the plan, including benefits of employees of other employers

In addition to disclosures of multiemployer pension plans, the ASU ex-pands disclosures for multiemployer other postretirement benefit plans.

The ASU does not change the recognition provisions of existing GAAP under which an employer recognizes its required contribution to the plan as pension or other postretirement benefit cost for the period, and recognizes a liability for any contributions due at the reporting date. That guidance is unchanged by these ASU amendments.

COMPArISOn OF U.S. GAAP WITH IFrS

U.S. GAAP differs from International Financial Reporting Standards (IFRS) in recognition and measurement of an employer’s participation in multiemployer plans for both plans that provide pension benefits and those


that provide other postretirement benefits. Under U.S. GAAP, the current recognition and measurement guidance for an employer’s participation in a multiemployer plan requires that an employer treat the transaction as if it were a defined contribution plan by recognizing its required contribution to the plan as pension or other postretirement benefit cost for the period and recognizing a liability for any contributions due at the reporting date. Unlike a single-employer plan, an employer of a multiemployer plan does not record the actuarial benefit obligation.

On the international side, international standards require that an em-ployer account for a defined benefit multiemployer plan as a defined benefit plan, recognizing a defined benefit asset or liability if sufficient information is available to do so. However, under IFRS, an employer may account for a defined benefit multiemployer plan as a defined contribution plan if there is insufficient information to apply defined benefit accounting, as is often the case.

On the disclosure side, this ASU brings U.S. GAAP disclosures for employers of multiemployer plans closer in line with IFRS. In June 2011, the IASB issued amendments to international standards by issuing IAS 19, Employee Benefits, to enhance disclosures about an employer’s participation in a multiemployer plan.

Even after the issuance of ASU 2011-09, U.S. GAAP disclosures are similar, but not identical, to the IFRS disclosures, with the key remaining differences consisting of the use of information, terminology, and the greater level of specificity found in the FASB’s disclosure requirements.

rEQUIrEMEnTS OF ASU 2011-09

ScopeThe amendments in ASU 2011-09 apply to nongovernmental entities (public and nonpublic) that participate in:

Multiemployer pension plans Multiemployer plans that provide postretirement benefits other than pensions

The ASU amendments do not apply to plans that are not multiemployer plans such as:

Single-employer plansMultiple-employer plansSubsidiaries who participate in one single-parent plan

ASU 2011-09 does provide a modified disclosure for certain subsidiaries and not-for-profit organizations, which is discussed later in this chapter.


Definitions Used Within ASC 715 related to ASU 2011-09

Multiemployer plans: A pension or other postretirement benefit plan to which two or more unrelated employers contribute, usually pursuant to one or more collective-bargaining agreements. A characteristic of multiemployer plans is that assets contributed by one particular employer may be used to provide benefits to employees of other participating employers since assets contrib-uted by an employer are not segregated in a separate account or restricted to provide benefits only to employees of that employer. A multiemployer plan is usually administered by a board of trustees composed of manage-ment and labor representatives and may also be referred to as a joint trust or union plan. Generally, many employers participate in a multiemployer plan and an employer may participate in more than one plan. The employers participating in multiemployer plans usually have a common industry bond, but for some plans the employers are in different industries and the labor union may be their only common bond. Some multiemployer plans do not involve a union. For example, local chapters of a not-for-profit entity (NFP) may participate in a plan established by the related national organization.

Single-employer plan: A pension plan that is maintained by one employer. The term also may be used to describe a plan that is maintained by related parties such as a parent and its subsidiaries.

Multiple-employer plans: In substance, aggregations of single-employer plans, combined to allow participating employers to pool plan assets for investment purposes or to reduce the costs of plan administration. Such plans ordinarily do not involve collective-bargaining agreements. They may also have features that allow participating employers to have different benefit formulas, with the employer’s contributions to the plan based on the benefit formula selected by the employer.

nonpublic entity: An entity that does not meet any of the following criteria:Its debt or equity securities are traded in a public market, including those traded on a stock exchange or in the over-the-counter market (including securities quoted only locally or regionally).It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).Its financial statements are filed with a regulatory agency in preparation for the sale of any class of securities.

Pension benefits: Periodic (usually monthly) payments made pursuant to the terms of the pension plan to a person who has retired from employment or to that person’s beneficiary.


Postretirement benefits other than pensions: All forms of benefits, other than retirement income, provided by an employer to retirees. Those benefits may be defined in terms of specified benefits, such as health care, tuition assistance, or legal services that are provided to retirees as the need for those services arises. They may also be defined in terms of monetary amounts that become payable on the occurrence of a specified event, such as life insurance benefits.

STUDY QUESTIOnS

1. Which of the following is a unique characteristic of a multiemployer plan?

a. Assets contributed by one employer for its own employees are only used to provide benefits for those employees.

b. If a participating employer fails to make its required contributions, the unfunded obligations of the plan are not the responsibility of the remaining employers.

c. A company that withdraws from a plan may be required to pay the plan a withdrawal liability.

d. A multiemployer plan consists of one employer who administers several plans.

2. Which of the following is a key change made by Asu 2011-09?

a. the amendments require that the disclosures of multiemployer pension and other postretirement benefit plans be combined.

b. the disclosures apply to governmental and non-governmental plans.c. the changes apply to both single-employer and multiemployer plans.d. the Asu affects disclosures for multiemployer other postretirement benefit

plans.

Disclosures required for Employers of Multiemployer Pension PlansFollowing are the new disclosures required by ASU 2011-09 for multiem-ployer pension plans, and include all items recognized as net pension costs. The disclosures based on the most recently available information shall be the most recently available through the date at which the employer has evaluated subsequent events.

narrative: An employer that participates in a multiemployer plan that provides pension benefits shall provide in its annual financial statements a narrative description both of the general nature of the multiemployer plans that provide pension benefits and of the employer’s participation in the plans that would indicate how the risks of participating in these plans are different from single-employer plans.

Tabular format disclosures: When feasible, the following information shall be provided in a tabular format while information that requires greater


narrative description may be provided outside the table. For each individually significant multiemployer plan that provides pension benefits, an employer shall disclose the following:

Legal name of the planThe plan’s Employer Identification Number (EIN) and, if available, its plan numberFor each statement of financial position presented, the most recently available certified zone status provided by the plan, as currently defined by the Pension Protection Act of 2006 or a subsequent amendment of that Act (Green > 80 percent funded, Yellow or Orange 65-80 percent funded, Red <65 percent funded). The disclosure shall specify the date of the plan’s year-end to which the zone status relates and whether the plan has utilized any extended amortization provisions that affect the calculation of the zone status. If the zone status is not available, an em-ployer shall disclose, as of the most recent date available, on the basis of the financial statements provided by the plan, the total plan assets and accumulated benefit obligations, whether the plan was:

Less than 65 percent fundedBetween 65 percent and 80 percent fundedAt least 80 percent funded

The expiration date(s) of the collective-bargaining agreement(s) requiring contributions to the plan, if any

nOTE

If more than one collective-bargaining agreement applies to the plan, the employer shall provide a range of the expiration dates of those agreements, supplemented with a quali-tative description that identifies the significant collective-bargaining agreements within that range as well as other information to help investors understand the significance of the collective-bargaining agreements and when they expire (e.g., the portion of employees covered by each agreement or the portion of contributions required by each agreement).

For each period that a statement of income (or statement of activities for nonpublic entities) is presented:

The employer’s contributions made to the planWhether the employer’s contributions represent more than five percent of total contributions to the plan as indicated in the plan’s most recently available annual report (Form 5500 for U.S. plans) (If this quantitative information cannot be obtained without undue cost and effort, the quantitative information may be omitted and the employer shall describe what information has been omitted and why. In that circumstance, the employer also shall provide any qualitative information as of the most recent date available that would help users understand the financial information that otherwise is required to be disclosed about the plan.)


nOTE

the disclosure shall specify the year-end date of the plan to which the annual report relates.

As of the end of the most recent annual period presented:Whether a funding improvement plan or rehabilitation plan (FIP or RP) (e.g., as those terms are defined by the Employment Retirement Security Act of 1974) had been implemented or was pendingWhether the employer paid a surcharge to the planA description of any minimum contribution(s), required for future pe-riods by the collective-bargaining agreement(s), statutory obligations, or other contractual obligations, if applicable

nOTE

In determining whether a multiemployer plan is individually significant, factors other than the amount of the employer’s contribution to a plan, such as the severity of the underfunded status of the plan, may need to be considered.

The disclosures above assume that other information about the plan is avail-able in the public domain such as plan information in Form 5500 being publicly available. In circumstances in which plan level information is not available in the public domain, an employer shall disclose the following ad-ditional information about each significant plan, which shall be included in a separate section of the tabular disclosure required above:

A description of the nature of the plan benefitsA qualitative description of the extent to which the employer could be responsible for the obligations of the plan, including benefits earned by employees during employment with another employerOther quantitative information, to the extent available, as of the most recent date available, to help users understand the financial informa-tion about the plan, such as total plan assets, actuarial present value of accumulated plan benefits, and total contributions received by the plan (If this quantitative information cannot be obtained without undue cost and effort, the quantitative information may be omitted and the employer shall describe what information has been omitted and why. In that circumstance, the employer also shall provide any qualitative information as of the most recent date available that would help users understand the financial information that otherwise is required to be disclosed about the plan.)


An employer shall disclose the following in a tabular format for each annual period for which a statement of income or statement of activities is presented:

Its total contributions made to all plans that are not individually significantIts total contributions made to all plans

Other disclosures: An employer shall provide a description of the nature and effect of any significant changes that affect comparability of total employer contributions from period to period, such as:

A business combination or a divestitureA change in the contractual employer contribution rateA change in the number of employees covered by the plan during each year

Disclosures required for Employers of Multiemployer Plans That Provide Postretirement benefits Other Than PensionsFollowing are the new disclosures required by ASU 2011-09 for multiem-ployer plans that provide postretirement benefits other than pensions, such as health insurance.

An employer shall disclose the amount of contributions to multiemployer plans that provide postretirement benefits other than pensions for each an-nual period for which a statement of income or statement of activities is presented. The disclosures shall include a description of the nature and effect of any changes that affect comparability of total employer contributions from period to period, such as:

A business combination or a divestitureA change in the contractual employer contribution rateA change in the number of employees covered by the plan during each year

The disclosures also shall include a description of the nature of the benefits and the types of employees covered by these benefits, such as medical benefits provided to active employees and retirees.

Special rules for Subsidiaries and not-for-Profit EntitiesUnder current U.S. GAAP, subsidiaries that participate in their parent entity’s single-employer defined benefit pension plan and local chapters of not-for-profit entities that participate in their national organization’s defined benefit pension plan have accounted for and disclosed their participation in such plans as multiemployer plans. Some of the disclosures required by the amendments in ASU 2011-09 are less relevant in these situations.

The FASB noted that stakeholders have not cited a lack of information about the subsidiaries’ and not-for-profit chapters’ involvement with these plans that would warrant significant changes to the historical disclosures.


The FASB, in ASU 2011-09, did amend the disclosure requirements for these entities, but they are only required to disclose:

The name of the planThe amount of contributions made to the plan in each annual period for which an income statement is presented

The parent entity should account for the pension plan as a single-employer pension plan in its consolidated statements.

Sample Disclosure

Example 1: Disclosures for Multiemployer Plans That Provide Pen-sion BenefitsThe following sample disclosure was extracted from ASU 2011-09, and modified by the Author.

Facts: Entity A contributes to numerous multiemployer defined benefit pension plans as required under collective-bargaining agreements. Following is a sample disclosure that is required under the amendments to ASU 2011-09.

NOTE X: Multiemployer Plans That Provide Pension BenefitsThe Company contributes to a number of multiemployer defined benefit pension plans under the terms of collective-bargaining agreements that cover its union-represented employees. The risks of participating in these multiem-ployer plans are different from single-employer plans in the following aspects:

1. Assets contributed to the multiemployer plan by one employer may be used to provide benefits to employees of other participating employers.

2. If a participating employer stops contributing to the plan, the unfunded obligations of the plan may be borne by the remaining participating employers.

3. If the Company chooses to stop participating in some of its multi-employer plans, the Company may be required to pay those plans an amount based on the underfunded status of the plan, referred to as a withdrawal liability.

Entity A’s participation in these plans for the annual period ended December 31, 20X0, is outlined in the table below reflective of the following data:

EIN/Pension Plan Number: The “EIN/Pension Plan Number” column provides the Employee Identification Number (EIN) and the three-digit plan number, if applicable. Certified zone information: Unless otherwise noted, the most recent Pension Protection Act (PPA) zone status available in 20X0 and 20X9


is for the plan’s year-end at December 31, 20X9, and December 31, 20X8, respectively. The zone status is based on information that Entity A received from the plan and is certified by the plan’s actuary. Among other factors, plans in the red zone are generally less than 65 percent funded, plans in the yellow zone are less than 80 percent funded, and plans in the green zone are at least 80 percent funded. One of the plans, Plan Fund 46, utilized an extended amortization provision that affects the calculation of the zone status.FIP/RP status: The “FIP/RP Status Pending/Implemented” column indicates plans for which a financial improvement plan (FIP) or a rehabilitation plan (RP) is either pending or has been implemented. The last column lists the expiration date(s) of the collective-bargaining agreement(s) to which the plans are subject.

The number of employees covered by Entity A’s multiemployer plans de-creased by five percent from 20X9 to 20X0, affecting the period-to-period comparability of the contributions for years 20X9 and 20X0. The significant reduction in covered employees corresponded to a reduction in overall busi-ness. There have been no significant changes that affect the comparability of 20X8 and 20X9 contributions.

Each multiemployer pension plan requires the Company to contribute to the plan a fixed contracted amount per hour worked by each employee covered by the collective-bargaining agreements. In future periods, the Company is not required to make any minimum contributions by the collective-bargaining agreements or by statutory or other contractual obligations except that Fund 73 has a minimum annual contribution requirement of $1 million.

Legal name of Pension Fund

EIn/Pension Plan

number

Pension Protection ActCertified Zone Status Contributions of Entity A FIP/rP

Status Pending/

Implemented

Surcharge paid to

the plan

Expiration Date of

Collective-bargaining Agreement20x0 20x9 20x0 20x9 20x8

Plans for which plan financial information is publicly available outside Entity A’s financial statements:

fund 34 32-1899999 red as of 9-30-X9

Yellow as of 9-30-X8

$1,883,000 $2,309,000 $2,226,000 Yes Yes 12-31-20X13

fund 37 52-5599999-002 Green Yellow 3,342,000 3,609,000 3,586,000 no no 12-31-20X12 to 12-31-20X13 (a)

fund 40 92-3499999 Yellow Yellow 5,798,000 6,435,000 6,374,000 no no 12-31-20X15

fund 43 82-4299999 red red 3,539,000 3,234,000 3,218,000 Pending Yes 12-31-20X14fund 46 (b) 82-6899999 Green Green 778,000 816,000 833,000 no no 12-31-20X13fund 49 52-6199999 Yellow Yellow 534,000 547,000 491,000 no no 12-31-20X12fund 52 72-8599999-001 red Green 1,349,000 1,134,000 1,050,000 Implemented no 12-31-20X15fund 55 82-2999999 Green Green 1,224,000 1,046,000 1,151,000 no no 12-31-20X14other funds, individually not significant [(3)(a)] 147,000 160,000 169,000

Plans for which plan financial information is not publicly available outside Entity A’s financial statements:

fund 61 (c) n/A n/A n/A 418,000 482,000 491,000 n/A n/A 12-31-20X12fund 73 (d) n/A n/A n/A 1,872,000 1,764,000 1,693,000 n/A n/A 12-31-20X12

total contributions $20,884,000 $21,536,000 $21,282,000


(a) Entity A is party to two significant collective-bargaining agreements that require contributions to Fund 37. Agreements D and E expire on 12/31/20X12, and 12/31/20X13, respectively. Of the two, Agreement D is more significant because 70 percent of Entity A’s employee participants in Fund 37 are covered by that agreement. Agreement E also is significant because its participants are involved in multiple projects that Entity A is scheduled to start in 20X14.

(b) Fund 46 utilized the special 30-year amortization rules provided by Public Law 111-192, Section 211 to amortize its losses from 20X8. The plan recertified its zone status after using the amortization provisions of that law.

Plans for which plan level information is not available in the public domain:

Entity A has two plans, Funds 61 and 73, for which plan level informa-tion is not publicly available. Following is additional information about each of these two plans:

(c) ABC Fund 61: Plan information for Fund 61 is not publicly available. Fund 61 provides fixed, monthly retirement payments on the basis of the credits earned by the participating employees. To the extent that the plan is underfunded, the future contributions to the plan may increase and may be used to fund retirement benefits for employees related to other employers who have ceased operations. Entity A could be assessed a withdrawal liability in the event that it decides to cease participating in the plan. Fund 61’s financial statements for the years ended June 30, 20X0 and 20X9 indicated total assets of $62 million and $51 million, respectively; total actuarial present value of accumu-lated plan benefits of $120 million and $110 million, respectively; and total contributions for all participating employers of $9 million and $8 million, respectively. The plan’s financial statements for the plan years ended June 30, 20X0 and 20X9 indicate that the plan was less than 65 percent funded in both years.

(d) ABC Fund 73: Plan information for Fund 73 is not publicly available. Fund 73 provides fixed retirement payments on the basis of the credits earned by the participating employees. However, in the event that the plan is underfunded, the monthly benefit amount can be reduced by the trustees of the plan. Entity A is not responsible for the underfunded status of the plan because Fund 73 operates in a jurisdiction that does not require withdrawing participants to pay a withdrawal liability or other penalty. Entity A is unable to provide additional quantitative information on the plan because Entity A is unable to obtain that information without undue cost and effort. The collective-bargaining agreement of Fund 73 requires contributions on the basis of hours worked. The agreement also has a minimum contribution requirement of $1 million each year.


Entity A was listed in its plans’ most recently available Forms 5500 as providing more than five percent of the total contributions for the following plans and plan years:

Pension Fund Year Contributions to Plan Exceeded More Than Five Percent of Total Contributions (as of December 31 of the Plan’s Year-End)

ABC fund 34 20X9 and 20X8ABC fund 43 20X8ABC fund 52 20X8ABC fund 61 20X9

At the date the financial statements were issued, Forms 5500 were not avail-able for the plan years ending in 20X0.

-End of disclosure-

Transition related to ASU 2011-09The amendments in ASU 2011-09 shall be applied in annual periods for fiscal years ending after December 15, 2011, except for nonpublic entities, which shall apply the amendments in annual periods for fiscal years ending after December 15, 2012. In the period of initial adoption, the reporting entity shall provide for comparative purposes for any previous periods pre-sented the disclosures required by ASU 2011-09. Earlier application of the amendments in the ASU is permitted.

STUDY QUESTIOnS

3. If plan level information is not available in the public domain, which of the fol-lowing is additional information that an employer must disclose?

a. Plan information in form 5500A b. A qualitative description of the extent to which the employer could be re-

sponsible for the obligations of the planc. A quantitative analysis of the extent to which the employer could be respon-

sible for the obligations of the pland. A probability weighted analysis that provides the user with information as to

the likelihood that the employer might be exposed to additional loss

4. Which of the following statements is true in regards to the disclosure requirements under Asu 2011-09 as they relate to subsidiaries and not-for-profit entities?

a. Disclosure requirements for these entities are greatly expanded.b. full disclosures apply to subsidiaries but not to not-for-profit entities.c. selected disclosures are required for subsidiaries and not-for-profit entities.d. Both subsidiaries and not-for-profit organizations are exempt from the ad-

ditional disclosures required by Asu 2011-09.


UnFUnDED PEnSIOn PLAnS AnD THE LOADED PISTOL

The next crisis facing a U.S. bailout involves pension plans; namely single- and multiemployer pension plans, mostly involving union employees. In general, defined benefit plans involving both single- and multiemployer plans are grossly underfunded by as much as 50 percent of the total liability.

In March 2012, Credit Suisse published a report entitled, Crawling Out of the Shadows, in which it evaluated the pension data of 1,354 pension plans of large and small to medium-cap U.S. companies. The results were staggering:

Multiemployer plans cover approximately 10 million U.S. workers (seven percent of the workforce), and are partially insured by the Pension Benefit Guarantee Corporation (PBGC).Multiemployer plans are $428 billion underfunded (46 percent funded) with most of the underfunding belonging to companies outside the S&P 500.

Based on the most recent Form 5500 filings, multiemployer plans reported an unfunded liability of only $(101) billion as compared with Credit Suisse’s $(428) billion. (Note: Most plans have been in underfunded status since at least 2008.)

The underfunding is heavily weighted in the construction, transports, supermarkets, and mining industries.Companies could be adversely affected by the extreme underfunding by increased contribution requirements, difficult labor negotiations, higher withdrawal liabilities, and weaker credit ratings. Multiemployer plans are playing games with the actuarial computations of plan funded status, using an average expected rate of return on assets of 7.5 percent, which is significantly higher than the actual return of high-grade investments.The pension shortfalls are affecting not only large cap companies, but also mid- to small-cap ones.

Credit Suisse recomputed the funded status of 1,354 of a total of 1,459 multiemployer plans that are insured by the PBGC, by using the fol-lowing assumptions:

The pension liabilities and assets were computed at fair value instead of actuarial value.The expected rate of return used by Credit Suisse was 4.7 percent (re-turn on high-grade corporate bonds), instead of 7.5 percent used in the actuarial computations.


Funded Status of Multi-Employer Plans (based on 1,354 sample)

In billions

reported Actuarial basis (Form 5500)

recomputed by Credit Suisse

Assets $426 $360 Liabilities (527) (788)net position $(101) $(428) % funded 81% 46%

Source: Credit Suisse

The Pension Protection Act of 2006 established zones for evaluating the funded status of pension plans, using the following system:

Color Zone % funded Additional contributions

Green (Healthy)

> 80% funded none

Yellow (Endangered)

65-80% or

the plan has an accumu-lated funding deficiency or is expected to have one during any of the next six years.

Funding Improvement Plan required:n Must increase future contributions and/or re-

duce future pension benefit accruals to improve the plan’s health, and

n funded status must improve by one third within 10 years.

orange (seriously Endangered)

65-80% and

the plan has an accumu-lated funding deficiency or is expected to have one during any of the next six years.

Funding Improvement Plan required:n Must increase future contributions and/or re-

duce future pension benefit accruals to improve the plan’s health, and

n funded status must improve by one fifth within 15 years.

red (Critical)

< 65% funded Rehabilitation Plan required:n Must increase future contributions and/or re-

duce future pension benefit accruals to improve plan’s health.

n Can also cut previously earned “adjustable” benefits (e.g., early retirement).

n Plan must emerge from critical condition within 10 years



Credit Suisse reported that the top 10 multiemployer plans are significantly underfunded as compared with the reported funded status in their 2010 Form 5500 filings:

Top 10 Largest Multi-Employer Pension PlansFunded Status—2010

reported % funded

recomputed % funded(Credit Suisse)

Central states, southeast and southwest Areas Pension Plan 63% 39%Western Conference of teamsters Pension Plan 89% 56%Central Pension fund of the IuoE & Participating Employers 86% 45%Participating Employers national Electrical Benefit fund 86% 47%Boilermaker-Blacksmith national Pension trust 80% 44%1199 sEIu Health Care Employees Pension fund 100% 50%I.A.M. national Pension Plan 108% 58%new England teamsters & trucking Industry Pension 52% 25%Plumbers And Pipefitters national Pension fund 68% 37%Bakery & Confectionery union & Industry International Pension fund 87% 46%

Source: Credit Suisse based on Form 5500 Filings

Funded Status— by Percentage

% Funded ZonePer Form 5500 Filings

recomputed(Credit Suisse) % of plans

> 100% (Green)Healthy>80

218 21

4%90-100% 256 980-90% 378 29

65-80%(Yellow and orange)Endangered or seriously Endangered

309 114 8%

55-65%

< 65% red (Critical) Zone

116 246

88%45-55% 50 42535-45% 13 37125-35% 4 112< 25% 8 25rounding 2 2

1,354 1,354


ObSErvATIOn

once the pension plan status was recomputed at fair value, only four percent of plans were in the Green Zone (healthy), while 88 percent were in the red Zone (critical).

What Happens If Companies Cannot Fund Their Funding Shortfalls?One of the most pervasive issues related to multiemployer plans is that em-ployers are jointly liable for the plan liabilities. That means if one company fails to pay its obligations, the remaining employers must pay the shortfall. It


is sometimes referred to as the “last man standing” principle. If there are five employers in a multiemployer plan and four are defunct, the fifth remaining employer is liable for the entire unfunded status of the plan. Yet, prior to the new disclosures required by ASU 2011-09, companies were not required to disclose their risk of joint liability for the plan obligations.

Who Is Going to Pay for the Pension Shortfall If Employers Cannot?Take your pick:

The U.S. Government as part of a bailout The Pension Benefit Guaranty Corporation Both of the above

The first line of defense in funding deficient pension plans (including multiemployer and single-employer plans) is the PBGC. The PBGC bails out defunct defined benefit pension plans, including single- and multi-employer plans. But who will bail out the PBGC? For the past few years, the PBGC has had negative funding positions and significant exposure for future bailouts. Congress will likely have to subsidize the PBGC in the next few years.

Part of the problem is that the PBGC only guarantees benefits up to $12,870 per employee per year, which is not enough to fund most of the overall shortfalls.

Based on the latest data published, as of its 2012 fiscal year end, the PBGC’s financial position shows a deficit of $(29.1) billion, with overall exposure of $(322) billion for potential claims for both single- and multi-employer plans.

September 30

PBGC status: (In billions)

2012 2011

Assets $83.0 $78.9Liabilities (112.1) (102.2)net position $(29.1) $(23.3)

Possible exposure $(322.0) $(250.0)

Source: PBGC, 2012 Annual Management Report, November 2012

At September 30, 2012, the PBGC had exposure to fund defunct pension plans in the amount of $322 billion, consisting of $295 billion related to single-employer plans, and $27 billion related to multiemployer plans.

A large portion of the $322 billion of possible exposure was concentrated in the manufacturing and transportation industries.


On one side, the PBGC is simply not receiving the cash flow needed to function as fewer plans are available to pay it fees. On the other side, companies (in particular those in older, established, union-based businesses) have learned how to play the bankruptcy game as a method to eliminate two burdens: union contracts and large unfunded pension obligations. Upon filing bankruptcy, companies can shift the pension shortfall to PBGC with no recourse. Classic examples of such strategies have occurred in the airline industry. All it takes is one company with a sizeable unfunded pension plan to turn PBGC upside down.

The U.S. Government to the rescue?There is no surprise that Congress has been lobbied by the various unions for it to approval a bailout of the pension liabilities for multiemployer plans. Since most of the multiemployer plans involve union employees, the union lobbies are extensive. There have been several bills proposed in Congress that would provide for the U.S. taxpayer to fund or guarantee the funding of the multiemployer plan deficits after the PBGC pays its share of the losses. To date, nothing has passed.

In addition, Congress may be required to bail out the PBGC for other shortfalls related to single-employer plans.

Consider a rough computation of the total unfunded obligation that could exist between single-and multiemployer plans along with the PBGC that could require U.S. taxpayer bailout:

(In billions)

Multiemployer plans: funding deficiency $(428) billion x 88% in the red Zone $(377)

single-employer plans: Potential exposure per PBGC (295)

total potential exposure $(672)Assets in PBGC 83 net exposure to bailout $(589)

In looking at the above table, if one considers that portion of the multiem-ployer plans that is in Red Zone status (< 65 percent funded), along with the PBGC’s exposure to single-employer plan deficiencies, the net potential exposure to bail out the plans could be $(589) billion. The PBGC has only $83 billion of assets as of its 2012 financial statements.


STUDY QUESTIOnS

5. According to the Credit suisse report on multiemployer plans, which of the fol-lowing is true?

a. Multiemployer plans continue to be overfunded due to a strong stock market.b. Multiemployer plans cover approximately 50 percent of the workforce.c. Multiemployer plans are grossly underfunded.d. Most multiemployer plans have been overfunded for several years.

6. If an entity’s pension plan is 86 percent funded, which color zone does the plan fall into as defined by the Pension Protection Act?

a. Yellowb. Greenc. oranged. Pink

97


Changes Coming with Lease accounting

Since the Sarbanes-Oxley Act became effective, the FASB has focused on standards that enhance transparency of transactions and that eliminate off-balance-sheet transactions. Accounting for leases is one of the areas that the FASB has concentrated on. An exposure draft issued in 2010 entitled, Leases (Topic 840), would replace existing lease accounting rules found in ASC 840 and its counterpart in Europe, IASB No. 17.

This chapter discusses the changes that would be made to accounting for leases based on the exposure draft, and the effects those changes may have.

LEArnInG ObjECTIvES


Discuss the changes that will be made under the proposed lease standardDescribe how lessees would account for leases under the new standardList the items that are considered part of the lease payment under the new standardExplain how the lessee calculates the liability for a lease under the new standardstate how existing leases will be handled when the new statement is adoptedDiscuss the effect the new standard may have on future lease termsExplain how the new standard may affect book/tax differences, EBItA, and debt-equity ratios

bACkGrOUnD

Under current GAAP, ASC 840, Leases (formerly FAS 13), divides leases into two categories: operating and capital leases. Capital leases are capital-ized while operating leases are not. In order for a lease to qualify as a capital lease, one of four criteria must be met:

The present value of the minimum lease payments must equal or exceed 90 percent or more of the fair value of the asset.The lease term must be at least 75 percent of the remaining useful life of the leased asset.There is a bargain purchase at the end of the lease.There is a transfer of ownership.

In practice, it is common for lessees to structure leases to ensure they do not qualify as capital leases, thereby removing both the leased asset and obligation from the lessee’s balance sheet. This approach is typically used by restaurants, retailers, and other multiple-store facilities.


ExAMPLE

Lease 1: the present value of minimum lease payments is 89 percent of the fair value of the asset and the lease term is 74 percent of the remaining useful life of the asset.

Lease 2: the present value of minimum lease payments is 90 percent of the fair value of the asset or the lease term is 75 percent of the remaining useful life of the asset.

Lease 1 is an operating lease not capitalized, while Lease 2 is a capital lease under which both the asset and lease obligation are capitalized.

THE SEC PUSHES TOWArD CHAnGES In LEASE ACCOUnTInG

In its report entitled Report and Recommendations Pursuant to Section 401(c.) of the Sarbanes-Oxley Act of 2002 On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuer, the SEC targeted lease accounting as one of the areas that resulted in significant liabilities being off-balance-sheet.

According to the SEC Report focused on U.S. public companies: Sixty-three percent of companies record operating leases while 22 percent record capital leases.Companies have approximately $1.25 trillion in operating lease obliga-tions that are off-balance-sheet.

Moreover, 70 percent of all leases held by U.S. public companies involve the leasing of real estate (CFO.com).

In its Report, the SEC noted that because of ASC 840’s bright-line tests (90 percent, 75 percent, etc.), small differences in economics can completely change the accounting (capital versus operating) for leases.

Keeping leases off the balance sheet while still retaining tax benefits is an industry unto itself. So-called synthetic leases are commonly used to maximize the tax benefits of a lease while not capitalizing the lease for GAAP purposes. In addition, lease accounting abuses have been the focus of restatements with approximately 270 companies, mostly restaurants and retailers restating or adjusting their lease accounting in the wake of Section 404 implementation under Sarbanes-Oxley.

Retailers have the largest amount of operating lease obligations outstanding that are not recorded on their balance sheets, as noted in the following table:Operating Leases Outstanding-Major retailers

retailerLease Obligations (in thousands)

office Depot Inc $1,104Walgreens Co. 27,434Cvs 38,917Whole foods 6,322sears 7,608


M o d u l e 2 — C h a p t e r 5 — C h a n g e s C o m i n g W i t h l e a s e a c c o u n t i n g 99

FASb-IASb LEASE PrOjECT

Since the Sarbanes-Oxley Act became effective, the FASB has focused on standards that enhance transparency of transactions and that eliminate off-balance-sheet transactions, the most recent of which was the issuance of ASC 810, Consolidation of Variable Interest Entities (formerly FIN 46R). The FASB added to its agenda a joint project with the IASB that would replace existing lease accounting rules found in ASC 840 and its counterpart in Europe, IASB No. 17. The FASB and IASB started deliberations on the project in 2007, and issued a discussion memorandum in 2009, following by the issuance of an exposure draft in 2010 entitled, Leases (Topic 840). The FASB and IASB have agreed to make further edits to the 2010 exposure draft to be incorporated in a second exposure draft to be issued in 2013.

Conclusions reached by the FASB and IASB include a key change under which most leases would be treated as capital leases, thereby eliminating use of the operating lease concept.

Following are some of the changes that the FASB and IASB have included it their proposed new lease model.

SCOPE

The proposed standard would apply to leases. An entity would determine whether a contract contains a lease on the basis of the substance of the con-tract, by assessing whether:

The fulfillment of the contract depends on the use of a specified asset, and The contract conveys the right to control the use of a specified asset for a period of time.

nOTE

A contract would convey the right to control the use of an asset if the customer has the ability to direct the use, and receive the benefit from use, of a specified asset throughout the lease term.

A “specified asset” refers to an asset that is explicitly or implicitly identifiable. A physically distinct portion of a larger asset of which a customer has exclusive use is a specified asset. A capacity portion of a larger asset that is not physically distinct (e.g., a capacity portion of a pipeline) is not a specified asset.

A lease and a sublease would be accounted for as separate lease transactions.

The proposed statement would replace ASC 840and IAS 17 in countries using international financial reporting standards.

The bright-line test based on four requirements for capitalizing a lease under ASC 840 (e.g., 90 percent rule, 75 percent rule, etc.) would be eliminated.The capital versus operating lease concept would be eliminated.


The following leases would not be within the scope of the leases standard:Leases of intangibles Leases for the right to explore for use of minerals, oil, natural gas, and similar non-regenerative resourcesLeases of biological assets, including (U.S. GAAP only) timber

nOTE

the fAsB has not determined whether leases of internal-use software in accordance with subtopic 350-40, Intangibles–Goodwill and Other Internal-Use Software, would be included within the scope of the proposed lease standard.

Most existing operating leases would be brought onto the balance sheet. For certain leases, income tax expense would be front-loaded as there would be a shift from straight-line rent expense to interest expense and amortization expense of the leased asset.

METHOD USED UnDEr THE PrOPOSED STAnDArD

Both the lessees and lessors would use the “right-of-use” model to account for all leases (including leases of right-of-use assets in a sublease).Under the right-of-use model a lessee and lessor would be required to:

Recognize and initially measure lease assets and lease liabilities at the date of commencement of the leaseUse a discount rate calculated at the date of commencement when initially measuring lease assets and lease liabilities

The discount rate to be used by lessees and lessors would be as follows:The lessee would use the rate the lessor charges the lessee when that rate is available; otherwise, the lessee would use the lessee’s incremental borrowing rate.The lessor would use the rate the lessor charges the lessee.

nOTE

the rate the lessor charges the lessee could be the lessee’s incremental borrowing rate, the rate implicit in the lease or for property leases, and the yield on the property. When more than one indicator of the rate that the lessor charges the lessee is available, the rate implicit in the lease should be used.

Lessees and lessors would capitalize initial direct costs by adding them to the carrying amount of the right-of-use asset (lessee) and the right


to receive lease payments (lessor), respectively. Initial direct costs are defined as costs that are directly attributable to negotiating and arrang-ing a lease that would not have been incurred had the lease transaction not been made.The proposed standard would include guidance on:

Accounting for costs incurred and lease payments made by the lessee before the date of commencement of a leaseA lessee would deduct all lease incentives provided by the lessor to the lessee from the initial measurement of the right-of-use asset.

STUDY QUESTIOnS

1. under existing GAAP—Leases (AsC 840), in order for a lease to qualify as a capi-tal lease, which one of the following conditions must be satisfied?

a. the future value of the minimum lease payments must be equal to or exceed 75 percent or more of the fair value of the asset.

b. the lease term must be no more than 50 percent of the remaining useful life of the leased asset.

c. there must be a bargain purchase at the end of the lease.d. there must not be a transfer of ownership.

2. Which of the following models does the proposed lease standard include?

a. right-of-use modelb. operating lease modelc. Capital lease modeld. true lease model

LESSEE ACCOUnTInG

The proposed standard would require a lessee to do the following: At the inception of the lease, the lessee would recognize an asset and corresponding liability at the present value of the lease payments during the lease term, using a discount rate.

Asset: Lessee would recognize an asset for the lessee’s right to use the leased asset (right-of-use asset) for the lease term. The asset would be measured at the present value of the lease payments over the lease term, plus any initial direct costs incurred by the lessee. Initial direct costs would be included in the lease asset that is recorded at inception.Liability: Lessee would recognize a liability to make lease payments at the present value of the lease payments using a discount rate over the lease term.

Lessee would account for expense using one of the following two ap-proaches determined at the commencement of the lease:


Approach 1: Interest and Amortization (I&A) ApproachThis approach would apply to leases of other than property (such as equip-ment) unless either of the following is true:

The lease term is an insignificant portion of the economic life of the underlying asset.The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

nOTE

If the I&A Approach is not applicable because the lease term is an insignificant portion of the economic life of the underlying asset, or the present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset, then the company should use the other approach, the straight- Line Expense (sLE) Approach (discussed below).

Using the I&A Approach, the lessee would:Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease payments.Subsequently measure the liability to make lease payments using the effective interest method.Amortize the right-of-use asset on a systematic basis that reflects the pat-tern of consumption of the expected future economic benefits.Recognize interest expense and amortization expense separately in the income statement.

The following items would be recognized on the lessee’s income statement:Amortization expense, based on amortizing the right-of-use asset over the expected lease term or the useful life of the underlying asset, if shorterInterest expense on the lease payments on the liabilityAny changes in the liability resulting from reassessment of the expected amount of contingent rentals or expected payments under term option penalties and residual value guaranteesAny impairment losses on a right-of-use asset

Approach 2: Straight-Line Expense (SLE) ApproachThis approach would apply to leases of property (land or a building—or part of a building—or both) unless either of the following is true:

The lease term is for the major part of the economic life of the underly-ing asset.The present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.


nOTE

If the sLE approach is not applicable because the lease term is for a major part of the economic life or the present value of the lease payments account for substantially all of the fair value of the underlying asset, then the company would use the I&A Approach.

Using the SLE Approach, the lessee would:Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease payments.Subsequently measure the liability to make lease payments using the effective interest method.Measure the right-of-use asset each period as a balancing figure such that the total lease expense would be recognized on a straight-line basis, regardless of the timing of lease payments.Recognize lease expense as one amount on the income statement (consist-ing of the combination of interest expense and amortization expense).

The following item would be recognized on the lessee’s income statement:Lease expense (combined interest and amortization expense)

LESSOr ACCOUnTInG

At the inception of the lease, a lessor would distinguish between leases to which the Receivable and Residual Approach applies, and leases to which an Operating Lease Approach applies using the same criteria as noted for lessee accounting.

Approach 1: receivable and residual ApproachA lessor would apply the Receivable and Residual Approach to leases for which the lessee acquires and consumes more than an insignificant portion of the underlying asset over the lease term.

For all lease contracts within the scope of the receivable and residual approach, a lessor would:

Initially measure the right to receive lease payments at the present value of the lease payments, discounted using the rate the lessor charges the lessee, and subsequently measure at amortized cost applying an effective interest method. Initially measure the residual asset as an allocation of the carrying amount of the underlying asset. The initial measurement of the residual asset comprises two amounts:

The gross residual asset, measured at the present value of the estimated residual value at the end of the lease term discounted using the rate the lessor charges the lessee


The deferred profit, measured as the difference between the gross residual asset and the allocation of the carrying amount of the un-derlying asset

Subsequently measure the gross residual asset by accreting to the estimated residual value at the end of the lease term using the rate the lessor charges the lessee. The lessor would not recognize any of the deferred profit in profit or loss until the residual asset is sold or re-leased.Present the gross residual asset and the deferred profit together as a net residual asset.

When applying the Receivable and Residual Approach, a lessor would measure the underlying asset as the sum of the carrying amount of the lease receivable (after any impairment) and the net residual asset when re-recognizing the underlying asset on termination of the lease before the end of the lease term.

Approach 2: Operating Lease ApproachFor all leases not within the scope of the Receivable and Residual Approach, a lessor would continue to recognize the underlying asset and recognize lease income over the lease term.

LEASE TErM USED bY LESSEE AnD LESSOr

Assets and liabilities recognized by lessees and lessors would be measured based on the following rules:

The present value of lease payments over the lease term would be used by estimating the probability of occurrence for each possible term, taking into account the effect of any options to extend or terminate the lease.The lease term would include not only the non-cancellable lease period, but also any options to extend or terminate if the lessee has a significant economic incentive to exercise the option.

Lease term: (for both lessees and lessors) is defined as:

… the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any op-tions to extend or terminate the lease when there is a significant economic incentive for the lessee to exercise an option to extend the lease, or for the lessee not to exercise an option to terminate the lease.

nOTE

A lessee and a lessor should reassess the lease term only when there is a significant change in relevant factors such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.


ExAMPLE

Determining the Lease Term

Company X has a lease that has a non-cancellable 10-year term and an option to renew for five years at the end of the 10 years. Because X has made significant improvements to the leased premises and is located in a strategic location, there is a significant economic incentive for X to exercise its five-year option.

Because X has a significant economic incentive to renew the lease, the lease term is 15 years (10 years plus the five-year option). therefore, at inception of the lease, X would measure a lease asset and related liability based on the present value of all the lease payments for the 15-year period.

ObSErvATIOn

the lessee and lessor each would evaluate their lease term independent of each other. that means that with respect to a lease that has lease options, the lessee may have a lease term that is different than the lessor’s lease term solely because the lessee evaluates the likelihood that it will renew its lease options differently than the lessor does.

LEASE PAYMEnTS

In determining lease payments used to measure the lease asset and liability, such payments would include any of the following that is specified in the lease:

Contingent rentals Variable lease payments Term option penalties Residual value guarantees Purchase options

Lease payments include the following elements:Contingent rentals: Lease payments that arise under the contractual terms of a lease because of changes in facts or circumstances occurring after the date of inception of the lease, other than the passage of timeVariable lease payments: Lease payments that arise under the contractual terms of a lease because of changes in facts or circumstances occurring after the date of inception of the lease, other than the passage of timeResidual value guarantees: (for both the lessee and lessor) amounts expected to be payable under residual value guarantees (exclusive of amounts pay-able under guarantees provided by an unrelated third party)Term option penalties: Penalties the lessee is required to pay if a lessee does not renew the lease and the renewal period has not been included in the lease term


Purchase options: Lessees and lessors should include the exercise price of a purchase option (including bargain purchase options) in the mea-surement of the lessee’s liability to make lease payments and the lessor’s right to receive lease payments, if the lessee has a significant economic incentive to exercise the purchase option. If the lessee has a significant economic incentive to exercise the purchase option, the right-of-use asset recognized by the lessee should be amortized over the economic life of the underlying asset, rather than over the lease term.

ObSErvATIOn

the first exposure draft did not include the purchase option in the lease payment and computation of the lease asset and liability measurement. Instead, in that first exposure draft, the fAsB proposed that a lease contract would be accounted for as a purchase by the lessee and a sale by the lessor only when the purchase option is exercised. In the second exposure draft, the fAsB will change the proposed rule to include the purchase option in the lease amount if the lessee has a significant economic incentive to exercise that option.

Accounting for the residual Asset When There are variable Lease PaymentsThe proposal would deal with variable lease payments received by a lessor as follows:

If the rate the lessor charges the lessee does not reflect an expectation of variable lease payments, the lessor would not make any adjustments to the residual asset with respect to variable lease payments.If the rate the lessor charges the lessee reflects an expectation of variable lease payments, the lessor would adjust the residual asset on the basis of its expectation of variable lease payments by recognizing a portion of the cost of the residual asset as an expense when variable lease payments are recognized in profit or loss. Any difference between actual and expected variable lease payments would not result in any further adjustment to the residual asset with respect to variable lease payments.

rEASSESSMEnT OF LEASE

Both the lessee and lessor would be required to reassess the lease and to update the assets, liabilities, and lease term when changes in facts and circumstances indicate that there would be a significant change in the assets and liabilities since the previous reporting period.

A lessee and lessor would be required to: Reassess the length of the lease term and amount of lease payments based on whether a lessee has a significant economic incentive to exercise:

An option to extend or terminate a lease, or An option to purchase the underlying asset.


nOTE

the threshold for evaluating a lessee’s economic incentive to exercise options to extend or terminate a lease and options to purchase the underlying asset should be the same for both initial and subsequent evaluation, except that a lessee and lessor should not consider changes in market rates after lease commencement when evaluating whether a lessee has a significant economic incentive to exercise an option.

Reassess the expected amount of any contingent rentals, expected pay-ments under term option penalties, residual value guarantees, or purchase options.

Changes in lease payments that are due to a reassessment in the lease term would result in:

A lessee adjusting its obligation to make lease payments and its right-of-use assetA lessor adjusting its right to receive lease payments and any residual asset, and recognizing any corresponding profit or loss (pending the Boards’ decision on lessor accounting)

STUDY QUESTIOnS

3. under the proposed lease standard, expense on the lessee’s income statement would consist of which of the following components under the I&A Approach?

a. rent expenseb. Interest and depreciation expensec. rent and interest expensed. Amortization and interest expense

4. How would options to extend be accounted for in determining the lease term under the proposed lease standard?

a. the lease term should take into account the effect of any options to extend the lease in certain cases.

b. Lease options are only considered once they are exercised.c. the proposed standard states that options are too vague and should not be

considered in determining the lease term.d. only certain options to extend within a short-term period are considered be-

cause it is difficult to estimate the likelihood of the options being exercised.


rEASSESSMEnT OF THE DISCOUnT rATE

The discount rate should not be reassessed if there is no change in the lease payments. The discount rate should be reassessed when the changes below are not reflected in the initial measurement of the discount rate:

When there is a change in lease payments that is due to a change in the assessment of whether the lessee has a significant economic incentive to exercise an option to extend a lease or to purchase the underlying assetWhen there is a change in lease payments that is due to the exercise of an option that the lessee did not have a significant economic incentive to exercise

nOTE

If there is reassessment of the discount rate, a lessee or lessor would determine a revised discount rate using the spot rate at the reassessment date and would then apply that rate to the remaining lease payments (e.g., to the remaining payments due in the initial lease plus the payments due during the extension period or upon exercise of a purchase option).

COnTrACT MODIFICATIOnS Or CHAnGES In CIrCUMSTAnCES AFTEr THE DATE OF InCEPTIOn OF THE LEASE

A modification to the contractual terms of a contract that is a substantive change to the existing contract would result in the modified contract being accounted for as a new contract. The change is a substantive change if it results in a different determination of whether the contract is or contains a lease.

A change in circumstances other than a modification to the contractual terms of the contract that would affect the assessment of whether a contract is, or contains, a lease would result in a reassessment as to whether the con-tract is, or contains, a lease.

SHOrT-TErM LEASES

A lessee would not be required to recognize lease assets or lease liabilities for short-term leases. A short-term lease is defined as follows:

… a lease that, at the date of commencement of the lease, has a maximum possible term, including any options to renew, of 12 months or less.

For short-term leases, the lessee would recognize lease payments as rent expense in the income statement on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern in which use is derived from the underlying asset.

A lessee would be permitted (but not required) to record a lease asset and liability for a short-term lease.


ObSErvATIOn

the second exposure draft will change the way in which short-term leases are accounted for. under the first exposure draft, an entity was permitted to record a lease asset and liability on an undiscounted basis, but was not allowed to record the lease as an operating lease. under the second exposure draft, a lessee that has a short-term lease of 12 months or less will be permitted to choose not to record the lease on the balance sheet and, instead, record the lease as an operating lease and recognize rent expense on a straight-line basis.

SALE AnD LEASEbACk TrAnSACTIOnS

A transaction would be treated as a sale and leaseback transaction only if the transfer meets the conditions for a sale of the underlying asset and proposes to use the same criteria for a sale as those used to distinguish between purchases or sales and leases. An entity would apply the control criteria described in the revenue recognition project to determine whether a sale has occurred.

When there is a sale-leaseback transaction, the transaction would be accounted for as a sale, and then a leaseback. If a sale has not occurred, the entire transaction would be accounted for as a financing arrangement.

STUDY QUESTIOn

5. Which of the following is correct as it relates to reassessing the discount rate under the proposed lease standard?

a. the discount rate should never be reassessed.b. the discount rate should not be reassessed if there is a change in the lease

payments.c. the discount rate should be reassessed when there is a change in lease pay-

ments due to a change in a variable payment.d. the discount rate should be reassessed when the lease payments have

changed due to the exercise of an option to extend a lease.

PrESEnTATIOn AnD DISCLOSUrE

The proposed standard would require a series of both qualitative and quan-titative disclosures.

Financial Statement Presentation—Lessee

Statement of Financial Position. On the statement of financial position, the lessee would present the assets, liabilities, income (or revenue), expenses, and cash flows arising from leases separately from other assets, liabilities, income, expenses, and cash flows.


The lessee would present the lease obligation separately from other financial liabilities on the face of the balance sheet.The right-of-use asset would be presented with Property, Plant, and Equip-ment (PP&E) (as if the underlying asset were owned), but separately from other assets that are owned but not leased. There would be no requirement to clarify whether the right-of-use asset is a tangible or an intangible asset even though the lease asset would be presented as part of PP&E.

nOTE

If right-of-use assets and liabilities to make lease payments are not separately presented in the statement of financial position, the disclosures would indicate in which line item in the statement of financial position the right-of-use assets and liabilities to make lease payments are included.

Statement of Comprehensive Income (Income). If the I&A Approach is used, lessee would present or disclose amortization and interest expense separately from other amortization and interest expense either on the face of the income statement or in the notes. Interest expense and amortization expense would not be combined and not presented as part of lease or rent expense.

If the SLE Approach is used, lessee would present or disclose one line entitled “lease expense” which is the combined total of interest and amor-tization expense.

Statement of Cash Flows. The statement of cash flows would:Classify or disclose cash paid for lease payments similar to how debt payments are handled:

Interest expense would be presented in operating activities.Principal portion would be presented in financing activities.

Classify cash paid for variable lease payments not included in the mea-surement of the liability to make lease payments as operating activities.Classify cash paid for short-term leases not included in the liability to make lease payments as operating activities.

Disclosures. The lessee would disclose the following:A reconciliation of the opening and closing balance of right-of-use assets, disaggregated by class of underlying assetA reconciliation of the opening and closing balance of the liability to make lease paymentsA maturity analysis of the undiscounted cash flows that are included in the liability to make lease payments, showing the undiscounted cash flows to be paid in each of the first five years after the reporting date, and a total of the amounts for the years thereafter. The analysis would reconcile to the liability to make lease payments.


Information about the principal terms of any lease that has not yet com-menced if the lease creates significant rights and obligations for the lesseeAll expenses relating to leases recognized in the reporting period in a tabular format, disaggregated into: (a) amortization expense; (b) interest expense; (c) expense relating to variable lease payments not included in the liability to make lease payments; (d) expense for those leases for which the short-term practical expedient is elected, to be followed by the principal and interest paid on the liability to make lease payments; and (e) lease expenseQualitative information to indicate if circumstances or expectations about short-term lease arrangements are present that would result in a material change to the expense in the next reporting period as compared with the current reporting periodThe future contractual commitments associated with services and other non-lease components that are separated from a lease contract.The expense recognized in the reporting period for variable lease pay-ments not included in the liability to make lease paymentsThe acquisition of a right-of-use asset in exchange for a liability to make lease payments as a supplemental noncash transaction disclosure

Financial Statement Presentation—Lessor

Statement of Financial Position. The lessor would present the lease receiv-able and the residual asset separately in the statement of financial position summing to a total “lease assets,” or present the lease receivable and residual asset in the statement of financial position as “lease assets,” with those two amounts disclosed in the notes to the financial statements.

Statement of Comprehensive Income (Income). Lessor would present:The accretion of the residual asset as interest incomeThe amortization of initial direct costs as an offset to interest incomeLease income and lease expense (e.g., revenue and cost of sales) in the statement of comprehensive income either in separate line items (gross) or in a single line item (net), on the basis of which presentation best reflects the lessor’s business model

nOTE

A lessor would separately identify income and expenses arising from leases by either separate presentation in the statement of comprehensive income or disclosure in the notes to the financial statements. If disclosed, the notes would reference the line item in which the income is presented.

Statement of Cash Flows. A lessor would classify the cash inflows from a lease as operating activities in the statement of cash flows.


Disclosures. The lessor would disclose the following:A table of all lease-related income items recognized in the reporting period disaggregated into: (a) profit, recognized at lease commencement (split into revenue and cost of sales if that is how the lessor has presented the amounts in the statement of comprehensive income); (b) interest income on the lease receivable; (c) interest income on the residual asset; (d) variable lease income; and (e) short-term lease incomeInformation about the basis and terms on which variable lease payments are determinedInformation about the existence and terms of options, including for renewal and terminationA qualitative description of purchase options in leasing arrangements, including information about the extent to which the entity is subject to such agreementsA reconciliation of the opening and closing balance of the right to receive lease payments and residual assetsA maturity analysis of the undiscounted cash flows that are included in the right to receive lease payments showing, at a minimum, the undis-counted cash flows to be received in each of the first five years after the reporting date and a total of the amounts for the years thereafter. The analysis would reconcile to the right to receive lease payments.Information about how the entity manages its exposure to the underlying lease asset, including: (a) its risk management strategy in this respect, (b) the carrying amount of the residual asset that is covered by residual value guarantees, and (c) whether the lessor has any other means of re-ducing its exposure to residual asset risk (e.g., buyback agreements with the manufacturer from whom the lessor purchased the underlying asset; options to put the underlying asset back to the manufacturer)Other disclosures for lessors with leases of investment property

STUDY QUESTIOn

6. the proposed lease standard would provide additional disclosures consisting of _________________ information on leases.

a. Qualitative onlyb. Quantitative onlyc. Both qualitative and quantitatived. Abbreviated


TrAnSITIOn—ExISTInG LEASES

Existing leases would not be grandfathered, thereby requiring existing op-erating leases to be brought onto the balance sheet. All existing outstanding leases would be recognized and measured at the date of initial application using a simplified retrospective approach.

EFFECTIvE DATE

A final statement should be issued in 2013 or early 2014, with an effective date sometime in 2015.

Comparison of Existing GAAP versus Proposed GAAP for Leases

Description Current GAAP for Operating Leases Proposed GAAP

Lease type Leases are classified as operating or capital leases (financing arrangements) based on satisfying one of four criteria:n 75% rulen 90% rulen Bargain purchasen transfer of ownership

All leases are classified as financing arrangements (as if purchases)

Lease asset and lease obligation are recorded at present value of payments over the lease term.

Lease term non-cancellable periods

option periods generally are not included in lease term.

Lease term is defined as the non-can-cellable period, together with any op-tions to extend or terminate the lease when there is a significant economic incentive for the lessee to exercise an option to extend the lease.

Contingent rents are excluded from lease payments. When paid, they are period costs.

Contingent rents (variable rents) are included in lease payments used to measure asset and liability.

Income statement

operating leases—lease expense, straight-line basis

Capital leases—depreciation and interest expense

two Approaches:

Interest & Amortization (I&A) Approach: Interest and amortization expense are recorded.

Straight-Line Expense (SLE) Approach: Lease expense is recorded as combina-tion of interest and amortization.

Assessment terms are not re-assessed. requirement that there be a continual re-assessment of renewal options and contingent rents and adjustments made to leases as needed.

THE IMPACT OF CHAnGES TO LEASE ACCOUnTInG

The proposed lease accounting changes would be devastating to many companies and would result in many more leases being capitalized, which would impact all financial statements. In particular, retailers would be af-fected the most. If leases of retailers, for example, are capitalized, the impact on financial statements would be significant, as noted below:


Lessee’s balance sheets would be grossed up for the recognized lease assets and the lease obligations for all lease obligations.

nOTE

Including contingent lease payments and renewal options may result in overstated li-abilities given the fact that contingent payments must be included in the lease payments, and renewal options must be considered in determining the lease term.

Lessee’s income statements would be adversely affected with higher lease expense in the earlier years of new leases. On average, a 10-year lease would incur approximately 15-20 percent higher annual lease expense in the earlier years, if capitalized, as compared with an operating lease. That higher lease amount would reverse in the later years. On the statement of cash flows, there would be a positive shift in cash from operations from cash from financing activities. A portion of rent expense previously deducted in arriving at cash from operations would now be deducted as principal payments in cash from financing activities. Thus, companies would have higher cash from operating activities and lower cash from financing activities.In most cases, lease expense for GAAP (interest and amortization) would not match lease expense for income tax purposes, thereby resulting in deferred income taxes.

Changes to both the balance sheets and income statements of companies would have rippling effects on other elements of the lessee companies. On the positive side, a lessee’s EBITDA may actually increase as there is a shift from rent expense under operating leases to interest and amortization expense under the proposed standard.

Both interest and amortization expenses are not deducted in arriving at EBITDA while rent expense is.Changes in EBIDTA may affect existing agreements related to compensa-tion, earn outs, bonuses, and commissions.

On the negative side, debt-equity ratios would be affected with entities car-rying significantly higher lease obligation debt than under existing GAAP. Higher debt-equity ratios could put certain loan agreements into default. Moreover, net income would be lower in the earlier years of the lease term due to higher interest and amortization expense replacing rental expense.

Following is an example that illustrates the differences between an exist-ing operating lease under existing GAAP as compared with the proposed standard.


Example 1: Company X is a retailer who enters into a lease for certain retail space located in a strip mall. The terms of the lease follow:

Five-year base lease: $10,000 per month for the first year plus five percent escalation per yearFirst five-year option: $15,000 per month plus five percent escalation per yearSecond five-year option: $20,000 per month plus five percent escalation per year

The following is a schedule of the lease payments.

Lease Payments Schedule

Year Monthly lease payment Annual lease payments

BAsE LEAsE:

1 $10,000 $120,000

2 10,500 126,000

3 11,025 132,300

4 11,576 138,915

5 12,155 145,861

fIrst oPtIon:

1 15,000 180,000

2 15,750 189,000

3 16,538 198,450

4 17364 208,373

5 18,232 218,791

sEConD oPtIon:

1 20,000 240,000

2 21,000 252,000

3 22,050 264,600

4 23,152 277,830

5 24,310 291,722

Total lease payments- 15-year period $ 2,983,841

Because the base lease is only five years and X has spent significant funds on leasehold improvements, X believes that it has a significant economic incentive to exercise both of its five-year options so that the total lease term is 15 years. The useful life of the leased real estate is 30 years. The lease term (potentially 15 years) is a major part of the economic life of the underlying leased real estate.


X does not know the implicit interest rate charged by the lessor in the lease. X’s incremental borrowing rate is six percent per year. Under the pro-posed standard, the lease must be capitalized as a right-of-use asset as follows:

Because X believes that it has a significant economic incentive to exercise both of its five-year options, the lease term is 15 years.The asset and liability are measured at the present value of the lease payments over the 15-year period, discounted at the six percent incre-mental borrowing rate. The six percent incremental borrowing rate is used because X does not know the implicit interest rate charged by the lessor in the lease.As to the way in which expense is recognized, X would use the I&A Method. Because the lease term (15 years) is for a major part of the economic life of the leased asset (30 years), the SLE Approach is not applicable. Therefore, X must use the I&A Approach.

Using the I&A Approach, X would:Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease payments.Subsequently measure the liability to make lease payments using the effective interest method.Amortize the right-of-use asset on a systematic basis that reflects the pat-tern of consumption of the expected future economic benefits.Recognize interest expense and amortization expense separately in the income statement.

The following items would be recognized on the lessee’s income statement:Amortization expense, based on amortizing the right-of-use asset over the expected lease term or the useful life of the underlying asset, if shorterInterest expense on the lease payments on the liabilityAny changes in the liability resulting from reassessment of the expected amount of contingent rentals or expected payments under term option penalties and residual value guaranteesAny impairment losses on a right-of-use asset

In this example, the present value of the lease payments, discounted at six percent per year, over the 15-year period is $1,806,705 (given) based on the following schedule:


Lease Amortization Schedule One 15-Year Lease Term

Annual lease payments

PrInCIPAL AnD InTErEST

PrincipalInterest

(6% per year) Total

BAsE LEAsE1 $120,000 $18,845 (b) $101,155 (b) $120,0002 126,000 16,386 109,614 126,0003 132,300 23,873 108,427 132,3004 138,915 32,146 106,769 138,9155 145,861 41,269 104,592 145,861

fIrst oPtIon1 180,000 78,908 101,092 180,0002 189,000 93,026 95,974 189,0003 198,450 108,478 89,972 198,4504 208,373 125,369 83,004 208,3735 218,791 143,811 74,980 218,791

sEConD oPtIon1 240,000 174,483 65,517 240,0002 252,000 197,580 54,420 252,0003 264,600 222,719 41,881 264,6004 277,830 250,056 27,774 277,8305 291,721 279,756 11,965 291,721

$2,983,841 $1,806,705 (a)

$1,177,136 $2,983,841

Entry to record the lease at inception:

YEar 1:

1 Lease asset (right-to-use asset) (a) 1,806,705 Lease obligation 1,806,705

2 Interest expense (b) 101,155 Lease obligation (b) 18,845 Cash, AP, (10,000 x 12 months) 120,000

3

Amortization expense(c) 120,447 Accumulated amortization- lease asset 120,447

(a) Present value of lease payments, 15 years, six percent.(b) see principal and interest schedule on previous page.(c) $1,806,705 /15 years straight-line basis = $120,447 amortization expense.

ObSErvATIOn

the lease in this example would be treated as an operating lease under existing GAAP. now, under the proposed standard, this lease would be capitalized as a financing transaction under which both an asset and liability are recorded using the present value of the lease payments over the 15-year lease term which, in this case, includes the lease option periods.


Once the asset and liability are computed at $1,806,705, the lease payments are recorded and split between principal and interest just like a loan related to an asset acquisition.

As to amortization, the proposal states that the lease is amortized on a systematic basis over the lease term or the useful life of the underlying asset, whichever is shorter. In this example, the 15-year lease term is less than the 30-year useful life of the building, thereby resulting in the 15-year term used for amortization. The author has chosen to amortize the asset on a straight-line basis. The proposal does allow for an alternative method of amortization such as an accelerated method provided it is done on a systematic basis.

How Does Capitalizing the Lease Impact the Financial Statements as Compared with an Operating Lease Under Existing GAAP?The impact of capitalizing this lease is significant to X for several reasons:

X has to bring onto its balance sheet a sizeable liability in the amount of $1,806,705 with a corresponding asset.Interest and amortization expense are recorded instead of rent expense.Balance sheet at the end of Year 1:

Company X balance Sheet

December 31, 20X1AssEts:

Property, Plant and Equipment: Equipment $XX Less: Accumulated depreciation XX total equipment XX

right-of-use lease assets (a) 1,806,705 Less: accumulated amortization 120,447 total right-to-use assets 1,686,258

total plant and equipment XX

LIABILItIEs:

Current liabilities: Current portion of long-term debt XX Current portion of right-of-use lease obligation (b) 16,386

Long-term liabilities: Long-term debt Long-term right-of-use lease obligation (b) (c) 1,771,474

(a) Proposed statement would require that the right-to-use (leased) asset be presented separately from owned assets within the property, plant and equipment section. the proposed statement does not appear to provide the option of making the segregation in the notes in lieu of on the balance sheet.

(b) the proposed statement would require that the lease obligation be presented separately from other debt on the balance sheet.

(c) $1,806,705 – first year principal payments $(18,845) less current portion of debt $(16,386) = $1,771,474.


Company X Statement of Income


net sales $XXCost of goods sold XXGross profit on sales XX

operating expenses: Interest expense XX Interest expense—right-of-use lease obligations (a) 101,155 Depreciation and amortization XX amortization expense—right-of-use lease assets (a) 120,447 Payroll and payroll-related expenses XX utilities XX rent XX office expenses XX sundry other expenses XX total operating expenses XX

net operating income XX

(a) the proposed statement requires that interest expense from the lease obligation and amor-tization expense related to right-of-use leased assets be separated from other interest and amortization expense. the proposed statement would allow the separation to be disclosed in the notes instead of the face of the income statement.

Company X Statement of Cash Flows


Cash flow from operating activities:net income (a) $XX

Adjustments to reconcile net income to cash from operating activities: XX Depreciation and amortization XX amortization expense—right-of-use leased assets (a) 120,447

Investing activities:

financing activities: repayments of long-term debt repayments of right-of-use lease obligations (18,845)

(a) Includes a deduction for interest expense on the lease obligation in the amount of $18,845.


What is the Overall Impact from Treating this Lease as a Capitalized right-of-Use Asset and Obligation Instead of a Straight Operating Lease?The impact of capitalizing this right-to-use lease is huge.

Take a look at the following table:

Comparison of Total Lease Expense Operating Lease (Existing GAAP) vs. right-to-Use (Capitalized) LeaseOne 15-Year Lease Term

OPErATInG LEASE ExPEnSE

(rEnT ExPEnSE)(1)

rIGHT-TO-USE LEASE ASSET- ExPEnSE

ExPEnSEDIFFErEnCE

Amortization expense

Interest expense Total expense

BAsE LEAsE1 $120,000 $120,447 $101,155 $221,602 $101,602 2 126,000 120,447 109,614 230,061 104,061 3 132,300 120,447 108,427 228,874 96,574 4 138,915 120,447 106,769 227,216 88,301 5 145,861 120,447 104,592 225,039 79,178

fIrst oPtIon 1 180,000 120,447 101,092 221,539 41,539 2 189,000 120,447 95,974 216,421 27,421 3 198,450 120,447 89,972 210,419 11,969 4 208,373 120,447 83,004 203,451 (4,922)5 218,791 120,447 74,980 195,427 (23,364)

sEConD oPtIon1 240,000 120,447 65,517 185,964 (54,036)2 252,000 120,447 54,420 174,867 (77,133)3 264,600 120,447 41,881 162,328 (102,272)4 277,830 120,447 27,774 148,221 (129,609)5 291,721 120,447 11,965 132,412 (159,309)

$2,983,841 $1,806,705 $1,177,136 $2,983,841 $ 0

(1) for purposes of this example, the author is assuming rent expense under existing GAAP is the same as the lease payment terms. GAAP actually requires that lease/rent expense on operating leases be recorded to expense on a straight-line basis. If the operating lease expense were presented on a straight-line basis, the conclusions reached would not change.

The previous chart illustrates one of the more profound impacts that the pro-posed standard would have on a lessee’s income statement. Because the lease is capitalized, rent expense that would have been the sole income statement item as an operating lease (under existing GAAP) is replaced with interest and amortization expense. There is a front-loading of interest expense and amortization expense so that many lessees would have higher total expense (interest and amortization) in the earlier years of the lease.

The following chart presents a comparison of total expense under an operating lease (rent expense) to total expense when the lease is capitalized under the proposed standard and there is interest expense and amortiza-tion expense.


350,000

300,000

250,000

200,000

150,000

100,000

50,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

totaL EXPEnSE—EXIStInG GaaP vS. ProPoSaLto

tal E

xpen

se

operating lease expense— existing GAAP

total interest/ amortization

Lease term (including options)

Notice the high total expense using the I&A Approach in the earlier years under the proposed standard, as compared with an existing operating lease under which rent expense is steady in the early years with gradual escalations during the lease term. If the I&A Approach is used, the longer the lease, the greater the gap between the two approaches at the beginning and end of the lease. Conversely, if the lease is shorter (e.g., lease option periods are not included), the spread between expense is not as sharp at the beginning and end of the lease.

STUDY QUESTIOn

7. Which of the following would probably be an effect of the proposed lease stan-dard?

a. the lessee’s income statement would have lower total lease expense in the earlier years of new leases.

b. there would be a negative shift in cash from operations from cash from financing activities in the statement of cash flows.

c. In most cases, total expense for GAAP would be the same as total expense for income tax purposes.

d. the lessee’s EBItDA may increase as there is a shift from rent expense to interest and amortization expense.

What Would Happen if the Previous Example had Contingent Lease Payments, a residual Guarantee, or an Option to Purchase?The proposed standard would require that contingent rentals, expected pay-ments under term option penalties, residual value guarantees, and purchase options that are specified in the lease be included in the computation of the lease asset and obligation.

As for a purchase option, in the first exposure draft, the FASB concluded that a purchase option would not be included in the lease valuation and


instead, accounted for when it was exercised. In the second exposure draft, the FASB decided to include the amount of the purchase option as part of lease payments and, thus, as part of the lease asset and liability valuation.

Example 2: Straight-Line Expense (SLE) ApproachSame facts as Example 1 except for the following:

Let’s assume that X is not sure whether it will exercise either of the two, five-year options because it believes there is not a significant economic in-centive for X to exercise the options. Therefore, the lease term consists of the base five-year lease only.

The lease would be capitalized using a five-year lease term only, instead of the 15-year period that includes the two five-year option periods. Con-sequently, if X ultimately exercises each option, X would capitalize three separate five-year leases. As to the way in which expense is recognized, X would use the SLE Approach.

Because the lease term is only five years and the economic life (useful life) is 30 years, one would reach the conclusion that lease term at commence-ment of the lease is not a major part of the economic life (five years versus a total of 30 years), and the present value of the lease payments does not account for substantially all of the fair value of the leased asset. Thus, the SLE Approach should be used under which the lessee would:

Initially recognize a liability to make lease payments and a right-of-use asset, both measured at the present value of the lease paymentsSubsequently measure the liability to make lease payments using the effective interest methodMeasure the right-of-use asset each period as a balancing figure such that the total lease expense would be recognized on a straight-line basis, regardless of the timing of lease paymentsRecognize lease expense as one amount in the income statement

The following table presents the revised amortization table.Lease Amortization Schedule—Three Separate Five-Year Lease TermsProposed Standard

Annual lease

payments

PrInCIPAL AnD InTErESTPrincipal Interest

(6% per year)Total

OrIGInAL LEASE: (YEArS 1-5) (b)

1 $120,000 $91,064 $28,936 $120,0002 126,000 99,824 26,176 126,0003 132,300 112,457 19,843 132,3004 138,915 126,194 12,721 138,9155 145,861 141,116 4,745 145,861

$663,076 $570,655 $92,421 $663,076

(a)

(a) and (b): see amortization schedule for P&I breakout.


Computation of Straight-Line Expense

YearInterest Expense

(b)

Amortization of lease asset (PLUG)

(c)Total lease expense

(d)

1 $28,936 $103,679 $132,6152 26,176 106,439 132,6153 19,843 112,772 132,6154 12,721 119,894 132,6155 4,745 127,871 132,616

92,421 $570,655 $663,076

(c) right-of-use (leased) asset is amortized as a “balancing figure” so that total lease expense is measured on a straight-line basis.

(d) shown as lease expense in the statement of income.

Entry to record the lease at inception:

YEar 1:

1 Lease asset (right-of-use asset) (a) 570,655 Lease obligation 570,6552 Interest (b) 28,936 Lease obligation (b) 91,064 Cash, AP, (10,000 x 12 months) 120,000 3 Amortization expense(c) 103,679 Accumulated amortization- lease asset 103,679

(b) see principal and interest schedule on previous page.(c) Amortization expense is recorded in an amount so that total lease expense (interest and

amortization) is a straight-line amount.

YEar 2:

1 Interest (b) 26,176 Lease obligation (b) 99,824 Cash, AP, (10,500 x 12 months) 126,000 2 Amortization expense(c) 106,439 Accumulated amortization- lease asset 106,439




YEar 3:1Interest (b) 19,843Lease obligation (b) 112,457 Cash, AP (11,025 x 12 months) 132,300

2Amortization expense(c) 112,772 Accumulated amortization- lease asset 112,772

(b) see principal and interest schedule on previous page.(c) Amortization expense is recorded is an amount so that total lease expense (interest and


YEar 4:

1 Interest (b) 12,721 Lease obligation (b) 126,194 Cash, AP, (11,576.25 x 12 months) 138,915 2 Amortization expense(c) 119,894 Accumulated amortization- lease asset 119,894



YEar 5:

1 Interest (b) 4,745 Lease obligation (b) 141,116 Cash, AP, (12,155.08 x 12 months) 145,861 2 Amortization expense(c) 127,871 Accumulated amortization- lease asset 127,871




Company Xbalance Sheet



right-of-use lease assets 570,655 Less: accumulated amortization 103,679 total right-to-use assets 466,976

total plant and equipment XX

LIABILItIEs:

Current liabilities: Current portion of long-term debt XX Current portion of right-of-use lease obligation (b) 99,824

Long-term liabilities: Long-term debt Long-term right-of-use lease obligation (b) 379,767

(b) $570,655- first year principal payments ($91,064) less current portion of debt ($99,824) = $379,767.

Company XStatement of Income


net sales $XXCost of goods sold XXGross profit on sales XX

operating expenses: Interest expense XX Lease expense (1) 132,615 Depreciation and amortization XX Payroll and payroll-related expenses XX utilities XX rent XX office expenses XX sundry other expenses XX total operating expenses XX

net operating income XX

(1) under the straight-Line Expense (sLE) Method, interest expense and amortization expense are presented as “lease expense” as a single line item on the income statement.

Computation: Year 1: Interest expense ($28,936) plus amortization expense ($103,679) equals $132,615 total lease expense.


Company XStatement of Cash Flows


Cash flow from operating activities:net income (a) $XX

Adjustments to reconcile net income to cash from operating activities: XX Depreciation and amortization XX Portion of lease expense related to amortization of right-of-use leased assets (a) 103,679

Investing activities:

financing activities: repayments of long-term debt repayments of right-of-use lease obligations (91,064)

(a) Portion of lease expense that consists of amortization of the right-of-use asset.

ObSErvATIOn

In its lease proposal, the fAsB states that when the sLE Approach is used, total expense, consisting of interest and amortization, is presented on the income statement as one line item, called “lease expense.” When the statement of cash flows is presented, that portion of lease expense consisting of amortization of the right-of-use asset is an add-back item. the author has called this line item “portion of lease expense related to amortization of right-of-use leased assets” instead of amortization expense because it is embedded in total lease expense. there is no authority as to how to label this statement of cash flows adjustment.

There are other issues that come into play that the FASB will have to resolve. For example, should that portion of lease expense consisting of interest (in this example, it is $28,936) be disclosed as interest expense in the notes or as interest paid for purposes of the cash flows disclosure? It is not clear.

ObSErvATIOn

the shorter the lease term, the more likely that the entity can justify that the sLE Approach can be used for a real estate lease. the sLE Approach may be used unless the lease term is for a major part of the economic life of the lease asset, or the present value of fixed lease payments is substantially all of the fair value of the lease asset. the shorter the lease life relative to the useful (economic) life of the leased asset, the easier it is to justify that the lease term is not a major part of the asset life. thus, the sLE can be used.

For many companies, using the SLE is important because it allows the total expense to be spread evenly over the lease.


Must the Lessee and Lessor Make any adjustments to the Computation of the Lease asset and Liability after the Initial recording?The proposed standard states that after the date of commencement of the lease, the lessee and lessor would be required to reassess the carrying amount of the liability arising from each lease if facts or circumstances indicate that there would be a significant change in the asset and liability since the previ-ous reporting period. Such changes may occur because of changes in the amount of contingent rentals, option penalties, residual value guarantees, or purchase options, along with changes in the estimated lease term. When such indications exist, a lessee and lessor would be required to:

Reassess the length of the lease term and amount of lease payments based on whether a lessee has a significant economic incentive to exerciseReassess the expected amount of any contingent rentals, expected payments under term option penalties, residual value guarantee, or purchase option

Any changes in lease payments that are due to a reassessment in the lease term would result in both:

A lessee adjusting its obligation to make lease payments and its right-of-use assetA lessor adjusting its right to receive lease payments and any residual asset, and recognizing any corresponding profit or loss (pending the Board’s decision on lessor accounting)

For example, an entity, at the inception of the lease, may not have included lease renewal option periods in the lease term as there was not a significant economic incentive for the entity to exercise the option. Subsequently, the company decides it does have a significant economic incentive to exercise the renewal options. In this case, the company would reassess the liability and related asset and would remeasure the asset and liability to include the extended term and cash flow related to that term. Any adjustment to the liability would be made to the asset because it impacts future periods. The period for amortizing the lease asset would also be adjusted to reflect the remaining longer useful life.

In re-Assessing the Lease, Should the Lessee reflect Changes in the Discount rate?The proposed standard states that the discount rate would not be reassessed if there is no change in the lease payments. However, the discount rate should be reassessed when there is a change in lease payments due to a change in the assessment of whether the lessee has a significant economic incentive to exercise:

An option to extend a leasePurchase the underlying assetOther option


Further, if there is a reassessment of the discount rate, the lessee or lessor should determine a revised discount rate using the spot rate at the reassess-ment date and should then apply that rate to the remaining lease payments (i.e. to the remaining payments due in the initial lease plus the payments due during the extension period).

ObSErvATIOn

the worst situation is for a company to record a right-of-use lease asset and obligation mea-sured using a low incremental borrowing rate in a low-interest rate environment. the lower the discount rate, the higher the obligation that is recorded. In general, once the obligation is recorded using a low interest rate, the obligation cannot be reassessed (reduced) as interest rates rise, unless there is a change in the lease payments due to a reassessment of an op-tion. thus, the company is locked in with a high obligation that may be in place over a 10-, 15- or possibly 20-year period if the renewal option periods are included in the lease term.

Conversely, if interest rates are high, a company may be incentivized to record its lease at the longest lease term (one that includes option periods) and lock in the lower lease obligation.

What Happens to Existing Operating and Capital Leases on the Date of Adoption of the Proposed new Standard?The proposed standard would not grandfather any existing leases. Therefore, on the date of initial application (to be determined), a lessee would recognize:

A liability to make lease payments for each outstanding lease, measured at the present value of the remaining lease payments, dis-counted using the lessee’s incremental borrowing rate on the date of initial applicationA right-of-use asset for each outstanding lease, measured at the amount of the related liability to make lease payments

There is a rule in the exposure draft that provides that when lease pay-ments are uneven over the lease term, a lessee would be required to adjust the right-of-use asset recognized at the date of initial application by the amount of any recognized prepaid or accrued lease payments.

For existing capital leases recorded under existing GAAP (ASC 840), the carrying amount of the lease asset and obligation would be adjusted to the recomputed carrying value under the proposed standard. In cases where the capital lease does not have options, contingent rentals, term option penalties, or residual value guarantees, the carrying amount under existing GAAP may not be significantly different from the proposed standard so that no adjustment may be required.

On the lessor side, the lessor would be required to record a lease asset for the right to receive lease payments and the related lease liability measured at the same amount as the lease asset.


Because the initial asset and liability would be recorded at the same amount, there should be no income statement effect from implementing the proposed standard from both the lessee and lessor perspective.

How Significant Would the Change to the Proposed Lease Standard be for U.S. Companies?As previously quoted in the SEC’s report, there are approximately $1.25 trillion of operating lease obligations that are not recorded on public company balance sheets. That $1.25 trillion is magnified by the many non-public companies that have unpublished operating lease obligations that are unrecorded.

The author estimates that unrecorded lease obligations of non-public operating leases is at least $6.3 trillion based on the following computation:

Computation of Estimated Unrecorded Lease Obligations of non-Public U.S. Companies

Estimated annual lease payments ($5,000 x 12) $60,000Estimated average number of years remaining 5Gross lease payments $300,000Present value factor, five years, five percent 4.212Present value of lease obligation $1,263,600

Estimated # non-public entities in the u.s. with leases that would be subject to the proposed standard:20 million non-public companies x 25% 5,000,000unrecorded lease obligations- u.s. non-public companies $6.3 trillion

Source: The Author

In the previous table, the author makes a rough computation as to the total amount of lease obligations that are unrecorded by non-public companies. Using what may be conservative numbers, the author computes the present value of unrecorded operating lease obligations at $6.3 trillion which is likely to be low. Adding the $6.3 trillion for non-public companies to the $1.25 trillion for public companies results in $7.5 trillion of estimated unrecorded lease obligations that would be recorded on company balance sheets under the proposed lease standard.

Consider the following estimated impacts of shifting those operating leases to capitalized right-of-use leases [Report issued by Change & Adams Consult-ing, commissioned by the U.S. Chamber of Commerce, and others (2012)]:

Earnings of retailers would decline significantly. One recent study sug-gested that there would be a median drop in earnings per share of 5.3 percent and a median decline in return on assets of 1.7 percent.Public companies would face $10.2 billion of added annual interest costs.There would be a loss of U.S. jobs in the range of 190,000 to 3.3 million.Cost of compliance with the new standard would lower U.S. GDP by $27.5 billion a year.


Lessors would lose approximately $14.8 billion in the value of their commercial real estate.Balance sheets would be loaded with significant lease obligations that would impact debt-equity ratios (Bear Stearns research study).

Aggregate debt of nonfinancial S&P 500 companies would increase by 17 percent if all leases were capitalized.Return on assets would decline as total assets (the denominator) would increase by approximately 10 percent.The S&P 500 would record an estimate of $549 billion of additional liabilities under the proposed lease standard on existing operating leases [Leases Landing on Balance Sheet (Credit Suisse)]. U.S. companies as a whole (public and non-public), would record approximately $7.5 trillion of additional liabilities if operating leases are capitalized.

According to a Credit Suisse study, 494 of the S&P 500 companies are ob-ligated to make $634 billion in total future minimum lease payments under operating leases [Leases Landing on Balance Sheet (Credit Suisse)]. On a pres-ent value basis, including contingent rents, the $634 billion translates into an additional liability under the proposed standard of $549 billion. Of the $549 billion of additional liabilities, 15 percent relates to retail companies on the S&P 500.

In some cases, the effect of capitalizing lease obligations under the proposed lease standard is so significant that the new lease liability would exceed the company’s market capitalization. Consider the following table:

Estimated Off-balance Sheet Operating Lease Liability as a Percentage of Market Capitalization

(in millions)

Estimated off-balance sheet operating lease liability Market cap

Liability as % of market cap

office Depot Inc. $2,278 $1,104 206%Walgreens Co. 29,614 27,434 108%supervalue Inc. 2,445 2,342 104%Cvs 23,826 38,917 61%Whole foods 4,545 6,322 72%sears 4,550 7,608 60%


The previous table identifies the sizeable problem that exists for many of the U.S. retailers which is that there are huge off-balance-sheet operating lease liabilities as a percentage of company market capitalization. Under the proposed lease standard, these obligations would be recorded, thereby having a devastating impact on those retailers’ balance sheets. For example, look at Office Depot and its $2.2 billion liability in relation to its market capitalization of $1.1 billion.


Note further that in the previous table, the off-balance-sheet liabilities are gross lease payments under operating leases. Under the proposed lease standard, these liabilities would have to be adjusted downward for the pres-ent value effect of the obligation but would also be increased for contingent rents and possibly a longer lease term due to extension options.

How Would the Proposed Lease Standard Impact How Leases are Structured?Companies are going to consider the balance sheet impact when structuring leases and in deciding whether to lease or buy the underlying asset. There are several likely actions that would come from the proposed standard. By implementing the proposed standard, the GAAP differences between leasing and owning an asset would be reduced. Having to capitalize all leases may have a significant effect on the lease versus purchase decision, particularly with respect to real estate:

Tenants, in particular those in single-tenant buildings with long-term leases, may choose to purchase a building instead of leasing it:

A similar amount of debt would be included on the tenant’s balance sheet under a long-term lease as compared with a purchase.GAAP depreciation under a purchase may actually be lower than a lease because the depreciable life under the lease (generally the lease term) is likely to be shorter than the useful life under a purchase.

ExAMPLE

Assume there is a 10-year lease with two, five-year lease options, resulting in a maximum lease term of 20 years. Assume further that the useful life of the building is 30 years for depreciation purposes.

If the entity leases the real estate, the right-of-use asset would be amortized over 20 years (the shorter of the 20-year lease term or the 30 year useful life of the building). If, instead, the entity purchases the real estate, the building would be depreciated over the useful life of 30 years.

The tenant would receive the reward of ownership in terms of ap-preciation of the asset and amortization of the mortgage.

nOTE

In some instances, lessees may choose to purchase the leased asset rather than lease it if the accounting is the same. In particular, the purchase scenario may be more appealing for longer-term leases that have significant debt obligations on the lessee balance sheets. Lessees with shorter-term leases will not be burdened with the extensive debt obligations and, therefore, may choose not to purchase the underlying lease asset.


Lease terms are likely to shorten. For many companies who do not wish to purchase the underlying leased asset, lease terms may shorten to reduce the amount of the lease obligation (and related asset) that is recorded at the lease inception. The proposed lease standard would affect not only the landlords and tenants, but also brokers, as there would be much greater emphasis placed on executing leases for shorter periods of time, thereby increasing the paperwork and the commissions earned.

Deferred tax assets would be created. Because many operating leases would now be capitalized, total GAAP expense (interest and amortization) would be greater than lease expense for tax purposes, resulting in deferred tax assets for the future tax benefits that would be realized when the temporary difference reverses in later years.

Under existing GAAP, most, but not all, operating leases are treated as operating leases (true leases) for tax purposes. Therefore, rarely are operat-ing leases capitalized for tax purposes. Now, the game is about to change if operating leases are capitalized as right-of-use assets under GAAP, while they continue to be treated as operating leases for tax purposes. As we have seen in the previous examples, most leases capitalized under the proposed standard would result in the creation of a deferred tax asset.

Let’s bring back an example discussed earlier in this section under which Company X capitalizes a 15-year lease. Below is the balance sheet that exists at the end of the first year of the lease.


December 31, 20X1

AssEts:


right-of-use lease assets 1,806,705 Less: accumulated amortization 120,447 total right-to-use assets 1,686,258 total plant and equipment XX

LIABILItIEs:

Current liabilities: Current portion of long-term debt XX Current portion of right-of-use lease obligation 16,386

Long-term liabilities: Long-term debt Long-term right-of-use lease obligation 1,771,474


For tax purposes, the lease would likely be an operating lease so that lease payments would be currently deducted with no capitalized asset and liability.

Assuming X is a C corporation and its federal and state tax rate is 40 percent, a deferred tax asset would be created as follows:

Asset/liability Book tax temporary difference

right-of-use asset $1,686,258 $ 0 $1,686,258Debt (a) (1,787,860) 0 (1,787,860)

$(101,602) $ 0 (101,602) tax rate 40% Deferred tax asset $40,641

(a) Debt: Current portion ($16,386) + long-term portion ($1,771,474) = $1,787,860

YEar 1: additional entry

1 Deferred tax asset 40,641 Income tax expense- deferred 40,641

The revised balance at the end of year 1 of the lease, inclusive of the deferred tax asset, follows:

Company X balance Sheet


Property, Plant and Equipment: Equipment XX Less: Accumulated depreciation XX total equipment XX

right-of-use lease assets 1,806,705 Less: accumulated amortization 120,447 total right-to-use assets 1,686,258 total plant and equipment XX

other assets: Deferred tax asset 40,641

LIABILItIEs:

Current liabilities: Current portion of long-term debt XX Current portion of right-of-use lease obligation 16,386

Long-term liabilities: Long-term debt Long-term right-of-use lease obligation 1,771,474


Note that the deferred tax asset is presented as a long-term asset because it follows the classification of the asset and liability that created the tempo-rary difference. In this case, the temporary difference is created from the right-of-use lease asset and lease obligation, both of which are long-term items. In reality, a small portion of the deferred tax asset ($6,554) related to the current portion of the lease obligation ($16,386 x 40% = $6,554) should be shown as a current asset, but is kept as long-term because it is not material.

STUDY QUESTIOn

8. one change that may occur as a result of the proposed lease standard being implemented is____________.

a. Companies that typically purchase a single-tenant building may choose to lease instead of buy.

b. tenants in multi-tenant buildings would likely sign longer-term leases.c. tenants in single-tenant buildings with long-term leases may choose to buy. d. there is likely to be no change.

What About the Impact on Smaller non-Public Entities?One leasing organization noted that more than 90 percent of all leases in-volve assets worth less than $5 million and have terms of two to five years. That means that smaller companies have a significant amount of leases, most of which are currently being accounted for as operating leases. Unless these smaller, non-public entities choose to use the income tax basis for their financial statements, under GAAP, these companies will be required to capitalize their operating leases.

What about related-Party Leases?Some, but not all, related-party leases result in the lessee (parent equivalent) consolidating the lessor (subsidiary equivalent) under the consolidation of variable interest entity rules (ASC 810) (formerly FIN 46R). The common example of a related-party lease is where an operating company lessee leases real estate from its related party lessor. In general, under FIN 46R, if there is a related party lessee and lessor, consolidation is required if both:

The real estate lessor is a variable interest entity (VIE) (e.g., it is not self-sustaining).The lessee operating company and/or the common shareholder provide financial support to the real estate lessor in the form of loans, guarantees of bank loans, above-market lease payments, etc.

If these two conditions are met, it is likely that the real estate lessor must be consolidated with the operating company lessee’s financial statements.


If there is consolidation, capitalizing the lease under the proposed standard would be moot because the asset, liability, and lease payments would be eliminated in the consolidation.

But there are many instances in which consolidation is not required between a related party lessor and lessee. For example, under ASC 810, there is no consolidation if the real estate lessor is not a VIE. The real estate entity is not a VIE if it has low leverage (usually 60 percent or less loan to value) so that the real estate entity could obtain a non-recourse bank loan without the assistance of guarantees provided by the operating company lessee and/or the common owner. In such cases, there is no consolidation and the lease must be recorded.

When it comes to a related-party lease, the parties will have to account for that lease as a right-of-use lease asset and obligation, just like any other lease transaction. Consequently, under the proposed standard, the operating company lessee would be required to record a right-of-use asset and lease obligation based on the present value of the lease payments.

Many related parties either do not have formal leases or the leases are short-term. If the operating company lessee is going to have to record a significant asset and liability, it may make sense to have a related-party lease that is either 12 months or less, or a tenant-at-will arrangement.

With respect to a related-party lease that is 12 months or less, the pro-posed standard would permit (but not require) use of the short-term lease rules as follows:

A lessee would treat the short-term lease as an operating lease with no recognition of the lease asset or lease liability. The rental payments would be recognized as rent expense on a straight-line basis.The lessor would record rental income on a straight-line basis and not record the lease asset and liability.Either the lessee or lessor could elect to record the lease asset and liability using the proposed standard rules.

With many related-party leases, the operating company lessee may issue financial statements while the real estate lessor does not. Therefore, how the lessee accounts for the transaction under GAAP may be more important than the lessor’s accounting for the transaction.

Let’s look at a simple example:Company X is a real estate lessor LLC that leases an office building to

a related party operating Company Y. X and Y are affiliated by a common owner. The companies sign an annual 12-month lease with no renewals, and no obligations that extend beyond the 12 months.

Monthly rents are $10,000.Y issues financial statements to its bank while X does not issue finan-cial statements.X is self-sustaining and the companies do not consolidate under the VIE rules.


Because the entities have a short-term lease of 12 months or less, Y, as lessee, would qualify for the short-term lease rules. Therefore, Y would not record a lease asset and liability and, instead, would record the monthly rent payments and rent expense on a straight-line basis over the short-term lease period. Y could elect to treat the short-term lease as a standard lease by recording both the lease asset and liability.

The lessor would also not record the lease asset and liability and, instead, would record rental income on a straight-line basis over the 12-month period.

ObSErvATIOn

If the proposed standard is issued in final form, many non-public entities will take steps to avoid its arduous rules. one approach will likely be to make sure the related-party leases have terms that are 12 months or less so that the lease can be treated as an operating lease and not capitalized.

STUDY QUESTIOn

9. under AsC 810, if there is a related-party lessee and lessor, which of the follow-ing would possibly result in consolidation of the two entities?

a. the real estate entity is self-sustaining.b. the real estate lessor is a variable interest entity.c. the real estate lessor guarantees its own loan.d. the lease is at market value.

OTHEr COnSIDErATIOnS

The proposed lease standard casts a wide web across the accounting profes-sion. By capitalizing leases that were previously off-balance-sheet as operating leases, there may be consequences.

One example is that many states compute the apportionment of income assigned to that state using a property factor based on real and tangible personal property held in that particular state. When it comes to rent ex-pense, most states capitalize the rents using a factor such as eight times rent expense. Although each state has its own set of rules, the implementation of the proposed standard may have a sizeable positive or negative impact on state tax apportionment based on shifting rent expense to capitalized assets.

On the other hand, capitalizing leases might have a positive effect in tax planning. One example is where there is a C corporation with accumulated earnings and exposure to an accumulated earnings tax (AET). The additional lease obligation liability would certainly help justify that the accumulation of earnings is not subject to the AET.


Companies should also be aware that not only would the proposed standard increase liabilities, but would also increase total assets. In some states, there are total asset thresholds that drive higher taxes and report-ing requirements.

DEALInG WITH FInAnCIAL COvEnAnTS

A critical impact of the proposed standard would be that certain loan cov-enants may be adversely impaired, thereby forcing companies into violations of their loans. Consider the following ratios:

ratio Likely impact of proposed lease standard

EBItDA:

[Earnings before interest, taxes, depreciation and amortization]

favorable impact due to shift from rental expense to interest and amortization expense, both of which are added back in computing EBItDA

Interest coverage ratio:

Earnings before interest and taxes Interest expense

May be a negative impact from lower ratio

Debt-equity ratio:

Total liabilities Stockholders’ equity

negative impact from higher ratio

There would be a favorable impact on EBITDA by implementing the pro-posed standard. Rent expense recorded for operating leases under existing GAAP would be reduced while interest expense and amortization expense would increase once the leases are capitalized.

As to the interest coverage ratio, in many instances changes would have a negative impact on this ratio. Earnings before interest and taxes would likely be higher as rent expense is removed and replaced with interest and amortization expense. The denominator increases significantly due to the higher interest expense. On balance, the slightly higher earnings before interest and taxes divided by a higher interest expense in the denominator yields a lower interest coverage ratio.

Perhaps the most significant impact of capitalizing leases under the proposed lease standard would be on the debt-equity ratio. With piles of liabilities being recorded, this ratio would likely turn quite negative and severely impact company balance sheets. In some cases, the debt-equity ratio would result in violation of existing loan covenants, thereby requiring a company to renegotiate the covenants with its lenders or at least notify lenders in advance of the likely lack of compliance with loan covenants.

139


aICPa technical Practice aids—Extraordinary Items and Involuntary Conversions

This chapter discusses several issues that have been addressed by the AICPA, including those related to extraordinary items and involuntary conversions.

LEArnInG ObjECTIvES


Discuss how to classify terrorist acts or acts of God on the statement of operationsIndicate how an involuntary conversion is treated under GAAPExplain how business interruption insurance recoveries should be displayed in the statement of operationsstate the criteria that must be met in order to recognize liabilities under Concept statement 5

tIS SECtIon 5400, EXtraorDInarY anD unuSuaL ItEMS

.05 aCCountInG anD DISCLoSurES: GuIDanCE For LoSSES FroM naturaL nonGovErnMEntaL EntItIES

A natural disaster (such as a hurricane, tornado, fire, or earthquake) strikes and causes substantial damage. Though extreme in the loss of life and finan-cial harm caused, the nature and location of the disaster may be such that one might reasonably expect that type of activity of nature to strike again in greater or lesser magnitude of damage.

What are Some of the Accounting Issues That Arise and Which Accounting Literature Provides Guidance for in recognizing, Measuring, and Disclosing Losses from natural Disasters?The following questions may arise in accounting for losses incurred as a result of a natural disaster:

1. How should losses from a natural disaster of a type that is reasonably expected to reoccur be classified in the statement of operations?

2. When should an asset impairment loss related to a natural disaster be recognized?

3. When should a liability for non-impairment losses and costs related to a natural disaster be recognized?


4. What is the accounting for insurance recoveries to cover losses sustained in a natural disaster? Also, what are the additional considerations related to business interruption insurance recoveries?

5. What are the required disclosures regarding the impact of a natural disaster?

Issue 1—How Should Losses from a natural Disaster of a Type That is reasonably Expected to reoccur be Classified in the Statement of Operations?FASB ASC 225-20-45-2 describes an extraordinary item as an item that is both unusual in nature and nonrecurring. A natural disaster of a type that is reasonably expected to reoccur would not meet both conditions.

The magnitude of loss from a particular natural disaster does not cause that disaster to be unusual in nature or unlikely to reoccur. If losses from such natural disasters meet the criteria for disclosure of unusual or infrequently occurring items in FASB ASC 225-20-45-16, they should be reported as a separate component of income from continuing operations either on the face of the statement of operations or in the notes to the financial statements.

ObSErvATIOn

the magnitude of the disaster does not, in and of itself, make it extraordinary. for example, previously the fAsB ruled that the terrorist act of 9/11 was not extraordinary even though its magnitude was high. similarly, Hurricane Katrina and Japan’s tsunami did not qualify for extraordinary treatment because it is reasonably possible that both could occur again.

Issue 2—When Should an Asset Impairment Loss related to a natural Disaster be recognized?FASB ASC 360, Property, Plant, and Equipment, provides guidance on recognition and measurement of impairment losses on long-lived assets. That literature should be used to determine when an impairment loss on long-lived assets resulting from a natural disaster should be recognized, and how that impairment loss should be measured.

FASB ASC 310, Receivables, provides guidance on recognition and measurement of impairment losses on loans. The FASB ASC glossary defines a loan as “a contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor’s statement of financial position.” According to FASB ASC 310, a loan is impaired when, “based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.” In measuring impairment losses on loans, creditors should follow FASB ASC 310-10-35-22, which states:

M o d u l e 2 — C h a p t e r 6 — a I C pa te c h n i c a l p r a c t i c e a i d s 141

When a loan is impaired … , a creditor shall measure impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedi-ent, a creditor may measure impairment based on a loan’s observ-able market price, or the fair value of the collateral if the loan is a collateral-dependent loan.

FASB ASC 350, Intangibles—Goodwill and Other, provides guidance on recognition and measurement of impairment losses on intangible assets and goodwill.

FASB ASC 450, Contingencies, provides guidance on recognition and measurement of impairment losses on assets not covered by specific other literature.

Issue 3—When Should a Liability for non-Impairment Losses and Costs related to a natural Disaster be recognized?FASB ASC 450-20-25-2 requires a loss accrual by a charge to income, if it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements and the amount of loss can be reason-ably estimated.

Paragraph 63 of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, provides that liabilities should be recognized when all of the following are true:

The item meets the definition of a liability.

nOTE

Paragraph 35 of Concepts statement 6 defines liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events” (footnote references omitted).

The liability can be measured with sufficient reliability.The information about the liability is capable of making a difference in user decisions.The information about the liability is representationally faithful, verifi-able, and neutral.

Other authoritative literature to consider includes FASB ASC 420, Exit or Disposal Cost Obligations, and FASB ASC 450-20, Contingencies - Loss Contingencies.


Issue 4—what is the accounting for Insurance recoveries to Cover Losses Sustained in a natural Disaster? also, what are the additional Considerations related to business Interruption Insurance recoveries?FASB ASC 605-40, Revenue Recognition-Gains and Losses, clarifies the accounting for involuntary conversions of nonmonetary assets (such as property or equipment) to monetary assets (such as insurance proceeds).

FASB ASC 605-40-45-1 states:

Gain or loss resulting from an involuntary conversion of a nonmon-etary asset to monetary assets shall be classified in accordance with the provisions of Subtopic 225-20 (Extraordinary and Unusual Items).

It requires that:A gain or loss should be recognized when a nonmonetary asset is in-voluntarily converted to monetary assets even though an enterprise reinvests or is obligated to reinvest the monetary assets in replacement nonmonetary assets. An asset relating to the insurance recovery should be recognized only when realization of the claim for recovery of a loss recognized in the financial statements is deemed probable (as that term is used in FASB ASC 450).

In addition, under FASB ASC 450, Contingencies, a gain (that is, a recov-ery of a loss not yet recognized in the financial statements or an amount recovered in excess of a loss recognized in the financial statements) should not be recognized until any contingencies relating to the insurance claim have been resolved. It is important to note that in some circumstances, losses and costs might be recognized in the statement of operations in a different (earlier) period than the related recovery.

An additional consideration relates to FASB ASC 225-30, Income Statement-Business Interruption Insurance, which indicates that entities may choose how to classify such recoveries in the statement of operations, pro-vided that classification does not conflict with existing GAAP requirements.

ObSErvATIOn

one issue to consider is that an entity is not allowed to record a receivable due from the insurance company for the insurance proceeds from a recovery until realization of the amount of insurance is probable. the reason is because the receivable is considered a gain contingency until the amount of the insurance to be received is settled with the insurance company. What that means is that there could be a fire or other calamity that occurs in the middle of a year but is not settled with the insurance company by year end. the entity is not allowed to record a receivable for the estimated insurance receivable until the company has settled the claim with the insurance company. recording a “best estimate” as a receivable is not allowed because to do so would result in the company recording a gain contingency, which is not allowed under GAAP.


What Happens If an Entity receives Federal Assistance for victims of an Act of God or natural Disaster?Federal assistance provided to victims should be reported on a gross basis in the victim’s statement of operations as part of income from continu-ing operations.

Issue 5—What Are the required Disclosures regarding the Impact of a natural Disaster?In disclosing the impact of a natural disaster in the financial statements, entities should follow the guidance in FASB ASC 225-20-45-16 pertain-ing to presentation and disclosure of a material event or transaction that is unusual in nature or occurs infrequently.

As it relates to the issues covered in this section, entities also should consider the disclosure requirements of FASB ASC 275, Risks and Un-certainties; FASB ASC 310; FASB ASC 350; FASB ASC 360; FASB ASC 410, Asset Retirement and Environmental Obligations; FASB ASC 420; and FASB ASC 450.

In looking at the TIS, it is obvious that losses related to a natural disaster are recorded as extraordinary only if they meet the two criteria for extraor-dinary treatment:

Infrequency of occurrence: The underlying event or transaction is of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which an enterprise operates.Unusual in nature: The underlying event or transaction possesses a high degree of abnormality and is of a type clearly unrelated to, or only inci-dentally related to, the ordinary and typical activities of the enterprise, taking into account the environment in which the enterprise operates such as the industry, geographic location of its operations, and nature and extent of governmental regulation.

Both of the above criteria must be met in order for an item to be presented as extraordinary. A material event or transaction that meets one, but not both of the two criteria, should be reported as a separate component of income from continuing operations, and should be disclosed.

The following table summarizes official and unofficial positions of the FASB on various transactions for which extraordinary treatment was sought.


based on the above criteria, the following is a listing of events that may or may not meet the extraordinary criteria:

Event Infrequent unusual Extraordinary

florida citrus grower’s crop is damaged by frost. no no no

An earthquake damages a plant located in san francisco. no no no

An earthquake destroys a plant in vermont where there has never been an earthquake.

Yes Yes Yes

A tobacco crop is destroyed by hail in a location where hail is rare.

Yes Yes Yes

A company writes off receivables relating to bankruptcy. no no no

Costs are incurred by a company to defend against a take-over attempt.

no no no

An entity is a steel fabricator who sells the only land it owns. the land was acquired 10 years ago for future expansion, but shortly thereafter, plans for expansion were abandoned and the land was held for appreciation.

Yes Yes Yes

terrorist acts Yes no no

STUDY QUESTIOnS

1. A transaction is categorized on the income statement as extraordinary if:

a. It is infrequent in occurrence.b. It is unusual in nature.c. It is either infrequent in occurrence or unusual in nature.d. It is both infrequent in occurrence and unusual in nature.

2. Which of the following transactions should be treated as extraordinary in the income statement?

a. An earthquake in ohio where there has never been an earthquakeb. A terrorist attackc. A write-off of a company’s receivables relating to bankruptcyd. A hail storm in Maine

InvOLUnTArY COnvErSIOnS

For tax purposes, Internal Revenue Code (Code) Sec. 1033 provides a special rule to deal with disasters under the involuntary conversion rules.

Code Sec. 1033 states that if property is damaged due to a condem-nation, theft, seizure, or destruction, and a taxpayer receives insurance procedures, the gain or loss from the involuntary conversion is not taxable if reinvested in qualified replacement property within a period of time. Specifically, the gain from receipt of insurance proceeds is non-taxable to the extent that the insurance proceeds are used to purchase qualifying replacement property (e.g., property that is similar to, or related to in use to, the property that was lost or taken). The property must be purchased


within a two-year period that ends two years after the close of the of the first tax year in which any part of the gain on the conversion is realized (three years for certain condemned property). Under the involuntary conversion rules, in lieu of recording a gain, the insurance proceeds reduce the basis of the replacement property.

Do the Involuntary Conversion rules Apply to GAAP?The non-recognition of gain rules found in Code Sec. 1033 do not apply to GAAP.

ASC 605-40-25, Revenue Recognition-Gains and Losses Recogni-tion, states:

An involuntary conversion of a nonmonetary asset to monetary assets (e.g., cash) and the subsequent reinvestment of the monetary assets is not the equivalent to an exchange transaction between an entity and another entity. The conversion of a nonmonetary asset to monetary assets is a monetary transaction, whether the conver-sion is voluntary or involuntary, and such a conversion differs from exchange transactions that involve only nonmonetary assets. To the extent the cost of a nonmonetary asset differs from the amount of monetary assets received, the transaction results in a gain or loss that shall be recognized.

Therefore, for GAAP purposes, an involuntary conversion is treated as a sale of the converted property and a gain or loss is recognized on the income statement. Deferred income taxes must be recorded on the basis difference for GAAP and tax purposes. For tax purposes, the basis of the replacement property is lower than GAAP because of the reduction in the tax basis for the non-recognition of the gain.

Dealing With the Timing of an Involuntary ConversionThe GAAP for involuntary conversions noted above requires that the transaction be recorded as a sale of the asset when the asset (building, etc.) is converted to a monetary asset. That means a gain or loss on the transac-tion is recorded when the entity receives cash or records a receivable for the insurance amount that is settled with the insurance company.

However, it can take an extensive amount of time to settle with the insurance company and that timeline can extend over one or more report-ing periods. In such a situation, the entity is precluded from recording a receivable for the insurance settlement and a gain or loss on the transaction. Further, until the transaction is settled and a gain or loss is recognized, the entity cannot remove the underlying fixed asset from its records.


What Should an Entity Do With the Damaged Asset While It Waits for the Settlement?Existing GAAP for involuntary conversions found in ASC 605-40-25, Revenue Recognition-Gains and Losses-Recognition, implicitly assumes that an involuntary conversion is settled with the insurance company and recorded within the same reporting period in which the underlying event occurs. This assumption is not realistic in today’s slow-moving insurance industry environment.

Let’s look at an example:

Facts: Company X has a fire on September 30, 20X1 that damages its plant, making it inoperable. X’s year end is December 31, 20X1.

The plant’s carrying value at the date of the fire is:

Cost $1,500,000Accumulated depreciation (600,000)Book value $900,000

At December 31, 20X1, the company is still negotiating with the insur-ance company and has received an advance in the amount of $100,000 to start repairing the facility. The company expects to receive approximately $500,000 in total from the insurance company but has not settled on that amount at December 31, 20X1.At December 31, 20X1, the company has spent about $200,000 for miscellaneous improvements to secure the property. No new renovations were started until 20X2.At December 31, 20X1, the company estimates that the fair value of the damaged building is$500,000, the amount it expects to receive from the insurance company.

Conclusion: Because X has not settled with the insurance company, it is precluded from recording a receivable and a gain and loss as if the property was sold. Thus, the following has to be done at December 31, 20X1:

Insurance proceeds received in advance ($100,000) should be recorded in a deposit account as a liability.The $200,000 spent on repairs to date should be recorded as either re-pairs and maintenance, or as construction in progress (CIP) if it is part of the new construction. The building should be written down to $500,000 (its estimated fair value) with an impairment loss.


Entries: December 31, 20X1:

Cash 100,000 Deposit liability- insurance proceeds 100,000

Construction in progress 200,000 Cash 200,000

Impairment loss 400,000 Plant 400,000

[$900,000 - $500,000]

Assume further that in March 20X2, X settles with the insurance company for $525,000 and receives a check for $425,000 ($525,000 less $100,000 advance received in 20X1).

Conclusion: A gain or loss on the transaction should be recorded as follows:

Insurance proceeds $525,000Basis:

Cost (1) 1,100,000Accumulated depreciation (600,000)Book value 500,000

Gain on transaction $25,000

(1) original cost $1.5M less impairment loss $(400,000) = $1.1 million.

Entries: March 20X2:Cash 425,000

Deposit liability- insurance proceeds 100,000Building 1,100,000

AD- building 600,000Gain on transaction 25,000

ObSErvATIOn

Because of the timing of settling the insurance proceeds, an entity will likely have to record an impairment loss in one period, and then record a gain on the transaction in the following period once the insurance proceeds are settled. the result is a mismatch of revenue and expense in that the impairment loss results in a lower basis and thus, a higher gain in the subsequent period.

Because GAAP does not allow an entity to estimate the insurance proceeds and record the receivable prior to settlement, there is a distortion of revenue and expenses among periods.

Change the facts: Assume that at December 31, 20X1, the fair value of the building is estimated to be $2 million, which is the insurance proceeds that the company expects to receive in 20X2, even though it has not been settled at December 31, 20X1. All other facts are the same as the previous example.


Conclusion: There would be no writedown of the building for impairment. Under ASC 360, an impairment of a fixed asset (the building in this case), exists if the undiscounted future cash flows from its use (and sale) are less than its carrying amount. In this case, the estimated future undiscounted cash flows consist of the insurance proceeds that are expected to be $2 million, which exceeds the carrying amount of $900,000. Thus, there is no impair-ment and no writedown of the building at the end of 20X1.

The result is as follows:

Entries: December 31, 20X1:

Cash 100,000 Deposit liability- insurance proceeds 100,000

Construction in progress 200,000 Cash 200,000

Impairment loss 0 Plant 0

Assuming that in March 20X2, X settles with the insurance company for $2 million and receives a check for $1.9 million ($2 million less $100,000 advance received in 20X1).

Conclusion: A gain or loss on the transaction should be recorded as follows:

Insurance proceeds $2,000,000Basis: Cost (1) 1,500,000 Accumulated depreciation (600,000) Book value 900,000Gain on transaction $1,100,000

Entries: March 20X2: Cash 1,900,000 Deposit liability- insurance proceeds 100,000 Building 1,500,000AD- building 600,000Gain on transaction 1,100,000

Income Statement Display of business Interruption Insurance recoveries

How Should Business Interruption or Property Insurance Recoveries be Displayed in the Statement of Operations?The governing authority is found in ASC 225-30, Income Statement-Business Interruption Insurance (formerly found in EITF Issue No. 01-13), which deals with business interruption insurance, and ASC 605, Revenue Recognition, for insurance proceeds related to property damage.


An entity may choose how to classify business interruption insurance recoveries in the statement of operations, as long as that classification is not contrary to existing GAAP.

With respect to property insurance recoveries, ASC 605, Revenue Rec-ognition, (formerly found in FASB Interpretation No. 30), provides that any insurance recoveries are netted against the related loss on the same income statement line.

Specifically, ASC 605, Revenue Recognition, states that a gain or loss should be recognized on the difference between the carrying amount of the asset and the amount of monetary assets received (insurance recov-ery received) in the period of the involuntary conversion. As a result, the insurance recoveries are netted against the related loss (the carrying amount of the insured asset) and shown in the other income section of the income statement.

As to whether any gain or loss from an insurance recovery would qualify as an extraordinary item on the income statement, GAAP provides that in order to classify insurance recoveries as an extraordinary item, the require-ments of extraordinary item classification (infrequent and unusual) must be met. Rarely will this happen.

However, the following information should be disclosed in the notes to finan-cial statements in the period(s) in which the insurance recoveries are recognized:

The nature of the event resulting in the business interruption lossesThe aggregate amount of insurance recoveries recognized during the period and the line item(s) in the statement of operations in which those recoveries are classified (including amounts reported as an extraordinary item in accordance with ASC 225)

ObSErvATIOn

AsC 225 gives companies latitude in presenting a business interruption insurance recov-ery in the income statement. Because the underlying losses may not be recorded, such as lost revenue, there may not be a particular line item(s) to which the recovery relates. one approach would be to present the insurance recovery in the lines to which the “lost items” related.

Note that although ASC 225 applies to business interruption insurance recoveries, the same concept applies to other insurance recoveries, including property insurance recoveries.

ExAMPLE

Assume there is a fire in a building. the building is condemned and the owner recovers $250,000 for lost rents and another $500,000 for property damage, while the property is being repaired. other information follows:


rent revenue $2,000,000operating expenses (900,000)Insurance recovery ($250,000 + $500,000) 750,000net amounts $1,850,000

Assume the lost rents recovery is calculated as follows:

Lost rents $400,000saved utilities and other direct costs (150,000)Business interruption insurance recovery- lost rents $250,000

Assume the book value of the building (without land) that is condemned is $200,000 so that there is a gain on that portion of the transaction of $300,000 as follows:

Property insurance proceeds $500,000Book value of real estate (200,000)Gain on building condemnation $300,000

Conclusion: the $300,000 gain on the property insurance should be shown as an other income item, unless it can qualify for extraordinary gain treatment by being infrequent and unusual in nature. (Assume in this case that extraordinary treatment does not apply because the criteria have not been met.)With respect to the $250,000 business interrup-tion insurance, AsC 225 permits a company to present the $250,000 business interruption insurance portion of the recovery in any way an entity chooses on its income statement. following are two suggested presentation formats.

option 1 is to categorize the recovery in those sections of the income statement to which the “lost items” relate. In this case, the $250,000 recovery would be split into two sections: $400,000 presented as a credit to rental income, and the other $150,000 presented as an increase to operating expenses.

Initial amounts

Allocation of the recovery

Income statement presentation

rent revenue $2,000,000 $400,000 $2,400,000

operating expenses (900,000) (150,000) (1,050,000)

Insurance recovery 250,000 (250,000) 0

net income $1,350,000 $ 0 $1,350,000

the income statement presentation would look like this:

X real Estate CompanyStatement of IncomeFor the Year Ended December 31, 20X1

rent revenue $2,400,000operating expenses (1,050,000)other income: Gain on condemnation of building 300,000net income $1,650,000


option 2 is to present the business interruption insurance recovery as another income item as follows:

X real Estate CompanyStatement of IncomeFor the Year Ended December 31, 20X1

rent revenue $2,000,000operating expenses (900,000)net operating income 1,100,000other income: Business interruption insurance recovery 250,000 Gain on condemnation of building 300,000net income $1,650,000

for tax purposes, the $500,000 of property insurance proceeds would be credited to the building asset under the involuntary conversion rules in Code sec. 1033, resulting in a $300,000 basis difference, which would be a temporary difference for deferred income tax purposes as follows:

GAAP Tax purposesTemporary difference

Book value- building $200,000 $200,000

Entry to record sale of real estate condemned (200,000) 0

Entry to record reduction of basis for IrC 1033 0 (500,000)

Basis before capitalization of construction costs $0 $(300,000) $(300,000)

Assuming that the Company’s federal and state tax rate is 40 percent, deferred income taxes would be recorded as follows:

Entry:

Income tax expense- deferred federal/state (1) 120,000 Deferred income taxes 120,000

(1): $300,000 x 40% = $120,000

Following is a disclosure that would apply to the above example:

nOTE x: InSUrAnCE rECOvErY

In 20X1, the Company incurred a fire at its apartment building located at 120 Main street, nowhere, Massachusetts, which resulted in the building being condemned.

under its insurance policy, the Company received recovery of costs to reconstruct the build-ing into its condition immediately prior to the fire, and business interruption insurance.

the Company received $500,000 as an insurance settlement to reconstruct the building. the insurance recovery, less the carrying amount of the building, resulted in a gain of


$300,000 which is presented in the other Income section of the statement of income. In 20X1, the Company started the reconstruction the building and capitalized $200,000 as part of Construction in Progress at year end.

In addition to receiving the $500,000 insurance settlement, under its business interrup-tion insurance policy, the Company received recovery of rental revenue lost during the construction period, net of certain related costs. the total amount of insurance received was $250,000 which is presented in the other Income section of the income statement.

ObSErvATIOn

In the previous example, the difference between the carrying amount of the building for GAAP and tax purposes results in a temporary difference that creates deferred income taxes. the difference is a byproduct of the basis being reduced by the $500,000 of insur-ance proceeds for tax purposes under the involuntary conversion rules in Code sec. 1033, while being recorded as part of a gain for GAAP.

When the entity reconstructs the building, the costs would be capitalized for both GAAP and tax purposes.

What Would Happen if the Company Does Not Spend the $500,000 Insurance Proceeds Within the Required Two-Year (or Three-Year, in Some Cases) Period Required in Code Sec. 1033?Code Sec. 1033 requires that the entire amount of the $500,000 insurance proceeds be spent on qualified replacement property, including reconstruc-tion of the condemned building, within two, or three-year qualified period, depending on the circumstances. If a portion of those funds are not spent on qualified replacement property within the qualified period, the shortfall is taxable and the deferred income taxes on that portion of the temporary difference set up for the deferred gain would be reversed.

STUDY QUESTIOn

3. According to AsC 225 (formerly EItf Issue no. 01-13), an entity may choose how to classify business interruption insurance recoveries in the statement of opera-tions:

a. Without any restrictionsb. As long as the recovery is insignificantc. As long as that classification is not contrary to existing GAAPd. As long as the amount is characterized as unusual

153


Accounting Practice Issues

This chapter discusses several practice issues including those arising from imputing goodwill on personal financial statements, the disclosure of policies not applicable to the current year, immaterial GAAP departures, presentation of income tax items, and OCBOA financial statements.

LEArnInG ObjECTIvES


Describe how assets should be presented on personal financial statementsDiscuss whether policies should be disclosed on the financial statements if they are not applicable to the current yearExplain how immaterial departures from GAAP should be handled.Calculate the amount of deferred tax assets and liabilities that should be recordedDiscuss how certain items should be recorded on income tax basis financial statements

IMPUTInG GOODWILL On PErSOnAL FInAnCIAL STATEMEnTS

In Preparing Personal Financial Statements, is it Appropriate to record an Asset for a brand value/Personal Goodwill at Estimated Current value?

Facts: John Perfect is a celebrity chef and real estate developer. The “Perfect” brand is on numerous products including cook books, underwear (“Perfect” Undies), a downtown NY City hotel (“Absolutely Perfect Hotel”), and several restaurants. John has also franchised use of the “perfect” name on two restaurants who John does not own. (John even has the “perfect wife.”)

John and his wife, Mary, are issuing personal financial statements for the year ended December 31, 20X1, which will be submitted to a bank. John wants to record an asset on his statement of net worth for the “perfect” brand (personal goodwill) because he believes there is a separate value to the perfect name. Because personal financial statements include assets at their estimated current amount, John believes that recording personal goodwill/brand value at estimated current amount is appropriate.

response: The authority for personal financial statements is found in ASC 274, Personal Financial Statements (formerly SOP 82-1). ASC 274 requires that personal financial statements present assets at their estimated current


value and liabilities at their estimated current amount. For an asset, estimated current value is the amount at which the item could be exchanged between a buyer and seller.

ASC 274-10-35-10 states that:

… intangible assets shall be presented at the discounted amounts of projected cash receipts and payments arising from the planned use or sale of the assets if both the amounts and timing of the cash flows can be reasonably estimated.

The ASC does not specifically address personal goodwill. However, if John is able to obtain a valuation of the “perfect” brand, it would appear that recording a brand value/personal goodwill asset at estimated current amount may be appropriate.

ObSErvATIOn

Donald trump recorded a $3 billion asset labeled “brand value” on his personal financial statement published in his book, time to Get tough.

On the following page is Donald Trump’s personal financial statement as published in his book.

M o d u l e 2 — C h a p t e r 7 — a c c o u n t i n g p r a c t i c e I s s u e s 155

Donald j. TrumpSummary of net Worth

As of june 30, 2010

AssEts:

Cash and marketable securities- as reflected herein is after the acquisi-tion of numerous assets (i.e., multiple aircraft, golf courses, etc.), the paying off of significant mortgages for cash and before the collection of significant receivables $270, 300,000

real and operating properties owned 100% by Donald J. trump through various entities controlled by him: Commercial properties (new York City) 1,370,650,000 residential properties (new York City) 348,450,000 Club facilities & related real estate 1,220,000,000

Properties under development 261,000,000

real properties owned less than 100% for Donald J. trump:1290 Avenue of the Americas- new York CityBank of America Building- san francisco, California and others– total value, net of debt 652,200,000

real estate licensing deals 107,800,000

Miss universe, Miss usA and Miss teen usA Pageants 20,000,000

other assets (net of debt) 133,160,000

brand value (see below) 3,000,000,000

total assets 7,383,560,000

LIABILItIEs: Accounts payable 4,900,000 Loans and mortgages payable on real and operating properties as reflected above 373,760,000 total liabilities 378,660,000

nEt WortH $7,004,900,000

note: Mr. trump’s Brand value has been estimated at $3 billion and is reflected herein. the Brand value has been established by Predictiv, the highly respected brand valuation company. Predictiv assists Global 500 corporations and government agencies to improve management performance, marketing and strategy, Predictiv measures for financial Impact of Intangibles such as brand, strategy execution, innovation and post-merger integration.

source: Page 182, Time to Get Tough, Donald J. trump


ObSErvATIOn

Presumably, Donald trump was able to measure the $3 billion of brand value using some form of discounted cash flow or other method. Assuming Donald trump is able to estimate cash flows and the timing of those cash flows from use of the Donald trump brand, AsC 274 permits him to record an intangible asset using the discounted cash flow or other method.

What About recording a brand value or Personal Goodwill for a Typical Individual Who Does not Have the Expansive brand Use?Arguably, everyone has some amount of personal goodwill (or, in some cases, negative goodwill). But whether that goodwill or brand name value is mea-sureable is another issue. ASC 274 states that an intangible is recorded using a discounted cash flow or other method, if both the amounts and timing of cash flows can be reasonably estimated. In most situations, an individual is unable to measure personal goodwill because of the lack of specificity as to both the amounts and timing of cash flows that create personal goodwill. Consequently, only in rare cases, such as in the case of Donald Trump’s brand, will an individual be able to measure an intangible asset for the brand value or personal goodwill.

DISCLOSUrES OF POLICIES nOT APPLICAbLE TO THE CUrrEnT YEAr

Recently issued GAAP statements require the disclosure of certain policies in the summary of significant accounting policies. Examples include:

ASC 740, Income Taxes (FIN 48), requires disclosure of the entity’s policy on classification of interest and penalties assessed by taxing authorities.ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, requires disclosure of:

The policy for placing trade receivables on nonaccrual status (e.g., discontinuing accrual of interest)The policy for recording payments received on nonaccrual financing receivables, if applicableThe policy for resuming accrual of interest on past due accountsThe policy for determining past due or delinquency status of trade receivables

There are many more.Assume an entity does not have a policy for a particular item that must

be disclosed, or does not have the component to which the policy applies.


ExAMPLE

for year ended December 31, 20X1, Company X has no official policy for classifying interest and penalties assessed by taxing authorities (such as the Irs), and further has no interest and penalties in 20X1. Must the entity still disclose the policy under GAAP?

there is no authority on this issue other than to apply common sense. Disclosures are included to provide the user of financial statements with information on those financial statements. If a particular component of financial statements (e.g., interest and penalties) does not exist for a reporting period, it would seem useless to include a policy about an item that does not exist. that is the practical answer.

However, there is another side to this issue. First, many companies and their accountants choose to include certain policies in the notes because the components to which disclosures apply might exist in one period, but not in another. Therefore, it may be easier to retain the policy in the notes from year to year for ease and to ensure that the policy is not missed in a subsequent period in which the component does appear. Second, many accountants are concerned about dealing with an overzealous peer reviewer who chastises the accountant for missing a disclosure that is required under GAAP. In such instances, it is easier to include the disclosure in the notes than risk challenge in peer review.

Let’s look as one example of a useless disclosure related to ASC 740, Ac-counting for Uncertainty in Income Taxes (formerly FIN 48) and the policy for recording interest expense and penalties assessed by taxing authorities, such as the IRS:

nOTE x: Tax Uncertainties

the Company’s policy is to record interest expense and penalties in operating expenses. for years ended December 31, 20X2 and 20X1, there was no interest and penalties expense recorded and no accrued interest and penalties.

the Company’s federal and state tax returns are open for examination for the years 20X4, 20X5 and 20X6.

The previous example satisfies the requirement of ASC 740 (formerly FIN 48) which is to disclose the policy for recording interest and penalties. However, there are no interest and penalties in the subject years of 20X2 and 20X1. Some accountants include the above disclosure solely because they do not want to be challenged in peer review, and it will be in the notes in the event there are interest and penalties in future periods. Nevertheless, it is not required in 20X2 and 20X1.


STUDY QUESTIOn

1. Company X has no interest and penalties assessed by any taxing authorities. Which of the following is the way in which X should address the disclosure re-quired under AsC 740 regarding an entity’s policy on classification of interest and penalties assessed by taxing authorities?

a. GAAP requires the disclosure even if X has no interest and penalties.b. GAAP does not permit the disclosure.c. there is no authority as to whether a disclosure is required.d. GAAP provides a specific option for disclosure in this situation.

GAAP DEPArTUrE nOT MATErIAL

Consider the following example:Company X purchases a company in 20X1, and records goodwill in the

amount of $150,000. Total assets of X at December 31, 20X1 (including goodwill) are $1,400,000. X’s GAAP pre-tax income is about $300,000 for 20X1. GAAP requires that the goodwill not be amortized but be tested for impairment each year.

For GAAP purposes, X chooses to amortize goodwill over the tax life of 15 years on a straight-line basis ($10,000 per year), and ignore the GAAP rules. X’s argument is that the $10,000 overstatement of amortization expense for GAAP is not material to X’s income and the understatement of the asset ($10,000 in year one) is not material.

Mary Johnson, CPA is the accountant for Company X and is performing a review engagement on a GAAP basis for 20X1. Mary does not consider the $10,000 of additional amortization and the $10,000 understatement of the goodwill asset to be material to the financial statements. In fact, the $10,000 is about three percent of pretax book income ($10,000 divided by $300,000). Further, the $10,000 understatement of the goodwill asset is less than one percent of total assets. Mary does consider goodwill of $150,000 to be material to the balance sheet as it is just over 10 percent of total assets ($150,000/$1,400,000). Therefore, Mary believes the goodwill asset should be disclosed. How should Mary disclose the GAAP departure in her review report and notes to financial statements?

response: The question is whether the GAAP departure is material. In this case, X’s GAAP departure is not material to the financial statements. There-fore, Mary would have no report modification and no disclosure about the GAAP departure of amortizing goodwill. So, what should Mary disclose?

Certainly, Mary should not disclose the fact that goodwill is amortized over 15 years. Remember, the GAAP departure is not material and therefore should not be disclosed.


Here is what should be done:Because goodwill is material to the balance sheet, it should be disclosed separately on the balance sheet. However, the author recommends pre-senting goodwill at the $150,000 GAAP amount, and presenting the $10,000 of accumulated amortization in another asset account by netting the $10,000 against an “other assets” account. Amortization expense of $10,000 should not be presented separately on the income statement, statement of cash flows, or operating expenses schedules. This amount is not material. Amortization should be presented at zero in the financial statements.In the summary of significant accounting policies, the company should disclose that goodwill is not amortized and is tested annually for impair-ment.Any other disclosures related to goodwill should be made presenting data based on the assumption that goodwill is not amortized.

Take a look at the following recommended presentation:


December 31, 20X1(See Independent accountants’ review report)

AssEts:

Current assets: Cash $100,000 trade receivables, net of allowance of $10,000 500,000 Inventories 300,000 total current assets 900,000

fixed assets: Cost 1,000,000 Less accumulated depreciation 700,000 total fixed assets 300,000

other assets: Goodwill 150,000 other assets, net 50,000 (1)

$1,400,000

(1): $10,000 of accumulated amortization is netted in the other assets.


Company XStatement of Income

For the Year Ended December 31, 20X1(See Independent accountants’ review report)

net sales $4,000,000Cost of sales 3,000,000Gross profit on sales 1,000,000

operating expenses: Payroll and payroll related expenses 380,000 Insurance 20,000supplies 10,000office expenses 30,000rent 50,000Depreciation 60,000amortization 0 (1)utilities 10,000sundry other expenses, net 40,000 (1) total operating expenses 600,000

net income before income taxes 400,000

Income taxes 120,000

net income $280,000

(1): Amortization of $10,000 is netted in sundry other expenses as it is not material. Amortization expense is shown as zero. further, on the statement of cash flows, the $10,000 of amortization should not be shown as an adjustment in cash from operating activities. Instead, the $10,000 should be shown in a miscellaneous line somewhere on the statement of cash flows.

Company Xnotes to Financial Statements

For the Year Ended December 31, 20X1(See Independent accountants’ review report)

notE 1: Summary of Significant accounting Policies:

Goodwill:

the excess of the purchase price over the fair value of identifiable tangible and intangible assets is allocated to goodwill. Goodwill is not amortized unless events or circumstances occur indicating that an impairment exists. Impairment losses, if any, are recorded in the statement of income as part of income from operations.

Goodwill: the changes in the carrying value of goodwill follow:

Goodwill: Carrying value- beginning of year: $0new acquisitions 150,000 amortization 0Impairment losses ( 0)Carrying value- end of year: $150,000


ObSErvATIOn

If there is a GAAP departure that is not material, the departure should be ignored throughout the financial statements because it is immaterial. thus, the effects of the departure should not be identified in the financial statements or notes. In other words, the financial statements should present goodwill as if it had not been amortized and in full compliance with GAAP.

Perhaps just as important, the accountant or auditor should make sure he or she documents in his or her working papers the fact that the GAAP departure is not material as this issue may be addressed in peer review.

Should the Goodwill be Tested for Impairment?Yes, it should be tested for impairment. However, it is likely that any impair-ment, if any, would not be material.

What if the $150,000 of Goodwill is not Material to the balance Sheet?If the goodwill is not material, it should not be mentioned in the financial statements. Instead, it would make sense to include goodwill in the other assets section and not present it as a separate item on the balance sheet. Further, if goodwill is not material, there would be no disclosures required for goodwill.

Direct Write-Off MethodGAAP requires that the allowance method be used to account for bad debts. The direct write-off method, although required for tax purposes, is not ac-ceptable for GAAP. However, there are instances in which the result using the direct write-off method is not materially different from the result had the allowance method been used. This may be in a situation when, historically, the company has not had a material amount of bad debts. In such a situa-tion, the company may opt to simply use the direct write-off method and argue that the company is using the allowance method with a zero allowance balance required. Under no circumstances should the company disclose that it used a non-GAAP method (direct write-off method) unless it is going to identify a GAAP departure in the notes and report.

InCOME TAxES

Presentation of Tax benefit of nOL Carryforward

How should the use of an unused net operating loss carryover be presented on the income statement?

response: ASC 740, Income Taxes (formerly FAS 109), requires the tax benefit of the NOL to be presented as a direct reduction in the current portion of income tax expense with a corresponding disclosure.


Example: A company has a $300,000 NOL carryforward in 20X1 and records a deferred income tax asset as follows:

Entry: 20X1

DIt asset ($300,000 x 34%) 102,000 Income tax expense- deferred 102,000

The $300,000 unused NOL is carried over from 20X1 to 20X2.

20X2 information:

taxable income before noL $800,000 noL carryforward utilized (300,000) taxable income 500,000 tax rate 34% Current fIt provision $170,000

Conclusion: The December 31, 20X2 entry consists of two components:Current accrual provision of $170,000 Reversal of the $102,000 deferred income tax asset that is used in 20X2

Entry: 20X2

Income tax expense- current provision 170,000 Accrued fIt 170,000 Income tax expense- deferred 102,000

Deferred income tax asset 102,000

The total federal income tax expense in 20X2 looks like this:

Current provision (net of noL) $170,000 Deferred 102,000

total provision (fIt expense) $272,000

Presentation on the statement of income: net income before income taxes $XX Income tax expense 272,000 net income $XX


The notes to financial statements should show the components of income tax expense as follows:

nOTE 1: Income Taxes

the provision for income taxes includes federal taxes currently payable and deferred in-come taxes arising from assets and liabilities whose basis is different for financial reporting and income tax purposes. the majority of the deferred tax provision is the result of basis differences in recording depreciation and accruing certain expenses.

The provision for income taxes is summarized as follows:

Federal:

Currently payable $272,000(1)Deferred 102,000reduction due to use of net operating loss carryforward (102,000)(2) total federal provision 272,000

State: Currently payable xxDeferred xx total state provision xx total provision xx

(1) 800,000 x 34% = 272,000(2) 300,000 x 34% = (102,000)net current provision 170,000

Tax rate to Use for DITs

A company is a C corporation with taxable income ranging from $50,000 to $100, 000 per year. In recording deferred tax assets and liabilities, what federal tax rate should be used?

response: ASC 740-10-30 states that a deferred tax liability or asset is recorded using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.

In situations in which graduated (margin) tax rates are a “significant factor,” ASC 740-10-30 states that the deferred liability or asset shall be measured using the average graduated tax rate applicable to the amount of estimated annual taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized. Thus, the average gradu-ated tax rate should be used based on the level of taxable income (including reversal of the temporary difference) in the reversal years.


Consider the following table:

Taxable income increment

Cumulative taxable income

(b)

Marginal tax rate on increment

Marginal tax

Cumulative Tax(A)

Average graduated tax rate

(A)/(b)

$50,000 $50,000 15% $7,500 $7,500 15%25,000 75,000 25% 6,250 13,750 18%25,000 100,000 34% 8,500 22,250 22%

100,000 200,000 39% 39,000 61,250 31%100,000 300,000 39% 39,000 100,250 33%

35,000 335,000 39% 13,650 113,900 34%65,000 400,000 34% 22,100 136,000 34%

100,000 500,000 34% 34,000 170,000 34%9,500,000 10,000,000 34% 3,230,000 3,400,000 34%

>$10,000,000 35% 35%

ExAMPLE

Company X has a temporary difference related to accumulated depreciation in the amount of $40,000 which will reverse evenly over the next 10 years. Assume that X estimates that its taxable income, including the reversal of the temporary difference, will be ap-proximately $100,000 in each of the 10 reversal years.

Because estimated taxable income in the 10 reversal years will be approximately $100,000, the graduated tax rates range from 15 percent to 34 percent and those rates will be a significant factor. therefore, GAAP requires that average graduated tax rates for the es-timated amount of taxable income (including the reversal of the temporary difference) should be used to record the deferred income tax liability. the average graduated income tax rate on $100,000 of taxable income is 22 percent (see previous chart).the deferred tax liability should be recorded as follows:

temporary difference $40,000Average graduated tax rate 22%Deferred tax liability $8,800

What about using the effective tax rate to record deferred tax liabilities or assets?ASC 740 is clear that deferred tax liabilities and assets should be recorded using enacted tax rates, and not effective tax rates.

STUDY QUESTIOn

2. A company has an unused net operating loss carryover to the current year. the tax benefit of the noL should be presented as which of the following?

a. As a separate line item on the income statementb. As a direct reduction in the current portion of income tax expensec. As income presented in the other income section of the income statementd. GAAP does not give guidance on the presentation.


OCbOA (InCOME TAx bASIS FInAnCIAL STATEMEnTS)— PrACTICE ISSUES

Section 179 Depreciation - OCbOACompany X is a C Corporation which issues income tax basis (accrual) OCBOA financial statements. For the year ended December 31, 20X1, X had a Section 179 deduction for fixed asset additions totaling $125,000. X’s taxable income before the Section 179 deduction was $75,000. Be-cause of the taxable income limitation, X was able to use only $75,000 of the Section 179 depreciation, with the remainder $50,000 carried forward unused.

In preparing its 20X1 financial statements on the income tax basis of ac-counting, should X record the entire $125,000 of Section 179 depreciation or only the $75,000 with a carryover of the remainder $50,000 unused to 20X2?

There is no authority on this particular point. However, the definition of income tax basis is:

Income tax basis of accounting is based on the principles and rules for accounting under the federal income tax laws and regulations.

Although there are instances in which income in income tax basis financial statements differs from tax return income, those instances are generally lim-ited to non-taxable and non-deductible (permanent) differences. Examples of such non-taxable and non-deductible items include, among others:

Non-taxable interestNon-deductible life insuranceNon-deductible meals and entertainmentPenalties

Those non-taxable and non-deductible items are permanent differences and are shown on the income tax basis financial statements as income and expense items even though excluded from the tax return. Thus, net income on income tax basis financial statements generally may differ slightly from taxable income per the tax return.

With respect to Section 179 depreciation, the amount of such depreciation shown on the income tax basis financial statements should be the same as the amount deducted on the tax return. Thus, in this example, $75,000 of Section 179 depreciation should be shown on the financial statements with the remaining $50,000 carried over to the next year and disclosed. Thus, financial statement net income on an income tax basis is zero, assuming no permanent differences.

What do you do with the $50,000 depreciation difference on the bal-ance sheet?


In the above example, there is a math problem and a $50,000 item (the unused 179 deduction) that results in retained earnings not balancing. If X records the $125,000 of depreciation as a credit to accumulated deprecia-tion, but only deducts $75,000 of depreciation on the OCBOA income statement, how does retained earnings balance?

It doesn’t balance. Instead, a balance sheet adjustment must be made to reflect the $50,000 of depreciation not deducted in 20X1. Although there is no authority, the best way to handle the difference is to reduce accumulated depreciation by the $50,000 to essentially reverse the section 179 depreciation for that portion unused. The result is that only $75,000 of depreciation is recorded as a credit to accumulated depreciation. What this means is that the OCBOA financial statements balance sheet accumulated depreciation does not agree with accumulated depreciation on Schedule L of the tax return. There is a $50,000 difference.

ObSErvATIOn

If X were an s corporation or partnership, there would be no limit on the deduction of the section 179 depreciation. Instead, the entire $125,000 of section 179 depreciation would be recorded on the oCBoA income statement. thus, by being a C corporation, oCBoA net income is different than oCBoA net income if the entity were an s corporation or a partnership. some companies treat the unused section 179 depreciation as an adjustment to retained earnings, similar to a schedule M-1 item.

Option 1: record only the $75,000 of Section 179 depreciation expense on the income statement and carry forward the unused $50,000.

Income Statement—Income tax basis

net sales $XXCost of sales XXGross profit on sales XXoperating expenses: Depreciation (75,000)net income XX

retained earnings—income tax basis Beginning of year XX End of year $(75,000)


balance Sheet—Income tax basisfixed assets: Cost XXLess accumulated depreciation (75,000)

stockholders’ equity: Common stock, XX retained earnings—income tax basis: (75,000)

Entry:

Depreciation 75,000 AD 75,000

Option 2: record the $75,000 of Section 179 depreciation expense on the income statement and record the other $50,000 as an adjustment to retained earnings:

Income Statement—Income tax basisnet sales $XXCost of sales XXGross profit on sales XXoperating expenses: Depreciation (75,000)net income XX

retained earnings (accumulated deficit)—income tax basis Beginning of year XX adjustment for additional depreciation (50,000) End of year XX

balance Sheet—Income tax basisfixed assets: Cost XX Less accumulated depreciation (125,000)

stockholders’ equity: Common stock XX retained earnings (accumulated deficit)—income tax basis (125,000)

Entry:

Depreciation 75,000retained earnings 50,000 AD 125,000


ObSErvATIOn

the author thinks the option 2 is flawed and should not be followed. After all, the income tax basis of accounting should follow the “principles and rules for accounting under the federal income tax laws and regulations.” that means that the income statement should follow the income tax return, other than permanent differences. flowing the unused $50,000 of section 179 deduction through retained earnings appears inconsis-tent with the principles and rules for accounting under the federal income tax laws and regulations. of course, there is no authority in this situation. following the first option of recording the $75,000 of depreciation only on the income statement and reversing off the other $50,000 through accumulated depreciation appears to make more sense even if the accumulated depreciation on the oCBoA balance sheet does not agree with schedule L on the tax return.

Agreements not to Compete—OCbOACompany X issues income tax basis financial statements. In 2004, Company X entered into an agreement not to compete with a party that had a five-year term which has now expired. Yet, the company continues to amortize the agreement over 15 years for tax purposes even though the economic life (five years) has expired. Is this the correct approach?

Yes, because the company is issuing OCBOA (income tax basis) finan-cial statements and thus is subject to the amortization rules of the Internal Revenue Code which provides for 15-year amortization under Code Sec. 197. In this case, the company continues to amortize the agreement even though the five-year period has expired.

Should the company continue to disclose the terms of the agreement because it has expired but is still being amortized for income tax purposes?

There is no hard and fast rule. Given the fact that the agreement is not in effect, it would appear the disclosure of the terms of the agreement could be eliminated from the disclosure although the other disclosures related to intangible assets should be included such as:

Amortization policyAmortization expenseEstimated amortization expense for the five subsequent yearsGross carrying amount of the intangible asset and accumulated amortization


nOTE 1: Summary of Significant Accounting Policies

Agreement not to compete:

Intangible assets consist of an agreement not to compete that is amortized on a straight-line basis over 15 years in accordance with the Internal revenue Code.

nOTE 2: Intangible Assets

the following is a summary of intangible assets at December 31, 2013:

Gross carrying amount

Accumulated amortization

agreement not to compete $300,000 $200,000

$300,000 $200,000

As a part of its 2004 purchase of the net assets of ABC Manufacturing, the company entered into an agreement not to compete with a key officer of ABC Manufacturing. under the terms of the agreement, the officer was paid $300,000 in exchange for his agreement not to compete in the business of manufacturing certain products sold by the company for a period of five years through 2008. In accordance with the Internal revenue Code, the Company is required to continue to amortize the agreement not to compete through year 2018.

Amortization expense was $20,000 in 2013.

Based on intangible assets owned by the Company at December 31, 2013, estimated amortization expense for the five years subsequent to 2013 follows:

YearEstimated

Amortization expense2014 $20,0002015 20,0002016 20,0002017 20,0002018 20,000

Beyond 2018 0$100,000

STUDY QUESTIOn

3. In using income tax basis financial statements, the amount of section 179 depreciation that should be shown on such statements of a C corporation should ____________.

a. Be deferredb. Always be the same as what would be recorded on the tax return for an s

corporationc. Be the same as the amount shown on the tax returnd. Be recorded in its entirety even if it creates a loss


CPE nOTE: When you have completed your study and review of chapters 4-7, which comprise Module 2, you may wish to take the Quizzer for this Module.



171

MoDuLE 3: otHEr CurrEnt DEvELoPMEnts – CHAPtEr 8

aSu 2013-04: Joint and Several Liability arrangements with Fixed obligations

This chapter discusses ASU 2013-04, Liabilities (Topic 405), Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation is Fixed at the Reporting Date. It examines require-ments of the ASU including the scope, disclosures, and transition rules. Numerous examples are included.

LEArnInG ObjECTIvES

upon completion of this chapter, the reader should be able to:

Indicate how a reporting entity measures an obligation under Asu 2013-04state the obligations to which Asu 2013-04 appliesDescribe how a liability for a guarantor is measured under AsC 460state the transition rules and effective date of Asu 2013-04

OvErvIEW

ASU 2013-04, Liabilities (Topic 405), Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation is Fixed at the Reporting Date was issued in February 2013. The objective of the amendments in ASU 2013-04 is to provide guidance for the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation within the scope of this guidance is fixed at the reporting date. It does not apply to obligations addressed within existing guidance in U.S. GAAP.

bACkGrOUnD

In some instances, several entities may engage in a transaction in which each entity is jointly and severally liable for the joint obligations of the entities; that is, a liability is established that is shared by more than one party. Examples of such obligations include:

Debt arrangements Contractual obligations Settled litigation and judicial rulings


Currently, U.S. GAAP offers no specific guidance on accounting for such obligations, including the recognition, measurement, and disclosure of such obligations. Consequently, there are variations in practice.

Some entities record the entire amount of the obligation under the joint and several liability. This is on the basis of the concept of a liability and based on the premise that the amount recorded should equal the amount that must be satisfied to extinguish a liability under the guidance in ASC 405-20, Li-abilities—Extinguishments of Liabilities.

Other entities record a portion of the total obligations allocated among all ob-ligors. The allocation method may be based on the amount allocated among the entities, the amount of proceeds received, or the portion of the amount the entity agreed to pay among its co-obligors. This allocation method is based on guidance found in the contingent liabilities rules in ASC 450-20, Contingencies—Loss Contingencies, and ASC 410-30, Asset Retirement and Environmental Obligations—Environmental Obligations. ASC 410-30 permits an entity to record its estimated portion of the total obligation subject to joint and several liability.

nOTE

International standards also do not offer specific guidance on the accounting and dis-closures related to obligations under joint and several liability arrangements. Instead, international standards require an entity to treat that portion of a joint and several liability that is expected to be met by other parties as a contingent liability under International Accounting standards (IAs) 37, Provisions, Contingent Liabilities and Contingent Assets. Although the guidance of IAs 37 applies to contingent liabilities, contingent liabilities are not included within the scope of Asu 2013-04. However, the measurement approach in IAs 37 for joint and several liabilities is rather consistent with the measurement approach in Asu 2013-04. In effect, Asu 2013-04 does not eliminate any existing differences that currently exist between u.s. GAAP and Ifrs.

ASU 2013-04 was put on the agenda by the FASB’s Emerging Issues Task Force (EITF), which decided to issue the ASU to provide guidance and consistency in practice to deal with joint and several obligations. In the end, ASU 2013-04 requires an entity to measure obligations resulting from joint and several liability arrangements for which the total amount of the obliga-tion is fixed at the reporting date, as the sum of two components:

The amount the reporting entity agreed to pay on the basis of its ar-rangement among its co-obligorsAny additional amount the reporting entity expects to pay on behalf of its co-obligors

M o d u l e 3 — C h a p t e r 8 — a S u 2 0 1 3 - 0 4 173

nOTE

the fAsB Emerging Issues task force (EItf) chose not to define the term “expects to pay.” Consequently, an entity should weigh all facts and circumstances to determine the amount that an entity expects to pay on behalf of all co-obligors (co-borrowers).

If there is some amount within a range of the additional amount the report-ing entity expects to pay that is a better estimate than any other amount within the range, that amount shall be the additional amount included in the measurement of the obligation. If no amount within the range is a better estimate than any other amount, then the minimum amount in the range shall be the additional amount included in the measurement of the obligation.

ObSErvATIOn

use of the “better estimate” within a range or, absent a better estimate, the minimum amount within the range, is consistent with the rules found in AsC 450, related to loss contingencies.

ObSErvATIOn

AsC 410-30-30, Asset Retirement and Environmental Obligations, Environmental Obli-gations-Initial Measurement, offers a parallel to the accounting for the joint and several obligation situation found in Asu 2013-04. In AsC 410-30-30, an entity is required to record an environmental remediation liability based on that entity’s estimate of its al-locable share of the joint and several remediation liability. In making that estimate, the entity is required to take certain actions that include assessing the likelihood that other parties will pay their full allocable share of the joint and several remediation liability. In Asu 2013-04, the fAsB EItf does not require that the co-borrower assessment the “likelihood” that other parties will pay. Instead, the Asu states that the company should calculate the amount it “expects to pay,” which does not reflect likelihood.

The guidance in the ASU also requires an entity to disclose the nature and amount of the obligation as well as other information about those obligations.

Problem with Current PracticeOne of the problems with existing practice that led to the issuance of ASU 2013-04 was that several co-borrowers involved with each other under a joint and several liability arrangement would potentially record duplicate liabilities to account for the same liability obligation.


ExAMPLE

Companies X, Y, and Z are co-borrowers of a loan in the amount of $3 million. Each of the companies receives one-third of the proceeds ($1 million) and each is jointly and severally liable for the entire $3 million. Because each company is potentially liable for $3 million, each company records the entire $3 million liability even though each only receives $1 million. the result is that the entire liability recorded among the three entities is:

Liability recorded

Company X $3,000,000 Company Y 3,000,000 Company Z 3,000,000

$9,000,000

Because of the fact that each company is jointly and severally liable for the entire $3 million, the companies collectively record total liabilities of $9 million. there is clearly redundancy.

SCOPE

The amendments in ASU 2013-04 apply to all entities, both public and nonpublic, that have obligations resulting from joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date and for which no specific guidance exists. The ASU applies to obligations that have the following two criteria:

1. There must be a joint and several liability arrangement. 2. The total amount under the arrangement must be fixed at the report-

ing date.

ASU 2013-04 does not apply to obligations accounted for under the fol-lowing ASC topics:

Asset Retirement and Environmental Obligations, ASC Topic 410 Contingencies, ASC Topic 450 Guarantees, ASC Topic 460 Compensation—Retirement Benefits, ASC Topic 715 Income Taxes, ASC Topic 740

In order for the total amount of an obligation to be considered fixed at the reporting date, there can be no measurement uncertainty at the reporting date relating to the total amount of the obligation. However, although the obligation must be fixed at the reporting date, the total amount of the obli-gation may change subsequent to the reporting date because of factors that are unrelated to measurement uncertainty.


ExAMPLE

Company X has a line of credit obligation under a joint and several arrangement with another company. Both X and the other company have joint and several liability under the line of credit. At the reporting date, the amount of the line of credit outstanding is fixed. Although the amount of the line of credit outstanding is fixed at the reporting date, the total amount of the obligation (line of credit) may change in future periods because an additional amount is borrowed under the line of credit, or because the interest rate on the line of credit changes. the fact that the amount of the obligation might change subsequent to the reporting date does not negate the fact that the obligation is fixed at the reporting date.

The ASU applies to all joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date, regardless of the relationship among parties involved in the arrangement. A joint and several liability arrangement is not excluded from the scope of the ASU because the parties involved are unrelated or related.

The ASU does not apply to guarantors of an obligation. A joint and several liability arrangement involving an entity as a guarantor (instead of borrower) of an obligation must follow the guidance of ASC 460, Guarantees, and not ASU 2013-04.

Liabilities subject to a measurement uncertainty (e.g., not fixed) are excluded from the scope of the ASU and should continue to be accounted for under the guidance in ASC 450, Contingencies, or other U.S. GAAP.

STUDY QUESTIOnS

1. In order for Asu 2013-04 to apply to an entity, the total amount under the ar-rangement must be _________________.

a. Predictableb. Calculablec. fixedd. Determinable

2. Asu 2013-04:

a. Does not apply to guarantors of an obligationb. Applies to guarantors as long as AsC 460 is followedc. Applies to a guarantor only if the guarantor is not the primary obligord. Does not address whether it applies to guarantors


ADDITIOnAL rULES

An arrangement may be included in the scope of the ASU at the inception of the arrangement (such as a debt arrangement), while in other circumstances, the arrangement may be included in the scope of the ASU after the incep-tion of the arrangement (such as when the total amount of the obligation becomes fixed in a subsequent period).

At the inception of a guarantee, the guarantor shall recognize in its state-ment of financial position a liability for that guarantee. The initial measure-ment of the liability is the fair value of the guarantee. The fair value of the liability shall be based on a standalone arm’s-length transaction. When a guarantee is issued in a standalone arm’s-length transaction with an unrelated party, the liability recognized at the inception of the guarantee should be the premium received or receivable by the guarantor.

related Party GuaranteesASC 460 does not apply to related party guarantees. Therefore, if an entity guarantees the debt of a related party, the guarantor is not required to record a liability (at fair value) in accordance with ASC 460.

ExAMPLE 1

Company X guarantees the debt of its related party, Company Y. Because X is a guarantor of a related-party’s debt, the rules found in AsC 460, Guarantees, apply. under those 460 rules, X is exempt from having to record a liability for the guarantee obligation, because X is giving a related-party guarantee.

If, instead, X and Y were not related parties, X would be recorded to record a liability at the inception of the guarantee, based on the fair value of the guarantee on that date.

ExAMPLE 2

Company X is a co-borrower of the debt of its related party, Company Y. Because X is a co-borrower (and not a guarantor) of a related-party, joint and several obligation that is fixed in amount, X must comply with the provisions of Asu 2013-04, which require X to record a liability. that liability is recorded on X’s balance sheet at:

the amount that X agreed to pay on the basis of its arrangement with Y, and Any additional amount that X expects to pay on behalf of its co-obligor, Y.

the corresponding entry or entries to recording the obligation depend on the facts and circumstances of the obligation. Examples of some corresponding (debit) entries include:

Cash for proceeds from a debt arrangement An expense for a legal settlement A receivable (that is assessed for impairment) for a contractual right An equity transaction with an entity under common control where there is equity ownership


nOTE

In instances in which a legal or contractual arrangement exists to recover amounts funded under a joint and several obligation from the co-obligors, the fAsB EItf noted that a re-ceivable could be recognized at the time the corresponding liability is established. After recording, that receivable would need to be assessed for impairment. When no legal or contractual arrangement exists to recover the funded amounts from the co-obligors, the fAsB EItf noted that an entity should consider all relevant facts and circumstances to determine whether the gain contingencies guidance found in AsC 450-30, Gain Contingen-cies, or other guidance would apply in recognizing a receivable for potential recoveries.

Disclosures An entity shall disclose the following information about each obligation, or each group of similar obligations, resulting from joint and several liability arrangements:

The nature of the arrangement, including: How the liability arose The relationship with other co-obligors The terms and conditions of the arrangement

The total outstanding amount under the arrangement, which shall not be reduced by the effect of any amounts that may be recoverable from other entities The carrying amount, if any, of an entity’s liability and the carrying amount of a receivable recognized, if any The nature of any recourse provisions that would enable recovery from other entities of the amounts paid, including any limitations on the amounts that might be recoveredIn the period the liability is initially recognized and measured or in a period the measurement changes significantly:

The corresponding entry Where the entry was recorded in the financial statements

nOTE

the disclosures required by the Asu do not affect the related-party disclosure require-ments in AsC 850, Related Party Disclosures. the disclosure requirements in the Asu are incremental to those requirements.

Transition and Effective DateASU 2013-04 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. For nonpublic entities, it is ef-fective for fiscal years ending after December 15, 2014, and interim and annual periods thereafter. Earlier application is permitted.


The ASU must be applied retrospectively to all prior periods presented for those obligations resulting from joint and several liability arrangements within the scope of the ASU that exist at the beginning of an entity’s fiscal year of adoption. An entity may elect to use hindsight for the comparative periods presented in the initial year of adoption (if it changed its accounting as a result of adopting the ASU) and shall disclose that fact. The use of hind-sight would allow an entity to recognize, measure, and disclose obligations resulting from joint and several liability arrangements within the scope of this Subtopic in comparative periods using information available at adoption rather than requiring an entity to make judgments about what information it had in each of the prior periods to measure the obligation.

An entity shall disclose information required in ASC 250, Accounting Changes and Error Corrections, within paragraphs 250-10-50-1 through 3, in the period the entity adopts the new content.

ExAMPLE 1

Company X and Y are co-borrowers of a $2 million loan, with each party receiving $1 mil-lion of cash from the loan. under X and Y’s agreement, X and Y agree to be co-borrowers on a 50-50 basis. to the extent that either party is required to pay more than 50 percent of any loan deficit in default, the other party agrees to indemnify that party for the per-centage paid in excess of 50 percent. Both X and Y are financially solvent and have the financial wherewithal to satisfy each entity’s share of the guarantee. At December 31, 20X1, the loan balance is $2 million. What is the amount of liability that X should record on its balance sheet?

Conclusion:

under Asu 2013-04, obligations resulting from joint and several liability arrangements where the total amount under the arrangement is fixed at the report date shall be mea-sured as the sum of the following:

1. the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors, and

2. Any additional amount the reporting entity expects to pay on behalf of its co-obligors, using the guidance similar to the rules found in AsC 450, Contingencies.

In this example, the obligation is fixed at the December 31, 20X1 balance sheet date, which is $2 million. X should record a liability for its share of the obligation as follows:

the amount that X agrees to pay on the basis of its arrangement with Y: $1,000,000Any additional amount that X expects to pay on behalf of Y: $0total liability $1,000,000

Entry:

Cash 1,000,000 Liability 1,000,000


Because the amount of the total obligation is fixed at $2 million at the balance sheet date, X must record a liability for the joint and several obligation. the recorded amount has two parts. first is the amount that X agrees to pay under its debt obligation, which is $1 million. the second portion is any additional amount that X expects to pay on behalf of Y. Because Y is solvent, X should not expect to pay any additional amount beyond the $1 million.

ExAMPLE 2

same facts as Example 1 except that Company Y is having financial problems at December 31, 20X1. X is concerned that if the $2 million loan is called, X may have to pay a portion of Y’s share of the obligation. X believes that the range of possible exposure to Y’s share of the liability is $500,000 to $1 million with no amount within the range being a better estimate.

Conclusion:

X should record a liability for its share of the obligation as follows:

the amount that X agrees to pay on the basis of its arrangement with Y: $1,000,000Any additional amount that X expects to pay on behalf of Y: 500,000total liability $1,500,000

Entry:

receivable—Company Y 500,000 Cash 1,000,000 Liability 1,500,000

the amount of the liability related to the joint and several obligation is the sum of two parts. the first part is the amount that X agrees to pay under its joint venture agreement with Y, which is the $1 million that was received in cash. the second part consists of the additional amount that X expects to pay on behalf of Y. Because Y is having financial difficulties, X expects that if the total loan is called, X may have to pay an additional amount ranging from $500,000 to $1 million with no amount within the range being a better amount.

Asu 2013-04 states that when there is a range of additional amounts, and there is no better estimate within the range, the entity should record the minimum amount within the range, which in this case is $500,000. thus, the total liability that X should record under its joint and several obligation is $1,500,000.

now to the debit side of the entry. X should record cash for the $1 million it received for its share of the loan proceeds. In addition, X should record a receivable for $500,000 due from Company Y for the additional amount that Y would owe X as reimbursement under X and Y’s joint venture agreement.

once the $500,000 receivable is recorded, it should be tested for impairment each period. In fact, given that Y has financial difficulties, it may be difficult for X to justify that it would be able to collect the $500,000 from Y.


What if X does not have a contractual right to recover the receivable from Y?

Assume that in Example 2, X and Y have not contractually agreed to indemnify each other for any portion of the total obligation that one entity has to pay beyond its 50 percent share.

If that is the case, would X have a right to recover the $500,000 receivable from Y if X had to pay that excess portion of the obligation belonging to Y?

Because there is no legal or contractual arrangement to recover the funded amounts from Y, as co-obligor, X should consider whether the $500,000 represents a gain contingency instead of a receivable. When there is a gain contingency, the guidance of AsC 450-30, Gain Contingencies, applies, which states that a gain contingency should not be recorded until realized. In this case, without a contractual right to recovery, the receivable becomes realized only once there is an agreement for recovery, either by settlement agreement or court order. the odd part of this situation is that if the $500,000 receivable cannot be recorded because it is a gain contingency, then what is the debit to the entry? (the fAsB EItf did not opine as to the debit side of the entry.)

ExAMPLE 3

Companies C and D are sued as co-defendants and settle the case for $5 million. under the settlement agreement, C and D agree to pay the $5 million to the plaintiff over the next five years. C and D have joint and several liability. C and D also consummate an agreement between themselves under which each party agrees to pay $2.5 million toward the $5 million. If either party fails to pay its $2.5 million share and the other party pays the shortfall, the paying entity will be indemnified by the other party.

the balance sheet date is December 31, 20X1. Company C is issuing financial statements and wants to know how much liability to record. Both entities are solvent.

Conclusion:

Because the total obligation is fixed at $5 million at the December 31, 20X1 balance sheet date, the rules of Asu 2013-04 apply. that means that C must record a liability for its share of the obligation as follows:

the amount that C agrees to pay on the basis of its joint and several obligation arrangement: $2,500,000Any additional amount that C expects to pay on behalf of D: $0total liability $2,500,000

Entry:Legal settlement expense 2,500,000 Liability 2,500,000

C’s share of the fixed obligation is $2,500,000. Because D is solvent, C does not expect to pay an additional amount for any shortfall by D. thus, the total liability that C should record at December 31, 20X1 is $2,500,000.


ExAMPLE 4

same facts as Example 3, except that D is having financial trouble. C is concerned that it may have to pay a portion of C’s obligation under its joint and several obligation. C estimates the range of possible liability is $1 million to $2.5 million.

Conclusion:

C should record $3.5 million for its share of the obligation, computed as follows:

the amount that C agrees to pay on the basis of its joint and several obligation arrangement: $2,500,000Any additional amount that C expects to pay on behalf of D: 1,000,000 total liability $3,500,000

Entry:

receivable—Company D 1,000,000 Legal settlement expense 2,500,000 Liability 3,500,000

Because D is having financial trouble, C’s liability should include not only its share of the settlement amount ($2.5 million) but also an additional amount that C expects to pay of D’s $2.5 million obligation. C estimates that the range of possible payment that C may have to pay of D’s share of the liability is $1 million to $2.5 million, with no better estimate within that range. thus, C should record the lowest amount within the range, which is $1 million. total estimated liability is $3.5 million.

the debit consists of $2.5 million of legal settlement expense, and a receivable due from Company D for the $1 million of estimated additional liability C expects to pay from D’s share of the obligation. once the receivable is recorded, C should evaluate that receiv-able for impairment.

ExAMPLE 5

Companies C and D are sued but at December 31, 20X1, there is no settlement with the plaintiff.

Conclusion:

the rules of Asu 2013-04 do not apply because the joint and several obligation is not fixed at the balance sheet date. Instead, C should follow the contingency rules found in AsC 450, Contingencies. under those rules, C would record a liability if it meets the probable and estimable criteria.


STUDY QUESTIOn

3. In accordance with Asu 2013-04, if an entity has no legal or contractual arrange-ment to recover the funded amounts from a co-obligor, the debit side of the transaction may be considered a _______________.

a. Loss contingencyb. Gain contingencyc. Deferred creditd. operating expense

Dealing With related Parties Involved in joint and Several ObligationsASU 2013-04 applies to joint and several obligations where the obligation amount is fixed at the balance sheet date. The ASU does not differentiate be-tween those joint and several obligations among unrelated or related parties. Thus, related-party entities that are co-obligors (co-borrowers) must follow ASU 2013-04’s guidance. It is not uncommon for one entity to act as a co-borrower for another related party that requires the financial strength of its affiliate.

ExAMPLE 1

Company E and f are related parties, both owned by Johnny James. Company f needs to borrow $5 million for its operations. Company E agrees to be a co-borrower with f in obtaining the $5 million loan. All of the proceeds from the loan are received by f to be used in f’s operations.

E and f agree that each will be responsible for $2.5 million of the loan. Although E is financially stronger than f, E expects that f will be able to pay off its share of the $2.5 million loan. What is the amount of liability that E should record with respect to its co-borrowing under the $5 million loan?

Conclusion:

E should record the following liability:

the amount that E agrees to pay on the basis of its joint and several obligation arrangement with f: $2,500,000Any additional amount that E expects to pay on behalf of f: $0 total liability $2,500,000

Entry—Company E:

receivable—Company f 2,500,000 Liability—bank loan 2,500,000

What entry should f make?

Entry—Company f:

Cash (loan proceeds) 5,000,000 Liability—bank loan 2,500,000 Liability—Company E 2,500,000


Assuming f reaches the same conclusion as E, f would record $2,500,000, consisting of the portion of the $5 million loan that f agrees to pay on the basis of its joint and several obligation arrangement with E. the remainder of the $2.5 million is payable to Company E, representing its share of the loan proceeds that it did not receive.

ExAMPLE 1A

same facts as Example 1 except that f is financially weak and needs Company E to be a co-borrower in order for f to obtain the $5 million loan. E expects to pay all $2.5 million of f’s share of the obligation if the loan is called.

E should record the following liability:

the amount that E agrees to pay on the basis of its joint and several obligation arrangement with f: $2,500,000Any additional amount that E expects to pay on behalf of f: $2,500,000 total liability: $5,000,000

Entry—Company E:

receivable—Company f 5,000,000 Liability—bank loan 5,000,000

once the liability and related receivable are recorded, E would have to test the $5 mil-lion receivable for impairment and possible writedown. the fact that f is having financial difficulty may indicate that the receivable is not recoverable.

f’s entry:

the amount that f agrees to pay on the basis of its joint and several obligation arrangement: $2,500,000Any additional amount that f expects to pay on behalf of E: $0 total liability $2,500,000

Entry—Company f

Cash (loan proceeds) 5,000,000 Liability—bank loan 2,500,000 Liability—Company E 2,500,000

notice that there is the potential for double recording of the same liability. Company E records a total liability of the bank loan of $5 million while f records an additional $2.5 million, for a total of $7.5 million. Yet, the total bank loan balance is only $5 million.

As E records an additional $2.5 million of the obligation to reflect that portion of f’s obligation that E expects to pay, there is no corresponding reduction of the liability on f’s books. the result is that the total liability recorded is $7.5 million.

this is a perfect example of a situation in which two parties can reach different conclusions that do not result in transactions being a mirror of each other.


ObSErvATIOn

It is quite common for related parties to act as co-borrowers on one single bank loan. typi-cally the loan proceeds are scattered among the entities and all of the parties remain jointly and severally liable. In such situations, one or more of the related-party co-borrowers might be financially weak with no ability to repay its share of the loan obligation. When this occurs, a stronger entity might be required to record an additional liability for that portion of the total obligation that the entity “expects to pay” on behalf of a financially weaker related party entity.

ExAMPLE 1b

Company E and f are related parties, both owned by Johnny James. f needs to borrow $5 million for its operations. Company E agrees to act as a guarantor (not a co-borrower) of f’s $5 million bank loan. All of the proceeds from the loan are received by f to be used in f’s operations. E and f have no formal agreement as to indemnification for the guarantee. What is the amount of liability that E should record with respect to its co-borrowing under the $5 million loan?

Conclusion:

E should record no liability. Because the joint and several obligation involves E in the capac-ity as a guarantor, not a co-borrower, the rules of Asu 2013-04 do not apply. Instead, E should follow the guarantee rules found in AsC topic 460, Guarantees. AsC 460 requires a guarantor to record a liability.

185

MoDuLE 3: otHEr CurrEnt DEvELoPMEnts—CHAPtEr 9

Selected Accounting and reporting Developments

This chapter discusses several ongoing issues in accounting and reporting including the proposed liquidation basis of accounting, going concern as-sessment by management, politically motivated disclosures, and the effects of post office changes on working capital.

LEArnInG ObjECTIvES


Discuss the major proposed guidance for the liquidation basis of accounting.List the financial statements that would have to be included on a liquidation basis under the proposed guidance.recognize the fAsB decisions related to an entity’s going concern assessment and disclosures.List some of the new disclosures required under the Dodd-frank Act.state the possible accounting impacts from the change in the u.s. Post office delivery policy.

PrOPOSED LIQUIDATIOn bASIS OF ACCOUnTInG

Current GAAP assumes that an entity will continue as a going concern which is the reason why financial statements are recorded at a mixture of cost, lower of cost or market, fair value, and other measurements.

If an entity is not going to continue as a going concern, the entity’s bal-ance sheet should be recorded at liquidation value. In fact, the reason why an auditor modifies his or her audit report when there is “substantial doubt” of an entity’s ability to continue as a going concern is because that entity’s balance sheet is incorrectly presented. That is, if there is substantial doubt of going concern, the balance sheet should be adjusted to liquidation value.

To date, there has been little authoritative guidance as to when liquidation accounting should be used and how to apply it as well as required disclosures.

In July 2012, the FASB issued an exposure draft entitled Presentation of Financial Statements (Topic 205)-The Liquidation Basis of Accounting. The exposure draft is slated to pass as a final statement in 2013.

The project will focus on the following:

Liquidation: The process by which an entity converts its assets to cash or other assets and partially or fully settles its obligations with creditors in anticipation of the entity ceasing its operations. Any remaining cash or other assets are


distributed to the entity’s owners. Liquidation may be compulsory or volun-tary. Dissolutions via acquisition or merger do not qualify as liquidations.

Liquidation basis of accounting: The proposed statement would include the following rules for the adoption and application of the liquidation basis of accounting.

An entity would prepare financial statements on the liquidation basis of accounting when “liquidation is imminent.”

The liquidation basis of accounting would be applied prospectively from the day that an entity meets the “imminent” threshold, with a cumulative-effect adjustment made to the statement of changes in net assets in liquidation.

Liquidation would be imminent when either of the following occurs:A plan of liquidation is approved by the person or persons with the authority to make such a plan effective and the likelihood is remote that the execution of the plan will be blocked by other parties, such as protective rights.A plan for liquidation is imposed by other forces, such as involuntary bankruptcy, and the likelihood is remote that the entity will return from liquidation.

Limited-life entities: If a plan for liquidation was specified in an entity’s governing documents at the entity’s inception, an entity would be con-sidered a limited-life entity.

When an entity is a limited-life entity, liquidation would be im-minent when either:

Significant management decisions about furthering the ongoing operations of the entity have ceased.Significant management decisions are substantially limited to those necessary to carry out a plan for liquidation other than the plan specified at inception.

Measurement and re-measurement using the liquidation basis of ac-counting:

Assets and liabilities would be measured to reflect the estimated amount of cash or other consideration that an entity expects to collect or pay to carry out its plan for liquidation. Estimated costs to dispose of assets or liabilities would be accrued and presented in the aggregate separately from the measurement of those assets or liabilities. Other costs and income that an entity expects to incur or earn (e.g., payroll expense and interest income) would be accrued through the date at which the entity expects to complete its liquidation. At each reporting date, an entity would remeasure its assets, liabilities, and the accruals of disposal or other costs or income to reflect the actual or estimated change in value since the previous reporting date.

M o d u l e 3 — C h a p t e r 9 — S e l e c t e d a c c o u n t i n g a n d re p o r t i n g d e v e l o p m e n t s 187

At a minimum, liquidation basis financial statements shall consist of the following:

Statement of Changes in Net Assets in Liquidation: A statement that in-cludes information about the changes during the period in net assets avail-able for distribution to investors and other claimants during liquidationStatement of Net Assets in Liquidation: A statement that includes in-formation about the net assets available for distribution to investors and other claimants during liquidation as of the end of the reporting period

DisclosuresIn addition to all other disclosures required by U.S. GAAP, an entity shall disclose all of the following when it prepares financial statements using the liquidation basis of accounting:

That the financial statements are prepared using the liquidation basis of accounting, including the facts and circumstances surrounding the adoption of the liquidation basis of accounting A description of the entity’s plan for liquidation, including, at a mini-mum, a description of the manner by which the entity expects to dispose of its assets and liabilities and the expected duration of the liquidation.The methods and significant assumptions used to measure assets and li-abilities, including subsequent changes to those methods and assumptions. Significant methods and assumptions might include, for example, the nature and source of expected future cash flows and discount rates usedThe type and amount of costs and income accrued in the statement of changes in net assets in liquidation

ExamplesThe exposure draft offers several examples to illustrate its application. Fol-lowing are the examples, as modified by the author.

ExAMPLE 1

nOrMAL OPErATInG EnTITY

Entity A is a manufacturer of goods. In 20X2, Entity A began experiencing financial dif-ficulty because of declining market demand for its goods. on september 19, 20X2, Entity A’s board of directors approved a plan for liquidation. the board of directors had the legal authority to make this plan effective, and there were no parties with protective rights that could block the execution of this plan.

Conclusion:

Entity A should begin preparing its financial statements using the liquidation basis of accounting as of september 19, 20X2, which is the date that Entity A’s board of directors approved the plan for liquidation.


ExAMPLE 2

LIMITED-LIFE EnTITY WITH UnPLAnnED LIQUIDATIOn

Entity B’s governing documents at its inception identify a plan for liquidation after 10 years of existence. thus, B is considered a limited-life entity. Entity B purchased various real estate properties in Years 1 through 3 with the intention of selling those properties on or before its 10-year contractual expiration date. on March 11 of Year 6, Entity B be-gan prematurely disposing of its real estate properties because it was no longer solvent. Entity B’s operating decisions were limited to decisions related to the maintenance of its properties pending their sale. All other operating decisions were insignificant.

Conclusion: Entity B should begin preparing its financial statements using the liquidation basis of ac-counting as of March 11 of Year 6, which is the date that Entity B’s significant management activities became limited to those related to carrying out a plan for liquidation in a manner different from that which was specified in Entity B’s governing documents (10 years). In order for this rule to apply, B first had to be considered a limited-life entity by having a plan of liquidation (contractual life of 10 years) in its governing documents at its inception.

ExAMPLE 3

LIMITED-LIFE EnTITY THAT LIQUIDATES AS PLAnnED AT InCEPTIOn

Entity C is a limited-life entity with a contractual life of 10 years in its governing docu-ments. Entity C purchased various real estate properties in Years 1 through 8. Management continued to actively make decisions related to managing and increasing the value of its investments through Year 8. In Year 9, as planned in Entity C’s governing documents, management began to sell the properties as it wound down the entity, headed toward the end of its 10-year contractual life. Entity C did not experience financial difficulty and was able to complete its planned cycle of 10 years.

Conclusion: In this case, Entity C should not prepare its financial statements using the liquidation basis of accounting at any time because its actual liquidation was consistent with the 10-year plan specified in Entity C’s governing documents.

ObSErvATIOn

Examples 2 and 3 both deal with limited-life entities, which are entities that at inception, within their governing documents, have a limited, defined life. the fAsB was concerned that such entities, by definition, would be treated on the liquidation basis of accounting as they had a defined limited life. In the exposure draft, the fAsB included a stop gap under which liquidation basis of accounting would be used by a limited-life entity prior to the end of its contractual life, only when significant management decisions about furthering the ongoing operations of the entity have ceased or significant management decisions are substantially limited to those necessary to carry out a plan for liquidation other than


the plan specified at inception. thus, a limited-life entity with a finite contracted life of 10 years at inception would not use the liquidation basis accounting unless prior to the end of the 10-year period, significant management decisions are substantially limited to those necessary to carry out a plan of liquidation other than the original 10-year plan.

Project Status The FASB expects to issue a final statement in 2013.

STUDY QUESTIOn

1. under the fAsB’s proposed liquidation basis of accounting proposal, in order for an entity to be considered a limited-life entity, a plan for liquidation must have been specified _____________.

a. Within 10 years of the entity’s inceptionb. At any time prior to formal liquidationc. During a board of directors’ meetingd. In the entity’s governing documents

GOInG COnCErn ASSESSMEnT bY MAnAGEMEnT

The FASB has a project on the docket that has changed several times since its inception in 2008. The project started with a focus on an entity’s ability to continue as a going concern.

In 2007, the FASB added the going concern project to its docket with the goal to develop a new GAAP standard that would directly deal with go-ing concern. Instead of only the auditor making the decision as to whether there is a going concern issue, that onus would also be placed on manage-ment. Thus, management would be responsible for evaluating whether its company could continue as a going concern.

In October 2008, the FASB issued an exposure draft entitled Going Concern. The proposed statement had as its original objective to provide guidance on the preparation of financial statements as a going concern and on management’s (in lieu of the auditor’s) responsibility to evaluate a report-ing entity’s ability to continue as a going concern.

In 2010, the FASB tabled the going concern project and focused on its liquidation basis of accounting project (discussed previously).

In 2012, the FASB going concern project was put back on the FASB’s agenda.Currently, the rules for going concern are found in auditing literature

in AU-C Section 570, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern (formerly SAS No. 59), which requires an auditor to assess whether an entity has the ability to continue as a going concern for at least one year from the balance sheet date. Because going


concern is a GAAP issue, it also belongs within accounting literature, in addition to auditing standards.

The new proposed going concern project would require management to make a going concern assessment so that upon passage, both management and its auditor would make independent assessments of an entity’s going concern.

Although a new exposure draft has not yet been issued, the FASB has made the following decisions related to an entity’s going concern assessment and disclosures:

At each reporting period, management would assess an entity’s potential inability to continue as a going concern and the need for related disclosures. In doing so, management would consider the likelihood of an entity’s po-tential inability to meet its obligations as they become due for a reasonable period of time.

In performing the assessment, management would consider existing events or conditions that may result in an entity’s inability to meet its ob-ligations within a reasonable period of time. A reasonable period of time would represent 12 months from the financial statement (period end) date. In addition, the assessment would consider the effect of existing events or conditions that are probable of resulting in an entity’s inability to meet its obligations beyond the initial 12 months. Reasonable period of time would be limited to a practical amount of time in which the future impact of ex-isting events or conditions can be identified, not to exceed a period of 24 months from the period end date.

Management would start providing disclosures in its financial statements when existing events or conditions indicate it is near more likely than not that the entity may be unable to meet its obligations in the ordinary course of business, within a reasonable period of time from the balance sheet date. In assessing the need for disclosures, the mitigating effect of management’s plans would be considered unless such plans involve actions that are out-side the ordinary course of business. Actions outside the ordinary course of business would include management’s plans that would require actions of a nature, magnitude, or frequency inconsistent with actions customary in carrying out an entity’s ongoing business activities.

Examples of actions that are outside the ordinary course of business include:

Management’s plans specifically intended to mitigate concerns about an entity’s ability to meet its obligations within a reasonable period of time Management’s plans that are not definitive, or are in early stages of implementation when assessing the need for disclosures

Consistent with the disclosure considerations outlined in present auditing standards, the proposed standard would require an entity to disclose sufficient


information to enable users to understand the principal events giving rise to an entity’s potential inability to meet its obligations, their possible effects, and management’s plans.

Management would assert in the financial statements that there is substan-tial doubt about an entity’s ability to continue as a going concern when the likelihood of the entity’s inability to meet its obligations within a reasonable period of time reaches probable. In evaluating the need for this assertion, management would consider the effect of all management plans. Nonpublic entities would not be required to make a substantial doubt assertion in their financial statements, but would still be required to apply all other provisions and disclosures of the new going concern model.

Application of Proposed Going Concern Project

threshold Period of time action required non-public Entities

More likely than not that the entity may be unable to meet its ob-ligations in the ordinary course of business

reasonable period of time:

n 12 months from the balance sheet date

n Extended to up to 24 months for events or conditions that are probable

Disclosures required Disclosures required

Probable that the entity may be unable to meet its obligations in the ordinary course of business

Management would assert (in disclosures) that there is substantial doubt of the entity’s ability to function as a going concern

not required to assert substantial doubt

The proposed standard would be applied prospectively. An exposure draft is scheduled to be issued in 2013.

ObSErvATIOn

the going concern project has created some concerns among practitioners. In particular, the respondents are concerned that there is not an integration between the going concern assessment done at the audit level under Au-C section 570, the Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, and the proposed assessment to be performed by management. there is no question that the financial statements are the responsibility of management and, therefore, management should make an assessment under GAAP. However, the auditor’s assessment, which has a one-year from the balance sheet bright line, is potentially shorter than the proposed GAAP assessment period which could extend to 24 months.

Moreover, some respondents are concerned that management will not be able to objec-tively assess its own going concern given the extreme effects of an entity’s inability to function as a going concern. A core piece of any assessment is considering the viability of management’s plans. It may be difficult for management to objectively make its own assessment as to its ability to fulfill its own plan to continue as a going concern.


STUDY QUESTIOn

2. Currently, the going concern assessment is done by __________.

a. the auditorb. Managementc. Board of directorsd. no assessment is done

THE POLITICS OF DISCLOSUrES

There is a movement afloat to force public companies to expand environ-mental disclosures including those related to greenhouse gases (GHG) and climate change. Although there may be some useful information that such disclosures provide stakeholders, there is little doubt that politics is playing some role in the SEC’s push toward expanded disclosures.

Expanding environmental disclosures is not the only example where public company disclosures are a byproduct of the political landscape. Dodd-Frank Wall Street Reform and Consumer Protection Act was made monumental changes to many aspects of the financial services industry. Embedded in Dodd-Frank is a series of disclosures that public companies are now required to disclose in many of their public reports including those issues quarterly, annually and proxy statements.

new Disclosures Under Dodd-Frank Act

Section and required disclosure When required

Section 942: requires issuers of asset-backed securities, at a minimum, to disclose asset-level or loan-level data, including:n Data having unique identifiers relating to loan brokers or originatorsn the nature and extent of the compensation of the broker or originator of the

assets backing the securityn the amount of risk retention by the originator and the securitizer of such assets

registration statements

Section 951: requires disclosure of:n Any agreements that a company has with its executive officers concerning

any compensation that a company will pay out to its executive officers that is based on the acquisition, merger, consolidation, sale, or disposition of substantially all of the assets, and the total compensation that may be paid and the conditions upon which it will be paid

Proxy or consent material

Section 952: requires disclosure of whether:n A company’s compensation committee retained or obtained the advice of a

compensation consultantn the work of the compensation consultant has raised any conflict of interest

and, if so, the nature of the conflict and how the conflict is being addressed




Section 953: require disclosure of:n the median of the annual total compensation of all employees of the issuer,

except the chief executive officer (a) n the annual total compensation of the chief executive officer (or any equiva-

lent position) of the issuer (b)n the ratio of (a) to (b)


Section 955: requires disclosure as to whether any employee or member of the board of directors is permitted to purchase financial instruments that are designed to hedge or offset any decrease in the market value of equity securities:n Granted to the employee or member of the board of directors as part of the

company compensation, orn Held, directly or indirectly, by the employee or member of the board of directors.


Section 1502: requires disclosure when a company uses “conflict minerals” (gold, wolframite, columbite-tantalite, etc.) that are necessary to the functional-ity or production of its product (such as jewelry manufacturing, etc.):n Whether conflict minerals originated in the Democratic republic of the

Congo (DrC) or an adjoining country

note: If conflict minerals did originate in the DrC, the company must submit an audited report to the sEC that includes a description of the measures taken to exercise due diligence on the source and chain of custody of such minerals.

n A description of the products manufactured that are not DrC conflict free, the entity that conducted the independent private sector audit, the facilities used to process the conflict minerals, the country of origin of the conflict minerals, and the efforts to determine the mine or location of origin with the greatest possible specificity.

note: “DrC conflict free” means products that do not contain minerals that directly or indirectly finance or benefit armed groups in the Democratic republic of the Congo or an adjoining country.

Annual reports and filings

Section 1503: If a company or its subsidiary is an operator of a coal or other mine, the company must disclose the following:

1. for each coal or other mine:n the total number of violations of mandatory health or safety standards

that could significantly and substantially contribute to the cause and effect of a coal or other mine safety or health hazard for which the operator received a citation from the Mine safety and Health Administration

n the total number of ordersn the total number of citations and orders for unwarrantable failure of the

mine operator to comply with mandatory health or safety standardsn the total number of flagrant violationsn the total number of imminent danger orders issuedn the total dollar value of proposed assessments from the Mine safety and

Health Administrationn the total number of mining-related fatalitiesn the receipt of an imminent danger order issued by the federal Mine safety

and Health Actn the receipt of written notice from the Mine safety and Health Administra-

tion that the coal or other mine has a pattern of violations of mandatory health or safety standards that are of such nature as could have signifi-cantly and substantially contributed to the cause and effect of coal or other mine health or safety hazards, or the potential to have such a pattern

Quarterly and 8K reports



Section 1503 (cont’d):

2. A list of such coal or other mines, of which the company or its subsidiary is an operator, that receive written notice from the Mine safety and Health Administration of:n A pattern of violations of mandatory health or safety standards that are of

such nature as could have significantly and substantially contributed to the cause and effect of coal or other mine health or safety hazards, or

n the potential to have such a pattern

3. Any pending legal action before the federal Mine safety and Health review Commission involving such coal or other mine.

Quarterly and 8K reports

Section 1504: requires each resource extraction company (oil, natural gas, or minerals) to disclose any payment made by the company (directly or indirectly) to a foreign government or the federal Government for the purpose of the com-mercial development of oil, natural gas, or minerals, including:n the type and total amount of such payments made for each project of the

resource extraction issuer relating to the commercial development of oil, natural gas, or minerals

n the type and total amount of such payments made to each government

Annual reports and filings

Source: Dodd-Frank Wall Street Reform and Consumer Protection Act

There are other bills pending that would require companies to disclose information ranging from political contributions (discussed later) to details about business dealings with Iran.

It is not clear whether such disclosures will spread into the financial statements of non-public companies. The SEC has the power to put pressure on the FASB to enhance disclosures. Although the emphasis in expanding disclosures surrounds public companies, we continue to see the FASB’s unwillingness to carve out disclosure exclusions for non-public companies.

One can see a future in which there is an expansion of politically charged disclosures that are wrapped into existing GAAP.

SEC Focuses on Missing DisclosuresBeyond the new requirements under Dodd-Frank, the SEC has expanded its review of company disclosures in annual and interim reports.

SEC comment letters have focused on the following key areas:

1. Revenue Recognition, including the accounting policy used2. Related-party transactions and disclosures3. Fair-value measurements, including management’s judgment used to

determine fair value4. Intangible assets and goodwill, including testing for impairment5. Disclosure controls including wording used in the certificate6. Executive compensation7. Management Discussion and Analysis, including more information

about liquidity, accounting estimates and capital resources


8. Segment reporting including how companies are dividing business units9. Non-GAAP measures, including information that is being disclosed in

press releases, websites, and analyst calls10. Debt and equity issues including valuation and disclosure

SEC Conflict Minerals DisclosuresOn August 22, 2012, the SEC adopted rules requiring companies to pub-licly disclose their use of conflict minerals that originated in the Democratic Republic of the Congo or an adjoining country.

The rules were mandated by Section 1502 of the Dodd-Frank Act and Section 13(p) of the Securities Exchange Act of 1934 (the “Exchange Act”). Section 1502 directs the SEC to issue rules requiring certain companies to disclose their use of conflict minerals if those minerals are “necessary to the functionality or production of a product” manufactured by those companies.

The scope of the new rules is expansive, both in terms of the number of public companies potentially impacted and the extent of information required to be reported. The expense required to comply with the new rules could be quite substantial for those companies required to make disclosure.

The disclosures required under the new rules will be filed on a “Conflict Minerals Report” using a new form, Form SD. The first reports cover calendar year ended December 31, 2013 and is due May 31, 2014.

For purposes of the new rules, “conflict minerals” are defined as:Cassiterate Columbite-tantalite (also known as coltan) GoldWolframite and their derivatives: tantalum, tin and tungsten

These conflict minerals are commonly known to originate, and in some cases finance, armed groups in the Democratic Republic of Congo and the adjoining countries that include Angola, Burundi, the Central African Republic the Republic of Congo, Rwanda, Sudan, Tanzania, Uganda and Zambia (collectively, the “Covered Countries”).

Under the rules, companies must take a three-step process:

Step One: A company must determine if it is subject to the new rules based on its use of conflict minerals. A company is subject to the rules if both of the following exist:

It is a public company under the SEC.Conflict minerals are necessary to the functionality or production of a product manufactured by the company or contracted by the company to be manufactured.


nOTE

Whether a company “contracts to manufacture” a product depends on the degree of influence exercised by the issuer on manufacturing of the product. the sEC has indicated that issuers will not be viewed as “contracting to manufacture” a product if their actions involve no more than:

specifying or negotiating contractual terms with a manufacturer that do not relate directly to manufacturing of the product Affixing its brand, marks, logo, or label to a generic product manufactured by a third party, and servicing, maintaining, or repairing a product manufactured by a third party. But it is understood, for example, that a semiconductor supplier that relies on third party foundries for production of its products would ordinarily be covered by the rules.

Step Two: A company that is subject to the rules must conduct a country of origin inquiry to determine if the conflict minerals it uses originated in one of the Covered Countries or came from recycled or scrap sources.

Step Three: A company that determines, or has reason to believe, that its conflict minerals originated in a Covered Country and are not from recycled or scrap sources must conduct diligence as to the source and chain of custody and may be required to file a Conflict Minerals report. All conflict minerals disclosures must be provided using new Form SD.

nOTE

the disclosure will not be automatically incorporated into registration statements filed under the securities Act of 1933 and will not be covered by executive officer certifications required in connection with the form 10-K.

The SEC estimates the initial compliance costs for the Conflict Minerals Rule to be about $3 to $4 billion, and ongoing compliance costs at about $200 to $600 million annually.

retailers and the Conflict Minerals ruleIn the first version of the SEC rule, retailers such as Target and Wal-Mart that sell goods produced by outside contractors would have been subject to the conflict minerals rule if they sold retail products under their own brand. However, in the final vote, the SEC ruled that such retailers are exempt from the conflict minerals rule if they don’t have any control over the manufacture of products sold under their brand name.


Proposal to Disclose Political ContributionsThe latest round of political influence being placed on the SEC and, in turn, SEC companies, is a push by certain groups to force SEC companies to dis-close their political contributions. This movement, driven by the Corporate Reform Coalition, is motivated by the sizeable Super PAC contributions that were made during the 2012 presidential election. Companies were able to make limitless contributions to Super PACs, which funded certain political parties.

In December 2012, the SEC posted an agenda item with the Office of Information and Regulatory Affairs which states:

“The Division (SEC) is considering whether to recommend that the Commission issue a proposed rule to require that public companies provide disclosure to shareholders regarding the use of corporate resources for political activities.”

Apparently, the SEC has been under public pressure to consider the disclo-sure rule after the U.S. Supreme Court ruled that companies could fund unlimited political contributions in Citizens United v. Federal Election Commission [558 U.S. 310 (2010)]. Corporate political spending increased by four times from 2006 to 2010, just after the Citizens United decision. The S&P 500 spent well in excess of $1 billion on political contributions in 2010 and 2011.

Opponents are concerned that if the SEC requires disclosures of political contributions, SEC companies may be reluctant to make contributions in fear of public backlash. In 2013, the issue of disclosing political contributions is likely to be debated along with many other politically charged disclosures required of SEC companies.

STUDY QUESTIOn

3. In order for a company to be subject to the use of conflict minerals rules, conflict minerals are necessary to the ____________.

a. Distribution of a productb. Production of a product manufacturedc. retailing of a productd. Expansion of the product

IMPACT OF POST OFFICE CHAnGES On WOrkInG CAPITAL

In January 2013, the U.S. Post Office announced that effective in August 2013, it is eliminating Saturday delivery of most mail. On the surface, this change might appear to be a mere inconvenience for most businesses.


However, the change is expected to cost U.S. companies a significant amount of working capital as accounts receivable collections will slow down.

A 2012 study by REL Consulting (Post Office Changes Could Slow Collec-tions, Cost Large Companies Up to $100 Million Annually) noted the following impacts from the change in the U.S. Post Office delivery policy:

Overall impact for U.S. companies will be that accounts receivable will in-crease by approximately $100 million.

Smaller U.S. companies will be impacted the greatest because of their lack of technology in collecting receivables.Approximately 60 percent of all invoices of U.S. companies are still handled by mail with that percentage being higher for smaller companies.

There is expected to be a total of two days lag on days sales outstanding (DSO) for a portion of receivables due to the change:

One day added on for the delay in the customer receiving the invoiceOne day added on for receipt of the accounts receivable collection

ObSErvATIOn

there is potentially a total of two days of additional time in the accounts receivable cycle for a portion of receivables, due to not delivering saturday mail.

On one side, an invoice that would typically be received by a customer on Saturday (and processed early on Monday morning) would be delivered to that customer later in the day on Monday, resulting on one additional day for the customer to receive the invoice. That additional day pushes the pay-ment date by one day.

On the other side, when the customer mails in the payment that would typically be received on Saturday and deposited early on Monday, will now be received later on Monday and processed late Monday or early Tuesday.

Of course, this potential two-day lag will only affect that portion of invoices and payments received on Saturday.

Consider the following computation:

Additional number of days 2Portion of receivables affected (one sixth) X 16.66%Increase in number of days outstanding in receivables .33rounded .5 day

Companies should expect their number of days outstanding in sales to in-crease about one half of one day, so that if the number of days is historically 35 days, that number is likely to increase to about 35.5 days.


The REL Study recommended that companies take certain actions to mitigate the effect of the change in the mail delivery time:

Bill more quickly and send bills out by email or electronic data inter-change (EDI) instead of mail.Change payment terms with customers:

Change the payment due date based on the invoice date and not the invoice receipt date. Shorten the incentive payment time to reflect the impact on the new mail float.Change 2/10, net 30 to 2/6, net 26.

ObSErvATIOn

Each cause has a corresponding effect. In the case of the Post office first-class mail deliv-ery changes, for each company that carries higher days sales in receivables, there will be a company that also carries higher trade payables. for companies that are in a negative cash flow position, the Post office changes might give them a free loan in the form of high accounts payable float.

201

MoDuLE 3: otHEr CurrEnt DEvELoPMEnts – CHAPtEr 10

Selected aSus 2012–2013

This chapter discusses several Accounting Standards Updates (ASUs) issued in 2012 and 2013, including ASU 2013-05 regarding foreign currency matters, ASU 2013-02 concerning comprehensive income, ASU 2013-01 concerning disclosures about offsetting assets and liabilities, and ASU 2012-05 dealing with not-for-profit cash flow statements.

LEArnInG ObjECTIvES


Indicate the accounting rules concerning the sale of an investment in a foreign entityDescribe how the effect of reclassifications of accumulated comprehensive in-come on the line items in the income statement should be presentedExplain how certain donations to not-for-profit entities should be classified on the statement of cash flows

ASU 2013-05: FOrEIGn CUrrEnCY MATTErS (TOPIC 830)

OverviewASU 2013-05, issued March 2013, is entitled Foreign Currency Matters (Topic 830): Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity. Its objective is to resolve the inconsistencies in practice about whether ASC Subtopic 810-10, Consolida-tion—Overall, or ASC Subtopic 830-30, Foreign Currency Matters—Transla-tion of Financial Statements, applies to the release of the cumulative transla-tion adjustment into net income when a parent either sells a part or all of its investment in a foreign entity, or no longer holds a controlling financial interest in a subsidiary or group of assets.

background Translation adjustments to convert an entity’s financial statements from its functional currency to the currency used for financial statement reporting are presented as another comprehensive income item, included in stockholders’ equity. Translation adjustments accumulate from year to year in stockholders’ equity and are labeled “cumulative translation adjustment.”


ASU 2010-02 (ASC Subtopic 810-10, Consolidation: Accounting and Reporting for Decreases in Ownership of a Subsidiary—a Scope Clarification) requires that a parent deconsolidate a subsidiary or derecognize a group of assets (other than a sale of in substance real estate or conveyance of oil and gas mineral rights), if the parent ceases to have a controlling financial inter-est in that group of assets.

The derecognition guidance in ASC 810-10 supports releasing the cumu-lative translation adjustment into net income upon the loss of a controlling financial interest in such a subsidiary or group of assets. However, the ASC 810-10 guidance does not distinguish between sales or transfers pertaining to an investment in a foreign entity and to a subsidiary or group of assets within a foreign entity.

Further, ASC 830-30, Foreign Currency Matters—Translation of Financial Statements, provides for the release of the cumulative translation adjustment into net income only if a sale or transfer represents a sale, or complete or substantially complete liquidation of an investment in a foreign entity.

ASU 2013-05 resolves the variations in practice for the treatment of business combinations achieved in stages (referred to as step transactions) involving a foreign entity. In practice, some entities treat step acquisitions as being composed of two events:1. The disposition of an equity method investment2. The simultaneous acquisition of a controlling financial interest

As part of the two-step transaction, those entities generally release the cu-mulative translation adjustment related to the equity method investment.

Other entities view step acquisitions as being composed of a single event (increasing an investment), and generally do not release the cumulative translation adjustment in practice. Thus, there is confusion in practice.

ASU 2013-05 addresses entities that cease to hold a controlling financial interest in a subsidiary or group of assets within a foreign entity when: 1. The subsidiary or group of assets is a nonprofit activity or a business

(other than a sale of in substance real estate or conveyance of oil and gas mineral rights), and

2. There is a cumulative translation adjustment balance associated with that foreign entity.

ASU 2013-05 also includes amendments that affect entities that lose a controlling financial interest in an investment in a foreign entity, by sale or other transfer event. Additionally, it includes those that acquire a business in stages, such as in a step acquisition, by increasing an investment in a foreign entity from one accounted for under the equity method to one accounted for as a consolidated investment.

M o d u l e 3 — C h a p t e r 1 0 — S e l e c t e d a S u s 2 0 1 2 – 2 0 1 3 203

rules

Cessation of a controlling financial interest. When a reporting entity (a par-ent) ceases to have a controlling financial interest in a subsidiary or group of assets that is either a nonprofit activity or a business (other than a sale of in-substance real estate or conveyance of oil and gas mineral rights) within a foreign entity, the parent is required to apply the guidance in ASC Subtopic 830-30, Translation of Financial Statements, to release any related cumulative translation adjustment into net income.

Under ASC Subtopic 830-30, upon sale or upon complete or substantially complete liquidation of an investment in a foreign entity, the cumulative translation adjustment component of equity shall be both:

Removed from the separate component of equityReported in net income as part of the gain or loss on sale or liquidation of the investment for the period during which the sale or liquidation occurs

The sale of an investment in a foreign entity includes both: Events that result in the loss of a controlling financial interest in an investment in a foreign entityEvents that result in an acquirer obtaining control of an acquiree in which it held an equity interest immediately before the acquisition date

Partial sales. If a parent has an equity method investment in a foreign entity, the partial sale rules in ASC 830-30-40, Foreign Currency Matter, Transla-tion of Financial Statements, Derecognition, should be followed. Under ASC 830-30-40, if a reporting entity sells part of its ownership interest in an equity investment that is a foreign entity, a pro rata portion of the cumula-tive translation adjustment component of equity attributable to that equity method investment shall be released into net income.

nOTE

If the sale of part of the equity method investment results in a loss of significant influence, the entity should follow the rules found in AsC 323-10, Investments—Equity Method and Joint Ventures, paragraphs 35-39, for guidance on how to account for that pro-rata por-tion of the cumulative translation adjustment component of equity attributable to the remaining investment. that discussion is not addressed in this section.

If the partial sale involves ownership in a non-foreign entity, the pro-rata portion rule in 2(a) does not apply. In those instances, the cumulative transla-tion adjustment is released into net income only if the partial sale represents a complete or substantially complete liquidation of the foreign entity that contains the equity method investment.


Transition and Effective DateASU 2013-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. For nonpublic entities, it is ef-fective for fiscal years beginning after December 15, 2014, and interim and annual periods thereafter. An entity shall provide the disclosures in ASC 250-10-50, Accounting Changes and Error Corrections, Overall, Disclosure (paragraphs 1 through 3) in the period the entity adopts the ASU.

The ASU shall be applied prospectively for the following:A sale or transfer of a subsidiary or group of assets that is a nonprofit activity or a business within a foreign entity after the effective dateA sale of ownership interests in a foreign entity after the effective date A business combination achieved in stages after the effective date (Prior periods shall not be adjusted.)

Earlier application of the ASU is permitted. If early application is elected, an entity shall apply the ASU from the beginning of an entity’s fiscal year of adoption to account for the release of the cumulative translation adjustment in the same manner for all disposition and deconsolidation events and step acquisitions within that fiscal year.

The flow chart on the following page is extracted from ASU 2013-05 and illustrates the ASU’s amendments to the cumulative translation adjustment derecognition guidance in ASU 830-30, for the derecognition of certain subsidiaries or groups of assets within a foreign entity and for changes in an investment in a foreign entity.

STUDY QUESTIOnS

1. Company X sells its investment in a foreign entity. How should X deal with the cumulative translation adjustment component?

a. retain that amount in equity.b. remove that amount from equity in its entirety.c. remove a portion of the component and retain the remainder in equity.d. reclassify the component to a separate section of equity and re-label it.

2. Company Y makes a partial sale of its investment in a non-foreign entity that is accountedfor using the equity method. the sale does not represent a complete or substantiallycomplete liquidation. Which of the following is correct?

a. the pro rata portion rule applies.b. the entire cumulative transaction adjustment should be released into income.c. none of the adjustment should be released into income.d. the adjustment should be reclassified into a separate section of equity.


ASU 2013-02: COMPrEHEnSIvE InCOME (TOPIC 220)

OverviewThe objective of ASU 2013-02: Comprehensive Income (Topic 220) Report-ing of Amounts Reclassified Out of Accumulated Other Comprehensive Income is to improve the reporting of reclassifications out of accumulated other comprehensive income. This ASU was issued in February 2013. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2012. For nonpublic entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2013. Early adoption is permitted.

not within the scope of this update. refer to other guidance

in topic 830

release 100% of cumluative translation adjustment

Do not release cumulative transation adjustment

Do not release cumulative translation adjustment. Account of the chagne in ownership interest in

accordance with paragraphs 810-10-45-23 through

45-24

release 100% of cumulative translation

adjustment

release a pro rata portion of cumulative translation

adjustment related to the equity method investment

release a prorata portion of cumulative translation

adjustment related to the equity method investment and apply

guidance in paragraphs 323-10-35-37 through 35-39

Combioned or consolidated foreign entity

Equity method investment that is a foreign entity

Does the deconsolidation or derecognition result in a complete or substantially

complete liquidation of the foreign entity?

nO YES YES nO

Did the parent lose control of the foreign entity?

Does the change qualify as a step acquisition as described in

paragraphs 805-10-25-9 through 25-10?

What is the type of foreign entity investment?

YESnO

Does the change in investment result in loss of significant influence?

Is the entire equity method investment

derecognized?

Has there been a change in an investment in a foreign entity?

nO

YES

nO

YES

Is the deconsolidation or dercogniton of a subsidiary or

group of assets that is a nonprofit activity or a business within a

foreign entity?

YES nO

release of Cumulative Translation Adjustment

Source: ASU 2013-05: Foreign Currency Matters (Topic 830)


backgroundGAAP requires an entity to display comprehensive income in a financial statement format. Comprehensive income is defined by FASB Concepts Statement No. 6, Elements of Financial Statements of Business Enterprises, as: “the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources.”

Comprehensive income consists of two components:Net incomeOther comprehensive income

The formula for comprehensive income is:net income

+(–) other comprehensive income (presented in stockholders’ equity, net of tax)

= Comprehensive income

Other comprehensive income consists of certain items that bypass the in-come statement and are recorded directly in stockholders’ equity, net of the tax effect. Under current GAAP, there are four items that are part of other comprehensive income, thereby recorded in stockholders’ equity instead of in the income statement:1. Foreign exchange translation adjustments (ASC 830)2. Certain derivative transactions (ASC 815)3. Unrealized gains and losses on available-for-sale securities (ASC 320)4. Certain pension transactions (ASC 715)

There are instances in which an entity can have a potential double counting in comprehensive income in the same year.

ExAMPLE

An entity may have had an unrealized gain on a security available for sale that is presented in stockholders’ equity as part of other comprehensive income. In that same year, the entity might sell one of the securities and have a realized gain in the income statement. In such a situation, GAAP requires the entity to remove the realized gain from the transaction and record it separately as a reclassification adjustment. the term reclassification adjustment is a distorted one and really should be called “double accounting avoidance adjustment.”

ASC 220, Comprehensive Income, defines reclassification adjustments as:

Adjustments made to avoid double counting in comprehensive income items that are displayed as part of net income for a period that also had been displayed as part of other comprehensive income in that period of earlier periods.


The purpose of ASC 2013-02 is to provide the rules as to how and where to present a reclassification adjustment in financial statements. That is, where does an entity present the reclassification adjustment to avoid double count-ing a transaction; once as a realized gain transaction in the income statement, and once as an unrealized transaction in other comprehensive income?

In 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (ASC Topic 220) ASU No. 2011-05: Presentation of Comprehensive Income, which was followed up with the issuance of ASU No. 2011-12: Deferral of the Effective Date.

ASU 2011-05 changed the presentation of comprehensive income under U.S. GAAP. As part of ASU No. 2011-5, the FASB sought to change the presentation of reclassification amounts by requiring such reclassifications to be presented on the income statement instead of having the option of presenting them in the notes.

Because of concerns by constituents, the FASB issued ASU No. 2011-12 and deferred the effective date of the change to reclassification adjustments until the FASB could study the matter further.

ASU 2013-02 represents the FASB’s final opinion on the presentation of reclassification adjustments.

rules

Current period reclassifications. An entity shall present separately for each component of other comprehensive income, current period reclassifications out of accumulated other comprehensive income and other amounts of current-period other comprehensive income. Both before-tax and net-of-tax presenta-tions are permitted provided the entity complies with certain requirements.

Significant amounts. An entity shall separately provide information about the effects on net income of significant amounts reclassified out of each component of accumulated other comprehensive income, if those amounts are required under GAAP to be classified to net income in the same reporting period. An entity shall provide this information together, in one location, in either of the following ways:

On the face of the statement where net income is presented As a separate disclosure in the notes to the financial statements

If an entity chooses to present information about the effects of significant amounts reclassified out of accumulated other comprehensive income on net income, on the face of the statement, the entity shall present parentheti-cally, by component of other comprehensive income, the effect of significant reclassification amounts on the respective line items of net income. An entity also shall present parenthetically the aggregate tax effect of all significant


reclassifications on the line item for income tax benefit or expense in the statement where net income is presented.

If an entity is unable to identify the line item of net income affected by any significant amount reclassified out of accumulated other comprehensive income in a reporting period (including when all reclassifications for the period are not to net income in their entirety), the entity must follow the guidance in the following paragraph.

If an entity chooses to present information about significant amounts reclassified out of accumulated other comprehensive income in the notes to the financial statements, it shall present the significant amounts by each component of accumulated other comprehensive income, and provide a subtotal of each component of comprehensive income. The subtotals for each component shall agree with the other presentations within the ASU. Both before-tax and net-of-tax presentations are permitted provided the entity complies with the other requirements.

For each significant reclassification amount, the entity shall identify, for those amounts that are required under other GAAP to be reclassified to net income, each line item affected by the reclassification on the statement where net income is presented. For any significant reclassification for which other GAAP does not require that reclassification to net income, the entity shall cross-reference to the note where additional details about the effect of the reclassifications are disclosed.

Disclosure. An entity is required to disclose the effect of reclassifications on the line items in the statement in which net income is presented, presented on either a before-tax or a net-of-tax basis consistent with the entity’s method of presentation for the line items in the statement where net income is pre-sented. In either case, the total for this disclosure should agree with the total amount of reclassifications for each component of comprehensive income that complies with the presentation requirements.

STUDY QUESTIOn

3. Company X has current period reclassifications out of accumulated other com-prehensive income. How should X present the current period reclassification?

a. only on the face of the income statementb. only as a separate disclosure in the notesc. Either a. or b.d. Either a separate disclosure in the notes, on the face of the income state-

ment, or in supplementary information clearly marked as such.


ASU nO. 2013-01: bALAnCE SHEET (TOPIC 210)

OverviewThe primary objective of ASU 2013-01: Balance Sheet (Topic 210)-Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities issued January 2013 is to address implementation issues about the scope of ASU 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. An entity is required to apply the amendments in for fiscal years beginning on or after January 1, 2013, and interim periods within those annual peri-ods. An entity should provide the required disclosures retrospectively for all comparative periods presented.

backgroundASU 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities, was issued in December 2011. It addresses the offsetting (net-ting) of assets and liabilities with the goal to eliminate most of the differences between offsetting requirements in the U.S. and international standards. The ASU requires that entities disclose both gross and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement.

The confusion rests with the scope of ASU 2011-11, which includes derivatives, sale and repurchase agreements and reverse sale and repurchase agreements, and securities borrowing and securities lending arrangements. Since its passage, third parties have told the FASB that because the scope in ASU 2011-11 is unclear, there is variation in practice that needs clarification.

According to the FASB, there has been feedback from stakeholders that standard commercial provisions of many contracts would equate to a mas-ter netting arrangement. Those stakeholders have asked whether it was the FASB’s intent to require disclosures for such a broad scope, which would significantly increase the cost of compliance. Thus, the FASB issued ASU 2013-01 to clarify the scope of the offsetting disclosures.

rulesASU 2013-01 states that the scope of ASU 2011-11 applies to derivatives accounted for in accordance with ASC 815, Derivatives and Hedging. That list includes the following that are either offset or subject to an enforceable master netting arrangement or similar agreement:

Bifurcated embedded derivativesRepurchase agreements and reverse repurchase agreements Securities borrowing and securities lending transactions


ASU nO. 2012-05: STATEMEnT OF CASH FLOWS (TOPIC 230) nOT-FOr-PrOFIT EnTITIES

OverviewThe objective of ASU No. 2012-05: Statement of Cash Flows (Topic 230) Not-for-Profit Entities: Classification of the Sale Proceeds of Donated Financial Assets in the Statement of Cash Flows issued October 2012 is to address the variation in practice about how to classify cash receipts arising from the sale of certain donated financial assets, such as securities, in the statement of cash flows of not-for-profit entities (NFPs).

This ASU is effective prospectively for fiscal years, and interim periods within those years, beginning after June 15, 2013. Retrospective application to all prior periods presented upon the date of adoption is permitted. Early adoption from the beginning of the fiscal year of adoption is permitted. For fiscal years beginning before October 22, 2012, early adoption is permitted only if a not-for-profit’s (NFP’s) financial statements for those fiscal years and interim periods within those years have not yet been made available for issuance.

backgroundCurrently, there are differences in practice as to how to present the cash re-ceipts from the sale of donated financial assets in the statement of cash flows. Some companies classify the cash receipts from the sale of donated financial assets in the statement of cash flows as a cash flow from an investing activity. Other entities classify the receipts from the sale of donated financial assets as operating cash inflows or financing cash inflows. ASU 2012-05 eliminates the diversity in practice.

rulesIn the statement of cash flows, all of the following are to be categorized as cash inflows from investing activities:

Receipts from collections or sales of loans made by the entity and of other entities’ debt instruments (other than cash equivalents, and certain debt instruments that are acquired specifically for resale, and certain donated debt instruments received by not-for-profit entities (NFPs))Receipts from sales of equity instruments of other entities (other than certain equity instruments carried in a trading account and certain do-nated equity instruments received by NFPs and from returns of invest-ment in those instruments)Receipts from sales of property, plant, and equipment and other produc-tive assetsReceipts from sales of loans that were not specifically acquired for resale (i.e., if loans were acquired as investments, cash receipts from sales of those loans shall be classified as investing cash inflows regardless of a change in the purpose for holding those loans)


nOTE

receipts from disposing of loans; debt or equity instruments; or property, plant, and equip-ment include directly related proceeds of insurance settlements, such as the proceeds of insurance on a building that is damaged or destroyed.

Cash receipts resulting from the sale of donated financial assets (e.g., do-nated debt or equity instruments) by NFPs that upon receipt were directed for sale without any NFP-imposed limitations, and were converted nearly immediately into cash, shall be classified as operating cash flows.

If the donor restricted the use of the contributed resource to a long-term purpose, then those cash receipts shall be classified as a financing activity.

Cash receipts from the sale of donated financial assets that were not directed for sale and had no restrictions should be classified as cash flows from investing activities by the NFP.

STUDY QUESTIOn

4. Company Y, a not-for-profit organization, has receipts from collections of loans made by the entity. How should that receipt be presented on the statement of cash flows?

a. non-cash disclosureb. financing activityc. Investing activityd. operating activity

SuMMarY oF aSus – 2009 to 2013

ASU Description

2009-01 topic 105—Generally Accepted Accounting Principles—amendments based on—state-ment of financial Accounting standards no. 168—the fAsB Accounting standards CodificationtM and the Hierarchy of Generally Accepted Accounting Principles

2009-02 omnibus update—Amendments to various topics for technical Corrections

2009-03 sEC update—Amendments to various topics Containing sEC staff Accounting Bulletins (sEC update)

2009-04 Accounting for redeemable Equity Instruments—Amendment to section 480-10-s99 (sEC update)

2009-05 fair value Measurements and Disclosures (topic 820): Measuring Liabilities at fair value

2009-06 Income taxes (topic 740): Implementation Guidance on Accounting for uncertainty in Income taxes and Disclosure Amendments for nonpublic Entities

2009-07 Accounting for various topics—technical Corrections to sEC Paragraphs (sEC update)

2009-08 Earnings per share—Amendments to section 260-10-s99 (sEC update)


ASU Description

2009-09 Accounting for Investments—Equity Method and Joint ventures and Accounting for Equity-Based Payments to non-Employees—Amendments to sections 323-10-s99 and 505-50-s99 (sEC update)

2009-10 financial services—Broker and Dealers: Investments—other—Amendment to subtopic 940-325 (sEC update)

2009-11 Extractive Activities—oil and Gas—Amendment to section 932-10-s99 (sEC update)

2009-12 fair value Measurements and Disclosures (topic 820): Investments in Certain Entities that Calculate net Asset value per share (or Its Equivalent)

2009-13 revenue recognition (topic 605): Multiple-Deliverable revenue Arrangements—a consensus of the fAsB Emerging Issues task force

2009-14 software (topic 985): Certain revenue Arrangements that Include software Elements—a consensus of the fAsB Emerging Issues task force

2009-15 Accounting for own-share Lending Arrangements in Contemplation of Convertible Debt Issuance or other financing—a consensus of the fAsB Emerging Issues task force

2009-16 transfers and servicing (topic 860): Accounting for transfers of financial Assets

2009-17 Consolidations (topic 810): Improvements to financial reporting by Enterprises Involved with variable Interest Entities

2010-01 Equity (topic 505): Accounting for Distributions to shareholders with Components of stock and Cash—a consensus of the fAsB Emerging Issues task force

2010-02 Consolidation (topic 810): Accounting and reporting for Decreases in ownership of a subsidiary—a scope Clarification

2010-03 Extractive Activities—oil and Gas (topic 932): oil and Gas reserve Estimation and Disclosures


2010-05 Compensation—stock Compensation (topic 718): Escrowed share Arrangements and the Presumption of Compensation (sEC update)

2010-06 fair value Measurements and Disclosures (topic 820): Improving Disclosures about fair value Measurements

2010-07 not-for-Profit Entities (topic 958): not-for-Profit Entities: Mergers and Acquisitions

2010-08 technical Corrections to various topics

2010-09 subsequent Events (topic 855): Amendments to Certain recognition and Disclosure requirements.

2010-10 Consolidation (topic 810): Amendments for Certain Investment funds

2010-11 Derivatives and Hedging (topic 815): scope Exception related to Embedded Credit Derivatives

2010-12 Income taxes (topic 740): Accounting for Certain tax Effects of the 2010 Health Care reform Acts (sEC update)

2010-13 Compensation—stock Compensation (topic 718): Effect of Denominating the Exercise Price of a share-Based Payment Award in the Currency of the Market in Which the underlying Equity security trades—a consensus of the fAsB Emerging Issues task force

2010-14 Accounting for Extractive Activities—oil & Gas—Amendments to Paragraph 932-10-s99-1 (sEC update)

2010-15 financial services—Insurance (topic 944): How Investments Held through separate Accounts Affect an Insurer’s Consolidation Analysis of those Investments—a consensus of the fAsB Emerging Issues task force


ASU Description

2010-16 Entertainment—Casinos (topic 924): Accruals for Casino Jackpot Liabilities—a consensus of the fAsB Emerging Issues task force

2010-17 revenue recognition—Milestone Method (topic 605): Milestone Method of revenue recognition—a consensus of the fAsB Emerging Issues task force

2010-18 receivables (topic 310): Effect of a Loan Modification When the Loan Is Part of a Pool that Is Accounted for as a single Asset—a consensus of the fAsB Emerging Issues task force

2010-19 foreign Currency (topic 830): foreign Currency Issues: Multiple foreign Currency Exchange rates (sEC update)

2010-20 receivables (topic 310): Disclosures about the Credit Quality of financing receivables and the Allowance for Credit Losses

2010-21 Accounting for technical Amendments to various sEC rules and schedules Amendments to sEC Paragraphs Pursuant to release no. 33-9026: technical Amendments to rules, forms, schedules and Codification of financial reporting Policies (sEC update)


2010-23 Health Care Entities (topic 954): Measuring Charity Care for Disclosure—a consensus of the fAsB Emerging Issues task force

2010-24Health Care Entities (topic 954): Presentation of Insurance Claims and related Insurance recoveries (a consensus of the fAsB Emerging Issues task force)

2010-25 Plan Accounting—Defined Contribution Pension Plans (topic 962): reporting Loans to Participants by Defined Contribution Pension Plans (a consensus of the fAsB Emerging Issues task force)

2010-26 financial services—Insurance (topic 944): Accounting for Costs Associated with Acquiring or renewing Insurance Contracts (a consensus of the fAsB Emerging Issues task force)

2010-27 other Expenses (topic 720): fees Paid to the federal Government by Pharmaceutical Manufacturers (a consensus of the fAsB Emerging Issues task force)

2010-28 Intangibles—Goodwill and other (topic 350): When to Perform step 2 of the Goodwill Impairment test for reporting units with Zero or negative Carrying Amounts (a consensus of the fAsB Emerging Issues task force)

2010-29 Business Combinations (topic 805): Disclosure of supplementary Pro forma Information for Business Combinations (a consensus of the fAsB Emerging Issues task force)

2011-01 receivables (topic 310): Deferral of the Effective Date of Disclosures about troubled Debt restructurings in update no. 2010-20

2011-02 receivables (topic 310): A Creditor’s Determination of Whether a restructuring Is a troubled Debt restructuring

2011-03 transfers and servicing (topic 860): reconsideration of Effective Control for repurchase Agreements

2011-04 fair value Measurement (topic 820)- Amendments to Achieve Commonfair value Measurement and Disclosure requirements in u.s. GAAP and Ifrss

2011-05 Comprehensive Income (topic 220): Presentation of Comprehensive Income

2011-06 other Expenses (topic 720): fees Paid to the federal Government by Health Insurers (a consensus of the fAsB Emerging Issues task force)

2011-07 Health Care Entities (topic 954): Presentation and Disclosure of Patient service revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities (a consensus of the fAsB Emerging Issues task force)

2011-08 Intangibles—Goodwill and other (topic 350): testing Goodwill for Impairment


ASU Description

2011-09 Compensation—retirement Benefits—Multiemployer Plans (subtopic 715-80) Disclosures about an Employer’s Participation in a Multiemployer Plan

2011-10 Property, Plant, and Equipment (topic 360): Derecognition of in substance real Estate—a scope Clarification (a consensus of the fAsB Emerging Issues task force)

2011-11 Balance sheet (topic 210): Disclosures about offsetting Assets and Liabilities

2011-12 Comprehensive Income (topic 220): Deferral of the Effective Date for Amendments to the Presentation of reclassifications of Items out of Accumulated other Comprehensive Income in Accounting standards update no. 2011-05

2012-01 Health Care Entities (topic 954): Continuing Care retirement Communities—refundable Advance fees

2012-02 Intangibles—Goodwill and other (topic 350): testing Indefinite-Lived Intangible Assets for Impairment

2012-03 technical Amendments and Corrections to sEC sections: Amendments to sEC Paragraphs Pursuant to sEC staff Accounting Bulletin no. 114, technical Amendments Pursuant to sEC release no. 33-9250, and Corrections related to fAsB Accounting standards update 2010-22 (sEC update)

2012-04 technical Corrections and Improvements

2012-05 statement of Cash flows (topic 230): not-for-Profit Entities: Classification of the sale Proceeds of Donated financial Assets in the statement of Cash flows (a consensus of the fAsB Emerging Issues task force)

2012-06 Business Combinations (topic 805): subsequent Accounting for an Indemnification Asset recognized at the Acquisition Date as a result of a Government-Assisted Acquisition of a financial Institution (a consensus of the fAsB Emerging Issues task force)

2012-07 Entertainment—films (topic 926): Accounting for fair value Information that Arises after the Measurement Date and Its Inclusion in the Impairment Analysis of unamortized film Costs (a consensus of the fAsB Emerging Issues task force)

2013-01 Balance sheet (topic 210): Clarifying the scope of Disclosures about offsetting Assets and Liabilities

2013-02 Comprehensive Income (topic 220): reporting of Amounts reclassified out of Accumulated other Comprehensive Income

2013-03 financial Instruments (topic 825): Clarifying the scope and Applicability of a Particular Disclosure to nonpublic Entities

2013-04 Liabilities (topic 405): obligations resulting from Joint and several Liability Arrangements for Which the total Amount of the obligation is fixed at the reporting Date

2013-05 foreign Currency Matters (topic 830): Parent’s Accounting for the Cumulative translation Adjustment upon Derecognition of Certain subsidiaries or Groups of Assets within a foreign Entity or of an Investment in a foreign Entity

2013-06 not-for-Profit Entities (topic 958): services received from Personnel of an Affiliate (a consensus of the fAsB Emerging Issues task force)

2013-07 Presentation of financial statements (topic 205): Liquidation Basis of Accounting

CPE nOTE: When you have completed your study and review of chapters 8–10, which comprise Module 3, you may wish to take the Quizzer for this Module.



215


Answers to Study Questions

MODULE 1 — CHAPTEr 1

1. a. Incorrect. The test of goodwill impairment is done last, not first.b. Incorrect. ASC 350 and ASC 360 do not allow for goodwill and all other tangible and intangible assets to be combined and tested for impairment simultaneously.c. Correct. GAAP requires that all tangible and intangible assets other than goodwill be tested and adjusted first. Then, the adjusted numbers are included in the test for goodwill impairment.d. Incorrect. GAAP does not provide for goodwill and all intangible assets being tested together, separate from the test of tangible assets.

2. a. Incorrect. The original cost has nothing to do with the valuation of goodwill.b. Incorrect. There are specific rules regarding whether goodwill may be written up.c. Correct. An impairment writedown may not be restored under any circumstances.d. Incorrect. There are no factors involved with whether a writedown may be restored.

3. a. Correct. A company could have a negative amount in the first step. When the second step is performed, the implied goodwill value may be higher than the carrying amount, resulting in no impairment writedown.b. Incorrect. If there is an impairment in the first step, that does not mean that there is an automatic writedown in step 2. After performing Step 2 it may be determined that a writedown is not required.c. Incorrect. If there is an impairment in step 1, there could be a writedown of goodwill in step 2. d. Incorrect. Goodwill cannot be written up.

4. a. Incorrect. There is no impairment that allows the entity to bypass the two-step impairment test.b. Incorrect. The entity may bypass both steps, and not only the first step, because there is no impairment.c. Correct. Because it is more likely than not that the fair value is not less than its carrying amount, there is no impairment and the entity may bypass the two-step test for impairment.d. Incorrect. There is no impairment and the entity is not required to perform both steps of the two-step impairment test.


5. a. Correct. The ASU eliminates use of the special goodwill impairment test carryforward rule that was included in the originally issued ASC 350. The rule offered a special relief provision under which an entity might be able to test for impairment in the first year and carryforward the test to each successive year with no update.b. Incorrect. The ASU does not add a new special goodwill impairment test carryforward rule, but it does provide a clarification regarding disclosures about goodwill impairment.c. Incorrect. The ASU does make a change to the special goodwill impair-ment test carryforward rule.d. Incorrect. The ASU does not add a new safe harbor rule for goodwill impairment, but it does allow for use of a qualitative assessment to test impairment of goodwill.

6. a. Incorrect. Fluctuations in foreign exchange rates, not stable foreign exchange rates, is an example of a qualitative factor.b. Incorrect. A limitation on accessing capital, and not an abundance of capital, is an example of a factor to consider.c. Correct. Entity specific changes such as a change in key personnel, management, customers, or strategy, is a factor to consider in making the qualitative assessment.d. Incorrect. An increase, not decrease, in the competitive environment is a factor to consider.

7. a. Incorrect. An intangible asset (other than goodwill) with an indefinite life must be tested for impairment at least annually, or more often if an event or circumstance occurs between annual tests indicating that the asset might be impaired.b. Correct. The entity is required to perform a one-step quantitative test by calculating the fair value of the intangible asset and performing the impairment test.c. Incorrect. There is only a one-step, not two-step, quantitative impairment test on indefinite-lived intangibles.d. Incorrect. Once the qualitative assessment is performed, there are no ad-ditional qualitative procedures required.

8. a. Incorrect. The $200,000 represents a future tax deduction which does not create a deferred income tax liability.b. Correct. The $200,000 writedown creates an $80,000 deferred income tax asset to reflect the future tax benefit for the tax deduction.c. Incorrect. The $200,000 represents a temporary difference for which deferred taxes must be recorded.d. Incorrect. The $200,000 creates one of these, but not both.

217A n s W E r s to s t u DY Q u E s t I o n s — M o d u l e 1 — C h a p t e r 2

9. a. Correct. The aggregate amount of impairment losses must be pre-sented as a separate line item in the income statement before the subtotal income from continued operations.b. Incorrect. Impairment losses are not part of other comprehensive income, which is the difference between net income and comprehensive income.c. Incorrect. Impairment losses are not presented as a separate line item, net of the tax effect. Impairment losses associated with a discontinued operation should be included (on a net-of-tax basis) within the results of discontinued operations.d. Incorrect. There is no requirement that the impairment losses be included in the other income section in the income statement. For a not-for-profit organization, the loss is presented in income from continuing operations in the statement of activities.


1. a. Incorrect. The fair value measurement framework in Topic 820 doesn’t specify when to measure at fair value. That determination is driven by other GAAP guidance outside Topic 820.b. Correct. The framework sets out how to measure, not when to measure. It applies only when directed by other GAAP. Some other areas of GAAP require fair value measurements (for example, certain share-based pay-ments) or measurements similar to fair value, but those measurements aren’t subject to the Topic 820 framework.c. Incorrect. Valuation is a broader activity than measurement for financial reporting purposes. The framework addresses fair value measurement, not all kinds of valuation for all kinds of purposes.d. Incorrect. Although there are a handful of substantive differences (and some editorial differences), guidance on fair value measurements under the framework is essentially the same as under International Financial Reporting Standards (IFRSs).

2. a. Incorrect, as this is an important aspect of the fair value concept. The idea of an orderly transaction is an important aspect of the fair value concept. If a transaction were forced or occurred too fast for the parties to gather in-formation, the price would not be consistent with the concept of fair value.b. Correct, as the price of an actual completed transaction is not part of the fair value concept. While comparable recent transactions may pro-vide inputs to valuations that ultimately lead to fair value, the fair value concept relates to a hypothetical transaction as of the measurement date, not simply to historical transactions.


c. Incorrect, as this is an important aspect of the fair value concept. The characteristics of the parties are important to the concept of fair value and are captured in the idea of market participants. If one of the parties was not acting in its own best interest because it was related to the other party, the related price would not be consistent with the concept of fair value.d. Incorrect, as this is an important aspect of the fair value concept. A valua-tion as of a date other than the measurement date is not consistent with the fair value concept. The hypothetical transaction embodied in the fair value concept occurs as of the measurement date.

3. a. Incorrect. The market with the greatest volume and level of activity for an item is called the principal market. If no one market meets that definition, an entity has to further assess the markets to which it has access.b. Incorrect. A transaction cost is considered in determining which of the markets to which the entity has access is the most advantageous market. However, because a transaction cost is not an attribute of the item, it is not part of the amount being measured.c. Incorrect. If an item has to be transported to market, then the related transportation cost is part of the amount being measured without regard to whether the market is the principal market or another market.d. Correct. Distinguishing between markets is only relevant if an entity has access to two or more markets at the measurement date.

4. a. Incorrect. This phrase defines the farm price used in certain transactions by certain producers of farm products.b. Incorrect. This phrase defines the term “entry price.” An entry price is not consistent with the fair value concept.c. Correct. The fair value concept focuses on an exit price because that price embodies expectations about future flows associated with the item.d. Incorrect. This phrase defines the exercise price of an option.

5. a. Incorrect. GAAP requires just the opposite: Unobservable inputs should be minimized and observable inputs should be maximized.b. Incorrect. Although GAAP doesn’t specify a particular income approach as superior, it does set out minimum expectations that must be part of any income approach used. For example, an income approach has to incorporate a risk premium for uncertainty inherent in the future flows.c. Correct. Also known as “current replacement cost,” the cost approach must consider physical, technological, and economic obsolescence.d. Incorrect. GAAP emphasizes that selecting an appropriate amount within the range of estimates under an income approach requires judgment about all relevant factors, whether qualitative and quantitative.


6. a. Incorrect, as this is a required assumption. Even if a restriction exists on the transfer of the liability or equity instrument, no adjustment should be made related to that restriction.b. Incorrect, as this is a required assumption. The entity has to assume the liability or equity instrument will remain outstanding and is not extinguished or cancelled as of the measurement date.c. Correct, as this is not a required assumption. Rather, the entity has to assume that the liability or equity instrument is transferred to a mar-ket participant. A related party cannot meet the GAAP definition of a market participant.d. Incorrect, as this is a required assumption. The transaction has to meet the definition of an “orderly transaction” assumed to occur at the measurement date under current market conditions.

7. a. Incorrect, as this is a true statement. Users need information about the approaches an entity uses to subsequently measure items at fair value and the related inputs.b. Correct, as this statement is false. An entity’s change to its approach, its way of applying the approach, or its underlying inputs are all matters of importance in understanding the entity’s fair value measurements.c. Incorrect, as this is a true statement. Given the nature of Level 3 measure-ments, the extent of their effects is important information.d. Incorrect, as this is a true statement. Although generally accepted account-ing principles set out the disclosure objectives, it is each reporting entity that must determine how those objectives will be met.


1. a. Incorrect. The FASB and IASB are working on an international standards convergence project that will ultimately result in one set of international GAAP standards. Changes will be required to existing U.S. GAAP standards and many of those changes will not be important to non-public entities.b. Correct. The FASB has issued several extremely controversial FASB statements and interpretations that are costly and difficult for non-public entities to implement and are not meaningful to the third parties they serve. One example is the issuance of ASC 810.c. Incorrect. Sarbanes-Oxley mandates that FASB’s funding come primarily from SEC registrants, thereby suggesting that the FASB’s focus continues to be on issues important to public entities, not non-public entities. d. Incorrect. Actually, accountants from smaller firms are not serving as FASB staff or board members, which results in no small business representation or perspective on the FASB.


2. a. Correct. Consolidation of Variable Interest Entities is one of the con-troversial statements that is extremely difficult to implement for smaller closely held companies. It requires that certain companies consolidate off-balance-sheet entities referred to as variable interest entities. b. Incorrect. Disclosure about Fair Value of Financial Instruments is one instance where the FASB has limited GAAP to public companies and large non-public entities, thereby exempting smaller non-public entities from its application. c. Incorrect. Earnings per Share is one instance where the FASB has limited GAAP to public companies, thereby exempting non-public entities.d. Incorrect. Segment Reporting is one instance where the FASB has limited GAAP to public companies, thereby exempting non-public entities.

3. a. Incorrect. Historical cost is the model. Fair value is eliminated except for available-for-sale securities.b. Incorrect. Depreciation is based on useful lives of assets, not tax return depreciation.c. Incorrect. A company has a choice of recording deferred income taxes or booking only the current taxes payable.d. Correct. The principle for goodwill is that goodwill is amortized gener-ally over the same period as that used for federal income tax purposes. If not amortized for federal income tax purposes, it is amortized over a period of 15 years.


1. a. Incorrect. Assets contributed by one employer may be used to provide benefits to employees of other employer plans.b. Incorrect. If a participating employer fails to make its required con-tributions, the unfunded obligations of the plan may be borne by the remaining employers.c. Correct. If a company withdraws from a plan, it may be required to make a final payment called a withdrawal liability.d. Incorrect. A multiemployer plan consists of more than one employer, not a single employer.z

2. a. Incorrect. The amendments require additional separate disclosures for multiemployer pension and other postretirement benefit plans.b. Incorrect. The disclosures apply to non-governmental plans but not to governmental plans.c. Incorrect. The changes apply to multiemployer plans but not to single-employer plans.d. Correct. The ASU expands disclosures for multiemployer other post-retirement benefit plans.


3. a. Incorrect. The additional information would not be required if informa-tion from Form 5500A is publicly available.b. Correct. One of the additional disclosures is a qualitative description of the extent to which an employer could be responsible for the obligations of the plan, including benefits earned by employees during employment with another employer.c. Incorrect. The additional disclosures do not include a quantitative analysis of the extent to which the employer could be responsible for the obligations of the plan, although they do include other quantitative information, to the extent available, as of the most recent date available, to help users understand financial information about the plan.d. Incorrect. This is not one of the three additional disclosures.

4. a. Incorrect. Stakeholders have not cited a lack of information about the subsidiaries’ and not-for-profit chapters’ involvement with these plans that would necessitate major changes to historical disclosures.b. Incorrect. Full disclosures are not required for subsidiaries.c. Correct. The ASU requires only two disclosures for subsidiaries that participate in their parent entity’s single-employer defined benefit pen-sion plan and for local chapters of not-for-profit entities that participate in their national organization’s defined benefit pension plan. They are the name of the plan and the amount of contributions made to the plan in each annual period for which an income statement is presented. d. Incorrect. Neither subsidiaries nor not-for-profit organizations are exempt from the additional disclosures requirements.

5. a. Incorrect. Multiemployer plans are not overfunded but are underfunded by about $428 billion.b. Incorrect. Multiemployer plans cover only about seven percent of the workforce.c. Correct. Multiemployer plans are grossly underfunded at about a 46 percent funded level.d. Incorrect. Most multiemployer plans have been in underfunded status since at least 2008.

6. a. Incorrect. Yellow is between 65 percent and 80 percent funded status.b. Correct. Green zone occurs at a funded status of more than 80 percent.c. Incorrect. Orange occurs between 65 percent and 80 percent funded status.d. Incorrect. Pink is not a color code used by the Pension Protection Act.



1. a. Incorrect. In order for a lease to qualify as a capital lease, the present value of the minimum lease payments must be equal to or exceed 90 percent or more of the fair value of the asset.b. Incorrect. In order for a lease to qualify as a capital lease, the lease term must be at least 75 percent of the remaining useful life of the leased asset.c. Correct. If there is a bargain purchase at the end of the lease, the lease is a capital lease.d. Incorrect. If there is a transfer of ownership, the lease qualifies as a capital lease.

2. a. Correct. The proposal uses the right-of-use model under which a lease obligation is recorded at the present value of cash flows with the recording of a corresponding right-of-use asset.b. Incorrect. Operating leases are part of existing GAAP and have nothing to do with the proposed lease standard.c. Incorrect. The term “capital lease” is part of existing GAAP although the new model does capitalize leases.d. Incorrect. The concept of “true lease” is found in taxation and not in GAAP.

3. a. Incorrect. Operating leases record rent expense while the proposed standard does not account for a lease as an operating lease. b. Incorrect. One of these expenses is recorded but not the other.c. Incorrect. Interest expense, but not rent expense, is a component of a lease recorded under the proposed standard. Rent expense applies to an operating lease and not a lease capitalized under the proposed standard. d. Correct. Both amortization and interest expense are components of expense recorded under the proposed standard. Amortization relates to the asset capitalized while interest expense relates to the payments of the lease obligation.

4. a. Correct. The lease term should take into account the effect of any options to extend the lease or terminate the lease in certain cases.b. Incorrect. The proposed standard does not provide for lease options being considered only once they are exercised.c. Incorrect. The proposed standard states that options should be considered.d. Incorrect. The proposed standard does not differentiate between an option to extend within a short-term period as compared with one that is long-term.

5. a. Incorrect. There are instances in which the discount rate should be reassessed.b. Incorrect. The discount rate should be reassessed if there is a change in the lease payments.


c. Incorrect. The discount rate should be reassessed only if the change in lease payment relates to an option.d. Correct. The discount rate should be reassessed when the lease pay-ments have changed due to the exercise of an option that the lessee did not have a significant economic incentive to exercise.

6. a. Incorrect. The disclosures are not limited to qualitative information.b. Incorrect. The disclosures are not limited to a quantitative information.c. Correct. The proposed standard expands disclosures that include both qualitative and quantitative information.d. Incorrect. The proposed standard expands disclosures and certainly does not abbreviate them.

7. a. Incorrect. Total expense (interest and amortization) on the lessee’s income statement would be higher, not lower, in the earlier years of new leases.b. Incorrect. There would be a positive (not negative) shift to cash from op-erations from cash from financing activities in the statement of cash flows.c. Incorrect. Total expense for GAAP may differ from total expense for income tax purposes resulting in deferred income taxes being recorded.d. Correct. The lessee’s EBITDA may increase as there is a shift from rent expense to interest and amortization expense. Interest and amortization are not deducted in arriving at EBITDA, while rent expense under exist-ing operating leases is deducted.

8. a. Incorrect. The proposed standard is not likely to expand leases because those leases will have lease obligations that have to be recorded on the les-see’s balance sheet.b. Incorrect. Shorter, not longer leases will be the trend so that smaller li-abilities are recorded on the lessee’s balance sheet.c. Correct. Tenants in single-tenant buildings with long-term leases may choose to buy because they already have to record lease obligations that are similar to the debt they will have to record in a purchase.d. Incorrect. The status quo is not likely to be the case given the enormity of the impact of the proposed standard on company balance sheets.

9. a. Incorrect. Consolidation may be required only if the real estate entity is not self-sustaining.b. Correct. If the real estate lessor is a VIE, consolidation may be required.c. Incorrect. If the lessee operating company or the common shareholder guarantee the lessor’s loan, consolidation may be required. This is not to case where the real estate lessor guarantees its own loan.d. Incorrect. If the lease is above market, and not at market value, consolida-tion may be required.



1. a. Incorrect. Only one of the criteria for extraordinary treatment is that there is an infrequency of occurrence.b. Incorrect. Only one of the criteria is that the transaction is unusual in nature.c. Incorrect. If a material transaction is either infrequent in occurrence or unusual in nature, but not both, it is not extraordinary and should be reported as a separate component of income from continuing operations.d. Correct. In order for an item to be presented as extraordinary, it must be both infrequent in occurrence and unusual in nature, such as a natu-ral disaster in an area that has never experienced that type of natural disaster before.

2. a. Correct. Because an earthquake has never occurred in Ohio, it is an infrequent occurrence and is unusual in nature, making the transaction extraordinary.b. Incorrect. Terrorist attacks are not extraordinary. Although such an attack might be infrequent, it is not unusual. Thus, the answer is incorrect.c. Incorrect. The write-off of receivables relating to bankruptcy is not infre-quent and not unusual in nature. Thus, it is not extraordinary. d. Incorrect. Because hail storms have occurred in the state of Maine, such an event is not infrequent and not unusual. Thus, it is not extraordinary.

3. a. Incorrect. There is one limitation as to how the classification must be made. b. Incorrect. The size of the insurance recovery is not a limitation in its classification.c. Correct. An entity may choose how it wants to classify business inter-ruption insurance recoveries as long as the classification is not contrary to existing generally accepted accounting principles.d. Incorrect. There is no limitation that the amount be characterized as unusual or infrequent.


1. a. Incorrect. GAAP does not require the disclosure if X has no interest and penalties.b. Incorrect. There is no restriction about including the disclosure.c. Correct. There is no authority as to whether a disclosure is required when the subject matter (interest and penalties, in this case) does not exist.d. Incorrect. GAAP provides no a specific option for disclosure in this situation.

2. a. Incorrect. It is presented on the income statement, but not as a separate line item on the income statement.b. Correct. The tax benefit is presented as a direct reduction in the current portion of income tax expense, with a corresponding disclosure.


c. Incorrect. GAAP does not provide for presenting the tax benefit as income.d. Incorrect. GAAP does give guidance on the presentation and the cor-responding disclosure.

3. a. Incorrect. The amount should not be deferred unless also deferred for tax purposes.b. Incorrect. If the entity were an S corporation or partnership, there would be no limit on the deduction of the Section 179 depreciation, which could result in a difference from a C corporation.c. Correct. The amount deducted on the financial statements should be the same as the amount shown on the tax return. If there is unused Section 179 depreciation it should be carried over to the next year and disclosed.d. Incorrect. Because, for a C corporation, tax law limits the amount of Sec-tion 179 deduction to the amount that brings income to zero, the amount recorded cannot include any amount that creates a loss.


1. a. Incorrect. Predictability is not a requirement under ASU 2013-04. The total amount of the obligation may change subsequent to the reporting date.b. Incorrect. The ASU does not use the term “calculable.”c. Correct. The total amount must be fixed in order for ASU 2013-04 to apply. However, the total amount may change subsequent to the report-ing date because of factors unrelated to measurement uncertainty. d. Incorrect. The term “determinable” is not used within the ASU.

2. a. Correct. The ASU does not apply to guarantors who must follow the guidance of ASC 460, Guarantees.b. Incorrect. Whether the guarantor follows ASC 460 has no effect on whether ASU 2013-04 applies.c. Incorrect. Whether the guarantor is the primary obligor is not a factor in determining whether ASU 2013-04 applies.d. Incorrect. The ASU does address whether it applies to guarantors as op-posed to borrowers.

3. a. Incorrect. Because the transaction is a debit, it cannot be a loss contingency.b. Correct. Where there is no contractual arrangement for recovery of the funded amounts, the entity should consider whether the receivable is a gain contingency.c. Incorrect. There is no reason why the debit would ever be considered a deferred credit.d. Incorrect. There is no reason why the debit would be treated as an operat-ing expense.



1. a. Incorrect. The plan must be at a specific time but it is not within 10 years.b. Incorrect. The definition requires a plan for liquidation at a particular time, not at any time prior to formal liquidation.c. Incorrect. A plan during a board of directors’ meeting does not mean it is a limited-life entity. d. Correct. A limited-life entity must have a plan of liquidation within the entity’s governing documents at inception.

2. a. Correct. Currently, the going concern assessment is found only in auditing literature and not GAAP. b. Incorrect. Currently, there is no requirement for management to assess going concern, although the proposed standard could affect that.c. Incorrect. Currently, there is no requirement for the board of directors to assess going concern.d. Incorrect. Currently, an assessment is required by a specific party.

3. a. Incorrect. There are two requirements for a company to be subject to the conflict mineral rules. Distribution of a product is not one of these and does not make an entity subject to the conflict mineral rules.b. Correct. Conflict minerals must be necessary to the functionality or production of a product manufactured by the company. The company must also be a public company under the SEC.c. Incorrect. Retailers are exempt from the conflict mineral rules if they don’t have any control over the manufacture of products sold under their brand name.d. Incorrect. There are two requirements for a company to be subject to the conflict mineral rules. Expansion of the product is not an action that makes an entity subject to the conflict mineral rules.


1. a. Incorrect. Once the investment is sold, the translation adjustment is not retained in equity and is reported in net income.b. Correct. ASU 2013-05 clarifies that upon sale, the component is re-moved from equity and reported in net income.c. Incorrect. ASU 2013-05 does not provide for removing a portion of the component and retaining the remainder in equity, when it relates to the sale of a foreign investment. The sale of an investment in a foreign entity includes two types of events, including events that result in an acquirer obtaining control of an acquiree in which it held an equity interest immediately before the acquisition date.

227A n s W E r s to s t u DY Q u E s t I o n s — M o d u l e 3 — C h a p t e r 1 0

d. Incorrect. Upon sale, the component is not reclassified to a separate section of equity. The sale of an investment in a foreign entity includes two types of events, including events that result in the loss of a controlling financial interest in an investment in a foreign entity.

2. a. Incorrect. The pro rata portion rule does not apply to a partial sale of a non-foreign entity.b. Incorrect. The entire cumulative transaction adjustment is released into income only if the sale represents a complete or substantially complete liq-uidation, which in this example, it does not.c. Correct. Because the sale is that of a non-foreign entity and the sale does not represent a complete or substantially complete liquidation, the adjustment should not be released into income.d. Incorrect. There is no rule under which the adjustment should be reclas-sified into a separate section of equity, regardless of whether the entity is foreign or non-foreign.

3. a. Incorrect. X may present the information on the face of the income statement, but that is not the only option.b. Incorrect. The reclassification can be presented as a separate disclosure in the notes, but that is not the only option.c. Correct. ASU 2013-02 provides an option of presenting the information either on the face of the statement where net income is presented, or as a separate disclosure in the notes.d. Incorrect. ASU 2013-02 provides options for presenting the reclassifica-tions, but one of them is not in supplementary information.

4. a. Incorrect. The transaction creates cash flow and is not a non-cash disclosure.b. Incorrect. This would not be considered a financing activity. If a donor restricted the use of a contributed resource to a long-term purpose, then those cash receipts would be classified as a financing activity.c. Correct. ASU 2012-05 requires that receipts from collections (or sales) of loans made by the entity be classified as an investing activity in the statement of cash flows.d. Incorrect. There is no authority within ASU 2012-05 that permits the receipt from the collection of a loan to be classified as an operating activity. An example of an operating activity would be the cash receipt from the sale of a donated equity instrument that upon receipt was directed for sale without any NFP-imposed limitations, and was immediately converted into cash.

229

A

accounting policy disclosures … 156–157

accounting practice issues … 153–170

accounting standards, recently issued difficult … 65

accounts receivable, effect of u.S. Post office changes on … 198

accumulated other comprehensive income, reclassifications out of … 205–208

active market, definition of … 52

agreements not to compete, oCboa disclosure of … 168–169

american Institute of Certified Public accountants, Financial reporting Framework (FrF) for SMEs of … 66–67

differences between u.s. GAAP and … 71–72exposure draft issued as framework for … 70financial statements prepared under … 73as non-authoritative … 72as principles-based … 71Q&A of issues for … 73–74, 75as special purpose framework under

auditing standards … 70–71status of … 72

american Institute of Certified Public accountants (aICPa) technical practice aids … 139–152

accounting and disclosures for losses from natural nongovernmental entities in … 139–144

apportionment of state taxes … 136

aSC 225-30, Income Statement—Business Interruption Insurance … 142, 148, 149–150

aSC 250, Accounting Changes and Error Corrections … 46, 178

250-10-50, Accounting Changes and Error Corrections, Overall, Disclosure … 204

aSC 260, Earnings Per Share … 64

aSC 274, Personal Financial Statements … 153–154, 156

aSC 275, Risks and Uncertainties … 143

aSC 280, Disclosures About Segments of an Enterprise and Related Information … 64

aSC 310, Receivables … 140–141, 143

aSC 350, Intangibles: Goodwill and Other … 2, 3–5, 9, 69, 143

disclosing impairments under … 27–29, 141displaying impairments on financial

statements under … 26–27ignoring … 29, 30–34

aSC 360, Property, Plant, and Equipment … 2, 4, 21, 60, 140, 143

aSC 405-20, Liabilities—Extinguishments of Liabilities … 172

aSC 410, Asset Retirement and Environmental Obligations … 143, 174

410-30, Asset Retirement and Environmental Obligations—Environmental Obligations … 172

410-30-30, Asset Retirement and Environmental Obligations—Environmental Obligations—Initial Measurement … 173

aSC 420, Exit or Disposal Cost Obligations … 141, 143

aSC 450, Contingencies … 141, 142, 143, 174, 175

450-20, Contingencies—Loss Contingencies … 141, 172

aSC 460, Guarantees … 174, 176

aSC 605, Revenue Recognition … 149

aSC 605-40, Revenue Recognition—Gains and Losses … 142

605-40-25, Revenue Recognition—Gains and Losses—Recognition … 145, 146

aSC 715, Compensation—Retirement Benefits … 174

aSC 715-80, Compensation—retirement benefits—Multiemployer Plans … 77

definitions in … 81–82

aSC 740, Income taxes … 64, 69, 156, 157, 161, 174

740-10-30, deferred tax liability or asset in … 163–164

aSC 805, Business Combinations … 1, 3, 69

aSC 810, Consolidation of Variable Interest Entities … 64, 69, 99, 134–136

810-10, Consolidation—Overall … 201

aSC 815, Derivatives and Hedging … 60, 69

aSC 820, Fair Value Measurements … 2, 35–62framework under GAAP for … 35, 36


Index


aSC 825, Disclosure About Fair Value of Financial Instruments … 64

aSC 830-30, Foreign Currency Matters—Translation of Financial Statements … 201, 202

830-30-40, Foreign Currency Matter—Translation of Financial Statements, Derecognition … 203 …

aSC 840, Leases … 97bright-line tests under … 98joint fAsB-IAsB project to replace … 99–107

aSC 850, Related Party Disclosures … 40

aSu 2010-02, ASC Subtopic 810-10, Consolidation: Accounting and Reporting for Decreases in Ownership of a Subsidiary—A Scope Clarification … 202

aSu 2010-20, Disclosures About the Credit Quality of Financing Receivables and the Allowance for Credit Losses … 156, 212

aSu 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requires in U.S. GAAP and IFRSs … 37, 213

aSu 2011-08, Intangibles—Goodwill and Other (Topic 350), Testing Goodwill for Impairment … 2, 9–14, 213

carryforward rule of … 12disclosures clarification under … 12qualitative assessment as

mandatory under … 12–14qualitative assessment under … 9–12, 15–20transition to … 14–15

aSu 2011-09, Compensation—Retirement Benefits—Multiemployer Plans (Subtopic 715-80) Disclosures About an Employer’s Participation in a Multiemployer Plan, 214

background of … 77–79changes made by … 79disclosures required by … 79, 82–85goals of … 79issuance in september 2011 of … 77sample disclosure from … 86–89scope of … 80transition to … 89

aSu 2011-11, Balance Sheet (Topic 210): Disclosures About Offsetting Assets and Liabilities … 209, 214

aSu 2012-02, Intangibles—Goodwill and Other (Topic 350) Testing Indefinite-Lived Intangible Assets for Impairment … 3, 214

changes made by … 22–24effective date of … 24issuance of … 20objective of … 20–21

aSu 2012-05, Statement of Cash Flows (Topic 230) Not-for-Profit Entities: Classification of the Sale Proceeds of donated Financial Assets in the Statement of Cash Flows … 210–211, 214

background of … 210effective date of … 210issuance in october 2012 of … 210overview of … 210rules of … 210–211

aSu 2013-01, Balance Sheet (Topic 210)—Clarifying the Scope of Disclosures About Offsetting Assets and Liabilities … 209, 214

background of … 209overview of … 209rules of … 209

aSu 2013-02, Comprehensive Income (Topic 220) Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income … 205–208, 214

background of … 206–207disclosures required by … 208effective date of … 205issuance in february 2013 of … 205overview of … 205rules of … 207–208

aSu 2013-04, Liabilities (Topic 405), Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date … 171–184, 214

background of … 171–174effective date of … 177issuance in february 2013 of … 171joint and several obligations of related

parties under … 182–184overview of … 171rules for … 176–177scope of … 174–175, 176transition to … 177–181

aSu 2013-05, Foreign Currency Matters (Topic 830): Parent’s Accounting for the Cumulative Translation Adjustment upon Recognition of Certain Subsidiaries or Groups of Assets Within a Foreign Entity or of an Investment in a Foreign Entity … 201–205, 214

background of … 201–202cumulative translation adjustment

derecognition guidance of … 204, 205effective date of … 204overview of … 201rules for controlling financial interest of … 203

transition to … 204

auditing Standards board (aSb), diminished role of … 64

I N D E X 231

b

bad debts, allowance method under GaaP for … 161

balance sheetdisclosure of material and not material

items on … 159, 161leases on, under Leases (Topic 840) exposure

draft of fAsB-IAsB … 114, 118, 129, 130, 132–133

offsetting assets and liabilities in … 209section 179 depreciation on oCBoA … 167, 168

bankruptcy of companies with pension funding shortfalls … 94

big GaaP, definition of … 63

big GaaP–Little GaaP … 63–76new impetus for … 64

blue ribbon Panel … 66

brand valueon net worth of typical individual … 156on personal financial statement of Donald

trump … 154–156

business combinations 1–2equity interest used in … 57reported for multiemployer

pension plans … 85variations in treatment of … 202

business interruption insurance recoveries … 148–152

CCarrying amount

of intangible asset with indefinite life … 21–22

of stockholders’ equity … 18–20

Citizens United v. Federal Election Commission ruling … 197

Comprehensive income, components of … 206

Concepts Statement 5, Recognition and Measurement in Financial Statements of Business Enterprises … 141

Concepts Statement 6, Elements of Financial Statements of Business Enterprises … 206

Conflict mineralscountries of origin of, list of … 195country of origin inquiry for … 196Covered Countries for … 196retailer rules for … 196sEC rules requiring public disclosure of

use of … 195steps for companies reporting

use of … 195–196

Conflict Minerals report, Form SD for … 196

Consolidation of variable interest entity rules of aSC 810 … 134–136

Consolidations for SMEs … 72

Contractual obligations, joint … 171

Corporate reform Coalition … 197

Credit risk … 57

Credit Suisse report of multiemployer pension plans, Crawling Out of the Shadows … 90–92

D

Days sales outstanding (DSo) lag due to u.S. Post office changes … 198–199

Debt arrangements, joint obligations for … 171

Debt-equity ratio for leases … 137

Deferred tax assetcreation and presentation of … 132, 133–134federal tax rate for recording … 163–164impairment of … 25–26

Deferred tax liability, federal tax rate for recording … 163–164

Defined benefit plan, multiemployer pension plan as … 77, 78, 80

Defined contribution plan, GaaP treatment of … 78, 80

Demand deposit, fair value measurement of … 37

Derivative instrumentsfair value measurements for … 35of sMEs … 72

Direct write-off method … 161

Disclosuresadded to GAAP … 64–65for all fair value measurements … 60–61of Dodd-Frank Wall Street Reform and

Consumer Protection Act … 192–194environmental greenhouse gas … 192fair value measurements as basis for … 35, 36of GAAP departures … 158–161of going concern assessment

by management … 190–191of impairment losses … 27–29

of joint and several liability arrangements with fixed obligations … 171–184

Leases (Topic 840) exposure draft of fAsB-IAsB requirements for … 109, 110–111, 112

level of detail in … 59–60missing … 194–195for multiemployer pension plans … 77–95


for natural disasters … 143–144for nonpublic entities … 37objectives of … 58–59of policies not applicable to

current year … 156–157politics of … 192–197of reclassifications out of accumulated other

comprehensive income … 208for small- and medium-sized entities … 71

Discount-rate-adjustment methods … 48

Discount rate used for leases … 100–101, 108

Dodd-Frank Wall Street Reform and Consumer Protection Act … 192–194

Donated financial assets, cash receipts from … 211

E

Earnings before interest, taxes, depreciation, and amortization (EbItDa) for leases … 137

Entry price, definition of … 44

Equity method for SMEs … 72

Exit pricedefinition of … 44difference of transaction price and … 45

Expected cash flow (expected present value) methods … 48–49

Extraordinary and unusual items (tIS Section 5400) … 139–144

meeting criteria for … 143–144

FFair value

definition of … 38evidence of … 52of instrument in equity … 57of liability … 56–57

Fair value concept … 37–45

Fair value hierarchyLevel 1 … 51Level 2 … 51

Fair value measurements … 35–62in business combinations … 1–2disclosure requirements for … 58–62of impairments … 2of intangible asset with

indefinite life … 21–24interaction with other guidance of … 37of nonfinancial asset … 55–56recurring versus nonrecurring … 59–60uses of … 35valuation approaches for … 46, 58

Federal disaster recovery assistance … 143

Financial accounting Foundation (FaF) … 66PCC created and reporting by … 67, 68

Financial accounting Standards board (FaSb)conformance and convergence of guidance

with IAsB of … 37, 64controversial statements and

interpretations by … 64disclosures added to GAAP by … 64–65Emerging Issues task force (EItf) of … 172funding for … 64joint lease accounting project of

IAsB and … 99–107Private Company Council (PCC) of … 66–69, 75reflection of needs of non-public

companies by … 65–66

Financial asset portfolio, management of … 57–58

Financial instrumentscost measurements for … 71fair value measurements for … 35, 71

Financial statementsamortization of goodwill presented as

zero on … 159–160components of income tax expense in

notes to … 163disclosures for multiemployer

pension plans in … 82–85display of impairments on … 26–27GAAP for … 74, 75income-tax basis … 29–30, 65, 75, 165–169insurance recoveries disclosed in notes to … 149lease presentation on, under Leases

(Topic 840) exposure draft of fAsB-IAsB … 109–111, 135

liquidation basis … 187of nonpublic entity … 81oCBoA … 29–30, 65, 75, 165–169personal, goodwill on … 153–156policies in notes to … 157of sMEs, frf for … 72–75

Foreign entity, controlling financial interest rules for … 202–204

cessation of … 202, 203partial sales of … 203

G

GaaP (generally accepted accounting principles), u.S.

avoiding recording impairment losses under … 29–34

bad debts under … 161conformance with Ifrss with … 37, 64departure from, not material … 158–161departure from, referencing … 29, 30disclosures added to … 64–65exceptions to, for non-public

companies … 65–66, 75

I N D E X 233

exceptions to, in auditor’s report … 65exit price of asset under … 44framework for fair value

measurements under … 35–62for going concern … 189ignoring standards of … 65initial measurement of items under … 35–36involuntary conversions under … 145–152for leases, comparison of existing and

proposed … 113multiemployer pension plan rules of

Ifrs and … 79–80for non-public entities … 75subsequent measurement of

items under … 35, 36two-step test of goodwill i

mpairment of … 5–9, 13

Going concern assessment … 189–192disclosures related to … 190–191

Going Concern exposure project … 189–190

Goodwillamortization of … 72, 158–160definition of … 3disclosing impairments to … 27–29disclosure on balance sheet of … 159GAAP for … 3–9identifying impairment of … 5–6impairment test rules for … 1–34, 72, 161measuring loss of … 6–8on personal financial statements … 153–156qualitative assessment of … 9–12writedown of … 6, 8–9, 25

Guaranteesrecognition of … 36related party … 176–177

Guarantors of obligation … 175

HHighest and best use

of asset … 55definition of … 55of land … 56

Historical cost as measurement basis … 71

Historical cost versus fair value … 35

I

IaSb 17 for lease accounting … 97joint fAsB-IAsB project to replace … 99–107

Impairment lossesavoiding recording, for GAAP … 29–34disclosures required by AsC 350 of … 27–29financial statement presentation of … 26–27for fixed assets … 148natural disaster related to,

recognition of … 140–141

sample auditor’s … 33–34sample compilation report for … 31sample review report for … 32

Impairment test rules … 1–34GAAP … 3–9for goodwill … 161for intangible assets with

indefinite lives … 22–24, 25for sMEs … 72

Impairmentsdisclosures of … 27–29display on financial statements of … 26–27

Income statement. See Statement of income

Income taxes … 161–164noL carryforward for … 161for sMEs … 72tax rate for DIts for … 163–164

Inputsdefinition of … 50hierarchy of strengths of … 51–54Level 1 (fair value) … 51, 52–53, 54, 60Level 2 (fair value) … 51, 53–54, 60Level 3 (unobservable) … 51, 54, 59, 60, 61–62observable versus unobservable … 50–51, 54

Insurance recoveriesfor business interruption … 142, 148–152for losses sustained in natural disaster … 142receivable due in … 142taxation of unspent … 152

Intangible assets … 1–34. See also Goodwillwith finite lives … 1, 2, 21with indefinite lives … 1, 2, 20–25long-lived … 1–2, 21

Interest coverage ratio for leases … 137

International accounting Standards board (IaSb)

conformance and convergence of guidance with fAsB of … 37, 64

joint lease accounting project of fAsB and … 99–107

International Financial reporting Standards (IFrSs)

conformance of u.s. GAAP with … 37differences between frf for sMEs and

that of … 73–74multiemployer pension plan rules of GAAP

and … 79–80for sMEs, use by u.s. private

companies of … 74–75

Inventory measurement … 71

Investment company accounting … 37

Investment company, measuring investment in … 58

Involuntary conversions … 144–152


GAAP treatment as sale in … 145nonrecognition of gain from … 144–145period before settlement with insurance of,

GAAP for … 145–152timing of … 145

j

Joint and several liability arrangements with fixed obligations … 171–184

disclosures for … 177recording duplicate liabilities in … 173–174

Judicial rulings, joint and several liability arrangements for … 171

L

Lease accounting … 71, 97–137. See also Leases (Topic 840) exposure draft of FaSb-IaSb; retailers, leases of

current GAAP … 97IAsB 17 for … 97, 99–100impact of changes to … 113–137sEC initiatives for changes in … 98

Lease amortization schedule … 117, 122

Lease obligations, unrecorded … 98, 129–130

Lease payments under Leases (Topic 840) exposure draft of FaSb-IaSb … 105–106, 107

contingent … 121–122schedule of … 115straight-line approach to … 122

Leases. See also retailers, leases ofbargain purchase at end of … 97capital … 97, 98capitalizing … 118–121, 122, 132, 137contract modifications or changes in

circumstances of existing … 108discount rate used for … 100–101, 108existing, under Leases (Topic 840) exposure

draft of fAsB-IAsB … 113fair value measurements involving … 37, 97long-term … 131operating … 97, 98, 114–122, 129–132, 137purchases of asset versus … 131reassessment of, under Leases (Topic 840)

exposure draft of fAsB-IAsB … 106–107related-party … 134–136restatements focused on … 98right-of-use … 129–130, 134short-term … 108–109, 135–136straight-line expense approach for … 122–126synthetic … 98term of, under Leases (Topic 840)

exposure draft … 104–105, 132transfer of ownership for … 97

Leases (Topic 840) exposure draft of FaSb-IaSb … 97–98, 99–137

adjustments to computation of lease asset and liability under … 127

contract modifications or changes in circumstances of … 108

cost of compliance of … 129disclosures under … 110–111, 112discount rate under … 100, 127–128effective date of … 113, 128–129existing leases under … 128–129financial covenants under … 137financial statement

presentation under … 109–112impact of … 113–136impairment to loan covenants under … 137interest expense under … 126lease payments under … 105–106, 107lease term under … 104–105, 132lessee accounting under … 101–103lessor accounting under … 103–104method used under … 100–101for non-public companies … 134proposed to replace AsC 840 and

IAsB 17 … 97, 99reassessment of lease under … 106–107for related parties … 134–136sale and leaseback transactions under … 109scope of … 99–100short-term leases under … 108–109structure of leases under … 131–134transition for existing leases under … 113

Lessee accounting under Leases (Topic 840) exposure draft … 101–103

Lessee disclosures under Leases (Topic 840) exposure draft of FaSb-IaSb … 110–111

Lessor accounting under Leases (Topic 840) exposure draft … 103–104

Lessor disclosures under Leases (Topic 840) exposure draft of FaSb-IaSb … 112

Lessors, value of commercial real estate of … 130

Liability measurementfair value … 56–57present value method for … 49

Liquidation basis of accounting … 185–189. See also Presentation of Financial Statements (Topic 205)—The Liquidation Basis of Accounting

measurement and re-measurement using … 186

rules in exposure draft for … 186

Liquidation, definition of … 185–186

Little GaaP. See also big GaaP–Little GaaPAICPA proposal for … 66–67creating … 63

I N D E X 235

definition of … 63fAsB PCC proposal for … 66–69prior attempts at creating … 65–66recommendations for features of … 66

Loan covenant ratios … 137

Loan impairment … 141

Loss recognition, measurement, and disclosures for natural disasters … 139–144

M

Market participantGAAP definition of … 38, 40liability transferred to … 56source of knowledge of … 38–39

Matrix pricing … 47–48

Measurementdefinition of … 35distinguished from valuation … 35

Most advantageous marketdefinition of … 41principal market versus … 41–43

Multiemployer pension plans … 77–95annual report on form 5500 of … 83–84background of … 77–79certified zone status for … 83, 91, 94collective-bargaining agreement(s) for … 83Credit suisse report on funding of … 90–92crisis involving funding of … 90–94difference between single-employer pension

plans and … 78disclosures for … 77–95employer contribution rate for … 85financial statements for … 82–85GAAP versus Ifrs rules for … 79–80number of employees covered by … 85recognition of contributions to … 79risks of liabilities under … 78, 82, 92–94sample disclosure for … 86–89underfunded status of … 84, 90–94unfunded obligations of … 78unique characteristics of … 78users of … 77withdrawal of employer from … 78

Multiemployer plan, definition of … 81

Multiperiod, excess earnings methods … 48

Multiple employer plan, 80definition of … 81

n

natural disastersdisclosures required about impact of … 143–144entity receipt of federal assistance for

victims of … 143

expected to reoccur, losses in statement of operations for … 140

insurance recoveries to cover losses sustained in … 142

losses incurred as result of … 139–144recognition of asset impairment loss

related to … 140–141recognition of non-impairment losses and

costs from … 141

net operating loss (noL) carryforward … 161–163

net pension cost items … 82

nonfinancial asset, fair value of … 55–56

non-impairment losses and costs of natural disaster … 141

nonperformance risk … 56, 57

non-public companies. See also american Institute of Certified Public accountants, Financial reporting Framework (FrF) for SMEs of

accounting frameworks for, table of … 75attributes for small- and medium-sized … 74creating Little GAAP for … 63–76exemptions from disclosures by … 65leases of … 134proposals to reflect accounting

needs of … 65–66

nonpublic entity, definition of … 81

not-for-profit entities, special rules for pension plans of … 85–86

O

observable inputs … 50–51

oCboa-income tax basis financial statements … 29–30, 65, 165–169

agreements not to compete amortization in … 168–169

section 179 depreciation in … 165–168

off-balance-sheet transactionseliminating … 97, 99, 136fAsB standards addressing … 99of retailer operating lease liabilities,

table of … 130–131sEC report of, for lease accounting … 98

offsetting requirements of u.S. and international standards … 209

option-pricing models … 48

orderly transactiondefinition of … 38transfer of liability in … 56

other comprehensive incomecurrent period reclassification

of accumulated … 207


items in … 206significant amounts reclassified out of

components of accumulated … 207–208unrealized transaction in … 207

P

Pension benefit Guaranty Corporation (PbGC) … 93–94

Pension benefitsdefinition of … 81shortfall statistics for … 90–94

Pension Protection Act of 2006, certified zones for pension plans created by … 83, 91

Political contributions, proposal to disclose … 197

Post office. See u.S. Post office

Postretirement benefit plan, multiemployer other 77

disclosures required for … 79recognition of contributions to … 79

Postretirement benefits other than pensionsdefinition of … 82disclosures required for … 85

Presentation of Financial Statements (Topic 205)—The Liquidation Basis of Accounting … 185–189

for limited-life entity that liquidates as planned at inception … 188–189

for limited-life entity with unplanned liquidation … 188–189

for normal operating entity … 187project status for … 189

Principal marketdefinition of … 41market participant transaction in … 38most advantageous market versus … 41–43

Private companies. See non-public companies

Private Company Council (PCC)creation of … 66–67issues addressed in first meeting of … 69responsibilities and operating

procedures of … 67–68use of framework of, by non-public

companies … 75

Private Company Financial reporting Committee (PCFrC) … 65–66

Public companiesDodd-Frank Wall Street Reform and

Consumer Protection Act disclosure requirements for … 192–194

future minimum lease payments of … 130interest costs on leases of … 129sEC recent disclosure and reporting

requirements for … 192, 194–197worldwide statistics for … 74

Public Company accounting oversight board (PCaob) as auditor standard-setter … 64

Q

Qualitative assessment of goodwill impairment … 9–14

bypassing … 22examples for applying … 15–20, 23–24for indefinite-lived intangible assets … 20–25mandatory … 12–14steps in performing … 23–24transition for use of … 14–15

Quantitative impairment test comparing fair value to carrying amount … 22

Quoted priceadjustment to … 52, 53Level 1 input as, 52, 54for multiple items … 53

r

ratios of loan covenants under proposed lease standard … 137

real estate, operating company leases for … 134–136

reconciliation of opening and closing balances … 61–62

related partiesin joint and several obligations … 176,

182–184leases of … 134–136transaction between … 45

related party, GaaP definition of … 40

reporting unit level testing of goodwill … 3, 5, 26

reporting unit, measurement of … 46

retailers, Conflict Minerals rule for … 196

retailers, leases ofcapitalization … 113–121, 129contingent payments, residual guarantee, or

option to purchase of … 121–122operating leases of … 97, 98, 117–121, 130straight-line expense approach to … 122–126

I N D E X 237

S

Sale and leaseback transactions under Leases (Topic 840) exposure draft of FaSb-IaSb … 109

Sample reportsauditor’s … 33–34compilation … 31review … 32

Sarbanes-Oxley Act of 2002 … 64, 97, 99

Section 179 depreciation in oCboa financial statements … 165–168

Securities and Exchange Commission (SEC)conflict minerals disclosure

requirements of … 195–196focus on missing disclosures by … 194–195initiative to expand required

disclosures by … 192political contribution disclosures

considered by … 197report on changing lease accounting by … 98

Settled litigation … 171

Share-based payment transaction … 37

Short-term lease … 108–109, 135–136definition of … 108

Single-employer pension plansbenefits and disadvantages of … 78changes to historical disclosures of … 85crisis involving funding of … 90–94definition of … 81difference between multiemployer pension

plans and … 78, 80

Small- and medium-sized entities. See american Institute of Certified Public accountants, Financial reporting Framework (FrF) for SMEs of; non-public companies

Specialized asset for lease contracts … 99

Statement of cash flowscash inflows in … 210–211goodwill on … 159, 160impairment loss presentation on … 27leases on, under Leases (Topic 840) exposure

draft of fAsB-IAsB … 110, 111, 114, 126

Statement of changes in net assets in liquidation … 187

Statement of comprehensive income, leases on, under Leases (Topic 840) exposure draft of FaSb-IaSb … 110, 111

Statement of financial positionfair value measurement of items in … 58leases on, under Leases (Topic 840) exposure

draft of fAsB-IAsB … 109–110, 111for multiemployer pension plan … 83

Statement of incomedisplay of business interruption insurance

recoveries in … 148–152goodwill on … 159, 160under Leases (Topic 840) exposure draft of

fAsB-IAsB … 114, 119section 179 depreciation on oCBoA … 166,

167–168

Statement of net assets in liquidation … 187

Statement of operationsbusiness interruption or property insurance

recoveries in … 145–152classification of insurance recoveries in … 142classification of losses from natural

disaster in … 140goodwill on … 159, 160

Stockholder’s equity, carrying amount of … 12–14

examples of … 18–20

Straight-line expense (SLE) approach to leases under Leases (Topic 840) exposure draft of FaSb-IaSb, 122–126

Subsidiariesentities ceasing to hold controlling financial

interest in … 202special rules for pension plans of … 85–86

Summary of net worth … 155–156

T

tax planning, effect of capitalizing leases in … 136

tax rates for deferred tax assets and liabilities … 163–164

third-party credit enhancement … 53

transaction costsdefinition of … 43transaction costs reflecting … 45transportation costs versus … 43

transaction price … 45

transportation costs … 42definition of … 43transaction costs versus … 43

U

union initiatives addressing pension funding shortfall … 94

unit of accountdifferences of transaction price and exit price

for more than one … 45highest and best use as

not changing … 55–56


item measured as … 39quoted price for identical item of … 52–53used by issuer of debt security … 53

unobservable inputs … 50–51

unrecorded lease obligations, statistics for … 98, 129–130

u.S. Post office … 197–199

v

valuationas broader than financial reporting … 35definition of … 35

valuation approach … 46–51cost … 46, 47description of, for Level 3

fair value measurement … 61income … 46, 48–49market … 46, 47–48for subsequent fair value measurements … 58weight of … 46

Wworking capital, impact of u.S. Post office

changes on companies’ … 197–199

239


CPE Quizzer Instructions

This CPE Quizzer is divided into three Modules . To obtain CPE Credit, go to CCHGroup.com/PrintCPE to complete your Quizzers online for immediate results and no Express Grading Fee . There is a grading fee for each Quizzer submission .

Processing Fee: $84.00 for Module 1$98.00 for Module 2$42.00 for Module 3$224.00 for all Modules

recommended CPE:6 hours for Module 17 hours for Module 23 hours for Module 316 hours for all Modules

Instructions for purchasing your CPE Tests and accessing them after purchase are provided on the CCHGroup.com/PrintCPE website .

To mail or fax your Quizzer, send your completed Answer Sheet for each Quizzer Module to CCH Continuing Education Department, 4025 W. Peterson Ave., Chicago, IL 60646, or fax it to (773) 866-3084 . Each Quizzer Answer Sheet will be graded and a CPE Certificate of Completion awarded for achieving a grade of 70 percent or greater . The Quizzer Answer Sheets are located at the back of this book .

Express Grading: Processing time for your mailed or faxed Answer Sheet is generally 8-12 business days . To use our Express Grading Service, at an ad-ditional $19 per Module, please check the “Express Grading” box on your Answer Sheet and provide your CCH account or credit card number and your fax number. CCH will fax your results and a Certificate of Comple-tion (upon achieving a passing grade) to you by 5:00 p .m . the business day following our receipt of your Answer Sheet . If you mail your Answer Sheet for Express Grading, please write “ATTN: CPE OVERNIGHT” on the envelope. NOTE: CCH will not Federal Express Quizzer results under any circumstances .

recommended CPE credit is based on a 50-minute hour. Participants earning credits for states that require self-study to be based on a 100-minute hour will receive ½ the CPE credits for successful completion of this course. Because CPE requirements vary from state to state and among different licensing agencies, please contact your CPE governing body for information on your CPE requirements and the applicability of a particular course for your requirements.




Date of Completion: If you mail or fax your Quizzer to CCH, the date of completion on your Certificate will be the date that you put on your Answer Sheet . However, you must submit your Answer Sheet to CCH for grading within two weeks of completing it .

Expiration Date: December 31, 2014

Evaluation: To help us provide you with the best possible products, please take a moment to fill out the course Evaluation located after your Quizzer . A copy is also provided at the back of this course if you choose to mail or fax your Quizzer Answer Sheets .

CCH is registered with the national Association of state Boards of Accountancy (nAsBA) as a sponsor of continuing professional education on the national registry of CPE sponsors. state boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be addressed to the national registry of CPE sponsors, 150 fourth Avenue north, suite 700, nashville, tn 37219-2417. Web site: www.nasba.org.

CCH is registered with the national Association of state Boards of Accountancy (nAsBA) as a Quality Assurance service (QAs) sponsor of continuing professional education. state boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be addressed to nAsBA, 150 fourth Avenue north, suite 700, nashville, tn 37219-2417. Web site: www.nasba.org.

one complimentary copy of this course is provided with certain copies of CCH publications. Ad-ditional copies of this course may be downloaded from CCHGroup.com/PrintCPE or ordered by calling 1-800-248-3248 (ask for product 10024493-0001).


241


Quizzer Questions: Module 1

1. How should intangible assets with indefinite lives be accounted for?

a. Should be amortized and tested annually for impairmentb. Should not be amortized and should be tested annually for impairmentc. Should be amortized but not tested for impairmentd. Should not be amortized and should not be tested for impairment

2. Which of the following is correct as it relates to goodwill?

a. Goodwill should be amortized over 15 years with no test for impair-ment required.

b. Goodwill should not be amortized and should be tested for impair-ment only if there is a reason to do so.

c. Goodwill should be amortized over its useful life and tested for impairment at least annually.

d. Goodwill should not be amortized and should be tested for impair-ment at least annually.

3. Under GAAP, the test for impairment of goodwill is performed at the____________ level.

a. Entity b. Reporting unitc. Consolidated entityd. Individual asset and liability

4. Which of the following would be an event or circumstance that may warrant an entity performing an interim goodwill impairment test?

a. A deterioration in general economic conditionsb. A positive change in cash flowsc. Cost factors such as decreases in the cost of raw materials or labord. An increase in actual revenue or earnings


5. Which of the following is the formula used to perform the second step, to measure the impairment loss for goodwill?

a. Fair value of the entity’s stockholders’ equityLess: Fair value of the entity’s individual assets and liabilities (excluding goodwill)Equals: Implied goodwill valueLess: Carrying value of goodwillEquals: Impairment loss

b. Fair value of the entityLess: Carrying value of assigned assets and liabilities Equals: Computed goodwill valueLess: Carrying value of goodwillEquals: Impairment loss

c. Fair value of the entityLess: Carrying value of entityEquals: Implied goodwill valueLess: Fair value of goodwillEquals: Impairment loss

d. Fair value of individual assets and liabilitiesLess: Carrying value of individual assets and liabilitiesComputed goodwill valueLess: Fair value of goodwillEquals: Impairment loss

6. If, based on the qualitative assessment, it is more likely than not (more than 50 percent probability) that the fair value of a reporting unit (entity) is less than its carrying amount, which of the following actions is required?

a. The entity must perform both steps to the two-step impairment test.b. The entity must perform the first step of the two-step impairment

test and then, if necessary, perform the second step.c. The entity may bypass performing both steps of the impairment

test as there is no impairment.d. The entity may bypass the first step and go directly to the second

test of the two-step impairment test.

Q U I Z Z E R Q U E S T I O N S — M o d u l e 1 243

7. Company X is testing its goodwill for impairment. The fair value is greater than the carrying amount of X’s stockholders’ equity. The car-rying amount is greater than zero. How should X proceed?

a. There is a potential impairment; X should go to the second step and measure the impairment

b. There is no potential impairment, but X should go to the second step and measure the impairment

c. There is a potential impairment; X should not go to the second step and measure the impairment

d. There is no potential impairment, and X should not go to the second step and measure the impairment.

8. How do the rules for the qualitative assessment of goodwill impair-ment apply when an entity or unit has a carrying amount that is zero or negative?

a. The qualitative assessment does not apply.b. The qualitative assessment can be used if the carrying amount is

zero, but not negative.c. The qualitative assessment can be used if the carrying amount is

negative, but not zero.d. The qualitative assessment is mandatory.

9. In performing an impairment test of an intangible asset with an in-definite life, using a qualitative assessment, if it is not more likely than not that the asset is impaired, which of the following is the result?

a. The two-step impairment test is required.b. Performing an impairment test is unnecessary.c. A single impairment test must be performed.d. A further qualitative assessment is required.

10. If an impairment loss is recognized for an indefinite-lived intangible asset, which of the following is correct? Subsequent reversal of the previously recognized loss is ______.

a. Permitted up to the original costb. Prohibitedc. Permitted up to the current year loss onlyd. Not addressed in current GAAP


11. How should deferred tax assets and liabilities be handled in the testing of goodwill of a reporting unit?

a. Deferred tax assets, but not deferred tax liabilities, are excluded from the fair value of the recognized assets of the unit.

b. Deferred tax assets and deferred tax liabilities are included in the fair value used to test goodwill.

c. Deferred tax assets, but not deferred tax liabilities, are included in the fair value used to test goodwill.

d. Deferred tax assets are excluded, but deferred tax liabilities are included in the fair value calculation.

12. If an entity uses income tax basis financial statements, how should goodwill be accounted for?

a. Not amortized and tested for impairmentb. Amortized over 15 yearsc. Amortized over the GAAP life but not tested for impairmentd. Not amortized and not tested for impairment

13. ASC 805 requires that goodwill be initially recognized as an asset based on __________.

a. Excess of carrying amount over fair value of assetsb. Excess of the cost of the acquired entity over the net amounts as-

signed to assets and liabilities assumedc. A formula to value goodwill using a capitalization rated. Excess of book value of individual assets over carrying amount of

net assets

14. Company X has goodwill and is performing its annual test for im-pairment. The carrying amount of its reporting unit is less than zero. Further, it is more likely than not (more than 50 percent probability) that goodwill is impaired. Which of the following is true?

a. X has no potential impairment.b. X must perform the second step in the impairment test.c. The second step of measuring the impairment is not required.d. More data is needed to reach a conclusion as to whether there is a

potential impairment.


15. Which of the following is not a disclosure required for goodwill impair-ment losses?

a. The aggregate amount of impairment losses recognizedb. A description of the facts and circumstances leading to the impairmentc. The amount of the impairment loss d. The acquisition price of the goodwill and the date it was recorded

16. Which of the following corresponds best to the concept of fair value?

a. A hypothetical transaction price under the most favorable and transparent conditions available at the measurement date.

b. The known price of the most recently completed actual transaction in an active market for the item.

c. The best valuation result available based on management’s judgment.d. The amount based on the most competent appraisal available from

a professional appraiser.

17. Which price best describes the GAAP objective of fair value?

a. Entry priceb. Exercise pricec. Exit priced. Reacquisition price

18. Which of the following costs does GAAP define as resulting directly from and being essential to the disposal of an asset?

a. Installation costb. Transportation costc. Transaction costd. Labor cost

19. Which market is characterized by the greatest volume and level of activity for an item?

a. Principal marketb. Most advantageous marketc. Primary marketd. Most beneficial market


20. Which of the following is not an attribute of a market participant?

a. Able to enter into a transaction.b. Independent of the other party to the transaction.c. Forced to enter into the transaction.d. Knowledgeable about the transaction

21. An income approach to valuation needs to consider all of the follow-ing except:

a. The time value of moneyb. The estimated future cash flowsc. The inherent uncertainty in cash flowsd. The risk that a third-party guarantor won’t perform

22. Which of the following is an unobservable input?

a. A quoted price for an identical item in an active marketb. A credit spreadc. An interest rate that cannot be corroborated or derived from

market datad. A quoted price for a similar item in a market that isn’t active

23. Which valuation approach focuses on the current replacement cost for an asset?

a. Cost Approachb. Income Approachc. Market Approachd. Build-Up Approach

24. The “highest and best use” concept considers all of the following except that which is…

a. Physically possibleb. Financially feasiblec. Humanly possibled. Legally permissible

25. Nonperformance risk includes, but may not be limited to…

a. Foreign currency riskb. Credit riskc. Basis riskd. Interest rate risk


26. Disclosures about fair value measurements must do all of the follow-ing except:

a. Inform the user about the valuation approaches and inputs usedb. Provide extensive detail in a uniform format consistent between all

reporting entitiesc. Identify the extent of Level 3 measurements on earnings, change

in net assets, or other comprehensive incomed. Present quantitative information in tables

27. With respect to the Big-GAAP, Little-GAAP issue, accountants and their clients have defaulted to several techniques to avoid the burdensome task of having to comply with recently issued difficult and irrelevant account-ing standards. Such techniques including all of the following except:

a. Ignore the new GAAP standardsb. Include a GAAP exception in the accountant’s/auditor’s reportc. Issue OCBOA (income tax basis) financial statementsd. Issue standard GAAP statements

28. One of the challenges of the AICPA’s FRF for SMEs is that the frame-work is _________.

a. Too complex to followb. Non-authoritativec. Lacking core disclosures required by third partiesd. Costly to implement

29. Which of the following is a key difference between IFRS for SMEs and IFRS?

a. IFRS for SMEs has simpler reporting needs.b. IFRS for SMEs is more complex than full IFRS.c. IFRS for SMEs applies to large companies while IFRS applies to

small to medium-sized companies.d. IFRS for SMEs has more disclosures than IFRS.

30. Which of the following is an example of an attribute found in the IFRS for SMEs?

a. Topics that are not relevant to larger, public companies have been omitted.

b. Revisions to the IFRS for SMEs are limited to once every decade.c. There are thousands of pages in the IFRS for SMEs.d. It is organized by topic within 35 sections.


31. Which of the following is true as it relates to U.S. companies and their use of IFRS for SMEs?

a. U.S. private companies are not yet permitted to adopt IFRS for SMEs.

b. U.S. private companies are required to adopt IFRS for SMEs.c. U.S. public companies may adopt IFRS for SMEs.d. U.S. private companies are permitted to adopt IFRS for SMEs.

249



32. ASU 2011-09 requires an employer to provide additional ___________.

a. Qualitative disclosures onlyb. Quantitative disclosures onlyc. Quantitative and qualitative disclosures d. Neither qualitative nor quantitative disclosures

33. The amendments in ASU 2011-09 apply to:

a. Both multiemployer pension plans and multiemployer plans that provide postretirement benefits other than pensions

b. Neither multiemployer pension plans, nor multiemployer plans that provide postretirement benefits other than pensions

c. Multiemployer pension plans, but not multiemployer plans that provide postretirement benefits other than pensions

d. Multiemployer plans that provide postretirement benefits other than pensions, but not multiemployer pension plans

34. A _______________ consists of Aggregations of single-employer plans, combined to allow participating employers to pool plan assets.

a. Aggregated-employer planb. Multiple-employer planc. Multiemployer pland. Combined employer plan

35. Which of the following is correct with respect to multiemployer plans?

a. Such a plan is usually administered by a board of trusteesb. All such plans involve a unionc. Such plans are from different industriesd. Assets contributed by an employer are segregated into a separate

account for the benefit of that employer’s employees only


36. Which of the following information does not have to be disclosed in a tabular format under ASU 2011-09?

a. Legal name of the planb. The plan’s Employer Identification Number (EIN)c. The expiration date(s) of the collective-bargaining agreement(s)

requiring contributions to the plan d. The number of employees covered by the plan segregated by age,

sex and years of employment

37. One disclosure required by ASU 2011-09 is _____________ provided by the plan.

a. Certified Zone Statusb. Certified Environmental Statusc. Recommended Funding Status d. Minimum Funding Zone Initiative Status

38. The Credit Suisse study concluded that companies were using an aver-age expected rate of return that was ________.

a. Slightly higher than the actual return for high-risk investmentsb. About the same as the actual return for high-grade investmentsc. Significantly higher than the actual return of high-grade investmentsd. Lower than the return for similar investments

39. When Credit Suisse recomputed the funded status of the sampled multiemployer plans, it concluded that _______ was in the green zone.

a. Four percentb. Eight percentc. 88 percentd. At least 50 percent

40. In accordance with the color zones of the Pension Protection Act, if a pension plan is funded 62 percent, it is categorized in the _________ zone.

a. Blackb. Redc. Blued. White

251Q u I Z Z E r Q u E s t I o n s — M o d u l e 2

41. If a single-employer plan has a deficiency, the first line of defense is __________.

a. U.S. taxpayersb. A private insurance planc. The Pension Benefit Guarantee Corporationd. All the other single-plan sponsors

42. One key change under the proposed lease standard is:

a. A small portion of operating leases, but no capital leases, would be brought onto the balance sheet.

b. Capital leases, but not operating leases, would be brought onto the balance sheet.

c. No leases would be capitalized.d. Most existing operating leases would be brought onto the bal-

ance sheet.

43. Under the proposed lease standard, which of the following is true as it relates to the lessee?

a. An asset is recognized representing the sum of the lease payments over the lease term.

b. An asset is not recognized.c. An asset is recognized representing the lessee’s right to use the leased

asset for the lease term.d. An asset is recognized only if four criteria are met.

44. Under the proposed lease standard, how would a lessee account for initial direct costs incurred in connection with a lease?

a. Initial direct costs are included in the lease asset that is recorded at inception.

b. Initial direct costs are not part of the lease asset.c. Initial direct costs are expensed as period costs.d. The proposed lease standard is silent as to how to account for initial

direct costs.

45. Under the proposed lease standard, the lessee recognizes the liability at the present value of the lease payments discounted at __________________.

a. The lessor’s borrowing rateb. The discount ratec. The interest rate for similar obligations in the marketd. 110 percent of the applicable federal rate


46. Facts: A company is a lessee of a lease with a lease term of 12 months. How may the lessee account for this lease under the proposed lease standard?

a. The company is required to record a lease asset and liability.b. The company is required to record the lease as an operating lease.c. The company has the option to record the lease asset and liability,

or record the lease as an operating lease.d. The proposed standard does not deal with shorter lease terms.

47. Company X (a lessee) is required to pay contingent rentals to the les-sor. Under the proposed lease standard, how would these contingent rentals be reflected in the lease computation?

a. The contingent rentals would be ignored because they are variable.b. The contingent rentals would be included in the computation only

if they occur in the first five years of the initial lease.c. The contingent rentals would be included in the computation of

the lease asset and obligation.d. Contingent rentals would be included only if they are formulaic.

48. Which of the following is not considered part of lease payments under the proposed lease standard?

a. Term option penaltiesb. Amortization on the underlying leased assetc. Residual value guaranteesd. Purchase options

49. What happens to existing leases on the date of adoption of the proposed lease standard?

a. Existing operating leases are grandfathered but capital leases are not.b. Existing capital leases are grandfathered but operating leases are not.c. The proposed standard does not grandfather any existing leases.d. Existing leases are phased into the new standard over a four-year period.


50. Under the proposed lease standard, which of the following is true?

a. Lease terms are likely to shorten to decrease the amount of the lease obligation.

b. Lease terms are likely to get longer to reduce the amount of the lease obligation.

c. Lease terms are likely to shorten to increase the amount of the lease asset recorded.

d. Lease terms are likely to get longer to reduce the amount of the lease asset recorded.

51. The proposed lease standard would likely result in which of the fol-lowing occurring for existing operating leases?

a. Total lease expense for tax purposes would be greater than total GAAP expense.

b. Total GAAP expense would be greater than lease expense for tax purposes.

c. GAAP and tax expense would be identical.d. There would be no change in the total expense for GAAP or tax

purposes from current practice.

52. Under the proposed lease standard, which of the following is true?

a. Deferred tax assets would likely be created.b. Deferred tax assets would likely be reduced.c. Deferred tax liabilities would likely be created.d. Deferred tax liabilities would likely be reduced.

53. One potential impact from the proposed lease standard would be that EBITDA would have a/an______________.

a. Favorable impact because interest would decrease while rental ex-pense would increase

b. Unfavorable impact because depreciation would increase while rental expense would decrease

c. Favorable impact because interest and depreciation expense would increase while rental expense would decrease

d. Unfavorable impact because interest, depreciation, and rental ex-pense would all increase


54. One potential impact from the proposed lease standard would be that the debt-equity ratio would be ________________.

a. Higherb. Lowerc. The samed. Either higher or lower depending on several factors

55. The author notes a simple rule with respect to the proposed lease standard if the I&A Approach is used, which is:

a. The longer the lease term, the smaller the lease expense at the incep-tion of the lease

b. The shorter the lease term, the greater the lease expense at the inception of the lease

c. The longer the lease term, the greater the lease expense at the incep-tion of the lease

d. The length of the lease has no impact on the amount of lease expense

56. Annual GAAP depreciation expense for a purchase of a leased asset may be ___________annual amortization expense under a lease, assuming the I&A Approach is used:

a. Higher than annual amortization expense under a leaseb. Lower than annual amortization expense under a leasec. The same as annual amortization expense under a leased. Either higher or lower than amortization expense under a lease,

depending on whether options are part of the lease term

57. A loss incurred as a result of a terrorist act or act of God should be classified as:

a. An extraordinary item on the income statementb. Part of income from continuing operations in the statement of operationsc. Part of discontinued operationsd. A deferred asset on the balance sheet


58. As it relates to a natural disaster, the magnitude of the loss _________________.

a. Directly impacts whether the disaster is unusual in nature, but not unlikely to reoccur

b. Directly impacts whether the disaster is unlikely to reoccur, but not whether the disaster is unusual in nature

c. Does not cause that disaster to be unusual in nature or unlikely to reoccur

d. Directly determines whether the loss is extraordinary

59. For GAAP purposes, an involuntary conversion is treated as__________.

a. A non-recognition of the gain consistent with tax lawb. A deferred income transaction until the property is replacedc. A sale of the converted property with a gain or loss recognized on

the income statementd. An extraordinary income item

60. In presenting business interruption insurance recoveries, how must it be displayed in the statement of operations?

a. As part of other incomeb. As part of gross salesc. Netted against insurance expensed. None of the above

61. According to Concept Statement 5, liabilities should be recognized when certain criteria are met. Which of the following is not included in these criteria?

a. The items meet the definition of a liability.b. The liability can be measured with sufficient reliability.c. The liability is due within one year.d. The information about the liability is representationally faithful,

verifiable, and neutral.

62. Under ASC 274, personal financial statements present assets at ____________.

a. Estimated current valueb. Fair valuec. Liquidation valued. Carrying value


63. Which of the following statements is true?

a. All policies should be disclosed on the financial statements whether or not they are applicable to the current year.

b. Policies should be disclosed on the financial statements if not ap-plicable to the current year only if they have been applicable in prior years.

c. Policies should never be recorded on the financial statements if they are not applicable to the current year.

d. There is no authority as to whether policies should be disclosed on the financial statements if they are not applicable to the current year.

64. Assume a company has a GAAP departure and that departure is not material. How should the company handle the departure in the financial statements?

a. The departure should be ignored because it is immaterial.b. The departure should be disclosed, but not recorded.c. The departure should be identified in the report and disclosed.d. The departure should be disclosed, but not identified in the report.

65. When graduated tax rates are a significant factor, GAAP requires that a deferred tax asset or liability be recorded using which of the following tax rates?

a. Marginal tax rateb. Average graduated tax ratec. Incremental tax rated. Lowest graduated tax rate within a range of rates

66. How should a company that issues income tax basis financial statements amortize an agreement not to compete?

a. Amortize it over the 15-year tax lifeb. Amortize it over the life of the agreementc. Not amortize it, but test it for impairmentd. Not amortize it and not test it for impairment

257



67. In ASU 2013-04, a reporting entity measures an obligation that is sum of two parts. One part consists of any additional amount the reporting entity ______ on behalf of its co-obligors.

a. Expects to payb. Plans to incurc. Would prefer to recordd. Is permitted to fund

68. ASU 2013-04 applies to an obligation accounted for under which of the following ASC topics?

a. Asset retirement and environmental obligationsb. Contingenciesc. Guaranteesd. Joint and several obligations

69. Under ASC 460, at the inception of a guarantee, the guarantor shall recognize a liability for that guarantee, measured at ___________.

a. Net realizable valueb. Carrying valuec. Fair valued. The face value of the guarantee

70. How should ASU 2013-04 be applied?

a. Prospectively to all future periodsb. Retrospectively to all prior periods presentedc. As a cumulative effect with the adjustment presented in the state-

ment of incomed. As an extraordinary item adjustment in the statement of income

71. Under ASU 2013-04, if two related parties are co-obligors, how should the transaction be accounted for?

a. No liability should be booked as related parties are exempt from ASU 2013-04.

b. The entities should still follow ASU 2013-04. c. The parties should follow the contingency rules.d. The parties should follow the special guarantee rules in ASC 460.


72. In accordance with the FASB’s proposed liquidation basis of account-ing project, the liquidation basis of accounting would be used when liquidation is _________.

a. Likelyb. Anticipatedc. Imminentd. Probable

73. The FASB’s proposed liquidation basis of accounting project would require that certain financial statements be included on a liquidation basis. One such statement that would be required at a minimum would be ______________.

a. Statement of changes in financial positionb. Statement of changes in net assets in liquidationc. Statement of liquidationd. Statement of income, liquidation basis

74. The FASB’s going concern project would define the term “reasonable period of time” to be which of the following?

a. 12 months from the financial statement dateb. Six months from the financial statement datec. As long as five years from the financial statement date depending

on whether certain criteria are metd. The statement does not quantify the term “reasonable period of time”

75. Under Section 953 of the Dodd-Frank Act, which of the following must be disclosed by public companies?

a. The annual total compensation of the CEO or equivalent positionb. Whether a company’s compensation committee retained or obtained

the advice of a compensation consultant c. Asset-level or loan-level data, including data having unique identi-

fiers relating to loan brokers or originatorsd. Whether any employee or member of the board of directors is

permitted to purchase financial instruments that are designed to hedge or offset any decrease in the market value of equity securities


76. Which of the following was noted by a 2012 study as impacts from the change in the U.S. Post Office delivery policy?

a. Smaller U.S. companies will be impacted the least.b. Approximately 60 percent of all invoices of U.S. companies (more

for smaller companies) are still handled by mail.c. There is expected to be one day’s lag on DSO for a portion of

receivables. d. None of the above

77. The sale of an investment in a foreign entity includes which of the following?

a. Events that result in the loss of a controlling financial interest in an investment in the foreign entity

b. Events that result in an acquirer losing control of an acquireec. The sale of a domestic, non-foreign entityd. A transaction in which an entity gains control of another entity

78. Under ASC 830-30-40, if a reporting entity sells a part of its ownership in a foreign entity, how should the cumulative translation adjustment component be treated?

a. A pro rata portion should be released into income.b. All of the adjustment should be released into income.c. None of the adjustment should be released into income.d. All of the adjustment should be reclassified into a separate section

of equity.

79. ASU 2013-02 provides that an entity that discloses the effect of reclas-sifications on the line items in the statement in which net income is presented, should do so ____________.

a. On either a before-tax basis or a net-of-tax basis b. Only on a before-tax basisc. Only on a net-of-tax basisd. Without any allocation of taxes to the transaction


80. Company Z is a not-for-profit organization. Z receives a donated equity security from a donor who directs the security for sale without any not-for-profit (NFP) imposed limitations. Z sells the security im-mediately upon receipt. How should the cash receipt be classified on the statement of cash flows?

a. Disclosure onlyb. Financing activityc. Operating activityd. Investing activity

81. Company Y is a not-for-profit organization. Y has a cash receipt from the sale of a donated financial asset that was not directed for sale and had no restrictions. How should the cash receipt be classified on the statement of cash flows?

a. Disclosure onlyb. Financing activityc. Operating activityd. Investing activity

261

toP ACCountInG IssuEs for 2014 CPE CoursE (10014576-0002)

Module 1: Answer Sheet

nAME ________________________________________________________________________________

CoMPAnY nAME ______________________________________________________________________

strEEt _______________________________________________________________________________

CItY, stAtE, & ZIP CoDE ________________________________________________________________

BusInEss PHonE nuMBEr _____________________________________________________________

E-MAIL ADDrEss _______________________________________________________________________

DAtE of CoMPLEtIon _________________________________________________________________

Please go to CCHGroup.com/PrintCPE to complete your Quizzer online for instant results and no Express Grading fee. A $84.00 processing fee will be charged for each user submitting Module 1 for grading.

If you prefer to mail or fax your Quizzer, remove both pages of the Answer sheet from this book and return them with your completed Evaluation form to: CCH Continuing Education Depart-ment, 4025 W. Peterson Ave., Chicago, IL 60646-6085 or fax your Answer sheet to CCH at 773-866-3084. You must also select a method of payment below.

METHOD OF PAYMEnT:

Check Enclosed visa Master Card AmEx

Discover CCH Account* ____________________________________

Card no. _____________________________________________ Exp. Date ____________signature _________________________________________________________________________

EXPrESS GraDInG: Please fax my Course results to me by 5:00 p.m. the business day following your receipt of this Answer sheet. By checking this box I authorize CCH to charge $19.00 for this service.

Express Grading $19.00 fax no. _________________________________

* Must provide CCH account number for this payment option

PAGE 1 of 2


263

PAGE 2 of 2



Please answer the questions by indicating the appropriate letter next to the corresponding number.

1. 9. 17. 25.

2. 10. 18. 26.

3. 11. 19. 27.

4. 12. 20. 28.

5. 13. 21. 29.

6. 14. 22. 30.

7. 15. 23. 31.

8. 16. 24.

Please complete the Evaluation Form (located after the Module 3 answer Sheet) and return it with this Quizzer answer Sheet to CCH at the address on the previous page. thank you.

265

PAGE 1 of 2



nAME ________________________________________________________________________________

CoMPAnY nAME ______________________________________________________________________

strEEt _______________________________________________________________________________



E-MAIL ADDrEss _______________________________________________________________________




METHOD OF PAYMEnT:








267

PAGE 2 of 2




32.

33.

34.

35.

36.

37.

38.

39.

40.

41.

42.

43.

44.

45.

46.

47.

48.

49.

50.

51.

52.

53.

54.

55.

56.

57.

58.

59.

60.

61.

62.

63.

64.

65.

66.


269

PAGE 1 of 2



nAME ________________________________________________________________________________

CoMPAnY nAME ______________________________________________________________________

strEEt _______________________________________________________________________________



E-MAIL ADDrEss _______________________________________________________________________




METHOD OF PAYMEnT:








271

PAGE 2 of 2




67.

68.

69.

70.

71.

72.

73.

74.

75.

76.

77.

78.

79.

80.

81.


Customer Support: If you have any questions about or need assistance with the CCH Learning Center or have any account related issues, CCH Customer Support is readily available at 1-800-248-3248.

CCH Learning CenterAt CCH, a part of Wolters Kluwer, we recognize the value of Continuing Professional Education—to educate and train your workforce, bring added value to your clients or organization, and gain a competitive edge in the marketplace. But keeping up with legislative and regulatory changes and industry developments can be a full-time job. Let CCH and the CCH Learning Center serve as your gateway to compelling self-study CPE courses and research resources. With the CCH Learning Center you get:

4025 W. Peterson Ave.Chicago, IL 60646-6085800 248 3248CCHGroup.com

n More than 250 Up-to-Date Courses: The CCH Learning Center offers more than 250 informative courses covering tax, financial and estate planning, and accounting/auditing issues, with new courses being added all the time. Go to the Course Catalog at CCHGroup.com/CPE to see descriptions of all the courses you can take.

n expert authors and Superior Content: Our team of professional analysts, editors, and contributing authors has more experience and more expertise than any other tax publisher in the country, which ensures you get current, reliable, real-world insights to help you handle the toughest topics and issues.

n approved CPe: CCH is an approved QAS (Quality Assurance Service) provider with NASBA—one of the first CPE sponsors to be approved under the rigorous new CPE requirements.

n 24/7 access: CCH Learning Center courses are available online 24 hours a day, seven days a week and you get immediate Quizzer results and certification, so you can make sure you hit your CPE deadlines.

n Opportunities to apply Knowledge: CCH Learning Center courses provide integrated learning activities, study questions, client letters, checklists, and other resources that let you apply what you learn.

n Convenient Print Formats: CCH Learning Center lets you print out hard copies of the courses, giving you a quick and easy way to take the course whenever you want—away from the computer at home, on the plane, wherever!

n Links to CCH® inteLLiCOnneCt™ and accounting research ManagertM: For additional research, guidance, and access to late breaking developments, CCH Learning Center’s tax courses include links to sources of additional explanation and authority within Intelliconnect™ and the accounting and auditing courses include links to authoritative and proposed literature within Accounting Research Manager™.

To purchase a subscription or learn more about the CCH Learning Center, contact your CCH Representative at 1-888-CCH-REPS or visit the Online Store at www.CCHGroup.com.

Top Accounting Issues for 2014 CPE Course - CCH

Documents

Transcript of Top Accounting Issues for 2014 CPE Course - CCH