F1 - Conceptual Framework and Financial Reporting

M1 - Standards & Conceptual Framework

1. Standard-setting bodies in the US
-SEC (1934-1939) (Security Exchange Act) - has issued accounting rules & regulations in Regulation S-X
-CAP (1939-1959) (Committee of Accounting Procedure) - was part-time committee of AICPA that
determined GAAP from 1939 to 1959
-APB (1959-1973) (Accounting Principal Board) - another part-time committee of AICPA, which
determined GAAP in that period
-FASB (1973-Presen) (Financial Accounting Standards Board) - independent full-time organization that
has determined GAAP from 1973 to Present.
Effective July 1, 2009 FASB Accounting Standards Codification became the single source of
nongovernmental GAAP.
The Codification is updated via "Accounting Standards Updates", which are not authoritative literature,
but provide “background information,” update codification, and describe the basis for conclusions on
changes.
2. Conceptual Framework for Financial Reporting (found in SFAC-Statements of Financial Accounting
Concepts):
Objective: of general purpose financial reporting is to provide financial information about the reporting
entity useful to primary users of general purpose financial reports in making decisions about providing
resources to the reporting entity.
Primary users of general purpose financial reports: investors, lenders & creditors
Fundamental Qualitative Characteristics of useful financial information:
Relevance: Faithful Representation:
1. Predictive Value 1. Complete
2. Confirmatory Value 2. Neutral
3. Materiality 3. Free of Error
Enhancing Qualitative Characteristics:
V Verifiability
C Comparability
U Understandability
T Timeliness
Applying those characteristics is a process that does not follow a prescribed order.
Nonbusiness organizations:
Objectives in Financial Reporting:
-Resource allocation decisions
-Assessing services and the ability to provide services
-Assessing management stewardship and performance
Characteristics:
-Resources come from contributions and grants
-Operating purposes are other than to provide goods or services for profit
-Lack ownership interests
Users: Resource providers; Constituents; Governing and oversight bodies; Managers
Recognition and Measurement in FS:
Full set of financial statements (5):
-Balance Sheet
-Income Statement
-Comprehensive Income (PUFIE)
-Cash Flows
-Changes in Owners’ Equity
Fundamental Recognition Criteria:
-Definitions
-Measurability
-Relevance
-Reliability
Measurement Attributes for Assets & Liabilities:
-Historical Cost - PP&E
-Current Cost - Inventory
-Net Realizable Value - A/R = It is used when the entity decides to end operation and dispose assets
-Current Replacement Cost = used in optional supplemental price level FSs
-Current Market Value - Market Securities
-PV of future cash flows - Bonds & Notes
Fundamental Assumptions and Principles:
1. Entity Assumption = economic can be accounted for when considering an identifiable set of activities.
(e.g. a separate corporation or division)
2. Going Concern Assumption = it is presumed the entity will continue to operate in the foreseeable
future.
3. Monetary Unit Assumption = money is the appropriate basis to measure economic activity
4. Periodicity Assumption = economic activity to be divided into quarters or years
5. Measurement Principle = assets & liabilities get measured in various ways
6. Accrual Accounting
a) Revenue Recognition Principle - Revenue recognized when the entity satisfies the performance
obligation
b) Expense Recognition Principle - "matching principle" - expenses incurred to generate the revenue in
a period are matched against that revenue.
7. Full Disclosure Principle - notes
Elements of Financial Statements:
Assets
Liabilities
Equity (or Net Assets)
Investments by Owners
Distribution to Owners
Comprehensive Income
Revenues - inflows or other enhancements of assets and/or settlements (decreases) in liabilities
resulting from the entity's ongoing major operations, NOT from "incidental" operations
Expenses
Gains & Losses
Present Value - Five Elements (Notes Receivable & Bonds) :
-Estimate of future cash flow
-Expectations about timing variations of future cash flows
-Time value of money (the risk-free rate of interest)
-The price for bearing uncertainty
-Other factors (liquidity issues and market imperfections)
PV Computations:
1. Traditional Approach - one discount rate used (e.g. PV Bonds-scheduled known payments)
2. Expected Cash Flow Approach -in more complex cases, the risk-free rate of return is used as the
discount rate and then turns its attention to a range of future cash flows and determines the weighted
average(e.g. PV Warranties).
M2 - Income Statement and Balance Sheet
Cost and Unexpired Costs (costs that will expire in future periods):
Unexpired costs (Asset) Expired costs (Expense)
Inventory COGS
Prepaid insurance Insurance expense
NBV of fixed assets Depreciation expense
Unexpired cost of patents Amortization
Gross Concept: Revenues & Expenses are reported at their gross amounts of consideration (operating)
Net Concept : Gains & Losses are reported at their net amounts = proceeds less net book value
(nonoperating)
Multiple-Step Income Statement = reports operating revenues and expenses separately from non-
operating revenues and expenses and other gains and losses.
The benefit of it = enhances user information because the separately reported line items provide data
to the users for the calculation of ratios.
Group together the following lines:
1. Inventory Cost (balance Sheet) = Purchase price, freight in
2. Selling expenses = freight out, salaries & commissions, advertising
3. General & administrative = Officer's salaries, accounting & legal, insurance
4. Nonoperating = auxiliary activities, interest expense
5. Discontinued operations = after Income from continuing operations and reported net of tax
Single-Step Income Statement = the benefit of it is the simple design and the fact that the presentation
of the revenues and expenses do not appear to the user to be classified as more important than others.
Balance Sheet:
Non-Current Assets: Investments (except for those in trading securities which are current assets), Fixed
Assets (PP&E & Intangible), Other Assets (Pensions, Deferred Income Tax Asset)
Liabilities = upon liquidation, creditors have 1st claim
Stockholders' Equity = Residual Interest and also includes Treasury Stock - contra account
Prepaid Insurance = current asset ONLY up to 12 months; the rest is non-current asset (e.g. 3 year
insurance contract paid on Dec 31 Y0=Y1 or 12 mo. is Prepaid Ins Current asset and 24 mo noncurrent)
Advertising Costs = Selling Expenses and NOT General & Admin Expenses!!!
Income (loss) from Continuing operations = is displayed NET OF TAX and the line item displayed
before considering the tax, is Income (loss) from continuing operations before tax.
Unusual and infrequent items are reported separately in the "unusual & infrequent items" section.
M3 - Revenue Recognition: Part 1
Five-Step Approach - ISTAR:
Step 1: Identify the contract with the customer
-All parties have approved and have committed
-Rights of each party identified
-Payment terms identified
-Commercial substance - future CF expected to change as a result of the contract
-It is probable that the entity will collect substantially all the consideration
Contract Modification = treated as a new contract if both the scope increases due to the additional
goods or services and the price increases appropriately reflects the stand-alone selling price.
Step 2: Identify the separate performance obligations in the contract:
-Distinct Good or Service = promise to transfer a separately identifiable good or service
-Promise to transfer good or service is separately identifiable
-The customer can benefit either from the good or service independently
Example of separately identifiable = Software developer transfers license; performs installation; and
provides technical support in a form of a contract ---- 3 different identifiable services.
NOT separately identifiable when:
1. Highly interrelated or interdependent
2. Integrating the good or service with other goods or services (e.g. building a multi-unit complex
to include construction, piping, wiring, etc.; all those services although separately distinct cannot
be separately identified until the whole complex finished and all services will be accounted for as
a single performance obligation)
Step 3: Determine the transaction price :
Significant financing = Recognized @ PV and if Less than one year - discount is unnecessary
Noncash consideration = @ FV at contract inception (Example: Contract signed today but settlement
Jan 1st ---- the Revenue is recognized at FV on signing day, NOT the settlement day).
Consideration payable to the customer = Reduce transaction price
Example of significant financing: Furniture store sold furniture for $4000 with a 3-year interest free
credit. The discount rate based on the customer's credit rating is 8%. PV Factor = 1 / (1.08)^3 or PV =
$3175 ($4K x 1/1.08^3). Recognize interest income over the 3 years: Y1 - $3175 x 8% = $254; Y2 -
($3,175 + $254) x 8% = $274; and Y3 - (3175+254+274) x 8% = $296.
Step 4: Allocate the transaction price to the separate performance obligations :
Proportional basis (FMV) = allocate the transaction price to each separate performance obligation
Stand-alone Selling Price = total transaction price should be allocated in proportion to the stand-alone
selling prices.
Discounts - allocated proportionally
Transaction price change - allocated to the performance obligations on the same basis that was used at
inception
Changes in stand-alone selling prices after inception should not be reallocated.
Satisfied over time:
Step 5: Recognize revenue when or as the entity satisfies each performance obligation.
Benefits are received by the buyer as the seller performs.
Examples: Annual services; Subscription; Not basic inventory
In order to recognize revenue, the entity must be able to reasonably measure progress towards
completion. Progress can be measured using 2 methods:
Output method = (example: Newspaper) Revenue is recognized based on the value to the customer of
the good or service transferred to date relative to the remaining good or service promised. Examples:
units produced, time elapsed; milestones achieved, surveys and appraisals of results achieved.
Input method = (examples: CPA firm/lawyers) Revenue is recognized based on the entity's efforts in
satisfaction of the performance obligation relative to total expected costs. Examples: costs incurred
relative to total expected costs, resources consumed, labor hours expended.
Example of "over time": Landlord receives a nonrefundable fee for a signed 1-year contract of $540.
The $540 is recognized over the next 12 months equally ($540 / 12 mo).
Satisfied at a point in time (example = department store):
1. Entity has a right to payment
2. Customer has legal title
3. Entity transferred physical possession of the asset
4. Customer has significant rewards and risks of ownership
5. Customer has accepted the asset
Difference btw "over time" and "at a point in time":
Over Time = service contract of a house that requires nonrefundable deposit + progress payments;
and if the customer fails to make the progress payments, the entity has the right to all of the
consideration if it completes the unit. Also, prohibits the entity to sell the house to another customer.
Point of Time = service contract that requires only deposit (refundable) at the beginning and the
remainder of the price at the completion of the construction and if the customer defaults before
completion, the entity had the right to ONLY retain the deposit.
Presentation : Contract asset = reflects the entity’s right to consideration in exchange for goods or
services that the entity has transferred to the customer. Example: Receivable
Contract liability: booked when an entity has an obligation to transfer goods or services to a customer
M4 - Revenue Recognition: Part 2
Incremental Costs of Obtaining a Contract:
Capitalize: when costs would not have occurred if contract was not obtained and
the entity expects it will recover these costs.
Example: Capitalize legal fees to draw up the contract, sales commissions (Do Not capitalize travel
costs to deliver the proposal to the customer - instead expense b/c would have incurred anyway).
Costs to Fulfill a Contract: Capitalize: DL, RM and FOH and Expense: SG&A
Principal vs. Agent:
Principal: controls the good or service before it is transferred to the customer ; responsible for fulfilling
the contract; carries inventory risk; has discretion in establishing the selling price
The Recognized revenue = gross consideration expected to be received
Agent: arranges for the other party to provide the good or service to the customer and the Recognized
revenue = fee or commission
Repurchase Agreements: Entity sells an asset and also either promises to or has the option to
repurchase the asset. 3 Main Forms:
1. Forward = entity's obligation to repurchase
2. Call option = entity's right to repurchase the asset
3. Put Option = entity's right to repurchase at the customer's request
Forward or Call Option: Entity's accounting for the contract will depend on whether it must "forward"
or can "call" repurchase the asset:
1. The repurchase price < original selling price = LEASE
2. The repurchase price >= original selling price (and the expected market value) = Financing
arrangement (in this case the entity recognizes the asset and also recognizes a financial liability for the
consideration received and interest expense for the difference btw the received amount and the
repurchase price)
Put option:
1. If the repurchase price < original selling price, then treat it as either of these 2 options:
---Lease: if customer is likely to exercise right or
---Sale with right of return: customer unlikely to exercise right
2. If the repurchase > original selling price, treat it as:
---Financing arrangement: if the repurchase price > FMV or
---Sale with right of return: if the repurchase price <= FMV
Bill-and-Hold Arrangements
No revenue recognition UNLESS ALL of the following met:
1. There must be a substantive reason (Customer requested the arrangement)
2.The product has been separately identified as belonging to the customer
3. Currently ready for transfer
4. Entity cannot use or sell the product to others
Consignment: Revenue recognition when the distributor sells the product to a customer.
It’s a consignment when:
1. Entity controls the product until sale
2. Distributor does not have an unconditional obligation to pay the entity for the product
3. Entity can require the return of the product
Warranties:
I: Customer has the option to purchase the warranty separately: Distinct service → performance
obligation → allocate a portion of the overall transaction price
II: Customer doesn’t have the option to purchase the warranty separately, thus No performance
obligation
No performance obligation for warranties if the following exist:
1. Law requires warranty
2. Shorter coverage period
3. Must perform specific tasks
Refund liabilities and the right to return
Refund liability =record when customer anticipates having to refund a portion or all of the consideration
Long-Term Construction Contracts:
Percentage-of-Completion Method = Revenue over time:
Balance Sheet Presentation:
1. Construction in progress-Inventory=report the constr. costs and the estimated gross profit earned
2. Progress billings - contra-inventory = accumulate the billings on construction in this account
3. These 2 accounts are netted against each other and it depends on the result we have 2 accounts:
---Current Asset Accounts = Due on accounts (receivable) AND costs and estimated earnings of
uncompleted contracts in excess of progress billings (or "construction in progress") OR
---Current Liability Account = progress billings in excess of costs and estimated earnings
Computation of Gross Profit:
Step 1: Contract Price
<Estimated total cost>
Gross Profit
Step 2: Total Cost incurred to date / total estimated cost of contract to date = % of completion
Step 3: Step 1 x Step 2 = Profit to date
Step 4: Profit to date at current YE
<Profit to date at the beg. of the period>
Current YTD GP
See Example on page F1-41
Estimated loss: recognized immediately in the year it is discovered.
Completed Contract Method
1. No GP recognized until contract is completed
2. Losses recognized in full the year they are discovered
GAAP allows both methods. It is a preferability issue. However, if a company switches from one
method to the other, it is considered a change in accounting principle!
M5 - Income Statement: Discontinued Operations
Types of entities to be considered:
1. Has been disposed of OR
2. Classified as held for sale
Conditions to be met: a disposal of a component is reported in discontinued operations if the disposal
represents a strategic shift that has or will a major effect on an entity's operations. Such strategic shift
may include the following:
1. Disposal of a major geographical area
2. Disposal of a major equity method investment
3. Disposal of a major line of business
Discontinued Operations include :
--Employee relocation costs associated with the disposition
--Additional Pension Costs associated with the decision to dispose.
Calculation:
1. Results of Operations of the component for the current period ONLY
2. Gain or Loss on disposal of the component reported in the year of sale ONLY
3. Impairment loss (and subsequent increases in FV) of component
Initial and Subsequent Impairment Losses: a loss is recognized for recording the impairment
Subsequent increases in FV: a gain is recognized for any subsequent increase in FV minus the costs
to sell (but not in excess of the previously recognized cumulative loss)
Depreciation STOPS: Once decided to dispose, no depreciation or amortization
Measurement and Valuation: A component classified as "held for sale" is measured at the LOWER of
its CV or NRV, which is the FV less costs to sell. Example = A company moved out of the building it
owns, moving to a new building. The old building was put on the market for sale. The old building will
be valued at the LOWER of CV or NRV (FV less the cost to sell), reclassified as an "asset held for sale",
and it will no longer be depreciated. It will NOT be valued at historical cost.
Presentation and Disclosure: Present as a Separate Component of Income, NET of TAX, below income
from continuing operations. Disclosure is either in Face OR in Notes.
Items reported on the Income statement:
1. Impairment loss 2. Gain/Loss from actual operations 3. Gain/Loss on disposal in year of disposal
M6 - Accounting Changes and Error Corrections
Changes in Accounting Estimate - Prospective
Events resulting in estimate changes:
1. Useful life of fixed assets
2. Adjustment of YE accruals of officers' salaries
3. Write-downs of obsolete inventory
4. Material, nonrecurring IRS adjustments
5. Settlement of litigation
6. Changes in accounting principle that are inseparable from a change in estimate, such as "To LIFO" OR
"Change in depreciation method"
7. Revisions of estimates regarding discontinued operations
Reporting a change in Estimates: accounted for PROSPECTIVELY. They do not affect previous periods
(no effect on previously reported R/E).
Change in Estimates affecting Future Years: If the change affects several future years, should be
disclosed in the notes. NOTE: if "ordinary accounting estimates", such as inventory adjustments, do not
have to be disclosed unless material.
Changes in Accounting Principle - Retrospective: GAAP to GAAP Only (Non-GAAP to GAAP is an error)
Example = Change from Completed-contract method to Percentage-of-completion method (GAAP
allows both and thus changing from one to the other, it is considered an accounting principle change).
Rule of Preferability: the change is preferable to fairly present the information and thus Justified (No
income smoothing)
Cumulative effect = adjust beginning R/E net of tax when 2 events:
1. Changes in Accounting Principle AND
2. Comparative Financials are presented (FSs should be restated using the new method).
Exception to the Rule = switching to LIFO and Change in Depreciation method = prospectively, NOT
retrospectively!!!
Changes in Accounting Entity - Retrospective and RESTATE= occurs when the company being reported
on, has changed composition, such as consolidations.
If a change in accounting entity occurs in the current year, all previous FSs that are presented in
comparative FSs along with the current year should be restated to reflect the info for the new reporting
entity.
Error Correction - Prior Period Adjustment = RESTATE
Examples of errors:
---mathematical mistakes,
---mistakes in the application of US GAAP
---misuse of facts
---change from a non-GAAP method of accounting to a GAAP method of accounting
Reporting: Non-comparative: Beg R/E in the earliest period presented OR Comparative: Previous years
affected restated (retroactive application) or Beg R/E in the earliest period presented
NOTE: When disclosure presented: Cumulative effect on beginning R/E of the earliest period
presented (NOT required --- cumulative impact on R/E each year)
Neither an accounting principle change, not an error correction = Examples:
1. Changing Investment % (from 10%, which requires FV method, to 30%, which requires the equity
method) and we use Prospective approach
2. Instituting a pension plan, which requires GAAP treatment. Thus, the company switches from cash
method to accrual method. However, this is neither an accounting principle change, nor an error and it
is a Prospective approach.
M7 - Statement of Comprehensive Income
Comprehensive Income=represents all changes in stockholders' equity that come from non-owner
sources. Comprehensive income would NOT include investments by owners nor distributions to
owners.
Net Income + Other Comprehensive Income = Comprehensive Income
Net Income includes = Income from continuing operations +Income from Discontinued operations
Net Income is after the Tax reducing the income!
Example = Net Income $650,000
Unrealized loss on trading securities ($35,000)
Loss on discontinued operations ($75,000)
Foreign currency translation gain $150,000
Tax rate is 40%
Solution: 1) unrealized loss on trading securities & the discontinued operations' loss are already
included in the Net Income!
2. Foreign currency translation gain net of tax = $90,000 ($150K x 40%)
3. Comprehensive Income = Net Income (Tax was already deducted) + OCI (net of tax)= $650K + $90K =
$740K
Other Comprehensive Income: PUFIE
--Pension Adjustments = gains/losses, amortization of the pension loss (increases AOCI), prior service
costs, and net transition assets & obligations
--Unrealized Gains and Losses (AFS debt securities)
--Foreign Currency Translation Adjustments (Translation = OCI but Re-measurement = Income Stmt);
also Effective economic hedges of a net investment in a foreign entity
--Instrument-Specific Credit Risk = Liabilities with FV option elected, changes in FV that are
attributable to instrument-specific credit risk are included in OCI.
--Effective Portion of Cash Flow Hedges
Comprehensive income should not be reported on a per share basis!
Under US GAAP, comprehensive income may be presented in 2 ways:
1. Single-Statement Approach: the OCI items are displayed individually (each net of income tax or
before related tax effects but with one amount shown for aggregate income tax expense) and in total
(NET OF INCOME TAX), below the net income amount, and totals them for comprehensive income.
2. Two-Statement Approach: displays comprehensive income as a separate statement that
immediately follows the income statement.
Income tax expense or benefit allocated to each component of OCI is disclosed either on the face of
the statement or in the notes to the FSs.
Required disclosures :
--Tax effects of each component
--Changes in the accumulated balances of each component (on the face or in the notes)
--Total AOCI on BS as equity
--Reclassification adjustments to avoid double counting in net income (previously reported unrealized
gains/losses but realized this current year). These reclassification adjustments MUST be presented on
the face of the statement, NOT in the FOOTNOTES!!!
M8 - Adjusting Journal Entries
Rules for Recording AJE:
--Recorded by end of fiscal year, before the preparation of financial statements
--Never involve the cash accounts
--All adjusting entries will hit 1 income statement account & 1 balance sheet account
Service contract with repair costs spent on service revenue = example: 40% of the costs incurred
evenly during 1st year and 60% incurred evenly during 2nd year = Evenly means 50% of 40% for Y1!
F2 - Financial Reporting and Disclosures
M1 - Notes to Financial Statements
Summary of Significant Accounting Policies
Disclosures:
 --Basis of consolidation
--Depreciation methods
--Amortization of intangibles
--Inventory pricing
--Use of estimates
--Fiscal year definition
--Special revenue recognition issues
--Which investments are cash equivalents
Items Not included in the Notes:
--Detailed dollar amounts of account balances
--Details relating to changes in accounting principles
--Dates of maturity and amounts of LTD
--Yearly computation of depreciation, depletion and amortization
Remaining Notes to the Financial Statements:
--Material information regarding inventory, PP&E
--Changes in Stockholders' equity
--Required marketable securities disclosure -- CV or FV, gross unrealized Gain/Loss (Investment in
bonds that are held to maturity should be reported at amortized cost or Current Value and NOT FV).
--FV estimates
--Contingency losses / Highly probable contingency gains
--Contractual obligations (Bonds Payable, N/P), restrictions on specific assets or liabilities
--Pension plan description
--Segment reporting
--Subsequent events
--Discontinued segment outside ordinary course of business
--Changes in accounting principles
--Related party
--Concentration risk (One major Donor disclosure reveals the vulnerability if that funding source
disappear)
Disclosure of Risks and Uncertainties:
1. Nature of operations - major products/services and its principle markets, including the locations of
those markets (1/2 of companies have this as the first footnote)
2. Use of estimates in the preparation of financial statements
3. Certain significant estimates - when reasonably possible that an estimate will change in the near
term. Examples: Obsolete inventory; deferred tax asset; capitalized computer software costs; loan
valuation allowance; litigation-related obligations.
4. Current vulnerability due to certain concentrations = arises when an entity is exposed to risk of loss
that could be mitigated through diversification.
Concentration should be disclosed if all the following exists:
1. Concentration exists
2. Concentration makes the entity vulnerable
3. It is at least reasonably possible that the events that could cause the severe impact will occur in the
near term
NOTE: The concentration in a specific geographic region is NOT a criterion for disclosure of
"vulnerability to a concentration", because not only a specific area concentration, but other
concentrations, such as a specific customer or a specific supplier, are of importance and must also be
disclosed!
Examples of Concentrations in:
--Concentration in the volume of business transacted with a Particular customer, supplier, lender,
grantor, or contributor
--Concentration in revenue from Particular products/services/fundraising events
--Concentration in the available Supply of resources
--Concentration in Market or geographic area
M2 - Subsequent Events
Recognized subsequent events = Conditions that existed at the BS date (Record JE & disclose)
Examples of recognized subsequent events:
--Settlement of litigation
--Loss on an uncollectible receivable
Non-recognized subsequent events = Conditions did not exist at the BS date but before the date the
FSs are issued or available to be issued (Disclose only and Disclosure is NOT required!!!)
Examples of non-recognized subsequent events:
--Sale of bond or capital stock
--Business combination
--Settlement of litigation, if the litigation arose after the BS date
--Loss of plant or inventory due to fire or natural disaster
--Changes in FV of A, L, or foreign exchange rates
--Entering into significant commitments or contingent liabilities
--Loss on receivables resulting from conditions occurring after the BS date
Subsequent Event Evaluation Period
1. Public companies: through the date the FSs are issued
2. Private companies: through the date the FSs are available to be issued
Reissuance of FS = Should not recognize events that occurred between original issuance date and re-
issuance date, unless an adjustment is required by GAAP or other regulatory requirements.
Revised Financial Statements = are FSs revised to correct an error or reflect retrospective application
of GAAP. They are considered reissued FSs.
SEC filer: disclosure NOT required, of dates through which subsequent events have been evaluated
Non-SEC filer: disclose is required in revised FS of the dates through which subsequent events have
been evaluated
M3 - Fair Value Measurements
Fair Value = Exit price or the price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants in the principal (or most advantageous) market
at the measurement date under current market conditions.
Cash & Cash equivalents are an example of financial instruments and are measured at their FV.
Bonds that are held to maturity are valued at their amortized cost (initial investment +/- amortization
of discount or premium or CV), and NOT at FV!!!
1. Fair Value = Market-based measure (not entity-based measure)
Fair Value is measured for a specific asset/liability and the company applies FV to financial
instruments on an instrument-by-instrument basis.
2. Fair Value is measured in the principal market or most advantageous market
3. Fair Value is an Exit price (NOT an entrance price)
4. Fair Value should reflect all of the assumptions that market participants would use in pricing the
asset or liability
5. Fair Value does not include transaction costs, but may include transportation costs if location is an
attribute of the asset or liability (used to calculate most advantageous market)
6. The Fair Value of a Nonfinancial asset (example of Land)assumes the highest and best use of the
asset. Example: Land that could be used as a farmland has a FV of $600K, but if a developer builds a
shopping plaza on it and offers $850K for the land, $850K is the FV measure of the land.
Fair Value Terminology:
--Orderly transaction =transactions in which the assets or liabilities are exposed to the market. Orderly
transaction cannot be a forced transaction.
--Market Participants = independent and NOT related parties
--Principal Market = market with the greatest volume or level of activity
-- Most advantageous market (if no principal market) = market with the best price for the asset or
liability after considering transaction costs.
NOTE: Although transaction costs are used to determine the most advantageous market, transaction
costs are not included in the final FV measurement. Also, before even considering the stock prices
minus the transaction cost, we need to look at which market has the greatest volume or level of
activity.
Fair Value Measurement Framework
Valuation techniques:
1. Market approach uses prices from market transactions involving identical or comparable A or L
2. Income approach converts future amounts, incl. cash flows or earnings, to a single discounted
amount (PV of FCF). Example: Patent = Calculate the PV of the future cash flows, but then multiplies
by the royalty rate = FV of the patent.
3. Cost approach uses current replacement cost.
Change in valuation technique (cost approach to income approach) is a change in accounting estimate
Hierarchy of Inputs (Level 1 is most reliable and Level 3 is least reliable):
1. Level 1 Inputs = Quoted prices in active markets for identical assets or liabilities that the reporting
entity has access to on the measurement date.
2. Level 2 Inputs = inputs other than quoted market prices that are directly or indirectly observable for
the asset or liability. Level 2 inputs include:
---Similar assets or liabilities in active markets
---Identical or similar assets in markets that are not active
3. Level 3 Inputs = Unobservable inputs. Unobservable inputs reflect the reporting entity's assumptions
and should be based on the best available information. They should be used only when there are no
level 1 or level 2 inputs.
Fair Value Disclosures to include:
--Valuation techniques and inputs for "Level 3" Inputs
--Uncertainty in FV measurements as of the reporting date
--How changes in FV measurements affect entity’s performance and CF
--Specifically the entity must provide the following:
1. Quantitative information about significant unobservable inputs
2. Discussion of the sensitivity of level 3 measurements to changes in unobservable inputs disclosed
--Measurements differ from highest and best use for nonfinancial A&L
--Hierarchy for items not measured on BS but are disclosed in notes
Exceptions to FV Measurement exist when:
1. Not practical to measure FV
2. FV cannot be reasonably determined
3. FV cannot be measured with sufficient reliability
M4 - Segment Reporting
A public entity is required to disclose segment profit & Loss, segment assets, but not required to report
segment cash flow.
Required disclosures for all public entities:
--Operating segments
--Products and services
--Geographic areas
--Major customers
Use same accounting principles as the main financial statements.
Intercompany transactions not eliminated for reporting . Transactions between the segments of an
entity are not eliminated in a consolidation between the parent company and subsidiaries
Operating Segment = component that earns revenues and incurs expenses . Its operating
results are regularly reviewed by the entity’s chief operating decision maker.
Discrete financial information is available (traceable cash flows).
Not every component is an operating segment:
1. Corporate headquarters not an operating segment and
2. Pension plan not an operating segment.
Operating segments that exhibit similar long-term financial performance may be aggregated into a
single operating segment. Similar characteristics are:
1. nature of the product
2. nature of processes
3. type of class of customer
4. methods to distribute products
5. nature of regulatory environment (insurance, banking)
Quantitative Thresholds for Reportable Segments:
10 Percent Size Test --either one of the following, and must report that segment:
1.Revenue=The segment's revenue, including both sales to external customers and intersegment sales
or transfers (excluding interest income) is >=10% of the combined revenue of all operating segments
Headquarters or Pension Plan Revenues IGNORED!
2. Reported Profit or Loss:
Segment profit >= 10% of combined reported profit of all operating segments that reported a profit
Segment loss >= 10% of combined reported loss of all operating segments that reported a loss
When there are segments with Gains and also with Losses, we combine the segments with gains
separately from combining the segments with losses. The absolute total of Gains and the absolute
total of Losses are compared and we select the Larger Absolute total for the 10% Test.
3. Assets: Segment assets >= 10% of the combined assets of all operating segments
75 % Reporting Sufficiency Test:
If the total of external (consolidated) revenue (excluding intersegment sales) reported by operating
segments < 75% of Total External Consolidated Revenue, additional operating segments need to be
identified as reportable, even though they do not meet the 3 tests. The practical limit to the # of
segments is 10.
All other segments = Combined and disclosed in an “all other segments” category
Comparative Reporting:
An operating segment that was reportable in the preceding period but not in the current period, may
be reported separately if management judges its significance.
Segment Profit (or Loss) Defined :
Revenues - Direct Traceable Costs - Reasonably Allocated Costs = Operating Profit (or Loss) = EBIT
Items excluded from segment profit:
--General corporate revenues/expenses
--Interest expense
--Income taxes
--Equity in earnings and losses of an unconsolidated subsidiary
--Gains or losses from discontinued operations
--Minority interest
Reportable Segment Disclosures:
Products & Services, Geographic areas, Regulatory environments (the usual)
Measurement Criteria:
Basis of accounting (may differ from the entity's basis)
The nature of any differences between measurements of the reportable segments’ profits or losses
and the entity’s consolidated income
The nature of any differences between measurements of the reportable segments’ assets and the
entity’s consolidated assets, if not apparent from the reconciliation provided
Reconciliation disclosure:
1. Total segments' revenue to entity's revenue
2. Total segments' P&L to entity's consolidated income before income tax, discontinued operations
3. Total of segments' assets to entity's consolidated assets
Entity-wide Disclosures (applied regardless of the # of reportable segments)
--Products & Services, Geographic areas, Major customers (10% or more of the entity's revenue to a
single customer must be disclosed)
--Revenues from external customers that are from: Entity’s country; All foreign countries if material;
Individual foreign countries if material
Long-lived assets that are located in: Entity’s country; All foreign countries; Individual foreign
countries if material
M5 - SEC Reporting Requirements
Form 10-K (annual) includes:
--Summary of financial data
--MD&A
--Audited financial statements
Form 10-Q includes (quarterly):
--Unaudited financial statements
--Interim period MD&A
--Certain disclosures
Filing Deadlines:
10-K Filing Deadline(after fiscal year) 10-Q Filing Deadline(after fiscal quarter)
Large accelerated 60 days 40 days
Accelerated 75 days 40 days
All others 90 days 45 days
Large accelerated filer defined by SEC is an issuer with a worldwide market value of outstanding
common equity (OCE) of =>$700M.
Accelerated filer is an issuer with OCE =>$75M, but less than $700M.
Smaller reporting companies are entities w/ OCE of less than $75K & annual revenue of less than
$100M.
Other Forms:
Form 11-K = Employee benefit plans
Form 20-F = Non-US 10-K includes Summary of financial data; MD&A and Audited financial statements
Form 40-F = Canadian 10-K includes Summary of financial data; MD&A and Audited financial statements
Form 6-K is filed semiannually by foreign private issuers and contains Unaudited financial statements;
Interim MD&A and Certain disclosures
Form 8-K = filed to report Major corporate events, such as corporate asset acquisitions; mergers;
accountant changes; management changes.
Forms 3, 4, and 5 are required to be filed by 10% owners, directors and officers
Regulation S-X:
Requirements for Interim Financial Statements:
GAAP that were used in most recent annual report, would be used in the interim FSs.
Interim FSs Must be reviewed by an independent public accountant.
Statements and Periods presented:
--Balance sheet = as of the end of the most recent fiscal quarter and as of the end of the preceding
fiscal year.
--Income Statement = for the most recent fiscal quarter, for the period btw the end of the preceding
fiscal year and the end of the most recent fiscal quarter, and for the corresponding periods of the
preceding fiscal year.
--Statements of CFs = for the period btw the end of the preceding fiscal year and the end of the most
recent fiscal quarter, and for the corresponding period for the preceding fiscal year.
Statements presented (10-Q, 6-K) = Balance Sheets; Income Statements; Statements of Cash Flows
Condensed financial statements = Interim FSs may be condensed!
Disclosure =b/c users have the most recent annual FS, interim FSs may omit the summary of significant
accounting policies, the details of accounts that have not changed significantly since the end of the
most recent FY
Required Disclosures = Material contingencies AND Subsequent events
According to Regulation S-X Requirements for Annual Financial Statements:
--Must be audited by an independent public accountant
--Statements presented: Balance Sheets of the 2 most recent FYs; Income Statements of the 3 most
recent FYs and Cash Flow Statements for each of the 3 FYs preceding the date of the most recent
audited BS.
--Disclosures: Dividends per share; principles of consolidation; assets subject to lien; preferred shares
SEC XBRL Reporting Requirements:
XBRL = software that uses XML data tags to describe financial information for business and financial
reporting. XBRL is a next-generation language after HTML. HTML tells computers how to display text.
XML and XBRL tell computers how to interpret the context of the text.
XBRL is a type of XML, which is not interchangeable with HTML, nor SQL!
Tag = Machine-readable code that gives a standard definition for each line item in BS, IS, Cash Flow
Tags include descriptive labels, definitions, references to US GAAP, and other elements that provide
contextual information that allow data to be recognized and processed by software.
Taxonomy = defines the specific tags used for individual items of business or financial data.
XBRL utilizes a taxonomy with tags that identify and define data found within the FSs and supporting
footnotes.
Data Tagging Details: 4 different levels
Level 1: Each complete footnote and schedule is tagged as a single block of text
Level 2: Each significant accounting policy within the significant accounting policies footnote is tagged
as a single block of text
Level 3: Each table within each footnote or schedule is tagged as a separate block of text
Level 4: Within each footnote or schedule, each amount is required to be separately tagged
30-Day Grace Period = each company 's initial interactive data exhibit will be required within 30 days
after the earlier of the due date or filing date
Posted to corporate website = Information submitted by a filer to the SEC in interactive data format
must also be posted to the filer's corporate website.
The SEC Interactive Data Rule requires a US public company submitting Form 10-K to present FSs,
including B/S, Stmt of comprehensive income, and all footnotes in an exhibit prepared using XBRL.
The MD&A is not required to be presented in the exhibit prepared using XBRL!
M6 - Special Purpose Frameworks
Other Comprehensive Bases of Accounting (OCBOA):
--Cash basis
--Tax basis
--Price-level adjusted FS
--Regulatory basis
General Presentation Guidelines:
--Financial stmt titles should differentiate the OCBOA FSs = Don’t use GAAP terms
--Statement of CF not required
--Disclosures in OCBOA FSs = similar to GAAP
Cash Basis financial Statements include:
1. Statement of Cash and Equity = Balance Sheet
2. Statement of Cash Receipts and Disbursements = Income Statement
Modified Cash Basis Financial Statements = hybrid method that includes elements of both cash basis
and accrual basis accounting.
Common Modifications include:
--Capitalizing and depreciating FA
--Accrual of income taxes
--Recording liabilities
--Capitalizing inventory
--Reporting investments at FV
Presentation (Do NOT use GAAP terms):
1. Statement of Assets and Liabilities = Balance Sheet (modified cash basis)
2. Statement of Revenues and Expenses = Income Statement (modified cash basis)
Income Tax Basis:
Nontaxable revenues and expenses may be reported as:
--Separate line items OR
--Additions and deductions to net income OR
--Disclosure in a note
Presentation:
1. Statement of Assets and Liabilities and Equity = Balance Sheet (income tax basis)
2. Statement of Revenues and Expenses = Income Statement (income tax basis)
Converting Cash Basis Financial Statements to the Accrual Basis
Simple Approach:
1. Start with the Cash-basis Net Income
2. Add Increases in Current Assets
3. Subtract Decreases in Current Assets
4. Add Decreases in Current Liabilities
5. Subtract Increases in Current Liabilities
1. Converting Cash Basis Revenue to Accrual Basis Revenue:
Formula: Cash Basis Revenue
 + Ending A/R
- Beginning A/R
-Ending Unearned Revenue
+ Beginning Unearned Revenue
Accrual Basis Revenue
2. Converting Cash Paid for Purchases to Cost of Goods Sold:
Formula: Cash paid for purchases
- Ending Inventory
+ Beginning Inventory
+ Ending A/P
- Beginning A/P
Cost of Goods Sold
3. Converting Cash paid for Operating Expenses to Accrual Basis:
Formula: Cash paid for Operating Expenses
+ Ending Accrued Liabilities
- Beginning Accrued Liabilities
- Ending prepaid Expenses
+ Beginning Prepaid Expenses
- Capitalized Fixed Asset Purchase (recorded as an expense on cash basis)
+ Depreciation Expense
Accrual Basis Operating Expenses
Calculate Amount of Insurance premiums paid and coded to Prepaid Insurance (Asset Account):
Beginning prepaid insurance + Payments made - Insurance Expenses = Ending balance Prepaid Ins.
M7 - Ratio Analysis
Liquidity Ratios :
Current Ratio = Current Assets
Current Liabilities
Quick Ratio = Cash & Cash Equivalents + ST Marketable Securities + Receivables (net)
Current Liabilities
Activity Ratios:
A/R Turnover = Net Sales
AVG A/R (net)
Days Sales in A/R = Ending A/R (net)
Sales Net / 365
A/P Turnover = Net COGS
AVG A/P
Days Payable in A/P = Ending A/P
COGS/ 365
Inventory Turnover = COGS
AVG Inventory
Days in Inventory = Ending Inventory
 COGS / 365
Cash Conversion Cycle = Days Sales in A/R + Days in Inventory - Days of Payables in A/P
Asset Turnover = Net Sales
AVG Total Assets
Working Capital Turnover = Net Sales
AVG (Current Assets - Current Liabilities)
Profitability Ratios:
Profit Margin = Net Income
Sales (net)
Return on Assets = Net Income
AVG Total Assets
Dupont Return on Assets = Profit Margin x Asset Turnover OR Net Income X Net Sales
Sales (net) AVG Total Assets
Return on Equity = Net Income
AVG Equity
Return on Assets = Net Income
AVG Total Assets
Return on Sales = Income before Interest Expense, Interest Income, and taxes (EBIT)
Sales (net)
Gross (Profit) Margin = Sales (net) - COGS
Sales (net)
Operating Cash Flow Ratio = Cash Flow from operations
Current Liabilities
Coverage Ratios:
Debt-to-Equity Ratio = Total Debt
Total Equity
Total Debt Ratio = Total Liabilities
Total Assets
Equity Multiplier = Total Assets
Total Equity
Times Interest Earned = Income before interest expense & taxes (EBIT)
Interest Expense
Investor Ratios :
EPS = Income available to common shareholders
Weighted AVG common shares outstanding
Price Earnings Ratio = Price per Share
Basic Earnings per Share
Dividend Payout = Cash Dividend
Net Income
M8 - Partnerships
Admission of a Partner
By purchase or sale of existing partnership interest = outside partnership transaction => No JE on the
partnership books.
Formation of a Partnership
Assets valued at:
GAAP rule = Use FV
Tax rule = Use NBV
Liabilities recorded at present value
Partner’s capital account = FV of contributed assets - PV of liabilities
Creation of a New Partnership Interest with Investment of Additional Capital
Exact Method = Equal to Book Value
Rules-Problem-Solving Steps:
1. Determine the exact amount a new partner will have to pay to get his capital account in the exact
proportional interest to the new assets of the partnership.
2. There is no goodwill or bonus.
3. Old partner's capital account "dollars" stay the same
4. Old partners' "% ownership" changes
Example: A, B and C are partners, and their capital accounts are at $20K, $30K and $50K respectively.
D is admitted as a new partner with a 25% interest. How much should D contribute?
Equity of the new partnership = 20K + 30K + 50K + D's contribution, or
Total New Equity (100%) =100K + 25% Total New Equity (D's portion)
D's Contribution = 25% Total new equity = 100K - 100% Total new equity or
Total new equity = $100K/75% = $133,333
D's contribution = $133,333 x 25% = $33,333
Bonus Method = Recognize Inter-capital Transfer
When the purchase price is more than the NBV of the capital account purchased, bonuses are
adjusted btw the old and the new partners' capital accounts and do not affect the partnership assets.
Rules = Problem-Solving Steps:
1. Determine total capital and interest to the new partner.
2. If interest less than amount contributed, bonus to old partners.
3. If interest greater than amount contributed, bonus to new partner.
Under the bonus method, the bonus will be credited to the following partner:
To existing partners = when new partner pays more than NBV
To new partners = when new partner pays less than NBV
Example: Bonus to existing partners: A and B are partners 60:40 with capital accounts of $30K and
$10K. The new partners agrees to contribute $35K. Thus, total new capital accounts = $75K
(30k+10k+35k). $75K / 3 partners = $25K each. The new partner gets $25K in his capital account and
the rest of the $35K contributed by the new partner gets split btw the old partners in their old
prorated % (60/40), or $6K for A and $4K for B.
Example: Bonus to new partner: A and B have capital accounts of $30K and $10K at 60/40 split. The
new partner invests $14K. Thus total capital is now $54K and divided by 3 partners = $18K. The new
partner gets $18K in his capital account, which means the difference of $4K ($18k - $14k that was
contributed by new partner) comes out of partners A and B's capital accounts prorated 60/40.
Goodwill method = Recognize Intangible Asset
Goodwill is recognized based upon the total value of the partnership implied by the new partner's
capital contribution.
Rules = Problem-Solving Steps:
1. Compute new assets before Goodwill
2. Compute new "capitalized net assets" and compare "Capitalized Net Assets" with "Net Assets before
Goodwill"
3. The difference is "Goodwill" to be allocated to the old partners according to their old partnership
profit ratios.
Example of Goodwill recognized: A and B are partners with capital accounts of $30K and $10 and ratio
60/40. C agrees to invest $35K for 1/3 interest of ABC partnership. The partners agreed to recognize
Goodwill.
Implied New Value of the Partnership is $105,000 ($35K x 3--for 33% x 3=100%). And total capital
accounts are $75K (30k+10k+35k). The difference of $30K gets split btw partners A and B and they get
a boost in their capital accounts of $18K (60%) for A and $12K for B (40%).
Pass Key:
Exact Method
--The incoming partner’s capital account is their actual contribution (CALCULATE)
--No adjustment to existing partner’s capital accounts is required
Bonus Method
--Balance in total capital accounts controls the computation
--The incoming partner’s capital account is their percentage of the partnership total NBV (after their
contribution)
--Adjust the existing partner’s capital accounts to balance
Goodwill Method
--Going in investment (dollars) controls the computation
--The incoming partner’s capital account is their actual contribution
--Goodwill (implied) is determined based upon the incoming partner’s contribution, and shared by the
existing partners
Profit and Loss Distribution: Income and Loss is distributed among partners in accordance with their
agreement, and in the absence of such all partners share equally irrespective of what their capital
accounts reflect.
All interest, salaries, and bonuses are deducted from total profit before calculating Distributions!
Withdrawal of a Partner
Bonus Method = The assets get revalued to their FV at the date of withdrawal. The difference btw the
balance of the withdrawing partner's capital account and the amount that person is paid, is the amount
of the "Bonus". Bonus is allocated among the remaining partners’ capital accounts in accordance with
their remaining P&L ratios.
Journal Entry #1 to revalue assets at FV:
Debit Asset Adjustment to FV
Credit A, Capital account (%)
Credit B, Capital account (%)
 Credit X, Capital account (%)-the withdrawing partner
Journal Entry #2 to pay off the withdrawing partner:
Debit X, Capital account (100%)
Debit A, Capital account (%)to make up the difference
Debit B, Capital account (%) to make up the difference
Credit Cash
Goodwill Method = Implied goodwill is allocated to all of the partners in accordance with their P&L
ratios.
JE #1 from "Bonus method" above is the same.
JE #2 to record Goodwill to make withdrawing partner's capital account equal payoff:
Debit Goodwill
Credit X, Capital account (%)
Credit A, Capital account (%)
Credit B, Capital account (%)
JE #3 to pay off the withdrawing partner:
Debit X, Capital account (100%)
Credit Cash
Liquidation of a Partnership
Order of Preference regarding Distribution of Assets
1. Creditors = Paid first, including partners who are creditors
2. Partners’ Capital = Paid last = Right of offset between a partner’s loans to and from the partnership
Losses Considered in Liquidation = All possible losses must be provided for in a liquidation before any
distribution is made to the partners
Losses in liquidating a partnership are charged to the partners in accordance with the partnership
agreement.
Convert Noncash Assets = the general procedure is all noncash assets are converted into cash, pay all
liabilities, distribute remainder to partners.
Capital Deficiency:
1. Right of Offset = use their loan account
2. Remaining Partners Charged = If negative partner runs out of $
3. If a deficiency still exists, the remaining partners must absorb the deficiency according to their
respective (remaining) P&L ratios.
F3 - Assets and Related Topics
M1 - Cash and Cash Equivalents
Cash = includes currency & demand deposits
Cash equivalents = Short-term, highly liquid investments that are both readily convertible to cash and
so near their maturity when acquired by the entity (<90 days)that they present insignificant risk in
changes in value.
Examples of Cash & Cash Equivalents:
--Coin, currency on hand, petty cash
--Checking and savings accounts
--Money market funds
--Deposits held as compensating balances not legally restricted
--Negotiable paper
--Bank checks, money orders, traveler’s checks, bank drafts, cashier’s checks
--Commercial paper and T-bills
--CDs (<90 days original maturity)
Items NOT Cash or Cash Equivalents
--CDs with original maturity >90 days
--Legally restricted deposits held as compensating balances
Restricted or Unrestricted
Restricted cash is cash that has been set aside for a specific use or purpose (purchase of property for
example). Unrestricted cash is used for all current operations.
If the restriction is associated with a current asset or current liability, classify as a current asset but
separate from unrestricted cash.
If the restriction is associated with a non-current asset or non-current liability, classify as a non-current
asset but separate from either the Investments or the Other Assets section.
Bank Reconciliations :
Simple Reconciliation
1. Add: Deposits in Transit
2. Deduct: Outstanding Checks
3. Deduct: Bank Service changes
4. Bank Collections: add deposits collected from the bank on behalf of the depositor
5. Errors: made by either the bank or the depositor are another reason for difference.
6. Add: Interest Income
7. Deduct: Non-Sufficient Funds
M2 - Trade Receivables
Accounts Receivable = Net Realizable Value measurement = Balance of the A/R adjusted for allowance
for A/R that maybe uncollectable, sales discounts, and sales returns and allowances.
Valuation of AR with Discounts:
Sales or Cash Discounts (2/10, n/30)
Gross Method = Records a sale without regard to the available discount. If payment received within
discount period, a sales discount (contra-revenue) account is debited.
Net Method = Records a sale net of the available discount. If payment received after discount period,
"sales discounts not taken account" must be credited.
Trade Discounts = are quoted in %. Sales revenue & A/R are recorded net of discounts. Trade discounts
are applied sequentially. Examples: C&B sells coats w/ a list price of $1K minus trade discounts of 40%
and 10%. $1,000 - $400 ($1,000 x 40%) = $600, then $600 - $60 ($600 x 60%) = $540.
A/R Rollforward = details all the transactional A/R activity in a period, with the beginning and ending
balances tying back to the source report.
Estimating Uncollectible AR:
1. Direct Write-Off Method (NOT GAAP) = No JE until written off . This is the method used for federal
income tax purposes. Doesn’t properly match the bad debt with the revenue. AR always overstate.
2. Allowance Method (GAAP) = Percentage of Accounts Receivable at YE Method (B/S approach)
Step 1: Calculate ending balance in Allowance for doubtful accounts account
Step 2: Back into CY Bad Debt expense
3. Aging of Receivables Method = The sum of the product for each aging category will be the desired
ending balance in the allowance account. Example: Current A/R $10,000 x 0.01 = $100
31-61 days $6,667 x 0.03 = $200
61-90 days $5,000 x 0.10 = $500
Over 90 days $4,000 x x0.20 = $800
$25,667 $1,600
Write-off of a specific A/R = When a receivable is formally determined to be uncollectable, the JE is:
Debit Allowance for doubtful accounts
Credit A/R
Subsequent collection of A/R written off:
Direct Write-off method = Debit Cash / Credit Uncollectable accounts recovered
Allowance method = Debit A/R / Credit Allowance for uncollectable accounts, Then:
Debit Cash / Credit A/R
Pledging (Assignment) = Footnote only = A/R account is NOT adjusted. It is the process whereby the
company uses existing A/R as collateral for a loan.
Factoring of Accounts Receivable = process by which a company can convert its receivables into cash by
assigning them to a "factor" either w/o or w/ recourse.
1. Without Recourse = The sale is final and the assignee assumes the risk of any losses on collections.
JE is: Debit Cash
Debit Due from factor
Debit Loss on sale of receivable
Credit A/R
If the returns, discounts, and allowances are less than the retained amount, the balance will be returned
to the seller
2. With Recourse = the factor has an option to re-sell any uncollectible receivables back to the seller.
Treated as a sale if ALL:
--Obligation for uncollectible accounts can reasonably be estimated;
--Transferor surrenders control;
--Transferor cannot be required to re-purchase the receivables, but may be required to replace the
receivables.
Treated as a loan: Footnote only
Securitization = A/R are transferred to a different entity, such as a trust or subsidiary. The entity then
sells securities that are collateralized by the A/R. Investors receive cash as the A/R are paid.
Notes Receivable = written promises to pay a debt. They are either Current Asset or LT Asset.
Valuation and Presentation = Accrue interest over time, not when $ received
Face Value - Unearned Interest and finance charges = PV
Discounting Notes Receivable = arise when the holder endorses the note w/ or w/o recourse to a 3-rd
party and receives a sum of cash. With Recourse = N/R that are discounted w/ recourse are reported on
the B/S w/ a corresponding contra-account (N/R Discounted). Without Recourse = the holder assumes
no liability. Such N/R discounted w/o recourse have been sold outright and should, therefore, be
removed from the B/S.
Example-Discounting the Note at a Bank:
A 90-day note from a customer of $40K w/ 12% interest.
1. First, Calculating the maturity value = $41,200 ($40K x 12% x 90/360-for 3 mo. b/c the Note is a 90-
day or 3-month note).
2. Second, in 30 days (1 month after the Note issued to customer), the Note holder takes the Note to
the Bank. Thus, calculating the bank discount on the payoff value at maturity (bank charging 15%) =
$1,030 [$41,200 (the Note w/ the Accrued interest) x 15% x 60/360 (60 days are left from the holding
period of the Note and the Bank will hold it and pay it on behalf of the comapny)
3. Then, we compute the amount paid by the bank to the company: $40,170 ($41,200 - $1,030). Thus,
the company receives $40,170, which includes interest income of $170 (it is smaller than the $1,200
that was going to be received from the customer at maturity in 90 days, but the company received the
money from the bank immediately, NOT waiting 60 days).
M3 - Inventory
Types of Inventories:
--Retail inventory
--RM inventory
--WIP inventory
--FG inventory
DM + DL + Indirect Materials & Labor (Overhead), insurance on the manufacturing equipment are
costs counted in the Inventory.
Goods and Materials to be Included in Inventory
General Rule: Any goods and materials in which the company has “legal title” should be included in Inv.
Goods in Transit = FOB Shipping Point (Freight In) = Title passes to the buyer when the seller delivers
the goods to a common carrier. FOB Destination (Freight Out) = Title passes to the buyer when the
buyer receives the goods from the common carrier.
Shipment of Nonconforming Goods = if the seller ships the wrong goods, the title reverts to the seller
upon rejection by the buyer.
Consigned Goods = Consignor should include the consigned goods in its inventory because title and
risk of loss is retained by the consignor even though the consignee possesses the goods. Revenue will be
recognized when the goods are sold to a third party.
Sales w/ a mandatory buyback = if a seller has a mandatory requirement to re-purchase goods from the
buyer, the seller should include the goods in inventory even though title has passed to the buyer.
Installment Sales = if the seller retains legal title as security for the loan, the goods should be included
in the seller's inventory if the % of uncollectable debts cannot be estimated.
Valuation of Inventory
General Rule =GAAP requires that Inventory be stated at its cost
Cost includes freight-in!
Departures from the Cost Basis = Precious Metals and Farm Products are recorded @ NRV = Selling
price - costs of disposal
Lower of Cost or Market, and Lower of Cost and Net Realizable Value:
In the ordinary course of business, when the utility of goods is no longer as great as their cost, loss on
sale is expected.
Recognize Loss in Current Period = Write-down in COGS, unless the amount is material, in which case
the loss should be identified separately in the Income Stmt.
Reversal of Inventory Write-Downs = Under US GAAP Reversals are Prohibited.
Lower of Cost or Net Realizable Value= used with FIFO and Weighted Average
NRV = Net selling price - Costs to complete and dispose of the inventory
Lower of Cost or Market = used for LIFO and Retail Methods
Applying the lower of cost or market rule separately to each item (item by item) results in the lowest
inventory amount.
Market value = It is the Middle value between the following:
--Replacement Cost
--Market ceiling = NRV
--Market floor = NRV - Profit margin
Lower-of-Cost-or-Market Example:
Cost = $26
Replacement = $20
Selling Price = $30
Cost of completion = $2
Normal Profit margin = $7
Market value is the middle value btw Replacement cost, NRV (Selling price - cost of completion) and
the Market Floor (NRV - Profit margin).
Thus, NRV= $28 ($30 - $2) and Market Floor = $28 - $7 = $21
The middle value btw Repl. cost, NRV and Market floor is $21, the market floor.
Then, we compare the Cost and the Market (the middle value or the market floor in this case) and the
Market Floor of $21 is the lower!
Disclosure = Substantial and unusual losses from the subsequent measurement of inventory should be
disclosed in the financial statements. Small losses from a decline in value are included in the COGS.
Periodic Inventory System vs. Perpetual Inventory System
Periodic Inventory System = 1 JE at time of sale
Quantity of inventory is determined only by physical count, usually at least annually
COGS = determined after each physical inventory by squeezing the difference between beginning
inventory plus purchases less ending inventory, based on physical count.
Perpetual Inventory System = 2 JEs at time of sale. Each item of inventory is updated for each purchase
and each sale as they occur. COGS are recorded at sale.
Primary Inventory Cost Flow Assumptions = Cost flow assumption used by a company is not required to
have a rational relationship with the physical inventory flows.
Special Identification Method: cost of each item in inventory is uniquely identified. This method is
usually used for Physically large or High-value items.
FIFO Method = Uses both Periodic or Perpetual and Ending Inventory will be the same with both
methods. Ending Inventory and COGS are the same whether a periodic or perpetual inventory system.
In Period of rising prices, FIFO results in Highest Ending Inventory; Lowest COGS and Highest NI.
Weighted Average Method = Uses Periodic. It is determined by dividing the total costs of inventory
available by the total number of units of inventory available. Example:
$40,250 COGAFS = $4.4722 per unit and thus 4,000 sold units x $4.4722 = $17,889 is COGS and
9,000 units AFS 5,000 remaining units x $4.4722 = $22,361 is the Inventory
Moving Average Method = Uses Perpetual. Computes the weighted average cost after each purchase.
Inventory is equal to the sum of the value of current inventory and the value of the new inventory
purchase, divided by the total Inventory units.
NOTE: On the row that lists the sale of units, the AVG cost per unit would be the same as the previous
row with the purchased units!
LIFO Method = Uses Periodic and Perpetual and Ending Inventory will be different with both
methods. Better matches expenses against revenues because it matches current costs with current
revenues. If sales exceed production (or purchases) for a given period, LIFO will result in a distortion of
Net Income because old inventory costs will be matched with current venue. In period of rising prices,
the LIFO method results in Lowest Ending Inventory; Highest COGS and Lowest Net Income.
Dollar-Value LIFO = Inventory is measured in dollars and is adjusted for changing price levels.
Uses Internally Computed price Index.
Because Dollar-value LIFO inventory measures inventory in dollars and uses a price index to adjust for
changing price levels (inflation/deflation), it best reflects the true economic value of the inventory.
Formula for Price Index = Ending Inventory at Current Year Cost
Ending Inventory at Base Year Cost
LIFO layer in the Current Year = the LIFO layer at Base Year cost x price index.
If we know the Price Index and also the Current Year Ending Inventory but not the Ending Inventory of
the Base Year, we can divide the Current Ending Inventory by the Price Index to get the Base Year EI.
$577,500 / $525,000 = 1.10
Gross Profit Method = used for interim FSs as part of a periodic inventory system. Inventory = valued
at retail and the Average GP % is used to determine the inventory cost for the interim FSs. GP % =
used to calculate cost of sales.
Conventional Retail Method = converts inventory at retail to inventory "at cost". A cost/retail ratio is
computed. Markups are included and markdowns are excluded.
Example: At Cost At Retail
Beginning Inventory $15,000 $35,000
Purchases $5,000 $12,000
Markups - $3,000
Available for Sale $20,000 $50,000 = 40% Cost/Retail ratio ($20,000/$50,000)
Sales ($30,000)
Markdowns ($5,000)
Ending Inventory at Retail $15,000 x 40% = $6000
Ending Inventory at LCM $6,000
Firm Purchase Commitments = Legally enforceable agreement to purchase a specified amount of
goods at some time in the future. If the amount to be purchased is not a "fixed" amount but instead it
states "purchase between 50K and 70K units", there is no commitment and no losses are reported.
Disclosed in either the financial statements or the notes thereto. Rule of Conservatism = If the
contracted price exceeds the market price and if it is expected that losses will occur when the
purchase is actually made, the loss should be recognized at the time of the decline in price.
FOB Destination Shipping = means the title passes when received by the buyer, and thus the
packaging, shipping and handling are costs of the seller.
Agriculture products (and precious metals) may be stated at NRV and Revenue is recognized at time of
production and NOT at time of sale.
M4 - PP&E: Cost Basis
Valuation of Fixed Assets
Fixed Assets = Land, Buildings and Equipment.
Historical Cost = Purchase price + bringing it to the location + condition necessary for its intended use
Donated Fixed Assets = recorded at their FV along w/ incidental costs incurred.
Assets that are purchased requiring fixed payments extending beyond one year (under a deferred
payment contract), should be valued at the PV of all future payments.
Cost of Land = all costs incurred up to excavation for the new building are considered land costs, incl.:
--Purchase price
--Accrued Property Tax
--Broker's commissions
--Title & Recording fees
--Legal fees
--Draining of swamps
--Clearing of brush & trees
--Site development, such as grading of mountain tops; filling in and leveling
--Mortgage assumed by the buyer
--Costs of razing (tearing down) an old building (demolition)
--Less proceeds from sale of existing buildings, standing timber
Land Improvements = are depreciable + interest costs during construction
--Fences
--Water systems
--Sidewalks
--Paving
--Landscaping
--Lighting
Plant
Cost of Plant includes the following:
--Purchase price
--Repair charges “neglected” by the previous owner (deferred maintenance)
--Alterations and improvements
--Architect’s fees
--Possible addition of construction-period interest
Land cost = Filing in a hole or leveling
Building cost = Digging a hole for the foundation
Basket Purchase of Land and Building = Allocate the purchase price based on the ratio of appraised
values of individual items
Equipment
Cost of Equipment = All expenditures related directly to the acquisition or construction of the
equipment to include:
--Invoice price Less Discounts
--Add: Freight-in and Installation charges (including testing and preparation for use)
--Sales and federal excise taxes
--Construction period interest
Capitalize vs. Expense:
Capitalize if the Life of the Asset is extended OR the Efficiency is Improved. Example = Replacement of
Cracked windows from a nearby explosion is an ordinary R&M expense, b/c it does not extend the
building's life nor its efficiency!
Additions = Capitalize (if they increase life of the asset)
Improvements/Replacements = Capitalize (if they increase usefulness)
1. If carrying value of old asset is known = remove it and recognize any gain or loss. Then capitalize the
cost of the improvement/replacement to the asset account.
2. If carrying value of the old asset is unknown, the asset's life is extended, we then debit the A/D for
the cost of the improvement/replacement.
Repairs = Ordinary repairs should be expensed. Extraordinary repairs should be capitalized.
Fixed Assets Constructed by a Company:
Costs to Capitalize:
--DM and DL
--Repairs and maintenance that add value to the FA
--Overhead Construction period interest
--Capitalization of Interest Costs (Capitalized based on weighted average of accumulated expenditures
as part of the cost of producing fixed assets)
Computing Capitalized Cost:
1. Weighted Average Amount of Accumulated Expenditures:
Applying an interest rate to the average amount of accumulated expenditures for the qualifying asset
during the period (avoidable interest). Example: The construction expenditures were $200K on Jan 2,
$600K on May 1, and $300K on Dec 1. The AVG expenditures get calculated this way:
--$200K x 4/12 (for Jan-April) = $66,667
--$800K (200k + 600K) x 7/12 (for May-Nov)=$466,667
--$1,100K (200K + 600K + 300K) x 1/12 (Dec)=$91,667
$625,000 = AVG Expenditures
AVG Interest = 2 loans of $600K at 8% and $800K at 9%. Total interest is $1,200,000 ($480K on 1st loan
and $720K on 2nd loan). We divide total interest by the total loan funds or $1,200K / $14,000K
= 8.57% is the AVG interest.
2. Interest Rate on Borrowings = the interest rate paid on borrowings (specifically for asset
construction) during a particular period should be used to determine the amount of interest cost.
3. Interest Rate on Excess Expenditures (Weighted Average):
If the Average accumulated expenditures outstanding > amount of related specific new borrowing,
interest cost should be computed on the excess.
4. Not to Exceed Actual Interest Rate = Total capitalizable interest costs for any particular period may
not exceed the total interest costs actually incurred.
Two Rules
1. Only capitalize interest on money actually spent, NOT on the total amount borrowed
2. The amount of capitalized interest is the lower of:
Actual interest cost incurred, or
Computed capitalized interest (avoidable interest)
Capitalization of Interest Period:
Begins when ALL 3 conditions are met:
1. Expenditures have been made (Building decision made)
2. Activities necessary to get the asset ready for its intended use are in progress (permits filed)
3. Interest cost is being incurred
Continues as long as the three conditions are present.
Stops during intentional delays in construction, but continues during ordinary construction delays.
Ends when asset is substantially complete.
Expense the interest BEFORE decision is made to build!
Disclosure in the FSs:
1. Total interest cost incurred 2. Capitalized interest cost for the period
Rule: Interest Costs incurred on manufacturing of machinery for sale to customers (inventory) should
be expensed in the Income Statement for the period incurred.
M5 - PP&E: Depreciation and Disposal
Physical Depreciation = related to an asset's deterioration
Functional Depreciation = arises from obsolescence or inadequacy of the asset to perform efficiently
Component Depreciation = Separate depreciation of each part of an item of PP&E that is significant to
the total cost of the fixed asset
Composition of Fixed assets should NOT be disclosed in "summary of significant accounting policies".
Composite or Group Depreciation = Averaging the economic lives of a number of property units and
depreciating the entire class of assets over a single life. Asset Retirement = When a group or composite
asset is sold or retired and if the AVG service life has not been reached, G/L that results from the
retirement is absorbed in the A/D account. Depreciation Method for Composite or Group Assets = Any
acceptable depreciation method. Formula = Total of the components' depreciable costs divided by the
total of the annual depreciation expense for all the components = AVG composite life.
Sum-of-the Years'-Digits Depreciation = Starts at a higher level than straight-line and declines at
constant rate!
Asset with a 4-year useful life: 1+2+3+4=10 or n(n+1) / 2 where n=4 or 4(4+1)/2 = 10
Thus Y1 = 4/10 x $10,000 (purchase price of asset) = $4,000 depreciation
Y2 = 3/10 x 10,000 = $3,000 depreciation
Y3 = 2/10 x 10,000 = $2,000 depreciation
Y4 = 1/10 x 10,000 = $1,000 depreciation
Total of $10,000
Units-of-Production (Productive Output) Depreciation:
Step 1: Cost - Salvage Value = Rate per Unit or Hour
Estimated Units or Hours
Step 2: Rate per Unit (hour) X # of Units produced (or hours worked) = Depreciation Expense
Declining Balance Depreciation: the only method that ignores salvage value!
Double-declining balance = starts at a high level of depreciation and declines rapidly but NOT at a
constant rate!
First, the regular straight-line method % is determined.
Second, Calculate the 1st year depreciation using straight-line method. Example: if $10K purchase
price and useful life of 10 years, the 1st year depreciation would be $1,000. We double the $1,000 or
we have $2,000 in depreciation using the declining method. $2,000 / 10,000 is 20%.
Third, calculate depreciation: Y1 = 20% x $10K (purchase price of asset) = $2,000 depreciation
Y2 = 20% x $8K (10K - $2K-first year depreciation) = $1,600 depreciation
Y3 = 20% x 6,400 (10K - $3600 (1st & 2nd year depreciations) = 1,280 depreciation
and on and on until all exhausted, which may take less than 10 years.
Disposal = when depreciation is taken "individually", not as a group, then we recognize Gain/Loss.
Disclosures:
--Depreciation expense for the period
--Balance of major classes of depreciable assets
--A/D allowances by classes or in total
--Methods used, by major classes, in computing depreciation
Depletion:
Purchase cost includes any expenditures necessary to purchase and prepare the land for removal of
resources or to prepare the asset for harvest .
Residual Value = similar to salvage value.
Depletion Base (Cost minus Residual Value) = is the cost to purchase the property minus the estimated
net residual value remaining after resources have been removed from the property.
Methods of Depletion:
--Cost depletion = GAAP
--Percentage depletion - not GAAP = based on % of sales.
Calculation of Depletion: Unit Depletion Rate = Depletion Base
Estimated Recoverable Units
Total Depletion = Unit Depletion Rate x # of Units Extracted
Depletion Base:
--Cost to purchase property
--Plus Development costs to prepare the land for extraction
--Plus any estimated restoration costs
--Less residual value of land after the resources are extracted
Recognition of Depletion = If all units extracted are not sold, then depletion must be allocated
between COGS and inventory.
Permanent Impairment of Depreciable Asset = the impairment is basically an additional depreciation
and gets added to the A/D balance!
M6 - Nonmonetary Transactions
Exchanges Having Commercial Substance =They do have commercial substance if future cash flows
change as a result of the transaction. The change could be in the areas of risk, timing, or amount of
Cash Flows. In other words, if the economic position of the 2 parties changes b/c of the exchange,
then the exchange has "commercial substance".
Exchanges w/ commercial substance use the FV approach.
Pass Key: FV of asset given up = FV of asset received PLUS any cash given or minus cash received.
Recognizing Gains and Losses = Always recognized in exchanges having commercial substance.
Example = Foxy Company exchanged used cars for a building. Future cash flows will significantly
change. The BV of the cars totals $40,000 and the cars' FV is $45,000. Foxy must pay $20,000 cash as
part of the exchange.
The exchange is with commercial substance and the Gain is $5,000 ($45,000 - $40,000)!
The Gain is the difference btw the FV and the BV of the old asset (given up).
Calculation of Basis of Acquired Asset = Cash paid + FV of assets/stock given up
When exchanges have commercial substance we use either the FV of the given up asset or the FV of
the received asset, whichever is more evident.
FV of asset acquired when new asset's FV not evident = Old asset's FV + Cash Paid!
Example #2 = Pete exchanges land with a CV of $320,000 and FV of $450,000 plus $50,000 Cash for
another piece of land from Bissell, which has FV of $500,000 and CV of $350,000.
1. Bissell reports the exchange this way:
Dr Land $450,000
Dr Cash $50,000
Cr Gain on Sale of Asset $150,000 ($500K FV - $350K CV)
Cr Old Land $350,000
2. Pete will report the exchange this way:
Dr Land $500,000
Cr Old Land $320,000
Cr Gain on Sales of asset $130,000
Cr Cash $50,000
Exchanges Lacking Commercial Substance = LACKS commercial substance if projected cash flows are
not expected to change significantly.
Exchanges w/o commercial substance = the reported BV of the surrendered asset is used to record the
newly acquired asset.
Step 1: Determine Gain or Loss = FV (old) - BV (old) = G/L
Step 2: Follow rules:
Gains :
1. No boot received = No gain
2. Boot is paid = No gain if the boot is less than 25% of total consideration received
3. Boot is received = Recognize proportional Gain if the boot is less than 25% of total consideration
4. Boot Received or Paid is 25 % or more of total consideration, both parties account for the
transaction as a monetary exchange and recognize gains or losses in their entirety.
Example = Same facts from Example #2 above:
1. Bissell will record the exchange this way:
Dr Cash 50,000
Cr Old Asset $350,000
Cr Gain $15,000 [Total gain is $150,000 x 10% (50K Cash/$500,000 total consideration)]
Dr New Land $315,000 (Plug)
2. Pete will record the exchange this way (NO Gain because the Cash paid is < 25% of total
consideration received):
Dr New Land $370,000 (Plug)
Cr Cash $50,000
Cr Old Land $320,000
FV approach is used for exchanges with commercial substance
BV approach is used for the exchanges lacking commercial substance!
Rule of Conservatism = if loss is indicated, Recognize the loss
Involuntary Conversions = Entire gain or loss is recognized
M7 - Intangibles
Intangible Assets = long-lived assets with legal rights and competitive advantages developed or acquired
by a business enterprise.
Classification of Intangible Assets = patents, copyrights, trademarks and goodwill.
They may be identifiable (e.g. patents, copyrights, franchise) or not specifically identifiable (e.g.
goodwill).
Manner of acquisition:
--Purchased = Capitalize at cost
--Internally developed = Expense because GAAP prohibits capitalization of R&D costs.
Example of Internally developed = video game manufacturer = Expense unidentifiable costs, such as
game development expenses paid to employees or expenses to retain the distributors. Capitalize the
identifiable costs, such as design costs of trademarks, copyrights, or legal fees.
Expense the following:
1. Trademarks (except the capitalizable costs identified below)
2. Testing for evaluation of new products
2. Goodwill from advertising
3. The cost of developing, maintaining or restoring Goodwill
Exception to Expensing (need to Capitalize because these costs are identifiable):
1. Legal Fees to a successful defense of the asset (unsuccessful defense is expensed)
2. Registration or consulting fees
3. Design Costs (e.g., of a trademark)
4. Other direct costs to secure the asset
Capitalization of Costs:
--Amount of cash disbursed or the FV of other assets distributed
--PV of amounts to be paid for liabilities incurred
--FV of consideration received for stock issued
Amortization = straight-line method = Amortize if the intangible asset has a FINITE life. Useful life
should reflect the periods over which the asset will contribute to cash flows. Amortization should be
cost less residual value.
Goodwill and assets with indefinite life get an impairment testing.
Patent = amortized over the shorter of its estimated economic life or remaining legal file.
Change in useful life of the intangible assets = change in estimate = prospective
Sale of Intangible Assets = Calculate G/L
Valuation:
Finite Life Intangible assets = reported at Cost less Amortization and Impairment
Indefinite life intangible assets = reported at cost less impairment
Franchisee Accounting:
Initial franchise fees = intangible asset and amortize
Example: Initial Franchise Fee is $75K, paid by cash of $25K and a note payable of $50K. The PV note is
$37,908. Thus, the amount to be capitalized as an intangible asset is $62,908 ($25K + $37,908).
JE to record the initial Franchise Fees as an asset is:
Debit Franchises $62,908 Credit N/P $50,000
Debit Discounts on the N/P $12,092 Credit Cash $25,000
Continuing Franchise Fees = Expense as incurred
Start-up Costs = Expenses incurred in the formation of a corporation (e.g., legal fees) and should be
expensed as incurred.
Start-up costs include:
--Organizing a new entity
--Opening a new facility
--Introducing a new product or service
--Conducting business in a new territory or with a new class of customer
--Initiating a new process in an existing facility
Start-up costs do NOT include:
--Routine, ongoing efforts to improve the quality of existing products
--Mergers or acquisitions
--Ongoing customer acquisition
Pass Key: Organizational expenses are NOT capitalized as an intangible asset. Rather, they are
expensed immediately.
Research and Development Costs = Expense
Research is the planned efforts of a company to discover new info that will help either create a new
product, service, process, or technique or significantly improve the one in current use. Development
takes the findings generated by research and formulates a plan to create the desired item or to
improve significantly the existing one.
Example of R&D = Redesign of product pre-release
Exceptions:
1. DO NOT EXPENSE Materials, equipment, or facilities that have alternative future uses.
2. R&D Costs of any nature undertaken on behalf of others under a contractual arrangement.
Capitalize R&D Costs in regards to Software after Feasibility!
3. Do NOT expense Admin Costs as R&D!
Items not considered R&D:
--Routine periodic design changes to old products
--Marketing research
--Quality control testing
--Reformulation of a chemical compound
Computer Software developed to be Sold, Leased, or Licensed:
1. Expense Costs, such as planning, design, coding, and testing, incurred until technological feasibility
has been established for the product.
2. Capitalize costs, such as coding, testing, and producing product masters, incurred after
technological feasibility has been established up to the point of sale.
Capitalized costs are reported at the lower of cost or market (NRV). And amortization of the
capitalized costs starts once the product is released for sale (to be licensed).
Technological feasibility is established upon completion of a detailed program design or working
model.
Amortization of Capitalized Software Costs (Sold, Leased, Licensed):
Annual amortization is the greater of:
1. Percentage of Revenue = Total Capitalized amount x Current Gross Revenue
Total Projected Revenue for product
2. Straight Line = Total Capitalized amount / Estimate of Economic Life
Computer Software Developed Internally or Obtained Only for Internal Use:
1. Expense costs incurred for the preliminary project idea and costs incurred for training.
2. Capitalize costs incurred after preliminary idea and for upgrades, including direct materials and
services, cost of employees and Interest costs.
General & Admin costs related to training and software maintenance get expensed, even though they
occurred after the establishment of the technological feasibility.
Amortization of software developed internally and for internal use only = Straight-line
Revenue Recognition = if software previously developed for internal use is Subsequently sold to
outsiders, proceeds received should be applied first to carrying amount of the software, then as
revenue.
M8 - Impairment
Impairment of Intangible Assets Other Than Goodwill (Patent, Trademark, copyright)
Intangible assets with indefinite useful life (including Goodwill) are tested for impairment at least
annually, and intangible assets with finite life are tested whenever there are indications that the
carrying amount may not be recoverable.
Intangible Assets with Finite Lives = 2-step Impairment Test:
Step 1: The carrying amount of the asset is compared with the sum of the undiscounted cash flows
expected to result from the use of the asset.
Step 2: If the carrying amount > the total undiscounted future cash flows, then the asset is impaired
and we record an Impairment loss, which is equal to the difference of the CV and the FV/PV (or the
discounted cash flows). Impairment loss = CV - FV or PV of discounted CFs
Intangible Assets with Indefinite Lives = 1-Step Impairment Test (only with this type we do NOT worry
about the sum of the undiscounted CFs)
Use only Step 2 from above = Step 2: If CV > FV or PV (or Discounted CFs) = the Impairment loss
Reporting impairment loss = continuing operations before income taxes.
Assets held for use = If impaired, we write down, amortize the new cost and NO restoration permitted.
Assets held for Disposal or Sale = If impaired, we write it down, NO amortization taken, Restoration
Permitted.
Test for recoverability compares the undiscounted future cash flows (and NOT the PV of future CFs) to
carrying value.
Impairment of PP&E = Reviewed at least annually or whenever triggering events happen
Test of Recoverability = use same 2-Step process from above.
Test of Recoverability is ONLY performed on intangible assets with a limited life. We would perform
such test on a Patent, BUT NOT on Goodwill or any Intangible asset with indefinite useful life.
F4 - Investment, Business Combinations, and Goodwill
M1 - Financial Instruments
Financial Assets and Financial Liabilities:
Financial Assets:
1. Cash (deposits and foreign currencies), Stock certificates, partnership interests
2. Contract that conveys to one entity a right to receive cash (bond investments, notes receivable)
3. Contract to exchange other financial instruments on Favorable terms (stock options, futures/forward
contracts, and other derivatives)
Financial Liabilities:
1. Contract that delivers cash (Bond obligations, notes payable)
2. Contract that obligates an exchange of other financial instruments on Unfavorable terms (stock
options, futures/forward contract, and other derivatives)
Fair Value Option = Unrealized G/L are reported in earnings. The FV option is irrevocable and applied to
individual financial instruments.
Eligible Financial Instruments for FV Option = AFS and Equity Method (significant influence
Fair value changes attributable to instrument-specific credit risk = Financial instruments other than
derivative liabilities that are designated under the FV option, the portion of the change in FV that
relates to a change in instrument-specific credit risk is recognized in OCI. Notes/bonds = OCI BUT
Derivative liabilities = Net Income.
Investments in Debt Securities - No voting, thus no significant influence. Debt Securities include:
--Corporate bonds
--Redeemable Preferred Stock
--Government securities
--Convertible debt
--Commercial paper - Notes/drafts
Classification of Debt Securities:
1. Trading Securities = generally reported as Current Assets
2. Available-for-Sale Debt Securities = reported either as Current or Non-Current Assets
3. Held-to-Maturity Debt Securities = classified as such ONLY if the corporation has the positive intent
and ability to hold these securities to maturity.
Reported as Current or Non-Current Assets. Both types are reported at CV (amortized cost)unless
there is a permanent decline in market value.
Reported at Amortized cost (FMV distracter) .
HTM debt security purchased at par value , will be reported at the purchase price until it matures!
Valuation of Debt Securities = Debt Securities Reported at FV (TS and AFS)
--Unrealized gains and losses of Trading Securities = report in Income stmt
--Unrealized gains and losses of AFS = report in OCI
--Realized gains and losses for both in IS
--Financial Assets Reported at Amortized Cost (HTM - debt only) No unrealized G/L, and no realized G/L
on sale
Reclassification = Transfers btw categories should occur only when justified. Any transfer of a particular
security from one group to another group is accounted for at FV.
Summary of Transfers between Categories
From To Transfer Acct for Unrealized G/L
Trading Any other FV No adjustment
Any other Trading FV IS
HTM AFS FV OCI
AFS HTM FV Amortize G/L from OCI
with premium/discount
Income from Investments in Debt Securities = Interest Income from Trading or AFS securities recorded
in Income Stmt.
Impairment of Debt Securities = under the current expected credit losses (CECL) model AFS and HTM
debt securities should be reported at the net amount expected to be collected using an allowance for
expected credit losses.
A credit loss is recognized as a current period expense on the I/S and as an offsetting allowance on the
B/S.
Impairment of HTM Securities = If it is determined that the amounts due (principal + interest) reported
on the B/S at amortized cost will NOT be collected , the investment should be reported at PV.
The credit loss is the difference btw the PV and the amortized cost.
Ignore FV if given! It is a distracter!
Example = TGPO purchased HTM security, a 4-year Bond of $500K w/ annual interest of 4.25%. At the
end of Y3, TGPO determined that it would only collect $11,500 each year of interest instead of the full
$21,250 ($500K x 4.25%). First step is to calculate the PV of the Bond. PV is $473,073, thus we have an
impairment of $26,927. The JE is: Debit Credit Loss Expense and Credit Allowance for Credit Loss
(contra account to the HTM security Asset) for the $26,927.
Impairment of AFS Debt Securities = accounted for differently from HTM debt security's impairment,
b/c the investor has the option to sell an AFS security if the loss on the sale will be less than the
expected credit loss.
Example = We have a $500K (original cost) AFS bond security and 3 scenarios:
1. $510K FV and $10K Unrealized gain reported in OCI
2. $480K FV and $20K Expected Credit Loss reported in I/S
3. $450K FV BUT this FV is less than the PV we calculated in the example above (See impairment of
HTM), which is $473,073. Thus, we would report a credit loss in I/S of $26,927 ($500K CV - $473,073
PV) and $23,073 Unrealized loss in OCI.
NOTE: The $500K original price we are using in the 3 scenarios above, would be different in different
cases because we need to take under consideration the amortized value and that $500K may be
$456,639 ($500K - the discount) and on and on.
The Credit Loss = the difference btw the CV (amortized cost) and the PV. However, if the PV is less than
the FV of the AFS security, then the credit loss is equal to the difference btw the CV and FV.
And the rest of the loss, which would be the difference btw the PV and the FV, we ignore and do NOT
record unrealized loss in AOCI. Example: AFS debt security with cost of $150K, PV = $142K and FV =
$144K. Since the FV > PV, the credit loss is limited to the FV and thus we have $6K in credit loss,
reported on I/S. There will NOT be $2K loss, the difference btw FV and PV is not recorded, because the
company always has the option of selling at FV.
The credit loss reported in the I/S is limited to the amount by which FV is below amortized cost.
Sale of Debt Securities:
1. Trading Securities = Realized G/L is the difference btw the Cost (original cost plus/minus unrealized
G/L previously recognized in I/S) and the Selling price.
2. AFS Securities = the unrealized G/L reported previously in AOCI must be reversed at time of sale.
Investment in Equity Securities = represents an ownership interest in an enterprise
Equity Securities include Common, preferred stock shares; Stock warrants, rights, and call options; Put
options. They do NOT include: P/S redeemable; Treasury stock; and Convertible bonds.
Classification = Fair Value through NI (FVTNI). Practicality Exception = Cost - impairment (nonpublic)
Valuation of Equity Securities = Equity Securities are generally reported at FV. Unrealized G/L are
reported in earnings (NOT AOCI) by debiting Unrealized G/L and crediting a Valuation contra account.
Income from Investments in Equity Securities:
Normal (non-liquidating)Dividend = report as Dividend Income in Net Income
Liquidating dividend = distribution that exceeds investor’s share of the investee’s R/E. Liquidating
Dividend is a return of capital that decreases investor’s basis.
Impairment of equity investments = Equity investments that do not have readily determinable FV are
measured at cost minus impairment.
An entity should consider the following qualitative indicators for determining whether an equity
investment with no readily determined FV is impaired:
--Ability of an investee to continue as a going concern
--Significant and adverse changes in the industry, geographic area, technology, or regulatory or
economic environment
--Significant decline in earnings, business prospects
--Offers to buy from the investee (and willingness to sell on the part of investee) the same or a similar
investment for less than the investor’s carrying value.
When a qualitative assessment indicates that impairment exists, the cost basis of the equity security is
written down to FV and the amount of write-down is accounted for as a realized loss and included in
earnings.
AFS Debt Securities Impairment Loss = recorded in Allowance for credit losses and gets reassessed
each year and adjusted. No reversal allowed if the allowance for credit losses goes below zero.
Sale of Equity Security = realized G/L = SP - CV (original cost +/- unrealized G/L) = realized G/L
Required Disclosures for Investments in Debt Securities (AFS and HTM) = Disclose FV/amortized cost
and Gross unrealized G/L; Contractual maturities; Impairment changes; Concentration/Credit risk.
Disclosure for most financial instruments: CV and FV
Disclosures for Investments in Equity Securities = Disclose unrealized G/L
Fair Value = All public and private entities must disclose on the B/S or in the notes. Public business
entities must provide FV information regarding the classification level in the measurement hierarchy.
Concentrations of Credit Risk = MUST be Disclosed!
Credit Risk is the Possibility of loss from the failure of another party to perform according to the terms
of a contract
Concentration of Credit Risk occurs when an entity has contracts of material value w/ one or more
parties in the same industry or region or having similar economic characteristics.
Market Risk = Possibility of loss from changes in market value due to economic circumstances. Under US
GAAP, all entities are encourages, but NOT required to disclose market risk information.
Ineligible Reclassification = we cannot reclass a security from a
Trading/Marketable security to a Held-to-Maturity.
Investment to be held indefinitely is reported at FV, non-current asset, with
unrealized G/L into NI.
HTM designations ONLY exist with DEBT SECURITIES!!!
M2 - Equity Method
When to use equity method = 20-50% ownership → exercise significant influence
Even if the ownership is under the 20% but the ability to exercise significant influence exists, the equity
method is the correct method of accounting.
Equity method not appropriate in the following situations:
--Bankruptcy of subsidiary
--The investment is Temporary
--A lawsuit is filed
--A standstill agreement is signed
--Another small group has the majority ownership and operates the company w/o regard to the
investor (The investor even though w/ more than 20% ownership is NOT a member of the Board) = FV
method to be used in this case
--The investor cannot obtain the financial information to apply the equity method
--The investor cannot obtain representation on the board of directors = use FV method instead!
Non-voting Preferred Stock investment (even if it is more than 20%) = account for the investment using
the FV method and NOT the Equity Method (due to non-voting stock).
Equity Method Accounting: Journal Entries
1. To record investment at cost (FV + legal fees) = Debit Investment / Credit Cash
2. To record increase in the investment by the investor's share of earnings = Debit the Investment
account / Credit Income account
3. To record decrease in the investment by the investor's share of the cash dividends received from
the investee = Debit cash / Credit the investment account (Stock dividends are just memo entries)
Stock Dividends for FV method for securities with less than 20% ownership are NOT Dividend Income!
Investment in Investee Common Stock and Preferred Stock:
The "significant influence" test is generally met by the amount of CS (excluding PS) owned, which is
the only voting stock.
Calculation of the earnings from the Investee with more than 20% but less than 50% is this:
Total Earnings
<Preferred Dividends>
Net Income available to Common shareholders
Differences between the Purchase Price and Book Value (NBV) of the Investee’s Net Assets:
With the Equity method ONLY there are additional adjustments necessary to the investment account
due to the difference btw the NBV of the investee's assets and their FV.
The difference is attributable to:
1. Asset FV Difference = The excess of an asset's FV over its NBV is amortized over the life of the asset.
To record the depreciation of the excess of the assets' FV over CV, we debit Equity in
Earnings/investee income - an I/S account (NOT Depreciation expense account)!!!
2. Goodwill = The FV excess attributable to Goodwill is NOT amortized and is NOT subject to a
separate impairment test. However, the total equity investment MUST BE analyzed at least annually
for impairment.
Income reported by the investee = record it to Equity in Earnings/Investee Income - I/S account!
Example = Kean Co. purchases 30% of Pod Co. for $250,000. Pod's stockholder's equity was $500,000.
However, Pod's assets' FV exceeded their CV by $200,000 contributed to the land.
Pod's equity $500,000
Excess FV $200,000
Total Pod's FV $700,000
Kean's purchase x 30%
Kean's net assets acquired $210,000
Purchase price of 30% <$250,000>
Goodwill $40,000
Equity Method Impairment = Impairment loss occurs when FV falls below CV and the Decline in value
is not temporary. Report the Impairment loss on I/S.
Transition to the Equity Method = When significant influence is added to the investment, a change
from FV method to equity method is necessary. We need to do the following:
1. Add the cost of the additional interest acquired to the CV of the investment.
2. Adapt the equity method as of the date of acquisition of the new interest and going forward.
Retroactive adjustments are NOT REQUIRED!
M3 - Basic Consolidation Concepts
Voting Interest Model
Control (over 50% ownership) = Parent status is established. Under US GAAP, all majority-owned
subsidiaries must be Consolidated.
Exceptions to Consolidation (SHOUL NOT consolidate) and SHOULD USE EQUITY METHOD (both
internally and externally):
--Subsidiary in legal reorganization
--Bankruptcy OR subsidiary operates under severe foreign restrictions.
Controlling Interest and Non-controlling Interest (NCI):
Controlling Interest = Investors with more than 50% of a sub has a controlling interest
NCI = The portion of the equity (net assets) of a sub that is not attributable to the parent.
NCI is reported at FV in the equity section of the consolidated B/S, separately from the parent's
equity.
Variable Interest Entity (VIE) Model = A corp., partnership, trust, LLC or other legal structure used for
business purposes that either does not have equity investors with voting rights or lacks the sufficient
financial resources to support its activities.
Primary beneficiary = is the entity required to consolidate the VIE. The Primary Beneficiary has the
power to direct the activities of the VIE and thus absorbs at least 50% of the Losses or Gains.
The Primary Beneficiary MUST Consolidate the entity and use Consolidation method of
accounting!
Identifying a Variable Interest in a Business Entity:
--Company (Parent) and Business Entity (Subsidiary) have an arrangement. The following conditions
need to be met to be considered a VIE:
1. The company significantly participates in the business entity's design.
2. Substantially all of the business entity's activities are conducted on behalf of the company.
3. More than half of the total of the equity and subordinate debt are provided by the company.
4. The Business Entity is a Legal Entity and NOT a person.
5. The Business Entity fails to qualify for Exclusion, such as:
---non-for-profit organization
---employee benefit plan
---governmental organizations
6. Interest is more than Insignificant
Business Entity is a Variable Interest Entity = the company (parent) MUST determine!
1. The business entity has insufficient level of Equity investment at Risk, which means the entity
cannot operate on its own w/o the financial support. Example = the business entity needs a guarantee
to obtain a bank loan. A Guarantee is a Variable Interest and that business entity is a VIE.
2. The business entity is unable to make decisions or direct activities.
3. A business entity is a VIE if the holders of the total equity investment at risk have no right to receive
the entity's expected residual returns, nor the obligation to absorb the entity's expected losses.
4. If some of the equity investors have Disproportionately Few Voting Rights in comparison to their
economic interests.
Private Company May elect not to consolidate if:
1. The lessee and the lessor are under common control
2. The lessee has a leasing arrangement with the lessor
3. Substantially all activities between the lessee and lessor are related to leasing activities
4. If the lessee explicitly guarantees or collateralizes any obligation of the lessor, then the principal
amount of the obligation does not exceed the value of the asset leased by the private company from the
lessor.
M4 - Acquisition Method: Part 1
Application of the Acquisition Method = in a combination accounted for as an acquisition, the
subsidiary may be acquired for cash, stock, debt securities and it is measured at FV of the
consideration given or the FV of the consideration received, whichever is more clearly evident.
Business combination btw Parent and Sub is NOT a legal combination, rather reflects an economic
reality!
The accounting for an acquisition begins at the date of acquisition.
Journal Entry to record the acquisition for parent common stock (Use FV at date the transaction
closes, and not the announcement date):
Debit Investment account for Parent and Credit Common Stock (Parent at Par) and Credit APIC
Consolidation Adjustments = For external reporting / CAR IN BIG
1. Common Stock, APIC, Retained Earnings of Subsidiary eliminated
2. Investment in subsidiary eliminated
3. Non-controlling Interest created
4. Balance sheet of subsidiary adjusted to FV at acquisition date
5. Identifiable intangible assets of the subsidiary recorded at their FV
6. Goodwill or Gain plugged
Investment in Subsidiary :
--Original carrying amount = Measured by FV at date of acquisition
DO NOT Capitalize the following to Investment in Sub:
1. Direct out-of-pocket costs are expensed as incurred, such as legal fees.
2. Indirect costs are expensed as incurred.
3. PV of Estimated Relocation Costs of the main office should be expensed and NOT added to the
acquisition cost!
4. Stock registration and issuance costs, such as SEC filing fees are direct reduction of the value of the
stock issued (debit parent's APIC account)
Example: Big Corp exchanges 10,000 shares of $10 par value C/S w/ a FV of $415K for 100% of the
outstanding stock of Sub Corp. Big pays $35K in legal fees and $20K in stock registration fees.
The Journal Entry to record the acquisition price is:
Debit Investment in Sub $415K
Debit Legal Expense $35K
Credit Common Stock $10 par value $100K
Credit APIC $295K ($415K - $100K - $20K-registration cost)
Credit Cash $55K
Contingent Consideration = it is recorded by the parent on the acquisition date by:
1. Adding an estimate of the probable settlement cost to the investment in the subsidiary, such as an
additional $100K if the Sub's AVG income during the next 4 years exceeds $50K annually. The
contingency liability recorded by the parent depends on the probability %. If the probability is 50% that
the income would exceed $50K, then we record a contingent liability of $50K ($100K x 50%) by debiting
the Investment in Sub account and credit the contingency liability account.
Changes in Contingent Consideration = the adjustment is included in earnings (debit an expense
account and credit the contingency liability account if the consideration would increase).
Parent Company Accounting for the Investment in SUB = used for internal accounting ONLY:
1. Cost Method where no changes are made to the investment account after acquisition and the
dividends received are dividend income.
2. Equity Method
Consolidation must be used for external FSs when a company exercises control (more than 50%).
Equity Method is NOT used for external FSs when there is 50 and more % control.
Consolidation is NOT used internally! Instead equity method or cost method are used!
When Significant influence exists, even though the % ownership is less than 20% , the equity method
should be used.
M5 - Acquisition Method: Part 2
Non-controlling Interest (NCI) = Computation of NCI = FV of Subsidiary x NCI's %
NCI after acquisition date:
Beginning NCI + NCI shares of subsidiary's net income - NCI share of Subsidiary's dividends (using the
"equity method")
The Consolidated Income Statement will include 100% of the sub's revenues and expenses after the
acquisition date.
Balance Sheet Adjustment to FV, Identifiable Intangible Asset Adjustment to FV, and Goodwill (Gain)
The Goodwill (Gain) Value is reported in FULL (even though the Parent owns less
than 100%) on the Consolidated FSs!!!
FV of Subsidiary = Acquisition Cost + NCI at FV
There will be differences btw the Acquisition Cost and the CV of assets.
First, adjust CV of assets to FV
Second, Identifiable Intangible Assets of the Sub are recorded at FV
Third, Goodwill is recognized for any excess of the total Sub's FV over the Sub's FV of assets
List of Identifiable Intangible Assets:
Agreements and Contracts; permits; Rights; Patents; Copyrights; Trademarks; Franchises; Computer
Programs; Customer lists; non-competes
In-Process Research & Development = Recognize as an intangible asset separately from Goodwill at the
acquisition date.
Identifiable Intangible Assets are w/ finite life (amortize) and indefinite life (do not amortize, but test
for impairment).
Private Company would not separately recognize intangible assets from non-compete agreements and
customer-related intangible assets. Instead, these assets would be included in goodwill.
Acquisition with Gain = When acquiring a subsidiary w/ a FV that is less than the FV of 100% of the
underlying assets acquired, the following steps are required:
Step 1: Balance sheet adjusted to FV
Step 2: Identifiable intangible assets to FV
Step 3: Gain
Measurement Period Adjustments = the values assigned to the assets and liabilities of a sub are not
always known w/ certainty on the acquisition date. Thus, the values recorded on the acquisition date are
provisional and get adjusted later during the measurement period.
Measurement Period = Cannot exceed one year from acquisition date and Ends when improved
information is available.
Adjustments are offset against Goodwill (or gain). Adjustments to depreciation and amortization are
reported in the period the adjustments are determined (no restatements required).
Under US GAAP The full Goodwill method is used and thus if the Parent owns 75% of the Sub, we still
need to report 100% of the Goodwill calculated at acquisition date on the consolidated
statements(NOT 75%).
Technical Expertise is NOT an identifiable intangible asset and thus upon acquisition it gets added to
the Goodwill!
M6 - Intercompany Transactions
Eliminating Intercompany Transactions:
Balance Sheet = 100% of all intercompany payables and receivables
Income Statement = Interest expense/interest income; Gain on sale/depreciation expense for
intercompany fixed assets sales; Sales/COGS
Commonly Tested Intercompany Transactions
Intercompany Inventory/Merchandise Transactions = When inventory has been sold intercompany and
the CPA Examiners require us to correct the accounts, we need to reverse the original intercompany
transactions:
Inventory sold to outsiders → correct COGS
Inventory still on hand → correct EI
Intercompany Bond Transactions = If one member of the consolidated group acquires an affiliate's
debt from an outsider, the debt is considered to be retired and a G/L is recognized.
Example of Bond purchase from a Sub: On Dec 31, A Corp issued bonds at CV of $300K & a face value
of $250K, thus a premium of $50K. On the same day B Corp-A's Sub, acquired all the bonds from the
original purchaser for $275K. On the consolidation workpapers the intercompany balances need to be
Eliminated. This is the JE:
Debit Bonds Payable $250K
Debit Premium $50K
Credit Bonds Investment $275K
Credit Gain on extinguishment of Bonds $25K
Eliminate the following:
Intercompany interest: eliminate intercompany accounts such as interest expense, interest income,
interest payable, and interest receivable
Amortization of Discount or Premium: eliminate amortization of the discount or premium
Subsequent Years: the elimination of realized but unrecorded G/L on extinguishment of bonds in
subsequent years would be Adjusted to RE.
Intercompany Sale of Land = G/L remains unrealized until land is sold to outsider. In the Intercompany
elimination workpapers the G/L from the sale of the land get eliminated. In the subsequent years until
the land is sold to 3rd party, R/E of the Parent would be debited and land would be credited to
eliminate the Intercompany profit.
Intercompany Profit on Sale of Depreciable Fixed Assets = G/L remains unrealized until asset sold to
outsider. In the Intercompany elimination workpaper, we adjust the asset and A/D/Depreciation
Expense to their original balance on date of sale. In subsequent years, the G/L from the original
intercompany sale/purchase get eliminated, as well as Depreciation Expense reduced to what it
should be if parent kept the asset and both eliminations are recorded through R/E.
Income statement Elimination = Dividends paid by the subsidiary to the Parent should be eliminated!
Remember to use the CARINBIG mnemonic to ensure that you eliminate all the appropriate accounts:

Common stock – Eliminate the par value of the common stock of the subsidiary at the date of
 C
the acquisition; the par value of the common stock is taken directly from the trial balance.
Additional paid-in capital – Eliminate the additional paid-in capital of the subsidiary at the date
 A
of acquisition; the additional paid-in capital is taken directly from the trial balance.
Retained earnings – Eliminate the retained earnings of the subsidiary at the date of acquisition;
 R
amount is taken directly from the trial balance.
 I Investment – Eliminate the Parent Company's investment in Subsidiary.
 N Non-controlling Interest – In this instance, it is not applicable as it was 100% acquisition.
Balance sheet adjusted to fair value – Increase or decrease the book value of the subsidiary's
 B
plant and equipment to equal its FV.
Identifiable intangible assets recorded at FV – No identifiable intangibles are identified in this
 I
problem.
 G Goodwill – Establish a goodwill account as necessary.
M7 - Consolidated Financial Statements
Consolidated B/S = The Equity includes ONLY the Parent's C/S, APIC and R/E + NCI
Consolidated I/S = Includes 100% of the Parent's Revenue & Expenses and all of the Subsidiary's
Revenues & Expenses after the date of acquisition. The Consolidated I/S should show separately
consolidated NI, NI attributable to NCI, and NI attributable to the parent company.
Consolidated Comprehensive Income Stmt = sale as regular I/S applies.
Consolidated Statement of Changes in Equity = NCI is presented in this stmt as well.
Consolidated Statement of Cash Flows = the preparation of it, is similar to a non-consolidated entity.
Considerations when preparing consolidated Cash Flow Stmt:
1. Total consolidated NI, incl. NI attributable to both the Parent and the NCI, should be used.
2. The financing section should report dividends paid by the subsidiary to the NCI shareholders.
Dividends paid by the subsidiary to the parent should not be reported.
NCI is calculated as follows:
Facts: A company purchased 80% of B company for $120K. Thus, total FV of the subsidiary is $150K
($120K / 80%) and the NCI is $30K.
The beginning R/E of the subsidiary is $36K and year end R/E is $51K.
The subsidiary issued $5K in dividends.
Solution: 1. The NI for the subsidiary could be found this way: $36K beg R/E - $5K (dividends) -$51K
ending R/E = $20,000 total NI for the subsidiary.
2. NCI' Net Income is $4,000 ($20,000-total NI x 20%)
3. NCI's balance at the end of the year = $30,000 (beg. balance) + $4,000 (NI portion) - $1,000
(Dividend portion) = $33,000
M8 - Goodwill, Including Impairment
Goodwill = represents the intangible resources and elements connected with an entity that cannot be
separately identified and reported on the B/S.
Goodwill from Business Combinations = Under Acquisition method Goodwill is the excess of an
acquired entity's FV over the FV of the entity's net assets.
Equity method = Significant Influence = Goodwill is the excess of the stock purchase price over the FV of
the net assets acquired.
Maintaining Goodwill = Costs associated with maintaining, developing, or restoring goodwill are NOT
capitalized as goodwill, instead expensed. Additionally, Goodwill generated internally or not at arm’s
length is not capitalized.
Goodwill Impairment = calculated at the Reporting Unit level, which is an operating segment.
Step 1: Perform first Qualitative Evaluation of Goodwill Impairment before the Quantitative Test
Examples of Qualitative factors:
--Macroeconomic conditions
--Overall financial performance
--Industry & Market conditions
The Quantitative test is NOT necessary if the Qualitative Test shows that it is more likely than not that
the FV of the reporting unit is less than the CV.
If the Qualitative Test shows that there is more than 50% chance that the FV is less than the CV, then
we need to perform a Quantitative Test.
Step 2: Quantitative Evaluation of Goodwill Impairment (only if Qualitative Test indicated it):
1. If the FV exceeds the CV = no impairment
2. If the FV is less than the CV= Impairment Charge is recorded. The Impairment charge cannot exceed
the value of goodwill allocated to that reporting unit.
Private Company Accounting Alternative = Amortize goodwill Straight Line over 10 years. Test goodwill
for impairment at either the entity level or the reporting unit level when a triggering event occurs.
When testing for Goodwill Impairment, we consider the FV and CV of the total reporting unit's Value
(all assets incl. Goodwill). (PV of future CFs if given in MCQ, is IRRELEVANT).
F5 - Liabilities
M1 Payables and Accrued Liabilities
Trade Accounts Payable:
Gross method = records purchases without regard to the discount
Net method = records purchases net of discount. If payment is made after the discount period, a
purchase discount lost account is debited.
Periodic Payment of Interest is NOT A/P, but instead an accrued liability or debt!
Liability that is secured by collateral should be classified as a loan payable.
Trade Notes Payable = May include a stated interest rate
Current Portions of LTD = The principal due within a year (or operating cycle) will be classified as a CL.
Current obligations expected to be refinanced = Excluded from current liabilities and included in non-
current debt if the company intends and has the ability to refinance on a long-term basis, evidenced by:
1. Actual refinancing prior to the issuance to the FSs, OR
2. Existence of a non-cancelable financing agreement
Accrued Liabilities/Expenses = Unpaid portion of salaries and wages
Property Taxes Payable = two methods:
1. Accrued prior to the receipt of tax invoice and matched with the year for which the invoice pertains
2. Recorded as a payable upon the receipt of the tax invoice and expensed in the year of receipt
Sales Taxes Payable = Not an expense!!! Credited to a payable account
Employee-Related Liabilities = Unemployment Taxes and Employer’s Share of Payroll Taxes = Expense
Payroll Deductions = From employee = Payable
Bonuses = should be recorded to Salaries and wages expense
Accrued Vacation = recorded in the year earned at the current pay rate if all of the following
conditions are met:
1. The compensation for accrued vacation is attributable to services already rendered by the employee
2. The employer's obligation relates to rights that vest (are not contingent on employee's future
services)
3. Payment of compensation is probable
4. The amount can be reasonably estimated
NOTE: The accrued vacation in the prior year is at the prior year's pay rate. However, if the pay rate is
increased in the following year and the vacation is taken in the following year, then we record the
difference between the accrued vacation amount and the actual pay of the vacation at the current pay
rate to salary expense.
Debit Salaries Payable (accrued prior year at old rate) $1,200
Debit salaries (for the difference) $400
Credit cash $1,600
Exit or Disposal Activities (closing location or downsizing)
Exit and Disposal Costs include:
1. Involuntary employee termination benefits (Severance pay)
2. Costs to terminate a contract that is not a capital lease (Landlord makes you pay). Operating Lease
is part of the Exit Costs!
3. Costs to consolidate facilities or relocate employees
Criteria for Liability Recognition = Footnote only until announced, and after announcement , a liability
should be recognized.
A liability is recorded when the following criteria are met:
1. Obligating event occurred = announced publicly
2. Results in a present obligation to transfer services
3. Cannot avoid future transfer of assets or services
Future Losses expected to incur as part of an exit or disposal activity are recognized in the periods
incurred.
Liability Measurement = @ FV (discounted NPV)
Income Statement Presentation = Loss in "continuing operations" OR Loss in "discontinued operations"
→ major strategic shift
Disclosures = include:
1. Description of the exit or disposal activity
2. For each activity disclose Total amount expected to be incurred
3. Reconciliation of the beginning and ending balances
4. Line items in the I/S in which the costs are aggregated
5. Costs incurred for each reporting segment
6. Liability not recognized because FV cannot be reasonably estimated? Disclose the reasons
Asset Retirement Obligations (AROs)
ARO Recognition if:
--Duty or responsibility
--Little or NO discretion to avoid
--Obligating event
Record ARO liability when Law requires; Contract requires or Promissory Estoppels exits.
Initial Measurement
ARO = Liability @ PV
ARC = the amount capitalized (Asset) that increases the carrying amount of the long-lived asset when
ARO liability is recognized.
Subsequent Measurement
Accretion (Interest) expense = It is the increase in the ARO liability due to the passage of time.
The PV for ARC and ARO is calculated using the risk-free rate that reflects the company's
credit standing!
Each year the Accretion expense will be INCREASING!
Debit Accretion Expense and Credit ARO liability (the amount is calculated = accretion rate of 10% x
the Discounted ARO Obligation at PV). At the end of the accretion period, the ARO Liability should be
brought up to the original estimated amount of the obligation.
At the end of the period, the cumulative accretion and the A/D should equal the ARO (Total Cost).
Depreciation expense = decreases the ARC asset reported on the B/S. At the end of the accretion
period the asset retirement cost (the asset) should be fully depreciated. Debit Depreciation Expense
and Credit A/D (contra account to the ARC Asset that was recorded at PV, using straight line method).
Example for ARO and ARC = Brown Company estimates it will pay $500K to dismantle a mine. The PV
factor for 4 years at 10% is 0.68301, which means the ARO and ARC will be $341,505 ($500K x 0.68301)
To record initial ARC and ARO:
Dr ARC $341,505
Cr ARO $341,500
To record accretion and depreciation expenses:
Dr Accretion Expense $34,150.50 ($341,505 x 10%, the accretion rate)
Cr ARO $34,150.50
Dr Depreciation Expense $85,376.25
 Cr Acc. Depreciation $85,376.25 ($341,505 / 4 years)
Revisions to Cash Flow Estimates:
Cost more → add new liabilities → use current discount rate
Cost less → remove old liabilities → use historical or WA discount rate
P/S cumulative dividends in arrears are non-current liability!
If ST liability gets paid off by issuing Common Stock subsequent to the YE, but before the FSs are
issued, We Debit the ST Liability and Credit LT Liability (NOT the Common Stock Equity account).
M2 - Contingencies and Commitments
Contingency = existing condition, situation or set of circumstances involving uncertainty as to possible in
gain or loss that will ultimately be determined when a future event occurs of fails to occur
Loss Contingencies:
--Collectability of receivables
--Warranty obligations
--Fire Losses
--Risk of Loss from catastrophe
--Environmental Damages
--pending Lawsuits
--Agreements to repurchase assets
Gain Contingencies:
--Expected favorable pending lawsuits
--Possible tax disputes refunds
Recognition and Measurement of Gain Contingencies = Gains are NOT recognized in the FSs!
Recognition and Measurement of Loss Contingencies:
Probable and Reasonably Estimated= Accrue Estimated amount or the minimum and Disclose
Reasonably possible and not reasonably estimated = Only Disclose
Remote = Usually Ignore, however disclosure should be made for "guarantee-type" contingencies:
1. Debts of others guaranteed (officers/related parties)
2. Obligations of commercial banks under standby letters of credit
3. Guarantees to repurchase receivables (or related parties) that have been sold or assigned.
Loan Guarantee = Disclosure (even if no accrual needed)
= Accrual is required when the Guarantor of the loan will be required to perform
under the terms of the guarantee due to the default of the borrower and also the
the amount could be reasonably estimated.
Letter of Credit = Disclosure whether accrual or not
= Accrual is NOT required when the beneficiary (a supplier) of the letter of credit has
not delivered the inventory to the applicant of the letter of credit.
When a contingent loss is probable and a range of probable losses is given, GAAP requires that the
best estimate be accrued!
When a range of probable losses is given and no amount is a better estimate than the other in the
range, the minimum amount in the range should be accrued.
When a range is given for a probable loss, but it is stated that the midpoint of the range is the
most likely result, then we accrue the midpoint!
Appropriation of Retained Earnings = Any appropriation of R/E, such as for loss contingencies, must be
shown within the Equity section and clearly identified.
Premiums and Warranties = accrued if probably and can be reasonably estimated
Premiums = offers to customers for the purpose of stimulating sales. They are offered in return for
coupons, labels. The cost of the premiums is charged to sales in the periods that benefit from the
premium offer. The # of outstanding premium offers must be estimated.
Total # of coupons issued x Estimated Redemption Rate = Total estimated coupon redemptions
Example: 1,500,000 cans of soup were sold. We have 200,000 purchased premiums and 600,000
coupons redeemed. 5 Coupons must be presented to receive a premium that costs $2. It is estimated
that 70% of the coupons will be redeemed.
Total estimated coupon redemptions = 1,050,000 ($1.5M x 70%)
Coupons redeemed = (600,000)
Coupons to be redeemed = 450,000
Outstanding premium claims = 90,000 (450,000 / 5 coupons for 1 premium)
The estimated liability for the premiums would be $180,000 (90,000 x $2)
Contingency Gain should be disclosed in the notes UNLESS the likelihood of the gain being realized is
remote. And the FULL RANGE of possible outcomes/settlements should be disclosed.
Warranties: : Examples: If the warranties are estimated at 2% in the year of sale, and 4% and 6% in the
following 2 years, we add up all three %s to a total of 12%to use for each year.
Facts: Sales Actual Warranty Costs
Year 1 $250,000 $10,000
Year 2 $500,000 $20,000
Year 3 $750,000 $30,000
JE for Year 1:
Debit Warranty Expense ($250,000 x 12%) $30,000
Credit Warranty Liability $30,000
Debit Warranty Liability $10,000
Credit Inventory $10,000
JE for Year 2:
Debit Warranty Expense ($500,000 x 12%) $60,000
Credit Warranty Liability $60,000
Debit Warranty Liability $20,000
Credit Inventory $20,000
JE for Year 3:
Debit Warranty Expense ($750,000 x 12%) $90,000
Credit Warranty Liability $90,000
Debit Warranty Liability $30,000
Credit Inventory $30,000

M3 - Long-Term Liabilities
Annuity = involves multiple payments or receipts. Examples are bond interest payments and lease rental
payments.
Ordinary vs. Annuity Due
Ordinary Annuity = payments are at the end of each period
Annuity Due = payments are in the beginning of each period
PV Factor = 1 / (1+r)^n
PV = Future Value
(1+r)^n
Pass Key = If interest compounds on an "other-than-annual basis", the # of periods and the interest
rate must be adjusted. Example, if the annual interest rate is 12% and interest compounds quarterly
over 10 years, then the periodic interest rate is 3% and the total # of compounding periods is 40.
Future Value of $1 = it is the amount that would accumulate at a future point in time if $1 were invested
now. Future Value = PV x (1+ r)^n
Example = Your partner is retiring in 5 years and it will cost $300K to purchase her interest. You invest
now $200K, earning 10% compounded annually.
The Future Value (FV) = $200K x (1+ 0.10)^5 = $322,102, which is > $300K, thus you'll be able to buy her.
NOTE = FV and PV are inverse of each other =
PV of Ordinary Annuity = Annuity Payment x PV of ordinary annuity of $1 for n periods and interest rate
PV of Annuity Due = PV of Ordinary Annuity x (1+r)
In an annuity due each cash flow is discounted one less period.
PV of an ordinary annuity of 1 at 6% for 2 periods = 1.8334
PV of an annuity due of 1 at 6% for 2 periods = 1.8334 x 1.06 = 1.9434
PV of an annuity due of 1 at 6% for 3 periods = 1.8334 + 1.00 = 2.8334
Long-Term Liabilities - Record @ PV. They are probable sacrifices of economic benefits associated with
present obligations not payable within the current operating cycle or reporting year, whichever is
greater. Examples: Bonds; LT Leases; LT contingent liabilities; LT promissory notes.
Distinguishing Liabilities from Equity = Certain financial instruments have characteristics of both
liabilities and equity.
Financial Instruments that MUST be classified as Liabilities:
--Mandatorily redeemable Preferred Stock that represent an unconditional obligation to the issuer
--Financial instruments that represent obligation to repurchase the issuer's equity shares by transferring
assets
--Financial instruments that represent obligation to issue a variable number of shares
Notes Payable = must be reported at PV. If a note is non-interest bearing or the interest rate is
unreasonable (below market), the value of the note must be determined by imputing the market rate of
the note and by using the effective interest method.
Stated Interest Factors = A note issued solely for cash equal to its face value is presumed to earn the
interest stated.
Imputed Interest = When a note contains No interest or unreasonable rate of interest. This involves
determining the PV of the note at the market interest rate, and
1. Recording payable at its face amount
2. Recording the item received in exchange for the note at PV of the obligation
3. Recording difference between face and PV as discount that must be amortized over the life of the
note.
The higher the implied interest rate is, the lower the PV of the Note is and the higher the discount
amount is.
Imputing Interest NOT Required:
1. Short-term notes
2. Payables Paid in property or services (no cash)
3. Payables that represent security deposits
4. Payables btw parent & Subsidiary
5. Payables w/ interest rates determined by Government agencies
Amortization of the Discount = The payable must be amortized over the life of the note using the
effective interest method.
Disclosures:
The Discount is inseparable from the related note payable and is added to the note payable to
determined the CV.
A full description of the payable, the effective interest rate, and the face amount of the note should
be disclosed in the FSs or notes.
Imputed Interest Example:
Company purchased a machine for $10K w/ no interest due in 5 years. The PV of $1 at 10% for 5 years
is 0.621. Thus the PV of the machine and the note is $6,210.
JE to record the Note: Debit Machine $6,210
Debit Discount on the Note $3,790 ($10K - $6210)
Credit Note Payable $10,000
JE to record the amortization of the discount in Year 1:
Debit Interest Expense $621 ($6210 x 10%)
Credit Discount on the Note $621
Balance of the Note at the end of Y1: $10,000
<3,169> which is ($3,790 - $621)
$6,831
Interest less than the Market interest rate Example:
A 5-year note for $10K with 3% interest rate, but market interest rate is 8%. What is the amount of
the note at maturity? It is $11,500 ($10,000 face value + $1,500 (5 years x 3%)). Thus, $11,500 x PV
Factor 0.680 at 8% and 5 years = $7,820 PV of the Note at 8% interest rate.
Straight Line method of amortizing non-interest bearing note's discount:
Calculate the Discount (Face amount of the Note - PV). Then divide the Discount by the term periods.
Debt Covenants = Creditors use debt covenants in lending agreements to protect their interest by
limiting or prohibiting the actions of debtors. Goal is maintain debtor’s credit rating to protect value of
debt . Common Debt Covenants:
--Limitation on issuing additional debt
--Restriction on dividend payments
--Limitations on the disposal of certain assets
--Minimum working capital required
--Collateral requirement
--Maintenance of ratios
Violation of Debt Covenants = Debtor is in technical default and creditor can demand repayment. Most
concessions are negotiated and real default is avoided. Concessions can result in the violated covenants
being waived temporarily or permanently. Concessions can result in a change in interest rate or other
terms of the debt.
Example of Debt Covenant: Loan received for $1M but with $100K Restricted Cash:
Debit Cash $900K
Debit Restricted Cash (Compensating balancing) $100K
Credit Note Payable $1M
Tangible Net Worth = Total Stockholders' Equity less Intangible Assets
M4 - Bonds: Part 1
Bond Indenture = Contract btw the issuer and the bond holder
Face (Par) Value = basis on which periodic interest is paid
Stated (Nominal or Coupon) Interest Rate = Interest to be paid to the investor in cash
Market (Effective) Interest Rate = Rate of interest actually earned by the bondholder
Discount = when the market rate is higher than the stated rate
Premium = when the market rate is lower that the stated rate
Types of Bonds:
--Debentures = Unsecured bonds
--Mortgage bonds = Secured by real property
--Collateral trust bonds = Secured bonds
--Convertible bonds = Convertible into common stock of the debtor at the option of the bondholder
1. Non-detachable Warrants = The Convertible bond itself must be converted into capital stock
2. Detachable Warrants = The Bond is not surrendered upon conversion, only the warrants plus cash
representing the exercise price of the warrants. The warrants can be bought and sold separately from
the bonds.
--Participating Bonds = are bonds that not only have a stated rate of interest, but participate in income
if certain earnings levels are obtained
--Term Bonds = Bonds with Single fixed maturity date
--Serial Bonds = Pre-numbered bonds that the issuer may call and redeem a portion by serial number.
Serial Bonds are redeemed pro-rata over the life of the issue and would include Registered bonds
maturing annually and Commodity bonds maturing annually.
--Income Bonds = bonds that only pay interest if certain income objectives are met
--Zero Coupon Bonds = Deep discount bonds that are sold with no stated interest, but rather at a
discount and redeemed at the face value without periodic interest payments
--Commodity-Backed Bonds = Asset-linked bonds that are redeemable either in cash or stated volume
of a commodity, whichever is greater
Bonds Payable vs. Notes Payable = The accounting for LT notes payable is similar to the accounting for
bonds payable.
Overview of Bond Terms = Bonds are recorded as LT liability at face value and adjusted to PV by either
subtracting unamortized discount or adding unamortized premiums.
Coupon Rate = the stated interest rate on the bond
Bond Interest = Coupon rate x Face Value
Principal Payoff is always the full face amount.
Accounting for the Issuance of Bonds
1. Find the PV of the bond (using markets rates)
Example for Bond issued at Par = Corp. issued a 10% $1M bond due in 5 years. Bond was issued Jan 1st
and interest is due on June 30th and Dec 30th. The market rate is also 10%.
Solution = PV is calculated based on 10 periods, since the interest is paid twice a year and the Market
rate should be 5% (half of the actual market rate of 10%). PV factor for $1 at 5% for 10 periods is
0.61913 and we use it to find the PV of the principal, the $1M. The PV factor of an annuity of $1 at 5%
for 10 periods is 7.721735, used for the interest payments of $50,000 ($1M x 10% x 6/12).
JE to record the investment for the bond holder:
Debit Bond Investment $1M
Credit Cash $1M
JE the record the issuance of the bond by the issuer:
Debit Cash $1M
Credit Bond Payable $1M
Example for Bond issued at a Discount (Deferred Loss to the Issuer):
Same facts as the above example, except now the market rate is 12%.
1. The PV of the Principal at maturity uses market rate of 12% or 6% for semi-annual payments and 10
periods (payments twice a year for 5-year bond ) and the PV factor is 0.558395, thus the PV of the
principal is $558,395.
2. The PV of the semi-annual interest payments of $50K each uses PV factor of 7.360087, thus PV of
the annuity is $368,004.
3. The proceeds received by the issuer from the bond holder are $926,399 ($558,395 + $368,004).
JEs are Different:
For the Issuer:
Debit Cash $926,399
Debit Bond Discount $73,601
Credit Bond Payable $1M
For Bond Holder:
Debit Bond Investment $926,399
Credit Cash $926,399
Example for Bond issued at a Premium (Deferred Gain to the Issuer):
JE for the Issuer:
Debit Cash $1,081,109
Credit Bond Payable $1M
Credit Bond Premium $81,109
JE for the Bond Holder:
Debit Bond Investment $1,081,109
Credit Cash $1,081,109
Stated Interest Rate = Dictates coupon payment = Annuity
Effective Interest Rate = Market rate
Discounts = Stated < Market
Unamortized Discount = direct reduction from Face Value of the Bond
Amortization of the Discount = Bond discount represents additional interest to be paid to investors at
the bond maturity. The discount is amortized over the life of the bond, w/ amortized amounts increasing
interest expense each period.
Premiums = Stated > Market
Unamortized Premium = addition to Face Value of the Bond
Amortization of the Premium = represents interest paid in advance to the issuer by the bondholder who
then in return receives larger periodic interest payments. The premium is amortized over the life of the
bond, w/ amortized amounts decreasing interest expense each period.
Carrying Value of a Bond = Face Value + the balance of unamortized premium or Face Value minus the
balance of unamortized discount.
Bond Issuance Cost = transaction costs incurred when bonds are issued. Examples: Legal fees,
accounting fees, underwriting commissions, and printing.
RULE: All Costs associated with the issuance of the bonds should be amortized over the bond term.
Bond Issuance Costs are presented on the B/S as a direct reduction to the CV of the bond, similar to a
Bond Discount.
When Bonds are issued, the bond proceeds are recorded "net of" the bond issuance costs. Proceeds =
PV - Bond Issuance Cost
Bond Issuance Cost are amortized as interest expense over the life of the bond using the effective
interest method.
Example: The Bond at a discount is $926,399 and the bond issuance costs are $20,000.
The JE is:
Debit Cash $906,399
Debit Discount & Bond Issuance Costs $93,601($20K Bond Issuance costs + $73,601 Discount)
Credit Bond Payable for $1M.
Effective Interest Rate = Determines the interest expense for the period
Deferred Bond Issuance Costs = Bond issuance costs incurred before the issuance of the bonds are
deferred on the B/S until the Bond Liability is recorded.
M5 - Bonds: Part 2
Bond Amortization Methods
Amortization Period = The period over which to amortize a bond premium or discount and bond
issuance costs is the period that the bonds are outstanding (from the date the bonds are sold)
Straight-Line Method = Simply divide the unamortized discount or premium by the number of periods
that the bonds are outstanding and amortize the same amount of discount or premium each period.
This method results in a constant dollar amount of interest expense each period. It is Not GAAP but
allowed under US GAAP if the results are not materially different from the effective interest method.
Example of SL Method with a Discount: A 5-year Bond of $1M with a coupon rate of 10% and market
rate of 12%. The PV of Principal and Interest combined is $926,399, thus the Discount is $73,601.
Using the Straight-Line method, we divide the amount of the Discount by 10 periods (5-year Bond
with semi-annual interest payments, thus 5 x 2=10), or each year the amortization would be $7360.10
($73,601 / 10). However, the interest payments will be $50K each and we will make the following JEs:
For the Issuer/borrower:
Debit Interest Expense $57,360.10 ($50K interest + $7,360.10 amortization)
Credit $7,360.10 Bond Discount
Credit $50,000 Cash
For the Bond Holder:
Debit Cash $50,000
Debit Bond Investment $7,360.10
Credit Bond Interest Revenue $57,360.10
If there is a Premium with the Bond but using SL Method, the approach is similar to the Discount
example above. However, the amortized amount of the premium reduces the Interest Expense
recorded. Here are the JEs:
PV of the Bond is $1,081,109 and thus the Premium of $81,109 gets amortized over 10 periods.
For the Bond Issuer:
Debit Interest Expense $41,889.10
Debit Bond Premium $8,110.90
Credit Cash $50,000
For the Bond Holder:
Debit Cash $50,000
Credit Bond Investment $8,110.90
Credit Interest Revenue $41,889.10
Effective Interest Method:
Interest Expense = CV at the Beg. of the period x Market Interest Rate
Discount Amortization = Interest Expense - Interest Payment (per coupon rate)
Premium Amortization = Interest Payment (per coupon rate) - Interest expense (Interest
expense will be less than the total coupon payment)
Lower Market Rates relative to the coupon rates would result in a higher initial CV or the PV would be
higher. Thus, we will have a smaller Discount to be amortized. And opposite applies: Higher market
rates will reduce the value of the Bond.
The amortization of the Premiums and the Discounts is similar to the Straight Line method, however
each amount for each period is different (not the same as with the SL method).
Bond Amortization including Bond Issuance Costs = The PV of the Bond is reduced by the Bond
Issuance Costs and that is the Beginning CV for the amortization table.
Example: PV of a Bond with a Discount is $926,399, but the issuer paid $20,000 in Bond Issuance Costs
and thus, the beginning CV of the Bond for amortization purposes is $906,399 ($926,399 - $20,000).
Bond Issued Between Interest Dates = Bonds are usually sold between interest dates, which requires
additional entries for accrued interest at the time of sale. The amount of interest that has accrued since
the last interest payment is added to the price of the bond.
Example: Bond w/ a Discount was sold for $926,399 plus accrued interest for 3 months. The amount of
interest is $25,000. Thus the selling proceeds are $951,399 ($926,399 + $25,000). The JE for the Issuer is:
Debit Cash $951,399
Debit Bond Discount $73,601
Credit Bond Payable $1M
Credit Interest Payable (or Interest Expense) $25,000
Year-End Bond Interest Accrual = Regardless of if/when coupon paid, interest accrued for each quarter
Example: If the Interest payment is due Jan 1 in the following year, we still need to accrue for 6 months.
The JE is: Debit Interest Expense $55,919 (Bond with a Discount)
Credit Interest Payable $50,000
Credit Bond Discount $5,919
Disclosure Requirements Companies with Many Debt issues often report one balance sheet total with
comments and schedules in notes. Notes often show details about Liability maturity dates, Interest
rates, Call and conversion privileges, Assets pledged as security, Borrower-imposed restrictions.
Redeeming the Bond = Buying it back
M6 - Troubled Debt Restructuring and Extinguishment
Troubled Debt Restructuring = Creditor allows the debtor certain concessions to improve the collection.
Concessions include items such as reduced interest rates, extension of maturity dates, reduction of the
face amount of the debt, and reduction of the amount of accrued interest.
Restructuring = The restructured CFs (the Loan amount, whether reduced or not, considering a new
interest rate) should be discounted at the rate used PRIOR to the restructuring using the new,
modified payment period (e.g. 8 years reduced from 10 years). MCQ-05138
Accounting and Reporting by Debtors:
Transfer of Assets:
First, The debtor will recognize a Gain/Loss:
FV of assets transferred
<NBV of assets transferred>
Gain/Loss
Second, Record the discharge of the debt (Always a Gain)
Carrying amount of the payable
<FV of assets transferred>
Gain
Transfer of Equity Interest:
Always recognize a Gain!
Carrying amount of the payable
<FV equity transferred>
Gain
When assets are transferred in a troubled debt restructuring , the asset (real estate) is adjusted to FV
and an ordinary G/L is recorded.
RULE = Gain on Troubled Debt is the difference btw the CV of the payable at date of transfer and the
FV of the asset at the date of the transfer.
The G/L from the difference btw CV and the FV of the asset transferred is reported as ordinary gain.
Modification of Terms = Debtor usually accounts for the effects of the restructuring prospectively.
Under a modification of terms, the debt has not been extinguished; the terms have been adjusted so
that the debtor has a greater ability to fulfill its obligation
Total Future Cash Payments = Principal and any accrued interest at the time of the restructuring that
continues to be payable by the new terms
Interest Expense = computer using Effective interest method
Future Payments =When the total (undiscounted) future cash payments are less than the carrying
amount, the debtor should reduce the carrying amount accordingly and recognize the difference as a
gain. Liability
<Undiscounted Cash Flows>
Shortfall, which means a Gain
Combination of Type = When restructuring involves a combination of assets or equity transfers and
modification of terms, the FV of any asset or equity is used first to reduce the carrying amount of the
payable.
Accounting and Reporting by Creditors
Recognition of Impairment = A loan is considered impaired if it is probable (likely to occur) that the
Creditor will be unable to collect all amounts due under the original contract.
Measurement of Impairment :
Receipt of Assets or Equity: When creditor receives either assets or equity as full settlement of a
receivable, these are accounted for at their FV.
Modification of Terms (Use PV) = Impairment should be measured based on the loan's PV of expected
future cash flows discounted at the loan's historical effective interest rate. In a modification, the
debtor accounts for the effects prospectively and does NOT change the CV or show a Gain unless the
CV exceeds the total future cash payments specified by the new terms. If CV > PV of discounted CFs,
then book a Gain in current operations and reduce the debt's CV to the PV.
The impairment is recorded by creating a valuation allowance with a corresponding charge to bad debt
expense: Debit Debt Expense and Credit Allowance for credit Loss
Example 1: Hull Co. owes $560K to Alpha Co. Alpha agrees to settle the loan for a piece of land that cost
Hull Co. $360K, but its FV is $450K.
Solution: For Hull: The gain on the Asset is $90K ($450K - $360K)
The gain on discharge of the debt is $110K ($560K - $450K)
For Alpha: Debit Land $450K
Allowance for Credit Loss $110K
Credit Note Receivable $500K
Credit Interest Receivable $60K
Example 2: In Year 3 Hull's debt is $500K with accrued interest of $60K. Alpha forgave the accrued
interest of $60K and reduced the interest rate for Y4 and Y5 to 3%.
Face amount + Accrued Interest $560,000
Future cash payments (Y4 & Y5 Interest + Face amount) <$530,000>($500K x 3% for each of the 2 years)
$30,000 Gain on restructuring of the Debt
JE for the Borrower: Debit Note Payable $500,000
Debit Accrued Interest $60,000
Credit Note Payable $530,000
Credit Gain $30,000
JE for the lender: Debit Bad Debt Expense $136,050
Credit Allowance for Credit Losses $136,050
The $136,050 is calculated by calculating the PV of the Future Cash Flows, which is $530,000 (Face
amount of $500K + $30K - the 2 interest payments at 3%). The PV for $500K due in 2 years at 12% =
0.7972 x $500K = $398,600. And the PV of $15,000 interest payable annually for 2 years (the pay
periods left over) at 12% (The interest rate at the issuance of the Bond and NOT the reduced rate of
3%) = 1.6900 x $15,000 = $25,350. Thus the total PV is $423,950 ($398,600 + $25,350). $500K - PV of
$423,950 = $136,050.
Extinguishment of Debt = Corps issuing bonds may call or retire them prior to maturity. Refundable
bonds allow an existing issue to be retired and replaced with a new issue at a lower interest rate.
Definition of Extinguishment = Debtor pays the creditor and is relieved of its obligations for the liability.
Bond Extinguishment at Maturity = If a bond is paid at maturity, CV = FV and no G/L is recorded.
Bond Extinguished before Maturity = G/L is usually recorded.
In-Substance Defeasance Not Extinguishment = arrangement in which a company places purchased
securities into an irrevocable trust and pledges them for the future principle and interest payments on
its LT loan.
Gain or Loss on Bond Extinguishment before Maturity = Adjust items in the FSs, such as Any related
unamortized bond issuance costs; Any related unamortized discount or premium and The difference
between the bond’s face value and reacquisition proceeds.
Reacquisition Price = face Value x % (example $100,000 x 102%)
Example: A bond of $1M with a current Discount Balance at $62,792, is redeemed at 101.
JE is as follows: Debit Bond Payable $1M
Debit Loss on Extinguishment of bonds $72,792
Credit Cash $1,010,000 ($1M x 101%)
Credit Bond Discount $62,792
F6 - Leases, Derivatives, Foreign Currency Accounting, and Income Taxes
M1 Leases: Part 1
Lease = a contract btw a lessor who conveys the right to use real or personal property and a lessee who
agrees to pay consideration for this right over a specific period of time.
In order for a contract to be a lease, both of these criteria must be met:
1. Identifiable asset that the lease depends on and the lessor does not have a substantive substitution
right, which means there is no right to substitute the asset for another one that is not comparable, the
substitute needs to be comparable.
2. Right to control the use of the asset over the lease term must be conveyed to the lessee.
Lease Contracts: Lease vs. Non-lease Components = decision whether the contract is a lease or
contains a lease must be Made at contract inception.
Once determined the contract is or contains a lease, the Lessee must determine whether separate lease
components within the contract should be combined or separated from any related non-lease
components.
Combining Contracts = contracts should be combined when all these criteria are met:
1. One or more contracts contains or is a lease
2. Contracts are entered at approximate same time
3. The parties to the contract are the Same or related parties
4. One or more of the following need to be met:
--One contract affects the consideration paid in the other contract(s)
--Same commercial objectives
Separate Lease Components:
The accounting for separate lease components from a lessee perspective is a 2-step process:
Step 1: Identify each right to use an underlying within the contract
--One right to use = one separate lease component
--More than one right to use an asset = Lessee must determine whether each right equates to a
 separate lease component
Separate if both are met: 1. The right benefits the lessee on a stand-alone basis or together
with other resources and 2. The rights are NOT highly dependent of each other or interrelated
Step 2: For a contract that includes both lease and non-lease components, the lessee has 2 options:
Option 1 Option 2
Lease components Each separate lease
are separate units of component is combined with
account from non-lease related non-lease components
components into one unit of account
If Option 1 is chosen, contract consideration can be allocated to the separate lease and non-lease
components based on relative stand-alone prices.
If Option 2 is chosen, contract consideration will be allocated to each combined unit of account based
on relative stand-alone prices.
Example = A microscope is leased along with a maintenance contract (non-lease component) for a
monthly payment of $7,750 in a 4-year lease contract. Stand -alone prices are $400K for the
microscope lease and $30K for the maintenance contract. Based on the stand-alone prices, the
maintenance contract is 6% and the lease is 94% of the total $430K stand-alone price. However, total
lease contract is $372K ($7750 x 48 months) and thus, the maintenance contract consideration would
be $22,320 ($372K x 6%) and the lease contract consideration would be $349,680.
Lease Classification as Operating or Finance:
1. The lessee accounts for a lease as either an Operating or a Finance lease.
2. The lessor accounts for a lease as an Operating, Sales-type, or Direct Financing lease.
If One of the following 5 criteria is met, classify a lease as a Sales-type lease by the lessor and as a
Finance lease by the lessee:
O Ownership of the underlying asset transferred from lessor to lessee by the end of the term
W The lessee has a Written Option to purchase the underlying asset
N Net PV of all lease payments and the guaranteed residual value by the lessee equal or exceed
substantially the underlying assets' FV
E Economic Life of the underlying asset is represented (at least a major part of it) by the lease term
S The asset is Specialized, which means it won't have an alternative use to the lessor when the lease
term ends
If none of the above criteria are met, or if the lease is Short Term (less than 12 months), it should be
treated as an Operating Lease by the lessee. And for the lessor, it will depend whether both of the
following criteria are met:
P Present Value of the sum of all lease payments , lessee guaranteed residual value NOT included in
the lease payments, and any 3-rd party guaranteed residual value, is equal to or substantially
exceeds the underlying assets' FV.
C Collection of the lease payments and the residual value are Probable.
When both of these criteria are met, the lessor will classify the lease as a Direct Financing Lease.
If one or neither are met, the lessor will classify the lease as Operating.
Quantitative Approach:
For the PV criteria (N Criteria) = 90% or more of the FV of the underlying asset would reasonably be
considered "substantial" or PV > 90% of FV (e.g. Asset's FV is $3,500 and the total PV is $3,170. $3,500 x
90% = $3,150, which is less than the PV of $3,170 and thus we account for the lease as a Finance Lease
by the lessee).
For the Economic Life (E Criteria) = 75% or more would be considered a "major part" of the remaining
life of the asset (e.g. Lease term is 4 years and the asset's life is 10 years, thus 4/10=40%, which is less
than 75% and thus the Economic life criteria is NOT met).
Pass Key:
Lessor
Sales-Type Lease = at least one of the OWNES criteria is met
Direct Financing Lease = None of the OWNES criteria met, but both of the PC criteria met
Operating Lease = None of the OWNES nor PC criteria met
Lessee
Finance Lease = at least one of the OWNES criteria met (Capitalize)
Operating Lease = None of the OWNES criteria met (Capitalize)
Finance Leases (not ST) = lessees must recognized a ROU-right of use asset and a lease liability.
Lease Payments:
Lessee will include all of the following:
1. Required contractual fixed payments less any incentives
2. Exercise option reasonably assured (the right to purchase the underlying asset)
3. Purchase price at the end of the lease of the underlying asset
4. Only indexed or rate variable payments (No increases or decreases to future lease payments s/b
assumed based on index or rate. Instead, any changes in the payments due to index or rate are
expensed in the period incurred). If the variable payments due to index or rate are known at inception
of the lease and are part of the lease, they are included in the PV calculation and thus, the lease
payments will include those variable payments and they should not be changed since the variable
payments are part of the PV. If an MCQ asks whether the lease/interest payments change when the
index or rate changes, the answer is NO.
5. Residual guarantees likely to be owed = the lessee includes the residual value guarantee at the end
of the lease in the PV test.
6. Termination penalties reasonably assured
Option for the lessee to include or not to include the following:
--Non-lease components
--Guarantees of lessor debt by lessee or 3-rd party
--Other variable lease payments
Example 1: The lessee leases equipment for a-year period with a maintenance contract of $8K. The
monthly lease payments are $3,450. There is a purchase option in the lease worth of $12,500, which the
lessee will not exercise. Thus, the lessee includes ONLY the $3,450 lease fixed payments.
Example 2: Lessee A's lease is based on the changes in the CPI index, thus the calculation of the lease
payments will include the variable monthly payments because they are based on an index. Lessee B's
lease is based entirely on the use of the leased asset. Thus, the variable payments due to the CPI
changes will be recognized as an expense and NOT included in the lease payments b/c the lease
payments are contingent on asset usage.
Discount Rate for the Lessee = either the rate implicit in the lease (if known) or the incremental
borrowing rate of the lessee
Initial Direct Costs = Costs that incurred as a result of the execution of the lease should be Capitalized.
Do NOT capitalize costs incurred before the lease was signed, such as document preparation, credit
check, etc.
Sale-Leaseback Transactions = occurs when the party ( the seller) that has control of an asset transfers it
to another party (the buyer), with a subsequent lease of the same asset where the seller becomes the
lessee and the buyer becomes the lessor. Having control of the asset means being able to direct its use
and obtaining substantially all of its benefits.
RULE = If the underlying lease in a sale-leaseback is a finance lease, it is considered equivalent to a
repurchase and will therefore be considered a "Failed Sale". It should be an Operating Lease"!
In Sale-Leaseback, the seller is the lessee and the buyer is the lessor!
To qualify as a sale, the revenue recognition requirements must be met:
1. a contract exists and
2. control has transferred from the seller to the buyer.
If the asset transfer does not meet these 2 requirements, this will be treated as a Financing
transaction.
Repurchase Option: To meet the criteria to be a sale, both of these criteria must be met:
1. The option’s exercise price is the same as the underlying asset’s FV at time of exercise
2. Alternative assets that are substantially equivalent to the underlying asset are readily available in
the marketplace
If both of these criteria are NOT met, the repurchase option will result in a "failed sale" and this will be
treated as a Financing transaction.
Residual Value Guarantee = A sale cannot take place if control of the asset has not transferred to the
buyer. It is a qualitative judgment, but the more significant the guarantee, the more unlikely it is that
control has transferred and if "no control transferred" equals to Financing transaction.
Sale-Leaseback - Sales Criteria Met
If the criteria are met for a sale, each party must Determine whether the transaction is at FV. To make
that determination, 2 steps are needed:
Step 1: Choose between “Asset sale price and FV” and “PV of lease payments and PV of market rental
payments” , whichever is more readily determinable.
Step 2: Of the one that is more determinable, identify the Difference between the two data points. If a
difference exists, this will require an adjustment to either the sales price or the purchase price.
Increase in sales or purchase price = treated as Prepaid rent via an adjustment to the ROU asset in the
leaseback.
Decrease in sales or purchase price = treated as additional financing provided by the buyer-lessor to
the seller-lessee
Example = Company A sells an equipment to Company B for $490K. The FV of the asset is $470K, the
purchase price is $500K and its NBV is $415K ($85K Acc. Depreciation). Company B agrees to lease
back the equipment to Company A. If the criteria for Sale are met, then we do record the following JE
for the Seller:
Debit Cash $490K
Debit A/D-Equipment $85K
Credit Equipment $500K
Credit Financing Liability $20K ($490K selling price - $470K FV)
Credit Gain $20K
"Failed Sale" = Example: same facts as above = Selling price $490K and the lease-back terms are 10
years and 4.75% interest rate. Thus, for the seller and the lessee in the lease-back contract we record
the JE:
Debit Cash $490K
Credit Financing Liability $490K
Also, we record Interest expense and depreciation:
Debit Interest Expense $23,275 ($490K x 4.75%)
Credit Financing Liability $23,275
Debit Depreciation Expense $41,500($415K/10)
Credit A/D $41,500
M2 - Leases: Part 2
Lessee Accounting
Operating Leases (Capital) = No OWNES
--Report ROU Asset and lease liability in the B/S and both will be amortized using effective interest
method.
--On the I/S Lease expense will be recognized each year using SL method.
--JE for Operating Lease: Capitalize the Lease by debiting ROU Asset and Crediting Lease Liability.
JE to record one payment for an operating lease:
Facts:
1. Monthly lease payments of $18K
2. The PV for 3-year lease at 5.75% is $48,338 ($18K x 2.685424).
The interest expense for the 1st period would be $2,779 ($48,338 x 5.75%)
Thus, the amortization expense is $15,221 ($18K - $2,779, the interest)
JE is as follows:
Debit Lease Expense $18,000
Debit Lease Liability $15,221
Credit Acc. Amortization - ROU $15,221
Credit Cash $18,000
Finance Leases (Capital) = OWNES
ROU Asset = PV lease payments owed + initial direct costs (commissions paid, legal & consulting fees) -
incentives received by the lessee
JEs for Finance Lease by the lessee using the example above in yellow:
Initially record Debit ROU Asset $48,338 and Credit Lease Liability $48,338
Subsequent JEs:
Debit Interest Expense $2,779
Debit Lease Liability $15,221
Credit Cash/Lease Payable $18,000
Debit Depreciation Expense $16,113 ($48,338 / 3 (it is a 3-year lease term)
Credit Acc. Amortization -ROU Asset $16,113
Differences btw Finance and Operating Leases:
Finance Lease = in the early years of the lease, expense recognition is front-loaded as interest expense,
plus the amortization expense will create a higher total expense than under the Operating Lease.
Accounting Policy Election = Lessees can Choose to not recognize ROU assets and lease liabilities for
leases with terms of 12 months or less.
Residual Value guaranteed by a 3-rd party is NOT included in Lessee's PV Calculation.
Lessor Accounting
Sales-Type Lease = Lessee gains control of the underlying asset and the Lessor derecognizes the asset
and recognizes a net investment in the lease, as well as profit or loss.
If there are any direct costs incurred as part of the lease, expense the direct costs at the
commencement date.
Example: Facts: A lease for $5,000 a year; initial direct cost of $450; implicit rate of 6%; the NBV of the
asset is $22,000 and its FV is 24,216. The asset also has a residual value of $8,700.
JE at commencement:
Debit Lease Expense $450
Debit Residual Asset $6,891 (PV of $8,700 at 6% and 4-year lease)
Debit Lease Receivable $17,325 (PV of $5,000 yearly payments for 4 years at 6%)
Credit Cash $450
Credit NBV of Asset $22,000
Credit Gain $2,216
Direct Financing Lease = Lessee does not gain control and the Lessor derecognizes the asset and
recognizes a net investment in the lease.
Any gain will be deferred and amortized. Also, the initial direct costs incurred as part of the
lease, will be deferred and amortized, which means we will include them in the Lease
Receivable.
Example = same facts as the above example for the Sales-type lease, except the NBV and FV of the
underlying asset are $24,216.
Lease Inception:
Debit Residual Asset $6,891
Debit Lease Receivable (to include the direct cost of $450) $17,775 (PV of $17,325 + $450)
Credit Asset $24,216
Credit Cash $450
First Payment:
Debit Cash $5,000 (yearly payments)
Credit Interest Income $1,480 (6% x the sum of the PV of the lease of $17,775 + the PV of the
residual asset of $6,891)
Credit Lease Receivable $3,520
Operating Lease = Lessor will keep the asset on its B/S, depreciating it and recognizing any
impairment. Lessor does NOT report Interest Income; the payment received is all Rental Revenue.
Lease Income will be recognized on a straight-line basis and Initial direct co sts will be deferred and
amortized over the lease term.
JE at the lease inception:
Debit Lease Receivable (NO PV, just total payments over the term of the lease)
Credit Unearned Rental Income
JEs to record subsequent lease payments:
Debit Cash and Credit Rental Income
Debit Depreciation Expense and Credit Acc. Depreciation
Financial Statement Presentation
Balance Sheet = ROU Assets may either be Recognized as separate line items or included with other
assets/liabilities and disclosed separately.
The portion of the lease liability due within a year should be reported in the current section.
Finance and operating lease ROU assets and lease liabilities cannot be presented together.
Finance Lease:
ROU Asset = amortize over the underlying asset's useful life if Ownership & Written option criteria are
met. Amortize over the shorter of the lease term or the useful life of the asset if Net PV, Economic life,
or Specialized Asset criteria are met.
Income Statement
1. Operating Leases = Lease expense will be included in Income from continuing operations
2. Finance leases = The I/S will include the Amortization of the ROU Asset and portion of the lease
expense related to interest
Cash Flow Statement
Operating Leases = Lease payments are classified as payments from Operations. Any payments needed
to bring the asset to a better condition are considered Investing Activities.
Finance Leases = the principal portion of the lease payment is a cash flow from Financing and the
Interest portion of the lease payment is a cash flow from operations. Any variable lease payments and
ST lease payments not included in the lease payments are classified as cash flows from operations.
Disclosures
Lessee Disclosures:
Qualitative:
--Nature of the leases (covenants and restrictions)
--Options to extend or terminate
--Residual value guarantees, Information on leases that have not commenced
--Significant assumptions and judgments
--Sale-leaseback terms and conditions
--Entity’s accounting policy related to ST Leases and combination of lease & non-lease components
Quantitative:
--Finance lease costs
--Operating lease costs
--Short-term lease costs
--Weighted average remaining lease term and discount rate
--Separate maturity analyses for operating and finance lease liabilities for five years
Lessor Disclosures:
Qualitative:
--Description of the lease
--Existence and terms/conditions of options to extend or terminate the lease
--Options for the lessee to purchase the leased asset
--Significant assumptions and judgments, incl. whether the contract contains a lease
--Related party leases
--Accounting policies on lessor accounting
Quantitative:
--Profit or Loss recognized at commencement day
--Interest income
--Income related to operating lease payments received
--Income from variable lease payments
--Components of the net investment in sales-type and direct financing lease
--Information on assets that are subject to operating leases
--Separate maturity analysis of lease receivables
M3 - Derivatives and Hedge Accounting
Derivative Instrument = Derives its value from the value of some other instrument and has all of the
following characteristics:
--One or more underlyings AND one or more notional amounts (emphasis on AND)
--Requires no initial net investment or one that is smaller than would be required
--Settled for cash or by delivery of an asset
Underlying = is a specified price, rate or other variable (e.g. Interest rate, Price
per share, security or commodity price, foreign exchange rate)
Notional Amount = Specified Unit of measure (e.g. currency, share, bushels)
Value or Settlement Amount = Notional amount x the underlying (for example,
shares of stock times the price per share)
Forward Rate = is the exchange rate existing at the present time for exchanging 2 currencies at a
specified future date.
Payment Provision = determinable settlement that is to be made if the underlying behaves in a
specified way
Hedging = is the use of a derivative to offset anticipated losses or to reduce earnings volatility. When a
hedge is effective, the changes in the value of the derivative offsets the changes in value of a hedged
item or the cash flows of the hedged item.
Common Derivatives:
Option Contract = a contract btw 2 parties that gives one party the right, but NOT the obligation, to
buy or sell something to the other party at a specified price. The option buyer (the holder) must pay a
premium to the option seller (the writer) to enter into the option contract. A call option gives the holder
the right to buy from the option writer at a specified price during a specified period of time. A put
option gives the holder the right to sell to the option writer at a specified price during a specified
period of time.
Buyer of a Call Option = Buyer will purchase the stock at a specified price and time = Buyer will benefit
if the stock price goes UP.
Seller in a Call Option = Seller receives the premium paid from the Buyer of the option and also,
receives the Purchase price of the stock from the buyer if the option is exercised. Benefits if the stock
price goes down, because then the Buyer won't exercise the option and the Seller will profit from the
received premium.
Buyer of a Put Option = Buyer of the option will pay a premium and sell the option at a specified price
and time. Benefits if the stock price goes down.
Future Contracts = one party takes a long position, meaning it agrees to buy a particular item, while the
other party takes a short position, meaning it agrees to sell that item. Unlike the Options, Future
Contracts obligate the parties to perform according to the terms. Future Contracts are made through
clearinghouses and have standard notional amounts and settlement dates.
Forward Contract = Similar to futures contracts, except that they are privately negotiated. They do not
have standardized notional amounts or settlement dates.
Most Forward Contracts are settled through a cash settlement, but they also can be settled by
physically delivering the underlying asset!
Swap Contract = A private agreement btw 2 parties, generally assisted by an intermediary, to exchange
future cash payments. Examples: interest rate swaps; currency swaps; equity swaps; commodity
swaps. A swap agreement is equivalent to a series of forward contracts.
Example of Interest Swap = Company A has a loan with fixed interest rate payments. Makes a swap with
Company B that has a loan with a variable interest rate. Thus, Company A pays to Company B the
amount of its loan payment at fixed rate and at the same time receives a payment from Company B the
payment they owe at the variable rate.
Interest Rate Swap = Cash Flow Hedge when future interest payments (cash
outflows) will increase as interest rates increase.
Derivative Risks:
1. Market Risk = A risk that the entity will incur a loss on the derivative contract. Derivatives are a "zero
sum games". Every derivative has a loser and a winner.
2. Credit Risk = A risk that the other party to the derivative contract won't perform according to the
terms of the contract.
3. Liquidity Risk = the risk that a party to a derivative transaction cannot unwind the position in a timely
manner. It is one of the primary risks for a derivative.
4. Volatility Risk = NOT a Primary Risk associated with a derivative. In fact, derivatives are used to
reduce such risk or to offset anticipated losses.
Perfect Hedge = results in neither gains nor losses. In a perfect hedge, the gain or loss on the
derivative instrument exactly offsets the loss or gain on the item or transaction being hedged.
Accounting for Derivative Instruments including Hedges
Balance Sheet:
--All derivatives are recognized as either assets or liabilities. (if winner-Asset and if loser-Liability)
--All Derivatives are measured at FV!
--All Derivatives are presented at Gross FV (NOT net FV)!
Reporting Gains and Losses:
Derivative instruments NOT designated as a hedging = Just Speculation = G/L are reported on I/S,
similar to trading securities
FV Hedge = Instrument designated as a Hedge of the exposure to changes in the FV of a recognized
asset or liability or of an unrecognized firm commitment. G/L are reported on I/S in the same period.
The Derivative is expected to be highly effective in offsetting the FV change of the hedged item.
Cash Flow Hedge = Instrument designated as hedging the exposure to variability in expected future
cash flows attributed to a particular risk. G/L on the ineffective portion are reported on I/S. G/L on the
effective portion are reported in OCI.
Foreign Currency Hedge = AR denominated in foreign currency = risk FC decreases. AP denominated in
foreign currency = risk FC increases.
Foreign Currency FV Hedge = G/L are reported in Earnings.
Foreign Currency CF Hedge = G/L of the Effective Portion are reported in OCI. G/L of the Ineffective
Portion are reported in Earnings.
Foreign Currency Net Investment Hedge = G/L are reported in OCI as part of the cumulative translation
adjustment for the effective portion and current income for the ineffective portion.
Reporting Cash Flows:
Cash Flows from Derivatives with No hedging designation should be accounted for in Investing
Activities, UNLESS the Derivative is held for trading purposes, then the cash flows are accounted in
Operating activities.
Derivatives held as a Hedging = Cash Flows accounted in the Same category as the item being hedged
Derivative with significant financing element at transaction inception = cash flows from it would be
reported under the financing section of the CF stmt.
Derivative Disclosures
--Entity’s objectives
--Primary underlying risk exposure
--Volume of the company’s derivative activity
--Location and FV on gross basis of derivative instruments reported on the BS. The FV of assets &
liabilities are reported separately.
--Location and amount of G/L on I/S and in OCI
M4 - Foreign Currency Accounting
Foreign Currency Transactions = Transactions with a foreign entity denominated in a foreign currency
Foreign Currency Translation = Conversion of FSs of a foreign entity into FSs expressed in the domestic
currency
Exchange Rate = the price of one unit of a currency expressed in units of another currency
Direct Method = the domestic price of one unit of another currency. For example, one euro costs
$1.47. For a retailer in Great Britain, the direct method quote will be 1 US Dollar = 0.63 British pounds.
Example = From the perspective of an European company, Direct method quote is 1 US$ expressed in
terms of Euros. 1 US$ = 0.89 EU
Indirect Method = the foreign price of one unit of another currency. For example, 0.68 euro buys $1.00.
Example = From the perspective of an European Company, Indirect method quote is 1 Euro expressed
in terms of US $. 1 EU = 1.27 US$
Historic Exchange rate = the rate in effect at the date of issuance of a stock or acquisition of assets
WA Rate = takes into effect the fluctuations of the exchange rate within a period. (Example = Sales)
Reporting Currency = is the currency of the entity ultimately reporting financial results of the foreign
entity.
Functional Currency = is the currency of the primary economic environment in which the entity
operates, usually the local currency or the reporting currency.
Foreign Currency Translation = is the restatement of FSs from the functional currency (if sub has
functional currency) to the reporting currency
Foreign Currency Re-measurement = is the restatement of foreign FSs from the foreign currency to the
entity's functional currency in the following situations:
1. The reporting currency is the functional currency
2. The FSs must be restated in the entity's functional currency prior to translating the FSs from
functional currency to the reporting currency
Monetary Items = Assets and Liabilities that are fixed or denominated in dollars (e.g. cash, A/R +
allowance, LT Receivables, Non-convertible Bonds, A/P, Accrued Expenses, Bond Payable)
Non-monetary items = Assets and Liabilities that fluctuate in value with inflation and deflation (e.g., a
building, marketable common stock, inventory, investment in a subsidiary (equity), Intangible assets,
Deferred charges & Credits, Preferred stock, Common stock)
Foreign FS Translation = before a parent company can consolidate the FSs of a foreign subsidiary, the
subsidiary's FC FSs must be restated in the parent's reporting currency. (from functional currency to
reporting currency)
Steps in restating foreign FSs:
Step 1: Prepare in Accordance with GAAP/IFRS (Is Sub using same GAAP as Parent?)
Step 2: Determine the Functional Currency. Under US GAAP, the entity's local currency qualifies as the
functional currency if it is the currency of the primary economic environment in which the company
operates, and all of the following conditions exist:
--The foreign operations are self-contained and integrated within the country
--The day-to-day operations do not depend on the parent's functional currency
--The local economy of the foreign entity is NOT highly inflationary, which is defined as cumulative
inflation of 100% over 3 years.
Step 3: Determine Appropriate Exchange Rates = The functional currency of the foreign entity
determines the exchange rates
Step 4: Re-measurement and/or Translate the FSs
1. Parent Company = The Reporting currency is the Functional currency:
--The reporting currency is the functional currency and the RE-MEASUREMENT method must be used
when: a) The Foreign Sub is highly integrated with the Parent and serves as a sales outlet for the
Parent; b) Day-to-day operations depend on the reporting currency and c) the Foreign Sub operates
in a highly inflationary economy.
2. Parent Company = Reporting Currency:
--The foreign currency = the functional currency and the TRANSLATION method must be used when:
a) the Foreign Sub is relatively self-contained and independent and operates primarily in local
markets and b) The day-to-day operations do NOT depend on the reporting currency.
3. Parent Company = Reporting Currency:
--When the Functional Currency of the Sub differs from both the Sub's Local Currency and the
Reporting Currency, the Sub's FSs must first be RE-MEASURED from the LC to FC, and then must be
TRANSLATED from the FC to the Reporting Currency.
Re-Measurement method (Temporal Method) = Convert Foreign Sub's FSs from foreign currency to
Functional currency.
Steps to take when Re-Measure:
Step 1: Start with Balance sheet:
Monetary Items = Year-End rate
Non-monetary items = Historical rate
Step 2: Income Statement:
Non-balance sheet related Items = WA rate
Balance sheet related accounts = Historical (Depreciation, COGS, Amortization)
Step 3: Subtract (L+E) from Assets to get the amount for the R/E. Then, subtract the net Income from
the R/E to get the G/L. (see TBS in Review)
Translation Method (Current Rate Method) = Convert the FSs of the foreign sub's Functional currency
to the Reporting currency.
Steps to take to Translate:
Step 1: Start with Income statement:
All I/S items = WA rate
Step 2: Balance Sheet:
Assets = Current/YE Rate
Liabilities = Current/YE Rate
Common Stock/APIC = Historical Rate
R/E = Roll Forward
Step 3: The calculated NI gets added to the R/E. Then, we subtract the Assets from L & E and the
difference is the G/L that is recorded in AOCI.
Individual Foreign Transactions = FC transactions G/L occur when a company buys from or sells to a
foreign company and agrees to pay or accept a payment in FC.
Types of FC Transactions:
--Changes in Exchange Rate = Adjust to current exchange rate and recognize G/L in I/S
--Transaction not settled at B/S date = Adjust the FC balances to the current "spot" rate and G/L is
recognized in the current I/S.
Example: Company A purchased goods on credit for 100,000 pesos on 12/01/Y1.
Rates: 12/01/Y1 $0.10
12/31/Y1 $0.08
JE to record the purchase on credit: Debit Inventory $10K and Credit A/P $10K
JE to adjust the A/P on 12/31/Y1: Debit A/P $2K and Credit FC Transaction Gain $2K
--Valuation of Assets and Liabilities = Historical rate = The Assets/Liabilities resulting from FC
transactions s/b recorded in the US company's books using the exchange rate in effect at the date of the
transaction.
Unrealized G/L are actually Recognized G/L on the PnL.
M5 - Income Taxes: Part 1
Intra-period Tax Allocation = Within this year’s income statement
This allocation involves apportioning the total tax provision btw the income or loss from:
--Income from continuing operations
--Income from discontinued operations
--Accounting principal change (retrospective)
--OCI (PUFIE)
--Components of stockholders' equity (R/E for prior period adjustments retrospective accounting
principal changes and items of AOCI)
Comprehensive Inter-period Tax Allocation = the objective here is to recognize through matching
principle the amount of current and future tax related to events that have been recognized in the
financial accounting income.
The primary objective of accounting for income taxes = to recognize the amount of deferred tax
liabilities and deferred tax assets reported for future tax consequences.
Current Year Tax = Payable (liability) or Refundable (Asset)
OR
Future Year Taxes = Deferred tax asset or deferred tax liability
Permanent Differences = They ONLY affect the current tax computation. They DO NOT affect the
deferred tax computation.
Temporary Differences = They affect current & deferred taxes
Comprehensive Allocation = The asset & Liability method (referred to as Balance Sheet method) is
required by GAAP for comprehensive allocation.
Accounting for Inter-period Tax Allocation
--Current income tax expense/benefit = income tax payable or refundable for the current year as
determined on the corporate income tax return
--Deferred income tax expense/benefit = change in deferred tax liability or asset account on the B/S
Permanent Differences = Only affect Current Taxes and Not deferred taxes
A permanent difference is a transaction that affects only income per books or taxable income, but not
both. Examples
--Tax-exempt interest
--Life insurance proceeds on officer’s key man policy
--Life insurance premiums (payments) when corporation is the beneficiary
--Certain penalties, fines, bribes, kickbacks, etc
--Nondeductible portion of meal and entertainment expense
--Tax-free Investment
--Charitable Contributions
---Lobbying/political expense
--Federal Income taxes
--Dividends-received deduction for corporations (50% of Dividend received is not taxable
permanently)
--Excess percentage depletion over cost depletion
Goodwill Impairment vs. Amortization = Temporary Difference
NOTE: when the differences btw taxable income and income per FSs is caused by solely Permanent
Differences, the tax expense = tax liability amount and NO deferred taxes!
Temporary Differences = Cause deferred taxes
Transactions that Cause Temporary Differences:
Deferred Tax Asset= More Actual Taxes paid now and Less Taxes owed in the future!
Deferred Tax Liability = Less Actual Taxes Paid now and More Taxes owed in the future!
Deferred Tax Asset & Deferred Tax Liability are NON-Current balances and MUST be NETTED and
presented as one amount (unless they belong to different business components)
1. Income reported on FSs, but NOT taxed yet = Deferred tax liability
1. Installment sales(Report 100% sale on FSs, but on tax return only %)
2. %-completion vs. completed contracts
3. Equity method (undistributed dividends)
2. Expenses reported on FSs, but NOT on the return yet = Deferred Tax Asset
1. Bad Debt Expense (Allowance for Doubtful accounts Balance is reversed for tax purposes and the
Direct Write-off method is used).
2. Warranty expenses
3. Start-up expenses
3. Income reported on the tax return, but NOT yet on the FSs = Deferred Tax Asset
 1. Prepaid Rent (unearned)
2. Prepaid Interest (unearned)
3. Prepaid Royalties (unearned)
4. Expenses reported on the tax return, but NOT yet on the FSs = Deferred Tax Liability
1.Depreciation Expense
2. Amortization of franchise
3. Prepaid expense (cash basis for tax)
The Accrual Method of accounting DOES NOT create Temporary Differences!
Deferred Tax Liabilities = occurs in situations in which future taxable income is greater than the FSs
income. Example = FSs show Profit of $225K, but the tax return shows $200K Profit. The difference is
Temporary = Depreciation of $25K extra on tax basis. Tax rate is 21% and the current tax return expense
is $42K, but the FS tax is 47,250. Thus, we record the following JE:
Debit income Tax Expense-current $42K
Debit Tax Expense-deferred $5,250
Credit Deferred Tax Liability $5,250
Credit Tax Payable $42K
Deferred Tax Asset = situations in which the taxes paid in the current period exceed the amount of
income tax expense in the current period.
We do consider the 80% loss limitation when calculating DTA and we estimate the following year's
taxable income will be the last taxable income (after that there will be losses).
Valuation Account (Contra-Account to Deferred Tax Asset) = we use it when it is more likely than not (a
likelihood of more than 50%) that part or all of the deferred tax asset will not be realized. The change in
the opening balance of a Valuation Allowance account is recognized in income from continuing
operations in the period of change.
Example for Deferred Tax Asset = FS Profit is $500K (to include $300K warranty expenses), but the Tax
return profit is $800K. Tax rate is 21% and thus the tax return tax is $168,000 ($800K x 21%) and FS tax is
$105,000 ($500K x 21%). The JE is as follows:
Debit Income tax expense-current $168K
Income tax liability $168K
Debit Deferred Tax Asset $63K
Credit Income Tax Benefit-deferred $63K
NOTE: DO NOT forget to add/subtract back the Permanent Differences from the FS's Income first, in
order to get to the taxable Income, because on tax basis and FS basis, no tax is calculated! Then,
consider temporary differences.
NOTE: In the final year of depreciation, the difference btw the tax basis and the FS basis of
depreciation needs to be eliminated and thus the Deferred tax liability will be also eliminated. Think of
what the tax rate for the current and previous years was to come up with the YTD balance of the
deferred liability and Debit that Liability in the year of final depreciation on the FSs.
When Future Taxable or Deductible amounts are stated, but we are also given beginning balances for
DTA and DTL, the current amounts calculated for DTA and DTL get reduces by the beginning balances.
M6 - Income Taxes: Part 2
Uncertain Tax Positions = Two-Step Approach
Step 1: Recognition of the Tax Benefit: Would you win > 50%?
“More likely than not” - must be met to recognize tax benefit
Threshold Considerations = Each tax position evaluated separately
Test Failed = < 50% chance of winning = tax expense increases
Step 2: Measurement of the Tax Benefit: Even if you win → by how much?
 Recognize largest amount of tax benefit with > 50% chance being realized upon ultimate
settlement of the taxing authority
Example = Company A has taken a deduction for $2,000 that resulted in a $420 tax savings (21% tax
rate). Company A believes that if challenged through an audit, the tax deduction would be sustained
(the more-likely-than-not test is met), but if challenged, it would negotiate a settlement. Thus, its
assessment determines that $300 (out of $420 tax savings) would be the more than 50% likelihood.
Company A needs to make an adjustment and recognize a $120 (420-300) tax liability.
Enacted Tax Rate = Used for deferred taxes = it is the tax expected to apply to taxable items (temporary
differences) in the periods the taxable item is expected to be paid (liability) or realized (asset).
DO NOT use the following tax rates: Anticipated; Proposed; Unsigned (it is a trick by the examiners)
Treatment of and Adjustment for Changes
Changes in Tax Laws or Rates = the liability method requires that the deferred tax account balance
(asset or liability) be adjusted when the tax rates change. If the future tax rates have been enacted (not
just proposed or estimated), the deferred tax liability and asset accounts will be calculated using the
enacted future effective tax rates.
Changes in tax laws or rates are recognized in the period of change (enactment)
The amount of the adjustment is measured by the change in applicable laws/rates applied to the
remaining cumulative temporary differences.
Change in Tax Status of an Enterprise
1. Becomes taxable entity from non-taxable = DTL/DTA recognized for any temporary differences
2. Becomes nontaxable entity from taxable = DTL/DTA eliminated (written off). The effect from the
elimination should be recognized in Income from Continuing Operations in the period of change.
Net Temporary Adjustment (from Beginning Balance)
Example = Company A had a beginning balance in DTL of $2,000 ($10,000 temporary difference x 20%
enacted tax rate at the time). Current year temporary difference is a $20,000 depreciation difference
and the enacted future tax is 21%. Calculations: Total difference is $30,000 ($10K beg. + $20K current) x
21%-new enacted tax = $6,300, which should be the ending DTL balance. Thus, in order to determine
our tax expense adjustment, we subtract $2,000-the beginning balance of the DTL from the Newly found
ending balance of $6,300 to get the Deferred income tax expense adjustment. JE is as follows:
Debit Income tax Expense - Deferred $4,300
Credit DTL $4,300
Operating Losses = Creates a deferred tax benefit (DTA)
NOLs arising in 2018, 2019, 2020 can be carried back 5 years and carried forward indefinitely, and they
are NOT subject to a taxable income limitation.
NOLs arising in 2021 or later = carried forward indefinitely, but there is a taxable income 80%
limitation before the NOL deduction.
NOL Carrybacks = Refund = If carried back to a year before 2018 when the tax rate was 35%, tax
receivable should be measured at the 35%.
Operating Loss Carryforwards = Valuation account/Contra account to DTA is used = The "more likely
than not to be realized" method is used to recognized the tax effect. We record the tax benefit NOT
EXPECTED to be used under "Valuation Allowance". Example = Total DTA calculated is $7,350 (NOL
carryforward of $35,000 x 21% tax rate), but we determined that maximum income to be reported in the
near future will be only $10K, or DTA should be only $2,100 ($10,000 x 21%). Thus, we offset the total
DTA of $7,350 via the Valuation account for the difference of $5,250 ($7,350 - $2,100).
Dividends-Received deduction for the investees based on their ownership investment %.
Ownership 0-19% = 50% Exclusion
Ownership 20-80% = 65% Exclusion
Ownership over 80% = 100% Exclusion
Dividends-Received Deduction is a Permanent Difference!
Example = Investee with a 25% ownership (According to GAAP, equity method is used and thus income
is reported in I/S and NOT Dividends received) reports $600,000 income from the investment for income
stmt purposes and $500,000 in dividends received for tax purposes.
Tax Return Income Statement
Dividends Received $500,000 Income/Equity in Earnings $600,000)
65% DRD ($325,000) ($500K x 65%) 65% DRD ($390,000) ($600K x 65%)
Taxable Income $175,000 Taxable Income $210,000
Tax Rate x 21% Tax Rate x 21%
Tax Expense $36,750 Tax Expense $44,100
The difference of $7,350 ($44,100-$36,750) is the deferred portion.
JEs to record the above:
Debit Income tax expense-current $36,750
Debit Income Tax expense-deferred $7,350
Credit Tax Liability $36,750
Credit DTL $7,350
Income Tax Disclosures
DO NOT disclose Permanent Differences
1. Balance Sheet
--All DTL, DTA
--Valuation allowance
-- Net change for valuation allowance
--Tax effect of each type of temporary differences
--The nature and amount of each type of NOL and tax credit carryforward
2. Income Statement
--Current tax expense or benefit
--Deferred tax expense or benefit
--Investment tax credits
--Government grants
--Benefits of NOL carryforwards
When preparing interim FSs, income tax expense is estimated each quarter using the effective tax rate
expected to apply to the entire year (NOT the statutory tax rate, which is 21% currently).
The tax rate used to compute the DTA and DTL should be the enacted tax rate for the year the
temporary difference is expected to reverse.
F7 - Equity, EPS, and Cash Flows
M1 - Stockholders’ Equity: Part 1
Capital Stock (Legal Capital) = this is the amount of the Capital that must be retained by the corporation
for the protection of creditors. The par or stated value of both preferred and common stock is legal
capital and is frequently referred to as "Capital" Stock.
Par Value = In general, Preferred stock is issued with a par value, but Common Stock may be issued
with or without a par value. No-par common stock may be issued as true no-par stock or no-par stock
with a stated value.
Authorized, Issued, and Outstanding:
Authorized Capital Stock = the amounts of stock a company may legally issue
Issued Capital Stock = authorized capital stock that is issued
Outstanding Capital Stock = Issued capital stock less the treasury stock the corporation purchased back
from shareholders
The number of shares of each class of stock authorized, issued, and outstanding must be disclosed.
Common Stock = basic ownership interest in a corporation. Common shareholders bear the ultimate
risk of loss and receive the ultimate benefits of success, but they are not guaranteed assets or
dividends upon dissolution. Common shareholders generally control management and they the right
to vote, the right to share in earnings, and the right to share in assets upon liquidation after claims of
creditors and preferred shareholders. Common shareholders may have "Preemptive Rights" to a
proportionate share of any additional common stock issued.
Book Value per Common Share = Common Share Earnings
Common Shares Outstanding
Common Stockholders' Equity Formula =
Total Shareholders' Equity (A +L)
- Preferred Stock outstanding (at greater of call price or par value)
- Cumulative Preferred Dividends in Arrears
= Common Shareholders' Equity
Preferred Stock = Equity Security with preferences. It may include a preference relating to dividends,
which could be cumulative or non-cumulative and participating or non-participating. Usually Preferred
stock does not have voting right.
Cumulative Preferred Stock = all or part of the preferred dividend not paid in any year accumulates and
must be paid in the future before dividends can be paid to common shareholders. The accumulated
amount = dividends in arrears. The amount in dividends in arrears is NOT a Liability (legal), but it must
be disclosed on the B/S or in the footnotes.
Non-cumulative Preferred Stock = dividends not paid in any years DO NOT accumulate.
Participating Preferred Stock = preferred shareholders participate in excess dividends without limit.
Generally, preferred shareholders receive their preference dividend first, and then additional dividends
are shared btw common and preferred shareholders.
Example of Cumulative Participating P/S = Company A issued 100,000 shares of $5 par C/S and 25,000
of $10 par fully participating 8% cumulative P/S. No dividends were paid in Y1. Cash dividends of
$101,000 were declared and paid in Y2.
Cash dividends $101,000
Y1 preferred dividends in arrears ($20,000) = $25,000 x $10 x 8%
Preferred Dividends accumulated in Y2 ($20,000)
$61,000
Common Stock (100,000 x $5) x 8% ($40,000) 8% used here because the % is shared equally
Remaining for proration btw P/S & C/S $21,000 = Share pro rata
Proration: we have a total of 750,000 total par value (250,000 P/S and 500,000 C/S)
1. P/S = 250,000 / 750,000 x $21,000 = $7,000
2. C/S = 500,000/ 750,000 x $21,000 = $14,000
Total Dividends Schedule:
P/S $7,000 + $20,000 + $20,000 = $47,000
C/S $14,000 + $40,000 = $57,000
Total cash dividends distributed = $101,000
Non-participating Preferred Stock = No share in Excess dividends.
Preference upon liquidation = If the liquidation preference is significantly greater than the par or stated
value, the liquidation preference must be disclosed.
Convertible Preferred Stock =may be exchanged for common stock (at the option of the stockholder).
Callable (Redeemable) Preferred Stock = may be called (repurchased) at a specified price (at the option
of the issuing corporation). Must be disclosed either on the B/S or in the footnotes.
Mandatorily Redeemable Preferred Stock (Liability) = it is issued with a maturity date. Similarly to
debt, it must be bought back by the company on the maturity date.
Additional Paid-In Capital (APIC) = it is usually contributed capital in excess of par or stated value.
however, it could also arise from the following:
---Sale of Treasury Stock at a gain
---Liquidating Dividends
---Conversion of Bonds
---Small Stock Dividends
Retained Earnings (R/E) = accumulated earnings (or losses) during the life of the corporation that have
not been paid out as dividends. R/E is reduced by distributions to stockholders and transfers to APIC for
stock dividends.
Formula for R/E = Net Income/Loss
- Dividends (cash, property, and stock) declared
+/- Prior Period Adjustments (Corrections of Errors)
+/- Accounting changes reported retrospectively
Retained Earnings
Dividends declared/paid reduce the R/E. Example = Property dividends of Inventory , but report the
dividends at the FMV of the Inventory, NOT the CV of the Inventory!!!
Stock Dividend = Increase the C/S and reduce the R/E. Example = Current C/S at 500,000 shares at $1
par and a 10% stock dividend is issued. Thus, debit R/E $50,000 (500,000 x $1 x 10%) and credit C/S.
Classification of R/E (Appropriations)/Restricted = objective of appropriation/restriction is to disclose
to shareholders that some of the R/E are not available to pay dividends because they have been
restricted for legal or contractual reasons or as a discretionary act of management for specific
contingency purposes. NOTE: If an MCQ states the company has $2M of cash restricted for the
retirement of bonds, that is NOT "appropriation of R/E", unless the MCQ strictly mentions it. It is
actually "sinking fund cash", which reduces regular cash and does not affect R/E.
Treasury Stock (T/S) = is a corporation's own stock that has been issued to shareholders and
subsequently reacquired (but not retired). Treasury shareholders are not entitled to any of the rights of
ownership given to common shareholders, such as voting rights or dividends.
NOTE: Treasury stock reduces total stockholders' equity!!!
Methods of accounting for Treasury stock = Cost and legal (par/state value)
Par Value Method will report LOWER amount of APIC and the same amount for R/E compared to cost
method.
Cost Method = used 95% of the time
--The Treasury shares are recorded and carried at their reacquisition costs.
--A gain/Loss will be determined when Treasury stock is reissued or retired.
--APIC from T/S is credited/debited for G/L when T/S is reissued at prices that differ from the
reacquisition cost.
--Losses may also decrease R/E if the APIC from T/S account does not have a balance large enough to
absorb the loss.
--Net Income or R/E will never be increased through T/S transactions.
Example of Cost Method:
Original Issue = 10,000 shares $10 par value C/S sold for $15 per share
Debit Cash $150,000
Credit C/S (10,000 x $10) $100,000
Credit APIC-C/S $50,000
Buy Back above issue price = 200 shares were repurchased for $20/per share, which becomes T/S's cost
Debit T/S $4,000 (200 shares x $20)
 Credit cash $4,000
Reissue above cost = 100 shares repurchased for $20 (Cost) were resold for $22/per share
Debit Cash $2,200 (100 shares x $22)
Credit T/S $2,000 (100 shares x $200, the Cost)
APIC-T/S $200
Reissuance below the Cost = 100 shares repurchased for $20 were resold for $13/per share
Debit Cash $1,300 (100 shares x $13)
Credit T/S $2,000 (100 shares x $20, the Cost)
Debit APIC-T/S $200 (Use the APIC-T/S gain generated from the previous sale)
Debit R/E $500 (Plug the loss to R/E)
Legal (or Par/Stated Value) Method = used 5% of the time
--The Treasury shares are recorded by reducing the amounts of par value and APIC received at the time
of the original sale
---T/S is debited for its par value and APIC-C/S is debited (reduced) for the pro rata share of the original
issue price attributable to the reacquired shares, and APIC-T/S is credited/debited for G/L when the T/S
is repurchased at price that differs from the original selling price.
Example for Par value Method:
Original Issue = 10,000 shares at $10 par value C/S sold for $15/per share
Debit Cash $150,000
Credit C/S (10,000 x $10 par) $100,000
Credit APIC-C/S $50,000 (10,000 x $5/per share)
Buy back above issue price = 200 shares were repurchased for $20 per share
Debit T/S $2,000 (200 shares x $10, the par)
Debit APIC-C/S $1,000 (200 shares x $5/per share)
Debit R/E $1,000 (Loss)
Credit Cash $4,000
Buy Back below issue price = 200 shares repurchased for $12 per share
Debit T/S $2,000 (200 shares x $10 per)
Debit APIC-C/S $1,000 (200 shares x $5) To reverse the Gain sitting in APIC-C/S
Credit Cash $2,400
Credit APIC-T/S $600
Reissue shares = 100 shares repurchased for $20 were sold for $22/per share
Debit Cash $2,200
Credit T/S $1,000 (at par)
Credit APIC-C/S $1,200 (100 shares x $12)
Reissue Shares = 100 shares repurchased for $20 were sold for $13 per share
Debit Cash $1,300
Credit T/S $1,000 (at par)
Credit APIC-C/S $300 (100 shares x $3)

Buy-Back entity's stock Re-Sell Treasury Stock

#2 DR Treasury Stock (at par) #1 DR Cash

#2 DR APIC-C/S (at original sold APIC) #2 CR Treasury Stock (at Par)

PAR #3 DR APIC-T/S (if there is a credit balance in APIC-T/S) (if need more debits) #3 CR APIC-C/S
#3 DR R/E (to balance out the entry) (if need more debits)
#1 CR Cash
 #3 CR APIC-T/S (if need more
credits)
#2 DR Treasury Stock (at cost) #1 DR Cash
#1 CR Cash #3 DR APIC-T/S (if there is credit balance in APIC-T/S) (if need more debits)
COS
T #3 DR R/E (To balance out entry) (if need more debits)
#2 CR Treasury Stock (at cost)
#3 CR APIC-T/S (if need more credits)
NOTE: Step #3 is used to balance out the entries. Also, you can only debit APIC-T/S up to the credit balance. It is not allowed to have a debit balance.

Effect of Cost and Par Value Methods on B/S Presentation

Cost Method : Par Value Method
Common Stock at par $100,000 Common Stock at par $100,000
APIC 50,000 Less: Treasury Stock at par (2,000)
R/E 75,000 Common stock o/s at par 98,000
Less: Treasury Stock at cost (4,000) APIC 49,000
Total stockholders' equity $221,000 R/E 47,000
Total stockholders' equity $221,000
Retirement of Treasury Stock rather than reissued
Cost Method = 200 shares of $10 par C/S originally sold for $15 and reacquired for $20 are retired
Debit C/S (200x $10 par) $2000
Debit APIC-C/S (200 x $5) $1000
T/S (200 x $20-cost) $4,000
Debit R/E $1,000
Par Value Method
Debit C/S (200 x $10 par) $2,000
Credit T/S (200 x $10) $2,000
Donated Stock = at FM
Debit Donated T/S at FV
Credit APIC at FV
If donated stock is sold:
Debit Cash
Debit APIC (if SP < original FMV)
Credit Donated T/S (at original FMV)
Credit APIC (if SP > original FMV)
The donation of treasury stock by a shareholder to the company results in:
1. No change to total equity
2. The # of common stock shares outstanding declines
3. The book value per common share increases b/c the outstanding shares have decreased
M2 - Stockholders’ Equity: Part 2
Accounting for a Stock Issuance to Nonemployees
Stock Issued Above Par Value = Credit APIC for excess
Stock Issued At Par Value = No entry to APIC
Stock Issued Below Par Value = Debit APIC
Stock Subscriptions = it is a contractual agreement to sell a specified number of shares at an agreed-
upon price on credit. Upon full payment, stock certificate evidencing ownership is issued.
Sale of Subscriptions = Dr Subscription Receivable, Cr C/S subscribed and APIC. Subscriptions NOT paid
at YE are treated as a contra-equity item, offsetting the amount of par value and APIC related to
subscriptions not paid for at YE.
As soon as the subscription is received, the excess of the subscription price over the par value of the
C/S is recorded to APIC:
JE to record subscription receivable for sale of 1,000 shares @ sales price of $100/share:
Debit Subscriptions receivable (Contra-Equity account)$100,000
Credit C/S Subscribed ($10 par value x $1,000 shares) $10,000
Credit APIC (plug) $90,000
Collection of Subscriptions = Dr Cash, Cr Subscriptions Receivable
Issuance of Stock Previously Subscribed = Dr C/S subscribed and Cr C/S (issued)
Default/Forfeiture of a Subscription = The accounting treatment of it depends on the agreement.
There are 3 ways:
---Issue stock in proportion to the amount paid, or
---Refund the partial payment ,or
---Retain the partial payment by a credit to APIC
Stock Rights = provides an existing shareholder with the opportunity to buy additional shares. The right
usually carries a price below the market price. No JE until exercised, just a Memorandum entry needed.
When the right is exercised = Debit Cash; Credit C/S and Credit APIC for the difference btw par and
market price (No entry to R/E, b/c this is a "capital" transaction and NOT an "operation" transaction).
Other Stock Valuation Issues = stock issued for outside services should be recorded @ FV of the stock.
Distribution to Shareholders = Dividend = pro rata distribution
Date of Declaration = the board officially approves a dividend. Dr R/E and Cr Dividends payable
Date of Record = the date the board specifies as the date the names of the shareholders to receive the
dividend are determined. No JE
Date of Payment = Dr Dividends payable and Cr Cash
Cash Dividends = paid only on authorized, issued, and outstanding shares. They are paid on T/S.
Property (In-Kind) Dividends = Nonreciprocal transfers of nonmonetary assets from the company to the
shareholders. On the Date of Declaration, Restate property to FV and recognize G/L in I/S. Thus, when
a property dividend is issued, R/E will be debited at the FV of the property and also debited/credited
the Gain or the Loss generated from the difference btw CV and FV of the property.
Scrip Dividends = Notes payable where a corporation commits to paying a dividend at some later date.
Used with cash shortage. On the date of declaration, R/E is debited and N/P (instead of Dividend
Payable) is credited.
Liquidating Dividends = Dividends exceeding R/E. Such dividends should be charged first against APIC,
then against CS and PS.
Stock Dividends = they distribute additional shares of the company's own stock to its shareholders.
The shares issued as Dividends are equal to the declared % of all shares outstanding on the date of
stock dividend declared! No need of retrospective calculation of shares as we do for EPS calculations!
Small Stock Dividend (20-25%) = Less than 20-25% of the outstanding capital stock recorded at FV!
When less than 20-25% of the shares previously outstanding are distributed, the dividend is treated as
a small stock dividend b/c the issuance is not expected to affect the market price of the stock.
Example: The company has 100,000 shares at $10 par and declares a stock dividend of 5,000 shares
when the FMV is $15 per share. 5,000/100,000 = 5% = small stock dividend. JE to record the stock
dividend:
Debit R/E $75,000 (5,000 x $15)
Credit C/S $50,000 (5,000 shares x $10 par)
Credit APIC (plug) $25,000
Treatment of Large Stock Dividends (>20-25%) = Greater than 20-25% of the capital stock and is
recorded at Par Value!
It is expected to reduce the market price of the stock, similar to a stock split. Reduce R/E by par.
Example: A corporation declares a 40% stock dividend on its 1M shares w/ par $10. On the date of
declaration, the FMV of the stock was $30 per share, but WE IGNORE the FMV. The JE would be: Debit
R/E $4M (400,000 shares x $10 par) and Credit C/S $4M.
Stock Dividends on T/S = not distributed b/c T/S are not outstanding stocks.
Stock Splits = they occur when the company issues additional shares of its own stock to current
shareholders and reduces the par value per share. Total equity does no change. The # of outstanding
shares increases, and the par value is decreased. Only memo entry is needed.
Reverse Stock Splits = reduce the shares outstanding and increase the par value.
Statement of Changes in stockholders' equity = Provides specific information about changes in an
entity’s primary equity components.
M3 - Stock Compensation
Employee Stock Options
Non-compensatory Stock Options/Purchase Plans =NO Compensation Expense. No JE until employee
purchases the stock, since no compensation is recorded (which gets recorded first, before the
purchase of the stock with the Compensatory stock options). Used to raise capital or diversify
ownership among employees or officers.
Non-compensatory plan is this employee stock purchase plan that meets ALL of the following:
1. Substantially All full-time employees meeting limited employee qualifications may participate.
Excluded are officers and employees owning a specific amount of the o/s stock in the corporation.
2. Stock is offered to eligible employees equally
3. The time allowed to exercise the rights is reasonable and NO extension on the exercisable period
allowed!
4. Any discount from the market price is as reasonable as if it were given to shareholder.
Compensatory Stock Options/Purchase Plans - Record compensation expense . Compensatory stock
options and plans are valued at FV (NOT market price) of the options issued.
Option price or exercise price = Strike price at which the underlying stock could be purchased pursuant
to the option contract.
Exercise Date = Date by which the option holder must use the option to purchase the underlying stock
Fair Value of the Option = determined by an economic pricing model such as Black-Scholes method.
Grant Date = Date option is issued and FV calculated, no JE yet.
Vesting Period = Period over which the employee has to perform services in order to earn the right to
exercise the option.
Service Period = the period over which Compensation expense is recognized (the period the employee
performs the service). The service period is generally the vesting period, which is the time btw the
grant date and the vesting date.
Compensation Expense = Calculated on the grant date and is allocated over the service period, in
accordance with the matching principle. The service period is the period BEFORE the date the option
could be exercised!
The first JE with Compensatory Stock options is at the Service period date when the compensation
expense is recognized!
The amount of Compensation Expense is determined on the Grant Date and equals the stock options
at their FV on the grant date!
Compensation expense is unaffected by the expiration of the stock option.
Example = On Jan 1, Y1 Company A granted options exercisable after Dec 31, Y2 to purchase 10,000
shares of $5 C/S for $25 per share (strike price). According to an acceptable valuation model, the FV of
the option is $50,000, which is determining the compensation amount to be recorded in Y1 and Y2.
JE on "grant date", Jan 1, Y1 = NONE needed.
JEs on Dec 31, Y1 and Dec 31, Y2 (identical):
Debit Compensation Expense $25,000 ($50K x 1/2 of total compensation per the valuation model)
Credit APIC-stock options $25,000
JE on Jan 1, J3 when the option is exercised (if the market price on this date is given to us = IGNORE)
Debit Cash $250,000 (10,000 shares x $25, the price on grant day)
Debit APIC-stock option $50,000 (we are reversing the entry to APIC from the compensation JEs)
Credit C/S (10,000 shares x $5 par) $50,000
Credit APIC $250,000
Stock Options Outstanding (sitting in the APIC) should be reduced at the exercise date!!!
Compensation Expense relative to the stock option is recognized regardless of whether the option is
exercised or not. Example: the president of the company was granted a stock option, which expires in
2 years. The FV of the options was $20K. The company recorded $10K in Compensation in Y1. On Dec
31, Y2, the presidents resigns and does not exercise the option, BUT the other half of the
compensation expense gets recorded on Dec 31, Y2, regardless of the option being NOT exercised.
Expiration of Options = We just need to reverse the entry to APIC-stock options. Compensation expense
is NOT reversed. From the example above, if the option is not exercised, we make the following JE:
Debit APIC-stock option $50,000
Credit APIC-expired stock options $50,000
Compensation Costs are NOT immediately deductible for tax purposes! They are deductible on the tax
return once the stocks are exercised. Debit Deferred Tax Asset and credit Deferred Tax Benefit for the
amount!
Stock Appreciation Rights (SARs) = entitles an Employee to receive an amount equal to the excess of the
market price of stock at exercise date over a predetermined amount (usually market price at grant
date). The Excess multiplied by the # of rights outstanding is recorded as compensation expense and a
liability. Compensation expense for SARs must be adjusted annually for changes in the market price of
the stock. Adjust Prospectively and do not restate.
Example of SARs = On Jan 1, Y1 L Company granted its President 10,000 stock appreciation rights
expiring Jan 1, Y4. Upon exercise, the president may receive cash for the excess of market price of the
stock on that date over the market price on the grant date, the service period runs for 2 years. Market
prices were:
Jan 1, Y1, the grand date $30
Dec 31, Y1 $45
Dec 31, Y2 $40
Dec 31, Y1, the market price has increased $15 ($45 - $30-at grant date). Thus, total compensation is
$150,000 ($15 x 10,000 shares). Since the service period was agreed on is 2 years, we need to divide the
total $150K compensation into 2 years. Thus, only $75,000 is recorded in Y1:
Debit Compensation expense $75,000
Credit Liability for SAR plan $75,000
Dec 31, Y2, the market price has increased $10 ($40 - $30, the grant date). Thus, the compensation is
calculated at $100,000 ($10 x 10,000 shares). However, we already have $75,000 coming in from Y1
calculation. Thus, we debit Compensation with only $25,000 in Y2:
Debit Compensation Expense $25,000
Credit Liability for SAR plan $25,000
When the SARs are exercised, L Company will make the following JE:
Debit Liability for SAR plan $100,000
Credit Cash $100,000
M4 - Earnings per Share
Under US GAAP all Public entities are Required to present EPS on the face of the I/S
2 types of Capital Structure:
Simple Capital Structure = the entity has only C/S outstanding and presents Basic per-share amounts
Complex Capital Structure = the entity presents Basic and Diluted per-share amounts
Discontinued operations = also present basic and diluted either on the face or notes
Simple Capital Structure (Report Basic EPS only)
Basic EPS = Incomes available to the common shareholders
WA # of Common Shares O/S
Income available to Common shareholders:
Income from Continuing operations
LESS: Dividends declared in the period on noncumulative
preferred stock (regardless of whether they have been paid)
LESS: Dividends accumulated in the period on cumulative
preferred stock (regardless of whether they have been declared)
If there is a loss from continuing operations (or a net loss), the amount of the loss should be increased
by the preferred shareholders' dividends or claims to determine income available to the common
shareholders.
Weighted Average Number of Common Shares Outstanding (WACSO)
Shares O/S at the beg. of the period
+ Shares sold during the period (on a time-weighted basis)
- Shares reacquired during the period(on a time-weighted basis)
+ Stock dividends and stock splits (retroactively adjusted)
- Reverse stock splits ( retroactively adjusted)
WA # of common shares O/S
Example: Date Transaction Change in Shares Total Shares
1/1 Shares O/S 1,000,000
3/31 2-for-1 Stock Split 1,000,000 2,000,000
4/1 Additional shares sold 3,000,000 5,000,000
12/1 Reacquired shares (treasury) (500,000) 4,500,000
Solution: 1. Period Jan-March we have 2,000,000 shares (stock split is retroactive)
2,000,000 x 3/12 = 500,000
2. April-November we have 5,000,000 shares
5,000,000 x 8/12 = 3,333,333
3. Dec we have 4,500,000 x 1/12 = 375,000
Total WA # of shares is 4,208,333 (500,000 + 3,333,333 + 375,000)
Stock dividends and splits = must be treated as though they occurred at the beginning of the period.
The shares o/s before the stock splits/dividends must be restated for the portion of the period before
the stock dividend/split.
Complex Capital Structure (Report Basic and Diluted EPS) = Entity has a complex capital structure when
it has securities that can potentially be converted to common stock and would therefore dilute EPS.
Both basic and diluted EPS must be presented.
Potentially dilutive securities include:
--Convertible securities
--Warrants and other options
--Contracts that may be settled in cash or stock
--Contingent shares
Each potentially dilutive security is considered separately for its dilutive effect.
Diluted EPS = Income available to C/S S/H + Interest on dilutive securities
WA # of common shares (assuming all dilutive securities are converted to C/S)
Dilution from Options, Warrants, and Their Equivalents = Treasury stock method is used. The Treasury
stock method assumes that the proceeds from the exercise of stock options, warrants and their
equivalents will be used by the company to repurchase treasury shares at the prevailing market price,
resulting in an increase in shares O/S.
Dilutive vs. Anti-dilutive = Options and similar instruments are only dilutive when the AVG market price
of the underlying common stock exceeds the exercise price of the option.
Dilutive = Market price > Exercise (strike) price ("in the money"), b/c it's likely the options will be
exercised.
Anti-dilutive = Market price < Exercise (strike) price ("out of the money"), b/c it is unlikely the options
to be exercised.
Example = Company A has issued 10,000 incentive stock options with an exercise price of $30 to its
employees and a YE market price of $25 per share. Well, since the market price is LESS than the
exercise price ($25 < $30), the stock option is "out of the money" and anti-dilutive!
Options & Warrants - Treasury Stock Method
Example = 1,000 options to buy 1,000 C/S shares (1 share per option)
$15 exercise price per share
$20 average market price
The Options are dilutive b/s the Market price > the exercise price.
Solution: Total Option C/S shares 1,000
Cash corp. received (hypothetically) $15,000 ($15 x 1,000 options)
How many shares can the corp. repurchase hypothetically, considering the market price of
$20? It could repurchase 750 (Received $15,000 from the Options / $20-market price).
Thus, we add 250 to the C/S Outstanding (1,000 - 750)
Dilution From Convertible Securities: Bonds or Preferred Stock =The "if-converted" method assumes
that the securities were converted to common stock at the beginning of the period.
Convertible Bonds = use the "if-converted" method the following way:
1. Add to the numerator (the numerator is income available to common shareholders) the Interest
expense net of tax (assuming the conversion of the bonds to C/S)
2. Add to the denominator (WACSO) the number of common shares associated with the assumed
conversion
Example = Actual Pretend
$100 Income $100
<20> Bond Interest <0>
80 Income before taxes $100
<32> Taxes of 40% <40>
$48 NI available to common S/H $60
NOTE = If we are given the basic EPS, DONT forget that the P/S Dividends have been excluded! Thus,
add back those P/S dividends for the diluted EPS calculation. However, if we are given just the NI and
no basic EPS amount, we do not add the P/S dividends when calculate diluted EPS, b/c they have not
been subtracted from the NI. Thus, just use the NI as it is and do NOT add the P/S dividends!
Anti-dilution = Do not include if assumed conversion is anti-dilutive; include only if it results in dilution.
Each issue will be separately considered in sequence from most to least dilutive, with options and
warrants generally included first.
Example = Company A has 100,000 C/S shares and $500,000 in 6% bonds convertible into 10 shares for
each 1,000 bond. Net income is $100,000. Income tax rate is 34%.
Solution: $500,000 in bonds per 1,000 means we have 500 bonds (500,000/1,000). And 500 bonds could
be converted to 5,000 C/S shares (500 x 10 shares each).
Thus, diluted shares O/S are 105,000 (100,000 C/S + 5,000 from conversion of bonds) and
diluted income is $119,800 ($100,000 pretax income + $19,800 bond interest), where $19,800 is
calculated this way: $500,000 x 6% x (1 - 34% tax)
Diluted EPS = $119,800 / 105,000 = $1.14
Basic EPS = $100,000 / 100,000 shares = $1.00
Thus, Diluted EPS > Basic EPS and we do not report Diluted EPS!
Convertible Preferred Stocks = Ignore Taxes
1. Add back Preferred Dividends to the numerator
2. Add the number of shares associated with the assumed conversion to the denominator
Example = Company A has 100,000 C/S shares and 10,000 shares of convertible preferred stock into 5
shares of C/S for each share of preferred (10,000 P/S converted into 50,000 C.S). Net income is
$100,000. Dividends declared for the year were $20,000 to preferred S/H and $30,000 to C/S S/H. We
ignore the $30,000 C/S dividends.
Solution = Diluted shares O/S = 150,000 (100,000 + 50,000 (potentially converted P/S shares))
Diluted net Income = $100,000 (this the net income before the P/S dividends declared)
Diluted EPS = $100,000 / 150,000 shares = 0.67
Basic EPS = $100,000 - $20,000 (P/S dividends) / 100,000 shares (not diluted) = $0.80
Since diluted EPS is less than the basic EPS, the P/S is dilutive and the dilutive EPS needs to be
disclosed.
Dilution from Contingent shares = Contingent shares do not require consideration and depend on some
future events. Contingent shares are included in basic EPS if all conditions for issuance are met. If the
conditions were not satisfied by the end of the period, the # of contingently issuable shares included in
the diluted EPS is based on shares that would be issuable. Contingent shares (that are dilutive) are
included in the calculation of basic EPS if all the conditions for issuance are met.
Stock Options are NOT included in the calculation of basic EPS, but it would be included in the diluted
EPS calculation!
Disclosures
1. Cash Flow per share should not be reported (PROHIBITED)
2. Reporting basic EPS and diluted EPS on the Face of I/S for income from continuing operations
3. Reporting basic EPS and dilutive EPS for discontinued operations on the face of I/S or in notes
4. Reconciliation of the numerator and denominator of the basic and dilutive per0share computations
for income from continuing operations
5. The effect that has been given to preferred dividends
6. Securities that could potentially dilute basic EPS
Pass Key = Diluted
1. Options & Warrants = AVG market price > Exercise (strike) price
= Treasury stock method = repurchase C/S at the AVG price
2. Convertible Bond = "if-converted" method = Adjust NI for Interest Expense reduced by tax
3. Convertible P/S = "if-converted" method = Do NOT reduce NI by the P/S dividend
4. Contingent Issues = based upon conditions having met to date
M5 - Statement of Cash Flows
Operating Cash Flows = cash receipts & disbursements from transactions reported on the I/S and
current assets and current liabilities
Investing Cash Flows = cash receipts & disbursements from non-current assets
Financing Cash Flows = cash receipts & disbursements from Debt and Equity
Cash and Cash Equivalents
Cash = Actual cash, such as currency and demand deposits
Cash equivalents = short-term, liquid investments that are Quickly convertible in to Cash and So near
maturity (original maturity < 3 months). Example of Cash Equivalent = T-bills w/ 3-month maturity are
merely changing the form of Cash held and do not change the cash position of the entity. Thus, the
purchase of T-bills and any other cash equivalents are NOT reported on the Statement of Cash Flows
(ONLY disclosure is needed).
Methods of Presenting Statement of Cash Flows = Direct and Indirect methods
Sections of the Formal Statement:
Operating Activities = US GAAP requires a reconciliation of NI to net cash by operating activities under
both the direct method and the indirect method.
Direct Method for Operating Activities: The following categories must be reported separately:
1. Cash received from Customers:
Revenues
-Increase in Receivables
+Decrease in Receivable
- A/R written off
+ Increase in Unearned Revenue
- Decrease in Unearned Revenue
Cash received from customers
2. Interest and Dividends received (increase cash)
3. Other receipts, such as insurance proceeds (increase cash)
4. Cash received from sale of securities classified as trading (increases cash)
5. Cash paid to Suppliers:
Cost of goods sold
+ Increase in Inventory
- Decrease in inventory
-Increase in A/P
+ Decrease in A/P
Cash paid to suppliers
6. Cash paid to Employees:
Salaries & Wages Expense
- Increase in Wages payable
+ Decrease in Wages payable
Cash paid to Employees
7. Interest paid (decrease cash)
8. Income tax paid (decrease cash)
9. Cash paid to acquire securities classified as trading securities
10. Other operating cash payments:
Other operating expenses
- Decrease in prepaid expenses
+ Increase in prepaid expenses
+ Decrease in accrued liabilities
- Increase in accrued liabilities
Cash paid for other expenses
Indirect Method for Operating Activities:
 Net Income
+ Depreciation/Amortization
+ Losses (except for the Loss from Trading Securities treated as Current Assets)
- Gains (except for the Gain from Trading Securities treated as Current Assets, b/c the cash Flow from
the sale should be included in Operating Activities)
- Amortization of Bond Premium
+ Amortization of Bond Discount
- Equity Earnings
+/- Deferred Taxes (they are part of Operating activities, even though they are LT)
- (+/-) Change in Operating Assets
+ (+/-) Change in Operating Liabilities (If it states "Accrued Liabilities", means ST Liabilities)
Operating Cash Flow
Investing Activities = Cash Flows from the purchases or sales of Non-Current Assets
1. Making Loans to other entities (cash outflows). Example = Purchase of Bonds Payable represents an
investment in the debt of others.
2. Purchases & Sales of Trading Securities-classified as non-current assets; AFS securities and HTM
investments.
3. Acquiring & Disposing of PP&E. Example= Vehicle sold for $10,000 and a replacement was
purchased for 15,000. The difference of $5,000 in cash outflow and inflow DOES NOT get consolidated
as one amount on the CF stmt. Instead, we report separately the cash inflow of $10,000 and the cash
outflow of $15,000.
4. Acquiring of another entity under the acquisition method
Financing Activities = Cash Flows from Non-Current Liabilities and Equity activities
Financing Activities include cash flow transactions from Short-term credit lines, even though not LT!
1. Equity Activities = Issuing Stock (Cash inflow) or Paying Cash Dividends (Cash outflow)
2. Non-Current Liabilities Activities = Issuing Bonds, Notes or Payments of the Principal on a borrowed
amount (Interest payment NOT included here, instead included in Operating Activities)
Both methods report Noncash Investing and Financing Activities = Material ones should be provided
separately in a supplemental disclosure. Examples:
1. A purchase of fixed assets by issuance of stock
2. The conversion of bonds to Equity
3. Acquiring Assets through the incurrence of a capital lease obligation. Example = Increase in Capital
Lease Payable , would be disclosed in the supplemental section. (b/c this does not involve cash)
4. The exchange of one non-cash asset for another non-cash asset
1st Disclosure for Indirect Method ONLY =Supplemental Disclosure of Cash Flow Information (after
disclosure of all 3 types of activities)
Cash paid during the year:
1. Interest (net of amount capitalized) = needs to be disclosed separately, since it was part of NI
2. Income Taxes = separately stated, since part of NI
1st Disclosure for Direct Method, a Reconciliation of NI to Net Cash provided by Operating Activities
follows the Financing Activities' section.
M6 - Financial Statements of Employee Benefit Plans
A pension plan and a sponsoring company are two separate legal entities.
Required Financial Statements for Defined Benefit Pension Plans :
1. Statement of Net Assets Available for Benefits = B/S - Assets
Assets
+ Receivables
 + Cash
- Liabilities
Net Assets available for benefits
2. Statement of Changes in Net Assets Available for Benefits = I/S
Net Investment (Interest + Dividends)
- Investment expenses
+Participants' Contributions
+ Rollovers
+ Employer Contributions
Total Additions
- Benefits paid directly to participants
- Admin Expenses
Total Deductions
Net Increases
Net Assets available for benefits
3. Statement of Accumulated Plan Benefits = B/S - Liabilities
Vested Benefits
+ Unvested benefits
Total actuarial PV of accumulated plan benefits
4. Statement of Changes in Accumulated Plan Benefits = Liability Changes
Actuarial PV of accumulated plan benefits - beginning of the year
Increase during the year:
--Plan amendment
--Change in actuarial assumptions
--Benefits accumulated
--Benefits paid
Net Increase
Actuarial PV of accumulated plan benefits
Example = Beg. balance of PV of accumulated plan benefits = $4,500,000
Plan amendments = $350,000 (in favor of the employees)
Changes in actuarial assumptions = $140,000 (in favor of the employees)
Accumulated Benefits = $220,000
Benefits paid out to retirees = $180,000
Solution = $4,500,000 + $350,000 +$140,000 + $220,000 - $180,000 = $5,030,000
Benefits paid to Beneficiaries are reported on BOTH FSs, Stmt of Changes in Net Assets and Stmt of
Changes in Accumulated Plan Benefits!
Definitions:
1. Accumulated Plan Benefits = the future benefit payments that are attributable to the employee's
services rendered.
2. Accrual Present Value of Accumulated Plan Benefits = the amount that results from applying
actuarial assumptions to the accumulated benefits
3. Net Assets available for Benefits = The difference btw the plan's assets and liabilities, excluding the
participants' accumulated plan benefits.
Disclosures for pension plans:
1. Components of net periodic pension cost
2. The amount of unrecognized prior service cost
3. A detailed description of the plan including employee groups covered
DO NOT include "differences" btw executive and non-executive plans!
Defined benefit and defined contribution plans can have separate plan FSs!
Accounting for Defined benefit plan is complex compared to the relatively simple accounting for a
defined contribution plan.
A defined contribution plan cannot be overfunded or underfunded.
Contributions for a defined benefit plan are based on actuarial assumptions or future benefits while
defined contribution plan is based on management decision w/o respect to any required accumulation
or benefit payout.
Defined Contribution pension plan Required FSs:
-- Statement of Net Assets Available for Benefits AND
-- Statement of Changes in Net Assets Available for Benefits
Cash Flow Statement is optional for either, the Defined Contribution plan or the Defined benefit plan!
F8 - NFP Accounting and Governmental Accounting: Part 1
M1 - Not-for-Profit Financial Reporting: Part 1
FASB - Codification 958
Industries:
--Healthcare organizations = hospitals, nursing homes, hospice
--Educational institutions = colleges & universities & other schools
--Voluntary health and welfare organizations = United Way; American Red Cross
--Other private NFP organizations = Cemetery Organizations, Labor Unions, Museums, Libraries,
Professional Organizations, such as AICPA
Users = donors, members, creditors
Users Need to have the ability to assess:
--Services the organization provides
--Organization’s ability to continue to provide those services
--Method the organization’s managers use to discharge their stewardship responsibility
NFP Organizations use Full Accrual Basis Accounting
The external FSs of NFP entities Do not present funds
NFP Financial Reporting Standards:
FASB ASC: 958-280
Consistent external reporting is required!
Fund accounting is not used
Governmental NFPs are governed by GASB
Required Financial Statements
1. Statement of Financial Position - B/S
2. Statement of Activities - I/S
3. Statement of Cash Flows - CF/S
Reporting Expenses by Nature and Function
All NFPs must report info about the relationship btw functional and natural classifications.
Functional Classifications = Categorizing costs by Major classes of program and support services
Natural classifications: Salaries, rent, utilities, interest expense
Three ways to report using Functional & Natural classifications:
--Face of the Statement of Activities
--Schedule in the notes of FSs
--Separate financial statement
Statement of Financial Position = Balance Sheet
Components = Assets + Liabilities + Net assets (equity)
Net Assets = Residual Interest
Net Assets Without Donor Restrictions = available to general operations and may be expended at the
discretion of the governing board.
Internal board-designated funds are classified as net assets without donor restrictions.
Board-designated funds should be disclosed in the Notes to the FSs.
Net Assets With Donor Restrictions = are Subject to specific, externally imposed limitations made by a
donor. Info regarding the restrictions should be either reported within the FS or in the notes. Examples
= support of particular operating activity, Use in specified period, acquisition of long-lived asset.
Contributions with Donor restrictions = $1,000,000 endowment with the stipulation from the donor
that the income from the endowment must be used for a specific activity. Thus, $1M of endowment
contributed in Y1 + $80K in dividends in Y1 = $1,080,000 is the total Contribution for Y1.
Disclosures for the Statement of Financial Position = NFPs must disclose relevant info about the
liquidity or maturity of assets and liabilities including restrictions.
--Qualitative information = how is NFP managing its liquid recourses to meet cash needs for general
expenditures. Disclose the type of assets with limited use; nature and amount of limits.
--Quantitative information = discloses the availability of its liquid resources (the nature of the
resources, external limits imposed by donors or internal limits imposed by governing board).
Statement of Activities = Income Statement
Statement of Activities = Reports revenues and expenses (shown gross), gains and losses (often shown
net). Required Elements :
1. Change in total net assets
2. Change in net assets without donor restrictions
3. Change in net assets with donor restrictions
Prior period adjustments and changes in accounting principle are reported as adjustments to
beginning net assets (equity).
Items classified as OCI are presented in the statement of activities after operating income.
Contribution of Debt Securities (Bonds) is recorded at their FV, which is the FV at the time of the gift! It
is NOT recorded at the Face Value of the bond! Then, changes in the Bond's value over the years is
recorded in the Investment Income. Thus, the Investment income will represent a combination of
Change in bond's value and the Interest Earned!
Classification of Revenue, Gains, and Other Support = classified into 1 of 2 categories depending on
whether restrictions exist:
Net Assets Without Donor Restrictions:
--Fees from rendering services
--Contributions that have no explicit donor stipulation restricting use
--Gains and losses recognized on investment not accompanied with explicit donor restrictions
Net Assets With Donor Restrictions:
--Contributions subject to Expenditure for a specified purpose
--Contributions subject to Passage of time
--Contributions associated with Restrictions that are otherwise temporary in nature
--Contributions requiring Investments in perpetuity with returns eligible for appropriation
Reclassification of Restrictions:
Donor-imposed restrictions are recognized as donor-restricted support in the period in which they are
received and recognized as an increase to net assets with donor restrictions.
When a donor restriction is satisfied → reclassification is reported on the statement of activities.
Donor-imposed restrictions met in the same period they are received, may be recorded as an increase
to net assets without donor restrictions, thus NFP has the option of immediately reporting the
subsidies received as an increase to net assets w/o donor restrictions.
Expense Classification in the Statement of Activities = all expenses are reported as decreases in net
assets w/o donor restrictions. Investment expense is netted against investment returns.
Program Services = are the activities the NFP is chartered with.
--Universities: Education and research
--Hospitals: Patient care and education
--Union: Labor negotiations and training
--Day Care: Child care
Support Services = everything not classified as a program service.
--Fundraising = expenses spent to induce contributions, such as sending unsolicited merchandise
--Management and general (admin expenses)
--Membership development
Combined Costs = Example = Fundraising & Education = should be allocated btw functions
The expense categories used by NFPs generally fall under 2 main headings: program services and
support services.
Program services relate to functional expenses which directly relate to the mission of the
organization.
Support services summarize the functional expenses related to the G&A costs, costs of membership
development, and fundraising.
Fundraising contemplates inducing donors to contribute to the entity.
Membership activities involve seeking prospective members, ensuring current member satisfaction,
etc. Membership activities mimic marketing activities in commercial settings.
Disclosures of Functional Expenses as displayed on the Stmt of Activities, analyzed by object
classification is REQUIRED!
M2 - Not-For-Profit Financial Reporting: Part 2
Statement of Cash Flows = Either the direct or the indirect (Direct does NOT require reconciliation of
net income to cash flows).
Classification of Sources and Uses of Cash
Operating Activities:
--Settlement of lawsuits
--Insurance settlements
--Refunds from suppliers and to customers
--Cash received as a good faith advance
--Short term bank loan interest payments
--Charitable contributions
--Contributions, program income, interest or dividend income
--Unrestricted resources
--Proceeds from the sale of financial assets not restricted for LT
--Cash payments to Suppliers and employees
--Interest payments
--Agency transactions
Contributions of unrestricted revenue later earmarked (board designated) for construction or purchase
of long-lived assets is classified as cash flows from operating activities.
Investing Activities
--Investments in PP&E
--Disbursements of donor-restricted contributions for investments
--Proceeds from the sale of assets that were received in prior periods and whose sale proceeds were
donor-restricted to investment in equipment or other LT Assets (INCLUDING the G/L, which should
NOT be reported in operating activities)
--Proceeds from sale of Artworks
--Insurance proceeds associated with the loss of Artwork (a statute was stolen for example). These
proceeds get recorded in "Investing Activities".
A NFP that does not capitalize the artwork collection should report the following on the face of the
statement of activities separate from Revenues, Expenses, G/L:
1. Cost of collection items as a decrease in the appropriate class of net assets
2. Proceeds from sale of collection items as an increase in the appropriate class of net assets
3. Proceeds from insurance recoveries of lost destroyed collection items as an increase in the
appropriate class of net assets
Financing Activities = include not only the typical cash transactions related to borrowing, but also
include cash transactions related to certain restricted contributions.
--Proceeds from issuing bonds, mortgages, notes
--Repayment of amounts borrowed
--Receipts from contributions restricted for PP&E or annuity agreements
--Contributions restricted for the purpose of establishing a donor-restricted endowment fund
Cash and cash equivalents = Exclude donor-restricted securities
Noncash Transactions = Disclosed should be the following:
--Contributed securities
--Construction in progress
--Contributions of beneficial interests
--Noncash debt refinancing transactions
M3 - Not-for-Profit Revenue Recognition
Revenue from Exchange Transactions = Earns resources in exchange for a service performed.
Revenues from exchange transactions are classified as increases to net assets without donor
restrictions.
Example = Pharma Corp. is a large for profit corporation provides resources to Atlantic University to
perform clinic trial research on an experimental drug. The University needs to comply with strict
specifications. The trials the University performs have commercial value to the Corporation. The
resources are provided in exchange for research results and do NOT constitute a contribution.
Contributions Received = Unconditional transfer of cash or assets to a new owner (title passes)
voluntarily and non-reciprocally.
Recognition of Contributions = Contributions received are recognized as revenue or gains and reported
as either an increase to net assets w/o donor restrictions or donor-restricted support in the period
received and as assets, decreases of liabilities, or expenses, depending on the form of the benefits
received. A Contribution is classified as Revenue if it is part of the ongoing major or central activities.
Contribution is classified as a gain if the transaction is incidental to the purpose of the NFP.
Cash Contributions: Received = Revenue and measured at their FV at the date of the gift.
Promises to Give (Pledges):
Unconditional promise to give, called a pledge, is a Contribution and it is reported as Revenue at its FV.
Conditional promise to give or a pledge is a transaction depending on the occurrence of a future and
uncertain event. Recognition does not occur until the conditions are substantially met. Conditional
Pledges are still subject to important contingencies and are NOT recorded as Receivable Revenue.
If resources are provided but with a conditional pledge a refundable advance as a Liability is recorded
and it is not a portion of net assets.
Multiyear Pledge =recorded at their PV at the date the pledge is made. The difference btw the
previously recorded PV and the current amount collected is recognized as Contribution revenue, NOT
interest income.
Multi-year Pledge is a Contribution With Donor Restriction measured at PV, since the contribution has
yet to be collected. There is an implied time restriction on the receivable.
Placed-in-Service Approach = In the absence of specific donor restrictions, NFPs must use the place-in-
service approach to report the expiration of restrictions on contributions associated with long-lived
assets.
Example = If the donation is a building with a stipulation to be used for a specific activity, the building
gets recorded as an asset and the contribution as donor-restricted. However, the depreciation on the
building will be reclassified each year from net assets w/ restrictions to net assets w/o restrictions.
Allowance for Uncollectible Pledges = No bad debt expense recognized, instead both the pledge and
the related contribution revenue are reported net of any allowance. Thus, the allowance for bad debt
(typical for commercial accounting) is reported separately as a contra-account, instead reduces the
contributions Receivable.
Split-Interest Agreements = represent donor contributions of trusts or other arrangements under
which the NFPs receive benefits that shares with other beneficiaries. Examples are remainder trusts,
charitable trusts.
Split-interest Contributions should be Measured at their FV.
Split-interest Contributions are estimated based on the PV of estimated future distributions.
Split-interest Contributions are Donor-restricted.
DR Assets Held in Trust
CR Liability to Beneficiaries
CR Contribution Revenue (w/ donor restrictions)
Disbursements associated with split-interest agreements are classified as Financing Activities on the
Stmt of CF.
Donated Services = recorded as Contributions @ FV if they meet the following requirements:
1. They create or enhance a nonfinancial asset (land, building, inventory)
2. They require Specialized skills that the provider (donor)possesses
3. They are needed by the organization
4. They are Easily Measurable at FV
JE to record Donated Services that meet the requirements above:
Debit Expense or Asset at FV
Credit Contributions - w/o restrictions
Volunteer Recruitment = Fundraising expense
Donated Collection Items = Works of art or historical treasures. They are Not required to be recorded if
ALL of the following are met:
1. Item is part of a collection
2. Collection is cared for, preserved, and protected by the organization
3. Organization has a policy that requires any proceeds from the sale of donated items to be
reinvested in other collection items
NOTE: If these requirements are not met, the donation must be recognized as an asset and revenue.
Donated Materials:
--If significant in amount, donated materials should be record at FV on the date of receipt.
--If the donated materials Merely pass through to an ultimate beneficiary, such as used clothing, should
NOT be recorded.
Gifts-in-Kind = Noncash contributions, such as donated Investments or a Rental space. They are
recognized at a FV as a donation w/o donor restrictions and an equal expense in the period used,
which has no effect on net assets.
Accounting for Promises to Contribute and Other Support Transactions:
Contributions w/o Donor Restrictions:
Unconditional promises to contribute are reported and recognized initially as donor-restricted support
(implied time restriction), at their PV. If they are expected to be collected within a year, they are
measured at NRV:
Initially upon being pledged:
Debit Pledge receivable-w/ donor restriction
Credit Allowance for doubtful accounts
Contributions-w/ donor restrictions
Later, when collected assets w/ donor restrictions are adjusted (move it when restriction is released):
Debit Cash-w/ donor restrictions
Credit Pledge receivable-w/ donor restrictions
Debit Satisfaction of time restriction-w/ donor restriction
Credit Cash-w/ donor restriction
Move it to the Cash w/o donor restrictions:
Debit Cash-w/o donor restriction
Credit Satisfaction of time restriction-w/o donor restriction
Donor-Restricted Support (Contributions w/ Donor Restrictions):
Donor-imposed restrictions limit the use of contributed assets.
They are recognized as revenue in the period received.
Initially recorded:
Debit Pledge Receivable-w/ donor restrictions
Credit Allowance for doubtful accounts
Credit Donor-restricted Support (Revenue)
Later after the receivable is collected and when money is spent on restricted purpose:
Use the account "Reclassification-satisfaction" account to move the cash from "w/ restrictions" to
"w/o restrictions".
Debit Reclassification-satisfaction of donor restriction
Credit Cash-w/ donor restrictions
Debit Cash- w/o donor restrictions
Credit Reclassification-satisfaction of donor restrictions
Spending the donation on the intended purpose:
Debit Operating Expense
Credit Cash-w/o donor restrictions
Fundraising = When a NFP offers premiums, such as mugs, calendars, etc., to donors as part of a
fundraising campaign, the cost of the premiums is classified as fundraising expense.
Generally, the difference btw the contribution by the donor and the FV of any premiums is the revenue:
Total Contribution received
<FV of premium>
Contribution Revenue
Industry-Specific Revenue Recognition
Educational Institutions: Colleges and Universities
Revenues = Student tuition and fees ; Government aid, grants, and contracts ; Gifts and private grants;
Endowment income; Sales and services of educational departments, such as publications and testing
services; Revenues of auxiliary enterprises, such as food service, residence halls, campus store, and
athletics
Student tuition and fees are reported at the gross amount. Only Refunds are netted against the
Revenue. Scholarships and tuition remissions are shown separately as expenditures.
Assessed student tuition and fees
<Canceled classes>
Gross Revenue from tuition and fees
Also, Scholarships offered to students by the University are part of Gross Revenue!
Debit Cash $2,500,000
Debit Expenses-scholarships $400,000
Debit Expenses-tuition remission $100,000
Credit revenues-tuition and fees $3,000,000
Gains & Losses on investments and other assets, classified as w/ or w/o restrictions, are reported in the
statement of activities.
Revenue Recognition in Health Care Organizations
Patient Service Revenue = Although recorded on a Gross basis, deductions are made from gross
revenue.
Charity Care = defined as health care services that are provided but never expected to result in cash
flows to the hospital. Charity care should be disclosed in the FSs. Charity Care is NOT recognized as
receivable or revenue, nor as a bad debts expense.
Gross Patient Services Revenue
<Charitable Services>
Net Patient Services Revenue
Deductions are Subtracted from patient service revenue to arrive at “net patient service revenue”.
Deductions = Contractual adjustments for third-party payments + Policy discounts + Administrative
adjustments + Bad debts associated with services billed prior to the organization’s assessment of the
patient’s ability to pay.
Bad Debt could be reported in 2 different ways:
1. As operating Expense
2. As Deduction from Revenue
Capitation Agreements = Revenue that is a fixed amount per individual that is paid periodically to a
provider as a compensation for providing health care services for that period.
Other Operating Revenue of a health care organization:
--Tuition from schools
--Revenue from educational programs
--Donated supplies and equipment
--Specific purpose grants
--Revenue from auxiliary activities
--Cafeteria revenue
--Parking fees
--Gift shop revenue
--Medical transcription fees
Non-operating Revenue and Support Gains and Losses:
--Interest and dividend income from investment activities
--Gifts and bequests
--Grants
--Income from endowment funds
--Income from board-designated funds
--Donated services
M4 - Not-for-Profit Transfers of Assets and Other Accounting Issues
Transfers of Assets to a NFP Organization or Charitable Trust That Raises or Holds Contributions for
Others = Accounting for asset transfers to other NFPs, such as foundations, and how should those
transfers be accounted for: 1. As Contribution OR 2. As Liability OR 3. As Change in interest in net
assets .
Financially Interrelated Organizations = they have the following characteristics:
1. Ability to influence
2. Economic interest in the assets of the other organization.
Recipient Accounting = A NFP is a recipient entity when it accepts assets from a resource provider and
agrees to use the assets on behalf of, or transfer the assets to a specified beneficiary.
Not financially interrelated = Without variance power = acts as an Agent = no benefit, no power.
This is an organization that accepts assets from a resource provider and agrees to use or manage
them on behalf of a specified beneficiary without variance power.
Assets are valued at FV.
Recipient recognizes a liability to the beneficiary :
Debit Asset at FV
Credit Refundable advance liability
The Beneficiary records Contributions (Revenue).
Assets transferred to recipient organizations are not contributions and are accounted for as liabilities
when one of the following conditions are met:
1. The resource provider can change the beneficiary
2. The resource provider's asset transfer is conditional
3. The resource provider controls the recipient organization and specifies an unaffiliated beneficiary
Not financially interrelated: With variance power = no benefit, has power; NFP acts as an agent.
The Organization has the unilateral Authority to redirect assets to another beneficiary.
Assets are valued at FV.
For the Recipient NFP = Assets are recognized as a contribution when received and expensed when
distributed to the beneficiary.
Debit Asset at FV
Credit Contributions
For the Beneficiary = Does NOT record anything!
Financially interrelated: With or Without Variance Power = An organization financially interrelated w/
a beneficiary that accepts assets from a resource provider and agrees to use or manage them on
behalf of a beneficiary follows donee accounting.
Debit Asset at FV
Credit Contributions
Beneficiary Accounting = Beneficiaries recognize their rights to assets held by the recipient unless the
recipient is explicitly granted variance power. The rights will be recorded as receivables and
Contribution, beneficial interest, or change in interest in the net assets of the recipient.
Receivable and Contribution = in cases that Do not involve financial interrelationship or beneficial
interests, the beneficiary recognizes a receivable and a contribution.
Not Financially Interrelated: Beneficial Interest = Unconditional right to receive specified cash flows as
Contribution revenue:
Debit Beneficial Interest
Credit Contributions
Financially Interrelated: Interest in the Net Assets of the Recipient = Beneficiaries recognize a change
in their interest in the net assets of the recipient when the organizations are financially interrelated.
Debit Interest in recipient net assets
Credit Change in interest in recipient net assets
Example = State University, a private NFP, established the State Foundation, a NFP, to raise funds for
the university and to account for and manage the investments. The university and the foundation are
financially interrelated . The foundation is the recipient but it does not have variance power, b/c the
donations must be used to fund university scholarships.
The foundation will record the following JE:
Debit Investments
Credit Contributions (Revenue)
The university (the beneficiary) will record the following JE:
Debit Interest in State Foundation net assets $25M
Credit Change in interest in State Foundation net assets $25M
Other Accounting Issues
Financial Instruments = All debt securities and those equity securities with readily determinable FV are
measured at FV @ date of gift.
Gains and Losses = Realized and unrealized gains & losses on investments are reported in the statement
of activities as Increases or decreases in net assets without donor restrictions unless donor-restricted.
If stipulations for restrictions are met in the same period → report an increase in net assets without
donor restrictions.
Derivatives = recognize the Change in FV in the period of the change.
Dividends, Interest, and Other Investment Income = Reported in the period earned as increases in
unrestricted net assets unless restricted. Net of related investment expense.
Endowment Funds = Established to provide income for the maintenance of a NFP entity and maybe
classified as either net assets w/o donor restrictions or w/ donor restrictions.
Duration of the Endowment = maybe established in perpetuity or for a specified period of time.
Source of Restrictions for Endowment = they are generally established by a donor-restricted gift. Types
of endowment funds include:
1. Board-designated Endowment Funds (w/o restrictions)
2. Donor-Restricted endowment funds (w/ restrictions)
Accounting and Reporting for Endowment Funds = reported in 2 different ways based on existence of
restrictions:
1. Net Assets With Donor Restrictions → Increase net assets with donor restrictions
2. Net Assets Without Donor Restrictions → Increase net assets without donor restrictions
Specific Issues Regarding Changes in Value of Donor-Restricted Endowments:
1. Upon Inception the original gift and related returns should be accounted for as net assets w/ donor
restrictions.
Unless donor restrictions exist, investment income is deemed available for spending and classified as
net assets w/o donor restrictions.
Returns on the Endowment Assets Subject to Donor Restriction
Investment returns subject to restriction by donor are reported as Net assets with donor restrictions
until appropriated for expenditure. Upon approval for expenditure = appropriated for expenditure.
Underwater Endowments = Donor-restricted endowment fund for which the FV of the fund at the
reporting date is less than the original gift amount. Underwater Endowment funds Report
accumulated losses together with the endowment fund in net assets with donor restrictions.
Disclosures for Underwater Endowments:
--FV of the underwater endowment
--Endowment gift’s original amount
-- The amount of Deficiency
Required Disclosures for All Endowment Funds
--Governing board’s interpretation of requirements
--Policies for appropriation
--Investment policies
--Composition of NFP endowment
--Reconciliation of the beginning and ending balance
Basis of Assets = Purchased Fixed Assets are carried at cost, as required by GAAP.
Donated Fixed Assets are carried at their FV @ date of gift
Depreciation is recorded in accordance w/ GAAP.
Works of art and historical treasures are NOT depreciated.
M5 - Governmental Accounting Overview
Governmental Accounting and Reporting Concepts
Objectives of governmental reporting = governmental financial reporting is designed to demonstrate
the accountability of each organization for the stewardship of resources in their care.
Objectives of Fund accounting and reporting = fund accounting enables organizations to monitor and
report compliance with spending purposes, spending limits and other fiscal accountability objectives.
Industries that use Governmental Accounting and Reporting Principals:
1. Governmental Units = federal, state, county, municipal, local
2. Colleges & Universities
3. Health Care Organizations = hospitals, nursing care facilities, home health care, clinics
Generally Accepted Accounting Principles for Governmental Entities = GASB (Governmental
Accounting standards Board) establishes accounting and reporting standards for governments.
Information used by the Financial Report Users:
1. General Purpose External Financial Reporting includes:
Basic FSs
Required supplemental information
Comprehensive annual financial reporting
2. all financial reporting includes the 3 items above plus Budgets & other special purpose reports.
3. Other information, such as economic indicators could be added.
Governmental-type activities = supported by taxes
Business-type activities = supported by fees
Users of Governmental financial reports = citizens, taxpayers, media, researchers, legislative &
oversight bodies, investors and creditors.
Characteristics of Information in Governmental Financial Reports:
--Understandability (information should be expressed as simply as possible)
--Reliability (reports should be verifiable and free from bias and should faithfully represent the subject
matter)
--Relevance (information provided should have a close logical relationship to the purpose for which it is
provided). Relevance is the most difficult to report for Government entity.
--Timeliness (information should be issued in time to have an effect on decisions)
--Consistency (the accounting principles should not change year over year)
--Comparability (Differences btw Financial reports should be due to substantive differences in
underlying transactions rather than the selection of methods).
Accountability = the Primary Objective of Governmental financial reporting.
A balanced budget demonstrates inter-period equity. Inter-period equity is a significant part of
accountability on behalf of a governmental entity. It helps users assess whether current year
Revenues are sufficient to pay for the services provided that year and whether future taxpayers will
be required to assume burdens for services previously provided.
Residual equity transfers is an absolute term included as a distracter.
Key Concepts in Governmental Accounting and Reporting:
Fund structure:
--Governmental funds = GRaSPP
--Proprietary funds = SE
--Fiduciary funds = CIPPOE
Fund FSs should be presented separately for governmental, proprietary and fiduciary funds in order to
report additional & detailed information about the primary government.
Fund accounting = checkbooks
External Reporting = reporting requirements include both Fund-based and government-wide financial
statements supported by notes and required supplementary information.
Presentation of a Reconciliation of Fund FSs to Government-wide FSs is also required.
M6 - Government Fund Structure and Fund Accounting
Governmental Funds = GRaSPP = No profit motive
--Fund accounting = Modified accrual basis of accounting
--Current financial resources measurement focus (no FA and no LTD)
Fund types of Governmental Funds:
General Fund: ordinary operations financed from taxes and other general revenues. All transactions not
accounted for in other funds are accounted for here.
Special Revenue Funds: revenues from specific taxes or other earmarked sources that are restricted or
committed to finance particular activities of government.
Debt Service Funds: Accumulation of resources and the payment of interest and principal on all “general
obligation debt,” other than that serviced by enterprise funds or by special assessments in another fund.
Resources of the fund are restricted, committed, or assigned to debt service expenditures.
Capital Projects Funds: Resources restricted, committed, or assigned for the acquisition or construction
of major capital assets by a governmental unit, except those projects financed by an enterprise fund
Permanent Fund: Resources legally restricted to the extent that income, and not principal, may be used
for purposes supporting the reporting government’s programs.
Proprietary Funds:
Fund accounting = Full accrual basis of accounting
Economic resources measurement focus
Fund types of Proprietary Funds:
Internal Service Funds: Goods and services provided by departments on a cost-reimbursement fee basis
to other departments and agencies within a single governmental unit or to other governmental units.
Example of Internal Service Fund = building maintenance department.
Enterprise Funds: Account for acquisition and operation of governmental facilities and services intended
to be primarily (>50%) self-supported by user charges (Primarily external customers).
Enterprise funds are Required when ANY one of these 3 criteria is met:
--The activity of the fund is Financed by debt secured by a pledge of fee revenue
--Law requires Collection fees
--Pricing policies are established to Produce fees to recover costs
Fiduciary (Trust) Funds:
Fund accounting = Full accrual
Economic resources measurement focus
Fund types of Fiduciary Funds:
Custodial Funds: Resources in temporary custody of the governmental unit
Investment Trust Funds: External investment pools
Private Purpose Trust Funds: Activities not properly accounted for either as pension or investment trust
funds, in which assets are dedicated to providing benefits to recipients in accordance with benefit terms
and assets are legally protected from creditors of the government.
Pension and Other Employee Benefit Trust Funds: Resources of defined benefit plans, defined
contribution plans, post-employment benefit plans, and other long-term employee benefit plans
Fund Accounting:
Modified accrual basis is used with the current financial resources (GRaSPP funds)
Accrual basis of accounting is used with the economic resources measurement focus (SE, CIPPOE funds)
Measurement Focus of a Fund = identifies what transactions should be recorded and how they should
be reported. For Governmental Funds, the stmt of Revenues & Expenditures should report resources
received and consumed during the current period. The balance sheet shows available resources and
current obligations. Thus, for Governmental Funds the measurement focus is the Current financial
resources and the resulting Financial position. The Measurement focus for Proprietary and Fiduciary
Funds is the Income!
Current Financial Resources (GRaSPP) = Modified accrual = No fixed assets and No non-current liabilities.
Adding FA excluded from government fund FSs and subtracting the exluded LTD are 2 of the most
significant reconciling items btw government-wide FSs and governmental funds.
Economic Resources (SE-CIPPOE and Government-Wide) = Full accrual =FA and LTD are reported
Modified Accrual (GRaSPP):
Revenue: recognized when measurable and available to finance the expenditures of the current period.
Available, under modified accrual method, means collectible within the current period or soon
enough thereafter to be used to pay liabilities in the current period (generally within 60 days after YE).
Expenditures: generally recorded when the related fund liability is incurred.
Full Accrual (SE-CIPPOE and Government-wide):
Revenue: recognized when earned
Expense: recognized when incurred
M7 - Budgetary and Accounting Activities
Accounting for Governmental Funds:
Budgetary: Budgetary accounting is used to Control spending
Activity: Activity accounting emphasizes the Flow of current financial resources
Encumbrance: Encumbrance accounting is used to Record purchase orders
The initial JE to set up the encumbrance is:
Debit Encumbrances Account
Credit Budgetary Control Account
The Budgetary Control account functions as a constraint that reduces the Fund balance availability.
So, the credit to the Budgetary control account reduces the Fund availability.
Budgetary Accounting = based on estimated revenues and appropriations.
Sources of Governmental Resources:
Revenue Other Financing Sources
Income & Sales Taxes Debt Proceeds (bonds & Notes)
Property & RE Taxes Inter-fund Transfers
Fines & Penalties
Licenses & Permits
Intergovernmental Revenues
NOTE = The Debt Proceeds & the Inter-Fund Transfers are classified separately from "Estimated
Revenues "as "Other Financing Sources" in the Budgetary Entry!
Budgetary Accounting JEs:
Beginning of the Year = the difference btw estimated revenues and appropriations goes to an account
called "budgetary control".
NOTE = The credit to appropriations control, below, includes both transfers and estimated
expenditures. CPA Exam questions often segregate appropriations and budgeted transfers.
The estimated revenue and the approved expenditures (Appropriations) are posted on the opposite
side of the T accounts compared with actual amounts.
Debit Estimated Revenue
Debit Estimated Other Financing Sources
Debit Budgetary Control (negative/deficit)
Credit Appropriation Control (Approved Spending)
Credit Budgetary Control (positive/surplus)
End of the Year = budget is reversed and closed. The JE uses the same amounts that were recorded at
the beginning of the period plus or minus any amendments.
Unassigned fund balance = Assuming no encumbrances at YE and the actual expenditures turned to be
less than the appropriations from the budget, the Unassigned fund balance will increase!
Activity Accounting = Matching principle is NOT used
Non-exchange Revenue includes:
Derived Tax Revenues = represent taxes imposed on or derived from exchange transactions, such as
commercial sales (Sales taxes), taxpayer income (Income taxes), etc.
Imposed Non-exchange Revenues = represent Taxes imposed, such as Fines, or Property taxes.
Pass Key = Receivables are recognized if the government has an enforceable claim (tax levy on
property)
Property Tax JEs:
Debit Property Tax Receivable-Current $1,800,000
Credit Revenue-Property Taxes $1,620,000
Credit Allowance for uncollectible tax receivable-current $180,000
NOTE: The Allowance account reduces Revenue and there is no Bad Debt Expenditure!
JE to re-class Receivables to Delinquent:
Debit Property Tax Receivable-delinquent $342,000
Credit Property Tax Receivable-current $342,000
JE to add more to the Allowance:
Debit Revenues-Property Taxes $162,000
Debit Allowance for uncollectible taxes-current $180,000
Credit Allowance for uncollectible taxes-delinquent $342,000
Non-exchange transactions are a significant source of revenue for government entities.
Non-exchange transaction is a transaction in which an entity gives/receives value w/o directly
receiving/giving equal value in return.
Exchange transactions, typical for commercial entities, involve giving/receiving equal value in an
arm's-length transactions. So, the major difference btw exchange and non-exchange transactions for
governmental units is the relationship btw the amount of value given and received.
Government-Mandated Non-exchange Transactions = represent instances in which a Higher level of
government (state) provides funds and mandates certain activities by another level of government
(county), such as environmental cleanup.
Voluntary Non-exchange Transactions = represent instances in which the Government receives
resources and does not provide equal value, such as grant agreements.
Revenue Recognition Requirements:
1. Time Requirements = Revenues are recognized first in the period in which resources must be used.
ALL Revenues are subject to Time Requirements!
Derived and Imposed tax revenues are ONLY subject to Time Requirements.
2. Required Characteristics of Recipient = the Resource Provider, such as the Federal Government
specifies certain characteristics for the recipient (for example the entity receiving the revenue must be a
local government).
Only Government-mandated and voluntary non-exchange transactions are subject to Eligibility
Requirements.
3. Reimbursements = Allowable expenditures must be incurred before Revenue may be recognized.
4. Contingencies (ONLY applicable to Voluntary non-exchange transactions) = Actions must be taken
before revenue is earned (e.g., compliance with usage restrictions)
Only voluntary non-exchange transactions are subject to Contingency Requirements!
Measurable and Available Criteria:
The following items are accrued as Receivables and Revenue when time requirements are met (collected
within 60 days of YE):
1. Billed/Recorded = Revenue
RE Taxes (due) and Fines & Penalties
2. Received = Revenue
Income taxes and Sales taxes
3. Earned = Revenue
Revenue collected in advance, unearned when collected
RE taxes paid in advance (unearned)
Restricted grants (Earned when Spent)
Expenditures = Capital purchases, debt service payments and operating expenditures are considered
spending of funds and treated as current year expenditures.
Example of expenditure in the General Fund = Lease principal payment
Bond Discount is NOT an expenditure in a General Fund. It would most likely appear in a capital
project fund or a debt service fund.
Transfer Out = it is NOT an expenditure in a General Fund. It is displayed in the FSs in the category
titled "Other financing sources and uses".
The timing of the expenditure recognition is consistent with accrual accounting and is governed by
when the voucher payable is recorded. The modified accrual basis of accounting does not delay the
expenditure until the cash payment is made. JE is Debit Expenditure and Credit Voucher Payable.
Thus, we account for expenditures NOT only the paid claims & judgments in the current year BUT also
the increase in the Liability account of Claims & Judgments.
Alternatives for Expenditure Recognition:
1. Purchase Method:
---Record an expenditure when purchased
---Record Current Asset and non-spendable fund balance at YE for any items not used (still on hand)
JE when buying the item: Debit Expenditure and Credit Voucher Payable
NO JE when usage of an item purchased
JE when accounting for what's still on hand at YE: Debit Supplies Inventory and Credit Non-spendable
fund balance-Inventory
2. Consumption Method:
---Record a Current Asset when purchased
---Record an expenditure as consumed during the period
JE to record the purchase of the items: Debit Supplies Inventory and Credit Voucher payable
JE to record the usage of items: Debit Expenditures and Credit Supplies Inventory
NO JE at YE.
Expenditures extending over more than one period may be allocated btw or among accounting
periods or may be accounted for as expenditure of the period of acquisition. Example = insurance
extending over more than one accounting period.
Classification of Government Expenditures
Function or Program:
1. Function groups expenditures into Major Services of governmental entity, such as Public safety,
Highways, Education, Health & Welfare.
2. Program groups expenditures into activities, operations, or units, such as Program for Elderly, for
Drug addicts, for Education.
Organizational Unit = Police and Fire Department
Activity = Drugs, Highway
Character = refers to determining what fiscal period the expenditures are presumed to benefit:
Current expenditures = benefit the current fiscal period
Capital outlays = benefit both the present and future periods
Debt service = benefit the prior, present and future periods
Intergovernmental = One governmental unit Transfers resources to another.
Object Classes = Chart of accounts
Fixed Assets = Expenditure (not capitalized/not depreciated)
Debts (Long-Term) = other financing sources.
Debit Cash from Bond Issuance $1M
Credit Other financing sources - Bond Issuance $1M
The governmental funds Do NOT carry the LT debt.
Repayment of LTDs are recorded as expenditures of both principal and interest.
Other Financing: Leases = Leases Convey control of the right to use another entity’s nonfinancial assets
as specified in the contract for a period of time
Lease Term = Contract period during which the asset will most likely be used
Lease Classifications:
1. Short-term leases = max term of 12 mo. or less. Accounting is similar to commercial standards.
Lessee recognizes expenditures or expenses. Dr Expenditure Credit Cash/Payable
Lessor recognizes Rent Revenue. Dr Receivable and Cr Rent Revenue
2. Contracts that transfer ownership (sales-type) = transfer of ownership of the underlying asset to the
lessee who accounts for as a financed purchase and the lessor reports a sale.
Lessee JE for GRSPP funds: Dr Capital Outlay Expenditure Cr Other Financing Source
Example = Initial recording of the Lease:
Dr Expenditure-capital outlay $25,000
Cr Other Financing Source $25,000
Recording the Lease Payments:
Dr Expenditure-principal $7,553 ($10,053, the monthly lease - $2,500, the interest)
Dr Expenditure-Interest $2,500 (10% x $25,000)
Cr Cash $10,053 (the monthly lease payment)
Lessor JE for GRASPP Funds: Dr Receivable and Cr Current Revenue & Deferred Inflow
Example = Initially recorded Lease:
Dr Lease Receivable $25,000
Cr Revenue $7,533 (Current payment $10,053 - Interest of $2,500)
 Cr Deferred inflow of resources $17,447
Dr Interest Receivable $2,500
Cr Interest Revenue $2,500
Record the receipt of the lease payment
Dr Cash $10,053
Cr Lease Receivable $7,553
Cr Interest Receivable $2,500
Lessee JE for SE & CIPPOE Funds: Dr Capital Asset acquired and Credit Lease Liability
Lessor JE for SE & CIPPOE Funds: Dr Receivable and Cr Revenue
3. Leases other than short-term leases and contracts that transfer ownership
Lessee JE for GRASPP Funds = Dr Capital Outlay Expenditure and Cr Other Financing Source
Lessor JE for GRASPP Funds = Dr Receivable Cr Current Revenue and Deferred Inflow
Lessee JE for SE & CIPPOE Funds = Dr Right-of-Use Asset and Cr Lease Liability
Example for SE & CIPPOE Funds (Lessee prospective)= Lessee reports initially:
Dr Right-of Use asset $25,000
Cr Lease Liability $25,000
JE for the Lease Payments:
Dr Lease Liability $7,533
Dr Interest Expense $2,500
Cr Cash $10,053
Dr Amortization $8,333 ($25,000 / 3 year term)
Cr Acc. Amortization (ROU) $8,333
Lessor JE for SE & CIPPOE Funds = Dr Receivable and Cr Deferred Inflow
Example for SE & CIPPOE Funds (Lessor prospective)
Lessor initially reports:
Dr Lease Receivables $25,000
Cr Deferred Inflow of Resources $25,000
Lessor reports received payments:
Dr Cash $10,053
Cr Interest Income $2,500
CR Lease Receivable $7,553
Dr Deferred inflow of resources $8,333 (1/3 of $25,000)
Cr Revenue $8,333
F9 - Governmental Accounting: Part 2
M1 - Encumbrances and Other Transactions
Encumbrances = Open purchase orders represent an encumbrance or commitment of the available
appropriations of a government. In order for governmental managers to effectively monitor the usage of
the budgetary appropriations, Governmental accounting systems must reflect not only the expenditures
but also the obligations to spend (purchase orders).
Encumbrance account in the General Fund includes ONLY Outstanding PO amounts. It does NOT
include excess of the amount of PO over the actual expenditures.
Nature of Encumbrances = Not GAAP expenditure
Example = A city has appropriated $100,000 for the purchase of 2 trucks. However, the trucks were
estimated to cost $45K a piece and PO is issued for $90K.
JE to issue the approved PO and set up the encumbrance:
Debit Encumbrance $90,000
Credit Budgetary Control $90,000
The actual cost of each truck though ends up being $44K.
First, reverse the encumbrance posting for the same original amount:
Debit Budgetary Control $90,000
Credit Encumbrance $90,000
JE to record the actual expenditure:
Debit Expenditure $88,000 (2 x $44K)
Credit Voucher Payable $88,000
Recording Encumbrances = Recorded for spending/appropriations control purposes.
Encumbrances Outstanding at YE = If encumbrance (PO) is still outstanding at YE and appropriations
do not lapse (government will honor outstanding POs), reverse JE and include outstanding
encumbrances in an appropriate fund balance classification. Usually encumbrances will be included in
"fund balance, committed" or "fund balance, assigned".
Example = Using the above example, assuming one of the trucks was on a backorder and not received
yet at YE. JEs to report:
1. Reverse the encumbrance:
Debit Budgetary Control $45,000 (estimated cost)
Credit Encumbrance $45,000
2. To close budgetary accounts related to outstanding PO:
Debit Unassigned fund balance (YE surplus) $45,000
Credit Fund balance, committed $45,000
Encumbrances → Fund balance, committed
Defray = provide money to pay
Accounting In the following year = this is the JE recorded:
Debit Expenditure-Prior Year $45,000
Credit Vouchers Payable $45,000
In the following year, when the item is received and paid, it is NOT reported as an expenditure in the
budget and actual comparison schedules because it is NOT a charge against CURRENT period
appropriations.
Remember to close the budget, activity and encumbrances separately, DO NOT try to net them.
The rule is:
Budget is books → Budget is closed for the same amount
Activity is booked →Activity is closed for the actual amount
Encumbrances are booked → Encumbrances are reversed for the same amount
At YE, encumbrances serve to reduce unassigned fund balances to determine the degree of spendable
available resources that can be carried forward into the next spending cycle.
Other Transactions and Events
Inter-fund Activity = the flow of resources btw funds and btw the primary government and its
component units.
Reciprocal Inter-fund Activity = Inter-fund Loans and Inter-fund services provided and used.
Inter-fund loan = temporary extensions of credit to other funds that are expected to be repaid and are
accounted for as Receivables and Payables. Unrealized balances are reclassified as transfers.
Inter-fund services provided and used = sales and purchases between funds at external pricing.
Example is the sale of water and sewer by the enterprise fund to the city and internal service fund
activities.
Nonreciprocal Inter-fund Activity = Inter-fund Transfers and Inter-fund Reimbursements
Inter-fund Transfers = Flows of assets between funds without the exchange of equivalent value inter-
fund Transfers are accounted for in the FSs as other financing sources and uses after non-operating
revenues and expenses.
Inter-fund transfers do affect the results of operations for a Fund, even though the transfers are not
recorded as Revenue nor Expenditure, but just as "Other Financing Sources".
Inter-fund Reimbursements= Payments of expenses made by one fund on behalf of another fund are
accounted for as reimbursements. Reimbursements will net to zero. The entries will be eliminated and
NOT be displayed on the FSs.
Special Items' Characteristics = Items under the control of management either unusual or infrequent,
but not both.
Pass Key = Special Items are distinguished from extraordinary items by their characteristics.
Extraordinary items must be both unusual in nature and infrequent in occurrence, while special items
must only be Unusual OR infrequent.
Examples of Special Items:
--Sales of certain governmental capital assets
--Termination benefits resulting from workforce reductions
--Early retirement program offered to all employees
--Significant forgiveness of debt
Examples of Extraordinary Items:
--Environmental disaster
--Significant damage in a community
FS presentation for Special items = reported before extraordinary items.
Deferred Inflows and Outflows = result from the acquisition of net assets in one period that are
applicable to future periods.
Pass Key = The use of the term "deferred" is Limited to items reported as deferred outflows of
resources or deferred inflows of resources and should not be used in connection with any other
account title.
Sources of Deferred Outflows/Inflows of Resources:
Imposed Non-exchange Revenue Transactions (Time Requirements Not Met)
Examples = Property Taxes recorded in December but NOT fully levied until January
= Occupational licenses billed in November for business licenses valid in the following year
Government-Mandated Non-exchange Transactions and Voluntary Non-exchange Transactions =
Multi-year government-mandated non-exchange transactions or voluntary non-exchange transactions
may be entirely recognized as revenue, formal time restrictions create the possibility of deferred
inflow/outflow treatment
Refunding of Debt = The difference btw the reacquisition price and the net carrying amount of the old
debt should be reported as a Deferred outflow (loss) or deferred inflow (gain) and recognized as a
component of interest expense over the remaining life of the old debt or the new debt, whichever is
shorter.
Sales and Intra-entity Transfers of Future Revenues = Governments that factor their receivables,
initially record the proceeds from sale as a deferred inflow that is recognized over time.
Leases = G/L from sale and leaseback result in a deferred inflow or deferred outflow that are recognized
over the life of the lease. Leases classified as Other than short-term and contracts that transfer
ownership are accounted for as a Lease Receivable and Deferred Inflow by the Lessor.
Regulated Operations = Deferred inflows of resources that may result from rate actions by a regulator
that impose limitations on the assets of the government.
--Establishment of current rates at a level adequate to recover costs that are expected to be incurred in
the future
--Refund of gains or reductions of net allowable costs to be given to customers over future periods
Example = The state-regulated Electrical Authority has secured approval from the state to increase
electric rates in the coming year. The increase is intended to fund system improvements. The
incremental increase associated with the approved rate adjustments would be accounted for as an asset
and as a deferred inflow.
Assets Associated with Unavailable Revenues (MAC Not Met) = Revenue not available ( measurable,
not collected until more than 60 days after YE, then Report a deferred inflow of resources.
Asset Retirement Obligations (ARO) = Deferred outflow of resources = ARO
Accounting and Financial Reporting for Pensions:
Expensed = pension liability that result from current service costs and interest net of return on plan
assets are expensed
Deferred Outflows and Deferred Inflows = Changes in a government’s pension liability that result from
changes in actuarial assumptions, differences between expected and actual return on plan assets, and
some prior service costs
Derivative Instruments and Hedge Accounting = Derivatives are reported at FV
--Changes in value of derivatives used as investments are displayed within the investment revenue
classification
-- Changes in value of derivatives used for hedging activities are reported as either deferred outflows
or deferred inflows
Example of Forward Contract= township secures a forward contract to purchase fuel at a specific price in
the future. By the end of the year, the price of fuel has fallen below the guaranteed price of the contract,
thus reducing the value of the forward contract by $35K.
Debit Deferred outflows or resources $35,000
Credit Forward Contract $35,000
Fund Balances and Components Thereof (GRaSPP)
Categories of Fund Balances:
1. Non-spendable Fund Balance = generally comprises available, spendable resources. It is represented
by current Assets, such as Prepaid Expenditures, Inventories, and also a contractually required to be
maintained intact Permanent Fund Principal, etc. Used by General Fund and Special Revenue Fund.
2. Restricted Fund Balance = Debt Covenants/Bond Indenture. Resources associated with assets
restricted by external authorities, such as legislation, grantors, creditors. ALL Funds could be
Restricted.
Restricted Funds = there is a restriction on the governmental assets imposed by external authorities.
3. Committed Fund Balance = resources associated with assets obligated by a formal action of the
government's highest decision-making authority. Example of a committed fund balance is encumbered
appropriations. Used by General, special Revenue, Debt Service and Capital Projects Funds.
Committed Funds = there is a restriction on the governmental assets imposed by the highest internal
Gov authority.
4. Assigned Fund balance = resources intended to be obligated BUT NOT formally committed. Used by
General, Debt Service and Capital Projects Funds.
5. Unassigned Fund Balance = spendable assets that are neither restricted, committed, not assigned.
ONLY the General Fund should have a Positive Unassigned Fund balance. The Other Funds may have
Negative Unassigned funds.
Net Position and Components Thereof (SE and Government-wide)
Net Position is reported in the government-wide and proprietary fund balance sheets and represents
net equity (the difference btw assets plus deferred outflows and liabilities plus deferred inflows).
Deferred outflows Example = Hedge Accounting:
JE for the decline in value of a derivative instrument:
DR Deferred Outflows of Resources
CR Derivative Instrument
Net Investment in Capital Assets = Capital assets reduced by accumulated depreciation and by
outstanding debt incurred to acquire, construct, or improve those assets.
Capital assets included in the calculation of Net Investment in capital assets include the following:
Tangible Capital Assets, such as land, buildings
Intangible Capital Assets, such as patents, rights
Assets excluded from the calculation of Net Investment in capital assets:
Unspent resources for capital purposes
Equity interest in capital assets of joint ventures
Restricted = Restricted assets and deferred outflows reduced by related liabilities and deferred inflows.
Restrictions are Externally imposed by creditors, grantors, contributors, or laws.
Unrestricted: Net amount of the assets + Deferred outflows - Liabilities + Deferred inflows NOT included
in the determination of net investment in capital assets or restricted net position.
Designations of an Enterprise Fund's net position for future equipment replacement would be
displayed as Unrestricted net Position.
Net position includes Investment in Capital Assets net of related debt, Amounts Restricted by external
sources and Unrestricted components. Internal designations are classified as unrestricted.
M2 - Governmental Funds Financial Statements: Part 1
General Fund = it is created at the beginning of the government unit and it exists throughout the life of
that unit. it accounts for the general activities of a government that are not accounted by any other fund
Revenue Sources:
1. Taxes = Revenue when recorded/billed (and owed). Examples = property tax, franchise, public service
2. Public Safety and Regulation = fees and fines, license and permit revenues
3. Intergovernmental = shared or grant revenues from other governments
4. Charges for Services = Exchange revenues that support general fund activities
5. Other Revenues = Investment earnings, miscellaneous earnings
Expenditure Types:
1. General Government = administrative functions of the government
2. Public Safety = police department, fire department, jail, and building inspections department
3. Culture and Recreation = Include parks, libraries, etc. ○ Unique Accounting Issues
Major fund status = one general fund per reporting entity and it is always reported as a major fund
Internal financing = The general Fund automatically finances other funds by:
--Making a loan
--Making a contribution of equity or revenue to a debt service fund or internal service fund
--Making up a deficit in an enterprise fund
Default Classification = The General Fund is an operating "catch-all" fund for the items not accounted
for in other funds, such as Major and miscellaneous revenues and Major and miscellaneous
expenditures.
Financial Statements = Balance Sheet (Current assets + deferred outflows = Current Liabilities +
deferred inflows + Fund Balance) and Statement of Revenues, Expenditures, and Changes in Fund
balance.
Balance Sheet = NO Fixed Assets, instead all expenditures and NO LTD, instead Other Financing Sources
Fund Balance (Equity) = NUCAR = Non-Spendable (Inventory); Unassigned; Committed; Assigned and
Restricted Funds
Statement of Revenues, Expenditures, and Changes in Fund balance = NO Depreciation Expense; and
Other Financing Sources comprise of Bond Proceeds and Transfers
Special Revenue Fund = Legally restricted or committed for specific purposes. The life of the fund may
be limited or unlimited but resources are expendable (CAN SPEND).
Examples = Sales tax fund; Gasoline tax fund to finance road repairs; Funds to account for specific fees;
Grant funds, such as State grants (state juvenile rehab fund) and Federal grants (federal assistance
programs)
Cash confiscated from illegal activities (disbursements can be used ONLY for law enforcement
activities) is a Special Revenue Fund because the Gov is agreeing to accept cash and spend it in a
specific way.
Levies on affected property owners to install sidewalks = NOT a Special Revenue Fund. They are
accounted for in a Capital Projects Fund.
Revenue Sources = Legally restricted for specific purposes and are often classified as either
intergovernmental revenue or fees
Expenditure Types = Include current operating expenditures (street maintenance) and capital outlays
(highway construction-not special assessment)
Unique Accounting Issues:
Expendable Trust Activities, such as scholarships and endowment funds, represent funding whose
principal and income may be expended in the course of their designated operations so that they are
depleted by the end of their designated lives. Principal and income may be expended.
Character of Expenditures = Expendable trust activities may include capital outlay expenditures,
depending on the character of the endowment
Donations = When a donation is received by an expendable trust, cash or current assets is debited and
revenue is credited
Grants = The recipient Government monitors and/or determines eligibility
PASS KEY = Rule of thumb for use of the correct fund is:
1. Monitoring (administrative involvement) = Special revenue fund
2. Non-monitoring (no administrative involvement) = Custodial funds
Financial Statements = Revenues + Expenditures + Other financing sources (uses)
Debt Service Fund =is created to account for the accumulation of resources and the payment of
currently due interest and principal on LTD. Pays off the debt of the GRaSPP funds, but does not pay off
the debt of the SE-CIPPOE funds.
Revenue and Other Financing Sources:
In general, the debt service fund's resources are derived from allocated portions of property taxes,
which are transferred from other funds. However, when a Special Tax levy exclusively restricted for
debt repayment would be accounted for in the Debt Service Fund, and thus reported as Revenue, and
NOT as a Transfer.
Example = The General Fund transfers $10,000 cash to the Debt Service Fun, which is an Inter-fund
Transfer: Debit Cash $10,000 and Credit Inter-fund Transfers $10,000
Expenditure Types = when the debt service payment is LEGALLY DUE, the debt service fund recognizes
principal and interest as expenditures. NO ACCRUALS.
Under the modified accrual basis of accounting, expenditures are generally recognized when incurred
or measurable. An exception to this General Rule is the treatment of interest and principal payments
for LTD, including lease agreements structured as contracts that transfer ownership, which are
recorded when become Due & Payable, NOT when they accrue.
Unique Accounting Issues = Debt Service Fund Requirement:
1. Legal Mandate = Debt service funds are required only when legally mandated and/or when
resources are being accumulated for general long-term debt principal and interest payments maturing in
future years. Example = On Jan 2 of current year City of Walton issued $500,000, 10-year, 7% bond.
Interest is payable annually, but it does NOT start until Jan 2nd, following year. Thus, we do not record
any interest expenditure in the Stmt of Revenue, Expenditure and changes of Fund balance for the
current year!
2. Repayment of Other Governmental Debt = The general fund may pay interest and principal directly
to the bondholders instead of directly to the debt service fund, unless the use of a debt service fund is
mandated.
Asset Balances = the operations of this fund are similar to a Commercial accounting “sinking fund”
Debt Balances = Debt service fund expenditures are only used to pay currently payable principal and
interest (matured bonds/interest payable). The full face value of the general obligation is NOT reported
in this fund.
Closing entries = BAE BAE
B = Budget should be closed
A = Activities should be closed for the actual amounts
E = Encumbrances should be closed
The debt service fund services General debt. It does NOT service debt for the SE CHIPPOE Funds!
M3 - Governmental Funds Financial Statements: Part 2
Capital Projects Funds = established for the construction, purchase, or leasing of significant fixed
assets(Used by GRASPP funds and NOT by SE & CIPPOE funds).
The life of a Capital Project Fund is SHORT and is limited to 1 to 3 years project periods.
Revenue and Other Financing Sources = Capital Projects Funds are generally funded by Bond Proceeds.
The project may be funded by a transfer from another fund (Reported as a Transfer and NOT as
Revenue), specific tax revenue or capital grants (Both reported as Revenues), as well as Investment
earnings. GRANTS are REVENUES and NOT Other Financing Sources!!!
Capital Grants = Received in advance = recorded as a liability
= Restricted = Revenue when expended
(Dr Cash and Cr Revenue collected in advance - Deferred Revenue)
= Recognize Revenue Restricted when spent:
(Dr Expenditures and Cr Voucher Payable)
(Dr Revenue collected in advance and Cr Revenue)
= Unrestricted = recognized as revenue immediately (Dr Cash and Cr Revenue)
Special Assessments = are taxes or fees levied against property owners who will directly benefit from
the project (sidewalks and street lights).
Primarily or Potentially Liable = when the governmental unit is primarily liable for the special
assessment debt, the government unit should account for the capital project and debt-related
transactions through the appropriate governmental or proprietary fund. The debt should be classified in
that fund as "Contribution from property owners". Assets and Liabilities should be reported in the
government-wide FSs.
NOT Primarily or Potentially Liable = when the governmental unit is NOT primarily liable, the associated
Revenues DO NOT qualify as Revenues of the government. the Transactions should be reported in a
Custodial fund and the Assets & Liabilities should be excluded from government-wide presentations.
Bond Issue Proceeds = Other financing sources → I/S
Bond Premium or Discount = No amortization of premiums and discounts
Bond Par Value = bond proceeds (sources)
Premium = financing source
Discount = financing use
Bond issue cost and bond underwriter fees = debt service expenditures
Example of Capital Project Fund Bond Proceeds Receipt = Bond at par value of $2,000,000 was issued
for $2,080,000 at a premium for the building of a new convention center (government building).
Dr Cash $2,080,000
Cr Other Financing Sources-Bond issue proceeds $2,000,000
 Cr Other Financing Sources-premium on bonds $80,000
The bond premium is immediately transferred to the Debt Service Fund:
Dr Inter-fund Transfer (To Debt Service) $80,000
Cr Cash $80,000
NOTE: If the Bond was sold at a discount, either the project would have been reduced by the amount
of the discount or the shortfall of the funding could be transferred from another fund.
Expenditure and Encumbrance Types = Capital Project Fund expenditures are usually entirely classified
as capital outlay. Encumbrances are recorded as commitments are incurred. Vouchers are recorded
when a liability is incurred and the expenditure is known.
Unique Accounting Issues
Asset balance = not displayed on the capital projects fund B/S
Liability balance = Bond liability = Not reported in Capital Project Fund B/S, instead Reported in
Government-wide FSs ONLY.
Short-term borrowing = Other financing sources or current liabilities = Often these borrowings are
"Bond anticipated Notes" to be repaid upon issuance of the Bonds.
Bond anticipated notes =Other Financing Sources
Tax Anticipation Notes or Revenue Anticipation notes or Bond Anticipation notes are Current Liability
Bond Anticipation notes are recorded as a Current Liability when the Government unit has no ability to
refinance.
Bond Issuance Notes are recorded as Other Financing Sources when the entity has the ability and
intent to refinance.
Closing Entries for the Capital Project Fund = BAE BAE
Outstanding encumbrances at YE should be carried forward as a component of fund balance. The
entire amount of the Capital Projects Fund is presumed to be restricted for capital outlay. The
outstanding encumbrances would be disclosed as a budgetary obligation of resources restricted for
capital projects but they would not be shown on the face of the FSs.
Composition of Restricted Fund balance:
Beginning fund balance, restricted $100,000
Bond Issuance $2,080,000
Interest Income $40,000
Expenditures ($600,000)
Inter-fund Transfers to Debt Services ($120,000)
Ending fund balance, restricted $1,500,000
NOTE: Special Revenue Fund has operating expenditures
Debt Service Fund has debt service expenditures
Capital Projects Fund has capital outlay expenditures
Permanent Funds = should be used to report resources that are Legally Restricted to the extent that
only earnings and NOT principal may be used for the purpose of the government's programs.
Investments in Permanent Funds are recorded at FV!
Revenue Sources = Investment earnings
Expenditure Types = related to the operating purposes, such as cemetery maintenance.
PASS KEY = 2 of the GRASPP Funds do NOT record Encumbrances:
Debt Service Fund
Permanent Fund
PASS KEY = Public-Restricted Funds are recorded as follows:
Special Revenue Fund → Principal & Interest
Permanent Fund → Interest Only
M4 - Proprietary Funds Financial Statement
Internal Service Fund = Customer, not citizen
Other departments fund the operations by paying fees = they are customers
Internal Service Funds are established to finance and account for services and supplies provided
exclusively to other departments within a government unit.
SE - CIPPOE = Accrual; Record FA & LTD; Economic resources measurement focus
Examples of Internal Service Funds:
--Central Janitorial Department
--Central Garage & Motor Pools
--Central Printing & Duplicating Services
A self-Insurance fund is Internal Service Fund because city departments are the exclusive users of the
fund benefits.
Revenue Sources:
1. Restricted Grant Revenues = recognized as Revenue in the year monies are spent
2. Operating Revenues = billings or services provided and recognized when earned
JE to record billings for services rendered to other funds:
Dr Cash (or due from other find)
Cr billings to other departments (operating revenue)
Pass Key = even though billings is btw funds, the transaction is not treated as an inter-fund transfer,
instead treated as Revenues, and the fund paying for the services records expenditure or expense of
equal amount as the Revenues.
Non-operating Revenues = such as interest earnings
Expense Types
1. Operating Expenses = normal and customary expenses
2. Non-operating Expenses = such as interest expense
Unique Accounting Issues:
Internal service funds may be established by contributions from other funds or inter-fund transfers
from other funds.
JE to record a nonreciprocal transfer to establish the fund:
Dr Cash
Inter-fund Transfer
JE to record a contribution of Assets from the General Fund to establish the fund:
Dr Capital Assets
Cr Contribution
JE to record long-term advances from other funds:
Dr Cash
Cr Due to Other Fund
Financial Statements = Statement of Net Position (Full Accrual + carries FA & LTD)
Net position = Equity = RUN = Restricted; Unrestricted and Net investment in Capital Assets
Enterprise Fund = Customer, not citizen. Enterprise Funds are used to account for operations that are
financed and operated in a manner similar to private business enterprises.
Enterprise Funds are financed primarily by fees and user charges (NOT taxes).
Examples = Public utilities, Public hospitals, Public universities; Public Transportation Systems;
Airports; Public benefit corporations; Lotteries; Public Housing
Revenue Sources:
1. Operating Revenues, such as Charges for Services (water & sewer billings) and
2. Non-operating Revenues, such as earnings or non-exchange transactions (taxes & certain fees) and
interest. Example = State appropriations to a State University (Enterprise Fund) are State Grants or
Subsidies, which are non-exchange transactions and are reported as Non-Operating Revenues!
Shared revenues = Non-Operating Revenues collected by one government (State) and shared on a
predetermined basis with another government (Local)
Expense Types:
Operating expenses = personal services, utilities, and depreciation
Non-operating expenses = most commonly include interest expense
Unique Accounting Issues = BAE BAE not used
Public colleges may use Enterprise Fund (Depreciation expense is recorded), but they may use a
Governmental Fund, which does NOT record depreciation expense!
Reporting on the Statement of Revenues, Expenses, and Changes in Net Position
Revenue Valuation = Revenues are reported either net of discounts and allowance w/ appropriate
disclosure of the allowance OR reported gross w/ related discount or allowance amounts reported on
the face of the FSs. Bad Debt expense is NOT recognized.
Contributed Capital = resources from Capital Contributions or additions to endowments are displayed
after non-operating revenues and expenses.
Special and Extraordinary Items = reported separately after non-operating revenues and expenses
Transfers = Displayed after contributions and special and extraordinary items
Presentation of line items on a Proprietary Fund statement of revenues, expenses, and changes in fund
net position:
Income (operating)
Non-operating income & expenses
Capital contributions
Additions to endowments
Special items
Extraordinary items
Transfers
Establishing an Enterprise Fund:
1. Capital contributions, which capital assets contributed from governmental funds. They are not
classified as transfers.
Dr Capital Assets
Cr Capital Contributions
2. LTD recorded (or Other LT Financing agreement, such as a Lease Contract that transfers ownership)
Dr Cash
Cr LT bonds Payable
Municipal Landfills (the Dump)
Reporting and Disclosure = The estimated total current costs and the Post-closure care
Cost Components (adjusted annually):
--Cost of equipment near or after the date that the MSWLF stops
--Cost of a gas monitoring
--Cost of final cover
Equipment Purchases = do NOT increase assets
Financial Statements = Statement of Net Position (Full Accrual + carries FA & LTD)
Net position = Equity = RUN = Restricted; Unrestricted and Net investment in Capital Assets
Statement of Cash Flow = Direct method required
= Reconcile to Operating Income (NOT to Net Income as it is with commercial)
M5 - Fiduciary Funds Financial Statements
Fiduciary Funds - General = CIPPOE = Activities that qualify as a fiduciary activity must have the
following characteristics:
--Assets associated with the Funds are Controlled by government
--Government holds the assets OR
--Ability to direct the use of assets for the benefit of intended recipients
Assets associated with the Fund activities are NOT derived from revenues generated by a government
itself. Assets associated with the activity must have one or more of the following:
Assets are:
--Administered through a trust in which the government itself is not a beneficiary
--Dedicated to providing benefits to recipients
--Legally protected from the creditors
Assets are:
--For the benefit of individuals
--Not derived from the government’s provision of services or goods
--Government does not have administrative involvement or direct financial involvement
Administrative involvement = includes the following characteristics:
Monitoring compliance with the requirements of the activity that are established by the Gov
Determination of eligible expenditures established by the Gov
Ability to exercise discretion over how assets are allocated
Direct financial involvement by the Gov = Government providing matching resources
PASS KEY = Fiduciary activities have the following characteristics:
--Assets are controlled by the Government
--Assets are NOT Government's "own-source" of revenue
--Assets are NOT subject to administrative involvement by the government
Custodial Fund = collects cash to be held temporarily for an authorized recipient to whom it will be later
disbursed. Examples = Tax collection fund; Clearance funds; Special assessment
Custodial Funds are used to account for assets, such as taxes collected held by a governmental unit (a
county) acting as a collection agent in a fiduciary capacity for another governmental unit, a school
district.
ALL fiduciary funds have NO CF Statements
Revenue source examples = additions are reported which are normally expected to be held for three
months or less. Funds collected by a sales tax custodial fund are accounted for in "Due to General
Fund" account.
Expense type examples = deductions which are normally expected to be held for three months or less
Revenue and Expenses are not recognized in a Custodial Fund as the purpose of the fund
is to collect and hold cash, which is later disbursed to an authorized recipient.
Custodial Fund reports in the stmt of fiduciary net position current assets and current
liabilities, but no Fund balance and has NO YE balance as the money is periodically transferred to an
authorized recipient.
Unique accounting issues:
Tax collection funds = a local Gov collects a tax for an overlapping Gov unit and remits the amount
collected, less admin charges, to the recipient unit. Examples = Sales tax custodial funds, payroll
withholding custodial funds, real estate tax custodial funds
Clearance funds = are used to accumulate a variety of revenues from different sources and apportion
them to various operating funds in accordance with a statutory formula or procedure. Clearance Funds
do NOT have monitoring or admin involvement. Examples = Pass-through grants, food stamps, traffic
citations, alimony, child support, etc.
PASS KEY = If a Gov unit has monitoring or similar admin involvement, the Special Revenue Fund is
used!
Special Assessments = when the Gov is NOT otherwise obligated for the debt (not primarily or
potentially liable. IF LIABLE: USE CAPITAL PROJECTS & DEBT SERVICE Funds
Custodial Fund Title = The Only fund without the word “trust”
Financial Statements:
1. Statement of Fiduciary Net Position
2. Statement of Changes in Fiduciary Net Position (No Revenues & Expenditures words in the name)
--Additions and deductions (not Revenues & Expenditures/Expenses)
Fees withheld by the Custodial Fund from the collections of taxes levied and collected on behalf of
a city or district, get recorded as "Liability-die to other funds" and NOT as "Additions".
Investment Trust Funds = CF not required
Revenue (Addition) Sources = include Contributions ; Net appreciation/depreciation of the FV of plan
assets; Realized and unrealized gains and losses; Premiums and discounts on debt securities (not
amortized as part of investment income)
Expense (Deduction) Types = Payments to beneficiaries and administrative expenses
Unique Accounting Issues = The plan's net Assets are reported on FV basis
Private Purpose Trust = it is the designated fund for reporting all other trust arrangements for the
benefit of Specific individuals, private organizations, or other governments. NO CF statements
required! Examples = escheat property funds, retainage on construction contracts for the benefit of a
contractor.
It accounts for fiduciary transactions that relate to specific private, NOT general public, purposes other
than Public employee retirement systems OR Investment pools held on behalf of other governments.
Revenues (Addition) Sources = Assume the principle of the fund is invested and the interest income is
transferred to a private individual:
Dr Deductions
Cr Accounts Payable
Expense (Deductions) Types = benefits or administrative charges
Capital gains/losses = adjustments to income/expense
Unique Accounting Issues = Escheat property is property that reverts to a Gov entity in the absence of
legal claimants or heirs at the time the estate is settled. revenue is reduced and a fund liability is
reported to the extent that property will be probably reclaimed.
Chart for Restricted Funds:
Special Revenue Fund → Public Use → Interest & Principal are expendable
Permanent Fund → Public Use → Interest Only expendable
Private Purpose Fund → Private Use → Interest and/or Principal expendable
Pension (and Other Employee Benefit) Trust = account for Gov sponsored defined benefit & defined
contribution plans and other employee benefits such as postretirement health care benefits. CF NOT
REQUIRED.
Revenue (Addition) Sources = Employer and employee contributions
JE to record the receipt of money from other funds (Additions and NOT Revenue or Other Financing
Sources):
Dr Cash
Cr Additions-employer contributions-restricted
Other fund contributing money to the pension fund:
1. From GRASPP Funds (Modified accrual) = JE within the GRASPP fund : Dr Expenditures and Cr Cash
2. From SE-CIPPOE funds = JE within those funds = Dr Expense and Cr Cash
Income from investments = recorded as Additions
Expense (Deduction) Types = Benefits payments, refunds, and administrative expense
Financial Statements:
Assets at FV
<Liabilities>
Net position restricted for pension = A - L
PASS KEY = The net pension liability and the change in the net pension liability are NOT included on
the B/S of the pension fund FSs.
Statement of Changes in Fiduciary Net Position = I/S
--Additions include contributions received from employees and employers + net
appreciation/depreciation of FV of the plan assets to include the realized and unrealized G/L +
premiums and discounts on debt securities (not amortized)
--Deductions include benefit payments to retirees and beneficiaries and admin expenses
Statement of CF: Fiduciary Funds =NO CF Stmts, but Proprietary Funds = Yes to CF Stmts
F10 - Governmental Accounting: Part 3
M1 - Form and Content of the Comprehensive Annual Financial Report
Governmental Financial Reporting Requirements of GASB 34
Operational Accountability = The focus of government-wide FSs is whether the Gov has met its
operating objectives efficiently and effectively, using all the resources available for that purpose.
Fiscal Accountability = The focus of fund FSs is to demonstrate that the Gov has complied with public
decisions concerning the raising and spending of public funds in the short-term. Integrated Approach =
financial accounting and disclosures show operational and fiscal accountability and their relationship
through reconciliation.
Management's Discussion and Analysis (MD&A)
↓
Gov-wide FSs ↔Fund FSs → Reconcile
Notes to the FSs
↓
Required Supplementary Info (Other than MD&A)
The Integrated approach requires a reconciliation of the fund FSs to the government-wide FSs to link
the accountability objectives of the two levels of reporting. This reconciliation may appear on the face
of the Fund FSs or in the notes to the Gov-wide FSs.
Required Reporting for General Purpose Governmental Units:
1. MD&A: Before FS = Narrative analysis (includes discussion of significant variances from budget)
2.Basic Financial Statements
Government-wide Financial Statements
Statement of Net Position
Statement of Activities
Fund Financial Statements
Governmental Funds - GRaSPP (Balance sheet & Stmt of Rev., expenditures, changes in Fund)
Proprietary Funds - SE (Smt of Net Position, Stmt of Rev, expenditures, changes & Stmt of CFs)
Fiduciary Funds - CIPPOE (Stmt of Fiduciary net position & Stmt of changes in fiduciary net position)
Optional = Summary of non-major funds
Notes to Financial Statements
3. Required Supplementary Information (RSI) Other Than MD&A: After FS
Pension
 Budget
Infrastructure (Road & Bridge assets reported using the modified approach)
4. Other Supplementary Information (Optional)
Combining statements for non-major funds
Variance btw originally adopted and final amended budget
Variance btw final amendment budget and actual
Comprehensive Annual Financial Report = Not required by GAAP
Introductory Section (Unaudited)
Letter of transmittal
Organizational chart
List of principal officers
Basic Financial Statements and Required Supplementary Information (Audited)
MD&A
Gove-wide FSs
Fund FS
Notes to the FS
Required Supplemental Info
Statistical Section (Unaudited) - NOT part of the basic FS
Ten years of selected financial data
Ten years of economic data (e.g., mileage rates, appraised values)
Other data
The Financial Reporting Entity = The focus of the Gov-wide FSs should be on the Primary Gov.
General Purpose Governmental Units = States, Counties, Towns, Municipalities, Villages
Special purpose local governments = Examples = Hospital authority or a School District
They meet the following criteria (SELF):
SE---Separately elected governing body
L---Legally separate
F---Fiscally independent of other state and local governments
Special purpose Gov Units that are fiscally accountable to a primary Gov, are NOT Primary Gov.
Component Unit = the elected officials of the Primary Gov are Financially accountable for the
component units
Blended presentation = Used when ANY of the following is present:
--Board of the component unit is substantively the same as that of the Primary Gov
--The Component Unit Serves the primary government exclusively
--The Component is NOT a separate legal entity
Features of the Blended Presentation:
--Combined financial info w/ the primary Gov
--Financial info of the component unit is NOT presented in separate columns
Discrete Presentation (or Separate Presentation), which is The default method = If not blended, then
discrete.
PASS KEY = Assume discrete presentation unless the fact pattern specifically provides evidence that
the blended presentation is met.
The Financial Reporting Entity Summary:
Begin
↓
Primary Gov ← YES ← Does the Entity meet the SELF test?
↓NO
Component Unit
 ↓
Is the board of the Primary Gov the same as the component unit?
OR
Blended ← YES ← Does the Component unit serve the Primary Gov exclusively?
OR
Does the organization NOT qualify as a legal entity?
↓NO
Discrete
Criteria for Discrete Presentation
Legally separate, tax-exempt organizations should be reported as discrete component unit (separate
column) if they meet the following criteria:
--Resources are for the Near-exclusive benefit of the primary government
--The Primary government has access to a majority of the resources
--Resources are significant to the Primary Gov
Criteria for Other Component Unit Presentation
Legally separate, tax-exempt organizations Meeting the criteria of a financially integrated entity should
be classified as component unit of the primary Gov if their relationship is So significant.
M2 - Government-wide Financial Statements
Statement of net position (A Consolidated Statement):Net Position Format
Assets & Deferred Outflows of Resources
<Liabilities & Deferred Inflows of Resources>
Net Position (RUN)
Net position is divided into 3 components:
1. Net Investment in Capital Assets = All capital assets, net of accumulated depreciation, reduced by the
outstanding balances of bonds, mortgages, notes PLUS Deferred outflows and deferred inflows of
resources.
2. Restricted = Restricted assets reduced by liabilities and deferred inflows of resources related to those
assets. Restrictions are imposed by external activity.
3. Unrestricted = Everything else
Treatment of Inter-fund Receivables and Payables = Elimination of inter-fund activities within major
activity categories is displayed for Gov-wide presentation to avoid 'grossing up".
Internal Service Funds = Reported in the governmental activities column
Capital Assets: Capitalization and Depreciation
Construction period interest = NOT included in the historical cost of a capital ASSET, instead reported
as interest expense
Infrastructure assets = street, bridges, gutters. Should be reported as general capital assets. They are
recorded ONLY in Gov-wide FSs.
Required approach = All assets meeting capitalization requirements should be recorded and
depreciated.
Modified approach = Infrastructure expenditures are reported as expenses unless the outlays result in
additions or improvements, in which case they would be capitalized.
Infrastructure assets that are part of a network or a subsystem of a network are NOT required to be
depreciated if 2 requirements are met:
1. The Asset Management System Meets Certain Conditions:
--The Gov maintains an up-to-date inventory of eligible infrastructure assets (map of roads, bridges)
--Condition assessment of the infrastructure assets is performed
--Estimate is made of the amount necessary to maintain and preserve the infrastructure assets
2. Documentation Includes Data on Asset Preservation
--A complete Condition assessment
--Reasonable assurance the results of the last 3 condition assessments Support assertions
Modified approach reporting:
1. Schedule reporting on condition
2. Comparison schedule of needed and actual expenditures to maintain the Gov's infrastructure
Modified approach accounting changes → Change in estimates
Impairment = Physical damage = measured using the restoration cost approach. The Loss = estimated
cost to restore the asset.
Enactment of laws or obsolescence = measured using the service units approach. The Loss = the
productive units available before and after the impairment.
Asset life (duration) or reduced utility = measured using the service unit approach.
Artwork and historical treasures = GR: Capitalize @ historical cost or FV at date of donation.
Gov may elect NOT to capitalize artworks if all 3 conditions are met:
--The collection is held for Public exhibition
--The collection is Protected
--Proceeds from sales used to acquire other items for collections.
Statement of Activities of Gov-wide FSs = Full accrual basis
Functions/Programs:
--Primary governmental activities = GRaSPP + S
--Primary business-type activities = E (not CIPPOE)
--Component units = Rescue squad & board of education
Expenses = full accrual basis
Program Revenue = full accrual basis (AR with allowance)
Revenue is recorded as earned net of any allowance for uncollectable amounts.
Program Revenue Category Types (SOC):
S--- Charges for Service to customers or applicants who directly benefit from goods
Charges for services to other governments
Fines and forfeitures
O---Operating Grants and Contributions = Mandatory & Voluntary non-exchange transactions w/
other Govs, organizations, individuals. Restricted for use in a particular program
C---Capital Grants and Contributions = Restricted for use in a particular program
Net (Expense) Revenue and Changes in Net Position = presented in 3 categories:
--Primary governmental activities = GRaSPP + S
--Primary business-type activities = E (not CIPPOE)
-- Component units = Rescue squad & board of education
General Revenues = presented in these same 3 above categories and a total column. Examples of
General Revenue = taxes, interest earnings, and other revenues that are not specifically associated
with a functional expense.
Special Items = reported separately. Example = sales of Gov properties at a G/L
Change in Net Position = Net Revenue (expense) less General Revenue
Eliminations = Internal transactions that artificially “double up” on activity should be eliminated
Inter-fund services, such as water and other utilities, should NOT be eliminated
Internal activity associated with blended component units should be reclassified as inter-fund activity
Internal activity associated with discretely presented component units should be reported as external
transactions
Internal Service Funds = GRaSPP + S
Special Assessment Debt maturing in 5 years, to be repaid from general resources of the Gov, is
reported in the Gov-wide statement of net position, and NOT in Custodial Fund. Such debt in the
Custodial Fund would be repaid from third parties, NOT from the Gov's general resources.
M3 - Fund Financial Statements
Major Fund Rules = To be a major fund, the Fund needs to meet 2 criteria:
--10% Test within its category (All governmental funds OR all enterprise funds) AND
-- 5% Test = All governmental funds AND all enterprise funds > 5%
10% Test = A fund may be a major fund if it has 10% or more of total Revenues,
expenditures/expenses, assets and deferred outflows of resources, OR liabilities and deferred inflows
of resources of:
--All Governmental Funds
OR
--All Enterprise Funds
5% Test = A fund is a major Fund if it meets the 10% Test AND ALSO has 5% or more of Revenues,
expenditures/expenses, assets and deferred outflows of resources, or liabilities and deferred inflows
of resources of:
--All Governmental Funds
AND
--All Enterprise Funds
Other Major Fund Considerations:
--The General Fund is ALWAYS a Major Fund
--Gov officials may elect to report a fund as major if they believe the public interest is served
--Internal Service Funds are NOT considered in the evaluation of major and non-major funds. The only
proprietary fund considered here is the Enterprise Fund.
--Extraordinary items and Transfers are NOT considered in major fund determinations.
--The aggregate fund balance/equity is NOT used in either test.
Governmental Funds - GRaSPP = present financial position as a Balance Sheet that displays:
Assets + deferred outflows of resources = Liabilities + deferred inflows of resources + fund balance
Proprietary Funds - SE = Statement of Net Position displays:
Assets + Deferred Outflows of resources = Liabilities + Deferred inflows + Net position (RUN)
Proprietary Funds' Statement of Cash Flows = Just like commercial, with the following seven
differences:
--Direct method REQUIRED
--Reconciliation of operating income (not net income)
--Four categories, instead of 3 in commercial accounting:
Operating activities
Capital and related financing activities
Noncapital financing activities
Investing activities
--Order of financing and investing are reversed
--Interest & Dividend income = Investing activities
--Interest expense = either Capital financing activities or Non-capital Financing
--Capital asset purchases = financing activities (NOT investing activities)
PASS KEY = The reconciliation of the operating income to net cash provided by the operations includes
depreciation and changes in current A & L, but does NOT include adjustments for G/L b/c G/L & non-
operating items are NOT included in operating income.
--Current A & L changes (Current portion of revolving debt NOT included)
Operating Activities include:
--Cash inflows from sales
--Cash outflows to suppliers or employees
--Cash inflows from inter-fund reimbursements and exchanges including payments in lieu of taxes
Investing Activities include:
--Cash inflows & outflows associated with loans to others
-- Cash inflows & outflows associated with equity transactions
Capital and Related Financing Activities include:
--Cash flows from issuing debt associated with capital assets (including the interest expense)
--Cash inflow from capital grants
--Cash inflow from contributions associated with capital assets
--Cash activity related to special assessments associated with capital assets
Non-capital Financing Activities include:
--Cash flows from issuing debt for non-capital purposes (including the interest expense)
--Cash receipts from grants or subsidies
--Cash receipts from property taxes (not restricted for capital use)
--Operating Transfers
Fiduciary Funds - CIPPOE = NOT included in the Gov-wide FSs
Statement of Fiduciary Net Position = B/S
Net Position = [Assets + Deferred outflows] - [Liabilities + Deferred inflows]
Statement of Changes in Fiduciary Net Position = I/S (Additions - Deductions = Change in Net Position)
M4 - Deriving Government-Wide Financial Statements and
Reconciliation Requirements
Reconciliation of Governmental Fund Financial Statements to Government-wide Financial Statements
Reconciliation Requirements:
--Measurement Focus Differences → Adjustment of capital asset and long-term debt accounts
--Basis of Accounting Differences → Elimination of the effect of using the modified accrual basis
Reconciliation of the Governmental Funds Balance Sheet to the Government-Wide Statement of Net
Position (CAN + other adjustments):
Adjustments for the difference in measurement focus:
C - Add capital (non-current) assets
A - Subtract related accumulated depreciation
N - Subtract non-current liabilities = LTD
Adjustments for the difference in basis of accounting:
--Eliminate Deferred Inflows associated with recognized revenues
--Subtract accrued liability for interest payable
Consolidation entries:
S - Add internal service fund net position
I T - Inter-fund Transfers
Extra ADJ: Deferred Income at the end of prior year, recognized as revenue under the modified accrual
in the current year, needs to subtracted from Net Position.
Total Governmental Fund Balance
+ Capital Assets (Existing & Current)
- Acc. Depreciation
- Non-current Liabilities (existing)
+ Eliminate/reverse deferred inflows
- Accrued Interest Payable
+ Internal Service Fund net position
Net position from governmental activities
Reconciliation of Governmental Funds Statement of Revenues, Expenditures, and Changes in Fund
Balance to the Government-wide Statement of Activities:
Adjustments for measurement focus:
C--Add Capital Outlay expenditures
P--Add Principal payment on debt
A--Subtract BV of Assets disposed of
S--Subtract debt proceeds shown as Other Financing Sources
Adjustments for the difference in basis of accounting:
R--Add Recognized Revenues that are measurable but unavailable
I--Subtract Accrued Interest Expense
D--Subtract Depreciation Expense
E--Consolidation Entries:
S--Add Internal Service Fund change in net position
I T--Inter-fund Transfers
Extra ADJ: Deferred Income recorded at the end of the previous year and recognized under the
modified accrual method as revenue in the current year, should be reversed and thus subtracted from
current year income, because it should have been recognized as revenue in the prior year.
Deriving Government-wide Financial Statements
Converting the Governmental Fund F/S to Gov-wide F/S:
Measurement Focus Differences
--Capital outlay expenditures - capitalize, NOT expenditure
--Debt service expenditures - LTD, NOT other financial sources
--Debt proceeds included in other financing sources
Basis of Accounting Differences
--Differences in revenue recognition and differences in expense vs. expenditure recognition
Revenue is earned
Accrue interest expense/payable
Depreciation expense
Excluded Funds - need to include now = GRaSPP + S
--B/S - Addition of internal service net position
--I/S - Inclusion of profits earned by internal service funds
Workpaper JEs used to convert Gov fund presentations that use measurement focus accounting to the
commercial style accounting used by the Gov-wide GSs:
Measurement focus entries:
JE to recognize non-current assets used in Gov activities purchased in prior years:
Dr Capital Assets
Cr Net Position
JE to recognize acc. depreciation on these same Capital Assets:
Dr Net position
Cr Acc. Depreciation
JE to recognize non-current liabilities issued in prior years used to finance Gov activities:
Dr Net Position
Cr Non-current Liabilities
JE to recognize capital assets that were recorded as expenditures on the Gov fund statement of Rev:
Dr Capital Assets
Cr Capital Outlay
JE to eliminate the Principal payments of LTD recorded as expenditures on the Gov fund stmt of Rev.:
Dr LTD
Cr Principal payments expenditures
JE to eliminate the sold asset and related acc. depreciation:
Dr Other Financing Sources: proceeds from asset disposal
Dr Acc. Depreciation
Cr Cost of Asset
Cr Gain on Disposal
JE to record LTD received in the current period, recorded as Other Financing Sources in Gov fund FSs:
Dr Other Financing Sources
Cr LTD
Basis of Accounting Entries:
JE to recognize measurable but unavailable tax revenue:
Dr Deferred Inflows
Cr Tax Revenue
JE to accrue Interest on un-matured debt:
Dr Interest Expense
Cr Accrued Interest Payable
JE to record current period depreciation:
Dr Depreciation Expense
Cr Acc. Depreciation
Internal Service Fund Entries & Eliminations:
Dr Assets: Governmental activities
Dr Internal Service Fund Revenue
Cr liabilities: Governmental activities
Cr Internal Service Fund Expenses
Cr Governmental Fund expenditures
This JE integrates internal Service Fund Assets & Liabilities into the governmental activities and
eliminates Internal Service Fund's profits by reducing the Governmental expenditures.
JE to eliminate the Inter-fund Transfers:
Dr Inter-fund Transfers In
Cr Inter-fund Transfers Out
Dr Due to Other Funds
Cr Due from Other Funds
M5 - Notes and Supplementary Information
MD&A = Displayed before the FSs and Required in government financial reporting
The following should be included in MD&A:
--An easy readable analysis of the Gov's F/S
--Condensed FS info from the Gov-wide FSs (NOT from the fund FSs)
--Comparison of current year results to the prior year with emphasis on the current year
--Analysis of overall Financial Position and results of operations
--Analysis of balances and transactions of individual funds
--Analysis of significant variances btw the original and the final budget
--A description of the significant assumptions of use of the modified approach for accounting for
infrastructure
--MD&A Does NOT include Reconciliation of Fund FSs and Gov-wide FSs. The reconciliation is part of
the Basic FSs.
Identity of the Primary Government and Discrete Component Units:
Major Initiatives = describes capital asset and LTD activities during the year.
Notes to the Financial Statements = displayed after FSs and should focus on the Primary Gov:
--Governmental activities
--Business-type activities
--Major funds
--Non-major funds in the aggregate
--Additional info about the discretely presented component units
Generic Governmental Disclosures:
--Noting the Exclusion of fiduciary funds = CIPPOE
--Noting the Elimination of internal activity
Specific Governmental Disclosures:
--Description of activities for Major Funds, Internal Service Funds and Fiduciary Funds
--GR: Modified accrual basis (60 days)
--Action taken to Correct material noncompliance
Required Supplementary Information (Other than MD&A) = After the F/S and the Notes
--Budgetary Comparison Reporting for the General Fund and for each Major Special Revenue Fund.
The budgetary comparison schedule must show the original budget, the final amended budget and
actual amounts.
--Variances btw budget & actual is Optional
--Differences btw the original and the final amended budget is Optional.
--Infrastructure Information (Required to use modified approach) = Disclose:
1. Inventory of Assets
2. Summary of condition assessments
3. Amount necessary to maintain and preserve the condition of the assets.
--Pension Information = should be presented for each of the 10 most recent fiscal years.
Sources of changes in net pension liability
Info about the components of the net pension liability
Significant methods and assumptions used to calculate the actuarially determined contributions
Other Supplementary Information (Optional)
--Combining statements for non-major funds = Failed 10% + 5%
--Variance between original and final amended budget
--Variance between final amended budget and actual
Inter-fund Receivables and Payables btw Governmental & Enterprise funds should be reported as
Internal Balances in preparing the Gov-wide FSs, and NOT as Due to/Due From.