GAAP: A to Z and Everything In Betweenddntzgzn81wae.cloudfront.net/uploadpdf/A017-0255_Course.pdf · Everything You Never Wanted to Know About GAAP 9 SECTION I. GAAP Q & A Introduction:

GAAP: A to Z and Everything In Between

Publish Date: February 2017

Everything You Never Wanted to Know About GAAP

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GAAP: A to Z

The author is not engaged by this text or any accompanying lecture or electronic media in the rendering of legal, tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this material have been reviewed with sources believed to be reliable, concepts discussed can be affected by changes in the law or in the interpretation of such laws since this text was printed. For that reason, the accuracy and completeness of this information and the author's opinions based thereon cannot be guaranteed. In addition, state or local tax laws and procedural rules may have a material impact on the general discussion. As a result, the strategies suggested may not be suitable for every individual. Before taking any action, all references and citations should be checked and updated accordingly. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert advice is required, the services of a competent professional person should be sought. —-From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a Committee of Publishers and Associations.

All rights reserved. Copies of this document may not be made without expressed written permission from the author. Copyright 2017 Steven Fustolo

Certain information has been adapted from AICPA Compilation and Review and Audit Risk Alerts-Copyright, American Institute of Certified Public Accountants, Inc. New York, NY 10036-8775


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GAAP: A to Z

Objectives: This course is divided into two sections. The purpose of Section I is to review unusual reporting and disclosure issues that develop in practice including questions such as how to disclose life insurance, leases, catastrophes, agreements not to compete, and investments. Section II deals with how to disclose and present tax-basis financial statements.

After reading the Section I course material, you will be able to:

Recall the accounting treatment for non-monetary exchanges

Recognize the formula for measuring an impairment of real estate

Identify the accounting for different types of investments such as securities, investments using the equity method, and partnerships

Recognize some of the disclosures required for trade receivables

Recall inventoriable costs

Recall the GAAP rules to account for an intangible asset with a finite useful life

Identify the GAAP treatment for endorsement split dollar arrangements

Identify the accounting for environmental contamination costs

Identify examples of costs associated with exit activities

Recognize the accounting and classification of shipping and handling costs

Recognize the accounting for vendor sales incentive arrangements and cash rebates from a vendor

Identify options to avoid having to maintain two depreciation schedules

Recall how to account for certain lease arrangements including those involving subleases

Recognize how to account for certain transactions on the statement of cash flows

Identify examples of group concentrations

Identify the basic accounting for fresh start reporting

Identify how web development costs are accounted for during certain stages of development

Recognize when an entity may elect the fair value option and identify the eligible items for which the option is available

After reading the Section II course material, you will be able to:

Recognize some of the M-1 differences that do not apply to tax-basis financial statements

Recognize how to account for an accounting change in tax-basis financial statements

Recall how to account for and present nontaxable and nondeductible items in tax-basis financial statements

Identify the disclosure requirements for tax-basis financial statements

Recognize the appropriate and inappropriate financial statement titles for tax-basis financial statements


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Field of study Accounting Level of knowledge: Overview Prerequisite: General understanding of GAAP and tax-basis financial statements Advanced Preparation: None Recommended CPE hours 16


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EVERYTHING YOU NEVER WANTED TO KNOW ABOUT GAAP

Table of Contents

SECTION I. GAAP Q & A ................................................................................................................9

I. BALANCE SHEET .............................................................................................................. 9

A. Comparative Statements/ Individual Statements ............................................................ 9

B. Property and Equipment ...............................................................................................10

Review Questions and Suggested Solutions .................................................................27

C. Cash and Investments ..................................................................................................30


D. Receivables ..................................................................................................................56

E. Inventories ....................................................................................................................61

F. Cash Value of Life Insurance ........................................................................................67

G. Intangible Assets ..........................................................................................................69


H. Current Liabilities ..........................................................................................................90

I. Notes Payable ................................................................................................................97

J. Other Liabilities ............................................................................................................ 103

K. Stockholders' Equity .................................................................................................... 109

Review Questions and Suggested Solutions ............................................................... 119

II. REVENUE AND EXPENSES .......................................................................................... 123

A. Income Statement Title ............................................................................................... 123

B. Involuntary Conversions .............................................................................................. 123

C. Percentage Revenue .................................................................................................. 123

D. Accounting for Shipping and Handling Costs Billed ..................................................... 124

E. Income Statement Characterization of Reimbursements Received ............................. 128

F. Reporting Revenue Gross Versus Net ........................................................................ 129

G. Cash Received by a Reseller from a Vendor .............................................................. 136


H. Depreciation and Amortization .................................................................................... 143

I. Other Expense and Income Items ................................................................................ 151


J. Cash Flows .................................................................................................................. 165

K. Concentrations ............................................................................................................ 175

L. Fiscal Years ................................................................................................................ 182


M. Personal Financial Statements ................................................................................... 188

N. Related Party Disclosures and Transactions ............................................................... 191


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O. Miscellaneous Disclosures.......................................................................................... 196

P. Income and Other Taxes ............................................................................................. 215


Q. Dealing with Acts of God (Natural Disasters), Terrorist Acts and Insurance Related Thereto ............................................................................................................................ 237

R. Accounting for Entities in Bankruptcy .......................................................................... 250

S. Accounting for Web Site Development Costs .............................................................. 252

T. Fair Value Disclosures ............................................................................................... 259

U. Subsequent Events Under GAAP ............................................................................... 269

V. Peer Review Deficiencies ........................................................................................... 274


SECTION II. TAX-BASIS FINANCIAL STATEMENTS ...............................................................284

A. Overview ......................................................................................................................... 284

B. Definition of Special Purpose Framework and Tax Basis ................................................ 284

C. New Definition of Tax-Basis Financial Statements .......................................................... 285

D. When to Use and Not Use Tax-Basis Financial Statements ............................................ 287

E. Present Reporting and Disclosure Authority- Tax Basis .................................................. 288

F. Items Peculiar to Tax-Basis Financial Statements ........................................................... 289

G. Disclosure and Financial Statement Requirements- Tax Basis ....................................... 290

H. Making Tax-Basis Financial Statements Simpler to Use and Understand ....................... 291

I. Converting to Tax-Basis Financial Statements ................................................................. 317

J. Cash Flows Statement .................................................................................................... 320

K. Tax-Basis Financial Statement Titles .............................................................................. 320

L. Disclosure and Financial Statement Requirements- Tax Basis ........................................ 322

M. Authority for Tax-Basis Disclosures ................................................................................ 323

N. Disclosures of Fair Value- Tax Basis .............................................................................. 326

O. Miscellaneous Disclosures – Tax Basis .......................................................................... 327

P. Other Tax Basis Issues ................................................................................................... 327

Q. Using the Tax Basis Based on a Method That Differs From the Income Tax Return ....... 328

R. Combining Financial Statements Prepared in Accordance With the Tax-Basis of Accounting .......................................................................................................................... 332

S. Disregarded Entities and Tax-Basis Financial Statements .............................................. 333

T. Tax Basis and the “Uses to File” Criterion ....................................................................... 335

U. Tax-Basis Financial Statements- State Tax-Basis of Accounting ................................... 336

V. Section 179 Depreciation- Tax Basis .............................................................................. 336

W. Presenting Section 179 and Bonus Depreciation on the Tax Basis Income Statement .. 339

X. Agreements Not to Compete - Tax-Basis Financial Statements ...................................... 342

Y. Presenting Insolvency in Tax-Basis Financial Statements .............................................. 343



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GLOSSARY .................................................................................................................................352

INDEX ..........................................................................................................................................354


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SECTION I. GAAP Q & A Introduction: In 2009, the FASB completed its Accounting Standards Codification™ (Codification) which was published in FASB No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (FASB ASC 105). The Codification was effective for interim and annual periods ending after September 15, 2009. With the Codification, the FASB had as its goal to consolidate U. S. GAAP into one system that can be more easily researched by topic, rather than by reference number. The Codification changes the citations for GAAP from the typical FASB or APB statement number to an Accounting Standards Codification (FASB ASC) reference. For example, FASB No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, has been codified into FASB ASC Topic 825, Financial Instruments. In this course, the author has included the original U.S. GAAP reference (e.g., FASB No. 115) parenthetically along with the FASB ASC topic number under the Codification (e.g., FASB ASC 320). For abbreviation purposes, the author uses the terms ASC, FASB ASC and FASB ASC Topic, interchangeably. I. BALANCE SHEET A. Comparative Statements/ Individual Statements Question: Are both a balance sheet and an income statement (and also a statement of cash flows) required for all annual reports, and must all such statements be in comparative form for at least two years? Response: ASC 205, Presentation of Financial Statements (formerly ARB No. 43), recommends, but does not require comparative financial statements. However, the SEC requires comparative financial statements for publicly held companies. Question: Is either statement alone a fair presentation? Does a balance sheet alone fairly present the financial position if the client incurred a material operating loss during the current year? Response: With respect to presenting one financial statement, reference can be made to SAS No. 122, AU-C Section 805, Special Considerations- Audits of Single Financial Statements and Specific Elements, or Items of a Financial Statement. AU-C 805 permits the auditor to report on a single financial statement, such as a balance sheet or income statement. The auditor may be asked to report on one basic financial statement and not on the others. For example, he or she may be asked to report on the balance sheet and not on the statements of income, retained earnings or cash flows. These engagements do not involve scope limitations if the auditor's access to information underlying the basic financial statements is not limited and if he applies all the procedures he considers necessary in the circumstances.


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Therefore, a separate balance sheet may fairly present financial position, and a separate statement of income may fairly present results of operations. Question: When financial statements are presented, should the notes to financial statements disclose details for both periods? Response: Generally, notes should relate to all periods presented, provided such information is relevant to both periods. In practice, many practitioners present certain disclosures comparatively (e.g., fixed assets, long-term debt), yet other disclosures for the current period only (e.g., short-term notes receivable and payable). B. Property and Equipment 1. Idle Property and Equipment Question: What is the appropriate balance sheet classification and presentation of idle property and equipment? Should the property and equipment continue to be depreciated while idle? Response: ASC 360, Property, Plant and Equipment, states that when a long-lived asset ceases to be used, the carrying amount of the asset should equal its salvage value, which should not be less than zero. Accounting Research Study No. 7, Inventory of Generally Accepted Accounting Principles for Business Enterprises, provides further guidance by stating:

“Plant assets may include property held with reasonable expectation of it being used in the business. It is not customary to segregate or indicate the existence of temporarily idle plant, reserve, or standby equipment.

Property abandoned but not physically retired or no longer adapted for use in the business, if material in amount, should be removed from plant accounts and recorded separately at an estimated (net) realizable amount, appropriately explained.

When a material portion of plant and equipment has been idle for a protracted period with no apparent likelihood of resuming operations, the amount should be set forth separately with an appropriate caption.

Depreciation should continue only if the equipment is temporarily idle and it is expected that operations will resume at some time.”

2. Categorization of a Building Question: A corporation purchased a building and intends to sell it within six months. Should it be accounted for as an investment or fixed asset? Should it be depreciated? Response: ASC 360, Property, Plant and Equipment (formerly ARB 43), states that GAAP requires that the cost of a productive facility be spread over its expected useful life. Because the building is not a productive facility, and no services will be derived from it, it should not be depreciated. Instead, it should be carried at the lower of cost or net realizable value (estimated selling price less selling costs) and categorized as a current asset since it will be converted into cash within six months.


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3. Deposit on Machinery Question: What is the balance sheet classification of a deposit on machinery to be purchased within one year? Response: ASC 340, Other Assets and Deferred Costs (formerly ARB No. 43), states that the concept of a current asset excludes any resources that are restricted as to withdrawal or use for other than current operations. Accordingly, the deposit should be presented as a long-term asset even though the equipment will be purchased within one year. 4. Non-Monetary Exchanges Question: What are the accounting rules for non-monetary exchanges? Response: The authority for non-monetary transactions is found in ASC 845, Non-Monetary Transactions (formerly FASB No. 153). The general rule is that exchanges of nonmonetary assets should be accounted for at the fair value of the asset surrendered or asset received, whichever is more determinable. ASC 845 provides three exceptions from the general rule under which the transaction is recorded at carrying value (book value) instead of fair value. These exceptions are:

a. Fair value is not determinable: The fair value of the asset(s) received or the asset(s) relinquished is not determinable within reasonable limits.

b. Exchange transaction to facilitate sales to customers: The transaction is an exchange of

a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange.

c. Exchange transaction that lacks commercial substance: The transaction lacks com-

mercial substance.

1) A transaction lacks commercial substance if the configuration (risk, timing, and amount) of the future cash flows of the asset received do not differ significantly from the future cash flows of the asset transferred.

Using the carrying value (book value) approach the transaction is recorded as follows: Book value of the + Cash = Cost of asset received asset given paid Although the first two exceptions may be relevant, the third one (the transaction lacks commercial substance is the most common to consider in practice and is the focus of the discussion in this section.


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How do you determine whether a transaction lacks commercial substance? ASC 845 provides that the assessment of commercial substance may be made either quantitatively (e.g., cash flow analysis) or qualitatively by comparing the configuration (risk, timing, and amount) of the future cash flows of the assets exchanged. Further, ASC 845 states that a significant difference in any one of the three elements (risk, timing and amount) of cash flows means that the transaction has commercial substance and thus is recorded at fair value. A practical way in which to determine whether a transaction lacks commercial substance is to focus only on the “timing” element of future cash flows because it can be easily assessed qualitatively. This qualitative assessment of the timing of cash flows can be made simply by comparing the remaining useful lives of the exchanged assets with the theory being that the useful lives represent the remaining time over which the assets will generate cash flows for the entity. If the remaining useful life of the asset received differs significantly from the useful life of the asset surrendered, the transaction has commercial substance and is recorded at fair value. Conversely, if the useful lives do not differ significantly, a carrying value approach should be used. Following are several examples that illustrate the application of ASC 845. Example 1: Company X trades in a motor vehicle with a carrying value of $10,000 for a new motor vehicle. No cash is exchanged. The remaining useful life of the old motor vehicle at the time of the exchange is 3 years. The useful life of the new motor vehicle is 3 years. Conclusion: The transaction lacks commercial substance and is recorded at carrying value. The configuration (risk, timing and amount) of future cash flows of the motor vehicle received does not differ significantly from that of the motor vehicle transferred. More specifically, the timing of the cash flows to be generated from the asset received (3 years) is the same as the timing of the cash flows generated from the asset given (3 years). Entry: New motor vehicle 10,000 Book value of old motor vehicle 10,000

Example 2: Company X trades in a motor vehicle with a carrying value of $10,000 for a new motor vehicle plus $8,000 cash paid. The fair value of the new motor vehicle is $22,000. At the time of the exchange, the remaining useful life of the old motor vehicle is 2 years while the new motor vehicle’s useful life is 5 years. Conclusion: The transaction does not lack commercial substance and is recorded at fair value. The configuration (risk, timing and amount) of future cash flows of the motor vehicle received differs significantly from that of the motor vehicle transferred. The reason is because the large amount of cash paid suggests the upgrade in assets is significant. Thus, the useful life of the new asset (5 years) is significantly longer than the old motor vehicle transferred (2 years), resulting in the timing of cash flows differing significantly between the two assets.

Entry: New motor vehicle 22,000 Book value of old motor vehicle 10,000

Cash 8,000

Gain on exchange 4,000


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Example 3: Company X exchanges a commercial rental property for 100 acres of land to be used for future development. The commercial property is currently rented to several tenants. The new land will be held for future development or speculation. At the earliest, the land would be sold or developed in five years. Details associated with the exchange follows:

Commercial rental property given: Carrying value of rental property (cost less accumulated depreciation)

$2,000,000

Fair value 4,000,000 Land received:

Fair value of rental property given $4,000,000 Cash paid 1,000,000 Total fair value given for land $5,000,000

Conclusion: The transaction should be recorded at fair value, with the land recorded at the fair value of the property given ($5,000,000). The reason is because the exchange has commercial substance. In this example, using a qualitative analysis, it is evident that the future cash flows of the new land are expected to significantly change as a result of the exchange. First, the risk associated with the future cash flows will change as the land will be held for speculation or future development. Second, the timing of the cash flows will change with the current cash flows from net rental income related to the commercial property being replaced with long-term cash flows from the land development or sale not likely to occur for another five years. Finally, the amount of the cash flows is likely to be different between the two properties.

Entry: Land 5,000,000 Book value-commercial property 2,000,000 Gain on exchange of property* 2,000,000

Cash 1,000,000

* Gain: Fair value of old property ($4,000,000)- carrying value of old property ($2,000,000) = Gain ($2,000,000)

May the commercial substance test be performed quantitatively? Conclusion: Yes. ASC 845 allows the test to be done either quantitatively or qualitatively. In most instances, a qualitative analysis such as the one given in the above three examples is the easiest and most effective way to determine commercial substance. The following example illustrates how a quantitative analysis can be done. Example 4: Company X has a plant with a carrying value of $1,000,000 with no debt outstanding. X purchases a new plant for $12 million by exchanging the old plant (fair value of $3,000,000) plus cash and financing paid of $9,000,000. The transaction is summarized as follows: Carrying value of old plant (cost less accumulated depreciation)

$1,000,000


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New plant: Fair value of old plant exchanged $3,000,000 Cash paid 4,000,000 Financing obtained for new purchase 5,000,000 Total purchase price- new plant $12,000,000

Future cash flows expected to run the new plant, versus the old plant follows: New plant Old plant Net operating income- annual

$2,000,000

$1,200,000

Add: depreciation 400,000 200,000 Debt service- principal payments (200,000) 0 Average annual cash flows 2,200,000 1,400,000 # years – useful life of plant 30 10 66,000,000 14,000,000 Residual value- assume sale at the end of the useful life

10,000,000

1,000,0000

Total cash flows over the useful life of each asset

$76,000,000

$15,000,000

Conclusion: The transaction should be recorded at fair value as the transaction has commercial substance. The reason is because the future cash flows are expected to significantly change as a result of the exchange to the new plant. In this example, the configuration (risk, timing and amount) of future cash flows of the new plant differs significantly from the configuration of the future cash flows of the old plant transferred. Because the new plant is partially financed, there is risk associated with the new plant as compared with the old plant. The timing of the cash flows differs because the new plant will generate cash flows over a longer period of time. Finally, the amount of the future cash flows is greater with the new plant versus the old one ($76,000,000 versus $15,000,000). Note that future cash flows of each asset reflect the assumption that the asset is sold at the end of the useful life of the asset. Second, although not necessary to this analysis, the entity-specific value of the new plant differs from the entity-specific value of the old plant, and the difference is significant in relation to the fair values of the assets exchanged.

Entry: New plant 12,000,000 Book value of old plant Gain on exchange of old plant

1,000,000 2,000,000

Cash 4,000,000

Note payable 5,000,000

(1) Gain: Fair value of old ($3,000,000)- carrying value of old plant ($1,000,000) = Gain ($2,000,000)

Note further that the analysis could have been done on a qualitative (rather than a quantitative) basis, thereby eliminating the need to perform the cash flow computations. How is cash received accounted for in an exchange that lacks commercial substance?


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If cash is received in a transaction that lacks commercial substance, a partial gain is recognized on the transaction based on the following ratio:

Cash received x Gain realized

= Gain recognized Total FMV received

Example: A motor vehicle with a book value of $5,000 is traded in for a new vehicle and the receipt of $1,500 cash. The useful lives of the assets are about the same so that the transaction lacks commercial substance and should be recorded at carrying value. The new motor vehicle has a FMV of $4,500. Step 1: Calculate the realized gain:

Total FMV received: FMV of new motor vehicle $4,500 Cash received 1,500 Total FMV received 6,000 BV of motor vehicle given up 5,000 Gain realized $1,000

The gain recognized for GAAP purposes is based on the ratio of cash received to total fair value received computed as follows:

Cash received 1,500 = 25%

x 1,000 = 250 gain recognized Total FMV received 6,000

Entry: Cash New motor vehicle (plug)

1,500 3,750

Gain BV of old motor vehicle

250 5,000

Note that when cash is received in an exchange that lacks commercial substance, the result is a hybrid transaction under which a partial gain is recognized with the remainder of the transaction being recorded at carrying value. The theory behind this approach is that a portion of the old asset was sold for cash resulting in a partial gain being recognized while the remainder of the old asset was exchanged at carrying value. What if there is an exchange that lacks commercial substance that results in an indicated loss? Should the loss be recorded for GAAP? Yes. ASC 845 has an indicated loss rule that should be followed in dealing with exchanges recorded at carrying value, including those that lack commercial substance. Example: A company has a fleet of motor vehicles for its sales staff. Once a vehicle reaches 50,000 miles, it is traded in for a new vehicle. This usually occurs after approximately 16-18 months. The motor vehicle exchanges are accounted for at carrying value, as non-monetary exchanges that lack commercial substance. After several exchanges, the book value of several assets appears much higher than its fair value. How should this be accounted for? Response: ASC 845 states that an exchange that lacks commercial substance is accounted for at carrying (book) value. The new vehicle is recorded at the book value of the old vehicle plus any cash or boot paid. However, ASC 845 provides an indicated loss rule based on the concept of


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conservatism. The indicated loss rule states that the new asset should never be recorded at more than its fair value. If the new asset is recorded at more than its fair value, it should be written down to its fair value and an indicated loss should be recorded on the income statement. Example: A company has an old motor vehicle with a book value of $25,000. The old vehicle is traded in for a new vehicle and the company pays a cash difference of $5,000. The cash selling price (FMV) of the new vehicle is $26,000.

Entries New motor vehicle 30,000 Book value- old vehicle 25,000 Cash 5,000

To record the trade in: book value of the old asset plus cash paid equals the cost of the new asset

Loss 4,000

New motor vehicle 4,000 To write down the new vehicle to market

value of $26,000

Note: If the fair value of the new motor vehicle were $38,000, the second entry would not be made, nor would an entry be made to record any unrealized gain. This is because the fair value of $38,000 is greater than the recorded value of $30,000. Note: For tax purposes, like-kind exchanges under section 1031 of the IRC are the same for book purposes as for tax purposes provided the transaction involves an exchange of asset for asset with no cash or where cash is given. However, the indicated loss is not allowed for tax purposes. Further, when cash is received, section 1031 requires gain recognition up to the amount of cash (boot) received (limited, of course to the total gain). How to deal with the GAAP Treatment of Delayed Exchanges: Section 1031 of the IRC Question: Section 1031 of the IRC permits a taxpayer to defer a gain on the exchange of certain property. How are delayed exchanges treated for GAAP? Response: Section 1031 allows a taxpayer to use the technique known as a delayed like-kind exchange. This technique is the most popular one used under Section 1031 because it does not require an actual direct exchange of one property for another between two parties. Here’s how it works! An entity (the seller) sells rental Property A for $500,000 cash under a transaction treated as a delayed exchange under section 1031. The basis of this property for tax purposes is $200,000, resulting in a realized gain of $300,000 ($500,000 less $200,000). The cash is held in an escrow account by an independent party (referred to as a qualified intermediary) on behalf of the seller until the seller finds a new investment property (the replacement property) to acquire with the escrowed cash. Within 45 days of the sale of property A, the seller must identify a replacement property (Property B) to acquire with the $500,000 cash. Further, the intermediary must purchase Property B on behalf of the seller within 180 days of the sale of property A. All of the $500,000


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cash must be spent on the acquisition of the new Property and, there are special net boot rules relating to mortgages as well as qualifying replacement property, both of which are details beyond the scope of this discussion. If this transaction is structured properly, Property B’s basis is the same as Property A’s, $200,000 with no gain recognition. Replacement Property B $500,000 cash to seller within 180 days to intermediary

Replacement Property B

$500,000 cash $500,000 cash

Does a delayed exchange qualify for GAAP as an exchange that lacks commercial substance so that it is recorded at carrying value? In reviewing the GAAP codification, there is no authority dealing with the accounting treatment for delayed exchanges. However, the FASB has offered an unofficial position that a delayed exchange does not qualify as an exchange that lacks commercial substance for purposes of applying ASC 845. Instead, for GAAP purposes, the delayed exchange should be treated as two monetary transactions, each recorded at fair value as follows: Transaction 1: Sale of first property and recognition of a gain on the sale Transaction 2: Purchase of new property for cash In the above example, there is a gain recognized on the sale of Property A and a step up in the basis in the new property to the acquisition price of $500,000.

Seller

Property A

Selling price $500,000

Basis 200,000

Qualified Intermediary (Escrow Account for Seller)

$500,000 cash

Replacement property- identified within 45 days and purchased within 180 days of sale or

original property

Property A- Sold to Buyer for $500,000 cash


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Example: Same facts as above applied to GAAP: GAAP Entries:

Transaction 1: Sale of Property A: Cash 500,000

Book value- Property A 200,000 Gain on sale of Property A 300,000

To record sale of Property A and recognition of gain.

Transaction 2: Purchase of Property B: Property B 500,000

Cash 500,000 To record purchase of Property B.

Tax Entries (if made for tax purposes): If entries are actually made for tax purposes, the entries to record the deferred gain under Section 1031 of the Internal Revenue Code would be as follows:

Cash escrow account 500,000 Book value of Property A 200,000 Deferred gain 300,000

To record sale of Property A Property B 200,000 Deferred gain 300,000

Cash escrow account 500,000 To record purchase of Property B as replacement property for sale of Property A.

As a result of the transaction, the basis of Property B is different for GAAP ($500,000) and tax ($200,000) purposes. The book-tax basis difference of $300,000 is a temporary difference and deferred taxes should be set up on this difference, if material. One way of avoiding the need to record the new property at fair market value would be to issue taxbasis financial statements under which the new property would be recorded using the IRC Section 1031 rules- at the book value of the property sold, rather than at its fair market value. Another option is to record the transaction at book value and note a GAAP exception in the report. Is the FASB’s position on delayed exchanges documented or codified? The FASB has not published its position on delayed exchanges despite numerous requests for it to do so. Absent a published opinion, a company or its accountant could ignore the FASB’s unofficial position based on the argument that there is no written authority on delayed exchanges. What about reverse exchanges? Section 1031 permits use of a so-called “reverse exchange.” Under this exchange, a seller actually purchases the replacement property before selling the initial property. In essence, the transaction is done in “reverse” of a typical exchange. The IRS has published safe-harbor guidance under which such an exchange qualifies as a 1031 exchange (e.g., no gain or loss recognized on the sale with the replacement property receiving substituted basis), if certain criteria are met.


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As for the GAAP treatment of a reverse exchange, there is no formal authority that has been issued by the FASB. Because the transactions are not simultaneous, the author believes the FASB’s position would be to consider such a transaction as two separate and distinct transactions. That is, transaction one would be to purchase a property at fair value, followed by a second transaction which is the sale of an initial property and recognition of a gain. 5. Dealing with the Impairment of Real Estate Held for Use Question: What are the rules for testing real estate for impairment? Response: ASC 360, Property Plant and Equipment (formerly FASB No. 144), requires a company to recognize an impairment loss on a long-lived asset when certain conditions are met and the carrying amount of a long-lived asset exceeds its fair value. The ASC applies to both personal and real property.

Specifically, ASC 360 states that an impairment loss exists when the carrying amount of real estate exceeds its fair value.

There are essentially three steps to applying the impairment test:

Step 1: Perform a Review of Events and Changes in Circumstances

Step 2: Test for Impairment Step 3: Measure the Impairment Loss

Observation: During the past few years, impairment of real estate has become an ongoing phenomenon in light of the softening in real estate values. Consequently, certain real estate has to be tested for impairment even though such tests were not required in previous years. Following is the application of the three steps: Step 1: Perform a review of events and changes in circumstances: An impairment test of real estate is performed only if there is an indication that an impairment might exist. Thus, an annual test is typically not required in a strong real estate market, because there is unlikely to be events and changes in circumstances that would indicate an impairment. Real estate is tested whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. In Step 1, the entity reviews all of the events and changes in circumstances to determine if a potential impairment exists- that is, the carrying amount of the asset(s) may not be recoverable. Examples of events and changes in circumstances that might warrant a test include:

Significant decline in the market price of the real estate or similar real estate

Continued decline in rental rates and vacancies

Failure to meet debt service on a regular basis

Change in the use of the property

Known environmental contamination, and,

Legal changes such as rent control or use restrictions. If any of the above factors are known to exist, a test for impairment (Step 2) should be performed. Step 2: Test for impairment:


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If the review of the events and changes in circumstances in Step 1 indicates that there might be an impairment (e.g., carrying value may not be recoverable), Step 2 should be performed.

The formula for testing for impairment of the real estate in Step 2 is as follows:

The carrying amount of the real estate is compared with the estimated future undiscounted cash flows to be generated from use of ultimate disposition of the real estate.

Estimated future cash flows

Carrying amount of the real estate

= No impairment exists (no further action required)

Estimated future cash flows

Carrying amount of the real estate

= Impairment exists- (Go to Step 3 and measure the impairment)

Step 3: Measure the impairment: If, based on Step 2, estimated future cash flows are less than the carrying amount of the real estate, the real estate carrying amount is not recoverable. Therefore, an asset impairment must be measured in Step 3.

Formula for measuring an impairment:

Carrying amount of the real estate Less: Fair value of the real estate Equals: Impairment loss If the carrying amount is less than the fair value of the real estate, an impairment loss is recorded as follows: Impairment loss xx Real estate xx After an impairment loss is recognized, the reduced carrying amount shall become the new cost and is depreciated over the real estate's remaining useful life. Restoration of previously recognized impairment losses is prohibited. Consider the following example: Example 1: Harry owns a commercial office building in downtown Boston. He purchased the property in the height of the real estate market. Presently, there is a glut of vacant commercial space and events and circumstances suggest that the building might be impaired.

Assume: Carrying amount of the land and building $2,000,000 Estimated net cash flows per year $110,000 Remaining useful life of the building 30 years Fair value of the building $1,100,000

Step 1: Review of events and changes in circumstances:


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Presently, there is a glut of vacant commercial space and events and circumstances suggest that the building might be impaired. Thus, a test for impairment should be performed under Step 2. Step 2: Test for impairment:

Estimated annual future cash flows $110,000 x 30 years = $3,300,000 Estimated future > cash flows $3,300,000

Carrying amount $2,000,000

= NO IMPAIRMENT

Step 3: Measure the impairment loss: Not applicable. Step 2 did not result in an impairment so that Step 3 is not required. If Step 3 had been done, the impairment loss would have looked like this:

Carrying amount of all assets and liabilities

$2,000,000

Fair value (above) 1,100,000 Impairment loss $(900,000)

Conclusion: The real estate has declined to the extent that the fair value of $1,100,000 is less than the carrying amount of $2,000,000. However, that decline in value is not recorded as an impairment loss. The reason is because Step 2 did not result in an impairment. The estimated future cash flows of $3,300,000 exceed the carrying amount of $2,000,000. Because the remaining useful life of the real estate is 30 years, cash flows for the impairment test are accumulated over a 30-year period, resulting in ample cash flow to exceed the carrying amount and, thus, avoid having to measure an impairment in Step 3. This example is in contrast to a test for impairment of machinery or equipment, where cash flows must be accumulated using a much shorter remaining life of perhaps five years. Let’s consider the steps to testing and measuring an impairment of real estate. Step 1: Review of the events and change in circumstances: As previously noted, events and changes in circumstances that suggest that real estate might be impaired include:

Significant decline in the market price of the real estate or similar real estate

Continued decline in rental rates and vacancies

Failure to meet debt service on a regular basis

Change in the use of the property

Known environmental contamination

Legal changes such as rent control or use restrictions If any of the above factors are known, a test for impairment should be performed. Step 2: Test for impairment: In testing for impairment, there are a few issues that are indigenous to real estate: 1. Annual net cash flows should include:

a. Net operating income (rental income less operating expenses) before interest, depreciation and amortization, but after principal payments.

Note: The cash flows should reflect estimated increases or decreases in rental income and operating expenses over the remaining useful life of the property.


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b. Estimated capital expenditures needed to maintain the property over the remaining

useful life.

Examples:

Roof replacement every 8 years

Apartment renovation during turnovers

Painting and porch replacement

Note: Capital expenditures that would increase the future service potential of the asset (e.g., qualify the property for an alternative use), are not included in the future cash flows.

c. Salvage (residual) value at the end of the life of the real estate assuming the real estate

is sold. The residual value should be net of selling costs such as commissions, and should reflect the payoff of any remaining mortgages on the property at the expected time of sale.

Salvage value formula:

Estimated sell price at the end of the asset’s useful life $XX Less: Estimated costs to sell, commissions, advertising, etc. (XX) Less: Mortgage payoff at estimated time of sale (XX) Salvage value (net) $XX

The cash flow formula is summarized like this:

Annual

net cash flow

Net operating income before interest, depreciation and amortization* $XX - Principal payments on mortgages secured by real estate (XX) - Estimated reserves for capital expenditures and replacements needed to

maintain the property

(XX) + Salvage value at the end of the asset’s life, assuming the real estate is sold

(net of costs to sell)

XX NET CASH FLOW $XX * Rental income less cash operating expenses, accrual basis.

2. The remaining useful life should be based on the remaining life in the hands of the entity.

a. The remaining useful depreciable life is a strong indicator of the remaining life for purposes of computing cash flows.

b. If an entity plans to sell the property within a certain period of time (e.g., next five years),

the remaining useful life should not exceed the estimated remaining time that the entity plans to hold the property.

c. The ability to obtain renewed or replacement financing should be a factor in determining

the remaining useful life of the asset.

Step 3: Measure the impairment:


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If there is an impairment determined in Step 2, the real estate impairment loss must be measured. If the real estate is rental property, the best way to determine fair value is to use a capitalization rate. Example: Net operating income / Capitalization rate = Fair value of real estate If the property is land, fair value should be determined based on the quoted market price or price for similar land. Example 2: The following example illustrates a more complex application of ASC 360 to real estate. Facts: Company X is a real estate company that has 100 commercial and residential rental properties. Property C is a residential rental property that was purchased 12 years ago at the height of the real estate market. Management believes that the real estate might be impaired. The neighborhood in which the property is located has deteriorated significantly since the date of purchase, resulting in declining rents and higher-than-usual vacancies. Management believes that in the future, the property may be located in a valuable location where a downtown redevelopment may occur. As a result, Management has decided to hold onto the property indefinitely. When the property was purchased, X obtained a 20-year commercial mortgage. For GAAP purposes, management has selected 39 years as the useful life, which is consistent with management’s intent to use the property and, coincidentally the same life as the tax life. Specific details follow:

Carrying amount: Land $500,000 Building Fixtures and appliances

7,200,000 100,000

Total 7,800,000 Mortgage on property (1,000,000) Net carrying amount of asset group $6,800,000 Remaining useful life (based on depreciation schedule)

27 years*

Fair value of asset group

2,500,000**

* Original life: 39 years less 12 years depreciation = 27 years remaining. ** NOI $350,000/10% capitalization rate = $3,500,000 less mortgage balance $(1,000,000) = $2,500,000.

Estimated future cash flows follow:


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ESTIMATED FUTURE CASH FLOWS

Year

Operating

cash flows*

Capital expenditures

**

NOI

Principal payments

Salvage value of assets***

Total undiscounted

cash flows

1 $400,000 ($50,000) $350,000 $(50,000) $0 $300,000 2 250,000 (50,000) 200,000 (50,000) 0 150,000 3 250,000 (50,000) 200,000 (50,000) 0 150,000 4 250,000 (50,000) 200,000 (50,000) 0 150,000 5 250,000 (50,000) 200,000 (50,000) 0 150,000 6 250,000 (50,000) 200,000 (50,000) 0 150,000 7 250,000 (50,000) 200,000 (50,000) 0 150,000 8 250,000 (50,000) 200,000 (50,000) 0 150,000 9 250,000 (50,000) 200,000 (50,000) 0 150,000 10 250,000 (50,000) 200,000 (50,000) 0 150,000

11-15 1,250,000 (250,000) 1,000,000 (250,000) 0 750,000 16-20 1,250,000 (250,000) 1,000,000 (250,000) 0 750,000 21-25 1,000,000 (250,000) 750,000 0 0 750,000

26 200,000 (50,000) 150,000 0 0 150,000 27 200,000 (50,000) 150,000 0 1,500,000 1,650,000 $6,550,000 $(1,350,000) $5,200,000 $(1,000,000) $1,500,000 $5,700,000

Calculations: * Rental income less operating expenses (real estate taxes, insurance, maintenance, utilities, management). Excludes depreciation, amortization and interest.

** Estimated capital expenditures to maintain the existing property such as roof replacement,

windows, apartment renovation.

*** Estimated salvage at the end of the property’s life: Year 27 NOI $150,000/10% capitalization rate = $1,500,000 estimated value in year 27.

Step 1: Review of events and changes in circumstances: Management believes that Property C might be impaired. The neighborhood in which the property is located has deteriorated significantly since the date of purchase, resulting in declining rents and higher-than-usual vacancies. Thus, a test for impairment should be performed under Step 2.

Step 2: Test for impairment:

Estimated future < cash flows $5,700,000


= IMPAIRMENT

Because the estimated future cash flows is less than the carrying amount of the property, there is an impairment, and Step 3 must be performed to measure the impairment loss. Step 3: Measure the impairment loss:

Carrying amount of the property $6,800,000

Fair value (above) (2,500,000)

Impairment loss $(4,300,000)

The loss should be allocated to the components of the long-lived assets (building, land and equipment) based on each asset’s relative carrying amount as follows:


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Carrying amount:

Carrying amount

% of

total CV

Allocation of

loss

Revised carrying amount

Land $500,000 6.4 $(275,200) $224,800

Building 7,200,000 92.3 (3,968,900) 3,231,100

Fixtures and appliances 100,000 1.3 (55,900) 44,100

Total $7,800,000 100% $(4,300,000) $3,500,000

Entry for impairment loss

Impairment loss 4,300,000 Land 275,200 Building 3,968,900 Fixtures and appliances 55,900

After the assets are written down, the revised carrying amount of the building and fixtures and appliances should be depreciated over the remaining useful life of the assets. Further, once written down, the assets may not be written back up. Observation: In computing net cash flows from real estate, the amount of principal payments is deducted in arriving at the net cash flow amount. At first glance, one might think that an accelerated mortgage amortization schedule could result in negative cash flows and, thus, an impairment of real estate. However, this is not the case. Although it is true that an accelerated amortization schedule reduces net cash flows per year, the offset occurs in the year in which the asset is assumed sold. The net salvage value of the real estate is computed after deducting the mortgage balance and costs to sell. Therefore, an accelerated principal schedule results in reductions in cash flows in earlier years, but a smaller reduction or no reduction in the salvage value in later years when the mortgage balance is lower. Question: How should an entity deal with the impairment of land that does not generate cash flow? Response: An impairment loss is more likely to be incurred for land as compared with rental property. The reason is primarily due to the fact that land’s only cash flow may be from the ultimate disposition of the property, resulting in the carrying amount not being recoverable. Example: Assume Company X holds land for investment. The only cash flows related to the property are carrying costs (real estate taxes and insurance) and proceeds from the ultimate sale of the property. The Company’s plan is to hold the property for another five years and then sell it. Management is concerned that the asset might be impaired given the deterioration of the surrounding area coupled with the economic downturn. The property was originally purchased for $5,000,000 and presently has a fair value of $3,000,000 as indicated in the table below:

Carrying amount $5,000,000 Fair value 3,000,000**

** Based on quoted market value per acre for similar properties in the area.


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Management tentatively plans to hold the property for another five years. It believes that, at worst, the fair value of the property will not deteriorate any further and could be sold for $3,000,000 at the end of five years. Estimated future cash flows over the next five years are as follows:

ESTIMATED FUTURE CASH FLOWS

Year

Operating

cash flows*

Capital

expenditures

NOI

Salvage value

of assets

Total undiscounted

cash flows

1 $(50,000) $ 0 $(50,000) $ 0 $(50,000)

2 (55,000) 0 (55,000) 0 (55,000)

3 (60,000) 0 (60,000) 0 (60,000)

4 (65,000) 0 (65,000) 0 (65,000)

5 (75,000) 0 (70,000) 3,000,000 2,930,000

$(300,000) $ 0 $(300,000) $ 0 $2,700,000

* Consists of costs to maintain the property including real estate taxes insurance and maintenance. There is no income other than salvage value.

Step 1: Review of events and changes in circumstances: Management is concerned that the asset might be impaired given the deterioration of the surrounding area, coupled with the economic downturn. Step 2: Test for impairment:

Estimated future cash flows $2,700,000

<


= IMPAIRMENT

Step 3: Measure the Impairment Loss:

Carrying amount $5,000,000 Fair value (above) (3,000,000) Impairment loss $(2,000,000)

Entry for impairment loss

Impairment loss 2,000,000 Land 2,000,000

Observation: The above example illustrates how easy it is to record an impairment loss on land versus rental property. Because rental property generates net cash flow over an extended useful life of usually twenty to thirty years, rarely will a rental property fail the impairment test. That is, future estimated cash flows will most likely exceed the carrying amount, notwithstanding unusual facts and circumstances. The result is that Step 2 does not result in an impairment and therefore, Step 3 is not performed to measure an impairment. With respect to non-leased land, the result may be different. It is more likely that land that has declined in value may be written down to recognize an impairment loss. Because non-leased land does not generate annual cash flows, exclusive of the net proceeds from the ultimate sale of the land, it is possible that the future cash flows from ultimate use of the land will be less than the carrying amount, resulting in an impairment in Step 2 of the test. Then, Step 3 is performed to measure the impairment in which the carrying amount is written down to the fair value of the land.


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 1. Which of the following is correct with respect to non-SEC companies: a) GAAP requires that a company present comparative balance sheets but not comparative

income statements b) GAAP requires that a company present a comparative income statement but not a

comparative balance sheet c) There is a mandatory two-year comparative financial statements rule found in GAAP d) A company is not required to present comparative financial statements 2. What is the proper balance sheet classification and presentation of temporarily idled property

and equipment: a) it should be removed from plant accounts b) it should be recorded separately at an estimated realizable amount c) it should not be segregated, and should continue to be depreciated d) it should be written off as obsolete 3. According to ASC 845 (formerly FASB No. 153), which of the following is one of the three

exceptions to the general rule regarding non-monetary exchanges: a) the fair market value must be determinable b) the carrying value is higher than the fair value c) the transaction is an exchange transaction to facilitate sales to customers d) the transaction must have commercial substance 4. Which of the following is the formula for recording a nonmonetary exchange under GAAP

where the transaction lacks commercial substance: a) Fair value of asset given = Cost of asset received b) Book value of the asset given + cash paid = Cost of asset received c) Book value of the asset given – cash paid = Cost of asset received d) Fair value of asset given – cash paid = Cost of asset received 5. According to GAAP codification, how should a delayed exchange be treated for GAAP: a) as a single monetary transaction b) as two monetary transactions c) as an exchange that lacks commercial substance

d) there is no authority dealing with the accounting treatment of delayed exchanges 6. Which of the following is correct as it relates to a test for the impairment of real estate: a) an impairment test of real estate must be performed annually

b) an impairment test of real estate is performed only if there is an indication of an impairment c) an impairment test is never required because the real estate is depreciated

d) an impairment test is optional if the entity elects not to depreciate the real estate


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SUGGESTED SOLUTIONS 1. A: Incorrect. ASC 205 recommends, but does not require, a comparative balance sheet.

B: Incorrect. ASC 205 recommends, but does not require, a comparative income statement. C: Incorrect. GAAP does not have a mandatory two-year rule. The two-year rule is an SEC

requirement, not one found in GAAP. D: Correct. A key distinction between a public and non-public entity is that GAAP’s

ASC 205 permits, and even recommends, that all financial statements be presented in a comparative form, which, in practice, is typically two comparative years. Thus, there is no requirement for comparative financial statements, making the answer correct.

2. A: Incorrect. It is not customary to segregate or indicate the existence of temporarily idle

plant, reserve, or standby equipment. The reason is because the idle nature of the asset is temporary, so that there is an intent for the asset to be used again. B: Incorrect. Recording the property and equipment at estimated realizable amount may be

appropriate for permanently idle property and equipment, but not appropriate for temporarily idled property and equipment.

C: Correct. Because the temporarily idled property and equipment will be used again, the appropriate GAAP treatment is that it should continue to be depreciated if it is expected that operations will resume at some time. By definition, the fact that the property and equipment is “temporarily” idle means that it is expected to be resume operations in the future.

D: Incorrect. Temporarily idled property and equipment should not be written off as obsolete. The reason is because it is expected to be used again in the future and therefore has a future benefit to the organization. Thus, the answer incorrect.

3. A: Incorrect. One of the three exceptions to the general rule regarding non-monetary

exchanges is if the fair market value of the asset(s) received or the asset(s) relinquished is not determinable within reasonable limits. Thus, this answer is incorrect.

B: Incorrect. The carrying value being higher than the fair value is not one of the exceptions noted in ASC 845, thereby making the answer correct.

C: Correct. One of the exceptions to the general rule that ASC 845 identifies is that the transaction is an exchange of product or property held for sale in the ordinary course of business. Further, the exchange involves a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange. Thus, the answer is correct.

D: Incorrect. One of the three exceptions occurs when the transaction lacks commercial substance, rather than having commercial substance. Thus, the answer is incorrect.

4. A: Incorrect. Because the transaction lacks commercial substance, the transaction is

recorded using a book value, not fair value approach. Thus, use of fair value is not appropriate.

B: Correct: Under GAAP, if a transaction lacks commercial substance, the book value approach is used under which the book value of the asset given, plus any cash paid, equals the cost of the asset received.

C: Incorrect. Although the book value of the asset given is correct, the cash paid adds to cost of the new asset. Thus, the cash is added, not deducted to arrive at the cost of the asset received.

D: Incorrect. There are two problems with this formula. First, fair value is not appropriate because the transaction lacks commercial substance. Second, cash paid should be added, not subtracted, to arrive at the cost of the asset received.


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5. A. Incorrect. GAAP does not codify the proper accounting treatment for delayed exchanges. However, unofficially, the FASB has stated that a delayed exchange should not be accounted for as a single transaction. Thus, in all cases, the answer is incorrect.

B: Incorrect. Although the FASB has offered an unofficial position that a delayed exchange should be treated as two money transactions, each recorded at fair value, this is not codified by GAAP. Thus, the answer is incorrect.

C: Incorrect. FASB has offered an unofficial position that a delayed exchange does not qualify as an exchange that lacks commercial substance, but, this position is not codified in GAAP.

D: Correct. In reviewing GAAP codification, there is no authority dealing with the accounting treatment for delayed exchanges.

6. A: Incorrect. GAAP does not require that an annual impairment test be performed on real estate making the answer incorrect.

B: Correct. GAAP provides that rest estate is only tested for impairment if there some event that indicates there could be an impairment. Absent such an event, an impairment the test is not required.

C: Incorrect. The fact that real estate is depreciated does not mean that it could not be impaired. GAAP does not provide for any particular rules that states that because the real estate is depreciated, it is not tested for impairment. Thus, the answer is incorrect.

D: Incorrect. GAAP does not offer that an impairment test is optional.


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C. Cash and Investments 1. Classification of Outstanding Checks Question: Should the amount of outstanding checks that have been mailed and out of the control of the payer be reported as a reduction of cash or reclassified to accounts payable? Response: Cash represents amounts within the control of the payer. Therefore, any checks that are out of the control of the payer should be treated as a reduction of cash and not reclassified as a current liability. However, in the circumstance where the checks have been prepared, yet not mailed at the balance sheet date, it would be appropriate to reclassify them as a liability because the payer has not relinquished control over them. Note further that any cash overdraft balance should be presented as a current liability, and not as a negative current asset. If comparative financial statements are presented with one year having a negative cash balance and the other having a positive cash balance, the negative cash balance should be presented as a current liability with the positive balance presented as a current asset. Question: Cash and temporary investments are presented as one amount on the balance sheet without disclosing the individual components or as an item of "cash and cash equivalents" without disclosing the nature of cash equivalents. Are these presentations acceptable? Response: ASC 210, Balance Sheet (formerly ARB No. 43) states that major components of current assets should be separately reported or disclosed. Therefore, major elements of cash and temporary investments should be disclosed individually in the notes if not presented individually on the balance sheet. Question: Assume a company has three bank accounts with the following balances at year end.

Account 1- No Loan Bank $200,000 Account 2- No Interest Bank (100,000) Account 3 -No Money Bank (20,000) Net cash balance $80,000

How should the three accounts be presented on the balance sheet? Response: The accounts should be shown on the balance sheet as follows:

Current assets: Cash

$200,000

Current liabilities: Cash overdraft

(120,000) Account 1 with the positive balance of $200,000 is shown as cash while the two accounts with negative balances (Account 2 $(100,000) and Account 3 $(20,000)) should be combined and shown as a current liability in the amount of $(120,000).


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Change the facts: Assume the bank accounts look like this:

Account 1- No Loan Bank $200,000 Account 2- No Interest Bank (100,000) Account 3 – No Loan Bank (20,000) Net cash balance $80,000

How should the accounts be shown on the balance sheet? Response: Although not authoritative, the Author believes that Accounts 1 and 3 should be combined and shown as one net cash asset in the amount of $180,000, while Account 2 should be shown as a current liability of $100,000, as presented below:

Current assets: Cash

$180,000

Current liabilities:

Cash overdraft

(100,000)

The reason why Accounts 1 and 3 should be combined is because they are with the same bank. Thus, the bank has a legal right of offset whereby the assets in Account 1 can be used to pay off the liability in Account 3. Question: How should the change in the cash overdraft account be presented on the statement of cash flows? Response: There is no authoritative guidance on this issue. However, AICPA Technical Practice Aid (TPA) 1300-15 states that the net change in overdrafts during the period is a financing activity. Observation: The TPA is not authoritative and still does not resolve an inconsistency in practice. Some companies argue that the change in overdrafts should be presented as an adjustment in the operating activities section of the statement of cash flows, similar to the way a change in accounts payable is presented. Those that support presenting the change in the financial activities section argue that the change reflects a short-term loan received from the bank and, thus, it should be reflected as such in the financing activities section. In fact, as part of their cash management system, many companies have agreements with their banks to issue short-term loans to cover cash overdrafts. Part of the confusion lies with whether an overdraft is a book cash overdraft or a bank cash overdraft. Consider the following situation:

20X2 20X1 Change Bank balance- cash $(175,000) $(100,000) $(75,000) Outstanding checks (225,000) (200,000) Book balance- cash $(400,000) $(300,000) (100,000)

Conclusion: For book purposes, there is a decrease in cash in the amount of $(100,000). Typically, this change would be shown on the statement of cash flows as a change in the operating activities section of the statement of cash flows. However, notice that there is a negative $(75,000)


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change in the bank balance which really represents a loan from the bank. This amount really should be shown as a cash inflow from financing activities similar to receipt of a bank loan. The result is that the negative $100,000 change in cash consists of a $75,000 loan from the bank and $25,000 of cash float.

20X2 Cash from operating activities:

Net income $XX Depreciation XX Change in accounts receivable XX Change in cash overdraft 25,000

Cash flow from financing activities: Increase in bank cash overdraft 75,000

Change the facts and assume that the cash overdraft consists of the following:

20X2 20X1 Change Bank balance- cash $200,000) $250,000 Outstanding checks (600,000) (550,000) Book balance- cash $(400,000) $(300,000) $(100,000)

Conclusion: Because there is no bank overdraft, the entire $(100,000) change in cash overdraft is due to mail/cash float which should be shown as follows:

20X2 Cash from operating activities:

Net income $XX Depreciation XX Change in accounts receivable XX Change in cash overdraft 100,000

Cash flow from financing activities: Increase in bank cash overdraft 0

Note: A study1 concluded the following treatment of cash overdrafts based on a survey of publicly held companies. 1. Some companies are presenting overdrafts as part of accounts payable instead of as a

separate line entitled “cash overdraft.”

2. In general, disclosures of overdraft balances are rather weak.

3. Although the majority of companies present the change in cash overdrafts as a financing activity, many others report it as an operating activity to increase cash from operations.

By presenting an increase in cash overdraft as an operating activity instead of a financing activity, a company increases cash from operations.

Observation: A company may have an incentive to present a cash overdraft either as part of accounts payable, or at least present the change in the operating activities section. By flowing the

1 A Re-examination of Cash Flow Reporting in the Presence of Overdrafts, Dupree Financial Analysis Lab, Georgia Tech.


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change through operating activities, an entity can increase its cash from operations which is a key factor looked at by analysts and third parties. Note further that there still is an argument for presenting the change in overdraft as an operating activities adjustment. The reasoning is based on the fact that in many cases, the overdraft represents checks that were cut but may be held to maximize float. If this is the case, the checks actually should be reversed back to accounts payable because they represent unpaid bills held at period end. If, instead, the checks have been mailed, there is a cash overdraft balance. Even though there is a negative cash balance for book purposes, there may be a positive cash balance for bank purposes with the difference representing float. If the bank balance continues to be positive, one can argue that there is no short-term loan from the bank, thus no financing activities. Instead, the cash flow could be considered an operating activity. Even though the TPA is helpful, companies can select between operating and financing activities to place a change in a cash overdraft balance. 2. Securities Issues Under FASB ASC 3202 Question: ASC 320, Investments-Debt and Equity Securities (formerly FASB No. 115), requires that securities (debt and equity) be categorized into one of three categories:

Debt securities held-to-maturity

Trading securities

Available for sale- debt and equity securities

Are options on securities covered by ASC 320?

Response: Yes. An investment in an option on an equity security is covered by ASC 320 if, like the underlying security, it has a fair value that is currently available on a securities exchange. The definition of an equity security includes any security representing a right to acquire an ownership interest at a fixed or determinable price (e.g., warrants, rights, and call options). It does not include cash-settled options or options on equity-based indexes, because those instruments do not represent ownership interests.

Options on debt securities are not covered by ASC 320. Question: An entity invests in a limited partnership interest (or a venture capital company) that meets the definition of an equity security in ASC 320, but does not have a readily determinable fair value that is currently available on a securities exchange. However, all of the underlying assets of the partnership consist of debt and equity securities that have readily determinable fair values. Is it appropriate to "look through" the limited partnership to the underlying investments to determine whether ASC 320 applies? Response: No. An entity should not "look through" the form of its investment to the nature of the underlying securities. In the above example, the investment (in the partnership) would be considered an equity security that does not have a readily determinable fair value. Therefore, ASC 320 would not apply. Instead, the investor would follow the guidance in ASC 323,

2 In 2016, the FASB issued ASU 2016-01, Financial Instruments-Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 amends ASC 320 and adds a new ASC 321,

to require that equity securities be recorded at fair value with all unrealized gains and losses recorded in the income statement. The ASU does not make any substantive changes to the accounting for debt securities. ASU 2016-01 changes are effective for fiscal years beginning after December 15, 2018 (calendar year 2019). Because the effective date of ASU 2016-02 is delayed until 2019. the author has not addressed its changes in this course.


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Investments- Equity Method and Joint Ventures (formerly EITF No. D-46) relating to accounting for limited partnership investments. Question: May securities classified as held-to-maturity be pledged as collateral and still maintain the held-to-maturity classification? Response: Yes, provided that the entity intends and expects to be able to repay the borrowing and recover access to its collateral. Question: How often must sales occur to consider an activity "trading" for purposes of ASC 320? Response: ASC 320 indicates that with respect to trading securities, the entity’s intent is to sell them in the near term (usually within one year of the balance sheet date) and will be held for only a short period of time. Therefore, if a security is acquired with the intent of selling it within hours or days, clearly the security must be classified as trading. However, a longer holding period does not preclude from classifying the security as trading at the acquisition date. Further, a security may be classified as trading even if it intends to sell the security beyond one year. The FASB deliberately used the terms "generally" and "principally" in describing the trading category. Question: Assume an entity records an unrealized gain on equity securities in the amount of $100,000. How should this unrealized gain recorded on the securities be presented on the statement of cash flows if the securities are:

Trading securities?

Available for sale? Response: The unrealized gain on trading securities should be presented on the income statement. The gain would be shown as an adjustment in the operating activities section of the statement of cash flows if the indirect method is used. If the direct method is used, the transaction is not presented in the statement. Example of statement of cash flow presentation: Indirect Method: Presentation of unrealized gain on trading securities: Operating activities: Net income xx Adjustments: Increase in accounts receivable xx Decrease in inventories xx Deferred income taxes xx Unrealized gain on trading securities (100,000) Net cash provided by operating activities xx The unrealized gain on securities available for sale would be presented in stockholders’ equity, as part of other comprehensive income, net of applicable federal and state income taxes. Assume that the tax rate is 40%, the net gain would be as follows:

Unrealized gain $100,000


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Tax effect: deferred income taxes (40,000) Net unrealized gain presented in stockholders’ equity (other comprehensive income)

$60,000

Entry: Allowance for appreciation 100,000 Deferred income taxes 40,000 Unrealized gain (stockholders’ equity) 60,000

Presentation on the statement of cash flows: Unrealized gain on securities available for sale: None. Because the net gain of $60,000 does not affect cash or flow through the income statement, the transaction is not presented on the statement of cash flows. In analyzing the change in the investment account in the preparation of the statement of cash flows, the $100,000 change should be ignored along with the $40,000 change in deferred income taxes and the $60,000 unrealized gain in stockholders’ equity. 3. Preferred Stock Received for Common Stock Dividend Question: In lieu of cash, a company receives shares of preferred stock as its common stock dividend. How should this investment in preferred stock be valued, cost or market value? Response: ASC 845, Nonmonetary Transactions (formerly FASB No. 153) appears to be the only authoritative guide in this area. The non-monetary asset received (investment in preferred stock) should be recorded at the fair value of the asset received. Therefore, the investment and related dividend income should be recorded at the fair value of the preferred stock at the date of the transaction as follows: Investment in preferred stock (fair value) xx Dividend income on common stock xx Observation: Although not authoritative, other authors have suggested that the above transaction should be accounted for similarly to a stock dividend, whereby dividend income is not recorded. Instead, the carrying value of the common stock is merely reallocated to the preferred stock. 4. Presentation of Available for Sale Securities on the Balance Sheet3 Question: A company has equity securities at year-end. At the date of acquisition, they were categorized as available for sale as the company purchased them without the intent to trade them. Because the company has not committed to trade them within the near term (one year), it believes that the securities should be presented as long-term on the balance sheet. How should securities categorized as available for sale be presented on the balance sheet, current or long-term? Response: There is no answer to this question. It depends on the facts involved. First, there seems to be confusion in practice regarding the interrelation between the categorization of securities (e.g., held to maturity, trading, or available for sale) and the presentation on the balance sheet. In theory, they have nothing to do with each other. ASC 320 states that the categorization of a security should be determined at the date of purchase based on the intent of management.

3 This section does not reflect changes made to ASC 320 by ASU 2016-01, Financial Instruments-Overall (Subtopic

825-10) Recognition and Measurement of Financial Assets and Financial Liabilities. which are not effective until fiscal years beginning after December 15, 2018 (calendar year 2019).


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Securities that, based on management's intent to sell them in the near term, are presented as trading securities. Those debt securities that management plans to hold to maturity are categorized as held to maturity. And, by default, all other securities (debt and equity) are categorized as available for sale. Now to the balance sheet classification. ASC 320 requires trading securities to be presented as current assets, by definition, unless there are extenuating circumstances. Debt securities held to maturity should be categorized as current or long-term depending on the maturity date. In practice, many of the confusing aspects of ASC 320 relate to “available for sale” securities. These securities are categorized as available for sale because, at the date of purchase, management did not have the intent to sell them in the near term (trading). Does this mean that if there are no plans to sell them in the near term (usually within one year), they should be categorized as long-term on the balance sheet? Not necessarily. The intent that categorized the securities into AFS took place at the date of purchase, not at year end. The determination of whether the securities should be shown as current or long-term on the balance sheet should be determined at year end, not at the date of purchase, and should be based on ASC 210, Balance Sheet (formerly ARB 43, paragraph 4) criteria. That is, an asset is current if it will be converted into cash, sold or consumed within one year or the operating cycle. At the end of the year, the company must decide whether it plans to sell the AFS securities within one year. If so, they are shown current. If not, they should be presented as long-term. The author believes that many closely held businesses do not have planned investment strategies where intent is considered. Instead, a typical small business may have idle excess cash that it invests in a mutual fund. The intent is to leave it in the fund until the cash is needed. Does the company intend to liquidate the fund within one year? Who knows. In this case, the author believes that there is a strong argument for presenting the mutual fund balance as a long-term asset. Observation: The author has reviewed various companies' treatment of available for sale investments in the AICPA's Accounting Trends & Techniques, and has observed that most companies overwhelmingly present securities available for sale as current assets.

5. Writedowns of Investment Losses that are Other-Than-Temporary4

Question: With the cyclical nature of the stock market and its periodic decline, many companies are holding equity investments (publicly or non-publicly held), that have significant unrealized losses. The accounting for these investments depends on numerous factors including whether the investments are securities (publicly held) or not, and the intent of management. Existing GAAP generally assumes that investments will fluctuate over time and, therefore, unrealized gains and losses may reverse over time. However, there are instances in which an investment has an unrealized loss that management believes will not reverse. That is, the loss is other-than-temporary and will not likely recover over time. In such instances, GAAP provides an overall rule requiring the unrealized loss to become realized. At what point does an unrealized loss become other-than-temporary and is realized on the income statement?

4 This section does not reflect changes made to ASC 320 by ASU 2016-01, Financial Instruments-Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities. which are not effective until fiscal years beginning after December 15, 2018 (calendar year 2019).


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Response: The accounting for investments is covered by several sets of rules which are generally based on the degree of ownership. The table below presents the tiers of ownership and accounting treatment.

Accounting for Investments

% Ownership in voting stock Accounting treatment

Less than 20% Securities covered by ASC 320: Recorded at fair value or cost depending on management’s intent Non-securities covered by ASC 325, Recorded at cost

20-50% ownership or significant influence

Equity method

More than 50% Consolidate

When there is ownership of less than 20% of the outstanding voting shares, two sets of rules

apply depending on whether the investment consists of securities or non-securities.

Investments in non-securities: If the investments are non-securities, such as closely held stock, convertible debt or redeemable preferred stock, the investments are recorded at cost in accordance with ASC 325, Investments-Other. Subsequently, the investments are adjusted to the lower of cost or market value only if there is a significant loss and that loss is other-than-temporary. Investments in securities: If the investments are securities (e.g., traded on a public exchange), the rules of ASC 320, Investments-Debt and Equity Securities (formerly FASB No. 115) apply. ASC 320 places investments in securities into three categories and has separate rules for each category. 5

The three (3) categories are as follows:

1. Debt securities held to maturity- Debt securities that management plans to hold until maturity.

2. Trading securities- Both debt and equity securities that are bought and held for the

purpose of selling them in the near term (generally within one year).

3. Available for sale securities- Both debt and equity securities that are not categorized as either held to maturity or trading securities, are automatically categorized as available-for-sale. In this category, management has essentially not decided what it plans to do with the securities.

At the time of purchase, a security is placed into one of the three categories based on management's positive intent and ability. Once a security is placed in a particular category, it generally can be changed only where there are significant unforeseeable circumstances. If there is a decline in the fair value of individual investments below amortized cost that is other-than-temporary, the cost basis should be written down to fair value with the recording of a realized loss. The written down cost basis becomes the new basis going forward.

5 For non-profit organizations, the accounting for securities is found in ASC 958, which requires that investments in securities be recorded at fair value with unrealized gains and losses presented in the statement of activity.


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The following table summarizes the accounting treatment for investments.

--------------------------Securities--------------------------

Non-securities

Debt securities held to maturity

Trading securities

Available for sale securities

All non-security investments

Type Debt Debt and equity

Debt and equity Debt or equity

Intent Hold to maturity Sell in the near term

Undecided Not applicable

Record at Cost Fair value Fair value Cost

Unrealized gains or losses

Not applicable Presented on income statement

Presented in stockholders’ equity, net of tax

Not applicable

Balance sheet Based on maturity date

Current even if sale is expected beyond one year

Based on management’s intent at year end

Current or non-current based on management’s intent

Other-than- temporary

losses

Investment written down and realized loss recognized on

income statement

Generally, most investment unrealized losses are temporary in that there is an expectation that the losses will reverse (recover) within a reasonable period of time. Other losses may be other than temporary in that it becomes unlikely that the loss will reverse within the reasonable period of time, or at all. The result of having an investment loss that is other-than-temporary versus temporary is significant. If a security encounters an other-than-temporary loss, the result is that a realized loss is recorded on the income statement regardless of whether the investment is a security or non-security. In comparison, a temporary loss involving a held-to-maturity or available-for-sale security would not result in a realized loss affecting the income statement. For a trading security, the result of having an other-than-temporary loss is not significant because unrealized losses are presented on the income statement anyway. Further, trading securities are expected to be sold in the near term resulting in a realized gain or loss being recognized on the income statement. With a non-security investment, an other-than-temporary loss has a similar impact to a security investment. A non-security is recorded at cost with no recording of unrealized gains or losses. Yet, an other-than-temporary loss creates a realized loss on the income statement that would not have occurred otherwise. Regardless of the type of security, the decision as to whether an investment loss is temporary, or other-than-temporary is significant and subject to management manipulation. Look at the following two examples that illustrate the author’s point.

Example 1: Company X has securities that are categorized as available-for-sale. The portfolio has an unrealized loss that is presented as part of other comprehensive income in stockholders’ equity, net of tax. X is having a great year and wishes to manage its earnings by accelerating future expenses to the current year. Conclusion: X could argue that its investment losses are other-than-temporary and that the investment should be written down with a realized loss recorded on the income statement.


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Example 2: Same facts as Example 1 except that X is having a terrible year and wishes to avoid recording any losses on investments. Certain investments have losses that appear to be other-than-temporary resulting in the possibility of a realized loss being recorded on the income statement. Conclusion: In order to avoid recording a realized loss, X may try to argue that the loss on the investments is temporary and that such a loss should be recorded as part of other comprehensive income in stockholders’ equity as an available-for-sale category.

Whichever example applies, what is clear is that the determination of whether a loss is other-than-temporary or temporary can have significant implications on the income statement. Question: What is the definition of “other-than-temporary” as it relates to the impairment of investments? Response: ASC Subtopic 320-10, Investments- Debt and Equity Securities- Overall, provides guidance on the other-than-temporary threshold using a three-step approach. a. ASC 320-10’s Three-Step Approach to Impairment: At the end of each reporting period, an investor should perform the following tests on its investments. ASC 320 uses a three-step approach to determine whether an investment has an other- than-temporary impairment: Step 1: Determine whether the investment is impaired.

Step 2: Evaluate whether the impairment is other-than-temporary. Step 3: Recognize an impairment loss on the income statement equal to the difference between the investment’s cost and its fair value (measured at the date of the

financial statements). Step 1: Determine whether the investment is impaired: a. It is assumed that if at the end of a reporting period, an investment’s fair value is less than its

cost6, it is deemed to be impaired. Fair value < Cost = Impairment If the fair value is less than cost, the investment is impaired. Proceed to Step 2. b. Determining fair value for Step 1:

1) Other than cost method investments (securities): Use the readily determinable fair value

in the market in which the security is sold.

6 Cost includes adjustments that have been made to the cost basis of the investment for amortization, accretion, previous other-than-temporary impairments, foreign exchange, and hedging.


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2) Cost method investments (non-securities): Because the fair value of a cost method investment is not readily determinable, fair value shall be based on the following procedures:

a) Use fair value determined for other purposes: If an investor has estimated fair value of

a cost method investment for another purpose (such as for ASC 825 fair value disclosure), that estimate should be used as fair value for Step 1.

b) Consider impairment factors: Consider if there was any event or change in

circumstances that occurred during the reporting period that may have a significant adverse effect on the fair value of the investment.

Impairment indicators include, but are not limited to, the following:

1. A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee

2. A significant adverse change in the regulatory, economic, or technological environment of the investee

3. A significant adverse change in the general market condition of either the geographic area or the industry in which the investee operates

4. A bona fide offer to purchase (whether solicited or unsolicited), an offer by the investee to sell, or a completed auction process for the same or similar security for an amount less than the cost of the investment

5. Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.

If any one impairment indicator exists, fair value is considered less than cost and the

cost method investment is impaired. Go to Step 2. c. In previous periods, if an investment was impaired (Step 1) and the test for impairment under

Step 2 resulted in the investment not being other than temporarily impaired, the investor should continue to perform Step 1 (determine whether the investment is impaired (fair value is less than cost)) in each subsequent reporting period until either:

1) The investment fair value recovers up to or beyond its cost, or 2) The investor recognizes an other-than-temporary impairment loss. Step 2: Determine whether the impairment is other-than-temporary: If, in Step 1, the fair value is less than cost, the investment is impaired. Once impaired, Step 2 requires that a test be performed to determine whether the impairment is temporary or other-than-temporary. If other-than-temporary, the loss should be realized and recorded on the income statement.


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Factors that should be considered in determining whether an investment is other-than temporary include: 1. The financial condition and near-term prospects of the issuer, including: Any specific events which may influence the financial condition of the issuer such as:

a. The fair value of the investment after the balance sheet date but before the financial statements are issued and whether any losses have been recorded subsequent to the balance sheet date

b. The regulatory, economic, or technological environment of the investee c. The general market condition of either the geographic area or the industry in which the

investee operates d. Forecasts about the investee’s financial performance and near-term prospects, such as

earnings trends, dividend payments, asset quality, and analysts’ or industry specialists’ forecasts

e. The security rating and whether it has been downgraded by a rating agency f. Whether the financial condition of the issuer has deteriorated, and g. Whether dividends have been reduced or eliminated or schedule of interest payments

have not been made.

2. Ability and intent to hold an investment for period of time sufficient to allow for any anticipated recovery:

a. Ability to hold an investment: In demonstrating the ability to hold an investment: 1) Consideration should be given as to whether working capital requirements or

contractual or regulatory obligations may require the investor to sell the investment before the forecasted recovery of fair value occurs.

2) An investor should consider the issuer’s ability to settle the security during the

forecasted recovery period, such as in the case of an issuer using a call provision to repurchase the investment prior to the recovery of the investment.

b. Intent to hold an investment: Although not presumptive, a pattern of selling investments

prior to the forecasted recovery of fair value may call into question the investor’s intent to hold the investment throughout the forecast recovery period.

3. Severity and duration of the impairment: a. Severity of the impairment should be based on the extent to which fair value is below cost.

b. Duration is the period of time that a security has been impaired.

c. There is a direct relationship between severity and duration versus evidence about a forecasted recovery that is required, as noted in the following table:

Interrelation of Severity-Duration and Recovery Evidence Required

Range of Severity and Duration

Worst Best

Severity of impairment* Severe Not severe


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Duration of impairment Long period Short period

Amount of evidence of forecasted recovery of fair value required

Greater (positive) evidence required

Less (positive)

Evidence required

* Cost – Fair value = Severity

Observation: The above table is not referenced in ASC 320 nor in any other authoritative literature, yet it was noted in the original EITF Issue No. 03-1, which was superseded by ASC 320. The author has chosen to keep it in the chapter because its conclusion is still useful. Most of the authoritative literature states that one key factor in determining whether an impairment is other-than-temporary is the length of time (duration) and extent to which the market value is less than cost (severity). Implicit in that requirement is that the longer the duration of the impairment, the more likely it is to be other than temporary. Moreover, the terms severity and duration are not used in accounting literature although they were introduced by EITF Issue 03-1 prior to being nullified by ASC 320. Instead, other GAAP and SEC literature uses the terms “length of time” and “extent to which the market value has been less than cost.” Example: Company X has had an impairment for three years. The impairment loss (as a percentage of fair value) is significant. The impairment was and continues to be a result of several company-specific factors including the entity’s existing and forecasted profitability and cash flows, going concern issues, etc. Conclusion: The severity of X’s impairment is high and the duration is long. Consequently, greater evidence about a forecasted recovery is required. The severity is high because the amount of the impairment loss as a percentage of the fair value is significant and the nature of the events causing the impairment is severe due to several internal issues that were noted in the example. The duration of the impairment is long at three years. What if a decision to sell the security after the balance sheet date has been made? When an investor has decided to sell an impaired available-for-sale security and the investor does not expect the fair value to fully recover prior to the expected time of sale, the security shall be deemed other-than-temporarily impaired in the period in which the decision to sell is made. However, the investor shall recognize an impairment loss when the impairment is deemed other-than-temporary, even if a decision to sell has not been made. Is the term other-than-temporary the same as permanent? No. In fact, in SEC Staff Accounting Bulletin No. 111, the SEC specifically states that the term other than temporary is not the same as permanent. Therefore, an investment impairment may exist and be other-than-temporary even if it is likely that some day it will recover. What if a debt security is likely to be held to maturity and the investor will receive the full face value at that time? ASC states:


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“If it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred.”

Further SEC Topic 5M reiterates ASC 320’s position by stating:

“Unless evidence exists to support a realizable value equal to or greater than the carrying value of the investment, a writedown to fair value accounted for as a realized loss should be recorded.”

The conclusion is that if an entity has both the ability and intent to hold a debt security to maturity, and it is probable that the investor will receive the face value of the investment at maturity, the impairment is temporary (not other-than-temporary) even though there has been a decline. Thus, no write down would be required.

Example: Company X has a $1 million investment in Y bonds that mature in 20X3. X has the ability and intent to hold the bonds until maturity. Further, all indications are that it is probable that X will be able to collect the bonds in full along with all interest thereon. The bonds have declined in value to $700,000 and the value has not recovered in the past two years. Conclusion: X can consider the impairment to be temporary (not other-than-temporary) as long as X has the ability and intent to hold the bonds until recovery of the fair value (the maturity date of 20X3), and X determines that it is not probable that X will be unable to collect the bond and interest thereon under the contractual terms. In this example, X may consider the impairment to be temporary. Thus, there is no other-than-temporary writedown and no recording of a $300,000 realized loss.

Step 3: Recognize an impairment loss: If an investment is impaired in Step 1, and determined to be an other-than-temporary impairment in Step 2, the final step is to record an impairment loss using the following rules: 1. The difference between the investment’s cost and its fair value at the balance sheet date of

the reporting period for which the assessment is made, should be recognized as a loss on the income statement.

2. After the writedown, the fair value becomes the new cost basis. 3. Subsequent recoveries in fair value should not be restored. 4. Any unrealized losses previously recorded on available-for-sale securities should be reversed

out of stockholders’ equity. Example 1: In 20X2, Company X purchased an equity investment in Company Y for $500,000. At December 31, 20X2, X categorizes the investment as available for sale in accordance with ASC 320. At December 31, 20X2, information on the security follows:

Carrying value- cost $500,000 Fair value 300,000 Unrealized loss $(200,000)


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X’s marginal tax rate (federal and state) is 40%. At December 31, 20X2, X makes the following entry:

Unrealized loss (stockholder’s equity) 120,0007 Allowance for writedown of security 200,000 Deferred income tax asset (40% x 200,000) 80,000

At December 31, 20X2, the unrealized loss of $120,000 is presented in stockholders’ equity as part of other comprehensive income, in accordance with ASC 320. At December 31, 20X2, X considers whether the impairment loss is other-than-temporary and whether it should be recognized on the income statement. Additional facts include: X has the ability and intent to hold the investment for the next few years until the forecasted recovery period (approximately two years) because the cash invested is idle cash that is not needed for working capital or other internal uses. Evidence indicating that Y’s loss appears to be temporary due to a dip in stock values within Y’s entire industry. X estimates that the fair value of Y’s stock will recover back to at least the $500,000 cost within the next two years and there is no negative evidence to the contrary. Should X record the $200,000 loss as a realized loss on the income statement as of December 31, 20X2? Conclusion: Probably not. Although there is an impairment at December 31, 20X2, there is little evidence to support the conclusion that the impairment is other-than-temporary. Following is the logic applied to this example: Step 1: Is there an impairment at December 31, 20X2? There is an impairment because the fair value of $300,000 is less than the cost of $500,000. Therefore, X must go to Step 2 and perform a test to determine whether the impairment is other-than-temporary. Step 2: Is the impairment other-than-temporary? No. In this example, following are the conclusions reached based on the facts given. 1. Factor 1: Ability and intent to hold the investment: With respect to Factor 1, X has the

ability and intent to hold the investment for the next few years until the forecasted recovery period (approximately two years) because the cash invested is idle cash that is not needed for working capital or other internal uses. There is no evidence that the company would be required to sell the investment for working capital or other requirements.

2. Factor 2: Based on the facts given, there are no specific events which may influence the

financial condition of the issuer. The loss appears based on a dip in the stock market.

7 $200,000 gain less $80,000 deferred income taxes (40% x 200,000) = $120,000 net gain.


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3. Factor 3: The only key factor that is provided is the severity and duration of the impairment. The severity of the impairment is significant while the duration is short.

Severity should be based on the extent to which fair value is below cost. The extent of the impairment loss is significant ($200,000 loss versus a cost of $500,000).

The duration of the impairment is rather short (approximately two years) which mitigates

the severity of the impairment. Given the fact that the severity of the impairment is significant but the duration short, and there is no other evidence that contradicts a recovery within a reasonable period of time (e.g., 2 years), the conclusion is that the impairment is temporary (not other-than-temporary) and a loss should not be recognized on the income statement. Example 2: Continue with Example 1 into 20X4. At December 31, 20X3, the fair value of the investment in Y was still approximately $300,000 and X concluded that the impairment was not other-than-temporary because the investment was expected to recover at the end of December 31, 20X4.

At December 31, 20X4, the fair value of the investment in Y is still approximately $300,000 and has not recovered despite X’s original forecast that it would recover by the end of December 31, 20X4. Not only has X’s fair value not improved, but neither has the industry, as a whole. Y’s financial performance is fair and its prospects for improvement in the near-term are not strong. Moreover, although the entity has the ability to continue to hold the investment indefinitely, there is a question as to whether it plans to hold it much longer. Conclusion: It appears the investment impairment is other-than-temporary and that a realized loss should be recorded on the income statement. The conclusion reached is based on the following assessment: Factor 1: Although the entity has the ability to continue to hold the investment until it recovers, the intent may be lacking. Factor 2: Based on the facts given, there are specific events which may influence the financial condition of the issuer based on the following information: 1. The general market condition of both the individual company and industry in which the

company operates has not improved and is not likely to improve in the near term. 2. Y’s financial performance is fair and its prospects for improvement in the near term are not

strong. Factor 3: The severity of the impairment is now rather strong and the duration is much longer. The extent of the impairment loss is significant ($200,000 loss versus a cost of $500,000). The duration of the impairment is now much longer (almost three years). Because the severity of the impairment is stronger and the duration longer, these factors lead to a conclusion that the impairment is other-than-temporary.


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The result is that the $200,000 impairment in the Y investment is other-than-temporary requiring X to writedown its investment in Y and record a $200,000 realized loss. In doing so, X must reverse its allowance account and unrealized loss recorded for its investment in Y as categorized as available for sale. Entry at December 31, 20X4:

Unrealized loss (stockholders’ equity) 120,000 Allowance for writedown of security 200,000 Deferred income tax asset 80,000

To reverse off unrealized loss on security available for sale

Realized loss on investment Y (income statement) 200,000 Investment in Y 200,000 Deferred income tax asset 80,000 Income tax expense- deferred 80,000

To record realized loss on writedown of other-than-temporary investment

Company X Statement of Stockholders’ Equity

For the Year Ended December 31, 20X4

Total

Accumulated other

comprehensive income

(Unrealized loss on securities)

Retained earnings

Common stock

Beginning balance $480,000 $(120,000) $500,000 $100,000 Comprehensive income:

Net income 175,000 175,000 Reversal of unrealized loss on securities (net of tax effect: $80,000)

120,000

120,000

$775,000 $ 0 $675,000 $100,000

Company X Statement of Income

For the Year Ended December 31, 20X4 Net sales $xx Cost of sales xx Gross profit on sales Xx Operating expenses xx Net operating income xx Other income: Realized loss on securities writedown

(200,000)

Net income before income taxes xx


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Income taxes xx Net income $xx

Example 3: Same facts as Example 2 except that in assessing all information, X reaches the following conclusions about the impairment loss at December 31, 20X4. In March 20X5, before issuance of the December 31, 20X4 financial statements, Y has made a substantial recovery in its fair value. Evidence supports that Y’s financial performance will continue to improve based on Y’s earnings trends, including the signing of a significant contract with a major customer. X determines that it believes its investment in Y is recoverable within a reasonable period of time and certainly within the time that it intends to hold the investment. Conclusion: X satisfies both factors and demonstrates that the impairment is not other-than-temporary. Thus, the impairment loss should not be recognized on the income statement. Factor 1: The entity has both the ability and intent to continue to hold the investment until it recovers. Factor 2: There are specific events which may influence the financial condition of the issuer based on the following information:

1. Forecasts about the investee’s financial performance and near-term prospects, such as earnings trends, dividend payments, asset quality, and analysts’ or industry specialists’ forecasts, show a positive trend.

2. The fair value of the investment has recovered after the balance sheet date but before the

financial statements are issued. Because the above information supports the fact that the cost is recoverable within a reasonable period of time, and there is no evidence to the contrary, the impairment is temporary (not other than temporary), at December 31, 20X4.

6. Determining Whether an Investor Should Apply the Equity Method to Certain

Investments Question: Should an investor apply the equity method of accounting to investments other than common stock if the investor has the ability to exercise significant influence over the operating and financial policies of the investee? Response: ASC 323, Investments-Equity Method and Joint Ventures (formerly APB No. 18), provides the accounting standards for common stock investments using the equity method. In general, ASC 323 provides that the equity method should be used for an investment in common stock if the investor has the ability to exercise significant influence over operating and financial policies of an investee even though the investor holds 50% or less of the voting stock. Thus, absent evidence to the contrary, it is assumed that significant influence exists between 20% and 50% ownership in the voting stock.


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However, ASC 323 states that the equity method does not apply to investments other than voting common stock such as:8 a. Non-voting common stock b. Preferred stock c. Partnerships and limited liability companies. Since the issuance of ASC 323 (formerly APB No. 18), the type and form of investments have expanded beyond traditional voting common stock. Examples of such investments include convertible debt, preferred stock, options, warrants, investments in unincorporated entities (such as partnerships and LLCs), complex licensing and management arrangements, and various other financial instruments. Many of these vehicles have attributes similar to those of voting common stock and can convey any combination of rights, privileges, or preferences including:

a. The right to vote with common stockholders b. The right to appoint members of the board of directors c. Substantive participating rights9 d. Protective rights e. Cumulative and participating dividends, and f. Liquidation preferences.

As a result, there may be instances in which, through an investment vehicle, an investor may gain the ability to exercise significant influence over the operating and financial policies of an investee without holding any investment in voting common stock of the investee. ASC 323, states that the equity method should be used if two criteria are met: 1. An investor has the ability to exercise significant influence over the operating and financial

policies of the investee, and 2. The investment is either:

a. Common stock, and/or b. In-substance common stock.

Definition of in-substance common stock: In-substance common stock is an investment in an entity that has risk and reward characteristics that are substantially similar to that entity’s common stock.10 1. If the investor determines that any one of the three following characteristics indicates that an

investment in an entity is not substantially similar to an investment in that entity’s common stock, the investment is not in-substance common stock:

8 ASC 323 reemphasized that the provisions of ASC 323 apply only to investments in common stock of corporations. However, ASC 323 also states that use of equity method would be appropriate in accounting for investments in unincorporated entities, such as partnerships and joint ventures. 9 Substantive participating rights are described in ASC 810 (formerly part of EITF Issue 96-16). 10 ASC 260 (formerly FASB No. 128) defines common stock as a stock that is subordinate to all other stock of the issuer. If an investee has more than one class of common stock, the investor should perform the analysis by comparing its investment to all classes of common stock.


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a. Subordination: An investor should determine whether the investment has subordination characteristics that are substantially similar to that entity’s common stock.

b. Risks and rewards of ownership: An investor should determine whether the investment

has risks and rewards of ownership that are substantially similar to an investment in that entity’s common stock.

c. Obligation to transfer value: An investment is not substantially similar to common stock

if the investee is expected to transfer substantive value to the investor and the common shareholders do not participate in a similar manner.

7. Accounting for Investments in Limited Liability Companies Question: Should an LLC be accounted for similar to a corporation or partnership in determining whether the equity method should be used? Response: ASC 323, Investments- Equity Method and Joint Ventures, prescribes the accounting for investments in the common stock of corporations that are not consolidated. ASC 323 specifies that investments that allow the investor to exercise significant influence over the operating and financial policies of an investee should be accounted for using the equity method. ASC 323 also establishes a presumption of significant influence for investments of between 20 to 50 percent of the investee’s outstanding voting stock. ASC 323 indicates that "many of the provisions of the equity method would be appropriate for partnerships and joint ventures” even though ASC 323 only applies to investments in common stock of corporations. ASC 323 further states that investors in unincorporated entities such as partnerships and unincorporated joint ventures generally shall account for their investments using the equity method if the investor has the ability to exercise significant influence over the investee. 8. Accounting for LLC Losses in Excess of the Investment Account Balance Question: How should an investor in an LLC account for losses in excess of the investment account balance? Response: There are instances in which an investor has losses in excess of the investment in an LLC. An example is where the investor is a guarantor of an LLC’s obligations. ASC 970 (formerly SOP 78-9) provides authority for accounting for such losses for real estate ventures. The SOP’s guidance should be followed for non-real estate ventures, as well. The rules of ASC 970, as applied to an investment in an LLC, follow:

a. An investor should account for its share of excess losses to the extent that the investor is liable for obligations of the venture or otherwise committed to provide additional financial support to the venture.

b. If the investor does not recognize excess losses and the LLC subsequently reports net

income, the investor should resume recorded net income using the equity method only after net income equals the share of net losses that were not recorded.


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c. If it is probable that one or more other investors cannot bear their share of losses, the remaining investors should record their proportionate shares of losses otherwise allocable to investors considered unable to bear their share of losses.

d. The investor should record the excess, including loans and advances, as a liability in its

financial statements. Example 1: Company X invests $100,000 for a 10% share of ABC LLC. X also guarantees a loan of ABC in the amount of $50,000. In 20X2, X’s share of ABC’s GAAP loss is $130,000. Conclusion: Because X has an investment in an LLC of 10%, X should use the equity method. X’s share of ABC’s losses exceeds X’s investment by $30,000 ($130,000 loss - $100,000 investment). ASC 970 states that excess losses should be recorded to the extent that an investor is a guarantor or committed to provide additional financial support to the LLC. In this example, X is guarantor of a $50,000 loan of ABC. Thus, X should record excess losses up to $50,000.

Entry 1: Equity losses 130,000 Investment in ABC LLC 100,000 Excess losses in equity investment in LLC 30,000

To record X’s share of losses in ABC LLC The excess loss of $30,000 should be shown as a liability.

Current liability:

Accounts payable Accrued expenses Excess losses from investment in LLC 30,000

The determination of whether the liability is current or long-term should be based on when the liability is expected to be settled; that is, when the LLC is expected to generate enough income to absorb X’s $30,000 of excess losses. Example 2: Continue on with Example 1 to 20X3. In 20X3, X’s share of ABC’s net income is $40,000. Conclusion: The excess losses of $30,000 should be reversed with the remaining $10,000 recorded as equity income as follows:

Entry 1: Excess losses liability- equity investment in LLC 30,000 Investment in ABC LLC 10,000 Equity income 40,000

To record X’s share of ABC LLC net income and reverse excess loss liability.

Example 3: Same facts as Example 1 and 2 except that X did not guarantee a $50,000 loan for ABC LLC.


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Conclusion: In 20X2, X’s share of ABC’s losses should be recorded only to the extent of the investment account as follows:

Investment activity- 20X2: Investment balance $100,000 ABC losses ($130,000) recorded (100,000) Investment balance 12-31-X2 $ 0

X’s share of ABC losses: 20X2 losses $(130,000) Portion recognized 100,000 Unused portion of losses $(30,000)

Because X is not a guarantor nor has X committed to additional financial support in the future, X should not record any LLC losses in excess of X’s investment account. Consequently, only $100,000 of equity method losses should be recorded with the remaining $30,000 not recorded. In 20X3, X’s share of ABC’s net income is $40,000. The 20X3 entry is as follows:

Entry 1: Investment in ABC LLC 10,000 Equity income 10,000

To record X’s share of ABC LLC net income. Because X did not record the excess $30,000 of losses, X does not record the entire $40,000 of 20X3 equity income. Instead, X starts recording equity income once the income equals the $30,000 of prior year losses. Therefore, out of the $40,000 of income, only the excess over the $30,000 of unrecorded losses is recognized.

20X3 equity income recorded: X’s share of 20X3 income- ABC LLC $40,000 X’s 20X2 unused losses- ABC LLC (30,000) Portion of 20X3 income recorded $10,000


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 7. Outstanding checks that have been mailed prior to the balance sheet date should be treated

as: a) a reduction of cash b) a negative current asset c) a current liability d) a restricted asset

8. Which of the following is correct regarding the AICPA Technical Practice Aid (TPA) 1300-15:

a) it provides authoritative guidance on the treatment of cash overdrafts on the statement of cash flows

b) it resolves the inconsistent treatment of outstanding checks on the balance sheet c) is not authoritative and does not resolve an inconsistency of the treatment of cash

overdrafts on the statement of cash flows d) it recommends that the net change of cash overdrafts be reported as an operating activity

9. Which of the following is not covered by ASC 320 (formerly FASB No. 115) with respect to

investments in securities: a) options on debt securities b) options on equity securities c) warrants and call options d) investments in public company stock

10. ASC 320 (formerly FASB No. 115) generally requires trading securities to be presented as:

a) current assets b) long-term assets c) either current or long-term depending on the company’s intent d) split between current and long-term

11. What is the proper accounting treatment for investments in which there is more than 50%

ownership: a) they should be recorded at fair value or cost depending on management intent b) they should be recorded at cost c) they should be accounted for under the equity method d) they should be consolidated

12. Which one of the following is an indicator of an impairment in an investment:

a) a significant improvement in the earnings performance b) a significant positive change in the regulatory environment c) a bona fide offer to purchase the investment at an amount that is equal to the cost of the

investment d) a significant adverse change in the general market condition of the industry


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13. According to ASC 323 (formerly APB No. 18), the equity method applies to which of the

following: a) voting common stock b) preferred stock c) non-voting common stock d) treasury stock


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SUGGESTION SOLUTIONS 7. A: Correct. The proper treatment of outstanding checks that have been mailed and

out of the control of the payer is to report them as a reduction of cash. B: Incorrect. Once the checks have been mailed, they are out of the control of the payer and

should be treated as a reduction of cash. They should never be treated as a negative current asset.

C: Incorrect. Because they are out of the control of the payer, they should no longer be treated as a current liability.

D: Incorrect. There is no authority to treat outstanding checks as a restricted asset. 8. A: Incorrect. The AICPA Technical Practice Aid (TPA) relates to the treatment of cash

overdrafts on the statement of cash flows, but is not authoritative. B: Incorrect. TPA 1300-15 does not relate to the treatment of outstanding checks on the

balance sheet making the answer incorrect. C: Correct. TPA 1300-15 is not authoritative, but recommends that the net change in

overdrafts during the period be reported as a financing activity on the statement of changes. Because it is not authoritative, it really does not resolve inconsistencies in practice regarding the treatment of cash overdrafts on the statement of cash flows.

D: Incorrect. TPA 1300-15 recommends that the net change be reported as a financing activity rather than an operating activity, making the answer incorrect.

9. A: Correct. Options on debt securities are not covered by ASC 320.

B: Incorrect. Options on an equity security are covered by ASC 320 if the options have a fair value that is currently available on a securities exchange.

C: Incorrect. ASC 320 covers equity securities. Included in the definition of an equity security is any security representing a right to acquire an ownership interest at a fixed or determinable price, which includes warrants, rights, and call options.

D: Incorrect. Investments in equity securities are covered by ASC 320. Therefore, this answer is incorrect.

10. A: Correct. ASC 320 requires trading securities to be presented as current assets, by

definition, unless there are extenuating circumstances. B: Incorrect. Generally, trading securities should be presented as current rather than long-

term per ASC 320. C: Incorrect. ASC 320 does not offer any flexibility for presentation of trading securities on

the balance sheet as anything other than current. In comparison, ASC 320 does provide that securities available for sale (AFS) should be presented as current or long-term based on the company’s intent at the end of the year.

D: Incorrect. ASC 320 does not allow for the splitting of a trading security between current and long-term on the balance sheet.

11. A: Incorrect. Investments with more than 50% ownership should not be recorded at fair

value. Fair value treatment only applies to investments in securities at less than 20% ownership.

B: Incorrect. Cost treatment applies to investments of less than 20% ownership in non-securities covered by ASC 325.

C: Incorrect. Equity method generally applies when there is significant influence which is assumed to occur with ownership between 20-50% ownership.

D: Correct. In general, ownership of more than 50% requires consolidation.


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12. A: Incorrect. A significant deterioration in earnings, and not a significant improvement, is an indicator of an impairment.

B: Incorrect. A significant negative change, and not a positive change, in the regulatory environment, is an indicator of an impairment.

C: Incorrect. An indicator of impairment is where there is a bona fide offer at an amount that is less than the cost of the investment, not equal to the cost of the investment.

D: Correct. One indicator of an impairment is a significant adverse change in the general market condition of the industry.

13. A: Correct. ASC 323 states that the equity method applies to voting common stock

only. B: Incorrect. ASC 323 states that the equity method does not apply to preferred stock. C: Incorrect. Per ASC 323, the equity method does not apply to non-voting common stock. D: Incorrect. ASC 323 specifically states that the equity method does not apply to treasury

stock.


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D. Receivables 1. Installment receivables Question: Should installment receivables be presented as current assets? Response: ASC Subtopic 210-10, Balance Sheet- Overall (formerly found in ARB No. 43), states that the term "current assets" includes installment or deferred accounts and notes receivable “if they conform generally to normal trade practices and terms within the business.” As a result, the entire installment receivable should be presented as a current asset if it is a normal trade practice within the industry to do so. Absent a normal trade practice, the author believes an installment receivable should be split so that the portion receivable within the current year (or operating cycle) would be presented as a current asset while the remainder shown as a non-current asset. 2. Accrued Interest on Doubtful Receivables Question: When should a lender stop accruing interest revenue on doubtful receivables? Response: There is no authoritative guidance in this area. In practice, many banks stop accruing interest when loan payments stop. It is most likely prudent to stop accruing interest on any account for which an allowance has been established based on the premise that it is unrealistic to recognize income which probably will not be collected. 3. Allowance for Uncollectible Accounts11 Question: Must an entity establish an allowance for uncollectible accounts even though, based on an analysis of receivables and past write-off experience, it believes that no accounts are uncollectible at the balance sheet date? Response: ASC 450, Contingencies, (formerly FASB No. 5), states that there should be an accrual for a loss if both of the following conditions are met: a) Information available prior to issuance of the financial statements indicates that it is

probable that an asset has been impaired at the balance sheet date, and b) The amount of loss can be reasonably estimated. If both of these conditions are not met, the allowance would not be required. Further, there would not be any requirement to disclose the absence of a loss accrual. Question: If no allowance is recorded, should the company disclose that the allowance balance is zero and that the “direct writeoff method” is used?

11 In 2016, the FASB issued ASU 2016-13, Financial Instruments- Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments. ASU 2016-xx makes substantive changes to the way in which an allowance for credit losses is computed for loans, trade receivables and other financial instruments. In particular, the ASU requires an entity to measure expected credit losses based on relevant information about historical experience, current conditions, and forecasts of amounts collectible. The ASU has a delayed effective of fiscal years beginning after December 15, 2021 (calendar 2022). Because the ASU is not effective until 2022, the author has not included a detailed discussion of its affects on trade receivables and the allowance for uncollectible accounts.


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Response: ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, amends ASC Topic 310, Receivables, (formerly SOP 01-6), and requires an entity to disclose the balance of the allowance for doubtful accounts or credit losses. There is no requirement to disclose that the company uses the allowance method. That requirement was eliminated by ASU 2010-20. Under no circumstances should the company state that it uses the direct writeoff method. Instead, it actually uses the allowance method with a zero balance. Nevertheless, GAAP does require that there be a disclosure of the balance in the allowance account at the end of the year. There are two ways to disclose that amount. Option 1: Present it parenthetically on the balance sheet:

XYZ Company Balance Sheet

December 31, 20X1

ASSETS Current assets Cash XX Accounts receivable (net of allowance for doubtful accounts of $0)

XX

Inventories XX

Option 2: Disclose the allowance balance in the notes as follows:

Note X: Trade Receivables: At December 31, 20X1, trade receivables had net balances in the amount of $xxxx, net of an allowance for doubtful accounts of zero.

4. Disclosures for Trade Receivables Question: What are the disclosure and presentation requirements for trade receivables, the allowance for uncollectible accounts, and bad debt writeoffs? Response: ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, amends ASC Topic 310, Receivables, (formerly SOP 01-6), to provide guidance. The ASU applies to most entities that have trade receivables. Entities subject to the ASU (as noted above) must follow the following recognition and measurement principles. Balance sheet presentation:


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1. Trade receivables should be presented net of the allowance for uncollectible accounts.

2. Trade receivables may be presented on the balance sheet as aggregate amounts.

Receivables held for sale should be presented in a separate balance-sheet category from other receivables.

Major categories of loans or trade receivables should be presented separately either in the balance sheet or in the notes to financial statements.

The following items should be disclosed either on the balance sheet or in the notes:

- Allowance for doubtful accounts or credit losses - Unearned income - Unamortized premiums and discounts - Net unamortized deferred fees and costs

Disclosures: 1. The Company should make the following additional disclosures in its summary of

significant accounting policies. a. Accounting policies for trade receivables:

The basis for accounting for trade receivables.

The method for recognizing interest income on loans and trade receivables, including a statement about the entity’s policy for treatment of related fees and costs, such as the method of amortizing net deferred fees or costs.

b. Accounting policies for nonaccrual and past due trade receivables and loans including:

The policy for placing trade receivables on non-accrual status (or discontinuing accrual of interest) and recording payments received on trade receivables), and the policy for resuming accrual of interest.

The policy for charging off uncollectible trade receivables and loans.

The policy for determining past due or delinquency status (e.g., whether past due status is based on how recently payments have been received or contractual terms).

Non-accrual and past due trade receivables and loans: The recorded investment in trade receivables and loans on non accrual status should be disclosed in the notes as of each balance-sheet date. Note: The recorded investment is the face amount increased or decreased by accrued interest and unamortized premium, discount, finance charges, or acquisition costs and may also reflect a previous write-down of the investment.


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The recorded investment in trade receivables and loans that are past due ninety days or more and are still accruing interest should be disclosed in the notes.

The carrying amount of loans, trade receivables, securities and financial instruments that serve as collateral for borrowings shall be disclosed.

Observation: Previously, SOP 01-6 required an entity to disclose a description of the accounting policies and methodology used to estimate its allowance for doubtful accounts. The issuance of ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which amends ASC 310, Receivables. The ASU eliminated this allowance for bad debts disclosure for trade receivables, although the ASU expanded the disclosures for other financing receivables such as loans receivable. Also note that use of the direct-writeoff method is not permitted by GAAP. The only acceptable method to record bad debts is the allowance method.

Examples of Disclosures and Presentation Under ASC 310, as amended by ASU 2010-20: In the following section, the author offers a series of disclosures that are required under ASC 310. Example of Disclosures and Presentation Under ASC 310: Facts:

Company X is a manufacturer who extends credit to its customers.

The company records an allowance for doubtful accounts on a percentage of accounts that exceed 90 days old, and write off accounts when they are deemed uncollectible after exhausting collection efforts.

At year end, accounts receivable was $2,000,000 on which an allowance was recorded for $100,000.

The Company has a policy of charging interest on accounts more than 90-days old. At the end of the year, there were $400,000 of accounts more than 90 days old on which the company continued to charge interest.

The Company has a policy of suspending the accruing of interest on accounts that are in collection which totaled $50,000 at year end.


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Required disclosure under ASC 310:

NOTE X: Summary of Significant Accounting Policies: Trade receivables: Trade receivables are recorded at net realizable value consisting of the carrying amount less the allowance for uncollectible accounts. Accounts are considered past due once the unpaid balance is 90 days or more outstanding, unless payment terms are extended by contract. When an account balance is past due and attempts have been made to collect the receivable through legal or other means, the amount is considered uncollectible and is written off against the allowance balance. The Company’s policy is to charge interest on all customer account balances that exceed 90 days old. Interest income on such loans is recorded as earned. The recording of interest is suspended when an account is placed in collection or written off, and interest accrual resumes when a customer commences payments on a past-due account in accordance with an agreed-upon payment plan. The company’s policy is to apply payments received on past due accounts first against the account balance without regard to accrued interest, with any remainder recorded against interest receivable. At December 31, 20X2, customer balances that exceeded 90 days old on which the company continued to accrue interest income totaled $400,000 while balances past due on which the company suspended recording interest totaled $50,000. At December 31, 20X2, trade receivables had net balances in the amount of $1,900,000, net of an allowance balance of $100,000.

Is an entity required to disclose the policy for using an allowance for bad debts for trade receivables? No. ASU 2010-20 amended ASC 310 to remove the requirement that a company disclose the policy for using an allowance account with respect to trade receivables. Disclosure of the allowance account policy is required for loans, but not trade receivables. However, an entity is required to disclose the amount of the allowance for doubtful accounts at the balance sheet date, either presenting it on the balance sheet or in the notes to financial statements. 5. Use of the Installment Sales Method Question: A company sells real estate and receives a note receivable from a buyer. The transaction qualifies for installment sales treatment for tax purposes. The Company also wishes to use the installment sales method for GAAP. Is the installment sales method appropriate for GAAP financial statements? Response: Not usually. ASC 605, Revenue Recognition (formerly found in ARB No. 43 and APR No. 10), specifically prohibits use of the installment sales method for financial statement purposes unless collectibility of the note cannot be reasonably estimated or assured. In those rare cases where this is the fact, a Company may use either the installment sales or cost recovery method for GAAP. Otherwise, the accrual method must be used.


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In the case noted in this example, there is a note involved, yet, there is no evidence that collectibility cannot be reasonably estimated or assured. Thus, the installment sales method is probably not appropriate. Instead, the full gain should be recognized in the year of sale. E. Inventories 1. Uniform Capitalization (UNICAP) Rules - GAAP Question: Do the additional 263A costs capitalized for tax purposes in accordance with section 263A of the IRC constitute inventoriable costs for GAAP? Response: ASC Subtopic 330-10, Inventory- Overall, addressed this issue as follows:

“The fact that a cost is inventoried for tax purposes does not, in itself, indicate that it is preferable, or even appropriate, to inventory that cost for financial statement purposes. Certain of the additional costs that are required to be capitalized for tax purposes may also be capitalized for financial reporting purposes, depending on such factors as the nature of the enterprise’s operations and industry practices. The determination, however, can only be made after an analysis of the individual facts and circumstances.”

In essence, the FASB's comments appear somewhat ambiguous, providing little guidance on the matter. To provide more specific guidance, one must review the definition of inventory costs found in ASC 330-10-30, which states:

“As applied to inventories, cost means....the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. It is understood to mean acquisition and production costs… Under most circumstances, general and administrative expenses shall be included as period charges, except for the portion of such expenses that may be clearly related to production and thus constitute a part of inventory costs (production charges). Selling costs constitute no part of inventory costs… ”

Based on the above definition, it would appear that any costs incurred, that can be shown to bring the inventory to its existing condition and location, are inventoriable. Selling costs are clearly expensed as period costs. A review of major categories of additional section 263A costs as they relate to GAAP follows:


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GAAP Accounting for Costs

Category of costs

Inventoriable

May be inventoriable

Not inventoriable

Purchasing costs (1) X

Handling and receiving costs (1) X

Warehousing and storage costs (2) X

Tax depreciation (3) X

Manufacturing overhead costs, excluding G&A

X

G&A (4) X

Interest during production (5) X

(1) Purchase, handling and receiving costs are costs to bring the inventory into its existing condition and location and are capitalizable overheads. (2) Some warehousing and storage costs are overheads such as those for storage of raw materials. (3) GAAP depreciation, and not tax depreciation related to production equipment and facilities should be included in overhead costs. If tax depreciation is not materially different than GAAP depreciation, total tax depreciation may be capitalized for GAAP purposes. (4) G&A is generally not related to bringing inventory into its existing condition and location, and is therefore expensed. (5) For tax purposes, section 263A(f) generally follows ASC 835, Interest with respect to interest capitalization. In general, interest is not capitalized on routinely manufactured inventories.

G&A costs are generally the category of additional 263A costs that may not be capitalized for GAAP. However, many companies still capitalize G&A costs based on lack of materiality. If G&A costs are included in both the beginning and ending inventory, there is little impact on the income statement from year to year. Assuming one justifies that G&A costs capitalized under 263A are not material, most of the remainder of the section 263A costs should be inventoriable; that is, they can be included in fixed overhead costs. However, one last issue that needs to be addressed is lower of cost and net realizable value12 In some instances, by adding additional 263A costs to the inventory, the value may exceed net realizable valueThe result is that the cost of the inventory may exceed net realizable value, thereby resulting in a writedown to lower of cost or net realizable value and an elimination of all or a portion of the UNICAP add-on. In accordance with ASC 330, Inventory, GAAP lower of cost and net realizable value is calculated as follows:

Estimated selling price $XX Costs to, complete, sell and dispose (XX) Net realizable value XX

12 ASU 2015-11, Inventory (Topic 330), Simplifying the Measurement of Inventory, amends GAAP by requiring companies who use FIFO or average cost inventory valuation methods to measure them at lower of cost and net realizable value. For such inventories, lower of cost or market is replaced with lower of cost and net realizable value. The changes are effective for fiscal years beginning after December 15, 2016 (calendar year 2017).


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In computing market value, replacement cost is compared to the above range. If replacement cost is within the ceiling and floor range, replacement cost is considered market value and compared with cost to determine lower of cost or market value. Assume the following fact pattern:

Without UNICAP add-on

With UNICAP add-on

Cost (A): Without UNICAP add-on

$40

With UNICAP add-on $60

Net realizable value:

Estimated selling price 70 70

Costs to complete, selling and dispose (15) (15)

Net realizable value $55 $55

Lower of cost or market value (lower of (A) or (B))

$40 $55

In the above example, if UNICAP costs are capitalized to inventory, a portion of the add-on ($5) is eliminated when the inventory is written down to lower of cost and net realizable value. For example, the UNICAP add-on is $20 ($60 versus $40) yet, only $15 is actually capitalized ($55 less $40) because $5 is eliminated in lower of cost and net realizable value. This is not the case if UNICAP costs are not capitalized whereby LCM is the cost of $40. Note: In July 2015, the FASB issued ASU 2015-11, Inventory (Topic 330), Simplifying the Measurement of Inventory. ASU 2015-11 states that an entity should measure inventory at the lower of cost and net realizable value. Net realizable value is defined as estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. Thus, once ASU 2015-11 becomes effective, measuring inventory using lower of cost or market, and use of a ceiling and floor is eliminated. For nonpublic entities, the ASU is effective for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017. The ASU change does not apply to inventory measured using LIFO or the retail inventory method. Until the effective date of ASU 2015-11 (which is generally calendar year ending December 31, 2017), companies should follow the existing guidance for measuring inventory using the lower of cost or market. 2. Classification of Slow-Moving Inventory Question: A client has slow-moving products that are not considered obsolete, and it has been properly written down to lower of cost or market. The client estimates that it will take approximately five years to liquidate all the slow-moving inventory. Should all or a portion of it be classified as a long-term asset? Response: In accordance with ASC 210, Balance Sheet (formerly ARB 43), a current asset is one that is cash or resources reasonably expected to be realized in cash or sold during the normal


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operating cycle of the business. Therefore, the portion of the inventory not reasonably expected to be realized in cash during the client's normal operating cycle should be classified as a long-term asset. Author's Observation: Had the normal business cycle been five years (e.g., wine vineyard), the inventory would have been presented as a current asset. 3. Disclosure of LIFO Reserve Question: Should a company using a LIFO method of inventory valuation disclose the LIFO reserve? Response: Yes. The only guidance on this is found in the Accounting Standards Division Issues Paper Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories which states that the LIFO reserve or replacement cost and its basis for determination should be disclosed. 4. Converting from LIFO Back to FIFO Because of the relatively low inflation period encountered in the past decade, many companies on LIFO have not seen significant increases in the LIFO reserve- that is, the difference between FIFO and LIFO inventories has remained the same with no significant increase in the LIFO reserve due to inflation. In some cases, depending on the industry, companies have seen a reduction in the LIFO reserve due to deflation or decrements in the inventory levels. In other circumstances, there has been a need to revalue the layers in the LIFO reserve. For example, if a company converts from a C corporation to an S corporation, it is required to revalue the layers to recapture the LIFO reserve at the beginning of the year of change, and pay the tax on the LIFO recapture income over a four-year period. In such a case, the company may retain LIFO, but must revalue the layers using a new LIFO base year (the first year under S corporation status). At that point, sometimes it does not make sense to continue use of LIFO. If a company converts from LIFO to FIFO, the issue is how to account for the change for GAAP purposes. For tax purposes, it is a change in accounting method that requires permission and usually there is a spread in the section 481(a) adjustment (the pickup of the LIFO reserve). For GAAP purposes, ASC 250, Accounting Changes and Error Corrections (formerly FASB No. 154), states that when there is a voluntary change in accounting principle, the balance sheet is converted to the new principle as of the beginning of the year of change. The effect of the change is shown as an adjustment to the opening balance of retained earnings for that period. Financial statements for each individual prior period presented are adjusted to reflect the period-specific effects of applying the new accounting principle. Example: Effective January 1, 20X2, Company X converts from C to S corporation status. As part of that change, for tax purposes X is required to revalue its LIFO layers as of December 31, 20X1 and to pay a tax on the LIFO reserve, payable over four years. X decides that it wants to change its method from LIFO to FIFO effective January 1, 20X2. Conclusion: Assuming X presents comparative financial statements for 20X2 and 20X1, here is what X should do:


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a. Restate the 20X1 comparative financial statements to exclude the effect of using LIFO. The January 1, 20X1 beginning retained earnings should be restated to exclude the effect of LIFO retroactively.

b. The 20X1 income statement is restated to exclude the LIFO reserve adjustment and the

tax effect of that adjustment. c. For December 31, 20X2, X should use the new FIFO method.

5. Purchase and Sales of Inventory with Two Parties Question: It is common for two entities to swap inventories to facilitate the sales process. How should the inventories be accounted for? Response: An entity may sell inventory to another entity in the same line of business from which it also purchases inventory. The purchase and sale transactions may be part of the same contractual arrangement or separate arrangements. The inventory may be in the form of raw materials, work-in-progress, or finished goods. One example is the automotive business in which two auto dealers may exchange automobiles to accommodate a particular customer. In some instances, the automobiles exchanged may be identical except for having different colors. The authority to address this issue is found in ASC 845, Non-Monetary Transactions (formerly found in EITF Issue No. 04-13) which states:

1. Inventory purchase and sales transactions with the same counterparty that are entered into in contemplation of one another should be combined and treated as a single exchange under ASC 845. That is, the goods received should be recorded at the carrying value of the goods given with no gain or loss recognized unless cash is received in the transaction.

a. If the transactions were not entered into in contemplation of one another, they should be treated as two separate monetary transactions, in which each is recorded at fair value, without consideration of the other.

2. Definition of “in contemplation of one another”: In situations in which an inventory transaction

is legally contingent upon the performance of another inventory transaction with the same counterparty, the two are in contemplation of one another and should be combined by applying ASC 845.

. ASC 845 provides the following factors that may indicate that a purchase transaction and a sales transaction with the same counterparty were entered into in contemplation of one another.


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Factor indicating two transactions were entered into in contemplation of one another

Comments

There is a legal right of offset of obligations between counterparties involved in inventory purchase and sales transactions.

The ability to offset receivables and payables related to separately documented inventory transactions indicates there is a link between them.

Inventory purchase and sales transactions with the same counterparty are entered into simultaneously.

An inventory purchase transaction that is simultaneously entered into with another inventory sales transaction with the same counterparty, is an indication that the transactions were entered into in contemplation of one another.

Inventory purchase and sales transactions were at off-market terms.

If a company enters into an off-market inventory transaction with a counterparty, it is an indication that the transaction is linked to, and entered into, in contemplation of another inventory transaction with that same counterparty.

There is relative certainty that reciprocal inventory transactions with the same counterparty will occur.

A company may sell inventory to a counterparty and enter into another arrangement with that same counterparty whereby that counterparty may, but is not contractually required to, deliver an agreed-upon inventory amount.

Example 1: Sale and purchase of inventory between two manufacturers Manufacturer A has a longstanding relationship with Manufacturer B, whereby each will buy and sell inventory from each other on an as-needed basis at market prices. Manufacturer A sells materials to B based on a purchase order from B. Two days later, B sells materials to A based on a separate purchase order from A. Neither transaction was predicated on the occurrence of the other transaction occurring through either an implied arrangement or a contractual one. Historically, A has sold twice as much in value to B as B has sold to A. Both of these transactions are gross-cash settled at market prices. Conclusion: As a result, the inventory purchase and sales transactions should not be considered a single exchange in applying ASC 845 (at carrying value). Instead, the transactions should be treated as two separate transactions recorded at market value. This assessment is supported by the following factors: a. The reciprocal inventory purchase and sale transactions were not negotiated between the two

parties at the same time. b. There is no correlation between the value of goods delivered to B to the value of the goods

received from B. c. A’s inventory purchase and sales transactions were not entered into in contemplation of one

another.


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Example 2: Sale and purchase of inventory between auto dealers Dealer A has excess inventory of cars and does not have enough pickup trucks for near-term demand. Dealer B has excess inventory of pickup trucks and not enough cars. A and B negotiate an arrangement whereby A sells a specified number of cars to B. Although not committed to do so, B may deliver pickup trucks of equivalent value at wholesale prices to A as consideration for the cars. A must purchase pickup trucks from B if B chooses to deliver the trucks the following week. Historically, B has always delivered trucks to A under these arrangements. At the time A delivers cars to B, A believes B will ship trucks the following week. Each transaction is separately documented and gross-cash settled at wholesale prices on the date of delivery. Conclusion: From A’s perspective, the transactions with B should be treated as a single nonmonetary exchange under ASC 845. The trucks received should be recorded at the carrying value of the cars given. The reason is because A entered into the sales transaction with B in contemplation of a reciprocal inventory purchase transaction from B. This conclusion is based on the following factors: 1. As a condition of selling inventory to B, A must accept delivery of trucks from B at a later date

if B chooses to make such a delivery. 2. The mutual agreement between A and B is “off-market” at wholesale prices. 3. When A enters into the arrangement with B, A fully expects to purchase the trucks; that is,

there is relative certainty that reciprocal inventory transactions with the same counterparty (B) will occur.

The fact that each transaction is recorded gross and separately documented has no impact on whether the transaction should be treated as a single exchange under ASC 845. F. Cash Value of Life Insurance 1. Balance Sheet Classification of Policy Loans Question: A company borrows against its cash value of life insurance. Is it proper to classify the cash value as non-current and the policy loan as a current liability? Is it appropriate to offset the cash value against the policy loan? How should unpaid interest on the policy loan be handled? Response: ASC 210, Balance Sheet (formerly part of ARB No. 43), specifically excludes the cash value of life insurance from the current assets category. It further states that policy loans should be classified as current liabilities when, by their terms or by intent, they will be repaid within one year. The pledging has no effect on the categorization of the cash value as an asset.


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When a policy loan is obtained with the intent that it will not be repaid until the cash value is liquidated, the loan should be classified as a long-term liability. With respect to the netting of the asset and liability, ASC 210, Balance Sheet (formerly part of APB No. 10), states:

“It is a general principle of accounting that the offsetting of assets and liabilities in the balance sheet is improper except where a (legal) right of offset exists.”

Because there is a legal right of offset, a company may elect to net the policy loan against the cash value in accordance with ASC 210, Balance Sheet. The unpaid interest on the loans usually should be shown as part of accrued interest if the intent is to pay it. If, however, the interest will be netted against the cash value of the policy along with the policy loans, the interest should be shown as part of the policy loan and, most likely netted against the cash value. Author's Observation: In most cases, policy loans are presented as long-term liabilities because the company does not plan to liquidate the liability until the cash value is surrendered. Unlike most liabilities, the company usually has full control over when the policy loan will be repaid because the company is the owner of the underlying policy. 2. Disclosure of Life Insurance on Principal Stockholders Question: A company maintains life insurance on several of its shareholders which will be used to repurchase the shareholder’s stock in the event of a shareholder’s death. The cash value is disclosed on the balance sheet. Is further disclosure required? Response: Yes. The agreement is a commitment of the company that should be disclosed in accordance with ASC 450, Contingencies, (formerly FASB No. 5) and ASC 505, Equity (formerly FASB No. 129). A sample disclosure follows: NOTE X: AGREEMENTS

The company is the owner and beneficiary of key-man life insurance policies carried on the lives of Larry Lifeless and Edgar Eternity, its principal shareholders, with face value amounts of $500,000 each. No loans are outstanding against the policies, but there is no restriction in the policy regarding loans. The life insurance contracts are accompanied by mandatory stock purchase agreements to the amount of the proceeds of the life insurance. In the event of the insured's death, the fair market value of the stock will be established by an appraisal company. The insured's estate will be obligated to sell, and the company will be obligated to purchase the insured's common stock at the lower of the appraisal value of the stock or the proceeds of the insurance.

Question: What if there is a cross-purchase agreement between the shareholders instead of with the company? Should this agreement be disclosed? Response: Probably not because the obligation to purchase the shares is with the shareholders, and not the company. The exception is where the company has a secondary obligation to repurchase the stock if it is not purchased by the shareholder. 3. Corporation's Policy on Life of Debtor Corporation's Officer


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Question: A company takes out a life insurance policy on the life of a debtor, Old Man Willie, presently age 88, with the intent that they can make a tax-free "killing" (no pun intended) when Old Man Willie dies. It is highly likely that Willie will die before the note is paid in the year 2050. How should the payments, cash value and any loans against the cash value be presented? Would it be appropriate to accumulate the payments in an "investment" account until the note is paid? Response: This transaction should be handled similarly to any other key-man life insurance policy. The payments should be allocated between the cash value asset and insurance expense. 4. Split Dollar Life Insurance Question: How should split dollar life insurance be handled? Response: Under split-dollar insurance policies, policy proceeds are split between the company and the named beneficiaries upon the death of the insured. The company receives the amount of accumulated premium payments with the remainder paid to the named beneficiaries. However, if the policy is canceled prior to death, the company usually is only reimbursed for the cash value at the cancellation date. Therefore, the lesser of the cash value or accumulated premium payments should be recorded on the balance sheet of the company making the payments. 5. Recording a Receivable and Income For a Death Benefit Question: A company has a $5 million key-man life insurance policy insuring the life of Charlie, its president. Charlie has led a good life but it is about to come to an end. As of the company’s year end, Charlie is terminally ill and with death imminent any day. Is it appropriate for the company to record a $5 million receivable and recognize income at year end for the $5 million that will be due upon Charlie’s death, based on the argument that it is probable that the death benefit will be received and the company can estimate the amount that it will collect? Response: No. First of all, the probable and estimable criteria apply only to loss contingencies, and not to gain contingencies. Further, ASC Subtopic 325-30, Investments-Other, addresses the issue of recording gains on life insurance prior to death, by stating:

“It is not appropriate for the purchaser of life insurance to recognize income from death benefits on an actuarial expected basis. The death benefit shall not be realized before the actual death of the insured, and recognizing death benefits on a projected basis is not an appropriate measure of the asset.”

Consequently, the company is not permitted to record a receivable and the related death benefit income prior to Charlie’s death. G. Intangible Assets 1. Treatment of Agreement Not to Compete Question: A company enters into an agreement not to compete with an outgoing officer which calls for periodic payments of $100,000 for the next five years. How should the agreement be recorded?


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Response: There is no authority on this issue. There are two possible ways of handling this transaction: 1) Option 1: Record as asset and liability for the present value of the $100,000 payments

at an interest rate commensurate with the risk involved as follows:

Entries: Agreement not to compete 380,000 Discount 120,000 Obligation 500,000 To set up the agreement: PV of an annuity, 5 years, 8% interest (3.80) $100,000 x 3.80 = $380,000 PV of the agreement (asset) Obligation 100,000 Cash 100,000 To record first payment Interest expense 30,400 Discount 30,400 To record amortization of discount at the end of year 1: Carrying value of obligation 380,000 x 8% = 30,400 Amortization expense 76,000 Agreement not to compete 76,000 To record amortization of agreement after year 1: 380,000/5 years = 76,000 Other assets: Agreement not to compete

304,000***


Current portion of obligation under agreement not to compete net of discount of $22,400

77,600*

Long-term debt: Obligation under agreement not to compete, net of current portion (net of discount of $67,200)

232,800** * Current portion ($100,000) less portion of discount ($22,400) = $77,600 ** Long-term portion ($300,000) less portion of discount ($67,200) = $232,800 *** Original amount of $380,000 less amortization of $76,000 = $304,000

2) Option 2: Do not record the asset and liability. Instead, record the agreement each year

as earned and disclose the commitment in the footnotes.

Entry each year for five years: Compensation under agreement not to compete 100,000 Obligation under agreement not to compete 100,000 To record set up of obligation each year for five years Obligation under agreement not to compete

100,000


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Cash 100,000 To record annual payment of obligation, each year for five years

Author's Observation: Advocates of the Option 2 method argue that a liability should not be recorded because the event obligating the entity has not occurred yet (e.g., officer's forbearance from competition). Further, an asset should not be recorded unless the asset embodies a probable future benefit. Thus, under this argument, an asset would only be recorded if payment occurred prior to the forbearance period, resulting in a future benefit. Because the authority is limited, practitioners may choose either option. 2. Legal Expenses to Defend a Patent Infringement Suit Question: A company is sued for patent infringement. Should the cost to defend the patent be capitalized or expensed? Response: The response depends on the outcome of the lawsuit. If the defense is unsuccessful, the legal costs along with the remaining carrying value of the patent should be expensed in accordance with FASB Concepts Statement No. 6. However, if the defense is successful, the legal costs should be capitalized and amortized over the remaining life of the patent. This rule would apply to all intangibles, not limited to patents. 3. Amortization Period for Agreement Not To Compete Question: A company purchases the assets of a target company with a portion of the purchase price allocated to a five-year agreement not to compete. For tax purposes, the agreement must be amortized over a fifteen-year period in accordance with IRC section 197. Over what period should the agreement be amortized for GAAP purposes? Response: For GAAP purposes, the agreement should be amortized over the period over which the company will benefit from the agreement, which is five years. The result is that the agreement will have a different unamortized basis for book and tax purposes resulting in a temporary difference and deferred income taxes if the entity is a C corporation. Question: Same facts as the previous example except the company uses tax-basis financial statements. Over what life should the agreement be amortized? Response: Because tax basis follows the Internal Revenue Code, the agreement should be amortized over the period required in IRC section 197, which is fifteen (15) years. This means that in income tax basis financial statements, an agreement not to compete will continue to be amortized well after the term of the agreement. 4. Intangible Asset Disclosures under ASC 805 and ASC 350 Question: What are the disclosure requirements for intangible assets assuming an entity does not make the private company election to amortize goodwill and reduce disclosures related to goodwill. Response: Two statements deal with the accounting and disclosures for intangible assets, including goodwill. The two statements are:

- ASC 805, Business Combinations (formerly FASB No. 141R), and


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- ASC 350, Intangibles- Goodwill and Other (formerly FASB No. 142) ASC 805 requires all companies to use the acquisition method to account for such acquisitions regardless of whether the acquisition involves the purchase of stock or assets. Under the acquisition method, the purchase price of the acquisition is assigned to tangible and intangible assets at fair value, with the remainder being assigned to goodwill. ASC 805 prohibits use of the pooling method to account for acquisitions. ASC 350 deals with the accounting for intangibles (including goodwill) after the assignment of fair value is complete under ASC 805. ASC 350 places intangible assets into three categories as follows:

Goodwill

Intangible assets (other than goodwill) with finite lives

Intangible assets (other than goodwill) with indefinite lives The following chart summarizes the treatment of these three categories of intangible assets:

Accounting for Intangible Assets

Type of intangible asset

Accounting treatment Impairment test

Goodwill Not amortized Tested annually for impairment

Intangibles with indefinite lives

Not amortized Tested annually for impairment

Intangibles with finite lives

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

Companies are required to make certain disclosures related to the categories of intangible assets, including goodwill. The following is a sample template of disclosures that are required under ASC 805 and 350. Amounts are given. Facts: Assume the following balance sheet as of December 31, 20X2 and 20X1.

Company A

Balance Sheets December 31, 20X2 and 20X1

($000s) Assets: Current assets:

20X2 20X1

Cash $xx $xx Accounts receivable xx xx Inventory xx xx Other current assets xx xx


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Total current assets xx xx Property, plant and equipment, net xx xx Other assets:

Goodwill 39,000 39,000 Other intangibles assets, net 13,800 15,200 Total other assets 52,800 54,200 Total assets

$xx

$xx

The disclosures required by ASC 805 and 350 follow: NOTE 1: Summary of Significant Accounting Policies: Goodwill and Other Intangible Assets: Intangible assets are amortized over the following estimated useful lives using primarily a straight-line basis. Life in years Agreement not to compete 5 Patents 17 Trademarks and tradenames acquired are not amortized as they are considered to have indefinite useful lives. The excess of the purchase price over the fair value of identifiable tangible and intangible assets is allocated to goodwill. Goodwill is not amortized unless events or circumstances occur indicating that an impairment exists. Impairment losses, if any, are recorded in the statement of income as part of income from operations. NOTE 2: Goodwill and Other Intangible Assets: Intangible assets other than goodwill: The following is a summary of intangible assets, other than goodwill, at December 31, 20X2 and 20X1.

December 31, 20X2

December 31, 20X1 Gross

carrying amount

Accumulated amortization

Gross carrying amount


Intangible assets subject to amortization: Agreement not to compete

$2,000

$1,200

$2,000

$800 Patents 17,000 9,000 17,000 8,000 19,000 10,200 19,000 8,800

Intangible assets not subject to amortization:

Tradenames and trademarks 10,000 5,000 10,000 5,000

$29,000 $15,200 $29,000 $13,800


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Amortization expense was $1,400 in 20X2 and $2,400 in 20X1. A summary of estimated amortization expense for the five years subsequent to 20X2 follows:

Year

Amortization expense13

20X3 $1,400 20X4 1,400 20X5 1,400 20X6 1,400 20X7 1,400

Goodwill: The changes in the carrying value of goodwill follow:

Goodwill: 20X2 20X1 Carrying value- beginning of year:

Goodwill $41,000 $41,000 Accumulated impairment losses (2,000) (2,000)

Net carrying value 39,000 39,000

New acquisitions Amortization

0 ( 0)

0 ( 0)

Impairment losses ( 0)

0)

Carrying value- end of year: $39,000 $39,000 Additional non-recurring footnotes: The disclosures noted above are recurring and should be included for each period for which an entity has intangible assets, including goodwill. In the year in which an acquisition is made, and the following year (if comparative financial statements are presented), the following acquisition footnote is required. Note 1: Acquisitions: (Required in the year in which a material business combination is completed) On June 30, 20X2, Company A acquired certain assets of Company B. Company B is a leading provider of data networking products and services in 38 states, Canada, and Mexico, and was acquired because it would provide Company A with the leader position in B's markets and result in reduced costs of both companies through economies of scale.

The aggregate acquisition cost was $10 million consisting of certain equipment, inventories, and

intangible assets totaling $10.5 million, and the assumption of $500,000 of trade liabilities. The

purchase price consisted of $3 million cash and $7 million of seller financing.

13 Includes amortization on intangibles other than goodwill.


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The fair value of the assets acquired and liabilities assumed at the date of acquisition are summarized below. Company A is in the process of obtaining third-party valuations of certain acquired assets; thus, the allocation of the purchase price is subject to refinement.

As of June 30, 20X2

($000s) Fair value Current assets $3,500 Property and equipment 2,500 Identifiable intangible assets 2,000 Goodwill 2,500 Total assets acquired 10,500 Current liabilities assumed (500) Net assets acquired $10,000

The results of Company B's operations have been included in the consolidated financial statements since the acquisition date (June 30 to December 31, 20X2). (The acquisition footnote is expanded as follows, if the amounts assigned to goodwill or other intangible assets acquired are significant in relation to the total cost of the acquired entity.)

At the date of acquisition, the identified intangible assets included the following:

Fair value ($000s)

Weighted-average amortization period

Intangible assets subject to amortization:

Patents $800 7 years Agreement not to compete 300 5 years Intangible assets not subject to amortization: Trademarks

1,100

900 900 $2,000

6.5 years None

The portion of the purchase price assigned to goodwill was $2,500. Significant elements of goodwill include the expected synergies between Company A and B (related to economies of scale and process improvements), competitive advantage, and distribution channels that will provide a market reach in both communications and networking. The amount of goodwill and intangible assets not subject to amortization that will ultimately be deductible for income tax purposes is $2,500 and $900, respectively. Observation: There appears to be confusion about the disclosure of goodwill and intangibles assets that will ultimately be deductible for tax purposes. First, this required disclosure applies only in the year of a new acquisition (and, the subsequent year if shown comparatively), and only if goodwill and/or intangibles not amortized are significant relative to the purchase price. If not, the disclosure of the amount of deductible goodwill and intangible assets is not required. Further, the “amount deductible for tax purposes” is nothing more than the book value for GAAP purposes. It is assumed that the book value at the date of the acquisition will ultimately be


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deductible for tax purposes over a period of time as it is amortized over, presumably 15 years for tax purposes. 5. Private Company Election to Amortize Goodwill Question: Is a private (nonpublic) company authorized to amortize goodwill under GAAP? Response: Yes. Effective for years ending on or after December 15, 2015, private companies (nonpublic entities) may make an election to amortize goodwill over ten years on a straight-line basis, and reduce some of the disclosures related to goodwill. The election is authorized by ASU, 2014-02, Intangibles-Goodwill and Other (Topic 350): Accounting for Goodwill- a consensus of the Private Company Council. and is available to private companies only. If a private company makes an election to apply the accounting alternative and amortize goodwill, the private company must follow these rules: 1. An entity that elects the accounting alternative for goodwill shall apply it to all goodwill related

subsequent measurement, derecognition, other presentation matters, and disclosure requirements upon election.

2. The accounting alternative, once elected, shall be applied to:

a. Existing goodwill, and b. All additions to goodwill recognized in future transactions

3. Under the accounting alternative to amortize goodwill: a. Goodwill shall be amortized on a straight-line basis over 10 years, or less than 10 years if

the entity demonstrates that another useful life is more appropriate.

b. An entity may revise the remaining useful life of goodwill upon the occurrence of events or changes in circumstances that warrant a revision to the remaining amortization period. However, the cumulative amortization period of goodwill cannot exceed 10 years (e.g., number of years amortized plus the revised estimated remaining number of years cannot exceed 10 years).

4. Goodwill is tested for impairment only if there is a triggering event. The annual goodwill

impairment test is no longer required if goodwill is amortized under the 10-year election. If a private (nonpublic) entity elects to amortize goodwill over 10 years, is the goodwill amortization expense included as part of the five-years estimated amortization expense disclosure? One issue that appears to be confusing in practice is whether the disclosure of amortization expense for each of the five years subsequent to a reporting year includes goodwill amortization expense if the ASU 2014-02 alternative is elected. The answer is that the five-years amortization expense does not include goodwill amortization although there is nothing that prevents a company from including goodwill amortization as part of the disclosure. The previous disclosure does, in fact, include all amortization (including goodwill amortization) in the five-year disclosure, even though goodwill amortization is not required to be included.


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The authority in this area is found in ASC 350, Intangibles- Goodwill and Other. 1. ASC 350-30, Intangibles- Goodwill and Other, General Intangibles Other Than Goodwill,

applies to intangibles other than goodwill.

2. The definition of ASC 350's "intangible asset" excludes goodwill.

3. ASC 350-30-50-2 requires that certain disclosures be made for intangibles other than goodwill.

4. Specifically, for each balance sheet that is presented, an entity is required to disclose the

following for intangible assets subject to amortization:

a. The gross carrying amount and accumulated amortization, in total and by major intangible asset class

b. The aggregate amortization expense for the period c. The estimated aggregate amortization expense for each of the five succeeding

fiscal years

In looking at the list of disclosures, the aggregate amortization expense (item b), and the five-year disclosure (item c) pertain to intangible assets other than goodwill. Thus, a literal read of the standard is that the aggregate amortization expense and five-year estimated future amortization disclosures do not include any amortization expense related to goodwill. However, for simplicity purposes, nothing prevents an entity from including all amortization (including goodwill amortization) in the five-year disclosure.

6. Intangible Assets With Finite and Indefinite Lives Question: What are the general rules for determining whether intangible assets have finite lives or indefinite lives? Response: ASC 350, Intangibles- Goodwill and Other (formerly FASB No. 142), provides three categories of intangible assets which are addressed in this section.

Goodwill


Intangible assets (other than goodwill) with indefinite lives The following chart summarizes the treatment of these three categories of intangible assets which is discussed in detail further on in this section.

Accounting for Impairments of Assets

Type of asset Authority for impairment

Accounting treatment

Impairment test

Goodwill14 ASC 350 Not amortized Tested annually for impairment

14 Effective for years ending on or after December 15, 2014, ASU 2014- 02 permits a private company to


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(formerly FASB No. 142)

Intangibles with indefinite lives (tradenames, etc.)

Certain trademarks and tradenames

Licenses such as liquor and broadcast licenses

Taxi medallions

Franchises without fixed contract terms

Airport routes

ASC 350 (formerly FASB No.

142)


Intangibles with finite lives (patents, etc.)

Refinancing costs

Leasehold improvements

Patents

Copyrights

Franchises with fixed contract terms

ASC 360 (formerly FASB No.

144)

Amortized over useful life

Tested for impairment only if there is an indication that an impairment might exist

Goodwill is not amortized but is tested for impairment at least annually. If it is impaired, goodwill is written down and an impairment loss is recorded. The exception is that ASU 2014-02 permits a private company to elect to amortize goodwill over a straight-line basis over a period not to exceed 10 years.

With respect to intangible assets other than goodwill, such assets are segregated into two categories: intangibles with finite lives and intangibles with indefinite lives.

elect to amortize goodwill over a period not to exceed 10 years, straight-line.


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Category Accounting treatment

Intangible assets with finite lives Amortized over their estimated useful lives

Tested for impairment only if there is a reason to do so

Intangible assets with indefinite lives Not amortized until the lives become finite

Tested annually for impairment

Since the issuance of ASC 350 (formerly FASB No. 142), there has been confusion as to whether certain intangible assets have finite or indefinite lives because the difference is significant.

Intangible Assets with Finite Useful Lives:

a. An intangible asset with a finite useful life15 should be amortized over its useful life unless

that life is determined to be indefinite.

b. If an intangible asset has a finite useful life, but the precise length of that life is not known, the intangible asset shall be amortized over the best estimate of its useful life.

c. The method of amortization should reflect the pattern in which the economic benefits of

the intangible asset are consumed or used up. If the pattern cannot be reliably determined, the straight-line method should be used.

d. The useful life is the period over which the asset is expected to contribute directly or

indirectly to future cash flows of the entity. The useful life is not the period of time that it would take an entity to internally develop an intangible asset that would provide similar benefits.

e. Pertinent factors to consider in determining the useful life include:

The expected use of the asset by the entity.

The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate (e.g., mineral rights to depleting assets).

Any legal, regulatory, or contractual provisions that may limit the useful life.

Any legal, regulatory, or contractual provisions that enable renewal or extension of the asset's legal or contractual life without substantial cost. (Provided that there is evidence to support renewal or extension and renewal or extension can be accomplished without material modifications of the existing terms and conditions.)

The effects of obsolescence, demand, competition, and other economic factors (e.g., the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels).

The level of maintenance expenditures required to obtain the expected future cash flows from the asset, such as a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life.

Example: R is a retail store that leases retail space in a shopping mall. At the inception of the lease, R spends $200,000 on leasehold improvements. The lease is for 5 years and provides for an additional 5-year extension option. The lease terms provide that once installed, the leasehold

15 For purposes of this discussion, a finite life is defined as a life that is not an “indefinite life.”


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improvements belong to the landlord and cannot be removed by R at the end of the lease. R expects to exercise the lease option for the additional 5 years and all evidence supports R’s ability to do so.

Conclusion: In determining the useful life of the leasehold improvements, consideration should be given to several factors which include a) the entity’s expected use of the asset, b) any extensions of the asset’s legal or contractual life without substantial cost, and c) whether the extension can be accomplished without material modifications of the existing terms and conditions. In this case, R expects to use the asset for the lease term and for the 5-year extension, meaning that it expects to generate cash flows from use of the asset over a total 10-year period. Second, because the lease provides for a renewal option that can be exercised with minimal cost, the lease option period is considered in determining the useful life. Third, because the extension is part of the lease, it is unilateral and can be accomplished without material modifications to the existing lease. Thus, the $200,000 leasehold improvements should be amortized over a 10-year period, which includes the five-year option. Change the facts: Same facts as above except that the company does not like doing business in the mall and does not plan to exercise the additional five-year option. Conclusion: Even though R has the ability to exercise the option, the fact that it does not plan to do so should be considered in determining the useful life. In this case, the leasehold improvements should be amortized over the initial 5-year period, not including the additional 5-year option period.

Change the facts again: Same facts as the immediate previous examples except that after 2 years, R changes its mind and decides that it will exercise the option after the 5-year period expires. Conclusion: The original useful life of 5 years has changed so that the revised remaining useful life is 8 years (3 years remaining on the original lease plus 5 years on the option). Therefore, the remaining unamortized balance in the leasehold improvements should be amortized over the revised remaining useful life of 8 years. The change in the life is treated prospectively without affecting the 2 previous years. Intangible Assets with Indefinite Useful Lives:

a. An intangible asset with an indefinite life should not be amortized until its life is determined

to be no longer indefinite. b. An intangible asset is deemed to have an indefinite life if there is no legal, regulatory,

contractual, competitive, economic, or other factors that limit the useful life of an intangible asset. That is, there is no limit placed on the end of the assets useful life to the reporting entity.

Examples of intangible assets that might have indefinite lives include:


Certain licenses such as liquor and broadcast licenses

Taxi medallions

Franchises

Airport routes

c. The term "indefinite" does not mean "infinite" or “indeterminate.”


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d. A life is indefinite if it extends beyond the foreseeable horizon (e.g., there is no foreseeable limit on the period of time over which it is expected to contribute to cash flows of the reporting entity).

e. An intangible life that has a limited legal life is considered indefinite if:

Evidence exists to support that the legal life can be renewed indefinitely without substantial cost, and

The entity is in compliance with all laws and regulations that permit it to be renewed in the future.

Examples: Licenses, trademarks and tradenames that have legal lives that can be renewed with minimal cost and no evidence of any objection to that renewal.

f. If the life subsequently becomes finite, the intangible asset shall then be amortized

prospectively over its estimated remaining useful life. g. Each reporting period, an entity must evaluate whether events and circumstances

continue to support an indefinite useful life. h. An intangible asset (other than goodwill) with an indefinite life is not amortized but should

be tested for impairment annually, or more frequently on an interim basis if an event or circumstance occurs between annual tests indicating that the asset might be impaired.

Formula for Annual Impairment Test: Fair value of intangible asset Less: Carrying value of intangible asset Equals: Impairment loss

1) If an impairment loss is recognized, the written down carrying amount of the intangible shall be the asset’s new basis for subsequent impairment tests.

2) The reversal of previously recognized impairment losses is prohibited so that an

intangible asset that is written down for impairment may not be written back up in subsequent periods.

i. Optional qualitative assessment- Intangible assets with indefinite useful lives In July 2012, the FASB issued Accounting Standards Update (ASU) 2012-02 entitled, Intangibles—Goodwill and Other (Topic 350) Testing Indefinite-Lived Intangible Assets for Impairment. The ASU permits (but does not require) the use of an optional qualitative assessment of impairment for intangible assets with indefinite lives. The ASU provides the following rules:

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

2) If, after assessing the totality of qualitative factors, an entity determines that it is not

more likely than not (not more than 50% probability)that the indefinite-lived intangible


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asset is impaired, then calculating the fair value of the asset and performing the impairment test is unnecessary.

3) If, after assessing the totality of qualitative factors, an entity determines that it is more

likely than not (more than 50% probability) that the indefinite-lived intangible asset is impaired, then the entity shall calculate the fair value of the intangible asset and perform the impairment test.

Formula for Annual Impairment Test- Indefinite Lived Intangible: Fair value of intangible asset Less: Carrying value of intangible asset Equals: Impairment loss

6. Renewable Licenses Question: How should a renewable license be categorized under ASC 350 (formerly FASB No. 142)? Response: One of the more confusing aspects of ASC 350, is the treatment for licenses and other intangibles that can be renewed on a regular basis at minimal cost, such as broadcast or liquor licenses. Many of these licenses are short-term (from one to three years) and require renewal simply by paying a nominal renewal fee. Provided the entity is not in violation of certain laws at the time of renewal (e.g., did not sell liquor to minors), the probability of renewal is high. Thus, in viewing the license, it is likely that the license will continue to be renewed in the foreseeable future. The question is whether the asset is a finite- or infinite-lived asset. Further, is the life limited to the current renewal period of one to three years, or should the life reflect the future periods for which the license is likely to be renewed? ASC 350 states that an intangible asset that has a limited legal life is considered indefinite if:

Evidence exists to support that the legal life can be renewed indefinitely without substantial cost, and

The entity is in compliance with all laws and regulations that permit it to renew in the future.

Examples: Licenses, trademarks and tradenames that have legal lives that can be renewed with minimal cost and no evidence of any objection to that renewal.

If the company can renew a license indefinitely without incurring significant cost, and the company is in compliance with all laws and regulations that allow it to renew the license, then the license has an indefinite life and should not be amortized.

If the life subsequently becomes finite, the intangible asset shall then be amortized prospectively over its estimated remaining useful life. Example: Company X purchases a broadcast license for $1,000,000 which is renewable after three years. At the time of renewal, X is in compliance with all laws and regulations that provide for renewal, and such renewal can be made by paying a nominal licensing fee. Unless the Company violates FCC laws and regulations, the company believes the license is renewable indefinitely. Conclusion: The asset has an indefinite life and is not amortized. Instead, it should be tested annually for impairment.


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Change the facts: With two years remaining on its three-year license, the Company has been charged with violating FCC rules and there is concern that its license may not be renewable. Conclusion: Because there is a question as to whether the license can be renewed indefinitely, the life is now finite. The license should be amortized over the remaining number of years in the license period, which is two years. 7. Useful Life of Intangibles in an Age of Piracy Question: How does piracy of intangible asset rights impact the useful life used to amortize intangible assets? Response: Piracy is having a dramatic effect on the value of intangible property in the United States. Background: The estimated value of intellectual capital in the United States is more than $10 trillion, according to the Federal Reserve. The recent developments of piracy highlight the serious economic harm posed by counterfeiting and piracy of intellectual capital and other violations of intellectual property rights. The illegal appropriation of American intellectual property affects different industries to varying degrees, with a strong, natural correlation between the severity of these problems and the level of an industry’s intellectual capital and intangible assets. One primary target, therefore, has been the “core” copyright industries, including software, musical recording, and motion pictures, which represent approximately 6 percent of U.S. GDP.

The software industry estimates that more than 40 percent of all software installed throughout the world is pirated, with commercial value of $51 billion.

Estimated software piracy rates range from 20 percent in the United States -- the lowest rate of 42 countries sampled – to 63 percent of installed software in Turkey, 63 percent of the entire Latin American market, and 87 percent of the Russian market.

The pharmaceutical industry loses billions to counterfeit medicines that often cause injuries and death. Estimated costs to the pharmaceutical industry is about $12 billion per year.

Piracy is crippling the entertainment industry rampant copies of movies and music being copied and sold worldwide. Music piracy alone is costing U.S. industry more than $12.5 billion per year.

When piracy is rampant, it requires U.S. companies to reduce the useful lives of their intangible assets, which has a direct effect on return on investment. What is the impact of piracy on the useful lives of intangible assets? The answer is significant. The legal life of an intangible asset is now significantly longer than the true economic life over which the entity will generate cash flows from using the patent, trademark, or other intangible asset.


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Let’s look at the GAAP rules for intangible assets. ASC 350, Intangibles- Goodwill and Other (formerly FASB No. 142), provides three categories of intangible assets which are addressed in this section:

Goodwill


Intangible assets (other than goodwill) with indefinite lives The following chart summarizes the treatment of these three categories of intangible assets which is discussed in detail further on in this section.

Accounting for Impairments of Assets

Type of asset Authority for impairment

Accounting treatment16

Impairment test

Goodwill ASC 350 (formerly FASB

No. 142)


Intangibles with indefinite lives (tradenames, etc.)


Licenses such as liquor and broadcast licenses

Taxi medallions

Franchises without fixed contract terms

Airport routes

ASC 350 (formerly FASB

No. 142)


Intangibles with finite lives (patents, etc.)

Refinancing costs

Leasehold improvements

Patents

Copyrights

Franchises with fixed contract terms

ASC 360 (formerly FASB

No. 144)

Amortized over useful life

Tested for impairment only if there is an indication that an impairment might exist

Intangible Assets with Finite Useful Lives:

a. An intangible asset with a finite useful life17 should be amortized over its useful life unless

that life is determined to be indefinite.

b. One pertinent factor to consider in determining the useful life is:

The effects of obsolescence, demand, competition, and other economic factors (e.g., the stability of the industry, known technological advances, legislative action

16 ASU 2014-02 amends ASC 350 to permit a private (nonpublic) company to amortize goodwill over 10 years. 17 For purposes of this discussion, a finite life is defined as a life that is not an “indefinite life.”


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that results in an uncertain or changing regulatory environment, and expected changes in distribution channels).

How does piracy affect the useful life of intangibles with finite lives? Historically, companies have used the legal life as the useful life, because it was measurable. Therefore, most patents have been amortized over 17 years and copyrights over 28 years. Now, companies have had to reduce useful lives of intangible assets down to 3 to 5 years to reflect the negative impact of piracy and patent infringement on the intangible asset value. Example: Company X develops a patent on certain products. Although the legal life is 17 years, the Company is being pummeled in the marketplace by counterfeit products that adversely affect X’s on-line sales, a significant portion of its business. X estimates that the patents are defendable and will generate sufficient cash flow over the next 5 years, after which time the effect of piracy will diminish sales to an unsustainable level. Conclusion: Although the legal life of the patents is 17 years, in determining the useful life of the patents for GAAP purposes, X must consider not only the legal life, but also the “effects of obsolescence, demand, competition, and other economic factors (e.g., the stability of the industry, known technological advances, legislative changing regulatory environment, and expected changes in distribution channels.” Clearly, piracy impacts X’s estimate of the useful life. X should amortize the patent over a shorter useful life of 5 years, well short of the legal life of 17 years.


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 14. ASC 450 (formerly FASB No. 5), states that there should be an accrual for a loss if:

a) it is remote that an asset has been impaired at the balance sheet date b) the amount of loss can be reasonably estimated c) it is likely that there is a loss incurred d) it is unlikely that the loss will be recovered 15. Trade receivables should be presented: a) net of the allowance for uncollectible accounts

b) in aggregate with those held for sale c) gross, without an allowance for bad debts d) as a long-term asset

16. The direct writeoff method:

a) is required by GAAP b) is not permitted for GAAP purposes c) should be used for GAAP if it is used for tax purposes d) is not allowed for income tax purposes

17. Slow-moving inventory should be:

a) written off if it cannot be sold in one year b) written down to lower of cost or market c) included in current assets, regardless of how long it will take to sell d) valued using its fair value and classified as a long-term asset

18. Which of the following is considered a factor indicating two transactions were entered into in

contemplation of each other: a) there is no legal right of offset of obligations between counterparties involved in inventory

purchase and sales transactions b) inventory purchase and sales transactions with the same counterparty are entered into at

different times c) inventory purchase and sales transactions involve a cash transaction as well d) there is relative certainty that reciprocal inventory transactions with the same counterparty

will occur

19. Which of the following is not the proper balance sheet classification regarding cash value of life insurance and loans borrowed against the cash value of a company’s life insurance: a) the cash value of the life insurance should be included in the current assets category b) the policy loan should be classified as a current liability if it will be repaid within one year c) the policy loan should be classified as a long-term liability if it will not be repaid until the

cash value is liquidated d) a company may elect to net the policy loan against the cash value


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20. Which of the following is not one of three categories of intangible assets according to ASC

350 (formerly FASB No. 142): a) goodwill

b) intangible assets (other than goodwill) with infinite lives c) intangible assets (other than goodwill) with finite lives d) intangible assets (other than goodwill) with indefinite lives 21. ASC 350 (formerly FASB No. 142) states that an intangible life that has a limited legal life is

considered indefinite if certain conditions are met. Which one of the following is a condition: a) there are no conditions. An intangible with a limited legal life never is considered

indefinite regardless of the conditions that exist b) if evidence exists to support the legal life cannot be renewed indefinitely without

substantial cost c) if the entity is in compliance with all laws and regulations that permit it to renew in the

future d) if the intangible asset estimated useful life is at least five years


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SUGGESTED SOLUTIONS 14. A: Incorrect. The requirement is that it must be “probable” that an asset has been impaired,

not “remote” making the answer incorrect. B: Correct. One of the conditions is that the amount of the loss can be reasonably

estimated, making the answer correct. C: Incorrect. ASC 450 does not use the “likely” threshold in determining whether an accrual

should be made. D: Incorrect. ASC 450 does not use the “unlikely” threshold in determining whether an accrual

should be made. 15. A: Correct. According to ASC 310, Receivables, trade receivables should be presented

net of the allowance for uncollectible accounts. B: Incorrect. According to ASC 310, trade receivables held for sale should be a separate

balance sheet category from other receivables, not aggregated. C: Incorrect. According to ASC 310, trade receivables should be presented net rather than

gross. D: Incorrect. Trade receivables should be presented as a current asset, not a long-term

asset. 16. A: Incorrect. GAAP requires that the allowance method be used to account for bad debts.

B: Correct. The direct writeoff method is not permitted for GAAP making the answer correct. The reason is because it fails to match bad debt expense with revenue and may overstate the balance sheet receivable amount.

C: Incorrect. GAAP provides no linkage to the method used for tax purposes. Thus, the method used for GAAP has nothing to do with the method used for tax purposes.

D: Incorrect. The direct writeoff method is required for tax purposes. 17. A: Incorrect. Slow-moving inventory should not be written off, but classified as a long-term

asset if it is not reasonably expected to be realized in cash during the client’s normal operating cycle.

B: Correct. It is proper to write down the inventory to the lower of cost or market particularly with respect to slow-moving inventory which might be obsolete.

C: Incorrect. If the slow-moving inventory is not reasonably expected to be realized in cash during the client’s normal operating cycle, it should not be classified as a current asset.

D: Incorrect. It would be proper to classify the inventory as long-term if it is not reasonably expected to be realized in cash during the client’s normal operating cycle, but it should not be valued at fair value. GAAP provides for valuing inventory at lower of cost or market value, but not fair value.

18. A: Incorrect. One factor is that there is a legal right of offset of obligations. The fact that there

is no legal right of offset makes the answer incorrect. B: Incorrect. The fact that the transactions occur at simultaneous, not at different times, is a

factor indicating two transactions. C: Incorrect. The exchange of cash does not necessarily indicate that transactions were

entered into in contemplation of one another, making the answer incorrect. D: Correct. One factor identified by GAAP is that the relative certainly of reciprocal

inventory transactions. For example, a company may sell inventory to a counterparty and enter into another arrangement with that same counterparty whereby that counterparty may, but is not contractually required to, deliver an agreed-upon inventory.


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19. A: Correct. ASC 210 specifically excludes the cash value of life insurance from the current assets category.

B: Incorrect. It is appropriate to report policy loans as current if by the terms (or intent) the policy loans will be repaid within one year, making the answer incorrect.

C: Incorrect. It is appropriate to report policy loans as long-term if the intent is not to repay them until the cash value is liquidated, making the answer incorrect.

D: Incorrect. According to ASC 210, because there is a legal right of offset, a company may elect to net the policy loan against the cash value, making the answer incorrect.

20. A: Incorrect. Goodwill is one of the noted three categories found in ASC 320.

B: Correct. Intangibles with infinite lives is not one of the three noted categories. GAAP specifically states that the term “infinite” is not the same as “indefinite.”

C: Incorrect. Intangibles with finite lives is one of the noted three categories. D: Incorrect. Intangibles with indefinite lives is one of the noted three categories. An indefinite

life is one that extends beyond the foreseeable horizon. 21. A: Incorrect. There are certain circumstances that, if met, result in an intangible asset with a

limited legal life being considered indefinite. Thus, the answer is incorrect. B: Incorrect. One requirement is that evidence exists to support the legal life can (rather than

cannot) be renewed indefinitely without substantial cost. Thus, the answer is incorrect. C: Correct. One requirement is that the entity must be compliance with all laws and

regulations that permit it to renew in the future. The theory is that there must not be any significant impediments for an entity to renew the intangible asset. If a license, for example, can be renewed from period to period without any obstacles, it is as if the useful life is indefinite. Thus, the answer is correct.

D: Incorrect. There is no authority found in ASC 350 that provides that a five-year useful life makes an intangible asset indefinite lived. Thus, the answer is incorrect.


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H. Current Liabilities

1. Accrual for Employer Co-Insurance Arrangements

Question: A company has a self-insured medical insurance program with a "stop-gap" insurance policy covering medical expenses in excess of $10,000 per employee. What amount should the company accrue to cover its liability? Response: Although ASC 450, Contingencies, (FASB No. 5), excludes employment-related costs, that statement guidance may be appropriate for this situation. In accordance with ASC 450, a liability should be accrued if the loss is probable and the amount can be estimated. The company should record a liability for medical expenses incurred by the employees during the year yet not paid at year end, including expenses incurred during the reporting period but submitted subsequent to the balance sheet date. Any liability will be reduced by any excess over $10,000 which will be covered by the insurance policy. 2. Accrual for Sick Pay

Question: A company is concerned that its employees will vote for a union. In order to safeguard against this, they institute several benefits including sick or personal days option. Under this policy, employees earn one personal day each quarter that they work. At the end of the year, the employees can take any unused personal days in the form of cash paid out in January of the following year. In January 20X1, the company paid $76,000 for personal days earned but not taken in 20X0. Should the $76,000 be recorded as a liability as of December 31, 20X0?

Response: Yes. ASC 710-10, Compensation-General, (formerly FASB No. 43), requires a company to record a liability for any compensated absence (vacation, holiday or sick pay) if four criteria are met:

The compensation has been earned

It vests or accumulates

It is probable that it will be paid, and

The amount can be estimated.

Based on the above information, the four criteria have been met and the liability should be accrued. Although in this example, sick pay is accrued, usually, sick pay does not satisfy the four criteria and is therefore not usually accrued. 3. Accrual for Sabbatical Leave and Other Similar Benefits Question: A company offers its employees sabbatical leave under which its employees are entitled to paid time off after working for the company for 10 years During the sabbatical leave, the individual is still a compensated employee of the company and is not required to perform any duties for the company. Should the employer record an accrual for the liability for the sabbatical leave similar to an accrual for vacation pay? Response: An entity may provide its employees with a benefit in the form of a compensated absence known as a sabbatical leave under which the employee is entitled to paid time off after working for an entity for a specified period of time. During the sabbatical leave, the individual continues to be a compensated employee and is not required to perform any duties for the entity.


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Historically, companies have followed the guidance of ASC 710-10, Compensation-General, in determining whether the cost of a sabbatical or other arrangement should be accrued. ASC 710-10 states that an employer shall accrue a liability for employees’ compensation for future absences if four criteria are met: 1. The compensation has been earned.

2. The obligation relates to rights that vest or accumulate. 3. Payment of the compensation is probable. 4. The amount can be reasonably estimated.

Vested rights are those for which the employer has an obligation to make payment, even if an employee terminates, and are not contingent on an employee’s future service. Rights accumulate if rights have been earned but unused rights may be carried forward to future periods, even if there may be a limit to the amount that can be carried forward. ASC Subtopic 710-10-25, Sabbatical Leave Benefits, provides further guidance by stating:

“An employee’s right to a compensated absence under a sabbatical or other similar benefit arrangement a) that requires the completion of a minimum service period, and b) in which the benefit does not increase with additional years of service, accumulates under ASC 710-10 (e.g., the second criterion is met) as long as the employee”:

1. Continues to be a compensated individual, and 2. Is not required to perform duties for the entity during the absence. That is, the third criterion for accrual (the obligation relates to rights that vest or accumulate) is satisfied if the above-noted guidance is satisfied. Therefore, assuming the other three requirements for accrual are also met (e.g., compensation is earned, payment is probable, and amount can be reasonably estimated), the compensation cost associated with a sabbatical or other similar benefit arrangement should be accrued over the requisite service period to earn the sabbatical leave. For example, if an employee must work 10 years to earn a thirty-day sabbatical leave with pay, that thirty days of sabbatical leave pay should be accrued during the 10 years over which the employee earns the sabbatical pay. Arrangements in which employees are required to engage in research or public service to enhance the reputation of or otherwise benefit the employer are not within the scope of ASC 710-10. 4. Accounting for Deferred Compensation and Postretirement Benefit Aspects of

Endorsement Split-Dollar Life Insurance Arrangements Question: How should a company account for the liability associated with deferred compensation and postretirement benefit aspects of split-dollar life insurance arrangements? Response: Companies purchase life insurance for various reasons that may include protecting against the loss of “key” employees, funding deferred compensation and post-retirement benefit obligations, and providing an investment return. One form of this insurance is split-dollar life insurance. There are two common types of split-dollar insurance arrangements which vary depending on who owns and controls the policy:


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Endorsement split-dollar life insurance: The company purchases, owns and controls a life insurance policy which insures the life of a key employee and pays a single premium. The employer may terminate the benefits promised to the employee if the employee departs the company prior to retirement. The employer enters into a separate agreement with the employee to split the policy benefits with the employee. Upon death of the employee, the employee’s beneficiary receives a portion of the death benefit with the remainder going to the employer. The employee’s beneficiary receives the benefit either directly from the insurance company or from the employer. The employee’s portion of the death benefit is typically based on any of the following: a. Amounts that exceed the gross premiums paid by the employer

b. Amounts that exceed the sum of the gross premiums paid by the employer and an additional fixed or variable investment return on those premiums

c. Net insurance at the date of death (e.g., face amount of the death benefit less the cash value), and

d. Amounts equal to a multiple of the employee’s base salary at retirement or death (e.g., twice the employee’s base salary).

Collateral assignment split-dollar life insurance: An employer buys the policy to insure the life of an employee and then transfers ownership to the employee. The employee owns the policy and controls the rights of ownership. The employer pays all or a substantial part of the premium. The employee assigns a portion of the death benefit to the employer. Upon retirement, the employee may have an option to buy the employer’s interest in the policy. In practice, an endorsement policy is the most popular form used. Accounting guidance: The asset side: ASC Subtopic 325-25 (formerly FASB FTB 85-4) provides guidance on the accounting for the investment (asset) in life insurance in requiring that the amount of the asset recorded at the balance sheet date be equal to the amount that could be realized from the policy on that date (e.g., cash value). The liability side: ASC Subtopic 710-10, Compensation-General (formerly APB No. 12) and ASC Subtopic 715-60, Compensation-Retirement Benefits-Defined Benefit Plans-Other Postretirement (formerly FASB No. 106), deal with deferred compensation arrangements related to employees. ASC Subtopic 710-10 provides guidance on the accounting for deferred compensation contracts with individual employees when those contracts, in the aggregate, do not constitute a plan. Conversely, ASC 715-60, provides guidance on the accounting for postretirement benefits that are part of a plan for retirees but are not part of a pension plan.


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Statement Accounting Treatment

ASC 710-10 (formerly APB No. 12)- deferred compensation for individuals, that are not part of a plan.

Requires that deferred compensation costs, including future death benefits, be recognized over the service period in a systematic and rational manner (e.g. , typically straight-line basis). Accrual for future benefits to be paid should be made at the end of each period within the service period. At the end of the service period, the accrued amount should equal the then present value of the benefits expected to be provided to the employee and his/her beneficiaries.

ASC 715 (formerly FASB No. 106) post retirement benefits for retirees that are part of a plan.

Post retirement benefits cost is recognized and measured based on the actuarial present value of all future benefits attributed to an employee’s services rendered to that date. Benefit costs are allocated over the required service period.

Endorsement split dollar arrangements: ASC Subtopic 715-60 (formerly found in EITF Issue 06-4) states: 1. Endorsement split-dollar arrangements that provide a benefit to employees postretirement are

within the scope of ASC 710 (formerly APB No. 12) and ASC 715 (formerly FASB No. 106).

Note: ASC 715 defines postretirement benefits to include “all forms of benefits, other than retirement income, provided by an employer to retirees… they may be defined in terms of monetary amounts that become payable on the occurrence of a specified event, such as life insurance benefits. ”

2. An employer should recognize a liability for future benefits: a. In accordance with ASC 710-10 (formerly APB No. 12) if, in substance, an individual

deferred compensation plan exists. b. In accordance with ASC 715 (formerly FASB No. 106) (if in substance, a postretirement

benefit plan exists) based on the substantive agreement with the employee. If a substantive plan exists, ASC 715 is followed. If not, ASC 710-10 is followed.

1) A postretirement benefit plan exists: If an employer has effectively agreed to maintain

a life insurance policy during the employee’s retirement, the benefit during retirement is the maintenance of the life insurance policy, and not the death benefit. Therefore, the cost of the insurance policy during the postretirement periods should be accrued in accordance with ASC 715 (if there is a plan) or ASC Subtopic 710-10 (if it relates to an individual). The employer should accrue an amount over the employee’s service period that would equal, at the full eligibility date, the present value of the cost of maintaining an insurance policy during the post-retirement period until estimated death.


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2) If an employer has effectively agreed to provide the employee with a death benefit, the employer should accrue, over the service period, a liability for the actuarial present value of the future death benefit as of the employee’s expected retirement date.

3. The liability for the benefit obligation is not settled (eliminated) by the company purchasing

an endorsement split-dollar life insurance arrangement. Example 1: Company X offers an employee a death benefit in the amount of $100,000 if the employee works 10 years and retires no earlier than age 62. Although X purchases a $200,000 split-dollar policy of which $100,000 will go to fund the death benefit, the death benefit is not explicitly tied to the insurance policy. Thus, if the policy lapses or expires, X still has the $100,000 death benefit obligation to fund. Conclusion: Because the death benefit is not explicitly tied to an insurance policy, the amount of the postretirement benefit to accrue should be the death benefit promised to the employee. Example 2: Company Y offers an employee a death benefit in the amount of $100,000 if the employee works 10 years and retires no earlier than age 62. Y purchases a $200,000 split-dollar policy of which $100,000 will go to fund the death benefit. However, the terms of the arrangement provide that Y has no obligation to fund the death benefit upon default by the insurance company. Conclusion: Because there is no obligation to fund the death benefit if the insurance company defaults, the postretirement benefit is a promise to maintain the life insurance policy during the employee’s retirement, and not the death benefit, itself. Thus, Y should accrue the amount over the employee’s service period that would equal, at the full eligibility date, the present value of the cost of maintaining the insurance policy (e.g., premium payments) during the postretirement period until the employee’s estimated date of death. Observation: The fact that there is an insurance policy in place has nothing to do with the fact that the company has an obligation to the employee. The decision to obtain life insurance is a financial one unrelated to accounting. Thus, whether an employer self-insures a death benefit or chooses to fund it with life insurance should have no effect on the accounting treatment of the obligation. Collateral assignment split-dollar arrangements: ASC Subtopic 715-60-35 (formerly EITF Issue 06-10) states:

1. An employer should recognize a liability for the postretirement benefit related to a collateral assignment split-dollar life insurance arrangement as follows:

a. If the employer has agreed to maintain a life insurance policy during the employee’s

retirement, the company should accrue the estimated cost of maintaining the insurance policy during the postretirement period.

b. If the employer has agreed to provide the employee with a death benefit, the employer

shall accrue a liability for the actuarial present value of the future death benefit as of the employee’s expected retirement date.

Example: An employer has effectively agreed to maintain a life insurance policy during the employee’s retirement at a rate of $5,000 per year.


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Conclusion: The $5,000 annual cost of maintaining the insurance policy during the postretirement period should be accrued. The employer should accrue a liability for the actuarial present value of the insurance policy premiums over the post-retirement life of the employee. Example: An employer has effectively agreed to provide the employee with a $100,000 death benefit upon retirement, not funded by insurance. Conclusion: The employer should accrue a liability for the actuarial present value of the future death benefit as of the employee’s expected retirement date.

c. All available evidence should be considered in determining the substance of the

arrangement, such as explicit written terms of the arrangement, communications made by the employer to the employee, the employer’s past practices in administering the same or similar arrangements, and whether the employer is the primary obligor for the postretirement benefit.

d. An employer has agreed to maintain a life insurance policy if the employer has a stated

or implied commitment to provide loans to an employee to fund premium payments on the underlying insurance policy during the postretirement period.

Absent evidence to the contrary, it shall be presumed that an employer will provide loans to an employee to fund premium payments on the underlying insurance policy in the postretirement period if the employer has provided loans in the past or if the employer is currently promising to provide loans in the future.

Example: The terms of an arrangement provide that the employer has no obligation, either stated or implied, to provide loans to an employee to cover insurance policy premiums in the postretirement period.

Conclusion: Absent evidence to the contrary, that fact may be an indication that there is no post-retirement obligation.

Example: An employer, through its collateral assignment arrangement with the employee, has an obligation, either stated or implied, to provide loans to an employee to cover the experience gains and losses of the insurance company.

Conclusion: The fact that the employer has such an obligation to fund the loans may indicate that the employer has a postretirement benefit obligation.

e. Employers should continue to evaluate whether a change in facts and circumstances

(such as an amendment to the arrangement or change from the employer’s past practices) has altered the substance of the collateral assignment split-dollar life insurance arrangement, which could result in a liability or an adjustment to a previously recognized liability, for a postretirement benefit.

2. ASC Subtopic 715-60-35 further concludes that an employer should recognize and

measure an asset based on the nature and substance of the collateral assignment split-dollar life insurance arrangement.

a. In determining the nature and substance of the arrangement, the employer should

assess what future cash flows the employer is entitled to, if any, as well as the employee’s obligation and ability to repay the employer.


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Example: If the arrangement limited the amount the employer could recover to the amount of the cash value of the life insurance policy held by the employee (or retiree), and if the employer’s loan to the employee (or retiree) is greater than the cash surrender value, at the balance sheet date the employer’s asset would be limited to the amount of the cash value of the policy.

b. If the arrangement required the employee (or retiree) to repay the employer

irrespective of the collateral assigned and the employer (a) has determined that the employee loan is collectible, and (b) intends to seek recovery beyond the cash surrender value of the life insurance policy, the employer should recognize the value of the loan (including accrued interest).

c. An employer should evaluate all available information in determining the nature and

substance of the collateral assignment split-dollar life insurance arrangement. 5. Environmental Liabilities Question: A company must remove underground storage tanks and remediate the soil in accordance with the environmental laws. The costs will be approximately $100,000. Should the cost be expensed or capitalized? Response: ASC 410, Asset Retirement and Environmental Obligations (formerly EITF 90-8), provides guidance. General Rule: Environmental contamination treatment costs should be charged to expense. However the ASC provides exceptions which the entity may elect (but is not required) to capitalize the expenditure if any one of the following criteria is met:

a. The costs extend the life, increase the capacity, or improve the safety or efficiency of

property owned by the company. Note: For purposes of this criterion, the condition of the property after the costs are

incurred must be improved as compared with the condition when originally constructed or acquired, if later.

b. The costs mitigate or prevent environmental contamination that has yet to occur and that

may result from future operations or activities, of property owned by the company. Note: As with condition 1) on the previous page, the costs must improve the property

compared with its condition when constructed or acquired. c. The costs are incurred in preparing the property for sale.

Note: ASC 410-30 (formerly EITF 89-13) states that the costs incurred for removal of asbestos may be capitalized as the removal improves the safety and efficiency of the property. In this example, the costs to remove the tanks and remediate the soil should be expensed since the activity does not satisfy any of the three (3) exceptions noted previously.


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Change the facts: Not only are the old tanks removed for $100,000, but the company also spends $200,000 to install new tanks. Response: The $100,000 expenditure to remove the tanks should be expensed. However, the $200,000 to install new tanks should be capitalized as a fixed asset addition. Change the facts: The Company is required by law to remove the tanks and install the tanks by November 30, 20X2. In preparing the December 31, 20X1 financial statements, should the company accrue a liability for the $100,000 removal expenditure? For the $200,000 cost of installation of the new tanks? Response: Yes for the $100,000, and no for the $200,000. The $100,000 should be recorded as a liability in accordance with ASC 450, Contingencies, (formerly FASB No. 5), which states that a loss should be recorded when it is probable that an asset has been impaired or liability incurred and the amount can be reasonably estimated. Both of these criteria have been met with respect to the $100,000 as of December 31, 20X1. However, the $200,000 should not be recorded. ASC 450 only applies to loss contingencies, not capital expenditures. Therefore, the company should not record a $200,000 liability using the probable and estimable criteria. Instead, the $200,000 should be recorded when the expenditure is actually incurred in 20X2. Question: A company is required to remove asbestos from basement pipes. The asbestos was in place when the company purchased the property. Should the cost be capitalized or expensed? Response: ASC Subtopic 410-30 deals with how to handle the costs of removing asbestos from property. In accordance with the ASC, the costs of removing asbestos may be capitalized since the removal is considered to improve the safety of the property as compared with its original condition when constructed or acquired. I. Notes Payable 1. Prepaid Interest Question: A company records its installment loans as follows: Cash (principal portion) xx Prepaid interest (accumulated interest during the loan) xx Installment loan (total P& I loan payments) xx How should the prepaid interest (discount) on an installment loan be presented- as a prepaid asset or as a direct reduction of the installment loan? How should the interest be amortized during the life of the loan? Response: ASC 835, Interest (formerly APB No. 21), requires the deferred or prepaid interest be shown as a direct reduction of the loan payable. It should not be classified as a separate deferred charge (asset) because it is not an asset separable from the note which gives rise to it. Further, a portion of the deferred interest should be allocated between the current and long-term portion of the loan. In accordance with ASC 835, the deferred interest should be amortized using the effective interest method (carrying value of note x interest rate). A straight-line method should not be used unless the result is not materially different than that derived from using the effective interest method. 2. Amortization of Deferred Financing Costs


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Question: A company pays $20,000 for refinancing costs and points on a mortgage refinancing. The note term is three years with an amortization period of fifteen years. The bank has informally indicated a willingness to extend the note for another three years provided the borrower is in good standing after three years. Over what period should the $20,000 be amortized? Response: The refinancing costs represent a deferred charge incurred to secure the mortgage note. These costs should be amortized over a three-year period, not six years nor fifteen years. Although it is possible that the note may be extended by another three years, the mortgage does not provide the borrower with the legal right to extend it. Therefore, the additional three-year period should not be considered until a legal right to this extension is obtained. (The fifteen- year period is used to amortize the loan and has nothing to do with the note term.) Question: When the deferred financing costs are amortized, what expense account should the expense be recorded in? Response: Interest expense. A common error accountants make is to record the amortization of deferred financing costs as amortization expense, when the correct category is interest expense. ASC 835-30, Interest, Imputation of Interest, states that amortization of debt issuance costs (deferred financing costs) shall be reported as interest expense, not amortization expense. Question: Should the amortization of deferred financing costs be included as part of the disclosure of total amortization expense and the estimate of amortization expense during each of the five subsequent years? Response: No. The amortization of deferred financing costs is part of interest expense, not amortization expense. Consequently, that amortization is disclosed as part of interest expense and not amortization expense. 3. Balance Sheet Classification of Revolving Line of Credit Question: A company has a revolving line of credit with a bank. The company is only required to pay monthly interest. If the credit line is called, the principal is due 12 months after the call date. Should this loan be classified as a current or long-term liability? Response: ASC 210, Balance Sheet (formerly part of ARB No. 43), states that liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period of time, usually 12 months, should be classified as current liabilities. If the line of credit has not been called at the balance sheet date, it should be presented as a long-term liability because it will not be paid off within 12 months. The exception is where, despite a requirement to do so, the company has the ability and intent to repay the line within 12 months. In this case, ASC 210 (formerly part of FASB No. 6), requires that the line be presented as a current liability. Change the facts: The company has had the line of credit with the same bank for ten years. Although the note is payable upon demand, the company does not plan to pay it off within one year and, there is no indication that the bank will call the loan within the next year. Should the loan be shown current or long-term on the balance sheet? Response: The note should be shown current. ASC 210 states that a demand loan is shown as a current liability. The exception is where the entity has both the ability and intent to repay the


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loan beyond the current operating cycle. In this instance, the company has the intent, but not the ability to repay the loan beyond the current operating cycle. 4. Violation of a Loan Agreement Covenant Question: At December 31, 20X1, a company was in violation of its long-term debt covenant. Upon request, the bank was unwilling to provide a waiver of the default. In the 20X1 financial statements, the loan was classified as current and properly disclosed as a violation in the notes. In 20X2, the violation was cured. How should the loan be classified in the 20X2 financial statements for both 20X2 and 20X1, comparatively? Response: Reference should be made to ASC 470, Debt, (formerly part of FASB No. 78), which states that a long-term liability should be classified as current if the liability is callable because the debtor either violates the debt agreement or does not cure a violation within a specified grace period. The exception is when the creditor waives the violation. In this situation, the debt should be presented as long-term in the 20X2 financial statements because the violation was cured. However, in the 20X1 financial statements presented comparatively with 20X2, the debt should remain as a current liability because it was a current liability using the facts in place at the 20X1 balance sheet date. 5. Disclosure of Five-Year Maturities on Long-Term Debt Question: A company has a 15-year loan payable with monthly principal payments plus interest at a variable rate of prime plus one percent. Should the five years of maturities disclosure include both principal and interest payments, or only principal payments? Response: ASC 440, Commitments (formerly FASB No. 47) requires a company to disclose scheduled principal payments only for each of the five succeeding years. The interest portion of the required payments should not be disclosed. 6. Disclosure of Unused Lines of Credit Question: Should nonpublic companies disclose the existence of unused lines of credit that are available at the balance sheet date? Response: For publicly-held companies, the SEC requires disclosure of significant unused lines of credit. No such requirement exists for nonpublic companies. However, it may be advisable to disclose the unused lines based on the concept of adequate disclosure. Further, it is generally understood that notes, as well as the financial statements, should be informative of matters that may affect their use, understanding, and interpretation. 7. Letters of Credit Question: Should a company report its outstanding letters of credit as a liability in the financial statements? Response: ASC 450, Contingencies, (formerly FASB No. 5), requires disclosure of letters of credit. They represent commitments that should be disclosed but not recorded as a liability. 8. Covenants on Loan Agreements


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Question: A company's loan agreement includes several restrictive covenants related to working capital levels, debt/equity ratios, and maximum amount of retained earnings available for dividends, etc. Should these covenants be disclosed in the notes to financial statements? Response: Yes. ASC 450, Contingencies, (formerly FASB No. 5) requires disclosure of restrictive covenants. 9. Disclosure of a Lender’s Name Question: In preparing a debt footnote, must the name of the lender be disclosed? Response: No. There is nothing in accounting literature that requires disclosure of the lender’s name. 10. Disclosure of Interest Expense and Depreciation Expense in Supplementary Information Question: GAAP requires that interest expense and depreciation expense be disclosed. Is this requirement satisfied if these items are disclosed as separate line items within an operating expense schedule presented as supplementary information? Response: No. Supplementary information is not considered part of the primary financial statements and related disclosures unless they are included as such and the accountant's report clearly includes this information as part of the primary information. Therefore, interest expense and depreciation expense must be presented within the primary financial statements (e.g., income statement, statement of cash flows, balance sheet, statement of comprehensive income) or notes to the statements in order to be considered adequately disclosed. 11. Debt Convertible into Stock Question: A company has debt outstanding that is convertible into common stock of the company at the company's option. The debt is considered long-term in the balance sheet. The company intends to call the debt and issue common stock within one year of the balance sheet date. Should the debt be classified as current? Response: No. The expected call of the debt will not consume current assets or create a new current liability. Consequently, it does not meet the definition of a current liability and should continue to be classified as a long-term debt. ASC 210, Balance Sheet (formerly part of ARB No. 43, Chapter 3A), defines a current liability as one whose liquidation is reasonably expected to require the use of existing current assets or the creation of other current liabilities. The conversion of the debt will not meet the definition. 12. Where and How to Disclose Minimum Lease Payments and Maturities on Long-Term Debt Question: What is the difference between the five-year minimum lease payments disclosure per ASC 840, Leases (formerly FASB No. 13), and the five-year principal amortization disclosure for long-term debt per ASC 440, Debt, (formerly FASB No. 47)?


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Response: In practice, a common disclosure error is in the treatment of the two. Although both disclosures have a "five-year rule," they do differ as follows:

Leases (ASC 840) Debt (ASC 440)

Operating leases: Requires disclosure of future rental payments in total and for each of the next five years Capital leases: Requires disclosure of minimum future lease payments in total and for each of the next five years, showing deductions for executory costs and imputed interest to reduce the minimum payments to present value

Requires disclosure of the combined total of maturities for all long-term debt borrowings for each of the next five years.

Payments beyond five years are not required

Maturities beyond five years are not required

Payments in total are required Total maturities are not required

The lease disclosure is more expansive than the disclosure for long-term debt. In particular, the disclosure for long-term debt requires payments (maturities) for the next five years and not beyond that five years, while the disclosure for leases (operating or capitalized) must present five years of minimum lease payments plus the total minimum payments. Compare the following two disclosures: Leases: The Company has entered into various equipment leases with total monthly payments of $8,000 and various expiration dates through 20XX. A summary of the future minimum lease payments under these operating leases follows:


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Year

Minimum lease

payments 20X1 $50,000 20X2 50,000 20X3 50,000 20X4 50,000 20X5 50,000 Beyond 20X5 *75,000 Total minimum lease payments **$325,000

* optional ** required Long-term debt:

A summary of the annual maturities of long-term debt for the five years subsequent to year end follows:

Year

Principal Payments

20X1 $100,000 20X2 100,000 20X3 100,000 20X4 100,000 20X5 100,000 Beyond 20X5 *300,000 *$800,000

*optional

Notice that the operating lease note presents minimum lease payments for five years, and a total minimum lease payments during the lease term, while the total principal payments is not required for the long-term debt note. Some practitioners elect to include the debt payments beyond the fifth year by "lumping" the remainder into a "Beyond 20X5" category similar to what is done for leases. By doing so, they ensure that the total principal payments on the five-year table agree with long-term debt on the balance sheet.

Question: If a company has a capital lease obligation, in accordance with ASC 840, it is required to disclose the minimum lease payments with an adjustment for imputed interest to bring the total payments to present value. However, the capital lease obligation is also part of long-term debt requiring disclosure of the five-year maturities per ASC 440. Isn't this a duplication of disclosures?

Response: No. ASC 440, Debt (formerly FASB No. 47) does not require disclosure of five-year maturities for capital lease obligations already disclosed in the lease footnote. To do so, there would be a duplication of disclosure. Also, the ASC 840 lease disclosure is more extensive than the ASC 440 long-term debt disclosure. Specifically, ASC 840 requires total lease obligations while ASC 440 requires only principal payments for the five-year period subsequent to year end. Second, ASC 840 requires that the minimum lease obligations be converted to present value which is not required in a long-term debt note per ASC 440. In an instance where a capital lease obligation is already disclosed in the lease note, the long-term debt note could read like this:


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Long-term debt: A summary of the annual maturities of long-term debt (exclusive of capital lease obligations) for the five years subsequent to year-end follows:

Year

Principal Payments

20X1 $100,000 20X2 100,000 20X3 100,000 20X4 100,000 20X5 100,000

J. Other Liabilities 1. Accounting for Coupon Discounts Question: A company includes with its consumer product a coupon which provides for a discount off the next purchase of the product. How should the discount be recorded? a. As a reduction of the sales price of the first purchase? b. As a sales discount at the time of the first purchase? c. As a reduction of the sales price of the second purchase? Response: ASC 450, Contingencies (formerly FASB No. 5), considers the possible future coupon claim as a loss contingency to be evaluated as a future event. Assuming, based on experience, it is probable that the coupons will be redeemed, and the percentage of redemption can be reasonably estimated, the amount should be accrued and charged to an expense at the time of the first sale, not at the time it is redeemed for the second sale. Example: Assume the first sale is for $1,000 providing a $50 coupon toward the second purchase. Further, based on history, 10% of the coupons are redeemed.

Entry at the time of the first sale: Cash 1,000 Sales 1,000 Promotions expense ($50 x 10%) 5 Accrual for promotions 5

2. Defined Benefit Plan Obligations Question: How should the funded status of a defined benefit pension plan be presented on the balance sheet? Response: The authority is found in ASC Topic 715, Compensation- Retirement Benefits (formerly FASB No. 158). Under ASC 715, a business entity that sponsors one or more single-employer defined benefit plans shall recognize the funded status of a benefit plan, measured as the difference between the fair value of plan assets and the benefit obligation, in its balance sheet.

Fair value of plan assets $XX Benefit obligation (Projected benefit obligation (PBO)) (XX)


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Funded status of plan (under) over $XX The following general rules apply in presenting the funded status: 1. Plans should be aggregated as follows:

a. Aggregate all overfunded plans and recognize that amount as an asset in the balance

sheet. b. Aggregate all underfunded plans and recognize that amount as a liability in the balance

sheet.

2. Balance sheet classification:

a. Assets: The overfunded asset is classified as a noncurrent asset on the balance sheet.

b. Liabilities: The underfunded liability is classified as follows: Current: (Determined on a plan-by-plan basis) for the amount by which the actuarial present value of benefits included in the benefit obligation payable in the next 12 months (or operating cycle, if longer) exceeds the fair value of plan assets. Long-term: Remainder of liability that is not current.

c. Comprehensive income: The following items should be presented as part of other comprehensive income in stockholders’ equity, net of tax effect:

Gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost of the period

Gains or losses, prior service costs or credits, and transition assets and obligations remaining from the initial application of ASC 715 that are subsequently recognized as components of net periodic benefit cost pursuant to the recognition and amortization provisions of ASC 715.

d. Measurement date of plan assets and benefit obligations:

1) A business entity shall measure plan assets and benefit obligations as of the date of

its fiscal year-end balance sheet unless:

The plan is sponsored by a subsidiary that is consolidated using a fiscal period that differs from its parent’s, as permitted by ASC 810, Consolidated Financial Statements.

The plan is sponsored by an investee that is accounted for using the equity method of accounting under ASC 323, Investments- Equity Method and Joint Ventures (formerly APB No. 18), using financial statements of the investee for a fiscal period that is different from the investor’s fiscal year.

3. Liabilities for the Costs Associated with Exit or Disposal Activities Question: A company is closing down a plant and will incur exit costs related to employee termination benefits, terminating its lease, and other closing costs. How should the company account for the liability associated with these exit activities?


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Response: The authority is found in ASC 420, Exit or Disposal Cost Obligations (formerly found in FASB No. 146). The ASC applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by ASC 350, Property, Plant and Equipment. Under the ASC, the following rules apply in dealing with exit activity costs: 1. A liability for a cost associated with an exit or disposal activity shall be recognized and

measured initially at its fair value in the period in which the liability is incurred. a. Fair value is the amount at which the liability could be settled in a current transaction

between willing parties other than in a forced liquidation.

b. If the fair value cannot be reasonably estimated, the liability is recognized when it can be reasonably estimated.

2. Examples of costs associated with an exit activity include, but are not limited to:

Termination benefits

Contract termination costs, such as the costs to terminate a lease

Other costs including those costs to consolidate facilities or relocate employees. Termination benefits, are defined as:

a. One-time termination benefits that occur when all of the following criteria have been met:

Management, having the authority to approve the action, commits to a plan of termination.

The plan identifies the number of employees to be terminated, their job classifications or functions and their locations, and expected completion date.

The plan establishes the terms of the benefit arrangement, including the benefits that employees will receive upon termination (including cash payments) in sufficient detail to enable employees to determine the type and amount of benefits they will receive if they are involuntarily terminated, and

Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

b. If employees are not required to render service until they are terminated in order to receive

termination benefits, or if employees will not be retained to render service beyond the minimum retention period, a liability for the termination benefits shall be recognized and measured at its fair value at the communication date.

c. If employees are required to render service until they are terminated in order to receive

the termination benefits and will be retained to render service beyond the minimum retention period, a liability for the termination benefits shall be measured initially at the communication date based on the fair value of the liability as of the termination date.


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The liability is recognized ratably over the future service period.

Any change from a revision to either the timing or amount of estimated cash flows over the future service period shall be measured using the credit-adjusted, risk-free rate that was used to measure the liability initially. The cumulative effect of the change shall be recognized as an adjustment to the liability in the period of change.

Present value is appropriate to determine fair value.

Example 1: A company plans to cease operations in a particular location and determines that it no longer needs the 100 employees that currently work in that location. The entity notifies the employees that they will be terminated immediately. Each employee will receive as a termination benefit a cash payment of $6,000. Conclusion: Because the employees are not required to render service beyond their termination date in order to receive their termination benefits, a liability shall be recognized and measured at the fair value at the communication date. In this case, the amount is $600,000 ($6,000 x 100 employees). Change the facts: Same facts as Example 1 except that each employee will be required to work six months in order to receive the $6,000 cash payment. Conclusion: A liability would be recognized at the communication date and measured at its fair value as of the termination date (six months later). The fair value at the termination date ($600,000) should be discounted by six months. Assuming a discount rate of 6%, the $600,000 would be discounted by 6% for six months which is $582,000.* The $582,000 should be amortized to compensation expense over the six-month employment period.

* PV of $600,000 @ 6% for 6 months = $582,000

Entry on the communication date:

Deferred compensation (asset) *** 582,000 Deferred interest **18,000 Termination liability 600,000 ** The deferred interest should be amortized to expense over the remaining 6-month

period using the effective interest method. *** The deferred compensation should be amortized to compensation expense over the 6-

month compensation period.

Contract Termination Costs:

a. Contract termination costs (such as costs to terminate an operating lease) consist of:

1) Costs to terminate the contract before the end of its term, or 2) Costs that will continue to be incurred under the contract for its remaining term without

economic benefit to the entity.

b. A liability for costs to terminate a contract before the end of its term shall be recognized and measured at its fair value when the entity terminates the contract in accordance with


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the contract terms (written notice is given within the notification period or a period otherwise negotiated.)

c. A liability for costs that will continue to be incurred under a contract for its remaining term

without economic benefit to the entity shall be recognized and measured at its fair value when the entity ceases using the right conveyed by the contract (the cease-use date).

1) Operating leases: The fair value of the liability at the cease-use date is based on the

remaining lease rentals, reduced by estimated sublease rentals that could be reasonably obtained for the property, even if the entity does not intend to enter into a sublease, but not less than zero.

Example: A company leases a facility under a 10-year lease at annual lease payments of $100,000. After leasing the facility for five years, the company commits to an exit plan under which the company will cease using the facility in one year. At that time, four years will remain on the lease ($100,000 x 4 years = $400,000). If the company were to sublease the facility, it could do so at $75,000 per year. However, because of competitive issues, the company will not sublease the facility. Conclusion: At the cease-use date (end of year 6), the company must recognize a liability for the remaining lease rentals, reduced by actual or estimated sublease rentals.

Calculation of liability: Remaining lease rentals ($100,000 x 4) $400,000 Estimated sublease rentals ($75,000 x 4) (300,000) Expected net cash flows $100,000 Present value of $25,000 per year, 4 years at credit-adjusted risk-free rate: 8%

$88,000

Year

Beginning

carrying amount

Payment

Deferred interest

amortization

Ending carrying amount

7 $88,000** $(25,000) $6,000 $69,000

8 69,000 (25,000) 4,000 48,000

9 48,000 (25,000) 2,000 25,000

10 25,000 (25,000) 0 0

** Present value of a $25,000 annuity due, at 8%.

Entry: End of Year 6 (Cease-Use Date): Lease exit expense 88,000 Deferred interest 12,000 Lease exit liability 100,000

Assume that the Company does not sublease the property, each payment of $100,000 must be split between the $25,000 which was set up as part of the lease exist liability, and the $75,000 remainder as follows:

Entry: End of Year 7 Lease exit liability 25,000


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Lease expense 75,000 Cash 100,000 Interest expense 6,000 Deferred interest 6,000 Entry: End of Year 8 Lease exit liability 25,000 Lease expense 75,000 Cash 100,000 Interest expense 4,000 Deferred interest 4,000 Entry: End of Year 9 Lease exit liability 25,000 Lease expense 75,000 Cash 100,000 Interest expense 2,000 Deferred interest 2,000 Entry: End of Year 10

Lease exit liability 25,000 Lease expense 75,000 Cash 100,000

Note: ASC 420 requires that the exit liability be established based on the assumption that the entity subleases the property even if there is no intention to do so. Assuming the entity does not sublease the property, the liability consists of only $25,000 per year versus the $100,000 that must be paid each year for the four remaining years. The result is that for each of the remaining four years (Years 7-10), as the company pays $100,000 per year, the payment must be split between $25,000 recorded against the exit liability, and the remainder ($75,000) recorded directly to lease expense.

Other associated costs:

a. Other costs associated with an exit or disposal activity include costs to consolidate or close facilities, relocate employees, etc.

b. A liability for other costs shall be recognized and measured at the fair value in the period in which the liability is incurred (usually when goods and services associated with the activity are received).

3. Disclosures:

a. Disclosures are required for the period in which an exit or disposal activity is initiated and any subsequent period until the activity is completed. Such disclosures include: 1) A description of the activity, including the facts and circumstances leading to the

expected activity and expected completion date.

2) For each major type of cost associated with the activity, such as one-time termination benefits, contract termination costs, and other associated costs:


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Total amount expected to be incurred in connection with the activity, the amount incurred in the period, and the cumulative amount incurred to date.

A reconciliation of the beginning and ending liability balances showing separately the changes during the period attributable to costs incurred and charged to expense, costs paid or otherwise settled, and any adjustments to the liability with an explanation of the reasons therefore.

3) The line item(s) in the income statement or statement of activities in which the costs

are aggregated.

4) For each reportable segment, the total amount of costs expected to be incurred in connection with the activity, the amount incurred in the period, and the cumulative amount incurred to date, net of any adjustments to the liability with an explanation of the reasons therefore.

5) If the liability for a cost associated with the activity is not recognized because fair value cannot be reasonably estimated, that fact and the reasons therefore.

K. Stockholders' Equity 1. Contributed Capital Question: A corporation has a loan payable to its sole shareholder. The bank requires the company to remove the loan from the balance sheet as part of a bank loan refinancing. How should the loan be handled? Response: GAAP requires related party loans (receivables and payables) to be treated as equity transactions. ASC 470, Debt (formerly found in APB No. 26), clearly states that "the extinguishment transactions between related parties may be, in essence capital transactions." Thus, any forgiveness should be credited to equity as additional paid in capital. Recording the transaction as forgiveness of debt income on the income statement would not be appropriate given the related party nature of the loan. 2. Preferred Stock Dividends Question: A company has cumulative preferred stock, and has not paid dividends for the past four years. Because there is an obligation to pay the dividends prior to paying any other dividends, should the company accrue the dividends? Response: No. Because the dividends do not become a liability until declared, no accrual is needed. However, ASC 210, Balance Sheet (formerly APB No. 10), requires that the dividends in arrears be disclosed. 3. Changes in Stockholders' Equity and Retained Earnings Question: Harry "the hack" CPA is preparing a compilation report on financial statements that omit substantially all disclosures and the statement of cash flows. Must he include a statement of stockholders' equity in the set of financial statements? Response: No. ASC 225, Income Statement (formerly APB No. 9), requires that the change in retained earnings be disclosed for each year an income statement is presented. ASC 505, Equity


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(formerly APB No. 12), requires that all changes in stockholders' equity be disclosed. Disclosure may be made by a) issuing a separate statement of equity, b) providing a separate footnote disclosure for the changes, or c) if the only change in equity is retained earnings, showing the change in retained earnings on the statement of income. Because the financial statements omit substantially all disclosures, it would appear that disclosure of the changes in retained earnings and other equity accounts would not be required, regardless of the format used. 4. S Corporations: Disclosure of Retained Earnings Question: A company is an S Corporation. Is it appropriate to present one single amount for retained earnings on the balance sheet? Response: Yes. An S Corporation should present one amount for retained earnings. The individual tax accounts such as AAA, other adjustments and previously taxed income may be disclosed in the notes or in supplementary information, but such disclosure is not required. 5. Exchange of No Par Common Shares for Par Value Preferred Shares Question: As part of an estate plan, shareholders of a company exchange their no- par-value common shares for preferred shares with a par value. How should this transaction be recorded? Response: The difference between the carrying value of the common stock and the preferred stock should be credited to additional paid-in capital. If a debit is needed, it should be first charged to additional paid-in capital, with any balance charged to retained earnings. Once retained earnings is adjusted to zero, any additional debit should be recorded as a discount on preferred stock, provided state law allows this adjustment. 6. Quasi-Reorganizations Question: A company has a large deficit in its retained earnings which is having a major impact on its ability to obtain financing. Several of its assets on the balance sheet have significant unrealized gains. Is there any way this company can justify restating its balance sheet by writing up its net assets to market value and eliminating the deficit in retained earnings? Response: Yes. One procedure is a quasi-reorganization. A quasi-reorganization is defined by the SEC as:

“A corporate procedure in the course of which a company, without the creation of a new corporate entity and without the intervention of formal court proceedings, is enabled to eliminate a deficit and to establish a new earned surplus account. The procedure accomplishes the restatement of assets as well as appropriate modifications of capital and capital surplus......”

Assets and liabilities may be written up or down to market value. The result of a quasi-reorganization is that the company should look like a new one without having to go through a formal reorganization. Brief example of entries to effect a quasi-reorganization:

Land, buildings, other assets *** XX


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APIC** XX Common stock** XX Deficit (retained earnings) XX ** APIC and common stock are adjusted only if necessary to remove the remaining deficit in retained earnings. *** All assets and liabilities must be adjusted to market value.18

Note: The SEC will generally not recognize a quasi reorganization if it results in a debit balance in any stockholders' equity account. Thus, in many cases a quasi-reorganization is not possible unless there are significant unrealized gains in the net assets of the company adequate to absorb the deficit in retained earnings. Note: Subsequent to a quasi-reorganization, retained earnings must be dated so as to inform the reader as of the date that retained earnings were restated. Observation: Although use of quasi-reorganizations has been infrequent, their use can be very effective to get a deficit entity a clean or fresh start as if that entity had been through a formal reorganization under Chapter 11. 7. Disclosure of Shares Question: Must a nonpublic company disclose the number of shares authorized, issued and outstanding on the balance sheet (in the stockholders’ equity section) or in the notes? Response: No. There is nowhere in accounting literature that requires a nonpublic entity to disclose the number of shares authorized, issued and outstanding. The SEC requires this disclosure for publicly-held companies. However, for non-public entities, this disclosure has become generally accepted by application rather than by codification. Many non-public companies disclose the number of shares authorized, issued and outstanding in the stockholders’ equity section of the balance sheet as a matter of habit rather than to provide useful information. 8. Accrual of S Corporation Distributions Question: Harry is a 100% shareholder of Corporation A, an S corporation. The Corporation’s 20X1 net income is $400,000 which, of course, will be included on Harry’s personal tax return. In order for Harry to pay the taxes on this income, the Corporation will make an S distribution to Harry sometime in April 20X2 equal to $130,000. Should the Corporation accrue the distribution as of December 31, 20X1 as follows? Retained earnings 130,000 S distribution payable 130,000 Should the Corporation disclose the distribution in the 20X1 financial statements? Response: GAAP treats an S distribution as a dividend, and therefore, follows the accounting treatment for dividends.

18 The quasi-reorganization rules use the old terminology of “market value” which has been replaced with “fair value.” To date, the FASB has not gone through all the various GAAP documents to replace the terms. Until the terminology is changed, users should treat the terms “market value” and “fair value” interchangeably.


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Generally, a dividend is only recorded when declared by the board of directors. Because the dividend has not been formerly declared as of December 31, 20X1, it does not represent an obligation of the entity. Thus, no entry should be made until payment is made in April 20X2. With respect to disclosure, there is no disclosure required because there is no obligation to pay the dividend. However, if the payment of the dividend will be made prior to the financial statements being available for issue and the distribution is material, an argument could be made that a disclosure should be made as a subsequent event. In the above scenario, payment is likely to occur after issuance of the financial statement assuming the statements will be issued sometime in March 20X2. 9. Non-controlling Interests Question: How should a non-controlling interest in an entity’s equity be presented in a balance sheet? Response: The authority is found in ASC Subtopic 810-10 Consolidation-Overview (formerly FASB No. 160). Under the ASC, a noncontrolling interest (previously referred to as a minority interest) is presented using the following rules: 1. A noncontrolling interest is the portion of equity (net assets) in a subsidiary not attributable,

directly or indirectly, to a parent.

a. The ownership interest in the subsidiary held by owners other than the parent is a noncontrolling interest.

Example: If 80 percent of a subsidiary’s ownership (equity) interest is held by the subsidiary’s parent, and the other 20 percent is held by other owners, the 20 percent not owned by the parent is considered a noncontrolling interest.

2. Presentation on the balance sheet: a. The noncontrolling interest is reported in the consolidated balance sheet within the equity

section, separately from the parent’s equity, clearly identified and labeled as “noncontrolling interest in subsidiaries,” or similar caption.

b. Noncontrolling interests in more than one subsidiary may be presented in the aggregate

in the consolidated financial statements.


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Equity: ABC Co. shareholders’ equity: Common stock, $1 par value $XX Paid-in capital XX Retained earnings XX Accumulated other comprehensive income XX Total ABC Co. shareholders’ equity XX Noncontrolling interest XX Total shareholders’ equity XX

3. Presentation of income and comprehensive income:

a. Revenues, expenses, gains, losses, net income or loss, and other comprehensive income are reported in the consolidated financial statements at the consolidated amounts, which include the amounts attributable to the owners of the parent and the noncontrolling interest.

b. Net income or loss and comprehensive income or loss shall be attributed to the parent

and the noncontrolling interest. c. The excess of any losses attributable to the parent and the noncontrolling interest over

the equity interests shall be attributable to each interest, even if it results in a deficit noncontrolling interest balance.

d. The amount of intercompany income or loss to be eliminated is not affected by the

existence of a noncontrolling interest. The elimination of the intercompany income or loss may be allocated between the parent and noncontrolling interests.

Example: ABC Company (parent) owns 80% of the equity of XYZ Company (subsidiary) resulting in a noncontrolling interest in XYZ of 20% of its equity. XYZ’s 20X1 net income is $100,000 which is included in the consolidated financial statements of ABC. ABC’s consolidated income statement would be presented as follows:

ABC Company Consolidated Statement of Income

For the Year Ended December 31, 20X1

Net sales $XX Cost of sales XX Gross profit on sales XX Operating expenses XX Income from continuing operations before income tax XX Income taxes XX Income from continuing operations XX Discontinuing operations, net of tax XX Net income XX Less: Net income attributable to the noncontrolling interest (1) (20,000) Net income attributable to ABC Company $XX (1) $100,000 x 20%.


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10. Disclosure of Capital Structure Question: What must a company disclose about its capital structure? Response: ASC 505, Equity (formerly FASB No. 129), requires that the rights and privileges of the various securities outstanding be disclosed. The ASC defines “securities” to include any evidence of debt or ownership or a related right, including options, warrants, debt and stock. Thus, any public or nonpublic entity that has issued equity is considered to have securities and must satisfy the disclosure rules in ASC 505. ASC 505 requires disclosures about the following related to an entity’s equity: 1. Information about:

a. The pertinent rights and privileges of securities outstanding including:

Dividend and liquidation preferences Participation rights Call prices and dates Conversion or exercise prices, or rates and pertinent dates Sinking-fund requirements Unusual voting rights Significant terms or contracts to issue additional shares

b. The number of shares that were issued due to a conversion, exercise, or satisfaction of a required condition or obligations

2. Liquidation preference of preferred stock including:

a. The liquidation preference of the preferred stock b. The aggregate or per-share amounts of preferred stock that may be called or that is

subject to redemption through sinking-fund operations, etc., and c. Any arrearages in cumulative preferred dividends

3. The amount of redemption requirements for all issues of capital stock that are redeemable at fixed or determinable prices on fixed or determinable dates in each of the five years following the date of the latest balance sheet presented.

Following is a sample note:

NOTE XX: CAPITAL STRUCTURE The Company has 1,000 shares of $50 par value per share preferred stock authorized, issued and outstanding. The shares are non-voting and non-participating. Dividends are cumulative and are paid annually at a rate of 6% of the par value of shares outstanding. No dividends were paid in 20X2 and 20X1. Dividends in arrears totaled $3,000. Under the terms of the preferred stock agreement, preferred stockholders receive certain preferential rights not available to common stockholders. These rights include payment of dividends to all preferred stockholders prior to paying any common stock dividends. And, in the event of an involuntary liquidation, preferred stock stockholders receive a distribution of


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net assets equal to the par value of preferred shares outstanding, prior to the distribution of any assets to common stock stockholders. The Company also has 1,000 of $100 par value common stock authorized, issued and outstanding. Common shares are voting and dividends are paid at the discretion of the board of directors which amounted to zero in 20X2 and 20X1. All common and preferred shares outstanding are restricted from transfer without the Company being offered the first right to repurchase shares at a market-value price. The Company has signed a redemption agreement with all preferred shareholders under which the Company agrees to redeem all shares of preferred stock at $60 per share equally over a five-year period. A summary of the redemption amounts required under this agreement for the five years subsequent to 20X1 follow:

Year

Redemption amount of preferred stock

20X2 $12,000 20X3 12,000 20X4 12,000 20X5 12,000 20X6 12,000

Observation: For an entity with a simple capital structure consisting of only common stock, the note is limited to the following:

NOTE XX: CAPITAL STRUCTURE The Company also has 1,000 of $100 par value common stock authorized, issued and outstanding. Common shares are voting and dividends are paid at the discretion of the board of directors which amounted to zero in 20X2 and 20X1. All common shares outstanding are restricted from transfer without the Company being offered the first right to repurchase shares at a market-value price.

11. Disclosure of Number of Shares Question: Is a nonpublic company required to disclose the number of shares of common stock that is authorized, issued and outstanding? Response: No. For nonpublic entities there is no requirement to disclose the number of shares authorized, issued and outstanding and the par value per share. SEC companies are required to make such a disclosure, but not nonpublic entities. Even though not required and generally useless, as a matter of habit, many nonpublic entities do, in fact, disclose the number of shares outstanding and par value per share. In fact many disclosure checklists include the requirement to disclose the number of shares authorized, issued and outstanding, but fail to offer any authority supporting the requirement for this information.


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ASC 505, Equity (formerly FASB No. 129), does require an entity to disclose the number of shares that were issued due to a conversion, exercise, or satisfaction of a required condition or obligations, but not to disclose the number of shares authorized, issued, and outstanding. 12. Redeemable Shares Fixed Versus Death Example 1: Facts: Harry and Fred are 50%-50% equity owners in XYZ Company, a non-public company. Harry is age 85 and wants to work until he is age 100. (Harry is the eternal optimist.) Fred is only age 50. On December 31, 20X6, XYZ Company signs a stock redemption agreement with Harry and Fred under which, upon the death of the first to die, the company will redeem his shares at fair value. The company is obligated to fulfill the obligation. The redemption will be funded, in part, by life insurance. XYZ is the owner of two, key-man life insurance policies, each with a face value of $1 million on each of the shareholders. Question: Should the company record a liability for the redemption obligation? Response: No. ASC 480-10 (formerly FASB No. 150), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, deals with mandatorily redeemable financial instruments. The ASC requires entities that have financial instruments issued in the form of shares (e.g., common stock or other equity), all of which are mandatorily redeemable financial instruments to be classified as liabilities, and to describe those instruments as “shares subject to mandatory redemption” in the balance sheet to distinguish those instruments from other liabilities. A mandatorily redeemable financial instrument is defined as:

“a financial instrument issued in the form of shares that embodies an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date(s) or upon an event certain to occur (e.g., death or termination).19

However, ASC 480-10-65-1 provides a deferral of the requirements of ASC 480 for nonpublic entities. Under ASC 480-10-65-1, mandatorily redeemable financial instruments of certain nonpublic entities are handled as follows:

1. Financial instruments issued by nonpublic entities that are mandatorily redeemable on fixed dates for amounts that are either fixed or are determined by reference to an interest

19 In determining if an instrument is mandatorily redeemable, all terms within a redeemable instrument shall be considered. A term extension option, a provision that defers redemption until a specified liquidity level is reached, or a similar provision that may delay or accelerate the timing of a mandatory redemption does not affect the classification of a mandatorily redeemable financial instrument as a liability.


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rate index, currency index, or another external index, the classification, measurement, must be reclassified as a liability.

2. For all other financial instruments that are mandatorily redeemable (including those based on the death of a party), the provisions of the ASC are deferred indefinitely.

That means that if there is a stock redemption agreement that is triggered upon the death of one of the parties, that transaction should be recorded as a liability. However, the ASC exempts nonpublic entities from recording the transaction as a liability under the indefinite deferral. Getting back to Example 1: Thus, the example with Harry and Fred would not require the company to reclassify the obligation as a liability because the redemption is triggered upon the death of Harry or Fred and XYZ is a non-public entity for which an indefinite deferral exists. However, XYZ should disclose the redemption agreement and related obligation. Example 2: Change the facts: Assume that on December 31, 20X6, the redemption agreement requires that XYZ must redeem Harry’s on December 31, 20X9 (Harry’s 88th birthday) for $2 million fixed. Conclusion: Because the redemption is to take place on a fixed date at a fixed amount, XYZ must reclassify the transaction as a liability. The indefinitely deferral for nonpublic entities does not apply. The liability is presented as follows:

At December 31, 20X6:

Stockholders’ equity: (given) Book value: Common stock $200,000 Retained earnings 2,400,000 Total book value 2,600,000 Redemption amount 2,000,000 Excess book value over redemption amount $600,000


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XYZ Company Balance Sheet

December 31, 20X6

ASSETS: Current assets $100,000 Property, plant and equipment 2,500,000 Other assets 200,000

$2,800,000 LIABILITIES AND EQUITY:

Current liabilities $50,000 Long-term liabilities:

Liabilities other than shares 150,000 Shares subject to mandatory redemption 2,000,000

Total liabilities 2,200,000 Stockholders’ equity: Excess of carrying value over redemption amount of shares subject to redemption

600,000 (1)

$2,800,000

(1) Redemption amount $2,000,000 less $2,600,000 book value = $600,000 excess.


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 22. According to ASC 710 (formerly FASB No. 43), a company is required to record a liability for

vacation, holiday, or sick pay if certain criteria are met: Which of the following is one of those criteria:

a) the compensation has yet to be earned b) it does not accumulate c) it vests d) the amount cannot be estimated 23. Which of the following is a situation in which an entity may elect to capitalize the costs for

environmental contamination treatment: a) the costs do not extend the life, increase the capacity, or improve the safety or efficiency

of property owned by the company b) the costs fail to mitigate or prevent environmental contamination that has yet to occur and

that may result from future operations or activities, of property owned by the company c) the costs are incurred in preparing the property for sale d) the costs remove tanks and remediate soil

24. A company has a line of credit with the same bank for ten years with the note payable upon

demand. If the company does not plan to pay it off within one year, and there is no indication that the bank will call the loan within the next year, how should the loan be presented: a) as a current liability on the balance sheet b) as a long-term liability on the balance sheet c) partially as a current liability, with the remainder as a long-term liability on the balance

sheet d) GAAP is silent on the matter

25. ASC 450, Contingencies (formerly FASB No. 5), requires that letters of credit be accounted

for in which of the following ways: a) disclosed b) recorded as a liability c) parenthetically show in the liability section of the balance sheet d) no disclosure or recording as a liability

26. Which of the following is correct regarding disclosures found under ASC 840, Leases and

ASC 440, Debt: a) the lease disclosure requires disclosure of five years of minimum lease payments only b) the lease disclosure requires disclosure of five years of annual minimum lease payments

and total minimum lease payments c) the long-term debt disclosure requires disclosure of payments for the next five years plus

a total of the remaining balance d) the long-term debt disclosure requires disclosure of payments for the next five years, total

beyond five years, and total payments 27. A company includes with its consumer product a coupon that provides for a discount off the

next purchase of the product. It is probable that the coupons will be redeemed, and the


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percentage of redemption can be reasonably estimated. How should the discount be recorded: a) as a reduction of the sales price of the first purchase b) as an accrual and charged to expense c) as a deferred credit on the balance sheet d) as an extraordinary charge

28. What is the required presentation of retained earnings for an S corporation:

a) the S corporation should present one amount for retained earnings b) the S corporation should present the individual tax accounts of retained earnings on the

balance sheet c) the S corporation must disclose the individual tax accounts of retained earnings in the

notes to the financial statements d) the S corporation must disclose the individual tax accounts of retained earnings in

supplementary information 29. Which of the following is correct regarding the disclosure of the number of shares of common

stock authorized, issued and outstanding: a) nonpublic entities must present the number of shares on the balance sheet b) nonpublic entities must disclosure the number of shares in the notes to the financial

statements c) the SEC requires this disclosure for publicly held companies d) nonpublic entities only have to present the number of shares if they are contemplating

going public

30. A non-controlling interest should be presented in a balance sheet: a) as part of debt b) as part of equity c) in a section between debt and equity called “minority interest” d) as either debt or equity at the option of the company


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SUGGESTED SOLUTIONS 22. A: Incorrect. The compensation must be earned. B: Incorrect. The compensation must accumulate. C: Correct. One of the criteria is that the compensation vests, making the answer correct. D: Incorrect. The amount of the compensation must be estimated. 23. A: Incorrect. An entity may elect to capitalize costs that do extend the life, increase the

capacity, or improve the safety or efficiency of property owned by the company. Thus, the answer is incorrect.

B: Incorrect. An entity may elect to capitalize the costs to mitigate or prevent environmental contamination that has yet to occur and that may result from future operations or activities, of property owned by the company. Thus, the answer is incorrect.

C: Correct. GAAP provides that an entity is permitted to capitalize costs to prepare a property for sale based on the theory that such costs should be expensed against the gain or loss on sale.

D: Incorrect. The costs to remove tanks and remediate soil must be expensed as such costs provide no benefit to future periods.

24. A: Correct. The loan is a demand loan. Therefore, ASC 210 states that a demand loan is shown as a current liability.

B: Incorrect. ASC 210 does not provide any flexibility for classifying the debt based on the intent of the parties. The fact is that the loan is a demand loan. Consequently, classifying the loan as a long-term liability instead of a current liability, is incorrect.

C: Incorrect. ASC 210 does not provide for a portion of a demand loan to be presented current with the remainder as long-term, unless the loan agreement allows for repayment based on that structure. Thus, the answer is incorrect.

D: Incorrect. GAAP is not silent on the presentation of a demand loan, making the answer incorrect.

25. A: Correct. ASC 450 does, in fact, require disclosure of letters of credit because the

letter of credit represents a commitment. B: Incorrect. ASC 450 does not require that letters of credit be recorded as a liability because

a formal obligation does not exist. Thus, the answer is incorrect. C: Incorrect. There is no requirement to parenthetically disclose the letter of credit. Thus, the answer is incorrect. D: Incorrect. At a minimum, the letters of credit must be disclosed as a commitment, making the answer incorrect.

26. A: Incorrect. Specifically, ASC 840 requires lease disclosures consisting of minimum lease

payments over the next five years and total lease payments. B: Correct. GAAP requires disclosure of both the five years of annual minimum lease

payments and total minimum lease payments. C: Incorrect. ASC 440 require disclosure of annual payments for each of the next five

years but not a total for the remaining balance. D: Incorrect. With respect to long-term debt, ASC 840 requires that only annual payments for

each of the next five years be disclosed. The total beyond five years, and the total payments are not required. Thus, the answer is incorrect.

27. A: Incorrect. GAAP provides that the transaction should not be recorded as a reduction of

the sales price of the first purchase. The reason for not recording it as a reduction of sales price is because the discount pertains to the next sale, not the current sale.


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B: Correct. If it is probable that the coupons will be redeemed, and the percentage of redemption can reasonably be estimated, the amount should be accrued and charged to expense at the time of the first sale. The reason is because the discount is treated as a form of marketing and sales cost to entice the customer to purchase the next time.

C: Incorrect. The discount is a period cost and should not be deferred on the balance sheet. It should be matched against the sale that created the discount.

D: Incorrect. The discount is not extraordinary as it is not infrequent and unusual. In fact, it is quite usual. 28. A: Correct. Because GAAP does not provide other guidance, only one amount should

be presented for retained earnings on the balance sheet. B: Incorrect. There is no requirement for the S corporation to present the individual tax

accounts on the balance sheet, although a company may elect to do so. C: Incorrect. GAAP does not require that the individual tax accounts be disclosed in the notes

to financial statements. D: Incorrect. GAAP provides no requirement for the S corporation to present the individual

tax accounts in supplementary information. 29. A: Incorrect. There is nowhere in accounting literature that requires nonpublic entities to

present the number of shares information on their balance sheets, but it has become generally accepted by application.

. B: Incorrect. GAAP does not require nonpublic entities to disclose the number of shares in the notes.

C: Correct. The SEC has required such disclosure for public companies. D: Incorrect. The fact that a nonpublic entity is contemplating going public has no impact on

the fact that GAAP does not require the number shares to be presented or disclosed. 30. A: Incorrect. A non-controlling interest is not presented as part of debt but instead is

presented as part of equity. B. Correct. ASC Subtopic 810-10 requires that a noncontrolling be presented on the

balance sheet in the equity section. C: Incorrect. GAAP does not permit the noncontrolling interest to be presented between debt

and equity on the balance sheet. The term “minority interest” is no longer used. D: Incorrect. GAAP does not give a company the option of presenting a noncontrolling

interest as debt or equity on the balance sheet.


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II. REVENUE AND EXPENSES A. Income Statement Title Question: What title is suggested for the "Statement of Income" when a "net loss" exists in one or more years? Response: Based on the annual survey in Accounting Trends & Techniques, companies that had a net loss in the income statement usually describe the statement as the "Statement of Operations" or "Statement of Income (Loss)." Very rarely do companies use the title "Statement of Loss." B. Involuntary Conversions Question: A tornado virtually destroys a company's building on June 12, 20X1. The company's fiscal year ends June 30, 20X1. The company expects to be reimbursed by its insurance company for the costs of repairs. On August 15, 20X1, prior to issuing the financial statements, the company receives a check in excess of the carrying amount of the building. Information is as follows: Proceeds received $1,200,000 Book value of the plant 800,000 Gain $400,000 Should the company record the gain on the involuntary conversion at June 30, 20X1? Response: No. Because the Company was reimbursed for an amount in excess of the carrying value of the building, the excess of $400,000 is considered a gain contingency at June 30, 20X1. In accordance with ASC 450, Contingencies, (formerly FASB No. 5), gain contingencies are generally not recorded until realized upon receipt on August 15, 20X1. However, nothing precludes the Company from disclosing the gain as a subsequent event. Author's Observation: Although a stretch, it could be argued that the gain was realized at June 30, 20X1 because there was a legally binding contractual right to the proceeds from the insurance company. Thus, a bona-fide receivable for the insurance proceeds existed at June 30, 20X1. Change the facts: Same facts as the previous example except that the reimbursement results in a loss? Response: The Company would have a loss contingency that should be recorded at June 30 since the loss is probable and the amount can be reasonably estimated in accordance with ASC 450. C. Percentage Revenue Question: A company sells a segment of its management consulting division for $500,000 cash plus 5% of revenue earned over the next three years, with a cap of $1,000,000 per year. The company believes that it will earn the maximum amount each year. How much should the company record as the sales price on this transaction and when? Response: ASC 450, Contingencies (formerly FASB No. 5), states that revenues from contingencies that might result in gains usually are not recognized prior to realization. Unless it is assured that the contingency revenue will be received each year, the contingency portion should


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be recorded each year as earned. However, if it is assured that the revenue will be realized (which rarely occurs), revenue should be recorded at the sales date based on the present value of the projected cash receipts ($1 million x 3 years plus $500,000) $3,500,000 in accordance with ASC 835, Interest (formerly APB No. 21). In this case, it would be very difficult to be sure that the revenue would be realized. Consequently, revenue should be recognized as follows: Date of sale: $500,000 Thereafter, revenue shall be recognized over each of the three years as earned as a percentage of revenue. D. Accounting for Shipping and Handling Costs Billed The following background relates to a series of questions that follow: Background: Most companies collect shipping and handling costs from the customer. Some pass through the shipping and handling costs by charging the customer the same amount that the company pays for the shipping and handling costs. Others mark up the costs by charging the customer a different amount than the actual cost of the shipping and handling incurred. Consider the following example that illustrates a common abuse: Example: Company X sells goods for $100 and charges $10 shipping. The cost of shipping is only $6. X wishes to increase its gross profit on sales and decides to classify the transaction as follows:

Sales: Products

$100

Shipping 10 110 Cost of goods sold xxx Gross profit xxx Operating expenses: Selling and delivery

(6)

Net income $xxx By presenting the shipping billing as revenue and the offsetting cost below the line as part of selling and delivery expenses (instead of cost of goods sold), the Company has increased its gross profit on sales. The accounting treatment for shipping and handling costs varies among companies as follows:

Treatment 1: The amount billed for shipping and handling is displayed as revenue with the costs as expenses. Treatment 2: The amount billed for shipping and handling is netted (credited) against the cost.

With respect to the classification of shipping and handling costs on the income statement, some companies include the costs in cost of goods sold, while others include them in selling expenses. Assume the following example:


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Facts: A retail clothing company, Big Jimmy's T's, sells T-shirts via mail order catalog, a proprietary Internet site, and several retail stores. Typically, in addition to the price of the T-shirt, a company offers three delivery alternatives: next-day delivery, 2-day delivery, and "regular" parcel post. Each delivery alternative has a stated additional charge. For example, the company receives an on-line order for 10 shirts at a price of $10 per shirt. The customer selects parcel post delivery that carries an additional charge of $6 for shipping and handling. When goods are shipped, an itemized invoice is e-mailed to the customer, listing, for example, a purchase of 10 shirts for $100 and shipping and handling charges of $6, for a total invoice of $106. The actual cost incurred by the company is $3.00 for shipping and $1.50 for handling, for a total cost of $4.50.

The numbers associated with the above example follow:

Record as revenue

Net the revenue against the cost

Sales: T- shirts

$100.00

$100.00

Shipping and handling 6.00 -__ 106.00 100.00 Costs-shipping and handling (net credit) 4.50 (1.50) Net $101.50 $101.50

The authority for accounting for shipping and handling costs is found in ASC 605-45 Revenue Recognition-Principal Agent Considerations (formerly found in EITF Issue No. 00-10): Shipping and handling activities consist of the following:

Shipping costs: Costs incurred to physically move a product from a seller's place of business to a buyer's designated location. Shipping costs may consist of payments to third-party shippers as well as internal costs incurred directly by the seller.

Handling costs: Costs incurred to store, move, and prepare the product for shipment. Handling costs are incurred from the point the product is removed from finished goods inventory to the point the product is provided to the shipper and may also include an allocation of internal overhead.

Note: In reading the definition of handling costs provided by ASC 605, the definition seems to be inconsistent. Specifically, the definition states that handling costs are incurred from the point the product is removed from finished goods inventory, to the point the product is provided to the shipper. This would suggest that warehousing costs (e.g., the costs to store the goods up to the point in time that the goods are removed from inventory) are not part of handling costs. Yet, the first line of the definition states that handling costs include costs to store, move and prepare the product for shipment. (In further research of this issue with the FASB, the author believes that the part relating to "store" deals with interim storage where goods are being moved between warehouses, not the longer-term warehousing that occurs when the goods are being inventoried. For example, assume goods are warehoused in Warehouse A. The goods are shipped to a central shipping facility for order fulfillment. The goods are then stored at the central facility for one week before being packaged and shipped. The author believes that the costs associated with warehousing in Warehouse A are not handling costs. Handling costs consist of the costs to move the goods from Warehouse A, temporarily store the goods in the central warehouse, and package the goods for shipment. This issue could be important to many companies that have significant


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warehousing costs and, by reading the definition, erroneously believe the warehousing costs must be included as part of handling costs for purposes of satisfying the requirements of ASC 605.)

ASC 605 does not use the term “fulfillment” because of the inconsistent use of the term to describe various functions including simple shipping services provided by an unrelated party, order-taking, billing, customer support, product supply, inventory management, handling, shipping, and warranty claims processing. Instead, the ASC focuses on activities related to shipping and handling, regardless of whether those activities are included in the company's definition of fulfillment activities. Question 1: In a sale of goods, how should the seller classify in the income statement amounts billed to the customer for shipping and handling? Response: ASC 605 states that all amounts billed to a customer in a sales transaction related to shipping and handling, if any, represent revenues earned for the goods provided and should be classified as revenue.

Question 2: How should the seller of shipping and handling classify in the income statement costs incurred for shipping and handling? Response: ASC 605 states:

a. The classification of shipping and handling costs is an accounting policy decision that should be disclosed in the notes to financial statements.

b. If the gross shipping and handling costs are significant and are not included in cost of

goods sold, the amount of shipping and handling costs and the line item(s) that include them should be disclosed.

Moreover, ASC 605 states that shipping and handling costs should not be netted against shipping and handling revenue billed to the customer. Example 1: Company X is a mail order company. The company charges its customers for shipping its product and, in turn, pays the shipping costs. Specifics for year 20XX follow:

Gross sales

$1,000,000

Billings for shipping 100,000 Shipping costs presented as part of selling and delivery expenses

(80,000)

Conclusion: In accordance with ASC 605, the financial statements for 20XX would look like this:


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Company X

Statement of Income For the Year Ended December 31, 20XX

Sales $1,100,000* Cost of goods sold xxxxxxxx Gross profit on sales xxxxxxxx Operating expenses: Selling and delivery 80,000** General and administrative xxxxxxxx Net income before income taxes xxxxxxxx Income taxes xxxxxxxx Net income $xxxxxxxx

* Gross sales ($1,000,000) + billed shipping and handling fees ($100,000) = $1,100,000 ** Shipping and handling costs of $80,000 are presented as part of selling and delivery costs in accordance with the

company's policy.

Notes to Financial Statements

NOTE 1: Summary of Significant Accounting Policies: Shipping and Handling Costs: Shipping and handling costs include mailing and fulfillment charges associated with delivery of goods from the company's central warehouse to each customer's designated location. The company's policy is to classify shipping and handling costs as part of selling and delivery expenses in the statement of income. Total shipping and handling costs were $80,000 in 20XX.

Observation: The first line of the disclosure presented in italic type is not required and is a description of the types of costs included in shipping and handling costs. GAAP only requires disclosure of the company's policy for classifying shipping and handling costs, with no mention of any description of the types of costs included in the category. The author has included the first line to round out the disclosure and make it more meaningful even though it is not required. How does the disclosure change if the shipping and handling costs are presented as part of cost of goods sold? ASC 605 requires that the accounting policy for classification of shipping and handling costs be disclosed. Further, if such costs are not presented as part of cost of goods sold, the total amount of costs must be disclosed. If, instead, shipping and handling costs are presented as part of cost of goods sold, the amount of such costs does not have to be disclosed. Only the accounting policy for classifying shipping and handling costs would have to be disclosed. Change the facts: Assume the same facts as Example 1 above except that the company presents the $80,000 of shipping and handling costs as part of cost of goods sold. The disclosure would be changed to look like this:


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NOTE 1: Summary of Significant Accounting Policies: Shipping and Handling Costs: Shipping and handling costs include mailing and fulfillment charges associated with delivery of goods from the company's central warehouse to each customer's designated location. The company's policy is to classify shipping and handling costs as part of cost of goods sold in the statement of income. [amount removed- not required]

Observation: If the shipping and handling costs are presented as part of cost of goods sold, disclosure of the amount of shipping and handling costs is not required. How does the disclosure change if shipping and handling costs are disclosed as a separate line item on the statement of income or presented as part of a schedule of selling and delivery expenses in supplementary information? The fact that the costs are presented on the face of the statement of income would satisfy the disclosure of the amount of shipping and handling costs. However, it would not satisfy the disclosure of the policy. Therefore, a disclosure similar to the above disclosure which presents the policy but excludes the amount of the costs, would be required. If the shipping and handling costs are instead presented in a supplementary schedule of selling and delivery expenses, that fact would not change the disclosure requirement. Anything presented in supplementary information is not part of the body of the financial statements. Therefore, a disclosure would be required that includes the company's policy for classifying shipping and handling costs as part of selling and delivery expenses. Further, because these costs are not classified as part of cost of goods sold, the company would be required to disclose the amount of shipping and handling costs. E. Income Statement Characterization of Reimbursements Received Question: How should an entity account for the reimbursement received for out of pocket expenses incurred? Response: The authority is found in ASC Subtopic 605-45, Revenue Recognition- Principal Agent Considerations, (formerly EITF Issue No. 01-14). ASC 605-45 addresses the accounting for reimbursements received for out-of-pocket expenses incurred, for example, a law or CPA firm charges a client for its expenses. Such expenses include, but are not limited to, expenses related to airfare, mileage, hotel stays, out-of-town meals, photocopies, telecommunications and facsimile charges. The way such expenses are reimbursed vary from company to company. Some companies reimburse the actual amount of expenses while others pay a single flat fee per month. Should such reimbursements be treated as a reduction in expenses or as revenue? ASC 605-45 states that out-of-pocket expenses incurred should be characterized in the income statement as revenue and not as a reduction of expenses incurred. Example: Dewy, Charge and Howe, attorneys at law, bill out expense reimbursements for telephone, travel and courier services to their clients. Specific information follows:


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Revenue from legal services $5,000,000 Expenses incurred: Telephone, travel and courier expenses Expense reimbursements received Other operating expenses

(600,000)

600,000 (2,000,000)

Net income $3,000,000 Conclusion: The Firm must present the $600,000 of out-of-pocket reimbursements as revenue, and not as an expense reimbursement. The presentation should look like the following example:

Revenue from legal services, including reimbursements

$5,600,000* Expenses incurred: Telephone, travel and courier expenses Other operating expenses Total expenses

(600,000)

(2,000,000) (2,600,000)

Net income $3,000,000 * $5,000,000 + $600,000 reimbursement

Observation: ASC 605-45’s approach to presenting reimbursements as revenue continues to be unpopular among constituents on the grounds that it is contrary to most industry practices. That is, most companies record expense reimbursements as a reduction of the related expenses based on the assumption that the company or firm is not in the business of generating revenue from receiving expense reimbursements. Instead, the reimbursements are merely incidental to the primary revenue recognition function. Recording reimbursements as revenue and not as expense reductions is consistent with conclusions reached in other areas. Specifically, in ASC 605, shipping and handling fees billed to customers are classified as part of revenue on the income statement. Moreover, ASC 605 also provides that revenue is recorded gross, rather than net, if certain criteria are met. F. Reporting Revenue Gross Versus Net Question: What are the rules that determine whether revenue related to certain transactions should be presented on a gross or net basis on the income statement? Response: The general authority is found in ASC Subtopic 605-45, Revenue Recognition-Principal Agent Considerations (formerly found in EITF Issue 99-19).20 Specifically, in ASC 605- 45, the FASB states that whether a company should report revenue based on the gross amount billed to a customer or the net amount retained depends on the relevant facts and circumstances. The following factors and indicators should be considered in the evaluation of gross versus net treatment of sales transactions. However, the FASB concluded that none of the following factors, by itself, is presumptive or determinative.

20 In 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers, Principal versus Agent Considerations (Reporting Revenue Gross versus Net). ASU 2016-08 amends previously issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) to address criteria that determine when revenue should be recorded and presented gross or net on the income statement. The changes made by ASU 2016-08 are generally effective for periods beginning after December 15, 2018 (calendar 2019) although there are certain early application provisions. Prior to the effective date of ASU 2016-08, an entity should determine whether revenue is recorded gross or net based on the existing guidance and eight factors found in ASC Subtopic 605-45, Revenue Recognition-Principal Agent Considerations.


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Factors Supporting Gross Revenue

Reporting Factors Supporting Net Revenue Reporting

1. The company is the primary obligor in the arrangement.

The company is responsible for providing the product or service to the customer including fulfillment, acceptability of the product or services ordered or purchased by the customer.

Note: Simply arranging transportation for the product or service is not responsibility for fulfillment. Strength of factor: Strong

1. The supplier (not the company) is the primary obligor in the arrangement.

The fact that the supplier (and not the company) is responsible for fulfillment, (including the acceptability of the product or services ordered or purchased by the customer), may indicate that the company does not have the risks and rewards of ownership.

The terms of the sales contract and other representations (written or otherwise) generally will provide evidence as to whether the company or supplier is responsible for fulfillment.

Strength of factor: Strong

2. The company has latitude in establishing price.

The company has reasonable latitude, within economic constraints, to establish price with the customer.

Strength of factor: Weaker

2. The amount the company earns is fixed.

The company may be considered an agent of the supplier if it earns a fixed dollar amount per customer transaction regardless of the amount billed to the customer, or a stated percentage of the amount billed to the customer.


3. The company has credit risk for the amounts billed to the customer.

The company is responsible for collecting the sales price from the customer.

The company must pay the supplier regardless of whether the sales price is fully collected.

Credit risk is not present if there is a requirement that the company return or refund only the net amount it earned if the transaction is cancelled, or if the company fully collects the sales price prior to the delivery of the product or service to the customer including obtaining authorization of credit card payment in advance of shipment or service performance.


3. The supplier (not the company) has credit risk.

Sales price has not been fully collected prior to delivering the product or service but the supplier is responsible for collecting the sales price from the customer.



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4. The company adds meaningful value by changing the product or performing part of the service.

The company physically changes the product (beyond its packaging) or performs part of the service ordered by the customer.

Value is added to the product or service as evidenced by the selling price of the product or service being increased due to the company's physical change of the product or performance of the service.

Value is not added based on the company's attributes such as marketing skills, market coverage, or reputation.

Strength of factor: Moderate

4. The company generally does not add meaningful value to the product or service.

The company does not make significant changes to the product (beyond its packaging) or does not perform significant service ordered by the customer.


5. The company has discretion in selecting a supplier.

The company is able to select its supplier of the product or service from multiple suppliers.


5. The company generally does not have discretion in selecting a supplier.

The customer or other party may have discretion in selecting a supplier.


6. The company is involved in the determination of product or service specifications.

The company must determine the nature, type, characteristics, or specifications of the product or service ordered by the customer.


6. The company has very little involvement in the determination of product or service specifications. Strength of factor: Moderate


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7. The company has physical loss inventory risk after the customer order or during shipping. Physical loss inventory risk exists if:

title to the product is transferred to the company at the shipping point (e.g., supplier's facilities) and is transferred from the company to the customer upon delivery, or

the company takes title to the product after a customer order has been received but before the product has been transferred to a carrier for shipment.


7. The company has no physical loss inventory risk after the customer order or during shipping. Strength of factor: Weaker

8. The company has general inventory risk before the customer order is placed or upon customer return.

The company maintains product in inventory.

The company takes title before the product is ordered by a customer or will take title if the product is returned by the customer and the customer has the right to return it.


8. The company does not have inventory risk before the customer order is placed or upon customer return.

The company does not take title before the product is ordered.

The company has the right to return unsold products to the supplier or receive inventory price protection from the supplier.

The supplier, and not the company, takes title to product if it is returned by the customer.


The following examples illustrate the application of the gross versus net issue, some of which are published in ASC 605 and have been reformatted by the author. Example 1: Special Furniture Product Orders A reseller of office furniture receives an order for a large quantity of desks with unique specifications. The reseller and the customer develop the specifications for the desks and negotiate the selling price for the desks. The reseller is responsible for selecting the supplier. The reseller contracts with a supplier to manufacture the desks, communicates the specifications, and arranges to have the supplier deliver the desks directly to the customer. Title to the desks will pass directly from the supplier to the customer upon delivery. The reseller never holds title to the desks. The reseller is responsible for collecting the sales price from the customer and is obligated to pay the supplier when the desks are delivered, regardless of whether the sales price has been collected. The reseller extends 30 days payment terms to the customer after performing a credit evaluation. The reseller's profit is based on the difference between the sales price negotiated with the customer and the manufacturer's price. The order contract between the reseller and the


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customer requires the customer to seek remedies for defects from the manufacturer under its warranty. The reseller is responsible for customer claims resulting from errors in specifications. Should the reseller report revenue at the gross amount with the corresponding cost of sales, or at the net amount of the profit earned on the transaction? Conclusion: Revenue from the transaction should be reported at the gross amount earned. Factors that support this conclusion of gross reporting include: 1. The Company is the primary obligor in the arrangement. 2. The Company has complete latitude in negotiating and establishing the selling price for

the desks. Price is variable, not fixed.

3. The Company has credit risk from financing amounts billed to customers as accounts receivable.

4. Because the Company is involved in developing customer specifications, the Company

adds meaningful value to the product. 5. The Company has discretion in selecting a supplier among alternatives. 6. The Company is involved in the determination of product specifications. Factors that support net reporting include: 1. The Company has no physical loss inventory risk during shipping. 2. The Company does not have inventory risk before the customer order. The Company

never takes title to the product. The gross factors out weigh the net factors so that a gross presentation is warranted. Example 2: Travel Discounter Travel Discounter negotiates with major airlines to obtain access to airline tickets at reduced rates compared to the cost of tickets sold directly by the airlines to the public. Travel Discounter determines the price at which the tickets will be sold to its customers and markets the tickets through advertising in newspapers, magazines and the Internet. When marketing and selling tickets to customers, the carrier for a trip is identified. The reduced rate paid to an airline by Travel Discounter for each ticket sale is negotiated and agreed to in advance. Travel Discounter pays airlines only for tickets it actually sells to customers. Customers pay for airline tickets using credit cards with Travel Discounter being the merchant of record. Although credit card charges are pre-authorized, Travel Discounter incurs occasional losses from disputed charges. Travel Discounter is responsible for delivery of the ticket to the customer and bears the risk of physical loss of the ticket while in transit even though the airlines have a procedure for refunding lost tickets. Travel Discounter also assists the customer in resolving complaints with the service provided by the airlines. However, once a customer receives the ticket, the airline is responsible for fulfilling all obligations associated with the ticket, including remedies to a customer for service satisfaction.


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Should the Company report revenue at the gross amount with the corresponding cost of sales, or at the net amount of the profit earned on the transaction? Conclusion: Revenue should be reported at the net amount. Although there are two factors that support a gross presentation, six of the other factors support a net presentation. Factors to support the net reporting: 1. The Company is not the primary obligor from the customer's perspective, but the airline

is. 2. The Company does not have discretion in selecting the supplier (airline) since it may only

suggest a named airline to a customer. The customer has discretion to accept or reject the airline.

3. There is no general inventory risk before the customer order is placed. Tickets are

purchased only as they are sold to customers. 4. The Company does not add meaningful value to the product. 5. The Company does not have physical loss inventory risk during shipping. If a ticket is lost,

the airlines have a procedure for refunding lost tickets. 6. The Company has no involvement in the determination of product specifications. The

airlines are responsible for the specifications. Factors to support the gross reporting: 1. The Company has latitude in establishing price. 2. The Company does have credit risk for collecting amounts charged to credit cards. Observation: Example 2 should be compared with the accounting for revenue of a travel agency. Based on the above factors, many travel agents mishandle the accounting for revenue by recording all revenue on a net basis. The traditional revenue for a travel agency is generated from the agency selling a product for an airline or hotel/cruise and receiving a commission. Clearly, this type of transaction is recorded on a net basis for the amount of commission revenue earned given that most of the eight factors support a net presentation. For example, a travel agency is not the primary obligor in the sale of airline tickets. The agency does not have latitude in establishing price since that responsibility lies with the airlines. There is no credit risk as credit cards are processed by the airlines. These are just a few of the eight factors that support a net presentation of revenue in the sale of airline tickets and most hotels and cruises. But there are also revenue segments within a travel agency that should be recorded at the gross amount. For example, many agencies get involved in group and incentive business whereby they purchase the travel product (e.g., flights, hotel rooms, etc.) directly by signing contracts with the travel vendor and by placing nonrefundable deposits to secure the contracts. Then, the agency earns its profit by reselling the travel product at a profit. It is in this instance that the author believes the factors found in ASC 605 support the conclusion that revenue should be recorded gross. First, the agency is the primary obligor in the arrangement. Second, the agency has full latitude in pricing the product. Third, the agency has credit risk in being responsible for collecting the amount billed from the customer. Fourth, generally the agency has discretion in selecting the supplier such as the hotel or cruise line or even the airline on which the group will travel. Fifth,


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there is general inventory risk before the customer order is placed. That is, if the customer does not purchase the inventory, the agency might be responsible for inventory loss for the unused portion of the inventory. We have just listed five strong factors that support a gross presentation for certain types of group and incentive business. Example 3: Athletic Shoe Store A major Chain of athletic shoe stores obtains 60 percent of its seasonal shoes from an overseas source. The lead time for the order is four months and the selling season lasts three months. The Company takes title to the products upon delivery and is obligated to pay the supplier according to typical industry payment terms. Selling prices for the products are determined exclusively by the Company. As long as the Company devotes at least 20 percent of its advertising budget to the supplier's brands and prices the shoes within 20 percent of the national average price, the company may return for full credit any unsold shoes and any customer returns within 60 days of the end of the season. Sales to customers are by cash or credit card. Should the Company report revenue at the gross amount with the corresponding cost of sales, or at the net amount of the profit earned on the transaction? Conclusion: Revenue should be reported at the gross amount earned. Factors supporting a gross presentation:

1. The Company is the primary obligor to the customer, as the Company is responsible for fulfillment and customer remedies in the event of dissatisfaction.

2. The Company has full latitude in establishing prices even though product pricing may

affect the Company's ability to return goods and exposes it to a greater inventory risk. 3. The Company has credit risk for credit card transactions. 4. The Company has general inventory risk due to taking title to the inventory, although some

of that risk is mitigated by the ability to return the goods to the supplier. 5. The amount earned varies with the selling price. From the example, it is difficult to evaluate the other three factors. However, nothing suggests that any of those factors would favor a net presentation. Consequently, a gross presentation should be used. Pending changes to the gross versus net revenue issue In 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers, Principal versus Agent Considerations (Reporting Revenue Gross versus Net). ASU 2016-08 amends previously issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) to address criteria that determine when revenue should be recorded and presented gross or net on the income statement. ASU 2016-08 provides some general rules:

1. The determination as to whether revenue is recorded gross or net is made separately for each specific good or service.


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2. If an entity is a principal, it records revenue gross, while if the entity is an agent, it records revenue on a net basis.

3. An entity is considered a principal if it controls a specified good or service before it

transfers it to the customer.

4. The ASU offers three Indicators to consider in determining if an entity controls the specified good or service before it is transferred to the customer (and is therefore a principal):

a. The entity is primarily responsible for fulfilling the contract promise to provide the

specified good or service.

b. The entity has inventory risk before the specified good or service has been transferred to a customer, or after transfer of control to the customer (for example, if the customer has a right of return).

c. The entity has discretion in establishing the price for the specified good or service.

5. If any entity does not satisfy the three Indicators, it is likely to be an agent and should

record revenue net with respect to the to consider in determining if an entity controls the specified

The changes made by ASU 2016-08 are generally effective for periods beginning after December 15, 2018 (calendar 2019) although there are certain early application provisions. Prior to the effective date of ASU 2016-08, an entity should determine whether revenue is recorded gross or net based on the existing guidance and eight factors found in ASC Subtopic 605-45, Revenue Recognition-Principal Agent Considerations. G. Cash Received by a Reseller from a Vendor Question: How should consideration received by a reseller from a vendor that is a reimbursement by the vendor for honoring the vendor’s sales incentive offered directly to consumers (e.g., coupons) recorded? Should it be recorded as a reduction of the cost of the reseller’s purchases from the vendor and, therefore, characterized as a reduction of cost of sales, or should it be recorded as revenue. Response: ASC 605-50, Revenue Recognition-Customer Payments and Incentives (formerly EITF Issue No. 03-10), is the authoritative guidance in this area. Manufacturers/vendors often sell products to resellers who then sell those products to consumers or other end users. In some cases, manufacturers/vendors will offer sales discounts and incentives directly to consumers, such as rebates and coupons, in order to stimulate consumer demand for their products. The discount or incentive may be handled in two ways:

Scenario 1: (Vendor’s sales incentive) Reseller handles the coupons and gets reimbursed from the vendor (manufacturer): Because the reseller has direct contact with the consumer, the reseller may agree to accept, at the point of sale to the consumer, the manufacturer’s incentives that are tendered by the consumer (e.g., honoring the manufacturer’s coupons as a reduction to the price paid by consumers and then seeking reimbursement from the manufacturer).


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Scenario 2: Consumer remits coupon directly to manufacturer for reimbursement: Consumer purchasing the product from the reseller but dealing directly with the manufacturer related to the manufacturer’s incentive or discount (such as a mail-in-rebate).

Generally the reseller benefits from the manufacturer’s/vendor’s direct-to-customer incentives through increased sales volume, although the reseller has no control over which consumers or consumer groups participate in the incentive program. Further, because the manufacturer/vendor reimburses the reseller for the value of the discount or incentive provided to the consumer, the reseller’s gross margin on the product is the same regardless of whether or not the consumer purchases the product with the manufacturer’s incentive. ASC 605-50 offers the following example to illustrate the point: Facts: A manufacturer sells cereal to Reseller for distribution to consumers. Manufacturer charges Reseller $3.00 per box. Reseller offers the product to the consumer at a price of $4.00 per box. Manufacturer also offers coupons to consumers that are distributed weekly in the newspapers, that provide a $.50 discount on the purchase of the box of cereal. Result: Regardless of whether the Reseller acts as a clearinghouse for the manufacturer’s coupon (Scenario 1) or the consumer remits the coupon directly to the manufacturer (Scenario 2), the Reseller receives its $4.00 total as follows:

Reseller’s cash collected

Scenario 1: Reseller collects the $.50 coupon from the consumer and remits it to the manufacturer

for reimbursement

Scenario 2: Reseller does not

collect the coupon from the consumer.

Consumer remits the coupon directly to manufacturer for reimbursement

Amount received from consumer $3.50 $4.00

Amount collected from manufacturer upon remitting the $.50 coupon

.50*

0

Total received by reseller $4.00 $4.00

* Excludes any handling fee that may be earned.

For purposes of ASC 605-50, a vendor’s sales incentive offered directly to consumers is limited to a vendor’s incentive that meets the following four criteria:

a. That can be tendered by a consumer at resellers that accept manufacturer’s incentives in partial (or full) payment of the price charged by the reseller for the vendor’s product,

b. For which the reseller receives a direct reimbursement from the vendor (or an authorized

clearing house) based on the face amount of the incentive,


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c. For which the terms of reimbursement to the reseller for the vendor’s sales incentive offered to the consumer must not be influenced by or negotiated in conjunction with any other incentive arrangements between the vendor and the reseller but, rather, may only be determined by the terms of the incentive offered to consumers, and

d. Whereby the reseller is subject to an agency relationship with the vendor, whether

expressed or implied, in the sales incentive transaction between the vendor and the consumer.

Conclusion reached in ASC 605-50: 1. Sales incentive arrangements that meet all of the four criteria described above for a vendor

sales incentive should be recorded as revenue by the reseller.

Using the example noted above, the entry made by the reseller would be as follows:

Cash 4.00 Revenue 3.50 Revenue .50

Cost of sales 3.00 AP, cash, etc. 3.00

Question: How should a cash rebate or refund received by a reseller from a vendor be accounted for by the reseller? Response: ASC Subtopic 605-50, Revenue Recognition states that a rebate or refund of a specified amount of cash consideration that is payable under a binding arrangement only if the customer (reseller) completes a specified cumulative level of purchases or remains a customer for a specified cumulative level of purchases or remains a customer for a specified period of time shall be recognized by the reseller (customer) as a reduction of the cost of sales. The reduction should be recorded using a systematic and rational allocation of the cash consideration offered to each of the underlying transactions that results in progress by the reseller (customer) toward earning the rebate or refund provided the amounts are probable and reasonably estimable. If the rebate or refund is not probable and reasonably estimable, it shall be recognized as the milestone(s) are achieved. Factors that may impair a customer’s ability to determine whether the rebate or refund is probable and reasonably estimable include:

a. The rebate or refund relates to purchases that will occur over a relatively long period

b. There is an absence of historical experience with similar products or the inability to apply such experience because of changes in circumstances

c. Significant adjustments to expected cash rebates or refunds have been necessary in the past

d. The product is susceptible to significant external factors such as technological obsolescence or changes in demand.

Example: For calendar year 20X1, Company X negotiates with a vendor to receive a 5% cash rebate if X achieves $10 million of purchases from the vendor in the calendar year.


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X has a history of achieving the $10 million of purchases from the vendor in the past and it is probable that X will achieve the $10 million milestone in the current year. Conclusion: Because it is probable that X will achieve the $10 million threshold and the amount can be estimated (5% x $10 million), the cash rebate should be recorded as a reduction of cost of sales as each purchase is made during the year toward the $10 million. Assume that in January 20X1, X purchases $500,000 from the vendor. The entry made for the purchase is as follows in January 20X1:

Purchases (cost of sales) 500,000 Accounts payable 500,000 Rebate receivable 25,000 Purchases (cost of sales) 25,000

Change the facts: Assume that in prior years, X has not achieved the rebate threshold for purchases from the vendor and at the beginning of 20X1, it is not probable that X will achieve the $10 million milestone. Conclusion: Because it is not probable that X will achieve the $10 million milestone, X should not record the rebate as each purchase is made. Instead, X should record the rebate only when X achieves the $10 million milestone. Same example: Assume X has purchases during the year of $8 million.

Purchases (cost of sales) 8.000,000 Accounts payable 8,000,000 Rebate receivable 0 Purchases (cost of sales) 0

Assume further that in November 20X1, X makes a purchase in the amount of $3,000,000 which results in the cumulative purchases being $11 million ($8 million plus $3 million) so that X has finally achieved the $10 million milestone. The entry in November 20X1 looks like this:

Purchases (cost of sales) 3,000,000 Accounts payable 3,000,000 Rebate receivable 550,000 Purchases (cost of sales) 550,000 (a)

(a): Cumulative purchases $11 million x 5% = $550,000

Because it was not probable that X would achieve the $10 million milestone, X should record the 5% refund only once X achieves the $10 million milestone. In this case, once X makes the $3 million purchase in November 20X1, X has achieved the $10 milestone and should record a $550,000 refund reflective of 5% of the actual purchases to date ($11 million) because X has a legal right to that $550,000 rebate.


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Once X has achieved the $10 million milestone, X should record the rebate receivable equal to 5% of any subsequent purchases. For example, if X makes another purchase of $1,000,000 in December 20X1, X should record a corresponding $50,000 (5% x $1,000,000) receivable.


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 31. A company has a fire in its warehouse and expects to be reimbursed by its insurance company

for the costs of repairs. At the balance sheet date, the company had not settled the insurance amount with the insurance company. After the balance sheet date, the company receives the insurance check before issuing the financial statements. The amount of insurance check is in excess of the carrying amount of the warehouse. Which of the following is correct: a) a gain should be recorded at the balance sheet date b) a loss should be recorded at the balance sheet date c) a disclosure should be made at the balance sheet date but no entry d) an entry for the loss and a disclosure is required at the balance sheet date

32. Which of the following is correct in terms of how to account for the reimbursement of out-of-

pocket expenses: a) the reimbursement of out-of-pocket expenses should be characterized as

revenue b) the reimbursement of out-of-pocket expenses should be credited to expense c) GAAP is silent as to how to present the reimbursement d) the reimbursement should be presented as a deferred credit on the balance

sheet until the expenses are paid 33. Which of the following factors is a factor to support gross revenue reporting: a) the company is the primary obligor in the arrangement b) the company has limited latitude in establishing the price c) the company adds little value to the product or service d) the company has minimal credit risk related to amounts billed to customers 34. Which of the following factors would support gross revenue reporting over net revenue

reporting: a) the company has credit risk for the amounts billed to the customer b) the company generally does not have discretion in selecting a supplier

c) the company has very little involvement in the determination of product or service specifications

d) the company does not have inventory risk before the customer order is placed or upon customer return

35. Which of the following factors may impair a customer’s ability to determine whether the rebate

or refund is probable and reasonably estimable: a) the rebate or refund relates to purchases that will occur over a relatively short period b) there is significant historical experience with similar products c) insignificant adjustments to expected cash rebates or refunds have been necessary in the

past d) the product is susceptible to significant external factors


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SUGGESTED SOLUTIONS 31. A: Incorrect. GAAP states that the gain is a gain contingency that should not be recorded

until the transaction is settled. Thus, there should be no entry at the balance sheet date.

B: Incorrect. There is no loss on the transaction making the answer incorrect. C: Correct. Disclosure only is required as it is a material transaction. No entry is

permitted under GAAP because the gain is a gain contingency given the fact that the insurance was not settled at the balance sheet date.

D: Incorrect. An entry should not be made because there is a gain (not loss) contingency. Thus the answer is incorrect.

32. A: Correct. GAAP requires the reimbursement to be presented as revenue.

B: Incorrect. GAAP does not permit the reimbursement to be credited to expense making the statement incorrect.

C: Incorrect. GAAP is not silent on the matter. ASC Subtopic 605-45 opines by stating that the reimbursement is presented as revenue.

D: Incorrect. GAAP does not provide for the reimbursement to be presented as a deferred credit on the balance sheet because it is a current expense.

33. A: Correct. Being the primary obligor is a strong factor to support gross revenue

reporting. B: Incorrect. Having latitude (not having limited latitude) in establishing the price is a factor.

C: Incorrect. Adding meaningful value, not little value, is a factor. D: Incorrect. Having credit risk related to amounts billed is a factor. 34. A: Correct. If the company, versus the supplier, is responsible for collecting the sales

price from the customer, gross revenue reporting is supported. B: Incorrect. Not having discretion in selecting a supplier is a factor supports net revenue

reporting and not gross reporting. C: Incorrect. Having very little involvement in the determination of product or service

specifications is a factor that supports net revenue reporting and not gross reporting. D: Incorrect. Having no inventory risk is a factor that supports net revenue reporting and not

gross reporting. 35. A: Incorrect. One factor is that the rebate or refunds relates to purchases that will occur over

a relatively long period, and not a short period. B: Incorrect. One factor is that there is an absence of historical experience, not significant

historical experience with similar products. C: Incorrect. One factor is that there are significant adjustments to expected cash rebates or

refunds, not insignificant ones. D: Correct. One factor is that the product is susceptible to significant external factors,

which is the correct answer.


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H. Depreciation and Amortization 1. Use of MACRS Question: Recently, a company began depreciating newly acquired assets using an accelerated method used for income tax purposes. The company believes that it can justify the useful lives used in MACRS (e.g., 5 and 7 years). May the company use the MACRS method for financial statement purposes? Response: MACRS depreciation may be used for financial statement purposes provided the MACRS lives and methods are reasonable. MACRS is essentially a 150-200% declining balance method for most assets with a straight-line method used for most real property. These methods are reasonable for financial reporting purposes. The useful lives used by MACRS range from 5-7 years for equipment and fixtures to 27½ to 39 years for real property. These lives may or may not be reasonable depending on the economic lives of the related assets. In practice, these lives are generally within acceptable useful lives. There are at least three situations under which MACRS may not be adequate for GAAP: 1. Leasehold improvements that are depreciated over 27½ or 39 years for tax purposes, yet,

for financial statement purposes, depreciated over the useful lives not to exceed the remaining lease term.

2. Depreciation limits on certain "listed" motor vehicles.

3. The section 179 expense deduction and bonus depreciation. If MACRS depreciation is used for GAAP, the following results may occur under the previously noted three scenarios:

Leasehold improvements related to a 10-year lease should not be amortized over 39 years.

Limits on listed motor vehicles may result in understated GAAP depreciation.

The section 179 deduction or bonus depreciation probably results in the acceleration of depreciation.

Assuming the difference is material to the financial statements, these items are not acceptable for GAAP because they do not result in a systematic and rational allocation of depreciation expense. However, a practitioner can bypass all of these limits based on the results not being materially different from a GAAP method. One last point relates to disclosure. If a practitioner can justify using MACRS, reference should not be made to the MACRS method in the notes to financial statements. Instead, the summary of significant accounting policies should disclose the fact that the company uses an accelerated method based upon certain useful lives. This issue has been a common deficiency found in peer review. Are there any options under which a company can still avoid having to maintain two depreciation schedules, one for book and one for tax purposes? Even with the recording of a Section 179 deduction, there still are a few options available.


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1. Record tax depreciation (including the Section 179 deduction and bonus depreciation) for

GAAP based on the argument that the difference is not material. 2. Record tax depreciation for GAAP and note a GAAP departure in the report. 3. Convert to tax basis21 financial statements. Option 1: Depreciation is not material: The difference between tax and GAAP depreciation may not be material even if there is Section 179 depreciation. In making the comparison between tax and GAAP depreciation, the GAAP depreciation can be computed using the most aggressive acceptable lives and methods available, which is usually double (200%) declining balance. If the difference is not material, tax depreciation is acceptable for GAAP. If a company can justify that by using MACRS the difference between the book and tax method is not material, reference should not be made to the MACRS method in the notes to financial statements. Instead, the summary of significant accounting policies should disclose the fact that the company uses an accelerated method based upon certain useful lives. Example:

NOTE X: Plant and Equipment Plant and equipment is stated at cost. Depreciation is computed using accelerated methods based on the following estimated useful lives:

Life in Years

Motor vehicles 5 Machinery and equipment 7 Leasehold improvements 39 Building 39

Observation: The above sample footnote illustrates a situation in which the company is using tax depreciation for GAAP because the GAAP-tax depreciation difference is not material. In such a case, the footnote should not reference the use of MACRS. Instead, reference should be made to the fact that “accelerated methods” are used. Option 2: Record the tax depreciation for GAAP and note a GAAP departure in the report: For some smaller companies, it may be prudent to record tax depreciation for GAAP purposes even if it violates GAAP. If the difference between tax and GAAP depreciation is material, the accountant can indicate a GAAP departure in his or her report. In most cases, the departure will not be a concern for third-party users. The report would look like this:

21 SSARS No. 21 changes the term "income tax basis” to "tax basis" under the new definition of a special purpose

framework. The change is effective for years ended on or after December 15, 2015.


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Compilation Report-SSARS No. 21: Using Tax Depreciation for GAAP

Management is responsible for the accompanying financial statements of XYZ Company, which comprise the balance sheet as of December 31, 20XX and the related statements of income, changes in stockholder’s equity, and cash flows for the years then ended, and the related notes to the financial statements in accordance with accounting principles generally accepted in the United States of America. I (We) have performed a compilation engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. I (we) did not audit or review the financial statements nor was (were) I (we) required to perform any procedures to verify the accuracy or completeness of the information provided by management. Accordingly, I (we) do not express an opinion, a conclusion, nor provide any form of assurance on these financial statements. Generally accepted accounting principles require that fixed assets be depreciated over their useful lives in a systematic and rational manner. Management has informed us that the Company has computed depreciation in accordance with methods required for federal income tax purposes which do not result in an allocation of depreciation over the assets’ estimated useful lives. The effects of this departure from generally accepted accounting principles on the Company’s financial position, results of operations, and cash flows have not been determined.

James J. Fox & Company LLP Burlington, Massachusetts March 18, 20X1


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Review Report- SSARS No. 21: Using Tax Depreciation for GAAP

Independent Accountant’s Review Report

Board of Directors XYZ Company I (we) have reviewed the accompanying financial statements of XYZ Company, which comprise the balance sheet as of December 31, 20XX, and the related statements of income, changes in stockholders’ equity, and cash flows for the year then ended, and the related notes to the financial statements. A review includes primarily applying analytical procedures to management’s (owners’) financial data and making inquiries of company management (owners). A review is substantially less in scope than an audit, the objective of which is the expression of an opinion regarding the financial statements as a whole. Accordingly, I (we) do not express such an opinion. Management’s Responsibility for the Financial Statements Management (owners) is (are) responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement whether due to fraud or error. Accountant’s Responsibility My (our) responsibility is to conduct the review engagements in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the American Institute of Certified Public Accountants. Those standards require me (us) to perform procedures to obtain limited assurance as a basis for reporting whether I am (we are) aware of any material modifications that should be made to the financial statements for them to be in accordance with accounting principles generally accepted in the United States of America. I (We) believe that the results of my (our) procedures provide a reasonable basis for our report. Accountant’s Conclusion Based on my (our) reviews, except for the issue noted in the Known Departure From Accounting Principles Generally Accepted in the United States of America paragraph, I am (we are) not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in accordance with accounting principles generally accepted in the United States of America. Known Departure From Accounting Principles Generally Accepted in the United States of America As disclosed in Note X to the financial statements, accounting principles generally accepted in the United States require that fixed assets be depreciated over their useful lives in a systematic and rational manner. Management has informed us that the Company has computed depreciation in accordance with methods required for federal income tax purposes which do not result in an allocation of depreciation over the assets’ estimated useful lives. The effects of this departure from generally accepted accounting principles on the Company’s financial position, results of operations, and cash flows have not been determined. James J. Fox & Company LLP Burlington, Massachusetts March 18, 20X1


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Audit Report: Using Tax Depreciation for GAAP

Independent Auditor’s Report

Board of Directors XYZ Company We have audited the accompanying financial statements of XYZ Company, which comprise the balance sheet as of December 31, 20XX, and the related statement of income, retained earnings, and cash flows for the year then ended, and the related notes to the financial statements. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified audit opinion. Basis for Qualified Opinion As more fully described in Note X to the financial statements, the Company has computed depreciation in accordance with methods required for federal income tax purposes which does not result in an allocation of depreciation over the assets’ estimated useful lives. In our opinion, generally accepted accounting principles require that fixed assets be depreciated using methods and lives that result in a systematic and rational allocation of the asset cost over future periods. The effects of this departure from generally accepted accounting principles on financial position, results of operations, and cash flows have not been determined.


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Qualified Opinion In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of XYZ Company as of December 31, 20XX, and the results of its operations and its cash flows for the year then ended in accordance with accounting principles generally accepted in the United States of America. James J. Fox & Company LLP Burlington, Massachusetts March 18, 20X1

If tax depreciation is used for GAAP and a report exception is noted, the footnote should explain the departure and the method and lives used as follows: NOTE X: Plant and Equipment Plant and equipment: The Company has computed depreciation in accordance with methods required for federal income tax purposes which do not result in an allocation of depreciation over the assets’ estimated useful lives. Generally accepted accounting principles require that fixed assets be depreciated using methods and lives that result in a systematic and rational allocation of the asset cost over future periods. The effects of this departure from generally accepted accounting principles on financial position, results of operations, and cash flows have not been determined. Plant and equipment is stated at cost. Depreciation is computed using accelerated methods authorized under the Internal Revenue Code based on the following recovery periods:

Recovery period

(in years)


In accordance with the Internal Revenue Code, the Company records additional depreciation in the year of acquisition of certain assets. In 20XX, the Company recorded additional first-year depreciation in the amount of $100,000. After deducting first-year depreciation, the remaining cost is depreciated using the recovery periods noted above.


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Option 3: Convert to tax-basis22 financial statements: Use of tax-basis financial statements is becoming more popular as differences between financial statement and tax return items become more pronounced. A key and common example of this difference is book and tax depreciation in light of section 179 and bonus tax depreciation. For smaller businesses that have material differences in depreciation methods and wish to avoid the complexity of maintaining two depreciation schedules, a viable solution is to convert to tax-basis financial statements. In doing so, depreciation is computed using the tax method, which includes the section 179 and bonus depreciation deduction, and MACRS depreciation. When using tax-basis financial statements, the depreciation footnote looks like this: NOTE X: Plant and Equipment Plant and equipment: Plant and equipment is stated at cost. Depreciation is computed using accelerated methods authorized under the Internal Revenue Code based on the following recovery periods:

Recovery period

(in years)


In accordance with the Internal Revenue Code, the Company records additional depreciation in the year of acquisition of certain assets. In 20X2, the Company recorded additional first-year depreciation in the amount of $100,000. After deducting first-year depreciation, the remaining cost is depreciated using the recovery periods noted above. 2. Disclosure of Depreciation Expense Question: FASB ASC 360, Property, Plant and Equipment (formerly APB No. 12) states that the financial statements should disclose depreciation expense. Does "expense" mean the total provision of depreciation (which may be included in several accounts including inventories) or only the portion presented on the income statement? Response: Practice varies. In general, depreciation should consist of the total depreciation provision (e.g., credit to accumulated depreciation) rather than the portion presented on the income statement. 3. Amortization of Leasehold Improvements Question: A company pays for the costs of leasehold improvements for one of its retail stores. The company's lease has five years remaining with a right to exercise another five-year option. The improvements have a useful life of 15 years. Over what period should the company amortize the leasehold improvements?

22 SSARS No. 21 changes the term "income tax basis” to "tax basis" under the new definition of a special purpose

framework. The change is effective for years ended on or after December 15, 2015.


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Response: The leasehold improvements should be amortized over their useful life, not to exceed the remaining lease term, because the improvements will revert to the lessor at the end of the lease. The question is what is the remaining lease term: five or ten years? The answer is based on whether the company plans on exercising the option. If yes, the remaining lease term is ten years, not five. If the entity is not sure whether the option will be exercised, the option life should not be considered and, the remaining lease term is five years. Therefore, the improvements will be amortized over five years (the lesser of the lease term (five years) and the useful life (15 years). 4. Leasehold Improvements: Retail Store Question: Old Foods, Inc. is a chain of six retail food stores. Its year end is December 31, 20X1. On July 1, 20X1, the board votes to close Store #1 effective at the end of its lease on June 30, 20X2. The company expects to move only fixtures from Store #1 to be used in other stores. All leasehold improvements will remain with the owner of the building. At July 1, 20X1, the leaseholds have a remaining book value of $600,000 and a remaining life of 10 years (the remaining life of the options). If the company knows it will close the store within a year, should leaseholds continue to be amortized over 10 remaining years or the one year period? Response: Because the company knows it will lose the future benefits of the improvements effective June 30, 20X2, the remaining useful life of those improvements is one year. Therefore, starting on July 1, 20X1, the book value of the improvements ($600,000) should be amortized over the remaining one-year period at $50,000 per month. This change in the estimated useful life of the asset is considered a change in accounting estimate in accordance with ASC 250, Accounting Changes and Error Corrections (formerly FASB No. 154). Such a change is handled prospectively. No retroactive restatement nor cumulative effect of a change is required. 5. Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination23 Question: What is the amortization period for leasehold improvements acquired in a business combination? Response: ASC 840, Leases (formerly found in EITF Issue No. 05-6), states that leasehold improvements acquired in a business combination should be amortized over the shorter of the useful life of the assets or the term that includes reacquired lease periods and renewals that are deemed to be reasonably assured at the date of acquisition. The rule does not apply to 1) amortization of intangible assets that may be recognized in a business combination for the favorable or unfavorable terms of a lease relative to market prices, and 2) preexisting leasehold improvements. Note: ASB ASC 840, Leases, requires that a lessee determine the lease term at the inception of a lease. A lease term is a fixed noncancelable term of the lease plus all periods covered by bargain renewal options or for which failure to renew the lease imposes a penalty on the lessee in such an amount that a renewal appears to be reasonably assured.

23 In 2016, the FASB issued ASU 2016-02, Accounting for Leases. For non-public entities, the ASU amends ASC 840, Leases effective for years beginning after December 15, 2019 (calendar year 2020). Because the changes made by ASU 2016-02 are not effective for several years, the author has not addressed its changes in this course.


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Once the lease term is determined, an entity can classify the lease as either capital or operating, and the period over which to recognize straight-line rents. Amortization of capital leases: ASC 840 requires that assets recognized under capital leases be amortized in a manner consistent with the lessee’s normal depreciation policy except that the amortization period is limited to the lease term (including renewal periods that are reasonably assured). That is, the lessee does not expect to receive any economic benefits from those leased assets in periods that are not reasonably assured of renewal. Leasehold improvements related to operating leases: ASC 840 does not address the amortization of leasehold improvements related to operating leases. Consequently, in practice, most entities follow the guidance found in ASC 840 related to amortization of capital leases as follows:

“Amortize the leaseholds in a manner consistent with the lessee’s normal depreciation policy except that the amortization period should be the lease term (including renewal periods that are reasonably assured).”

ASC 840 states that the lease term for purposes of lease classification cannot be changed unless either a) the provisions of the lease are modified in a manner that results in the lease being considered a new agreement, or b) the lease is extended or renewed beyond the existing lease term. In practice, questions have arisen as to whether the amortization period for leasehold improvements that are placed in service significantly after and not contemplated at or near the beginning of a lease can extend beyond the lease term that was determined at the lease inception. Moreover, a similar question has arisen about leases assumed in a business combination. ASC 840 requires that the acquiring entity retain the lease classification used by the acquired entity, unless certain conditions are satisfied. Therefore, questions have been raised as to whether the amortization period for leasehold improvements acquired in a business combination can extend beyond the lease term that was determined by the acquiree at lease inception. Question: What is the amortization period of leasehold improvements (related to an operating lease) that are placed in service significantly after and not contemplated at the beginning of the lease term? Response: ASC 840 gives guidance on the amortization period for leasehold improvements in operating leases that are placed in service significantly after the beginning of the initial lease term and not contemplated at the beginning of the lease term. Leasehold improvements that are placed in service significantly after and not contemplated at or near the beginning of the lease term should be amortized over the shorter of the useful life of the assets or the term that includes reacquired lease periods and renewals that are deemed to be reasonably assured at the date the leasehold improvements are purchased. I. Other Expense and Income Items 1. Expenses Taxable to Employees Question: A company includes the fair value of the use of an automobile in the W-2 of its employees. Should this amount be included as compensation expense on the income statement?


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Response: No. The fair value included in the W-2 has nothing to do with the company's automobile expense and is merely a tax compliance requirement. Automobile expense should include the amounts that the company actually incurred during the period in connection with operation and maintenance of its automobile, regardless of whether any portion, if any, of the amounts is included in an employee’s W-2. The amounts incurred by the company in operation and maintenance of its automobile should remain classified as automobile expense and should not be reclassified to compensation expense. 2. Accrual of Audit Fee Question: An accountant audits the financial statements of a company for the year ended December 31, 20X1. The entire audit is conducted in February 20X2. Should the audit fee be accrued in the December 31, 20X1 financial statements? Response: No. The audit fee was incurred in 20X2. Therefore, it should be accrued with the related expense in 20X2, not 20X1, although, a certain amount may be accrued in 20X1 for any planning work performed in 20X1. As a practical point, if the accrual is recorded consistently from year to year, the effect on net income should be insignificant assuming the fee remains consistent. The impact on the balance sheet is an overstatement of current liabilities which may or may not be material. 3. Life Insurance Proceeds Question: Fragile Phil, president of Fatty Foods Inc., dies. The controller is saddened by his death, yet joyful because he paid the recent invoice on the $1 million key-man life insurance policy, insuring Phil's life. The company receives the check for $1 million and is not sure how to present it on the income statement. How should the $1 million be presented on the income statement? Can it be presented as an extraordinary item? Response: ASC 225, Income Statement (formerly APB No. 30), provides general guidance on how to present certain transactions on the income statement. In January 2015, the FASB issued ASU 2015-01: Income Statement—Extraordinary and Unusual Items (Subtopic 225-20) Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items. The ASU does the following for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. 1. It states that transactions are no longer classified as extraordinary on the income statement

regardless of whether they satisfy the unusual nature and infrequency of occurrence criteria. 2. It retains the definitions previously used to classification a transaction as an extraordinary

item: unusual nature and infrequency of occurrence.

Unusual nature: The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates.


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Infrequency of occurrence: The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates.

3. The ASU states that: a. A material event or transaction that an entity considers to be of an unusual nature or of a

type that indicates infrequency of occurrence or both shall be reported as a separate component of income from continuing operations.

b. The nature and financial effects of each event or transaction shall be presented as a

separate component of income from continuing operations or, alternatively, disclosed in notes to financial statements.

The requirement is that one or both of the criteria be satisified in order for the transaction to be presented as a separate component of income from contuing operations. Again, under no circumstances is the item presented as extraordinary as that classification no longer exists. Using the above example, it would appear that the $1 million life insurance received would not satisfy the unusual nature criterion but probably satisfies the infrequency of occurrence criterion. After all, Phil can only die once. The transaction satisfies at lease one of the two criteria. Therefore, the $1 million should be presented as a separate component of income from continuing operations. Following is an example of how to present it on the income statement.

Net operating income

$XX

Other income: Proceeds from Life insurance (1)

XX

Income from continuing operations before income taxes

$XX

Income taxes XX Income from continuing operations XX

Discontinued operations (net of taxes of $XX)

(XX)

Net income

$XX

4. Free Rent Under Lease Arrangement Question: A company enters into a lease agreement whereby it will pay monthly lease payments as follows. The lease is an operating lease.

Year Annual

1 2 3 4 5

Total rent

Free rent

$100,000 120,000 180,000 200,000

$600,000


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How should the rent be accrued during the lease term? Response: This situation is common particularly during difficult economic times when lessors are willing to provide additional concessions to entice lessees. ASC 840, Leases (formerly part of FASB ASC 840), state the following: “If rental payments are not made on a straight-line basis, rental expense nevertheless shall be recognized on a straight-line basis.” Because the lease payments are not made on a straight-line basis over the lease term, the total rent expense of $600,000 should be accrued and recorded as rent expense on a straight-line basis over the entire five year period, including the first year of free rent. Thus, regardless of the lease payments, each year the company shall make the following entry: Years 1-5:

Annual accrual: Rent expense 120,000 Accrued rent 120,000*** Payments: Accrued rent XX Cash XX

*** Total rent $600,000 / 5 years = $120,000 per year.

Note: The lessor should handle the transaction in a manner that is similar to the lessee. Author's observation: In practice, many practitioners miss this issue and forego any rent expense in year one. The theory behind this straight-line method is that the transaction should be viewed as a one-time frame of five years, rather than five individual periods. Notice also that this would not be the case if the lease were a tenancy-at-will arrangement, under which expense would be recorded from year to year based on the current rental payments due. 5. Accounting for Subleases Question: A company subleases one half of its leased warehouse. The sublease did not alter the original lease between the company and the owner of the property. Should the sublease proceeds be netted against the lease payments or should each be presented on a gross basis on the income statement? Response: In accordance with ASC 840, Leases, (formerly FASB No. 13), the transaction should be accounted for as two separate leases, with each separately tested to determine whether it is an operating or capital lease. Assuming each is an operating lease, the rental income from the sublease should be presented as rental income with the rental payments on the original lease accounted for as rent expense. 6. Deferral of Rental Expense Until Occupancy Question: An entity enters into a three-year lease agreement. The entity is prevented from occupying the premises for the first three months while alterations are made. Should the lease payments for the first three months be deferred until the entity occupies the premises?


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Response: In general, rent expense under an operating lease should be recorded from the date the lessee takes possession of or controls the physical use of the property. Usually, the entity takes control only after it receives a certificate of occupancy. Thus, it would appear that the entity should defer the three months of lease payments and charge them to expense over the remaining lease term of 33 months. 7. Accounting for Rental Costs Incurred During a Construction Period Question: Should rental costs associated with ground and building operating leases that are directly related to a leased asset be capitalized as rental costs incurred during the construction period? Response: ASC 840-20-25, Operating Leases- Rent Expense During Construction, provides that:

1. Rental costs incurred during and after a construction period are for the right to control the use of a leased asset during and after construction of a lessee asset.

2. There is no distinction between the right to use a leased asset during a construction period

and the right to use that asset after the construction period. 3. Rental costs associated with ground or building operating leases that are incurred during

a construction period shall be recognized as rent expense and shall be included as part of income from continuing operations and shall not be capitalized.

Question: Over what period should the total rent be allocated and how should it be allocated? Response: In some lease arrangements, a lessee may take possession or be given control of leased property before it commences operations or makes rental payments under the terms of the lease. The leased property may include land and buildings. During this period, the lessee has the right to use the leased property and does so for the purpose of constructing a lessee asset, such as leasehold improvements. After construction is completed, the lessee commences operations and is required to make rental payments under the terms of the lease. Alternatively, some lease arrangements require the lessee to make rental payments when the lessee takes possession or is given control of the leased property. ASC 840-20, Operating Leases, provides the following rules in determining the period of time over which to allocate rent expense and the method by which to allocate it.

1. Rental payments by the lessee, including the escalated rents, shall be recognized as rental expense by the lessee on a straight-line basis starting with the beginning of the lease term.

a. The lease term begins when the lessee has the right to control the use of the leased

property which is the equivalent of having physical use of the property. 2. If the lessee controls the use of the lease property, recognition of rental expense shall not

be affected by the extent to which the lessee actually uses that leased property. Note: The above rules also apply to the lessor in recording rental income.


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Example: Company X enters into a five-year operating lease that begins July 1, 20X6 through June 30, 20X11. Monthly payments are due in the amount of $10,000 per month starting July 1, 20X6. Total rent for the lease term is $600,000 ($10,000 x 60 months). X is given control of the leased premises on January 1, 20X6 so that X can construct a building on it. During the period January 1, 20X6 through June 30, 20X6, X constructs a building at a cost of $500,000. Conclusion: The lease cost in the amount of $600,000 should be allocated over 66 months, not 60 months, for the period January 1, 20X6 though June 30, 20X11. The reason is because ASC 840-20 requires rental cost to be allocated to rent expense on a straight-line basis over the lease term, which begins when the lessee takes possession or is given control of the leased property. Thus, starting January 1, 20X6, rent expense is recorded at $9,091 per month ($600,000/66 months = $9,091).

Rent expense 9,091 Accrued rent 9,091

For the period January 1, 20X6 to June 30, 20X6, the company incurs $54,546 of rental payments ($9,091 x 6 months = $54,546). Although X has incurred $500,000 of construction costs to construct the building, it must expense the $54,546 of rental payments. Further, there is no distinction between the right to use the asset during the construction period and the right to use it after the construction period. Thus, the rent expense is not capitalized as part of construction in progress costs. Observation: For tax purposes, such costs would be capitalized under Section 263A of the Internal Revenue Code. 8. Start-Up Costs Question: How should start-up costs be accounted for? Response: ASC 720, Other Expenses (formerly SOP 98-5) requires start-up costs to be expensed, rather than capitalized. The expensing of start-up or organization costs is different than the tax treatment which calls for such costs to be capitalized and amortized over 60 months. Start-up costs, sometimes referred to as organization costs, represent one-time costs incurred to:

Open a new facility

Introduce a new product or service

Conduct business in a new territory

Conduct business with a new class of customer or beneficiary


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Example: A manufacturer who does all of its business with retailers attempts to sell merchandise directly to the public.

Initiate a new process in an existing facility

Commence some new operation

Organize a new entity (organization costs)

Activities are start-up costs regardless of the terms used such as preopening costs, pre-operating costs, and organization costs. Costs outside the scope of start-up costs under ASC 720 should be capitalized or expensed based on the requirements of other accounting principles. Start-up costs exclude:

Activities related to routine, ongoing efforts to refine, enrich, or otherwise improve upon the qualities of an existing product, service, process, or facility

Activities related to a merger or acquisition and to ongoing customer acquisition

Costs covered by ASC 720-45, Other Expenses-Business and Technology Reengineering (formerly EITF No. 97-13)

Costs incurred related to ongoing customer acquisition that are covered in ASC 310-10, Receivables- Other, such as policy acquisition costs and loan origination costs

Note: The one-time efforts to establish a new business with an entirely new class of

customers is covered as part of start-up costs; however, ongoing customer acquisition costs are not covered.

Costs of acquiring or constructing long-lived assets and getting them ready for their intended uses

Costs of acquiring or producing inventory

Costs of acquiring intangible assets

Costs related to internally developed assets (e.g., internal-use computer software costs)

Costs that are within the scope of research and development

Costs that are within the scope of ASC Subtopic 980-10, Regulatory Operations (formerly FASB No. 71)

Costs of fund raising incurred by not-for-profit organizations

Costs of raising capital such as refinancing costs

Costs of advertising that are covered by ASC 340 (formerly SOP 93-7)


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Precontract costs incurred in connection with existing contracts as per ASC 605-35, Revenue Recognition- Construction-Type and Production-Type Contracts.

Note: The costs of using long-lived assets, intangibles, or internal-use computer software costs that are allocated to start-up activities such as depreciation of computers, amortization of patents or internal-use software are covered by ASC 720.

Rules for start-up costs under ASC 720: 1. Costs of start-up activities, including organization costs, should be expensed as incurred. Observation: For many closely held businesses, the rule of ASC 720 is a nuisance in that the costs are now expensed for GAAP but continue to be capitalized and amortized for tax purposes. The result is that the company must keep track of an M-1 item and, if material, must set up deferred income taxes on the book-tax temporary difference. The author believes that in those cases where start-up costs are not material, it would not be unreasonable to capitalize and amortize them for GAAP as well as tax. Although this treatment is in violation of ASC 720, the accountant can take the position that by capitalizing and amortizing the costs, the difference is not material. Thus, no report modification (e.g., GAAP exception) would be needed. 9. Disclosure of 401(k) Plan Contributions Question: Are companies required to make disclosures about 401(k) plans? Response: Yes. Companies are required to disclose their 401(k) plans in accordance with ASC 715-70, Compensation-Retirement Benefits-Defined Contribution Plans (formerly FASB No. 132). For GAAP purposes, all pension plans that are not defined benefit plans are considered defined contribution plans. Thus 401(k) and profit sharing plans are considered defined contribution plans. ASC 715-70 has trimmed down the disclosures for defined contribution plans (including 401(k) plans) to limit the information included in such disclosures. Specifically, ASC 715-70 requires disclosure of the following for defined contribution plans, including 401(k) plans:

1. Defined contribution plan disclosures should be shown separate from those relating to defined benefit plans.

2. Defined contribution plan disclosures shall include the following components:

a. Amount of pension cost separate from any cost associated with defined benefit plans.

b. Description of the nature and effect of any significant changes during the period

affecting comparability.

Examples: Rate of employer contributions, business combination, or a divestiture. Note: A description of the defined contribution plan, including groups covered, basis for determining contributions, etc. is not required by ASC 715-70. However, the ASC encourages entities to include this information. Examples of disclosures follow:

Note X: Defined Contribution Plan


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The company sponsors a defined contribution retirement plan covering substantially all of its employees in both its chemical and automotive subsidiaries. The company’s contributions and cost are determined annually as 1.5 percent of each covered employee’s salary. Total pension cost relating to the defined contribution plan was $569,000 in 20XX. Note X: Profit-Sharing Plan The company sponsors a profit-sharing retirement plan. In accordance with the Plan, all employees, exclusive of those covered by collective bargaining agreements, are eligible to enter the Plan within one year of the commencement of employment. Contributions by the company are discretionary and total retirement plan expense was $xx in 20XX. Note X: 401(k) Plan:- Employer Contribution is Fixed The company sponsors a retirement plan authorized by section 401(k) of the Internal Revenue Code. In accordance with the Plan, all employees are eligible to participate in the Plan after one year of full-time employment. Each employee can contribute a percentage of compensation up to a maximum of $xx per year with the company contributing 50% of each employee’s contributions. Total retirement plan expense was $xx in 20XX. Note X: 401(k) Plan:- Employer Contribution is Discretionary The company sponsors a retirement plan authorized by section 401(k) of the Internal Revenue Code. In accordance with the Plan, all employees are eligible to participate in the Plan after one year of full-time employment. Each employee can contribute a percentage of compensation up to a maximum of $xx per year. Company contributions are discretionary. Total retirement plan expense was $xx in 20XX.

Observation: In the above examples relating to defined contribution plans (including profit-sharing and 401(k) plans), the language shown in italic is optional. This means that, technically speaking, a company is only required to disclose the retirement plan expense. The author believes that most companies should continue to include the optional language describing the plan and who is covered. The only other disclosure requirement for a defined contribution plan is that a description of the nature and effect of any significant changes during the period affecting comparability such as the rate of employer contributions, business combination, or a divestiture. Question: Is the company required to include a disclosure of its 401(k) plan if it does not contribute to the Plan (e.g., there is no pension expense)? Response: Today, in light of the weak economic climate, many companies have decided to eliminate the employer matching of 401(k) contributions. Under such a scenario, employees make their contributions to the Plan with no employer matching, resulting in no pension expense being recorded by the employer company. Because the employer no longer contributes to the plan, there is no pension expense to disclose for the current year even though, there may be some expense for the prior year that is presented comparatively. Therefore, in the year of transition from contributing to not contributing to the plan, the company still may be required to disclose pension expense for the prior comparative year for which there were contributions.


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Further, in the year of conversion to no contributions, it would appear that disclosure must be made as follows:

“A description of the nature and effect of any significant changes during the period affecting comparability such as the rate of employer contributions, business combination, or a divestiture.”

Because the company is making a “significant change” in the rate of contributions, it would appear that the company must disclose the fact that it is changing its policy from contributing to not contributing to the plan. After the transition year, no further disclosure would be required. Example: Starting in 20X3, Company X no longer contributes to the Company’s 401(k) plan although the plan is still alive and many employees contribute on their own behalf. For 20X2, the Company did contribute $100,000. Comparative statements for 20X3 and 20X2 are presented. Conclusion: In the 20X3 financial statements, X should include a 401(k) footnote that presents the following: 1. Pension expense for 20X2 of $100,000. (There is no expense for 20X3.) 2. A description of the nature and effect of any significant changes during the period affecting

comparability of the rate of employer contributions.

A sample footnote for 20X3 looks like this. Optional language is in italic while required language is in bold type.

NOTE X: 401(k) Plan: The company sponsors a retirement plan authorized by Section 401(k) of the Internal Revenue Code. In accordance with the Plan, all employees are eligible to participate in the Plan after one year of full-time employment. Each employee can contribute a percentage of compensation up to a maximum of $xx per year. Employer contributions are made at the sole discretion of the company. Starting in 20X3, the Company changed its policy of making contributions under which it chose not to contribute to the plan. The Company may elect to change its policy in the future. Total pension expense was $0 in 20X3 and $100,000 in 20X2.

Starting in 20X4, assuming the company continues with its new policy of not contributing to the plan, no disclosure is required. The reason is because there is no change in the policy from 20X3 to 20X4, and there is no pension expense for either year. If, in a future year, the company reinstitutes a policy of contributing to the plan, a disclosure would be required identifying the fact that the policy has changed, and, the amount of pension expense in the year of the change.


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 36. Which of the following is a common deficiency found in peer review:

a) the use of MACRS b) lack of reference of the use of the MACRS method in the notes to the financial statements c) lack of disclosure in the significant accounting policies of the use of an accelerated method

based upon certain useful lives d) the use of MACRS when the difference between the book and tax method is not material

37. Which of the following is correct as it relates to disclosure of depreciation:

a) depreciation disclosed is limited to depreciation expense on the income statement b) depreciation disclosed should be the total depreciation provision c) depreciation disclosed is limited to that portion of depreciation presented in cost of sales d) GAAP does not require a disclosure of depreciation

38. Leasehold improvements should be amortized for GAAP purposes:

a) over 39 years b) over their useful life c) over their useful life not to exceed the remaining lease term d) over their remaining lease term

39. Which of the following is true regarding the lease term under ASC 840 (formerly FASB No.

13): a) the lease term for purposes of lease classification cannot be changed b) the lease term for purposes of lease classification cannot be changed if the provisions of

the lease are modified in a manner that results in the lease being considered a new agreement

c) the lease term for purposes of lease classification can be changed if the lease is extended or renewed beyond the existing lease term

d) the lease term can be changed if the entity makes an appropriate disclosure 40. The money received from a life insurance policy due to the death of the company president

should be recorded on the income statement as: a) an extraordinary item b) a separate item as part of income from continuing operations c) gross revenue d) no entry. the proceeds should not be included on the income statement

41. Which of the following is correct. Rent expense under an operating lease should be recorded

from the __________________________. a) date the lessee signs the lease b) date the lessee takes possession of or controls the physical use of the property c) date the previous lessee vacates the premises d) date the first payment is made

42. Which of the following are not start-up costs:

a) costs incurred related to ongoing customer acquisition


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b) costs incurred to open a new facility c) costs incurred to conduct business in a new territory d) costs incurred to initiate a new process in an existing facility

43. Which of the following is a disclosure required for defined contribution plans:

a) description of the plan b) description of employees covered by the plan c) amount of pension cost d) actuarial present value of benefits


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SUGGESTED SOLUTIONS

36. A: Incorrect. The use of MACRS is not in itself a common deficiency found in peer review. B: Incorrect. Reference should not be made to the MACRS method in the notes to the

financial statements, so the lack of such reference would not be a deficiency. C: Correct. The failure to reference that a company uses an accelerated method of

depreciation (instead of using the term MACRS) is a common deficiency found in peer review.

D: Incorrect. If a practitioner can justify that by using MACRS the difference between the book and the tax method is immaterial, then MACRS is permitted. Thus, in this case, due to the immateriality of the item, there would be no deficiency.

37 A: Incorrect. Depreciation should consist of the total depreciation provision and not limited

to that portion of depreciation presented on the income statement. B: Correct. The total depreciation provision consisting of the credit to accumulated

depreciation should be disclosed. C: Incorrect. Depreciation is not limited to the portion presented in cost of sales making the

answer incorrect. D: Incorrect. GAAP does require a disclosure of depreciation making the statement incorrect.

38. A: Incorrect. The amortization period is not a specific number of years. The 39-year life is

generally a tax life and not a standard useful life for GAAP. B: Incorrect. The useful life, by itself, is not the correct amortization period. Under GAAP,

the useful life may not exceed the lease term making the answer incorrect. C: Correct. Since the improvements will revert to the lessor at the end of the lease, the

leasehold improvements should be amortized over their useful life not to exceed the remaining lease term.

D: Incorrect. If the lease term is longer than the useful life, the amortization period should be limited by the useful life. Thus, the answer is incorrect.

39. A: Incorrect. There are exceptions to the rule that the lease term cannot be changed for

purposes of lease classification. Thus, the answer is incorrect. B: Incorrect. GAAP provides that the lease classification can be changed if the provisions of

the lease are modified in a manner that results in the lease being considered a new agreement. Thus, the answer is incorrect.

C: Correct. One of the exceptions to the rule that the lease term cannot be changed for purposes of lease classification, is if the lease is extended or renewed beyond the existing lease term.

D: Incorrect. GAAP does not provide for the lease term being changed simply by making an appropriate disclosure. Thus, the answer is incorrect.

40. A: Incorrect. The new rules provide that transactions are no longer presented as

extraordinary on the income statement, making the answer incorrect. B: Correct. The new rules provide that a transaction that satisfies both or either of the

unusual nature and infrequency of occurrence criteria is presented as a separate item as part of income from contuing operations.

C: Incorrect. Because the income is not received as a normal part of doing business, it should not be included in gross revenue, but instead in other income or a similar category.

D: Incorrect. The insurance proceeds should be included on the income statement under GAAP because it represents an inflow of cash. Thus, the answer is incorrect.

41. A: Incorrect. Rent expense should not be from the date the lease is signed because the

tenant do not necessarily have possession of the lease premises at the time of signing.


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B: Correct. In general, rent expense should be recorded from the date the lessee takes possession of or controls the physical use of the property.

C: Incorrect. There is no correlation between the date on which the previous lessee vacates the premises and the recording of rent expense by the new lessee. The key date is the date on which the tenant takes possession of the premises which may be after the date that the previous lessee vacates the premises.

D: Incorrect. Rent expense is not based on cash payments for rent, making the answer incorrect.

42. A: Correct. The one-time efforts to establish a new business with an entirely new class

of customers would be considered a start-up cost, but ongoing customer acquisition costs are not.

B: Incorrect. Costs to open a new facility are considered start-up costs under GAAP because they involve a new activity.

C: Incorrect. Costs incurred to conduct business in a new territory are considered start-up costs under GAAP because they involve a new activity.

D: Incorrect. GAAP provides that costs to initiate a new process in an existing facility are considered start-up costs.

43. A: Incorrect. GAAP does not require a description of the plan although a company may elect

to include this information in a disclosure. B: Incorrect. There is no requirement to disclose the employees covered by the plan making

the answer incorrect. C: Correct. GAAP requires disclosure of the amount of pension cost separate from

any cost associated with defined benefit plans. D: Incorrect. Because the plan is defined contribution, there would be no actuarial present

value of benefits, making the statement incorrect.


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J. Cash Flows 1. Requirement of Statement of Cash Flows Question: When must an entity present a statement of cash flows? Are there any ways around presenting one for a smaller company? Response: ASC 230. Statement of Cash Flows (formerly FASB No. 95), states that a statement of cash flows must be presented anytime a balance sheet and income statement are presented in the same set of financial statements prepared in accordance with GAAP. Further, one statement of cash flows must be presented for each statement of income presented. Example 1: X Company presents a balance sheet for 20X1 and 20X2 and three statements of income, one for 20X0, 20X1 and 20X2. Conclusion: Because both a balance sheet and statement of income are presented, a statement of cash flows must also be presented. The next issue is how many statements of cash flows should be presented? The answer is three; one for each year for which a statement of income is presented (20X0, 20X1 and 20X2). There are two ways to avoid presenting a statement of cash flows.

a. Issue financial statements on a non-GAAP basis, such as an tax basis or cash basis. Thus, a statement of cash flows is not required.

b. In accordance with SSARS No. 21, issue a compilation report that omits substantially all disclosures and the statement of cash flows. Notice that this exception only applies to compilation and not review or audit engagements. Therefore, a statement of cash flows may not be excluded from a review or audit of GAAP statements.

2. Cash and Cash Equivalents Question: Which of the following are considered cash equivalents for purposes of the statement of cash flows?

a. An entity invests in a money market fund with a broker-dealer. Use of the fund is unrestricted and is accessed simply by writing a check.

b. A certificate of deposit is purchased with six months remaining to maturity. At year end

there is one month remaining until maturity. c. A certificate of deposit purchased with one month remaining to maturity. There is an

interest penalty for early withdrawal. d. A treasury bill purchased with two months remaining until maturity. e. Commercial paper. f. Equity securities. g. Restricted cash accounts.


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Response: Cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit or withdraw funds at any time without prior notice or penalty. A cash equivalent is defined by ASC 230 (formerly FASB No. 95) as a short-term highly liquid investment that is a) readily convertible to cash, and b) so near maturity that there is an insignificant risk of change in its value. For purposes of meeting the definition of b), all investments with an original maturity of three months or less are included. Note: If an investment is not a cash equivalent at the time of purchase, it never becomes one. Answers are as follows:

a. Yes. Money market funds qualify as cash equivalents. b. No. The CD was purchased with more than three months until maturity. Thus, it is not and

will never become a cash equivalent even when there are less than three months remaining.

c. Yes. The CD was purchased with three months or less until maturity. The early withdrawal

penalty does not restrict access to the cash. Therefore, the CD qualifies as a cash equivalent.

d. Yes. The treasury bill was purchased with three months or less to maturity. e. Yes. Commercial paper qualifies as a cash equivalent. f. No. Equity securities never meet the definition of cash equivalents. g. No. Restricted cash is not readily convertible to cash, and does not qualify as a cash

equivalent. 3. Presentation of a Cash Overdraft on the Cash Flow Statement Question: A company has accounts at three separate banks. One of the bank accounts is in an overdraft position at year end, and is presented as a liability on the balance sheet. Details of the accounts follow:

Current assets: Cash Account #1 $100,000 Account #2 50,000 Total cash, current asset 150,000 Current liabilities: Account #3 (20,000) Net cash balances $130,000

In preparing the statement of cash flows, should the company reconcile to the two cash accounts shown as a current asset ($150,000) or the net of all three accounts ($130,000)?


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Response: The company should reconcile to the $150,000 amount presented as a current asset, not the net of $130,000. ASC 230 (formerly FASB No. 95) states that the total amounts of cash and cash equivalents on the statement of cash flows shall be the same amounts as similarly titled line items or subtotals shown in the statements of financial position. Any change in the overdraft is a change in a current liability and should be presented as a reconciling item in the operating activities section if the indirect method is used similar to this: Indirect method: Net income xx Items not affecting cash: Depreciation xx Deferred income taxes xx Accounts receivable xx Cash overdraft xx Accounts payable xx Cash from operating activities xx 4. Categories of Cash Flows Question: What are the three (3) categories of cash flows on the statement of cash flows? Response: Listed below are the three (3) categories and their uses: a. Operating activities: cash flows from operations including:

Collections of revenues

Payment of expenses

Other transactions that are not investing or financing activities b. Investing activities:

Purchase and sale of assets, including fixed and intangible assets, investments, etc.

c. Financing activities: debt and stockholders’ equity transactions including:

Borrowing and repaying debt

Payment of dividends

Issuance of common or preferred stock

Purchase or reissuance of treasury stock

5. Classification of Increase in Cash Value of Life Insurance in Statement of Cash Flows

Question: How should the increase in the cash value of life insurance be presented on the statement of cash flows? Response: There is no formal authority. Some practitioners believe that the increase in cash value is the equivalent to a purchase of an investment and, thus, should be presented as an outflow within the investing activities section. Others believe that it belongs as a conversion of life insurance expense from accrual to cash basis, and should be presented as a reconciling item in the operating section. The AICPA has provided an unofficial response as follows:

If the increase in cash value is less than the premium paid, the entire increase should be presented as an outflow in the investing activities.


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If the increase in cash value is greater than the premium paid, the premium paid is an investing outflow with the remainder presented as a reconciling item within the operating activities section.

Author's Observation: Because the AICPA's position is unofficial, a practitioner can use any one of the above options. The author believes that the entire increase should be presented as a reconciling item, in the operating activities section, converting the life insurance expense (credit) from accrual to cash basis.

Example of author's recommended presentation: Cash flow from operating activities: Net income xx Items not affecting cash: Depreciation xx Deferred income taxes xx Increase in accounts receivable xx Decrease in accounts payable xx Increase in cash value of life insurance xx Cash from operating activities xx 6. Cash Flow Disclosures Question: What are the disclosures required by ASC 230 (formerly FASB No. 95) relating to the statement of cash flows? Response: ASC 230 requires that the following items be disclosed within the notes to financial statements or elsewhere:

Cash equivalents policy

Interest and income taxes paid

Non-cash investing and financing activities (see (7) which follows)

If the direct method is used, a reconciliation of the indirect method must be presented. Question: Assume the following facts related to income taxes for 20X2. Accrued taxes look like this for two different scenarios: Scenario 1: dr (cr) Accrued federal income taxes: Beginning balance (20X1 overpayment) $125,000 Current year accrual for federal taxes (300,000) Payments- 20X2 estimates 100,000 Ending balance $(75,000) 20X2 federal estimates were: 20X1 overpayment applied to 20X2 $125,000 20X2 estimates 100,000 $225,000 How much should the company disclose as income taxes paid on the cash flow statements or related notes?


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Response: ASC 230 (formerly FASB No. 95) does not define income taxes paid. Therefore, it is up to the company to decide how to define this term. For example, is it the actual cash paid out for the year ($100,000) or the total taxes paid including overpayments from the previous year applied ($225,000). The author believes that the answer is the actual amount of cash paid within the fiscal year which, in this case is $100,000. However, one might argue that by disclosing only $100,000, the user of the financial statements does not receive all the information necessary to evaluate cash flows. Let's change the facts above to the following analysis of the accrual: Scenario 2: dr (cr) Accrued federal income taxes: Beginning balance (20X1 overpayment) $225,000 Current year accrual for federal taxes (300,000) Payments- 20X2 estimates 0 Ending balance $(75,000) 20X2 federal estimates were: 20X1 overpayment applied to 20X2 $225,000 20X2 estimates 0 $225,000 The company has a 20X1 overpayment of $225,000 applied toward 20X2, and no estimated tax payments made in 20X2. If the company decides to take a literal interpretation of ASC 230 and disclose only cash paid for taxes in 20X2, the amount of income taxes paid would be $0. Yet, how does this example really differ from scenario 1. Both examples have taxes paid that total $225,000 yet, in scenario 1 the amount of taxes disclosed as paid is $100,000, while in scenario 2, it is $0. The author's only solution to resolve this inconsistency would be to disclose income taxes paid based on the amount paid in for taxes which in this case is $225,000. Absent this approach, companies will continue to show inconsistencies in practice. 7. Non-Cash Investing and Financing Transactions Question: How should non-cash investing and financing activities be presented in the statement of cash flows? Response: ASC 230 states that non-cash investing and financing activities should be disclosed, not presented within the statement of cash flows. The theory behind this requirement is that the statement should only present actual transactions that flow through the “checkbook.” Unless a transaction actually cash flows through the "checkbook," it does not appear on the statement. How should the following transactions be presented in the statement of cash flows? 1) A company purchases real estate for $500,000 by borrowing $500,000 from the seller at the

closing. Response: Disclose as a non-cash investing and financing transaction. This transaction should not be presented on the body of the statement. 2) A company purchases real estate for $500,000. The purchase funds are obtained from a bank.

The bank gives the buyer a check made payable to the buyer, who, in turn, endorses the check over to the seller at the closing.

Response: This transaction should be presented on the statement as follows:


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$(500,000) Investing activity outflow 500,000 Financing activity inflow Note: Although, at first glance, this transaction appears identical to the previous example, it isn't. Because the check is payable to the borrower, in substance, the borrower receives the cash and then pays the seller (endorses the check). It is as if the borrower deposits the check for the borrowed funds, and subsequently writes out a check for $500,000 to the seller. 3) A company purchases a motor vehicle for $25,000 by paying cash of $5,000 and financing

the remaining $20,000. Response: This is a partial cash transaction that should be presented as follows: $(5,000) Investing activity outflow 20,000 Non-cash disclosure 4) A company has a $100,000 note payable due to its shareholder. The bank requires the

company to capitalize the note as part of stockholders’ equity. Response: The conversion of the stockholder loan to equity is a non-cash financing activity which should be disclosed only. 5) An auto dealer purchases its inventory from a manufacturer which finances purchases under

a floor plan with a finance subsidiary. The finance subsidiary pays the manufacturer directly on behalf of the dealer. Cash is disbursed by the dealer to the finance company when the automobiles are sold.

Response: The purchase of inventory with floor plan financing represents a non-cash transaction which should be disclosed. When the financing is paid off at the time of sale, the transaction is accounted for as an operating activity outflow. Generally, the payment of debt is an outflow of a financing activity. However, ASC 230 states that principal payments on accounts and notes payable to suppliers for goods acquired for resale should be classified as outflows of operating activities, not financing activities. Example: Rickie's Rolls is an auto dealer with the following activity during the year.

Beginning End Inventories of automobiles and parts

$1,000,000

$1,700,000

Floor plan financing 800,000 1,200,000 Activity in each account is as follows:

Inventories

Floor

plan financing

Beginning balance $1,000,000 $ (800,000) Autos purchased with floor plan 5,000,000 (5,000,000) Other inventories purchased through payables and cash (a)

500,000

Inventories sold or used (a) (4,800,000) Payoff of floor plan financing (b) 0 4,600,000 Ending balance $1,700,000 $(1,200,000)


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Presentation on statement of cash flows:

a. Disclosure:

$5 million of inventories purchased with floor plan financing.

b. Operating activities:

Net income Adjustments:

Decrease in inventories 4,300,000**

Repayment of floor plan financing (4,600,000)***

** sum of (a) above ($4,800,000 - $500,000) *** sum of (b) above

8. Capital Leases Question: A company enters into an agreement to lease certain equipment. The lease qualifies as a capital lease. The company makes the following entries during the year. Capital lease 150,000 Obligation under cap lease 150,000

To set up the new capital lease Interest expense

8,000

Obligation under cap lease 12,000 Cash 20,000

To record payment of lease obligation How should these transactions be presented on the statement of cash flows? Response: The purchase of a capital lease of $150,000 is the equivalent of purchasing a fixed asset by borrowing. Such a transaction is treated as a non-cash investing and financing transaction requiring disclosure only. The $12,000 payment against the obligation is treated as repayment of debt and presented as an outflow in the financing activities section. 9. Miscellaneous Cash Flows Transactions Question: How should the following transactions be presented on the statement of cash flows? 1) A company purchases the following net assets of Company X in a transaction accounted for

using the acquisition method. The entire transaction is paid for by cash. Inventories $100,000 Fixed assets 200,000 Goodwill 300,000 Accounts payable assumed (50,000) Net purchase price $ 550,000


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Response: ASC 230 requires that a purchase of net assets be presented as one net outflow in the investing activities section as follows: Investing activities: Purchase of net assets of Company X $(550,000) 2) Same facts as #1 except that the net purchase price was paid for as follows: Cash $100,000 Note to seller 450,000 Total purchase price $550,000 Response: This is a partial cash transaction that should be treated as follows: Investing activities: Cash paid for purchase of net assets of Company X $(100,000) Disclosure: The company purchased the net assets of Company X by borrowing $450,000 of the purchase price from the seller. 3) Intercompany accounts The company has an affiliated company which is involved in several transactions during the year. An analysis of the intercompany account is as follows: Intercompany Account: dr (cr) Beginning balance-receivable $100,000 Management fees charged by the affiliate (50,000) Borrowed funds from affiliate, in cash (300,000) Ending balance-liability $(250,000) Response: An intercompany transaction should be handled like any other transaction. The origin of the transaction determines how it is presented on the statement. In this situation, the loan activity consists of two transactions: charge for intercompany management fees of $50,000 and cash loans of $300,000, which should be presented as follows.

Operating activities: Net income $XX Adjustments: Depreciation XX Change in inventory XX Decrease in intercompany receivable 50,000 Investing activities: Collection of intercompany receivable 50,000** Financing activities: Loan received from affiliate 250,000**

** The portion of the cash received that brings the intercompany balance to zero $(50,000) is considered a collection

of a loan receivable. The cash received that creates the loan payable $(250,000) is a borrowing resulting in an inflow of a financing activity.


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4) Revolving Line of Credit A company has a revolving line of credit with a bank. Activity follows: Beginning balance $500,000 Gross borrowings 20,000,000 Gross repayments (19,500,000) Ending balance $1,000,000 Response: The question is whether this transaction may be presented as a net increase of financing activities of $500,000 or gross as a $20,000,000 financing inflow and a $19,500,000 financing outflow. ASC 230 requires that transactions be presented gross instead of net. There is an exception whereby certain transactions may be presented net if:

Amounts turnover quickly

Amounts are large

Maturities are short, e.g., investments, or loans with an original maturity of three months or less.

Therefore, demand and revolving lines of credit qualify for net treatment under this provision. The company should present a net cash inflow of $500,000 in the financing activities section. 5) Sale of Assets A company sells a fixed asset as follows: Cash 100,000 Book value of asset 80,000 Gain 20,000 Response: This transaction is presented in two places in the statement: a) Investing activities: Proceeds from sales of fixed assets 100,000 b) Operating activities: indirect method: Net income xx Adjustments: Gain on sale of assets (20,000) 6) GAAP Presentation of Customer Notes Receivable Question: How should the change in notes receivable related to the creation of sales be presented on the income statement? Response: ASC 230 is not clear as to whether customer notes receivable should be presented in the operating activities section, although ASC 230 deals with a similar situation related to installment sales by stating:


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“A somewhat difficult classification issue arises for installment sales… for which cash inflows may occur several years after the date of transaction. The board agreed that all cash collected from customers should be classified as operating cash flows.”

Although ASC 230 addresses the collection of an installment sale, it does not specifically address the change in notes receivable. Instead, it does state that all cash collected from customers should be classified as operating cash flows, including notes receivable. Nevertheless, the author believes that logic supports the conclusion that any change in notes receivable created as a result of sales should be presented in the operating activities section of the statement of cash flows. In doing so, sales are converted from accrual to cash basis. The abuses in practice

A recent study indicates that companies are inconsistently accounting for the change in customer notes receivable as it relates to the statement of cash flows. More specifically, in certain industries it is common for companies to engage in sales involving notes receivable with their customers. Examples include:

Notes receivable arising from a floor-planning financing arrangement

Installment sale receivables

Franchise receivables

Lease receivables arising from sales-type lease transactions Many companies present the change in notes receivable in the investing activities section of the statement of cash flows, instead of the operating activities section. In doing so, cash from operations may increase significantly. Example: Assume the following:

Net sales $10,000,000 Operating expenses 7,000,000 Net income $3,000,000

Of the $10,000,000 of sales, $6,000,000 is collected in cash and the remaining $4,000,000 remains in notes receivable. Scenario 1: The $4,000,000 of change in notes receivable is presented in the operating activities section. The statement of cash flows is presented as follows:

Cash from operating activities: Net income $3,000,000 Adjustments: Change in notes receivable (4,000,000) Cash used in operating activities $(1,000,000)

Scenario 2: The $4,000,000 of change in notes receivable is presented in the investing activities section. The statement of cash flows is presented as follows:

Cash from operating activities:


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Net income $3,000,000 Adjustments: 0 Cash used in operating activities $3,000,000

Cash used in investing activities: Change in notes receivable (4,000,000)

By presenting the change in notes receivable in the investing activities section, it appears that the company has generated $3,000,000 of operating cash flow and then invested it in investing activities.24 Note: A Georgia Institute of Technology report concluded that numerous public companies were classifying the change in customer-related notes receivables as part of investing activities instead of operating activities. After the report was published, the SEC sent a letter to the CFOs of the companies they believed may have presented the changes in customer-related notes receivable as investing cash flow. In the letter, the SEC noted that such a presentation was not in conformity with GAAP and called for the firms to change their reporting practices by reclassifying the changes in the operating activities section. K. Concentrations 1. Disclosures Question: What are the disclosure requirements for concentrations of credit risk? Response: ASC 825-10-50-20, Financial Instruments-Overall-Disclosure, requires entities to disclose all significant concentrations of credit risk arising from all financial instruments. A financial instrument includes: a. Cash and cash equivalents

b. Investments in equities- common and preferred stock, partnerships, warrants, options, certificates of interest or participation, etc.

c. Contracts that:

1) impose on one entity an obligation to deliver cash or another financial instrument to the other entity, or exchange financial instruments on potentially unfavorable terms with the second entity, and

2) convey to the second entity a right to receive cash or another financial instrument from

the first entity, or exchange financial instruments on potentially favorable terms with the first entity.

Such contracts include: Trade receivables and payables, bonds, loan commitments,

debt, etc. Such contracts exclude: Inventory, fixed assets, leases, intangibles, prepaid

expenses, advances, deferred revenues, and warranty obligations.

24 Cash-Flow Reporting Practices for Customer-Related Notes Receivable, Georgia Tech College of Management.


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Note: A financial instrument can be an asset or a liability. d. Derivatives under ASC 815, Derivatives and Hedging. Note: The disclosure rules do not apply to certain financial instruments such as pension benefit and other postretirement obligations, certain insurance contracts, warranty obligations, unconditional purchase obligations, and financial instruments of a pension plan. The disclosures apply to all financial instruments including those that are recorded and those that are not recorded. The two (2) categories of disclosures are as follows: 1. Off-balance sheet risk of an accounting loss: Potential losses beyond the recorded value on

the balance sheet. Examples: Outstanding loan commitments, letters of credit, financial guarantees, options,

interest rate caps and floors, futures contracts, etc. 2. Concentrations of credit risk:

a. A group concentration exists that exposes the entity to the risk of not being diversified with respect to a financial instrument.

Examples: Large percentage of accounts receivable are due from one industry or geographic region. A large portion of an entity’s cash is held in one bank where, from time to time, balances exceed federally insured limits.

Note: There is no threshold for assessing the likelihood of risk. Therefore the disclosures apply even if the likelihood of a loss is remote.

Concentrations of credit risk disclosure:

a. An entity must disclose all significant concentrations of credit risk from individual counterparty or group concentrations.

Note: ASC 825 does not define the term “significant.” b. Group concentration of credit risk: Exists if a number of “counterparties” are engaged

in similar activities and have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions (e.g., the risk of not being diversified.)

Examples:

A large percentage of accounts receivable are due from customers within one industry or geographic region. A significant portion of a bank’s loan portfolio consists of loans to a specific region or industry.


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A significant portion of an entity’s cash is held in one bank with balances, from time to time, that exceed federally insured limits.

Disclosures required: a) Information about the shared activity, region or economic characteristic that

identifies the concentration.

b) The maximum loss due to credit risk that, based on the gross fair value of the financial instrument, the entity would incur if the parties that make up the concentration failed completely to perform according to the terms of the contracts and the collateral or other security, if any, for the amount due proved to be of no value to the entity.

c) With respect to collateral, all of the following:

The entity’s policy, if any, of requiring collateral or other security to support financial instruments subject to credit risk.

Information about the entity’s access to collateral or other security.

Nature and brief description of the collateral or other security supporting

those financial instruments.

d) With respect to master netting arrangements, if applicable, all of the following:

The entity’s policy for entering into master netting arrangements to mitigate the credit risk of financial instruments

Information about the arrangements for which the entity is a party

A brief description of the terms of the master netting arrangements,

including the extent to which they would reduce the entity’s maximum amount of loss due to credit risk.

Example 1: Concentration of Trade Receivables: Facts: A retailer of family clothing has three stores, all of which are located in Bigtown. The Corporation grants credit to customers, most of whom are residents of Bigtown. Receivable balances are significant. Disclosure:

NOTE X: Concentrations of Credit Risk: The Company is a retailer of family clothing with three stores, all of which are located in Bigtown. The Company grants credit to customers, substantially all of whom are local residents.

Example 2: Concentration of Trade Receivables Combined with Nature of Operations Disclosure: Facts: As an alternative to Example 1 above, the concentration of trade receivables could be combined with the nature of operations disclosure required by ASC 275, Risks and Uncertainties (formerly SOP 94-6).


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Disclosure:

NOTE X: Nature of Operations: The Company is a retailer of family clothing with three stores, all of which are located in Bigtown. Most of the company’s sales are made to retail customers who reside within Forkville County. On a regular basis, the Company grants credit to customers, substantially all of whom are local residents.

Example 3: Concentrations of Cash: Facts: XYZ Company is a wholesaler who maintains the majority of its cash in one local bank located in Winchester, MA. Periodically, cash balances exceed the federally-insured bank deposit limits of $250,000. Such balances can be substantial in relation to the Company’s total assets. Disclosure:

NOTE X: Concentrations of Credit Risk: The Company deposits the majority of its cash in one commercial bank located in Winchester, MA. From time to time, cash balances in this account exceed federally insured limits.

Example 4: Concentrations of Cash Combined with Cash Flow Disclosures: As an alternative, Example 3 above can be combined with the cash equivalent disclosure policy required by ASC 230, Statement of Cash Flows, as follows: Disclosure:

NOTE 1: Summary of Significant Accounting Policies: Cash and cash equivalents: For purposes of the statement of cash flows, the company considers all highly liquid, short-term investments with an original maturity of three months or less to be cash equivalents. The Company deposits the majority of its cash in one commercial bank located in Winchester, MA. From time to time, cash balances in this account exceed federally insured limits.

2. Major Customers Question: ASC 275, Risks and Uncertainties (formerly SOP 94-6). requires that all entities (public and non-public) disclose group concentrations within a business whereby there is a risk associated with that concentration that could result in a near-term (within one year) severe impact on the business. One of the typical concentrations found in businesses is “major customers.” What is the threshold for determining whether a customer is major? Must the entity name the customer(s)? Response: ASC 275, Risks and Uncertainties (formerly SOP 94-6) does not define a threshold for measuring a concentration of customers. Thus, the entity may make such a determination


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based on the facts and circumstances which may include volume of sales, profitability of a customer, etc. The only guidance that may be helpful is found in ASC 280, Segment Reporting (formerly FASB No. 131) which uses a 10% threshold (based on total sales) for disclosing segment information for publicly held entities. Although not authoritative for non-public entities, the 10% threshold should act as a safe harbor absent information to the contrary. There is no requirement that the name(s) of the customer(s) be mentioned in the disclosure. A sample disclosure looks like this:

Note 1: Major Customer: Approximately thirty percent of the company's revenue resulted from sales to two customers.

3. Key Personnel Question: Harry is the sole shareholder and President of Lucky Licks Ice Cream, the maker of a special-recipe premium ice cream. Harry is the founder of the company and the only person within the organization who can make the ice cream. In fact, if something happens to Harry, the company would be out of business within weeks. One more complication is the fact that Harry has been eating too much ice cream and has developed a terminal heart condition and has, at most, six months to live. Should Harry’s illness be disclosed in the company’s financial statements? Response: Probably not. However let’s look at the analysis. ASC 275, Risks and Uncertainties (formerly SOP 94-6) requires disclosure of concentrations in a business where a concentration within the business exposes the company to the risk of a near-term (within one year) severe impact. Clearly, the above scenario exposes the company to the risk of a severe impact on its operations within the next year. However, ASC 275 exempts disclosures related to key personnel. Thus, the concentration due to Harry’s illness is exempt from disclosure under ASC 275. However, there may be a going concern disclosure required under SAS No. 122, AU-C Section 570, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern (formerly SAS No. 59) requires disclosure when there is substantial doubt of an entity’s ability to continue as a going concern for at least one year from the balance sheet date. In this situation, the fact that Harry has approximately six months to live requires additional analysis as to whether there is substantial doubt, when considering all facts and circumstances. If there is substantial doubt, a disclosure about Harry’s illness would be required. 4. Acts of God Question: A company’s plant is located directly on an earthquake fault line in San Francisco. Recently, earthquake activity has been more frequent, and predictions are that there will be a major earthquake in the area over the next few years. The company is not insured with earthquake insurance. Should the fact be disclosed? Response: No. Although ASC 275 requires disclosure of concentrations that expose an entity to the risk of a near-term severe impact, the ASC specifically exempts acts of God, war or sudden catastrophes. However, the company may elect to disclose this fact even though it is not required.


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5. Terrorist Attacks Question: Does the concentration of terrorism risk result in a required disclosure under ASC 275? Response: No. ASC 275 states that disclosure requirements do not apply to risks and uncertainties involving “the possible effects of acts of God, war, or sudden catastrophes.” A terrorist attack is not necessarily an act of God, and may or may not be an act of war, but it would appear to fall into the category of a sudden catastrophe. Therefore, the author believes that regardless of where a business is located (downtown Manhattan, Boston), there is no disclosure requirement pertaining to a concentration of risk or uncertainty of a future terrorist attack. 6. Disclosures of Concentration of Risk from Climate Change Question: Are nonpublic companies required to make disclosures about climate change? ASC 275 requires reporting entities to make disclosures in their financial statements about the risks and uncertainties existing as of the date of those statements in the following areas:

a. Nature of operations b. Use of estimates in the preparation of financial statements c. Certain significant estimates d. Current vulnerability due to certain concentrations.

ASC 275’s disclosure requirements do not encompass concentrations of risks and uncertainties that might be associated with any of the following:

Management or key personnel

Proposed changes in government regulations

Proposed changes in accounting principles

Deficiencies in the internal control structure, and

The possible effects of acts of God, war, or sudden catastrophes. Out of the four disclosures required for risks and uncertainties, the only one that could require a nonpublic entity to make general climate change disclosures would be the disclosure about the “current vulnerability due to certain concentrations.”((d) above) ASC 275 states that the vulnerability from concentrations arises because an entity is exposed to risk of loss greater than it would have had it mitigated its risk through diversification. Financial statements shall disclose the concentrations if, based on information known to management before the financial statements are issued or are available to be issued, all of the following criteria are met:

1. The concentration exists at the date of the financial statements.

2. The concentration makes the entity vulnerable to the risk of a near-term severe impact.

3. It is at least reasonably possible that the events that could cause the severe impact will occur in the near term.


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In order for there to be a concentration that exposes an entity to a near-term severe impact. It must be at least reasonably possible that such a severe impact will occur in the near term. ASC 275 defines “near term”, and “severe impact” as the following:

Near term: is defined as a period of time not to exceed one year from the date of the financial statements. Severe impact: is defined as a significant financially disruptive effect on the normal functioning of an entity. Severe impact is a higher threshold than material. Matters that are important enough to influence a user's decisions are deemed to be material, yet they may not be so significant as to disrupt the normal functioning of the entity.

Examples of group concentrations: Concentrations can fall into the following categories, among others:

a. Concentrations in the volume of business transacted with a particular customer, supplier, lender, grantor, or contributor.

b. Concentrations in revenue from particular products, services, or fundraising events.

c. Concentrations in the available sources of supply of materials, labor, or services, or of licenses or other rights used in the entity's operations.

d. Concentrations in the market or geographic area in which an entity conducts its

operations. So, do the concentration of risk rules under ASC 275 require a nonpublic company to make general risk disclosures about climate change? The author believes there is no concentration of risk that requires disclosure pertaining to climate change or overall climate risk. Here is the reason. First, in order to have a concentration of risk and uncertainty disclosure under ASC 275, there must be a concentration of some kind. Then, three conditions must be satisfied: a. The concentration must exist at the date of the financial statements.

b. The concentration must make the entity vulnerable to the risk of a near-term severe impact.

c. It must be at least reasonably possible that the events that could cause the severe impact will

occur in the near term. As to climate change or general environmental disclosures, in order to the disclosure rules of ASC 275 to apply, three requirements must be satisfied:


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First, the concentration (exposure to climate change) must exist at the date of the financial statements. There could certainly be a concentration, particularly if an entity operates in an industry that is exposed to the risks from climate change. Second, the concentration (e.g., exposure to climate or environmental change) must make the entity vulnerable to a risk of a near term, severe impact. That means that the concen-tration (climate change) must expose the company to a significant financially disruptive effect on the normal operations, and it must be reasonably possible that it will occur within one year from the balance sheet date. Third, it must be reasonably possible (less than probable and greater than remote) that the events that could occur (e.g., climate change) could cause a near-term severe impact.

The problem with climate change is that if it is real (that is a big “if”), it would have its effect gradually over time and not necessarily within one year from the balance sheet. Thus, the ASC 275 rule that discloses that it is reasonably possible that the concentration of risk could cause a near-term severe impact, is not likely to apply. There is one additional point that supports that climate change disclosures are not required for nonpublic entities under ASC 275. Specifically, ASC 275’s disclosure requirements do not apply to risks and uncertainties that might be associated with any of the following:

Management or key personnel

Proposed changes in government regulations

Proposed changes in accounting principles

Deficiencies in the internal control structure

The possible effects of acts of God, war, or sudden catastrophes. Notice that the fifth exception is a concentration related to “the possible effects of acts of God, war, or sudden catastrophes.” There is an argument that climate change is an act of God for which GAAP (ASC 275) exempts disclosure of the risks and uncertainties. In conclusion, unless a nonpublic entity is exposed to a short-term (one year or less) severe impact on its business due to climate change, there is no disclosure required for that nonpublic entity. L. Fiscal Years 1. Disclosure of Change in Fiscal Year Question: What disclosure is required when a company changes its fiscal year? Response: GAAP does not specifically require any disclosure. However, an accountant may wish to include a disclosure to make the financial statements meaningful to the user. Further, in the first year of change to the new fiscal year, comparative statements should not be issued because the statements relate to different time periods. 2. Fiscal Years for Tax and Financial Reporting Purposes Differ Question: A company is an S corporation and must maintain a calendar year end for tax purposes. However, its business cycle actually ends on September 30. The company wishes to


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maintain two different fiscal years: December 31 for tax purposes and September 30 for GAAP. Is this possible? Response: Yes, but with some difficulty. There is no requirement in accounting literature that tax and GAAP fiscal years coincide. However, there can be complications with having different fiscal years. First, the company must essentially maintain two sets of books which can be tedious. Second, there can be problems with deferred income taxes if the entity is a C corporation or if there are deferred state taxes as an S corporation. The challenge lies with having to compute temporary differences between book and tax income for the same fiscal period. In order to do so, the company must reconstruct GAAP income for the same period as tax in order to develop temporary differences.


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 44. Which of the following is correct regarding the statement of cash flows:

a) a statement of cash flows is required anytime a company has net income b) a statement of cash flows is required any time a balance sheet and income statement are

presented in the same set of financial statements c) a statement of cash flows is required when statements are issued on a non-GAAP basis d) one statement of cash flows is required for each balance sheet presented

45. Which of the following should be included in the investing activities section of the statement of cash flows: a) purchase or reissuance of treasury stock b) issuance of common or preferred stock c) borrowing debt d) sale of intangible assets

46. Which of the following should be included in the financing activities section of the statement of cash flows: a) collections of revenues b) payment of expenses c) the purchase of assets d) payment of dividends

47. ASC 230 (formerly FASB No. 95) requires which of the following to be disclosed within the

notes to the financial statements or elsewhere: a) cash policy b) interest and income tax expense c) a reconciliation of the indirect method if the direct method is used d) principal payments made

48. Which of the following is the proper way to present the recording of a new capital lease on the

statement of cash flows: a) the transaction should be treated as both an investing and financing activity b) the transaction is treated as a non-cash investing and financing transaction which is

disclosed only c) the transaction should be treated as both an operating and financing activity d) the transaction should be treated as both an investing and operating activity

49. Which of the following is one of those criteria that must be satisfied to record certain

transactions net on the statement of cash flows: a) amounts turnover quickly b) amounts are small c) amounts are immaterial d) maturities are long

50. Which of the following is not true regarding the disclosure requirements for credit risk:

a) if the likelihood of loss is remote, the disclosures are not required


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b) there are two categories of disclosures c) an entity must disclose all significant concentrations of credit risk from individual

counterparty or group concentrations d) required disclosure information includes information about the shared activity, region or

economic characteristic that identifies the concentration 51. ASC 275 (formerly SOP 94-6) requires disclosures of concentrations that expose an entity to

the risk of a near-term severe impact, including which of the following: a) acts of God b) war c) sudden catastrophes d) major customers

52. According to ASC 275 (formerly SOP 94-6), which of the following is correct regarding

disclosure of major customers: a) non-public entities are not required to disclose concentrations of major customers, but

public companies are required to make such disclosures b) ASC 275 defines the threshold for measuring a concentration of customers c) there is no requirement that the name(s) of the customer(s) be mentioned in the disclosure d) public companies must disclose any concentration that is greater than 5%


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SUGESTED SOLUTIONS 44. A: Incorrect. A statement of cash flows is not required anytime a company has net income.

Net income is not the driver as to whether a statement of cash flows is required. Instead, the determinant is whether both a balance sheet and income statement are presented.

B: Correct. GAAP specifically states that a statement of cash flows is required any time a balance sheet and income statement are presented in the same set of financial statements prepared in accordance with GAAP.

C: Incorrect. If the statements are presented on a non-GAAP basis, a statement of cash flows is not required.

D: Incorrect. One statement of cash flows is required for each income statement that is presented, not each balance sheet, making the answer incorrect.

45. A: Incorrect. The purchase or reissuance of treasury stock is a financing activity, not an

investing activity. B: Incorrect. The issuance of common or preferred stock is a financing activity, not an

investing activity. C: Incorrect. Borrowing debt is a financing activity, not an investing activity. D: Correct. The sale of intangible assets is an inflow of an investing activity making

the statement correct. 46. A: Incorrect. Collections of revenues is an operating activity, not a financing activity. B: Incorrect. Payment of expenses is an operating activity, not a financing activity. C: Incorrect. The purchase of assets is an investing activity, not a financing activity. D: Correct. Financing activities include debt and stockholders’ equity transactions,

such as borrowing and repaying of debt, payment of dividends, issuance of common or preferred stock, and the purchase or reissuance of treasury stock.

47. A: Incorrect. A required disclosure is the cash equivalents policy, not the cash policy,

making the answer incorrect. B: Incorrect. A required disclosure is interest and income taxes paid, not interest and income

tax expense. C: Correct. One required disclosure is a reconciliation of the indirect method if the

direct method is used. D: Incorrect. GAAP does not require a disclosure of the principal payments made, making

the answer incorrect. 48. A: Incorrect. The transaction should not be treated as both an investing and financing activity

because the transaction itself does not impact cash flow. B: Correct. The transaction is a non-cash transaction and therefore it should be

disclosed only, with no presentation on the statement of cash flows. The reason is because the transaction to set up the lease involves an increase in a lease asset and liability, but no direct impact on cash flow.

C: Incorrect. Because the transaction is a non-cash transaction, it should not be presented on the statement of cash flows at all, making the statement incorrect. Moreover, under no circumstances would any part of the transaction be presented in the operating activity section.

D: Incorrect. The transaction does not impact cash flow and should not be recorded as both investing and operating activities. Not only is there no cash flow related to the transaction, but no part of the transaction involves an operating activity.

49. A: Correct. The amounts turning over quickly is one of the criteria supporting a net

presentation.


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B: Incorrect. Amounts that are large, not small, is one of the criteria supporting a net presentation.

C: Incorrect. The fact that amounts are immaterial is not one of the criteria supporting a net presentation.

D: Incorrect. Maturities that are long, not short, is one of the criteria supporting a net presentation.

50. A: Correct. There is no threshold for assessing the likelihood of risk. Therefore, the

disclosures apply even if the likelihood of a loss is remote. B: Incorrect. GAAP provides for two categories of disclosures involving credit risk. They are

1) off-balance sheet risk of an accounting loss, and 2) concentrations of credit risk. C: Incorrect. GAAP does require disclosure of all significant concentrations of credit risk from

individual counterparty or group concentration. D: Incorrect. GAAP does require disclosure about information a shared activity, region, or

economic characteristic that indentifies a concentration. 51. A: Incorrect. Although an act of God may be a concentration, ASC 275 specifically

exempts acts of God from disclosure. B: Incorrect. ASC 275 specifically exempts war from disclosure even if there is truly a

concentration in war that exposes an entity to the risk of a near-term severe impact. C: Incorrect. ASC 275 specifically exempts sudden catastrophes from disclosure of

exposure to the risk of a near-term severe impact. D: Correct. A major customer would be an example of a concentration that exposes

an entity to the risk of a near-term severe impact. 52. A: Incorrect. ASC 275 (formerly SOP 94-6) requires that all entities (public and non-public)

disclose group concentrations within a business whereby there is a risk associated with that concentration that could result in a near-term severe impact on the business.

B: Incorrect. ASC 275 (formerly SOP 94-6) does not define a threshold for measuring a concentration of customers. The entity must make a determination based on the facts and circumstances which may include volume of sales, profitability of a customer, etc.

C: Correct. There is no requirement in ASC 275 to name the customer(s) in the disclosure.

D: Incorrect. There is no 5% threshold for disclosure of concentrations by public companies. In other GAAP, such as ASC 840 (formerly FASB No. 14) for segment reporting, a 10% threshold (based on total sales) is used.


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M. Personal Financial Statements 1. Income Taxes Related to Personal Financial Statements: Question: Harry is preparing personal financial statements for Wilma and Fred Flintstone, both age 50. In preparing the statements, Harry plans to record an estimate of income taxes due in accordance with the requirements of ASC 274, Personal Financial Statements (formerly SOP 82-1), as follows: At statement date: Assets and liabilities: Estimated current value xx Tax basis xx Taxable gain xx Tax rate (s) x 32% federal and state Estimated taxes xx (1) (1) presented on the statement of financial position as a liability. One of the assets assumed sold is the couple's primary residence which has an unrealized gain of $800,000 and, when sold, will be subject to $500,000 gain exclusion on the sale of a primary residence. In computing the estimated tax liability, should Harry exclude the portion of the gain that will be eliminated from implementing these strategies? Response: Yes. ASC 274 requires that an estimated income tax liability be recorded on the statement of net worth based on the assumption that the individual(s) sell all of the net assets on the balance sheet statement date. ASC 274 requires that the estimated tax liability should be based on two assumptions:

a. All assets and liabilities are liquidated at their estimated current value as of the statement date, and

b. The provision should be based on applicable income tax laws and regulations. The method and assumptions used to compute the estimated tax liability relate to existing tax law, not on assumptions of future actions of the individual after the financial statement date. In this case, if the residence had been sold on the date of the statement of net worth, the $500,000 gain exclusion would apply. Therefore, up to $500,000 of the unrealized gain on the primary residence should be excluded in computing the estimated tax with the remaining $300,000 included. Change the facts: The couple is performing effective estate planning under which all assets shall be gifted to each other or other family members with no income tax liability? In computing the estimated tax liability, should the gain on those assets to be transferred be excluded? Response: The estate planning is considered a future action (future transfers of assets), not an action taken as of the financial statement date. Therefore, these potential tax saving actions should not be considered in computing the estimated tax liability. Consequently, the income tax liability on those assets still should be included on the financial statement even though the obligation will most likely not be paid.


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Question: Should the couple accrue the estate tax that will be due upon death? Response: No. Again, the estate tax is based on a future action (future death of one or both of the individuals). Thus, at the financial statement date, assuming both individuals are alive, there is no estate tax due. If, instead, one of the parties had died at the balance sheet date and there is an estate tax due, that estate tax would be shown on the statement of net worth as a liability, similar to any other liability that is owed. 2. Imputing Goodwill on Personal Financial Statements: Question: John Perfect is a celebrity chef and real estate developer. The “Perfect” brand is on numerous products including cook books, underwear (“Perfect” Undies), a downtown NY City hotel (“Absolutely Perfect Hotel”), and several restaurants. John has also franchised use of the “perfect” name on two restaurants which John does not own. John even has the “perfect wife.” John and his wife, Mary, are issuing personal financial statements for the year ended December 31, 20X1, which will be submitted to a bank. John wants to record an asset on his statement of net worth for the “perfect” brand (personal goodwill) because he believes there is a separate value to the perfect name. Because personal financial statements include assets at their estimated current amount, John believes that recording personal goodwill/brand value at estimated current amount is appropriate. In preparing personal financial statements, is it appropriate to record an asset for a brand value/personal goodwill at estimated current value? Response: The authority for personal financial statements is found in ASC 274, Personal Financial Statements (formerly SOP 82-1), as follows: ASC 274 requires that personal financial statements present assets at their estimated current value and liabilities at their estimated current amount. For an asset, estimated current value is the amount at which the item could be exchanged between a buyer and seller. ASC 274-10-35-10 states that:

“intangible assets shall be presented at the discounted amounts of projected cash receipts and payments arising from the planned use or sale of the assets if both the amounts and timing of the cash flows can be reasonably estimated.”

The ASC does not specifically address personal goodwill. However, if John is able to obtain a valuation of the “perfect” brand, it would appear that recording a brand value/personal goodwill asset at estimated current amount may be appropriate. Observation: Prior to becoming President, Donald Trump recorded a $3 billion asset labeled “brand value” on his personal financial statement published in his book, Time to Get Tough.25

25 Page 182, Time to Get Tough, Donald J. Trump.


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Donald J. Trump Summary of Net Worth

As of June 30, 2010 ASSETS: Cash and marketable securities- as reflected herein is after the

acquisition of numerous assets (i.e., multiple aircraft, golf courses, etc.), the paying off of significant mortgages for cash and before the collection of significant receivables

$270, 300,000

Real and operating properties owned 100% by Donald J. Trump through various entities controlled by him:

Commercial properties (New York City) 1,370,650,000 Residential properties (New York City) 348,450,000 Club facilities & related real estate 1,220,000,000 Properties under development 261,000,000 Real properties owned less than 100% for Donald J. Trump:

1290 Avenue of the Americas- New York City Bank of America Building- San Francisco, California and others- Total value net of debt

652,200,000 Real estate licensing deals

107,800,000

Miss Universe, Miss USA and Miss Teen USA Pageants 20,000,000 Other assets (net of debt)

133,160,000

Brand value (see below) 3,000,000,000 Total assets 7,383,560,000 LIABILITIES: Accounts payable 4,900,000 Loans and mortgages payable on real and operating properties as reflected above

373,760,000

Total liabilities 378,660,000 NET WORTH

$7,004,900,000

Source: Page 182, Time to Get Tough, Donald J. Trump Note: Mr. Trump’s Brand Value has been estimated at $3 billion and is reflected herein. The Brand Value has been established by Predictiv, the highly respected brand valuation company. Predictiv assists Global 500 corporations and government agencies to improve management performance, marketing and strategy, Predictiv measures for financial Impact of Intangibles such as brand, strategy execution, innovation and post-merger integration.

Observation: Presumably, President Trump was able to measure the $3 billion of brand value using some form of discounted cash flow or other method. ASC 274 states that “intangible assets shall be presented at the discounted amounts of projected cash receipts and payments arising from the planned use or sale of the assets if both the amounts and timing can be reasonably estimated.”


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Assuming President Trump is able to estimate cash flows and the timing of those cash flows, from use of the Donald Trump brand, ASC 274 permits him to record an intangible asset using the discounted cash flow or other method. What about recording a brand value or personal goodwill for a typical individual who does not have the expansive brand use? Arguably, everyone has some amount of personal goodwill. But whether that goodwill, or brand name value, is measureable is another issue. ASC 274 states that an intangible is recorded using a discounted cash flow or other method, if both the amounts and timing of cash flows can be reasonably estimated. In most situations, an individual is unable to measure both the amounts and timing of cash flows that would create the personal goodwill. Consequently, only in rare cases, such as the Donald Trump brand, will an individual be able to measure an intangible asset for the brand value or personal goodwill. N. Related Party Disclosures and Transactions 1. Officer’s Salary Question: Is a company required to disclose the salary of its officer and principal shareholder? Response: No. ASC 850, Related Party Disclosures (formerly FASB No. 57), requires disclosure of related party transactions; however, it explicitly excludes "compensation arrangements" when an individual is an owner-manager. As a practical point, some companies present officers’ compensation as a separate line item in the schedule of operating expenses in the supplementary information section. Of course, any information presented in supplementary information is not considered a disclosure. 2. Incorporation of a Sole Proprietor Question: A sole proprietor incorporates her business, and transfers her net assets to a corporation in exchange for its common stock. For tax purposes, the transfer is made tax-free under Section 351 of the Internal Revenue Code under which the net assets are recorded on the corporation at the basis of the transferor. How should this transaction be handled for GAAP? Response: Generally, such a transfer would be accounted for at fair value in accordance with nonmonetary exchanges. However, rules change with respect to exchanges and transfers between companies under common control (using a more than 50% common ownership test). Such a transfer is merely a change in legal organization which should be accounted for at historical cost. Consequently, with few exceptions, the transaction should be handled the same way for GAAP as it is for tax purposes, that is, at book value. 3. Shareholder Contribution of Assets Question: A sole shareholder contributes land to its corporation. At what value should the land be recorded by the corporation? Response: Because there is a controlling shareholder (more than 50%), the land should be recorded at historical cost (the basis in the hands of the shareholder).


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If the shareholder owned 50% or less of the common stock, the transaction would be recorded at the fair value of the land given. 4. Use of Shareholder’s Assets to Repay Corporate Loan Question: A shareholder of a corporation collateralizes the company's bank loan with personal assets. The company defaults on the loan and, as a result, the shareholder's assets are used to satisfy the company's debt. How should this transaction be accounted for? Response: The monies used to repay the bank loan are in substance a capital contribution by the shareholder. Therefore, the company should eliminate the bank loan and credit additional paid-in capital. 5. Intercompany Receivables Question: A common issue encountered in peer review is the fact that accountants and auditors don’t scrutinize the collectibility of intercompany accounts. How should the following scenario be handled? Facts: Harry owns 100% of the common stock of Company A and Company B. A and B have minimal transactions between each other except that A has lent $500,000 to B as an unsecured demand note. Harry has a significant net worth and the ability to fund either company, as needed. He says he will fund any company as needed but has not confirmed that fact in writing. Company A is a cash cow. In fact, it prints money for Harry. Conversely, Company B is a dog (that is, D. O. G.). It is losing money and is in financial trouble. You, as the accountant/auditor are preparing financial statements for both companies. Both companies have banks that will rely on your financial statements. What are the issues that the accountant should be concerned about?

Harry 100% owner of both companies

Harry’s got lots of cash

Company A

Shining Star Big profits Strong net worth AR- Company B $500,000

Company B Lousy Dog Big losses Negative net worth AP- Company A $(500,000)


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Response: The accountant has several issues to consider. First, what is the financial viability of Company B. Does B have the ability to function as a going concern? As part of that concern is whether Harry is willing to fund enough cash for B to survive for at least one year from the balance sheet date, the time frame that generally determines going concern. Second, the accountant has to be concerned about the collectibility of Company A’s receivable due from Company B. Even though both companies are affiliates with Harry as the common owner, they legally function as two separate and distinct entities. Therefore, the accountant should not make the error of considering them as being one entity under the ownership of Harry. For example, Harry could decide to have B file bankruptcy, while keeping A as a viable operating entity. In such a case, A would be one of many unsecured creditors of Company B. Because the accountant is fully aware of the troubled financial position of B, the accountant must take action on Company A’s receivable from B. It appears that there are only two options:

Option 1: Company A should set up an allowance against the $500,000 receivable.

Option 2: Company A can have Harry personally guarantee the note due from B, in which case A will not be required to set up an allowance against the note.

Option 2 may be a better choice. If an allowance is set up against the receivable, it may adversely affect Company A’s financial position and profitability, thereby affecting its relationship with its bank. Harry’s guarantee of the note will avoid the use of an allowance account. 6. Accounting for Certain Equity Transactions Question: Start-up companies typically issue stock in exchange for property, services, or other forms of assets other than cash. How should such transactions be accounted for? Response: When equity instruments are issued to non-employees for other than cash, the transaction should be recorded at the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. Previously, the AICPA's Professional Issues Task Force (PITF) issued a document entitled Accounting for Certain Equity Transactions. The Document was issued to provide assistance for accountants and auditors involved with essentially start-up companies. In a typical start-up situation, stock may be issued for goods or services. The issue is how to account for this type of transaction, among others. Six examples illustrate the application of GAAP for certain equity transactions. Example 1: Inventory for Common Stock: ABC Manufacturing purchased the inventory from their vendor XYZ Company. In lieu of cash, ABC issued 1,000 shares of common stock to XYZ. ABC is closely held and the value of its stock is not readily determinable. The fair value of the inventory was estimated at $2,500. Conclusion: ABC should record the transaction at the fair value of the inventory or the stock issued, whichever is more determinable. In this case, because the stock has no readily determinable fair value, the value of the inventory should be used to record the transaction as follows:


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Entry: Inventory 2,500 Common stock, APIC 2,500

Example 2: Services for Common Stock: Mr. Smith, a consultant who is not considered a founder or an insider of ABC, performs 1,000 hours of services for 10,000 shares of ABC's common stock. The stock has no readily determinable market value. Mr. Smith usually charges his clients $150 per hour. Conclusion: Because the stock does not have a determinable value, the value of the services rendered should be used to measure the transaction as follows: 1,000 hrs. x $150/ hour = $150,000.

Entry: Compensation expense 150,000 Common stock, APIC 150,000

In situations where both the value of the stock and the services received do not have a readily determinable value, a company should record the asset or service at a nominal value. Example 3: Land Contributed: Mr. Jones, who is not an employee, founder, or insider of the company, contributes raw land to a start-up company that will be used to build its manufacturing facility. The land was willed to Mr. Jones 25 years ago and has never been appraised. In exchange for the land, the company issues Mr. Jones 1,000,000 shares of the company's convertible preferred stock. The stock has no active trading, but a valuation was performed by a consultant six months before the land was donated. Mr. Jones is the consultant's uncle. How should this transaction be valued? Conclusion: This transaction may be difficult to value. First, the fact that the valuation on the company's stock was done by a related party of Mr. Jones may taint the reliability of the valuation. Instead, a valuation of the land or the company's stock should be done by an independent appraiser. If neither the land nor the stock can be reliably measured, the asset and stock should be recorded at a nominal value. Using the book, par or stated value of the stock as a basis for valuation is not appropriate. Example 4: Stock Issued to an Owner for Expertise or Intellectual Capital Contributed to the Business: Mr. Roberts is the founder of ABC Corporation. He contributes a patent to ABC in exchange for its stock immediately before ABC's IPO occurs. The cost of the patent to Mr. Roberts was $1,000 (the filing fees) with the remainder of the costs of the patent consisting of Mr. Roberts’ own time to develop the intellectual property. Mr. Roberts estimates the value of the time that he contributed to the patent at about $250,000. How should the patent be recorded upon the issuance of the stock? Conclusion: In SAB Topic 5-G, Acquisition of Assets from Promoters and Shareholders in Exchange for Common Stock, the SEC concluded that the transfer of nonmonetary assets to a company by its promoters or shareholders in exchange for stock prior to the time of a company's IPO normally should be recorded at the transferor's historical cost determined under GAAP. In this case, the transaction should be recorded at the transferor’s historical cost as follows:: Patent 1,000


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Common stock, APIC 1,000 Change the facts: What if the patent is transferred to the corporation for common stock and there is no IPO? Instead, the founder contributes a patent to a start-up company in exchange for common stock. Conclusion: Generally, the transfer of a patent to a company in exchange for the issuance of equity instruments should be recorded at the fair value of either the patent or equity, whichever is readily determinable. However, with respect to exchanges and transfers between companies and shareholders owning more than 50% of the common stock, the transaction should be recorded at the basis in the hands of the shareholder. Example 5: Patent Contributed in Exchange for Common Stock: John contributes a patent to a start-up company in exchange for 20% of the common stock. Conclusion: The patent and stock should be recorded at the fair value of the patent or the stock, whichever is more determinable. If the fair value of either the patent or the stock cannot be determined, the transaction should be recorded at a nominal amount, say $1. Example 6: Same facts as Example 5, except John receives 60% of the common stock. Conclusion: Because John owns more than 50% of the common stock, the patent and stock should be recorded at the basis of the patent in the hands of John. 7. Extinguishment of Related Party Debt Question: How should the forgiveness of debt due to or from a related party be handled? Response: Generally, regardless of whether the loan is a receivable or payable, the amount should be charged or credited to equity, rather than to the income statement. ASC 470, Debt (formerly found in APB No. 26), clearly states that "the extinguishment transactions between related parties may be, in essence capital transactions." 8. Related Party Receivables In Connection with the Issuance of Equity Question: How should related party receivables in connection with the issuance of equity be presented on the balance sheet? Response: ASC 505, Equity (formerly found in EITF Issue 85-1), states that an entity that receives a note, rather than cash, as a contribution to its equity, should report the note receivable as a reduction of shareholders' equity, not as an asset. The exception is when there is substantial evidence of the ability and intent to pay within a reasonably short period of time, generally prior to the issuance of the financial statements. Example: Fred starts XYZ company with Mary as 50%-50% owners. Mary pays $200,000 for 50% of the common stock. Fred is broke from a divorce and gives a $200,000 note for 50% of the common stock. The note is a five-year note with interest at 8% per year. How should the note be presented on the balance sheet? Conclusion: In accordance with ASC 470, Debt, the note should be shown in stockholders' equity as follows:


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Stockholders' equity: Common stock $400,000 Retained earnings xx Less: note receivable in connection with the issuance of common stock (200,000) Total stockholders' equity $xx Change the facts: Fred pays off the $200,000 note before the financial statements are issued. Conclusion: The $200,000 should be shown as a current asset at the balance sheet date. Is it appropriate to reclassify the note from stockholders' equity to a current asset during its term? This question brings forth an interesting issue. Using the previous example, assume Fred's note is outstanding for five years and that in year 6, he pays it off in full before the financial statements are issued. Would it be appropriate to present the note as a current asset in year 6, thus reclassifying it from stockholders' equity? ASC 470 does not address this issue. However, the author believes that logic supports an action to reclassify the note as a current asset. The intent of presenting the note as a reduction of equity is to protect against companies overstating equity by issuing notes that would never be repaid. Once there is evidence that the note will be repaid, the note is a bona fide current asset and should be presented as such in the balance sheet. O. Miscellaneous Disclosures 1. Discount sales Question: A client in the fast food business has a "one-cent sale" once a week. For example, the sale might be two cheeseburgers for the price of one ($5.00) plus $.01. The company records the transaction as follows.

Cash ($5.00 + .01) 5.01 Advertising expense 4.99 Sales ($5.00 x 2) 10.00

The company makes this entry so that their food costs are not distorted. Is this entry proper? Response: No. The recording of sales at the gross sales price with the discount to advertising is not acceptable. Realization of the full sales price cannot properly be imputed under such conditions as, to do so, would imply that the same quantities would have been sold if the price had not been reduced. Note: Although this example concludes that advertising expense is recorded, most other GAAP statements have reached the conclusion that sales incentives should be treated as a reduction of revenue and not as an expense. 2. Life Membership Fees in a Club


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Question: A client is engaged in a wholesale club in which members pay a lifetime membership fee. How should the club account for lifetime membership fees? Response: The fees should be allocated into income over the life the members are expected to use the services of the club. In practice, this treatment would require the use of an estimate of the average life of the club's members. 3. Disclosing Advertising Question: What are the requirements for disclosing advertising expense? Response: The authority is found in ASC 340-20, Other Assets and Deferred Charges- Capitalized Advertising Cost, (formerly SOP 93-7). The ASC requires the following: a. Advertising expense must be disclosed for all periods presented.

b. Direct-response advertising: must be capitalized as an asset and amortized to expense, if the advertising expenditure can be directly linked to the revenue generated from the advertising. Example: Revenue is linked to a response card, coded order form in an advertisement, or log of a telephone call from an advertisement or contest prize offer.

Calculation: Actual revenue generated Prepaid Current period from the advertisement x advertising = amortization of Estimated total revenue cost asset to advertising to be generated from expense the advertisement Example: A company incurs $75,000 of advertising costs relating to a nationwide magazine ad program which promotes its products through mail order. The sales can be directly linked to the advertising based on a coupon which appears in the ad. Therefore, the advertising qualifies as direct response advertising. Facts: Cost of advertising $75,000 Revenue generated in year one 200,000 Estimated total revenue 300,000 Entry: Prepaid advertising 75,000 AP 75,000 Entry to amortize in year one: Advertising expense (1) 50,000 Prepaid advertising 50,000 Calculation: (1) Actual revenue 200,000 = 66% x 75,000 = $50,000 expensed Est total revenue 300,000


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Most companies do not have direct response advertising, and as a result only have to comply with the disclosure provisions of ASC 340-20. Disclosures for all advertising: Regardless of whether advertising is direct response or not, a company must disclose the following: a. Accounting policy for recording advertising e.g., expense versus capitalize b. Total advertising expense for each period c. If direct-response advertising exists:

Description of direct-response advertising

Amortization period

Amount capitalized for each period

Asset at each balance sheet date

Amortization expense for each period Example Note: Advertising

NOTE 1: Summary of Significant Accounting Policies Advertising: (no direct-response advertising) The Company expenses advertising as incurred. Advertising expense was $200,000 for the year ended December 31, 20XX.

Advertising (including direct-response advertising): [segment in italic represents language required if there is direct response advertising]. The Company expenses advertising as incurred except for direct-response advertising, which is capitalized and amortized over its expected period of future benefits. Direct-response advertising consists primarily of magazine advertisements that include order coupons for the Company's products. The capitalized costs of the advertising are amortized over the period in which revenues are generated from the advertisement. At December 31, 20XX, $1,000,000 of advertising was reported as an asset, and advertising expense was $200,000.

Change the facts: What if advertising expense is already disclosed on the operating expense schedule which is presented as supplementary information? Does this satisfy the requirements of ASC 340-20? Response: No. Any information presented in supplementary information is not part of the body of the financial statements. Change the facts: Advertising expense is presented on the face of the statement of income. Response: Information presented on the face of a primary statement such as the statement of income does satisfy the requirement to disclose the amount of advertising expense. However, it does not disclose the accounting policy for recording advertising expense and therefore it represents an incomplete disclosure.


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4. Accounting for Advertising Barter Transactions

Question: How should a company account for an advertising barter transaction? Response: Companies in many industries, including Internet companies, may enter into transactions in which they exchange rights to place advertisements on each other's web site; that is, bartered advertising. In other transactions, the parties exchange similar amounts of cash. The accounting for these transactions is generally accounted for by recording an equal amount of advertising revenue and expense as follows:

Advertising expense XX Advertising revenue XX

By recording the above transaction on a gross basis, revenues are recorded for which there is no corresponding cash flow, thereby overstating revenues and artificially inflating the market capitalization. The authority is found in ASC 605-20, Revenue Recognition-Services (formerly found in EITF 99-17), which provides the following requirements to account for advertising barter transactions: 1. Revenue and expense from bartered advertising transactions should be recognized at the fair

value of the advertising surrendered only if the fair value of the advertising surrendered is determinable based on the entity's own historical practice of receiving cash, marketable securities or other consideration for similar advertising from buyers unrelated to the parties to the barter transaction.

a. An exchange between the parties of a barter transaction of offsetting consideration (e.g.,

swapping checks of equal amounts), is not evidence of the fair value of the transaction. b. If the fair value of the advertising surrendered is not determinable within the limits of this

Issue, the barter transaction should be recorded at the carrying value of the advertising surrendered, which is likely to be zero.

2. An entity’s own historical practice: In order to satisfy the requirements, the following criteria

must be met: a. A period not to exceed six months prior to the date of the barter transaction should be

used to determine whether a historical practice of selling similar advertising for cash exists.

A shorter (but not longer) period can be used if economic circumstances have changed

so that prior transactions are not representative of current fair value for the advertising surrendered.

It is not appropriate to consider cash transactions subsequent to the barter transaction to determine fair value.

b. The advertising surrendered for cash within the six-month period must be similar to the

advertising surrendered in the barter transaction. Advertising is similar if:


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1) It is in the same media and within the same advertising vehicle as the advertising in

the barter transaction. Example: The advertising must be in the same publication, same web site or broadcast

channel.

2) It has characteristics reasonably similar to those of the advertising in the barter transaction with respect to:

Circulation, exposure, or saturation within an intended market

Timing (e.g., daily, weekly, season, etc.)

Prominence (page on the web site, section of the periodical, location on the page, size of the advertisement)

Demographics of readers, viewers, or customers

Duration (length of time advertising is displayed)

c. The quantity or volume of advertising surrendered in the past can only evidence the fair value of an equivalent quantity or volume of advertising surrendered in subsequent barter transactions. When a previous cash transaction is used to support an equivalent quantity and dollar amount of barter revenue, the past transaction cannot be used as evidence of fair value for any other barter transaction.

3. Entities should disclose the amount of revenue and expense recognized from advertising

barter transactions for each income statement period presented. If an entity does not record advertising revenue and expense because it cannot determine the fair value, information should be disclosed regarding the volume, type of advertising surrendered and received (e.g., the number of equivalent pages, number or minutes, or overall percentage of advertising volume).

Example 1: Webstartup 1 (W1) enters into an agreement with Company B to advertise on each other's web site with no cash consideration. Because W1 is a startup, it does not have any history of selling similar advertising to the advertising surrendered, for cash. Conclusion: Because W1 has no historical practice (within the past six months) of receiving cash for similar advertising, the advertising should be recorded by W1 at the carrying value of the advertising surrendered, which is zero. Thus, no entry is recorded for the barter transaction. Example 2: Same facts as Example 1, except that both parties agree to swap checks for $50,000 each in order to record both sides of the transaction. W1 first writes a check to Company B. Once the check clears, B writes a check back to W1 for the same amount. Conclusion: On the face of it, the transaction would appear to result in the recording of $50,000 advertising revenue and $50,000 of corresponding advertising expense. However, GAAP specifically states that the exchange of offsetting consideration, such as swapping checks of equal amounts, is not evidence of fair value. Therefore, the gross transactions should be ignored, resulting in no recording of this transaction.

Change the facts: What if the checks are not of equal amounts? Conclusion: It is not clear. ASC 605 states that the exchange of offsetting monetary transactions, such as a swap of checks of equal amounts, is not evidence of the fair value of the transaction. If


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the checks are not of equal amounts, an argument can be made that the transaction is actually two different transactions for cash and not a barter of advertising. Although not authoritative, the author believes that factors to consider in whether an exchange of checks of different amounts qualifies as two different transactions include the spread between the amounts of checks, and the timing, if any, between exchange of the checks. Example 3: Company B enters into several agreements to swap advertising on its web site for advertising space received on three other companies' websites, Companies C, D and E. Each of the three companies receives a two-inch square ad on the Company's home page for a one-year period. Four months ago, the Company sold a similar ad on its web site for $500,000 with the same terms and prominence of the web page. No other advertising has been sold in the past six months for cash.

Conclusion: ASC 605 states that revenue and expense from bartered advertising transactions should be recognized at the fair value of the advertising surrendered only if the fair value of the advertising surrendered is determinable based on the entity's own historical practice of selling similar advertising to unrelated parties for cash within the past six months. A period not to exceed six months prior to the date of the barter transaction should be used to determine whether a historical practice of selling similar advertising for cash exists. However, ASC 605 places a restriction on the amount of previously sold advertising that can be used to measure the fair value of traded advertising. The quantity or volume of advertising sold for cash in the past six months can only be used to evidence the fair value of an equivalent quantity or volume of advertising surrendered in subsequent barter transactions. In this example, three, two-inch ads were traded. However, only one similar ad was sold for cash within the past six months. The result is that the one ad that was sold for $500,000 cash can be used to evidence the fair value of only one of the three ads. Because the other two ads do not have any evidence of fair value based on cash sales of similar advertising within the past six months, ads 2 and 3 should be recorded at the carrying value of the advertising surrendered, which is zero. Entries to record three ads exchanged look like this:

Ad 1: Recorded at fair value Advertising expense 500,000 Advertising revenue 500,000 Ad 2: Recorded at fair value Advertising expense 0 Advertising revenue 0 Ad 3: Recorded at carrying value Advertising expense 0 Advertising revenue 0

Change the facts: Assume the advertising that Company B sold four months ago was a five-inch square ad on a page linked to the home page. The duration of the ad is two years and costs $1 million. Conclusion: The advertising sold is not considered similar to the advertising traded and does not qualify as evidence of the company's historical practice of selling similar advertising for cash within the past six months. The reason is that the advertising has too many characteristics that differ


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from the bartered advertising. Examples of differing characteristics include a different size, location on the web site and duration of the advertising time frame. The result is that the three ads should be recorded at the carrying value of zero:

Entries for Ads 1, 2 and 3: Advertising expense 0 Advertising revenue 0

Example 4: Company X trades advertising with Company Y on its web site plus gives Y $10,000 to receive advertising space on Company Y's web site. Assume that within the past six months, Company X has not sold similar advertising to the advertising surrendered. Conclusion: Because the transaction involves a partial cash purchase and partial barter of advertising, the two segments should be segregated. The portion of the advertising relating to the barter should be recorded at fair value of the advertising surrendered if evidence of fair value can be determined using cash sales of similar advertising within the past six months. Since there are no cash sales within the past six months, the advertising is recorded at its carrying value of zero. The second portion of the advertising is that amount purchased for cash of $10,000 which should be recorded at the $10,000 paid. The entry looks like this:

Entry: Advertising expense 10,000 Cash 10,000 Advertising expense 0 Advertising revenue 0

Change the facts: Assume there was similar advertising sold for $100,000 cash within the past six months. Conclusion: The fair value of the advertising surrendered is $100,000, the cash sale of similar advertising within the past six months, with a portion recorded for cash of $10,000.

Entry: Advertising expense 10,000 Cash 10,000 Advertising expense 100,000 Advertising revenue 100,000

Example 5: Company A and B work out a barter advertising arrangement whereby each advertises on the other's web site. The agreement provides that each company will provide a two-inch advertising space on the other's home page for one year. Company A is deciding how to handle the transaction for accounting purposes. Historically, A has sold advertising on its web site to other companies for cash. Specifically, within the past six months, Company A sold a similar one-year, two-inch space on its web site to Company C for $50,000 cash.

Conclusion: In determining whether to record the advertising barter transaction with B at fair value, Company A must use similar advertising sold for cash during the past six months. The advertising with Company C appears similar in size, duration and frequency, suggesting that it may be used as the fair value for the advertising surrendered to B. Thus, the entry that Company A would make to record advertising with B follows:


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Advertising expense 50,000 Advertising revenue 50,000

Continuing on, assume that Company A also enters into a barter transaction with Company D. The cash advertising for Company C has already been used to validate the fair value of the barter transaction with Company B. Therefore, the cash advertising sold to Company C cannot be used to also validate the fair value of other barter advertising, such as in this case with Company D. Having Your Cake and Eating It- Capitalizing the Advertising Expenditure There is a loophole in present rules for accounting for advertising that could result in a company capitalizing an advertising asset and recording advertising revenue in connection with a bartered advertising transaction. Let's look at this fact pattern. Facts: Company X agrees to barter advertising with Company Y, with each providing advertising on the other's web site. Because X's web site has greater traffic, Y's ad will be placed on X's web site for one year, while X's ad will be placed on Y's site for a two-year period. Based on a six-month history, X has sold similar advertising on its web site for $500,000. X's advertisement that is displayed on Y's web site has a link to another web site with an order form for a customer to order a product based on a click. Historically, X has data that shows that 5% of all customers who visit Y's web site will click on X's icon. Of those customers who click onto X's icon, 30% will order the product at a price of $100. Presently, one million customers are visiting Y's web site per month. At the end of the first year, the company has actual sales of the Product through Y's web site totaling $20 million. How should this transaction be recorded? Response: The first issue is whether the transaction should be recorded at fair value or carrying value. Because X has a history of selling similar advertising for cash within the past six months, the sale of $500,000 supports the fair value of X's advertising surrendered to Y. Once the advertising is measured at fair value of $500,000, the second issue is whether the advertising debit should be expensed or capitalized. Existing authority for accounting for advertising is found in ASC 340-20, Other Assets and Deferred Costs- Capitalized Advertising Costs (formerly SOP 93-7) which states that advertising is expensed unless the advertising is direct-response advertising. Direct-response advertising is advertising that can be directly linked to the revenue generated from the advertising. That is, based on internally generated historical data, the company can estimate the amount of revenue that can be generated directly from the advertising. Because of the linkage between the revenue and the advertising expenditure, direct-response advertising is capitalized and amortized to expense as revenue is generated from the advertising using the following formula:


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Calculation

Actual revenue generated from the advertisement

X Prepaid advertising costs

Current period amortization of asset to advertising expense

Estimated total revenue to be generated from the advertisement

Following the above example, there is a link between the advertising on Y's web site and the revenue generated from customers who click on X's ad on Y's web site, calculated as follows:

Annual number of customers visiting Y's site 12,000,000 % of customers that click onto X's icon 5% Estimated number of customers who visit X 600,000 Estimated % that will purchase X's product 30% Estimated number of purchases of X's product 180,000 Average selling price $100 Estimated annual total revenue generated from advertisement $18,000,000 Number of years 2 Estimated total revenue generated during two years $36,000,000

X's entries in year one would be as follows:

Entry: Prepaid advertising cost 500,000 Advertising revenue 500,000* Advertising expense 275,000 Prepaid advertising cost 275,000**

** Revenue to date (given) $20 million x $500,000 = $275,000 Estimated total revenue $36 million * Included in year 1 because of the one-year advertising arrangement.

In Year 2, the remainder of the prepaid advertising cost ($225,000) would be amortized to expense. Change the facts: Assume instead that X does not trade advertising but instead simply pays $500,000 cash for the advertising on Y's web site. Conclusion: A similar result would occur in terms of how the advertising would be capitalized and then expensed based on a revenue ratio as follows:

Entry: Prepaid advertising cost 500,000 Cash 500,000 Advertising expense 275,000 Prepaid advertising cost 275,000

Observation: The above examples illustrate how the accounting for web advertising may significantly change from its non-web advertising counterpart. A simple link on a web site gives a


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company the measurement vehicle necessary to capitalize otherwise expensed advertising as direct-response advertising. A typical non-web advertising mode (e.g., print ads, radio and television) rarely qualifies as direct-response advertising. The reason is because it is usually difficult to link the advertising expenditure with estimated revenue generated from the advertising. For example, a radio or television advertisement may result in additional revenue but that revenue usually cannot be directly correlated with the advertising expenditure unless there is use of some coupon or contest prize to track the advertisement response. The result is that advertising expenditures related to most modes of advertising are expensed as incurred. The exception can be with direct mail where the revenue may be linked with an estimate of total revenue generated based on a historical response rate. With the web, the link between advertising and revenue can be easily measured through the use of technology. Most websites track the number of customers who visit the site, their purchase habits and the percentage of those customers that actually purchase products through the website. This extensive tracking system results in a much greater highly correlated relationship between web advertising costs and the revenue generated from those costs. For example, some web sites actually charge for advertising based on the number of clicks (visits) of customers on the website. The result is that companies may be able to justify use of the direct-response advertising exception and capitalize their advertising placed on websites. In order to capitalize advertising costs, the company must be able to measure estimated total revenue from the advertising based on an internal history of sales. This requirement would typically preclude a company from using direct-response advertising in the first year of operations where it has no history of sales. In the second year, the company may be able to estimate total revenue and start capitalizing its web-advertising as direct-response advertising. 5. Reference to Notes on the Financial Statements Question: Many companies make reference to a particular note or notes parenthetically in the balance sheet and income statement. Example: Balance Sheet: Fixed assets (Notes 1 and 3): Cost Accumulated depreciation Is reference to footnotes required by GAAP? Response: No. There is no requirement to include these parenthetically referenced notes on financial statements. In fact, such a presentation is becoming passé. The reason is that many disclosures no longer relate to a particular line item on the financial statements. An example is the disclosure of risk and uncertainties which may relate to many financial statement items. The result is that many companies have eliminated this practice or have adopted a modified version whereby only selected items (e.g. debt, fixed assets, etc.) are parenthetically disclosed. 6. Disclosures About Limited Liability Companies Question: What are the disclosure and financial statement presentation requirements for limited liability companies (LLCs)? Response: ASC 272, Limited Liability Entities (formerly Practice Bulletin No. 14), requires the following relating to LLC’s financial statements.


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a. A complete set of financial statements should include a:

Balance sheet

Statement of income

Statement of cash flows

Statement or disclosure of changes in members’ equity

b. The headings of the LLC’s financial statements should clearly identify that the entity is an LLC.

c. Equity section: 1) Should be titled “members’ equity” 2) If more than one class of members exists, the LLC is encouraged (but not required) to report the equity of each class separately within the equity section.

Note: If the LLC does not report the amount of each class separately within the equity section, it should disclose those amounts in the notes to financial statements.

3) A deficit in members’ equity should be presented in the equity section even though

members’ liability may be limited. 5) The LLC is permitted (but not required) to disclose the separate components of

equity either on the face of the balance sheet or in the notes to financial statements. Examples of separate components that may be disclosed include:

undistributed earnings

earnings available for withdrawal

unallocated capital

5) If amounts are due from LLC members for capital contributions, such amounts should be presented as a deduction of members’ equity, not as an asset.

Exception: ASC 505, Equity, provides an exception whereby amounts receivable from shareholders in connection with the issuance of stock may be recorded as an asset only if there is substantial evidence of the ability and intent to pay the amount(s) due within a reasonably short period of time. Although the exception relates to the issuance of stock, ASC 505 states that LLCs should follow the same rule.

Changes in Members’ Equity ASC 272 requires that the changes in members’ equity be presented either in a statement format or disclosed in the notes to financial statements. With respect to format, an entity has three options: a) Present a separate statement of changes in members’ equity b) Present the changes in equity in conjunction with the statement of income c) Disclose the changes in the notes to financial statements


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OPTION 1: Separate Statement of Changes in Members’ Equity Jones and Smith, LLC Statement of Changes in Members’ Equity For the year ended December 31, 20X2 Members’ equity, beginning of year xx Net income xx Capital contributed by members xx Capital drawings by members (xx) Member’ equity, end of year xx

Must an entity present or disclose members’ equity separately for each member? Response: No. There is no authority requiring this disclosure. However, it may be done and may be advisable in situations where individual members want to know their capital accounts. If this is the case, a recommended format might look like this:

OPTION 1: Separate Statement of Changes in Members’ Equity (Separated by Each Member) Jones and Smith, LLC Statement of Changes in Members’ Equity For the year ended December 31, 20X2 Jones Smith Total Members’ equity, beginning of year xx xx xx Net income xx xx xx Capital contributed by members xx xx xx Capital drawings by members (xx) (xx) (xx) Members’ equity, end of year xx xx xx OPTION 2: Changes in Members’ Equity Presented with Statement of Income Jones and Smith, LLC Statement of Income and Changes in Members’ Equity For the year ended December 31, 20X2 Net sales xx Cost of sales xx Gross profit on sales xx Selling and delivery expenses xx General and administrative expenses xx Net income xx Members’ equity: Beginning of year xx Capital contributed by members xx Capital drawings by members (xx) End of year xx


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OPTION 3: Disclosures of the Changes in the Notes to Financial Statements

Jones and Smith, LLC Notes to Financial Statements

For the year ended December 31, 20X2 NOTE X: Changes in Members’ Equity A summary of the changes in members’ equity follows: Members’ equity: Beginning of year xx Capital contributed by members xx Capital drawings by members (xx) End of year xx

Presentation of Members’ Equity in the Statement of Cash Flows: The members’ equity activity should be presented in the statement of cash flows in the following manner:

Jones and Smith, LLC Statement of Cash Flows

For the year ended December 31, 20X2 Cash Flows from Operating Activities: not supplied Cash Flows from Investing Activities: not supplied Cash Flows From Financing Activities: Proceeds from long-term debt $400,000 Capital contributions by members 100,000 Capital drawings by members (50,000) Net cash provided by financing activities 450,000

a. Disclosures

1. ASC 272 requires the following disclosures for LLCs: 2. A description of the fact that the entity is taxed as a partnership or a corporation. 3. A description of any limitations of its members’ liability. 4. Different classes of members’ interests and the respective rights, preferences, and

privileges of each class, and the amounts of each class if not otherwise presented. 5. The date the LLC will cease to exist if it has a finite life.


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6. For LLCs formed by combining entities under common control or by conversion from another type of entity, in the year of formation, the notes should include:

A disclosure that the assets and liabilities previously were held by a predecessor entity or entities

Combined entities under common control are encouraged to make relevant disclosures, and

LLCs subject to income tax in any jurisdiction should make relevant disclosures in accordance with ASC 740, Income Taxes.

EXAMPLE DISCLOSURES Facts:

Effective January 1, 20X1, Company X converts from a limited partnership to a limited liability company. The LLC qualifies to be taxed as a partnership for federal income tax purposes.

All assets and liabilities of the former limited partnership were transferred to the LLC at their book values. There is no difference in the book and tax bases of assets and liabilities at December 31, 20X1.

In accordance with the members’ agreement, the LLC will cease upon the death of any one of its members unless a vote to continue is unanimously made by the remaining members.

Under the new structure, there are two types of members’ interests. Class A members: are responsible for management and voting on LLC affairs. Class B members: consists of non-voting interests.


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DISCLOSURE

NOTE 1: Summary of Significant Accounting Policies Conversion of Entity to Limited Liability Company Effective January 1, 20X1, the Company converted from a limited partnership to a limited liability company (LLC) in accordance with the laws of the Commonwealth of Massachusetts. The basis of all assets and liabilities of the entity as a limited partnership were carried over to the limited liability company. In accordance with the members’ agreement, the LLC will cease upon the death of any one of its members unless a vote to continue is unanimously made by the remaining members. The limited liability company has two classes of members’ interests, both of which are restricted from transfer without approval from the majority of members. Class A members have unlimited voting rights and participate in the management of the company while Class B members have limited voting rights, do not participate in management, and receive a priority claim on net assets upon dissolution of the Company. A summary of the amounts of each class of members’ interests at December 31, 20X1 follows: Class A members $100,000 Class B members 300,000 For federal income tax purposes, the Company is taxed as a partnership under which no federal tax liability is incurred. Instead, members are taxed individually on their share of the Company’s net income (or loss) in accordance with percentages established in the members’ agreement. No provision for federal or state income taxes is reflected in the financial statements. The basis of the company’s assets and liabilities are essentially the same for financial statement and tax purposes.

7. Disclosures of Policies When They are Not Applicable to the Current Year Question: Recently issued GAAP statements require the disclosure of certain policies in the summary of significant accounting policies. Examples include: 1. ASC 740, Income Taxes (FIN 48):

a. The entity’s policy on classification of interest and penalties assessed by taxing authorities.

2. ASU No. 2010-20: Disclosures about the Credit Quality of Financing Receivables and the

Allowance for Credit Losses:

a. The policy for placing trade receivables on nonaccrual status (e.g., discontinuing accrual of interest)

b. The policy for recording payments received on nonaccrual financing receivables, if

applicable c. The policy for resuming accrual of interest on past due accounts


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d. The policy for determining past due or delinquency status of trade receivables

There are many more. Assume an entity does not have a policy for a particular item that must be disclosed, or does not have the component to which the policy applies.

Example: For year ended December 31, 20X1, Company X has no official policy for classifying interest and penalties assessed by taxing authorities (such as the IRS), and further has no interest and penalties in 20X1.

Must the entity still disclose the policy under GAAP? Response: There is no authority on this issue other than to apply common sense. Disclosures are included to provide the user of financial statements with information on those financial statements. If a particular component of financial statements (for example, no interest and penalties) does not exist for a reporting period, it would seem useless to include a policy about an item that does not exist. That is the practical answer. 8. Disclosure When a GAAP Departure is Not Material Question: Company X purchases a company in 20X1, and records goodwill in the amount of $150,000. Total assets of X at December 31, 20X1 (including goodwill) total $1,400,000. X’s GAAP pre-tax income is about $300,000 for 20X1. GAAP requires that the goodwill not be amortized but be tested for impairment each year. For GAAP purposes, X chooses to amortize goodwill over the tax life of 15 years on a straight-line basis ($10,000 per year), and ignore the GAAP rules. X’s argument is that the $10,000 overstatement of amortization expense for GAAP is not material to X’s income and the understatement of the asset ($10,000 in year one) is not material. Mary Johnson, CPA is the accountant for Company X and is performing a review engagement on a GAAP basis for 20X1.

Mary does not consider the $10,000 of additional amortization and the $10,000 understatement of the goodwill asset to be material to the financial statements. In fact, the $10,000 is about 3% of pretax book income ($10,000 divided by $300,000). Further, the $10,000 understatement of the goodwill asset is less than 1% of total assets.

Mary does consider goodwill of $150,000 to be material to the balance sheet as it is just over 10% of total assets ($150,000/$1,400,000). Therefore, Mary believes the goodwill asset should be disclosed.

How should Mary disclose the GAAP departure in her review report and notes to financial statements? Response: The question is whether the GAAP departure is material. In this case, X’s GAAP departure is not material to the financial statements. Therefore, Mary would have no report modification and no disclosure about the GAAP departure. So, what should Mary disclose?


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Certainly, Mary should not disclose the fact that goodwill is amortized over 15 years. Remember, the GAAP departure is not material and therefore should not be disclosed. Here is what should be done:

1. Because goodwill is material to the balance sheet, it should be disclosed as a separate component on the balance sheet. However, the author recommends presenting goodwill at $150,000 GAAP amount, and presenting the $10,000 of accumulated amortization in another asset account by netting the $10,000 against an “other assets” account.

2. Amortization expense of $10,000 should not be presented separately on the income

statement, statement of cash flows, or operating expenses schedules. This amount is not material. Amortization should be presented at zero in the financial statements.

3. In the summary of significant accounting policies, the company should disclose that

goodwill is not amortized and is tested annual for impairment. 4. Any other disclosures related to goodwill should be made presenting data based on the

assumption that goodwill was not amortized. Take a look at the following recommended presentation:

Company X

Balance Sheet December 31, 20X1

ASSETS:

Current assets: Cash $100,000 Trade receivables, net of allowance of $10,000 500,000 Inventories 300,000 Total current assets 900,000 Fixed assets: Cost 1,000,000 Less accumulated depreciation 700,000 Total fixed assets 300,000 Other assets: Goodwill 150,000 Other assets, net 50,000 (1) $1,400,000

(1): $10,000 of accumulated amortization is netted in the other assets.


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Company X

Statement of Income For the Year Ended December 31, 20X1

Net sales $4,000,000 Cost of sales 3,000,000 Gross profit on sales 1,000,000 Operating expenses:

Payroll and payroll related expenses 380,000 Insurance 20,000 Office expenses and supplies 40,000 Rent 50,000 Depreciation 60,000 Amortization 0 (1) Utilities 10,000 Sundry other expenses, net 40,000 (1) Total operating expenses 600,000 Net income before income taxes

400,000

Income taxes 120,000 Net income

$280,000

(1): In the statement of income, amortization of $10,000 is netted in sundry other expenses as it is not material. Amortization expense is shown as zero or there should be no line item for amortization. Further, on the statement of cash flows, the $10,000 of amortization should not be shown as an adjustment in cash from operating activities. Instead, the $10,000 should be shown in a miscellaneous line somewhere on the statement of cash flows.


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Company X

Notes to Financial Statements For the Year Ended December 31, 20X1

NOTE 1: Summary of Significant Accounting Policies: Goodwill: The excess of the purchase price over the fair value of identifiable tangible and intangible assets is allocated to goodwill. Goodwill is not amortized unless events or circumstances occur indicating that an impairment exists. Impairment losses, if any, are recorded in the statement of income as part of income from operations.

Goodwill: The changes in the carrying value of goodwill follow:

Goodwill: Carrying value- beginning of year: $0

New acquisitions Amortization

150,000 0

Impairment losses ( 0)

Carrying value- end of year: $150,000

Observation: If there is a GAAP departure that is not material, the departure should be ignored throughout the financial statements because it is immaterial. Thus, the effects of the departure should not be identified in the financial statements or notes. In other words, the financial statements should present goodwill as if it were not amortized and in full compliance with GAAP. Perhaps just as important, the accountant or auditor should make sure he or she documents in his or her working papers the fact that the GAAP departure is not material as this issue may be addressed in peer review. Should the goodwill be tested for impairment? Technically, it should be tested for impairment. However, it is likely that any impairment would not be material. What if the $150,000 of goodwill asset is not material to the balance sheet? If the goodwill is not material, it should not be mentioned in the financial statements. Instead, it would make sense to include goodwill in with other assets and not present it as a separate item on the balance sheet. Further, there would be no disclosures required for goodwill. Observation: An area in which it is common for companies to depart from GAAP is to use the direct writeoff method to record bad debts. In many instances, the result from using the direct writeoff method is not materially different from the result had the allowance method been used. In such a situation, the disclosures should state that the company uses the allowance method (GAAP method) and that there is no allowance balance at year end.


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GAAP requires that the allowance method be used to account for bad debts. The direct writeoff method, although required for tax purposes, is not acceptable for GAAP. However, there are instances in which the result using the direct write-off method is not materially different from the result had the allowance method been used. This may be in a situation when, historically, the company has not had a material amount of bad debts. In such a situation, the company may opt to simply use the direct writeoff method and argue that the company is using the allowance method with a zero allowance balance required. Under no circumstances should the company disclose that it used a non-GAAP method (direct writeoff method) unless it is going to identify a GAAP departure in the notes and report. P. Income and Other Taxes 1. Provision for Income Taxes on Partnership Income Question: A partnership agreement provides that in computing net profits for allocation to certain partners, a provision for income taxes is deducted as an expense. In preparing the income statement, should the deduction be shown as income tax expense? Response: No. The formula used to allocate net profits to partners has nothing to do with the financial statement presentation. Under no circumstances should income tax expense be presented on the partnership's income statement. 2. Taxes Collected From Customers Question: An entity collects sales taxes from its customers. How should taxes assessed by a governmental authority be presented in the income statement (that is, gross versus net presentation)? Response: The only guidance available is found in ASC 605-45, Revenue Recognition-Principal Agent Considerations (formerly EITF Issue 06-3). ASC 605-45 states that the presentation of taxes on a gross or net basis is an accounting policy decision.

A gross basis would result in the taxes being included in both revenues and costs.

A net basis would exclude the taxes from both revenue and expenses. That is, it is up to the company to determine whether taxes should be presented on a gross or net basis. If taxes are presented on a net basis, the cash receipts and payments would be recorded through a balance sheet liability account that would zero out upon payment of the taxes to the taxing authority. If taxes are reported on a gross basis (e.g., recorded in both revenue and expense), an entity should disclose the amount of the taxes in interim and annual financial statements for each period for which an income statement is presented if those amounts are significant. The disclosure of those taxes can be done on an aggregate basis. Example 1: Company X records sales taxes on a net basis by excluding both the sales tax withholding and payments from revenue and expenses.


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Conclusion: The Company should disclose the accounting policy for accounting for sales taxes. Because the taxes are not recorded on a gross basis, there is no need to disclose the amount of the taxes. Disclosure:

Summary of Significant Accounting Policies: Revenue: The company is required to collect, on behalf of the Commonwealth of Massachusetts, sales tax based on 6.25 percent of most gross sales. The company’s policy is to exclude sales taxes from revenue when collected, and expenses when paid and instead, record the collection and payment of sales taxes through a liability account.

Example 2: Company X records sales taxes on a gross basis by including the sales tax withholding as part of gross sales, and payments as an expense. In 20X6, sales taxes included in revenue and expense were $500,000 and $(500,000), respectively. Disclosure:

Summary of Significant Accounting Policies: Revenue: The company is required to collect, on behalf of the Commonwealth of Massachusetts, sales tax based on 6.25 percent of most gross sales. The company’s policy is to include sales taxes withheld as part of gross sales, and its payment as an expense. In 20X6, sales taxes included in gross sales and expenses were $500,000 and $(500,000), respectively.

3. Sole Proprietorship Question: Should the financial statements of a proprietorship show an income tax provision? Response: There is no GAAP requirement to disclose the proprietorship income tax provision because it is affected by many other items. 4. Presentation of Tax Benefit of NOL Carryforward Question: How should the use of a net operating loss carryover be presented on the income statement? ASC 740, Income Taxes (formerly FASB No. 109), requires the tax benefit of the NOL to be presented as a direct reduction in the current portion of income tax expense with a corresponding disclosure. Example: A company has a $(300,000) NOL carryforward in 20X1 and records a deferred income tax asset as follows:

Entry: 20X1 DIT asset ($300,000 x 34%) 102,000 Income tax expense- deferred 102,000

The $300,000 unused NOL is carried over from 20X1 to 20X2. 20X2 information:


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Taxable income before NOL $800,000 NOL carryforward utilized (300,000) Taxable income 500,000 Tax rate 34% Current FIT provision $170,000

Conclusion: The December 31, 20X2 entry consists of two components:

Current accrual provision of $170,000

Reversal of the $102,000 deferred income tax asset that is used in 20X2.

Entry: 20X2 Income tax expense- current provision 170,000 Accrued FIT 170,000 Income tax expense- deferred 102,000 Deferred income tax asset 102,000

The total federal income tax expense in 20X2 looks like this:

Current provision (net of NOL) $170,000 Deferred 102,000 Total provision (FIT expense) $272,000 Presentation on the statement of income: Net income before income taxes $XX Income tax expense 272,000 Net income $XX


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NOTE 1: Income taxes: The provision for income includes federal taxes currently payable and deferred income taxes arising from assets and liabilities whose basis is different for financial reporting and income tax purposes. The majority of the deferred tax provision is the result of basis differences in recording depreciation and accruing certain expenses. The provision for income taxes is summarized as follows: Federal: Currently payable $ 272,000 (1) Deferred 102,000 Reduction due to use of net operating loss carryforward (102,000) (2) Total federal provision 272,000 State: Currently payable xx Deferred xx Total state provision xx Total provision xx (1) 800,000 x 34% = 272,000 (2) 300,000 x 34% = (102,000) Net current provision 170,000

5. State Income or Franchise Tax? Question: Many states have a state tax that is based on a multiple-formula such as the greater of an income tax or franchise tax. How should these taxes be accounted for? Response: If this is the case, ASC 740, Income Taxes, states the following: a) Deferred income taxes are only provided on taxes based on income, not on franchise

taxes. b) To the extent that the state tax is based on factors other than income, the tax is shown as

an operating expense. Example: A company computes its state tax as follows: Tax is paid on the greater of franchise tax or income tax.

Scenario 1

Scenario 2

Franchise tax based on capital $100,000 $100,000 Based on income 70,000 130,000


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Conclusion: The tax expense should be presented as follows: Operating expenses $100,000 $100,000 Income tax 0 30,000

6. Classification of Section 444 Required Payment- S Corporation Question: How should the payment required under Section 444 of the IRC related to fiscal year ending S corporations be presented on the balance sheet? Response: It should be presented as a deposit on the balance sheet per ASC 740 (formerly found in EITF 88-4)). Further, in the statement of cash flows, it should be presented as an inflow or outflow of an investing activity. 7. Dealing with NOL Carryforwards Question: How should a net operating loss (NOL) be measured and valued? Response: Many companies have unused net operating losses available for carryforward to future years. Those losses represent future tax benefits that should, in most cases, be recorded as deferred tax assets. Let’s look at an example: Facts: At December 31, 20X1, a company has the following:

Net operating loss- tax purposes $(600,000) Loss carryback to prior years 200,000

Unused NOL carryforward $(400,000)

Ignore other temporary differences.

The $200,000 loss carryback results in an IRS refund due of $68,000. Conclusion: First, the company should make an entry to record the refund due for the NOL carryback: Entry:

FIT refund receivable 68,000 Income tax expense- current federal 68,000

Next, the Company should compute a deferred tax asset on the tax benefit of the NOL carryforward. The deferred tax asset should be computed using a tax rate(s) which represents the rate(s) that are estimated to be in existence when the NOLs are used in future years. Assume 34% is the marginal tax rate that is expected to be in effect in future years in which the NOL will be used. The deferred tax asset should be computed as follows:


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$400,000 x 34% $136,000 After the asset is computed, it must be tested for realization. That is, will there be enough future income during the NOL carryforward period (20 years) to utilize the NOL? A valuation allowance account (contra asset) must be established for all or a portion of the deferred tax asset if it is more likely than not (more than 50% chance) that a portion of the tax benefit of the deferred tax asset will not be realized. Additional Facts: Assume that historically, the company has earned about $200,000 of taxable income per year and that 20X1 happened to be an unusually bad year. The Company expects that it will earn an average of $200,000 taxable income during the NOL carryforward period of 20 years. Test of future income to realize the deferred tax asset: $200,000 x 20 years = $4 million NOL carryforward 400,000 Conclusion: There is enough future income ($4,000,000) to absorb the $400,000 NOL carryforward during the 20-year carryforward period. No valuation allowance account is needed. Entry: Deferred income tax asset 136,000 Income tax expense- deferred 136,000

Change the facts: Assume instead the estimated future taxable income during the 20-year NOL carryforward period is only $300,000. Conclusion: The NOL carryforward is not expected to be utilized in full during the carryforward period as follows:

NOL Carryforward ($400,000) Estimated future income during Carryforward period

300,000

Portion estimated to be unused $(100,000) Tax rate 34% Valuation allowance needed $(34,000)

Entry: Deferred income tax asset 136,000 Valuation allowance 34,000 Income tax expense- deferred 102,000

Observation: A company that has an NOL carryforward has 20 years to use it. As a result, it is quite difficult for an otherwise profitable company to have a situation in which there is not enough adequate future income to utilize the NOL. If it is more likely than not (more than 50% probability) that a company will not have enough future taxable income to use the NOL during the carryforward period, the accountant might want to consider whether the company also has a going concern problem. Many CPA firms use the so-called three-year rule to test deferred tax assets for realization. Under this rule, if a company has three consecutive years of pre-tax book losses (the current year plus the two prior years), estimated future income during the 20-year carryforward period is deemed


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to be zero in determining whether the deferred tax asset will be realized. Of course, the three-year rule is not found in GAAP, but is commonly used by companies and CPA firms as a guideline for testing deferred tax assets for realization. Balance sheet presentation: The deferred tax asset is shown on the balance sheet, net of the valuation account. The current and long-term portion should be based on the estimated reversal date of the asset.

Deferred tax asset $136,000 Valuation allowance (34,000) Net deferred tax asset $102,000

Assume the above example and that the $300,000 of future taxable income is expected to occur in the next two years as follows:

Year

Future

taxable income

20X2 $150,000 20X3 150,000 Total future income $300,000

The deferred tax asset would be presented in the current and long-term asset sections of the balance sheet as follows:

20X2 20X3 Total Future taxable income $150,000 $150,000 $300,000 Tax rate 34% 34% 34% Deferred income tax asset $51,000 $51,000 $102,000

The balance sheet presentation looks like this:

Current assets: Deferred income tax asset $51,000 Long-term assets

Deferred income tax asset (net of valuation allowance of $34,000)

$51,000

The valuation allowance is netted against the long-term portion of the deferred tax asset because it is in the second and subsequent years to which the valuation allowance relates.

In future years, if the estimate of future income changes, resulting in a change to the valuation allowance balance, the valuation is adjusted with the difference made to income tax expense.

The footnote disclosure for the NOL in 20X1 is as follows:


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NOTE X: Income tax expense: Federal: Current (credit) $(68,000) Deferred XX Tax benefit from net operating loss carryforward

(102,000)

XX State: Current XX Deferred XX XX Total income tax expense (credit) $XX

8. Tax Rate to Use for DITs Question: A C corporation has taxable income ranging from $50,000 to $100,000 per year. In recording deferred tax assets and liabilities, what federal tax rate should be used? Response: ASC 740-10-30-8: states that a deferred tax liability or asset is recorded using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized. In situations in which graduated (margin) tax rates are a “significant factor,” ASC 740-10-30-9 states that the deferred liability or asset shall be measured using the average graduated tax rate applicable to the amount of estimated annual taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized. Thus, the average graduated tax rate should be used based on the level of taxable income (including reversal of the temporary difference) in the reversal years. Consider the following table:

Taxable income

increment

Cumulative taxable income

(B)

Marginal tax rate

on increment

Marginal tax Cumulative Tax (A)

Average graduated

tax rate (A)/(B)

$50,000 $50,000 15% $7,500 $7,500 15%

25,000 75,000 25% 6,250 13,750 18%

25,000 100,000 34% 8,500 22,250 22%

100,000 200,000 39% 39,000 61,250 31%

100,000 300,000 39% 39,000 100,250 33%

35,000 335,000 39% 13,650 113,900 34%

65,000 400,000 34% 22,100 136,000 34%

100,000 500,000 34% 34,000 170,000 34%

9,500,000 10,000,000 34% 3,230,000 3,400,000 34%

>$10,000,000 35% 35%


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Example: Company X has a temporary difference related to accumulated depreciation in the amount of $40,000 which will reverse evenly over the next 10 years. Assume that X estimates that its taxable income, including the reversal of the temporary difference, will be approximately $100,000 in each of the 10 reversal years. Conclusion: Because estimated taxable income in the 10 reversal years will be approximately $100,000, the graduated tax rates range from 15% to 34% and those rates will be significant. Therefore, GAAP requires that average graduated tax rates for the estimated amount of taxable income (including the reversal of the temporary difference) should be used to record the deferred income tax liability. The average graduated income tax rate on $100,000 of taxable income is 22%. The deferred tax liability should be recorded as follows:

Temporary difference $40,000 Average graduated tax rate 22% Deferred tax liability $8,800

Question: What about using the effective tax rate to record deferred tax liabilities or assets? Response: ASC 740 is clear that deferred tax liabilities and assets should be recorded using enacted tax rates and not effective tax rates. 9. Accounting for Uncertain Tax Positions Question: What are the general rules for accounting for tax positions? Response: The authority for tax positions is found in ASC 740 Income Taxes (formerly FASB Interpretation No. 48 (FIN 48)), which provides guidance on the treatment of derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transition, as they relate to tax positions. The rules apply to all tax positions accounted for under ASC 740 (formerly FASB No. 109). A tax position is defined as:

“a position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets or liabilities for interim or annual periods.”

A tax position results in either:

A permanent reduction in income taxes payable

A deferral of income taxes otherwise currently payable to future years, or

A change in the expected realizability of deferred tax assets. The rules found in ASC 740 apply as follows:

1. If it is more likely than not (more than 50% probability) that a tax position will be sustained upon IRS or state tax examination (including any appeals or litigation process), the amount of the tax effect of a tax position is retained on the financial statements.


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2. If it is not more likely than not (not more than 50% probability) that the tax position will be

sustained upon an IRS or state tax examination, all of the tax effect of the tax position is eliminated in the financial statements by recording a liability for the hypothetical additional tax that will be paid when the tax position is disallowed upon IRS or state examination.

The rules for uncertain tax positions apply to federal, state and local and foreign income taxes, but do not apply to sales and use taxes, franchise taxes, real estate and personal property taxes, and fees that are not taxes. Example 1: Tax Deduction: Company X computes its 20X7 tax provision as follows:

Taxable Income

Tax rate

Tax (Federal/state)

Net sales $1,000,000

Operating expenses:

Travel (2,500)

All other (597,500)

Total operating expenses

(600,000)

NIBT 400,000 40% 160,000

M-1: Depreciation

(50,000)

40%

(20,000)

Taxable income $350,000 40% $140,000

Entry: Income tax expense 160,000 Deferred income tax asset 20,000 Accrued tax liability 140,000

Company X takes a $2,500 tax deduction for certain items that may be nondeductible travel related to a shareholder’s spouse. The tax benefit of the item embedded within the tax provision is $1,000 ($2,500 x 40%). X believes that if it were audited by the IRS and Massachusetts Department of Revenue, it is more likely than not (more than 50% probability) that the entire deduction is sustainable even if X has to go to appeals or even tax court. Conclusion: Because X believes it is more likely than not that the deduction would be sustained in the event of examination, including any required appeal or tax court decision, X would retain the tax benefit of the tax deduction on its financial statements. That means that X would not record an additional liability for the additional tax that would be paid if the deduction were disallowed upon examination. Change the facts: What if the more-likely-than-not threshold is not met for sustaining the deductibility of the $2,500?


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Assume X believes that upon examination, the entire $2,500 deduction would be disallowed. In this case, it is not more likely than not that the $2,500 deduction would be sustained resulting in an additional tax in the amount of $1,000, for which an additional liability is recorded as follows: The revised entry looks like this:

Revised Entry: Income tax expense 161,000* Deferred income tax asset 20,000 Accrued tax liability 140,000 Liability for unrecognized tax benefit 1,000 * Book income ($400,000) plus unrecognized deduction ($2,500) = $402,500 x 40% = $161,000.

Question: What types of entities are subject to the rules found in FIN 48? Response: FIN 48 applies to all entities including:

For-profit

Not-for-profit

Pass-through entities (S corporations, LLCs and partnerships, and

Entities taxed in a manner similar to pass-through entities such as REITs and registered investment companies.26

Note: Not-for-profit and pass-through entities, and tax-exempt organizations are subject to the Interpretation because they can pay taxes. For example, an S corporation can be subject to a built-in gain tax under IRC section 1374. Similarly, a not-for-profit entity can be subject to a tax on unrelated business income. A reporting entity must consider the tax positions of all entities within a related party group of entities regardless of the tax status of the reporting entity. ASU 2009-06 amended FIN 48 to include under the definition of a tax position an entity’s tax status such as an entity’s status as a pass-through entity (S corporation) or a tax-exempt not-for-profit entity. For example, one such tax position is the company’s position that it is properly in compliance with the IRC to be taxed as an S corporation, or it is an LLC that is taxed as a partnership instead of a corporation. Question: What are the disclosures required by FIN 48? Response: FIN 48 requires the following disclosures which apply to all entities: 1. The entity’s policy on classification of interest and penalties assessed by taxing authorities. 2. As of the end of each annual reporting period presented:

a. The total amounts of interest and penalties recognized in the statement of operations and the total amounts of interest and penalties recognized in the statement of financial position, assessed by taxing authorities.

26 Entities whose liability is subject to 100 percent credit for dividends paid (REITs and registered investment

companies).


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b. For positions for which it is reasonably possible that the total amounts of unrecognized tax

benefits will significantly increase or decrease within 12 months of the reporting date:

The nature of the uncertainty

The nature of the event that could occur in the next 12 months that would cause the change

An estimate of the range of the reasonably possible change or a statement that an estimate of the range cannot be made

c. A description of tax years that remain subject to examination by major tax jurisdictions.

3. Public companies only shall include the following additional disclosures as of the end of each annual reporting period presented:

a. A tabular reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of the period which shall include at a minimum:

The gross amounts of the increases and decreases in unrecognized tax benefits as a result of tax positions taken during a prior period.

The gross amounts of increases and decreases in unrecognized tax benefits as a result of tax positions taken during the current period.

The amounts of decreases in the unrecognized tax benefits relating to settlements within taxing authorities.

Reductions to unrecognized tax benefits as a result of a lapse of the applicable statute of limitations.

b. The total amount of unrecognized tax benefits that, if recognized, would affect the effective

tax rate. Example Disclosures: Following are sample disclosures. In parentheses, the author has included the disclosure reference from the table above.


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Example 1 Disclosure: Public Company

Note X: Tax Uncertainties The Company files income tax returns in the U.S. federal jurisdiction, and various states (not required). The Company is subject to U.S. federal and state income tax examinations for tax years 20X4, 20X5, 20X6 and 20X7. The Internal Revenue Service (IRS) commenced an examination of the Company’s U.S. income tax returns for 20X3 and 20X4 in the first quarter 20X7 which is expected to be completed by the end of 20X8. As of December 31, 20X7, the IRS has proposed certain significant tax adjustments to the Company’s research credits. Management is currently evaluating those proposed adjustments to determine if it agrees. If accepted, the Company anticipates that it is reasonably possible that an additional tax payment in the range of $80,000 to $100,000 will be made by the end of 20X8. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (public company disclosure only).

Balance at January 1, 20X7 $ 0 Additions based on tax positions related to the current year 210,000 Additions for tax positions of prior years 30,000 Reductions for tax positions of prior years (50,000) Reductions due to settlements with taxing authorities (40,000) Reductions due to lapse in statute of limitations (10,000) Balance at December 31, 20X7 $140,000

The Company’s policy is to record interest expense and penalties assessed by taxing authorities in operating expenses. For years ended December 31, 20X7, 20X6 and 20X5, the Company recognized approximately $12,000, $15,000 and $17,000, respectively of interest and penalties expense. At December 31, 20X7 and 20X6, accrued interest and penalties were $50,000 and $45,000, respectively. Included in the balance at December 31, 20X7 and 20X6 are $30,000 and $25,000, respectively, of tax positions that relate to tax deductions that upon audit could be disallowed, resulting in a higher effective tax rate. Management believes that it is more likely than not that these tax positions would be sustained in the event of audit (public company disclosure only).


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Example 2 Disclosure: Non-Public Company

Note X: Tax Uncertainties The Company’s policy is to record interest expense and penalties assessed by taxing authorities in operating expenses. For years ended December 31, 20X7 and 20X6, the Company recognized approximately $5,000 and $6,000, respectively of interest and penalties expense. At December 31, 20X7 and 20X6, accrued interest and penalties were $2,000 and $3,000, respectively. The Company is subject to U.S. federal and state income tax examinations for tax years 20X4, 20X5, 20X6 and 20X7. The Internal Revenue Service (IRS) commenced an examination of the Company’s U.S. income tax returns for 20X3 and 20X4 in the first quarter 20X7 which is expected to be completed by the end of 20X8. As of December 31, 20X7, the IRS has proposed certain significant tax adjustments to the Company’s research credits. Management is currently evaluating those proposed adjustments to determine if it agrees. If accepted, the Company anticipates that it is reasonably possible that an additional tax payment in the range of $80,000 to $100,000 will be made by the end of 20X8.

Example 3 Disclosure: Non-Public Company- Abbreviated Disclosure Most public companies do not have tax positions that require the recording of an unrecognized liability. In such cases, the minimum disclosures are as follows:

Note X: Tax Uncertainties The Company’s policy is to record interest expense and penalties in operating expenses. For years ended December 31, 20X7 and 20X6, there was no interest and penalties expense recorded and no accrued interest and penalties. The Company is subject to U.S. federal and state income tax examinations for tax years 20X4, 20X5, 20X6 and 20X7.

Observation: At a minimum, a company must disclose three items regardless of whether it has any unrecognized liability adjustments under FIN 48:

1. The Company’s policy is to record interest expense and penalties assessed by taxing authorities in operating expenses.

2. The total amounts of interest and penalties recognized in the statement of operations and

the total amounts of interest and penalties recognized in the statement of financial position assessed by taxing authorities, and

3. A description of tax years that remain open subject to examination by major tax

jurisdictions.


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Question: Are the three disclosures noted above required for an S corporation, LLC-partnership, a not-for-profit or tax-exempt entity, or an entity that has no liability for unrecognized tax benefit under FIN 48? Response: Yes. A literal reading of FIN 48 is that the above three disclosures apply to all entities that are subject to the requirements of FIN 48. FIN 48 specifically includes pass-through entities, tax-exempt entities and not-for-profit entities. Consequently, even if any entity has no liability recorded under FIN 48, the disclosures still apply. Thus, all entities must disclose, at a minimum, The Company’s policy is to record interest expense and penalties assessed by taxing authorities in operating expenses. The total amounts of interest and penalties recognized in the statement of operations and the total amounts of interest and penalties recognized in the statement of financial position. assessed by taxing authorities, and A description of tax years that remain open subject to examination by major tax jurisdictions. With respect to tax-basis financial statements, the recognition element of FIN 48 (e.g., whether to record a liability for an unrecognized tax effect that does not meet the more-likely-than-not threshold), does not apply because such a liability is not recognized under the Internal Revenue Code. Question: ASC 740, Income Taxes (formerly found in FIN 48) requires an entity to disclose those tax years that remain open for examination by major tax jurisdictions. Company X issues financial statements for 2016 on March 31, 2017. On March 31, 2017, X’s 2013, 2014 and 2015 federal and state income tax returns are open for examination. Tax returns for 2016 will not filed until September 15, 2017. Does the disclosure only apply to years for which tax returns have actually been filed? Response: Paragraph 15 of ASC 740-10-50, Income Taxes, Overall, Disclosure, requires the following disclosure: “A description of tax years that remain subject to examination by major tax jurisdiction.” Notice that the requirement states that a description of “tax years” and not “tax returns” is required. That means that there is no requirement that tax returns be actually filed for a particular year to be disclosed. Therefore, tax years that remain subject to examination include years 2013, 2014, 2015, and 2016 even though 2016’s tax returns have yet to be filed at the time the financial statements are issued. The disclosure can be made as follows:

The Company is subject to U.S. federal and state income tax examinations for tax years 2013 to 2016.


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or, The Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for tax years before 2013.

Question: Are the FIN 48 disclosures required if an entity has no uncertain tax position liability recorded? Response: There has been confusion as to whether the various disclosures required by FIN 48 apply if an entity has no uncertain tax position liability recorded. In May 2010, the AICPA's Financial Reporting Executive Committee (FinREC) issued a technical practice aid, TPA 5250-15. “Application of Certain FASB Interpretation No. 48 (codified in FASB ASC 740-10) Disclosure Requirements to Nonpublic Entities That Do Not Have Uncertain Tax Positions,” In that TPA, the AICPA concluded that when a nonpublic entity did not have uncertain tax positions the disclosure found in ASC 740-10-50-15(e) of the number of years that remain open subject to tax examination was still required to be disclosed. Since issuance of the TPA, critics have argued that the conclusion reached in the TPA is flawed and inconsistent with ASU 2009-6. In the Basis of Conclusions section of ASU 2009-6, the FASB states:

BC13. The board concluded that the disclosure requirements in paragraph 740-10-50-15(c.) through (e) still provide value to users of nonpublic entity financial statements even without the disclosure of total unrecognized tax balances. As a result, the Board decided not to require nonpublic entities to disclose total unrecognized tax positions at the balance sheet dates. BC14. One respondent asked if a disclosure would be required if management determined that there are no unrecognized tax benefits to record. The Board concluded that such a disclosure would not be required because it will set a precedent for requiring a similar disclosure for all accounting standards for which there was no material effect on the financial statements.

Although BC14 does not explicitly identify what "a disclosure" references, at a minimum it references the disclosure of the number of tax years that remain open as follows:

A description of tax years that remain open subject to examination by major tax jurisdictions

The FASB states that if there are no material uncertain tax positions recorded, the disclosure of "a description of tax years that remain open subject to examination by major tax jurisdiction" is not required. But TPA 5250-15 erroneously contradicted the FASB's conclusion by stating that the disclosure of the number of years open IS required even if an entity has no uncertain tax positions recorded. Some respondents have stated that the AICPA was not inconsistent with the FASB's position because the Basis of Conclusions section is not formally part of the FASB's Codification. The FASB and the Private Company Council (PCC) discussed FIN 48 at a February 2015 PCC


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meeting. At that meeting, the FASB reaffirmed its position in Paragraph B14 by stating that it did not intend to require disclosure of tax examination years that are open when a nonpublic entity does not have any (material) uncertain tax positions. Consequently, disclosure of the number of years that remain open for examination is not required unless an entity has recorded a liability for uncertain tax positions. As a result, the AICPA has deleted a previously issued Technical Practice Aid (TPA 5250-15) in which it had previously concluded that contradicted the FASB’s conclusion. Question: Are other FIN 48 disclosures required if the related item does not exist? Response: Once again, the three disclosures that are referenced above are:

1. The Company’s policy on classification of interest expense and penalties assessed by taxing authorities

2. The total amounts of interest and penalties recognized in the statement of operations and

the total amounts of interest and penalties recognized in the statement of financial position, assessed by taxing authorities, and

3. A description of tax years that remain open subject to examination by major tax

jurisdictions As the author just reviewed, if an entity has no material unrecognized tax positions, the third disclosure (description of tax years open) is not required. But what about the other two disclosures related to interest and penalties? Are they required if an entity has no interest and penalties related to taxes? Remember that Paragraph B14 of ASU 2009-6 states:

BC14. One respondent asked if a disclosure would be required if management determined that there are no unrecognized tax benefits to record. The Board concluded that such a disclosure would not be required because it will set a precedent for requiring a similar disclosure for all accounting standards for which there was no material effect on the financial statements.

The FASB notes that a disclosure is not required (of open tax years) if there are no unrecognized tax obligations or benefits. The FASB goes on to state that to require such an irrelevant disclosure would not be required because it will "set a precedent" meaning it would result in entities including disclosures on elements that do not exist. In other words, the FASB is saying that it does not want to set a precedent for requiring disclosures where an item to which the disclosure relates is not material to the financial statements. The same conclusion should apply to disclosures (1) and (2) above involving interest and penalties on taxes. If an entity has no interest or penalties related to their taxes, there is no requirement to disclose item (1) (the company's policy to record interest expense and penalties assessed, and item (2) (The total amounts of interest and penalties recognized in the statement of operations and the total amounts of interest and penalties recognized in the statement of financial position assessed by taxing authorities).


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Question: Are any of the unrecognized tax benefit obligation disclosures required for an entity using tax-basis financial statements? Response: As to the disclosure of the number of years open for examination, no disclosure is required if using tax-basis financial statements. The reason is because such a disclosure is not required unless an entity has an unrecognized tax benefit liability, which is not recorded for tax-basis financial statements. As to the disclosures about interest and penalties, such disclosures would only be required in a year in which an entity that uses the tax-basis of accounting, has interest and penalties related to a tax obligation that are either recorded as expense or accrued. Otherwise, no disclosures would be required.


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 53. In preparing a personal financing statement, how should estate taxes be accounted for:

a) there should be an accrual for the estate tax b) there should be an accrual for the estate tax and a disclosure of the estate tax c) there should be a disclosure that presents the “what if” estate tax assuming death on the

financial statement date d) there should be an accrual for the estate tax if one of the parties had died at the balance

sheet date and there was an estate tax due 54. Which of the following is correct regarding the disclosure of the salary of a company’s officer

and principal shareholder: a) the payment of the salary is considered a related party transaction that requires

disclosure b) the salary of an owner-manager cannot be included in the statements or the

supplementary information c) ASC 850 (formerly FASB No. 57), explicitly excludes disclosure of “compensation

arrangements” when an individual is an owner-manager d) companies are not permitted from presenting the officer’s compensation as a separate

line item in the schedule of operating expenses because this would be considered a disclosure

55. A company has a loan payable to a related party. The loan is forgiven. How should the

forgiveness be handled on the financial statements: a) the forgiveness of debt should be credited to equity b) the forgiveness of debt should be credited to income from continuing operations c) the forgiveness of debt should be recorded as a deferred credit on the balance sheet d) the forgiveness of debt should be credited income from discontinued operations 56. Which of the following is correct regarding advertising expense:

a) advertising expense must be disclosed for all periods presented b) advertising expense should only be disclosed if significant c) direct-response advertising should be expensed when incurred d) most companies use direct-response advertising

57. Which of the following is correct:

a) financial statements must make reference to a particular note parenthetically in the balance sheet and income statement

b) a balance sheet, but not an income statement, must make reference to a particular note parenthetically

c) an income statement, but not a balance sheet, must make reference to a particular note parenthetically

d) there is no requirement to parenthetically reference notes on any financial statements


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58. Which of the following is correct regarding the financial statement requirements of limited liability companies: a) the headings of an LLC’s financial statements should not identify that the entity is an LLC

because that fact is confusing to the reader b) the equity section should be titled “Members’ equity” c) a deficit in members’ equity should be presented as an asset d) amounts due from LLC members for capital contributions should be presented as an asset

59. ASC 272 (formerly Practice Bulletin 14) requires which one of the following disclosures for LLCs:

a) The amount of federal income taxes the partnership paid as a partnership b) the number of LLC members c) whether the entity has a finite life, but not necessarily the date the LLC will cease to

exist d) a description of any limitations on its members’ liability


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SUGGESTED SOLUTIONS 53. A: Incorrect. The estate tax due is based on a future event, not an action taken as of the

financial statement date. Thus no accrual is required or warranted. B: Incorrect. GAAP provides for no accrual of the estate tax and no disclosure required, as

there has not been any event (death) that has made the tax an obligation. C: Incorrect. No disclosure of the “what if” estate tax is required under GAAP. The reason is

because there has been no event that makes the payment of the estate tax reasonably possible.

D: Correct. The only time an accrual for the estate tax liability would be required is if one of the parties to the financial statements had died at the balance sheet date and there was an actual estate tax due.

54. A: Incorrect. Although the payment of the salary could be construed as a related party

transaction, ASC 850 (formerly FASB No. 57) specifically excludes from disclosure “compensation arrangements” when an individual is an owner-manager.

B: Incorrect. The salary information can be included in the supplementary information. C: Correct. Compensation arrangements with an individual who is an owner-manager

are exempt from disclosure. As a practical matter, some companies present officers’ compensation as a separate line item in the schedule of operating expenses in the supplementary information section.

D: Incorrect. There is no provision that precludes a disclosure of officer’s compensation anywhere in the financial statements or supplementary information. Note further that any information presented in the schedule of operating expenses in the supplementary information is not considered a disclosure.

55. A: Correct. ASC 470 states that the extinguishment of debt due to a related party

should be credited to equity, making the answer correct. B: Incorrect. ASC 470 does not permit the extinguishment of debt due to a related party to

be credited to the income statement as part of continuing operations. To present it on the income statement would allow a related party, through a forgiveness, to augment income when, in fact, there has been no earnings from the transaction.

C: Incorrect. ASC 470 does not provide for recording a deferred credit on the extinguishment of debt due to a related party. Thus, the answer is incorrect.

D: Incorrect. ASC 470 does not permit the extinguishment of debt due to a related party to be presented as part of discontinued operations as no part of the transaction can be presented on the income statement.

56. A: Correct. The authority for this requirement is ASC 340-20 (formerly found in SOP

93-7) which requires that advertising expense be disclosed for all periods presented.

B: Incorrect. According to ASC 340-20 (formerly found in SOP 93-7), advertising expense must be disclosed for all periods presented. It does not limit the disclosure for significant advertising. However, in general, any disclosure that is immaterial (not insignificant) may be omitted under GAAP.

C: Incorrect. According to ASC 340-20 (formerly found in SOP 93-7), direct-response advertising must be capitalized as an asset and amortized to expense.

D: Incorrect. Most companies do not have direct response advertising, and as a result only have to comply with the disclosure provisions of ASC 340-20 (formerly found in SOP 93-7) and expense advertising cost as incurred.


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57. A: Incorrect. There is no requirement within GAAP that financial statements make reference to any notes, making the answer incorrect.

B: Incorrect. There is no requirement to reference notes in the balance sheet, making the statement incorrect.

C: Incorrect. There is no requirement to reference notes in the income statement, making the statement incorrect.

D: Correct. Although a company may parenthetically reference notes in the financial statements, there is no requirement to do so, making the answer correct.

58. A: Incorrect. According to ASC 272 (formerly Practice Bulletin No. 14), the headings of the

LLC’s financial statements should clearly identify that the entity is an LLC. B: Correct. According to ASC 272 (formerly Practice Bulletin No. 14), the equity section

should be titled “members’ equity” making the answer correct. C: Incorrect. A deficit in members’ equity should be presented in the equity section, not as

an asset, even though members’ liability may be limited. D: Incorrect. If amounts are due from LLC members for capital contributions, such amounts

should be presented as a deduction of members’ equity, and not as an asset. 59. A: Incorrect. The ASC requires disclosing the fact that the entity is taxed as a partnership or

a corporation but not the amount of taxes paid as a partnership. The fact is that if the entity is taxed as a partnership, there are no federal income taxes paid by the entity.

B: Incorrect. ASC 272 (formerly Practice Bulletin No. 14) does not require the disclosure of the number of LLC members.

C: Incorrect. One required disclosure is the date on which the LLC will cease to exist if the life is finite. Thus, the answer is incorrect.

D: Correct. If there are any limitations on the members’ liability, that information must be disclosed as required by ASC 272.


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Q. Dealing with Acts of God (Natural Disasters), Terrorist Acts and Insurance Related Thereto 1. Accounting for Natural Disasters and Terrorist Acts Question: If there is a natural disaster, act of God or terrorist act, when should asset impairment losses be recognized? Response: The rules found in existing accounting literature (including ASC 350 (formerly FASB No. 142) and ASC 360 (formerly FASB No. 144) should be followed in testing and recognizing impairment losses on long-lived assets and goodwill. FASB ASC 360, Property, Plant, and Equipment, provides guidance on recognition and measurement of impairment losses on long-lived assets. That literature should be used to determine when an impairment loss on long-lived assets resulting from a natural disaster should be recognized and how that impairment loss should be measured. FASB ASC 310, Receivables, provides guidance on recognition and measurement of impairment losses on loans. FASB ASC 310-10-35-16 states that a loan is impaired when, “based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.” In measuring impairment losses on loans, creditors should follow FASB ASC 310-10-35-22, which states:

“When a loan is impaired as defined in paragraphs 310-10-35-16 through 35-17, a creditor shall measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is a collateral-dependent loan.”

FASB ASC 350, Intangibles—Goodwill and Other, provides guidance on recognition and measurement of impairment losses on intangible assets and goodwill. FASB ASC 450, Contingencies, provides guidance on recognition and measurement of impairment losses on assets not covered by specific other literature. Question: When should a liability for non-impairment losses and costs related to a natural disaster, act of God or terrorist act be recognized? Response: The previously issued EITF Issue 01-10 provides the following guidance: 1. The provisions of ASC 450, Contingencies (formerly FASB No. 5), should be followed in

determining when to recognize losses and costs incurred. a. ASC 450 states that a loss accrual with a charge to income is required if it is a) probable

that an asset has been impaired or a liability has been incurred at the balance sheet date, and b) the amount of the loss can be reasonably estimated.

Note: Under ASC 450, many of the losses and costs from the event will not qualify for

immediate recognition as a liability. Examples include the costs of restoration of a property to a condition suitable for occupancy should be recognized as the restoration efforts occur. The fact that an entity intends to incur costs as a result of a terrorist act or act of God does not necessarily mean that those costs should be immediately recognized as a liability.


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2. Paragraph 63 of FASB Concept Statement 5, Recognition and Measurement in Financial

Statements of Business Enterprises, states that liabilities should be recognized when the following criteria are met:

a. the item meets the definition of a liability. Paragraph 35 of Concepts Statement 6 defines

liabilities as "probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events" (footnote references omitted).

b. the liability can be measured with sufficient reliability. c. the information about the liability is capable of making a difference in user decisions. d. the information about the liability is representationally faithful, verifiable, and neutral.

3. An entity should recognize a liability as of a natural disaster, terrorist act or act of God for

operating lease rentals on temporarily unusable equipment or facilities provided that the period of time that the equipment or facilities will be unusable can be reasonably estimated.

4. A liability should be recognized as of the date of a natural disaster, terrorist act or act of God

for salaries and employee benefits that will continue to be paid while operations are temporarily suspended, if the four criteria for ASC 710, Compensation (formerly FASB No. 43) are met:

a. Employees’ services have already been rendered, b. Rights to the compensation vest or accumulate, c. Payment of the compensation is probable, and d. The amount can be reasonably estimated. 5. Operating lease expense on temporarily idled equipment or facilities should be recognized in

accordance with ASC 840 and related guidance during the period the equipment or facilities are idle. No change in the recognition principles for operating rentals on such equipment or facilities is appropriate even though they have been temporarily idled.

6. Depreciation and amortization expense on capitalized equipment or facilities that are

temporarily unusable or temporarily idle should be continued. Example 1: XYZ Company leases certain production equipment under noncancellable operating leases. As a result of the decline in demand for XYZ’s product, which management of XYZ attributes to the events of a natural disaster, the production equipment is temporarily idled. XYZ must continue to make its operating lease payments during the period that the equipment is idled and anticipates using the equipment again once demand for its product approximates the levels experienced before the event. Conclusion: XYZ should not accrue a liability at the date the equipment is idled. Instead, operating lease expense should continue to be recognized in accordance with ASC 840. Example 2: XYZ leases certain office equipment under noncancellable operating leases. As a result of a hurricane on September 1, 20X1, XYZ’s office building, which is in close proximity to the disaster site, has been temporarily closed by the State. Therefore, the equipment is temporarily unusable. Inspectors that have visited the facilities state that the equipment is still functional and only requires a thorough cleaning in order to operate. However, XYZ cannot


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retrieve any of the equipment because access to the building has been denied by the local authorities. XYZ must continue to make lease payments during the period that the equipment is not in use. The building is scheduled to reopen on June 30, 2002 and may be closed for even a longer period of time. Conclusion: XYZ should recognize a liability as of September 1, 20X1, for its operating lease payments on equipment that is temporarily unusable, provided XYZ can reasonably estimate the period of time that the equipment will be unusable. In this case, XYZ should recognize its operating lease rentals for the period September 1, 20X1 to June 30, 20X2, which is the minimum period of time that the building will be closed and the equipment unusable. Example 3: Same facts as Example 2 except that XYZ cannot estimate the period of time that the building will be closed and the equipment unusable. Conclusion: XYZ should not recognize a liability for future operating lease payments because the period of time during which the equipment is unusable could not be reasonably estimated. Example 4: Due to a hurricane on September 1, 20X1, Company X’s office building has been damaged and closed indefinitely as unusable. The Company’s computers and other documents are in the building and are not retrievable at the present time due to restrictions imposed by the local government. Further, 200 of the Company’s 500 employees are idle and are unable to work from home until documents and computers can be retrieved and alternative office space is located, which will be at least 90 days. The remaining 300 employees are able to work from alternative satellite office space or from their homes. X agrees to pay all of its employees, including those who are idle, and not charge their vacation time for any down time they experience. Conclusion: X should recognize a liability for the salaries of the 200 idled employees if the four criteria of ASC 710, have been met. Those criteria are: 1. Employees’ services have already been rendered, 2. Rights to the compensation vest or accumulate, 3. Payment of the compensation is probable, and 4. The amount can be reasonably estimated. Otherwise, the salaries and benefits should be expensed as incurred. Question: How should insurance recoveries of losses and costs incurred as a result of a natural disaster, terrorist act or act of God be classified in the statement of operations and when should those recoveries be recognized? Response: Following are the rules:

1. Any insurance recoveries of losses and costs incurred should be classified in a manner consistent with the related losses within the income from continuing operations.

2. An asset relating to the insurance recovery should be recognized only when realization of

the claim for recovery of the loss recognized in the financial statements is deemed probable.27

27 Under ASC 410, if a claim is the subject of litigation, a rebuttable presumption exists that realization of the claim is not probable.


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3. A gain should not be recognized until any contingencies relating to the insurance claim have been resolved.

Observation: In accounting for insurance payments to cover losses, entities should follow the guidance in FASB ASC 210-20; FASB ASC 225-20; FASB ASC 410-30; FASB ASC 605-40; and FASB ASC 815, Derivatives and Hedging. FASB ASC 605-40 clarifies the accounting for involuntary conversions of nonmonetary assets (such as property or equipment) to monetary assets (such as insurance proceeds). It requires that a gain or loss be recognized when a nonmonetary asset is involuntarily converted to monetary assets even though an enterprise reinvests or is obligated to reinvest the monetary assets in replacement nonmonetary assets. FASB ASC 605-40-45-1 states:

“Gain or loss resulting from an involuntary conversion of a nonmonetary asset to monetary assets shall be classified in accordance with the provisions of Subtopic 225-20 (Extraordinary and Unusual Items).”

That guidance generally requires that an asset relating to the insurance recovery should be recognized only when realization of the claim for recovery of a loss recognized in the financial statements is deemed probable (as that term is used in FASB ASC 450). In addition, under FASB ASC 450-30-25-1, a gain (that is, a recovery of a loss not yet recognized in the financial statements or an amount recovered in excess of a loss recognized in the financial statements) should not be recognized until any contingencies relating to the insurance claim have been resolved. It is important to note that in some circumstances, losses and costs might be recognized in the statement of operations in a different (earlier) period than the related recovery. An additional consideration relates to FASB ASC 225-30, which indicates that entities may choose how to classify such recoveries in the statement of operations, provided that classification does not conflict with existing GAAP requirements. One issue to consider is that an entity is not allowed to record a receivable due from the insurance company for the insurance proceeds from a recovery until realization of the amount of insurance is probable. The reason is because the receivable is considered a gain contingency until the amount of the insurance to be received is settled with the insurance company. What that means is that there could be a fire or other calamity that occurs in the middle of a year but is not settled with the insurance company by year end. The entity is not allowed to record a receivable for the estimated insurance receivable until the company has settled the claim with the insurance company. Recording a “best estimate” as a receivable is not allowed because to do so would result in the company recording a gain contingency, which is not allowed under GAAP. Following are examples that illustrate the applications just discussed: Example 1: Company X’s equipment was heavily damaged on August 31, 20X1 from a terrorist act. X maintains insurance on the equipment that provides for recovery of its replacement value. The equipment has a net book value of $1,000 and an estimated replacement value of $1,500 as of August 31, 20X1. Prior to its December 31, 2001 year end, X files a claim with its insurer for recovery of $1,500. Based on discussions with the insurer, X concludes that it is probable that the insurer will settle the claim for at least $1,200. However, as of December 31, 20X1, the insurer has communicated to X that the amount of final settlement is subject to verification of the identity of the equipment damaged and receipt of additional market data regarding its value. Conclusion: Because the insurance claim has not been resolved, a gain on the insurance claim cannot be recognized in X’s December 31, 20X1 year end income statement. X should record a


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claim receivable limited to the $1,000 net book value of the damaged asset because it is probable that there will be a recovery of the loss. The book value should be credited for $1,000 as the equipment is removed. Any remaining recovery beyond $1,000 should be recognized as a gain only when the insurance claim (contingency) has been resolved. That is, when the identity of the damaged equipment and the market data have been finalized to the satisfaction of the insurance company. Example 2: X owns and operates a retail store in downtown New York City and maintains insurance to cover business interruption losses. Under the policy, the Company receives compensation for lost profits in the event of a business interruption. In 20X1, X had a fire in its store. As of September 30, 20X1, X has filed a claim with its insurer to recover its estimated lost profit through September 30, 20X1. X has not previously filed a claim under its insurance policy and is uncertain of the final settlement amount. X believes there could be a dispute regarding the scope of coverage under the policy. The parties have not agreed on a settlement as of the date that X issues its financial statements for the period ended September 30, 20X1. Conclusion: X should not recognize a gain because contingencies related to the recovery remain unresolved. X should recognize a gain when those contingencies are resolved. Question: How should federal assistance provided as a result of a natural disaster, act of God or terrorist act, in the form of direct compensation, be classified in the statement of operations and when should the assistance be recognized? Response: 1. Federal assistance provided to a victim of an act of God or terrorist act, in the form of direct

compensation, should be classified as part of income from continuing operations in the statement of operations.

2. Any federal assistance recognized in the statement of operations should not be netted against

losses and costs incurred as a result of the events. Further, such assistance should not be recorded as operating revenue and thereby included in gross margin.

a. Federal assistance provided to victims should be reported on a “gross” basis in the victim’s

statements of operations. For example, a proper presentation is to present the items as a separate line item in the other nonoperating income section.

3. Federal assistance should be recognized when the compensated losses are incurred,

provided that collection of the federal assistance is probable and the victim has the right to retain the assistance.

a. The amount of assistance recognized by a victim should not exceed the lesser of its actual

direct and incremental losses incurred or its maximum allocation of the aggregate compensation.

Question: What disclosures should be made in the notes to financial statements regarding the losses and costs incurred as a result of a natural disaster, terrorist act or act of God? Response: Entities should follow the guidance of ASC 225, Income Statement (formerly found in APB No. 30) for presentation and disclosure of unusual or infrequently occurring items. At a minimum, entities should disclose the following information in the notes to financial statements in all periods affected by the events:


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a. A description of the nature and amounts of losses and cost recognized as a result of the events and the amount of related insurance recoveries.

b. A description of contingencies resulting from the events that have not yet been recognized

in the financial statements but that are reasonably expected to impact the entity’s financial statements in the near term (within one year), such as future losses or future insurance recoveries.

c. Applicable disclosures required by ASC 275 (formerly SOP 94-6). d. Applicable disclosures about environmental obligations and recoveries required by ASC

410, Asset Retirement and Environmental Obligations (formerly SOP 96-1). 2. Involuntary Conversions under GAAP Question: For tax purposes, the IRC section 1033 provides a special rule to deal with disasters under the involuntary conversion rules. IRC section 1033 states that if property is damaged due to a condemnation, theft, seizure, or destruction, and a taxpayer receives insurance procedures, the gain or loss from the involuntary conversion is not taxable if reinvested in qualified replacement property within a period of time. Specifically, the gain from receipt of insurance proceeds is non-taxable to the extent that the insurance proceeds are used to purchase qualifying replacement property (e.g., property that is similar to, or related to in use to, the property that was lost or taken) within a two-year period that ends two years after the close of the first tax year in which any part of the gain on the conversion is realized (three years for certain condemned property). Under the involuntary conversion rules, in lieu of recording a gain, the insurance proceeds reduce the basis of the replacement property. Do the non-recognition rules for involuntary conversions found in the IRC also apply to GAAP? Response: No. The non-recognition of gain rules found in IRC section 1033 do not apply to GAAP. Therefore, for GAAP purposes, an involuntary conversion is treated as a sale of the converted property and a gain or loss is recognized on the income statement. Deferred income taxes must be recorded on the basis difference for GAAP and tax purposes. For tax purposes, the basis of the replacement property is lower than GAAP because of the reduction in the tax basis for the non-recognition of the gain. ASC 605-40-25, Revenue Recognition-Gains and Losses Recognition, states:

“An involuntary conversion of a nonmonetary asset to monetary assets (e.g., cash) and the subsequent reinvestment of the monetary assets is not the equivalent to an exchange transaction between an entity and another entity. The conversion of a nonmonetary asset to monetary assets is a monetary transaction, whether the conversion is voluntary or involuntary, and such a conversion differs from exchange transactions that involve only nonmonetary assets. To the extent the cost of a nonmonetary asset differs from the amount of monetary assets received, the transaction results in a gain or loss that shall be recognized.”

Dealing with the Timing of an Involuntary Conversion The GAAP for involuntary conversions requires that the transaction be recorded as a sale of the asset when the asset (building, etc.) is converted to a monetary asset. That means a gain or loss


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on the transaction is recorded when the entity receives cash or records a receivable for the insurance amount that is settled with the insurance company. However, it can take an extensive amount of time to settle with the insurance company and that timeline can extend over one or more reporting periods. In such a situation, the entity is precluded from recording a receivable for the insurance settlement and a gain or loss on the transaction. Further, until the transaction is settled and a gain or loss is recognized, the entity cannot remove the underlying fixed asset from its records. What should an entity do with the damaged asset while it waits for the insurance settlement? Existing GAAP for involuntary conversions found in ASC 605-40-25, Revenue Recognition-Gains and Losses Recognition, implicitly assumes that an involuntary conversion is settled with the insurance company and recorded within the same reporting period in which the underlying event occurs. This assumption is not realistic in today’s slow-moving insurance industry. Let’s look at an example: Facts: Company X has a fire on September 30, 20X1 that damages its plant, making it inoperable. X’s year end is December 31, 20X1. The plant’s carrying value at the date of the fire was:

Cost $1,500,000 Accumulated depreciation (600,000) Book value $900,000

At December 31, 20X1, the company is still negotiating with the insurance company and has received an advance in the amount of $100,000 to start repairing the facility. The company expects to receive approximately $500,000 in total from the insurance company but has not settled on that amount at December 31, 20X1.

At December 31, 20X1, the company has spent about $200,000 for miscellaneous improvements to secure the property. No new renovations were started until 20X2.

At December 31, 20X1, the company estimates that the fair value of the damaged building is $500,000, the amount it expects to receive from the insurance company.

Conclusion: Because X has not settled with the insurance company, it is precluded from recording a receivable and a gain and loss as if the property was sold. Thus, the following has to be done at December 31, 20X1:

Insurance proceeds received in advance ($100,000) should be recorded as a deposit account as a liability.


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The $200,000 spent on repairs to date should be recorded as either repairs and maintenance, or as construction in progress (CIP) if it is part of the new construction.

The building should be written down to $500,000 (its estimated fair value) with an impairment loss.

Entries: December 31, 20X1: Cash 100,000 Deposit liability- insurance proceeds 100,000 Construction in progress 200,000 Cash 200,000 Impairment loss 400,000 Plant 400,000

[$900,000 -$500,000] Assume further that in March 20X2, X settles with the insurance company for $525,000 and receives a check for $425,000 ($525,000 less $100,000 advance received in 20X1). Conclusion: A gain or loss on the transaction should be recorded as follows:

Insurance proceeds $525,000 Basis: Cost (1) 1,100,000 Accumulated depreciation (600,000) Book value 500,000 Gain on transaction $25,000

(1) Original cost $1.5 million less impairment loss $(400,000) = $1.1 million.

Entries: March 20X2: Cash 425,000 Deposit liability- insurance proceeds 100,000 Building 1,100,000 AD- building 600,000 Gain on transaction 25,000

Observation: Because of the timing of settling the insurance proceeds, an entity will likely have to record an impairment loss in one period, and then record a gain on the transaction in the following period once the insurance proceeds are settled. The result is a mismatch of revenue and expense in that the impairment loss results in a lower basis and thus, a higher gain in the subsequent period. Because GAAP does not allow an entity to estimate the insurance proceeds and record the receivable prior to settlement, there is a distortion of revenue and expense among periods. To date, the FASB has not focused on this issue. Change the facts:


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Assume that at December 31, 20X1, the fair value of the building is estimated to be $2,000,000, which is the insurance proceeds that the company expects to receive in 20X2, even though it has not been settled at December 31, 20X1. All other facts are the same as the previous example. Conclusion: There would be no writedown of the building for impairment. Under ASC 360, Impairments, an impairment of a fixed asset (building in this case), exists if the undiscounted future cash flows from its use (and sale) are less than its carrying amount. In this case, the estimated future undiscounted cash flows consist of the insurance proceeds that are expected to be $2,000,000, which exceeds the carrying amount of $900,000. Thus, there is no impairment and no writedown of the building at the end of 20X1. The result is as follows:

Entries: December 31, 20X1: Cash 100,000 Deposit liability- insurance proceeds 100,000 Construction in progress 200,000 Cash 200,000 Impairment loss 0 Plant 0

Assuming that in March 20X2, X settles with the insurance company for $2,000,000 and receives a check for $1,900,000 ($1,900,000 less $100,000 advance received in 20X1). Conclusion: A gain or loss on the transaction should be recorded as follows:

Insurance proceeds $2,000,000 Basis: Cost (1) 1,500,000 Accumulated depreciation (600,000) Book value 900,000 Gain on transaction $1,100,000

Entries: March 20X2: Cash 1,900,000 Deposit liability- insurance proceeds 100,000 Building 1,500,000 AD- building 600,000 Gain on transaction 1,100,000

3. Income Statement Display of Business Interruption Insurance Recoveries Question: How should business interruption insurance recoveries be displayed in the statement of operations? Response: The governing authority is found in ASC 225-30, Income Statement-Business Interruption Insurance (formerly found in EITF Issue No. 01-13), which deals with business


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interruption insurance, and ASC 605, Revenue Recognition, for insurance proceeds related to property damage. In other areas, ASC 410, Asset Retirement and Environmental Obligations and ASC 605, Revenue Recognition, (formerly found in FASB Interpretation No. 30), provide that any insurance recoveries are netted against the related loss on the same income statement line. An entity may choose how to classify business interruption insurance recoveries in the statement of operations, as long as that classification is not contrary to existing generally accepted accounting principles. With respect to property insurance recoveries, ASC 605, Revenue Recognition, (formerly found in FASB Interpretation No. 30), provides that any insurance recoveries are netted against the related loss on the same income statement line. Specifically, ASC 605, Revenue Recognition, states that a gain or loss should be recognized on the difference between the carrying amount of the asset and the amount of monetary assets received (insurance recovery received) in the period of the involuntary conversion. As a result, the insurance recoveries are netted against the related loss (the carrying amount of the insured asset) and shown in the other income section of the income statement. Business interruption insurance differs from other types of insurance coverage in that it protects the prospective earnings or profits of the insured entity. It provides coverage if business operations are suspended due to loss of use of property and equipment resulting from a covered cause of loss. Business interruption insurance coverage usually provides for reimbursement of certain costs and losses incurred during the reasonable period of time to rebuild, repair, or replace the damaged property. Types of costs typically covered include the following:

Gross margin that was “lost” or not earned due to the suspension of normal operations

A portion of fixed charges and expenses in relation to that lost gross margin

Other expenses incurred to reduce the loss from business interruption, such as rental of a temporary facility and equipment, use of subcontractors, etc.

ASC 605 applies only to recoveries of certain types of losses and costs that have been recognized in the income statement. On the other hand, a portion of recoveries from business interruption insurance represents a reimbursement of “lost margin” rather than a recovery of losses or other costs incurred. As a result, there are no direct costs recorded on the income statement to which the insurance recovery relates. Conclusion of ASC 225: An entity may choose how to classify business interruption insurance recoveries in the statement of operations, as long as that classification is not contrary to existing generally accepted accounting principles. For example, in order to classify business interruption insurance recoveries as an extraordinary item, the requirements of ASC 225 related to extraordinary item classification (infrequent and unusual) must be met. However, the following information should be disclosed in the notes to financial statements in the period(s) in which the insurance recoveries are recognized: a. The nature of the event resulting in the business interruption losses.


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b. The aggregate amount of business interruption recoveries recognized during the period and the line item(s) in the statement of operations in which those recoveries are classified (including amounts reported as an extraordinary item in accordance with ASC 225).

Observation: ASC 225 gives companies latitude in presenting a business interruption insurance recovery in the income statement. Because the underlying losses may not be recorded, such as lost revenue, there may not be a particular line item(s) to which the recovery relates. One approach to display would be to present the insurance recovery in the lines to which the “lost items” related. Note that although ASC 225 applies to business interruption insurance recoveries, the same concept applies to other insurance recoveries, including property insurance recoveries. Example: Assume there is a fire in a building. The building is condemned and the owner recovers $250,000 for lost rents and another $500,000 for property damage, while the property is being repaired. Other information follows:

Rent revenue $2,000,000 Operating expenses (900,000) Insurance recovery ($250,000 + $500,000) 750,000 Net amounts $1,850,000

Assume the lost rents recovery is calculated as follows:

Lost rents $400,000 Saved utilities and other direct costs (150,000) Business interruption insurance recovery- lost rents $250,000

Assume the book value of the building (without land) that is condemned is $200,000 so that there is a gain on that portion of the transaction of $300,000 as follows:

Property insurance proceeds $500,000 Book value of real estate (200,000) Gain on building condemnation $300,000

The net income to be presented follows:

Rent revenue $2,000,000 Operating expenses (900,000) Business interruption insurance recovery 250,000 Gain on building condemnation 300,000

Net income $1,650,000 Conclusion: With respect to the $250,000 business interruption insurance, ASC 225 permits a company to present the $250,000 business interruption insurance portion of the recovery in any way an entity chooses on its income statement. Following are two suggested presentation formats. The $300,000 gain on the property insurance should be shown as an other income item, unless it can qualify for extraordinary gain treatment by being infrequent and unusual in nature. Assume in this case that extraordinary treatment does not apply because the criteria have not been met.


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With respect to the $250,000 business interruption insurance, Option 1 is to categorize the recovery in those sections of the income statement to which the “lost items” relate. In this case, the $250,000 recovery would be split into two sections: $400,000 presented as a credit to rental income, and the other $150,000 presented as an increase to operating expenses.

Allocation of business interruption insurance

Initial

amounts

Allocation of the

recovery

Income statement

presentation Rent revenue

$2,000,000

$400,000

$2,400,000

Operating expenses (900,000) (150,000) (1,050,000) Business interruption insurance recovery 250,000 (250,000) 0 Net income $1,350,000 $ 0 $1,350,000

The income statement presentation would look like this:

X Real Estate Company


Rent revenue $2,400,000 Operating expenses (1,050,000) Other income: Gain on condemnation of building

300,000

Net income $1,650,000

Option 2 is to present the business interruption insurance recovery as an other income item as follows:

X Real Estate Company


Rent revenue $2,000,000 Operating expenses (900,000) Net operating income 1,100,000 Other income:

Business interruption insurance recovery Gain on condemnation of building

250,000

300,000 Net income $1,650,000

For tax purposes, the $500,000 of property insurance proceeds would be credited to the building asset, resulting in a $300,000 basis difference, which would be a temporary difference for deferred income tax purposes as follows:


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GAAP

Tax purposes

Temporary Difference

Book value- building $200,000 $200,000 Entry to record sale of real estate condemned (200,000) 0 Entry to record reduction of basis for IRC 1033 0 (500,000) Basis before capitalization of construction costs $0 $(300,000) $(300,000)

Assuming that the Company’s federal and state tax rate is 40%, deferred income taxes would be recorded as follows:

Entry: Income tax expense- deferred federal/state (1) 120,000 Deferred income taxes 120,000 (1): $300,000 x 40% = $120,000

Following is a disclosure that would apply to the above example:

Note X: Insurance Recovery In 20X1, the Company incurred a fire at its apartment building located at 120 Main Street, Nowhere, Massachusetts, which resulted in the building being condemned. Under its insurance policy, the Company received recovery of costs to reconstruct the building into its condition immediately prior to the fire, and business interruption insurance. The Company received $500,000 as an insurance settlement to reconstruct the building. The insurance recovery, less the carrying amount of the building, resulted in a gain of $300,000 which is presented in the Other Income section of the statement of income. In 20X1, the Company started the reconstruction the building and capitalized $270,000 as part of Construction in Progress at year end. In addition to receiving the $500,000 insurance settlement, under its business interruption insurance policy, the Company received recovery of rental revenue lost during the construction period, net of certain related costs. The total amount of insurance received was $250,000 which is presented in the Other Income section of the income statement.

Observation: In the above example, the difference between the carrying amount of the building for GAAP and tax purposes results in a temporary difference that creates deferred income taxes. The difference is a byproduct of the basis being reduced by the $500,000 of insurance proceeds for tax purposes under the involuntary conversion rules in IRC section 1033, while being recorded as part of a gain for GAAP. When the entity reconstructs the building, the costs would be capitalized for both GAAP and tax purposes. What would happen if the company does not spend the $500,000 insurance proceeds within the required two-year, (or three-year, in some cases), period required in IRC section 1033?


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IRC section 1033 requires that the entire amount of the $500,000 insurance proceeds be spent on qualified replacement property, including reconstruction of the condemned building, within two, or three-year qualified period, depending on the circumstances. If a portion of those funds are not spent on qualified replacement property within the qualified period, the shortfall is taxable and the deferred income taxes on that portion of the temporary difference set up for the deferred gain, would be reversed. R. Accounting for Entities in Bankruptcy Question: An entity has been in bankruptcy for several years, and is about to come out of it. What is the accounting treatment for the post-bankruptcy entity? Response: The authority for this situation is found in ASC 852, Reorganizations (formerly SOP 90-7). In accordance with ASC 852, the entity may qualify for “fresh start” reporting under which it gets to “clean up” its balance sheet and start over as if it were a new entity. An entity whose plan has been confirmed by the court and has emerged from Chapter 11 may qualify for "fresh start" reporting (e.g., clean up its balance sheet) if: a. The reorganization value of assets of the emerging entity immediately before the date of

confirmation is less than the total of all postpetition liabilities, and b. Holders of existing voting shares (immediately before the confirmation date) receive less

than 50% of the shares of the emerging entity. Note: If the two criteria are met, there is, in substance, a new reporting entity requiring a revaluation of assets and liabilities at their fair market value. Example: Company A is emerging from Chapter 11. Information obtained immediately before the date of confirmation follows: Reorganization value of assets $1,000,000 Post-petition liabilities 1,400,000 Additionally, as part of the plan, preplan shareholders received less than 50% of the voting shares of the new entity. Conclusion: Both criteria for fresh start reporting are met:

a. The reorganization value ($1,000,000) is less than postpetition liabilities $(1,400,000), and b. Holders of existing shares receive less than 50% of the voting shares of the new entity.

In adopting fresh start reporting, assets and liabilities are revalued as of the confirmation date as follows:

1. A reorganization value of the entity shall be assigned to the entity’s assets and liabilities

in conformity with the procedures of ASC 805-20, Business Combinations (formerly FASB No. 141R) as follows:

a. Identifiable assets and liabilities: The entity recognizes the identifiable assets and

liabilities at fair value.


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b. The excess of the reorganization value over the fair value of the identified assets and liabilities is allocated to goodwill.

c. Deferred income taxes shall be recorded for temporary differences and the tax benefits

of unused carryforwards.

d. Retained earnings: Any deficit in retained earnings is adjusted to zero. e. Capital stock is recapitalized if part of the plan. 2. Recording writedowns of the balance sheet: All writedowns should be recorded as part of

the last financial statements of the predecessor entity. a. All amounts to adjust the assets, liabilities, and stockholders' equity to the "fresh start"

balance sheet should be recorded as gains and losses on the last income statement. b. Forgiveness of debt should be reported as an extraordinary item.

Example: New Lease on Life Co. emerges from Chapter 11 effective January 1, 20X2 and qualifies for “fresh start” reporting. Conclusion: The Company will adjust its balance sheet as of December 31, 20X1. All adjustments to assets liabilities and equity will be reflected on the December 31, 20X1 income statement including reporting forgiveness of debt as an extraordinary item. 3. Disclosures in Year 1 of Fresh Start Reporting a. Adjustments to historical amounts of individual assets and liabilities b. Amount of debt forgiveness c. Amount of retained earnings deficit eliminated d. Determination of reorganization value:

Methods and factors used: e.g. discount rates, tax rates, projected cash flows, etc.

Sensitive assumptions: Assumptions about which there is a reasonable possibility of a variation that would significantly affect measurement of reorganization value.

Assumptions about anticipated conditions that are expected to be different from current conditions.

4. Determining Reorganization Value a. Agreed upon by a vote of the parties of interest (e.g. debtor, creditors and equity

holders), or b. Determined by the court if an agreement cannot be made. c. Reorganization value:


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1) Approximate FMV immediately after the restructuring (confirmation date) 2) Amount a willing buyer would pay for assets assuming a going concern 3) Discounting of future cash flows of emerging entity

S. Accounting for Web Site Development Costs Question: How should web site development costs be accounted for? Response: The authority is found in ASC 350, Intangibles- Goodwill and Other (formerly found in EITF 00-02), which concludes that the development of a website should be segregated into certain stages and individually addressed in accordance with the application of existing accounting literature. The following chart depicts the stages of web site development as presented in ASC 350.

Development Stage/ Activity Accounting Treatment

Stage 1: Planning Stage: Work and planning done up to the date the web site development begins.

Costs expensed as incurred

Stage 2: Development Stage: a. Web Application and Infrastructure Development: Designing the web site infrastructure. b. Graphics Development: Designing the graphics of the web site. c. Content Development: Developing the content for the web site.

Costs capitalized Costs capitalized The FASB has not ruled on this segment. May be capitalized or expensed depending on the facts involved.

Stage 3: Post-Implementation/Operation Stage: a. Work done after the site is placed in service including training, security, and administration. b. Additional functionalities/upgrades and features after web site is launched.

Costs expensed as incurred. Capitalized if there are upgrades and enhancements that provide additional functionality

The following chart summarizes the treatment of costs during the three stages of development.


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Treatment of Web Costs During Three Stages of Development

Management commits Web site is substantially to the web project/ complete and ready development begins for use BEGINS ENDS

PLANNING STAGE

DEVELOPMENT STAGE

POST- IMPLEMENTATION/ OPERATION STAGE

Develop a business/project plan for the web site. Determine the functionalities of the site. Identify necessary hardware and web applications. Determine that the technology needed exists. Explore alternatives for achieving functionalities. Formulate concept/identify graphics and content. Invite bids from vendors. Select external vendors/consultants. Identify internal resources needed for the design and development.

Web Application and Infrastructure Development Acquire or develop the software tools. Obtain/register Internet domain name. Acquire/develop general web site operations software. Develop/acquire and customize database software and code for web applications. Develop HTML pages. Purchase the web and application servers, bandwidth, routers, staging servers, etc. Install the developed applications on the servers. Install the developed applications on the web servers.

Graphics/Content Development Create initial graphics, color images, overall look and feel of site. Create content/populate databases. Enter initial content into web site.

Training. Register web site with Internet search engines. Perform user administration activities. Update site graphics. Perform regular backups. Create new links and verify functioning of existing links. Add upgrades, functionalities and features.


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PLANNING STAGE

DEVELOPMENT STAGE

POST- IMPLEMENTATION/ OPERATION STAGE

Identify software tools and packages required. Address legal considerations.

Web Application and Infrastructure Development Initial creation of hypertext links to other web sites. Test web applications.

Graphics/Content Development

Costs expensed. Web application/infrastructure development/

graphics design: Costs capitalized and expensed depending on the type of cost. Costs capitalized:

Direct costs

Payroll

Interest Costs expensed:

Data conversion

G&A

Overhead Content development: FASB has not made a determination as to whether content development should be expensed or capitalized.

Costs expensed. Additional upgrades, functionalities/features: Capitalized if it is probable that the expenditures result in additional functionality and can be separated from normal maintenance.

STAGE 1: Planning Stage: Description: The planning stage involves all the preliminary thinking related to the web project. During this stage, the company is deciding what the overall goals are in developing the web site, including what the site will do (e.g., will it provide information or conduct e-commerce), a competitive analysis, identification of the target audience, identifying required hardware and software, the technological feasibility of the desired functions, exploring alternatives for achieving the same results, and dealing with potential legal considerations such as copyright and trademark issues. The planning stage generally begins with the first meeting and interaction regarding the web site development and ends with a plan and the selection of vendors (if used) and the signing of contracts for the web site development. Costs associated with the planning stage might include internal payroll of employees dedicated to the project, as well as the services of outside technology and marketing consultants. Accounting Treatment- Costs at the Planning Stage:


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The FASB decided that all costs involved in the planning of the web site development up to the time the actual development starts should be expensed as incurred. This position is consistent with the treatment of similar planning costs with respect to internal-use software covered under ASC 350 (formerly SOP 98-1), and costs of software to the sold, leased or marketed under ASC 985 (formerly FASB No. 86). Specifically, ASC 350 requires the costs of developing internal-use software to be expensed during the preliminary project stage. ASC 985 follows a similar model to ASC 350 by requiring that all costs of developing computer software to be sold, leased, or otherwise marketed, should be expensed until technological feasibility is established for the product. ASC 985’s technological feasibility threshold and ASC 350’s end of the preliminary project stage threshold usually converge at a similar time. That is, ASC 985’s technological feasibility threshold is achieved upon completion of a detailed program design or working model, which approximates the end of the preliminary project stage under ASC 350. STAGE 2: Development Stage: The Beginning and End of the Development Stage: The development stage begins when both of the following events have taken place: a. The planning stage is complete, and b. Management with relevant authority: 1) Authorizes and commits to funding a web project, and

2) It is probable that the project will be completed and the software will be used to perform the functions intended (e.g., to operate the web site).

The development stage ends when the web project is substantially complete and ready for its intended use, which is presumed to occur when substantial testing is completed. The development stage is segregated into two sections: the web site application and infrastructure development, and the graphics/content development. The web site application and infrastructure development involves acquiring and developing the software and hardware that operates the web site, including customizing the database software, HTML web page templates, installation of the applications on the web servers, creating the hypertext links, and testing the web applications. During the development stage, hardware is also purchased including the server, Internet connection (bandwidth) and routers. In lieu of a purchase, the hardware services may be provided by a third party under a hosting arrangement. Although hardware costs are not addressed by ASC 350, the costs of purchasing the servers and hardware should be capitalized and depreciated. If there is a hosting (lease) arrangement, payments for the hosting arrangement should be expensed over the period of benefit. The graphics/content development includes both graphics and content. Web site graphics refers to the graphics on a web page and are separate and distinct from the content of the page. Although graphics and content may appear to be the same or at least overlap, they are quite different in form and in accounting treatment. Graphics include the overall design of the web page including use of borders, background and text colors, fonts, frames, buttons and hyperlinks that affect the "look and feel" of the web page. Graphics generally remain the same regardless of changes in the content. The FASB decided that graphics on a web page cannot be distinguished from graphics included in traditional software applications (e.g., icons in Microsoft Word©) and should be treated as part of the underlying web software and capitalized.


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Content refers to the information that is included on the web site that could be in the form of text or a graphic presentation. Examples include articles, product photos, maps, stock quotes, charts, videos, and audios. Unlike graphics, content is constantly changing daily, even by the minute. In most cases, it may be difficult for the site visitors to differentiate between graphics and content. Content may be developed exclusively for the web site, or for other purposes. For example, a company may purchase new articles from a news service to place on its web site or license software and content from a third party instead of developing it itself. The FASB has had difficulty arriving at a conclusion as to how the costs of content should be accounted for. Depending on the circumstances, content can have attributes that support a series of accounting treatments. For example, if the home page has text that promotes the company's products, the costs to develop that text may be advertising that should be expensed. Conversely, if the company licenses or internally develops videos and audio products, there is an argument that the licensing fees or costs of development are intangible assets that should be amortized under ASC 350, Intangibles-Goodwill and Other (formerly FASB No. 142). Consequently, the FASB was not able to reach a consensus for accounting for content. Accounting for the Costs During the Development Stage: During the development stage, the FASB follows the requirements of ASC 350 with respect to internal-use software as it relates to costs of the web application and infrastructure development, including graphics. If there is a plan to market the software, the costs would be accounted for under ASC 985. The accounting for content is discussed below. Assuming the software is for internal use only, ASC 350 requires that certain costs be capitalized during the development stage. Consistent with ASC 350, the types of costs capitalized during the web site application and infrastructure development stage are limited to the following categories: 1. External direct costs: Third party costs associated with developing the web site including

materials and services consumed, consulting and professional fees for services provided by third parties and costs incurred to obtain software from third parties. a. Costs incurred to purchase software tools or internally developed tools are capitalized

unless they are used in a research and development project and do not have any alternative future uses.

b. Payments for Web-hosting arrangements are capitalized and amortized over the period benefited.

2. Payroll and payroll-related costs, for employees who are directly associated with and who

devote time to the web site development project, to the extent of their time spent directly on the project. Example: Employees who perform coding and testing of the web software during the web development stage.

3. Interest costs, incurred during the development stage should be capitalized in accordance

with ASC 835, Interest (formerly FASB No. 34).

All other costs incurred during the development stage should be expensed including training, maintenance, data conversion, general and administrative costs, and overhead.

How should content be handled?


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Because the FASB did not reach a conclusion on the accounting for content, the author believes the argument is most persuasive to account for content as advertising costs. Then, those advertising costs would either be expensed or capitalized as direct-response advertising. The exception for accounting for content outside the realm of advertising may be in the case where intangibles are developed or licensed such as music, video or audio that will be aired on the web site. However, even with intangibles used for content, there is a strong argument for also treating those costs as advertising. As for the costs of converting existing content that may be used elsewhere by the company, the author believes that those costs too should be expensed. ASC 350 provides a parallel by concluding that data conversion costs should be expensed as incurred. STAGE 3: Post-Implementation/Operation Stage:

Once the web site is substantially complete and ready to be placed in service, the development stage ends and the post-implementation/operation stage begins. During the post-implementation/operation stage, there is employee training, and administrative functions such as registration of the web site with Internet search engines, creating and verifying links, performing security checks, and fine tuning the web site graphics and correction of errors that may be discovered. The FASB concluded that costs incurred in the post-implementation/operation stage (exclusive of additional upgrades and enhancements) should be expensed as incurred. The FASB followed the guidance of ASC 350 and ASC 985, both of which expense costs once the development stage is complete. Exception for upgrades, functionalities and features:

Once the web site is operational, there is likely to be an ongoing effort to refine and upgrade the site with additional functions and features. Should these costs be capitalized or expensed? The FASB concluded that these costs should be capitalized only if they meet the definition of upgrades and enhancements ASC 350. Specifically, ASC 350 defines upgrades and enhancements as:

1. Modifications to existing internal-use software that result in additional functionality, or 2. New software specifications that may also require a change to all or part of the existing

software specifications. ASC 350 does not define the concept of additional functionality. However, what it does say is that internal costs of relatively minor upgrades and enhancements that cannot be reasonably separated from maintenance costs should be expensed. In the author's opinion, in order for an expenditure to qualify as an upgrade or enhancement, there must be a significant change in the function that evolves from the expenditure. Meaning, there should be a function that now can be performed that could not before. Example: A company's original web site did not have an e-commerce element allowing customers to purchase a product and pay by credit card in a secure encrypted environment. The company decides to add the e-commerce feature.


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Conclusion: The costs incurred to add the e-commerce feature probably qualify as an upgrade and should be capitalized. The reason is because the expenditure now provides additional functionality (e.g., e-commerce) that previously could not be performed. Question: What is the useful life of web site development costs? Response: Let's assume the rules for capitalization found in ASC 350 (formerly EITF 00-2) are followed resulting in the capitalization of an intangible asset called "web site development costs" relating primarily to the capitalized costs incurred during the development stage. This asset should be amortized over its estimated useful life. But what life? This issue has not yet been addressed anywhere in accounting literature and the FASB does not have it on its docket. In the following section, the author will present a few points to consider in terms of selecting a useful life for amortization of web site development costs. Like any tangible or intangible asset, web site development costs should be amortized in a systematic and rational manner over its useful economic life. The concept of systematic and rational suggests that the amortization or depreciation method should result in a proper matching of the amortization/depreciation with the estimated revenue expected to be generated from use of the asset over its estimated economic life. With respect to web site design costs, the costs should probably be amortized using a straight-line method unless it can be demonstrated that the revenue stream from the web site will be uneven. With web site design costs, there may be difficulty determining a useful economic life. Generally, an economic life may never exceed the physical life as in the case of a motor vehicle or equipment. With web site costs, physical obsolescence is not an issue since, conceivably, there is no wear and tear on the software. Instead, the life is dictated by limits on economic obsolescence. That is, at what point does the web site get outmoded due to rapid changes in technology and design? ASC 350 gives guidance for amortizing internal-use software which the author believes should also apply to the amortization of web-site development costs. The following requirements of ASC 350 have been adapted by the author to correspond to web site development costs. 1. The costs of web site development should be amortized on a straight-line basis over its

estimated useful life, unless another systematic and rational basis is more representative of the software’s use.

2. Factors to be considered in determining useful life include: a. Obsolescence, technology, competition, and other economic factors.

b. Whether management intends to replace technologically obsolete software (or hardware) used in the web site if rapid changes occur in the development of new software products, operating systems, and hardware.

3. The costs should be amortized beginning when the web site is ready for its intended use

regardless of whether the site will be placed in service in planned stages that may extend beyond a reporting period.

a. The web site is ready for its intended use after all substantial testing is completed.


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b. If the functionality of one module of a web site is entirely dependent on the completion of other modules (lead modules), amortization of that module should begin when both that module and the other modules (lead modules) are ready for their intended use.

Example: Assume a web site consists of a home page and five other web pages that feed off the home page. Assume the five web pages are complete but the home page is not. The five web pages can only be accessed through the home page. Conclusion: It is obvious that the functionality of the five web pages is dependent on the completion of the home page. Even though the five pages are ready to be placed in service, the amortization period of those pages should not begin until the home page is completed and ready for use. Observation: If one applies the guidance of ASC 350 regarding internal-use software to the amortization of web site costs, the entity must take into account the likelihood that management will replace or significantly upgrade its web site with new, more technologically superior web-site designs. As it relates to a web site, with advances in technology and competitive pressures, it is difficult to justify amortizing those costs over more than three years. Surely, management will be required to make some significant web site investment within three years just to stay current with its competition. Moreover, if a company is a startup, once the web-site development costs are capitalized, there may be the risk that the costs may not be recoverable from future cash flows from the web site. If this is the case the capitalized web site costs may have to be tested for impairment and written down or written off altogether.

T. Fair Value Disclosures 1. Scope of fair value disclosures Question: When is an entity required to include disclosures about fair value? Response: It depends. The authority for fair value is found in ASC Topic 820, Fair Value Measurement, as amended by ASU 2011-04, and ASC Subtopic 825-10-50, Financial Instruments-Overview-Disclosures. In general, the ASCs provide that the fair value disclosures found in ASC 820 and ASC 825 apply as follows:

Non-public entities: Fair value disclosures only apply to:

Any balance sheet assets or liabilities that are recorded at fair value at the balance sheet date.

Public entities and certain nonpublic entities:28 Fair value disclosures only apply to:

Any balance sheet assets or liabilities that are recorded at fair value at the balance sheet date, and

Any financial instruments that exist at the balance sheet date, whether recorded or not on the balance sheet, and regardless of whether recorded at fair value.

28 Certain nonpublic entities consist of those nonpublic entities that have either total assets of $100 million or more

at the balance sheet date, and/or has derivative instruments.


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For most non-public entities,29 fair value disclosures only apply if there is a balance sheet item that is presented on the balance sheet at fair value at the balance sheet date. Examples include:

Securities available for sale recorded at fair value

Trading securities recorded at fair value

Goodwill or other long-lived assets that are impaired and written down to fair value

Derivatives Question: Do fair value disclosures apply when there are assets and liabilities recorded at fair value on a nonrecurring basis? Response: There is confusion as to when an entity must comply with the fair value disclosures in connection with assets and liabilities recorded at fair value on a nonrecurring basis such as:

Assets and liabilities recorded at fair value in a business combination

Goodwill or other long-lived assets (fixed assets and intangibles) written down to fair value due to an impairment

Rules under ASC 820 (formerly FASB No. 157) as amended, are as follows for non-public entities: a. The fair value disclosure rules apply to assets and liabilities recorded at fair value at the

balance sheet date. b. If an asset or liability is measured at fair value during the year, but not recorded at fair value

at the balance sheet date, the fair value disclosure rules do not apply. One example relates to assets and liabilities recorded at fair value in a business combination that occurs during the year. In such an instance, although those assets and liabilities are recorded at fair value at the acquisition date, those same assets and liabilities are typically not recorded at fair value at the end of the year. Therefore, the fair value disclosures do not apply. Example 1: On June 1, 20X1, Company X purchases the net assets of Company Y and records the assets and liabilities at fair value. Assets recorded at fair value at the June 1, 20X1 acquisition date include inventory, fixed assets, and goodwill. At the December 31, 20X1 year-end balance sheet, none of the acquired assets are recorded at fair value. Inventory is recorded at cost which is lower than market value; and fixed assets and goodwill are recorded at carrying amount, and are not impaired. Conclusion: Although assets and liabilities related to the business combination were initially recorded at fair value at the June 1, 20X1 acquisition date, those same assets and liabilities are not recorded at fair value at the December 31, 20X1 year-end balance sheet date. Thus, the fair value disclosures do not apply. Example 2: Assume the same facts as Example 1 except that at year-end, goodwill is impaired and written down to fair value with a recorded impairment loss.

29 Nonpublic entities consist of those nonpublic entities that have less than $100 million of total assets and have no

derivative instruments.


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Conclusion: Because the goodwill is recorded at fair value at the December 31, 20X1 balance sheet date, goodwill is subject to the fair value disclosure rules for that year. Example 3: Assume further that at December 31, 20X2, goodwill is recorded at its carrying amount and not impaired. Conclusion: At December 31, 20X2, the Company has no assets recorded at fair value in that goodwill is recorded at carrying amount. Therefore, the fair value disclosures would not be required for goodwill for 20X2. Observation: The disclosures for recurring fair value measurements are rather straight forward and consistent because, by definition, recurring fair value measurements are made consistently from year to year-end balance sheet dates. With respect to nonrecurring measurements, there can be significant fluctuation of disclosures from year to year because such disclosures only apply if an asset or liability is measured and recorded at fair value at the balance sheet date. Balance sheet items such as fixed assets and goodwill, among others, are subject to the fair value disclosure rules only if those items are recorded at fair value at the balance sheet date. Such items are recorded at fair value only if they are impaired and recorded at fair value, meaning the fair value is less than the carrying amount. In any year in which fixed assets or goodwill is recorded at fair value due to fair value being less than carrying amount, the fair value disclosures apply. In another year in which fair value is not less than carrying amount, fixed assets or goodwill is recorded at carrying amount (not fair value), and the fair value disclosures do not apply. Fair value disclosures for similar measurements Question: Do the fair value disclosure rules apply to measurements that are similar to fair value, such as:

Market value for inventories recorded at lower of cost or market value

Current value for assets and liabilities recorded at current value (current amounts) in personal financial statements

Liquidation value for an entity using the liquidation basis of accounting Conclusion: No. An interesting issue relates to whether an entity with assets and liabilities recorded at “market value” or “current value” under GAAP should make disclosures similar to those disclosures required for fair value measurements. ASC 820-10-50-9 provides some guidance on this issue by stating:

“The reporting entity is encouraged, but not required, to….disclose information about other similar measurements (for example, inventories measured at market value under Topic 330), if practicable.”

Thus, an entity is encouraged to include disclosures similar to fair value disclosures, in situations in which market value, current value, liquidation basis, or other similar measurements are used to record assets or liabilities. But, the entity is not required to do so. Observation: The reality is that terms such as “market value” and “current value” are anti-quated, and are embedded in older FASB documents such as the lower-of-cost or market value rules for inventories. To date, FASB has yet to amend these documents to reflect the new term “fair value.”


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The change in terminology to fair value is a technical one that does not impact the substance of the issue which is that market value is close to, but not identical to, fair value. For example, with respect to inventory, market value is defined as the replacement cost of an item (subject to certain limitations) which is similar to the quoted market price of an identical item (Level 1 input) under the fair value measurement rules. Disclosure of fair value of non-financial assets Question: Is an entity permitted to disclose fair value of non-financial assets such as real estate? Response: Yes. An entity may wish to voluntarily disclose the fair value of certain non-financial assets, such as the fair value of real estate, intangible assets, etc. Is such a disclosure permitted? ASC 825-10-50-13 states:

“This Subtopic does not prohibit an entity from disclosing separately the estimated fair value of any of its nonfinancial intangible and tangible assets and nonfinancial liabilities.”

What this means is that an entity may choose to disclose the fair value of its nonfinancial assets, such as fixed assets and intangibles. An example of a disclosure follows:

NOTE X: FIXED ASSETS: At December 31, 20X1, the components of fixed assets were as follows:

Cost Accumulated depreciation

Land $1,000,000 $0 Building 3,000,000 1,500,000 Equipment 500,000 250,000 Fixtures 200,000 100,000 Motor vehicles 100,000 50,000 $4,800,000 $1,900,000

At December 31, 20X1, the company estimated that the fair value of its real estate, consisting of its land and building, was approximately $6,000,000.

Observation: Clearly, disclosing the fair value of nonfinancial assets should be done with caution. Because the fair value of such assets can be quite subjective, a company should want to ensure that the fair value disclosed is not misleading and overstated. Nevertheless, such a disclosure can be useful in limited cases in which a company wishes to disclose to a third-party user the estimated value of the collateral. Moreover, there is no requirement to disclose how the fair value ($6,000,000 in the previous example) was obtained. Given that the fair value disclosure pertains to a nonfinancial asset, the disclosure rules for financial instruments found in ASC 825 do not apply.


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Fair value disclosures for trade receivables and payables30 Question: Is an entity required to include fair value disclosures for trade receivables and payables given the fact that they are recorded at an approximate fair value at the balance sheet date? Response: No. ASC 825-10-50-14 states that fair value disclosures are not required for trade receivables and trade payables, if the carrying amount approximates fair value. The ASC does not define the term “approximates.” However, assuming trade receivables and payables have short-term maturities, the carrying amount (net realizable value) should be close to the fair value, and measured using the discounted cash flows. Thus, disclosure of fair value of trade receivables and payables is typically not required. Must the company disclose the fact that the carrying amount of trade receivables or payables approximates fair value? No. There is no requirement that an entity disclose the fact that the carrying amount of trade receivables and payables approximates fair value. However, some companies choose to include the following optional language:

Summary of significant accounting policies: Trade receivables: The carrying amount of trade receivables approximates its fair value (optional).

Using the fair value option Question: Is an entity permitted to record an asset or liability at fair value even though GAAP does not require that the item be recorded at fair value? Response: Yes, but not for all assets and liabilities. A company may elect to record any financial asset or liability at fair value even if that asset or liability is not required to be recorded at fair value under other GAAP. This fair value option (FVO) is covered under ASC Subtopic 825-10-25, Fair Value Option (formerly FASB No. 159). Following is a summary of the general rules under the ASC 825 fair value option: 1. General rules:

a. At specified dates, all entities may choose to measure eligible items at fair value (the fair value option).

b. The fair value option applies to the following eligible items only:

30 In 2016, the FASB issued ASU 2016-01, Financial Instruments-Overall (Subtopic 825-10) Recognition and

Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 amends certain fair value disclosures found in ASC 825. ASU 2016-01 changes are effective for fiscal years beginning after December 15, 2018 (calendar year 2019). Because the effective date of ASU 2016-02 is delayed until 2019. the author has not addressed its changes in this course.


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A recognized financial asset or liability

Financial asset: Cash, evidence of an ownership interest in an entity, or a contract. Financial liability: A contract that imposes on one entity a contractual obligation to deliver cash or another financial instrument to a second entity or to exchange other financial instruments on potentially unfavorable terms with the second entity.

Examples of financial assets and liabilities include the following: o Cash o Investments o Derivatives o Receivables o Trade payables o Loans receivable and payable

A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments

A written loan commitment

Rights and obligations under an insurance contract that is not a financial instrument

Rights and obligations under a warranty that is not a financial instrument, and

A host financial instrument resulting from a nonfinancial hybrid instrument under the derivative rules.

Observation: ASC Subtopic 825-10’s fair value option allows a company to record all investments in securities under ASC 320 (formerly FASB No. 115) at fair value and record the unrealized gain or loss on the income statement. In doing so, securities categorized as available for sale would have their unrealized gain or loss presented on the income statement instead of as part of other comprehensive income in stockholders’ equity.

c. The fair value option is not allowed for the following financial assets and liabilities:

Investments in a subsidiary that the entity is required to consolidate

An interest in a variable interest entity that the entity is required to consolidate

Employers’ and plans’ obligations (or assets from net overfunded positions) for pension benefits, other postretirement benefits, postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements

Financial asset and liabilities recognized under lease contracts under ASC Topic 840, Leases (formerly FASB No. 13)

Deposit liabilities, withdrawable on demand, of banks, savings and loan associations, credit unions, and other similar depository institutions, and

Financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including temporary equity), such as a convertible debt security with a noncontingent beneficial conversion feature.

d. The decision to elect the fair value option:

Is applied on an instrument-by-instrument basis

Is irrevocable, unless a new election date occurs, and

Is applied only to an entire instrument and not to only specified risks, cash flows, or portions of that instrument.


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e. An entity may choose to elect the fair value option for an eligible item only on an election

date, which is generally the first date on which the entity acquires the item, such as the date on which an entity obtains a new loan.

f. Financial statement presentations:

Income statement:

The unrealized gains and losses shall be recorded in earnings (or another indicator if the entity does not report earnings) at each reporting date. GAAP is silent as to how the unrealized gain or loss should be presented on the income statement. Note: Although the FVO does not address where the unrealized gain or loss should be presented on the income statement, the author believes the most appropriate location is in the other income (expense) section of the income statement.

Upfront costs and fees related to items recorded under the fair value option shall be recognized in earnings as incurred and shall not be deferred.

Balance sheet:

An entity shall report its assets and liabilities that are subsequently measured at fair value in a manner that separates those reported fair values from the carrying amounts measured differently. The FVO rules provide two options for presentation.

Option 1: Present two separate line items for the fair value and non-fair value carrying amounts, or

Option 2: Present the aggregate of those fair value and non-fair value amounts and parenthetically disclose the amount measured at fair value included in the aggregate amount.

Option 1:

Long-term debt: At fair value 60 At carrying value 40

Option 2:

Long-term debt ($60 at fair value)

100

Statement of cash flows: Cash flows related to financial assets and liabilities should continue to be classified in accordance with the statement of cash flows. 1) Unrealized gain or loss on change in fair value would be an adjustment under the

indirect method in computing cash from operating activities.


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Example:

XYZ Corporation Statement of Income

Year End December 31, 20XX Net sales

$XX

Cost of sales XX Gross profit XX Operating expenses XX Net operating income XX Other income (expense): Unrealized gain on adjustment of fair value of debt XX Net income before income taxes XX Income taxes XX Net income

$XX

2. Election dates for FVO:

a. An entity may choose to elect the fair value option for an eligible item only on the election date which is on one of the following dates: Date on which:

1) The entity first recognizes the eligible item. 2) The entity enters into an eligible firm commitment. 3) Financial assets that have been reported at fair value with unrealized gains and

losses included in earnings because of specialized accounting principles cease to qualify for that specialized accounting.31

4) The accounting treatment for an investment in another entity changes because:

The investment becomes subject to the equity method of accounting, or

The investor ceases to consolidate a subsidiary or variable interest entity (VIE) but retains an interest.

5) An event that requires an eligible item to be measured at fair value at the time of the

event (e.g., business combination) but does not require fair value measurement at each reporting date after that date (excluding recognition of impairment under lower-of-cost-or-market accounting or other-than-temporary impairment).

Examples include:

Business combinations, as defined in ASC Topic 805, Business Com-binations

Consolidation or deconsolidation of a subsidiary or variable interest entity

Significant modifications of debt.

Note: The acquirer, parent or primary beneficiary decides whether to apply the fair value option to eligible items of the 266cquire, subsidiary, or variable interest entity. However, that decision applies only in the consolidated financial statements. As it relates to the separate financial statements of the acquired entity, subsidiary or variable interest entity, the fair value option decision is made by the acquired entity, subsidiary, or variable interest entity, if they issue separate statements.

31 One example is a transfer of assets from a subsidiary subject to ASC Subtopic 946-10, to another entity within the consolidated reporting entity.


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Example 1: Company X acquires the net assets of Company Y, which include several assets and liabilities that are eligible for the fair value option, including an investment in equity securities and long-term debt. Conclusion: X will initially record the assets and liabilities at fair value under ASC 805 (formerly FASB No. 141R), Business Combinations. Because the investment and debt are eligible items (financial instruments) and X is required to measure those items at fair value but not at each subsequent reporting date, X may elect to use the fair value option for the investment and debt. If elected, X will not only record the investment and debt at fair value at the acquisition date, but also at each subsequent period date. Example 2: X (the parent) has consolidated Y (subsidiary) for several years. X sells the majority of its investment in Y, but retains a 5 percent interest. Conclusion: Because X ceases to consolidate Y but retains an interest in Y, X may elect the fair value option in connection with that investment.

Example: The following example illustrates the application of the fair value option under ASC 825-10-25. At December 31, 20X11, Company X has $8,000,000 of long-term mortgage notes payable with various rates and terms. The $8,000,000 of debt includes one particular note that was obtained in the amount of $3,000,000 on December 31, 20X11 with an interest rate of 4%. Effective December 31, 20X11 (the election date), X elects fair value treatment for this one $3,000,000 mortgage note under the fair value option. Federal and state tax rate is 40%. On December 31, 20X11, the election date, the Company records the $3,000,000 mortgage at its fair value of $3,000,000. At December 31, 20X12, the fair value of the mortgage note is $2,100,000 (based on the market interest rate of 8%), as follows:

Mortgage note balance $3,000,000 Fair value, PV discounted at 8% 2,100,000 Discount to fair value $(900,000)

Entry: Allowance for mortgage adjustment 900,000 Unrealized gain (income statement) 900,000 Deferred income tax expense 360,000 Deferred income tax liability (40% x $900,000) 360,000

The December 31, 20X12 year-end financial statements would present the above transactions as follows:


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Company X

Balance Sheet December 31, 20X12

Option 1: Long-term debt: Mortgage notes payable: At carrying value 5,000,000 At fair value 2,100,000 Option 2: Long-term debt: Mortgage notes payable (including $2,100,000 at fair value)

7,100,000

Company X Statement of Income

Year ended December 31, 20X12 Income from operations XX Other income (expense) Unrealized gain on writedown of mortgage note payable to fair value 900,000 Net income before income taxes

XX

Income taxes XX Net income

$XX

Company X Statement of Cash Flows

Year Ended December 31, 20X12 Net income $XX Items not affecting cash from operating activities Depreciation XX Deferred income taxes XX Unrealized gain on writedown of mortgage note payable to fair value (900,000) Cash from operating activities

XX

Observation: Due to the current low-interest-rate environment, companies can effectively use the FVO with respect to new long-term debt which carries historically low fixed interest rates. If the FVO option is elected, as interest rates climb, the fair value of the note payable declines resulting in the following entry:


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Allowance for writedown of long-term debt XX* Unrealized gain XX**

* Contra liability on balance sheet, netted against the loan account ** Presented on the income statement

Of course, the opposite result occurs if interest rates decline. However, given the current interest-rate climate, it is highly unlikely that long-term interest rates are going to decline by any significant margin. Note also that the election is made on the election date which essentially is the first date on which the entity first recognizes the items. That means that on the date on which an entity obtains a new loan (or refinancing of an existing loan), the FVO election is made. After that date, the entity is not permitted to elect FVO for that particular loan unless it is refinanced. A simple renewal at the same terms is not considered a refinancing of the date. Another key point is that the FVO is made on an instrument-by-instrument basis, so that an entity may make the election for one note payable, and not make the election for another note. Once elected, may a company rescind the fair value election? No. The statement is quite clear that the election with respect to a particular financial asset or liability is irrevocable. Observation: The fair value election has its advantages and disadvantages. For example, with respect to notes payable that have below market interest rates, a company may choose to elect fair value treatment in a rising interest rate environment during which the note value would be written down and unrealized gains recorded on the income statement. However, once interest rates fall, the unrealized gains would also reverse creating unrealized losses on the income statement. The entity would not be allowed to rescind the election. 3. Securities under FVO election If an entity elects the FVO for securities, the election is made at the time the entity purchases the securities (the election date) with all unrealized gains or losses recorded in the income statement. The impact of making this election varies depending on which category of securities is subject to the FVO. U. Subsequent Events Under GAAP Question: Who is responsible for testing and accounting for subsequent events? Response: There are several parties who are responsible for subsequent events. First, as to the financial statements, management is responsible for assessing subsequent events from a GAAP perspective. Yet, an auditor or accountant is also responsible for assessing subsequent events in connection with the auditor’s or accountant’s audit, review or compilation engagement. For years, the guidance for subsequent events has been included in auditing literature; under AU-C Section 560, Subsequent Events and Subsequently Discovered Facts, which requires the auditor to evaluate subsequent events. SSARS No. 21, Statements on Standards for Accounting and Review Services: Clarification and Recodification, provides that, in a review engagement, an accountant should consider subsequent events that come to the accountant’s attention. An


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accountant has no responsibility to address subsequent events in a compilation engagement unless the accountant discovers a subsequent event issue in which case he or she must address it to its conclusion. Although guidance for subsequent events exists within auditing, compilation and review literature for years, limited guidance existed in GAAP. In May 2009, the FASB issued a final statement, ASC Topic 855, Subsequent Events, which addresses the GAAP requirements for management to follow in assessing and recording or disclosing the effects of subsequent events. Thus, management is responsible for assessing subsequent events from a GAAP perspective due to the fact that management is responsible for the fair presentation of financial statements that are issued. The rules found in ASC Topic 855 apply to management as follows:

a. Subsequent events: events or transactions that occur after the balance sheet date but before financial statements are issued or are available to be issued.

1) Financial statements are considered issued when they are widely distributed to

shareholders and other financial statement users for general use and reliance in a form and format that complies with GAAP.

2) Financial statements are considered available to be issued when they are:

complete in a form and format that complies with GAAP, and

all approvals necessary for issuance have been obtained, such as those from management, the board of directors, and/or significant shareholders.

b. Subsequent event period:

1) An entity that meets either of the following criteria shall evaluate subsequent events through the date that the financial statements are issued.

It is a SEC filer, or

It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).

2) All entities other than those in (b)(1) above (non-public entities) shall evaluate

subsequent events through the date that the financial statements are available to be issued.

c. There are two types of subsequent events:

Type 1 subsequent events (recognized subsequent events): events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements-recognized on the balance sheet and disclosed in the financial statements.

Type 2 subsequent events (nonrecognized subsequent events): consists of events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date- disclosed only in the financial statements.


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Thus, under ASC 855, management must assess subsequent events through the issued date (for SEC companies) or the available to be issued date (for non-public entities) and, if applicable, record the effects or subsequent events and/or disclose the effects in the notes. Question: How do the requirements for management to assess subsequent events under GAAP interrelate with the requirements for an auditor or accountant to address subsequent events in an audit, review or compilation engagements? Response: The AICPA issued a technical practice aid (TPA) to address how management’s responsibility for assessing subsequent events affects an accountant’s responsibility under a compilation and review engagement. Although the TPA does not include audit engagements, the same concepts should apply to an auditor’s responsibility. More specifically, TIS Section 9150, Compilation and Review Engagements (Technical Practice Aid TPA 9150.26) The Accountant’s Responsibilities for Subsequent Events in Compilation and Review Engagements, states:

“FASB ASC 855, Subsequent Events, does not change the accountant’s responsibilities under AR Sections 80 and 90 related to compilation and review engagements. AICPA, Professional Standards), which state that an accountant performing a review engagement is still responsible for performing review procedures on subsequent events, which includes an inquiry of members of management concerning events subsequent to the date of the financial statements that could have a material effect on the financial statements. In a compilation engagement, the accountant has no responsibility with respect to subsequent events unless evidence or information comes to the accountant’s attention that a subsequent event that has a material effect on the financial statements has occurred. In such case where information comes to the accountant’s attention in a compilation or review engagement, the accountant should request that management consider the possible effects on the financial statements, including the adequacy of any related disclosure. If the accountant determines that a subsequent event is not appropriately accounted for in the financial statements or disclosed in the notes, he or she should consider whether a GAAP departure is warranted in the accountant’s compilation or review report.”

Although the TPA was issued prior to the issuance and effective date of SSARS No. 21, its application is still relevant. Question: How does the date through which management must assess subsequent events (issued or available to be issued date) compare with the date through which an auditor or accountant must consider subsequent events in an audit, review or compilation engagement? Response: There may be different dates through which subsequent events are considered by management in ASU 2010-09 versus dates through which an auditor or accountant must consider subsequent events in an audit, review or compilation engagement. For a non-public company, management is required to evaluate subsequent events through the date on which the financial statements are available to be issued which occurs when they are:

complete in a form and format that complies with GAAP, and

all approvals necessary for issuance have been obtained, such as those from management, the board of directors, and/or significant shareholders.


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As previously noted, AU-C 560, Subsequent Events and Subsequently Discovered Facts, requires an auditor to evaluate subsequent events through the auditor’s report date. The auditor’s report date is a date that is no earlier than the date on which the auditor has obtained sufficient appropriate audit evidence on which to base the auditor’s opinion on the financial statements, including evidence that:

The audit documentation has been reviewed;

All the statements that the financial statements comprise, including the related notes, have been prepared; and

Management has asserted that they have taken responsibility for those financial statements.

With respect to a review engagement, an accountant should generally inquire as to the existence of subsequent events through the report date, and include a representation in the management representation letter. In a compilation engagement, the accountant has no specific standards requirement to search or consider for subsequent events although, as a practical point, an accountant really should consider subsequent events through the date of the accountant’s compilation report. Consider the following chart:

Party Subsequent Event Period Through

Definition

GAAP- management responsibility

Date on which financial statements are available to be issued

Financial statements are available to be issued when:

Complete in a form and format that complies with GAAP, and

All approvals necessary for issuance have been obtained, such as those from management, the board of directors, and/or significant shareholders.

Audit Audit report date Audit report date:

The audit documentation has been reviewed

All the statements that the financial statements comprise, including the related notes, have been prepared, and

Management has asserted that they have taken responsibility for those financial statements.


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Review Review report date Review report date:

Not earlier than the date on which the accountant has accumulated review evidence (inquiry and analytical procedures) sufficient to provide limited assurance that there are no material modifications that should be made to the financial statements in order for the statements to be in conformity with the applicable financial reporting framework.

Compilation Compilation report date Compilation report date: Date of completion of compilation engagement which occurs when accountant has:

An understanding of the industry

Knowledge of the client: An understanding of the client’s business, accounting principles and practices

Read the financial statements and whether such financial statements appear to be appropriate in form and free from obvious material errors

The question is whether the subsequent events period for an audit, review or compilation engagement is the same as the subsequent events period for management under GAAP, in their respective evaluations of subsequent events. In looking at all of the subsequent event dates in the above-noted chart, the date through which an auditor or accountant considers subsequent events in an audit, review or compilation engagement should be very close to the date on which management is responsible for subsequent events for a non-public company (e.g., the date on which the financial statements are available to be issued). In each case, the financial statements are generally prepared and approved by management. Consequently, the author believes that the subsequent event period is essentially co-terminus for both management, as well as an accountant or auditor who performs an audit, review or compilation engagement. Technical Practice Aid TPA 9150.26, The Accountant’s Responsibilities for Subsequent Events in Compilation and Review Engagements, provides further guidance:

“In most cases, the date that management discloses as the date through which they have evaluated subsequent events (in the notes to the financial statements and, in a review engagement, in the management representation letter) will be the same date as the accountant’s compilation or review report. In order to coordinate that these dates (the note date, the representation letter date [in a review engagement], and the accountant’s compilation or review report date) are the same, the accountant may want to discuss these dating requirements with management in advance of beginning the compilation or review engagement. The accountant also may want to include, in the accountant’s understanding with the client regarding the services to be performed (engagement letter), that


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management will not date the subsequent event note earlier than the date of management’s representations (in a review engagement) and the date of the accountant’s compilation or review report.”

The conclusion is that except for unusual circumstances, the date through which management assesses subsequent events should be the same as the report date for an audit, review or compilation report. Question: What are the GAAP disclosures required by management under ASC Topic 855, Subsequent Events? Response: ASC 855 requires that all entities disclose the following: a. Standard disclosures:

1) The date through which subsequent events have been evaluated by management32

2) Whether that date is the date the financial statements were issued or the date the financial statements were available to be issued.

Note: An entity that is an SEC filer is not required to disclose the date through which subsequent events have been evaluated. This change alleviates potential conflicts between ASC Topic 855 and the SEC’s requirements.

b. For those non-recognized subsequent events that are of such a nature that they must be

disclosed to keep the financial statements from being misleading. For such events, an entity shall disclose the following:

The nature of the event

An estimate of its financial effect, or a statement that such an estimate cannot be made.

Example of a disclosure:

Following is a standard disclosure that is required for a non-public entity:

NOTE 4: SUBSEQUENT EVENTS: Company X has evaluated subsequent events through March 31, 20X3, which is the date through which the financial statements were available to be issued.

Note: The amendments found in ASU 2010-09 remove the requirement for an SEC filer to disclose a date in both issued and revised financial statements. V. Peer Review Deficiencies Question: What are some of the common deficiencies found in peer review?

32 This date should be the same as the date of the audit, review or compilation report.


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Response: Following is a summary of key deficiencies found in peer review. Many of these deficiencies are addressed in greater detail elsewhere in this course. a. Significant deficiencies: 1) Failure to:

a) Indicate, when appropriate, that the financial statements are presented in conformity

with a non-GAAP basis of accounting (such as tax basis). b) Indicate that a statement of cash flows is not presented (only available with respect to

a compilation).

c) Identify GAAP departures.

d) Indicate, when appropriate, that substantially all disclosures have been omitted.

e) Include reference to the Accountant's report at the bottom or top of each page of the financial statements for a compilation or review.

f) Disclose the Accountant's lack of independence.

2) Issuance of review report when CPA lacks independence.

3) Failure to disclose that tax basis is being used in a compilation report where substantially all disclosures have been omitted.

4) Failure to include a material amount or balance necessary for the basis of accounting

used. Examples include failure to amortize a significant intangible asset or depreciation a tangible asset, provide a significant allowance for uncollectible accounts, or material deferred income taxes.

5) Failure to perform analytical review and inquiry procedures in a review engagement.

6) Failure to obtain a management representation letter in a review engagement. 7) Failure to document significant matters discovered in the Accountant's inquiry and analytical procedures in a review engagement. b) Minor deficiencies: 1) Failure to:

a) reference all periods presented in the financial statements. b) refer to supplementary information or clearly indicate the degree of responsibility with

respect to supplementary information. c) present titles in the report that match the titles of the financial statements. d) use a review or compilation work program or checklist if required by firm policy.


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Note that standards do not require that a CPA use a work program or any checklists for compilation and review engagements.

3) The caption “Selected Information- Substantially All Disclosures Omitted” was missing

where selected disclosures were included in a compilation engagement. Peer review GAAP and disclosure deficiencies The following is the latest list of GAAP deficiencies found in peer reviews. The same items tend to show up from year to year. a. Omission of summary of significant accounting policies. b. Failure to include a summary of significant forecast assumptions in a financial forecast or

projection. c. Not separating statement of cash flows into operating, investing and financing activities. d. Improper accounting for a material transaction: Examples include recording a capitalized

lease as an operating lease. e. Omission of significant matters related to the understanding of the financial statements. f. Material GAAP departures from formats prescribed by industry accounting and audit guides. g. Missing disclosures for:

Accounting policies

Inventory

Valuation allowances- deferred income taxes

Long-term debt

Related party transactions

Concentrations of credit risk- receivables and cash

Deferred income taxes

Employee benefit plans- in particular, 401(k) plans

Using GAAP titles for tax-basis financial statements h. Assets:

Improper classification between current and long-term assets

Investment in subsidiary not consolidated (usually required if more than 50% of voting stock)

Cash overdrafts shown as a negative balance

Accounts receivable recorded on cash-basis financial statements

Investments in debt and equity securities not classified or measured properly

Impairment of long-lived assets not recognized, if appropriate

i. Liabilities:

Improper classification between current and long-term debt

Non-recognition of liability for compensated absences (e.g.,vacation and holiday pay)

Demand liabilities classified as long-term

Non-recognition of deferred tax liability

Non-recognition of capital leases (testing the four criteria)

Improper recognition of deferred revenue


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j. Equity:

No presentation of changes in equity accounts (in a separate statement, in the notes or on the income statement)

k. Statement of income:

No income tax provision recorded on interim financial statements

Reporting period was not clearly identified

Significant components of income tax expense were not disclosed

l. Statement of cash flows:

Not categorizing transactions by operating, investing or financing activities

Misclassification of activities between investing and financing

Not disclosing interest and income taxes paid if the indirect method is used

Not presenting a statement of cash flows for each period for which a statement of income is presented

No disclosure of non-cash investing and financing activities

Example of classic non-cash transaction mishandled in practice on the statement of cash flows: A company purchases a fixed asset for $100,000 and borrows $100,000 from the seller. How is this handled on the statement of cash flows? Option 1: INCORRECT (frequently mishandled in practice) Investing activities: Purchase of fixed asset (100,000) Financing activities: Borrowed note payable 100,000 Option 2: CORRECT: This transaction is not presented on the statement of cash flows as does not flow through the checkbook and has no effect on cash. Instead, it should be disclosed in the notes to financial statements or in a supplementary disclosure section immediately following the statement of cash flows as follows: Non-cash investing and financing transactions: In 20X1, the company financed the purchase of fixed assets in the amount of $100,000. Observation: The above non-cash transaction also applies to the set up of a capitalized lease and the related lease obligation that is actually the purchase of a fixed asset with financing. m. Missing addition disclosures:

Significant accounting policies

Basis of accounting other than GAAP

Modifications to cash basis of accounting

Cash equivalents

Concentrations of credit risk (cash and accounts receivable)

Disclosures about fair value of financial instruments (no longer required for smaller, non-public entities)

Disclosures about investments in debt and equity securities


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Disclosures about risks, uncertainties and nature of operations

Five-year debt maturities

Related party transactions

Leases (operating and capital)

Employee benefit plans (401(k) plans)

Deferred income taxes, including no breakout of expense by current and deferred components and between federal and state provision

n. Personal Financial Statements:

No estimated tax liability

No reporting of a GAAP departure for assets recorded at cost

Inadequate disclosure of methods used to determine FMV

Inadequate disclosure of assets and operating activities of investments in closely held corporations

o. Not-for-Profit Organizations:

Failure to:

identify a voluntary health and welfare organization

use a functional presentation style for a statement of revenue, expenses and changes in fund balance when revenue includes significant public support

present a statement of cash flows

present net assets and changes in net assets by unrestricted, temporarily restricted and permanently restricted asset classes


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 60. According to Concept Statement 5, liabilities should be recognized when certain criteria are

met. Which of the following is not included in these criteria: a) the items meet the definition of a liability b) the liability can be measured with sufficient reliability c) the liability is due within one year

d) the information about the liability is representationally faithful, verifiable, and neutral 61. Big Jim Johoula, CPA is the controller for Company X. X incurs a major flood and submits an insurance claim for recovery. X should record a receivable for the insurance recovery when: a) the loss is incurred b) realization is likely c) recovery of the claim is probable d) the claim is submitted 62. Federal assistance provided to a victim of an act of God or terrorist act, in the form of direct

compensation, should be classified in the statement of operations as: a) an offset of the expenses incurred due to the act of God or terrorist act b) part of income from continuing operations c) as an extraordinary item d) as an item under discontinuing operations 63. Company Z has an involuntary conversion for tax purposes from a building fire. How should

the transaction be accounted for under GAAP: a) as a nonrecognition transaction similar to the way it is handled for tax purposes b) as a split transaction with a partial gain or loss and partial nonrecognition c) as a monetary transaction with a gain or loss recognized d) the same way a 1031 transaction is accounted for under GAAP 64. According to ASC 225 (formerly EITF Issue No. 01-13), an entity may choose how to classify

business interruption insurance recoveries in the statement of operations: a) without any restrictions b) as long as they are insignificant

c) as long as that classification is not contrary to existing generally accepted accounting principles

d) as long as the amount is characterized as unusual 65. An entity whose plan has been confirmed by the court and has emerged from Chapter 11 may

qualify for “fresh start” reporting if certain criteria are met. One of them is that: a) holders of existing voting shares within 6 months of the confirmation date receive more

than 50% of the shares of the emerging entity b) holders of existing voting shares immediately before the confirmation date receive less

than 50% of the shares of the emerging entity c) none of the previous holders of shares are involved in the new entity d) holders of existing voting shares receive newly issued preferred stock or class B stock


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66. Which of the following is not a required disclosure in Year 1 of fresh start reporting:

a) adjustments to historical amounts of individual assets and liabilities b) amount of debt forgiveness c) amount of retained earnings deficit eliminated d) description of new management structure

67. With regards to website development costs, the costs incurred for developing the content for

the web site should be: a) expensed as incurred consistent with ASC 350 (formerly SOP 98-1) b) capitalized per ASC 350 (formerly SOP 98-1) c) may be capitalized or expensed depending on the facts involved d) disclosed only in the notes to financial statements 68. The costs of website development should be amortized _________________.

a) on a straight-line basis over its estimated useful life b) on an accelerated basis over its estimated useful life c) on a straight-line basis over a maximum five-year period d) on an accelerated basis over a two-year period

69. ASC 820 requires a non-public entity to make fair value disclosures for which of the following: a) an asset that is recorded at fair value at the interim date but not at the balance sheet date b) a financial instrument that is not recorded at fair value c) a liability recorded on the balance sheet at fair value d) fair value disclosures do not apply to non-public entities 70. A Type 1 subsequent event should be ______________. a) disclosed only b) recorded and disclosed c) neither disclosed nor recorded d) addressed in supplementary information


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SUGGESTED SOLUTIONS 60. A: Incorrect. One of the criteria is that the liability must meet the definition of a liability which

is a probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

B: Incorrect. One of the criteria is that the liability can be measured with sufficient reliability making the answer incorrect.

C: Correct. The criteria does not limit liabilities to be recognized to those that are due within one year. Thus, the answer is correct.

D: Incorrect. One of criteria is that a liability must be representationally faithful, verifiable and neutral, making the answer incorrect.

61. A. Incorrect. Because the transaction could result in a gain contingency, the receivable cannot be measured and recorded at the time the loss is incurred because there is no guarantee that the insurance will cover the loss and be collectible.

B. Incorrect. GAAP does not provide that the receivable should be recorded when realization is "likely" as such a threshold is not high enough. Probable is the threshold.

C. Correct. GAAP uses a probable threshold to determine when a receivable should be recorded. The reason is because a gain contingency might result from the recording of an insurance receivable. In order to record that receivable, the threshold must be very high at the probable level.

D. Incorrect. Recording the receivable when the claim is submitted does no mean the receivable is recoverable. For example, the claim could be denied by the insurance company. Thus, the answer is incorrect.

62. A: Incorrect. There is no authority to all for federal assistance recognized in the statement of

operations to be netted against losses and costs incurred as a result of the events. B: Correct. Federal assistance provided to victims should be reported on a gross basis

in the victim’s statement of operations as part of income from continuing operations.

C: Incorrect. The payment would not be considered unusual, and therefore would not meet the criteria for being extraordinary.

D: Incorrect. Since the payment is not related to discontinuing operations, this would not be the correct treatment.

63. A. Incorrect. GAAP states that an involuntary conversion is not the equivalent to an

exchange transaction and should not be treated the same way it is handled for tax purposes.

B. Incorrect. GAAP does not provide for splitting the transaction as there is no reason to do so.

C. Correct. GAAP provides that the involuntary conversion should be treated as a sale with a gain or loss recognized.

D. Incorrect. A 1031 transaction generally has no recognition of gain or loss which is not the way an involuntary conversion is treated for GAAP, making the answer incorrect.

64. A: Incorrect. There is a limitation in that the classification should not be contrary to existing

GAAP. Thus, the answer is incorrect. B: Incorrect. The size or significance of the insurance recovery is not a limitation in its

classification, making the answer incorrect. C: Correct. An entity may choose how it wants to classify business interruption

insurance recoveries as long as the classification is not contrary to existing generally accepted accounting principles.


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D: Incorrect. There is no limitation that the amount be characterized as unusual, making the answer incorrect.

65. A: Incorrect. Holders receive less than 50%, not more than 50%, of the shares, and they are

holders of shares immediately before the confirmation date, not 6 months of the confirmation date. Thus, the answer is incorrect.

B: Correct. Holders receive less than 50% of the shares of the emerging entity is the correct answer.

C: Incorrect. Previous holders are involved in the new entity by holding less than 50% of the shares of the emerging entity.

D: Incorrect. Receiving preferred or class B stock is not a criterion, making the answer incorrect.

66. A: Incorrect. Adjustments to historical amounts of individual assets and liabilities is one of the

required disclosures found in ASC 852, making the answer incorrect. B: Incorrect. Disclosure of the amount of debt forgiveness is one of the required disclosures

found in ASC 852, making the answer incorrect. C: Incorrect. The authority for fresh start accounting is ASC 852 requires that the amount of

retained earnings deficit eliminated be disclosed, making the answer incorrect. D: Correct. Disclosure of the description of new management structure is not a

required disclosure for fresh start reporting, making the answer correct. 67. A: Incorrect. ASC 350 does not provide for the costs of developing the content for a web site

to be expensed making the answer incorrect. B: Incorrect. ASC 350 does not provide for the costs of developing the content for a web site

to be capitalized making the answer incorrect. C: Correct. The FASB has not ruled on how the costs of developing the content for a

web site should be handled, thereby allowing a company to capitalize or expense those costs depending on the circumstances.

D: Incorrect. ASC 350 does not provide for such costs to be disclosed only, making the answer incorrect.

68. A: Correct. GAAP requires that the costs of website development should be amortized

on a straight-line basis over its estimated useful life. B: Incorrect. GAAP does not provide for using an accelerated method to amortize web-site

development costs making the answer incorrect. C: Incorrect. Although use of a straight-line basis is correct, GAAP does not provide for using

a maximum five-year period making the answer incorrect. D: Incorrect. GAAP does not provide for using an accelerated method and there is no two-

year amortization period. Thus, the answer is incorrect. 69. A: Incorrect. ASC 820 requires fair value disclosures for non-public entities that have assets

or liabilities at fair value at the balance sheet date, not the interim date. B: Incorrect. If an asset or liability is not recorded at fair value at the balance sheet date, no

fair value disclosure is required for a non-public entity. However, a public entity Is required to include a fair value disclosure for a financial instrument that is not recorded at fair value.

C: Correct. If a liability is recorded at fair value at the balance sheet date, the fair value disclosures are required.

D: Incorrect. Fair value disclosures are required for non-public entities making the answer incorrect.


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70. A: Incorrect. A Type 1 subsequent event is based on conditions that existed at the balance sheet date and should be recorded on the balance sheet and disclosed. Thus, the answer is incorrect.

B: Correct. A Type 1 subsequent event should be recognized on the balance sheet and disclosed, making the answer correct.

C: Incorrect. A Type 1 subsequent event must be recognized and disclosed. Thus, the answer is incorrect. Even if the subsequent event were a Type 2 (not based on conditions existing at the balance sheet date), at a minimum, the event would be disclosed.

D: Incorrect. There is no requirement for a Type 1 subsequent event to the addressed in supplementary information, making the answer incorrect.


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SECTION II. TAX-BASIS FINANCIAL STATEMENTS A. Overview Given the wave of complexity that has affected the accounting profession over the past decade, using tax-basis33 financial statements has become increasingly popular with non-public businesses. More than ever, major differences now exist between GAAP and taxable income due to two factors: First, there has been a continued upheaval in the tax code since the mid-1980s. Second, the FASB has issued numerous GAAP statements in the post-Enron period. As a result, small business owners find a continued conflict between balancing a desired lower taxable income for tax planning with higher financial statement income necessary to appease the bank or third party investor. In certain cases, tax basis statements act to bridge this gap so that tax and financial income are more congruous. B. Definition of Special Purpose Framework and Tax Basis Before the author continues in this section, the term "tax basis” is a term that was in effect prior to 2012. From 2012, that term is replaced with the new term "tax basis" based on newly issued auditing, compilation and review standards. Oddly enough, the rules for non-GAAP frameworks, such as tax basis , have existed within auditing literature since inception. SAS No. 62, Special Reports, originally introduced the concept of other comprehensive basis of accounting (OCBOA), a term that has included tax basis , regulatory basis, and regulatory basis of accounting. Parallel guidance was included with the SSARSs. Effective 2012, the Auditing Standards Board (ASB) reissued all auditing standards under its Clarity Project. In doing so, the ASB issued SAS Nos. 122-126, which was subsequently supplemented by SAS Nos. 127 and 128. As part of the reissuance of the SASs, the guidance found in SAS No. 62, Special Reports, was superseded by new AU-C 800: Special Considerations- Audits of Financial Statements Prepared in Accordance with Special Purpose Frameworks. AU-C 800 introduces a new term "special purpose framework" which encompasses non-GAAP frameworks used to issue financial statements. In essence, the special purpose framework concept replaces other comprehensive basis of accounting (OCBOA) that has been used to define non-GAAP frameworks such as income tax basis financial statements. One key change made is that the term "tax basis" is replaced with the term "tax basis." In October 2014, the AICPA's Accounting and Review Services Committee (ARSC) completed its own Clarity Project to recodify the compilation and review standards, by issuing SSARS No. 21, Statements on Standards for Accounting and Review Services: Clarification and Recodification. SSARS No. 21 supersedes all compilation and review standards found in SSARS No. 19 and other SSARSs (except one) and is effective for years ending on or after December 15, 2015. Early application is permitted.

33 The previous term "income tax basis” is superseded by the term "tax basis" under new auditing, compilation and review standards.


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SSARS No. 21 encompasses new standards for compilation and review engagements, and introduces a newly authorized "preparation of financial statements" engagement found in AR-C Section 70 of SSARS No. 21. A key change made by SSARS No. 21 is that it carries over the new definition of "special purpose framework" (and the new "tax basis" term) found in auditing standards within AU-C 800. Thus, after the effective dates of AU-C 800 (auditing standards) and SSARS No. 21 (compilation and review standards), there is a new set of rules that apply to "tax basis" financial statements under the concept of a special purpose framework. Those rules and definitions are consistent across the board for auditing, review and compilation engagements as well as the newly authorized preparation of financial statements engagement. C. New Definition of Tax-Basis Financial Statements AU-C 800 (auditing standards) and SSARS No. 21 (compilation and review standards), introduce the new term "special purpose framework" to encompass certain "non-GAAP" frameworks. AU-C 800 and SSARS No. 21 define a special purpose framework as a financial reporting framework other than GAAP that is one of the following bases of accounting:

Cash basis: A basis of accounting that the entity uses to record cash receipts and disbursements and modifications of the cash basis having substantial support (for example, recording depreciation on fixed assets).

Tax basis: A basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements. Tax basis can include cash basis, accrual basis or any method that clearly reflects income under Section 446 of the Internal Revenue Code.

Regulatory basis: A basis of accounting that the entity uses to comply with the requirements or financial reporting provisions of a regulatory agency to whose jurisdiction the entity is subject (for example, a basis of accounting that insurance companies use pursuant to the accounting practices prescribed or permitted by a state insurance commission.)

Contractual basis: A basis of accounting that the entity uses to comply with an agreement between the entity and one or more third parties other than the auditor.

Other basis: A basis of accounting that uses a definite set of logical, reasonable criteria that is applied to all material items appearing in financial statements.

The cash, tax, regulatory and other bases of accounting have been commonly referred to as other

comprehensive bases of accounting, although the term “OCBOA” is no longer included in any of the standards.

The following table compares the new definition of special purpose framework to the version of OCBOA previously found in old SAS No. 62, Special Reports.


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New Definition Special Purpose Framework AU-C 800 and SSARS No. 21

Previous Definition Other Comprehensive Basis of

Accounting (OCBOA) (SAS No. 62, AU 523)

Definition

Special Purpose Framework Other Comprehensive Basis of Accounting (OCBOA)

Cash basis A basis of accounting that the entity uses to record cash receipts and disbursements and modifications of the cash basis having substantial support

The cash receipts and disbursements basis of accounting, and modifications of the cash basis having substantial support

Tax basis Tax basis: A basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements

Tax basis : A basis of accounting that the reporting entity uses or expects to use to file its income tax return for the period covered by the financial statements

Regulatory basis

A basis of accounting that the entity uses to comply with the requirements or financial reporting provisions of a regulatory agency to whose jurisdiction the entity is subject

A basis of accounting that the reporting entity uses to comply with the requirements or financial reporting provisions of a governmental regulatory agency to whose jurisdiction the entity is subject

Contractual basis

A basis of accounting that the entity uses to comply with an agreement between the entity and one or more third parties other than the auditor

Previously permitted by SAS No. 62 but not defined.

Set of criteria that have substantial support

NA- not included under the new definition of Special Purpose Framework

A definite set of criteria having substantial support that is applied to all material items appearing in financial statements, such as the price-level basis of accounting

Other basis of accounting

A basis of accounting that uses a definite set of logical, reasonable criteria that is applied to all material items appearing in financial statements.

NA- not included in previous SAS No. 62 definition

Observation: Under AU-C 800, the term OCBOA is replaced with the term special purpose framework. Previously, the definition of other comprehensive basis of accounting (OBCOA) included any set of criteria that had substantial support. The new SAS does not include, under the definition of special purpose framework, any set of criteria having substantial support. Further, the definition of "tax basis" is changed slightly from the previous "income tax basis” one found in SAS No. 62. The SAS No. 62 definition of tax basis was “a basis of accounting that the reporting entity "uses" or "expects to use" to file its income tax return for the period covered by the financial statements.” The new definition removes “expects to use” from the definition. As a practical matter, eliminating “expects to use” from the definition should have no significant effect on its application.

Lastly, the term “income tax basis of accounting” has been replaced with the term “tax-basis of

accounting.”


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In this chapter, the author will focus solely on tax-basis financial statements, which is the basis of accounting used for income tax purposes. Definition of Tax Basis Statements Both AU-C 800 and SSARS No. 21 define the tax basis as:

"A basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements."

Implicit in the definition is that the tax basis is the basis of accounting based on the principles and rules for accounting under the [federal] income tax laws and regulations. However, there is nothing explicitly stated that tax basis must follow federal tax law. Instead, an entity could issue tax basis financial statements based on other tax laws such as those promulgated by state and local government, provided the taxing authority is identified.

Observation: One of the advantages of tax-basis financial statements is that there are few accounting issues that need to be addressed. Assuming the federal tax basis is used, all transactions are accounted for in accordance with the Internal Revenue Code and its regulations. D. When to Use and Not Use Tax-Basis Financial Statements Determining whether tax-basis financial statements are appropriate for a client to use requires overall consideration of several factors including the ultimate use of the financial statements. 1. When to use tax-basis financial statements:

Tax-basis financial statements are best used and most meaningful for a less financially sophisticated client where the client is more tax motivated and interested in cash flows. Further, it is helpful to have the owner who is actively involved in the day-to-day operations to ensure that the owner understands the real economics of the business. A third attribute is that the company should be strong financially so that it will not be forced into debt covenant violations by presenting a lower net income. From both the client and CPA's perspective, a tax basis engagement is generally less expensive to conduct. Overall audit, review or compilation procedures are generally less time consuming. Because revenue and expenses in tax-basis financial statements are based on the Internal Revenue Code, there are simply fewer items to audit, review or compile. For example, the allowance for uncollectible accounts is not present in tax-basis financial statements because bad debts are recorded on a direct write-off method. If the allowance is not present, the auditor or accountant eliminates the time needed to compute and test the allowance balance. With tax-basis financial statements, all deferred M-1 items are eliminated but permanent M-1s are still presented in tax-basis financial statements. Following is a list of deferred M-1 items that are not applicable to tax-basis financial statements.

Deferred M-1s Eliminated (Federal Tax Basis):

One depreciation method

No UNICAP difference


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No unrealized gains on securities- ASC 320 (formerly FASB No. 115)

No related party accruals

No vacation accruals

No allowance for bad debts

No impairment of assets issues

No deferred income taxes

No impairment of goodwill or amortization difference

No consolidation of variable interest entities

In addition, a statement of cash flows is not required for tax-basis financial statements. ASC 230, Statement of Cash Flows (formerly FASB No. 95) requires a statement of cash flows only if GAAP statements are issued. However, a statement of cash flows may be included in tax-basis financial statements at the option of the company. For not-for-profit organizations, tax-basis financial statements can be very effective at reducing overall engagement time. Specifically, those not-for-profits that wish to avoid the requirements of ASC 958 (formerly FASB Nos. 116 and 117) may do so using tax-basis financial statements. Consider the following short list of savings: a. Donated services are not recorded. b. Statement of cash flows is not required. c. Statement of functional expenses and presentation of the amount of unrestricted,

temporarily restricted and permanently restricted net assets are not required. The substance of this information may be presented in the notes or elsewhere.

2. When not to use tax-basis financial statements:

Tax-basis financial statements should not be used in every situation. Generally, they should not be considered where the statements may be misleading. The author believes there are two specific situations in which the use of tax-basis financial statements could be considered misleading.

a. Not having an allowance for bad debts under the tax basis can be a significant problem

for some companies with high uncollectibles.

b. Not recording a contingent liability under the tax basis where an entity has a large contingency for an environmental liability or litigaiton claim, can distort the financial statements.

These two situations can be resolved by issuing tax basis financial statement with a tax-basis departure for an allowance or an accrual for an environmental liability. Certainly, the client's intent must be considered in deciding whether to issue tax basis statements.

E. Present Reporting and Disclosure Authority- Tax Basis At present, there is limited authority for tax basis statements. The general authority is found as follows:

a. SAS No. 122, AU-C Section 800, Special Considerations- Audits of Financial Statements Prepared in Accordance with Special Purpose Frameworks


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b. SSARS No. 21, Statements on Standards for Accounting and Review Services: Clarification and Recodification Even though two sets of standards provide the overall authority for using tax-basis financial statements, there is little guidance that addresses the practical application of tax-basis financial statements including overall financial statement format, specific disclosures that are required, and other matters such as how to handle certain permanent M-1 items. F. Items Peculiar to Tax-Basis Financial Statements Because there is minimal authoritative guidance related to tax-basis financial statements, certain transactions are generally accounted for in practice as follows:

1. Accounting changes for tax purposes: Treated in accordance with federal tax law, usually requiring a 481(a) adjustment spread prospectively over four years.

2. Nontaxable revenues and nondeductible expenses (permanent differences): These items are included in tax basis statements, yet not included as part of taxable income. Therefore, tax basis income will not necessarily agree with taxable income per tax return (line 28 of Form 1120).

a. Example: 50% meals and entertainment, penalties, key man life insurance, and non-

taxable interest income b. There are generally four ways to present these items:

As income and expense items on the tax basis income statement

As separate items on the income statement in the other income and expense section

Adjustments through retained earnings

Disclosure only

Note: The most common method in practice is to present the permanent M-1 items on the income statement in a separate section or through retained earnings. M-1 shown in other income and expense section:

Statement of Income- Tax Basis Net sales $xx Cost of sales xx Gross profit xx Operating expenses xx Net income before income taxes xx Income taxes xx Net income before non-taxable and non-deductible items xx Non-taxable and non-deductible items:

Key-man life insurance (2,000) Non-taxable interest 3,000 Net income xx

c. Taxable income adjustments for prior years' IRS or state audit:


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Treated on tax basis statements as a prior-period adjustment, charged to retained earnings, net of taxes. If GAAP statements, only the tax effect would be adjusted.

Example: A Company is audited for 20X1 and the IRS capitalized $100,000 of expenditures that were charged to repairs and maintenance. The IRS and state tax assessment is $40,000. The company makes an entry to record the fixed assets and tax liability in 20X2. Entry: Fixed assets 100,000 Retained earnings 100,000 Retained earnings 40,000 Accrued taxes 40,000 Statement of Retained Earnings- Tax Basis- December 31, 20X2 Balance- beginning of year XX Net income- tax basis XX Prior period adjustment: Capitalization of expenditures previously expensed (net of tax effect of $40,000) 60,000 Balance- end of year XX Note: If GAAP statements were issued, the company would record the $40,000 tax effect only but not the fixed assets. Thus, the only entry to retained earnings would have been $40,000. Depending on materiality, the $40,000 might have to be adjusted through the current year income statement. G. Disclosure and Financial Statement Requirements- Tax Basis AU-C 800 and SSARS No. 21 require that certain disclosures be included in tax-basis financial statements as follows:

1. A description of the special purpose framework (tax basis) 2. A summary of significant accounting policies 3. An adequate description about how the special purpose framework (tax basis) differs from

GAAP. The effects of these differences need not be quantified, and 4. Informative disclosures similar to those required by GAAP when the financial statements

contain items that are the same as, or similar to, those in financial statements prepared in accordance with GAAP.

Note: In the case of financial statements prepared in accordance with a contractual basis

of accounting, the disclosures should adequately describe any significant interpretations of the contract on which the financial statements are based.

Fair Presentation and Adequate Disclosures- Tax Basis When the special purpose financial statements contain items that are the same as, or similar to, those in financial statements prepared in accordance with GAAP, informative disclosures similar to those required by GAAP are necessary to achieve fair presentation. 1. If special purpose financial statements contain items for which GAAP would require

disclosure, the financial statements may either:


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Provide the relevant disclosure that would be required for those items in a GAAP presentation, or

Provide qualitative information that communicates the substance of that disclosure. Note: Qualitative information may be substituted for quantitative information required by GAAP:

For example, GAAP requires disclosure of the future principal payments on long-term debt over the next five years. For tax-basis financial statements, this disclosure could be satisfied by merely disclosing the repayment terms of significant long-term borrowings without quantifying it in a schedule.

Note: Tax-basis financial statements should include the same GAAP disclosures provided they are relevant and applicable to the tax basis.

For example, A disclosure of unrealized gains on securities and actuarial disclosures for

defined benefit pensions would not be relevant to tax-basis financial statements. H. Making Tax-Basis Financial Statements Simpler to Use and Understand The following represents a sample of financial statement formats that the author believes may be useful in applying tax-basis financial statements.


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EXAMPLE 1: Compilation Report- Tax Basis: Substantially All Disclosures Omitted (SSARS No. 21)

Management is responsible for the accompanying financial statements of XYZ Company, which comprise the balance sheet-tax basis as of the year ended December 31, 20XX, and the related statement of income and retained earnings-tax basis, for the years then ended in accordance with the tax-basis of accounting, and for determining that the tax-basis of accounting is an acceptable financial reporting framework.34 We have performed a compilation engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. We did not audit or review the financial statements nor were we required to perform any procedures to verify the accuracy or completeness of the information provided by management. Accordingly, we do not express an opinion, a conclusion, nor provide any form of assurance on these financial statements. The financial statements are prepared in accordance with the tax-basis of accounting, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Management has elected to omit substantially all the disclosures ordinarily included35 in financial statements prepared in accordance with the tax-basis of accounting. If the omitted disclosures were included in the financial statements, they might influence the user’s conclusions about the company’s assets, liabilities, equity, revenue, and expenses. Accordingly, the financial statements are not designed for those who are not informed about such matters.

James J. Fox & Company CPA Burlington, Massachusetts March 20, 20X1

Observation: Notice that in the sample compilation report, the language “ordinarily included” has been used in lieu of the traditional language “Management has elected to omit substantially all disclosures and the statement of cash flows required by GAAP.” The reason for this change in language is due to the fact that there is no authority as to which disclosures are specifically required by a tax basis framework. Further, a statement of cash flows is not required for non-GAAP formats such as the tax basis, and therefore is not mentioned in this report paragraph.

34 AR-C 80 states that when special purpose framework financial statements are prepared and management has a

choice of frameworks, the accountant’s compilation report should reference management’s responsibility for determining that the framework is acceptable.

35 The term "ordinarily included" is used when tax-basis financial statements are issued in lieu of the term "required" for GAAP statements.


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Example 1: Balance Sheet- Tax Basis

XYZ Company

Balance Sheet- Tax Basis December 31, 20XX

ASSETS

Current assets:

Cash $200,000 Accounts receivable- trade 300,000 Inventories 450,000 Prepaid expenses 50,000 Total current assets 1,000,000

Plant and equipment: Cost 1,200,000 Less accumulated depreciation 500,000 Total plant and equipment 700,000

$1,700,000

LIABILITIES AND STOCKHOLDERS’ EQUITY


Accounts payable $300,000 Accrued expenses 100,000 Short-term note payable 500,000 Total current liabilities 900,000 Long-term debt:

700,000

Stockholders’ equity:

Common stock 100 Retained earnings 99,900 Total stockholders’ equity 100,000

$1,700,000


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Example 1: Statement of Income and Retained Earnings-Tax Basis Option 1: Income Statement- M-1 Items Shown in Separate Section on Income Statement

XYZ Company

Statement of Income and Retained Earnings- Tax Basis For the Year Ended December 31, 20XX

Net sales $1,000,000 Cost of sales- tax return

800,000

Gross profit

200,000

Deductible expenses:

Officer’s compensation 25,000 Salaries and wages 25,000 Utilities 10,000 Advertising and promotion 5,000 Insurance 2,000 Uncollectible accounts 21,000 Payroll taxes and fringe benefits 12,000 State excise taxes 5,000 Interest 18,000 Depreciation 20,000 Sundry other expenses 5,000

Total deductible expenses 148,000 Taxable state income State income taxes Taxable federal income

52,000 (5,000) 47,000**

Non-taxable and non-deductible item:

Federal income tax expense Non-deductible life insurance

(7,500) (12,000)

Non-deductible meals and entertainment (2,500) Non-taxable interest 3,000

Net income

28,000

Retained earnings:

Beginning of year 71,900 End of year ** Agrees with line 28 of tax return.

$99,900


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Example 1: Statement of Income and Retained Earnings-Tax Basis Option 2: Income Statement- M-1 Items Shown as Adjustments to Retained Earnings

XYZ Company



800,000

Gross profit

200,000




52,000 (5,000) 47,000**

Retained earnings: Beginning of year Non-taxable and non-deductible item:

71,900


(7,500) (12,000)


End of year

** Agrees with line 28 of tax return.

$99,900


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Example 1: Statement of Income-Tax Basis Option 3: S Corporation

XYZ Company (An S Corporation)

Statement of Income- Tax Basis For the Year Ended December 31, 20XX


800,000

Gross profit

200,000



Total deductible expenses 148,000 Taxable ordinary income

47,000**

Other taxable income (deductible expenses): Interest Dividends Additional depreciation deduction Total taxable income Non-taxable and non-deductible items:

1,000*** 5,000***

(19,000)***

34,000**

Non-deductible life insurance (12,000) Non-deductible meals and entertainment (2,500) Non-taxable interest 3,000

Net income

$22,500

** Agrees with Schedule K of Form 1120S. *** Schedule K items.


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Example 2: Review Report -Tax Basis (SSARS No. 21)


Board of Directors XYZ Company We have reviewed the accompanying financial statements of XYZ Company, which comprise the balance sheet-tax basis as of December 31, 20XX, the related statements of income and retained earnings-tax basis, and the statement of cash flows-tax basis36, for the year then ended, and the related notes to the financial statements. A review includes primarily applying analytical procedures to management’s financial data and making inquiries of management. A review is substantially less in scope than an audit, the objective of which is the expression of an opinion regarding the financial statement as a whole. Accordingly, we do not express such an opinion. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with the basis of accounting the company uses for income tax purposes; this includes determining that the basis of accounting the company uses for income tax purposes is an acceptable basis for the preparation of financial statements in the circumstances.37 Management is also responsible for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Accountant’s Responsibility Our responsibility is to conduct the review engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the American Institute of Certified Public Accountants. Those standards require us to perform procedures to obtain limited assurance as a basis for reporting whether we are aware of any material modifications that should be made to the financial statements for them to be in accordance with the basis of accounting the company uses for income tax purposes. We believe that the results of our procedures provide a reasonable basis for our report. Accountant’s Conclusion Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in accordance with the basis of accounting the company uses for income tax purposes. Basis of Accounting38 We draw attention to Note X of the financial statements, which describes the basis of accounting. The financial statements are prepared in accordance with the basis of accounting the company uses for income tax purposes, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our conclusion is not modified with respect to this matter. James J. Fox & Company, CPA Burlington, Massachusetts March 20, 20X1

36 A statement of cash flows is optional for non-GAAP frameworks such as a tax basis. 37 When management has a choice of financial reporting frameworks, AR-C 90 requires that the review report make

reference to management's responsibility for determining that the applicable financial reporting framework is acceptable in the circumstances.

38 When a special purpose framework report is issued, the review report must include an emphasis-of-matter paragraph labeled "Basis of Accounting" or a similar title.


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Example 2: Balance Sheet-Tax Basis

XYZ Company


ASSETS Current assets:

Cash $200,000 Accounts receivable- trade 300,000 Inventories 250,000 Prepaid expenses 150,000 Total current assets 900,000


Other assets: Agreement not to compete 100,000 Investment in mutual funds 50,000 Total other assets 150,000

$1,700,000



Accounts payable $700,000 Accrued expenses 200,000 Current portion of long-term debt 100,000 Total current liabilities 1,000,000

Long-term debt (net of current portion):

600,000


Common stock 100 Retained earnings 99,900

Total stockholders’ equity 100,000

$1,700,000

See notes to financial statements


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Example 2: Statement of Revenues and Expenses- Tax Basis Income Statement- M-1 Items Shown in Separate Section on Income Statement

XYZ Company



800,000

Gross profit

392,000


Officer’s compensation 25,000 Salaries and wages 25,000 Utilities 10,000 Advertising and promotion 5,000 Insurance 2,000 Uncollectible accounts 21,000 Rent expense 94,000 Retirement plan expense 23,000 Payroll taxes and fringe benefits 12,000 State excise taxes 5,000 Amortization 10,000 Interest 18,000 Depreciation 85,000 Sundry other expenses 5,000


52,000 (5,000) 47,000**



(7,500) (12,000)

Non-deductible meals and entertainment (2,500) Non-taxable interest income 3,000

Net income

28,000

Retained earnings:


$99,900

See notes to financial statements.


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Example 2: Statement of Cash Flows- Tax Basis

XYZ Company Statement of Cash Flows-Tax Basis For the Year Ended December 31, 20XX Cash flow from operating activities: Net income $28,000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 95,000 Change in trade receivables 100,000 Change in inventories 60,000 Change in accounts payable (30,000) Change in accrued expenses (20,000) Change in prepaid expenses (10,000) 223,000 Cash flows from investing activities: Purchases of equipment (150,000) (150,000) Cash flows from financial activities: Repayment of long-term debt (100,000) Decrease in cash and cash equivalents (27,000) Cash and cash equivalents: Beginning of year 227,000 End of year $200,000 Supplementary cash flow disclosures: Interest paid $18,000 Income taxes paid 12,500



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Example 2: Notes to Financial Statements

XYZ Company Notes to Financial Statements- Tax Basis For the Year Ended December 31, 20XX

NOTE 1. NATURE OF OPERATIONS The Company is a manufacturer of fine widgets used in the medical community. The Company has three retail outlets located in Notown, Everytown and Whichtown, Massachusetts. The majority of the company's sales are made to customers engaged in medical distribution within New England.

Note: The above disclosure satisfies the nature of business disclosure (ASC 275 (formerly SOP 94-6)) and the concentration of accounts receivable (ASC 825 (formerly 107).

NOTE 2. BASIS OF ACCOUNTING The accompanying financial statements present financial results on the accrual basis of accounting used for federal income tax purposes which differs from the accrual basis of accounting required under generally accepted accounting principles. The primary differences between the Company’s method and the method required by generally accepted accounting principles are that a) depreciation has been recorded using accelerated methods authorized in the Internal Revenue Code, b) Uncollectible accounts on accounts receivable are recorded when deemed uncollectible without use of an allowance account, c) Certain accruals for compensation and other expenses are recorded when paid rather than when incurred, and d) Certain costs are capitalized to inventory that are not typically capitalized under generally accepted accounting principles. NOTE 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash equivalents policy: (only if a statement of cash flows is presented.) For purposes of the statement of cash flows, the Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. The majority of the Company's cash is placed within one local banking institution. At times, the balance on deposit exceeds federally insured limits. To date, the Company has not experienced any losses in such account and believes it is not exposed to any significant credit risk on its cash and cash equivalents. (ASC 825). Trade receivables: Trade receivables are recorded at net realizable value. Interest is not accrued on past due balances. The Company uses the direct writeoff method to account for uncollectible accounts that are not recoverable. Using the direct writeoff method, trade receivable balances are written off to bad debt expense when an account balance is deemed to be uncollectible.


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Trade receivables (continued): Accounts are considered past due once the unpaid balance is 90 days or more outstanding, unless payment terms are extended by contract. When an account balance is past due and attempts have been made to collect the receivable through legal or other means, the amount is considered uncollectible and is written off to expense. The company’s policy is not to charge interest on past due trade receivable balances. At December 31, 20XX, trade receivables had a balance in the amount of $300,000.

Note: The above disclosure is the tax basis equivalent of the ASC 310 disclosure requirement in which an entity must disclose, among other items, the basis at which receivables are presented on the balance sheet.

Investments: Investments are stated at amortized cost and consisted of amounts deposited in a mutual fund with a balance of $50,000 and a fair value of $70,000 (based on quoted prices) at year end.

Note: Because the statements are presented on the tax basis, fair value accounting for investments per ASC 320 (formerly FASB No. 115) does not apply. However, the cost and fair value of the investments are generally disclosed.

Intangibles: Certain agreements not to compete in connection with asset acquisitions are amortized on a straight-line basis over fifteen years. Inventories: The Company values its inventories at cost using the first-in, first-out (FIFO) basis. Additionally, in accordance with Internal Revenue Code, certain general and administrative, and storage costs are capitalized, which approximates 5% of ending inventory. Plant and equipment: Plant and equipment is stated at cost. Depreciation is computed using accelerated methods authorized under the Internal Revenue Code based on the following recovery periods:

Recovery

period (in years)


In accordance with the Internal Revenue Code, the Company records additional depreciation in the year of acquisition of certain assets. The Company recorded additional first-year depreciation in the amount of $24,000 in 20XX. After deducting first-year depreciation, the remaining cost is depreciated using the recovery periods noted above.


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Advertising: Advertising is expensed as incurred and totaled $5,000. Use of estimates: The preparation of financial statements in conformity with the tax-basis of accounting requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Subsequent events: The Company has evaluated subsequent events through March 31, 20X1, which is the date through which the financial statements were available to be issued.

Note: ASC 855, Subsequent Events requires management to evaluate subsequent events through the date through which the financial statements were available to be issued, and to disclose that information. A similar disclosure is required for tax-basis financial statements.

Tax Uncertainties The Company’s policy is to record interest expense and penalties in operating expenses. For year ended December 31, 20XX, there was no interest and penalties expense recorded and no accrued interest and penalties. The Company’s federal and state tax returns are open for examination three years from the date of filing.

Note: ASC 740, Income Taxes, requires an entity to disclose certain information about uncertain tax positions including the tax years that are open for examination for the IRS or state authority. The same disclosure would apply to tax-basis financial statements.

NOTE 4: INVENTORIES Inventories consist of the following, by component: Raw materials and supplies $ 50,000 Work in process 50,000 Finished goods 120,000 220,000 Additional general and administrative and storage costs capitalized 30,000 $250,000 NOTE 5: RELATED PARTY TRANSACTIONS From time to time, the company borrows from a shareholder to accommodate cash flow requirements. Interest is payable at 5% per annum and is recorded as an expense when paid in accordance with Internal Revenue Code requirements.


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NOTE 6: PLANT AND EQUIPMENT The components of fixed assets and related costs are as follows:

Cost: Machinery and equipment $200,000 Computer and office fixtures 50,000 Leasehold improvements 900,000 1,150,000 Less accumulated depreciation 500,000 $650,000

Depreciation expense was $85,000, including $24,000 of additional first-year depreciation on certain equipment. NOTE 7: LONG-TERM DEBT Long-term debt consisted of the following at December 31, 20XX:

Bank Note: Mortgage loan payable in monthly principal payments of $6,667 (annual of $80,000) plus interest at 3% per annum. The unpaid note balance is due on December 31, 20X6. The note is secured by a first mortgage on certain company real estate.

$500,000

Shareholder: Unsecured term note requiring semiannual principal payments of $10,000 through June 30, 20X20, plus interest at 110% of the treasury bill rate (3.3% rate at December 31, 20XX)

200,000 700,000

Less current portion 100,000 $600,000

A summary of the annual maturities of long-term debt for the five years subsequent to year end follows:

Year

Principal payments

20X1 $100,000 20X2 100,000 20X3 100,000 20X4 100,000 20X5 100,000

Note: The five-year amortization is not required in this example. The reason is that the reader can obtain the principal payments for the five years based on the description of the loan terms above. SAS No. 122, AU-C Section 800 states that a GAAP format does not have to be followed for disclosures provided the reader can obtain the same result from the information given. Qualitative information prevails. Also, interest expense would normally be disclosed in this note. However, it is already disclosed on the face of the statement of income.


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NOTE 8: INCOME TAXES The provision for income taxes consists of federal and state income taxes currently payable. A summary of the provision follows:

Federal income taxes $7,500 State income taxes 5,000 $12,500

Note: Using the format of this statement of income, this disclosure is not required because the components of federal and state taxes are already presented on the statement of income.

NOTE 9: LEASES The Company has entered into various equipment leases with total monthly payments of $8,000 and various expiration dates through 20X6. A summary of the future minimum lease payments under these operating leases follows.

Year

Minimum lease payments

20X1 $96,000 20X2 96,000 20X3 96,000 20X4 96,000 20X5 96,000 Beyond 20X5 75,000

Total minimum lease payments $555,000 Total rent expense under these leases was $94,000.

Note: Similar to the long-term debt note, the table above could be replaced with qualitative information that provides the reader with the same information. For example, insert the following additional language into the description and remove the table as follows: The Company has entered into various equipment leases with total monthly payments of $8,000 and various expiration dates through 20X6. Total lease payments under these leases will approximate $50,000 per year during the next five years, with the balance beyond five years totaling approximately $75,000. Total rent expense under these leases was $94,000.

NOTE 10: PENSION PLANS The Company is the sponsor of a profit-sharing plan. All employees, exclusive of those covered by collective bargaining agreements, are eligible to enter the Plan within one year of the commencement of employment. Contributions to the Plan were $23,000.


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NOTE 11: CONTINGENCIES The Company has been named in a lawsuit that involved use of the company's product by a customer. The possible loss from this lawsuit could range from $50,000 to $200,000. Management believes that this suit is frivolous and, any liability, if any, will not have a material effect on the company. NOTE 12: SUBSEQUENT EVENT On February 5, 20X1, the Company entered into an agreement to purchase certain assets of ABC Corporation for $300,000. The assets to be purchased consist of certain plant and equipment, inventories and selected accounts receivable, along with a three-year agreement not to compete from an officer of ABC Corporation. NOTE 13: CAPITAL STRUCTURE As of December 31, 20XX, the company had 100 shares of no-par common stock issued and outstanding. Dividends are paid at the discretion of the board of directors. NOTE 14: AGREEMENT NOT TO COMPETE As part of a previous acquisition of certain assets of Z Company, the company entered into an agreement with the former owner of Z Company. The terms of the agreement provide that for a payment of $150,000, the owner will not compete in the medical market for a period of five years through September 30, 20X4. The agreement is amortized on a straight-line basis over a fifteen-year period in accordance with Internal Revenue Code requirements. As of December 31, 20XX, the unamortized balance of the agreement was $100,000. NOTE 15: MAJOR CUSTOMERS Approximately 30% of the company's sales were made to one customer.

--end of notes-


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Example 3: Tax-Basis Review Report with a Tax-Basis Departure Facts: Same as Example 2 except that an allowance for bad debts is set up for $10,000, which is a departure from the tax-basis of accounting. Assume that the tax effect on the entry is not material. Review Report- Tax-Basis of Accounting with Report Exception (SSARS No. 21)


Board of Directors XYZ Company We have reviewed the accompanying financial statements of XYZ Company, which comprise the balance sheet-tax basis as of December 31, 20XX, the related statements of income and retained earnings-tax basis, and the statement of cash flows-tax basis,39 for the year then ended, and the related notes to the financial statements. A review includes primarily applying analytical procedures to management’s financial data and making inquiries of management. A review is substantially less in scope than an audit, the objective of which is the expression of an opinion regarding the financial statement as a whole. Accordingly, we do not express such an opinion. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with the basis of accounting the company uses for income tax purposes; this includes determining that the basis of accounting the company uses for income tax purposes is an acceptable basis for the preparation of financial statements in the circumstances.40 Management is also responsible for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Accountant’s Responsibility Our responsibility is to conduct the review engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the American Institute of Certified Public Accountants. Those standards require us to perform procedures to obtain limited assurance as a basis for reporting whether we are aware of any material modifications that should be made to the financial statements for them to be in accordance with the basis of accounting the company uses for income tax purposes. We believe that the results of our procedures provide a reasonable basis for our report. Accountant’s Conclusion Based on our review, except for the issue noted in the Known Departure From the Basis of Accounting Used for Income Tax Purposes paragraph, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in accordance with the basis of accounting the company uses for income tax purposes. Basis of Accounting41 We draw attention to Note X of the financial statements, which describes the basis of accounting. The financial statements are prepared in accordance with the basis of accounting the company uses for income tax purposes, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our conclusion is not modified with respect to this matter.

39 When issuing tax-basis financial statements, the statement of cash flows is optional. 40 When management has a choice of financial reporting frameworks, AR-C 90 requires that the review report make reference to management's responsibility for determining that the applicable financial reporting framework is acceptable in the circumstances. 41 When a special purpose framework report is issued, the review report must include an emphasis-of-matter paragraph labeled "Basis of Accounting" or a similar title.


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Known Departure From the Basis of Accounting Used for Income Tax Purposes As described in Note XX, the tax-basis of accounting requires that writeoffs on uncollectible trade receivables be recorded using the direct writeoff method. Management has informed us that the allowance method has been used to record an estimate of uncollectible accounts. If the direct writeoff method had been used, stockholders’ equity and net income would have increased by $10,000. James J. Fox & Company, CPA Burlington, Massachusetts March 20, 20X1

Note: Typically, the effect of the departure on a net of tax basis would be disclosed in the report. In this example, there is no tax effect so that the amount is disclosed, gross in the amount of $10,000.


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Example 3: Reviewed Financial Statements With a Tax-Basis Departure

XYZ Company


ASSETS Current assets:

Cash $200,000 Accounts receivable- trade (net of allowance: $10,000) 290,000 Inventories 250,000 Prepaid expenses 150,000 Total current assets 890,000


Other assets: Agreement not to compete 100,000 Investment in mutual funds 50,000 Total other assets 150,000

$1,690,000



Accounts payable $700,000 Accrued expenses 200,000 Current portion of long-term debt 100,000 Total current liabilities 1,000,000

Long-term debt (net of current portion):

600,000


Common stock 100 Retained earnings 89,900

Total stockholders’ equity 90,000

$1,690,000

See notes to financial statements


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Example 3: Reviewed Financial Statements With a Tax-Basis Departure

XYZ Company



800,000

Gross profit

392,000


Officer’s compensation 25,000 Salaries and wages 25,000 Utilities 10,000 Advertising and promotion 5,000 Insurance 2,000 Uncollectible accounts 21,000 Rent expense 94,000 Retirement plan expense 23,000 Payroll taxes and fringe benefits 12,000 State excise taxes 5,000 Amortization 10,000 Interest 18,000 Depreciation 85,000 Sundry other expenses 5,000


52,000 (5,000) 47,000**



(7,500) (12,000)

Non-deductible meals and entertainment (2,500) Additional writeoffs of uncollectible accounts (10,000) Non-taxable interest income 3,000

Net income 18,000 Retained earnings:


$89,900



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Example 3: Reviewed Financial Statements with a Tax-Basis Departure

XYZ Company

Statement of Cash Flows-Tax Basis For the Year Ended December 31, 20XX

Cash flow from operating activities: Net income $18,000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 95,000 Change in trade receivables 110,000 Change in inventories 60,000 Change in accounts payable (30,000) Change in accrued expenses (20,000) Change in prepaid expenses (10,000) 223,000 Cash flows from investing activities: Purchases of equipment (150,000) (150,000) Cash flows from financial activities: Repayment of long-term debt (100,000) Decrease in cash and cash equivalents (27,000) Cash and cash equivalents: Beginning of year 227,000 End of year $200,000 Supplementary cash flow disclosures: Interest paid $18,000 Income taxes paid 12,500


Additional Note: Example 3 The following note would be added to the notes to financial statements, reflecting the tax basis departure:

NOTE XX: Uncollectible Accounts: The tax-basis of accounting requires that writeoffs on uncollectible trade receivables be recorded using the direct writeoff method, which records the writeoff and related expense when the account is deemed uncollectible. Management has informed us that the allowance method has been used whereby an estimate of uncollectible accounts has been recorded prior to the accounts actually becoming uncollectible. If the direct writeoff method had been used, stockholders’ equity and net income- tax basis , would have increased by $10,000.42

42 There is no tax effect to be disclosed.


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Report modification: compilation or audit engagements Assuming Example 3 relates to a compilation or an audit, each report would be modified as follows: EXAMPLE 3: Tax-Basis Compilation Report- Substantially All Disclosures Omitted and Departure for Allowance Account Compilation Report- Tax-Basis of Accounting with Report Exception (SSARS No. 21)

Management is responsible for the accompanying financial statements of XYZ Company, which comprise the balance sheet-tax basis as of the year ended December 31, 20XX, and the related statement of income and retained earnings-tax basis, for the year then ended in accordance with the tax-basis of accounting, and for determining that the tax-basis of accounting is an acceptable financial reporting framework.43 We have performed a compilation engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. We did not audit or review the financial statements nor were we required to perform any procedures to verify the accuracy or completeness of the information provided by management. Accordingly, we do not express an opinion, a conclusion, nor provide any form of assurance on these financial statements. The financial statements are prepared in accordance with the tax-basis of accounting, which is a basis of accounting other than accounting principles generally accepted in the United States of America. The tax-basis of accounting requires that writeoffs on uncollectible trade receivables be recorded using the direct writeoff method. Management has informed us that the allowance method has been used to record an estimate of uncollectible accounts. If the direct writeoff method had been used, stockholders’ equity and net income would have increased by $10,000. Management has elected to omit substantially all the disclosures ordinarily included44 in financial statements prepared in accordance with the tax-basis of accounting. If the omitted disclosures were included in the financial statements, they might influence the user’s conclusions about the company’s assets, liabilities, equity, revenue, and expenses. Accordingly, the financial statements are not designed for those who are not informed about such matters.


43 AR-C 80 states that when special purpose framework financial statements are prepared and management has a choice of frameworks, the accountant’s compilation report should reference management’s responsibility for determining that the framework is acceptable. 44 The term "ordinarily included" is used when tax-basis financial statements are issued in lieu of the term "required" for GAAP statements.


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Audit Report- Tax-Basis of Accounting with Report Exception (AU-C 800)


Board of Directors XYZ Company Boston, Massachusetts We have audited the accompanying financial statements of XYZ Company, which comprise the balance sheet-tax basis as of December 31, 20XX, and the related statement of income and retained earnings-tax basis for the year then ended, and the related notes to the financial statements. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with the tax-basis of accounting; this includes determining that the tax-basis of accounting is an acceptable basis for the preparation of financial statements in the circumstances. Management is also responsible for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the partnership’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the partnership’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified audit opinion. Basis for Qualified Opinion As described in Note X, the Company has recorded uncollectible trade receivables using the allowance method which estimates uncollectible accounts. The tax-basis of accounting requires that uncollectible accounts be recorded using the direct writeoff method. If the direct writeoff method had been used, stockholders’ equity and net income- tax basis would have increased by $10,000.


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Opinion In our opinion, except for the effects of not using the direct writeoff method as discussed in the Basis for Qualified Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the balance sheet of XYZ Company as of December 31, 20XX, and its income and retained earnings-tax basis for the year then ended, in accordance with the basis of accounting the Company uses for income tax purposes as described in Note X. Basis of Accounting We draw attention to Note X of the financial statements, which describes the basis of accounting. The financial statements are prepared on the basis of accounting the Company uses for income tax purposes, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our opinion is not modified with respect to this matter. [Auditor’s Signature] [Auditor’s City and State] [Date of the Auditor’s Report]


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Example 4: Tax-Basis Audit Report Accountants should consider using tax-basis financial statements more frequently for audit engagements. The key issue is whether third parties (e.g. banks, etc.) will accept them in lieu of GAAP statements. If a third party will accept tax-basis financial statements, there is no reason why tax-basis financial statements shouldn't be just as favorable for an audit client as reviewed or compiled statements. If an audit is conducted, the report looks like the example report noted below. Disclosures are the same as the review engagement shown in previously presented Example 2.


Board of Directors XYZ Company Boston, Massachusetts We have audited the accompanying financial statements of XYZ Company, which comprise the balance sheet- tax basis as of December 31, 20XX, and the related statements of income and retained earnings- tax basis, and statement of cash flows-tax basis, for the year then ended, and the related notes to the financial statements. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with the tax-basis of accounting; this includes determining that the tax-basis of accounting is an acceptable basis for the preparation of financial statements in the circumstances. Management is also responsible for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the partnership’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the partnership’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements.


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We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements referred to above present fairly, in all material respects, the assets, liabilities, and stockholders’ equity of XYZ Company as of December 31, 20XX, and its revenue, expenses and retained earnings, and cash flows for the year then ended, in accordance with the basis of accounting the Company uses for income tax purposes as described in Note X. Basis of Accounting We draw attention to Note X of the financial statements, which describes the basis of accounting. The financial statements are prepared on the basis of accounting the Company uses for income tax purposes, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our opinion is not modified with respect to this matter. [Auditor’s Signature] [Auditor’s City and State] [Date of the Auditor’s Report]

I. Converting to Tax-Basis Financial Statements When a company converts from GAAP statements to tax-basis financial statements, there are generally two options available in the year of conversion. 1. Comparative statements presented:

Restate the prior year's statements to tax basis and show both years on a comparative basis. The beginning retained earnings for the prior year must be restated to reflect the effect of the change to tax basis on prior years' income.

2. Current year statements presented only:

Restate retained earnings for the year of change and do not present comparative statements for the prior years. Two options to reflect the restatement:

As an adjustment to beginning retained earnings, or

As a cumulative-effect of a change on the income statement Observation: A change to tax-basis financial statements does not represent a change in accounting principle in accordance with ASC 250 Accounting Changes and Error Corrections (formerly FASB 154). Existing literature provides no guidance on how to present the change to tax basis statements. In the author's opinion, it is more appropriate to present the change as an adjustment to the beginning retained earnings balance. Regardless of whether the change is presented as a cumulative effect or an adjustment to beginning retained earnings, the adjustment should be shown net of income taxes in accordance with intraperiod tax allocation.


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The following provides an example of the options available in converting to tax-basis financial statements. Example: Effective January 1, 20X1, a company converts from GAAP to tax-basis financial statements. As of that date, the differences between GAAP and tax basis balance sheet are as follows: January 1, 20X1 GAAP Tax Return Accrued vacation pay 100,000 0 Allowance for bad debts 50,000 0 UNICAP add-on to inventory 0 10,000 Deferred F&S taxes 56,000 0 The entry to restate for the implementation of tax basis statements is as follows: January 1, 20X1: Accrued vacation pay 100,000 Allowance of bad debts 50,000 Inventory 10,000 Adjustment- tax basis 160,000 Adjustment- tax basis 56,000 Deferred F&S taxes 56,000 The net adjustment is $104,000 ($160,000 less $56,000) and may be presented as follows: Option 1: Restate beginning retained earnings:

Statement of Retained Earnings- Tax Basis For the year ended December 31, 20X1

Retained earnings, January 1, 20X1: As originally stated $xx Restatement to reflect change to tax basis

of accounting (net of income taxes; $56,000) 104,000 As restated xx 20X1 net income, tax basis xx Retained earnings, December 31, 20X1 $xx


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Option 2: Show restatement as a cumulative effect of change on income statement:

Statement of Income- Tax Basis For the year ended December 31, 20X1

Net sales $xx Cost of sales xx Gross profit on sales xx Selling and general administrative expenses xx Net income before income taxes xx Income taxes (Note 4) xx Net income before cumulative effect of change to tax-basis of accounting xx Cumulative effect of change to tax-basis of accounting (net of income taxes; $56,000) 104,000 Net income $xx SAMPLE NOTE:

NOTE 5: CHANGE TO TAX-BASIS FINANCIAL STATEMENTS: In 20X0, the Company prepared its financial statements using accounting principles generally accepted in the United States of America. Effective January 1, 20X1, the Company adopted the basis of accounting used for federal income tax purposes for its financial statements. The accompanying 20X1 financial statements have been restated to conform with the new basis of accounting. As a result, retained earnings at January 1, 20X1 have been restated in the amount of $104,000 to reflect the change to the new method.

Report in Year of Change to Tax Basis Statements From GAAP Although not required, a practitioner may wish to add an explanatory paragraph to his or her report (audit, review or compilation report), identifying the fact that the company changed from GAAP to tax-basis financial statements. Sample paragraph: (added at the end of the report)45

As disclosed in Note 1, in 20X1, the Company adopted a policy of preparing the financial statements on the accrual basis of accounting used for federal income tax purposes, which is a basis of accounting other than generally accepted accounting principles. Accordingly, the accompanying financial statements are not intended to present financial position and results of operations in conformity with accounting principles generally accepted in the United States of America. Retained earnings as of January 1, 20X1 have been restated to reflect the effect of the change on prior years' statements.

Note: If the prior year statements are restated to tax basis, the last sentence above should be replaced with: The financial statements for 20X0 have been restated to reflect the tax-basis of accounting adopted in 20X1.

45 A heading "Emphasis-of-Matter (or similar heading) should be added to the paragraph for a review or audit report, but not a compilation report.


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J. Cash Flows Statement A statement of cash flows is not required for non-GAAP financial statements such as tax basis. ASC 230, Statement of Cash Flows, (formerly FASB No. 95), requires entities to provide a statement of cash flows when GAAP financial statements are issued and there is a balance sheet and income statement presented. Consequently, when non-GAAP statements are presented, a cash flows statement is not required, but is optional. As a practical point, many practitioners do, in fact, include a statement of cash flows in tax-basis financial statements that are either reviewed or audited. The reason is because the user, typically a bank, wants the statement of cash flows included. K. Tax-Basis Financial Statement Titles Question: Is it appropriate to use the title: “Statement of Income-Tax Basis,” or “Balance Sheet-Tax Basis,” in preparing tax-basis financial statements? Response: AU-C 800 and SSARS No. 21 clarify that traditional GAAP titles, such as balance sheet, statement of income, may be used for special purpose framework financial statements, provided such titles are "appropriately modified." That means that the title must be altered so that the reader clearly understands that the tax basis (or other special purpose framework) is being used, and not GAAP. Examples of financial statement titles that are suitable for special purpose framework financial statements include, but are not limited to the following: Modified cash basis:

Income Statement-Modified Cash Basis

Statement of Income- Modified Cash Basis**

Statement of Cash Receipts and Disbursements Tax basis:

Balance Sheet- Tax Basis

Statement of Assets, Liabilities, and Equity-Tax Basis

Statement of Operations-Tax Basis

Statement of Revenue and Expenses-Tax Basis

Statement of Income- Tax Basis** Regulatory basis:

Statement of Income- Regulatory Basis

Balance Sheet- Regulatory Basis ** Added to list by author.

Observation: For years there has been confusion as to the titles that could be used for non-GAAP financial statements such as income tax basis financial statements. The general rules were originally found in SAS No. 62, Special Reports, which stated that other comprehensive basis of accounting (OCBOA) financial statements should be "suitably titled" so as not to imply they are GAAP financial statements. SAS No. 62 provided limited guidance as to what was "suitably titled" and what was not.


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Although not codified within SAS No. 62, some commentators, including the author, have believed that suitably titled financial statements could use the terms "balance sheet" and "statement of income" provided there was an appropriate suffix such as "tax basis” or "cash basis" etc. Thus, the titles "balance sheet-tax basis” and "statement of income-tax basis” were appropriate titles if reporting on income tax basis financial statements under the pre-SSARS No. 21 rules. Yet, some peer reviewers and other parties took a far more narrow position that the terms "balance sheet" and "statement of income" could not be used in an non-GAAP title regardless of whether an "tax basis" suffix was attached. Thus, many practitioners have used titles such as "statement of assets, liabilities and equity-tax basis” and "statement of revenues and expenses-tax basis" even though titles such as "balance sheet-tax basis" and "statement of income-tax basis" could have been used. SSARS No. 21 finally brings clarity to the situation by stating that with respect to special purpose frameworks, (such as tax basis), GAAP titles may be used provided such titles are "appropriately modified." SSARS No. 21 does offer some examples of titles that are considered "appropriately modified." Following are examples of "appropriate" special purpose framework titles:

Balance Sheet- Tax Basis**

Statement of Income- Tax Basis**

Statement of Income- Regulatory Basis

Balance Sheet- Regulatory Basis ** Title included by author, but not included in list found in SSARS No. 21. Does SSARS No. 21 permit use of the suffix “income tax basis” instead of “tax basis?” SSARS No. 21 changed the definition of a special purpose framework to include the “tax basis” which is defined in Paragraph .07 of AR-C 70 as a “basis of accounting that an entity uses to file its tax return for the period covered by the financial statements.” Previously, the term “income tax basis” was used within the concept of other comprehensive basis of accounting (OCBOA) financial statements. Although SSARS No. 21 does not explain the reason for using the term “tax basis” in lieu of “income tax basis,” the author believes it was changed to reflect the fact that certain tax authorities define their tax as something other than an income tax. For example, the Massachusetts state corporate tax is called an excise tax, not an income tax. So, the question is whether tax-basis financial statements can be titled with an “income tax basis” suffix instead of “tax basis.” The answer is that nothing precludes the use of the term “income tax basis” instead of “tax basis.” In fact, although SSARS No. 21 uses “tax basis” in its examples and financial statement titles, the AICPA Guide uses the term “income tax basis.” Thus, in using tax basis financial statement titles, all the following are acceptable:

Balance Sheet- Tax Basis Balance Sheet- Income Tax Basis Statement of Income- Tax Basis


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Statement of Income- Income Tax Basis Statement of Income and Retained Earnings- Tax Basis Statement of Income and Retained Earnings- Income Tax Basis Statement of Stockholders’ Equity- Tax Basis Statement of Stockholders’ Equity- Income Tax Basis Statement of Cash Flows- Tax Basis Statement of Cash Flows- Income Tax Basis

L. Disclosure and Financial Statement Requirements- Tax Basis As previously noted, AU-C 800 and SSARS No. 21 require that certain disclosures be included in tax-basis financial statements as follows:

1. A description of the special purpose framework (tax basis) 2. A summary of significant accounting policies 3. An adequate description about how the special purpose framework (tax basis) differs from

GAAP. The effects of these differences need not be quantified, and 4. Informative disclosures similar to those required by GAAP when the financial statements

contain items that are the same as, or similar to, those in financial statements prepared in accordance with GAAP.

Note: In the case of financial statements prepared in accordance with a contractual basis

of accounting, the disclosures should adequately describe any significant interpretations of the contract on which the financial statements are based.

When the special purpose financial statements contain items that are the same as, or similar to, those in financial statements prepared in accordance with GAAP, informative disclosures similar to those required by GAAP are necessary to achieve fair presentation. 1. If special purpose financial statements contain items for which GAAP would require

disclosure, the financial statements may either:

Provide the relevant disclosure that would be required for those items in a GAAP presentation, or

Provide qualitative information that communicates the substance of that disclosure. Note: Qualitative information may be substituted for quantitative information required by GAAP:

For example, GAAP requires disclosure of the future principal payments on long-term debt over the next five years. For tax-basis financial statements, this disclosure could be satisfied by merely disclosing the repayment terms of significant long-term borrowings without quantifying it in a schedule.

Note: Tax-basis financial statements should include the same GAAP disclosures provided they are relevant and applicable to the tax basis.

For example, A disclosure of unrealized gains on securities and actuarial disclosures for

defined benefit pensions would not be relevant to tax basis statements.


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M. Authority for Tax-Basis Disclosures SAS No. 122, AU-C Section 800: Special Considerations- Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks, and SSARS No. 21, Statements on Standards for Accounting and Review Services: Clarification and Recodification, provide guidance as to the extent of disclosures that are required when reporting on special purpose frameworks, which include tax-basis financial statements. AU-C 800 and SSARS No. 21 require that financial statements prepared on a special purpose framework (such as tax basis) should include the following disclosures:

A description of the special purpose framework (tax basis)

A summary of significant accounting policies

An adequate description about how the special purpose framework (tax basis) differs from GAAP. The effects of these differences need not be quantified, and

Informative disclosures similar to those required by GAAP when the financial statements contain items that are the same as, or similar to, those in financial statements prepared in accordance with GAAP.

When special purpose financial statements contain items that are the same as, or similar to, GAAP statements, the disclosures for depreciation, long-term debt, and owners’ equity should be comparable to those found in GAAP financial statements. In addition, there may be a need for disclosure of matters that are not specifically identified on the face of the statements such as:

related party transactions

restrictions on assets and owners’ equity

subsequent events

uncertainties How should the guidance of AU-C 800 and SSARS No. 21 be applied in evaluating the adequacy of disclosure in financial statements prepared on the cash, modified cash, or tax-basis of accounting? Response: First, the basis of accounting note may be brief with only the primary differences from GAAP being described. For example, assume that there are several differences between tax basis and GAAP as follows:

Allowance for bad debts Insignificant Depreciation difference Significant UNICAP- Section 263A adjustment Insignificant

In the basis of accounting note, only a brief description of the depreciation difference would be required with no mention of the other differences. Quantifying the differences is not required. Example: Basis of Accounting: The accompanying financial statements present financial results on the accrual basis of accounting used for federal income tax purposes which differs from the accrual basis of accounting required under generally accepted accounting principles. The primary difference between the Company’s method and the method required by generally accepted


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accounting principles is that depreciation has been recorded using accelerated methods authorized by the Internal Revenue Code. What disclosures are required in tax-basis financial statements? Tax basis disclosures should be the "same as, or similar to" GAAP disclosures. Following is guidance to be followed in determining which disclosures should be included in tax-basis financial statements:

1. If tax-basis financial statements contain elements, accounts, or items for which GAAP would require disclosure, the statements should either provide a relevant disclosure or provide information that effectively communicates the substance of that disclosure.

Qualitative information may be substituted for quantitative information required by GAAP.

Modification of the financial statement format is not required.

Example: GAAP requires disclosure of the future principal payments of long-term debt over the next five years. For tax-basis financial statements, this disclosure could be satisfied by merely disclosing the repayment terms of significant long-term borrowings without quantifying it in a schedule.

2. GAAP disclosures that are not relevant to tax-basis financial statements are not required.

Examples include:

1) Fair value information required for investments accounted for at fair value in accordance with ASC 320, Investments, (formerly found in FASB No. 115). Fair value information would not be relevant for tax basis because they would be recorded at cost.

2) For defined benefit plans, information based on actuarial calculations that ASC 715

(formerly FASB No. 158), required for GAAP financial statements would not be relevant to tax-basis financial statements.

3. The tax basis financial statement format should comply with GAAP requirements or

provide information that communicates the substance of those requirements. Such information may be communicated using qualitative information without modifying the financial statement format.


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Examples:

Financial Statement Item(s)

GAAP Tax Basis

Information about the effects of accounting changes, discontinued operations, and extraordinary items.

Must be shown on the statement of income, net of the tax effect.

May be shown on the statement of income, or, alternatively, may be disclosed in the notes, net of the tax effect.

A not-for-profit organization shows expenses by their functional classification.

Shown in the statement of activity, by functional classifications.

May be shown in the statement of activity, or, alternatively, may present expenses by their natural classification and, in a note, could use estimated percentages to communicate information about expenses incurred by major program and supporting services.

A not-for-profit organization shows the amounts of, and changes in, unrestricted, temporarily restricted, and permanently restricted net assets.

Such classifications are presented in the statement of activity and statement of net assets.

Totals may be shown on the statements of activity and net assets with a breakout presented in the notes using estimates or percentages.

Statement of Cash Flows Issues:

A statement of cash flows is not required for non-GAAP financial statements, such as those prepared on the tax basis. However, if cash receipts and disbursements basis of accounting is used, the income statement is effectively a cash flow statement. If a statement of cash flows is presented in tax-basis financial statements (or any other special purpose framework), the cash flow statement should either conform to the requirements for a GAAP statement of cash flows, or disclose the substance of those requirements.

Example: A Company issues tax basis accrual financial statements and decides to include a statement of cash flows, although not required. Conclusion: The statement of cash flows should either conform with the GAAP requirements for a cash flow statement, or the same types of cash flow disclosures should be made either on the statement or in the notes. For example, noncash transactions, such as purchasing a fixed asset with borrowings, should be disclosed in the notes.

4. Other disclosures:

If GAAP requires disclosure of other matters such as contingent liabilities, going concern, and significant risks and uncertainties, an entity should consider the need for that same disclosure. However, disclosures that are irrelevant to tax-basis financial statements need not be included.

Example: A disclosure about the use of estimates that is required by ASC 275 (formerly SOP 94-6) would not be relevant in a cash receipts and cash disbursements basis of accounting which has no estimates.

Observation: Qualitative information may be substituted for quantitative information, and the statements need not be modified. For example, the presentation of the five-year amortization of long-term debt could be eliminated if there is a description of the debt terms. This would also be the case with respect to operating leases.


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N. Disclosures of Fair Value- Tax Basis Question: If an entity presenting financial statements on the tax-basis of accounting, must fair value disclosures be included in the notes? Response: Generally not. GAAP requires an entity to record fair value disclosures as follows:

a. Items recorded on the balance sheet at fair value: all entities must include fair value disclosures.

b. Financial instruments not recorded at fair value: SEC companies, and nonpublic entities with either: 1) total assets of $100 million or more, or 2) recorded derivatives.

With respect to tax-basis financial statements, assets and liabilities that would otherwise be recorded at fair value (such as investments in equity securities, derivatives, etc), are recorded at cost. Therefore, an entity would not be required to include disclosures about fair value information with respect to those items. However, if a nonpublic entity has total assets of $100 million or more or recorded derivatives, GAAP requires that entity to include fair value disclosures for all financial instruments even if those instruments are not recorded at fair value. A similar disclosure would be required if that same large non-public entity ($100 million or more, or derivatives) issued tax-basis financial statements. Example: Company X is a nonpublic entity with total assets of $20 million for which tax-basis financial statements are issued. X has an investment in equity securities recorded at cost under the tax-basis of accounting. Conclusion: Fair value disclosures are not required for GAAP because X has no assets and liabilities recorded at fair value. Thus, no fair value disclosures are required for tax-basis financial statements for the investment in equity securities. Example 2: Company X is a nonpublic entity with total assets of $150 million for which tax-basis financial statements are issued. X has an investment in equity securities recorded at cost under the tax-basis of accounting. Conclusion: Because X has total assets of $100 million or more, GAAP requires X to include fair value information about financial instruments even if those instruments are not recorded at fair value. That’s the GAAP side of the rules. When tax-basis financial statements are issued, such statements much include disclosures that are the "same as, or similar to" those disclosures required by GAAP. Thus, X would have to include fair value disclosures about its financial instruments even though they are not recorded at fair value in the tax-basis financial statements. In this example, fair value disclosures would be required for the investment in equity securities even though that investment is recorded at cost. Should the fact that fair value is not used be disclosed as a primary difference between tax basis and GAAP financial statements? Yes. When tax-basis financial statements are issued, SAS No. 122, AU-C Section 800: Special Considerations- Audits of Financial Statements Prepared in Accordance With Special Purpose


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Frameworks, provides guidance as to the extent of disclosures that are required when reporting on special purpose frameworks, which include tax-basis financial statements. The AU-C requires that financial statements prepared on a special-purpose framework (such as tax basis) should include the following disclosures:

A description of the special purpose framework (tax basis)

A summary of significant accounting policies

An adequate description about how the special purpose framework (tax basis) differs from GAAP. The effects of these differences need not be quantified, and

Informative disclosures similar to those required by GAAP when the financial statements contain items that are the same as, or similar to, those in financial statements prepared in accordance with GAAP.

One of the differences that should be disclosed is the fact that certain assets that would be recorded at fair value under GAAP, are recorded at cost under the tax basis.

NOTE X: BASIS OF ACCOUNTING The accompanying financial statements present financial results on the accrual basis of accounting used for federal income tax purposes which differs from the accrual basis of accounting required under generally accepted accounting principles. The primary differences between the Company’s method and the method required by generally accepted accounting principles are that: a) depreciation has been recorded using accelerated methods authorized in the Internal Revenue Code, b) Uncollectible accounts on accounts receivable are recorded when deemed uncollectible without use of an allowance account, c) Certain accruals for compensation and other expenses are recorded when paid rather than when incurred, and d) Certain costs are capitalized to inventory that are not typically capitalized under generally accepted accounting principles, and e) certain investments are recorded at cost when such investments are recorded at fair value under generally accepted accounting principles.

The above element would only apply if the entity has investments that, under GAAP, would be recorded at fair value. O. Miscellaneous Disclosures – Tax Basis Question: Is an entity required to disclose information on management’s evaluation of subsequent events in tax-basis financial statements? Response: Yes. Such a disclosure is required for all financial statement frameworks. Question: Do the consolidation of variable interest entity rules and requirements found in FIN 46R apply to financial statements prepared using the tax-basis of accounting? Response: No. Because the Internal Revenue Code does not provide for consolidation of variable interest entities, the FIN 46R rules and their application do not apply to income tax basis financial statements. P. Other Tax Basis Issues Compliance with Bank Loan Covenant Requirement:


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Prior to converting to tax-basis financial statements, a company should make sure that the issuance of tax-basis financial statements would not be in violation of the bank loan covenants. Many loan documents specifically state that a company must submit audited (reviewed or compiled) financial statements prepared in accordance with GAAP. Issuing tax-basis financial statements may be in direct violation of that provision, and may require a waiver letter from the bank.

Q. Using the Tax Basis Based on a Method That Differs From the Income Tax Return Question: May an entity that uses the cash basis of accounting to prepare its federal income tax return use the tax-basis of accounting for its financial statements using the accrual basis? Response: AU-C 800 and SSARS No. 21 define tax basis as:

"A basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements."

What this means is that the entity must use the basis it uses to prepare its tax return. Thus, if the tax return is prepared on the cash basis, the tax-basis financial statements must also be prepared on a cash basis. Further, if the entity wishes to prepare tax-basis financial statements on an accrual basis, it must file its income tax return on an accrual basis. This situation is problematic for many companies who file their income tax return on a cash basis, yet wish to prepare tax-basis financial statements on an accrual basis, as it is more meaningful to do so. Such a scenario is not authorized by AU-C 800 and SSARS No. 21. There are two solutions:

1. Solution 1: Use a tax-basis of accounting departure 2. Solution 2: Issue the tax-basis financial statements within the "other basis" category of a

special purpose framework. SOLUTION 1: Use a tax-basis of accounting departure One way to issue tax-basis financial statements on an accrual basis, while continuing to file cash basis income tax returns, is to issue a report with a tax-basis of accounting departure, similar to a GAAP departure. The difference is that there is a departure from the rules for the tax-basis of accounting (found in AU-C 800 and SSARS No. 21). AU-C 800 and SSARS No. 21 require the basis to be the same as the one used for filing the income tax return. By preparing tax-basis financial statements on an accrual basis while the actual tax return is filed on a cash basis, the entity violates AU-C 800 and SSARS No. 21. Following are sample reports:

Compilation Report- Tax-Basis of Accounting with Report Exception for Tax-Basis Departure

Management is responsible for the accompanying financial statements of XYZ Company, which comprise the balance sheet-tax basis as of the year ended December 31, 20XX, and the related statement of income and retained earnings-tax basis, for the year then ended in


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accordance with the tax-basis of accounting, and for determining that the tax-basis of accounting is an acceptable financial reporting framework.46 We have performed a compilation engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. We did not audit or review the financial statements nor were we required to perform any procedures to verify the accuracy or completeness of the information provided by management. Accordingly, we do not express an opinion, a conclusion, nor provide any form of assurance on these financial statements. The financial statements are prepared in accordance with the tax-basis of accounting, which is a basis of accounting other than accounting principles generally accepted in the United States of America. The tax-basis of accounting requires that financial statements prepared on the tax-basis of accounting use the same basis used to file the Company’s income tax return. Management has informed us that the company has prepared the accompanying financial statements on the accrual basis of accounting while it files its federal income tax return on the cash basis of accounting. If the cash basis had been followed, net income and stockholders’ equity would have decreased by $100,000. Management has elected to omit substantially all the disclosures ordinarily included47 in financial statements prepared in accordance with the tax-basis of accounting. If the omitted disclosures were included in the financial statements, they might influence the user’s conclusions about the company’s assets, liabilities, equity, revenue, and expenses. Accordingly, the financial statements are not designed for those who are not informed about such matters.


46 AR-C 80 states that when special purpose framework financial statements are prepared and management has a choice of frameworks, the accountant’s compilation report should reference management’s responsibility for determining that the framework is acceptable. 47 The term "ordinarily included" is used when tax-basis financial statements are issued in lieu of the term "required" for GAAP statements.


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Review Report- Tax-Basis of Accounting with Report Exception for Tax-Basis Departure

Independent Accountant’s Review Report Board of Directors XYZ Company We have reviewed the accompanying financial statements of XYZ Company, which comprise the balance sheet-tax basis as of December 31, 20XX, the related statements of income and retained earnings-tax basis, and the statement of cash flows-tax basis,48 for the year then ended, and the related notes to the financial statements. A review includes primarily applying analytical procedures to management’s financial data and making inquiries of management. A review is substantially less in scope than an audit, the objective of which is the expression of an opinion regarding the financial statement as a whole. Accordingly, we do not express such an opinion. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with the basis of accounting the company uses for income tax purposes; this includes determining that the basis of accounting the company uses for income tax purposes is an acceptable basis for the preparation of financial statements in the circumstances.49 Management is also responsible for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Accountant’s Responsibility Our responsibility is to conduct the review engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the American Institute of Certified Public Accountants. Those standards require us to perform procedures to obtain limited assurance as a basis for reporting whether we are aware of any material modifications that should be made to the financial statements for them to be in accordance with the basis of accounting the company uses for income tax purposes. We believe that the results of our procedures provide a reasonable basis for our report. Accountant’s Conclusion Based on our review, except for the issue noted in the Known Departure From the Basis of Accounting Used for Income Tax Purposes paragraph, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in accordance with the basis of accounting the company uses for income tax purposes. Basis of Accounting50 We draw attention to Note X of the financial statements, which describes the basis of accounting. The financial statements are prepared in accordance with the basis of accounting the company uses for income tax purposes, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our conclusion is not modified with respect to this matter. Known Departure From the Basis of Accounting Used for Income Tax Purposes As described in Note 2, the tax-basis of accounting requires that financial statements prepared on tax-basis of accounting use the same basis used to file the company’s income tax return.

48 When issuing tax-basis financial statements, the statement of cash flows is optional. 49 When management has a choice of financial reporting frameworks, AR-C 90 requires that the review report make reference to management's responsibility for determining that the applicable financial reporting framework is acceptable in the circumstances. 50 When a special purpose framework report is issued, the review report must include an emphasis-of-matter paragraph labeled "Basis of Accounting" or a similar title.


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Management has informed us that the company has prepared the accompanying financial statements on the accrual basis of accounting while it files its federal income tax return on the cash basis of accounting. If the cash basis had been followed, net income and stockholders’ equity would have decreased by $100,000. James J. Fox & Company, CPA Burlington, Massachusetts March 20, 20X1

SOLUTION 2: Issue Tax-Basis Financial Statements Under the "Other Basis" Category There is a second solution when issuing tax-basis financial statements on a basis that is not identical to the one used to file the tax return. That solution is to issue the financial statements under the "other basis" category of the special purpose framework, instead of the tax basis category. The definition of a special purpose framework found in AU-C 800 and SSARS No. 21, includes any one of the following bases of accounting:


Tax basis: A basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements.

Regulatory basis: A basis of accounting that the entity uses to comply with the requirements or financial reporting provisions of a regulatory agency to whose jurisdiction the entity is subject.



As previously discussed in this section, the tax basis is defined as the basis”the entity uses to file its income tax return." Again, if an entity issues tax-basis financial statements on an accrual basis while the tax return is filed on a cash basis, those tax-basis financial statements violate the definition of "tax basis." The author suggests another solution which is to issue the financial statements as an "other basis" of accounting. The definition of an "other basis" is:

"A basis of accounting that uses a definite set of logical, reasonable criteria that is applied to all material items appearing in financial statements."

This definition is open-ended and essentially permits the issuance of financial statements using any non-GAAP format provided the basis represents a "definite set of logical, reasonable criteria." Clearly, issuing financial statements that follow the Internal Revenue Code should represent a


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"definite set of logical, reasonable criteria" although some commentators might argue that the Code is nothing but illogical. If tax-basis financial statements are issued under the "other basis" category, because the accrual basis is used while the tax return is filed on a cash basis, the reports would have the following basis of accounting paragraphs:

Compilation report: The financial statements are prepared in accordance with an other basis of accounting using logical, reasonable criteria established under the Internal Revenue Code, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Review report:

Basis of Accounting We draw attention to Note X of the financial statements, which describes the basis of accounting. The financial statements are prepared on an other basis of accounting using logical, reasonable criteria established under the Internal Revenue Code, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our conclusion is not modified with respect to this matter.

Audit report:

Basis of Accounting We draw attention to Note X of the financial statements, which describes the basis of accounting. The financial statements are prepared on an other basis of accounting using logical, reasonable criteria established under the Internal Revenue Code, which is a basis of accounting other than accounting principles generally accepted in the United States of America. Our opinion is not modified with respect to this matter.

R. Combining Financial Statements Prepared in Accordance With the Tax-Basis of Accounting Question: There is a group of brother-sister corporations in which each entity maintains its books and records on the basis of accounting used to file each entity’s income tax return. May the entities’ financial statements be combined on a tax basis even though a combined income tax return is not filed? Response: TIS Section 1400, Consolidated Financial Statements-Combining Financial Statements Prepared in Accordance With the Tax basis of Accounting, provides some guidance even though it applies to audit engagements and not directly to GAAP. The TIS, as modified, states:51 AU-C Section 800, Special Considerations-Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks, provides a definition of the tax-basis of

51 The TIS was originally issued with reference to SAS No. 62, Special Reports, which has been superseded by AU-C Section 800, effective at the end of 2012.


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accounting as “a basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements.” Nothing in the AU-C prohibits or precludes an auditor from reporting on a combined presentation as long as the basis of accounting for each of the entities presented is the basis that is used to file the income tax returns. In many instances, combining financial statements of brother-sister companies is more useful to users than the individual uncombined financial statements. As with all tax basis presentations, the auditor should consider whether the financial statements (including the accompanying notes) include all informative disclosures that are appropriate for the basis of accounting used. Although the TIS does not directly relate to GAAP, the author believes that an accountant should follow the same conclusion made for this practice aid for all engagements. Specifically, if an accountant performs a compilation or review engagement involving combined financial statements of related entities that do not file a combined tax return, the accountant is permitted to issue that report under the tax-basis of accounting. Even though a combined tax return is not filed with the IRS, the accountant is permitted to report on a tax basis combined financial statement as long as the financial statements of the individual entities are on the same basis used to file each entity’s federal income tax return. S. Disregarded Entities and Tax-Basis Financial Statements Questions: If the entity is disregarded for federal income tax purposes, is an accountant permitted to report on that entity as it is not recognized for tax purposes? Response: Yes. There are instances in which an accountant is permitted to report on tax-basis financial statements related to a disregarded entity, such as a:

Grantor trust

One-member LLC Example: Company X, a one-member LLC, does not file a tax return as it is a disregarded entity for income tax purposes. The sole member of X is John and Company X’s income is reported on John’s personal tax return. The accountant is Joe CPA and he wants to issue a review report on Company X. Joe is concerned that he may not be permitted to report on tax-basis financial statements for Company X because X does not file income tax returns. Is Joe permitted to report on tax-basis financial statements for Company X? Response: Yes. Under newly issued AU-C 800 and SSARS No. 21, a tax basis framework is considered a special purpose framework. Both AU-C 800 and SSARS No. 21 define a special purpose framework to include the following non-GAAP bases of accounting:



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Tax basis: A basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements.

Regulatory basis: A basis of accounting that the entity uses to comply with the requirements or financial reporting provisions of a regulatory agency to whose jurisdiction the entity is subject.



The tax basis is defined as a:

"basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements."

However, in this example, X does not file income tax returns. AU-C 800 and SSARS No. 21 do not address the issue of what happens if the reporting entity does not directly file income tax returns. However, there is a similar example found in an AICPA Technical Practice Aid, TIS Section 1400, Consolidated Financial Statements: Combining Financial Statements Prepared in Accordance With the Tax basis of Accounting. The TIS addresses the issue of whether an auditor is permitted to report on tax-basis financial statements that differ from the way in which tax returns are filed. The example found in the TIS deals with brother-sister entities, each of which files its own tax return. Yet, for financial statement purposes, the entities are combined and tax-basis financial statements are issued on a combined basis, which is not the same way in which the tax returns are filed. The nonauthoritative conclusion reached in the TIS is that nothing prohibits or precludes an auditor (or accountant) from reporting on the combined tax basis presentation as long as the basis of accounting for each of the underlying entities is the one each uses to file its income tax return for the reporting period. Although the facts are not quite the same in the previous LLC example, it would appear that a similar conclusion can be reached; that is, as long as the LLC’s financial statements are issued in the format used to file the LLC’s net income (taxable income) on John’s personal return (typically on Schedule E and C), tax-basis financial statements may be issued for the LLC and Joe CPA may report on them.

Question: Because the entity is disregarded, should the financial statements be titled as those related to a sole proprietorship (Schedule C or E) or as an entity (LLC or trust)? There is no authority for this matter. Some commentators believe that because the LLC or grantor is a disregarded entity, the entity form should be ignored in preparing the financial statements and should be titled as a sole proprietorship (Schedule C or E).


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Others believe that the substance of the transaction is that it is a separate LLC or trust and therefore, the identity of the entity should be retained even though the entity is disregarded for tax purposes. There is no authoritative answer. The author suggests that the best approach is to recognize the entity in the form of the financial statements even though the entity is disregarded for tax purposes. That means the accountant should report on the entity as a trust or LLC, and not as a sole proprietorship. Example: John James is the grantor and sole beneficiary of the JSM Realty Trust, a grantor trust for income tax purposes. The trust holds title to one piece of residential rental property. Mary Smith, CPA, is asked to issue a compilation report on the trust using the tax-basis of accounting. Mary does not issue a tax return for the grantor trust. Instead, the net rental income of the trust is recorded on Schedule E of John’s Form 1040. Conclusion: Mary is probably permitted to issue financial statements on the tax-basis of accounting for the trust even though the trust does not file an income tax return.

Question: Does the decision to report on a grantor trust as a trust (instead of a sole proprietorship) change if the accountant files a Form 1041 Grantor Trust information return for the grantor trust? Response: Although a grantor trust is a disregarded entity, the entity is permitted to file a Form 1041 grantor trust return with grantor information. If a Form 1041 trust return is filed for the grantor trust, the accountant should report on the trust as a trust and not a sole proprietorship. Question: What if a one-member LLC makes a check-the-box election to be taxed as a C corporation or an S corporation? Response: If the LLC is going to be taxed as a C or S corporation, that means that a Form 1120 or 1120S tax return will be filed. In such a case, the LLC should be reported on as an LLC and not as a sole proprietorship.

T. Tax Basis and the “Uses to File” Criterion Question: An accountant has Company X’s December 31, 20X1 tax return on extension and “expects” to file it on the accrual basis of accounting. On March 18, 20X2, the accountant decides to issue a compilation report on tax-basis financial statements that X prepared on the accrual basis of accounting, which is the method on which the accountant expects to file the tax return. On October 15, 20X2, the accountant actually files X’s income tax return on the cash basis. Is the fact that the accountant issues tax-basis financial statements on the accrual basis, and then files the tax return on the cash basis, mean that the originally issued financial statements were erroneously issued under the tax-basis of accounting?


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Response: SSARS No. 21 defines tax basis as “a basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements.” At the time the accountant issued the financial statements (March 18, 20X2), presumably the client expected to file the tax return using the accrual basis. The fact that in the end the client changed his or her mind and chose to file the tax return on the cash basis, does not necessarily mean that originally, the financial statements were improperly prepared using the accrual basis. Now, this scenario can apply in one year but probably cannot occur from year to year. If, the client repeatedly claims it is going to file its tax return on the accrual basis and then actually files it on a cash basis, tax-basis financial statements should be issued on the cash basis, which is the basis the entity uses to prepare its tax return. As a practical point, the author doubts that any third party is actually going to care whether the income tax basis financial statements follow the method actually used to file the tax return. Observation: The author believes that there is a fundamental flaw in the definition of tax-basis financial statements. The definition reflects the format that the entity “uses” to file its income tax return. That means that an entity that uses the cash basis to file its tax return may not be able to use the accrual basis in its income tax basis financial statements. A better approach would be for a definition of tax-basis financial statements to be changed to reflect financial statements that follow the Internal Revenue Code regardless of whether an entity files an income tax return. Such a change would allow an entity to issue tax-basis financial statements on either a cash or accrual basis, as long as such an approach was authorized by the Internal Revenue Code. U. Tax-Basis Financial Statements- State Tax-Basis of Accounting Question: Company X wishes to issue tax-basis financial statements. Because of the significant amount of depreciation taken for federal income tax purposes (due to Section 179 and bonus depreciation), X wishes to use the tax-basis of accounting based on its state income tax laws, not federal tax laws. By using the state tax basis, certain depreciation deductions are not allowed, thereby showing a slightly higher profit. Is X permitted to issue state income tax basis financial statements? Response: The definition of "tax basis" is part of a special purpose framework and defined in two sections within accounting and auditing literature: AU-C 800 and SSARS No. 21 define the tax-basis of accounting as: “A basis of accounting that the entity uses to file its income tax return for the period

covered by the financial statements.” Notice that the definition includes the language “income tax return” with no distinction between a federal or state tax return. Absent language to the contrary, there is no reason why an entity cannot issue tax-basis financial statements using the state tax basis of accounting, provided the entity discloses that fact.

V. Section 179 Depreciation- Tax Basis


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Question: Company X is a C Corporation that issues tax basis (accrual) financial statements. For year ended December 31, 20X1, X had a Section 179 deduction for fixed asset additions totaling $125,000. X’s taxable income before the Section 179 deduction was $75,000. Because of the taxable income limitation, X was able to use only $75,000 of the 179 depreciation, with the remainder $50,000 carried forward unused. In preparing its 20X1 financial statements on the tax-basis of accounting, should X record the entire $125,000 of Section 179 depreciation, or only the $75,000 with a carryover of the remainder $50,000 unused to 20X2? Response: There is no authority on this particular point. Although there are instances in which tax-basis financial statements differ from the tax return, those instances are generally limited to non-taxable and non-deductible (permanent) differences. Examples of such as non-taxable income and non-deductible items include non-taxable interest, life insurance, meals and entertainment, and penalties, among a few others. Those non-taxable and non-deductible items are permanent differences and are shown on the income tax basis financial statements as income and expense items even though excluded from the tax return. Thus, net income on tax-basis financial statements generally may differ slightly from taxable income per the tax return. With respect to Section 179 depreciation, the amount of such depreciation shown on the tax-basis financial statements should be the same as the amount deducted on the tax return. Thus, in this example, $75,000 of Section 179 depreciation should be shown on the financial statements with the remaining $50,000 unused, carried over and disclosed. Thus, financial statement net income on a tax basis is zero assuming no permanent differences. What do you do with the $50,000 depreciation difference on the balance sheet? In the above example, there is a math problem and a $50,000 item (the unused Section 179 deduction) that results in retained earnings not balancing. If X records the $125,000 of depreciation as a credit to accumulated depreciation, but only deducts $75,000 of depreciation on the tax basis income statement, how does retained earnings balance for the $50,000 difference? It doesn’t balance. Instead, a balance sheet adjustment must be made to reflect the $50,000 of depreciation not deducted in 20X1. Although there is no authority, the best way to handle the difference is to record only $75,000 of depreciation in accumulated depreciation on the tax-basis financial statements even though $125,000 is recorded to Schedule L accumulated depreciation. What this means is that the tax-basis financial statements balance sheet accumulated depreciation will not agree with accumulated depreciation on Schedule L of the tax return. There will be a $50,000 difference. Some companies treat the unused Section 179 depreciation as an adjustment to retained earnings, similar to a Schedule M-1 item. Option 1: Record only the $75,000 of Section 179 depreciation expense on the income statement and carry forward the unused $50,000.


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Statement of Income and Retained Earnings-Tax Basis

Net sales $XX Cost of sales XX Gross profit on sales XX Operating expenses: Depreciation (75,000) Net income XX Retained earnings- tax basis : Beginning of year XX End of year $(75,000)


Fixed assets: Cost XX Less accumulated depreciation (75,000) Stockholders’ equity: Common stock, XX Retained earnings- tax basis (75,000)

Entry: Depreciation 75,000 AD 75,000

Option 2: Record the $75,000 of Section 179 depreciation expense on the income statement and record the other $50,000 as an adjustment to retained earnings:

Statement of Income of Retained Earnings-Tax Basis

Net sales $XX Cost of sales XX Gross profit on sales XX Operating expenses: Depreciation (75,000) Net income XX Retained earnings (accumulated deficit) - tax basis: Beginning of year XX Adjustment for additional depreciation (50,000) End of year $XX


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Fixed assets: Cost XX Less accumulated depreciation (125,000) Stockholders’ equity: Common stock, XX Retained earnings (accumulated deficit)-tax basis : (125,000)

Entry: Depreciation 75,000 Retained earnings 50,000 AD 125,000

Observation: The author thinks the Option 2 is flawed and should not be followed. After all, the tax-basis of accounting should follow the principles and rules for accounting under the federal income tax laws and regulations (or other tax laws and regulations). That means that the income statement should follow the income tax return, other than permanent differences. Flowing the unused $50,000 of Section 179 deduction through retained earnings appears inconsistent with the principles and rules for accounting under the federal income tax laws and regulations. Of course, there is no authority to address this situation. Following the first option of recording the $75,000 of depreciation only on the income statement and through accumulated depreciation appears to make more sense even if the accumulated depreciation on the tax basis balance sheet does not agree with Schedule L balance sheet on the tax return. W. Presenting Section 179 and Bonus Depreciation on the Tax Basis Income Statement Question: XYZ Company has a large amount of Section 179 and bonus depreciation. X issues tax-basis financial statements (accrual basis) and is concerned that the large amount of depreciation distorts its income statement. Is there a way in which X can present the Section 179 and bonus depreciation? Response: Yes. Because the rules for tax-basis financial statements are limited, the company has flexibility in how depreciation is presented. One way that may be effective is to present Section 179 and bonus depreciation as an other income/deduction item. Following are two examples that illustrate this approach.


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Statement of Income and Retained Earnings- Tax Basis Section 179 and Bonus Depreciation Presented Separate from Other Depreciation

C Corporation

XYZ Company



800,000

Gross profit

400,000



Total deductible expenses 148,000 Taxable state income State income taxes Taxable federal income before accelerated depreciation

252,000 (25,000)

227,000

Additional first-year depreciation

(180,000)

Taxable federal income 47,000** Non-taxable and non-deductible item:


(7,500) (12,000)


Net income

28,000

Retained earnings:


$99,900


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Statement of Income-Tax Basis Section 179 and Bonus Depreciation Presented Separate from Other Depreciation

[S Corporation]

XYZ Company (An S Corporation)

Statement of Income-Tax Basis For the Year Ended December 31, 20XX


900,000

Gross profit

400,000



Total deductible expenses 148,000 Taxable ordinary income- state tax purposes

252,000**

State income taxes (25,000) Taxable ordinary income

227,000

Other taxable income (deductible expenses): Interest Dividends Additional first-year depreciation Total taxable income Non-taxable and non-deductible items:

1,000*** 5,000***

(180,000)***

53,000 **

Non-deductible life insurance (12,000) Non-deductible meals and entertainment (2,500) Non-taxable interest 3,000

Net income

$41,500

** Agrees with Schedule K of Form 1120S. *** Schedule K items.


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X. Agreements Not to Compete - Tax-Basis Financial Statements Question: Company X issues tax-basis financial statements. In 2007, Company X entered into an agreement not to compete with a party that had a five-year term that has now expired. Yet, the company continues to amortize the agreement over 15 years for tax purposes even though the economic life (five years) has expired. Is this the correct approach for tax-basis financial statements? Response: Yes. The company is issuing tax-basis financial statements and thus, is subject to the amortization rules of the Internal Revenue Code which provides for a 15-year amortization under IRC Section 197. In this case, the company continues to amortize the agreement over 15 years even though the five-year period has expired. Question: Should the company continue to disclose the terms of the agreement since it has expired, but is still being amortized for income tax purposes? Response: There is no hard and fast rule. Given the fact that the agreement is not in effect, it would appear the disclosure of the terms of the agreement could be eliminated from the disclosure although the other disclosures related to intangible assets should be included such as:

Amortization policy

Amortization expense

Estimated amortization expense for the five subsequent years

Gross carrying amount of the intangible asset and accumulated amortization Following is a sample disclosure related to an agreement not to compete in tax-basis financial statements.


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NOTE 1: Summary of Significant Accounting Policies Agreement not to compete: Intangible assets consist of an agreement not to compete that is amortized on a straight-line basis over fifteen years in accordance with the Internal Revenue Code. NOTE 2: Intangible Assets The following is a summary of intangible assets at December 31, 2014:

Gross carrying amount


Agreement not to compete $300,000 $160,000 $300,000 $160,000

[optional paragraph] As a part of its 2007 purchase of the net assets of ABC Manufacturing, the company entered into an agreement not to compete with a key officer of ABC Manufacturing. Under the terms of the agreement, the officer was paid $300,000 in exchange for his agreement not to compete in the business of manufacturing certain products sold by the company for a period of five years through 2011. In accordance with the Internal Revenue Code, the Company is required to continue to amortize the agreement not to compete through year 2021.

Amortization expense was $20,000 in 2014. Based on intangible assets owned by the Company at December 31, 2014, estimated amortization expense for the five years subsequent to 2014 follows:

Year

Estimated Amortization

expense 2015 $20,000 2016 20,000 2017 20,000 2018 20,000 2019 20,000

Beyond 2020 40,000 $140,000

Y. Presenting Insolvency in Tax-Basis Financial Statements Question: Section 108 of the Internal Revenue Code provides for a portion or all of cancellation of debt (COD) income to be excluded from taxable income under various tests, one of which is the “insolvency exception.”


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If an entity has Section 108 income that is excluded from taxable income under the insolvency exception, should that income be presented on tax-basis financial statements? Response: Nothing has been written authoritatively on this matter. However, there are parallel situations that have become generally accepted within tax-basis financial statements, involving nontaxable and nondeductible items (permanent differences). First, let’s understand Section 108. Section 108 of the IRC deals with cancellation of debt (COD) income. Under Section 108, the amount of COD income recognized is equal to the excess of the amount of debt forgiven over the fair value of the asset. Section 108 provides certain exclusions under which COD income is excludable from taxable income. One of those exclusions is the insolvency exception. The insolvency exception states that COD income is excludable from taxable income to the extent that “immediately before the discharge,” total liabilities exceed the fair value of total assets. Section 108 also has rules under which an entity (or taxpayer) must reduce its tax attributes (NOLs, credits, etc.) by the amount of excludable COD income. Insolvency is determined at different levels depending on the type of entity:

Partnership or LLC: Insolvency is determined at the member or partner level

S or C corporation: Insolvency is determined at the entity level Example: Company X has $1,000,000 of COD income. Immediately before the discharge of the debt that created the COD income, total liabilities exceeded the fair value of X’s assets by $600,000. Conclusion: $600,000 of the $1,000,000 is excludable from taxable income, while the remaining $400,000 is taxable. Now to the issue of income tax basis financial statements. Question: If an entity has COD income, a portion of which is excludable from taxable income, should that excluded income be presented on the income statement of tax-basis financial statements? Response: Although there is no specific authority dealing with Section 108 COD income, there is similar guidance that has been followed by most practitioners in connection with nontaxable income and nondeductible expenses, otherwise know as permanent differences. Examples include nondeductible meals and entertainment expense, penalties and fines, life insurance, and nontaxable interest. It has become generally accepted that although these permanent differences are not included on the tax return (and are treated as Schedule M-1 items), income tax basis financial statements include these items as income and expense items. Thus, net income on tax-basis financial statements does not agree with taxable income on the tax return.


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Section 108 COD income that is excluded from taxable income is nothing more than a permanent difference, just like other nontaxable income, such as nontaxable municipal interest income. Thus, the author believes that such excluded COD income should be presented on a statement of income as income under the tax basis of financial statements. Example: Company X, a C corporation, has the following information for year ended December 31, 20X1:

COD income $1,000,000 Portion excludable from taxable income under the insolvency exception

(600,000)

Taxable portion of COD income $400,000

Conclusion: X’s statement of income- tax basis would present the COD income as follows: Option 1: Present the COD income as part of other income, in total

Company X Statement of Income-Tax Basis

For the Year Ended December 31, 20X1 Net sales $20,000,000 Cost of sales 15,000,000 Gross profit on sales 5,000,000 Operating expenses 7,000,000

Net operating loss (2,000,000) Other income: Forgiveness of debt income 1,000,000 Interest income 100,000 Net loss before income taxes (900,000) Income taxes (credit) (300,000) Net loss- tax basis $(600,000)


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Option 2: Present the portion of COD income that is not taxable in a separate section

Company X

Statement of Income-Tax Basis For the Year Ended December 31, 20X1

Net sales $20,000,000 Cost of sales 15,000,000 Gross profit on sales 5,000,000 Operating expenses 7,000,000 Net operating loss (2,000,000 Other income: Forgiveness of debt income 400,000 Interest income 100,000 Net taxable loss before income taxes (1,500,000)

Non-taxable items: Non-taxable portion of forgiveness of debt income 600,000

Net loss before income taxes

(900,000)

Income taxes (credit) (300,000) Net loss- tax basis $(600,000)


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REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 71. Which of the following is correct regarding tax-basis financial statements: a) they have become increasingly more popular with small business clients b) they are more time-consuming to prepare than GAAP statements c) they are more costly to prepare than accrual basis GAAP statements d) they are less meaningful to most closely held businesses 72. Tax-basis financial statements can include all of the following except: a) cash method b) accrual method c) any method that clearly reflects the income under Section 446 of the IRC d) regulatory basis 73. Which of the following situations is well suited for tax-basis financial statements: a) when clients are more financially sophisticated b) when the owner is not actively involved in the day-to-day operations c) when a company has low uncollectible receivables d) when a client is willing to pay more for the cost of preparing a report 74. How should taxable income adjustments for prior years’ IRS or state audits be treated on tax

basis statements: a) charged to income, net of tax b) charged to retained earnings c) shown pre tax d) charged to income and presented as an extraordinary income, net of tax 75. Which of the following is correct regarding the disclosure requirements for tax-basis financial

statements: a) tax-basis financial statements should include the GAAP disclosures provided they are

relevant and applicable to the tax-basis of accounting b) qualitative information may not be substituted for quantitative information required by

GAAP c) GAAP disclosure format is required d) according to AU-C 800, tax-basis disclosures are essentially required to not be the same

relevant disclosures required for GAAP so that the reader is not confused as to whether the financial statements are GAAP

76. When a company converts from GAAP to tax-basis financial statements: a) there are generally two options for preparing statements in the year of conversion

b) a change in accounting principle has occurred in accordance with ASC 250 (formerly FASB No. 154)

c) the change must be shown as an adjustment to beginning retained earnings d) there is no adjustment to the beginning balance sheet 77. An explanatory paragraph identifying the fact that a company changed from GAAP to tax-

basis financial statements is ______________.


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a) required for an audit report b) required for a review report c) required for a compilation report d) not required but may be emphasized in a separate paragraph. 78. When non-GAAP statements are presented, a statement of cash flows is: a) required b) optional c) discouraged d) prohibited 79. Which of the following is correct regarding the adequacy of disclosure in tax-basis financial

statements: a) the basis of accounting note must be thorough to include all differences from GAAP b) only a brief description of significant differences in the basis of accounting is required c) a quantification of the differences between the GAAP and non-GAAP basis of accounting

is required d) no disclosure of the differences between GAAP and tax basis is required 80. Which of the following is correct regarding the use of tax-basis financial statements: a) tax-basis financial statements are always an acceptable alternative to GAAP statements b) bank loan documents cannot require GAAP statements

c) the use of tax-basis financial statements may be a direct violation of bank loan covenant requirements

d) if bank loan documents require GAAP statements, there is no alternative


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SUGGESTED SOLUTIONS 71. A: Correct. Given the recent wave of complexity that has affected the accounting

profession, tax-basis financial statements have become increasingly popular with, in particular, small business clients.

B: Incorrect. Generally, GAAP statements, not tax-basis financial statements, are more time-consuming to prepare.

C: Incorrect. Generally, accrual basis GAAP, not tax-basis financial statements, are more costly to prepare.

D: Incorrect. Because most closely held businesses are tax motivated, usually tax basis financial statements are more (not less) meaningful to such businesses.

72. A: Incorrect. Cash basis can be a tax basis if used for tax return purposes.

B: Incorrect. Accrual basis can be a tax basis if used for tax return purposes. C: Incorrect. Tax basis follows the Internal Revenue Code which consists of any method

that clearly reflects income making the answer incorrect. D: Correct. The regulatory basis, although a special purpose framework, is not tax

basis, making the answer correct. 73. A: Incorrect. Tax-basis financial statements are best used and most meaningful for a

less (not more) financially sophisticated client where the client is more tax motivated and interested in cash flows. B: Incorrect. Tax-basis financial statements are well suited for a client where the owner is

actively involved in the day-to-day operations to ensure that the owner understands the real economics of the business.

C: Correct. The lack of an allowance for bad debts can be a significant problem for some companies with high uncollectibles of receivables. The reason is because tax-basis financial statements do not include an allowance for bad debts.

D: Incorrect. From both the client and the CPA’s perspective, a tax basis engagement is generally less expensive to conduct than GAAP financial statements.

74. A: Incorrect. It has become generally accepted that such adjustments should not be

presented on the income statement because they relate to prior periods. Thus, the answer is incorrect.

B: Correct. The adjustment should be presented as a prior period adjustment through retained earnings, net of tax, because that adjustment pertains to a prior period and not the current period.

C: Incorrect. Such adjustment, if any, should be net of tax. D: Incorrect. Such an item should not be presented as an extraordinary item. Clearly, the

adjustment is not infrequent and unusual, criteria required to present an item as an extraordinary item.

75. A: Correct. The rules provide that tax-basis financial statements should include the

same GAAP disclosures that apply to GAAP if such disclosures are relevant and applicable to tax-basis financial statements. For example, a disclosure of fair value may not be relevant to tax-basis financial statements that do not have fair value measurements. B: Incorrect. Qualitative disclosures for tax-basis financial statements may substitute for

GAAP disclosures. For example, GAAP requires disclosure of the future principal payments on long-term debt over the next five years, but for tax-basis financial statements this disclosure could be satisfied by merely disclosing the repayment terms of significant long-term borrowings without quantifying it in a schedule.


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C: Incorrect. GAAP disclosure format is not required as long as the reader can extract the same information as GAAP statements.

D: Incorrect. AU-C 800 requires that tax-basis financial statements have disclosures that are similarly informative to those disclosures required by GAAP. There is no concern that the disclosures might confuse the reader that there are GAAP, instead of tax-basis, financial statements.

76. A: Correct. The statements can be presented on a comparative basis by restating the

prior year’s statements to tax basis, or present only the current year statements. B: Incorrect. A change to tax-basis financial statements does not represent a change in an

accounting principle according to ASC 250 (formerly FASB No. 154) Because ASC 250 applies to GAAP statements, not tax-basis financial statements.

C: Incorrect. When retained earnings are restated, the change can be reflected as an adjustment to beginning retained earnings or as a cumulative-effect of a change on the income statement. The authority for accounting changes found in ASC 250 does not apply.

D: Incorrect. Typically, the beginning balance sheet must be adjusted making the answer incorrect.

77. A: Incorrect. There is no requirement in the SASs that an explanatory paragraph be

included in the audit report noting the change to tax basis . B: Incorrect. The SSARSs provide no requirement that an explanatory paragraph be included

in a review report when there is a change from GAAP to tax basis . C: Incorrect. An explanatory paragraph is not required for a compilation report because the

SSARSs include no requirement for such a paragraph. D: Correct. Although not required, a practitioner may wish to add an explanatory

paragraph to his or her report (audit, review or compilation), identifying the fact that the company changed from GAAP to tax-basis financial statements. If such a paragraph is included in the report, it must also be disclosed in the notes.

78. A: Incorrect. A statement of cash flows is not required for non-GAAP (tax basis) statements. Under GAAP, a statement of cash flows is required only when GAAP statements are presented.

B: Correct. Even though a cash flows statement is not required for non-GAAP financial statements, a company may elect to include a cash flow statement. If such a statement is presented, it must include all the elements required for a typical GAAP statement of cash flows. C: Incorrect. Nothing in authoritative literature discourages the use of a cash flows statement

for tax basis (non-GAAP) financial statements. D: Incorrect. A cash flows statement is not prohibited in the presentation of non-GAAP (tax

basis) financial statements. 79. A: Incorrect. The basis of accounting note may be brief, and not thorough, making the

answer incorrect. B: Correct. The basis of accounting note may be brief, with only the primary

differences from GAAP being described. C: Incorrect. Quantifying the differences is not required. D: Incorrect. A disclosure of the differences is required making the answer incorrect.

80. A: Incorrect. There are situations where GAAP statements are required and tax basis financial statements are not acceptable. The key determination is whether the third party finds the tax basis format useful for the intended purpose.

B: Incorrect. Banks can set their own requirements, and may require GAAP statements.


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C: Correct. Prior to converting a client to tax-basis financial statements, a practitioner should make sure that such statements are not in violation of the bank loan covenants. For example, some loan documents specifically require GAAP financial statements. D: Incorrect. An entity can request a waiver letter from a bank if it wishes to use tax basis

financial statements.


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GLOSSARY Available for sale securities – Both debt and equity securities that are not categorized as either held to maturity or trading securities, are automatically categorized as available-for-sale. In this category, management has essentially not decided what it plans to do with the securities. Cash basis – A basis of accounting that the entity uses to record cash receipts and disbursements and modifications of the cash basis having substantial support (for example, recording depreciation on fixed assets). Commercial substance – If the future cash flows of the entity are expected to change significantly as a result of an exchange. Concentration of credit risk – When the entity is exposed to risk of not being diversified with respect to a financial instrument. Contractual basis – A basis of accounting that the entity uses to comply with an agreement between the entity and one or more third parties other than the auditor. Debt securities held to maturity – Debt securities that management plans to hold until maturity. Delayed exchange – Provides investors up to 180 days to purchase replacement property once the relinquished property is sold. The use of a qualified intermediary is required to facilitate a valid delayed exchange. In-substance common stock – An investment in an entity that has risk and reward characteristics that are substantially similar to that entity’s common stock. Impairment – Occurs when the fair value is less than cost. Off-balance sheet risk – Potential losses beyond the recorded value on the balance sheet. Other basis – A basis of accounting that uses a definite set of logical, reasonable criteria that is applied to all material items appearing in financial statements.

Regulatory basis – A basis of accounting that the entity uses to comply with the requirements or financial reporting provisions of a regulatory agency to whose jurisdiction the entity is subject. Substantive kick-out rights – The ability of an investor or another party to remove the decision maker. Substantive participating rights – The ability to effectively participate in certain actions of the limited partnership. Tax basis – A basis of accounting that the entity uses to file its income tax return for the period covered by the financial statements. Tax position – A position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets or liabilities for interim or annual periods.


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Trading securities – Both debt and equity securities that are bought and held for the purpose of selling them in the near term (generally within one year).


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INDEX

agreement not to compete, 71, 72, 343, 344 available for sale securities, 34, 35, 36, 37, 38, 39, 47, 55, 262, 266, 353 cash basis (definition), 287, 288, 332, 334, 353 commercial substance (definition), 11, 12, 13, 353 comparative statements, 6, 9, 161, 185, 318 concentrations of credit risk, 177, 178, 353 contractual basis (definition), 287, 288, 332, 335, 353 debt securities held to maturity, 37, 38, 39, 353 delayed exchanges, 16, 17, 18, 353 FASB No. 141, 72, 73, 74, 253 FASB No. 142, 73, 83, 88, 239, 258 impairment, 19, 20, 21, 22, 24, 25, 26, 27, 40, 41, 42, 43, 44, 45, 46, 47, 48, 73, 74, 77, 79, 80, 82, 83, 85, 213, 214, 216, 239, 246, 247, 261, 262, 353 in-substance common stock, 49, 50, 353

limited liability companies, 49, 50, 207, 236 non-monetary exchanges, 11, 15 off-balance sheet risk, 178, 353 other basis (definition), 287, 288, 332, 335, 353 outstanding checks, 31 regulatory basis (definition), 287, 288, 332, 335, 353 SAS No. 62, 286, 287, 288, 306, 321, 322, 324, 328, 333 section 179 depreciation, 7, 145, 338, 339 start-up costs, 157, 158, 159 substantive kick-out rights, 353 substantive participating rights, 49, 353 tax basis (definition), 7, 287, 288, 289, 332, 335, 337, 353 tax position, 225, 226, 227, 228, 229, 230, 232, 233, 305, 353 trading securities, 34, 35, 37, 38, 39, 262, 354

Documents

GAAP: A to Z and Everything In Betweenddntzgzn81wae.cloudfront.net/uploadpdf/A017-0255_Course.pdf · Everything You Never Wanted to Know About GAAP 9 SECTION I. GAAP Q & A Introduction: