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FAR - Notes Chapter 1 http://www.a-cfa.org

Sources of GAAP GAAP are those ing principles that have substantial authoritative The power to establish GAAP rests with the SEC however, it has essentially allowed the ing profession to establish GAAP and self regulate. Statements of Financial ing Concepts (SFAC) - establish the objectives and concepts for FASB standards. Serve as the foundation or basic reasoning of a standard Four most authoritative GAAP B ing Research Bulletins (ARBs) O ing Principles Board Opinions (APBOs) I FASB Interpretations (clarify GAAP) S FASB Statements of Financial ing Standards (not concepts) Objectives of financial reporting: 1. Disclose the entity’s performance 2. Focus on the informational needs of the external s The Objectives provide information useful in - investment and credit decisions - assessing future cash flows - assessing resources, debt and equity claims Characteristics of ing information - Material – could make a difference in decisions made by s - Benefits of the information > Costs of providing it - Understandable to decision makers - Decision usefulness – broken into 2 primary categories, Relevance and Reliability and 2 secondary characteristics, Comparability and Consistency Relevance – PFT Predictive Value Value Timeliness Reliability – NRFV Neutrality – free from bias Representational Faithfulness – information is valid Verifiability – the results could be duplicated using same techniques Comparability – Apple vs Microsoft Consistency – 2006 vs 2005, trend analysis Full Set of Financial Statements include - Statement of Financial Position (B/S) - Statement of Earnings (I/S) - Statement on Comprehensive Income - Statement of Cash Flows - Statement of Changes in Owners Equity Fundamental Assumptions - Entity assumption – separate corporation - Going concern assumption – entity will continue to operate in the foreseeable future - Monetary unit assumption – inflation is not reflected in the F/S - Historical cost assumption – as a general rule info based on cost no current market value 1


Revenue recognition principle – revenue should be recognized (recorded) when it is earned and when it is realized (you’ve been paid) or realizable (believe you’re going to get paid). 1. Earned – Goods – transfer of title, not possession Services – Are the services substantially complete 2. Realized or Realizable – claims to cash readily convertible to known amounts Matching Principle – all expenses incurred to generate revenue in a period are matched against that revenue Accrual ing – to record without an exchange of cash Full Disclosure principle – information that would make a difference in the decision process Conservatism principle – defer estimated gains until realized; and; record estimated losses immediately Elements of financial statements Comprehensive Income = Net income + PUFE Normal “recurring” operations Revenues – recognize revenue at gross amount (less allowances for returns and discounts given) Expenses – incurred Non-operating, unusual or infrequent Gains – selling price or net realizable value > book value Loss – selling price or net realizable value < book value; impairments and write downs Assets – probable future economic benefit; capable of generating revenue in the future Liabilities – Probable future sacrifices Investment of Owners – not a revenue or gain (excluded from comprehensive income) Distributions to Owners – not an expense or loss (excluded from comprehensive income) SFAC No. 7 provides a framework for ants to employ when using future cash flows as a measurement basis for assets and liabilities. There are five elements 1. Estimate future cash flow 2. Expectations of cash flow timing 3. Time value of money (risk free rate, discount rate) 4. Price for bearing uncertainty, risk 5. other factors (liquidity issues, market imperfections SFAC No. 7 allows the use of two approaches to determine present value Traditional approach – one discount rate used (bonds, scheduled known payments) Expected Cash flow approach – more complex cases (warrants, uncertain future payments

Reporting Net Income Reported on income statement I Income (or loss) from continuing operations (gross of tax) D Income (or loss) from discontinued operations (net of tax) E Extraordinary items (net of tax) – unusual and infrequent Reported on statement of retained earnings A Cumulative effect of change in ing principle (net of tax) Pg 17 & 18 show single step and multiple step income statement Discontinued operations 2


If you decide to sell a division within the next year, until its sold, the rev/exp are moved to discontinued operations To report in discontinued operations must - be eliminated from ongoing operations - no significant continuing involvement Assets within the discontinued operation are no longer depreciated or amortized A component classified as held for sale is measured at the lower of its carrying amount or fair value less costs to sell (no longer at historical costs) Extraordinary Items Must be both unusual and infrequent Examples: An expropriation (foreign govt seizes your business, nationalism), infrequent earthquake. So hurricanes in Florida are not considered and extraordinary item Cumulative effect of change in ing principle ing changes are broadly classified into 3 categories: estimate, principle and entity Change in ing estimate Apply prospectively – do not restate prior periods Not an error Affects current and future year income from continuing operations Examples - Change in fixed asset useful life - Adjustments of year-end accrual of officers salaries and bonuses - Write-downs of obsolete inventory - Material non-recurring IRS adjustments - Settlement of litigation - Change from instalment method to immediate recognition because uncollectible s can now be estimated Change in ing principle Apply retroactively – restate prior periods financial statements Can change ing principle only if the alternative principle is preferable and more fairly presents the information Cumulative effect – difference between the amount of beginning retained earnings in the period of change and what retained earnings would have been if the ing change had been retroactively applied. Exceptions, examples - Change in inventory method to LIFO (change in estimate) - Change in depreciation methods (change in estimate) - Change from non-GAAP to GAAP (error, change in entity) Change in ing entity Apply retroactively Examples - Corrections of an error - Retroactive restatements required by new GAAP pronouncement - Change from non-GAAP to GAAP

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Comprehensive Income = net income (per I/S) + Other comprehensive income (PUFE) Change in equity from non-owner sources Net income = income from continuing operations + discontinued operations + extraordinary items (IDE) Not reported on a per share basis Other comprehensive income includes those items excluded from net income P Pension minimum liability adjustment U Unrealized gains/losses F Foreign currency items E Effective portion of cash flow hedge Reclassification adjustment – items once displayed as other comprehensive income but now displayed as part of net income Accumulated other comprehensive income – includes the total of other comprehensive income for the period and previous periods. Shown in stockholders equity

Disclosures (notes to the financial statements) GAAP requires a description of all significant policies should be included as an integral part of the financial statements. The remaining notes contain all other information relevant to decision makers

Interim Financial Reporting Public companies must file quarterly reports Quarterly reports are unaudited For interim reporting only, timeliness is emphasized over reliability Interim F/S must be viewed as an integral part of the annual F/S Income tax expense is estimated each quarter. Use the estimated average effective tax rate that will apply for the entire year.

Segment Reporting Objective is to provide information on the business activities and the economic environment of a company Public companies must report segment information about - Operating segments (annual and interim) - Products and services - Geographic areas - Major customers Operating segment – discrete financial information is available (traceable) Must report as segment if it’s greater than 10% of either: A. Revenue - if segment’s revenue comprise more than 10% of all the company’s revenue B. Reported profit or loss C. Assets – if segment’s asset comprise more than 10% of all the company’s assets Until at least 75% of combined revenue is included in reportable segments Do not have to report as a segment if the segment s for 90% of company’s A,B or C 4


Revenues (for that segment including intercompany sales) Less: Directly traceable costs Less: Reasonable allocated costs = Operating profit (loss) for segment

Development-Stage Enterprises Start-ups/pioneering development – principal operations have not begun or principal operations have generates a insignificant amount of revenue A development state enterprise must issue the same financial statement as any other enterprise. The additional required disclosures include - In the B/S, describe cumulative net losses as “deficit accumulated during development stage”

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Timing Issues • Revenue from the sales of products or the disposal of assets is recognized on the date of sale • Generally for a sale to take place: delivery of goods and or transfer of title must occur • Revenue that stems from allowing others the use of the entity’s assets (interest rev, royalty rev, rental rev) is recognized with the assets are used Cash xx Unearned royalty xx Unearned royalty xx Earned royalty xx • Revenue from services is recognized in the period the services have been performs and are able to be billed Expenses should be recognized according to the matching principles Matching principle – expenses must be recognized in the same period as revenue Expired costs (expenses) – costs that expire during the period and have no future benefit Unexpired costs (expenses) – should be capitalized and matched against revenue (PPE, depreciation) Franchisor ing (Mcdonalds HQ) • The PV of future services (to be performed by the franchisor) should be recorded as unearned revenue. The unearned revenue is recognized once substantial performance has occurred. • Substantial performance means that all of the following have been met 1. Franchisor has no obligation to refund any payment received from franchisee 2. Initial services required of the franchisor have been performed 3. All other conditions of the sale have been met Franchisee ing • The PV of the amount paid (or to be paid) by a franchisee is recorded as an intangible asset on the B/S and amortized over the expected period of benefit for the franchise • Fees should be reported by the franchisee as an expense and as revenue by the franchisor in the period incurred Expense recognition The cost of intangible assets not required from others should be expenses against income incurred, examples: - Trademarks; goodwill from advertising; the cost of developing, maintaining and restoring goodwill Exception, certain costs associated with intangibles that can be capitalized, examples: - Legal fees in successful defense of the asset (litigation for patents and trademarks); registration or consulting fees; design costs (of a trademark); other direct costs to secure the asset A patent is amortized over the shorter of its estimated life (useful life) or remaining legal life. FASB 142, Test goodwill and adjust for impairments Startup costs – expenses incurred in the formation of a corporation (legal fees) and are considered organizational costs Organizational costs are not capitalized but expensed immediately Capitalize legal and registration fees incurred to obtain an intangible asset Capitalize legal fees incurred in successfully defending intangible assets as future benefit will be derived 1


When purchasing goodwill, the excess cost over the FMV is goodwill As a general rule, R&D is expensed immediately Exceptions: Materials and PPE that have alternative future uses; depreciate over the assets useful life, not the life of the R&D project R&D undertaken on the behalf of others Items not considered R&D Routine periodic design changes to old products Marketing research Quality control testing Reformulation of a chemical compound Computer software development costs, developed to be sold, leased or licensed Expense costs incurred until technological feasibility has been established for the product Capitalized costs incurred after technological feasibility has been established Technological feasibility is established upon the completion of either A detailed program design Completion of a working model Annual amortization of capitalized software costs is the greater of: a. Percentage of revenue= total capitalized amount * (current gross revenue for period ÷ total projected gross revenue for product) b. Straight line = total capitalized amount * (1 ÷ estimate of economic life) Computer software developed internally or obtained for internal use only Expense costs incurred for the preliminary project state and costs incurred for training and maintenance Capitalize costs incurred after the preliminary project state and for upgrades and enhancements including: - Direct costs of materials, services, employees - Interest costs incurred for project Capitalized costs should be amortized on a straight line basis Begin bal prepaid insurance + payments – expense = ending bal prepaid insurance Beg bal rent receivable + rental revenue – cash collections – writeoffs = end bal rent receivable Beg bal accrued salaries payable + salaries expense – salaries paid = end bal accrued salaries payable Sales revenue = credit sales to revenue ÷ (1 + sales tax rate)

Long Term Construction Contracts Completed contract method • Completed contract method recognizes income only on completion or substantial completion of the contract • Applicable overhead and direct costs should be charged to “construction in progress” (an asset) • Billing and/or cash received should be credited to “advances on construction” in progress (liability) • Losses should be recognized in full the year they are discovered Losses = contract price – costs incurred – estimated costs to complete Percentage of completion method • Use this method when collection is assured and - Can reasonably estimate profitability 2


- Provide reliable measure of progress toward completion • Income recognized is the percentage of estimated total. - Incurred costs to date bear to total estimated costs based on the most recent cost information - Example: Contract price is 10mil; estimated costs are 8mil; incurred 2mil of costs; therefore we recognize 2.5mil of revenue = (2/8)*10mil

Installment Sales • The installment method is used only when there is no reasonable basis for estimating collectibility. • Revenue is recognized when cash is collected Gross profit = sale – COGS Gross profit % = gross profit ÷ sales Gross profit earned/realized = gross profit % * cash collections Deferred gross profit = gross profit % * installment receivable B/S A/R = A/R – deferred gross profit Deferred gross is a contra asset so shown on the balance sheet Cost recovery method - no profit is recognized on sale until all costs have been recovered

ing for Non-monetary Exchanges SFAS No. 153 requires nonmonetary exchanges be classified into two group, resulting in two different acctg rules 1. Those that have “commercial substance” - an exchange has commercial substance is the future cash flows change as a result of the transaction. If the economic position of the two parties changes because of the exchange, then the exchange has commercial substance. 2. Those that lack “commercial substance” Exchanges having commercial substance The FMV of assets given up is assumed to be equal to the fair market value of the assets received Cash given up does not enter into the calculation of gain on an exchange. New Asset xx (FMV) Accum Dep xx (of asset given up) Cash received xx (if any) Loss xx (if any) Old asset xx (at historical cost) Cash given xx (if any) Gain xx (if any) F2-32 & 33 examples Exchanges lacking commercial substance (or when FMV is not determinable) • If no boot (cash) is received, no gain is recognized • If boot is paid, no gain is recognized • If boot is received, gain is recognized - All gain is recognized if boot received equals or is greater than 25% of the total consideration - Recognize a proportional gain if boot received is less than 25%of the total consideration Recognized gain = total gain * (boot received ÷ total consideration received) 3


Whenever a nonmonetary asset is involuntary converted (fire loss, theft, condemnation) to cash, the entire gain is recognized

Partnerships Exact method questions will ask how much should the new partner contribute to have an X% interest in the new partnership? Existing P/S total equity ÷ (1 - % interest desired) = New total P/S equity New total P/S equity – Existing P/S equity = new partner contribution amount Bonus method question will state that the partnership has decided not to recognize goodwill When the new partner pays more than the book value of the interest credit the old owners When the new partner pays less than the book value of the interest credit the new partner New total P/S equity * new partner % interest = book value Book value – amount contributed = bonus Goodwill method question will state that the partnership has decided to recognize goodwill Implied value = new partner contribution * total number of partners including the new partner Goodwill = Implied value – new partnerships total capital s Allocate goodwill to existing partners based on profit/loss F2-37-39 examples of all three methods Liquidation of a partnership – pg 57 example • Step 1: Liquidate assets • Step 2: Pay creditors (insiders or outsiders); if the liquidation of assets do not cover the costs to pay the creditors, then the losses are split • Step 3: If there is leftover after paying creditors, return capital to partners or split losses • Step 4: If there is anything left, divide profits

Financial Reporting and changes prices • • • •

Monetary assets and liabilities fixed or denominates in dollars (A/R) In periods of inflation, monetary assets will erode in value, while monetary liabilities will result in gain Non-monetary assets and liabilities will fluctuate with inflation (bonds, inventory) Contra s (allowance for doubtful s/accumulated dep) are classified based on the related ’s classification

Foreign Currency ing SFAS 52 FX transactions – transactions with a foreign entity denominated in a foreign currency FX translation – the conversion of F/S of a foreign entity to F/S expressed in the domestic currency Functional currency – currency of the primary economic environment in which the entity operates (usually the local currency or the US dollar) Remeasurement (temporal method) – from 3rd currency to functional currency Foreign company F/S must be translated/ remeasured to the functional currency of the company Any remeasurment gains/losses are recognized currently in the income statement 4


Translation (current method) – from functional currency to the reporting currency Any unrealized gains/losses are reported in other comprehensive income Remeasurement method (temporal method): US dollars = Functional currency = B/S • Monetary = year end FX rate • Non-monetary = historical FX rate • Plug retained earnings and use that amount as NI I/S • Non balance sheet related items (COGS) = weighted avg • B/S related items (Depreciation, Bond Amortization) = historical FX rate • Equity = historical fx rate • Currency gain/loss = plug - report in net income from continuing operations Translation method: foreign currency = functional currency I/S • Income = weighted avg FX rate • Expenses = weighted avg FX rate • Transfer NI to retained earnings B/S • Assets = Year end FX rate • Liabilities = year end FX rate • Equity = historical fx rate • Retained earnings = calculated NI from translation • Accumulated Translation adjustment = plug - report in other comprehensive income in the PUFE section

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Marketable Securities Securities should be classified into one of three categories 1. Trading Securities – securities (both debt and equity) bought and held for the purpose to sell them soon 2. Available for sale – securities (both debt and equity) that does not meet the definition of the other two - reported as either current or non-current asset, depending on the intent of the corporation 3. Held to Maturity Securities – debt securities that the corp intends to hold until maturity - reported as current if matures within 1 yr; non-current if matures in more than a yr - stocks don’t mature, so only debt securities are classified as this Trading and available for sale are reported at fair value (mark to market) Unrealized gain/losses on trading securities are included in earnings; IDEA; operating cash flow Unrealized loss on trading securities xx Valuation xx Unrealized g/l on available for sale are reported in other comprehensive income; PUFE; investing cash flow Unrealized loss on available for sale securities xx Valuation xx Reclassification; transfer of security from one group to another From To Adjustment Trading Any other no adjustment necessary (already recognized in income) Any other Trading Recognize in income immediately Avail for Sale (debt) Held to Mat unrealized g/l is amortized over the remaining life of debt Held to Mat (debt) Avail for Sale unrealized g/l at transfer date shall be reported in PUFE If there is a permanent decline in fair value, write down as impairment of asset and record as realized loss in current earnings IDEA A sale of security from any category results in a realized gain/loss and is reported in current income Cash xx Trading security xx Realized gain xx (IDEA) Cash xx Unrealized gain on Avail for sale xx (PUFE) Avail for sale security xx Realized gain on Avail for sale xx (IDEA) Unrealized gain/losses care not tax deductible and therefore cause a temporary difference

Business Combinations/Consolidations • Consolidated F/S ignore important legal relationships and emphasize economic substance over form • Consolidate all majority owned subsidiaries (over 50% voting) • Do not consolidate when company is under legal reorganization (bankruptcy) or control of sub is with a trustee Cost method (0-19% ownership) – do not consolidate, no significant influence Equity Method (20%-50%) – do not consolidate, significant influence Consolidate (50%>) – control 1


Cost Method (external reporting) – (also called fair value method or avail for sale) Do not consolidate B/S Record at cost (FMV + legal fees) Investment in investee Cash Adjust to FMV at year end Unrealized holding losses Marketable security

xx xx xx

Dividend distribution or return of capital Cash xx Investment in investee

xx

xx

I/S Dividends to the parent are reported as income Cash xx Div income xx Distributions that exceed parents share of the investee’s retained earnings Cash xx Investment in investee xx Most tested concepts on cost method • The “investment in investee” is not adjusted for investee earnings • The “investment in investee” is adjusted to FMV (FASB 115) • Cash dividends from the investee are reported as income by the parent

Equity Method (external reporting) – do not consolidate • Exercises significant influence – owns 20%-50% voting stock, largest shareholder or holds majority of board of director seats • So can own below 20% voting stock and still exert significant influence and therefore use equity method B/S Record at cost (FMV + legal fees) Investment in investee xx Cash xx When sub earns money/reports NI, increase by parents ownership % of investee’s earnings Investment in investee xx Equity in earnings/investee income xx Dividend distribution or return of capital, decrease by parents ownership % of dividends from investee Cash xx Investment in investee xx I/S Parents ownership % of investee’s earnings is recorded as income Investment in investee xx Equity in earnings/investee income xx 2


Investee cash dividends reduce parents investment Cash xx Investment in investee xx So easy way to is the GAAP ing rules for the equity method is to think of it like a bank Beginning Bal + investee earnings - investee dividends = ending balance Step by step acquisition (I was using cost method, but I bought more stock and now have to use equity method) • The investment and retained earnings are adjusted retroactively for the difference between cost method/available for sale method to equity method • Considered a change in ing principal (from cost to equity method) • Apply the new equity method to the prior periods old ownership % (1-20%), don’t apply the new percentage ownership when making the retroactive adjustment, you did not own that much of the company back then Consolidated financial statements – control: use purchase method, pooling of interests is no longer permitted

Purchase Method Parent company internal JE Purchase for cash (at FMV which is the cost on purchase date) Investment in subsidiary xx Cash xx or Purchase with parent common stock Investment in subsidiary xx Common stock xx (parent at par) APIC xx (Parent FMV-par) Paid more than net book value (NBV) for subsidiary () – should be recorded as goodwill Paid less than NBV for subsidiary (discount) – record as extraordinary gain Eliminate Sub’s old equity Consolidating workpaper eliminating journal entry C Common stock – sub xx A APIC xx R R/E – sub xx I Investment in Sub xx M Minority interest xx A Adjust – B/S of sub to FMV (paid) xx G Goodwill xx When CAR does not equal I then I reconcile using MAG When the questions says you purchased the sub on 1/1/01 but they give you the sub’s financial on 12/31/01 then you need to find beg retaining earning (1/1/01) so take the ending retaining earning + dividends – income 3


Investment in subsidiary • Original carrying amount of the investment in subsidiary on parents books = original cost – FMV • Direct out of pocket costs (finders fee, legal fees) are including in investment in sub (capitalized) Debit: investment in sub • Indirect costs are expensed as incurred Debit: expense • Stock registration fees and issuance costs (SEC filing fees) are a direct reduction of value of stock issued Debit: APIC • Bond issue costs are capitalized to “bond issue cost” and amortized Minority interest will be attributed when the parent does not own 100% of sub The consolidated I/S will include 100% of sub’s net income. The minority interest portion of the subs net income will be included as a line item deduction The consolidated B/S will include 100% of sub’s assets and liabilities (not sub’s equity / CAR). The minority interest share of the sub’s net assets should be presented on the B/S between LT debt and equity as “minority interest in net assets” = subs stock holders equity * minority interest Determining purchased goodwill or extraordinary gain Investment in Sub + liabilities assumed = purchase price - (Current assets + LT marketable securities) - Lower of cost or FMV of non-current assets = + its Goodwill; - it’s a extraordinary gain F3-30 example; F3-31 are the JE

Intercompany Transactions – eliminate 100% for external reporting They are eliminated because they lack the criteria of beings “arms length” Do no eliminate intercompany s if you do not consolidate When inventory has been sold intercompany reverse the original intercompany transaction (sale and COGS) and - if inventory is sold to outsiders  correct COGS - if inventory is still on hand  correct Ending Inventory If one member of the consolidated group acquired an ’s debt from an outsider, the debt is considered to be retired (because owned internally) and a g/l is recognized. Only extraordinary is unusual and infrequent

Combined F/S / Push Down ing Combined F/S are for a group of related companies, not consolidated because there is no parent company - Companies under common control (individual owns many companies) - Companies under common mgmt - Unconsolidated subsidiaries (many foreign subs) Push down ing reports assets and liabilities at fair value in separate F/S of the subsidiary 4


Working Capital and its Components Working capital = current assets – current liabilities Current ratio = Current assets ÷ current liabilities Quick ratio (acid test ratio) = (cash + net receivables + marketable securities) ÷ Current liabilities Current assets = assets to be consumed during the normal operating cycle or 1 year, which ever is longer Current liabilities = obligations due within 1 yr that requires the use of current assets or the creation of other current liabilities A short-term obligation may be classified as long term is it meets of the criteria - The actual refinancing prior to the issuance of the F/S - The existence of noncancelable financing agreement from a lender Cash equivalents = readily convertible to cash within 90 days or less of purchase date - Deposits held that are legally restricted are not considered cash equivalents If restricted cash is associated with a current asset of liability, classify as a current asset but separate from unrestricted cash 2/10 n/30 = get discount of 2% if paid within 10 days, or the entire amount is due in 30 days Gross method = records a sale without regard of discount A/R 100 Sales 100 If discount taken Cash 98 Sales disc 2 A/R 100 Net method = record including the discount A/R 98 Sales 98 If discount not taken Cash 100 Sales disc lost 2 A/R 98 Direct write-off method (Not GAAP) – is written off and the bad debt is recognized when the becomes uncollectible. (not GAAP because does not properly match the bad debt exp with revenue) GAAP allows two methods; % of sales method and aging of receivables method Bed debt expense – the amount that allowance for uncollectible (B/S) is increased When a receivable is formally determined to be uncollectible Allowance for doubtful s xx A/R xx Subsequent collection of previously written off A/R A/R xx Allowance for Uncollectible s Cash

xx

xx 1


A/R xx Pledging – company uses existing A/R as collateral for a loan Factoring of A/R – company can convert A/R to cash by asg them to a factor with or without recourse Without recourse – the assignee (the factor) assumes the risk of loss of collections Cash xx Due from Factor xx (built in return for factor) Loss on sale of A/R xx A/R xx With recourse – factor has the option to re-sell any uncollectible receivables back to the seller. Can be considered either a transfer (treated as a loan) or a sale To be considered a sale: 1. Transferor’s (seller’s) obligation for uncollectible amounts can be reasonably estimated 2. Transferor surrenders control of the future economic benefits of the A/R to the buyer 3. Transferor is not required to repurchase A/R; but may be required to replace the A/R with similar A/R If three conditions are met for surrender of control for an asset and there is no continuing involvement, the transfer is recorded as a sale (reduce A/R, record g/l) - Transferred assets have been isolated from the transferor - The transferee has the right to pledge or exchange the assets - The transferor does not maintain control over the transferred assets under a repurchase agreement If the three conditions are met and there is continuing involvement, the transfer is recorded using the financial components approach. The transferred assets are divided between those deemed sold and those not sold and a resulting g/l is recorded for sold items If the three conditions are not meant the transfer is treated as a secured borrowing Unearned interest and finance charges are deducted from the face amount of the related promissory note (in order to state the receivable at it present value) Adjusted cash balance = Unadjusted cash balance +/- bank errors + credit memos - service charges

Inventories F.O.B. shipping point – title es to buyer when the seller delivers the goods to a common carrier F.O.B. destination – title es to the buyer when the receives the goods If the seller ships the wrongs goods and the buyer rejects the goods. Then the goods are treated as the seller’s inventory even if the buyer still has possession of the goods. Consignor – the seller (author) Consignee – the agent (Barnes & Nobles) The consignor should include the consigned goods in its inventory as he/she bears the risk even though the consignee has possession Absorption or full costing - only product costs are included in inventory (required by GAAP) Period costs – non mfg/production costs Market ceiling – items net selling price less the costs to complete and dispose (net realizable value) Market floor – market ceiling less normal profit margin 2


Market Net realizable value (ceiling) Net realizable value less Normal profit margin (floor)

Periodic inventory system – quantity of inventory is determined only by physical count, usually at least annually Perpetual inventory system – inventory quantities are updated for each purchase and sale as they occur - most companies still perform either a complete physical count or test inventories at random In Period of inflation LIFO ending inv valuation < FIFO LIFO cost of goods > FIFO  NI under LIFO is lower

Weighted Avg method = total inventory costs ÷ total number inventory units available - this method is particularly suitable for homogenous products and periodic inventory system Moving Avg method – computes weighted avg cost after each purchase - total cost ÷ total units = avg cost - can only be used in a perpetual inventory system How do you calculate dollar value LIFO? Base Date 1/1/200 2000 Layer 2001 Layer

Year Cost $90,000 20,000 110,000 40,000 $150,000

LIFO Current Year Cost $90,000 30,000 120,000 80,000 $200,000

Inventory Layer $90,000 21,818 [Note 1] 111,818 El at 12/31/00 53,333 [Note 2] $165,151 El at 12/31/01

[Note 1]

Price Index LIFO Layer

$120,000/$110,000 $20,000 x 1.09

= =

1.09 $21,818

[Note 2]

Price Index LIFO Layer

$200,000/$150,000 $40,000 x 1.33

= =

1.33 Answer "c" $53,333

Current cost / bases costs = price index Price index * ending inventory = ending inventory value How do you calculate LIFO periodic = Ending inventory in units x oldest cost Gross Profit method – (1-gross profit percentage) = COGS %; COGS % * Sales = COGS - can only be used for interim financial statements as part of a periodic inventory system Conventional Retail method – take physical inventory count and price goods at lower of cost or market

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FIFO Retail method – ending inventory comes from the current period purchases, including markup and markdowns Firm purchase commitment – legally enforceable agreement to purchase a specified amount of goods some time in the future Beg inv + purchases + freight in – COGS = end inv understatement of beginning inventory creates an understatement of cost of goods. overstatement of ending inventory creates a understatement of cost of goods sold Applying the lower of cost or market rule separately to "each item" results in the lowest inventory amount. Ceiling, net realizable value (finished selling price − further processing costs) Replacement cost Floor, NRV less profit (NRV ceiling − (Gross Margin % * finished selling price) Market (Floor) Cost (FIFO) Lower of cost or market

XX XX XX given choose

Compare "floor" with "ceiling" and "replacement cost" (use middle amount) compare that middle amount with "cost." Use lower of the two

Fixed Assets • Improvements and replacement are capitalized - increase useful life, increase operational efficiency • Ordinary expenses should be expensed as repair and maintenance • Extraordinary repairs should be capitalized Land purchased to construct a building; all costs incurred to clear land for the new building are land costs - draining of swamps, brokers commission, legal fees, costs of tearing down old building, levelling, title guarantee insurance Land improvements should be capitalized - fences, water systems, sidewalks, paving, landscaping, lighting Interest costs during construction should be added to cost of land improvement based on weighted avg of acc dep Capitalized interest costs for a particular period are determined by applying an interest rate to the average amount of accumulated expenditures for the qualifying asset (known as avoidable interest Rule 1: Only capitalize interest on the money actually spent, not the total amount borrowed - borrow 100, spend 50 on the building, only capitalize interest on the 50 Rule 2: The amount of capitalized interest in the lower of - Actual interest costs incurred, or - Computed capitalized interest (avoidable interest) F4-38 example Disclose in F/S 1. Total interest cost incurred during the period 2. Capitalized interest cost for the period interest costs incurred during the construction period of machinery to be used by a firm as a fixed asset, should be capitalized as part of the historic cost of acquiring the fixed asset. Interest costs on the fixed asset subsequent to the

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FAR - Notes Chapter 4 http://www.a-cfa.org construction period as well as all interest costs on the routine manufacture of machinery for sale to customers (inventory) should be expensed in the income statement for the period incurred. interest incurred during the construction period should be capitalized, based on the weighted average of accumulated expenditures, as part of the cruise ship cost. Interest cost incurred before or after the construction period should be expensed as well as interest cost incurred during intentional delays in construction.

Depreciable Assets and Depreciation Component depreciation – own a fleet of trucks, depreciate one truck in the fleet Composite depreciation – avg economic lives and depreciate an entire class of assets over a single life - no gain or loss is recognized when one asset in the group is retired Sum of years digit – one of the accelerated methods of depreciation (higher depreciation in early years) - cost – salvage value = base - asset as a 3 year life; 1+2+3=6 which is the number is the denominator to calculate dep exp - 3/6 * base = dep exp for yr 1 - don’t factor carrying amount when computing dep exp - for assets with long life use the formula Sum of years digits = (N*(N+1)) ÷ 2 Double declining balance – also called 200% DD • Can be a different declining rate, double SL is just the most common • No salvage value subtracted out in the dep exp calculation • Factor in carrying value • Method always leaves a remaining balance Units of production – depreciation based on estimated production capability Rate per hour = (Cost – salvage value) ÷ estimated units or hours Depreciation exp = rate per unit or hour * number of units produced or hours worked Depletion – depreciation for natural resources (oil, gas, timber, minerals) Depletion base = cost of land + development costs + restoration costs – residual value [salvage value] Unit depletion rate = depletion base ÷ estimated removable units Total depletion = unit depletion rate * number of units extracted Depletion included in COGS = unit depletion rate * number of units sold

Impairment Read section (3 pages) Beg Accumulated depreciation + impairment loss [cost – accum dep – impairment value] + new dep = end accum dep

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Present Value and Annuities Ordinary Annuity – start at end of period (also called arrears) Annuity Due – payments start at beginning of year On the present value table: Annuity due – 1 = ordinary annuity On the PV table: Ordinary annuity + 1 = annuity due Present value of $1 – used for capital lease buyout at end of lease (bargain purchase buyout); bond principle payoff at end Future value of $1 – used bank savings Present value of an Ordinary annuity – used for periodic lease payments, periodic bond interest payments Future Value of an Ordinary annuity – investment an in IRA PV and FV of annuity due

ing for Leases Operating lease – Rental agreement Lessee ing – the renter The lessee records rent expense over the lease term, usually straight line Rent Exp xx Cash/rent payable xx Lease bonus (prepayment) for future expenses (real estate agent cost) is a deferred asset and amortized over the life of the lease Leasehold improvement – one permanently affixed to the property and reverts back to the lessor at end of lease - Should be capitalized as added to PPE - Should be depreciated/amortized over the lesser of: - Lease life - Asset/improvement life rent payments required for specific events are a period expense - renter has to pay additional amount if sales exceed a certain threshold Non-refundable security deposit – capitalized by the lessee as prepaid rent expense Refundable security deposit – reported as a receivable until refunded by the lessor Free or reduced rent – free months must be allocated evenly over lease term Lessor ing – the owner The cost of the property is included on the lessors books, PPE Depreciate over the assets useful life Cash/rent receivable xx Rental income xx Non-refundable security – booked as unearned revenue until the lessor considers the deposit earned Refundable security – treat as a liability by the lessor until the deposit is refunded

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The A exam tries to trick you into recognizing security deposits as revenue in advance of being earned by giving information in the question about the historical percentage of security deposits earned. Don’t be fooled into recognizing it early Capital Lease – purchase/ownership Lessee capital lease criteria – must meet one condition to capitalize (consider a capital lease) O Ownership transfers at end of lease (upon final payment or required buyout) W Written option for bargain purchase N Ninety % (90%) of leased property FMV is less than or equal to P.V of lease payments S Seventy-five (75%) or more of asset economic life is being committed in lease term If the lessee OWNS the asset in one aspect they need to capitalize it Lessor – seller; sales type/direct financing criteria; must meet all 3 L Lessee OWNS the leased property U Uncertainties do not exist regarding any unreimbursable costs to be incurred by the lessor C Collectability of the lease payments is reasonably predictable Sales type lease – has 2 profit streams - gain on sale - interest income Direct financing lease – has 1 profit stream - interest income Lessee capital lease ing Fixed asset – capital lease Liability – capital lease

xx xx

The lessee records the capitalized lease amount at the lower (lessor) of: - Fair market value of the asset at the inception of the lease - Cost = present value of the minimum lease payments Costs includes - required payments (beginning = PV of annuity due; ending = PV of annuity (ordinary annuity) - bargain purchase option (PV of $1) - guaranteed residual value back to lessor (PV of $1) Exclude executory costs (insurance, maintenance, and taxes paid) and optional buyout For the interest rate use the lower/lessor of: - Rate implicit in the lease (if known) - Rate available in market to lessee (not prime) Depreciation rules for the capitalized lease on the lessee’s books OW – depreciate over the asset life (OW you will actually own the asset at the end of lease term) NS – depreciate over lease life (NS will give it back to lessor at end of lease term; substance over form acctg) Asset retirement obligation (FASB 143) Expanded to other similar closure or removal type costs in other industries (such as oil and mining) ARO qualifies for recognition when it meets the definition of a liability - duty or responsibility - little or no discretion to avoid - obligating event 2


B/S Asset retirement cost xx (FMV) Asset retirement obligation

xx

I/S Depreciation exp – ARC xx Accretion exp – ARO

xx

Period to period changes in the ARO liability will result from - age of time (accretion expense) - Revisions in the timing and amount of cash flows Disclose everything - minimum future lease payments in total and for each of the next 5 years Lessor ing sales type lease (2 profit streams) • Gross investment = (Lease payment * # of yrs) + unguarenteed residual value [estimated FMV at end] Gross investment recorded as lease receivable • PV of minimum lease payments = lease payment * PV of annuity due Recorded as sales • Net investment = (lease payment * PV of annuity due) + (Unguaranteed residual value * PV of $1) • Unearned interest revenue = gross investment – net investment Recorded as unearned interest revenue which is a contra lease-receivable • COGS = (Lessors cost of leased asset + initial direct costs) – PV of unguarenteed residual value JE Lease payments receivable xx (gross investment) COGS xx Sales xx (PV of minimum lease payments) Equipment xx (Lessors cost of leased asset) Unearned interest revenue xx Lessor ing direct financing lease (1 profit streams) • Gross investment = (Lease payment * # of yrs) + unguarenteed residual value [estimated FMV at end] Gross investment recorded as lease receivable • Net investment = gross investment * PV • Unearned interest revenue = gross investment – net investment JE Lease payments receivable xx (gross investment) Unearned interest revenue xx Asset xx (lower of cost or FMV) PV = carrying amount of receivable = cost of asset sold Sale-leaseback Operating Lease Sale price - Asset NBV - PV of minimum lease payments = Excess Gain Capital Lease Sale price - Asset NBV - leaseback asset 3


= Excess Gain In "major" sale-leasebacks (capital lease), all gain is deferred. In "minor" sale-leasebacks (operating), there is no deferral [pv of leaseback is 10% or less of fmv of the asset sold] An “in-betweener” sale leasebacks, realize profit in excess of the pv of minimum lease payments, the "excess portion" of the profit should be recognized immediately and the balance should be deferred Right to remaining use of property retained by Seller-Lessee: • Substantially all rights retained (major) – PV of minimum lease payments > 90% - defer all gain and amortize over the leases asset • Rights retained less than substntial, more than minor (middle) – PV of min lease payments btwn 10% - 90% - defer gain up to PV of minimum lease payments, gain in excess is recognized immediately • Minor portion of rights retained (minor) – PV of minimum lease payments < 10% - no deferred gain, recognize all gain/loss immediately • Real economic loss – when the fair value of the asset is less than book value at the time of sale-leaseback loss recognized immediately • Artificial loss – sales price is below the fair value, loss is deferred and amortized over the leaseback term Sublease • The lessor classifies the sublease in the same category as the original lease • For the lessee - If the original lease was an operating lease, then the sublease is an operating lease - If the original lease was a capital lease due to OW, then the sublease is a capital lease - If the original lease was a capital lease due to NS, then the sublease is a operating lease

Investment in Debt securities (bonds held as assets) SFAS No 115 – investments in debt securities classified as held to maturity are measured at amortized cost (carrying amount) on the balance sheet Stated (nominal) rate = coupon rate Discount = market rate > stated rate = market rate < stated rate Total interest revenue = (principal + total coupon payments) – PV of the note

Long Term Liabilities and Bonds Payable Nondetachable warrants – the convertible bond itself must be converted into capital stock Detachable warrants – the bond is not surrendered upon conversion, the warrants can be sold bought and sold separately from the bonds The unamortized discount on bonds payable is contra to bonds payable The unamortized on bonds payable is presented on the B/S as a direct addition to the face (par) value Bond issue costs should be recorded as a deferred asset and amortized from the bond issuance date - examples: legal fees, ing fees, underwriting commissions 4


2 methods to bond amortization methods: Straight line and effective interest method Straight line: Periodic amortization = or discount ÷ number of periods bond is outstanding Interest expense = (Face value * stated interest rate) – amortization or + discount amortization Effective interest method – required by GAAP I/S Interest expense/earned = Net carrying value * effective interest rate [market rate] B/S Interest paid/receivable = Bond face value * coupon rate Amortization = interest expense – interest paid Unamortized discount = Face value - net carrying value If bond issued at discount add amortization to carrying value, if subtract from carrying value The bonds' book value equals the bond face value less the unamortized discount

Bonds sold or issued between interest dates requires additional entries for accrued interest at time of sale Total cash received = selling price + accrued interest [face * stated rate * (months of interest owed ÷ 12) Bond sinking fund – built up restricted cash to repay bond principal when due - non-current restricted asset Serial bonds – have principals that mature in instalments 2 amortization methods: - Effective interest method (already explained) - Bonds outstanding method (not GAAP) - review F5-52, its has been tested before Convertible bonds – nondetachable warrants Issued at more than face value due to value of conversion feature  However, the conversion feature cannot be assigned a specific value so issuance price allocated to the bonds with no recognition of the conversion feature The conversion is recorded under 2 methods: Book value method • No gain or loss is recognized (no I/S impact) • Common stock is credited (par), APIC is credited (bond carrying value – stock par value – conversion cost) Market Value Method • Recognize gain or loss • g/l = market value of the stock – book value of the bonds Convertible bonds – detachable warrants • at issue date allocate bond for proceeds separately; part goes to bond; part goes to warrant Recording JE at issue date Cash xx Bonds Payable xx APIC Warrants xx (FMV at issuance date) Recorded under 2 methods: Warrants only method – used if only the fair market value of the warrants is known 5


Market value method (warrants and bonds method) – used is the FMV of both the bonds and warrants are available - FMV of warrants / (FMV of bonds + FMV of Warrants ) = % yield - % yield * bonds face value = bond discount and APIC warrants - Bond face value – bond discount or + bond = bond payable

Extinguishment of debt Gain or loss = reacquisition price [face* % paid] – net carrying amount [Face+ unamortized prem or – disc] - included in income from continuing operations, may be considered extraordinary if its unusual and infrequent Bond settlement/retirement price is > than the book value = loss would be recognized

Troubled Debt Restructurings (impaired loans) A troubled debt restructuring is when the creditor allows the debtor certain concessions to improve the likelihood of collection. - examples: reduced interest rates, extension of maturity dates, reduction of the face amount Ordinary gain/loss = FMV debt discharged – NBV debt discharged Possible extraordinary gain/loss = (Face of payable + accrued interest) – FMV of debt discharged When total future cash payments are less than the carrying amount, the debtor should reduce the carrying amount accordingly and recognize the difference as a gain When a creditor receives either assets or equity as full settlement of a receivable, these are ed for at the fair value at the time of restructuring. Ordinary loss = recorded receivable – FMV of asset received As a general rule, Large write downs and write offs of assets are not considered extraordinary Impairment is recorded by creating a valuation allowance with a corresponding charge to bad debt expense Bad debt expense xx Allowance for credit losses xx Beg accrued int payable + interest expense – interest paid = end interest payable

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Pension Plans • The pension plan (trust that handles the fund) and the sponsoring company are two separate legal entities 2 main pension plan methods allowed by GAAP - Defined contribution plan – defines the amount contributed to the plan - Defined benefit plan – defines the benefits to be paid to employees upon retirement Accumulated benefit obligation (ABO) – PV of benefits using current salary levels Projected benefit obligation (PBO) – PV of benefits using future/projected salary levels Prior Service Cost (PSC) – cost of benefits based on past service; granted when - service prior to the initiation of the pension plan that retroactively receive credit - subsequent plan amendments PSC should be amortized over future periods benefited (avg expected future service life) F6-5 be able to redraw graph I/S expense formula S Current service cost I Interest cost (R) (Expected return on plan assets) A Amortization of unrecognized PSC G Gains/losses E Amortization of existing net obligation or net asset Net pension expense To record net pension expense for period Net pension expense xx Accrued pension cost

xx (current liability on the B/S)

To record payment of cash to pension plan Accrued pension cost xx Cash/prepaid pension xx S

Current service cost = PV of all benefits earned this period (an increase in PBO from employee services this period

I

Interest cost = beginning period PBO * settlement rate [rate agreed upon by stakeholders, not market or prime rate]

(R)

(Expected return on plan assets) – actual return adjusted for the diff btwn actual and expected return Expected return on plan assets = beg FV of plan assets * expected rate of return on plan assets or Beg FV of PA + contributions + actual return on PA – benefits paid = End FV of PA

A

Amortized of unrecognized PSC – increase in PBO amortized straight line over future periods

G

Gains/losses – arise from either - differences between expected and actual return on PA and - changes in actuarial assumptions If its material we record it, and anything over 10% amortize over the average remaining service period Unrecognized gain/loss (greater of 10% of PBO or market related value of PA) = excess 1


÷ avg remaining service life = minimum recognized amount to be reported [excess of 10% is amortized] E

Amortization of existing net obligation = PBO – FV of PA At transition date if PBO > FV of assets, amortization of difference in increase pension expense If PBO < FMV, means overfunded, amortization of difference will decrease pension expense Minimum amortization = (PBO – FMV of PA) ÷ (greater of 15 years or avg service life)

Unfunded accrued pension cost Beg balance prepaid cost + employer contributions - pension expense = End balance unfunded cost Prepaid pension costs = contribution – (pension cost – return on assets) B/S – the only time you use the ABO • No entry necessary when pension PA have FV > ABO • When ABO > than FV of PA, it creates a intangible pension asset - the plan is considered underfunded and the sponsor company must reflect a liability - only recognize amount up to the extent of unamortized PSC If the prepaid/accrued pension cost has a debit balance then its reported as a current asset Net pension expense xx Prepaid pension xx Cash xx Current liability = SIRAGE – payments – prior year prepaids Net pension expense xx Accrued pension cost/liability xx Non-current liability or accumulated other comprehensive income ABO [total we owe our people] (FMV of PA – current overfunded/prepaid) [less FMV of assets available to cover that liability] = Minimum pension liability [net liability that unfunded shortage] (accrued pensions cost) [less current liabilities] {net pension expense – contribution} = additional pension liability [non current liability] (unrecognized PSC) [less intangible asset] = amount goes to P in PUFE [other comprehensive income] Intangible asset – deferred pension cost xx Excess additional pension liab over unrecognized PSC xx (goes to PUFE) Additional pension liability xx Pension settlements - occur when the pension PA increase to the value where the company can buy annuity contracts Curtailments – reduce expected remaining years of service for present employees or eliminate defined benefits Termination benefits – when employees are paid to terminate their right to future pension payments Special term benefit = lump sum payment + PV of termination benefit (dr. exp, cr. liab) Pension plan disclosures – usually ask what are the disclosure requirements for _______? Choose the solution that reveals the most info; most disclosure - do not repeat information or predict or project good information 2


Postretirement benefits other than pensions (SFAS 106; modified by SFAS 132) Must accrue the cost of post retirement benefits if: • Obligation is attributable to employees services already rendered • Employees’ rights accumulate or vest • Payment is probable • Amount of the benefits can be reasonably estimated This cost must be projected and accrued during the period the employee works (attribution period) Accumulated Postretirement benefit obligation (APBO) – PV of benefits that have vested as of the measurement date Expected postretirement benefit obligation (EPBO) – PV of benefits expected to be paid as of the measurement date Two I/S approaches 1. Benefit of years service approach 2. Attribution period – PBO is accrued during the period the employee works (hire date to vesting date) I/S expense formula S Current service cost I Interest cost (on APBO) (R) (Actual return on plan assets) A Amortization of unrecognized PSC G Gains/losses E Amortization of existing transition amount (net obligation) Net postretirement benefit expense Can choose to expense or amortize (at the adoption of SFAS 106) Minimum amortization = (APBO – FMV of PA) ÷ (greater of 20 years or avg service life) Or Expense full amount immediately as an ing change (IDEA) B/S Current asset – prepaid/accrued pension cost Non current asset – there is none Current liability: Net cost [SIRAGE] (employer contribution) [paid in] Accrued postretirement benefit cost [current liability] Non current liability: no JE required, only disclosure required Unfunded noncurrent liab = (APBO – FV of PA) – unfunded SIRAGE or + overfunded SIRAGE only required to disclose the noncurrent liability in the footnotes

ing for Post employment Benefits (SFAS 112) Paid to employees fired; severance package Must report as a liability if it meets all four criteria: 1. Employers obligation to pay employee benefits is attributable to services already rendered 2. Obligation relates to rights that vest or accumulate 3


3. Payment of the compensation is probable 4. Amount can be reasonably estimated When all four are not met disclose in the footnote

Estimated Liability vs. Accrued Liability Estimated liability (looking forward) – probable future charge resulting from a prior act - estimated liability for warranties Accrued Liability (looking back) – expenses recognized or incurred but not yet paid - (accrued interest, accrued wages) Total payroll tax liability = Federal income tax withheld + Employee FICA + Employer matching FICA Payroll tax expense = wages * FICA tax rate Beg escrow liab + escrow receipts – escrow disbursements + interest earned = end escrow liab

Contingencies Classification of contingencies - Probable (record) – likely to occur - Reasonably possible (disclose) - more than remote but less than likely - Remote (ignore) – slight chance of occurring If a range is given for a probable loss (100 to 500). GAAP requires the best estimate. However, is no amount in the range is a better estimate than the other use the minimum amount in the range (100) and disclose the possibility of an additional 400 of loss Disclose “guarantee type” remote loss contingencies D Debts of other guaranteed by company O Obligations of commercial banks under letters of credit G Guarantees to repurchase receivables that have been sold or assigned If an asset was impaired or liability incurred after year end date but before F/S issuance, if material may need to disclose The contingent liability for a discounted note receivable is the maturity value and should be disclosed For gain contingencies wait until you realize

ing for Income Taxes Income taxes are governed by the IRS tax code F/S’s are governed by GAAP Permanent differences – only affect current taxes; no deferred taxes - current income tax expense/benefit is determined by corporate tax form of current year Temporary differences – affect deferred taxes - deferred income tax expense/benefit is the change in deferred tax liab or asset over the year - TI inc > F/S inc = DTA - TI inc < F/S inc = DTL 4


If its more than 50% likely that part of all of the deferred tax asset will not be realized, a valuation allowance should be established Use the enacted tax rate for temporary differences, not the anticipated or proposed or unsigned Changes in tax laws or rates are recognized in the period of change (enactment) - the adjustment enters into income tax expense for that period in income from continuing operation - IDEA B/S Presentation Rule 1: Deferred tax items should be classified based on the classification of the related asset or liability - not when its expected to reverse Rule 2: Deferred tax items not relating to an asset or liability should be classified based on the reversal date - example: NOL Rule 3: Net across – example: current DTA’s and DTL’s must be netted and presented as one amount Operating losses carrybacks - are 100% collectible, so no valuation - Loss carrybacks can be used to reduce taxes or to receive a refund and should be recognized in the period they occur Operating losses carryforwards – valuation allowance may be required if it is more than not likely that it will be realized – (must have future positive income to realize) Investee pays dividends to the parent Depending on the ownership % part of the dividend income is excluded from taxable income Ownership 0-19%: 70% exclusion Ownership 20-80%: 80% exclusion Ownership over 80%: 100% exclusion Total income received under completed contract - Total income received under % of completion = difference * enacted tax rate = DTL (if +)

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Financial Instruments Fair value disclosure required for financial instruments either in the body of the F/S or in the notes Credit risk – possibility of loss from the failure of another party to perform according to the contract Concentration of credit risk – overweight in some sector, region or companies with similar characteristics - must disclose all significant concentrations of credit risk in notes to the F/S Market risk (beta) – risk due to changes in economic circumstances Derivative instrument (SFAS 133) – financial instrument that derives its value from another instrument or asset - has one or more underlying assets and has notional amounts (unit of measure) - requires no initial net investment - there is a settlement Forwards are contracted between parties Futures are made through clearinghouses Reporting gains and losses Derivatives that are speculative (don’t hedge anything) are recognized currently in earnings Fair value hedge – derivative designed to hedge against changes in the fair value of an asset or liability - g/l’s on the derivative and the g/l on the hedged item are recognized currently in earnings Cash flow hedge – hedge exposure to expected future cash flows - effective portion of cash flow hedge – reported in other comprehensive income (PUFE) - ineffective portion of cash flow hedge – reported in current earnings Foreign operation currency hedge – report in other comprehensive income as part of cumulative translation adj.

Stockholders Equity Legal capital – amount of capital that must be retained by the corporation for protection of creditors - also known as par or “stated” value of both preferred and common stock Authorized stock – amount of stock hat board has authorized to issue Issued stock – authorized stock that is issued Outstanding stock – issued stock held by shareholders Cumulative preferred stock – dividends not paid accumulate. Get paid dividend in arrears before others Parcitipating preferred stock – receive their dividends first, then share additional dividends with others Convertible preferred stock – may be exchanged for common stock Dividends declared reduce retained earnings R/E Appropriated R/E – some portion of R/E that is legally restricted and not available to pay dividends Quasi-organization – an ing adjustment to eliminate negative R/E and have a fresh start Transactions with owners (issue/repurchase of stock, paying dividends) are never recorded on the I/S Treasury stock – is not entitled to any of the rights of common shareholders (no voting, no dividends) and is a contra equity 2 methods of ing: 1. Cost method 2. Legal or Par value method 1


• The primary difference between the two is the timing of the recognition of gain/loss on treasury stock transactions. • Both record the gain/loss as a direct adjustment to stockholders equity Cost method – used 95% of the time • Treasury shares are recorded and carried at their acquisition cost • Gain/loss will be determined when the treasury stock is reissued or retired Treasury stock xx (shares * acquisition price) Cash xx Repurchase at gain Cash xx (amount received) TS xx (cost) APIC-TS xx (plug) Repurchase at a loss and there is not enough is APIC to cover the loss Cash xx APIC-TS xx R/E xx (excess amount) TS xx (cost) Present on B/S after R/E before stockholders equity total Legal or par value method • Treasury shares are recorded by reducing the amounts of par value and APIC received at the time of original sale. • Gain/loss immediately calculated upon repurchase Repurchase at a gain Treasury stock xx (shares * original par value) APIC xx (shares * original APIC value) Cash xx (cash paid) APIC-TS xx (plug) Repurchase at a loss Treasury stock APIC R/E Cash

xx (shares * original par value) xx (shares * original APIC value) xx (plug) xx (cash paid)

Never increase R/E, only decrease if necessary Present on B/S after common stock Donated stock – no change in stockholders equity, record donated stock at FMV Donated TS xx APIC xx Stock issued above par value – credit APIC Stock issued at par value – no APIC entry Stock issued below par – debit APIC (decrease)

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Stock subscriptions – contractual agreement to sell a specified number of shares at an agreed upon price on credit. Subscriptions receivable xx (contra equity) Common stick subscribed xx APIC xx So no change in equity Stock issued for outside services should be recorded as the FMV of stock Expense for services xx (FMV of stock) C/S xx (par) APIC xx (excess/plug) Property dividends R/E xx (FMV of building) Accum Dep xx Build cost xx Gain xx (plug) Scrip dividends – special form of notes payable, corp pays a dividend at a later date - shifts from current liability to long term liability Liquidating dividends – when dividends to shareholders exceed R/E Stock dividend – no dividend income reported by the investor - Small stock dividend (less than 20-25%) - reduce R/E by the FMV of stock - Large stock dividend (more than 20-25%) – reduce R/E by par value R/E xx (FMV or Par) C/S xx (par value) APIC xx (plug) Stock splits – no change in total book value - multiply outstanding shares by 2 and divide par value by 2 Non-compensatory stock options (not meant as compensation) • No JE until options are exercised • Upon exercise Cash xx (# of shares * option price) C/S xx (# of shares * par value) APIC xx (plug) Compensatory stock options – SFAS 123R requires that compensatory stock options be valued at the fair value of the options issued • The compensation expense, calculated on the option grant date is allocated over the service period Expiration of stock options – no change to stockholders equity, compensation expense not affected APIC-stock options xx APIC- expired stock options xx 2 different approaches to transition to SFAS 123R (effective date June 15, 2005) 1. Modified prospective application – use this method after the effective date 2. Modified retrospective application – may use this method to periods before the effective date 3


Stock appreciation rights (SARS) • Incentive where officers are given cash if the stock increases above a hurdle price • Excess over the hurdle rate * # of stock appreciation rights = compensation expense to corporation • Must be adjusted annually, change in estimate so prospective Example F7-25

Earnings Per Share • FASB 128 requires all public entities to present EPS on the face of the income statement • Companies with complex capital structures (has convertible securities) must present basic and dilutive EPS Basic EPS = (NI – preferred dividends) ÷ weighted average number of common shares outstanding Weighted avg # of C/S outstanding = shares outstanding beg + shares sold – shares reacquired + stock div and stock splits – reverse stock splits - months till next issuance or year end are the numerator in the initial formula Stock dividends and stock splits must be treated as though they occurred at the beginning of the period Diluted EPS = (NI + (interest on dilutive securities * (1- tax rate) ÷ weighted avg # of C/S outstanding assuming dilutive securities are converted Dilution from options, warrants and their equivalents Treasury stock method – proceeds from the exercise of dilutive securities will be used to repurchase treasury stock at the prevailing market price. Options and other similar instruments are only dilutive when they are in the money For options and other similar instruments Additional shares outstanding = number of shares – ((number of shares * exercise price) ÷ avg market price) Dilution from bonds or preferred stock The “if-converted” method – assumes that the securities were converted to common stock at the beginning of the period For convertible bonds • Add interest expense, net of tax, to the numerator (it increases the income available to stockholders) • Add dilutive effect to denominator Only show diluted EPS if it is actually dilutive. Therefore, if its anti-dilutive do/show nothing For convertible preferred stock • Add associated preferred dividends to the numerator (it increases the income available to stockholders) • Add dilutive effect to denominator Cash flow per share should not be reported

Statement of Cash Flows The purpose of the statement of cash flows is to provide info about the sources of cash and uses of cash - Operating - Investing - Financing Regardless of the method, present the investing and financing section the same 4


Direct method required disclosures - Reports operating cash flows by major classes. - A reconciliation of net income to net cash flow from operations. - The amount of income taxes paid. Indirect method – adjust NI to reconcile it to net cash flows from operating activities Cash received from customers = cash sales + T (F7-38) Cash paid to suppliers = 2 steps Step 1: Beg inventory + purchases, cash paid – COGS = Ending inventory Step 2: Beg A/P + credit purchases – cash paid = end A/P Direct method – focuses predominately on working capital (CA and CL) Categories to report separately: Inflows (increase cash) • Cash received, interest received, div received [div paid is financing], cash on sales of trading securities [all other securities are investing] Outflows (decrease cash) • Cash paid to suppliers and employees, interest paid [paying principal is a financing], income taxes paid [current of deferred], cash paid to buy trading securities, other operating cash payments [rent, utilities, insurance] Indirect method – reconciliation DAALGUDI Net income per I/S + depreciation and amortization - amortization of s + amortization of discounts/goodwill + losses on sale of non-current assets (PPE/LT investments) - gains on sale of non-current assets - undistributed earnings from (equity method) + decrease in current assets (or – increase in CA) + increase in CL (or – decrease in CL) = cash flow from operations Cash proceeds from sales of non current assets is investing inflow [Selling price – NBV {cost – accum dep) = g/l] Investing section • Sale or Purchase of Non-current assets, net accum dep; if we buy then it’s a cash outflow; sell it’s a cash inflow • Making loans to other entities; outflow • Purchasing avail for sale or held to mat securities; outflow Financing section • Paying principal on notes, bonds, mortgages; outflow • Your own stock • Paying dividends 5


Material non-cash investing and financing activities require supplemental disclosure Begin bal bond payable + issuance of bonds - redemption of bonds payable = Ending bal bond payable

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Governmental ing Part B Operational ability – government wide F/S has met its objectives efficiently and effectively Fiscal ing ability – fund F/S demonstrate that the govt’s entity’s actions have been responsible Must reconcile fund F/S to gov’t wide F/S Required in F/S • MD&A (required supplemental information • Govt wide F/S - Statement of net assets - Statement of activities • Fund F/S - Governmental funds (GRaSPP) a. Balance Sheet b. Statement of revenues, expenditures, and changes in fund balances - Proprietary funds (SE) a. Statement of net assets b. Statement of revenues, expenses and changes in fund net assets c. Statement of cash flows - Fiduciary funds (PAPI) a. Statement of fiduciary net assets b. Statement of changes in fiduciary net assets • Notes to F/S • Required supplementary information Optional information • Comprehensive Annual Financial Report (CAFR) - Introductory section (unaudited) - Basic F/S and required supplementary information (audited) - Statistical section Primary government entities • State governments • General purpose local governments (city or a county) • Special purpose local governments (hospital or school district) has to meet the 3 criteria: SE Separately elected governing body L Legally separate F Fiscally independent of other state and local governments Component unit – unit of primary govt that is a legally separate organization; elected officials of the primary government are financially able Blended presentation – used in either of the following situations - A board of the component unit is substantively the same as that of the primary government - Component unit almost exclusively serves the primary government When the criteria for a blended presentation has not been met, then a discrete presentation is used Discrete presentation – separate presentation, most common Managements Discussion & Analysis (MD&A) • Required supplementary information 1


• No reconciliation of fund F/S to the Gov’t wide F/S • Description of the F/S - easily readable analysis - condensed F/S information - analysis of overall financial position including reasons for changes from the prior year - analysis of balances and transaction of individual funds and limitations on future uses of funds - analysis of significant variations between original and final budget • The identity of the primary government and discrete component units • Economic conditions and outlook • Major initiatives Government wide F/S • Statement of net assets • Statement of activities Statement of net assets (F9-9) Net assets = assets – liabilities Net assets is composes of 3 components - unrestricted net assets - restricted net assets - invested capital, net of related debt Infrastructure assets – streets, bridges, gutters and other govt assets - reported only on the govt wide F/S 2 depreciation approaches • Required approach – depreciation expense specifically identified with a functional category should be included in the direct expenses of that function • Modified approach – infrastructure assets are not required to be depreciate if two 2 requirements are met: (under this approach infrastructure expenditures are reported as expenses, unless the outlays are additions or improvements in which case they would be capitalized 1. Gov’t assets mgmt system keeps up-to-date info on amount, condition and make yearly estimates on maintenance to preserve the assets 2. Have documentation to prove number 1 ing changes (changes in estimate) Going from required to modified (visa versa) depreciation method Impairment determination Gov’t should capitalize artwork and historical treasures at historical cost or fair value at donation date Gov’t should capitalize but is not required to when the collection meets the following criteria - collection is held for public exhibition - collection is protected - proceeds from sales of collection are used to acquire other items for the collection Statement of activities Use full accrual Net revenue and expense for each function or program is classified into 3 categories • Primary gov’t governmental activities – GRaSPP + S • Primary gov’t business type activities - E • Component units – rescue squad or board of education 2


Category Types S Charges for services - charges for services to customers or applicants who directly benefit from goods or services - charges for services to other governments - fines and forfeitures O

Operating grants and contributions – restricted for use in a particular program

C

Capital grants and contributions - restricted for use in a particular program

SOC these revenue sources away Activity resulting from internal service funds should be reported in the governmental activities column unless the government’s enterprise funds are the primary recipient of internal service fund services F9-18 statement of activities, do I need to know the layout Fund Financial Statements To be considered a major fund that requires reporting must meet (both) 2 criteria: 1. Fund must comprise 10% of total revenues, expenditures, assets or liabilities of - all government funds or enterprise funds (the separate columns) 2. Fund must comprise 5% of revenues, expenditures, assets or liabilities - all government fund and all enterprise funds (the total columns) When determining is a fund qualifies as a major fund, that aggregate fund balance/ equity (net assets) is not used in either test The govt wide F/S must reconcile: • The differences in the fund balances of governmental funds and net assets in the govt wide F/S • The differences in net change in fund balances of governmental funds and the change in net assets for governmental activities To prepare the reconciliation use the following mnemonic B/S – GALS BARE G GRaSPP fund balance +A Assets (non-current) -L Liabilities (non-current) +S Internal service fund net assets Adjustments B Basis of ing A Accrued R Revenues E Expenses Statement of revenues, expenditures and changes in fund balance – GOES BARE G GRaSPP net change in fund balance -O Other financing sources +E Expenditure – capital outlay (net of depreciation) +S Internal service fund net income Adjustments B Basis of ing A Additional Accrued 3


R E

Revenues Expenses

Statement of Cash Flows • Similar to normal statement of cash flows except 6 differences: 1. Direct method is required (indirect method not allowed) 2. Reconcile operating income (not NI) to net cash provided by operations 3. Financing section is split into 2 sections (so 4 in total) - Capital and related financing activities - Non-capital financial activities 4. Interest income and cash receipts are reported are investing activities (not operating) 5. Interest expense/cash payments are including in one of the financing sections 6. Capital assets purchases are reporting in capital financing activities (not investing) Notes to F/S • Are considered integral to the F/S • Disclosures should include - description of gov’t wide activities noting the exclusion of fiduciary funds (PAPI) - policies relating to elimination of internal activity - description of the modified approach for reporting infrastructure if used - length of time defined for “available” in revenue recognition under modified accrual (usually 60 days) - actions taken to correct material non-compliance with finance related or legal compliance Required Supplementary Information (other than MD&A) Includes: budget, infrastructure and pension information • Budgetary comparisons that show the original budget, the final amended budget and the actual amounts • Computation of variances is optional • Budgetary comparison may use either GAAP or budgetary formats or basis of ing, but must include a reconciliation to GAAP • F/S prepared in accordance with the provisions of GASB 34 • Asses condition of infrastructure • Estimated annual amount to maintain and preserve infrastructure for each of the past 5 years • Presentation of 6 years of pension information - schedule of funding progress - schedule of employer contributions Other Supplementary Information (optional) • Combining statements for non-major funds Interfund activity – represents the flow of resources between funds and between primary governmental and its component units • Reciprocal interfund activity - Interfund loans – temporary extensions of credit to other funds - Interfund services provided and used • Non-reciprocal interfund activity - Interfund transfers - Interfund reimbursements 4


Interfund activities should only reported between the primary government and its fiduciary fund For all other relationships, eliminate interfund activities

Not-For-Profit Organizations • Use FASB not GASB (SFAS 117), so use full accrual • Overall emphasis is on basic information for the organization as a whole Required F/S • Statement of financial position (B/S) • Statement of activities (I/S) • Statement of cash flows • Statement of functional expenses (required for health and welfare organizations) Statement of financial position (B/S) Net assets – not for profits put their net assets into these categories • Unrestricted net assets - internally board designated funds are considered unrestricted • Temporarily restricted net assets – donor imposed stipulations either expire with time or by an action of the organization • Permanently restricted net assets These are different then the governmental net asset categories - Invested - Restricted - Unrestricted Statement of activities (I/S) Four elements presented in statement of activities • Change in total net assets • Change in unrestricted net assets • Change in temporarily restricted net assets • Change in permanently restricted net assets Contributions with donor imposed restrictions are recorded as restricted revenue when received and increase either temporarily or permanently restricted net assets Pledge receivable xx Allowance for doubtful s xx Restricted revenue xx When the restriction is satisfies, reclassify the asset Unrestricted net assets xx Restricted net assets xx Then when used Operating expense xx Unrestricted net assets xx If donor imposed restrictions are met in the same period they are received they may be recorded as unrestricted net assets as long as the organization discloses it Expenses are reported as decreased in unrestricted net assets. 3 categories 1. Program services 5


2. services 3. Combined costs Statement of cash flows • Can use either direct or indirect method Operating activity – gross receipts (contributions, program income, interest and dividend income), board designated unrestricted revenue for construction or purchase of LT asset are operating Financing activity – cash transactions related to borrowing, increases to an endowment, purchases of assets or annuity agreements Investing activities – sale or purchase of art, investment in equipment Exclude donor restricted securities that may otherwise meet the cash equivalent definition in commercial acctg Statement of functional expenses (required for health and welfare organizations) 3 main functional classifications 1. Program expenses 2. Fund raising expenses – unsolicited merchandise given out) 3. Management and general Resource inflows in not-for-profit organizations are generally classified in the F/S as revenue or other Revenues typically represent exchange transactions in which the not-for-profit organization earnes resources in exchange for a service performed Other typically represents operating income that is donated (contributed) as part of the central ongoing activities of the organization Cash contributions received are recognized as revenue Unconditional promises/pledges are recognized as revenue Conditional promises/pledges are recognized as revenue when its earned (conditions are substantially met) Multiyear pledges – current amount collected is contribution revenue, the PV of future collections are temporarily restricted revenues Allowance for uncollectible pledges – net realizable value Split interest agreements are shares with other beneficiaries - measured at fair value - displayed as temporarily restricted Donated services should be recorded at fair value and must meet the following criteria S Specialized skills required and possessed by the donor O Otherwise needed by the organization M Measurable E Easy to determine fair value) Expense or asset xx Contribution – non operating revenue

xx 6


Volunteers who solicit are classified as fund raising expenses regardless if they meet the SOME criteria Donated collection items are artwork and historical treasures. They are not required to be recorded is they meet all the following criteria - collection is held for public exhibition - collection is protected - proceeds from sales of collection are used to acquire other items for the collection Record donated materials at fair value Gifts in kind – non cash contributions, measured at fair market value Agency transaction – the organization has little or not discretion (variance power) over the funds (organization basically acts like an agent. - displayed in liabilities (not restricted revenues) Reciprocal transfers – each party receives and sacrifices something of approximately same value is termed an exchange transaction Cost of s (calendars, coffee mugs) given to potential donors as part of fundraising is classified as fund raising expense When donors purchase goods for a (cause they know it goes to a good cause) they difference between the and the product fair value is classified as a contribution Non-for profit has no variance power – acts like an agent Asset xx Refundable advance xx (liability) Granted variance power – acts like an agent but has some power, assets recognized as contribution revenue Asset xx Contribution revenue xx Beneficiaries of the assets When financially interrelated – equity Interest in net assets xx Equity transaction xx (statement of activities) Recognized beneficial interest – pools of assets – revenue Beneficial interest xx Contribution revenue xx Recognized receivable – revenue Receivable xx Contribution revenue xx Gains/losses on investments are reported in the statement of activities and increases or decrease in unrestricted net assets unless the use of the investment is restricted Derivatives (same as GAAP rule) recognize change in fair value in the period of change Interest, dividend income is reported in the period earned as increases in unrestricted net assets unless the use of the investment is restricted Endowment fund – permanently restricted net assets, principal must be retained Permanent endowment – Corpus (principal) is not permitted to be spent 7


Term endowment – held for a specified term then you can spend it Quasi-endowment – internal governing board (not the donor) has determined that the funds are to be retained and invested for a specific purpose (not restricted) College and Universities Revenues – tuition and fees, shown gross so scholarships, tuition wavers, cancelled classes are reductions to gross revenue Healthcare Organizations 3 main revenue sources 1. Patient service revenue – established using standard rates, even if the full amount is not expected to be collected, shown gross, so subtract deductions to get gross revenue - Deductions - contractual adjustments for third party payments - policy discounts - istrative adjustments - Charity care – not recorded as a receivable or revenue 2. Other operating revenue - donated supplies and equipment - medical transcription fees - cafeteria revenue 3. Non-operating revenue - donated services Voluntary Health and Welfare Organizations • Main income source is derived from contributions and pledges from the general public • Fundraising expenses must be shown separately on the face of the F/S as wither an expense or deduction from revenues (not as a simple net amount)

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