FINANCIAL 2
Matching (Revenue & Expenses), Foreign Currency Accounting, and
Other Financial Statement Presentations
1.
Timing issues: Matching of revenue and expenses, correcting and adjusting accounts
2.
Long-term construction contracts
3. Accounting for installment sales
28
...............................................................................................................................................
33
.
.
.
............................................................................... ............................................. ....
36
Financial reporting and changing prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
6. Foreign currency accounting
7.
3
.......................................................... .................................................................................
4. Accounting for nonmonetary exchanges
S.
.
............. ............ ...................................
.
.................................................................................................. ................... ...............................
............................... ........................... .................................................... . ................
S3
.....................................................................................................................................................
S8
Other financial statement presentations
8. Appendix I : The Codification
4S
.
..
9. Appendix II: IFRS vs. U.S. GAAP ............................ ..................................................................................................................... 81
10. Class questions
.........................................................................................................................................................................
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Financial 2
NOTES
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Financial 2
TIMING ISSUES
Ma t c h in g o f R e v e n u e a n d E x p e n s e s , C o r r e c t i n g a n d A d j us t i n g A c c o u n t s
I.
TERM INOLOGY AND BASIC CONCEPTS
A.
Assets
Assets are probable future economic benefits that are obtained or controlled by a particular
entity as a result of past events or transactions.
1.
Event
An event is something that happens to an entity, and it can occur either externally or
internally.
2.
Transaction
A transaction is an event that occurs external to the entity and typically involves a
transfer of value from one entity (or entities) to another.
B.
Liabilities
Liabilities are probable future sacrifices of economic benefits that an entity faces for
obligations to provide services or transfer assets due to past events or transactions.
C.
Revenues
Revenues are increases of assets or reductions of liabilities (and possibly both) during a
period of time. They stem from the rendering of services, delivering of goods, or any other
activities that may constitute the major ongoing or central operations of an entity.
1.
Revenue Recogn ition (U.S. GAAP)
a.
Requirements
Revenue should be recogn ized when it is realized (or realizable) and when it is
earned .
(1 )
(2)
All four criteria must be met for each element of the contract before any
revenue can be recogn ized:
(a)
Persuasive evidence of an arrangement exists;
(b)
Delivery has occurred or services have been rendered;
(c)
The price is fixed and determinable; and
(d)
Collection is reasonably assured.
Revenue from the sales of products or the disposal of other assets is
recognized on the date of sale of the product or other asset (i.e., the
delivery date).
Generally, the following criteria apply for a sale (exchange) to take place:
(a)
Delivery of goods or setting aside goods ordered (which would result
in a simultaneous recognition of revenue and expense), and/or
(b)
Transfer of legal title.
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Financial
2
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provienen de
b.
(3)
Revenue that stems from allowing others the use of the entity's assets
(e.g., interest revenue, royalty revenue, and rental revenue) is recognized
when the assets are used (Le . , as the time passes).
(4)
Revenue from the performance of services is recognized in the period the
services have been rendered and are able to be billed by the entity.
Objectivity
The reason for waiting for the sale to take place is "objectivity."
2.
Revenue Recognition ({FRS)
U nder I FRS, revenue transactions are divided into the following four categories. Each
category has its own revenue recognition rules.
a.
Sale of Goods
Revenue from the sale of goods is recognized when all of the following
conditions have been met:
b.
(1)
Revenue and costs incurred for the transaction can be measured reliably.
(2)
It is probable that economic benefits from the transaction will flow to the
entity.
(3)
The entity has transferred to the buyer the significant risk and rewards of
ownership.
(4)
The entity does not retain managerial i nvolvement to the degree
associated with ownership or control over the goods sold.
Rendering of Services
Revenue from the rendering of services is recognized using the percentage of
completion method when the outcome of the transaction can be estimated
reliably. The outcome of the transaction can be estimated reliably when all of the
following conditions have been met:
c.
(1 )
Revenue and costs incurred for the transaction can be measured reliably.
(2)
It is probable that economic benefits from the transaction will flow to the
entity.
(3)
The stage of completion of the transaction at the end of the reporting
period can be measured reliably.
Revenue from Interest, Royalties, and Dividends
Revenue from interest, royalties and dividends that arise from the use by others
of the entity's assets is recognized when all of the following conditions have been
met:
(1 )
Revenue can be measured reliably.
(2)
It is probable economic benefits from the transaction will flow to the entity.
Interest revenue is recogn ized using the effective i nterest method, royalties are
recognized on the accrual basis, and dividends are recognized when the
shareholders' rights to receive payment are established .
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d.
Financial 2
Construction Contracts
Contract revenue and contract costs are recognized as revenue and expenses
using the percentage of completion method when the outcome of the
construction contract can be estimated reliably. The outcome of the construction
contract can be estimated reliably when all of the following conditions have been
met:
(1 )
The contract revenue and contracts costs attributable to the transaction
can be measured reliably.
(2)
It is probable that economic benefits from the transaction will flow to the
entity.
(3)
Both the contract costs to complete the contract and the stage of contract
completion at the end of the reporting period can be measured reliably.
An expected loss on a construction contract is recognized immediately as an
expense.
3.
Multiple Element Arrangements
When a sales contract includes multiple products or services, the fair value of the
contract must be allocated to the separate contract elements. Revenue is then
recognized separately for each element based on the revenue recognition criteria
appropriate for each element.
4.
Exceptions and Other Special Accounting Treatments
a.
Deferred Credits
When cash is received before it is earned, a deferred credit (unearned revenue
or deferred revenue) is reported. A deferred credit is recognized as revenue as it
is earned. For example:
b.
(1)
Unearned interest income.
(2)
Unearned rental income.
(3)
Unearned royalty income.
Installment Sales
Revenue is recognized as collections are made. It is used when ultimate
realization of collection is in doubt (discussed later in this chapter).
c.
Cost Recovery Method
No profit is recognized on a sale until all costs have been recovered (discussed
later in this chapter).
d.
Non monetary Exchanges
The recognition of revenue depends upon the type of exchange (discussed later
in this chapter).
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Financial
Becker Professional Education I CPA Exam Review
2
e.
Involu ntary Conversions
The involuntary conversion due to fire, theft, etc. , of a nonmonetary asset to cash
would result in a gain or loss for financial accounting purposes (discussed later in
this chapter).
f.
Net Method of Accounting for Trade (Sales) Discounts
Sales are recorded net of any discounts; therefore, accounts receivable at year­
end does not include the discount offered . If the discount is not earned , the sales
discount amount is recorded as "other income," and cash or accounts receivable
is debited at that time (discussed in detail in F4).
g.
Percentage-of-Com pletion Contract Accounting
Revenue is recogn ized as "production takes place" for long-term construction
contracts having costs that can be reasonably estimated. If costs cannot be
reasonably estimated , then the "completed contract method" must be used
(discussed later in this chapter).
D.
Expenses
Expenses are reductions of assets or increases of liabilities (and possibly both) during a
period of time. They stem from the rendering of services, delivering of goods, or any other
activities that may constitute the major ongoing or central operations of an entity. Expenses
should be recognized according to the matching principle.
E.
Realization
Realization occurs when the entity obtains cash or the right to receive cash (i.e., from the
sale of assets) or has converted a noncash resource into cash.
F.
Recognition
Recognition is the actual recording of transactions and events in the financial statements.
G.
Matching Principle
One of the most important principles in financial accounting is the matching principle, which
indicates that expense must be recognized in the same period in which the related revenue is
recognized (when it is practicable to do so). Matching of revenues and costs is the
simultaneous or combined recognition of the revenues and expenses that results directly and
jOintly from the same transactions or events.
For those expenses that do not have a cause and effect relationship to revenue, another
systematic and rational approach to expense recognition should be used (e. g . , amortization
and depreciation of long-lived assets and the immediate expensing of certain administrative
costs, referred to as period costs (e.g., no future benefit)).
H.
Accrual Accounting
Accrual accounting is required by GAAP and is the process of employing the revenue
recogn ition rule and the matching principle to the recognition of revenues and expenses. It
records the transactions and events as they occur, not when the cash is received or
expended. Accrual accounting recognizes revenue when it is earned and expenses when the
obligation is incurred (i.e., typically when the expenses relate to the earned revenue).
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I.
Financial 2
Deferral
Deferral of revenues or expenses will occur when cash is received or expended but is not
recognizable for financial statement purposes. Deferral typically results in the recognition of
a liability or a prepaid expense.
J.
Accrued Assets and Liabilities
1.
Accrued Assets (or accrued revenues)
The recogn ition of an accrued asset (e.g., interest receivable) represents revenue
recognized or earned through the passage of time (or other criteria) but not yet paid to
the entity.
2.
Accrued Liabilities (or accrued expenses)
Accrued liabilities represent expenses recognized or incurred through the
passage of time (or other criteria) but not yet paid by the entity (e.g., accrued interest
payable, accrued wages, etc.).
3.
Estimated Liabil ities
Estimated liabilities represent the recognition of probable future charges
that result from a prior act (e.g. , the estimated liability for warranties,
trading stamps, or coupons).
K.
Costs May be Applicable to Past, Present, or Future Periods
1.
Expired Costs
Expired costs (expenses) are costs that expire during the period and have no future
benefit (e.g., the residual value or right to certain future revenues).
2.
a.
Insurance expense (e.g., the pro rata portion of a three year policy) is an indirect
expense and is systematically allocated to the period for which benefit is
received.
b.
Costs of goods sold are directly allocated to the periods in which the sales take
place, which matches the cause and effect of the transaction.
c.
Period costs are costs expiring in the period incurred (e.g . , selling, general, and
administrative expenses).
Unexpired Costs
Unexpired costs (e.g. , fixed assets and inventory) should be capitalized and matched
against future revenues. If future revenues are not certain or there is no residual value,
then those costs should be expensed as expired costs.
L.
Prepaid Expenses (current assets)
1.
Residual Value
Prepaid expenses relate to expenditures with a residual value (e.g. , prepaid insurance
with a cancellation value).
2.
Future Right to Services
Prepaid expenses may also occur where there exists a future right to services (e.g., a
service contract with no cancellation value).
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Financial 2
M.
Deferred Charges
1.
Not Charges to a Tangible Asset
Deferred charges result from expenditures or accruals that cannot be charged to a
tangible asset, but that do pertai n to future operations (e.g., bond issue costs).
2.
Intangible Assets and Noncurrent Prepaid Items
Deferred charges may include intangible assets (covered later in this lecture) and
noncurrent prepaid items.
REVEN U E RECOGN ITION
A.
B.
Deferred Credits (unearned revenue or deferred revenue)
1.
Deferred credits represent future income contracted for and/or collected in advance
(e.g., rental income, gift certificates, and magazine subscriptions collected in advance).
2.
Deferred credits have not yet been earned by the passage of time or other criteria.
3.
Deferred credits are located in the liability section of the balance sheet.
Royalty Revenue
Royalty revenue is recognized when earned. Royalty revenues can be earned in a variety of
ways (e.g., royalties received on patents sold or royalties received from publications sold). I n
the latter case, a company usually earns royalties based o n a stated percentage of sales.
Reporting royalty revenue requires accrual of the provision for revenues based on estimated
sales.
EXAMPLE - ACCRUAL OF ROYALTY REVENUE
TAG Company wrote a textbook and sold it to Fox Company for royalties of 25% of sales. Royalties are
payable semiannually on April 30 (for J uly through December sales of the previous year) and on October 31
(for January through June sales of the same year). During Year 1 and Year 2, TAG Company received the
following checks from Fox Company:
April 30
Year 1
Year 2
$14,000
$12,000
October 31
$ 17,000
$ 15,000
TAG estimated that textbook sales would total $80,000 for the last half of Year 2. How much royalty revenue
should TAG Company report in its Yea r 2 income statement for the year ended December 31, Year 2?
$ 15,000
October 31, Year 2 check (for January 1-June 30)
Earned J u ly 1 through December 3 1, Year 2 (25%
Royalty revenue for Year 2
F2-8
x
$80,000)
20,000
$ 35,000
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Financial
2
EXAMPLE - ROYALTIES RECEIVED IN ADVANCE
TAG Company receives royalties on its patents in two ways. In some cases, advance royalties are received and,
in other cases, royalties are remitted within sixty days after year end. These data are included in TAG
Company's December 3 1 balance sheets:
Royalties receivable
U nearned royalties
Year 1
$100,000
70,000
Year 2
Difterence
$95,000
45,000
($5,000)
25,000
During Yea r 2, TAG Company received royalty remittances of $180,000. In its income statement for the year
ended December 31, Year 2, what should TAG Company's royalty income be?
$ 180,000
Cash receipts
(100,000)
Receipts in Year 2 applied to 12/31/Year 1 receivables
Cash remaining
80,000
U nearned royalties, 12/31/Year 2
(45,000)
Preliminary Year 2 royalty income
35,000
U nearned royalties, 12/31/Year 1
70,000
Receivables balance, 12/31/Year 2
95,000
� 200,000
Royalty income, Year 2
The net method way to calculate royalty income would be:
Royalty collections
$ 180,000
Plus: Reduction in unearned royalties ($70,000 - $45,000)
25,000
Less: Reduction in royalties receivable ($100,000 - $95,000)
(5,000)
S 200,000
Year 2 royalty income
P A SS K EY
The examiners frequently test journal entry concepts, The correct journal entries for the collection and
recognizing of earned royalties are:
Cash
$XXX
Unearned royalty
U nearned royalty
Earned royalty
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$XXX
$XXX
$XXX
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Becker Professional Education I CPA Exam Review
Financial 2
C.
Unearned Revenue
Revenue received in advance is recorded as a liability because it is an obligation to perform a
service in the future and is reported as revenue in the period i n which it is earned, that is,
when no further future service is required . Examples include rent received in advance,
i nterest received in advance on notes receivable, and subscriptions received in advance.
EXAMPLE
Kristi Company sells magazine subscriptions for one- to three-year periods. The magazine subscriptions
collected in advance account had a bala nce of $ 1,200,000 at December 31, Year 1.
Information for Year 2:
Cash receipts from subscribers
Magazines subscription revenue
$ 1,400,000
1,000,000
In its December 3 1, Year 2 balance sheet, how much should Kristi Company report as the balance for
magazine subscriptions collected in advance?
The ending balance in the magazine subscriptions collected in advance is calculated as follows:
Balance at December 31, Year 1
Cash receipts
$ 1,200,000
1,400,000
2,600,000
Revenue recognized
Balance at December 31, Year 2
D.
(1,000,000)
$ 1,600,000
Revenue Recognition when the Right of Return Exists
Revenue from a sales transaction where the buyer has the right to return the product shall be
recognized at the time of sale only if all required conditions are met. If the following
conditions are not met, then the recognition of revenue shall be deferred (delayed):
F2-10
1.
The sales price is substantially fixed at the date of sale;
2.
The buyer assumes all risks of loss (e.g., fire or theft) because the goods are
considered in the buyer's possession;
3.
The buyer has paid some form of consideration;
4.
The product sold is substantially complete; and
5.
The amount of future returns can be reasonably estimated.
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E.
Financial 2
Franchises
Franchise operations include a franchisee that receives the right to operate one or more units
of a franchisor's business. Franchise accounting involves two types of fees.
1.
Initial Franchise Fees
These fees are paid by the franchisee for receiving initial services from the franchisor.
Such services might include site selection, supervision of construction, bookkeeping
services, and quality control.
2.
Continuing Franchise Fees
These fees are received for ongoing services provided by the franchisor to the
franchisee. Usually, such fees are calculated based on a percentage of franchise
revenues. Such services might include management training, promotion , and legal
assistance. Fees should be reported by the franchisor as revenue when they are
earned.
3.
Franchisor Accounting (franchise fee revenue)
a.
Unearned Revenue
The present value of any contract amounts relating to future services (to be
performed by the franchisor) should be recorded as unearned revenue.
Unearned revenue is recognized as revenue once substantial performance on
such future services has occurred.
b.
Earned Revenue
The franchisor should report revenue from initial franchise fees when all material
conditions of the sale have been "substantially performed." Generally,
"substantial performance" means that the following conditions have been met:
.
(1)
Franchisor has no obligation to refund any payment (cash or otherwise)
received.
(2)
Initial services required of the franchisor have been performed.
(3)
All other conditions of the sale have been met.
Generally, the conditions of the sale are not considered to be substantially
performed until the franchisee's first day of operations, unless the franchisor can
demonstrate otherwise.
c.
Other Recognition Methods
(1 )
Installment or cost recovery percentage methods may be used under
certain circumstances.
(2)
These methods shall be used for earlier recognition of the initial franchise
fee revenue only when:
(a)
Revenue is collectible over an extended period of time; and
(b)
There is no reasonable basis for estimating collectibility.
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F2-11
Financial
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2
EXAMPL E
Peter signed an agreement on J uly 1, Year 1 with Disco Records to operate as a franchisee in New York City. The
initial franchise fee was $75,000 and was paid by a $25,000 down payment with the balance paya ble i n five equal
annual payments of $10,000 begin ning July 1, Year 2. The present value of the five annual payments is $37,908.
Disco Records must perform substantial future services to earn the initial franchise fee. Disco Records must record
unearned fra nchise fee revenue of $62,908 ($25,000 + $37,908) on July 1, Year l.
Franchisor's journal entry to recordfees on July 1, Year 1 :
[till
Cash
[till
Notes receivable
$25,000
50,000
(tm
Discount on notes receiva ble (contra asset)
(tm
Unea rned franchise fee revenue
$12,092
62,908
EXPENSE RECOGNITION (measurement)
A.
-
I ntangi ble Assets-Overview,
Valuation, and Characteristics
I ntangible assets are long-lived legal rights and competitive advantages developed or
acquired by a business enterprise. They are typically acquired to be used in operations of a
business and provide benefits over several accounting periods.
I ntangible assets differ considerably in their characteristics, useful l ives, and relationship to
operations of an enterprise and are classified accordingly.
1.
Classification of Intangible Assets
a.
b.
Identifiability
(1)
Patents, copyrights, franchises, trademarks, and goodwill are the common
intangible assets tested on the CPA examination.
(2)
I ntangible assets may be either specifically identifiable (e.g., patents,
copyrights, franchise, etc.) or not specifically identifiable (e.g., goodwill).
Manner of Acquisition
(1)
Purchased Intangible Assets
I ntangible assets acquired from other enterprises or individuals should be
recorded as an asset at cost. Legal and registration fees incurred to obtain
an intangible asset should also be capitalized .
(2)
Internally Developed Intangible Assets
(a)
U nder U . S . GAAP, the cost of internally intangible assets not
acquired from others (i.e. , developed internally) should be expensed
against income when incurred because U . S . GAAP prohibits the
capitalization of research and development costs.
(b)
Examples (must be expensed)
(i) Trademarks (except for the capitalizable costs identified
below);
(ii) Goodwill from advertising; and
(iii) The cost of developing, maintaining, or restoring goodwill.
F2-12
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(c)
Financial 2
The exception is that certain costs associated with intangibles that
are specifically identifiable can be capitalized, such as:
(i) Legal fees and other costs related to a successful defense of
the asset;
(ii) Registration or consulting fees;
(iii) Design costs (e.g., of a trademark); and
(iv) Other direct costs to secure the asset.
c.
Expected Period of Benefit
Classification of the intangible asset depends upon whether the economic life
can be determined or is indeterminable.
d.
Separability
The classification of the intangible asset depends upon whether the asset can be
separated from the entity (e.g., a patent) or is substantially inseparable from it
(e.g., a trade name or goodwill).
U . S . G A A P V S. I F R S
Under IFRS, research costs related to an internally developed intangible asset must be
expensed, but an intangible asset arising from development is recognized if the entity can
demonstrate all of the following:
•
Technological feasibility has been established.
•
The entity intends to complete the intangible asset.
•
The entity has the ability to use or sell the intangible asset.
•
The intangible asset will generate future economic benefits.
•
Adequate resources are available to complete the development and sell or use the asset.
The entity can reliably measure the expenditure attributable to the development of the
intangible asset.
2.
Capital ization of Costs
A company should record the cost of intangible assets acquired from other enterprises
or i ndividuals in an "arm's length" transaction as assets.
a.
Cost is measured by:
(1 )
The amount of cash disbursed or the fair value of other assets distributed;
(2)
The present value of amounts to be paid for liabilities incurred; and
(3)
The fair value of consideration received for stock issued.
b.
Cost may be determined either by the fair value of the consideration given or by
the fair value of the property acquired, whichever is more clearly evident.
c.
The cost of unidentifiable intangible assets is measured as the difference
between the cost of the group of assets or enterprise acquired and the sum of
the costs assigned to identifiable assets acquired, less liabilities assumed.
d.
The cost of identifiable assets should not include goodwil l .
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F2-13
Becker Professional Education I CPA Exam Review
Financial 2
3.
Amortization
The value of intangible assets eventually d isappears; therefore, the cost of each type of
i ntangible asset (except for goodwill and assets with indefinite lives) should be
amortized by systematic charges to income over the period estimated to be benefited.
A patent is amortized over the shorter of its estimated life or remaining legal life.
a.
Method
The straight-line method of amortization should be applied unless a company
demonstrates that another systematic method is more appropriate. The method
and estimated useful lives of intangible assets should be adequately disclosed in
the notes to the financial statements. Expenses that increase the useful l ife of
the intangible asset require an adjustment to the calculation of the annual
amortization.
b.
Goodwill (impairment approach)
Amortization of purchased goodwill is not permitted. The required approach is to
test goodwill for impairment at least annually.
c.
Miscellaneous Rules
(1 )
Worthless
Write off the entire remaining cost to expense if an i ntangible asset
becomes worthless during the year (e.g., due to a technological
obsolescence or due to an unsuccessful patent defense lawsuit).
(2)
Impairment
Write down the intangible asset and recognize an impairment loss if an
intangible asset becomes impaired (e.g., due to a change i n circumstances
that indicate that the full carrying amount of the asset may not be
recoverable ).
(3)
Change in Useful Life
If the life of an existing intangible asset is reduced or extended, the
remaining net book value is amortized over the new remaining life.
(4)
Sale
If an intangible asset is sold, simply compare its carrying value at the date
of sale with the selling price to determine the gain or loss.
d.
Income Tax Effect
Amortization of acquired intangible assets that are not specifically identifiable
(e.g., goodwill) is deductible over a 1 5-year period in computing income taxes
payable. This may create a temporary difference, and interperiod allocation of
i ncome taxes is appropriate (discussed i n detail i n F6).
F2·14
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Becker Professional Education I CPA Exam Review
4.
Val uation
a.
U.S. GAAP
U nder U.S. GAAP, finite life intangible assets are reported at cost less
amortization and impairment. I ndefinite life intangible assets are reported at cost
less impairment.
b.
IFRS
U nder IFRS, i ntangible assets can be reported under either the cost model or the
revaluation model.
(1 )
Cost Model
U nder the cost model, intangible assets are reported at cost adjusted for
amortization (fin ite life intangible assets only) and impairment.
(2)
Revaluation Model
U nder the revaluation model, intangible assets are initially recogn ized at
cost and then revaluated to fair value at a subsequent revaluation date.
Revaluated intangible assets are reported at fair value on the
reval uation date adjusted for subsequent amortization (finite life intangible
assets only) and subsequent impairment.
Reva luation model carrying va lue
=
Fair value on revaluation date - Subseque n t
a m o rtization - Subsequent i m p a i rment
Revaluations must be performed regularly so that at the end of each
reporting period the carrying value of the intangible asset does not differ
materially from fair value. If an intangible asset is accounted for using the
revaluation model, all other assets in its class must also be revalued unless
there is no active market for the intangible assets.
(a)
Revaluation Losses
Revaluation losses (fair value on revaluation date < carrying value
before revaluation) are reported on the income statement, unless the
revaluation loss reverses a previously recognized revaluation gain.
A revaluation loss that reverses a previously recognized revaluation
gain is recognized in other comprehensive income and reduces the
revaluation surplus in accumulated other comprehensive income.
(b)
Revaluation Gains
Revaluation gains (fair value on revaluation date > carrying value
before revaluation) are reported in other comprehensive income and
accumulated in equity as revaluation surplus, unless the revaluation
gain reverses a previously recognized revaluation loss. Revaluation
gains are reported on the income statement to the extent that they
reverse a previously recognized revaluation loss.
(c)
Impairment
If revalued intangible assets subsequently become impaired , the
is recorded by first reducing any revaluation surplus in
equity to zero with further impairment losses reported on the income
statement.
impairment
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F2·15
Financial 2
Becker Professional Education I CPA Exam Review
EXAMPLE-IFRS INTANGIBLE ASSET REVALUATION
On December 31, Year 2 an entity that had adopted the I FRS revaluation model in Yea r 1 adjusted its patents
to fair value. On that date, the patents had the fol lowing carrying value and fair value:
Carrying Value
$8,200,000
Patents
Fair Value
$9,100,000
The entity had recorded a revaluation loss of $500,000 in Year 1. Compute the revaluation gains to be
reported in Year 2 net income and other comprehensive income.
Total revaluation gain
=
$9,100,000 - $8,200,000
=
$900,000
$500,000 of this ga in will be reported on the income statement as a reversal of the $500,000 revaluation loss
reported in Year 1. The remaining $400,000 ($900,000 - $500,000) gain will be reported in other
comprehensive income as reval uation surplus.
B.
Franchisee Accounting
1.
Initial Franchise Fees
The present value of the amount paid (or to be paid) by a franchisee is recorded as an
intangible asset on the balance sheet and amortized over the expected period of
benefit of the franchise (Le. , the expected life of the franchise).
2.
Continuing Franchise Fees
These fees are received for ongoing services provided by the franchisor to the
franchisee (often referred to as franchise royalties). Usually, such fees are calculated
based on a percentage of franchise revenues. Such services might include
management training, promotion, and legal assistance. Fees should be reported by the
franchisee as an expense and as revenue by the franchisor, in the period incurred.
EXAMPLE-FRANCHIS EE'S INTANGIBLE ASSETS
Peter signed an agreement on J uly 1, Year 1 with Disco Records to operate as a franchisee in
New York City. The initial franchise fee was $75,000 and was paid by a $25,000 down payment
with the balance payable in five equal annual payments of $10,000 beginning J uly 1, Year 2. The
expected life of the franchise is 10 years. The present value of the five annual payments is
$37,908. The amount to be capitalized as an intangible franchise asset on J uly 1, Year 1 is
$62,908 ($25,000 + $37,908).
Franchisee's journal entry to record the franchise at July 1, Year 1:
11m
Franchises
11m
Discount on notes payable (contra liability)
tWO
Notes payable
tWO
Cash
$62,908
12,092
$50,000
25,000
The discount will be recognized as i nterest expense by the fra nchisee over the payment period on an
effective interest basis. The franchise account would appear i n the franchisee's intangible assets
section of the balance sheet and would be amortized over the expected life of the franchise:
Year 1 Amortization
F2-16
=
(Franchise balance / Expected life)
=
($62,908 /10)
=
$3,145
x
x
Months
6/12 (July through December, Year 1)
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Becker Professional Education I CPA Exam Review
C.
Financial 2
Start-up Costs
Expenses incurred in the formation of a corporation (e.g . , legal fees) are considered
organizational costs.
1.
For Book Purposes
Start-up costs, including organizational costs, should be expensed when incurred .
a.
b.
2.
Start-up costs include costs of the one-time activities associated with:
(1 )
Organizing a new entity (e.g. , legal fees for preparing a charter,
partnership agreement, bylaws, original stock certifications, filing fees,
etc.).
(2)
Opening a new facility.
(3)
I ntroducing a new product or service.
(4)
Conducting business in a new territory or with a new class of customer.
(5)
I nitiating a new process in an existing facility.
Start-up costs do not include costs associated with:
(1 )
Routine, ongoing efforts to refine, enrich, or improve the quality of existing
products, services, processes, or facilities.
(2)
Business mergers or acquisitions.
(3)
Ongoing customer acquisition.
For Income Tax Purposes
A business may elect to deduct up to $5,000 each of organizational expenditures and
start-up costs. Each $5,000 amount is reduced by the amount by which the
organizational expenditures or start-up costs exceeds $50,000, respectively. Any
excess organizational expenditures or start-up cost is amortized over 1 80 months
(beginning with the month in which the active trade or business begins). This may
create a temporary difference, and interperiod allocation of income taxes is appropriate.
See lecture F6.
Remember that organizational expenses are not capitalized as an intangible asset. Rather, they are
expensed immediately.
D.
Goodwill
Goodwill is the representation of intangible resources and elements con nected with an entity
(e.g. , management or marketing expertise or technical skill and knowledge that cannot be
identified or valued separately). Goodwill means capitalized excess earni ngs power.
1.
Calculation of Goodwill
a.
Acquisition Method
U nder the acquisition method, goodwill is the excess of an acquired entity's fair
value over the fair value of the entity's net assets, i ncluding identifiable intangible
assets. See lecture F3.
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F2-17
Becker Professional Education I CPA Exam Review
Financial 2
b.
Equity Method
The equity method involves the purchase of a company's capital stock. Goodwill
is the excess of the stock purchase price over the fair value of the net assets
acquired. See lecture F3.
2.
Maintaining Goodwill
Costs associated with maintaining, developing, or restoring goodwill are not capitalized
as goodwil l (they are expensed). In addition, goodwill generated internally or not
purchased in an arm's length transaction is not capitalized as goodwill.
E.
Research and Development Costs
I
Research is the planned efforts of a company to d iscover new information that will help either
create a new product, service, process, or techn ique or significantly improve the one in
. current use. Development takes the findings generated by research and formulates a plan to
create the desired item or to improve significantly the existing one.
1.
Accou nting for Research and Development Costs (U.S. GAAP)
Under U . S . GAAP, the only acceptable method of accounting for research and
development costs is a direct charge to expense, except for:
a.
Materials, equipment, o r facilities (i.e. , tangible assets) that have alternate future
uses.
(1)
b.
2.
Capitalize and depreciate the assets over their useful lives (not the life of
the research and development project).
Research and development costs of any nature undertaken on behalf of others
under a contractual arrangement.
(1)
The purchaser (buying the R&D) will expense as research and
development the amount paid; and the provider (performing the R&D for
the purchaser) wil l expense the costs incurred as cost of sales.
(2)
The conclusion for charging most research and development costs to
expense under U . S . GAAP is the high degree of uncertainty of any future
benefits.
(3)
Disclosure is required in the financial statements or notes of the amount of
research and development charged to expense for the period.
Items Not Considered Research and Development
a.
Routine periodic design changes to old products or troubleshooting in production
stage (these are manufacturing costs, not research and development expenses).
b.
Marketing research.
c.
Quality control testing.
d.
Reformulation of a chemical compound.
1
Under IFRS, research costs must be expensed but development costs may be capitalized if
certain criteria a re met, as stated in the discussion of intangible assets.
F2·18
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Financial 2
Becker Professional Education I CPA Exam Review
EXAMPLE
Facts:
J u lile Co. incurred research and development costs in the current year as follows:
Materials used in research and development projects
$
Equipment acquired that will have alternate future uses in future research and
development projects
400,000
2,000,000
500,000
Depreciation on a bove equipment
1,000,000
Personnel costs of persons involved in research and development projects
Consulting fees paid to outsiders for research and development projects
100,000
Indirect costs reasonably allocable to research and development projects
200,000
Solution:
The following items would qualify as research and development costs and should be expensed
in the current year:
Materials used in research and development projects
Depreciation on equipment used in research and development
Personnel costs of persons involved in research and development projects
$
400,000
500,000
1,000,000
Consulting fees paid to outsiders for research and development projects
100,000
Indirect costs reasonably allocable to research and development projects
200,000
$ 2,200,000
Total
The equipment is not charged to research and development costs because it has alternative
future uses. It should be capitalized as a tangible asset and depreciated over the useful life of
the equipment. The depreciation expense should be charged to research and development.
F.
Computer Software Development Costs
U. s .
GAAP
vs.
IFRS
IFRS does not provide separate guidance regarding computer software development costs. U nder IFRS,
computer software development costs are internally generated intangibles. Research costs must be expensed
and development costs may be capitalized if certai n criteria are met (see the discussion of intangible assets).
1.
Computer Software Developed to be Sold, Leased or Licensed
a.
Tech nological Feasibility
Technological feasibility is established upon completion of:
b.
(1)
A detailed program design, or
(2)
Completion of a working model.
Accounting for Costs
(1 )
Expense costs (planning, design , coding, and testing) incurred until
technological feasibility has been established for the product.
(2)
Capitalize costs (coding, testing, and producing product masters) incurred
after technological feasibility has been established up to the point that the
product is released for sale.
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F2-19
Becker Professional Education I CPA Exam Review
Financial 2
(a)
Amortization of Capitalized Software Costs
Annual amortization (on a product by product basis) is the
GREATER of:
Percentage of revenue
=
Straight line =
(3)
Current-=-gross revenue for-'--period
Total capitalized
amount
x
-
Total capitalized
amount
x
-------
-
-
Total projected gross revenue for product
1
Estimate of economic life
Inventory Costs incurred to actually produce the product are product
costs charged to inventory.
-
A C C O U N T I N G F O R C O ST S
TECHNOLOGICAL
FEASIBILITY
ESTABLISHED
Program design,
planning, coding,
testing
Producing product
masters, including
additional coding/testing
RELEASE PRODUCT
FOR SALE
Duplicate
packaging
Amortization
Expense Begins
c.
Balance Sheet
Capitalized software costs are reported at the lower of cost or market, where
market is equal to net real izable value.
2.
F2-20
Computer Software Developed Internally or Obtai ned for Internal Use Only
a.
Expense costs i ncurred for the preliminary project state and costs incurred for
training and maintenance.
b.
Capitalize costs incurred after the preliminary project state and for upgrades and
enhancements, including:
(1 )
Direct costs of materials and services,
(2)
Costs of employees directly associated with project, and
(3)
Interest costs incurred for the project.
c.
Capitalized costs should be amortized on a straig ht-line basis.
d.
If software previously developed for internal use is subsequently sold to
outsiders, proceeds received (e.g. , from the license of computer software, net of
incremental costs) should be applied first to the carrying amount of the software,
then recognized as revenue (after the carrying amount of the software has
reached zero).
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Becker Professional Education I CPA Exam
IV.
Financial 2
Review
IMPAIRMENT
The carrying amount of intangibles (including goodwill) and fixed assets held for use and to be
disposed of needs to be reviewed at least annually or whenever events or changes in
circumstances indicate that the carrying amount may not be recoverable. Impairment of fixed
assets will be discussed in lecture F4.
A.
Impairment of Intangible Assets Other than Goodwill-U.S. GAAP
Under U . S . GAAP, the impairment test applied to an intangible asset other than goodwill is
determined by the asset's l ife. An i ntangible asset has a finite life when it is possible to
estimate the useful life of the asset. If it is not possible to determine the useful life of an
intangible asset, then the asset has an indefin ite (not infinite) life. If an intangible asset has a
finite life, it is amortized over that life. If it has an indefinite life, it is not amortized.
1.
Intangible Assets with Finite Lives (two step impairment test)
An i ntangible asset with a finite life is tested for impairment using a two step impairment
test.
Step 1-The carrying amount of the asset is compared to the sum of the undiscounted
cash flows expected to result from the use of the asset and its eventual disposition.
Step 2-lf the carrying amount exceeds the total undiscounted future cash flows, then the
asset is impaired and an impairment loss equal to the difference between the
carrying amount of the asset and its fair value is recorded .
P A SS K E Y
It i s important t o note the following when testing a fixed asset o r a n intangible asset with a finite life
for impairment:
2.
•
Determining the im pairment - use undiscounted future net cash flows
•
Amount of i m pairment - use fair value (FV)
Intangible Assets with Indefinite Lives (one-step impairment test)
When testing an intangible asset with an indefinite life (including goodwill) for
impairment, it is generally not possible to estimate total future cash flows expected to
result from the use of the assets and its disposition. As a result, an intangible asset
with an indefinite life is tested for impairment by comparing the fair value of the
intangible asset to its carrying amount. If the asset's fair value is less than its carrying
amount, an impairment loss is recogn ized in an amount equal to the difference.
As described in the following discussion of goodwill impairment, this quantitative
impairment test is not necessary if, after assessing relevant qualitative factors, an
entity determines that it is not more likely than not that the fair value of the indefinite life
intangible asset is less than its carrying amount.
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F2·21
Financial
2
Becker Professional Education I CPA Exam Review
3.
Reporting an Impairment Loss
An impairment loss is reported as a component of income from continuing operations
before income taxes, unless the impairment loss is related to discontinued operations.
The carrying amount of the asset is reduced by the amount of the impairment loss.
Restoration of previously recognized impairment losses is prohibited, unless the asset is
held for disposal.
U . S. G A A P V S . I F R S
Under I FRS, an im pairment loss for an intangible asset other than goodwill is calculated using a one­
step model in which the carrying value of the intangible asset is compared to the intangible asset's
recoverable amount. I FRS defines the recoverable amount as the greater of the asset's fair value less
costs to sell and the asset's value in use. Value in use is the present value of the future cash flows
expected from the intangible asset. IFRS allows the reversal of im pairment losses.
P A SS K E Y - U . S . G A A P
I
FINITE LIFE
I N D E F I N IT E L I F E
Life extends beyond the foreseeable
Useful life i s limited
Characteristics
future or cannot be determined
Amortization
Over useful economic life
None
Impairment test
Two-step test:
One-step test:
•
Undiscounted net cash flows
•
Fair value
•
Fair value
Undiscounted future net cash flows·
<
Net carrying value >
Assets held
for use
<
Assets held
for disposal
Fair value
Net carrying value >
Impairment loss
+ Cost of disposal
Total impairment loss
Fair value
Net carrying value >
Impairment loss
1.
Write asset down
3.
Restoration not permitted
<
2. Depreciate new cost
1. Write asset down
2. No depreciation taken
3.
•
When testing indefinite life intangible assets for impairment, fair value must be used instead of
undiscounted future net cash flows:
Fair value - Net carrying value
F2-22
Restoration permitted
=
Positive (no impairment) or Negative (impairment).
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11
Becker Professional Education I CPA Exam Review
Financial 2
E XA M PLE 1
Facts:
Assets net carrying value is $900,000
•
Net future cash flows are projected as $1,000,000
$1,000,000
<
900,000
>
$ 100,000
�
No impairment loss
EXAMPLE 2
Facts:
Assets net carrying value is $ 1,200,000
Net future cash flows are projected as $ 1,000,000
Assumption 1-Asset held for use, and
o
FV!PV net cash flows are $700,000
Assumption 2 -Asset is held for disposal, and
o
FV!PV net cash flows are $700,000
o
Cost of disposal will be $100,000
<
I
I
$1,000,000
$1,200,000 >
TI
Impairment
Assets held
Assets held
for use
for disposal
I
700,000
< $1,200,000 >
$ 500000
1. Write asset down.
Depreciate new cost.
3. Restoration not permitted.
2.
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$ 700,000
< 1,200 000 >
+
500,000
100000
$ 600000
1. Write asset down.
2. No depreciation taken.
3. Restoration is permitted.
F2-23
Becker Professional Education I CPA Exam Review
Financial 2
B.
Goodwill Impairment-U.S. GAAP
Goodwill impairment is determined using a different approach. Goodwill impairment is
calculated at a reporting unit level. Impairment exists when the carrying amount of the
reporting unit goodwill exceeds its fair value.
1.
Definition of Reporti ng Unit
A reporting unit is an operating segment, or one level below an operating segment.
The goodwill of one reporting unit may be impaired , while the goodwill for other
reporting units may or may not be impaired.
2.
Evaluation of Goodwill Impairment
The evaluation of goodwill impairment involves two major steps.
Step 1-ldentify potential impairment by comparing the fair value of each
reporting unit with its carrying amount, including goodwill.
a.
b.
(1)
Assign assets acquired and liabilities assumed to the various reporting
units. Assign goodwill to the reporting units.
(2)
Determine the fair val ues of the reporting units and of the assets and
liabilities of those reporting units.
(3)
If the fair value of a reporting unit is less than its carrying amount, there is
potential goodwill impairment. The impairment is assumed to be due to the
reporting unit's goodwill since any impairment in the other assets of the
reporting unit will already have been determined and adjusted for (other
impairments are evaluated before goodwill).
(4)
If the fair value of a reporting unit is more than its carrying amount, there is
no goodwill impairment and Step 2 is not necessary.
2-Measure the amount of goodwill impairment loss by comparing the
implied fair value of the reporting unit's goodwill with the carrying amount of that
goodwil l .
Step
(1)
Allocate the fair value of the reporting unit to all assets and liabilities of the
unit. Any fair value that cannot be assigned to specific assets and
l iabilities is the implied goodwill of the reporting unit.
(2)
Compare the implied fair value of the goodwill to the carrying value of the
goodwill. If the implied fair value of the goodwill is less than its carrying
amount, recognize a goodwill impairment loss. Once the goodwill
impairment loss has been fully recognized , it cannot be reversed .
P A SS K E Y
Under U.S. GAAP, t h e goodwill a n d indefinite l ife intangible asset impairment tests have been simplified
by a llowing companies to test qualitative factors to determine whether it is necessary to perform the
relevant quantitative impairment tests. Examples of qualitative factors include:
•
Macroeconomic conditions
•
I nd ustry and market conditions
•
Overall financial performance
•
Sustained decrease in share-price
Entity-specific events such as bankruptcy, litigation,
or changes in management, strategy, or customers
•
Cost factors that could have a negative effect
on earnings and cash flows
•
The quantitative impairment tests are not necessary if, after assessing the relevant qualitative factors, an
entity determines that it is not more likely than not that the fair value of the reporting unit or indefinite
life intangible asset is less than its carrying amount. If the qualitative assessment indicates that there is a
greater than fifty percent chance that the fair value of the reporting unit or indefinite life intangible asset is
less than its carrying amount, then the entity must perform the quantitative impairment test.
F2-24
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Financial 2
Becker Professional Education I CPA Exam Review
E X A M P L E - G O O D W I L L I M PA I R M E N T ( U .S. GAAP)
Omega I nc. has two reporting units, Alpha and Beta, which have book values including goodwill of $500,000
and $675,000, respectively. Alpha reports goodwill of $50,000 and Beta reports goodwill of $75,000. As part
of the company's annual review for goodwill impairment, Omega determined that the fair values of Alpha and
Beta were $480,000 and $700,000, respectively, at December 31, Year 1. Determine whether the reporting
units' goodwill is potentially impaired.
Alpha:
Reporting U nit FV-Reporting Unit BV
=
$480,000 - 500,000
=
($20,000)
Beta :
Reporting U nit FV-Reporting Unit BV
=
$700,000 - 675,000
=
$25,000
Solution:
Because Alpha's fair value is less than its book value, there is potential goodwill impairment. Beta's goodwill
is not impaired.
To determine the amount of Alpha's goodwill impairment loss, Omega assigned $460,000 of Alpha's $480,000
fair value to Alpha's assets and liabilities. The $20,000 d ifference ($480,000 - 460,000) cannot be assigned to
specific assets or liabilities and is Alpha's implied goodwill. Calculate Alpha's impairment loss at December 31,
Year 1.
Impairment Loss
=
Goodwill Implied FV - Goodwill BV
=
$20,000 - 50,000
=
($30,000)
Journal entry to record goodwill impairment at December 31, Year 1 :
Loss due t o impairment
$30,000
Goodwill
$30,000
u.s. GAAP vs.
I F RS
Under I FRS, goodwill impairment testing is done at the cash-generating u nit (CG U ) level. A cash-generating
unit is defined as the smallest identifiable group of assets that geneFates cash inflows that are largely
independent of the cash inflows from other assets or groups of assets. The goodwill impairment test is a one­
step test in which the carrying value of the CGU is compared to the CGU's recoverable amount, which is the
greater of the CGU's fai r value less costs to sell and its value in use. Value in use is the present value of the
future cash flows expected from the CGU. An impairment loss is recognized to the extent that the carrying
value exceeds the recoverable a mount. The impairment loss is first allocated to goodwill and then a llocated
on a pro rata basis to the other assets of the CGU.
v.
CORRECTING AND ADJUSTING ACCOUNTS
A.
Objective is to Match Expenses Against Related Revenues
The objective of an income statement presentation is to match related expenses with their
revenues. This exercise includes typical audit-type adjustments related to the matching of
expenses with revenues that the examiners have tested on the CPA exam.
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F2-2S
Financial 2
B.
Becker Professional Education I CPA Exam Review
Exercise-Three-year Net Income and Ending Balance Sheet
This exercise is designed to illustrate the effect on income of the following transactions.
3 Year Income Statement-
Net Income Per Books
Year 1
Year 2
(5,000)
(8,000)
(10,000)
(200)
100
(2,000)
2,000
1. The company purchased a $300, 3-year insurance policy on 1/1/Year
2 and expensed it all in Year 2.
2. $2,000 of credit sales made in Year 2 were not recorded until
collected in Year 3.
Year 3
3. $3,000 of Year 3 sales and related accounts receivable outstanding on
12/31/Year 3 was not recorded.
(3,000)
4. $1,500 of accounts payable (for expenses incurred) during Year 3
were omitted at 12/31/Year 3 and expensed when paid in Year 4.
1,500
5. $400 was paid in Year 3 and was charged to rent expense. This
payment covers rent for December Year 4 in a lease ending
12/31/Year 4.
6. The direct write off method (non-GAAP method) was used to write off
a $650 bad debt in Year 3. The original sale was made in Year 1.
(400)
650
Balance Sheet 12/31/Year 3
DR
CR
AIC Title
(Unexpired ins.)
prepaid insurance
100
Accounts
receivable
3,000
1,500
400
Accounts
payable
Prepaid rent
(650 )
7. Two identical inventory purchases were made by two separate
operating divisions - Division A and Division B. Both $1,300 purchases
of raw materials were purchased FOB shipping point and were in
transit on 12/31/Year 3. They were not included in the actual
12/31/Year 3 inventory count (the effect of this correction on the
financial statements is the same whether the perpetual or periodic
inventory system is used).
1,300
Inventory
a. Division A: Inventory and liability not recorded.
1,300
-0b. Division B: Inventory not recorded, but liability and "cost of sales"
were recorded.
(1,300)
(4,350)
Correct net income
(10,200)
1,300
I nventory
(11,750)
6,100
Balance sheet adjustments
2,800
3,300
•
Note: The brackets under the Years 1, 2, and
3
Accounts payable
Retained earnings
columns represent income, not losses. Thus Year 1 net income per books is $5,000 and the subsequent
$400 adjustment would increase income by $400.
F2-26
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Financial 2
Becker Professional Education I CPA Exam Review
Explanations:
1 . The $300 paid for insurance in Year 2 should have been debited to
prepaid insurance. At year-end of Year 2, two
years of insurance coverage are left and one year has expired . The ($200) is a credit to income i n Year 2 . This
combined with the $300 insurance expense already charged in Year 2, results in the proper $ 1 00 charge to
income. The $ 1 00 charge to income for Year 3, represents the correct amount of insurance expense for Year 3,
$ 1 00 per year. The $ 1 00 debit under balance sheet 1 2/3 1 IYear 3, reflects the correct balance of prepaid
insurance as of that date. As of 1 2/3 1 IYear 3, one year of insurance coverage remains.
2 . Accord ing to the revenue recog nition principle and accrual accou nting, sales should be recorded in the period the
revenue is earned. The Year 2 ($2,000) credit to income, properly records the credit sales. The Year 3, $2,000
charge to income removes the revenue recorded in that period.
3. The rationale for the income statement adjustment is the same as i n #2. The credit sales should be reflected i n
t h e period of sale, Year 3 , a n d the 1 2/3 1 IYear 3 balance sheet should reflect the correct $3,000 accounts
receivable balance.
4 . Expenses should be recorded i n the period "incurred . " The Year 3, $1 ,500 charge to income, records the correct
expense i ncurred. The 1 2/3 1 IYear 3 balance sheet will now show the $ 1 ,500 as accounts payable.
5. The $400 paid in Year 1 represents
prepaid rent. The ($400) adjustment to Year 1 removes the incorrect charge
prepaid rent.
to income, and the 1 2/31 IYear 3 balance sheet is adjusted to properly reflect the asset
6. According to the matching principle, expenses should be recorded in the same period as the related revenue. Since
the sale was made in Year 1 , the related expense of the sale (the bad debt expense) should be recorded in Year 1 .
The adjustment here ($650) removes the charge from Year 3 income and puts it in the proper year, Year 1 .
7. The correct journal entry for either division would have been:
IIlD
Inventory (perpetual system)
$1,300
Purchases (periodic system )
$1,300
Accounts payable
Since division A did not make any entry, the correction entry for division A is just the correct original entry. Since
division B charged cost of sales instead of inventory or purchases, the correction here removes the charge to
Year 3 income and sets up the proper inventory balance. Accounts payable is already correctly stated.
The final $3,300 increase to retained earnings, reflects all cumulative adjustments to income through Year 3:
-$200
+
100 - 2,000
+
2,000 - 3,000
+
1,500 - 400
+
650 - 650 - 1,300
=
-$3,300
Remember: In this schedule, ($) are credits or i ncreases to i ncome.
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F2-27
Financial
Becker Professional Education I CPA Exam Review
2
-----
I.
LO N G -T E R M C O N ST R U CTI O N CONTRACTS
COMPLETED CONTRACT M ETHOD (U.S. GAAP only)
The completed contract method recognizes income only on completion (or substantial
completion) of the contract.
A contract is regarded as substantially complete if the remaining costs are insignificant.
A.
Requirements
It is acceptable to use the completed contract method when :
B.
1.
It is difficult to estimate the costs of a contract in progress.
2.
There are many contracts in progress so that about an equal number are completed in
each year and an unequal recognition of income does not result.
3.
The projects are of short duration , and collections are not assured .
Balance Sheet Presentation
The excess of accumulated costs over related billings should be reflected in the balance
sheet as a current asset, and the excess of accumulated billings over related costs should be
reflected as a current l iability. In the case of more than one contract, the accumulated costs
or liabilities should be separately stated on the balance sheet.
The preferred terminology for the balance sheet presentation should be "Costs (billings) of
uncompleted contracts in excess of related billings (costs)."
"Progress billings" and "construction in progress" are merely different accounts representing
the same contract asset and should be shown net of their related contra accounts.
1.
2.
Current Asset Accounts
a.
Due on accounts (receivable).
b.
Cost of uncompleted contracts in excess of progress billings (sometimes called
"construction in progress").
Current Liability Account
Progress billings on uncompleted contracts in excess of cost.
C.
Accounting for the Completed Contract Method
The following are important points to remember in accounting for contracts under the
completed contract method :
1.
Applicable overhead and direct costs should be charged to a construction i n progress
account (an asset).
2.
Billings and/or cash received should be credited to advances on construction in
progress account (a liability).
3.
At completion of the contract, gross profit or loss is recognized as follows:
Contract price - Total costs
F2-28
=
G ross profit or loss
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Financial 2
Becker Professional Education I CPA Exam Review
D.
4.
At interim balance sheet dates, the excess of either the construction in progress
account or the advances account over the other is classified as a current asset or a
current liability. It is classified as current because of the current operating cycle
concept.
5.
Losses should be recognized in full i n the year they are discovered . An expected loss
on the total contract is determined by:
a.
Adding estimated costs to complete to the recorded costs to date to arrive at total
contract costs.
b.
Adding to advances any additional revenue expected to arrive at total contract
revenue.
c.
Subtracting (b) from (a) to arrive at total estimated loss on contract.
Advantages/Disadvantages
The primary advantage of the completed contract method is that it is based on final results
rather than on estimates.
The primary disadvantage of the completed contract method is that it does not properly
reflect the matching principle when the period of the contract extends over more than one
accounting period .
U.S
GAAP VS. I F RS
Under IFRS, the completed contract method is not permitted. The percentage of completion method must be
used unless the final outcome of the project cannot be reliably estimated, in which case the cost recovery
method is required. Under the cost recovery method, revenue can only be recognized to the extent that cash
collected exceeds the costs incurred.
II.
PERCENTAGE-OF-COMPLETION M ETHOD (U.S. GMP and IFRS)
A.
Requirements
It is appropriate to use the percentage-of-completion method when collection is assured and
the entity's accounting system can :
B.
1.
Reasonably estimate profitability; and
2.
Provide a reliable measure of progress toward completion.
Revenue Recognition
Revenue must be earned before it is recogn ized.
1.
Revenues are generally recognized when:
a.
The earnings process is complete or virtually complete; and
b.
An exchange has taken place.
2.
The percentage of completion method recognizes income as work progresses on the
contract.
3.
Accounting for long term construction contracts by the percentage of completion
method is an exception to the basic realization principle. This exception is based on
the evidence that the ultimate proceeds are available and the consensus that a better
measure of periodic income results (principle of matching revenues and costs).
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F2-29
Becker Professional Education I CPA Exam Review
Financial 2
C.
Determination of Reven ues Recognized
Income recognized is the percentage of estimated total income either:
D.
1.
That incurred costs to date bear to total estimated costs based on the most recent cost
information , or
2.
That may be indicated by such other measure of progress toward completion
appropriate to the work performed .
Material and Subcontract Costs
During the early stages of a contract, all or a portion of items such as material not used and
subcontract costs may be excluded in determining the percentage of completion if it appears
that the exclusion would produce a more meaningful allocation of periodic income.
E.
Losses
A provision for the loss on the entire contract should be made when current estimates of the
total contract costs indicate a loss.
F.
1.
However, when a loss is indicated on a total contract that is part of a related group of
contracts, the group may be treated as a unit in determining the necessity of providing
for losses.
2.
Income to be recognized under the percentage of completion method at various stages
should not ordinarily be measured by interim billings.
Balance Sheet Presentation
"Progress billings" and "construction-in-progress" are merely different accounts representing
the same contract asset and should be shown net of their related contra accounts.
1.
2.
Current Asset Accounts
a.
Due on accounts (receivable).
b.
Costs and estimated earnings of uncompleted contracts in excess of progress
billings (sometimes called "construction in progress").
Current Liability Account
Progress billings in excess of cost and estimated earnings on uncompleted contracts.
G.
Advantages/Disadvantages
The principal advantages of the percentage of completion method are the accurate reporting
of the status of the uncompleted contracts and the periodic recognition of income currently
(rather than irregularly) as contracts are completed .
The principal disadvantage of the percentage of completion method is the necessity of
relying on estimates of the ultimate costs.
1
1
I
1
F2-30
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,
Becker Professional Education I CPA Exam Review
H.
Financial 2
Accounting for the Percentage of Completion Method
The following are important points to remember in accounting for contracts under the
percentage of completion method :
1.
Journal entries and interim balance sheet treatment are the same as the completed
contract method except that the amount of estimated gross profit earned in each period
is recorded by charging the construction in progress account and crediting realized
gross profit.
2.
Gross profit or loss is recognized i n each period by the following steps:
Step
1: Com pute gross profit of completed contract:
Contract p rice
< Estimated tota l cost >
Gross profit
Step
2: Com pute "% of compl etio n " :
Tota l cost t o date
Tota l estimated cost of contract
Step
3: Com pute gross profit earned ( profit to date)
Step 4:
Com pute gross profit earned for current year:
Step 1
x
Step 2
=
PTD
PTD at current FYE
< PTD at b eginning of pe riod >
Current yea r-to-date G P
3.
An estimated loss on the total contract is recognized immediately in the year it is
discovered. However, any previous gross profit or loss reported in prior years must be
adjusted for when calculating the total estimated loss.
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F2-31
Becker Professional Education I CPA Exam Review
Financial 2
Long-term Contract Gross Profit Computation Worksheet
I.
Year 1
Year 2
Year 3
$4,000,000
$4,000,000
$4,000,000
$4,000,000
3,000,000
3,200,000
4,200,000
4,300,000
1,500,000
2,400,000
3,600,000
4,300,000
Facts:
Sales Price
Total (estimated) cost of contract
Costs incurred to date
Year 4
PERCENTAGE OF COMPLETION
Year 1
Year 2
Year 3
Year 4
$ 4,000
$ 4,000
$ 4,000
$ 4,000
STEP 1-Compute GP of Completed Contract:
Total contract sales price
Less: Total estimated cost of contract
Total gross profit
(3,000)
�)
(4,200)
(4,300)
$ 1,000
�
$
$ 1,500
$ 2,400
$ 3,600
$ 4,300
$3,000
$3,200
$4,200
$ 4,300
(200)
$
(300)
STEP 2-Compute "% of completion":
Costs incu rred to date
Total estimated cost of contract
Percentage of completion
50%
100%
75%
100%
( Loss Rule)
STEP 3-Compute GP earned to date:
$ 1,000
Total Contract GP
x
�
$
(200)
100%
75%
50%
% of completion
$
500
$
600
Previously recognized
$
-0-
$
500
�
Current year gross profit
$
500
$
100
$
GP earned to date (cumulative)
$
(200)
$
(300)
100%
$ (300)
STEP 4-Compute GP earned each year-
"% of completion method":
LWll)
(800)
$ (100)
(200)
$ (100)
COMPLETED CONTRACT
Compute GP earned each year-"Completed contract method" :
$
-0-
$
-0-
$
COMPUTATIONS
III.
OTHER CONSIDERATIONS
A.
Change in Method
A change in the method of accounting for long-term construction-type contracts is a change
in accounting principle. The general rule for presenting changes in accounting principle is
that changes are reported retrospectively. This type of change is reported retrospectively.
B.
Disclosure
Generally, long-term construction contracts require no special disclosure because they are, in
fact, the nature of the contractor's business. However, unusual extraordinary commitments
should be fully disclosed in the financial statements or footnotes thereto.
F2-32
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Becker Professional Education I CPA Exam Review
Financial
2
A C C O U N T I N G F O R I N S TA L L M E N T S A L E S
I.
ACCOUNTING FOR INSTALLMENT SALES
The installment method of accounting is used only when there is no reasonable basis for estimating
the degree of collectibility. U nder installment accounting, revenue is not recogn ized at the time a
sale is made but rather when cash is actually collected .
A.
Problem Solving Formulas
G ross p rofit
=
Sale - Cost of goods sold
G ross profit percentage
Earned gross p rofit
=
Deferred gross p rofit
=
G ross p rofit / Sales price
Cash collections
=
x
G ross profit percentage
I nsta l l ment receiva b l e
x
G ross p rofit percentage
EXAMP L E
Assume that TAG Company began operations o n January 1 , Year 1 , had $400,000 i n installment sales i n
Year 1 and a December 31, Year 1 , balance i n installment accounts receivable of $150,000. If the TAG
Company had $300,000 as its cost of goods sold, it would calculate realized profit and deferred profit
in Year 1 as follows:
Year 1
Step 1: Gross Profit
Sale on installment
$
Cost of goods sold
Total gross profit
400,000
(300,000)
$
100,000
Step 2: G ross Profit Percentage
Gross profit
$100,000
Sale on installment
400,000
Step 3: Earned Gross Profit
Sale on installment
$
Ending installment accounts receivable
Collections
(150,000)
$
Gross profit percentage
Gross profit earned
400,000
250,000
25%
$
62,500
$
150,000
Step 4: Deferred Gross Profit
Endings installment accounts receivable
Gross profit %
Deferred gross profit
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25%
�
37,500
F2-33
Becker Professional Education I CPA Exam Review
Financial 2
PASS KEY
Examiners require candidates to determine balance sheet presentation.
Balance Sheet Presentation
Accounts receivable
$ 150,000
less: Deferred gross profit*
-
Balance
$ 1 12,500
*
37,500
The deferred gross profit is a contra asset.
E X A M P L E - I N S TA L L M E N T S A L E J O U R N A L E N T R I E S
TAG Company would record the following journal entries during Year l.
Journal entry to record the installment sale:
Installment sale accounts receivable
$400,000
$300,000
Inventory
100,000
Deferred gross profit (contra-receivable)
Journal entry to recognize cash collection:
$250,000
Cash
$250,000
Installment sale accounts receivable
Journal entry to record profit on collection:
Deferred gross profit
Realized gross profit on installments sales
II.
$62,500
$62,500
COST RECOVERY M ETHOD
A.
General
U nder the cost recovery method , no profit is recognized on a sale until all costs have been
recovered. At the time of sale, the expected profit on the sale is recorded as deferred gross
profit. Cash collections are first applied to the recovery of product costs. Collections after all
costs have been recovered are recognized as profit.
F2-34
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Becker Professional Education I CPA Exam Review
Financial
2
EXAMPLE
Assume that TAG Company began operations on January 1, Year 1, had $400,000 in cost recovery sales i n Year
1 and a December 31, Year 1, balance in cost recovery accounts receivable of $150,000. If the TAG Company
had $300,000 as its cost of goods sold, it would calculate realized profit and deferred p rofit in Year 1 and Year
2 as follows:
Cost recovery sale
Cost of goods sold
Total gross profit
$ 400,000
(300,000)
$ 100,000
Cash collections:
Year 1
$ 250,000
Year 2
150,000
Journol entry to record the sole under the cost recovery method:
Cost recovery receivable
$400,000
$300,000
Inventory
100,000
Deferred gross profit
Journal entry to record the Year 1 collection:
$250,000
Cash
$250,000
Cost recovery receivable
Year 1: All of the $250,000 collected is treated as recovery of the $300,000 cost of the inventory.
Journal entries to record the Year 2 collection:
11m
(Wl1
$150,000
Cash
$ 150,000
Cost recovery receivable
and
11m
(Wl1
Deferred gross profit
Realized gross profit on cost recovery sales
$100,000
$100,000
Year 2: The first $50,000 collected is treated as recovery of cost of the inventory. The remaining $100,000
collected is gross profit.
B.
Comparison to Other Methods
The cost recovery method is similar to the installment sales method in that it may only be
used when receivables are collected over an extended period and there is no reasonable
basis for estimating their collectibility.
Because no profit is recognized u ntil all costs have been recovered, the cost recovery
method is the most conservative method of revenue recognition.
l
l
I
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F2-35
Financial
2
Becker Professional Education I CPA Exam Review
A C C O U N T I N G F O R N O N M O N E TA R Y E X C H A N G E S
I.
EXCHANGES HAVING COMMERCIAL SUBSTANCE
U .S . GAAP requires that exchanges of nonmonetary assets be categorized into one of two groups:
Those that have "commercial substance," and
Those that lack "commercial substance."
An exchange has commercial substance if the future cash flows change as a result of the
transaction . The change can either be in the areas of risk, timing, or amount of cash flows. I n other
words, if the economic position of the two parties changes because of the exchange, then the
exchange has "commercial substance." A fair value approach is used.
PASS KEY
The fair val ue of assets given u p is assumed to be equal to the fair value of assets received, including any cash given
or received in the transaction. A simple solution framework for a journal entry is as follows:
1))11
Accumulated depreciation of asset given u p
11m
Cash received
1))11
Loss (if any)
(till
tw:9
(till
A.
New asset (FV of consideration given)
1))11
Old asset at historical cost
Cash given
Gain (if any)
Recognizing Gains and Losses
Gains and losses are always recognized in exchanges having commercial substance and are
computed as the difference between fair value and book value of the asset given up.
EXAMPLE
Foxy Company exchanged used cars for a building that could possibly become Foxy Company's storage space.
Future cash flows will significantly change. The book value of the cars totals $40,000 (cost of $102,000 accumulated depreciation of $62,000). The cars' fair value is $45,000. In addition, Foxy must pay $20,000
cash as part of the exchange. Calculate the gai n to be recognized on the exchange.
$ 45,000
Fair value of cars
Book value of cars:
Cost of cars
Accumulated depreciation
Book value
Gain on disposal of cars
$ 102,000
(62,000)
(40,000)
$ 5,000
The cash given up does not enter into the calculation of gain on exchange, which is fair value less book value.
1
F2-36
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Becker Professional Education I CPA Exam Review
B.
Financial 2
Calculation of Basis of Acquired Asset
The cash given up in the exchange is used to calculate the building's basis on Foxy's books.
EXAMPLE
:
Given the same facts as i n the previous example, what would be the basis of the new building on Foxy
Company's books?
$ 45,000
Fair value of cars given up
20,000
Plus: Cash paid
$ 65,000
Building cost (basis)
Journal entry to record the exchange and the gain on the exchange:
11m
Building
11m
Accumulated depreciation - cars
ltm
$65,000
62,000
$102,000
Cars
ltm
5,000
Gain on disposal of cars
ltm
20,000
Cash
If the FV of the cars in the last example was $38,000 instead of $45,000, a loss of $2,000 (FV $38,000 - BV
$40,000) would be recognized and the basis of the building would be $58,000 ($38,000 FV + $20,000
cash).
Journal entry to record the exchange and the loss on the exchange:
11m
Building
11m
Accumulated depreciation - cars
11m
Loss
ltm
ltm
$58,000
62,000
2,000
Cars
$102,000
Cash
20,000
u.s
GAAP
vs.
IFRS
Under IFRS, nonmonetary exchanges are characterized as exchanges of similar assets and exchanges of
dissimilar assets. Exchanges of dissimilar assets a re regarded as exchanges that generate revenue and are
accounted for in the same manner as exchanges having commercial substance under U.S. GAAP. Exchanges
of similar assets are not regarded as exchanges that generate revenue and no gains are recognized.
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F2-37
Becker Professional Education I CPA Exam Review
Financial 2
II.
EXCHANGES LACKING COMM ERCIAL SU BSTANCE
If projected cash flows after the exchange are not expected to change significantly, then the
exchange lacks commercial substance. The following accounting treatment is used (note that this
method must also be used in any exchange in which fair values are not determinable, or if the
exchange is made to facilitate sales to customers):
A.
Gains
1.
No Boot is Received
=
N o Gain
If the exchange lacks commercial substance and no boot is received , no gain is
recognized.
2.
Boot is Paid
=
No Gain
If the exchange lacks commercial substance and boot is paid, no gain is recognized .
3.
Boot is Received
=
Recognize Proportional Gain « 25% rule)
If the exchange lacks commercial substance and the boot received is less than 25%
of the total consideration received, a proportional amount of the gain is recognized. A
ratio (the total boot received / the total consideration received) is calculated , and that
proportion of the total gain realized is recognized.
4.
Boot is 25% or More of Total Consideration
When the boot received equals or exceeds 25% of the total consideration, both parties
consider the transaction a monetary exchange and gains and losses are recognized in
their entirety by both parties to the exchange.
B.
Losses
If the transaction lacks commercial substance and a loss is indicated , the loss should be
recognized .
E XA M P L E - N O B O OT
=
NO GAIN RECOGNIZED
Assume:
•
Machine A is exchanged for Machine B
•
Machine A, carrying value (BV) " $10,000
•
Machine A, fair value (FV) " $12,000
•
Machine B, fair value (FV) " $12,000 (FV given " FV received)
1
1
1
Calculate the total gain as follows:
FV of asset given - BV of asset given
$12,000 - 10,000 " $2,000 ga in
The gain is not recognized because the exchange lacks commercial substance and boot is not included i n the
transaction. As a result, the basis of the acquired asset is equal to the basis of the old asset, which is also
equal to the assets fair value less the deferred gain.
Journal entry to record the above transaction:
11m
rI:D
F2-38
Machine B
Machine A
$10,000
$10,000
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Becker Professional Education I CPA Exam Review
Financial 2
EX A M P L E - B O O T I S P A I D
=
N O GA I N R E C O G N I Z E D
Assume:
•
Machine A and $2,500 is exchanged for Machine B
•
Machine A, carrying value (BV)
•
Machine A, fair value (FV)
=
$12,000
•
Machine B, fair value (FV)
=
$14,500 ( FV given
=
$10,000
=
FV received)
Calculate the total gain as follows:
FV of asset given* - BV of asset given*
$14,500 - 12,500
•
=
$2,000 gai n
Note that the assets given include Machine A plus $2,500.
The gain is not recognized because the exchange lacks commercial substance and boot is paid. As a result, the
basis of the acquired asset is equal to the basis of the old asset plus the cash paid.
Journal entry to record the above transaction:
$12,500
Machine B
$10,000
Machine A
Cash
2,500
EXA M P L E - B O OT I S R E C E I V E D « 25" R U L E )
=
PROPORTIONAL GAIN RECOGNI2ED
Assume:
•
Machine A is exchanged for Machine B and $2,500
•
Machine A, carrying value (BV)
•
Machine A, fair value ( FV)
=
$12,000
•
Machine B, fair value (FV)
=
$9,500 (FV given
=
$10,000
=
FV received)
Calculate the total gain as follows:
FV of asset given - BV of asset given
$12,000 - 10,000
=
$2,000 total gai n
T h e $2,500 cash is 2 1 % o f t h e consideration received ($2,500/$12,000
the gain is recognized:
Recognized gain
=
=
Realized gain
$2,000 x ($2,500/$12,000)
=
x
=
21%), s o a proportional amount of
(Boot received/FV received)
$417
Journal entry to record the above transaction:
11m
Machine B
11m
Cash
tD
tD
$7,917 (plug)
2,500
Machine A
Gain on exchange
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$10,000
417
F2-39
Becker Professional Education I CPA Exam Review
Financial 2
E X A M P L E - B O O T R E C E I V E D ( � 2 5 " R U L E)
=
All GAIN RECOGN IZED
Assume:
•
Machine A is exchanged for Machine B and $6,000
•
Machine A, carrying va lue (BV)
=
$10,000
•
Machine A, fair value (FV)
=
$12,000
•
Machine B, fair value (FV)
=
$6,000 (FV given
=
FV received)
Calculate the total gain as follows:
FV of asset given - BV of asset given
$12,000 - 10,000
=
$2,000 total gain
The $6,000 cash is 50% of the consideration received ($6,000/$12,000
and the machine acquired is recognized at fair value.
=
50%), so the entire gain is recognized
Journal entry to record the above transaction:
Machine B
$6,000 (plug)
Cash
6,000
Machine A
$10,000
Gain on exchange
2,000
EXAMPLE- lOSSES RECO G N IZED I N FUll
Assume:
•
Machine A is exchanged for Machine B
•
Machine A, carrying va lue ( BV)
•
Machine A, fair value (FV)
=
$8,000
•
Machine B, fair va lue (FV)
=
$8,000 (FV given
=
$10,000
=
FV received)
Calculate the total gain as follows:
FV of asset given - BV of asset given
$8,000 - 10,000
=
$(2,000)
Losses are recognized in full in all exchanges lacking commercial substance.
Journal entry to record the above transaction:
Machine B
Loss on Exchange
Machine A
F2-40
$8,000
2,000
$10,000
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Financial
Becker Professional Education I CPA Exam Review
III.
2
INVOLUNTARY CONVERSIONS
A.
Overview
Whenever a nonmonetary asset is involuntarily converted (e. g . , fire loss, theft, or
condemnation) to cash, the entire gain or loss is recogn ized for financial accounting
purposes.
E X A M P L E - G A I N O N C O N D E M N AT I O N
Facts:
On 12/1/Yr 1, Sykes Company received a condemnation award of $100,000 for the forced sa le of Sykes
Company's factory building. At that time, Sykes Company's building had a book value of $75,000. Compute
the gain or loss.
Solution:
$ 100,000
Proceeds from condemnation
(75,000)
Less: Book value of nonmonetary asset (factory building)
$
Gain on condemnation
25,000
Journal entry to record the above transaction
11m
t.tm
$100,000
Cash
Building
Gain on involuntary conversion
B.
$75,000
25,000
Tax Treatment
The rules for involuntary conversions are different for tax purposes. If a gain is recognized
for financial purposes in one period and for tax purposes in another period, a temporary
difference will result. I nterperiod tax allocation will be necessary (the interperiod tax
allocation is covered i n lecture F6).
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F2-41
Financial 2
Becker Professional Education I CPA Exam Review
F I N A N C I A L R E P O RT I N G A N D C H A N G I N G P R I C ES
I.
OVERVIEW
U nder U.S. GAAP, certain large, publicly held companies may disclose information concerning the
effect of changing prices.
A.
II.
1.
Historic cost - The actual exchange value in the dollars at that time an asset was
acquired or a liability was assumed .
2.
Current cost - The cost that would be incurred at the present time, the replacement
cost. Use the recoverable amount if lower.
3.
Nominal dollars
4.
Constant dollars -
- U nadjusted for changes in purchasing power.
Dollars restated based on calculations of CPI ratios.
MEASUREMENT M ETHODS AND CURRENT COST DETERMI NATION
A.
III.
Simple Defi nitions
There are four methods of measuring prices and the effects of price changes:
1.
Historic Cost/Nominal Dollars (HCND) is based on historic prices without restatement
for changes in the purchasing power of the dollar. This method is the basis for GAAP
used in the primary financial statements.
2.
is based on historic prices adjusted for changes
in the general purchasing power of the dollar. This method uses a general price index
(e.g. , Bureau of Labor Statistics Consumer Price I ndex-BLS CPI) to adjust historic
cost; it retains the historic cost basis.
3.
Current Cost/Nominal Dollars (CCND) is based on current cost without restatement for
(or recognition of) changes in the general purchasing power of the dollar.
4.
Current Cost/Constant Dollars (CCCD) is based on current cost adjusted for (giving
recogn ition to) changes in the general purchasing power of the dollar. This method
may use specific price indexes or direct pricing to determine current cost and will use a
general price index to measure general purchasing power effects.
Historic Cost/Constant Dollars (HCCD)
MONETARY AND NON-MONETARY ITEMS
A.
Definitions
1.
Monetary
Monetary assets and l iabilities are fixed or denominated in dollars regardless of changes
in specific prices or the general price level (e.g. , accounts receivable).
Holding monetary assets during periods of inflation wil l result in a loss of purchasing
power and holding monetary liabilities will result in a gain of purchasing power.
2.
Non-Monetary
Non-monetary assets and liabilities fluctuate in value with inflation and deflation.
Holders of nonmonetary items may lose or gain with the rise or fall of the CPI if the
nonmonetary item does not rise or fall in proportion to the change in the CPI . In other
words, a nonmonetary asset or liability is affected by ( 1 ) the rise or fall of the CPI and
(2) the increase or decrease in the fair value of the nonmonetary item.
F2-42
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B.
I
Financial 2
CPA Exam Review
Classification: Monetary and Non-Monetary
Assets
Cash
NonMonetary
X
Ma rketable com mon stock
X
Bonds-n on-convertible
X
Accounts/notes receiva b l e (and a l l owance)
X
I nventory
Long-term receiva b l es
monetary
X
X
I nvestment in subsidia ry (eq uity)
X
Plan, prope rty, and eq uipment (and acc u m . depr. )
X
I nta ngi ble assets- patents a n d trademarks
X
Liabilities
Accounts and notes paya b l e
X
Accrued expenses
X
Bonds/notes paya b l e
X
Deferred cha rges and credits
X
Equities
P referred stock
X
Common stock
X
Reta i ned earnings is neither. Use as a resid u a l
( pl ug).
A "contra-account" (allowance for doubtful accounts/accumulated depreciation) is classified as monetary or
nonmonetary based upon the classification of the related account.
An i mportant use for this information on the CPA exam relates to its use in foreign currency accounting when
the "Remeasurement" method is used (discussed on the following pages).
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Becker Professional Education I CPA Exam Review
Financial 2
C.
Purchasing Power Gains and Losses
1.
Monetary Asset vs. Monetary Liability
Purchasing
Power Gains
2.
F2-44
Purchasing
Power Losses
D u ri n g a period
D u ri n g a period
Holding monetary
assets
of defl ation
Holding monetary
liabilities
of i nflation
of i nflation
D u ri n g a period
D u ri n g a period
of defl ation
Inflation and Appreciation Comparison
Monetary
Purchasing Power
Gain/Loss
Non-monetary
Holding Gain/Loss
Inflation
Appreciation
Historical cost /
Nominal dollars
No
No
Historical cost /
Constant dollars
Yes
No
Current cost /
Nominal dollars
No
Yes
Current cost /
Constant dollars
Yes
Yes
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Financial 2
Becker Professional Education I CPA Exam Review
FOR E I G N C U R R E NCY ACCOU NTI NG
I.
INTRODUCTION
Foreign currency accounting is concerned with foreign currency transactions and translations.
A.
Foreign Currency Transactions
Foreign currency transactions are transactions with a foreign entity (e.g., buying from and
selling to) denominated in (to be settled in) a foreign currency.
B.
Foreign Cu rrency Translation
Foreign currency translation is the conversion of financial statements of a foreign entity into
financial statements expressed in the domestic currency (the dollar).
II.
PU RPOSE OF THE STANDARDS
A.
Impact of Cash Flows
The standards for foreign currency accounting are designed to:
B.
1.
Provide information regarding the effects of exchange rate changes on an enterprise's
cash flow and equity.
2.
Recognize in income from continuing operations the effects (gain or loss) of
adjustments for currency exchange rate changes that i mpact cash flows and exclude
from net income those adjustments that do not impact cash flows.
Purpose
Reflect in consolidated financial statements the financial results and relationships of the
affiliated entities as measured in the currency of the primary economic environment in which
each entity operates (called the "Functional Currency").
III.
TERMINOLOGY
A.
Exchange Rate
Exchange rate is the price of one unit of a currency expressed i n units of another currency;
the rate at which two currencies will be exchanged at equal value. The exchange rate may
be expressed as:
1.
Direct Method
The direct method is the domestic price of one u nit of another currency. For example,
one euro costs $1 .47.
2.
Indirect Method
The indirect method is the foreign price of one unit of the domestic currency. For
example, 0.68 euros buys $1 .00.
B.
Current Exchange Rate
Current exchange rate is the exchange rate at the current date, or for i mmediate delivery of
currency, often referred to as the spot rate.
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Financial 2
C.
Becker Professional Education I CPA Exam Review
Forward Exchange Rate
Forward exchange rate is the exchange rate existing now for exchanging two currencies at a
specific future date.
D.
H istorical Exchange Rate
The historical exchange rate is the rate in effect at the date of issuance of stock or acquisition
of assets.
E.
Weighted Average Rate
The weighted average exchange rate is calculated to take into account the exchange rate
fluctuations for the period . It would be impractical to account for the actual exchange rate in
effect for numerous, recurring transactions (e.g . , sales). The average rate, when applied to a
transaction normally assumed to have occurred evenly throughout the period, approximates
the effect of separate translations of each item.
F.
Forward Exchange Contract
A forward exchange contract is an agreement to exchange at a future specified date and rate
a fixed amount of currencies of different countries.
G.
Denominated or Fixed in a Currency
A transaction is denominated or fixed in the currency used to negotiate and settle the
transaction , either in U .S. dollars or a foreign currency.
H.
Reporting Cu rrency
The reporting currency is the currency of the entity ultimately reporting financial results of the
foreign entity.
I.
Functional Currency
The functional currency is the currency of the primary economic environment in which the
entity operates, usually the local currency or the reporting currency.
J.
Foreign Currency Translation
Foreign currency translation is the restatement of financial statements denominated in the
functional currency to the reporting currency using appropriate rates of exchange.
K.
Foreign Currency Remeasurement
Foreign currency remeasurement is the restatement of foreign financial statements from the
foreign currency to the entity's functional currency in the fol lowing situations:
F2-46
1.
The reporting currency is the functional currency.
2.
The financial statements must be restated in the entity's functional currency prior to
translating the financial statements from the functional currency to the reporting
currency.
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IV .
Financial 2
FOREIGN FINANCIAL STATEMENT TRANSLATION
A.
I ntroduction
Before a parent company can consolidate the financial statements of a foreign subsidiary, the
subsidiary's foreign currency financial statements must be restated in the parent company's
reporting currency. The method used to restate the foreign subsidiary's financial statements
is determined by the functional currency of the foreign subsidiary.
B.
Steps in Restati ng Foreign Financial Statements
1.
Prepare i n Accordance with GAAP/IFRS
Before performing any part of the translation process, it is necessary to ensure that the
financial statements expressed in the foreign currency were prepared in accordance
with U .S. GAAP or I FRS, as appropriate. If necessary, corrections must be made to
comply with GAAP or I FRS.
2.
Determine the Functional Cu rrency
The functional currency of a foreign entity determines the conversion methodology to
use. The functional currency can be the entity's local currency, the currency of the
reporting entity, or the currency of another country. U nder U . S . GAAP, an entity's local
currency qualifies as the functional currency if it is the currency of the primary
economic environment in which the company operates, and all of the following
conditions exist:
a.
The foreign operations are relatively self-contained and i ntegrated within the
country.
b.
The day-to-day operations do not depend on the parent's or investor's functional
currency.
c.
The local economy of the foreign entity is NOT highly inflationary, which is
defined as cumulative inflation of 1 00% over three years.
U.S. GAAP VS. IFRS
Under I FRS, the following factors must be considered in determining an entity's functional c urrency.
The first three factors have priority over the other factors:
•
•
•
The currency that influences sales prices for goods and services.
The currency of the country whose competitive forces and regulations mainly determine the
sales price of its goods and services.
The currency that mainly influences labor, material, and other costs of providing goods and
services.
•
The currency in which funds from financing activities are generated.
•
The currency in which receipts from operating activities a re usually retained.
•
Whether the activities of the foreign operation are a n extension of the parent's activities or
are carried out with a significant amount of autonomy.
•
Whether transactions with the parent are a large or small portion of the foreign entity's
activities.
•
Whether cash flows generated by the foreign operation directly affect the cash flow of the
parent and are available to be remitted to the parent.
•
Whether operating cash flows generated by the foreign operation are sufficient to service existing
and normally expected debt or whether the foreign entity will need funds from the parent to service
its debt.
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Becker Professional Education I CPA Exam Review
Financial 2
3.
Determine Appropriate Exchange Rates
The functional currency of the foreign entity determines the exchange rates to be used
in converting account balances and the treatment of the gains or losses associated with
the translation process.
4.
•
Remeasure and/or Translate the Financial Statements
Parent Company:
Reporting Cu rrency =
Functional Cu rrency
1
1
•
I
REMEASUREMENT
1
1
The reporting currency is the functional
currency and the remeasurement method
must be used when:
•
TRANSLATION
1
I
I
The foreign currency is the functional
currency and the translation method must
be used when
The foreign subsidiary is highly integrated
with the parent and serves primarily as a
sales outlet for the parent. Day-to-day
operations of the subsidiary depend on
the reporting currency.
•
Parent Company:
Reporting Currency
I
jl
TRANSLATION
jl
REMEASUREMENT
I
Foreign Subsidiary:
Functional Currency
Foreign Subsidiary:
Foreign Currency
l
1
1
When the functional currency of the
subsidiary differs from both the subsidiary's
local currency and the reporting currency,
the subsidiary's financial statements must
first be remeasured from the local currency
to the functional currency, and then must be
translated from the functional currency to
the reporting currency.
The foreign subsidiary is relatively selfcontained and independent and operates
primarily in local markets. Day-to-day
operations of the subsidiary do not
depend on the reporting currency.
The foreign subsidiary operates in a
highly inflationary economy.
a.
I
r
Foreign Subsidiary:
Foreign Currency =
Functional Currency
Foreign
Subsidiary:
Foreign
Currency
•
•
Parent Company:
Reporting Curre ncy
Remeasurement Method (temporal method)
If the financial statements of the foreign subsidiary are not in the subsidiary's
functional currency, the financial statements are remeasured to the functional
currency starting with the balance sheet.
(1 )
Balance Sheet
Monetary items
=
CurrenUYear-end rate
Non-monetary items
(2)
=
Historical rate
Income Statement
Non-balance sheet related items = Weighted average rate
Balance sheet related items
=
Historical rate
Depreciation/PP&E
Cost of goods sold/inventory
Amortization/bonds and intangibles
F2-48
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Financial 2
Becker Professional Education I CPA Exam Review
(3)
Remeasurement Gain or Loss (income statement)
Plug "Currency Gain/Loss" to get net income to the required amount
needed to adjust retained earnings in order to make the balance sheet
balance.
U.S. GAAP VS. I FRS
U.S. GAAP requires the use of the remeasurement method when a foreign subsidiary
operates in a highly inflationary economy. Under IFRS, the financial statements of a
foreign subsidiary operating in a highly inflationary economy must first be restated for
the effects of inflation and then must be converted from the foreign currency to the
reporting currency using the current/year-end rate for all elements of both the balance
sheet and income statement.
b.
Translation Method (current rate method)
If the financial statements of the foreign subsidiary are in the subsidiary's
functional currency, the financial statements are translated to the reporting
currency starting with the i ncome statement.
Foreign currency = Functional currency
(1 )
Income Statement
All income statement items = Weighted average rate
Transfer net income to retained earnings
(2)
Balance S heet
Assets
=
Liabilities
Current /year-end rate
=
Current Iyear-end rate
Common stocklAPIC
Retained earnings
=
=
Historical rate
Roll forward
Translated retained earnings is equal to the beginning translated
retained earnings plus translated net income for the current period less
translated dividends declared for the current period.
(3)
Translation Gain or Loss (other comprehensive income)
Plug "translation adjustment" to other comprehensive i ncome. The
translation adjustment is equal to the d ifference between the debits and
credits in the translated trial balance.
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Becker Professional Education I CPA Exam Review
Financial 2
PASS K E Y
To remember the significant differences i n order of steps a nd conversion rates, the summary chart below should help with
the basics:
Method
1st Step
2nd Step
Balance sheet
Income statement
Translation
•
@ Weighted
average
•
•
•
Balance sheet
•
Remeasurement
•
Monetary @ yearend rate
Nonmonetary @
historical
@ Year-end rate
CIS & APIC @
historical
Roll forward R/E
Plug
Reported
�
Accumulated other
comprehensive
income
PUEER
Income statement
•
•
@ Weighted
average
Historical for
balance sheet
related accounts
Gain/loss so I/S is at
amount necessary for
R.E. plug
IDEA
EXAMPLE
Financial statements of the Kristi Corporation, a foreign subsidiary of the Dollar Corporation (a U.S. company), are
shown below at and for the year ended December 31, Year 2. Two examples follow where the statements are first
translated using the LCU (local currency unit) as the functional currency (translation method), then the dollar as the
functional currency (remeasurement).
Assumptions:
1.
The parent company organized the subsidiary on December 3 1, Year 1.
2.
Exchange rates for the LCU were as follows:
December 31, Year 1 to March 31, Year 2
$
.18
April 1, Year 2 to June 30, Year 2
.13
July 1, Yea r 2 to September 30, Year 2
.10
October 1, Year 2 to December 31, Year 2
.10
Weighted Average
. 1275
3.
I nventory was acquired evenly throughout the year and sales were made evenly throughout the year.
4.
Fixed assets were acquired by the subsidiary on December 3 1, Year 1.
F2-S0
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Financial 2
KRISTI CORPORATION
Foreign Currency Financial Statements
Expressed in dollars at and for the year ended December 31, Yea r 2
TRANSLATION
REMEASUREMENT
METHOD
METHOD
Exchange
Rate
Income Statement
Sales
LCU
525,000
LCU
400,000
Dollars
Exchange
Rate
$66,938
Dollars
$66,938
Costs and expenses:
Cost of goods sold
$51,000
.12?5
$51,000
Depreciation expense
22,000
.tl.275
2,805
.18
3,960
Selling expenses
31,000
. tI.275
3,953
.1275
3,953
Other operating expenses
1 1,000
.tl.275
1,403
19,000
. tl.275
I ncome taxes expense
Total costs and expenses
LCU
483.000
2.423
2.423
S61.584
S62.739
Currency exchange (gain)
Net income
1,403
PLUG #2->
(6,854)
LCU
42.000
$5.354
$11,053
LCU
-0-
-0-
-0-
42.000
S5.354
Sl1.053
LCU
42.000
$5.354
$11.053
LCU
10,000
$1,000
. 10
$1,000
50,000
5,000
.10
5,000
Statement of Retained Earnings
Retained earnings, beginning of year
Net income
Retained earnings, end of year
Balance Sheet - Assets
Cash
Accounts receivable (net)
Inventories (at cost)
95,000
9,500
.1275
12,113
Fixed assets
275,000
27,500
.18
49,500
Accumulated depreciation
(22.000)
(2.200)
Total assets
(3.960)
LCU
408.000
$40.800
LCU
34,000
$3,400
. 10
$3,400
Long-term debt
132,000
13,200
. 0
13,200
Common stock, 10,000 shares
200,000
.18
36,000
#1-
11,053
S63.653
Liabilities and Stockholders' Equity
Accounts payable
Retained earnings
. 18
42,000
36,000
5,354
PLUG
Accumulated balance of other
comprehensive income
Total liabilities and stockholders' equity
PLUG ->
LCU
408.000
(17,154)
S40.800
S63.653
Note: The superimposed numbers are the order of steps in the two examples and as discussed on pages F2-48 and F2-49.
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F2-51
Financial 2
V.
Becker Professional Education I CPA Exam Review
IN DIVIDUAL FOREIGN TRANSACTIONS
A.
Introduction
Foreign currency transaction gains and losses occur when a company buys from or sells to a
foreign company with whom it has no ownership interest and agrees to pay or accept
payment in a foreign currency. Transactions between subsidiary and parent of a permanent
financing nature are not considered foreign currency transactions.
B.
Types of Foreign Currency Transactions
Foreign currency transactions include operating transactions (import, export, borrowing,
lending, and investing transactions) and forward exchange contracts (agreements to
exchange two different currencies at a specific future date and at a specific rate).
C.
Changes in Exchange Rate
A foreign exchange transaction gain or loss will result if the exchange rate changes between
the time a purchase or sale in foreign currency is contracted for and the time actual payment
is made.
D.
Transaction not Settled at Balance Sheet Date
A foreign exchange transaction gain or loss that is recognized in current net income must be
computed at each balance sheet date on all recorded transactions denominated in foreign
currencies that have not been settled. The difference between the exchange rate used in
recording the transaction in dollars and the exchange rate at the balance sheet date (current
exchange rate) is an unrealized gain or loss on the foreign currency transaction.
E.
Valuation of Assets and Liabil ities
The assets or l iabilities resulting from foreign currency transactions should be recorded in the
U . S . company's books using the exchange rate in effect at the date of the transaction .
EXAMP L E
O n 12/1/Yr 1 Olinto Company purchased goods o n credit for 100,000 pesos. Olinto Company paid for the
goods on 2/1/Yr 2. The exchange rates were:
Date
Rate
12/1/Yr 1
$ 0.10
12/31/Yr 1
$ 0.08
2/1/Yr 2
$ 0.09
What are the journal entries related to this foreign currency transaction?
12/1/Yr 1
11m
Purchases (100,000 pesos
[WD
Accounts payable
x
$10,000
$0.10 exchange rate)
$10,000
12/31/Yr 1
11m
[WD
Accounts payable
$2,000
(100,000 pesos x $0.10 - $0.08)
$2,000
Foreign exchange transaction gain
100,000 pesos can be purchased for $8,000 at 12/31/Yr 1. The d ifference between the $8,000 and the original
recorded liability of $10,000 is a foreign exchange transaction gain that increases net income for Year 1.
2/1/Yr 2
IIill
Accounts payable
11m
Foreign exchange transaction loss
[WD
F2-52
Cash ( 100,000 pesos
$8,000
x
$0.09)
[100,000
x
($0.08 - $0.09)]
$1,000
$9,000
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Financial 2
O T H E R F I N A N C I A L S TAT E M E N T P R E S E N TAT I O N S
I.
OTHER COMPREHENSIVE BASES OF ACCOUNTING (OCBOA)
Other comprehensive bases of accounting (OCBOA) are non-GAAP presentations that have wide­
spread understanding and support. OCBOA presentations include:
The cash basis and modified cash basis of accounting.
The tax basis of accounting.
A definite set of criteria have substantial support that is applied to all material financial
statement elements, such as price-level adjusted financial statements.
A regulatory basis of accounting.
The cash basis, modified cash basis, and tax basis of accounting are the most commonly used
OCBOA and may be tested on the CPA exam.
A.
General OCBOA Presentation Guidelines
The following guidelines apply to all OCBOA financial statement presentations:
B.
1.
Financial statement titles should d ifferentiate the OCBOA financial statements from
accrual basis financial statements.
2.
The required financial statements are the equivalents of the accrual basis balance
sheet and income statement.
3.
The financial statements should explain changes in equity accounts.
4.
A statement of cash flows is not required.
5.
Disclosures in OCBOA financial statements should be similar to the disclosures i n
GAAP financial statements a n d should include:
a.
A summary of significant accounting policies.
b.
I nformative disclosures similar to those required by GAAP for all financial
statement items that are the same as or similar to those in GAAP financial
statements.
c.
Disclosures related to items not shown on the face of the financial statements,
such as related party transactions, subsequent events, and uncertainties.
Cash Basis and Modified Cash Basis Financial Statements
Entities that are not required to use the accrual basis of accounting may choose to present
cash basis or modified cash basis financial statements because they are simple to prepare
and easy to understand. Cash basis financial statements are not well-suited for entities that
have complex operations.
Note: In 2013, the AICPA released the Financial Reporting Frameworkfor Sma/l- and Medium-Sized Entities
("FRF for SMEs"). The FRF for S M Es is an other comprehensive basis of accounting. The AICPA has stated that
the earliest the FRF for S M Es will be testable on the CPA Exam is 2015.
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1.
Cash Basis Financial Statements
Under the cash basis of accounting, revenues are recognized when cash is received
and expenses are recognized when cash is paid . Cash basis financial statements are
generally used by estates and trusts, civic ventures, and political campaigns and
committees.
a.
Presentation
Cash basis financial statements include a statement of cash and equity and a
statement of cash receipts and disbursements.
(1 )
Statement of Cash and Equity
In pure cash basis financial statements, cash is the only asset, no l iabilities
are recorded , and equity is equal to cash .
(2)
Statement of Cash Receipts and Disbursements
The statement of cash receipts and disbursements includes the following:
2.
(a)
Revenues received .
(b)
Debt and equity proceeds.
(c)
Proceeds from asset sales.
(d)
Expenses paid.
(e)
Debt repayments.
(f)
Dividend payments.
(g)
Payments for purchases of assets.
Modified Cash Basis Financial Statements
Most for-profit and not-for-profit organizations that produce cash basis financial
statements use the modified cash basis of accounting. The modified cash basis is a
hybrid method that includes elements of both cash basis and accrual basis accounting.
Modifications should not be so extensive that the modified cash basis financial
statements become accrual basis financial statements.
a.
Common Modifications
Modifications made to cash basis financial statements should have substantial
support. Substantial support means that the modification is logical and
equivalent to the accrual basis of accounting for that item. Common
modifications include:
F2-S4
(1 )
Capitalizing and depreciating fixed assets.
(2)
Accrual of income taxes.
(3)
Recording liabilities for long-term and short-term borrowings and the
related interest expense.
(4)
Capitalizing inventory.
(5)
Reporting investments at fair value and recognizing unrealized gains and
losses.
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b.
Financial 2
Presentation
Modified cash basis financial statements include a statement of assets and
l iabilities-modified cash basis or a statement of assets and liabilities arising
from cash transactions and a statement of revenues and expenses and retained
earnings-modified cash basis or a statement of revenues collected and
expenses paid. The specific elements included in these financial statements
depend on the modifications made by the entity.
C.
I ncome Tax Basis Financial Statements
Entities that are not required to use the accrual basis of accounting may choose to present
income tax basis financial statements. In contrast to cash basis financial statements, tax
basis financial statements are well-suited for entities that have complex operations.
1.
Accounting Issues
Tax basis financial statements are prepared based on the methods and principles used
to prepare the entity's tax return. Special accounting treatment must be given to
nontaxable revenues and expenses not reported on the tax return.
a.
Nontaxable Revenues and Expenses
Nontaxable revenues and expenses must be recognized in tax basis financial
statements in the period received or paid for cash-basis taxpayers and in the
period accruable for accrual-basis tax payers. Nontaxable revenues and
expenses may be reported as:
2.
(1 )
Separate line items i n the revenue and expense sections of the statement
of revenues and expenses,
(2)
Additions and deductions to net income, or
(3)
A disclosure in a note.
Presentation
Tax basis financial statements incl ude a statement of assets and liabilities and equity income tax basis or a balance sheet - income tax basis and a statement of reven ues
and expenses and retained earnings - income tax basis or a statement of income income tax basis. The specific elements included in an entity's tax basis financial
statements depend on the income and deductions reported on the entity's tax return.
II.
PERSONAL FINANCIAL STATEMENTS
Personal financial statements are financial statements of individuals or groups of related individuals
(families) and are generally prepared to organize and plan financial affairs. Such statements can be
used for obtaining credit and for tax, estate, and retirement planning purposes.
A.
Presentation
1.
Statement of Fi nancial Condition
The statement of financial condition is the basic personal financial statement and
presents assets and liabilities at estimated current values rather than at historical cost.
Assets and liabilities are recognized on the accrual basis versus the cash basis, and
personal net worth is the difference between total assets and liabilities included in the
statement.
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F2·SS
Becker Professional Education I CPA Exam Review
Financial 2
a.
b.
c.
Assets are reported at estimated current fair value.
(1 )
The present value of projected cash receipts is appropriate for estimating
the current value of monetary assets.
(2)
Life insurance loans payable are netted against the cash surrender value
of l ife insurance.
(3)
A business i nterest that constitutes a large part of an individual's total
assets should be presented as a single amount at estimated current value
separately from other investments. The assets and liabilities of the
business are not reported separately in the statement.
(4)
Vested pension plan benefits are reported at fair value.
Liabilities are reported at estimated current amount.
(1 )
This is generally the GAAP presentation; however, some loans may have a
present value less than cost. These would be d isclosed at the lower
present value.
(2)
A deferred tax liability is reported for estimated taxes due, as if all assets
were sold at fair value and all liabilities were paid at fair value.
Net worth at fair value is the difference between assets (at estimated current fair
value) and liabilities (at estimated current amounts).
In personal financial statements, assets and liabilities are valued at fair value. Remember to
determine the future taxes on any gains from selling assets.
d.
2.
The presentation of assets and liabilities i s made i n order of liquidity and
maturity, with no current and noncurrent classifications.
Statement of Changes in Net Worth
An optional personal financial statement is the statement of changes in net worth ,
which shows sources of increases and decreases in net worth . The statement
distinguishes between those changes in net worth that have been realized and those
that are unrealized. Presentation of comparative financial statements is optional.
3.
Disclosure
Personal financial statements should include sufficient d isclosures to make them
adequately i nformative. The nature and type of information disclosed in either the body
or notes of the financial statements mig ht include, for example:
F2-56
a.
The individuals covered by the statements.
b.
The ind ividuals' assets and liabilities at current estimated values.
c.
The methods used in determining estimated current values.
d.
Descriptions of intangible assets.
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Financial
e.
The face amount of life insurance policies owned by the individuals.
f.
The nature of joint ownership of assets held by these and other individuals.
g.
Tax information, including methods a n d assumptions used to compute estimated
income taxes; unused operating loss and capital loss carryforwards; other
u nused deductions and credits; and the differences between the estimated
current values of assets and liabilities and their tax bases.
h.
Maturities, interest rates, a n d other pertinent details relating to receivables and
debt.
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Financial 2
APPENDIX I
The Codification
S T U DY A I D NOTE
This appendix provides a detailed introduction to the FASB Accounting Standards Codification™ (http://asc./asb.org/) that
will serve as the Authoritative Literature for the Simulation Research Tasks included in the Financial Accounting and
Reporting (FAR) section of the CPA Examination. Students are encouraged to view the FASB Codification Tutorial as part of
their studies. While this appendix includes coverage on the research functionality available through the Professional View
of the Codification, the research functionality on the CPA Examination will be much less robust in its capabilities. Students
should view the CBT Tutorial and work the Research Tasks in the Simulations provided i n the Becker software to ensure
familiarity with the actual research functionality used on the CPA Examination.
HOW IS IT ORGANIZED?
I.
II.
A.
The codification is organized in a tiered/menu structure.
B.
I nformation i s organized into nine areas, ranging from industry specific to general financial
statement matters.
C.
Within each area are topics, subtopics, sections, subsections and paragraphs, where details
of the technical content reside.
D.
At the topic, subtopic and section levels, the codification material correlates to I FRS.
THE CODIFICATION USES A TOPICAL STRUCTURE
Guidance is organized into areas, topics, subtopics, sections and subsections as fol lows:
XXX-YY-zz
XXX-rJ..
XXX-10: Overa l l
XXX-YV-OO: Status
100s:
G eneral P r i n c i ples
200s:
Presentation
300s:
Assets
400s:
Lia bilities
25: Recognition
500s:
Equity
30: I nitial Measure m e nt
600s:
Revenue
700s:
Expenses
800s:
Broad Tra nsactions
900s:
I n d ustry
05: Overview & Backgro u n d
1 0 : Objectives
15: Scope & Scope Exceptions
20: Topical Defi nitio ns - G lossary
35: S u bsequent Measure m e nt
40: De-recognition
45: Other Presentation M atters
50: Disclosures
5 5 : I m plementation G u i d a n ce . ..
6 0 : Relatio nsh i ps
65: Tra nsition & Open Effect...
70: Links to G ra n dfathered ...
7 5 : X B R L Definitions
I
III.
AREAS
A.
F2·SS
�
TOPICS
N i ne Areas (contain nearly 90 topics)
1.
General Principles (Topic Code 1 05). There is only 1 topic in General Principles.
2.
Presentation (Topic Codes 205 - 299). These 1 5 Topics relate only to presentation
matters and do not address recognition, measurement, and de-recognition matters.
Topics include Income Statement, Balance Sheet, Earnings per Share, etc.
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3.
Asset (Topics 305 - 399); there are 9 topics in Assets.
4.
Liabilities (Topics 405 - 499); there are 9 topics in Liabilities.
5.
Equity (Topics 505 - 599); there is only 1 topic in Equity.
6.
Revenue (Topics 605 - 699); there is only 1 topic in Revenue.
7.
Expenses (Topics 705 - 799); there are 8 topics in Expenses.
8.
Broad Transactions (Topic codes 805 - 899). These 1 4 Topics relate to multiple
financial statement accounts and are generally transaction-oriented. Topics include
Business Combinations, Derivatives, Non-monetary Transactions, Leases, etc.
9.
I ndustries (Topic codes 905 - 999). These 32 Topics relate to accounting that is
unique to an industry or type of activity.
General Principles
105 - Generally Accepted Accounting Principles
Presentation
205 Presentation of Financial Statements
210 - Balance Sheet
215 Statement of Shareholder Equity
220 Comprehensive Income
225 - I ncome Statement
230 - Statement of Cash Flows
235 - Notes to Financial Statements
-
-
-
250 - Accounting Changes and Error Corrections
255 - Changing Prices
260 - Earnings Per Share
270 - Interim Reporting
272 - Limited Liability Entities
274 - Personal Financial Statements
275 - Risks and Uncertainties
280 - Segment Reporting
Assets
305 - Cash and Cash Equivalents
310 - Receivables
320 - Investments - Debt and Equity Securities
323 - Investments - Equity Method and Joint Ventures
325 - Investments - Other
330 - Inventory
340 - Other Assets and Deferred Costs
350 I ntangibles - Goodwill and Other
-
360 - Property, Plant, and Equipment
Liabilities
405 - Liabilities
410 - Asset Retirement and Environmental Obligations
420 - Exit or Disposal Cost Obligations
430
-
Deferred Revenue
440 - Commitments
450 - Contingencies
460 - Guarantees
Debt
480 - Distinguishing Liabilities from Equity
470 -
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Equity
50S - Equity
Revenue
60S - Revenue Recognition
Expenses
70S - Cost of Sales and Services
710 - Compensation - General
712 - Compensation - Nonretirement Postemployment Benefits
715 - Compensation - Retirement Benefits
718 - Compensation - Stock Compensation
720 - Other Expenses
730 - Research and Development
740 - Income Taxes
Broad Transactions
80S - Business Combinations
808 - Collaborative Arrangements
810 - Consolidation
815 - Derivatives and Hedging
820 - Fair Value Measurements and Disclosures
825 - Fina ncial I nstruments
830 - Foreign Currency Matters
835 - Interest
840 - Leases
845 - Nonmonetary Tra nsactions
850 - Related Party Disclosures
852 - Reorganizations
855 - Subsequent Events
860 - Transfers and Servicing
Industry
90S - Agriculture
908 - Airlines
910 - Contractors - Construction
912 - Contractors - Federal Government
915 - Development Stage Entities
920 - Entertainment - Broadcasters
922 - E ntertainment - Cable Television
924 - E ntertainment - Casinos
926 - E ntertainment - Films
928 - E ntertainment - M usic
930 - Extractive Activities - Mining
932 - Extractive Activities - Oil and Gas
940 - Financial Services - Broker and Dealers
942 - Financial Services - Depository and Lending
944 - Financial Services - Insurance
946 - Financial Services - Investment Companies
948 - Financial Services - Mortgage Banking
950 - Financial Services - Title Plant
952 - Franchisors
954 - Health Care Entities
•
F2-60
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958 - Not-for-Profit Entities
960 - Plan Accounting - Defined Benefit Pension Plans
962 - Plan Accounting - Defined Contribution Pension Plans
965 - Plan Accounting - Health and Welfare Benefit Plans
970 - Real Estate - General
972 - Real Estate - Common Internet Realty Associations
974 - Real Estate - Real Estate Investment Trusts
976 Real Estate - Retail Land
978 - Real Estate - Time-Share Activities
980 - Regulated Operations
985 Software
995 - U.S. Steamship Entities
-
-
IV.
INDUSTRY AREA (and topics)
A.
Codification Filtering Approach
General Principles
Presentation
Assets
The Codification team applied a filtering approach for identifying the Codification
topics that should contain specific content. The first filter related to industry
content. If a piece of content related solely to a single industry, the Codification
team authored the content in that particular industry.
1.
Broad Transaction Area (& topics)
The Codification team applied the following filtering approach
next:
a.
2.
The second filter related to broad transactions. If a piece of
content did not relate to a single industry and it related a
broad transaction, the Codification team authored the
content in that broad transaction.
Equity
Revenue
Expenses
Broad Transactions
Industry
General Principles
Presentation
Assets
Liabilities
Equity
Presentation and Financial Statement Areas (& topics)
The Codification team applied the following filtering approach next:
a.
V.
Liabilities
Revenue
Expenses
Broad Transactions
For all other content that did not meet the industry or broad transaction
filters, the Codification team authored the content in either:
(1 )
Financial statement account Topic
(2)
Presentation Topic
Industry
SU BTOPICS
A. Subtopics Represent subsets of a Topic and are generally distinguished by type or by scope.
-
I n other cases, the Overall Subtopic may not contai n overall guidance, but instead may
represent miscellaneous content that does not fit into another Subtopic.
B. Overal l XXX- 1 O-Subtopic that generally represents the pervasive guidance for the Topic.
C. Overall Subtopic Typically contains the pervasive scope for the entire Topic, including the
other Subtopics (in cases where a topic contains multiple Subtopics). The remaining Subtopics
then refer to the Overall SubtopiC and address the specific exceptions from the pervasive
Overall Scope.
-
•
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PASS K E Y
Users must be aware that the Overal l Subtopic is not a summary, but instead represents the scope for the
Overal l Subtopic and the baseline for the other Subtopics, which may include different scope inclusions or
exclusions.
D.
AdditionaI Subtopic-XXX-VY
Represents incremental or unique guidance not contained in the Overall Subtopic. I n some
cases, the Overall Subtopic represents overall guidance. Subtopics unique to a Topic use
classification numbers between 00 and 99.
E D I T O R O B S E R V AT I O N
•
One of the goals of the Codification was to eliminate redundant content.
•
FASB concluded that industry Topics should contain only incremental industry-specific guidance.
•
•
The entities within the scope of the industry must follow the industry-specific guidance and all other
relevant guidance contained in other Topics that does not conflict with the industry guidance.
Industry topics: May contain Subtopics that mirror the general Topics.
EXAMPLE
The Subtopic classification number is the classification number of the related Topic.
•
Agriculture - Receiva bles is 905-310.
•
Agriculture - Inventory is 905-330.
1 ex: 740-10-25
I "?
Notice to Constituents
General Prlrclples
Presentation
Assets
Liabilities
Equity
Revenue
Expenses
Broad Transactions
Master GlossarY
OTHER SOURCES
U . S . generally accepted accounting
�����====�
annual periods ending after September 15,
standard setter are superseded. Level (a)- ( d)
accounting li terature not included In the
GeneraIlY Accepted Accounting Principles, for
more than 200 people from multiple entities.
Is;H;;�d;�;;,;;;;---;tn���;;';���==lfITerp-;r/
of previous accounting standards. The
obtalnlng a good understanding of the
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What's New
lex: 7�O-10-25
I
Join SC!Clions
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Home' Notice to Constituents
1 ,, 7
I
Notice to Constituents
J Page I Print Functions
I
�
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IE
H O W T H E C O D I F I C AT I O N I S S T R U C T U R E D
Areas
100s:
Genera l Princi ples
200s:
Presentation
300s:
Assets
400s:
Lia b i l ities
500s:
Equ ity
600s:
Reve n u e
700s:
Expenses
800s:
Broad Tra nsactions
900s:
I n dustry
Topics
Subtopics
Sections
XM
XXX-YV
XXX-YY-U
XXX-l0: Overa l l
XXX-YV-OO: Status
05: Overview & Background
10: Objectives
1 5 : Scope & Scope Exceptions
20: To pical Defi nitions - G l ossa ry
90
1
(
XXX-9XX: I n d u stry
l
2 5 : Recognition
30: I n itial Measurement
3 5 : S u bsequent Measurement
40 : De-recogn ition
45: Other Presentation Matters
50: Disclosures
55: I m plementation G u i d a nce ...
60: Relationships
65: Tra nsition & Open Effect...
70: Links to G ra ndfathered ...
7 5 : XBRl Defi nitions
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VI.
Becker Professional Education I CPA Exam Review
SECTIONS
A.
Sections represent the nature of the content in a Subtopic such as Scope, Recognition,
Measurement, Subsequent Measurement, Derecognition, Disclosure, etc.
B.
Every Subtopic uses the same Sections, unless there is no content for a particular Section.
Similar to Topics, Sections correlate very closely with Sections of individual I nternational Accounting
Standards.
C.
The Sections of each Subtopic are as follows:
XXX-YY-ZZ where XXX = Topic, YY
=
Subtopic, ZZ
=
Section
XXX-YY-OO Status
XXX-YY-OS Overview And Background
XXX-YY-10 Objectives
XXX-YY-1S Scope and Scope Exceptions
XXX-YY-20 Topica l Definitions-Glossary
XXX-YY-2S Recognition
XXX-YY-30 Initial Measurement
XXX-YY-3S Subsequent Measurement
XXX-YY-40 De-Recognition
XXX-YY-4S Other Presentation Matters
XXX-YY-SO Disclosure
XXX-YY-SS I mplementation Guidance and Illustrations
XXX-YY-60 Relationships
XXX-YY-6S Transition and Open Effective Date Information
XXX-YY-70 Links To Grandfathered MATERIAL
XXX-YY-7S XBRL Definitions
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�
Accol':\n);G ST,'>""WARDS CODIFICATION
BROWSE
CODIFICATION
I ex: 740-1 0-25
Notice to Constituents
General Principles
Presentation
Assets
U.bllliles
Equily
Revenue
Expenses
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310
Receivables
Table of Contents
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8 310 Receivables
8 1 0 Overall
00 51.lus
I'i:] 05 Overview and Background
Broad Transactions
IE 15 Scope and Scope Exceptions
Indusby
. 20 Gloss.ry
Master Glossary
SEARCH
'
It! 25 Recognition
IE 30 Initial Measurement
(t) 35 Subsequent Measurement
40 0erecognltlon
OTHER SOURCES
Accounting standards Updates
Exposure Drans
Pre-Codification Standards
Maintenance Updates
IB 45 other Presentation hlatters
IE 50 Disclosure
55 Implementation Guidance and Illustrations
IE 60 Relationships
65 TransfHon and Open Effective Date Information
• 75 XBRL ElemBnls
SOD S1a1us
835 SubseQuent Measurement
8:l 845 other Presentation Matters
850 Disclosure
I±l S55 1mplementallon Guidance and illustrations
• 875 XBRL Elements
Ell S99 SEC III.IBrl.ls
ebt Securities AcquIred with Deteriorated CredIt Quality
Sections
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xxx
100s:
Genera l Princi ples
200s:
Presentation
300s:
Assets
XXX-YV
XXX-l0: Overa l l
XXX-YY-ZZ
XXX-YY-OO: Status
05: Overview & Backgro u n d
10: Objectives
15: Scope & Scope Exce ptions
20: To pical Defi nitions - G lossa ry
(
8
400s:
Lia b i l ities
500s:
Equity
600s:
Revenue
700s:
Expenses
800s:
Broad Tra nsactions
900s:
I n d ustry
1
2 5 : Recognition
30: I n itial Measurement
35: S u bsequent Measure ment
40: De-recognition
XXX-9XX: I n d u st ry
45: Other Presentation Matters
l
50: Disclosu res
55: I m ple mentation G u i da nce .
60: Relations h i ps
65: Tra nsition & Open Effect...
.
70: Links to G randfathered . ..
75: XBRL Defi nitions
SZZ: SEC SECTION
l
D.
The following is a description of the Sections:
1.
XXX-VY-OO Status
This Section includes references to the post-Codification standards that affect the
Subtopic. It is comparable to the status section currently contained in the FASB
Statements (and other standards) in Original Pronouncements.
I....
- -
EXAMPLE
'"
Section includes information similar to the following:
•
Paragraph 25-6 added by Codification Update 10-03
Paragraph 35-7 modified by Codification U pdate 09-02
Paragraph 50-3 superseded by Codification Update 09 -23
•
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2.
3.
XXX-VY-05 Overview and Background
a.
This Section provides a general overview and background
regarding the Subtopic.
b.
It does not provide historical background of the standard setter,
due process, or similar items.
c.
It may contain certain material generally considered useful to a �O Initial Measurement
user to understand the typical situations required by the standard. �5 Subsequent
d.
This material comes primarily from the I ntroduction section of
the standard or, in some cases, the Basis for Conclusions.
e.
This Section does not summarize the requirements of the
Subtopic.
XXX-VY-1 0 Objectives
When available, the Objectives Section states the high-level
objectives of the SubtopiC, but does not discuss the main principles of
the Subtopic.
4.
5.
6.
00 Status
u, uverv,ew andBackground
XXX-VY-1 5 Scope and Scope Exceptions
10 Objectives
15 Scope and Scope
Exceptions
o Topical
Definitions ·
�Iossary
�5 Recognition
� easurement
�O De'recognition
�5 Other Presentation
� atters
ISO Disclosure
�5 Implementation Guidance
�nd Illustrations
�O Relationships
5 Transition and Open
ffective Date Information
o Links to Grandfathered
Material
5
XBRL Definitions
a.
This Section outlines the items (for example, the entities, transactions,
instruments, or events) to which the guidance in the Subtopic does or does not
apply. It does not contain actual accounting or reporting guidance (for example,
subsequent measurement).
b.
The FASB concluded that u nless otherwise indicated, the content applies to all
entities.
XXX-VY-20 Glossary
a.
This Section contains all the glossary terms used in the Subtopic.
b.
In some cases, the terms originated from the Glossary of the original standard .
c.
In other cases, the term was embedded in the text of the original standard.
XXX-YY-25 Recogn ition
This Section addresses the criteria, timing, and location (within the financial
statements) for recognizing a particular item.
7.
Ii:)
XXX-VY-30 Initial Measurement
a.
This Section addresses the criteria and amounts used to measure a particular
item at the date of recognition.
b.
In many cases, this Section may be empty because the initial standards did not
include initial measurement.
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8.
XXX·VY·35 Subsequent Measurement
a.
b.
This Section relates almost exclusively to assets, liabilities, and equity.
It addresses the criteria and amounts used to measure a particular asset, liability,
or equity item subsequent to the date of recognition (for example, impairment,
fair value changes, depreciation, amortization, and similar items).
"
Income statement accounts do not generally have this section.
9.
XXX·VY-40 Derecognition
a.
b.
This Section relates almost exclusively to assets, liabilities, and equity.
It addresses the criteria, the basis to be relieved (for example, the method to
determine the amount), and the timing to be used when derecognizing a
particular asset, liability, or equity item for purposes of determining gain or loss, if
any.
10.
XXX·VY-45 Other Presentation Matters
This Section includes other presentation matters related to the Subtopic. Some
examples include:
11.
a.
Specific balance sheet classification.
b.
Specific cash flow requirements.
c.
Specific effects on earnings per share.
XXX·VY·50 Disclosure
a.
b.
This Section contains specific disclosure requirements for a Subtopic.
It does not include general disclosure requirements that may reside in the Notes
to Financial Statement Topic and other general presentation Topics.
c.
This Section may include references to general disclosure requirements that
encompass the items addressed by the Subtopic.
12.
XXX·VY·55 Implementation Guidance and Illustrations
a.
This Section contains implementation guidance and illustrations, which are an
integral part of the standards. The Codification separates implementation
guidance and illustrations from the main body of the standards, but provides
references and links in both directions.
b.
This Section provides guidance relating to the standards in simplified and
generalized situations. Applying the standards to actual situations requires
judgment and the implementation guidance and illustrations are intended to aid
in making those judgments.
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1 3.
XXX·YY·60 Relationships
a.
This Section includes references to other Subtopics that may contain guidance
related to the Subtopic. The references point to content in another Topic that is
either the object of the other Topic or in which the material otherwise relates to
the particular Topic.
E XAMPL E
The Income Taxes Topic may have discussions of LIFO reserves as the object of an illustration or
exa mple. In this case, the Relationships Section of the Inventory Topic would refer to the LIFO
material in the relevant I ncome Taxes Subtopic.
b.
The relationships provide simple references to the relevant content, but do not
include a complete description of the relationship. In addition, the Section does
not contain requirements.
While the goal is to include as many relevant relationships as possible, users should not assume
that the lists are exhaustive.
1 4.
XXX·YY·65 Transition and Open Effective Date Information
a.
This Section contains references to paragraphs within the Subtopic that have
open transition guidance.
b.
The transition guidance will appear in an emphasized manner in the text of the
standards Sections. After the transition period lapses, the Codification Research
System will remove the outdated guidance and the emphasis on the new
content.
P A S S I( E Y
•
•
•
•
1 5.
The Codification was written with an assumed effective date of December 31, 2008.
As a result, transition and open effective date guidance for dates prior to December 3 1,
2008 is not in the Codification (despite the fact that the effective date may not have
occurred yet) because of its imminent removal as authoritative content.
As such, there is no transition or effective date information in the Codification for such
guidance.
Users can search the original standards.
XXX·YY·70 Links to Grandfathered Material
a.
This Section contains descriptions, references, and transition periods for post­
December 31 , 2008, grandfathered standards.
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b.
For all Q@-December 31 , 2008, grandfathered literature, we will include a notice
indicating that the Codification represents standards as of December 31 , 2008,
and there is no transition or effective date g uidance in the Codification for older
standards.
Users must access the original standards for the guidance for pre-December 31, 2008
grandfathered literature.
00 Status
1 6.
0 5 Overview a n d
XXX-YY-75 XBRL Defin itions
Background
This Section is expected to contain the related XBRL definitions for
the Subtopic or relevant links to the definitions.
E.
10 Objectives
15 Scope and Scope
Exceptions
20 Topical Definitions -
Securities and Exchange Commission (SEC) Sections
Glossary
1.
Standards issued by the SEC are included for reference to improve the
usefulness of the Codification for public companies.
2.
The system attempts to embed relevant SEC content for reference in
the same Topics and Subtopics as all other content.
25 Recognition
30 Initial Measurement
35 Subsequent
Measurement
3.
b.
45 Other Presentation
Matters
50 Disclosure
An liS" precedes the SEC Section codes.
a.
40 De-recognition
55 Implementation
All original SEC content remains essentially intact in the S99SEC Materials Sections, except that SEC observer comments
made at EITF meetings are no longer shown with the related
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605 Reye nu e Recognition > 25 Multiple-Element Arrangements > 05 O erv l e w and Background
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On the bottom right, we see the screen breaks down the results By Area. To the right of each
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Let's check the box for Revenue and click "go ."
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The codification includes a cross-reference report that allows users to identify where
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Keyword
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G AA P standard
Now let's run a Cross Reference Report. Look at the Accounting Standards Codification's
(ASC's) top menu bar and select the "Cross Reference" tab.
CODIFICATION
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guidance
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We know the Codification reference to the appropriate guidance, now let's go
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Type i n the following under "By Codification": Topic 60S, Subtopic 25, Section
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25.
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CODIFICATION
lex 7·10·10·25
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Notice 10 C onsliluents
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APPENDIX I I
I F RS V S . U . S . G A A P
Note: Unless specifically noted, IFRS and U.S. GAAP accounting rules are the same. This chart highlights the significant
d ifferences between I FRS and U.S. GAAP covered i n this lecture.
ISSU E
IFRS
Revenue Recognition
·
U.S. GAAP
Revenue transactions are divided into four
categories:
·
1. Sale of goods.
2. Rendering of services.
·
Revenue is recognized when it is realized or realizable
and earned. Four criteria must be met for each
element of a contract before revenue can be
recognized:
3. Revenue from interest, royalties, and dividends.
1. Persuasive evidence of an arrangement exists.
4. Construction contracts.
2. Delivery has occurred or services have been
rendered.
Common revenue recognition criteria include:
0
0
Revenue and costs can be measured reliably.
3 The price is fixed and determinable.
It is probable that the economic benefits from the
4. Collection is reasonably assured.
transaction will flow to the entity.
0
Intangible Assets
·
·
Each category has additional revenue recognition
criteria.
Research costs related to internally developed
intangible assets must be expensed.
·
Research and development costs related to internally
developed intangible assets must be expensed.
Development costs may be capitalized if certai n
·
I ntangible assets are reported using the cost model
only.
·
Revaluation is prohibited.
criteria are met.
·
Intangible assets are reported using the cost model
or the revaluation model.
Reseorch and
·
Research costs must be expensed.
Development Costs
·
Development costs may be capitalized if certain
criteria are met.
Computer Software
·
·
Separate guidance is provided for computer software
developed to be sold, leased, or licensed, and
computer software developed or obtained for
internal use.
·
Costs before technological feasibility is
established/during the preliminary project stage are
expensed.
·
Costs after technological feasibility is
established/after the preliminary project stage are
capitalized.
·
For finite life intangible assets, an impairment loss is
calculated using a two-step model in which:
computer software development costs.
Development Costs
Impairment of
IFRS does not provide separate guidance regarding
Research and development costs must be expensed.
·
Computer software development costs are internally
generated intangibles.
·
Research costs must be expensed, but development
costs may be capitalized if certain criteria are met.
·
An impairment loss is calculated using a one-step
model in which the carrying value of the intangible
asset is compared to the asset's recoverable amount.
·
The recoverable amount is the greater of the asset's
fair value less costs to sell and the asset's value in
use.
·
Value in use is the present value of the future cash
Intangible Assets other
than Goodwi/l
1. The carrying amount of the asset is compared to
the sum of the undiscounted cash flows expected
from the asset, and then
2. If the carrying amount exceeds the sum of the
undiscounted cash flows, an impairment loss
flows expected from the intangible asset.
·
the carrying value exceeds the recoverable amount.
·
equal to the difference between the carrying
amount and fair value of the asset is recorded.
An impairment loss is recognized to the extent that
·
For i ndefinite life intangible assets, an impairment
loss is calculated using a one-step model in which the
carrying amount of the asset is compared to the fair
Reversal of impairment losses is permitted.
•
value of the asset.
Reversal of impairment losses is not permitted,
unless the intangible asset is held for disposal.
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Financial 2
ISS U E
IFRS
Goodwill Impairment
·
Goodwill impairment is calculated using a one step
test at the cash generating unit (CGU) level in which
·
U.S. GMP
Goodwill is calculated using a two-step test at the
reporting unit level in which:
the carrying value of the CGU is compared the CGU's
recoverable amount. The recoverable amount is the
1. The fai r value of the reporting unit is compared to
greater of the CGU's fair value less costs to sell and
its value in use.
2. If the fair value of the reporting unit is less than its
carrying value, an impairment loss is calculated by
its carrying value, including goodwill, and then
An impairment loss is recognized to the extent that
comparing the implied fair value of the reporting
unit's goodwill to the carrying value of the goodwill.
the carrying value exceeds the recoverable amount.
Canstruction Contracts
·
The impairment loss is first allocated to goodwill and
then allocated on a pro rata basis to the other assets
of the CGU.
·
The percentage of completion method is required
The percentage of completion method and the
unless the final outcome of the project cannot be
reliably estimated, in which case the cost recovery
method is required.
completed contract method are permitted.
•
Nonmonetary
·
The completed contract method is not permitted.
Nonmonetary exchanges are characterized as
·
·
·
Exchanges of dissimilar assets are regarded as
·
Exchanges that have commercial substance are
accounted for at fair value with all gains recognized.
exchanges that generate revenue and are accounted
for in the same manner as exchanges having
commercial substance under U.S. GAAP.
·
Exchanges of similar assets are not regarded as
·
In exchanges that lack commercial substance, gains
are only recognized when boot is received.
exchanges that generate revenue and no gains are
recognized.
·
Nonmonetary exchanges are characterized as
exchanges having commercial substance and
exchanges lacking commercial substance.
exchanges of similar assets and exchanges of
dissimilar assets.
Exchanges
Losses are recognized in full in all nonmonetary
transactions.
Losses are recognized in full in all nonmonetary
transactions.
Foreign Currency
Several factors must be considered in determining the
Translation
entity's functional currency. The two primary factors
that must be considered are:
1. The currency that influences sales prices for goods
and services, and
2. The currency of the country whose competitive
forces and regulations mainly determine the sales
price of its goods and services.
Foreign Currency
The financial statements of a foreign subsidiary
Translation
operating in a highly inflationary economy must first be
restated for the effects of inflation and then must be
converted from the foreign currency to the reporting
currency using the current/year-end rate for all
•
The functional currency is the currency of the entity's
primary economic environment.
•
The local currency is the functional currency when
the foreign operations are relatively self-contained
and integrated within the country, the day-to-day
operations do not depend on the parent's functional
currency and the local economy is not highly
inflationary.
The remeasurement method must be used when a
foreign subsidiary is operating in a highly inflationary
environment.
financial statement elements.
F2-S2
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Financial 2
C LASS QU EST I O N S
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2nd
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+
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NOTES
F2-84
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Financial 2
1 . CPA-00544
Roro, Inc. paid $7,200 to renew its only i nsurance policy for three years on March 1 , Year 5, the effective
date of the policy. At March 31 , Year 5, Roro's unadjusted trial balance showed a balance of $300 for
prepaid insurance and $7,200 for insurance expense. What amounts should be reported for prepaid
insurance and insurance expense in Roro's financial statements for the three months ended March 31 ,
Year 5?
a.
b.
c.
d.
Prepaid
Insurance
insurance
exgense
$7,000
$7,000
$7,200
$7,300
$300
$500
$300
$200
2. CPA-00545
Ward, a consultant, keeps her accounting records on a cash basis. During Year 2, Ward collected
$200,000 in fees from clients. At December 31 , Year 1 , Ward had accounts receivable of $40,000. At
December 31 , Year 2, Ward had accounts receivable of $60,000, and unearned fees of $5,000. On an
accrual basis, what was Ward's service revenue for Year 2?
a.
b.
c.
d.
$1 75,000
$1 80,000
$21 5,000
$225,000
3. CPA-00542
Gray Co. was granted a patent on January 2, Year 1 , and appropriately capitalized $45,000 of related
costs. Gray was amortizing the patent over its estimated useful life of fifteen years. During Year 4, Gray
paid $1 5,000 in legal costs in successfully defending an attempted infringement of the patent. After the
legal action was completed, Gray sold the patent to the plaintiff for $75,000. Gray's policy is to take no
amortization in the year of disposa l . In its Year 4 income statement, what amount should Gray report as
gain from sale of patent?
a.
b.
c.
d.
$1 5,000
$24,000
$27,000
$39,000
4. CPA-00548
On January 2, Year 1 , Paye Co. purchased Shef Co. at a cost that resulted in recogn ition of goodwill of
$200,000. During the first quarter of Year 1 , Paye spent an additional $80,000 on expenditures designed
to maintain goodwill. In its December 31 , Year 1 balance sheet, what amount should Paye report as
goodwill?
a.
b.
c.
$ 1 80,000
$280,000
$252,000
d.
$200,000
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5. CPA-00537
On December 3 1 , Year 1 , Byte Co. had capitalized software costs of $600,000 with an economic life of
four years. Sales for Year 2 were 1 0% of expected total sales of the software. At December 31 , Year
2, the software had a net realizable value of $480,000. In its December 31 , Year 2 balance sheet, what
amount should Byte report as net capitalized cost of computer software?
a.
b.
c.
d.
$432,000
$450,000
$480,000
$540,000
6. CPA-06397
I n Year 5, an entity which uses I FRS, revalued an indefinite life intangible to its fair value of $1 50,000 and
recorded a revaluation surplus of $30,000. On December 31 , Year 6, the intangible asset had a fair value
of $1 30,000. I n its December 31 , Year 6 financial statements, the entity will report:
a.
b.
c.
d.
A $20,000
A $20,000
A $1 0,000
A $30,000
revaluation
revaluation
revaluation
revaluation
loss on the income statement
loss in other comprehensive income
loss in accumulated other comprehensive income
surplus in accumulated other comprehensive income
7. CPA-06398
On December 31 , an entity analyzed a patent with a net carrying value of $500,000 for impairment. The
entity determined the following :
Fair value
Estimated costs to sell
Value in use
$480,000
1 5,000
475,000
What is the impairment loss that will be reported on the December 31 income statement under I FRS?
a.
b.
c.
d.
$0
$20,000
$25,000
$35, 000
Fz·S6
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Becker Professional Education I CPA Exam Review
8. TBS -0001 7
Pinetree Builders had the following data for its Rolling Hills construction project. Compute the estimated
total cost, estimated total profit and percentage of completion for the project in Year 1 and Year 2. Enter
the appropriate amounts in the shaded cells below.
Contract Price: $2,350,000
the year
Costs incurred
Estimated costs to complete
$1,210,000
$1, 195,000
990,000
o
Estimated total cost
profit
Percentage of completion
Enter the correct amounts in the shaded cells below:
Percentage of completion - Year 1
Percentage of completion - Yea r 2
Completed contract method - Year 1
Completed contract method - Year 2
9. CPA-00691
Lang Co. uses the installment method of revenue recognition. The following data pertain to Lang's
installment sales for the years ended December 31 , Year 3 and Year 4:
I nstallment receivables at year-end on Year 3 sales
Year 3
Year 4
$60,000
$30,000
I nstallment receivables at year-end on Year 4 sales
69,000
I nstallment sales
80,000
90,000
Cost of sales
40,000
60,000
What amount should Lang report as deferred gross profit in its December 31 , Year 4, balance sheet?
a.
b.
c.
d.
$23,000
$33,000
$38,000
$43,000
1 0. CPA-00707
Wren Co. sells equipment on installment contracts. Which of the following statements best justifies
Wren's use of the cost recovery method of revenue recognition to account for these installment sales?
b.
c.
The sales contract provides that title to the equipment only passes to the purchaser when all
payments have been made.
No cash payments are due until one year from the date of sale.
Sales are subject to a high rate of return.
d.
There is n o reasonable basis for estimating co\\ectibility.
a.
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1 1 . CPA-00720
On July 1 , Year 1 , Bait Co. exchanged a truck for 25 shares of Ace Corp.'s common stock. On that date,
the truck's carrying amount was $2,500, and its fair value was $3,000. Also, the book value of Ace's
stock was $60 per share. On December 31 , Year 1 , Ace had 250 shares of common stock outstanding
and its book value per share was $50. What amount should Bait report in its December 31 , Year 1
balance sheet as investment in Ace assuming the transaction had commercial substance?
a.
b.
c.
d.
$3,000
$2,500
$1 ,500
$1 ,250
1 2. CPA-01 258
During a period of inflation in which the amount in an asset account remains constant, which of the
following occurs?
a.
b.
c.
d.
A purchasing
A purchasing
A purchasing
A purchasing
power gain, i f the item i s a monetary asset.
power gain , if the item is a nonmonetary asset.
power loss, if the item is a monetary asset.
power loss, if the item is a nonmonetary asset.
1 3. CPA-01 272
Park Co.'s wholly-owned subsidiary, Schnell Corp . , maintains its accounting records in German marks.
Because all of Schnell's branch offices are in Switzerland, its functional currency is the Swiss franc.
Remeasurement of Schnell's Year 4 financial statements resulted in a $7,600 gain , and translation of its
financial statements resulted in an $8, 1 00 gain. What amount should Park report as a foreign exchange
gain in its i ncome statement for the year ended December 31 , Year 4?
a.
b.
c.
d.
$0
$7,600
$8, 1 00
$1 5,700
1 4. CPA-01 274
On September 22, Year 4, Yumi Corp. purchased merchandise from an unaffiliated foreign company for
1 0,000 u nits of the foreign company's local currency. On that date, the spot rate was $.55. Yumi paid the
bill in full on March 20, Year 5, when the spot rate was $.65. The spot rate was $.70 on December 3 1 ,
Year 4 . What amount should Yumi report as a foreign currency transaction loss i n its income statement
for the year ended December 31 , Year 4?
a.
b.
c.
d.
$0
$500
$1 ,000
$1 ,500
F2-88
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FINANCIAL 3
Marketable Securities and Business Combinations
1.
Marketable securities
2.
Business combinations/consolidations
3.
Cost method (external reporting)
4.
Equity method and joint ventures (external reporting) . . . . . ................................................. . . .................................................... 14
5.
Consolidated financial statements
......................................................... . ................................................................................................. ......
............. .................................................................................................... ....................
.
............................................................................................................................... .............
12
.
22
.................................................................................................................................... ..............................
23
.. . . . .
.
.
...
7.
Intercompany transactions
8.
Combined financial statements/push down accounting
9.
Appendix I: Illustrative consolidated financial statements
10. Appendix II:
10
. . . .. . .. . .......... ............ ............ .........................................................
..........................
6. Acquisition method
3
..
.
...................................................................................................... ................................ ................
..........................................................................................................
.
.
........................ ......................... .......................... ..........................
46
54
55
IFRS vs. U.S. GAAP ................................................................................................................................................. 57
11. Class questions
.........................................................................................................................................................................
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59
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Becker Professional Education I CPA Exam Review
NOTES
F3-2
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Financial 3
MARKET A B LE SECURI T IES
I.
INVESTMENTS IN MARKETABLE DEBT AND EQU ITY SECURITIES
A.
Definition of Equ ity Securities
Equity securities are defined as securities that represent an ownership interest in an
enterprise or the right to acquire or dispose of an ownership interest in an enterprise at fixed
or determinable prices.
1.
2.
B.
Equity securities may be represented by:
a.
Ownership shares (common, preferred, and other forms of capital stock),
b.
Rights to acquire ownership shares (stock warrants, rights, and call options), and
c.
Rights to dispose of ownership shares (put options).
Equity securities do not include:
a.
Preferred stock redeemable at the option of the investor or stock that must be
redeemed by the issuer,
b.
Treasury stock (the company's own stock repurchased and held), and
c.
Convertible bonds.
C lassification
Securities should be classified into one of three categories, based on the intent of the
company.
1.
Trading Securities
Trading securities are those securities (both debt and equity) that are bought
and held principally for the purpose of selling them in the near term. Trading securities
generally reflect active and frequent buying and selling with the objective of generating
profits on short-term differences in price. Securities classified as trading securities are
generally reported as current assets, although they can be reported as noncurrent, if
appropriate.
2.
Avai lable-for-Sale Securities
Available-for-sale securities are those securities (both debt and equity)
not meeting the definitions of the other two classifications (trading or held-to-maturity).
Securities classified as available-for-sale securities are reported as either current
assets or noncurrent assets, depending on the intent of the corporation. If the security
represents cash available for current operations, it is appropriate to report the security
as a current asset.
3.
Held-to-Maturity Securities (debt securities only)
Investments in debt securities are classified as held-to-maturity securities
only if the corporation has the positive intent and ability to hold these securities to
maturity. If the intent is to hold the security for an indefinite period of time, but not
necessarily to maturity, then the security would be classified as available-for-sale. If a
security can be paid or otherwise settled in a manner that the holder may not recover
substantially all of its investment, the held-to-maturity classification may not be used.
Securities classified as held-to-maturity are reported as current or noncurrent assets,
based on their time to maturity.
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F3·3
Financial 3
Becker Professional Education I CPA Exam Review
u.s.
G A AP
VS
IF R S
Under IFRS, marketable security investments can be classified as follows:
•
Financial assets at fair value through profit or loss,
•
Available-for-sale, or
•
Held-to-maturity
A financial asset at fair value through profit or loss is a financial asset that meets either of the
fol lowing conditions:
1. It is classified as held for trading (equivalent to trading securities under U.S. GAAP).
2. The asset is designated as an investment at fai r val ue through p rofit or loss using the fair value
option.
II.
VALUATION
A.
Trading and Avai lable-for-Sale Securities
Trading and available-for-sale securities must be reported at fair value. Fair value is the
market price of the security or what a willing buyer and seller would pay and accept to
exchange the security. Changes in the fair value of trading and available-for-sale securities
result in unrealized holdings gains or losses. The reporting of these gains or losses in the
financial statements depends on the classification of the securities. Note that although two
general ledger accounts are normally mainta ined (i.e., one for the original cost of the security
and the other for the valuation account), the presentation on the balance sheet is one net
amount.
1.
Unrealized Gains and Losses-Trading Securities
Unrealized holding gains and losses on trading securities are included in earnings.
Therefore, the unrealized gain or loss on trading securities is shown in the income
statement.
Journal entry to record loss on the Income Statement:
11m
lWI!
2.
$XXX
Unrealized loss on trading securities
$XXX
Valuation account (fair value adjustment)
Unrealized Gains and Losses-Available-for-Sale Securities
Unrealized holding gains and losses on available-for-sale securities (including those
classified as current assets) are reported in other comprehensive income.
Journal entry to record unrealized loss reported in other comprehensive income:
11m
Unrealized loss on available-for-sale securities
lWI!
Valuation account (fair value adjustment)
u.s.
GAAP
$XXX
$XXX
vs. IFRS
Under IFRS, unrealized gains and losses on available-for-sale securities are reported in other
comprehensive i ncome, except for foreign exchange gains and losses on available-for-sale debt
securities, which a re reported directly on the i ncome statement. Foreign exchange gains and losses on
available-for-sale equity securities a re included in other com p rehensive income.
F3-4
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,
Becker Professional Education I CPA Exam Review
3.
Financial 3
Realized Gains and Losses
Realized gains or losses are recognized when a security is sold and when an available­
for-sale security is deemed to be impa ired. All realized gains or losses are recognized
on the income statement.
B.
Held-to-Maturity Securities
Held-to-maturity securities are valued at amortized cost.
ClassificatIOn
I
Balance Sheet
Trading
Current or
Noncurrent
Available-far-Sale
Securities
Current or
Noncurrent
Held-ta-Maturity
Debt Securities
Noncurrent
Current or
I
Reported
I
II
Unrealized Gain/Lass
i
I
Cash Flaw
Fair Value
Income Statement
Operating or
Investing·
Fair Value
Other Comprehensive
Income (PUFER)
Investing
Amo rtized C ost
NONE
Investing
'Under U.S. GAAP, trading security transactions are classified in operating cash flows or investing cash flows based
on the nature and purpose for which the securities were acquired. If trading securities are classified as noncurrent
on the balance sheet, then trading security transactions will be reported as investing cash flows. If trading
securities are classified as current on the balance sheet, then trading security transactions will be reported as
operating cash flows.
C.
Reclassification
Transfers between categories should occur only when justified. Transfers
from the held-to-maturity category should be rare and should only be made when there is a
change in the entity's intent to hold a specific security to maturity that does not call into
question the entity's intent to hold other debt securities to maturity. Transfers to and from the
trading category should also be rare.
Any transfer of a particular security from one group (trading, available-for-sale, or held-to­
maturity) to another group (trading, available-for-sale, or held-to-maturity) is accounted for at
fair value. Any unrealized holding gain or loss on that security is accounted for as follows:
1.
From Trading Category
The unrealized holding gain or loss at the date of transfer is already recognized in
earnings and shall not be reversed.
2.
To Trading Category
The unrealized holding gain or loss at the date of transfer shall be recognized in
earnings immediately.
3.
Debt Security C lassified as Held-to-Maturity Transferred to Avaiiable·for·Sale
The unrealized holding gain or loss at the date of transfer shall be reported in other
comprehensive income. Remember that this debt security was valued at amortized
cost as a held-to-maturity security and is being transferred to a category valued at fair
value.
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F3·5
Financial 3
Becker Professional Education I CPA Exam Review
4.
Debt Security Classified as Available-for-Sale Transferred to Held-to-Maturity
The unrealized holding gain or loss at the date of t ransfer is a l ready reported in other
comprehensive income. The unrealized holding gain or loss shall be amortized over
the rema ining life of the security as an adjustment of yield in a manner consistent with
the amortization of any premi u m or discount.
D.
Trading
Any other
FV
It has already been recognized in income so
no adjustment is necessary
Any other
Trading
FV
Recognized in current earnings
Held-to-Maturity
(Debt Securities)
Available-forSale
FV
Record in Other Comprehensive Income
Available-for-Sale
(Debt Securities)
Held-to-Maturity
(Debt Securities)
FV
Amortize gain or loss from Other
Comprehensive Income with any bond
premium/discount amortization
Impairment of Securities
The enterprise needs to determine whether the decline in value below the adjusted or
amortized cost of any security classified as either ava ilable-for-sale or held-to-maturity is
other tha n temporary. U nder U . S . GAAP, if the decline in fair value is other than temporary,
the cost basis of the individual security is written down to fair value as the new cost basis and
the amount of the write-down is accounted for as a realized loss and included in earnings.
Under U . S . GAAP, the new cost basis should not be changed for subsequent recoveries in
fair value. S ubsequent changes in fair value a re not recognized if the security is classified as
held-to-maturity. If the security is classified as ava ilable-for-sale, a subsequent increase in
fair value is included in other comprehensive income. S ubsequent increases in fai r value are
not recognized on the income statement . Subsequent decreases in fair value of available­
for-sale securities, if not other than temporary, are also included in other comprehensive
income and accounted for as an unrealized loss.
U.S.
GAAP
V S . IF R S
Under I F RS, a n impairment loss is recognized i n earnings and the individua l security is written down by either
directly reducing the cost basis of the security or through the use of a valuation allowance. Additionally,
previously recognized impairment losses on held-to-maturity debt securities and available-for-sale debt
securities may be reversed , with the amount of the reversal recognized on the income statement. For a held­
to-maturity security, the carrying value of the security after the reversal can n ot exceed what the amortized
cost of the security would have been had the impairment not been recognized.
III.
FINANCIAL I NSTRU MENTS USED TO HEDGE THE FAIR VALUE OF INVESTMENTS
A.
Used to Hedge Trading Securities
Gains and losses on financial instruments that hedge trading securities should be reported in
earnings, consistent with the reporting of unrealized gains and losses on the trading
securities.
F3-6
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Financial 3
Becker Professional Education I CPA Exam Review
B.
Used to Hedge Available-for-Sale Securities
Gains and losses on derivative instruments that hedge available-far-sale securities are
recognized currently in earnings together with the offsetting losses or gains on the available­
for-sale securities attributable to the hedged risk.
IV.
SALE OF SECURITY
A sale of a security from any category results in a realized gain or loss and is reported on the
income statement for the period. The valuation account, if used, would also have to be removed on
the sale of a security. For trading securities, the realized gain or loss reported when the security is
sold is the difference between the adjusted cost (original cost +/- unrealized gains/losses previously
recognized on the income statement) and the selling price. For available-far-sale securities, the
realized gain or loss reported when the security is sold is the difference between the selling price
and the original cost of the security. Any unrealized gains or losses in accumulated other
comprehensive income must be reversed at the time the security is sold.
Trading securities:
11m
$XXX
Cash
rw:o
Trading security
rw:o
Realized gain on trading security (I DEA)
$XXX
XXX
Available-for-sale securities:
V.
$XXX
11m
Cash
11m
Unrealized gain on available-far-sale security (PUFE)
rw:o
Available-far-sale security
rw:o
Realized gain on available-far-sale security (I DEA)
XXX
$XXX
XXX
INCOME TAX EFFECTS
Tax effects of unrealized gains or losses entering into the determination of net income must be
reflected in the computation of deferred income taxes, because unrealized gains and losses are not
deductible for tax purposes.
However, the tax effects of unrealized capital losses should only be recognized when it is
absolutely certain that the benefit will be realized by the offset of the capital losses against capital
gains.
VI.
REQUIRED DISCLOSU RES
The following information concerning securities classified as ava ilable-for-sale
and separately for held-to-maturity securities must be disclosed in the financial statements or
appropriate notes thereto:
Aggregate fair value,
Gross unrealized holding gains and losses,
Amortized cost basis by major security type, and
I nformation about the contractual maturities of debt securities.
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F3-7
Financial 3
Becker Professional Education I CPA Exam Review
C O M P R E H E N S I V E E X A M P L E - M A RK E T A B L E S E C U R I T I E S
The following information pertains to Fox, I nc.'s portfolio of marketable i nvestments for the year ended December 31, Year 2:
Cost
Fair value at
12L31LYl
Held-to-maturity securities
Security ABC
Trading securities
Security DEF
Availa ble-for-sale securities
Security GHI
Security JKL
Year 2 activity
Purchases
Sales
$95,000
$100,000
$ 150,000
$160,000
190,000
170,000
165,000
175,000
Fair value at
12L31LY2
155,000
$175,000
160,000
Security ABC was purchased at par. All declines in fair value are considered to be temporary.
Required:
1.
2.
3.
4.
Calculate the carrying amount of each security on the balance sheet at December 31, Year 2.
Calculate any realized gain or loss on the Year 2 income statement.
Calculate any unrealized gain or loss on the Year 2 income statement.
Calculate any unrealized gain or loss to be reported at December 31, Year 2 as other comprehensive income
SOLUTION
1.
Carrying amount of each security at December 31, Year 2:
Security ABC
$100,000
At year end, held-to-maturity investments are reported at their carrying value (amortized cost), not fair value. Carrying
value of security ABC is the purchase price of $100,000.
Security DEF
$155,000
The year-end carrying a mount of trading investments is the fair value at year end. Fair val ue of security DEF is
$155,000.
Security GHI was sold
Security JKL
$160,000
The year-end carrying a mount of available-for-sale investments is the fair value at year end. Fair value of security JKL is
$160,000.
2.
Realized gain or loss on income statement:
Security GHI
($15,000)
The $175,000 sales proceeds less the $ 190,000 cost yields a realized loss of $15,000. The sale of security GHI will be
recorded with the following JE:
$175,000
Cash
15,000
Realized loss
Security GHI
Unrealized loss (OCI)
F3-8
$165,000
25,000
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Financial 3
S O L U T I O N (continued)
3.
Unrealized gain or loss on income statement:
Security DEF
($5,000)
Only adjustments to trading securities valuations are reported on the income statement. The $160,000 carrying value
of the trading securities must be reduced to the $155,000 fair value and an income statement unrealized loss of $5,000
is recognized.
4.
Unrealized gain or loss (current year change)-other comprehensive income:
Security GHI & JKL (net)
Security GH I
Security JKL
$10,000
12/31/Yl
Accumulated DC!
Gain<Loss>
<$25,000>1
5,OOOl
<$20,000>
Year 2 DC!
Gain<Loss>
$25,000
<15,000>
$10,000
12/31/Y2
Accumulated DC!
Gain<Loss>
-0<10,000>
<$10,000>
1- Security GHI - Loss in 12/31/Y1 ADel ; $165,000 fair value - $190,000 cost; <$25,000>
2 - Security JKL - Gain in 12/31/Y1 ADCI ; $175,000 fair value - $170,000 cost; $5,000
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F3-9
Financial 3
Becker Professional Education I CPA Exam Review
BUSINESS COM BINATIONS/CONSOLIDATIONS
I.
PRESUM PTION
The presumption is that consolidated financial statements are more meaningful than parent
company financial statements a nd/or parent company financial statements together with separate
subsidiary financial statements.
II.
A.
Consolidated financial statements (including segment reporting) are necessary for fair
presentation.
B.
The equity method is not a valid substitute for consolidation.
CONSOLIDATE D FINANCIAL STATEMENTS
Consolidated financial statements ignore important legal relationships and emphasize
economic substance over form. Consolidated financial statements are an economic truth but
a legal fiction.
III.
LIMITATIONS OF CONSOLIDATED FINANCIAL STATEMENTS
A.
Noncontrolling interest shareholders, creditors, and bondholders of the subsidiary remain
uninformed regarding the subsidiary's separate financial statements.
B.
Weak performance of one company (entity) may b e offset b y the strong performance of
another company.
C.
Ratio analysis of consolidated data is not reliable. For example:
1.
Poor income statement results of individual subsidiaries are hidden.
2.
I ntercompany eliminations affect ratios.
Retained earnings available for parent shareholders (the account from which dividends are
paid) are not segregated nor otherwise indicated .
D.
•
•
CIS
Parent
1
Parent
Company
[[]
Sub
/
1
Sub
�
"v
/
[[]
•
Sub
1 �/:� 1
Parent
Company
Company
F3-10
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Becker Professional Education I CPA Exam Review
IV.
Financial 3
CRITERIA OF WHEN TO AND WHEN NOT TO CONSOLIDATE
A.
Consolidate ALL majority-owned subsidiaries (over 50% of the voting interest is owned by
parent company) to have one management and one economic entity. This includes
domestic, foreign, similar, and dissimilar subsidiaries.
B.
DO NOT consolidate when control is not with owners (e.g . , under legal reorganization or
when control of a subsidiary is with a trustee).
C.
Companies that have different year ends can b e consolidated. The subsidiary merely
prepares special financial statements to correspond closely with the parent's fiscal year end.
If the year ends differ by three months or less, the parent company can use the subsidiary's
regular financial statements of a different period , g iving recognition to material intervening
events during the gap period to expedite the consolidation process.
Under U.S. GAAP, significant transactions during the gap period require disclosure. Under IFRS, the subsidiary
financial statements must be adjusted for significant transactions during the gap period.
D.
�
In a vertical chain, where parent company owns more than 50% of a subsidiary company and
the subsidiary owns more than 50% of a third company, consolidate:
1.
Third company into subsidiary company.
2.
Subsidiary company (now consolidated with third company) into parent company.
DEGREE OF CONTROL
The degree of control the investor has over the investee dictates how the investor reports the
investment in corporate equity securities.
Consolidation: A combination of the financial statements of two or more entities into a single set of
financial statements representing a single economic unit.
ACQUISITION
C O NS O L I DATE
A.
Cost Method/Do Not Consolidate
=
No Significant Infl uence (typically < 20%)
The investor accounts for the investment using the cost method (fair value method/available­
for-sale method) if the investor does not have the ability to exercise significant influence over
the investee.
B.
Equity Method/Do Not Consolidate
(typically 20%-50%)
=
Significant Infl uence but 50% or Less Ownership
The investor accounts for the investment using the equity method of accounting if the investor
can exercise significant influence over the investee and holds 50% or less of the voting stock.
C.
Consolidate
=
Control (greater than 50% ownership)
The investor should prepare consolidated financial statements with its investees when the
investor has control (more than 50% ownership) of the subsidiary. Internally, the investor
may use either the cost method or the equity method to account for its investments.
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F3-11
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Financial 3
COST METHOD
(External Reporting)
I.
COST METHOD « 20% / does not exercise significant influence)
The cost method, also known as the fair value method or the available-for-sale method, should
be used when the investor owns less than 20% of the investee's voting stock and does not
exercise significant influence. Lacking evidence to the contrary, it is assumed that no
significant influence can be exercised from 0%-20%. The original investment under the cost
method is accounted for in the same manner as marketable equity securities, generally as an
available-for-sale investment.
If a company owns less than 20% of the stock of an investee company, but exercises significant
influence, the equity method must be used .
A.
Balance Sheet-Investment in Investee
1.
2.
The carrying amount of the investments account on the investor's (parent's) books is
"original cost," measured by the FV of the consideration given , including legal fees.
The investment account stays the same from the date of acquisition unless:
a.
Shares of stock in the investee are purchased or sold.
b.
There is an accumulated dividend in excess of accumulated earnings resulting in
a return of capital (called a liquidating dividend).
c.
The basis is adjusted to FV as required for marketable equity securities.
d.
The investee incurs losses that substantially reduce net worth from the date of
acquisition.
Record at Cost
Journal entry to record all costs of acquisition (FV of consideration plus legal fees):
11m
CWH
3.
Investment in investee
$XXX
$XXX
Cash
Marketable Securities-Adjust to FV
Journal entry to record unrealized loss and adjust to FV at year-end:
11m
Unrealized holding losses
$XXX
Investment in investee (or valuation account)
$XXX
Journal entry to record unrealized gain and adjust to FV at year-end.
11m
CWH
4.
$XXX
$XXX
Unrealized holding gains
Reduce Investment in Investee for Return of Capital Distributions
Journal entry to record a return of capital distribution or liquidating dividend is a dividend in
excess of investor's share of retained earnings.
11m
CWH
F3-12
Investment in investee (or valuation account)
Cash
Investment in investee
$XXX
$XXX
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Becker Professional Education I CPA Exam Review
Financial 3
E X A M P L E - L I Q U I D AT I N G D I V I D E N D
ABC Corporation owns a 10% interest in XYZ Corporation. During the current year, XYZ Corp. paid a
dividend of $10,000,000. XYZ had retained earnings of $8,000,000 when the dividend was declared.
ABC will receive a dividend of $1,000,000 ($10,000,000 x 10%) from XYZ and will record dividend
income of $800,000 for its share of XYZ's reta ined earn ings ($8,000,000 x 10%). The $200,000
difference reduces ABC's investment in XYZ. ABC will record the following journal entry for this
liquidating dividend.
Journal entry to record $1,000,000 ($10,000,000 x 10%) dividend received from XYZ Corporotion:
11m
Cash
rwtl
Dividend income ($8,000,000
$1,000,000
x
10%)
$800,000
Investment in XYZ Corporation
B.
200,000
Income Statement
Record cash dividends from the investee's retained earnings. Do not recognize stock
dividends.
1.
Dividends to the Investor/Parent (from Investee) are Income (Earnings) to the
Investor/Parent
Journal entry to record the cost method does not recognize a prorated share of the investee's
earnings as income to the investor/parent:
11m
rwtl
2.
Cash
$XXX
Dividend income
$XXX
Distribution that Exceeds Investor's Share of the Investee's Retained Earni ngs
(reduce basis/return of capital distribution)
Journal entry to record distribution:
11m
rwtl
Cash
$XXX
Investment in investee
$XXX
PA S S K E Y
The following three issues are t h e most frequently tested "cost" concepts:
•
The "Investment in Investee" is not adjusted for investee earnings.
•
The "Investment in Investee" is adjusted to FV.
•
Cash dividends from the investee are reported as income by the investor (parent).
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F3·13
Becker Professional Education I CPA Exam Review
Financial 3
EQUITY METHOD AND JOINT VENTURES
(External Reporting)
I.
EQUITY M ETHOD (200/0-50% / exercises significant influence)
The equity method is used to account for investments if significant influence can be exercised by
the investor over the investee. The critical criterion for using the equity method is that the
investor exerts significant influence over the operating and financial policies of the investee. If no
direct evidence of significant influence exists, ownership of 20% to 50% of the investee's voting
stock is deemed to represent significant influence. Consolidated statements should be presented
when ownership is greater than 50%.
Under the equity method the investment is originally recorded at the price paid to acquire the
investment. The investment account is subsequently adjusted as the net assets of the investee
change through the earning of income and payment of dividends. The investment account
increases by the investor's share of the investee's net income with a corresponding credit to the
investor's income statement account, Equity in Subsidiary/lnvestee I ncome. The distribution of
dividends by the investee reduces the investment balance. Continuing losses by an investee may
result in a decrease of the investment account to a zero balance.
A.
Exercises Significant Influence
A company that owns 20%-50% of voting stock of another "investee" company is presumed
to be able to exercise significant influence over the operating and financial policies of that
investee and, therefore, must use the equity method when presenting the investment in that
investee in:
1.
Consolidated financial statements that include other consolidated entities, but not that
investee, or
2.
Unconsolidated parent company financial statements.
3.
Equity method not appropriate (even i f investor owns 20% to 50% of subsidiary):
a.
Bankruptcy of subsidiary.
b.
Investment in subsidiary is temporary.
c.
A lawsuit or complaint is filed.
d.
A "standstill agreement" is signed (under which the investor surrenders
significant rights as a shareholder).
e.
Another small group has majority ownership and they operate the company
without regard to the investor.
f.
The investor cannot obtain the financial information necessary to apply the equity
method.
g.
The investor cannot obtain representation o n the Board of Directors.
PASS
I(EY
The CPA Examination frequently presents questions where the ownership percentage is below 20%,
but the "ability to exercise significant influence" exists. The equity method is the correct method of
accounting for these investments.
F3-14
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Financial 3
Becker Professional Education I CPA Exam Review
B.
Balance Sheet-"Investment in Investee" using Equity
Journal entry to record at cost (FVof considerotion plus legal fees):
Investment in investee
$XXX
Cash
$XXX
Journal entry to record increase by the investor's/parent's ownership percentage of earnings of
investee
$XXX
Investment in investee
$XXX
Equity in earnings/investee income
Journal entry to record decrease by the investor's/parent's ownership percentage of cash dividends
from investee (stock dividends reduce unit cost of stock owned in investee):
$XXX
Cash
Investment in investee.
c.
$XXX
Income Statement-Record the investor's/parent's ownership percentage of earnings as
income (dividends are not income, treat as bank withdrawals).
Journal entry to record investee earnings (investor's/parent's percentage ownership of earnings of investee):
Investment in investee
$XXX
$XXX
Equity in earnings/investee income
PA S S
KEY
An easy way to remember all the GAAP accounting rules for the "equity method" is to think of it like a bank
account and use your base account analysis:
Beginning balance
Add: Investor's share of investee's earning (like bank interest; it is income when earned, not when taken out).
Subtract: Investor's share of investee's dividends (like bank withdrawals; and it is not income)
Ending balance
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F3-15
Financial 3
Becker Professional Education I CPA Exam Review
E X A M P L E - E Q U I T Y M E THO D
On January 1, Year 1, Big Corporation acquired a 40% interest in Small Company for $300,000. At the date of acquisition,
Small Co.'s equity (net assets) had a book value of $750,000. Therefore, there was no difference between the purchase price
and the book value of the net assets acquired ($300,000 40% x $750,000). During Year 1, Small Co. had net income of
$90,000 and paid a $40,000 dividend.
=
Journal entry to record the initial investment of 40%:
11m
Investment in Small Co.
$300,000
Cash
[WD
$300,000
Journal entry to recognize the investee's net income (40% x $90,000):
11m
$36,000
Investment in Small Co.
[WD
$36,000
Equity in investee income
Journal entry to recognize the dividend paid by the investee (40% x $40,000):
11m
$16,000
Cash
[WD
$16,000
Investment in Small Co.
On December 31, Year 1, the investment account on the balance sheet would show $320,000 ($300,000 + $36,000$16,000), and the income statement would show $36,000 as Big's equity in subsidiary income.
D.
Investments in I nvestee Common Stock and Preferred Stock
If an investor company owns both common and preferred stock of an investee company:
E.
1.
The "significant influence" test is generally met by the amount of common stock owned
(which is usually the only voting stock).
2.
The calculation o f the income from subsidiary (or investee) to b e reported o n the
income statement includes:
a.
Preferred stock dividends, and
b.
Share of earnings available to common shareholders (net income reduced by
preferred dividends).
Differences between the P urchase Price and Book Value (NBV) of the Investee's Net
Assets
Additional adjustments to the investment account under the equity method result from
differences between the price paid for the investment and the book value of the investee's net
assets. This difference is first attributable to:
1.
Asset Fair Value Differences
Differences between the book value and fair value of the net assets acquired.
2.
Goodwil l
Any remaining difference is goodwill.
PASS KEY
An easy way to solve this type of q uestion i s to set u p a building block box and plug i n the respective
dollar a mounts a nd then compare to the purchase price:
·I _-t
I--_G _OO_d W_ 'I_
•
•
••
..
�.����.� � �_
••. •••••
FV
x%
NBV
x%
=
..____...
$
I------f---.------------------------------
F3-16
�
Price
$
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Becker Professional Education I CPA Exam Review
3.
Financial
3
Amortize Asset Fair Value Difference (Premium) Over Related Asset Life
The excess of an asset's fair value over its book value is amortized over the life of the
asset (excess caused by land is not amortized). This additional amortization causes
the investor's share of the investee's net income to decrease.
11m
ttm
4.
Equity in investee income
$XXX
Investment in investee
$XXX
Goodwill Difference-Not Amortized and No Impairment Test
The fair value excess attributable to goodwill is not amortized and is not subject to a
separate impairment test. However, the total equity method investment (including
goodwill) must be analyzed at least annually for impairment.
P A S S KEY
To better understand t h e journal entry and its impact, think o f t h e a mortization o f excess purchase
price (premium) as a bank service charge. The "equity method," which we treat like a bank account,
will have the account balance (balance sheet asset) reduced by this "bank service charge" and also will
have the net earnings from the account reduced by this (service) charge.
The following diagram illustrates the relationships between the purchase price of the
equity method investment and the fair value and book value of the equity interest
acquired :
EQUITY METHOD
Purchase Price
of Investment
Difference is Goodwill
Fai r Value of
Equity Acquired
Difference is Asset
Fair Value Difference
(Premium)
Book Value of
Equity Acquired
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F3-17
cr
Financial 3
Becker Professional Education I CPA Exam Review
E X A M P L E - E Q U I T Y M E TH O D
On January 1, Year 1, Big Corporation acquired a 40% interest in Small Company for $300,000. At the date of acquisition,
Small Co.'s equity (net assets) had a book value of $550,000 and a fair value of $600,000. The difference between the book
value and fair va lue relates to equipment being depreciated over a remaining useful life of ten years. During Year 1, Small
Co. had net income of $90,000 and paid a $40,000 d ividend.
1.
Investment and Subsidiary Activity:
Journal entry ta record the initial investment of 40%:
$300,000
I nvestment in Small Co.
$300,000
Cash
Journal entry to recognize the investee 's net income (40% x $90,000):
$36,000
Investment in Small Co.
$36,000
Equity in investee income
Journal entry to recognize the dividend paid by the investee (40% x $40,000):
$16,000
Cash
$16,000
I nvestment in Small Co.
2.
Asset Adjustment and Depreciation:
------------------------------------------------=
FV
$600,000 x 40%
=
$240,000
NBV
$550,000 x 40%
=
$220,000
-
y-------,
$300,000
Excess
Goodwill
_________________________________________________
L.-___________
--'
Journal entry to record depreciation on undervalued equipment ($20,000 + 10 years):
Equity in investee income
$2,000
$2,000
Investment in Small Co.
3.
Goodwill- The
excess of t h e purchase price over t h e fai r value of net assets:
P u rchase p rice of the investment i n Small Co.
Less: Fair value of Big Co. 's equity in net assets of Small Co. (40%
Goodwill
x
600,000)
$ 300,000
(240,000)
$ 60,000
On December 31, Year 1, Big Co.'s investment in Small Co.'s account would show a balance of $318,000 ($300,000 + $36,000$16,000- $2,000), and the income statement would show $34,000 ($36,000 - $2,000) equity in investee income.
F3-18
(0 DeVry/Becker Educational Development Corp. All rights reserved.
Financial
Becker Professional Education I CPA Exam Review
F.
3
Unconsolidated Investment of Over 50% (equity method required)
A parent company that does not consolidate a 50%+ owned subsidiary (e.g., lack of control
due to a company being controlled by a bankruptcy trustee or a subsidiary that is likely to be
a temporary investment) must use the equity method when presenting the investment in that
subsidiary in:
II.
1.
Consolidated financial statements (without that subsidiary being consolidated).
2.
Unconsolidated parent company financial statements are NOT allowed to be issued to
stockholders as the "primary reporting entity." However, they may be presented as a
supplemental disclosure.
COMPARISON OF COST AND EQUITY METHODS
DO NOT CONSOLIDATE
COST
EQUITY
No significant influence
Significant influence
< 20%
20% - 50%
PURCHASE PRICE
Investment in investee
Cash
11m
lWD
PURCHASE PRICE
I,
11m
I'
lWD
Investment in i nvestee
Cash
+ INVESTEE INCOME
11m
MARKETABLE SECURITY
ACCOUNTING
Report investment at fair value
lWD
BALANCE SHEET
"Investment account"
Investment in i nvestee
Equity in earnings
11m
Equity in earnings
Investment in investee
- INVESTEE DIVIDENDS
11m
lWD
11m
Cash
Investment
Dividend income
lWD
Cash
Dividend income
Cash
I
I nvestment in investee
INVESTEE INCOME
LIQUIDATING DIVIDENDS
INVESTEE DIVIDENDS
I
- AMORTIZED FV > NBV
lWD
11m
I
11m
I nvestment in investee
lWD
Equity in earnings
AMORTIZED FV > NBV
INCOME STATEMENT
11m
"Reportable income"
lWD
Equity in earnings
I nvestment in investee
GOODWILL
I
(equity method only)
•
•
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Not amortized
Not impai red
F3-19
Becker Professional Education I CPA Exam Review
Financial 3
III.
JOINT VENTURE ACCOUNTING
Under both U.S. GAAP and I FRS, investors generally account for joint venture investments using
the equity method.
IV.
STEP-BY-STEP ACQUISITION (still not consolidating)
A corporation may acquire an investment in investee in more than one transaction. In this case,
any goodwill must be computed at the time of each transaction.
A.
Change from Cost Method to Equity Method
When significant influence is acquired, it is necessary to record a change from the
costlavailable-for-sale classification to the equity method. The investment account and the
retained earnings account are adjusted retrospectively for the difference between the availablefor-sale classification/cost method to the equity method.
1.
To Equity from Cost
When two or more purchases of stock cause ownership in an investee corporation to
go from not having significant influence « 20%) to having significant influence (� 20%
but less than 50%):
2.
a.
The equity method should be used and the periods during which the cost method
(fair value) was used are retrospectively adjusted.
b.
The year-end ownership percentage is used to make all equity entries.
Equity in Investee Income Calculation
When the additional investment is made sometime during the year, the investor will
calculate its share of the investee's income by multiplying the:
a.
Investee's income b y the fraction of the year that the cost method (available-for­
sale) was used and the percentage ownership before the change.
b.
This will then be added to the investee's income multiplied by the fraction of the
year remaining and the percentage of ownership after the change.
P A S S I( E Y
The key to a nswering q uestions relating to this issue correctly is to:
•
Apply the new method (equity) to the prior period's old percentage (1 < 20%).
•
Do not a pply the new percentage to the prior period (you did not own that percentage
back the n ! ) .
-
IFRS generally requires entities t o apply t h e equity method prospectively from t h e t i m e a t which
the investor obtains significant influence. Retroactive adjustment is not required.
F3-20
© OeVry/Becker Educational Development Corp. All rights reserved.
Becker Professional Education I CPA Exam
Review
Financial 3
EXAMPLE
On January 1, Year 1, Big Co. paid $20,000 for a 15% interest in Small Co. Big Co. does not have significant influence over
Small Co. The book value of net assets was $120,000. Any excess is attributable to a building with a 40-year life. Net
income reported by Small Co. during Year 1 was $35,000. Big Co.'s share of dividends declared by Small Co. amounted to
$750. The market value of the investment was $ 17,000 on December 31, Year 1. Under the cost method (availabl e-far-sale
treatment), in Year 1 Big Co. would record dividend income but would not recognize net income reported by Smal l Co. nor
amortize any asset premium (related to the building).
On January 1, Year 2, Big Co. increased its ownership in Small Co. to 50%, paying $60,000. The fair value and book val ue of
Small Co.'s net assets at January 1, Year 2 were $108,000.
On January 1, Year 2, Big Co. would record its additional investment and make the following adjustments to retroactively
convert from the available-far-sale treatment to the equity method.
Schedule 1: Building (premium) resulting from the investment on January 1, Year 1
Price paid/cost of the January 1, Year 1 investment
$ 20,000
N BV of the net assets acquired ($120,000 x 15%)
(18,000)
Building (premium)
$ 2,000
Building (premium) will be amortized over 40 years (equity method only)
.;. 40 yrs.
$2,000 ';' 40
$ 50.00
=
$50 amortization per year (equity method only)
Schedule 2: Calculation of the retrospective adjustment to the equity method at Janua ry 1, Year 2
Equity method:
o
0,
o
o
Year 1 investment (at cost)
Equity method adjustments:
Plus: Share of Small Co.'s net income ($35,000
$ 20,000
x
5,250
15%)
Less: Dividends received
(750)
Less: Amortization of building (premium) ($2,000 .,. 40)
�)
Balance of the investment account under the equity method
$24,450 [ 1 )
Cost/available-for-sale treatment:
December 31, Year 1 investment balance at market value
$17,000 [2)
Total adjustment to investment ([1] - [2])
$7,4S0
Adjustment to unrealized loss on available-far-sale securities
(3,000)
Retrospective adjustment to retained earnings
$ 4,450
Journal entry to record the retrospective adjustment to the investment and retained earnings account and write off the
unrealized loss on available-for-sale securities:
Investment in Smal l Co.
Retained earnings
Unrealized loss on available-far-sale securities
$7,450
$4,450
3,000
Journal entry to record the additional investment at January 1, Year 2:
Investment in Small Co.
Cash
ro DeVry!Becker Educational Development Corp. All rights reserved .
$60,000
$60,000
F3-21
Financial 3
Becker Professional Education I CPA Exam Review
CONSOLIDATED FINANCIAL STATEMENTS
I.
CONSOLIDATED FINANCIAL STATEMENTS
A.
Control (over 50%)
Consolidated financial statements are prepared when a parent-subsidiary relationship has
been formed . An investor is considered to have parent status when control over an investee
is established or more than 50% of the voting stock of the investee has been acquired.
U nder U.S. GAAP, all majority-owned subsidiaries (domestic and foreign) must be
consolidated except when significant doubt exists regarding the parent's ability to control the
subsidiary, such as when:
1.
The subsidiary is in legal reorganization, or
2.
Bankruptcy and/or the subsidiary operates under severe foreign restrictions.
U
S
G A A P VS
IFRS
U nder IFRS, a parent company must consolidate its investments in subsidiaries unless all of the following
conditions are met:
1. The parent company is itself a wholly owned subsidiary, or is a partially owned subsidiary of another entity
and the other owners do not object to the parent not presenting consolidated financial statements,
2. The parent company is not publicly traded and is not in the process of issuing securities in a public
market,
3. The ultimate or any intermediate parent of the parent company produces consolidated financial
statements in compliance with IFRS.
Ic/Sl
�
•
100
50
I
CONSOLIDATE
I
1
B.
Acquisition Method-Fundamental Principles
The acquisition method is required to be used to record the acquisition of a subsidiary under
both U.S. GAAP and I FRS. The main principles for applying the acquisition method are:
1.
Recognition Pri nciple
The acquirer recognizes all of the subsidiary's assets and liabilities, including
identifiable intangible assets.
2.
Measurement Principle
The acquirer measures each recognized asset and liability and any non controlling
interest at its acquisition date fair value.
F3-22
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Becker Professional Education I CPA Exam Review
Financial 3
A CQUISITION MET H OD
I.
ACQUISITION M ETHOD
In a business combination accounted for as an acquisition, the subsidiary may be
acquired for cash, stock, debt securities, etc. The investment is valued at the fair value of the
consideration given or the fair value of the consideration received, whichever is the more clearly
evident. The accounting for an acquisition begins at the date of acquisition.
Journal entry to record the acquisition for cash:
11m
�
$XXX
Investment in subsidiary
$XXX
Cash
Journal entry to record the acquisition for parent common stock (use FV at date transaction closes):
11m
$XXX
Investment in subsidiary
�
Common stock (parent at par)
�
A.P. I .e. (parent/FV - par)
$XXX
xxx
E X A M PLE I - DATE OF P U RCHASE- STOCK PR I CE G OES U P
Facts:
•
TAG Inc. announces that it has agreed to buy a Sub Co. on April 1, Year 1 for 1 million shares of its own common
stock.
•
Transaction closes on September 30, Year 1 - 1 million shares issued.
Market Price ofStock
Stock Price Goes Up
4/1/Yl (announced)
$10
9/30/yl (closed)
$14
E X A M P LE 2 - DATE O F P U RCHASE - S T OCK PR I CE G OES D O W N
Facts:
•
TAG Inc. announces that it has agreed to buy a Sub Co. on April 1, Year 1 for 1 million shares of its own common
stock.
•
Transaction closes on September 30, Year 1-1 million shares issued.
Market Price ofStock
Stock Price Goes Down
4/1/Yl (announced)
$10
9/30/Yl (closed)
$7
1,000,000 x $7
CI DeVry/Becker Educational Development Corp. A l l rights reserved.
F3-23
Becker Professional Education I CPA Exam Review
Financial 3
A.
Application of the Acquisition Method
The acquisition method has two distinct accounting characteristics: ( 1 ) 1 00% of the net
assets acquired (regardless of percentage acquired) are recorded at fai r value with any
unallocated balance remaining creating goodwill, and (2) when the companies are
consolidated, the subsidiary's entire equity (including its common stock, A. P. I .C., and retained
earnings) is eliminated (not reported).
PASS KEY
The parent's basis i s the acquisition price. The easy to remember formula is:
Acquisition price
=
Investment in subsidiary
An acquiring corporation should adjust the following items during consolidation:
1.
Common Stock, A.P. I.C. and Retai ned Earn ings of Subsidiary are Eliminated
The pre-acquisition equity (common stock, A.P. I .C. and retained earnings) of the
subsidiary is not carried forward in an acquisition. Consolidated equity will be equal to
the parent's equity balance (plus any Noncontrolling Interest). The subsidiary's equity
is eliminated by debiting each of the subsidiary's equity accounts in the Eliminating
Journal Entry (EJE) on the consolidating workpapers.
2.
Investment in Subsidiary is eliminated
The parent company will eliminate the "I nvestment in Subsidiary" account on its balance
sheet as part of the Eliminating Journal Entry (EJ E). This credit will be posted
on the consolidating workpapers.
3.
Noncontrolling I nterest (NCI) is Created
As part of the Eliminating Journal Entry (EJE) on the consolidating workpapers, the fair
value of any portion of the subsidiary that is not acquired by the parent must be
reported as noncontrolling interest in the equity section of the consolidated financial
statements, separately from the parent's equity.
4.
Balance Sheet of Subsidiary is Adjusted to Fair Value
All of the subsidiary's balance sheet accounts are to be adjusted to fair value on the
acquisition date. This is accomplished as part of the Eliminating Journal Entry (EJE) on
the consolidating workpapers. This adjustment is done, regardless of the amount paid
to acquire the subsidiary. The adjustment is for the full ( 1 00%) fair value of the
subsidiary's assets and liabilities, even if the parent acquires less than 1 00% of the
subsidiary.
5.
Identifiable Intangible Assets of the Subsidiary are Recorded at their Fair Value
As part of the Eliminating Journal Entry (EJE) on the consolidating workpapers, it is
required that the parent record the fair value of all Identifiable I ntangible Assets of the
subsidiary. This is done, even if no amount was incurred to acquire these items in the
acquisition.
6.
Goodwil l (or Gain) is Required
If there is an excess of the fair value of the subsidiary (acquisition cost plus any
noncontrolling interest) over the fair value of the subsidiary's net assets, then the
remaining/excess is debited to create Goodwill. I f there is a deficiency in the
acquisition cost compared to the subsidiary's fair value, then the shortage/negative
amount is recorded as a gain.
F3-24
It) OeVry/Becker Educational Development Corp_ All rights reserved.
Becker Professional Education I CPA Exam Review
I
Financial 3
ACQUISITION ILLU
S
TRA
TION
•
[]D
CIS
Parent
�
�
Sub
1
1
•
50
I
100
CONSOLI DATE
I
1
Sub
Company
7.
Consolidating Workpaper Eliminating Journal Entry
leAR IN BIGI
The year-end consolidating journal entry known as the consolidating workpaper
eliminating journal entry (EJ E) is:
11m
Common stock - subsidiary
11m
A. P. I.c. - subsidiary
XXX
11m
Retained earnings - subsidiary
XXX
$XXX
(II!
Investment in subsidiary
$XXX
(II!
Noncontrolling interest
XXX
11m
Balance sheet adjustments to FV
11m
Identifiable Intangible assets to FV
XXX
11m
Goodwill
XXX
$XXX
P A S S I( EY
Sub's Total (100%) Fair Value
Goodwill
NCI
. . . . . - - . - . - . . . . . . . - - - - - - - - -- - - - - - - - - - - - - - - - _ . _ -. . . - - - - - - - -
Identifiable Intangible
Assets FV
Investment
Balance Sheet
FV Adjustment
in Subsidiary
. . . . . . . . __ . . . . . . . __ . . . . . . . . . . __ . . . . . . . . . __ . . . . . . . . . . . . _ .
(acquisition price)
Book Value
(CAR)
I)Jll
(0 DeVry/Becker Educational Development Corp. All rights reserved.
A
(tJ8
F3-25
Becker Professional Education I CPA Exam Review
Financial 3
JOURNAL ENTRY FLOW CHART-ACQUISITION DATE CALCULATION
Com m o n stock - Sub
A . P. I .e.
- Sub
Retai ned earnings - Sub
<
<
Investm ent i n Sub
Noncontroliing i nterest
>
>
DI FFERENCE
- Balance Sheet F V Adjustment
DIFFERENCE
- Identifiable Intangible Assets
DIFFERENCE
Gain
Goodwill
The following diagram illustrates the relationships between the fair value of the subsidiary, the fair
value of the subsidiary's net assets and the book value of the subsidiary's net assets.
A C QU I SITION METHOD
Fair Value of Subsidiary
(Acquisition price + Noncontrolling
interest at fair value)
Difference is Goodwill
Fair Value of Subsidiary
Net Assets
Difference is Asset
Fair Value Dlfference(s)
Book Value of Subsidiary
Net Assets
F3-26
ro DeVry/Becker Educational Development Corp. All rights reserved.
Financial 3
Becker Professional Education I CPA Exam Review
B.
"CAR"-Subsidiary Equity Acquired
1.
I
CAR I N
BIG I
CAR Formu la
The following formula is used to determine the book value of the assets acquired from
the subsidiary:
Assets - Liabilities Equity
Assets - Liabilities Net book value
Assets - Liabilities CAR
=
=
=
2.
Acquisition Date Calculation (of CAR)
The determination of the difference between book value and fair value is computed as of
the acquisition date.
When the subsidiary's financial statements are provided for a subsequent period, it is
necessary to reverse the activity (income and d ividends) in the subsidiary's retained
earnings in order to squeeze back into the book value (Assets - Liabilities = CAR) at
the acquisition date.
8 ABeginning retained earnings
c i nd
t =�n=:=:=e=aS=rn=in=-g=-s---.:I�
=
:
8L=�;=:=i�= �=:=�
C.
I nvestment i n Subsidia ry
Common stock - Sub
A.P.I.e. - Sub
-S b
,
- Noncontrolling Interest
Balance sheet adjusted to FV
Identifiable Intangible Assets FV
Goodwill
' Ca r
AcqUISition
--
_
:::::::;:::
Same all year
Same all year
Squeeze back to
purchase date amount
D a tC'
I CAR BIG I
IN
The original carrying amount of the investment in subsidiary account on the parent's books is:
1.
Original cost-Measured by the fair value (on the date the acquisition is completed) of
the consideration given (Debit: investment in sub).
2.
Business combination costs/expenses in an acquisition are treated as follows:
a.
Direct out-of-pocket costs such as a finder's fee or a legal fee are expensed
(Debit: expense).
b.
Stock registration and issuance costs such as SEC filing fees are a direct
reduction of the value of the stock issued (Debit: additional paid-in capital
account).
c.
I ndirect costs are expensed as incurred (Debit: expense).
d.
Bond issue costs are capitalized and amortized (Debit: bond issue costs).
(0 DeVry/Becker Educational Development Corp. All rights reserved.
F3-27
Becker Professional Education I CPA Exam Review
Financial 3
On January 1, Year 1, Big Company exchanged 10,000 shares of $10 par value common stock with a fair value of $415,000
for 100% of the outstanding stock of Sub Company in a business combination properly accounted for as an acquisition. In
addition Big Co. paid $35,000 in legal fees. At the date of acquisition, the fair and book value of Sub Co.'s net assets totaled
$300,000. Registration fees were $20,000.
E X A M P L E - B U S I N E S S C O M B I N AT I O N A C C O U N T E D F O R A S A N A C Q U I S I T I O N
Journal entry to record the acquisition price and legal fees:
11m
11m
*A.P.I.C. -
Investment in subsidiary
Legal expense
Common stock - $10 par value
Additional paid-in capital - Big Co.
Cash
Big Co.
$415,000
35,000
$100,000
($315,000 - $20,000)
295,000*
($35,000 + $20,000)
=
$415,000 - $100,000
=
55,000
$315,000 - $20,000 $295,000
=
Total (100%) Fair Value
Goodwill
$ 115,000
Identifiable intangible
-0assets FV
Balance sheet FV
-0adjustment
1------+- --------------------------Book value (CAR)
$300,000
Sub's
-0-
NCI
$415,000
Investment
in subsidiary
}
D
11m
11m
11m
Common stock -subsidiary
A.P.I.e. -subsidiary
Retained earnings - subsidiary
Investment in subsidiary
Noncontrolling interest
Balance sheet adjustments to FV
Identifiable intangible assets to FV
Goodwill
� Whe" the CPA Exami",,,o" Ie'" 'hi' I,,'e, ..membe, '0 iook ",.." II,
D.
Noncontrolling Interest (NCI)
1.
$300,000
$415,000
-0-0-0$ 115,000
fo,
'he "" " '''0" ..i.Ied
",m
'hot m " be e>q>e_.
,
I CAR IN BIG I
Overview
Business combinations that do not establish 1 00% ownership of a subsidiary by a
parent will result in a portion of the subsidiary's equity (net assets) being attributed to
noncontrolling interest shareholders. Noncontrolling interest must be reported at fair
value in the equity section of the consolidated balance sheet, separately from the
parent's equity. This will include the noncontrolling interest's share of any goodwill
(even though there is no cost basis).
F3-28
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Becker Professional Education I CPA Exam Review
2.
Financial 3
Financial Statement Presentation
a.
Balance Sheet
The consolidated balance sheet will include 1 00% of the subsidiary's assets and
liabilities (not the sub's equity/CAR). The noncontrolling interest's share of the
subsidiary's net assets should be presented on the balance sheet as part of
stockholders' equity, separately from the equity of the parent company (see
Appendix 1 : Illustrative Consolidated Financial Statements).
(1 )
Acqu isition Date Computation
The noncontrolling interest is calculated by multiplying the total subsidiary
fair value times the noncontrolling interest percentage:
x
(2)
Fair value of subsidiary
Noncontrolling interest %
Noncontrolling interest
Noncontrolling Interest after the Acqu isition Date
After the acquisition date, the noncontrolling interest reported on the
consolidated balance sheet is accounted for using the equity method:
Beginning noncontrolling interest
NCI share of subsidiary net income
- NCI share of subsidiary dividends
Ending noncontrolling interest
+
( 3)
Allocation of Subsidiary Net Losses
Subsidiary net losses are allocated to noncontrolling interest even if the
allocation exceeds the equity attributable to the noncontrolling interest
(negative carrying balance).
b.
Income Statement
The consolidated income statement will include 1 00% of the subsidiary's
revenues and expenses (after the date of acquisition). The consolidated income
statement should show, separately, consolidated net income, net income
attributable to the noncontrolling interest, and net income attributable to the
parent (see Appendix 1 : Illustrative Consolidated Financial Statements).
(1 )
Computation of Net Income Attributable to the Noncontrolling Interest
Compute by multiplying the subsidiary's net income times the
noncontrolling interest percentage.
Subsidiary's income
Subsidiary's expenses >
Subsidiary's net income
Noncontrolling interest %
Net income attributable to
the noncontrolling interest
<
I�
II
x
<0 DeVry/Becker Educational Development Corp. All rights reserved .
F3-29
Financial 3
Becker Professional Education I CPA Exam Review
c.
d.
Comprehensive Income
The statement of comprehensive income should show, separately, consolidated
comprehensive income, comprehensive income attributable to the noncontroliing
interest, and comprehensive income attributable to the parent company (see
Appendix 1 : Illustrative Consolidated Financial Statements).
Statement of Changes in Equity
Because noncontroliing interest is part of the equity of the consolidated group, it
is presented in the statement of changes in equity. The consolidated statement
of changes in equity should present a reconciliation at the beginning and ending
of the period of the carrying amount of total equity, equity attributable to the
parent, and equity attributable to the noncontroliing interest (see Appendix 1 :
Illustrative Consolidated Financial Statements).
Gearty Co. acquires 60% of Foxy, Inc. for $69,000,000
The fair value of Foxy Inc. is $115,000,000
Noncontrolling interest is $46,000,000
Fair value of Foxy, Inc. (includes goodwill)
Fair value of Foxy, Inc. identifiable net assets
Book value of Foxy, Inc. net assets
E X A M P L E - N O N C O N T R O L L I N G I N TE R EST
•
•
•
•
•
•
}
($115,000,000 x 60% = $69,000,000)
($115,000,000 x 40% = $46,000,000)
$115,000,000
$100,000,000
$15,000,000
$ 20,000,000
$ 80,000,000
EXAMPLE
Goodwill
Identifiable intangible
assets FV
Balance sheet FV
adjustment
Book value (CAR)
IIlD
IIlD
IIlD
(D
(D
IIlD
IIlD
IIlD
Sub's Total (100%) Fair Value
$15,000,000
=
$46,000,000
NCI
$69,000,000
Investment
in subsidiary
$115,000,000
-0-
$20,000,000
�--------------------------------
$80,000,000
}
Commo" "o,k -"b,idi.cy
A.P.I.e. -subsidiary
Retained earnings - subsidiary
Investment in subsidiary
Noncontrolling interest
Balance sheet adjustments to FV
Identifiable intangible assets to FV
Goodwill
$ 80,000,000
$ 69,000,000
46,000,000
20,000,000
-015,000,000
$115,000,000
F3-30
$115,000,000
It) DeVry/Becker Educational Development Corp. All rights reserved.
Becker Professional Education I CPA Exam Review
Financial 3
Under IFRS, noncontrolling interest (and goodwill as discussed below) can be calculated using either
the "partial goodwill" method or the "full goodwill" method. The partial goodwill method is the
preferred method under IFRS, but entities can elect to use the full goodwill method on a transaction­
by-transaction basis.
U.S.
GAAP
VS. IFRS
The full goodwil method is the method used under U.S. GAAP (as described above), in which
noncontrolling interest on the balance sheet is calculated as follows:
NCI Fair value of subsidiary Noncontrolling interest %
Full GoodwillMethod
=
x
Under the partial goodwill method, noncontrolling interest is calculated as follows:
NCI Fair value of subsidiary's net identifiable assets Noncontrolling interest %
An example of the partial goodwil method is shown below following the discussion of goodwill.
Partial Goodwill Method
x
=
E.
Balance Sheet Adjustment to Fair Val ue, Identifiable I ntangible Asset
Adjustment to Fair Val ue, and Goodwill (gain)
1.
I CAR IN BIG I
Fair Value of Subsidiary (Acqu isition Cost + Noncontrolling Interest)
Reconciliation to Book Value of Subsidiary Net Assets
Under the acquisition method, the fair value of the subsidiary is equal to the acquisition
cost plus any noncontrolling interest at fair value. On the acquisition date, the fair value
of the subsidiary must be compared to the respective assets and liabilities of the
subsidiary. Any difference between the fair value of the subsidiary and the book value
acquired will require an adjustment to the following three areas:
a.
Balance Sheet Adjustment of the subsidiary's records from book value to fair
value.
b.
Identifiable Intangible Assets related to the acquisition of the subsidiary are
recorded at fair value.
c.
Goodwill is recognized for any excess of the fair value of the subsidiary over the
fair value of the subsidiary's net assets. If the fair value of the subsidiary is less
than the fair value of the subsidiary's net assets, a gain is recognized.
P A S S KEY
o
o
o
In Process Research and Development
Recognize as an intangible asset separately from goodwill at the acquisition date (need valuation).
Do not immediately write off.
In process research and development meets the definition of an "asset"-it has probable future
economic benefit.
e DeVry/Becker Educational Development Corp. All rights reserved.
F3-31
Becker Professional Education I CPA Exam Review
Financial 3
2.
Determining Acq uisitions with Goodwill
I CAR I N BIG I
Rule: When acquiring a corporation/subsidiary with a fair value (acquisition price
value of NCI) that is greater than the fair value of 1 00% of the underlying assets
acquired, the following steps are required:
a.
+
fair
Step 1 -Balance Sheet A djusted to Fair Value
Allocate the acquisition cost to the fair value of 1 00% of the Balance Sheet
accounts.
b.
Step 2-ldentifiable Intangible Assets to Fair Value
Allocate the remaining acquisition cost to the fair value of 1 00% of the identifiable
intangible assets acquired.
Illustrative List of Identifiable Intangible Assets
•
Agreements & Contracts
•
Computer Software & Licenses
•
Rights
•
Technical Drawings & Manuals
•
Permits
·
Customer Lists
•
Patents
•
Unpatented Technology
•
Copyrights
•
•
Trademarks & Trade Na mes
In-Process Research and
Development
•
Franchises
•
Noncompetes
These Identifiable Intangible Assets are separated into two categories:
(1)
Fin ite l ife
Amortize over the remaining l ife. Subject to the two-step impairment test.
(2)
Indefinite l ife
Do not amortize. Subject to the one-step impairment test.
P A S S KEY
I
Indefinite Life
c.
Finite Life
Cha racteristics
Life extends beyond the
foreseeable future
Useful life is limited
Amortization
None
Over useful economic life
Impairment Test
One-step test (fair value based)
Two-step test ( U.S. GAAP)
Step 3-Goodwill
Allocate any remaining acquisition cost (the difference between the fair value of
the subsidiary and the fair value of the subsidiary's net assets) to Goodwill. This
Goodwill is not amortized. Acquisition Goodwill is subject to impairment testing.
Accordingly, in the period it is determined to be impaired, it is written down and
charged as an expense against income on the I ncome Statement.
F3-32
© DeVry!Becker Educational Development Corp. All rights reserved.
Becker Professional Education I CPA Exam Review
Financial 3
Assembled Workforce
Distribution Channels
Technical Expertise
•
•
•
Training and Recruiting
Product/Service Support
Advertising Programs
Intangibles Now Subsumed into Goodwill
•
•
•
•
•
•
Geographic Presence
Technological Know-how
Government Relations
Under IFRS, goodwill (and noncontrolling interest as discussed above) can be calculated using either the "partial goodwill"
method or the "full goodwill" method.
U S GAAP VS. IFRS
The full goodwil method is the method used under U.S. GAAP (as described above), In which goodwill is calculated as follows:
Goodwill Fair value of subsidiary - Fair value of subsidiary's net assets
FullGqodwU/Methqd
=
Under the partial goodwil method, goodwill is calculated as follows:
Goodwill Acquisition cost - Fair value of subsidiary's net assets acquired
Note: Partial goodwil l and ful l goodwil l methods differ only when the parent owns l e ss than 100% of the subsidiary.
PartialGoodwilMethqd
l
=
TAG Inc. purchases 60% of Gearty Co.'s equity for $75,000,000 in cash. The fair value of Gearty is $125,000,000 ($125,000,000
60% $75,000,000). TAG uses the full goodwil method under IFRS. The fair value of Gearty Co. 's net identifiable assets is
$60,000,000 and carrying amount of Gearty's net assets is $50,000,000. Under the full goodwill method:
Noncontroliing interest $125,000,000 40% $50,000,000
Goodwill $125,000,000 - $60,000,000 $65,000,000
E X A M P L E - U . S . G A A P/ I F R S - F U L L G O O D W I L L
x
=
x
=
=
=
=
$65,000,000
Goodwill
Identifiable intangible
-0assets FV
Balance sheet FV
$ 10,000,000
adjustment
f------+ - ------ - --------- ------- --- -- ---$50,000,000
Book value (CAR)
S U B ' S TOTAL ( 1 0 0 % ) F A I R VA L U E
11m
11m
11m
r.wH
r.wH
11m
11m
11m
Common stock - subsidiary
A.'.I .o. - "b,;d;,,,
Retained earnings - subsidiary
Investment in subsidiary
Noncontrolling interest
Balance sheet adjustments to FV
Identifiable intangible assets to FV
Goodwill
}
$50,000,000
NCI
$75,000,000
Investment
in subsidiary
=
$12 5,000,000
$50,000,000
$75,000,000
50,000,000
10,000,000
-065,000,000
�125,000,OOO
() DeVry/Becker Educational Development Corp. All rights reserved.
�1251000,000
F3-33
Becker Professional Education I CPA Exam Review
Financial 3
E X A M P L E - I F R S - PA R T I A L G O O D W I L L
TAG Inc. purchases 60% of Gearty Co.'s equity for $75,000,000 in cash. TAG uses the partial goodwill method under I FRS.
The fair value of Gearty Co. 's net identifiable assets is $60,000,000 and carrying amount of Gearty's net assets is
$50,000,000. Under the partial goodwill method:
Noncontrolling interest
Goodwill
=
=
$60,000,000 x 40%
=
$24,000,000
$75,000,000 - ($60,000,000 x 60%)
=
$75,000,000 - $36,000,000
=
$39,000,000
I F R S PA R T I A L G O O D W I L L
Goodwill
$39,000,000
Identifiable intangible
assets FV
NCI
$75,000,000
I nvestment
in subsidiary
-0-
Balance sheet FV
$10,000,000
adjustment
1------+ - -------------------------------Book value (CAR)
$24,000,000
$50,000,000
IIlD Commo" ,'o,' - "b,;d;"y
}
IIlD A.P.I .e. - subsidiary
$50,000,000
IIlD Retained earnings - subsidiary
[W9
Investment in subsidiary
$75,000,000
[W9
Noncontrolling interest
24,000,000
IIlD Balance sheet adjustments to FV
IIlD Identifiable intangible assets to FV
IIlD Goodwill
10,000,000
-039,000,000
�991000,000
3.
�991000,000
Determining Acquisition with Gain
Rule: When acquiring a corporation/subsidiary with a fair value that is less than the fair
value of 1 00% of the underlying assets acquired, the following steps are required:
a.
Step 1 -Balance Sheet Adjusted to Fair Value
Allocate the acquisition cost to the fair value of 1 00% of the balance sheet
accounts (even if the acquisition cost is less than the fair value to be assigned).
This will create a negative balance in the acquisition cost account.
b.
Step 2-ldentifiable Intangible Assets to Fair Value
Allocate any remaining acquisition cost (if any) to the fair value of 1 00% of the
identifiable intangible assets acquired (even if the remaining acquisition cost is
less than the fair value to be assigned). This will create or increase the negative
balance in the acquisition cost account.
c.
Step 3-Gain
The negative balance in the acquisition cost account (due to the fair value of the
balance sheet assets and the identifiable intangible assets have been greater
than the acquisition cost) is to be recorded as a gain.
F3-34
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Becker Professional Education I CPA Exam Review
Financial 3
E X A M P L E - G A I N A L L O C AT I O N
•
Gearty Co. purchases 100% of Sub Co. for $1,000,000.
•
Total net book value of Sub Co. is $800,000.
•
Fair value of 100% of Sub Co.'s identifiable net assets is $1,200,000.
S U B S I D I A RY ' S T O T A L ( 1 0 0 % ) F A I R V A L U E
Goodwill
-0-
Identifiable
intangible
assets FV
-0-
Balance sheet FV
adjustment
$400,000
f------f
Book value (CAR)
=
$1 ,200,000
$200,000
Gain
- 0-
NCI
$1,000,000
Investment
in subsidiary
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . -. . . . .
$800,000
[Jill Common stock - subsidiary
[Jill A.'. I.C. - "b,;d;",
}
$800,000
[Jill Retained earnings - subsidiary
D
Investment in subsidiary
D
Noncontrolling interest
[Jill Balance sheet adjustments to fair value
[Jill Identifiable intangible assets to fair value
lIll
$1,000,000
-0400,000
-0-
Gain
200,000
�1,200,000
© DeVry/Becker Educational Development Corp. All rights reserved.
�1,200,000
F3·35
Becker Professional Education I CPA Exam Review
Flnanclal 3
CO N C E P T E X E R C I S E
On January 1, Year 1, Gearty Corporation (parent) acquired 100% of Olinto Corporation. Gearty Corp. issued
100,000 shares of its $10 par common stock, with a market price of $15 on the date the acquisition was
announced and $25 on the date the acquisition was completed, for all of Olinto Corp.'s common stock.
On that date the fair value of Olinto Corp.'s assets and liabilities equaled their respective carrying amounts with
the exception of land, which had a fair value that exceeded its book value by $200,000.
The fair value of Olinto Corp.'s identifiable intangibles (in process R&D) is $100,000. The in-process R&D will be
amortized over a useful life of 8 years.
For the year ending December 31, Year 1, Olinto reported net income of $350,000 and paid cash dividends of
$1 50,000.
Geartv
The stockholders' equity section of each company's balance sheet as of December 31, Year 1, was:
Common stock
Additional paid-in capital
Retained earnings
$5,000,000
Olinto
$1,000,000
1,000,000
400,000
3,000,000
500,000
$9,000,000
$1,900,000
Required-Calculate the acquisition date consolidation workpaper eliminating journal entry:
(1) Determine the carrying/book value (CAR) of the subsidiary at the date of acqui s i t ion
(2) Determine the acquisition pri c e (investment in subsidiary)
(3) Determine the fair value of any noncontrol l i ng interest
(4) Determine the balance sheet accounts fair value adjustments
(5) Determine the fair value of any identifiable intangibl e assets
(6) Determine the amount of goodwil
Solution:
Common stock - subsidiary
- subsidiary
Retained earnings - subsidiary (at purchase date)
o Beginning
o Add: income
o Subtract: dividends
o Ending
Answer:
A.P.I.e.
Net book value
Investment (100,000 shares x $25 FV)
Difference
Noncontrolling interest
Difference
Balance sheet adjustment to asset land
Difference
Identifiable intangible assets
Goodwil
F3-36
300,000
350,000
<150,000>
500,000
r
$1,000,000
400,000
300,000
II
1,700,000
2,500,000
800,000
-0800,000
200,000
600,000
100,000
500,000
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Financial 3
Becker Professional Education I CPA Exam Review
A C Q U I S I T I O N D A T E : S U B S I D I A RY ' S T O T A L ( 1 0 0 % 1
Goodwill
FA I R VA L U E $2,500,000
NCI
-0-
$500,000
.----------.-.------.--.-------.--
Identifiable intangible
assets FV
t----l
$100,000
Balance sheet FV
adjustment
$2,500,000
$200,000
Investment
in subsidiary
------------------------------------
Book value (CAR)
$1,700,000
6
---------------------------------- ------------------.---------_.---
C O N S O L I D A T I N G W O R K S H EE T - A C Q U I S I T I O N D A T E E L I M I N A T I N G J O U R N A L E N T R Y
rtm
Common stock - subsidiary
rtm
A.P. I.e. - subsidiary
400,000
rtm
Retained earnings - subsidiary
300,000
r.Il1
Investment in subsidiary
r.Il1
Noncontrolling interest
$1,000,000
$2,500,000
-0-
rtm
Balance sheet adjustment fair value
200,000
rtm
Identifiable intangible assets fair value
100,000
rtm
Goodwill
500,000
Assuming Gearty accounts for its investment in Olinto using the equity method for internal
accounting purposes, Gearty would report an Investment in Subsidiary of $2,700,000 ($2,500,000
beginning Investment in Subsidiary + $350,000 share of subsidiary net income - $ 1 50,000 share of
subsidiary dividends) on December 3 1 , Year 1 . The year-end eliminating journal entry would be:
C O N S O L I D A T I N G W O R K S H EE T - Y E A R · E N D E L I M I N A T I N G J O U R N A L E N T RY
rtm
Common stock - subsidiary
11m
A.P. I.e. - subsidiary
400,000
11m
Retained earnings - subsidiary
500,000
r.Il1
Investment in subsidiary
r.Il1
Noncontrolling interest
$1,000,000
$2,700,000
-0-
rtm
Balance sheet adjustment fair value
200,000
rtm
Identifiable intangible assets fair value
100,000
11m
Goodwill
500,000
co DeVry/Becker Educational Development Corp. All rights reserved .
F3-37
Financial 3
Becker Professional Education I CPA Exam Review
E X A M P LE - ACQU I S I T I O N O F 100% I N T E R E ST I N I N V E S T E E
Example
Subsidiarl!. NBV
Subsidiarl!. FV
$100,000
$100,000
25,000
25,000
200,000
250,000
Current assets
Long-term investment - marketable securities
Noncurrent assets
-0-
Identifiable intangible assets
Liabilities
100,000
50,000
Common stock
100,000
A.P. I .e.
100,000
Retained earnings
50,000
75,000
I
Premium
Fair value of subsidiary
Book value of net assets
Difference
Discount
..
•
$500,000
$425,000
$ 10,000
275,000
275,000
275,000
$225,000
$150,000
<$265,000>
<50,000>
<50,000>
<50,000>
<100,000>
<100,000>
<100,000>
-0-
<$415,000>
•
Step #1:
Balance sheet adjusted fair value
Step #2:
Identifiable intangibles fair value
Step #3:
Goodwill <Gain>
�
$75,000
The trick to properly calculating the proper amounts is to remember to always use fair value of the assets in Steps 1 and 2.
F3-38
ttl DeVry/Becker Educational Development Corp. All rights reserved.
Finandal 3
Becker Professional Education I CPA Exam Review
A C Q U I S I T I O N : C O N S O L I D AT I N G ( W O R K PA P E R ) E L I M I N AT I N G J O U R N A L E N T R I E S
Example #1
11m
Common stock - subsidiary
11m
A.P.Le. - subsidiary
11m
Retained earnings - subsidiary
[WD
Investment in subsidiary
[WD
Noncontrolling (minority) interest
$100,000
100,000
75,000
$500,000
-0-
Balance sheet adjustment FV
50,000
11m
Identifiable intangible assets
100,000
11m
Goodwill
11m
75,000
Example #2
11m
Common stock - subsidiary
11m
A . P Le. subsidiary
11m
Retained earnings - subsidiary
.
[WD
Investment in subsidiary
[WD
Noncontrolling (minority) interest
$100,000
100,000
75,000
$425,000
-0-
Balance sheet adjustment FV
50,000
11m
Identifiable intangible assets
100,000
11m
Goodwill
11m
o
Example #3
11m
Common stock - subsidiary
11m
A.P.Le. - subsidiary
11m
Retained earnings - subsidiary
[WD
Investment in subsidiary
[WD
Noncontrolling (minority) interest
$100,000
100,000
75,000
$ 10,000
-0-
11m
Balance sheet adjustment FV
50,000
11m
Identifiable intangible assets
100,000
[WD
Gain
<0 DeVry!Becker Educational Development Corp. All rights reserved.
$415,000
F3-39
Becker Professional Education I CPA Exam Review
Financial 3
F.
Journal Entry Flowchart-Acquisition Date Calculation
Com m o n stock - S u b
A. P. I .e. - Sub
Reta ined earnings - Sub
<
<
I nvestment i n S u b
Noncontro l l i n g i nterest
>
>
DIFFERENCE
- Bala nce Sheet F V Adjustment
DI FFERENCE
- Identifi a b l e I ntangible Assets
DI FFERENCE
Goodwi l l
Gain
P A S S KEY
I t i s important t o note that even i f the parent acquired less than 100% o f the subsidiary, the adjustment of the subsidiary's
assets to FV (purchase price) will always be the FV (100%).
c
Common
Stock
A
R
N
B
Retained
Earnings
Non­
controlling
Minority
Interest
B/S
Adj.
Assets
Investment
Beginning
+ Income
- Dividend
G
Identifiable
Intangible
Assets
Goodwill
o
o
o
o
End
F3-40
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Becker Professional Education I CPA Exam Review
G.
Financial 3
Consolidated Statement of Cash Flows
1.
Period of Acquisition
The preparation of the consolidated statement of cash flows in the period of acquisition
is complicated by the fact that the prior year financial statements reflect parent-only
balances while the year-end financial statements reflect consolidated balances. The
following steps are necessary in order to prepare a consolidated statement of cash
flows in the period of acquisition:
a.
The net cash spent o r received in the acquisition must b e reported in the
investing section of the statement of cash flows.
EXAM P L E
If the parent company spent $2,500,000 to acquire a subsidiary that had $800,000 cash, the
net decrease in cash of $1,700,000 would be shown as a n investing outflow on the statement
of cash flows as follows:
Payment for acquisition of subsidiary, net of cash acquired
b.
=
$1,700,000
The assets and liabilities of the subsidiary on the acquisition date must be added
to the parent's assets and liabilities at the beginning of the year in order to
determine the change in cash due to operating, investing, and financing activities
during the period.
EXAM PLE
A parent company that reported notes paya ble of $600,000 on January 1 acquired a subsidia ry
on May 1 that reported notes payable of $250,000 on the acquisition date. The December 3 1
consolidated balance sheet reported notes payable o f $750,000.
The financing section of the statement of cash flows would report a cash outflow of $100,000
from notes payable [($600,000 beginn i ng parent NP + $250,000 acquisition date subsidiary N P )
- $750,000 ending consolidated NPj.
2.
Subsequent Periods
In subsequent periods, the preparation of the consolidated statement of cash flows is
simplified by the fact that consolidated financial statements are available for the
beginning and end of the period. The consolidated statement of cash flows should
present the cash inflows and outflows of the consolidated entity, excluding cash flows
between the parent and subsidiary. The preparation of the consolidated statement of
cash flows should be similar to the preparation of a statement of cash flows for a
nonconsolidated entity, except for the following considerations:
a.
When reconciling net income to net cash provided by operating activities, total
consolidated net i ncome (including net income attributable to both the parent and
the noncontrolling interest) should be used.
b.
The financing section should report dividends paid by the subsidiary to
noncontrolling shareholders. Dividends paid by the subsidiary to the parent
company should not be reported.
c.
The investing section may report the acquisition of additional subsidiary shares
by the parent if the acquisition was an open market purchase.
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F3-41
Becker Professional Education I CPA Exam Review
Finandal 3
H.
Step Acquisition-Consolidation and Deconsolidation
O W N E R P E R C E N TA G E C H A N G E
A C C O U N T I N G T R E AT M E N T
•
Remeasure previously held equity
interests to fair value
•
The income statements will reflect
this adjustment
•
Equity transaction (no gain or loss
recognized on the income statement
- additional paid-in capital adjusted)
•
Recognize the gain or loss of the sale
of the stock
•
Remeasure the remaining nonconsolidating interest to fai r value
•
Recognize the adjustment to fair
value on the income statement
Non-control -7 Control (step transition)
Control -7 " More" or "less" control
Control -7 Non-control
PASS KEY
Gaining control/losing control is a remeasurement event because the parent exchanges a noncontrolling
Investment asset for a controlling financial i nterest i n all of the underlying assets and liabilities of the target.
E XA M P L E - PA R T I A L A C Q U I S I T I O N
In Year 1, TAG I nc. buys 10% of Gearty Co.'s equity for $20,000 when the fair value of Gearty Co.'s net
identifiable assets is $180,000. Four years later, in Year 5, TAG I nc. acquires an additional 50% (total now is
60% 10% + 50%) interest for $400,000 in cash. At the date of this additional acquisition, Gearty Co. had the
following:
=
Net identifiable assets
FV
$640,000
Net identifiable assets
N BV
$520,000
Noncontrolling i nterest (NCI)
FV
$320,000
GAAP Solution:
$400,000
FV for 50%
2
x
800,000
x
10%
80,000
FV for 100%
Prior % owned
FV - prior 10%
- 20,000
Paid
� 60,000
Gain
Journal entry to record adjustment to fair value in the previously held 10% investment in Gearty Co.:
IIlB
lWB
$60,000
Investment in subsidiary
$60,000
Gain
INVESTMENT I N SUBSI DIARY
Bealnn;nq Balance
$20,000
F3-42
FV Adjustment
+
$60,000
+
New Acquisition
$400,000
Endinq Balance
$480,000
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Becker Professional Education I CPA Exam Review
Financial 3
EXAMPLE
S U B S I D I A R Y ' S TOTA L 1 1 00%) F A I R VA L U E
$ 160,000
Goodwill
Identifiable intangible
assets FV
Balance sheet FV
adjustment
=
$800,000
$320,000
NCI
$480,000
I nvestment
in subsidiary
-0-
$120,000
----------------.----------------
Book value (CAR)
$520,000
11m Common stock - subsidiary
11m A.P. I.e. - subsidiary
11m Retained earnings - subsidiary
ttm
Investment in subsidiary
ttm
Noncontrolling interest
}
$520,000
$480,000
320,000
11m Balance sheet adjustments to FV
120,000
11m Identifiable intangible assets to FV
11m Goodwill
-0160,000
$800,000
�800,000
PASS KEY
If the parent acquires the remaining 40% from the noncontrolling interest shareholders, it is an equity transaction (not an
acquisition). No gain or loss is recognized on the income statement. Additional paid-in capital is adjusted.
I.
Acquisition Method Disclosures
The acquirer should disclose information that enables users of its financial statements to
evaluate the nature and financial effect of a business combination that occurred during the
current period or after the reporting date but before the financial statements are issued or
available to be issued. The following information should be disclosed:
1.
Name and description of the acquiree.
2.
The acquisition date.
3.
The percentage of voting interests acquired.
4.
The primary reasons for the business combination and a description of how the
acquirer obtained control of the acquiree.
5.
For transactions that are recognized separately from the acquisition of assets and the
assumption of liabilities, all of the following:
a.
A description
b.
The accounting for each transaction.
c.
The amounts recognized in each transaction and the financial statement line
items in which each amount is recognized .
of each transaction.
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F3-43
Becker Professional Education I CPA Exam Review
Financial 3
6.
7.
J.
In a business combination achieved in stages, the following:
a.
The acquisition date fair value of the equity interest in the acquiree held before
the acquisition date.
b.
The amount of any gain or loss recognized as a result of remeasuring the equity
interest held before the business combination to fair value.
c.
The valuation techniques used to measure the acquisition-date fair value of the
equity interest in the acquiree held by the acquirer immediately before the
business combination and the inputs used to measure fair value.
If the acquirer is a public entity, the following:
a.
The amounts of revenue and earnings of the acquiree since the acquisition date
included in the consolidated income statement for the reporting period.
b.
The revenue and earnings of the combined entity for the current reporting period
as though the acquisition date for all business combinations that occurred during
the year had been as of the beginning of the annual reporting period
(supplemental pro forma information).
c.
If comparative financial statements are presented, the revenue and earnings of
the combined entity for the comparable prior reporting period as though the
acquisition date for all business combinations that occurred during the current
year had occurred as of the beginning of the comparable prior reporting period
(supplemental pro forma information).
Consolidation Disclosures
Consolidated financial statements should disclose the consolidation policy that is being
followed.
1.
Parent companies with one or more less-than-wholly-owned subsidiaries should
disclose the following each reporting period :
a.
F3-44
Separately, on the face of the consolidated financial statements:
(1 )
The amounts of consolidated net income and consolidated comprehensive
income.
(2)
The amounts attributable to the parent and noncontrolling interest.
b.
In the notes or on the face of the consolidated income statement, amounts
attributable to the parent for income from continuing operations, discontinued
operations, and extraordinary items.
c.
In the consolidated statement of changes in equity or the notes, a reconciliation
at the beginning and end of the period of the carrying amount of total equity,
equity attributable to the parent, and equity attributable to the noncontrolling
interest. The reconciliation should separately disclose net income, transactions
with owners, and each component of other comprehensive i ncome.
d.
In the notes, a schedule that shows the effects of any changes in a parent's
ownership interest in a subsidiary on the equity attributable to the parent.
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Finandal 3
Becker Professional Education I CPA Exam Review
K.
Acquisition Method S ummary
ACQUISITION
Assets .......................................................................... ............................................. Fair value
Liabilities ........................ . . . . . . . . .......................... ............................... .......................... Fair value
Retained earnings ................................................................... ............................... Parent only
Income ...................................... ..... ................................. ............................... After acquisition
Acquisition cost .......................... .......................... . . .................................................. Expensed
Goodwill
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...........................................
Yes
Noncontrolling interest .................................... . . . . .. . . . . . . . . . . . . .............................. Yes (1% - 49%)
Investment in subsidiary .............................................. ..................................... ....... Eliminate
Asset adjustment ............ .......................................................... . . . ........................... Depreciate
Identifiable intangible assets .............................................................................. Amortization
Goodwill adjustment . . ................................................................................... Impairment test
Intercompany transactions ............................................... ......................... ............... Eliminate
Acquired (purchased) goodwill is not amortized; it is subject to the impairment test.
© DeVry/Becker Educational Development Corp. All rights reserved.
F3-45
Financial 3
Becker Professional Education I CPA Exam Review
I NTERCOM PANY TRANSA CTIONS
I.
INTERCOMPANY TRANSACTIONS
A.
Eliminate 1 00% of Intercompany Transactions (even when noncontrolling interest exists)
Intercompany transactions must be eliminated because they lack the criteria of being "arm's
length."
1.
Balance Sheet-Eliminate 100%
a.
Eliminate 1 00% of all intercompany payables and receivables.
IIlD
Accounts payable
[18
IIlD
Bonds payable (intercompany portion only)
[18
IIlD
Accrued bond interest payable
2.
B.
$XXX
$XXX
$XXX
Accrued bond interest receivable
Dividends payable (affiliate portion only)
[18
b.
$XXX
Bonds investment (in affiliate)
[18
IIlD
$XXX
Accounts receivable
$XXX
$XXX
Dividends receivable (from affiliate)
$XXX
Eliminate 1 00% of intercompany gross profit in ending inventory and fixed assets
of parent or subsidiary.
Income Statement-Eliminate 100%
a.
Interest expense / Interest income (bonds)
b.
Gain on sale / Depreciation expense (intercompany fixed asset sales)
c.
Sales / Cost of goods sold (intercompany inventory transactions)
Not Consolidated
=
Not Eliminated
Do not eliminate intercompany accounts if you do NOT consolidate.
C.
1.
Separate report in financial statements
2.
Footnote disclosure
Intercompany Inventory/Merchandise Transactions
It is common for affiliated companies to sell inventory/merchandise to one another. Often this
inventory/merchandise is sold at a profit. The total amount of this intercompany sale and cost
of goods sold should be eliminated prior to preparing consolidated financial statements. In
addition, the intercompany profit must be eliminated from the ending inventory and the cost of
goods sold of the purchasing affiliate. 1 00% of the profit should be eliminated even if the
parent's ownership interest is less than 1 00%. The intercompany profit in beginning inventory
that was recognized by the selling affiliate in the previous year must be eliminated by an
adjustment (debit) to retained earnings.
F3-46
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Financial 3
Becker Professional Education I CPA Exam Review
W O R K P A P E R E L I M I N AT I O N - I N T E R C O M PA N Y M E R C H A N D I S E T R A N S A C T I O N S
$XXX
I ntercompany sales
Retained earnings (profit in beginning inventory)
XXX
Intercompany cost of goods sold
Cost of goods sold (intercompany profit included in COGS of the purchasing affiliate)
Ending inventory (intercompany profit in the inventory remaining)
�
�
$XXX
XXX
XXX
PASS KEY
When inventory has been sold intercompany and the CPA Examination requires you to correct the accounts, remember to
reverse the original intercompany transaction (sale and cost of goods sold, internally) and:
Inventory sold to outsiders �
�
Inventory still on hand
Correct cost of goods sold
Correct ending inventory
E XA M P L E - I N T E R C O M PA N Y P R O F I T I N I N V E N T O R I E S
Gearty Corporation owns 100% of the common stock of Olinto Corporation. Gearty sold inventory with a cost of $1,000,000
to Olinto for $1,100,000 during Year 1. The Year 1 ending inventory of Olinto included goods purchased from Gearty for
$660,000. Olinto had a remaining account payable balance to Gearty of $200,000 on December 31, Year 1.
Journal entry to record the sale by Gearty:
11m
11m
$1,100,000
Accounts receivable
�
$1,100,000
Intercompany sales
$1,000,000
Intercompany cost of goods sold
�
$ 1,000,000
I nventory
Journal entry to record the purchase by Olinto:
11m
$1,100,000
Inventory
�
$1,100,000
Accounts payable
Year 1 Workpaper Elimination Entry: The intercompany sales and intercompany cost of goods sold must be eliminated from
Gearty's books and the intercompany profit on the sale of inventory must be eliminated from Olinto's books. The
intercompany accounts payable and accounts receivable must also be eliminated.
Step l -Calculate intercompany profit on sale of inventory:
I ntercompany profit on sale of inventory
=
$1,100,000 sales price - $1,000,000 cost
=
$100,000
Step 2-Allocate intercompany profit between purchaser's ending inventory and cost of goods sold
Beginning inventory
$
Purchases
1,100,000
Cost of goods available
1,100,000
o
Ending inventory
660,000 60%
Cost of goods sold
440,000 40%
Intercompany profit in Olinto's cost of goods sold ($100,000 x 40%)
Intercompany profit in Olinto's ending inventory ($100,000 x 60%)
11m
I ntercompany sales - Gearty
�
Intercompany cost of goods sold - Gearty
�
Cost of goods sold - Olinto
�
11m
�
Accounts receivable
!C DeVry/Becker Educational Development Corp. All rights reserved.
$ 60,000 [2]
$1,100,000
$1,000,000
40,000 [1]
60,000 [2]
Inventory - Olinto
Accounts payable
$ 40,000 [1]
$200,000
$200,000
F3-47
Becker Professional Education I CPA Exam Review
Financial )
D.
I ntercompany Bond Transactions
If one member of the consolidated group acquires an affiliate's debt from an outsider, the
debt is considered to be retired and a gain/loss is recognized on the consolidated income
statement. This gainlloss on extinguishment of debt is calculated as the difference between
the price paid to acquire the debt and the book value of the debt. This gainlloss is not
reported on either company's books, but is recorded through an elimination entry. All
intercompany account balances are also eliminated.
E X A M P L E - I N T E R C O M PA N Y B O N D T R A N S A C T I O N S
On December 31, Year 1, Gearty Corporation issued bonds with a carrying value of $300,000, and a face value
of $250,000. The premium on bonds payable was recorded as $50,000.
Journal entry to record the sale of the bonds on Gearty's books:
IIlB
Cash
$300,000
lWB
Bonds payable
lWB
Premium on bonds payable
$250,000
50,000
On December 31, Year 1, before any portion of the premium was a mortized, Olinto Corporation acquired all
the outstanding bonds from the original purchasers at a price of $275,000.
Journal entry to record the purchase of the bonds on OIinto's books:
IIlB
lWD
Investment in Gearty bonds
$275,000
Cash
$275,000
Workpaper elimination entry-Eliminated intercompany balances and recognizes the gain on extinguishment
of debt:
1.
IIlB
Bonds payable
IIlB
Premium
lWD
Investment in Gearty bonds
lWD
Gain on extinguishment of bonds
$250,000
50,000
$275,000
25,000
Intercompany Interest
Eliminate intercompany accounts such as interest expense, interest income, interest
payable, and interest receivable.
2.
Amortization of Discount or Premium
Eliminate amortization of the discount or premium, which serves as an increase, or
decrease in the amount of interest expense/revenue that is recorded. The unamortized
discount or premium on the intercompany bond is eliminated.
3.
F3-48
Subsequent Years
The elimination for realized but unrecorded gainlloss on extinguishment of bonds in
subsequent years would be adjusted to retained earnings. Noncontrolling interest
would be adjusted if the bonds were originally issued by the subsidiary.
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Financial 3
Becker Professional Education I CPA Exam Review
E.
Intercompany Sale of Land
The intercompany gain/loss on the sale of land remains unrealized until the land is sold to an
outsider. A workpaper elimination entry in the period of sale eliminates the intercompany
gain/loss and adjusts the land to its original cost.
E X A M P L E - I N T E RCO M PA N Y S A L E O F L A N D
On J uly 1, Year 1, Gearty Corporation sold land to Olinto Corporation for $200,000. The initial cost of the land
to Gearty was $175,000.
Journal entry to record the sale on Gearty's books:
11m
Cash
ltm
$200,000
Land
$175,000
Intercompany gain on sale of land
25,000
Journol entry to record the purchase on Olinto's books:
11m
ltm
Land
$200,000
$200,000
Cash
Workpaper elimination entry
cost:
-
Elimination of the intercompany gain and adjustment of land to its original
11m
Intercompany gain on sale of land
ltm
Land ($200,000 - $175,000)
$25,000
$25,000
In the subsequent year and every year thereafter until the land is sold to a third party,
retained earnings (Gearty) would be debited and land would be credited to eliminate the
intercompany profit. Retained earnings are debited in subsequent years because the gain
would have been closed to this account. Since Gearty (parent) was the seller of the land and
Olinto (subsidiary) was the purchaser, there is no need to divide the intercompany gain
between retained earnings and noncontrolling interest.
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F3-49
Financial 3
F.
Becker Professional Education I CPA Exam Review
Intercompany Profit on Sale of Depreciable Fixed Assets
The gain or loss on the intercompany sale of a depreciable asset is unrealized from a
consolidated financial statement perspective until the asset is sold to an outsider. A working
paper elimination entry in the period of sale eliminates the intercompany gainlloss and
adjusts the asset and accumulated depreciation to their original balance on the date of sale.
EXAMPLE
Facts: Olinto Corporation (subsidiary) sold equipment on January 1, Year 1 to Gearty Corporation (parent) for
$100,000. The equipment had a net book value of $70,000 (cost of $90,000 and accumulated depreciation of
$20,000), and a remaining life of ten years.
January 1, Year 1 journal entry to record the sale on Olinto's books:
11m
$100,000
Cash
20,000
Accumulated depreciation
$90,000
Machinery (original cost)
30,000
I ntercompany gain on sale of machinery
January 1, Year 1 journal entry to record the purchase on Gearty's books:
11m
rM.8
$100,000
Machinery
$100,000
Cash
December 31, Year 1 journal entry to record the depreciation on Gearty's books:
11m
Depreciation expense ($100,000 .,. 10)
rM.8
Accumulated depreciation
$10,000
$10,000
December 31, Year 1 workpaper elimination entry Elimination of intercompany gain and adjustment of the
machine and accumulated depreciation accounts to their original balance:
-
11m
I ntercompany gain on sale of machinery
rM.8
Machinery ($100,000 - $90,000)
rM.8
Accumulated depreciation
$30,000
$10,000
20,000
The depreciation expense recorded by Gea rty is overstated by the intercompany profit included in the cost of
the machinery.
N BV
Depreciation years
Depreciation
Workpaper elimination entry
-
F3-S0
Non-GAAP
Intercompany
$100,000
-'--_-=1""0 Yrs
$ 10,000
GAAP Original
$70,000
L-ill Yrs
$ 7,000
Difference
$30,000
±--.1Q Yrs
$ 3,000
Elimination of excess depreciation :
11m
Accumulated depreciation
rM.8
Depreciation expense
$3,000
$3,000
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Becker Professional Education I CPA Exam Review
Financial 3
E X A M P L E - S U B S E Q U E N T Y E A R W O R K P A P E R E L I M I N AT I O N J O U R N A L E N T R Y
In the subsequent years the intercompany gain/loss on the sale of the asset and the excess depreciation has
been closed to retained earnings. The elimination entries in subsequent years therefore adjust retained
earnings, and if appropriate, noncontrolling interest for the original gain or loss less the excess depreciation
previously recorded (unrealized gain/loss at the beginning of the year). Continuing with the previous
example, in Year 2, the workpaper elimination entries would be:
Journal entry to adjust fixed assets:
IIill
Retained Earnings
I.Wn
Machinery
I.Wn
Accumulated depreciation
$27,000*
$10,000
17,000**
Journal entry to adjust depreciation:
IIill
Accumulated depreciation
I.Wn
Depreciation expense
Original gain - Excess depreciation previously recorded
=
**
$3,000
$3,000
=
Unrealized gain at the beginning of the year. $30,000 - $3,000
$27,000.
Original accumulated depreciation difference of $20,000 less excess depreciation of $3,000 previously recorded.
(0 DeVry/Becker Educational Development Corp. All rights reserved.
F3-51
Financial 3
Becker Professional Education I CPA Exam Review
The December 3 1 , Year 1 financial statements of Gearty Corporation and Olinto Corporation are consolidated as follows
using the Concept Exercise on pages 36-37 and the intercompany transactions on pages 46-51:
C O N S O L I D AT E D F I N A N C I A L STAT E M E N T S
Gearty
Or(Cr)
Sales
Cost of goods sold
Operating expenses
Equity in earnings
Investment income
Interest expense
Gain on fixed asset sales
Gain on debt
Net income
Income Statement
RE, 1/1/Year 1
Net income
Dividends
RE, 12/31/Year 1
Cash
AR
Inventory
Marketable securities
Fixed assets (net)
In-process R&D
Goodwill
Investment in Sub
Total Assets
AP
Bonds payable (net)
Common stock
A.P.I.C.
RE
Liabilities & Equity
F3-S2
Elimination
Debits
$(18,400,000)
$(6,000,000)
11,480,000
4,210,000
5,505,000
1,330,000
12,5002
(350,000)
0
350,0004
(100,000)
0
80,000
140,000
(25,000)
(30,000)
Statement olRetained Earnlnfls
Balance Sheet
OIinto
Or(Cr)
Elimination
Credits
$1,100,0001
Adjusted
Balance
$(23,300,000)
1,000,0001
40,0001
14,650,000
3,0003
6,844,500
0
(100,000)
220,000
25,0005
30,0006
0
0
0
$(1,810,000)
$(350,000)
$1,517,500'
25,0007
(25,000)
$1,068,000'
$1,710,500
$(1,190,000)
$(300,000)
$300,0004
(1,810,000)
(350,000)
1,517,500'
$1,068,000'
150,0004
0
$1,817,500b
$1,218,000b
$(2,900,500)
$(1,190,000)
(1,710,500)
°
150,000
$(3,000,000)
$(500,000)
$1,120,000
$ 520,000
2,075,000
1,605,000
$200,0008
3,480,000
2,000,000
1,000,000
60,0001
2,940,000
1,225,000
275,000
275,0007
1,225,000
3,470,000
1,500,000
$200,0004
3,0003
25,0005
10,0006
20,0006
5,118,000
0
0
100,0004
12,5002
87,500
0
°
500,0004
$1,640,000
500,000
2,700,0004
0
$3,302,500
$14,990,500
2,700,000
°
$12,590,000
$4,900,000
$803,000
$(2,290,000)
$(1,250,000)
$200,0008
$(3,340,000)
(1,300,000)
(1,750,000)
250,0007
50,0007
(2,750,000)
(5,000,000)
(1,000,000)
1,000,0004
(5,000,000)
(1,000,000)
(400,000)
400,0004
(1,000,000)
(3,000,000)
(500,000)
1,817,500b
$(12,590,000)
$(4,900,000)
$3,717,500
$1,218,000b
(2,900,500)
$1,218,000
$(14,990,500)
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Financial 3
Becker Professional Education I CPA Exam Review
Explanation ofconsolidation adjustments:
1 . Elimination of the intercompany sale of inventory (see page 47):
$1,100,000
I ntercompany sales - Gearty
$1,000,000
Intercompany cost of goods sold - Gearty
Cost of goods sold - Olinto
$40,000
Inventory - Olinto
$60,000
2 . Amortization of in-process R&D over 8 years ($1 00,000/8
IIlD
=
Amortization expense
rJm
$12,500):
$12,500
In-process R&D
$12,500
3. Elimination of excess depreciation resulting from the intercompany sale of machinery (see page 50):
IIlD
Amortization depreciation
rJm
Depreciation expense
$3,000
$3,000
4. Elimination of Olinto's equity and Gearty's investment in Olinto and the recognition of the land fair value
adjustment, in-process R&D, and goodwill on December 3 1 , Year 1 (see page 37):
IIlD
Common stock - subsidiary
IIlD
A.P.I.e. - subsidiary
400,000
IIlD
Retained earnings - subsidiary
500,000*
rJm
Investment in subsidiary
rJm
Noncontrolling interest
$1,000,000
$2,700,000
-0 -
IIlD
Balance sheet adjustment FV
IIlD
Identifiable intangible assets FV
100,000
IIlD
Goodwill
500,000
*
$200,000
The ending retained earnings of the subsidiary is calculated as follows:
$300,000 beginning RE + $350,000 net income - $150,000 dividends $500,000 ending RE
=
5. Elimination of intercompany land transaction (see page 49):
IIlD
rJm
I ntercompany gain on sale of land
$25,000
Land
$25,000
6 . Elimination of intercompany sales of equipment (see page 50):
IIlD
Intercompany gain on sale of machinery
rJm
Machinery ($100,000 - $90,000)
rJm
Accumulated depreciation
$30,000
$10,000
20,000
7. Record the retirement of intercompany bonds (see page 48):
IIlD
Bonds payable
IIlD
Premium (Gearty's records)
rJm
$250,000
50,000
Investment in Gearty bonds (Olinto's records)
$275,000
25,000
Gain on extinguishment of bonds
8. Elimination of intercompany AR and AP resulting from intercompany sale of inventory (see page 47):
IIlD
rJm
Accounts payable
Accounts receivable
$200,000
$200,000
a. Total of net in come adj ust ments carried down to the statement of retained earnings.
b. Total of retained earn ing s adjustments carried down to the balance sheet .
© DeVry/Becker Educational Development Corp. All rights reserved.
F3-53
Financial 3
Becker Professional Education I CPA Exam Review
COM BI NED FINANCIAL S TA TEMEN TS
I.
PUSH DO WN A C COUNTIN G
COM B I NED FINANCIAL STATEMENTS
Combined financial statements of a group of related companies (not consolidated because there
is no parent company).
A.
Types
B.
II.
1.
Companies are under common control (e.g., individual owns many companies), or
2.
Companies are under common management, or
3.
Unconsolidated subsidiaries (e.g . , many foreign subs) are combined .
Requires
1.
Intercompany transactions and balances among these companies eliminated.
2.
Noncontrolling interests, etc. , be treated like consolidated financial statements.
3.
Capital stock and retained earnings be added across, not eliminated.
4.
Income statements be added across.
PUSH DOWN ACCOUNTING
I
Push down accounting reports assets and liabilities at fair value in separate financial statements
. of the subsidiary. In effect, consolidation adjustments are pushed down into the records (and
separate financial statements) of each subsidiary.
! ii
F3-S4
A.
Assets and liabilities are adjusted.
B.
Retained earnings of the subsidiary are transferred to paid-in capital (to the extent of parent
company's percentage of ownership).
C.
Net income of each subsidiary includes depreciation, amortization, and interest expense
based on fair values rather than historical cost.
D.
The SEC requires push down accounting for each substantially wholly-owned subsidiary.
<t> DeVry/Becker Educational Development Corp. All rights reserved.
Financial 3
Becker Professional Education I CPA Exam Review
A P PEND I X I
I l l u strat i ve Consol i d ated Financ ial State m ents
I.
SAMPLE-Consolidated Balance Sheet
Consolidated Businesses Inc. (CBI)
Consolidated Balance Sheet as of December 31
Year 3
Year 4
Assets
Cash
Accounts receivable
Available-for-sale securities
Plant and equipment
Total assets
$ 250,000
125,000
320,000
675,000
$1,370,000
$ 195,000
140,000
315,000
590,000
�1,240,000
$ 207,000
75,000
400,000
$ 682,000
$ 135,000
80,000
400,000
$ 615,000
CBI shareholders' equity:
Common stock, $1 par
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income
Total CBI shareholders' equity
Noncontrolling interest
Total equity
$ 275,000
130,000
220,000
23,000
$ 648,000
40,000
688,000
$ 275,000
130,000
165,000
19,000
$ 589,000
36,000
625,000
Total liabilities and equity
$1,370,000
�1,240,000
Liabilities
Accounts payable
Accrued expenses
Long-term notes payable
Total liabilities
Equitv
II.
SAMPLE-Consolidated Statement of Income
Consolidated Businesses Inc. (CBI)
Consolidated Statement of Income for the year ended December 31
Sales
Cost of goods sold
G ross profit
Selling, general, and administrative expenses
Operating income
Net interest expense
Income before tax
Income tax expense
Net income
Less: Noncontrolling interest in net income
Net income attributable to CBI
Ie DeVry/Becker Educational Development Corp. All rights reserved.
Year 4
Year 3
Year 2
$620,000
(280,000)
340,000
(224,000)
116,000
(12,000)
104,000
(36,000)
68,000
(3,000)
$ 65,000
$570,000
(255,000)
315,000
(190,000)
125,000
(8,000)
117,000
(40,000)
77,000
(7,000)
$ 70,000
$595,000
(265,000)
330,000
(226,000)
104,000
(6,000)
98,000
(44,000)
54,000
(2,000)
$ 52,000
F3-55
Becker Professional Education I CPA Exam Review
Financial 3
I
I I.
SAMPLE-Statement of Consolidated Comprehensive Income
Consolidated Businesses Inc. (CBI)
Statement of Consolidated Comprehensive Income for the year ended December 31
Year 3
Year 2
$68,000
$77,000
$54,000
5,000
6,000
4,500
Year 4
Net income
Other comprehensive income, net of tax:
Unrealized holding gain on available-for-sale securities, net of tax
Total other comprehensive income, net of tax
Comprehensive income
5,000
6,000
4,500
73,000
83,000
58,500
(4,000)
(8,500)
(3,000)
$69,000
$74,500
$55,500
Comprehensive income attributable to
noncontroliing interest
Comprehensive income attributable to CBI
IV.
SAMPLE-Consolidated Statement of Changes in Equity
Consolidated Businesses Inc. (CBI)
Consolidated Statement of Changes in Equity for the year ended December 31, Year 1
Total
Beginning balance
Comprehensive
Retained
Income
Earnings
$165,000
$625,000
AOc/
$19,000
Common Stock
$275,000
A.P.I.C.
$130,000
Nc/
$36,000
Comprehensive income:
Net income
68,000
68,000
5,000
5,000
3,000
65,000
OCI, net of tax:
Unrealized gain on
securities
Comprehensive income
Dividends on common stock
Ending balance
F3-56
1,000
4,000
73,000
(10,000 )
(10,000 )
$688,000
$73,000
$220,000
$23,000
$275,000
$130,000
$40,000
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Financial 3
Becker Professional Education I CPA Exam Review
A P PEND I X II
I FRS VS. u.s. GAAP
Note: U nless specifically noted, I FRS and U.s. GAAP accounting rules are the same. This chart highlights the significant
differences between I FRS and U.s. GAAP covered in this lecture.
ISSUE
IFRS
U.S. GAAP
Marketable securities-classification
Marketable security investments are
classified as:
Financial assets at fair value through profit
or loss (including securities classified as
held-for-trading or assets designated at
fair value through profit or loss using the
fair value option)
Available-for-sale
Held-to-maturity
Marketable security investments are
classified as:
Trading
Available-for-sale
Held-to-maturity
·
·
·
·
·
•
Marketable securities-available-for-sale
securities
·
·
Marketable securities-impairment
·
·
Equity Method-Step-by-Step Acquisition
Unrealized gains and losses on availablefor-sale securities are reported in other
comprehensive income, except for foreign
exchange gains and losses on available-forsale debt securities, which are reported
directly on the income statement.
Foreign exchange gains and losses on
available-for-sale equity securities are
included in other comprehensive income.
All unrealized gains and losses on
available-for-sale securities are included
in other comprehensive income.
Impairment losses are recognized in
earnings, and the individual security is
written down by either directly reducing
the cost basis of the security or through
the use of a valuation allowance.
Additionally, previously recognized
impairment losses on held-to-maturity
debt securities and available-for-sale debt
securities must be reversed, with the
amount of the reversal recognized on the
income statement. For a held-to-maturity
security, the carrying value of the security
after the reversal cannot exceed what the
amortized cost of the security would have
been had the impairment been recognized.
·
IFRS generally requires entities to apply the
equity method prospectively from the time
at which the investor obtains significant
influence. Retroactive adjustment is not
required.
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·
Impairment losses are recognized in
earnings and the cost basis of the
security is reduced.
o Subsequent changes in fair value are
not recognized if the security is
classified as held-to-maturity.
If the security is classified as availablefor-sale, a subsequent increase in fair
value is included in other
comprehensive income.
o Subsequent increases in fai r value
are not recognized on the income
statement.
When significant influence is acquired,
it is necessary to record a change from
the cost/available-for-sale classification
to the equity method. The investment
account and the retained earnings account
are adjusted retrospectively for the
difference between the available-for-sale
classification/cost method to the equity
method.
F3·57
Financial 3
Becker Professional Education I CPA Exam Review
ISSUE
IFRS
U.S. GAAP
Consolidation-parent and subsidiary with
different year-ends
If the year-ends differ by three months or
less, the parent company can use the
subsidiary's regular financial statements of a
different period, giving recognition to
material intervening events during the gap
period to expedite the consolidation process.
The subsidiary financial statements m ust be
adjusted for significant transactions during
the gap period.
If the year-ends differ by three months or
less, the parent company can use the
subsidiary's regular financial statements
of a different period, giving recognition to
material intervening events during the
gap period to expedite the consolidation
process. Significant transactions during
the gap period require disclosure.
Acquisition method-noncontrolling
interest and goodwill
Noncontrolling interest and goodwill are
calculated using either the partial goodwill
method or the full goodwill method. The
partial goodwill method is the preferred
method under IFRS, but entities can elect to
use the full goodwill method on a transactionby-transaction basis.
Noncontrolling interest and goodwill are
calculated using the full goodwill method.
F3-58
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Financial 3
Becker Professional Education I CPA Exam Review
C LASS QU EST I O N S
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Task-based simulation
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
1st
Questions correct
+ 17 questions
=
%
Questions correct
+ 1 questions =
%
2nd
Questions correct
+
17 questions
=
%
Questions correct
+ 1 questions =
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3rd
Questions correct
+ 17 questions
=
%
Questions correct
+ 1 questions =
%
Final
Total questions correct
CI DeVry/Becker Educational Development Corp. All rights reserved.
+ 18 questions
=
%
F3-59
Financial
3
Becker Professional Education I CPA Exam Review
NOTES
F3-60
co OeVry/Becker Educational Development Corp.
All rights reserved .
Financial 3
Becker Professional Education I CPA Exam Review
1 . CPA·00265
Entities should report marketable equity securities classified as trading at:
a.
b.
c.
d.
Lower of cost or market, with holding gains and losses included i n earnings.
Lower of cost or market, with holding gains included in earnings only to the extent of previously
recognized holding losses.
Fair value, with holding gains i ncluded in earnings only to the extent of previously recognized
holding losses.
Fair value, with holding gains and losses included in earni ngs.
2. CPA·00273
Information regarding Stone Co's available·for-sale portfolio of marketable equity securities is as follows:
Aggregate cost as of 1 2/31 IY2
Market value as of 1 2/31 IY2
$ 1 70,000
1 48,000
At December 3 1 , Year 1 , Stone reported an unrealized loss of $ 1 ,500 to reduce investments to market
value. This was the first such adjustment made by Stone on these types of securities. In its Year 2
statement of comprehensive income, what amount of unrealized loss should Stone report?
a.
b.
c.
d.
$30,000
$20,500
$22,000
$0
3. CPA·04697
Sun Co. is a wholly owned subsidiary of Star Co. Both companies have separate general ledgers, and
prepare separate financial statements. Sun requires stand-alone financial statements. Which of the
following statements is correct?
a.
b.
c.
d.
Consolidated financial statements should be prepared for both Star and Sun.
Consolidated financial statements should only be prepared by Star and not by Sun.
After consolidation, the accounts of both Star and Sun should be changed to reflect the consolidated
totals for future ease in reporting.
After consolidation, the accounts of both Star and Sun should be combined together into one general­
ledger accounting system for future ease in reporting.
4. C PA·00287
An investor uses the cost method to account for an investment in common stock. Dividends received
this year exceeded the investor's share of investee's undistributed earnings since the date of investment.
The amount of dividend revenue that should be reported in the investor's income statement for this year
would be:
a.
The portion of the dividends received this year that were in excess of the investor's share of
investee's undistributed earnings since the date of investment.
b. The portion of the dividends received this year that were not in excess of the investor's share of
i nvestee's undistributed earnings since the date of investment.
c. The total amount of dividends received this year.
d. Zero.
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F3-61
Becker Professional Education I CPA Exam Review
Financial 3
5. C PA-00285
Plack Co. purchased 1 0,000 shares (2% ownership) of Ty Corp. on February 1 4 , Year 1 . Plack received
a stock dividend of 2,000 shares on April 30, Year 1 , when the market value per share was $35. Ty paid
a cash dividend of $2 per share on December 1 5, Year 1 . In its Year 1 income statement, what amount
should Plack report as dividend income?
a.
b.
c.
d.
$20,000
$24,000
$90,000
$94,000
6. TBS-0001 9
O n January 1 , Year 1 , Perfect Tile Inc. purchased a 1 0% interest i n Stone Slabs Inc. by purchasing
1 0,000 shares of Stone Slabs' common stock for $20/share. Perfect Tile plans to hold the investment.
Stone Slabs' Year 1 net income was $400,000. During Year 1 , Stone Slab paid a dividend of $ 1 20,000.
On December 31 , Year 1 , Stone Slabs' common stock was selling for $23.50 per share.
Prepare the following journal entries.
Journal Entry 1 - Record the purchase of the investment
Journal Entry 2
-
Record the dividend received during Year 1
Journal Entry 3 - Adjust the investment account at year-end
What is reported as investment in Stone Slabs on the December 3 1, Year 1 balance sheet?
What is the total income from this investment reported on the Year 1 income statement?
What is the total other comprehensive income reported on the Year 1 statement of comprehensive
income?
F3-62
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Becker Professional Education I CPA Exam Review
Financial 3
7. CPA-00320
On January 2, Year 3, Well Co. purchased 1 0% of Rea, I nc.'s outstanding common shares for $400,000.
Well is the largest single shareholder in Rea, and Well's officers are a majority on Rea's board of
directors. Rea reported net income of $500,000 for Year 3 and paid dividends of $ 1 50,000. In its
December 3 1 , Year 3, balance sheet, what amount should Well report as investment in Rea?
a.
b.
c.
d.
$450,000
$435,000
$400,000
$385,000
8. CPA-00289
Birk Co. purchased 30% of Sled Co.'s outstanding common stock on December 31 for $200,000. On that
date, Sled's stockholders' equity was $500,000, and the fair value of its identifiable net assets was
$600,000. On December 31 , what amount of goodwill should Birk attribute to this acquisition?
a.
b.
c.
d.
$0
$20,000
$30,000
$50,000
9. CPA-00348
Park Co. uses the equity method to account for its January 1 , Year 1 , purchase of Tun, Inc.'s common
stock. On January 1 , Year 1 , the fair values of Tun's FIFO inventory and land exceeded their carrying
amounts. How do these excesses of fair values over carrying amounts affect Park's reported equity in
Tun's Year 1 earnings?
a.
b.
c.
d.
InventoCL. excess
Land excess
Decrease
Decrease
Increase
Increase
Decrease
No effect
Increase
No effect
1 0. CPA-00288
Puff Co. acquired 40% of Straw, Inc.'s voting common stock on January 2, Year 1 for $400,000. The
carrying amount of Straw's net assets at the purchase date totaled $900,000. Fair values equaled
carrying amounts for all items except equipment, for which fair values exceeded carrying amounts by
$ 1 00,000. The equipment has a five-year life. During Year 1 , Straw reported net income of $ 1 50,000.
What amount of income from this investment should Puff report in its Year 1 income statement?
a.
b.
c.
d.
$40,000
$52,000
$56,000
$60,000
© DeVry/Becker Educational Development Corp. All rights reserved.
F3-63
Flnandal 3
Becker Professional Education I CPA Exam Review
1 1 . CPA-00430
Company J acquired all of the outstanding common stock of Company K in exchange for cash. The
acquisition price exceeds the fair value of net assets acquired. How should Company J determine the
amounts to be reported for the plant and equipment and long-term debt acquired from Company K?
Long-term debt
Plantand equipment
a.
b.
c.
d.
K's carrying amount
Fair value
K's carrying amount
Fair value
K's carrying amount
K's carrying amount
Fair value
Fair value
1 2. CPA-00389
A business combination is accounted for as an acquisition. Which of the following expenses related to
the business combination should be included, in total, in the determination of net income of the combined
corporation for the period in which the expenses are incurred?
and consultants
Registration fees for
equity securities issued
Yes
Yes
No
No
Yes
No
Yes
No
Fees of finders
a.
b.
c.
d.
�
1 3. CPA-00391
On September 29, Year 1 , Wall Co. paid $860,000 for all the issued and outstanding common stock of
Hart Corp. On that date, the carrying amounts of Hart's recorded assets and liabilities were $800,000
and $1 80,000, respectively. Hart's recorded assets and liabilities had fair values of $840,000 and
$140,000, respectively. In Wall's September 30, Year 1 balance sheet, what amount should be reported
as goodwill?
a.
b.
c.
d.
$20,000
$1 60,000
$1 80,000
$240,000
F3-64
C> DeVry/Becker Educational Development Corp. All rights reserved.
Financial 3
Becker Professional Education I CPA Exam Review
1 4. CPA-06457
Penn Corp. paid $300,000 for 75% of the outstanding common stock of Star Co. At that time, Star had
the following condensed balance sheet:
Carrying
Amounts
Current assets
Plant and equipment, net
Liabilities
Stockholders' equity
$40,000
380,000
200,000
220,000
The fair value of the plant and equipment was $60,000 more than its recorded carrying amount. The fair
values and carrying amounts were equal for all other assets and liabilities. What amount of goodwill
related to Star's acquisition should Penn report on its consolidated balance sheet under U.S. GAAP?
a.
b.
c.
d.
$20,000
$40,000
$90,000
$ 1 20,000
1 5. CPA-06458
Penn Corp. paid $300,000 for 75% of the outstanding common stock of Star Co. At that time, Star had
the fol lowing condensed balance sheet:
Carrying
Amounts
Current assets
Plant and equipment, net
Liabilities
Stockholders' equity
$40,000
380,000
200,000
220,000
The fair value of the plant and equipment was $60,000 more than its recorded carrying amount. The fair
values and carrying amounts were equal for all other assets and liabilities. What amount of goodwill
related to Star's acquisition should Penn report on its consolidated balance sheet under the I FRS partial
goodwill method?
a.
b.
c.
d.
$20,000
$40,000
$90,000
$ 1 20,000
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F3-65
Financial 3
Becker Professional Education I CPA Exam Review
1 6. C PA·00455
Wright Corp. has several subsidiaries that are included in its consolidated financial statements. In its
December 3 1 , Year 2, trial balance, Wright had the following intercompany balances before eliminations:
Debit
Current receivable due from Main Co.
Noncurrent receivable from Main
Cash advance to Corn Corp.
Cash advance from King Co.
Intercompany payable to King
Credit
$32,000
1 1 4,000
6,000
$ 1 5,000
1 01 ,000
In its December 31 , Year 2, consolidated balance sheet, what amount should Wright report as
intercompany receivables?
a.
b.
c.
d.
$ 1 52,000
$ 1 46,000
$36,000
$0
1 7. CPA·00448
Perez, I nc. owns 80% of Senior, I nc. During Year 1 , Perez sold goods with a 40% gross profit to Senior.
Senior sold all of these goods in Year 1 . For Year 1 consolidated financial statements, how should the
summation of Perez and Senior income statement items be adjusted?
a.
b.
c.
d.
Sales and cost of goods sold should be reduced by the intercompany sales.
Sales and cost of goods sold should b e reduced b y 80% of the intercompany sales.
Net income should be reduced by 80% of the gross profit on intercompany sales.
N o adjustment is necessary.
1 8. CPA·00484
On January 1 , Year 1 0, Poe Corp. sold a machine for $900,000 to Saxe Corp . , its wholly-owned
subsidiary. Poe paid $1 , 1 00,000 for this machine, which had accumulated depreciation of $250,000.
Poe estimated a $ 1 00,000 salvage value and depreciated the machine on the straight-line method over
20 years, a policy which Saxe continued. In Poe's December 31 , Year 1 0, consolidated balance sheet,
this machine should be included in cost and accumulated depreciation as:
Accumulated
Cost
a.
b.
c.
d.
$ 1 , 1 00,000
$ 1 , 1 00,000
$900,000
$850,000
F3·66
degreciation
$300,000
$290,000
$40,000
$42,500
(C OeVry/Becker Educational Development Corp. All rights reserved.
FINANCIAL 4
Working Capital and Fixed Assets
1.
Working capital and its components
. .
2.
Inventories
3.
Fixed assets
4.
Depreciable assets and depreciation
.......................... .. ..... ..... ....................... . ............................................... .. . ...............
44
5.
Fixed asset impairment
.
55
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.............. ...... ..... ..... ... .................. ..... .............. ....... .............. .. . ......... ..... . ............................. ...
3
20
34
6. Appendix I: Other inventory cost flow assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 7
7. Appendix II: IFRS vs. U.S. GAAP
8.
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Class questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . :
www.become-a-cpa.webs.com/2014/
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Becker Professional Education
Financial 4
I
CPA Exam Review
NOTES
F4-2
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Becker Professional Education
I CPA Exam
Review
Financial 4
WORKING CAPITAL AND ITS COMPONENTS
I.
INTRODUCTION TO WORKING CAPITAL
A.
Working Capital
Working capital is defined as current assets minus current liabilities. It is often a measure of
the solvency of a company and is used in many financial ratios for analysis purposes.
Working capital
Current assets - Current liabilities
Current ratio
Current assets / Current liabilities
Quick ratio
B.
(Cash
+ Net receivables + Marketable securities) / Current liabilities
Current Assets
Current assets are those resources that are reasonably expected to be realized in cash, sold,
or consumed (prepaid items) during the normal operating cycle of a business or one year,
whichever is longer. Current assets typically consist of:
C.
1.
Cash.
2.
Trading securities.
3.
Other short-term investments (individual available-for-sale securities if liquidation is
anticipated within the operating cycle or one year, whichever is longer).
4.
Accounts and notes receivable.
5.
Trade installment receivables.
6.
Inventories (discussed later in this module).
7.
Other short-term receivables.
8.
Prepaid expenses.
9.
Cash surrender value of life insurance. Cash surrender value of life insurance can be a
current asset or a non-current asset depending on intent. If the policy owner intends to
surrender the policy for its cash surrender value during the normal operating cycle, it
would be a current asset; if the policy owner does not intend to surrender the policy, as
is normal, it would be a non-current asset. If an insurance policy has a cash surrender
value, any portion of the premium payment that does not add to that cash surrender
value is expensed.
Current Liabilities
Current liabilities are obligations whose liquidation is reasonably expected to require the use
of current assets or the creation of other current l iabilities. Obligations for items that have
entered the operating cycle should be classified as current liabilities. The concept of current
liabilities includes estimates or accrued amounts that are expected to be required to cover
expenditures within the year for known obligations ( 1 ) when the amount can be determined
only approximately (e.g. , provision for accrued bonuses payable), or (2) where the specific
person(s) to whom payment will be made is unascertainable (e.g., provision for warranty of a
product).
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F4-3
Becker Professional Education
Financial 4
I CPA Exam
Review
Current liabilities are an important indication of financial strength and solvency. The ability to
pay current debts as they mature is analyzed by interested parties both within and outside the
company.
1.
Sources of Current Liabilities
Current liabilities may arise from regular business operations (as is the case of
accounts payable and wages payable) or to meet cash needs through bank
borrowings.
2.
Types of Current Liabilities
Current liabilities typically consist of:
3.
a.
Trade accounts and notes payable.
b.
Current portions of long term debt.
c.
Cash dividends payable.
d.
Accrued liabilities.
e.
Payroll liabilities.
f.
Taxes payable.
g.
Advances from customers (deferred revenues if expected to be recognized within
one year).
Classification of Short-term Obligations Expected to be Refinanced
Under U .S. GAAP, a short-term obligation may be excluded from current liabilities and
included in noncurrent debt if the company intends to refinance it on a long-term basis
and the intent is supported by the ability to do so as evidenced either by:
a.
The actual refinancing prior to the issuance of the financial statements, or
b.
The existence of a noncancelable financing agreement from a lender having the
financial resources to accomplish the refinancing.
The amount excluded from current liabilities and a full description of the financing
agreement shall be fully disclosed in the financial statements or notes thereto.
The followingjournal entry would be used to record the reclassification:
ItlB Short-term liability
long-term liability
$XXX
$XXX
Under IFRS, short-term obligations expected to be refinanced on a Inn,a_t�'rn'll
classified as noncurrent.
F4-4
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Becker Professional Education I CPA Exam Review
II.
Financial 4
CASH AND CASH EQUIVALENTS
Cash includes both currency and demand deposits with banks and/or other financial institutions. It
also includes deposits that are similar to demand deposits (can be added to or withdrawn at any
time without penalty). The term cash equivalents broadens the definition of cash to
include short-term, highly liquid investments that are both readily convertible to cash and
so near their maturity when acquired by the entity (90 days or less from date of
purchase) that they present insignificant risk of changes in value.
A.
B.
C.
Examples of Cash and Cash Equivalents
1.
Coin and currency on hand (including petty cash)
2.
Checking accounts
3.
Savings accounts
4.
Money market funds
5.
Deposits held as compensating balances against borrowing arrangements with a
lending institution that are NOT legally restricted
6.
Negotiable paper
a.
Bank checks, money orders, traveler's checks, bank drafts, and cashier's checks
b.
Commercial paper and Treasury bills
c.
Certificates of deposit (having original maturities of 90 days or less)
Items Not Cash or Cash Equivalents
1.
Time certificates of deposit (if original maturity over 90 days)
2.
Legally restricted deposits held as compensating balances against borrowing
arrangements with a lending institution
Restricted or Unrestricted
Cash is classified as unrestricted or restricted. Restricted cash is cash that has been set
aside for a specific use or purpose (e.g., the purchase of property, plant, and equipment).
Unrestricted cash is used for all current operations. The nature, amount, and timing of
restrictions should be disclosed in the footnotes.
1.
If the restriction is associated with a current asset or current liability, classify as a
current asset but separate from unrestricted cash.
2.
If the restriction is associated with a noncurrent asset or noncurrent liability, classify as
a noncurrent asset but separate from either the Investments or Other Assets section.
3.
Examples of restrictions:
a.
If any portion of cash and cash equivalents is contractually restricted because of
financing arrangements with a credit institution (called a compensating balance),
that portion should be separately reported as "restricted cash" in the balance
sheet.
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Financial 4
b.
If any portion of cash and cash equivalents is restricted by management, it
should be reported as restricted cash and as a current or long-term asset
(depending on the anticipated date of disbursement).
c.
Some industries (such as public utilities) report the amount of cash and cash
equivalents as the last asset on the balance sheet because they report assets in
inverse order of liquidity.
l
E X A M P L E - I T E M S I N C LUDED I N CASH B A LA N c e
Smith Corporation's cash ledger balance on December 3 1 , Year 7, was $160,000. On the same date Smith
held the following items i n its safe:
•
•
•
A $5,000 check payable to Smith, dated Ja nuary 2, Year 8 that was not included in the December 3 1
checkbook balance.
A $3,500 check payable to Smith, deposited December 22 and included in the December 31 checkbook
balance, that was returned NSF. The check was re-deposited January 2, Year 8 and cleared January 7.
A $25,000 check, payable to a supplier and drawn on Smith's account, that was dated and recorded
December 31, but was not mailed until January 15, Year 8.
In its December 31, Year 7 balance sheet, what amount should Smith report for cash?
Smith's cash balance is calculated as follows:
Unadjusted balance of Smith's Cash Ledger Accou nt, December 3 1, Year 7
Add: Check Payable to supplier dated and recorded on December 31, Yea r 7,
but not mailed until January 15, Year 8
25 ,000
Less: NSF check returned by bank on December 30, Year 7
(3 ,500)
Adjusted balance, December 3 1 , Yea r 7
D.
$160,000
$181,500
Bank Reconciliations
There are two general forms of bank reconciliations. One form is called a simple
reconciliation. The other widely used form is entitled reconciliation of cash receipts and
disbursements.
1.
Simple Reconciliation
Differences between the cash balance reported by the bank and the cash balance per
the depositor's records are explained through the preparation of the bank reconciliation.
Several factors bring about this differential.
a.
Deposits i n Transit
Funds sent by the depositor to the bank that have not been recorded by the bank
and deposits made after the bank's cutoff date will not be included in the bank
statement. In both cases, the balance per the depositor's records will be higher
than those of the bank.
b.
Outstanding Checks
Checks written for payment by the depositor that have not been presented to the
bank will result in a higher balance per bank records than per depositor records.
F4-6
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c.
Financial 4
Service Charges
Service charges are deducted by the bank. The depositor will not deduct this
amount from its records until it is made aware of the charge, usually in the
following month. Balance per books is overstated until this amount is subtracted.
d.
Bank Collections
The bank may make collections on the depositor's behalf, increasing the
depositor's bank balance. If the depositor is not aware the collection was
credited to its balance, the balance per depositor's records will be understated .
e.
Errors
Errors made by either the bank or the depositors are another cause for
difference.
f.
Nonsufficient Funds
(NSF)
The bank may have charged the depositor's account for a dishonored check and
the check may not have been redeposited until the following month. This would
overstate the depositor's book balance as of the balance sheet date.
g.
Interest Income
Usually the depositor does not keep track of average daily cash balances, and so
will add this amount to its records once made aware of this revenue. Balance
per books is understated until this amount is added .
h.
Example of a Simple Bank Reconciliation
Although other methods can be used , the most common procedure is to
reconcile both book and bank balances to a common "true" balance. That
balance should then appear on the balance sheet under the caption "Cash and
Cash Equivalents."
Procedures:
(1)
Book balance i s adjusted to reflect any corrections reported by the bank
(e.g., NSF checks, notes collected by the bank and credited to the account,
monthly service charges, and other bank charges such as check printing
charges).
(2)
After the above adjustments are made:
I
(3)
ADJUSTED BOOK BALANCE
=
TRUE BALANCE
_
I
The bank balance per the bank statement is reconciled to the "true
balance," determined above.
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Financial 4
II
SIMPLE BANK RECONCILIATION
Burbank Company's records reflect a $12,650 cash balance on November 30, Year 3. Burbank's November bank statement
reports the following amounts:
Cash balance
$ 10,050
Bank service charge
10
NSF check
90
Deposits in transit equal $3,000 and outstanding checks are $500.
What is Burbank's November 30, Year 3 adjusted cash balance?
Bank Reconciliation for November Year 3
$12,650
Balance per books
Less:
Bank service charge
NSF check
$10
�
-11QQ)
Adjusted cash balance
$12,550
Balance per bank
$ 10,050
Add:
Deposits in transit
3,000
$13,050
Less:
Outstanding checks
Adjusted cash balance
2.
---1.2QQ)
$12,550
Reconciliation of Cash Receipts and Disbursements
The reconciliation of cash receipts and d isbursements, commonly referred to as the
four-column reconciliation or proof of cash, serves as a proof of the proper recording of
cash transactions.
Additional information is required in preparing the four-column reconciliation. The bank
reconciliation information for the present month and that of the prior month must be
obtained.
The object of the four-column approach is to reconcile any differences between the
amount the depositor has recorded as cash receipts and the amount the bank has
recorded as deposits. Likewise, this approach determines any differences between
amounts the depositor has recorded as cash disbursements and amounts the bank has
recorded as checks paid.
F4-8
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Financial 4
F O U R- C O LU M N A P P R OACH
Based on the information i n the previous example and additional information for the month of December, B urbank's
reconciliation of cash receipts and disbursements follows:
Burbank Company
Reconciliation of Cash Receipts and Cash Disbursements
For the Month of December, Year 3
Balance
1 1/30/year 3
December
Receipts
$12,550
$12,950
Balance per depositor's books
Note collected by bank
Bank service charge
NSF check received from customer
Error in recording check #350
$4, 948
3,050
15
(285 )
--..M
Adjusted balances
Balance per bank records
$10,050
Deposit in transit:
November 30
December 31
Outstanding checks:
November 30
December 31
NSF check
Adjusted balances
III.
December
Payments
Balance
12/31/Year 3
$20,552
3,050
( 15 )
(285)
�)
$15,715
$5,017
$23,248
$15,000
$2,400
$22,650
3,000
(3,000)
4,000
(500)
_l�J
$15,715
4,000
(500)
3,402
(285)
$5,017
(3,402)
$23,248
ACCOUNTS RECEIVABLE
Accounts receivable are oral promises to pay debts and are generally classified as current assets.
They are classified either as trade receivables (accounts receivable from purchasers of the
company's goods and services) or non-trade receivables (accounts receivable from persons other
than customers, such as advances to employees, tax refunds, etc.).
A,
Blank Account Analysis Format
The preparation of an account analysis may increase your ability to "squeeze" or otherwise
derive various answers to CPA Exam questions regarding accounts receivable, allowance for
doubtful accounts, and many other accounts.
o
o
BLA N K A N A L Y S I S F O R M AT
Beginning balance
$
_----
Add:
Subtotal
o
Subtract:
o
Ending balance
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$
====
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Financial 4
Becker Professional Education I CPA Exam Review
P A S S KEY
The Blank Analysis Format is a tool that is merely an "add-subtract" form of "T" account, but it often
provides a "foolproof" method of obtaining the correct result to many exa mination questions. You will
find that this format will assist you "squeezing" answers in many of the balance sheet items questions
on the CPA Exam!
1.
Accounts Receivable Account Analysis Format
Beginning Balance
Add:
Subtract:
$ 90,000
Credit sales
800.000
Subtotal
890,000
Cash col lected on account
$810,000
Accounts receivable converted to notes receivable
Accounts receivable written off as bad debts
7,000
23.000
Ending balance
(840.000)
$ 50.000
The net realizable value of accounts receivable is the balance of the accounts
receivable account adjusted for allowances for receivables that may be uncollectible,
sales discounts, and sales returns and allowances.
B.
Valuation of Accounts Receivable with Discounts and Returns
I n general, accounts receivable should be initially valued at the original transaction amount
(i.e., historical cost); however, that amount may be adjusted for items of sales or cash
discounts and for sales returns (and then further adjusted once information regarding
collection is obtained).
1.
Discounts
The offer of a cash discount on payments made within a specified period is widely used
by many companies. This practice encourages prompt payment and assumes that
customers will take advantage of the discount.
a.
Sales or Cash Discounts
The discount is generally based on a percentage of the sales price. For
example, a discount of 2/1 0, n/30 offers the purchaser a discount of 2% of the
sales price if the payment is made within 1 0 days. If the discount is not taken,
the entire (gross) amount is due in 30 days. The calculation of cash discounts
typically follows one of two forms, the determination of which method to use is
generally based upon the company's experience with its customers taking
discounts.
(1 )
Gross Method
The gross method records a sale without regard to the available discount.
If payment is received within the discount period, a sales discount (contra
revenue) account is debited to reflect the sales discount.
F4-10
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(2)
Financial 4
Net Method
The net method records sales and accounts receivable net of the available
discount. An adjustment is not needed if payment is received within the
discount period. However, if payment is received after the discount period,
a sales discount not taken account (revenue) must be credited .
E X A M P LE
Gearty Company sells $100,000 worth of goods to Smith Company. The terms of the sale a re
2/10, n/30. Show the journal entries for the accou nts receivable Gearty Company woul d
record using both t h e gross method and t h e net method .
Accounts receivable
$ 100,000
Sales
$98,000
$ 100,000
$98,000
The journal entries if payment is received within the discount period.
Cash
$98,000
Sales discounts taken
$98,000
2,000
Accounts receivable
$100,000
$98,000
The journal entries if payment is not received within the discount period.
Cash
$ 100,000
Accounts receivable
$100,000
$ 100,000
$98,000
Sales discounts not taken
b.
2,000
Trade Discounts
Trade discounts (quantity discounts) are quoted in percentages. Sales revenues
and accounts receivable are recorded net of trade discounts. Trade discounts
are applied sequentially.
EXAM PLE
Ann Klein coats have a l ist price of $1,000. They are sold to stores for list price minus trade
discounts of 40% and 10%. Calculate the Ann Klein accounts receivable balance if 100 coats are
sold on credit.
List price
Less: 40% discount
(40.000)
List price after 40% discount
60,000
Less: 10% discount
(6.000)
Accounts receivable balance
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$100,000
$ 54,000
F4·11
Becker Professional Education I CPA Exam Review
Financial 4
2.
Sales Returns and Allowances
Sales of goods often result in those goods being returned for a variety of reasons.
Goods returned represent deductions from accounts receivable and sales.
If past experience shows that a material percentage of receivables are returned, an
allowance for sales returns should be established.
Journal entry to record a sales return:
11m Sales returns and allowances (contra sales)
$60,000
Accounts receivable
C.
$60,000
Estimating Uncollectible Accounts Receivable
Accounts receivable should be presented on the balance sheet at their net realizable value.
Thus, the amount recorded at initial transaction should be reduced by the amount of any
uncollectible receivables. Two methods of recognizing uncollectible accounts receivable
exist (the direct write-off method and the allowance method); however, only the allowance
method is consistent with accrual accounting (and thus acceptable for GAAP).
1.
Direct Write-off Method (not GAAP)
Under the direct write-off method, the account is written off and the bad debt is
recognized when the account becomes uncollectible. The direct write-off method is not
GAAP because it does not properly match the bad debt expense with the revenue
(note, however, that the direct write-off method is the method used for federal income
tax purposes). An additional weakness of this method is that accounts receivable are
always overstated because no attempt is made to account for the unknown bad debts
included in the balance on the financial statements.
..
EX A M P LE
On December 15, Year 1, Roe Company recorded a credit sale of $10,000. On July 1, Year 2, the
company determined that the account receivable was uncollectible. The following journal entry is
recorded in Year 2 to write-off the bad debt. The revenue recorded in Year 1 is not properly matched
to the bad debt expense recorded in Year 2.
Journal entry to record the account balance of $10,000 as uncollectible:
11m Bad debt expense
Accounts receivable
2.
$10,000
$10,000
Allowance Method (GAAP)
The allowance for uncollectibles should be based on past experience. A percentage of
each period's sales or ending accounts receivable is estimated to be uncollectible.
Consequently, the amount determined is charged to bad debts of the period and the
credit is made to a valuation account such as "allowance for uncollectible accounts."
When specific amounts are written off, they are debited to the allowance account,
which is periodically recomputed. There are three generally accepted methods of
estimating uncollectible or doubtful accounts under the allowance method .
F4-12
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Becker Professional Education I CPA Exam Review
a.
Percentage of Sales Method (income statement approach)
Under the percentage of sales method , a percentage of each sale is debited to
the account "bad debt expense" and credited to the account "allowance for
doubtful accounts." The applicable percentage is based on the company's
experience.
EX A M P LE
ABC Co. bases estimated uncollectible accounts on total credit sales for the period. ABC Co.
estimates that 2% of its $200,000 sales on credit will not be collected. The credit balance in the
allowance for uncollectible accounts before adjustment is $ 1 ,000.
Journal entry to record increase in allowance account:
!1m Bad debt expense
tWH
$4,000
Allowance for uncollectible accounts
$4 ,000
Beginning balance in a llowance for uncollectible accounts
Additions as a result of new credit sales
4,000
Ending balance in allowance for uncollectible accounts
b.
$1,000
$5,000
Percentage of Accounts Receivable at Year-end Method (balance sheet
approach)
Uncollectible accounts may also be estimated as a certain percentage of
accounts receivable at year-end . Note that under this method , the amount of the
estimated allowance calculated is the ending balance that should be in the
allowance for doubtful accounts on the balance sheet. Therefore, the difference
between the unadjusted balance and the desired ending balance is debited (or
credited) to the bad debt expense account.
EXAMPLE
DEF Co. uses a percentage for uncollectibles based on the year-end balance i n accounts
receivable. DEF Co. estimates that the balance in the a llowance account must be 2% of year­
end accounts receivable of $80 ,000. The balance in the allowance account is $1,000 credit
before adjustment.
The amount to be credited to the allowance accounts is calculated below.
Required ending balance ($80,000 x .02 )
$1,600
Existing balance before adjustment
(1.000)
Credit to a llowance account needed
$ 600
Journal entry to record increase in allowance account
Bad debt expense
Allowance for uncoll ectible accounts
$600
$600
Note: If the $1,000 balance in the allowance account had been a debit, we would have added it
to the required ending balance. The entry would have then been for $2,600.
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Financial 4
c.
Aging of Receivables Method (balance sheet approach)
Another method that can be used in estimating uncollectible accounts is aging of
accounts receivable. A schedule is prepared categorizing accounts by the
number of days or months outstanding. Each category's total dollar amount is
then multiplied by a percentage representing uncollectibility based on past
experience. The sum of the product for each aging category will be the desired
ending balance in the allowance account.
II
EXAMPLE
The balance in the allowance account before adjustment is $1,000 credit. The ana lysis of the
aging of receivables requires the allowance account to have a net balance of $1,600.
Classification
by Due Date
Current
Balances in
Each Category
Estimated %
Uncollectible
Estimated
Uncollectible
Account
$10,000
.01
$ 100
3 1-61 days
6 ,667
.03
200
61-90 days
5 ,000
.10
500
Over 90 days
4,000
.20
800
$1,600
$25,667
Summarized from an analysis of individual invoices. The journal entry would be the same as that shown in
the previous example.
D.
Bad Debt Expense
The amount charged to earnings for the bad debt expense of the period usually includes
these two items:
E.
1.
The provision made during the period, and
2.
A n adjustment made a t year-end to increase/decrease the balance in the allowance for
uncollectible accounts, if needed.
Write-off of a Specific Account Receivable
When a receivable is formally determined to be uncollectible, the following
entry is made:
IJ.ill Al lowance for doubtful accounts
[lID
F.
Accounts receivable
$ XXX
$ XXX
Subsequent Collection of Accounts Receivable Written Off
If a collection is made on a receivable that was previously written off, the accounting
procedure depends upon the method of accounting used .
1.
Direct Write-off Method
Journal entry is as follows:
$ XXX
IJ.ill Cash
CIl1
Uncollectible accounts recovered
$ XXX
The "uncollectible accounts recovered" account is a revenue account.
F4-14
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2.
Financial 4
Allowance Method
To restore the account previously written off:
11m Accounts receivable
$ XXX
Allowance for uncollectible accounts
rwD
$ XXX
To record the cash collection on the account:
11m Cash
3.
$ XXX
Accounts receivable
rwD
$ XXX
Allowance for Doubtful Accounts Account Analysis Format
Beginning balance
$100,000
100,000
100,000
?
3,000
3,000
?
3,000
Add: Bad debt e x pense
Recoveries of bad debts
__
0
__
0
__
0
__
Subtotal
103,000
103,000
103,000
103,000
2.000
---
?
2.000
2.000
?
101.000
101,000
101.000
Less: Accounts receivable written off
Ending balance
0
(Note the different scenarios with missing information.)
E XA M P L E - C A L C U L AT I ON OF B A D D E BT E X P E N S E
Bost Company, at December 3 1, Year 5, adopted a new accounting method for estimating the
a llowance for unco l l ectible accounts using the percentage of accounts considered u ncollectible in
the year-end aging of accounts receivable.
The following data are available:
Allowance for uncollectible accounts, 1/1/Year 5
Provision for uncollectible accounts during Year 5 (2% of credit sales of $700,000)
Bad debts written off, 11/30/Year 5
Estimated total of uncollectible accounts, per aging at 12/31/Year 5
$20,000
14,000
12,500
20,500
After year-end adjustments, the Year 5 bad debt expense would be:
Allowance
Balance, 1/1/Year 5
Plus: Year 5 provision
Less: Year 5 write-offs
Preliminary balance
Desired balance
Decrease needed
$20,000
14,000
/12.500)
21,500
/20 .500)
$ 1,000
Provision
Original provision
Less: necessary adjustment
Year 5 bad debt expense
$14,000
/1.000)
$13,000
Journal entry to record the write off of bad debts at November 30, Year 5:
11m Allowance for uncollectible accounts
$12,500
Accounts receivable
$12,500
Journal entry to record the adjustment at December 31, Year 5:
11m Allowance for uncollectible account5
rwD
Bad debt expense
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$1,000
$1,000
F4-15
Becker Professional Education I CPA Exam Review
Financial 4
G.
Pledging (Assignment)
Pledging is the process whereby the company uses existing accounts receivable as col lateral
for a loan. The company retains title to the receivables but "pledges" that it will use the
proceeds to pay the loan. Pledging requires only note disclosure. The accounts receivable
account is not adjusted.
H.
Factoring of Accounts Receivable
Factoring is a process by which a company can convert its receivables into cash by assigning
them to a "factor" either without or with recourse. Under factoring arrangements, the
customer may or may not be notified.
1.
Without Recourse
If a sale is non-recourse, it means that the sale is final and that the assignee (the
factor) assumes the risk of any losses on collections. If the buyer is unable to collect
all of the accounts receivable, it has no recourse against the seller.
Journal entry to factor accounts receivable without recourse:
11m Cash
$XXX
11m Due from factor (factor's margin)
$xxx
11m Loss on sale of receivable
$xxx
Accounts receivable
rim
$XXX
The entry to the asset account "Due from Factor" reflects the proceeds retained by the
factor. This amount protects the factor against sales returns, sales discounts,
allowances, and customer disputes.
2.
With Recourse
If a sale is on a recourse basis, it means that the factor has an option to re-sell any
uncollectible receivables back to the seller.
If accounts receivable are transferred to a factor with recourse, two treatments are
possible. The transfer may be considered either a sale or a borrowing (with the
receivables as mere collateral).
a.
b.
F4-16
In order to be considered a sale, the transfer must meet the following conditions:
(1 )
The transferor's (seller's) obligation for uncollectible accounts can
reasonably be estimated.
(2)
The transferor surrenders control of the future economic benefits of the
receivables to the buyer.
(3)
The transferor cannot be required to repurchase the receivables, but may
be required to replace the receivables with other similar receivables.
If any of the above conditions are not met, the transfer is treated as a loan.
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Financial 4
Transfers and Servicing of Financial Assets
There are many different forms of transfers of financial assets. More complex types of
transactions raise issues regarding whether the transaction should be considered a sale (of
all or part of the financial assets) or a secured borrowing. They also raise issues about how
they should be accounted for, for both the transferor and the transferee.
1.
Objective
The objective of accounting for these transfers of financial assets (per SFAS No. 1 40)
is that each entity involved in the transaction should:
2.
only the assets it has control over (and the related liabilities it has
incurred in the process), and
a.
Recognize
b.
Oerecognize (i.e., remove previously recognized items from the balance sheet)
those assets only when control over them has been surrendered and those
liabilities only when extinguished (covered in class F5).
Financial-components Approach
The financial-components approach is the basis for the GAAP rules for transfers and
servicing of financial assets. Under this approach, which focuses on control, financial
assets and l iabilities may be divided into many components. These components may
have different accounting methods applied to them, depending upon the
circumstances.
3.
Definition of Surrender of Control
In order to determine the accounting rules to apply to a transaction of this type, one of
the first steps is to determine whether control has been surrendered. The following
three conditions must gll be met before control is deemed to have been surrendered:
4.
a.
The transferred assets have been isolated from the transferor,
b.
The transferee has the right to pledge or exchange the assets, and
c.
The transferor does not maintain control over transferred assets under a
repurchase agreement.
Control is Surrendered-No Continuing Involvement
If the three conditions for surrender of control are met and there is no continuing
involvement, the entire transfer is recorded as a sale, with appropriate reduction in
receivables and recognition of any gain or loss.
5.
Control is Surrendered-Continuing Involvement
If the three conditions for surrender of control are met and there is continuing
involvement, the transfer (i.e., the assets for which there is no retained interest) is
recorded as a sale using the financial-components approach. The transferred assets
are divided between those deemed "sold" and those "not sold," and a resulting gain or
loss is recorded for the sold items.
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Financial 4
Any retained interests in the financial assets are still carried on the books of the
transferor (including servicing assets) and are allocated at book value based on the
relative fair value of all transferred assets at the date of transfer.
6.
No Control is Surrendered
If the three conditions for surrender of control are not met (i.e., the transaction is not
deemed a "sale"), the transferee and transferor will account for the transfer as a
secured borrowing with pledged collateral and will recognize the appropriate
asseUliability amounts and interest revenue/expense amounts. The accounting for the
collateral (non-cash) held depends upon whether the debtor has defaulted and whether
the secured party has the ability to sell or re-pledge the collateral.
7.
Servicing Assets and Liabilities
When an entity is a party to a servicing contract to service financial assets, it should
record a servicing asset or liability for the contract (initially measured at the price paid
or fai r value), with certain exceptions. The contract (asset or liability) will then be
amortized in proportion to the estimated net servicing income (or loss). In addition, the
fair value will be determined at regular intervals throughout the life of the contract, and
the contract will be then assessed for impairment (or an increase in the liability) based
on that fai r value.
IV.
NOTES RECEIVABLE
Notes receivable are written promises to pay a debt, and the writing is called a promissory note.
Notes receivable are classified the same as accounts receivable. They are also either a current
asset or a long-term asset, depending upon when collection will occur.
A.
Valuation and Presentation
For financial statement purposes, unearned interest and finance charges are deducted from
the face amount of the related promissory note. This is necessary in order to state the
receivable at its present value.
Also, if the promissory note is non-interest bearing or the interest rate is below market, the
value of the note should be determined by imputing the market rate of interest and
determining the value of the promissory note by using the effective interest method. Interest
bearing promissory notes issued in an arms-length transaction are presumed to be issued at
the market rate of interest.
B.
Discounting Notes Receivable
Discounted notes receivable arise when the holder endorses the note (with or without
recourse) to a third party and receives a sum of cash. The amount received by the holder is
determined by applying a "discount rate" to the maturity value of the note. The difference
between the amount of cash received by the holder and the maturity value of the note is the
"discount."
F4-18
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Professional Education I CPA Exam
1.
Financial 4
Review
With Recourse
If the note is discounted with recourse, the holder remains contingently liable for the
ultimate payment of the note when it becomes due. Notes receivable that have been
discounted with recourse are reported on the balance sheet with a corresponding
contra account (Notes Receivable Discounted) indicating that they have been
discounted to a third party. Alternatively, the notes receivable may be removed from
the balance sheet and the contingent liability disclosed in the notes to the financial
statements.
2.
Without Recourse
If the note is discounted without recourse, the holder assumes no further liability.
Notes receivable that have been discounted without recourse have essentially been
sold outright and should, therefore, be removed from the balance sheet.
E X A M P L E - D I S C O U N T I N G A N O T E AT A B A N K
Facts and Requirement:
Jordan Corporation has a $40,000, 90-day note from a customer dated September 30, 20XX, d ue December
30, 20XX, and bearing interest at 12%. On October 30, 20XX (30 days after issue), Jordan Corporation takes
the note to its bank, which is willing to discount it at a 15% rate. The note was paid by Jordan's customer at
maturity on December 30, 20XX (60 days later).
Compute the amount to be paid by the bank for the note. What amount should Jordan Corporation report
as net interest income from the note?
Solution:
1.
Compute the maturity value of the note by adding the interest to the face amount of the note, as
follows:
Face value of the note
$40,000
Interest on note to maturity
1,200
Payoff value of note at maturity
2.
$41,200
Compute the bank discount on the payoff value at maturity. as follows:
15% discount x 60/360 days x $41,200
3.
=
$1,030
Determine the amount paid by the bank for the note.
Payoff value at maturity
$41,200
Less: Bank's discount
Amount paid by bank for note
4.
(1.030)
$40,170
Derive the interest income (or expense) by subtracting the face value of the note from the amount paid
by the bank for the note, as follows:
Amount paid by bank for the note
3.
($40,000 x 12% x 90/360)
$40,170
Less: Face value of the note
(40,000)
Interest income to Jordan Corporation
$
170
Dishonored Discounted Notes Receivable
When a discounted note receivable is dishonored, the contingent liability should be
removed by a debit to Notes Receivable Discounted and a credit to Notes Receivable.
Notes Receivable Dishonored should be recorded to the estimated recoverable amount
of the note. A loss is recognized if the estimated recoverable amount is less than the
amount required to settle the note and any applicable penalties.
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F4·19
Becker Professional Education I CPA Exam Review
Financial 4
IN VEN T ORIES
I.
TYPES OF INVENTORIES HELD FOR RE-SALE
Inventories of goods must be periodically counted, valued, and recorded in the books of account of
a business. In general, there are four types of inventories that are held for re-sale.
A.
Retail Inventory
Retail inventory is inventory that is re-sold in substantially the same form in which it was
purchased .
B.
Raw Materials Inventory
Raw materials inventory is inventory that is being held for use in the production process.
C.
Work in Process Inventory (WIP)
WIP is inventory that is in production but incomplete.
D.
Finished Goods Inventory
Finished goods inventory is production inventory that is complete and ready for sale.
II.
GOODS AND MATERIALS TO BE INCLUDED IN INVENTORY
The general rule is that any goods and materials in which the company has legal title should be
included in inventory, and legal title typically follows possession of the goods. Of course, there are
many exceptions and special applications of this general rule.
A.
Goods in Transit
Title passes from the seller to the buyer in the manner and under the conditions explicitly
agreed upon by the parties. If no conditions are explicitly agreed upon ahead of time, title
passes from the seller to the buyer at the time and place where the seller's performance
regarding delivery of goods is complete.
F.O.B. means "free on board" and requires the seller to deliver the goods to the location
indicated as F.O.B. at the seller's expense. The following terminology is most commonly
used in passing title from the sel ler to the buyer:
1.
F. O.B. Shipping Point
With F.O.B. shipping point, title passes to the buyer when the seller delivers the goods
to a common carrier. Goods shipped in this manner should be included in the buyer's
inventory upon shipment.
2.
F. O.B. Destination
With F.O.B. destination, title passes to the buyer when the buyer receives the goods
from the common carrier.
B.
Shipment of Non-conforming Goods
If the seller ships the wrong goods, the title reverts to the seller upon rej ection by the buyer.
Thus, the goods should not be included in the buyer's inventory, even if the buyer possesses
the goods prior to their return to the seller.
F4-20
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Becker Professional Education
C.
I CPA Exam
Review
Financial 4
Sales with a Right to Return
If goods are sold but the buyer has the right to return the goods, the goods should be
included in the seller's inventory if the amount of the goods likely to be returned cannot be
estimated.
If the amount of goods l i kely to be returned can be estimated, the transaction will be
recorded as a sale with an allowance for estimated returns recorded. Essentially, revenue
from a sales transaction where the buyer has the right to return the product shall be
recogn ized at the time of the sale only if all the following conditions are met (also covered in
revenue recognition in F2):
D.
1.
The sales price is substantially fixed at the date of sale,
2.
The buyer assumes all risk of loss because the goods are in the buyer's possession,
3.
The buyer has paid some form of consideration,
4.
The product sold is substantially complete, and
5.
The amount of future returns can be reasonably estimated.
Consigned Goods
In a consignment arrangement, the seller (the "consignor") delivers goods to an
agent (the "consignee") to hold and sell on the consignor's behalf. The consignor should
include the consigned goods in its inventory because title and risk of loss is retained by the
consignor even though the consignee possesses the goods.
If all of the conditions in item C (above) are not met, there is no revenue recognition from a
sale. Revenue will be recognized when the goods are sold to a third party. Until the sale, the
goods remain in the consignor's inventory. Title passes directly to the third-party buyer (not
to the consignee and then to the third-party buyer) at the point of sale.
E.
P u blic Warehouses
Goods stored in a public warehouse and evidenced by a warehouse receipt should be
included in the inventory of the company holding the warehouse receipt. The reason is that
the warehouse receipt evidences title even though the owner does not have possession.
F.
Sales with a Mandatory B uyback
Occasionally, as part of a financing arrangement, a seller has a requirement to repurchase
goods from the buyer. If so, the seller should include the goods in inventory even though title
has passed to the buyer.
G.
Installment Sales
If the seller sells goods on an installment basis but retains legal title as security for the loan,
the goods should be included in the seller's inventory if the percentage of uncollectible debts
cannot be estimated. However, if the percentage of uncollectible debts can be estimated, the
transaction would be accounted for as a sale, and an allowance for uncollectible debts would
be recorded.
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F4·21
Financial 4
III.
Becker Professional Education I CPA Exam Review
VALUATION OF INVENTORY
GAAP requires that inventory be stated at its cost. Where evidence indicates that cost will be
recovered with an approximately normal profit on a sale in the ordinary course of business, no loss
should be recognized even though replacement or reproduction costs are lower.
A.
Cost
Inventories are generally accounted for at cost, which is defined as the price paid or
consideration given to acquire an asset. In inventory accounting, cost is the sum of the
expenditures and charges, direct and indirect, in bringing goods to their required condition or
location. Selling expenses, including marketing costs and freight out, as well as abnormal
spoilage and idle plant capacity costs should not be considered a part of inventory costs.
B.
Departure from the Cost Basis
1.
Lower of Cost or Market (U.S. GAAP)
I n the ordinary course of business, when the utility of goods is no longer as great as
their cost, a departure from the cost basis principle of measuring inventory is required .
This is usually accomplished by stating such goods at a lower level designated as
market value, or the lower-of-cost-or-market principle.
2.
Precious Metals and Farm Products
Gold, silver, and other precious metals, and meat and some agricultural products are
valued at net realizable value, which is net selling price less costs of disposal . When
inventory is stated at a value in excess of cost, this fact should be fully disclosed in the
financial statements. I nventories reported at net realizable value include:
C.
a.
I nventories of gold and silver, when there is effective government-controlled market
at a fixed monetary value.
b.
Inventories of agricultural, mineral or other products meeting all of the following
criteria:
(1 )
Immediate marketability at quoted prices,
(2)
Unit interchangeability, and
(3)
Inability to determine appropriate costs.
Lower of Cost or Market (expanded discussion)
The purpose of reducing inventory to the lower of cost or market is to show the probable loss
sustained (conservatism) in the period in which the loss occurred (matching principle). The
lower-of-cost-or-market principle may be applied to a single item, a category, or total
inventory, provided that the method most clearly reflects periodic income.
1.
Recognize Loss in Current Period
Whatever the cause (e. g . , obsolescence, physical deterioration, changes in price
levels, etc.), the difference should be recognized as a loss for the current period.
Under U . S . GAAP, the term "market" i n the phrase "lower of cost or market" generally
means current replacement cost (whether by purchase or reproduction), provided the
current replacement cost does not exceed net realizable value (the "market ceiling") or
fall below net realizable value reduced by normal profit margin (the "market floor").
The write-down of inventory to market is usually reflected in cost of goods sold, unless
the amount is material, in which case the loss should be identified separately in the
income statement.
F4-22
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Becker Professional Education I CPA Exam Review
2.
Financial 4
Reversal o f Inventory Write-downs
Under U . S . GAAP, reversals of inventory write-downs are prohibited .
3.
Terms
a.
Market Value
Under GAAP, market value is the median (middle value) of an inventory item's
replacement cost, its market ceiling, and its market floor.
b.
Replacement Cost
Replacement cost is the cost to purchase the item of inventory as of the
valuation date.
c.
Market Ceiling
Market ceiling is an item's net selling price less the costs to complete and
dispose (called the net realizable val ue).
d.
Market Floor
Market floor is the market ceiling less a normal profit margin.
4.
Exceptions
The lower of cost or market rule will not apply if:
D.
a.
The subsequent sales price of an end product is not affected by its market
value, or
b.
The company has a firm sales price contract.
Lower of Cost or Net Realizable Value ({FRS)
1.
Cost under IFRS
I FRS require inventory to be reported at the lower of cost or net realizable value.
Similar to U.S. GAAP, cost is the sum of the expenditures and charges, direct and
indirect, in bringing goods to their required condition or location. Selling expenses,
including marketing costs and freight out, as well as abnormal spoilage and idle plant
capacity costs should not be considered a part of inventory costs.
2.
Net Realizable Value
Net realizable value is an item's net selling price less the costs to complete and
dispose of the inventory. Net realizable value under I FRS is the same as the "market
ceiling" under U . S . GAAP.
3.
Recognize Loss in the Current Period
I FRS do not specify where an inventory write-down should be reported on the income
statement.
4.
Reversal of Inventory Write-downs
I FRS allow the reversal of inventory write-downs for subsequent recoveries of inventory
value. The reversal is l imited to the amount of the original write-down and is recorded
as a reduction of total inventory costs on the income statement (COGS) in the period of
reversal.
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F4-23
Becker Professional Education I CPA Exam Review
Financial 4
MARKET
Replacement
Selling
Costs of
Normal
Item
Cost
Cost
Price
Completion
Profit
1
2
3
4
$20.50
26.00
10.00
40.00
$19.00
20.00
12.00
55.00
$25.00
30.00
15.00
60.00
$1.00
2.00
1.00
6.00
$6.00
7.00
3.00
4.00
Determine the lower of cost or market for the above four items.
Item 1:
Determine the maximum ("ceiling") and minimum ("floor") limits for the replacement cost.
$24.00 ($25 - $1)
$18.00 ($25 - $1) - $6
Ceiling
Floor
Since replacement cost falls between the maximum and minimum, market price is $19.00. Market ($19.00) is lower
than cost ($20.50), therefore i nventory would be valued at market ($19.00).
Item 2:
Determine the maximum and minimum limits for the replacement cost.
Ceiling
$28.00
Floor
$21.00
Since replacement cost is less than the minimum, market value is the minimum, or $21.00. Market ($21.00) is lower
than cost ($26.00), therefore inventory would be valued at market ($21.00).
Item 3:
Determine the maximum and minimum limits for the replacement cost.
$14.00
$11.00
Ceiling
Floor
Replacement costs falls within these limits. Since cost ($10.00) is less than replacement cost ($12.00), the cost of
$10.00 is used.
Item 4:
Determine the maximum and minimum limits for the replacement cost.
$54.00
$50.00
Ceiling
Floor
Since the replacement cost exceeds the maximum limit, the maximum ($54.00) is compared to cost ($40.00). Inventory
is valued at cost ($40.00).
When market is lower than cost, the maximum prevents a loss in future periods by valuing the inventory at its estimated selling
price less costs of completion and disposal. The minimum prevents any future periods from realizing any more than a normal
profit.
Journal entry to record the write-down to a separate account:
$XXX
IIl9 Inventory loss due to decline in market value
[tID
$XXX
Inventory
I N TER N AT I O N A L F I N A N C I A L R E P O R T I N G S TA N D A R D S
Selling
Costs of
Item
Cost
price
Completion
1
2
$28.50
21.00
$30.00
26.00
$3.00
4.00
Determine the lower of cost or net realizable value for the above two items.
Item 1:
Determine the net realizable value (NRV):
NRV $27.00 ($30 - $3)
=
Net realizable value ($27.00) is lower than cost ($28.50); therefore, inventory would be valued at net realizable value
($27.00).
Item 2:
Determine the net realizable value:
NRV
=
$22.00
Net realizable value ($22.00) is greater than cost ($21.00); therefore, inventory would be valued at cost ($21.00).
F4-24
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Becker Professional Education I CPA Exam Review
E.
Financial 4
Disclosure
When losses are both substantial and unusual from the application of the lower-of-cost-or­
market principle, the amount of the loss is disclosed in income from continuing operations in
the income statement and identified separately from the consumed inventory costs described
as cost of goods sold. Small losses from decline in value are included in cost of goods sold.
The basic principle of consistency must be applied in the valuation of inventory and the
method should be d isclosed in the financial statements. In the event that a significant change
takes place in the measurement of inventory, adequate disclosure of the nature of the change
and, if material (materiality principle), the effect on income should be disclosed in the financial
statements.
IV.
PERIODIC INVENTORY SYSTEM VS. PERPETUAL IN VENTORY SYSTEM
There are two types of inventory systems used to count inventory.
A.
Periodic Inventory System (method)
With a periodic inventory system, the quantity of inventory is determined only by
physical count, usually at least annually. Therefore, units of inventory and the
associated costs are counted and valued at the end of the accounting period . The actual
cost of goods sold for the period is determined after each physical i nventory by "squeezing"
the difference between beginning inventory plus purchases less ending inventory, based on
the physical count.
The periodic method does not keep a running total of the inventory balances. Ending
inventory is physically counted and priced. Cost of goods sold is calculated as shown below:
Beginn i ng inventory
+
-
B.
$70,000
Purchases
300,000
Cost of goods available for sale
370,000
Ending inventory (physical count)
(270,000)
Cost of goods sold
$100,000
Perpetual Inventory System (method)
With a perpetual i nventory system, the inventory record for each item of inventory is updated
for each purchase and each sale as they occur. The actual cost of goods sold is determined
and recorded with each sale. Therefore, the perpetual inventory system keeps a running
total of inventory balances.
C.
Hybrid Inventory Systems
1.
Units of Inventory on Hand-Quantities Only
Some companies maintain a perpetual record of quantities only, A record of units on
hand is maintained on the perpetual basis, and this is often referred to as the "modified
perpetual system." Changes in quantities are recorded after each sale and purchase.
2.
Perpetual with Periodic at Year-end
Most companies that maintain a perpetual inventory system still perform either
complete periodic physical inventories or test count inventories on a random (or
cyclical) basis.
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F4-25
Financial 4
Becker Professional Education I CPA Exam Review
C O M PA R I S O N O F P E R I O D I C A N D P E R P E T U A L I N V E N T O R Y M E T H O D S
To record the sale: ABC Company sold 20,000 units of inventory for $7 per u nit. The inventory had originally
cost $5 per unit. The journal entries to record the sale using the periodic and perpetual methods appear
below.
Journal entry to record sale under periodic method (cost oj goods sold will be recorded after the periodic
inventory count):
Cash
$140,000
Sales
$140,000
Journal entry to record sale under perpetual method:
Cash
$140,000
Sales
Cost of goods sold
$140,000
$100,000
Inventory
$100,000
To record the purchase: ABC Company purchased 50,000 units of merchandise for $6 a unit to be held as
inventory.
Journal entry to record purchase under periodic method:
Purchases
$300,000
Cash
$300,000
Journal entry to record purchase under perpetual method:
Inventory
Cash
V.
$300,000
$300,000
PRIMARY INVENTORY COST FLOW ASSUMPTIONS
Inventory valuation is dependent on the cost flow assumption underlying the computation. Under
U.S. GMP, the cost flow assumption used by a company is not required to have a rational
relationship with the physical inventory flows; however, the primary objective is the selection of the
method that will most clearly reflect periodic income.
When similar goods are purchased at d ifferent times, it may not be possible to identify and match
the specific costs of the item sold. Frequently, the identity of goods and their specific related costs
are lost between the time of acquisition and the time of sale. This has resulted in the development
and general acceptance of several assumptions with respect to the flow of cost factors (FIFO, LIFO,
and average cost) to provide practical bases for the measurement of periodic income.
Under IFRS, the accounting method used to account for inventory should be based on
products are sold relative to when they were put in inventory. Specific identification
possible. The LIFO method is prohibited under IFRS because it rarely reflects actual
requires the use of the same cost flow assumption for a l l inventories having a similar
U.S. GAAP does not have this restriction.
A.
be used whenever
I inventory flows. I FRS
and use to the entity.
Specific Identification Method
Under the specific identification method, the cost of each item in inventory is uniquely
identified to that item. The cost follows the physical flow of the item in and out of inventory to
cost of goods sold . Specific identification is usually used for physically large or high value
items and allows for greater opportunity for manipulation of income.
F4-26
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Becker Professional Education I CPA Exam
B.
Financial 4
Review
First In, First Out (FIFO) Method
Under F I FO, the first costs inventoried are the first costs transferred to cost of goods sold.
Ending inventory includes the most recently incurred costs; thus, the ending balance
approximates replacement cost. Ending inventory and cost of goods sold are the same
whether a periodic or perpetual inventory system is used.
P A S S KEY
In periods of rising prices, the FIFO method results in the highest ending inventory, the lowest costs of goods
sold, and the highest net income (i.e., current costs are not matched with current revenues).
E X A M PL E - F I F O M E T H O D
Facts a nd Req u i rement: During its first year o f operations, Helix Corporation h a s purchased all o f its
i nventory in 3 separate batches. Batch 1 was for 4,000 units at $4.25 per unit. Batch 2 was for 2,000 u n its at
$4.50 per unit. Batch 3 was for 3,000 units at $4.75 per u nit. 4,000 units in total were sold, 3,000 u n its after
the fi rst purchase and 1,000 units after the second p u rchase. What a re the amounts of ending inventory and
cost of goods sold using the FIFO method a nd the periodic and perpetual systems?
FIFO:
Periodic Inventory System
Ending
Inventory
Goods Available
for Sale
Units
Bought
Cost/Unit
4,000
$4.25
2,000
4.50
$ 9,000
9,000
3,000
4.75
14.250
14,250
$ 17,000
$40,250
$23,250
Cost of goods sold
FIFO:
(23.250\
$17,000
Perpetual Inventory System
Units
Bought
Units
Sold
4,000
Cost/Unit
Change in
Inventory
$4.25
$17,000
Inventory
Balance
3,000
4.25
4.50
9,000
1,000
4.25
(4,250)
9,000
4.75
14,250
23,250
2,000
3,000
(12,750)
$23.250
4,250 .
COGS
$12,750
13,250
4,250
$17,000
Solution:
Note that the ending inventory under both methods is $23,250 and the amount of cost of goods sold under
both methods is $17,000.
C.
Weighted Average Method
Under the weighted average method, at the end of the period, the average cost of each item
in inventory would be the weighted average of the costs of all items in inventory. The
weighted average is determined by dividing the total costs of inventory available by the total
number of units of inventory available, remembering that the beginning inventory is included
in both totals. This method is particularly suitable for homogeneous products and a periodic
inventory system.
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F4-27
Becker Professional Education I CPA Exam Review
Financial 4
E X A M P L E - W E I G H T E D AV E R A G E M E T H O D
II
Assume the same information for Helix Corporation as in the example for FIFO
(above). What are the amounts of ending inventory and cost of goods sold under the weighted average
method?
Facts and Requirement:
Solution:
Unit Cost
Units Purchased
$4.25
4.50
4.75
Total
4,000
2,000
3,000
9,000
Weighted average cost per unit
Cost of goods sold
=
$17,889
Ending inventory = $22,361
D.
=
Total
$ 17,000
9,000
14,250
$40,250
$4.4722 ($40,250/9,000)
(4,000 units
x
$4.4722)
(5,000 units x $4.4722)
Moving Average Method
The moving average method computes the weighted average cost after each purchase by
d ividing the total cost of inventory available after each purchase (inventory plus current
purchase) by the total units available after each purchase. The moving average is more
current than the weighted average. A perpetual inventory system is necessary to use the
moving average method.
E X A M P L E - M O V I N G AV E R A G E M E T H O D
Assume the same information for Helix Corporation as in the example for FIFO
(above). What are the amounts of ending inventory and cost of goods sold under the moving average
method?
Facts and Requirement:
Solution:
Inventor't, Balances (rounded!
Total
Quantit't, Average Cost
$17,000
$4.25
4,000
$4,250
$4.25
1,000
$13,250
$4.4167 1
3,000
$8,833
$4.4167
2,000
$23,083
$4.6166 2
5,000
Purchasesf.(Sales!
Total
Cost
Quantit't,
$17,000
$4.25
4,000
($12,750)
$4.25
(3,000)
$9,000
$4.50
2,000
($4,417)
$4.4167
(1,000)
$14,250
$4.75
3,000
1
Weighted average cost per unit
=
2
Weighted average cost per unit
=
Cost of goods sold is $17,167
($4,250 + $9,000) / 3,000
=
($8,833 + $14,250) / 5,000
$4.4167
=
$4.6166
($12,750 + $4,417)
Ending i nventory is $23,083
F4-28
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Becker Professional Education I CPA Exam Review
E.
Financial 4
IIM'I
Last In, First Out (LIFO) Method (not permitted under IFRS)
Under LIFO, the last costs inventoried are the first costs transferred to cost of goods sold.
Ending inventory, thus, includes the oldest costs. The ending balance of inventory will
typically not approximate replacement cost. LIFO does not generally relate to actual flow of
goods in a company because most companies sell or use their oldest goods first to prevent
holding old or obsolete items. If LIFO is used for tax purposes, it must also be used in the
GAAP financial statements.
1.
LIFO Financial Statement Effects
The use of the L I FO method generally better matches expense against revenues
because it matches current costs with current revenues; thus, LIFO eliminates holding
gains and reduces net income during times of inflation . If sales exceed production (or
purchases) for a given period , L I FO will result in a distortion of net income because old
inventory costs (called "LI FO layers") will be matched with current revenue. LIFO is
also susceptible to income manipulation by intentionally reducing purchases in order to
use old layers at lower costs.
PA S S K E Y
In periods of rising prices, the LIFO method generally results i n the lowest ending i nventory, the
highest costs of goods sold, and the lowest net income.
Remember: liFO
2.
=
lowest
LIFO Layers
The last-in, first-out method of determining i nventory requires that records be
maintained as to the base year inventory amount and additional layers that may be
added yearly. After an original L I FO amount is created (base year), it may decrease,
or additional layers may be created in each year according to the amount of ending
inventory. An additional LIFO layer is created in any year where the ending inventory
is greater than the beginning inventory. An additional L I FO layer is priced at the
earliest costs of the year in which it was created, because the L I FO method matches
the most current costs incurred with current revenues, leaving the first cost incurred to
be included in any inventory increase.
LIFO Layer Container Il l ustration
Purchases
Cost of goods sold
at varying costs
-
-
Last-in, first-out
LIFO
...
...
"
Layer 3 at $1.30
Layer 2 at $1.20
Layer 1 at $1.00
Ending inventory
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Becker Professional Education I CPA Exam Review
Financial 4
EXAMPLE-LIFO M ETHOD
II
Assume the same facts for Helix Corporation as above. What are the amounts of
ending inventory and cost of goods sold using the LIFO method and periodic and the perpetual systems?
Facts and Requirement:
LIFO: Periodic Inventory System
Units
Bought
Cost/Unit
Ending
Inventory
Goods Available
for Sale
4,000
$4.25
$17,000
$17,000
2,000
4.50
4,500
9,000
14.250
4.75
3,000
$40,250
(21,500)
$21,500
Cost of goods sold
LIFO:
$18,750
Perpetual Inventory System
Units
Bought
Units
Sold
4,000
3,000
2,000
1,000
3,000
Cost/Unit
Inventory
Balance
$4.25
$17,000
4.25
(12,750)
4.50
9,000
4.50
(4,500)
4.75
14.250
COGS
$12,750
4,500
$2 3,000
$17,250
Solution:
Under the periodic inventory system, ending inventory is $21,500 and cost of goods sold is $18,750.
Under the perpetual inventory system, ending inventory is $23,000 and cost of goods sold is $17,250.
Ending InventorY.
Cost otGoods Sold
FIFO
$23,250
$17,000
Weighted Average
$22,361
$17,889
LIFO
$21,500
$18,750
Ending InventorY.
Cost atGoods Sold
$23,250
$17,000
Moving Average
$23,083
$17,167
LIFO
$23,000
$17,250
Periodic InventorY. S't'.stem
Perl2etual lnventorY.S't'.stem
FIFO
These examples illustrate that in a period of rising prices, F I FO results in the highest ending
inventory and the lowest cost of goods sold, LIFO results in the lowest ending inventory and
the highest cost of goods sold, and the average method balances fall between the LIFO and
F I FO balances. Note that the moving average method results in higher ending inventory and
lower cost of goods sold than the weighted average method.
F4-30
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Becker Professional Education I CPA Exam Review
F.
Financial 4
Dollar-value LIFO
Under the regular LIFO method, inventory is measured in units and is priced at unit prices.
Under the dollar-value LIFO method, inventory is measured in dollars and is adjusted for
changing price levels. When converting from LIFO inventory to dollar-value LIFO, a price
index will be used to adjust the inventory value. In some problems the price index will be
internally computed. In other problems, the price index will be supplied.
1.
Internally Computed Price Index
When the price index is computed internally by the company, the price index will be
ending inventory at current year cost divided by ending inventory at base year cost:
. .
Price In d ex
Ending inventory at current year cost
=
----'
=---'--'--
Ending inventory at base year cost
To compute the L I FO layer added in the current year at dollar-value LIFO, the LIFO
layer at base year cost is multiplied by the internally generated price index.
E X A M P L E - D O L L A R - V A L U E L I F O - I N T E R N A L LY C O M P U T E D P R I C E I N D E X
Brock Co. adopted the dollar-value LIFO inventory method as of January 1, Year 1. A single
inventory pool and an internally computed price index are used to compute Brock's LIFO inventory
layers. Information about Brock's dollar-va lue inventory follows:
Date
At base
'Lear cost
At current
'Lear cost
At dol/arvalue LIFO
l/l/Year 1
$40,000
$40,000
$40,000
5.000
14,000
6,000 1
$45,000
$54,000
46,000 2
Year 1 layer
12/31/Year 1
Year 2 layer
12/31/Year 2
15,000
26,000
20,000 3
$60,000
$80,000
$66,000 4
Compute the LIFO layers added and ending inventory for Years 1 and 2 at dollar-value LIFO.
Year 1 price index
Year 1 LIFO layer added
=
2 Year 1 ending inventory
=
1
2.
Year 2 L I FO layer added
=
4
Year 2 ending inventory
=
=
$45,000
6/5 x $5,000
=
6
-
5
$6,000
$40,000 + $6,000 $46,000
=
Year 2 price index
3
$54, 000
=
4/3
$80, 000
=
x
4
=
$60, 000
$15,000
=
-
3
$20,000
$46,000 + $20,000 $66,000
=
Price Index Supplied
Where the price index is given in the problem, the year-end price index is multiplied by
the L I FO layer at the base year cost to calculate the LIFO layer added at dollar-value
LIFO.
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F4-31
Becker Professional Education I CPA Exam Review
Financial 4
E X A M P L E - D O L L A R - VA L U E L I F O - P R I C E I N D E X S U P P L I E D
Walt adopted the dollar-value LIFO inventory method as of January 1, Year 1 when its inventory was val ued
at $500,000. Walt's entire inventory constitutes a single pool. Using a relevant price i ndex of 1 . 10, Walt
determined that its December 3 1, Year 1 i nventory was $577,500 at current year cost, and $525,000 at
base year cost. Calculate Walt's dollar-value LIFO inventory at December 31, Year 1.
Although i n this problem the data was not presented i n tabular form, you should a rrange the data in
tabular form before computing the a nswer.
Date
l/l/Year 1
At current
vear cost
At do/lar­
value LIFO
$500,000
$500,000
$500,000
$525,000
$577,500
At base
vear cost
Year 1 layer
12/31/Year 1
The Year 1 layer at base year cost is $525,000 - $500,000
=
$25,000
The Year 1 layer at current year cost is $577,500 - $500,000
=
$77,500
The Year 1 layer at dollar-va lue LIFO is $25,000 ( base year layer)
The dollar-value LIFO ending i nventory is $500,000 + $27,500
=
x
1.10
=
$27,500
$527,500
Note: Read Appendix I: Other I nventory Cost Flow Assumptions for other examples of i nventory cost flow
assumptions that may be tested on the CPA Exam.
F4-32
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Becker Professional Education I CPA Exam
VI.
Financial 4
Review
FIRM P URCHASE C O MMITMENTS
A firm purchase commitment is a legally enforceable agreement to purchase a
specified amount of goods at some time in the future. All material firm purchase commitments must
be disclosed in either the financial statements or the notes thereto.
If the contracted price exceeds the market price and if it is expected that losses will occur when the
purchase is actually made, the loss should be recognized at the time of the decline in price. A
description of losses recognized on these commitments must be disclosed in the current period's
income statement.
EXAM PLE-LOSS O N P U RCHASE COMMITME NTS
and 5 Incorporated signed timber-cutting contracts i n Year 1 to b e executed at $5,000,000 i n Year 2 . The market
price of the rights at December 3 1, Year 1, is $4,000,000 and it is expected that the loss will occur when the contract
is effected in Year 2. What amount should be reported as a loss on purchase commitments at December 3 1, Year 1?
J
Price of purchase commitment
$5,000,000
Market price at 12/31/Year 1
(4,000,000)
Loss on purchase commitments
$1,000,000
Journal entry to record the loss:
IIlD
Estimated loss on purchase commitment
Estimated liability on purchase commitment
$ 1,000,000
$ 1,000,000
Note that the loss is recognized in the period when the price declined. The estimated loss on purchase
commitment is reported i n the income statement under other expenses and losses.
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Financial 4
Becker Professional Education I CPA Exam Review
F IXED A S SET S
I.
II.
CHARACTERISTICS OF FIXED ASSETS
A.
Fixed assets are acquired for use in operations and not for resale.
B.
They are long term in nature and subject to depreciation.
C.
They possess physical substance.
CLASSIFICATION OF FIXED ASSETS
The fol lowing must be shown separately on the balance sheet (or footnotes) at original cost
(historical cost):
A.
Land (property)
B.
B u ildings (plant)
C.
Equ ipment
Maybe show machinery, tools, furniture and fixtures separately, if these categories are
significant.
D.
Accumulated Depreciation Account (contra-asset)
May be combined for two or more asset categories.
III.
VALUATION OF FIXED ASSETS U NDER U . S. GAAP
A.
Historical Cost
Historical cost is the basis for valuation of purchased fixed assets. H istorical cost is
measured by the cash or cash equivalent price of obtaining the asset and bringing it to the
location and condition necessary for its intended use.
B.
Donated Fixed Assets
Donated fixed assets are recorded at fair market value along with incidental costs incurred.
Donated fixed assets result in the recognition of a gain on the income statement.
11m
Fixed asset (FMV)
Gain on nonreciprocal transfer
F4-34
$XXX
$XXX
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Becker Professional Education I CPA Exam Review
IV.
VALUATION OF FIXED ASSETS UNDER IFRS
Under I FRS, fixed assets are initially recognized at the cost to acquire the asset. Subsequent to
acquisition, fixed assets can be valued using the cost model or the revaluation model.
A.
Cost Model
Under the cost model, fixed assets are reported at historical cost adjusted for accumulated
depreciation and impairment.
Cost model carrying value
B.
=
Historical cost - Accumulated depreciation - I mpairment
Revaluation Model
Under the revaluation model, a class of fixed assets is revalued to fair value and then
reported at fair value less subsequent accumulated depreciation and impairment.
Revaluations must be made frequently enough to ensure that carrying amount does not differ
materially from fair value at the end of the reporting period. When fair value differs materially
from carrying value, a further revaluation is required.
Revaluation model carrying value Fair value at revaluation date - Subsequent accumulated
depreciation - Subsequent impairment
=
Revaluation must be applied to all items in a class of fixed assets, not to individual fixed
assets. Land and buildings, machinery, furniture and fixtures, and office equipment are
examples of fixed asset classes. When fixed assets are reported at fair value, the historical
cost equivalent (cost - accumulated depreciation - impairment) must be disclosed .
1.
Revaluation Losses
When fixed assets are revalued, revaluation losses (fair value < carrying value before
revaluation) are reported on the income statement, unless the revaluation loss reverses
a previously recognized revaluation gain. A revaluation loss that reverses a previously
recognized revaluation gain is recognized in other comprehensive income and reduces
the revaluation surplus in accumulated other comprehensive income.
2.
Revaluation Gains
Revaluation gains (fair value > carrying value before revaluation) are reported in other
comprehensive income and accumulated in equity as revaluation surplus, unless the
revaluation gain reverses a previously recognized revaluation loss. Revaluation gains
are reported on the income statement to the extent that they reverse a previously
recognized revaluation loss.
3.
Impairment
If revalued fixed assets subsequently become impaired, the impairment is recorded by
first reducing any revaluation surplus to zero with further impairment losses reported on
the income statement.
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Financial 4
Becker Professional Education I CPA Exam Review
"
EXAMPLE
On December 31, Year 1, an entity chose to revalue all of its fixed assets under IFRS. On that date, the fixed assets had the
following carrying values and fair values:
CarrYing Value
Fair Value
$10,500,000
$11,100,000
Buildings
6,400,000
6,000,000
Equipment
3,300,000
3,600,000
Land
Compute the revaluation gain and loss to be reported on the December 31, Year 1 financial statements.
Revaluation Loss:
The entity will report a loss on the reval uation of the buildings because fair value is less than carrying value:
Loss on Revaluation of Buildings
=
$6,000,000 - $6,400,000
=
($400,000)
The loss, which is essentially an impairment loss, will be reported on the income statement.
Revaluation Gain:
The entity will report a gain on the revaluation of the land and equipment because the fair values of these assets exceed
their respective carrying val ues:
Gain on Revaluation of Land
=
$11,100,000 - $10,500,000
Gain of Reval uation of Equipment
=
=
$600,000
$3,600,000 - $3,300,000
=
$300,000
The total revaluation gain of $900,000 would be reported as revaluation surplus in other comprehensive income.
v.
COST OF EQUIPMENT
Equipment is office equipment, machinery, furniture, fixtures, and factory equipment.
A.
Items to Include
All expenditures related directly to their acquisition or construction.
B.
1'-'M4'1
1.
I nvoice price
2.
Less cash d iscounts and other d iscounts (if any)
3.
Add freight-in (and insurance while in transit and while in construction)
4.
Add installation charges (including testing and preparation for use)
5.
Add sales and federal excise taxes
6.
Possible addition of construction period interest
Capitalize vs. Expense
Proper accounting is determined based upon the purpose of the disbursement.
1.
Additions
Additions increase the quantity of fixed assets.
lim
�
F4-36
Asset (machinery, etc.)
Cash/accounts payable
$XXX
$XXX
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Becker Professional Education I CPA Exam Review
2.
Improvements and Replacements
Improvements (betterments) improve the quality of fixed assets and are
capitalized to the fixed asset account (e.g., a tile or steel roof is substituted
for an old asphalt roof). In a replacement, a new similar asset is substituted for the old
asset (e. g . , an asphalt shingle roof is replaced with a new roof of similar material).
a.
If the carrying value of the old asset is known, remove it and recognize any gain
or loss. Capitalize the cost of the improvement/replacement to the asset
account.
b.
If the carrying value of the old asset is unknown, and:
(1 )
The asset's l ife is extended, debit accumulated depreciation for the cost of
the improvement/replacement.
11m
Accumulated depreciation
$XXX
Cash/accounts payable
(W8
$XXX
(2) The usefulness (utility) of the asset is increased , capitalize the cost of the
improvement/replacement to the asset account.
3.
Repairs
1l1li1
a.
Ordinary repairs should be expensed as repair and maintenance.
b.
Extraordinary repairs should be capitalized. Treat the repair as an addition,
improvement, or replacement as appropriate.
Reduce
I
S U M M A RY C H A R T
Accumulated
Expense
Additions: Increase quantity
Improvement/replacement:
Capitalize
Depreciation
../
Increase life
Increase usefulness
Ordinary repair:
Extraordinary repair:
VI.
Increase life
Increase usefulness
COST OF LAND
When land has been purchased for the purpose of constructing a building, all costs incurred up to
excavation for the new building are considered land costs. All the fol lowing expenditures are
included.
A.
Land Cost
Land cost (not depreciable) includes:
1.
Purchase price
2.
Brokers' commissions
3.
Title and recording fees
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Becker Professional Education I CPA Exam Review
Financial 4
B.
4.
Legal fees
5.
Draining of swamps
6.
Clearing of brush and trees
7.
Site development (e.g. , grading of mountain tops to make a "pad")
8.
Existing obligations assumed by buyer, including mortgages and back taxes
9.
Costs of razing (tearing down) an old building (demolition)
1 0.
Less: Proceeds from sale of existing buildings, standing timber, etc.
Land Improvements
Land Improvements (are depreciable), such as:
C.
1.
Fences
2.
Water systems
3.
Sidewalks
4.
Paving
5.
Landscaping
6.
Lighting
Interest Costs
Interest costs during construction period should be added to cost of land improvement based
on weighted average of accumulated expenditures.
VII.
COST OF BUILDINGS
Cost of buildings i nclude:
A.
Purchase price, etc.
B.
All repair charges neglected b y the previous owner ("deferred maintenance")
C.
Alterations and improvements
D.
Architect's fees
E.
Possible addition of construction period interest
P A S S KEY
When preparing the land for the construction of a building:
•
Land cost-filling in a hole or leveling
•
Building cost-digging a hole for the foundation
VIII. "BASKET PURCHASE" OF LAND AND BUILDING
Allocate the purchase price based on the ratio of appraised values of individual items.
F4-38
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Becker Professional Education I CPA Exam Review
IX.
Financial 4
INVESTMENT PRO PERTY (IFRS only)
A.
Definition
Under IFRS, land or buildings held by an entity or by a lessee under a finance (capital) lease
to earn rentals or for capital appreciation are classified and reported as investment property.
The investment property designation includes property under construction or development for
future use as investment property. U.S. GAAP does not include a specific definition or set of
accounting rules for investment property.
Investment property does not include owner-occupied property, property held for sale in the
ordinary course of business, or property being constructed or developed, unless the property
is under construction or development for future use as investment property.
B.
Cost of Investment Property
The initial cost of investment property includes:
C.
1.
Purchase price.
2.
Expenses directly related to purchase, including legal services, professional fees,
property transfer taxes, and other taxes.
Capitalize vs. Expense
The following costs are capitalized and added to the carrying value of investment property:
1.
Costs incurred to subsequently add to the property.
2.
Costs to replace part of the property.
3.
Costs to service the property.
The cost of investment property does not include the cost of day-to-day servicing, repairs and
maintenance costs, labor, or minor parts. These costs should be expensed in the period
incurred.
D.
Investment Property Measurement Models
After initial recognition , investment property can be reported under two different models:
1.
Cost Model
Under the cost model, investment property is reported on the balance sheet at
historical cost less accumulated depreCiation (if appropriate). When the cost model is
used, the fair value of the investment property must be disclosed.
2.
Fair Value Model
Under the fair value model, investment property is reported on the balance sheet at fair
value and is not depreciated. The best evidence for fair value is current prices in an
active market for similar property in the same location and condition. Fair value reflects
market conditions at the end of the accounting period.
Once adopted, fair value measurement must be applied consistently until the asset is
disposed of or can no longer be classified as investment property because it is owner­
occupied or will be developed for sale in the ordinary course of business.
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F4-39
Financial 4
Becker Professional Education I CPA Exam Review
a.
Gains and Losses (recognize in earnings)
Under the fair value model, the investment property should be revalued with
regularity so that the carrying value does not differ materially from fair value. A
gain or loss arising from a change in the fair value of investment property is
recognized in earnings in the period in which it arises.
X.
FIXED ASSETS CO NSTRUCTED BY A C OMPANY-COSTS INCLUDE:
A.
Direct materials and direct labor.
B.
Repairs and maintenance expenses that add value to the fixed asset.
C.
Overhead , including direct items of overhead (any "idle plant capacity" expense).
1.
D.
XI.
Include construction period interest.
D o not include profit.
CAPITALIZATION OF INTEREST COSTS
A.
Construction Period Interest
Should be capitalized (based on weighted average of accumulated expenditures) as part of
the cost of producing fixed assets, such as:
1.
Buildings, machinery, or land improvements, constructed or produced for others or to
be used internally.
2.
Fixed assets intended for sale o r lease and constructed a s discrete projects, such as:
a.
3.
Land improvements
a.
B.
Real estate projects.
If a structure is placed on the land, charge the interest cost to the structure (and
not the land).
Interest Cost
Interest cost is based on interest obligations having :
1.
C.
F4-40
Stated (explicit) interest rate, or if not stated, use:
a.
Imputed interest rate per ASC 835,
Interest.
b.
Imputed interest rate per ASC 840,
Leases.
Do Not Capitalize Interest Cost
1.
On inventory routinely manufactured; however, do capitalize interest on special order
goods on hand for sale to customers.
2.
On fixed assets held before o r after construction period.
3.
During intentional delays in construction; however, do capitalize interest cost during
ordinary delays in construction.
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Financial 4
Becker Professional Education I CPA Exam Review
D.
Computing Capitalized Cost
1.
Weighted Average Amount of Accumulated Expenditures
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 during
the period (this is known as the avoidable interest).
2.
Interest Rate on Borrowings
The interest rate paid on borrowings (specifically for asset construction) during
a particular period should be used to determine the amount of interest cost to be
capitalized for the period. Where a qualifying asset is related to a specific new
borrowing, the allocated interest cost is equal to the amount of interest incurred on the
new borrowing.
3.
Interest Rate on Excess Expenditu res (weighted average)
If the average accumulated expenditures outstanding exceed the amount of the related
specific new borrowing, interest cost should be computed on the excess. The interest
rate that should be used on the excess is the weighted average interest rate for other
borrowings of the company.
4.
Not to Exceed Actual Interest Costs
Total capitalized interest costs for any particular period may not exceed the total
interest costs actually incurred by an entity during that period. In consolidated financial
statements, this limitation should be applied on a consolidated basis.
5.
Do Not Reduce Capitalizable Interest
Do not reduce capitalizable interest by income received on the unexpended portion of
the loan.
PASS K E Y
For the CPA Exam, it is important to remember two rules concerning capitalized interest:
Rule 1: Only capitalize interest on money actually spent, not on the total amount borrowed.
Rule 2: The amount of capitalized interest is the lower of:
1.
Actual interest cost incurred, or
2.
Computed capitalized interest (avoidable interest).
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Financial 4
Becker Professional Education I CPA Exam Review
"
EXAMPLE
On January 1, Year 1, Conviser Soup Kitchen, Inc. signed a fixed-price contract to have a new kitchen built for
$1,000,000 . On the same day, Conviser borrowed $500,000 to finance the construction. The loan is payable
in five $100,000 annual payments plus interest at 11%. Conviser planned to finance the balance of the
construction costs using the company's existing debt, which had a weighted average interest rate of 9%.
During Year 1, Conviser had average accum ulated expenses of $600,000 and incurred actual interest costs on
all borrowings of $150,000. What would be Conviser's capitalized interest cost?
Weighted average of
accumulated expenditures
x
Applicable
interest rate
Amount of interest
to be capitalized
$500,000
x
11%
$55,000
$100,000
x
9%
9.000
Total capitalizable interest
$64,000
Note that since the capitalizable i nterest of $64,000 is less than the actual interest of $150,000, the ful l
$64,000 i s capitalized. The remainder of the actual interest i s expensed.
E.
Capitalization of Interest Period
1.
F.
Begins when three conditions are present:
a.
Expenditures for the asset have been made.
b.
Activities that are necessary to get the asset ready for its intended use are in
progress.
c.
I nterest cost is being incurred .
2.
Continues as long as the three conditions are present.
3.
Ends when the asset is (or independent parts of the asset are) substantially complete
and ready for the intended use (regardless of whether it is actually used).
Summary
Before
Construction
During
Construction
After
Construction
Expense
Expense
Expense
Borrowed funds (weighted average of
accumulated expense)
Not applicable
Capitalize
Expense
Excess (above amount borrowed) expenditures
(weighted average interest rate)
Not applicable
Capitalize
Expense
S U M M A RY
Borrowed funds (not used)
F4-42
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Becker Professional Education I CPA Exam Review
G.
Disclose in Financial Statements :
1.
Total interest cost incurred during the period.
2.
Capitalized interest cost for the period, i f any.
CONSTRUCTION PERIOD EXAMPLE
INTE REST
Capitalized
1/2/Year 1
Purchased $1,000,000 parcel of land for speculation; paid
$600,000 down, borrowed $400,000 at 12% per year
3/1
Paid interest cost of $8,000 (2 months)
3/2
Decision made to build condo project on land, and attorneys
a pply for zoning permits*
5/1
Paid interest cost of $8,000 (2 months) (charge to building)
5/2
Permits received
9/1
Begin grading and developing land and foundation; paid 4 months
interest (charge building)
9/2
Incurred expenses to date for attorney, architect, and land
development := $300,000 all paid with additional borrowed money
12/31/Year 1
Paid 4 months interest * *
$28.000
Total interest
$52,000
12/31/Year 1
-
$8,000
$8,000
architects begin plans
$ 16,000
Required disclosure of interest:
Total interest cost incurred during year
Interest cost capitalized
=
=
$60,000
$52,000***
1/2/Year 2
Wildcat strike stops construction (unintentional delay)
$$$
2/1
Wildcat strike over-construction continues
$$$
4/1
Glut on condo market, construction delayed intentionally
8/1
Construction contin ued
10/1
Floors 1-3 of the 10-story condo building are completed
and ready for sale (except for light fixtures and wall coverings)
12/15/Year 2
$8,000
Building and project completed
$$$
$$$
Floors 4-10
Floors 1-3
$$$
'Construction period begins at point decision is made to build on land, and ends when asset is substantially complete and ready for intended use.
" $400,000 + 300,000 = $700,000 x 12% x 4/12 = $28,000
" 'Capitalizable interest is based on weighted average of accumulated expenditures to date.
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F4-43
Financial 4
Becker Professional Education I CPA Exam Review
---
I.
DEPREC I A B LE A S SET S A N D DEPREC I A T I O N
OVERVIEW
The basic principle of matching revenue and expenses is applied to long-lived assets that are not
held for sale in the ordinary course of business. The systematic and rational allocation used to
achieve "matching" is usually accomplished by depreciation , amortization, or depletion, according
to the type of long-lived asset involved .
A.
Types of Depreciation
1.
Physical Depreciation
This type of depreciation is related to an asset's deterioration and wear over a period of
time.
2.
Functional Depreciation
Functional depreciation arises from obsolescence or inadequacy of the asset to
perform effiCiently. Obsolescence may result from diminished demand for the product
that the depreciable asset produces or from the availability of a new depreciable asset
that can perform the same function for substantially less cost.
B.
Terms
1.
Salvage Value
Salvage or residual value is an estimate of the amount that will be realized at the end
of the useful life of a depreciable asset. Frequently, depreciable assets have little or no
salvage value at the end of their estimated useful life and, if immaterial, the amount(s)
may be ignored in calculating depreciation.
2.
Estimated Useful Life
Estimated useful life is the period of time over which an asset's cost will be
depreciated . It may be revised at any time but any revision must be accounted for
prospectively, in current and future periods only (change in estimate).
it requires
The CPA Exam frequently will have an asset placed in service during the year.
computing depreciation for a part of the year rather than the full year. Candidates must always check the
date the asset was placed in service.
II.
DEPRECIATION METHODS
The goal of a depreciation method should be to provide for a reasonable, consistent matching of
revenue and expense by systematically allocating the cost of the depreciable asset over its
estimated useful life.
The actual accumulation of depreciation in the books is accomplished by using a contra account,
such as accumulated depreciation or allowance for depreciation.
The amount subject to depreciation is the difference between the cost and residual or salvage
value and is called the depreciable base.
F4-44
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Becker Professional Education I CPA Exam Review
U.S. GAAP VS. I FRS
Under IFRS, the depreciation method used should reflect the expected pattern of fixed asset consumption.
Additionally, under IFRS, estimated useful life, salvage value, and the depreciation method used should be reviewed
for appropriateness at each balance sheet date. These are not requirements under U.S. GAAP.
III.
COMPOSITE (ENTIRE UNIT) VS. COMPONENT DEPRECIATION
A.
B.
Advantages of Component Depreciation over Composite Depreciation:
1.
Depreciation expense for the year would be more accurate because each component
item would be depreciated over its useful life.
2.
Repair and maintenance expense would b e more accurate because replacements of
components would be excluded.
Component Depreciation
This is not available for MACRS recovery property for tax purposes because
depreciation expense under the component method is generally higher and
MACRS is already high. However, it does appear to be available when straight-line
depreciation is elected.
U.S
GAAP VS. IFRS
IFRS require component depreciation. Separate significant components of a fixed asset with different lives
should be recorded and depreciated separately. The carrying amount of parts or components that are
replaced should be derecognized.
EXAMPLE
On January 1, Year 1, a n entity that uses IFRS acquired a machine with a cost of $250,000 and a n estimated
life of 20 years. The cost of the machine included the cost of a cylinder that must be replaced every 5 years
for $20,000 and an inspection cost of $5,000. The machine must be reinspected every 10 years at an
additional cost of $5,000 per inspection. Under the component approach, the machine, the cylinder and the
inspection cost are recognized and depreciated separately:
Cost
Useful Ufe
DeQ,reciation
Machine
$225,000
20
$11,250
Cylinder
20,000
5
4,000
5.000
10
--..2QQ
Inspection cost
Total
C.
$250,000
$15,750
Composite (Dissim ilar Assets) or Group (Similar Assets) Depreciation
This is the process of averaging the economic lives of a number of property
units and depreciating the entire class of assets over a single life (e.g., all at five
years), thus simplifying record keeping of assets and depreciation calculations.
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1.
No gain or loss is recognized when one asset in the group is retired.
When a group or composite asset is sold or retired, the accumulated depreciation is
treated differently than the accumulated depreciation of a single asset. If the average
service life of the group of assets has not been reached when an asset is retired, the
gain or loss that results is absorbed in the accumulated depreciation account. The
accumulated depreciation account is debited (credited) for the difference between the
original cost and the cash received.
D.
These Methods Can Use SL, SYD, or DB Methods of Depreciation for GAAP Purposes
C O M P O S I T E ( G R O U P ) D E P R E C I AT I O N
A schedule of machinery owned by Lester Manufacturing Company is presented below:
Total Cost
Estimated
Salvage Value
Estimated
Lite in Years
Machine A
$550,000
$50,000
20
Machine B
200,000
20,000
15
Machine C
40,000
5
Lester computes depreciation on the straight-line method. Based upon the information
presented, the composite life of these assets ( in years ) should be 16 years, computed as follows:
Machine
Total
Cost
Estimated
Salvage Value
Depreciable
Cost
Estimated
Lite in Years
Annual
Deereciation
A
$550,000
$50,000
$500,000
20
$25,000
B
200,000
20,000
180,000
15
12,000
C
40,000
40,000
5
8,000
Totals
S790,000
Average composite life
=
Average composite rate
$720,000 divided by $45,000
=
S45,000
S720,000
S70,000
=
$45,000 divided by $790,000
16 years
=
5.70%
DISPOSAL O f GROUP OR COMPOSITE ASSET
"
Assume the Lester Company sells Machine A in 10 years for $260,000. Since the loss on d isposal is not
recognized, accumulated depreciation must be reduced or debited.
The journal entry is as follows:
11m
Cash
11m
Accumulated depreciation
lWD
F4-46
Asset A
$260,000
290,000
$550,000
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IV.
BASIC DEPRECIATION METHODS
A.
Straight-line
Straight-line depreciation is determined by the formula:
Cost - Salvage value
. .
------"--- = Depreclatlon
Estimated useful life
Estimated useful l ife is usually stated in periods of time, such as years or months.
EXAMPLE
Assume that a n asset cost $ 11,000, has a salvage value of $1,000 and has a n estimated useful life of five years.
$11,000 - $1,000
. .
-'--'-- = $ 2,000 depreCiatIOn per year
5 years
-'---'---
If the asset was acquired within the year instead of at the beginning of the year, a partial depreciation
expense is taken in the first year.
B.
Sum-of-the-Years'·Digits
The sum-of-the-years'-digits method is one of the accelerated methods of
depreciation that provides higher depreciation expense in the early years and lower charges
in the later years.
1.
Calculation
To find the sum-of-the-years'-digits, each year is progressively numbered and then
added. For example, the sum-of-the-years'-digits for a five-year life would be:
1 + 2
+
3 + 4 + 5 = 15
For four years:
1 + 2 + 3 + 4
10
For three years:
1 + 2 + 3
2.
=
6
Formula
The sum-of-the-years'-digits becomes the denominator. The numerator is the
remaining life of the asset at the beginning of the current year. For example, the first
year's depreciation for a five-year life would be 5/1 5 of the depreciable base of the
asset.
. .
DepreCiation expense = (Cost - Salvage value)
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x
Remaining life of asset
­
--=-
-
Sum-of-the-years' d igits
F4-47
Financial 4
Becker Professional Education I CPA Exam Review
3.
Calculating the Sum-of-the-Years' Digits
When dealing with an asset with a long life, it is necessary to use the general formula
for finding the sum-of-the-years'-digits:
S
=
+ l) -'.
_
_-N_
x-,(N
2
where: N
=
Estimated useful life
To find the sum-of-the-years'-digits for an asset with a 50-year life:
S=
_
s_
O_
x ,( sO
_+
_l
-'.)
2
S = 2,550 / 2
S = 1,275 Su m-of-the-years' digits for 50 years
Note:
The CPA Exam rarely tests sum-of-the-years'-digits depreciation for asset l ives longer than 5
years.
EXAM P LE-5U M-O F-TH E-YEARS'-O IG ITS M ETH 0 0
Assume that a n asset cost $ 11,000, has a salvage value of $1,000 and has a n estimated useful life of
four years.
The first step is to determine the depreciable base:
$11,000
Cost of asset
(1,000)
Less: Salvage value
$10,000
Depreciable base
The sum-of-the-years'-digits for four years is:
1 + 2 + 3 + 4
=
10
The first year's depreciation is 4/10, the second year's 3/10, the third year's 2/10, and the fourth
year's 1/10, as follows:
1st Year:
4/10 x $10,000 =
2nd Year:
3/10
x
$10,000 =
3rd Year:
2/10
x
$10,000 =
2,000
4th Year:
1/10 x $10,000 =
1,000
Total depreciation
F4-48
$ 4,000
3,000
$10,000
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Becker Professional Education I CPA Exam Review
C.
Declining Balance
The most common of these accelerated methods is the double-declining­
balance method , although other alternative (less than double) methods are acceptable.
1.
Calculation
Under double-declining balance, each year's depreciation rate is double the straight­
l ine rate. In the final year, the asset is depreciated to its salvage value, if any.
Double-declining balance depreciation is calculated using the following formula:
Depreciation expense = 2
2.
x
�
N
x
(Cost - Accumulated depreciation)
Salvage Value
No allowance is made for salvage value because the method always leaves a
remaining balance, which is treated as salvage value. However, the asset should not
be depreciated below the estimated salvage value.
E X A M P L E - D O U B L E - D E C LI N I N G- B A L A N C E M E T H 0 D
An asset costing $10,000 with a salvage value of $2,000 has an estimated useful life of 10 years.
Using the double-declining-balance method, the expense is computed as follows:
First, the regular straight-line method percentage is determined, which i n our case is 10% (10-year
life). The amount is doubled to 20% and applied each year to the remaining book value, as follows:
Year
Double
Percentage
Net Book Value
Remaining
Amount of
Depreciation
Expense
1
20
$10,000
2
20
8,000
$2,000
1,600
3
20
6,400
1,280
1,024
4
20
5,120
5
20
4,096
819
6
20
3,277
655
7
20
2,622
524
8
20
2,098
98
2,000
0
Salvage value
Had the preceding ill ustration been lX times declining balance (150%), the rate would have
been 15% of the remaining book value.
In the i l lustration above, if the asset (of a company on a calendar-year basis) had been placed i n
service on J u l y 1 , t h e first year's depreciation would have been $1,000 (one-half o f $2,000), and the
second year's depreciation would have been 20% of $9,000 (remaining value after the first year), or
$1,800.
Note that in year 8 only $98 depreciation expense is taken because book value cannot drop
below salvage value. In addition, no depreciation expense is recorded i n years 9 and 10.
PASS K E Y
A
f::f
The only methods that ignore salvage value i n the annual calculation of depreciation are the declining
balance methods. Salvage val ue is only used as the limitation on total depreciation.
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Financial 4
D.
Becker Professional Education I CPA Exam Review
Units-of-Produ ction (productive output)
The units-of-production method relates depreciation to the estimated production capability of
an asset and is expressed in a rate per unit or hour.
The formula is:
Cost - Salvage value
-=-- =
-
Estimated units or hours
Rate per unit
(or hour)
E.
x
Rate per unit or hour
# of units produced
(or hours worked)
=
Depeciation
expense
Partial Year Depreciation
When an asset is placed in service during the year, the depreciation expense is taken only for
the portion of the year that the asset is used. For example, if an asset (of a company on a
calendar year basis) is placed in service on July 1 , only six months' depreciation is taken.
F.
Disposals
1.
Sale of an asset during its useful life:
11m Cash received from sale
11m Accum ulated depreciation of sold asset
tWl1
$XXX
XXX
Sold asset at cost
$XXX
xxx
tWl1 / 11m The difference is gain/loss
2.
Write-off fully depreciated asset:
11m Accumulated depreciation ( 100%)
rtm
3.
$XXX
Total and permanent impairment:
11m Accumulated depreciation per records
11m Loss due to impairment (the difference)
rtm
F4-S0
$XXX
Old asset at full cost (100%)
Asset at full cost
$XXX
xxx
$XXX
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Becker Professional Education I CPA Exam Review
G.
Financial 4
Disclosure
Allowances for depreciation and depletion should be deducted from the assets to which they
relate.
The following disclosures of depreciable assets and depreciation should be made in the
financial statements or notes thereto:
H.
1.
Depreciation expense for the period.
2.
Balance of major classes of depreciable assets by nature or function .
3.
Accumulated depreciation allowances b y classes o r in total.
4.
The methods used, by major classes, in computing depreciation.
Advantages and Disadvantages of the Straight-line Method of Depreciation
1.
2.
I.
a.
Simple to compute.
b.
Applies to virtually all assets.
c.
Consistent from year to year.
d.
Wide acceptability.
e.
Similar to treatment of prepaid items.
Disadvantages
a.
Does not reflect difference in usage of asset from year to year.
b.
Does not accurately match costs with revenue.
Advantages and Disadvantages of the Machine Hours and Units-of-Production Method
1.
2.
J.
Advantages
Advantages
a.
Matches costs with revenues.
b.
Reflects activity of the enterprise.
Disadvantages
a.
If no activity, no depreciation expensed; however, in reality, all assets depreciate.
b.
Cannot be used for all assets (e.g., buildings).
c.
Can be complex because it requires clerical work and records.
Advantages and Disadvantages of the Declining-balance Methods
1.
Advantages
a.
Matches costs to revenues since greater utility i s reflected in greater depreciation
during earlier years.
b.
As the amount of depreciation decreases, repairs and maintenance charges
increase thereby tending to balance out one another.
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Becker Professional Education I CPA Exam Review
Financial 4
2.
V.
Disadvantages
a.
Does not reflect changes in the activity of the asset.
b.
Computation can be complex.
c.
Greater disparity in amount of depreciation between earlier years and later years.
d.
Possibility that with decreasing depreciation and increasing repairs and
maintenance, income is artificially smoothed over the years.
DEPLETION
A.
Definition
Depletion is the allocation of the cost of wasting natural resources such as oil, gas, timber,
and minerals to the production process.
B.
Terms
1.
Purchase Cost
Purchase cost includes any expenditures necessary to purchase and then prepare the
land for the removal of resources, such as d rilling costs or the costs for tunnels or
shafts for the oil industry (intangible development costs) or to prepare the asset for
harvest, such as in the lumber industry.
2.
Residual Value
The residual value is similar to salvage value. It is the monetary worth of a depleted
asset after the resources have been removed.
3.
Depletion Base (cost - residual value)
The depletion base is the cost to purchase the property minus the estimated net
residual value remaining after all resources have been removed from the property.
4.
Methods
a.
Cost Depletion (GAAP)
Cost depletion is computed by dividing the current estimated recoverable units
into unrecovered cost (less salvage) to arrive at a cost depletion rate which is
multiplied by units produced to allocate the costs to production.
b.
F4-S2
Percentage Depletion (not GAAP / tax only)
(1 )
It is based on a percentage of sales. It is allowed by Congress as a tax
deduction to encourage exploration in very risky businesses.
(2)
Percentage depletion can (and usually does) exceed cost depletion.
(3)
It is limited to 50% of net income from the depletion property computed
before the percentage depletion allowance.
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Becker Professional Education I CPA Exam Review
C.
Unit Depletion Rate (depletion per unit)
Unit depletion is the amount of depletion recognized per unit (e.g., ton , barrel, etc.) extracted.
It is calculated by dividing the depletion base by estimated removable units.
1.
Depletion Base
The depletion base may be calculated as:
2.
a.
Cost to purchase property.
b.
Plus: Development costs to prepare the land for extraction.
c.
Plus: Any estimated restoration costs.
d.
Less: Residual value of land after the resources (e.g., mineral ore, oil, etc.) are
extracted.
Calculation of Depletion
Total depletion is calculated by multiplying the unit depletion rate times the number of
units extracted.
If all units extracted are not sold, then depletion must be allocated between cost of
goods sold and inventory. The amount of depletion to be included in cost of goods sold is
calculated by multiplying the unit depletion rate by the number of units sold.
Depletion applicable to units extracted but not sold is allocated to inventory as direct
materials.
TOTAL D E P L E T I O N A N D COST O F G O O DS S O L D D E P LE T I O N
I n Year 1, Happy Mine Corporation purchased a mineral mine for $3,400,000 with removable ore estimated by geological
surveys at 4,000,000 tons. The property has an estimated value of $200,000 after the ore has been extracted. The company
incurred $800,000 of development costs preparing the mine for production. During Year 1, 400,000 tons were removed and
375,000 tons were sold.
1.
Requirement 1:
What is the depletion base?
Requirement 2:
What is the amount of depletion Happy M ine should record?
Requirement 3:
What is the amount of depletion that Happy M ine should include in its cost of goods sold for Year 1?
Calculate depletion base:
Depletion base = Cost of land + Development costs + Restoration - Residual value
$4,000,000 = $3,400,000 + $800,000 + 0 - $200,000
Then, calculate unit depletion rate:
Depletion base
.
.
U nit d ep I etlon = ---'------Estimated recovera ble units
$4,000,000
--'---'-- = $ 1 per ton
4,000,000 tons
2. Calculate depletion for Year 1:
Depletion for Year 1
3.
Unit depletion x U nits extracted
$1 per unit x 400,000 units
$400,000
Calculate the amount of depletion to be included in cost of goods sold:
COGS depletion
Unit depletion x Units sold
$1 per unit x 375,000 units
$375,000
Note t h at th e remain i ng $25,000 wou ld b e i nc l u d ed i n i nventory as di rect materia l s. *
*$400,000 - $375,000 $25,000
=
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PASS KEY
When computing depletion on land, remember it is REAL property:
Residual value (subtract)
Extraction/development cost
Anticipated restoration cost
Land purchase price
F4-S4
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Financial 4
F IXED A S SET
I.
OVERVIEW
As presented in chapter F2, the carrying amounts of fixed assets held for use and to be disposed of
need to be reviewed at least annually or whenever events or changes in circumstances indicate
that the carrying amount may not be recoverable.
II.
TEST FOR RECOVERABILITY
(U.S. GAAP)
When a fixed asset is tested for impairment, the future cash flows expected to result from the use of
the asset and its eventual disposition need to be estimated. If the sum of undiscounted expected
(future) cash flows is less than the carrying amount, an impairment loss needs to be recognized.
III.
CALCULATION OF THE IMPAIRMENT LOSS-GENERAL
(U.S. GAAP)
The impairment loss is calculated as the amount by which the carrying amount exceeds the fair
value of the asset.
Und iscounted future net cash flows*
<
Net carrying va l u e >
Positive
Negative
1
I
I
No i m pa irment loss
I m pairment
Assets held
Assets held
for use
for d isposal
I
FV or PV future net cash flows
<
I
Net ca r!:yi ng va l u e >
I m�a i rment loss
1 . Write asset down
I
FV or PV future net cash flows
<
Net ca r!:yi ng va l u e >
I m pa i rm e nt loss
+
Cost of dis�osal
Total i m�a i rm e nt loss
2. Depreciate new cost
3. Restoration not perm itted
1. Write asset down
2 . N o depreciation taken
3 . Restoration is permitted
* Undiscounted future net cash flows can be estimated for fixed assets and finite life intangible
assets, but cannot be estimated for indefinite life intangible assets (including goodwill). When
performing the test for recoverability on indefinite life intangible assets, fair value must be used
instead of undiscounted future net cash flows: Fair value - Net carrying value Positive (no
impairment) or Negative ( impairment).
=
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F4-55
Financial 4
IIFRS I
IV.
Becker Professional Education I CPA Exam Review
CALCULATION OF THE IMPAIRMENT LOSS (IFRS)
As presented in F2, a fixed asset impairment loss under I FRS is calculated using a one-step model
in which the carrying value of the fixed asset is compared to the fixed asset's recoverable amount.
IFRS define the recoverable amount as the greater of the asset's fair value less costs to sell and
the asset's value in use. Value in use is the present value of the future cash flows expected from
the fixed asset. I FRS allow the reversal of impairment losses.
V.
REPORTING THE IMPAIRMENT LOSS-GEN ERAL (U.S.
GAAP)
The impairment loss is reported as a component of income from continuing operations before
income taxes or in a statement of activities (related to not-for-profit entities). The impairment loss
is recognized by reducing the carrying value of the asset to its lower fair value. Restoration of
previously recognized impairment losses is prohibited under U.S. GAAP.
P A S S KEY
I t is i mportant to remember the fol l owing rules when performing your calculations under U.S. GAAP:
F4·S6
•
Determining the impairment-use undiscounted future net cash flows
•
Amount of the impairment-use fair val ue (FV) or discounted (PV) future net cash flows
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Financial 4
APPEND I X I
O t h e r I n v e n t o r ')' C o s t F l o w A s s u m p t i o n s
I.
OTHER INVENTORY COST FLOW ASSUMPTIONS
A.
Gross Profit Method
The gross profit method is used for interim financial statements as part of a periodic
inventory system. I nventory is valued at retail, and the average gross profit percentage is
used to determine the inventory cost for the interim financial statements. The gross profit
percentage is known and is used to calculate cost of sales.
EXAMPLE
Dahl Co. sells soap at a gross profit percentage of 20%. The following figures a pply to the eight months
ended August 31, Year 1:
Sales
Beginning inventory
Purchases
$200,000
100,000
100,000
On September 1, Year 1, a flood destroys all of Dahl's soap inventory. Estimate the cost of the destroyed
inventory.
Sales
COGS % ( 1.00 - .20)
Cost of goods sold
$ 200,000
80%
x
$ 160,000
Cost of goods sold is deducted from the total goods available to determine ending inventory, as follows:
Beginning inventory
Add: Purchases
Cost of goods available
Less: Cost of goods sold
Estimated cost of inventory destroyed
B.
$100,000
+ 100,000
$200,000
(160,000)
$ 40,000
Retail Method
The retail method is used by businesses that sell a large volume of items with
relatively low unit costs (e.g., department stores). The retail method is a perpetual system
that records inventory at the retail price and converts the retail price to GAAP cost through
the application of a cost-to-retail ratio. The cost-to-retail ratio used depends on the cost flow
assumption (i.e., FIFO, LI FO, etc.). The retail method tends to highlight deviations from
physical counts (i.e., shrinkage).
The retail method requires keeping aggregate records at both cost and retail and the periodic
determination of the relationship of one to the other. This allows a business to keep a
reasonably accurate inventory balance without the cost inconvenience of a physical count.
1.
Basic Calculation for Ending Inventory at Cost
By calculating the amount of goods available for sale at retail and subtracting retail
sales, we can determine ending inventory at retail. Multiplying ending inventory at
retail by the ratio of aggregate cost to aggregate retail gives us the estimated ending
inventory at cost.
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Financial 4
Becker Professional Education I CPA Exam Review
It is necessary to maintain records of purchases at both cost and selling price, and of
sales at selling price, in order to use the retail inventory method. With the information
available, a ratio of cost to retail can be calculated and applied to the estimated ending
inventory at retail to compute the approximate cost.
'
C O M P U TAT I O N O F C O S T T O R E TA i l R AT I d
Cost
I nventory, at beginning of period
$ 100,000
Purchases d u ring the period
Total s
Retail
$ 150,000
1,100,000
1,850,000
1,200,000
2,000,000
Cost-to-Retail Ratio
$1,200,000 / $2,000,000
=
60%
Sales d u ring the period
1,800,000
Estimated ending inventory at retail
Estimated ending i nventory at cost (60% x $200,000)
Estimated cost of goods sold
$ 200,000
120,000
$1,080,000
When the retail i nventory method i s used, physica l i nventories should be taken periodically as a
check on the accuracy of the estimated i nventories.
2.
Accounting for Changes in Selling Prices
The illustration above ignores the problem of changes made in selling prices after the
original pricing of the goods.
Original selling prices are often revised or modified, which necessitates an understanding
of the following terminology:
Original retail
Markups
Markdowns
Markup cancellations
Markdown cancellations
Net markups
Net markdowns
Markon
3.
The first selling price at which the goods are offered for sale
Increases in the selling price above the original selling price
Decreases in the selling price below the original selling price
Decreases in the markup selling price, but not below the original selling price
Increases in the markdown selling price, but not a bove the original selling price
Markups minus markup cancellations
Markdowns minus markdown cancellations
The difference between the cost and the original selling price
Conventional Retail Inventory Method
This method approximates the results that would be obtained by taking a physical
inventory and pricing the goods at the lower of cost or market.
In order to approximate the lower of cost or market in the computations, beginning
inventory, markups and markup cancellations are used in calculating the ratio of cost to
retail. Markdowns and markdown cancellations are excluded in calculating the ratio of
cost to retail and are subtracted from the retail inventory after the ratio is determined.
F4-S8
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Financial 4
LIFO Application of the Retail Method
4.
a.
Approximates Cost
Unlike the conventional retail method, the LIFO application approximates the
original cost of the merchandise.
b.
Differences in Calculations Using the LIFO Application
The LIFO method of evaluating inventory can be applied to the retail inventory
method by using procedures somewhat different from the conventional retail
method. Two differences have to be taken into consideration:
(1 )
Net markups and net markdowns are included in the cost to retail ratio
calculation.
(2)
Beginning inventory is excluded from the cost to retail ratio calculation.
C A L C U L AT I O N O F E N D I N G I N V E N T O R Y U S I N G C O N V E N T I O N A L R E TA I L I N V E N T O R Y
M E T H O D ( L C M ) A N D T H E L I F O R E TA I L I N V E N T O R Y M E T H O D
Assume the following information:
General Data
Inventory, beginning of the period
Purchases
Transportation i n
Cost
Retail
$200,000
$ 300,000
550,000
800,000
50,000
Markups
120,000
Markup cancellations
20,000
Markdowns
70,000
Markdown cancellations
10,000
Sales
750,000
Solution: Conventional Retail Inventory Method
The calculations would be:
Inventory, at begin ning of period
Purchases
Transportation i n
Cost
Retail
$200,000
$ 300,000
550,000
800,000
50,000
Markups
120,000
Markup cancellations
(20,000)
Totals (used to calculate cost to retail ratio)
$ 800,000
$1,200,000
Cost-to-Retail Ratio
$800,000 / $1,200,000
=
66,67%
Markdowns
(70,000)
Markdown cancellations
10,000
Total goods at retail
1,140,000
Less: Sales during the period
750,000
Inventory, ending (at retail)
Inventory, ending (66.67% x $390,000)
*
$ 390,000
$260,000 *
At estimated lower of cost or market
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S O L U T I O N : L I F O R E TA I L I N V E N T O R Y M E T H O
(LIFO
L AY E R A O D E D I
�
,
II
Solution:
Inventory, at the beginning of period
Purchase
Cost
Retail
omitted
omitted
$550,000
$800,000
50,000
Transportation
Markups
120,000
Markup cancellations
(20,000)
Markdowns
(70,000)
10/000
Markdown cancellations
$600/000
Totals (used to calculate cost to retail ratio)
840,000
Cost-to-Retail Ratio
$600,000 / $840,000
=
71.4%
Add : Inventory, at the beginning of period
300/000
Total goods at retail
1, 140,000
750/000
Less: Sales during the period
$ 390/000
Inventory, ending (at retail)
In this example, the computation is as follows:
Retail
Ending inventory
$390,000
Less: beginning inventory
300/000
$ 90/000
LIFO layer added
Due to the nature of LIFO inventory valuation, the LIFO layer added represents additions to the
inventory made after the beginning of the period. Therefore, to determine the cost of the LIFO layer
added, the LIFO layer added at retail, $90,000, is multiplied by the new cost to retail ratio. In this
example, the ratio is 71.4% ($600,000/$840,000).
Thus, the LIFO layer has a value, at cost, of $64,260 ($90,000 x 71.4%).
To calculate the ending inventory at cost, the LIFO layer added is combined with the beginning
inventory at cost. In this example, the computation is as follows:
Beginning inventory at cost
Plus: LI FO layer added, at cost
Ending inventory, at cost
F4-60
$ 200,000
64/260
$ 264/260
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Financial 4
C A L C U L AT I O N O F E N D I N G I N V E N T O R Y U S I N G L I F O R E TA I L
( L I F O LAY E R D E P L E T E D )
For this example, assume sales of $860,000.
Cost
Inventory, at the beginning of period
Purchases
Transportation
Retail
omitted
omitted
$550,000
$ 800,000
50,000
Markups
120,000
Markup cancellations
(20,000)
Markdowns
(70,000)
Markdown cancellations
10,000
Totals
$ 600,000
Add: Inventory, at the begin ning of period
840,000
300,000
Total goods at retail
1, 140,000
Less: Sales d uring the period
860,000
Inventory, ending (at retail)
$ 280,000
When the e n d i n g L I FO i nventory (at reta il) is less than the begin n i ng i nventory (at reta il), part or a l l
o f a L I FO layer h a s been used. To determine t h e L I FO layer d e pleted, t h e e n d i ng inventory at reta i l i s
su btracted from t h e begi n n i ng inventory at reta i l .
I n this example, the computation i s as follows:
Retail
Beginning inventory
$300,000
Less: Ending inventory
280,000
LIFO layer depleted
$ 20,000
Due to the nature of L I FO inventory va l uation, the L I FO layer d e pleted represents a d d itions to the
inventory made prior to the begi n n ing of the period. Therefore, to determine the cost of the L IFO
layer depleted, the L IFO layer depleted at retai l ($20,000) is multiplied by the i nventory cost to reta il
ratio applicable to the layer d e pleted. I n this exa m p l e, assum i n g the begi n n ing i nventory consists of
only one layer, this ratio is:
$200,000 cost / $300,000 retail
=
66.67%
Thus, the LIFO layer at cost is $13,334 ($20,000 x 66.67%).
To calculate the ending inventory at cost, the L IFO layer depleted at cost is subtracted from the
beginning inventory at cost. In this example, the computation is as follows:
Beginning inventory, at cost
Less: L I FO layer depleted, at cost
Ending inventory, at cost
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$ 200,000
(13.334)
$ 186,666
F4-61
Financial 4
Becker Professional Education I CPA Exam Review
5.
Cost Retail Inventory Method
Under the cost retail inventory method, the markdowns go above the "total available for
sale" line. Therefore, the result must be adjusted to "lower of cost or market."
Beginning inventory
Purchases
At Cost
At Retail
$25,000
$39,000
35,000
60,000
Markups
1,000
Markdowns
(2.000)
Total available for sale
$60.000
$98,000
Sales
(88.000)
Ending inventory at retail
$10,000
=
61.22% cost-to-retail ratio
Ending inventory at cost
($10,000 x 61.22%)
6.
$ 6,122
FIFO I Cost Retail Inventory Method
Under the F I FO cost retail method, the ending inventory comes from the current period
purchases, including markups and markdowns.
Beginning inventory
At Cost
At Retail
$25,000
39,000
35,000
60,000
$60,000
1,000
1,000
Purchases
Markups
Markdowns
Purchases
(2,000)
(2.000)
98,000
59.000
35, 000
-- =
59, 000
7.
Sales
(88,000)
Ending inventory at FIFO retail
$10,000
Cost complement
x 59.32%
Ending inventory at FIFO cost
$ 5,932
.
59.32% cost-to-retal'1 ratio
�.�----�
LIFO I Cost Retail Inventory Method
Under the LIFO cost retail inventory method , ending inventory comes from beginning
inventory plus an incremental increase for the period .
At Cost
Beginning inventory
Purchases
Markups
Markdowns
$25,000
35,000
At Retail
$39,000 = 64.10% cost-to-retail ratio
60,000
1,000
(2,000)
Sales
(88,000)
Ending inventory at retail
$10,000
Ending inventory at LIFO cost
($10,000 x 64.10%)
F4-62
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8.
Dollar Value LIFO I Cost Retail Inventory Method
In general, dollar value LIFO can also be used in a retail environment. The dollar value
LIFO cost retail process requires five steps:
a.
Count the inventory at year-end at retail.
b.
Convert the year-end balance to base year amounts via price indices.
c.
Compute the yearly increment (increase or decrease).
d.
Convert each yearly increment from base year amounts to year-end prices.
e.
Convert retail prices to cost.
December 31
Ending Inventory at
Price Index at
Yearly Cost
End ot Year Prices
December 31
Complement %
Year 1
$100,000
100
63%
Year 2
121,000
110
65%
Year 3
138,000
120
62%
Calculated Yearly Increments:
December 31
Base Year Amaunts
Increments
Year 1
100,000 x 100/100 = $100,000
100,000
Year 2
121,000 x 100/110 = $110,000
10,000
Year 3
138,000
100/120
5,000
x
=
$115,000
Convert to Year-end PriceS/Convert to Cost:
Year-end
December 31
Increments
Amounts
Cost %
Cost
Year 1
$100,000 x 100/100
$100,000
x
63%
$63,000
Year 2
$10,000 x 110/100
11,000
x
65%
7,150
6.000
x
62%
�
Year 3
$5,000
x
120/100
�117.000
9.
$73.870
Retail Method-Additional Rules
Certain additional rules apply to the retail method.
a.
Freight costs are added to the cost (not retail) of purchases.
b.
Purchase returns and allowances are reductions of both the cost and retail
amounts.
c.
Sales returns and allowances are subtracted from sales.
d.
Employee discounts are deducted from retail in a manner similar to sales discounts.
e.
Shrinkage is the difference between book ending inventory and the amount per
physical count.
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Financial 4
Cost
Retail
Beginning inventory
$20,000
$ 45,000
Purchases
100,000
210,000
Purchases returns
(2,000)
Freight-in
3,000
nfa
nfa
3,000
Markups
Total available for sale
$121,000
(6,000)
$252,000 = 48%
(204,000)
Sales, net of $2,000 returns
(4,000)
Net markdowns
Employee discounts
(2,000)
Ending inventory per books
42,000
Shrinkage (a "squeeze")
(2,000)
$40,000
Ending inventory at retail
Ending inventory at cost ($40,000 x 48%)
II.
$19,200
NON-GAAP IN VENTORY COST FLOW ASSUMPTIO N S
A.
Base Stock Method
The base stock method replenishes any reduction in LIFO layers with the old cost, not the
replacement cost.
B.
N ext In, First O ut (NIFO) Method
The next in, first out ( N I FO) method values cost of goods sold at the replacement cost.
III.
F4.64
GAAP INVENTORY DISCLOSURES
A.
Inventory detail (e.g., raw materials, WIP, and finished goods)
B.
Significant finance arrangements
C.
Pledged inventory
D.
Valuation method
E.
Cost flow method
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Financial 4
APPEND I X II
I F RS
v s .
U.S. GAAP
Note: Unless specifically noted, IFRS and U.S. GAAP accounting rules are the same. This chart highlights the important
differences between IFRS and U.S. GAAP covered in this chapter.
I SSUE
IFRS
U.s. GAAP
Inventory Valuation
I nventory is reported at the lower of cost or net
realizable value. Reversal of inventory write-downs is
allowed for subsequent recoveries of inventory value.
I nventory is reported at the lower of cost or market.
Inventory Cost Flow
Assumptions
•
•
The method used to account for inventory should
match the actual flow of goods
•
The use of LIFO is prohibited
•
Fixed Asset
Valuation
•
Fixed assets are reported using one of two models
•
Cost model:
The method used to account for inventory should be
the method that most clearly reflects periodic
income
The method is not required to have a rational
relationship with the physical inventory flow
•
The use of LIFO is permitted
•
Fixed assets are reported using the cost model:
Carrying value Historical cost - Accumulated
depreciation - I mpairment
=
Carrying value Historical cost - Accumulated
depreciation - Impairment
=
•
Revaluation model:
Carrying value Fair value on revaluation date Subsequent accumulated depreciation Subsequent impairment
=
o Revaluation losses are reported on the income
statement
o Revaluation gains are reported in other
comprehensive income as revaluation surplus
Investment
Property
•
•
•
Defined as land and/or buildings held to earn rental
income or for capital appreciation
Investment property is reported using one of two
models
Cost Model:
Carrying value
depreciation
o
•
No "investment property" classification
=
Historical cost - Accumulated
If the cost model is used, fair value must be
disclosed
Fair Value Model:
o Investment property is reported at fair value and
is not depreciated. Gains and losses from
changes in fair value are reported on the income
statement
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Financial 4
ISSUE
Fixed Asset
Depreciation
IFRS
·
·
·
Fixed Asset Impairment
·
U.S. GAAP
The depreciation method used should match the
expected pattern of fixed asset consumption.
Depreciation method, useful life, and salvage value
must be reviewed for appropriateness on each
balance sheet date.
Component depreciation is required.
Impairment is determined using a one-step test.
I mpairment exists if the carrying value of the fixed
assets exceeds the higher of:
1.
·
·
No requirement to review depreciation method,
useful life, and salvage value at each balance sheet
date.
·
Can use composite or component depreciation.
·
Impairment is determined using a two-step test.
·
Step 1: Test far Recoverability
0
FV - Costs to sell
2. Value in use (present value of the expected
future cash flows from the fixed asset)
·
Reversal of impairment losses is permitted.
·
An impairment loss must be recorded if the
carrying value of the fixed asset exceeds the
undiscounted expected future cash flows from
the asset.
Step 2: Calculate Impairment
0
0
F4-66
II
The depreciation method is not required to match
the expected pattern of fixed asset consumption.
The impairment loss is the difference between
the carrying value and fair value of the asset.
Reversal of impairment losses is only permitted
for assets held for sale.
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CL ASS Q U ES T IONS
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4.
5.
6.
7.
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10.
ll.
12.
13.
14.
Task-based simulation
G RADE
Attempt
Multiple-choice Questions
Task-based Simulations
1st
Questions correct
: 13 questions
=
%
Questions correct
"'" 1 questions
=
%
2nd
Questions correct
: 13 questions
=
%
Questions correct
"'" 1 questions
=
%
3rd
Questions correct
"'" 13 questions
=
%
Questions correct
"'" 1 questions
=
%
Final
Total questions correct
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"'" 14 questions
=
%
F4-67
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Financial 4
NOTES
F4-68
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Financial 4
1 . C PA-00067
On Merfs April 30, 1 993, balance sheet a note receivable was reported as a noncurrent asset and its
accrued interest for eight months was reported as a current asset. Which of the following terms would fit
Merfs note receivable?
a.
b.
c.
d.
Both principal and interest amounts are payable on August 31 , 1 993, and August 31 , 1 994.
Principal and interest are due December 31 , 1 993.
Both principal and interest amounts are payable on December 31 , 1 993, and December 31 , 1 994.
Principal is due August 31 , 1 994, and interest is due August 31 , 1 993, and August 31 , 1 994.
2. C PA-00061
Cook Co. had the following balances at December 31 , 1 992:
Cash in checking account
Cash in money-market account
U.S. Treasury bill, purchased 1 2/1 /92, maturing 2128/93
U .S. Treasury bond, purchased 3/1 192, maturing 2/28/93
$350,000
250,000
800,000
500,000
Cook's policy is to treat as cash equivalents all highly liquid investments with a maturity of three months
or less when purchased. What amount should Cook report as cash and cash equivalents in its December
31 , 1 992, balance sheet?
a.
b.
c.
d.
$600,000
$ 1 , 1 50,000
$1 ,400,000
$1 ,900,000
3. C PA-00049
I nge Co. determined that the net value of its accounts receivable at December 31 , 1 993, based on an
aging of the receivables, was $325,000. Additional information is as follows:
Allowance for uncollectible accounts, 1 /1 /93
Uncollectible accounts written off during 1 993
Uncollectible accounts recovered during 1 993
Accounts receivable at 1 2/31 /93
$30,000
1 8,000
2,000
350,000
For 1 993, what would be I nge's uncollectible accounts expense?
a.
b.
c.
d.
$5,000
$ 1 1 ,000
$1 5,000
$21 ,000
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Becker Professional Education I CPA Exam Review
4. CPA-00036
At January 1 , 1 994, Jamin Co. had a credit balance of $260,000 in its allowance for uncollectible
accounts. Based on past experience, 2% of Jamin's credit sales have been uncollectible. During
1 994, Jamin wrote off $325,000 of uncollectible accounts. Credit sales for 1 994 were $9,000,000. In
its December 31 , 1 994, balance sheet, what amount should Jamin report as allowance for uncollectible
accounts?
a.
b.
c.
d.
$ 1 1 5,000
$1 80,000
$245,000
$440,000
5. CPA-00034
Gar Co. factored its receivables without recourse with Ross Bank. Gar received cash as a result of this
transaction, which is best described as a:
a.
b.
c.
d.
Loan from Ross collateralized by Gar's accounts receivable.
Loan from Ross to be repaid by the proceeds from Gar's accounts receivable.
Sale of Gar's accounts receivable to Ross, with the risk of uncollectible accounts retained by Gar.
Sale of Gar's accounts receivable to Ross, with the risk of uncollectible accounts transferred to Ross.
6. C PA-00059
Roth, Inc. received from a customer a one-year, $500,000 note bearing annual interest of 8%. After
holding the note for six months, Roth discounted the note at Regional Bank at an effective interest rate of
1 0%. What amount of cash did Roth receive from the bank?
a.
b.
c.
d.
$540,000
$523,8 1 0
$51 3,000
$495,238
7. C PA-001 1 4
Bren Co.'s beginning inventory at January 1 , 1 993, was understated by $26,000, and its ending inventory
was overstated by $52,000. As a result, Bren's cost of goods sold for 1 993 was:
a.
b.
c.
d.
Understated by $26,000.
Overstated by $26,000.
Understated by $78,000.
Overstated by $78,000.
F4-70
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8. C PA-001 1 2
Herc Co.'s inventory at December 31 , 1 993, was $1 ,500,000 based o n a physical count priced at cost,
and before any necessary adjustment for the following:
•
•
Merchandise costing $90,000, shipped FOB shipping point from a vendor on December 30, 1 993, was
received and recorded on January 5, 1 994.
Goods in the shipping area were excluded from inventory although shipment was not made until
January 4, 1 994. The goods, billed to the customer FOB shipping point on December 30, 1 993, had a
cost of $1 20,000.
What amount should Herc report as inventory in its December 31 , 1 993 balance sheet?
a.
b.
c.
d.
$ 1 ,500,000
$ 1 ,590,000
$1 ,620,000
$1 ,71 0,000
9. C PA-06053
Based on a physical inventory taken on December 31 , an entity determined its inventory on a F I FO basis
to be $70,000, with a replacement cost of $65,000. The entity estimated that after further processing
costs of $8,000, the completed inventory could be sold for $75,000. The entity's normal profit margin is
30%. What amount should the entity report as inventory in its December 31 balance sheet under U . S .
GAAP?
a.
b.
c.
d.
$44,500
$65,000
$67,000
$70,000
1 0. CPA-06054
Based on a physical inventory taken on December 31 , an entity determined its inventory on a FIFO basis
to be $70,000, with a replacement cost of $65,000. The entity estimated that after further processing
costs of $8,000, the completed inventory could be sold for $75,000. The entity's normal profit margin is
30%. What amount should the entity report as inventory in its December 31 balance sheet under I FRS?
a.
b.
c.
d.
$67,000
$70,000
$75,000
$83,000
1 1 . CPA-00092
A company decided to change its inventory valuation method from F I FO to LI FO in a period of rising
prices. What was the result of the change on ending inventory and net income in the year of the change?
Ending inventofY.
Net income
a.
b.
c.
I ncrease
I ncrease
Decrease
Increase
Decrease
Decrease
d.
Decrease
Increase
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1 2. CPA-06055
Which of the following statements regarding the IFRS revaluation model is incorrect?
a.
b.
c.
d.
Revaluation gains are reported in other comprehensive income.
Revaluation losses are reported on the income statement.
Revaluation can be performed on individual fixed assets only or on classes of assets.
Further revaluation i s necessary when the carrying value of revalued fixed assets differs materially
from fair value.
1 3. CPA-001 39
On December 1 , 1 991 , Boyd Co. purchased a $400,000 tract of land for a factory site. Boyd razed an old
building on the property and sold the materials it salvaged from the demolition. Boyd incurred additional
costs and realized salvage proceeds during December 1 991 as follows:
Demolition of old building
Legal fees for purchase contract and recording ownership
Title guarantee insurance
Proceeds from sale of salvaged materials
$50,000
1 0,000
1 2,000
8,000
In its December 31 , 1 991 , balance sheet, Boyd should report a balance in the land account of:
a.
b.
c.
d.
$464,000
$460,000
$442,000
$422,000
1 4. TB5-00009
On January 1 , Year 1 , Great Garages I nc. purchased equipment for $300,000. The equipment has a
salvage value of $30,000 and a 3-year life. Compute the depreciation expense recorded in Year 1 -Year 3
using the following methods (enter the appropriate calculations and amounts in the shaded cells):
Straight-Line:
Sum-of-the-Years' Digits:
Double-Declining Balance:
F4-72
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