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FAR_ParticipantGuides_M1 1 27 May 2016 6:45 PM
FASB andStandard Setting
Lesson OverviewIn this lesson we will cover the primary purpose of financial accounting.
The professional organizations that are an integral part of the financial accounting environment
Primary PurposeFinancial accounting and reporting provides information to aid the decision making of the users of the financial statements—primarily the external users need this information to:
• Make investment and credit decisions.• Assess amount and timing of cash flows.• Assess economic resources and
obligations.
Generally Accepted Accounting Principles (GAAP)
GAAP addresses three aspects of financial reporting:
1. Recognition—when recorded on financial statements
2. Measurement—how recorded on financial statements
3. Disclosure—anything that is not on the financial statements
Organizations
The Financial Accounting Standards Board (FASB)
The Securities and Exchange Commission (SEC)
The American Institute of Certified Public Accountants (AICPA)
The Private Company Council (PCC)
FASBThe private sector body that establishes GAAP
Seven full time members—Effective
Mission to improve the usefulness of financial reporting
• Address deficiencies• Promote international convergence
Module 1FAR 1-1 Role and Standard-Setting
Process
1
COPYRIG
HTED M
ATERIAL
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FASBFinancial Accounting Foundation (FAF) appoints Board members and advisory councils, ensures funding, and exercises oversight
Financial Accounting Standards Advisory Council (FASAC) advises the FASB on current and possible new agenda items, policy issues, or formation of task forces
Emerging Issues Task Force (EITF) provides implementation guidance within GAAP
FASB Structure
FASBFASB
FASACProvides guidance on policy, priorities,
etc
FASACProvides guidance on policy, priorities,
etc
FAFProvides funding
FAFProvides funding
Standard-Setting Process
Adds Project to Agenda
Adds Project to Agenda
Conducts Research and ssues
DM
Conducts Research and ssues
DM
Public HearingPublic
Hearing
Issues EDIssues EDModifies ED
Modifies ED
Finalizes and Issues
ASU
Finalizes and Issues
ASU
SEC Formed by Congress in the 1933 Act
Authority to establish GAAP—but SEC relinquished that task to the private sector (FASB)
Enforcement authority
AICPA
Professional Organization for practicing CPAs
Substantial input into the standard-setting process
All past standard-setting bodies were created by the AICPA
GAAPAuthoritative GAAP
• FASB Accounting Standards Codification (ASC)
ASC is a compilation of pronouncements issued by FASB, APB, and CAP
Non-authoritative
FASB Concepts, AICPA Issues Papers, IFRS
SEC Guidance—considered part of authoritative GAAP for public companies
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FAR 1-1 Role and Standard-Setting Process 3
Summary
Make sure you are comfortable with the main organizations that make up the financial accounting environment.
Accrual Accounting
MUST know for the CPA exam!
Tested frequently andconsistently!
Types of Exam QuestionsConvert cash basis income to accrual basis income.
Convert accrual basis income to cash basis.
Given accrued expense or revenue and solve for cash paid or received (and vice versa).
Given deferred expense or revenue and solve for cash paid or received (and vice versa).
Accrual Basis AccountingAccrual basis accounting recognizes and reports the economic activities of an entity in the period the economic activity was incurred, regardless of when the cash activity takes place.
The Heart of Financial
Accounting and Reporting
Accrual Accounts
• Good or service received from vendor
Event• Accounts
Payable(liability)
Accrual Account
• Cash ReceivedCash
• Good or service provided to a customer
Event• Accounts
Receivable(asset)
Accrual Account
• Cash PaidCash
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Deferral Accounts
• Cash ReceivedCash
• Unearned Revenue (liability)
Deferral Account
• Good or service used
Event• Cash PaidCash• Prepaid
Expense (asset)
Deferral Account
• Good or service delivered
Event
Theme of Accruals and DeferralsThe common theme for accruals and deferrals:
When the economic event occurs firstyou create an accrual account (you are accruing the cash to be received or to be paid as an asset or liability).
When the cash activity occurs first you create a deferral account (you are deferring the recognition of an expense or revenue as an asset or liability).
Tools The Accounting Equation: A = L + E
• Use to reconcile accrual basis net income to cash basis net income
• Use to reconcile cash basis net income to accrual basis net income
T-accounts
• Use to solve for accrual basis revenue or expense
• Use to solve for cash received or paid
Use accounting equation to determine change in working capital accounts
1) A = L + E
2) ΔA = ΔL + ΔE
3) ΔCash + ΔOA = ΔL + ΔE
4) ΔCash = ΔL + ΔE – ΔOA
Accrual Net Income to Cash Net Income
Accrual to CashJ&L Pecans maintain accounting records on an accrual basis. J&L decided to convert to cash basis accounting. During the year J&L reported $95,178 of net income. On January 1, 20X5 and December 31, 20X5 J&L had the following amounts:
January December
Accounts receivable 9,250 15,927
Unearned revenue 2,840 4,111
Accrued expenses 3,435 2,108
Prepaid expenses 1,917 3,232
Conversion of Accrual Basis to Cash BasisΔCash = ΔL + ΔE – ΔOA
Net Income on accrual basis $95,178
increase in accounts receivable ($9,250 – $15, 927) (6,677)
increase in unearned service revenue ($2,840 –$4,111)
1,271
decrease in accrued expense ($3,435 – $2,108) (1,327)
increase in prepaid expenses ($1,917 – $3,232) (1,315)
Net income on a cash basis 87,130
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FAR 1-1 Role and Standard-Setting Process 5
Use accounting equation to determine change in working capital accounts (signs are opposite!)
1) A = L + E
2) ΔA = ΔL + ΔE
3) ΔA – ΔL = ΔE
4) ΔE = ΔA – ΔL
Accrual basis net income is essentially the change in equity (retained earnings)
Cash Net Income to Accrual Net Income
Cash to AccrualJ&L Pecans maintain accounting records on a cash basis. Assume J&L decided to convert to accrual basis accounting. During the year J&L reported $87,130 of cash basis income. On January 1 and December 31 J&L determined they had the following amounts:
January December
Cash Received or Revenue Recognized
Use T-accounts
Accounts receivable
Beginning balance
Revenue (sales) Cash collections
Ending balance
Unearned Revenue
Beginning balance
Revenue (sales) Cash collections
Ending balance
Solving for Cash CollectedA company has the following activity with respect to unearned consulting fees during the year.
Unearned consulting fees, Dec 31 2,000
Unearned consulting fees, Jan 1 3,500
Consulting fee revenue 25,000
How much cash was collected for consulting fees?
Solving for Cash CollectedInformation given on unearned revenue:
Unearned Revenue
Beginning balance 3,500
Revenue 25,000 Cash collections 23,500
Ending balance 2,000
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Solving for Cash CollectedWhat if the information was accounts receivable?
Accounts Receivable
Beginning balance 3,500
Revenue 25,000
Cash collections 26,500
Ending balance 2,000
Cash Paid or Expense RecognizedUse T-accounts
Solving for Cash PaidA company has the following activity with respect to prepaid insurance expense during the year.
Prepaid expense, Dec 31 2,000
Prepaid expense, Jan 1 3,500
Insurance expense 25,000
How much cash was paid during the year?
Solving for Cash Paid Information given on prepaid expense:
Prepaid Expense
Beginning balance 3,500
Cash paid 23,500
Expense 25,000
Ending balance 2,000
Solving for Cash Paid What if the information was on accounts payable?
Accounts Payable
Beginning balance 3,500
Cash paid 26,500
Expense 25,000
Ending balance 2,000
SummaryConvert cash basis income to accrual basis income or accrual basis income to cash basis.
Given accrued expense or revenue and solve for cash paid or received (vice versa).
Tools:
• The Accounting Equation: A = L + E
• T-accounts
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FAR 1-1 Role and Standard-Setting Process 7
Financial Statements
Income Statement
Reports accrual-based performance over a period of time. It is dated as fiscal year ended (FYE). For example, December 31
Captures all revenues, expenses, gains and losses that were incurred during the period
Certain items are excluded from the income statement but included in comprehensive income.
Statement of Comprehensive IncomeReports non-owner changes to equity over a period of time. It is dated as FYE. For example, December 31 includes:
• Unrealized gains/losses on investments in AFS securities
• Certain pension adjustments• Foreign currency translation adjustments• Certain hedge accounting adjustments
Balance SheetReports economic resources and obligations as of a specific date. It is dated as of December 31:
Assets presented in order of liquidity
Liabilities presented in order of maturity
Current/long-term designation
Various measurement attributes
Exam Question HintThe CPA exam tends to emphasize sections of the balance sheet, such as PPE or Equity.
As we cover the balance sheet items, make sure to understand not only the accounting, but also the reporting of these items.
Statement of Stockholders’ EquityReports the changes related to owners’ equity over a period of time. It is dated as FYE, for example, December 31.Owners’ Equity is presented in order of permanence:
1. Contributed capital is shown first, because it will not be returned to shareholders.
2. RE is shown last because it is less permanent because dividends are paid from RE.
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Statement of Cash FlowsReports changes in cash over a period of time. It is dated as FYE, for example, December 31.
Operating—cash flows related to income statement transactions
Investing—cash flows related to long-term assets and investments
Financing—cash flows related to liabilities and owners’ equity
Footnotes and OpinionFootnote disclosures and supplementary schedules:
• Footnotes are an integral part of the financial statements.
• Footnotes present information not captured on the statements.
Auditor’s opinion:
• Opinion on the statements in conformance with GAAP
Financial AccountingStandards Codification
What is the Codification?The Codification is a compilation and reorganization of all GAAP sources
• Accounting Standards Codification (ASC) is the official name of the Codification.
• Accounting Standards Updates (ASU) are how updates to GAAP are communicated. ASU’s are not GAAP. Organized based on a major area and topicA one-stop shop for all accounting guidance on that area or topic
Goals of CodificationThe FASB Codification Research System is on-line, real-time searchable data base in order to:
1. Simplify structure and accessibility of GAAP.
2. Place all authoritative literature in one place.
3. Reduce time and effort to research an issue.
4. Reduce risk of noncompliance with GAAP.
5. Facilitate updating GAAP.
6. Assist with IFRS convergence.
Codification Structure
AreasAreas
TopicsTopics
SubtopicsSubtopics
SectionsSections
Paragraphs
Subsections
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FAR 1-1 Role and Standard-Setting Process 9
Areas and Topics
• 100 Principles Example: Objectives• 200 Presentations Example: Balance SheetGeneral
• 300 Assets Example: Cash• 400 Liabilities Example: Debt• 500 Equity Example: Treasury Stock
Balance Sheet
• 600 Revenue Example: Products • 700 Expenses Example: Start-up Costs
Income Statement
• 800 Broad Transactions Example: Business Combinations
• 900 Industry Example: AgricultureOtherOther
Topic
Receivables (310)
Subsection -Paragraph
Origination Fees (2) and
(3)
Syndication Fees (4)
Subtopic
Nonrefundable (20)
Loans (30)
Section
Scope (15)
Initial Measurement
(30)
310-20-30-4
Topic
Leases (840)
Subsection -Paragraph
Lessees (2)
Lessors (3)
Subtopic
Operating (20)
Capital (30)
Section
Disclosure (50)
Scope (15)
840-20-15-2
Searching the CodificationLocate the citation in the relevant accounting standard to provide guidance for the following issue.
A firm has several securities outstanding that can become common stock in the future. Each has a potential positive effect on the numerator and denominator of Earnings Per Share (EPS). How does the firm decide the order of entering these potential common stock securities in the calculation of diluted EPS?
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AICPA.08211248FAR-I.A.II
U Co. had cash purchases and payments on account during the current year totaling $455,000. U’s beginning and ending accounts payable balances for the year were $64,000 and $50,000, respectively. What amount represents U’s accrual-basis purchases for the year?A. $441,000B. $469,000C. $505,000D. $519,000
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11
FAR 1-2 Conceptual Framework of Financial Reporting by Business Enterprises
Objectives, Qualitative Characteristics
OverviewThe Conceptual Framework guides the standard-setting process so that the resulting GAAP is cohesive and internally consistent.
Purpose of ConceptsThe Conceptual Framework is based on the overriding objective of financial reporting—decision usefulness.
The Conceptual Framework describes two primary qualitative characteristics of the information that will be decision useful.
There are four enhancing qualitative characteristics.
Decision Usefulness
Primary Characteristics
Faithful Representation
Completeness Neutrality Free from error
Relevance
Predictive Value
Confirmatory Value Materiality
Primary Characteristics
Faithful Representation
+Relevance
=
FaRR
Faithful RepresentationCan I Depend on it?
Complete
• Are all facts embedded in the information?
Neutral
• The information is free from bias; no one interest group is favored; focus is on objectivity and balance.
Free from error
• Would a sufficiently knowledgeable third party derive the same result?
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RelevanceDoes it Relate to my decision?
Helps me Predict• Helps form a prediction about future events; prediction
is best formed from elements in the financial statements expected to persist into the future
Helps me Confirm• Provides information about earlier expectations or
predictions; either as a confirmation or disconfirmation; helps understand how past actions have affected current financial position
RelevanceDoes it Relate to my decision?
The information is Material
• This is information that could influence my decision.
FaRR
Decision—useful information
Relevance• Relates to my decision,
helps me predict and confirm predictions. Is material to my decision
Faithful Representation• I can depend on the
information; it is complete, neutral, and free from error.
Enhancing Characteristics
• Between companies• Non uniformityComparability
• Independent observers would reach similar conclusionVerifiability
• Recent enough to make a differenceTimeliness
• Comprehensible by a user with reasonable understanding of business
Understandability
Example QuestionWhat are the Accounting Concepts intended to establish?A. Generally accepted accounting principles in
financial reporting by business enterprises
B. The meaning of "Presented fairly in accordance with generally accepted accounting principles”
C. The objectives and concepts for use in developing standards of financial accounting and reporting
D. The hierarchy of sources of generally accepted accounting principles
AnswerAnswer: C
Here is where careful reading will pay off!
The concepts assist the development of the standards, but they are not GAAP!
Don't fall for the GAAP answers in A, B, or D.
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FAR 1-2 Conceptual Framework of Financial Reporting by Business Enterprises 13
Example QuestionAccording to the FASB's Conceptual Framework, predictive value is an ingredient of:
FaithfulRepresentation Relevance
A. Yes Yes
B. Yes No
C. No No
D. No Yes
AnswerAnswer: D
Faithful representation answers the question “Can I depend on it?” Faithful representation is completeness, neutral, and free from material error.
Relevance answers the question “Does it relate to my decision?” Predictive value relates to the relevance of information. Relevant information contains predictive value and feedback value.
ConclusionNow you are ready to complete some questions on your own in study mode. Once you feel comfortable, continue on to the next lesson on the Conceptual Framework.
Study hint: If you had trouble with the terminology in this section, try the flash cards to help you learn the definitions. We strongly recommend that you understand the definitions—it will serve you well and take you farther than just memorization.
You can do it—once you put your mind to it!
Assumptions, AccountingPrinciples
Acronym for AssumptionsAssumptions come “Entirely from your GUT”
The four assumptions are:
1. Entity2. Going Concern3. Unit of measurement4. Time period
Entity Assumption
The entity is separate and distinct from its owners.
Example: The owners of the corporation are separate from the corporation itself. The assets of the corporation do not belong to the owners, but to the corporation.
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Going Concern AssumptionA business has an indefinite life that extends beyond the life of the owners.
Absent evidence to the contrary (such as imminent bankruptcy), a business will continue on.
Assets would not be recorded unless we assumed that the business will be there in the next period to use these assets.
Unit of Measurement AssumptionEverything is measured in terms of a stable monetary unit of measure.
Values are not adjusted for inflation
1. Example: Land purchased in 1960 is added to land purchased in 2015 even though the value of the dollar in 1960 is different than the value in 2015.
2. We do not adjust the 1960 dollars to the 2015 equivalent.
Time Period Assumption
Indefinite life is broken into timeframes, such as a year, a quarter, a month, etc.
PrinciplesThere are four Accounting Principles:
1. Revenue Recognition
2. Expense Recognition (matching)
3. Measurement
4. Full Disclosure
Revenue Recognition PrincipleRevenue is recognized when realized and earned.
• Recognized = Recorded on the financial statements
• Realized = Cash or near cash (AR) received
• Earned = Goods or service has been delivered
Much more on revenue recognition in separate lesson
Expense Recognition PrincipleOften referred to as the matching principle
Addresses when to recognize expenses
Recognizes expenses when they produce revenues
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FAR 1-2 Conceptual Framework of Financial Reporting by Business Enterprises 15
MeasurementAssets and liabilities are recorded at the value at the time of origin.
Historical cost: Land
Amortized cost: Plant and Equipment
Net realizable value: Accounts Receivable
Replacement cost: Inventory
Net present value: Bonds
Fair value: Investments
Full Disclosure PrincipleNot all information can be recognized on the financial statements.
• Example: Operating lease obligations
Disclosures are needed to help the financial statement user assess financial obligations of the business.
• Example: The future minimum lease payments are disclosed in the footnotes.
Constraint and Present Value
79
ConstraintCost-benefit
Cost of providing the information should not outweigh the benefit.
Using Cash Flow and PVThis concept refers to measurement when the present value of cash flows are used to estimate fair value.
Governs measurement not recognition
When using cash flows to determine present value, there are two ways to incorporate the risk associated with the cash flows:
1. Discounted cash flows: single cash flow value is discounted using the risk adjusted rate
2. Expected cash flows: probability weighted cash flows is discounted using the risk-free rate
ExampleA cash flow of $200,000 may be received in one year, two years, or three years, with probabilities of 20%, 50%, and 30%, respectively. The rate of interest on default risk-free investments is 5%. The PV factors are:
PV of 1, at 5%, for 1 year is 0.95238PV of 1, at 5%, for 2 years is 0.90703PV of 1, at 5%, for 3 years is 0.86384
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Solution$200,000 0.2 = $ 40,000 0.95238 = $38,095
$200,000 0.5 = $100,000 0.90703 = $90,703
$200,000 0.3 = $ 60,000 0.86384 = $51,830
Total $180,628
Example QuestionWhich of the following is not addressed in the concept statement on cash flows and fair value accounting measurements?
A. Measurement methods at initial recognition
B. Interest method of amortization
C. Expected cash flow approach
D. Determining when fresh-start measurements are appropriate
AnswerAnswer: D
The concept statement governs how to measure not when to measure items at present value.
Answers A, B, and C were all how to measure.
ConclusionThis concludes the third lesson on the FASB’s Conceptual Framework.
Make sure to be comfortable with the terminology and concepts presented in the Conceptual Framework lessons.
This material is integral to all other FAR topics.
Best of luck as you continue with your studies!
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FAR 1-2 Conceptual Framework of Financial Reporting by Business Enterprises 17
AICPA.901101FAR-TH-FA
According to the Conceptual Framework, the process of reporting an item in the financial statements of an entity is:A. Recognition.B. Realization.C. Allocation.D. Matching.
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18
Elements of Fair Value DefinitionFair value is a market-based measurement.
Fair value is determined for a particular asset, liability or equity item, which may be:
• A single item (e.g., a bond)• A group of related items (e.g., a
business)
Elements of Fair Value DefinitionFair value determination should consider attributes of the specific item being measured:
• Condition, location, restrictions on use• Fair value not based on buyers unique
perspective
Fair Value Framework—Introduction and Definitions
Fair Value Framework CoverageTopics covered in Fair Value Framework include:
• Definition of “fair value” and related elements
• Issues related to determination of fair value at initial recognition of an item
• Approaches to determining fair value• Inputs used in determining fair value and
input hierarchy• Disclosure requirements any time fair
value is used
US GAAP versus IFRS
As a result of the joint efforts of the IASB and the FASB, there are no significant differences between US GAAP and IFRS related to the meaning of fair value, its measurement, or required disclosures.
Fair Value Defined
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
FAR 1-3 Fair Value Framework
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FAR 1-3 Fair Value Framework 19
Elements of Fair Value Definition“Orderly transaction” is a hypothetical transaction:
• Assumed to occur at the measurement date
• Assumed to occur under current market conditions
• Not assumed to occur in a forced liquidation or distressed sale
Elements of Fair Value DefinitionHypothetical transaction is assumed to occur in principal market or most advantageous market for the item to which the entity has access:
• Principal market is the market available to the entity with greatest volume and level of activity for the item.
• Most advantageous market is the market available to the entity that maximizes selling price or minimizes transfer price.
Elements of Fair Value DefinitionFair value is determined in the principal or most advantageous market:
• Should not be adjusted for transaction cost—incremental direct cost to execute sale or transfer—which do not measure a characteristic of the asset, liability or equity item
• Should be adjusted for cost of transporting item to market (the location characteristic)
Elements of Fair Value Definition“Market participants” are buyers/sellers that are:
• Independent of the reporting entity• Acting in their economic best interest• Knowledgeable of the item being
measured and the transaction type• Able and willing to enter a transaction,
but not compelled to do so
Fair Value Definition Applied to Nonfinancial Assets
Assumes the highest and best use by market participants, even if it will be used in some other way by the reporting entity
Fair Value Definition Applied to Nonfinancial Assets
Highest and best use considers what is:
• Physically possible
• Legally permissible
• Financially feasible
Highest and best use may be:
• In-use—usually nonfinancial assets
• In-exchange—usually financial assets
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Fair Value Definition Applied to Liabilities
Assumes the liability is transferred to a third party, not settled:
• Liability continues, but as an obligation of another party (not based on the price to settle the liability).
• Nonperformance risk is assumed unchanged after transfer.
• Adjustment should not be made for transfer restrictions.
Fair Value Definition Applied to Shareholders’ Equity
Fair value requirements apply to shareholder equity items.
• For example: Equity interest issued as consideration in a business combination
Measurement is from the perspective of market participant that holds the equity item as an asset.
Recognition andMeasurement
Entry Price and Exit PriceEntry price and exit price are conceptually different:
Entry price = Amount paid to acquire an asset or received to assume a liability
Exit price = Amount received to sell an asset or paid to transfer a liability
At initial recognition of an item the entry price and exit price may or may not be the same value.
Reasons Entry Price ≠ Exit Price
Entry price may not be the same as exit price when:
• Transaction is between related parties• Seller is under duress• Unit of account/measure is different than
basis for fair value determination• Market is different than market for fair
value determination
Entry Price ≠ Exit PriceAccounting Treatment
If the transaction price (entry price) is different than the fair value (exit price) a gain or loss is recognized in Income
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FAR 1-3 Fair Value Framework 21
Possible Techniques or Approaches for Fair Value Determination
Market Approach: Uses prices generated by real market transactions for identical or similar items
Income Approach: Discounts future amounts to a current present value
Cost Approach: Uses current amount required to replace the service value of an existing asset
Use of Alternative Approaches for Fair Value Determination
Some cases: A single approach to determining fair value may be appropriate and adequate.
• Quoted market prices in active markets
Some cases: Multiple approaches to determining fair value may be appropriate
• Valuing an entire business• Professional judgment required if
assessing multiple outcomes
Fair Value OptionEntities can elect to measure the following at fair value:
• Recognized financial assets and financial liabilities (with few exceptions)
• Firm commitments not otherwise recognized and that involve only financial instruments
• Written loan commitments• Rights/obligations under warranties and
insurance contracts that can be settled by paying a third party
Items Not Available for Fair Value Option
Entities may not elect to measure the following at fair value:• Investments in entities to be consolidated• Obligations or assets related to pension
or other employee-oriented plans• Lease-related financial assets or
liabilities• Demand deposits of financial institutions• Instruments that are components of
shareholders’ equity
Fair Value Option Election Dates
Fair value option can be elected only:
• When the item is first recognized• When an eligible firm commitment occurs• When the accounting treatment of an
investment in another entity changes
Fair Value Option Application Requirements
Fair value option may be applied on an instrument-by-instrument basis (with certain exceptions)
• Does not have to be applied to all instruments issued or acquired in a single transaction
• Must be applied to an entire instrument, not just to specific elements of an instrument
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Fair Value Option Application Requirements
Fair value option is irrevocable, except when a new election date for a specific item occurs.
If applied to held-to-maturity investment securities, treatment is like investment securities held-for-trading.
Accounting at Eligible Election DateDetermine carrying value (CV).
Determine fair value (FV).
Determine difference between CV and FV.
Recognize difference as:
Write item up or down.
Recognize increase (gain) or decrease (loss) in current income.
Illustration—Accounting at Election Date
Eligible date = January 2, 20X1
CV = $100,000
FV = $110,000
FV > CV (Difference) = $ 10,000
Entry:
DR: Investment in Equity Investee $ 10,000
CR: Unrealized Gain—FV Option $ 10,000
Accounting After ElectionAt each subsequent reporting date:
• Adjust item to new fair value.• Recognize difference as:
1. Write item up or down
2. Recognize increase or decrease in current earnings.
Entry (assume an increase in FV of an asset):DR: Asset
CR: Unrealized Gain—FV Option
Inputs and Hierarchy
Fair Value Inputs Inputs are assumptions and data used in valuation techniques:
• Observable Inputs: Derived from market data from sources independent of the reporting entity
• Unobservable Inputs: Entity’s assumptions based on best information available in circumstances
Use of observable inputs should be maximized; use of unobservable inputs should be minimized.
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FAR 1-3 Fair Value Framework 23
Fair Value Measurement Inputs Hierarchy
Level 1: Unadjusted quoted prices at measurement date in active markets for identical items.• Highest level with most desirable inputs • Most reliable evidence of fair value• Should be used when available• Liquidity discount—permitted• Control premium—not permitted• Blockage discount—not permitted
Fair Value Measurement Inputs Hierarchy
Level 2: Inputs observable, either directly or indirectly, that do not meet all conditions for Level 1
• Quoted prices in active markets for similar items
• Quoted prices in markets that are not active
• Observable inputs other than quoted market prices that are relevant to an item being valued
Fair Value Measurement Inputs Hierarchy
• Inputs derived from or corroborated by observable market data using correlation or other means
• May need to be adjusted for characteristics of the specific item being valued (e.g., condition)
• Use of significant unobservable inputs to adjust observable inputs may result in a Level 3 measurement
Fair Value Measurement Inputs Hierarchy
Level 3: Unobservable inputs for the item being valued:
• Lowest level with least desirable inputs• May use reporting firm’s internal data• Based on assumptions or inferences that
market participants would make• Example: Determining fair value of
closely held stock
Disclosure Requirements
Distinctions for Disclosure Requirements
Disclosure requirements depend on whether fair value is used:
• On a recurring basis—Fair value is determined and
applied to an item period after period.
• On a nonrecurring basis—Fair value is determined and
applied only when certain conditions or situations occur.
For both of the bullets above, you must disclose the fair value at
reporting date, valuation techniques, and inputs used in those
techniques.
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Disclosure Requirements when Fair Value is Used on Recurring Basis
In interim and annual statements for each major category of asset or liability measured at fair value:
• Level of the fair value hierarchy within which measurements falls
• Transfers into and out of each level of the hierarchy shown and discussed separately
Disclosure Requirements when Fair Value is Used on Recurring Basis
In interim and annual statements for each major category of asset or liability measured at fair value:• For measurements in Level 3 a reconciliation of
beginning and ending balances, showing:Recognized gains and losses and whether reported in net income or other comprehensive income
Purchases, sales, issuances, and settlements
Transfers in/out of Level 3
Disclosure Requirements when Fair Value is Used on Recurring Basis
Fair value measurements that fall in Level 3:• Description of the valuation process used• Quantitative information about the
unobservable inputs used• Narrative description of sensitivity to
changes in unobservable inputs• Amount of gains/losses for period due to
change in unrealized gains/losses for items still held at measurement date and where reported
Disclosure Requirements when Fair Value is Used on Nonrecurring BasisIn interim and annual statements for each major category of asset or liability measured at fair value:• Reasons for the fair value measurement
• Level of the fair value hierarchy within which measurements fall
• For measurements in Levels 2 and 3 a description of any changes in techniques
Disclosure Requirements when Fair Value is Used on Nonrecurring BasisFor measurements that fall in Level 3, unobservable inputs:
• The effect of the measurement on earnings or OCI
• Quantitative information about the unobservable inputs used
If highest and best use of nonfinancial assets differs from current use, disclose that fact and why.
Disclosure for Fair Value OptionIdentify items to which the fair value option is applied and reasons for electing the fair value option
Information to enable users to understand how fair value is applied for each item (methods and assumptions)
The amount of gains and losses associated with the fair value changes
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FAR 1-3 Fair Value Framework 25
Coca-Cola, Inc.—Example Footnote Disclosure
Coca-Cola, Inc.—Footnote Excerpt
Coca-Cola, Inc.—Footnote Excerpt (continued)
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AICPA.080117FAR-FVF
Which of the following statements concerning the determination of fair value is/are correct?I. The determination of fair value is based on a hypothetical
transaction. II. The determination of fair value is based on an exit price. III. The determination of fair value of a nonfinancial asset should be based
on the intended use of the asset by the reporting entity.
A. I only. B. II only. C. I and II only. D. II and III only.
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FAR 1-3 Fair Value Framework 27
AICPA.090421FAR-SIM
In determining the fair value of a nonfinancial asset, assessing the highest and best use of the asset must take into account all but which one of the following?A. What is physically possible.B. What is financially feasible.C. How the reporting entity would use the asset.D. What is legally permissible.
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28
SEC—Role andStandard-Setting Process
Creation of the SEC
The SEC was created by Congress after the 1929 stock market crash.
The SEC has the legal authority to set accounting standards, but has delegated that responsibility to the private sector—currently the FASB.
Purpose of the SECThe SEC enforces compliance with US GAAP for all publicly traded companies.
• Compliance with IFRS for foreign registrants
To promote efficient allocation of capital through open, orderly and fair securities markets
Access to information that is decision-useful (relevant) to the market participant is critical
Foreign Issuers Reporting to the SECIn 2008, as part of the “roadmap” to international convergence, the SEC eliminated the reconciliation to US GAAP for foreign private issuers.
This is a significant step to acknowledging the IASB approved IFRSs.
Elimination of the reconciliation should encourage more foreign businesses to list on US exchanges.
Foreign Private Issuer
A foreign private issuer is any non-governmental foreign issuer that:
• Has the majority of its securities owned outside of the US
• Officers and directors are not US citizens or residents
• The majority of assets are outside the US• The business is administered principally
outside of the US
Securities Issued and TradedThe SEC regulates the initial issuance and subsequent trading of securities.
The SEC’s database is IDEA (Interactive Data Electronic Applications) where financial statement information is stored in XBRL (eXtensible Business Reporting Language)
• XBRL tags accounting data into a taxonomy to ease the access to the data
FAR 1-4 US Securities and Exchange Commission (SEC)
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FAR 1-4 US Securities and Exchange Commission (SEC) 29
Organizational Structure
Five commissioners appointed by the President of the US
Four divisions
Office of the Chief Accountant
Divisions
• Oversees compliance • Filings submitted to this division
Corporate Finance
Corporate Finance
• Investigates violations• Makes recommendations for punishment
EnforcementEnforcement
• Oversees the secondary markets and exchanges, brokers, and dealers
Trading and Markets
Trading and Markets
• Oversees investment advisors and investment companies
Investment ManagementInvestment
Management
Laws Administered by the SECThe Securities Acts of 1933 and 1934
The Public Utility Holding Company Act of 1935
Trust Indenture Act of 1939
Investment Company Act of 1940
Investment Advisors Act of 1940
Securities Investor Protection Act of 1970
Sarbanes-Oxley Act of 2002
Participation in Standard SettingEven though the SEC delegates standard setting to the FASB, the SEC participates in the setting of accounting standards.
SEC pronouncements along with the FASB Accounting Standards Codification comprise authoritative US GAAP for public companies.
Private companies do not have to comply with SEC pronouncements.
Pronouncements Issued
Financial Reporting Releases• Formal pronouncements—highest ranking authoritative source for public companies
FRR
Staff Accounting Bulletins• SEC’s current position on technical issuesSAB
Accounting and Auditing Enforcement Releases• Reports enforcement actions
AAER
SEC Reporting Requirements
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What is a Security?Section 2.1 of the 1933 Act defines a security as: Any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral trust certificate, reorganization certificate or subscription, transferable share, investment contract, voting trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt of, guarantee of, or warrant or right to subscribe to or to purchase any of the foregoing.
The Securities Act of 1933This act applies to the registration of the initial public offering (IPO) of securities.
Form S-1 is the basic registration form for new securities.
• Part 1 is the prospectus and provides information about the company, business operations, risks, financial statements and use of proceeds.
• Part 2 provides information about the cost of the issuance, information about the directors and officers, and additional financial schedules.
Financial Statements for IPO
The following audited financial statements must be presented:
• 2 years of balance sheets• 3 years of income statements, statements
of cash flow and statements of shareholders’ equity
IPO Process
IssuerIssuer Under-writerUnder-writer DealerDealer PublicPublic
The Securities Act of 1934This act applies to reporting information about securities that are already issued.
Regulation S-X provides detailed guidance on the reporting requirements
Form 10-K is the annual filing
Form 10-Q is the quarterly filing
Form 8-K reports significant events
Annual Filing—Form 10-KThe financial statements in Form 10-K must be audited by an independent registered auditor.
• 2 years of balance sheets• 3 years of income statements,
statements of cash flows, and statements of shareholders equity
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FAR 1-4 US Securities and Exchange Commission (SEC) 31
Annual Filing—Form 10-K
In addition to the audited financial statements, there are significant disclosures:
• Management Discussion and Analysis (MD&A)
• Reports on controls• Management certifications• Much, much more (see study guide)
Quarterly Filing—Form 10-Q
The financial statements in Form 10-Q are not audited, but are reviewed by the auditor.
Disclosures in the 10-Q are not as extensive as the 10-K.
Update on significant matters since the last quarter such as legal proceedings, changes in securities outstanding.
Coca Cola, Inc.—10-Q Income Statement Coca Cola, Inc.—10-Q Balance Sheet
Coca Cola, Inc.—10-Q Cash Flows
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AICPA.101196FAR-SIM
The SEC defines a foreign private issuer as any issuer other than a foreign government, except an issuer that where more than 50% of the outstanding voting securities are directly or indirectly owned by residents of the US and what other condition?A. The business of the issuer is administered principally in the foreign
country.B. More than 50% of the assets of the issuer are located in the foreign
country.C. The majority of its executive officers or directors are US citizens or
residents.D. All of the above.
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33
Balance Sheet/Statement of Financial Position
Balance Sheet
Statement of Financial Position
Measured at one point in time
Assets = Liabilities + Equity = Contra and adjunct accounts
Measurement Attributes
Historical cost—Land, prepaid insurance
Amortized historical cost—Fixed assets
Fair Market value —Marketable securities, derivatives
Net realizable value—Accounts receivable
Present value—Bonds
Contra and Adjunct Accounts
Contra accounts are subtracted from the balance sheet accounts.
Adjunct accounts are added to the balance sheet account.
Current Assets
Assets expected to be realized in cash or consumed within one operating cycle or year
Examples: accounts receivable, prepaid expenses, and investments (short-term)
Current LiabilitiesLiabilities expected to be extinguished with current assets or another liability within one operating cycle or year
Examples: accounts payable, accrued expenses
FAR 1-5 General-Purpose Financial Statements 1
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Noncurrent
By default accounts that are not current are classified as noncurrent.
Noncurrent asset examples: PPE, long term investments, and intangibles
Noncurrent liability examples: notes payable, bonds payable, and pension liabilities
Equity AccountsContributed Capital:
• The amount contributed by owners• Example: Common stock, preferred
stock, additional paid-in capital
Retained Earnings:
• The amount of earnings retained by the entity
• Cumulative net income less dividends paid
Coca-Cola, Inc.—Assets Coca-Cola, Inc.—Liabilities and Shareholders’ Equity
Income Statement
DefinitionsRevenues—increases in net assets or settlement of liabilities from PRIMARY activities—providing goods or services
DR: Cash or ARCR: Revenue or Sales
orDR: Unearned RevenueCR: Revenue or Sales
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FAR 1-5 General-Purpose Financial Statements 1 35
DefinitionsExpenses—decreases in net assets or incurrence of liabilities from PRIMARY activities—providing goods or services
DR: ExpenseCR: Cash or AP
orDR: ExpenseCR: AP or Accrued Liabilities
DefinitionsGains—increases in net assets from incidental activities
Losses—decreases in net assets from incidental activities
Examples: sale of assets, interest income, and interest expense
Multi-step Income StatementABC Company
FYE December 31SalesCost of Goods SoldGross profitOperating expenses+/– Other income/expensesIncome from continuing operations before taxIncome taxesIncome from continuing operations+/– Discontinued operationsNet Income
Coca-Cola, Inc.—Income Statement
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AICPA.950534FAR-FA
Which of the following should be included in general and administrative expenses?
Interest AdvertisingA. Yes YesB. Yes NoC. No YesD. No No
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37
Statement of Comprehensive Income
Definition
Comprehensive Income
Other Comprehensive
Income
NetIncome
Other Comprehensive Income Items
• Unrealized gains and losses on AFS securities
• Unrecognized gains and losses from pension costs
• Foreign currency translation adjustments
• Unrealized gains and losses from certain derivative transactions
PresentationComprehensive income can be presented in one of two ways:
• One-statement approach: In combination with the income statement
• Two-statement approach:A separate statement of income and a separate statement of comprehensive income
One-Statement Approach
Statement of Income and Comprehensive IncomeFYE December 31
Revenues $1,000
Expenses (900)
Net Income 100
Other comprehensive income items (net of tax)
Unrealized G/L foreign currency translation (2)
Unrealized G/L AFS Securities 14
Other comprehensive income 12
Comprehensive income $112
Two-Statement ApproachStatement of IncomeFYE December 31
Revenues $1,000
Expenses (900)
Net income $ 100
FAR 1-6 General-Purpose Financial Statements 2
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Two Statement ApproachStatement of Comprehensive Income
FYE December 31
Net Income $100
Other comprehensive income items (net of tax)
Unrealized G/L foreign currency translation (2)
Unrealized G/L AFS Securities 14
Other comprehensive income 12
Comprehensive income $112
Coca-Cola, Inc.—Statement of Comprehensive Income
Coca-Cola, Inc.—Comprehensive Income Disclosure
Example QuestionChoose the correct equation from the following:
A. Net income + Comprehensive income = Other comprehensive income
B. Comprehensive income = Net income + Prior period adjustments + Accounting principle changes
C. Comprehensive Income = Net income + Other comprehensive income
D. Comprehensive income = Total change in owners’ equity – Dividends declared
Statement of Changesin Equity
Changes in Owners’ EquityThis statement provides beginning balances, changes during the year and ending balances for the following items:
• Stock (common and preferred)
• APIC
• Retained Earnings
• Treasury Stock
• AOCI
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FAR 1-6 General-Purpose Financial Statements 2 39
PresentationChanges in owners’ equity can be presented in the footnotes, supplemental schedules or as a separate statement.
Most large companies present changes in owners’ equity in a separate statement.
Coca-Cola, Inc.—Statement of Shareowners’ Equity
Coca-Cola, Inc.—Statement of Shareowners’ Equity (continued)
Sources and Uses of Cash
Statement of Cash Flows (SCF)Since the SCF’s purpose is to explain the changes in cash and cash equivalents, we must define what is a cash equivalent.
What is cash?
Cash and cash equivalents:
• Are short-term, highly liquid investments• Are readily convertible to known amount
of cash• Bear no interest rate risk
Examples: T-bills, and money market funds
SCFs (continued)
The SCF is a basic statement like the income statement and balance sheet.
SCF is required for all business enterprises that report both a balance sheet and income statement.
The SCF presents information about the sources and uses of cash during the year.
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Purpose of SCFThe purpose of the SCF is to provide information so that users can:
• Assess past ability to generate and control cash inflows and outflows.
• Assess probable future ability of the company to generate cash inflows sufficient to meet future obligations.
• Assess the likelihood of future borrowing.
Information Reported
Cash flows related to operating activities
Cash flows related to investing activities
Cash flows related to financing activities
Acronym to Remember
Operating Ohhhhhhh
Investing
Financing
I could pass the CPA Exam!
IF. . .
Other Information ReportedEffects of foreign currency translation on cash flows
Reconciliation of cash at the beginning of the year to cash at the end of the year
If direct method is used must report a reconciliation of accrual net income to cash flow from operations
Significant non-cash transactions
Non-cash TransactionsA supplement schedule must be provided to present significant non-cash transactions.
Examples:
• Purchase of equipment with a note payable
• Settle a liability by paying with common stock and not cash
FormatABC Company
Statement of Cash FlowFYE December 31
Operating activities $1,000Investing activities 500Financing activities (300)
Foreign currency impact 50Change in cash 1,250Beginning cash 750Ending cash $2,000
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FAR 1-6 General-Purpose Financial Statements 2 41
ConclusionIn this lesson you learned:
• The basic purpose of an SCF is to present the reader with information about the sources and uses of cash
• What is cash or cash equivalents• The sources and uses of cash are
categorized into operating, investing and financing activities
• The impact of foreign currency translation and noncash activities are also required to be presented
Operating, Investing, andFinancing Activities
Operating Activities—Direct MethodCash inflows: • From customers • Interest income or dividend income• Sale of trading investments
Cash outflows: • To suppliers • To employees• To government • For interest or other operational
expenses
Coca-Cola, Inc. Statement of Cash Flows: Operating Activities
EMC Corp.—Statement of Cash Flows: Operating Activities
EMC Corp.—Statement of Cash Flows
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Investing ActivitiesCash inflows:
• Sale of property, plant or equipment • Sale of debt or equity securities of other
entities • Collection of loan principal
Cash outflows:
• Purchase of property, plant or equipment• Purchase of debt or equity securities of
other entities
Coca-Cola, Inc. Statement of Cash Flows: Investing Activities
Year Ended December 31, 2013 2012 2011
Financing ActivitiesCash inflows:
• From sale of equity securities • From issuance of debt (bonds and notes)
Cash outflows:
• To stockholders as dividends • To redeem long-term debt • To re-acquire capital stock
Coca-Cola, Inc. Statement of Cash Flows: Financing Activities
Year Ended December 31, 2013 2012 2011
Example QuestionWhich of the following items is included in the financing activities section of the SCF?
A. Cash effects of transactions involving making and collecting loans.
B. Cash effects of acquiring and disposing of investments and PPE.
C. Cash effects of transactions obtaining resources from owners and providing them with a return on their investment.
D. Cash effects of transactions that enter into the determination of net income.
Answer
Answer: C
Answer A is incorrect because when the entity lends and collects money with other parties it is acting as an investor. These inflows and outflows are investing activities
Answer B is incorrect because these are typical investing activities
Answer D is incorrect because it is an operating activity
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FAR 1-6 General-Purpose Financial Statements 2 43
Example QuestionIn an SCF, if used equipment is sold at a loss, the amount shown as cash inflow from investing activities equals the carrying amount of the equipment
A. Less the loss and plus the amount of tax attributed to the loss
B. Less both the loss and the amount of tax attributable to the loss
C. Less the lossD. With no additional addition or subtraction
AnswerAnswer: C
A journal entry helps to visualize the answer.
So for example if equipment is sold for $200 at a $50 loss the entry is:
Cash 200Loss (50)Equipment (book value) 250
The tax effects are irrelevant as they are an operating cash flow.
ConclusionIn this lesson you learned the sources and uses of cash are categorized into operating, investing and financing activities.
This lesson also presented the different classifications permitted under IFRS.
Complete the practice questions in this lesson—it will really help reinforce what transactions go into each category.
Also, there is a simulation for the SCF. Once you have completed the three SCF lessons—give it a try.
Operating Cash Flows—Indirect Method
Operating ActivitiesCash flow from operations can be presented in one of two ways:
1. Direct method—This method directly shows the amount of cash inflows and outflows from operations. It shows cash received from sales and cash paid in operations.
2. Indirect method—This method is a reconciliation of the accrual-based net income to derive cash flows from operations.
Operating Activities—Indirect Method
Since most recordkeeping is done on an accrual basis, most large companies do not have systems to track cash inflows and outflows from operations.
Therefore, the indirect method requires that the company start with net income and back outall of the accruals made by accrual accounting.
In addition, accrual net income is adjusted for “noncash” income/expenses such as depreciation.
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Operating Activities—Indirect Method (continued)
Often a schedule is used showing beginning and ending balances in operating accruals: AR, prepaids, AP, accrued liabilities, etc
Then the changes in those accrual accounts are added or subtracted from net income to derive cash flows from operations
We are going to use a simple approach to help you remember how to complete this reconciliation
Operating Activities—Indirect Method (continued)
A = L + E
ΔA = ΔL + ΔE
Δ Cash + Δ Other assets = ΔL + ΔE
Δ Cash = ΔL + ΔE – Δ Other assets
Non-cash Expenses Any non-cash expenses on the income statement need to be ADDED back to net income to derive cash flows from operations
• Examples: depreciation, losses, amortization
Any non-cash gains on the income statement need to be subtracted from net income to derive cash flows from operation
• Examples: Gains
Coca-Cola, Inc.—Statement of Cash Flows: Operating Activities
Coca-Cola, Inc.—Footnote Excerpt: Net Change in Operating Assets and
Liabilities
Example Question—Adjusting Net Income
Kresley Co. has provided the following 20X5 current account balances for the preparation of the annual statement of cash flows:
December 31 January 1Accounts receivable $11,500 $14,500 Allowance for uncollectible 400 500Prepaid rent / insurance 6,200 4,100 Accounts payable 9,7000 11,200
Kresley's 20X5 net income is $75,000. What would be reported as net cash provided by operating activities in the statement of cash flows?
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FAR 1-6 General-Purpose Financial Statements 2 45
Answer
Δ Cash = ΔL + ΔE – Δ Other assets
Net Income 75,000– Δ in AR (3,000)+ Δ in Allowance 100 Could also think of this net+ Δ in Prepaid 2,100 AR of (11,100 – 14,000) or
2,900+ Δ in AP 1,500CF from ops 75,700
Example Question—Adjusting SalesThe following information was taken from the 20X5 financial
statements of Plant Corp:
Accounts receivable, January 1, 20X5 $ 21,600
Accounts receivable, December 31, 20X5 30,400
Sales on account and cash sales 438,000
Uncollectible accounts 1,000
No accounts receivable were written off or recovered during the
year. If the direct method is used in the 20X5 statement of cash
flows, what should Planet report for C collected from customers?
AnswerΔ Cash = ΔL + ΔE – Δ Other assets
Sales — accrual basis 438,000
Δ in AR (8,800) (30,400 – 21,600)
Sales — cash basis 429,200
There were no write-offs or recovery of uncollectible during the year — so the allowance stayed the same and therefore it does not impact the calculation.
Example Question—Adjusting an Expense
Duke Co. reported cost of goods sold (COGS) as $270,000 for 20X5. Additional information is as follows:
December 31 January 1 Inventory $60,000 $45,000
Accounts payable 26,000 39,000
If Duke uses the direct method, what amount should Duke report as Cash paid to suppliers in its 20X5 Statement of Cash Flows?
AnswerΔ Cash = ΔL + ΔE – Δ Other assets
Since we are adjusting an expense, all signs for reconciliation are reversed because expenses decrease net income
COGS — accrual basis 270,000
+ Δ in Inventory (a increase) 15,000 (60,000 – 45,000 = increase)+ Δ in AP (a decrease) 13,000 (39,000 – 26,000 = decrease)COGS — cash basis 298,000
Example Question—Adjusting an Expense
Rory Co.'s prepaid insurance was $50,000 at December 31, 20X5 and $25,000 at December 31, 20X4. Insurance expense was $20,000 for 20X5 and $15,000 for 20X4.
What amount of cash disbursements for insurance would be reported in Rory's 20X5 net cash flows from operating activities presented on a direct basis?
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AnswerΔ Cash = ΔL + ΔE – Δ Other assets
Since we are adjusting an expense all signs for reconciliation are reversed because expenses DECREASE net income
Insurance expense – accrual Basis 20,000
+ Δ in Prepaid (an increase) 25,000 (50,000 – 25,000 = increase)
Insurance expense – cash basis 45,000
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FAR 1-6 General-Purpose Financial Statements 2 47
AICPA.910531FAR-TH-FA
In a Statement of Cash Flows, which of the following items is reported as a cash outflow from financing activities?I. Payments to retire mortgage notes;II. Interest payments on mortgage notes;III. Dividend payments.
A. I, II, and III.B. II and III.C. I only.D. I and III.
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AICPA.951148FAR-FA
Which of the following is not disclosed on the Statement of Cash Flows, either on the face of the statement or in a separate schedule, when prepared under the direct method?A. The major classes of gross cash receipts and gross cash payments.B. The amount of income taxes paid.C. A reconciliation of net income to net cash flow from operations.D. A reconciliation of ending retained earnings to net cash flow from
operations.
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49
Notes toFinancial Statements
Disclosures
Footnote disclosures are an integral part of the financial statements.
Remember disclosures are part of GAAP
Provide information about assumptions and estimates
Provide information that cannot be captured quantitatively
Basic DisclosuresSummary of Significant Accounting Policies
Related Party Transactions
Liability Disclosures
Capital Structure
Errors and Irregularities
Illegal Acts
Management’s Discussion and Analysis
Required narrative for publicly held firms
Includes a discussion about operations, liquidity and capital resources
Forward-looking information can be provided by management
Effects of Changing PricesDuring times of price instability and high levels of inflation firms were required to disclose the effect of changing prices.
There are currently no required disclosures.
Review the study text—this material has a low probability of being tested. Ratios—Liquidity/Solvency
and Operational
FAR 1-7 General-Purpose Financial Statements 3
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Categories of RatiosLiquidity/Solvency• Measures the ability to meet maturing
obligations
Operational• Measures the efficiency of operations
Profitability• Measures operational results
Equity• Measures sources of equity
This Lesson Covers…Liquidity/Solvency
• Measures the ability to meet maturing obligations
Operational
• Measures the efficiency of operations
Purpose of Ratio AnalysisRatio analysis quantifies the relationship between various elements of the financial statements.
Ratio analysis enables comparisons between entities.
Ratio analysis strips the information of magnitude and unit of measure.
Ratios Permit ComparisonAssume you want to compare the performance of a US-based company and a Japanese-based company.
Calculating the profit margin ratio will permit this comparison:
US: NI Sales = $100 $2,500 = 4%
Japan: NI Sales = ¥4,000 ¥65,000 = 6%
Liquidity/Solvency RatiosWorking Capital
Current Assets (CA) – Current Liabilities (CL)
Measures the extent to which CA exceed CL
If positive, then there are more CA than CL
Example: 100 – 80 = 20
If negative, then there are more CL than CA
80 – 100 = (20)
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Liquidity/Solvency RatiosCurrent Ratio (CR)
CA CL
States working capital (WC) in a ratio form
If WC is positive, then the CR > 1
Example: 100/80 = 1.25
If WC is negative, then the CR < 1
Example: 80/100 = .8
Liquidity/Solvency RatiosAcid or Quick Ratio
Cash + AR + Marketable Securities
Current Liabilities
Uses the most “liquid” assets to measure the ability to meet maturing obligations
Will always be less than the current ratio because the numerator excludes CA like inventory
Liquidity/Solvency RatiosTimes Interest Earned
NI + Interest Expense + Income Tax Exp
Interest Expense
Measures the ability of current earnings to cover interest costs for the period
Example: 1,000 + 50 + 300 = 27 times
50Current earnings can cover interest 27 times.
Operational RatiosAccounts Receivable (AR) turnover
Net credit sales Average AR
Example: 1,000 {(80 + 90) 2} = 11.76
Number of days in AR = 365 AR turnover
Example: 365 11.76 = 31 days
Measures the average number of days required to collect receivables
Operational RatiosInventory turnover
Cost of Goods Sold Average Inventory
Example: 800 {(75 + 85) 2} = 10
Number of days in Inventory = 365 Inventory turnover
Example: 365 10 = 36.5 days
Measures the average number of days inventory is sold or used
Example QuestionTod Corp. wrote off $100,000 of obsolete inventory at December 31, 20X5. The effect of this write-off was to decrease:
A. Both the current and acid-test ratios
B. Only the current ratio
C. Only the acid-test ratio
D. Neither the current nor the acid-test ratios
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Answer
The acid ratio includes only the most liquid assets, cash, AR and marketable securities.
The current ratio included inventory and prepaid assets.
Therefore writing off inventory will effect only the current ratio.
Answer: B
Ratios—Profitabilityand Equity
Categories of RatiosLiquidity/Solvency• Measures the ability to meet maturing
obligations
Operational• Measures the efficiency of operations
Profitability• Measures operational results
Equity• Measures sources of equity
This Lesson Covers…Profitability• Measures operational results
Equity• Measures return on equity and degree of
equity financing
Purpose of Ratio Analysis
Ratio analysis quantifies the relationship between various elements of the financial statements.
Ratio analysis enables comparisons between entities.
Ratio analysis strips the information of magnitude and unit of measure.
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FAR 1-7 General-Purpose Financial Statements 3 53
Profit Margin
Net Income (NI)
Sales
Measures net profitability on sales
Example: 100 1,000 = 10%
• There is a 10% net profit on sales or
• For every dollar of sales there is 10¢ of net profit.
Return on Assets
Net Income
Average Total Assets
Measures the rate of return on total assets; how effectively total assets generate NI
Example: 100 {(3,000 + 3,500) 2} = 3.08%
There is a 3.08% return on assets or
For every dollar of assets, 3¢ of NI is produced.
Return on Equity
Net Income
Average Common Stockholders’ Equity
Measures the rate of earnings on common shareholders’ investment
Example: 100 {(600 + 700) 2} = 15.38%
There is a 15.38% return on CSE or
For every dollar of CSE, 15¢ of NI is produced.
Earnings Per Share
Net Income – Preferred Dividends
Weighted Avg. Common Shares Outstanding
Measures the income per share of common stock (see EPS lessons!)
Example: 100 500 = $0.20
For each share of common stock, there was $.20 of net income.
Price–Earnings RatioStock price per share
Earnings per share
Measures the price of stock relative to its earnings per share; indicates how the market values the stock
Example: $2.50/$0.20 = 12.5 times
The market has priced this stock at 12.5 times earnings.
Debt–Equity or Leverage RatiosAll are measures of leverage because
A = L + E
L / E, E / A, or L / A
Example: 100 = 60 + 40
L / E = 60 / 40 = 150%: L is 1.5 times E
E / A = 40 / 100 = 40%: 40% financed by E
L / A = 60 / 100 = 60%: 60% financed by L
54 Wiley CPAexcel® Exam Participant Guide: Financial Accounting and Reporting
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AICPA.910538FAR-TH-FA
on December 30, year 1, Solomon Co. had a current ratio greater than 1:1 and a quick ratio less than 1:1.on December 31, year 1, all cash was used to reduce accounts payable. How did these cash payments affect the ratios?
Current ratio Quick ratioA. Decreased DecreasedB. Decreased IncreasedC. Increased DecreasedD. Increased Increased
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FAR 1-7 General-Purpose Financial Statements 3 55
AICPA.901157FAR-P1-FA
During year 1, Rand Co. purchased $960,000 of inventory. The cost of goods sold for year 1 was $900,000, and the ending inventory on December 31, year 1 was $180,000. What was the inventory turnover for year 1?A. 6.4B. 6.0C. 5.3D. 5.0