Accounting Principles and Standards: For Financial Analysts

Accounting Principles and Standards
For Financial Analysts
Corporate Finance Institute®

FMVA® Certification Program

Course Objectives
Understand the fundamental Understand why it is important Explore in some detail common
accounting principles that to have useful financial accounting standards most
underly accounting standards information and the commonly encountered by
characteristics of useful financial financial analysts
information

Accounting Principles Overview

Session Objectives
Identify some of the different Understand the importance of a Understand the key accounting
decisions users of financial sound framework for financial principles that establish the
information make information framework for detailed
accounting standards

The Purpose of Financial Reporting
Sound financial reporting provides useful financial information about an entity’s resources and claims
against those resources to existing and potential investors, lenders and other users in making decisions
relating to that entity.
Decisions users of financial

information make include:
Buying, selling, or holding Providing or settling loans Exercising rights to vote on

equity and debt and other forms of credit or influence management's
instruments actions that affect the use
of the entity's economic
resources

Accounting Principles Overview
Accounting Principles Accounting Standards
• Fundamental rules and concepts that apply • Specify how transactions and other events
to accounting in general. These principles are to be recognized, measured, presented
provide the framework on which more and disclosed in financial statements.
detailed accounting standards are based.
• When accounting principles become

generally accepted by businesses and
relevant authorities, they are referred to as
generally accepted accounting principles
or GAAP.

Why Accounting Principles Are Important
Accounting principles are important as they establish the framework for how transactions are recorded
and reported on financial statements.
A sound framework produces financial information that can be relied upon by a variety of interested
parties.
Ensures reliability and relevance Maintains consistency in financial

of financial statements reporting from company to
company across all industries
Sound
Framewor
k
Reduces the risk of erroneous Allows for uniform comparisons

financial reporting by having a between companies
defined framework in place

Fundamental Accounting Principles
Accounting principles establish a framework that guides accountants in recording and reporting financial
information.
Some of the most fundamental accounting principles are as follows:
Accrual Basis Revenue Historical Matching Materiality Conservatism

of Accounting Recognition Cost
Economic Going Monetary Full Consistency Objectivity

Entity Concern Unit Disclosure

Accrual Basis of Accounting Principle
Accrual Basis of Accounting Cash Basis of Accounting
• States that the financial aspects • States that revenues and

of economic events are
recorded in the accounting VS. expenses are recognized only
when cash or its equivalent are Accrual Basis of
period in which they occur exchanged. Accounting
regardless of whether cash
has been exchanged.
• Accrual accounting is a
requirement under Generally
Accepted Accounting
Standards in most cases.

Accrual Basis of Accounting Principle
Example:
The customer receives and

A utility company provides
then pays the bill at the
services to a customer.
end of the billing cycle.
Accrual Basis of
Accounting
The company accrues As cash has not yet been
(records) revenue related received, the company will
to the utility services as record a receivable from
soon as they are provided. the customer.

Revenue Recognition Principle
Consistent with accrual accounting, the revenue recognition principle

states that revenue is earned and recognized upon product delivery or
service completion without regard to the timing of cash flow.
Example:
The company accrues

The customer receives
A utility company (records) revenue
and then pays the bill
provides services to a related to the utility Revenue
at the end of the
customer. services as soon as Recognition
billing cycle.
they are provided. Principle
Revenue Recognized Cash Received
Services Rendered Payment

Revenue Recognition Principle
Another example:
A customer subscribes to 3 The service provider will

months worth of music recognize revenues over the 3-
streaming services and pays month period even though all
for it entirely upfront. the cash has been received.
Revenue
Recognition
Cash Received Principle
Payment
Revenue Recognized
Services Rendered Services Rendered Services Rendered

Historical Cost Principle
Assets and liabilities are recoded at the cost at which they were
acquired or assumed, where cost refers to the original amount expended
to acquire or assume the item.
Assets and liabilities remain on the financial statements at historical cost
without being adjusted for changes in market value.
Example:
Historical Cost
Land acquired 10 years ago for $1 million has a market value of $3 million. Despite
Principle
the value increase, land on the balance sheet remains at $1 million.
10 Years Ago Today

Historical Cost Market Value
Land Value $1 Million $3 Million
Financial Statements $1 Million

Matching Principle
The costs of doing business should be recorded in the same period as

the economic benefits they generate, irrespective as when they are
actually paid.
Example:
Depreciation expense is an example of the use of the matching principle. The cost of
a fixed asset is allocated over its useful life as it generates economic benefits over
that time. Matching
Principle
Equipment Cost
Payment
Depreciation Expense Depreciation Expense Depreciation Expense
Equipment Useful Life

Materiality Principle
Financial information is material to the financial statements if it

would change the opinion or view of a reasonable person.
All material financial The concept of Professional Materiality

information should be materiality is judgement is Principle
included in the relative in size and sometimes required
financial statements. importance; what to decide whether an
could be material to amount is material or
one company may not not.
be for another.

Materiality Principle
Example:
Two companies suffer extraordinary losses of $1 million during a hurricane.
Company A Company B
Materiality
Principle
Net Income $10 million $200 million
Loss $1 million $1 million
= 10% of net income = 0.5% of net income
Loss is material Loss is immaterial

Conservatism Principle
The principle of conservatism provides guidance on how to record

transactions particularly those involving uncertainty or estimates.
If a situation arises where there are two acceptable alternatives for
reporting an item, the alternative that will result in smaller net income
and/or asset balances should be used.
Conservatism
Principle
Alternative A Alternative B

Conservatism Principle
Example:
Potential losses from lawsuits are reported on the financial statements or in the
notes while potential gains from lawsuits are not reported.
The outcome of lawsuits is uncertain:
Potential Gains Potential Losses

Conservatism
May not be realized and Disclosing a potential loss
Principle
recording them in the provides information on
financial statements could the magnitude of a
be misleading to its users. potential future liability.
Do not record in financial Record in financial

statements statements

Economic Entity Principle
This principle is important in that it allows financial statement users to

assess the value and performance of a business separately from its
ownership activity.
Economic Entity
Transactions carried out by Transactions carried out by
Principle
a business are separated different businesses must
from its owner. be accounted for separately.

Economic Entity Principle
Example 1:
The asset cannot be

A business owner
recorded on the
purchases an asset
financial statements
with funds from his
according unless it is
personal bank
sold or contributed to
account.
the company.
Economic Entity
Example 2: Principle
An owner of two
Maintaining separate
unrelated subsidiaries
The expenses of one records will allow the
(a hotel chain and a
business cannot be performance and
restaurant chain) will
combined with the value of each business
need to maintain
other. to be assessed
separate accounting
separately.
records for each.

Going Concern Principle
Financial statements are prepared assuming that the organization will

continue to operate its business for the foreseeable future.
Every decision in a company is taken with the objective of operating the
business rather than liquidating it.
Going concern is a fundamental principle as without this assumption, it is
impossible to record items such as:
Going Concern
Principle
Accrued Expenses Prepayments Depreciation of

Long-life Assets

Going Concern Principle
Example:
COVID-19 has adversely Many retailers in CBL’s

impacted retailers, from properties had skipped
coping with furloughs, rental payments
supply chain challenges, causing CBL to be
shut down of retail stores unable to pay an $11.8
and dealing with social million interest
distancing requirements. payment.
Going Concern
Principle
In June 2020, mall owner As a result, CBL violated

CBL & Associates warned covenants in its senior
that its ability to continue secured credit facility.
as a going concern was in
doubt.

Monetary Unit Principle
Under the monetary unit principle, only business transactions that are
quantifiable and can be expressed in terms of a monetary unit are
recorded in the financial statements.
Furthermore, the monetary unit must be stable, reliable, relevant, and
useful to all companies.
Monetary Unit
Example:
Principle
Certain economic events are not easily quantified and, therefore, do not appear in
the company's accounting records.
The immediate value a new executive would bring to a company

cannot be expressed in monetary units and is not recorded in
the accounting records.

Full Disclosure Principle
Any information that would be considered material to a user of the

financial statements should be disclosed in the statements or the
footnotes thereto.
Full disclosure is important to

ensure material facts are known by
financial statements users. Full Disclosure
Principle
This allows them to understand

and make judgements of the
financial activities of a company.

Full Disclosure Principle
Generally, public companies are required to disclose only information that

can have a material impact on the financial results of the company.
Example:
Accounting policies and details of pending litigation are among the items disclosed in
Amazon’s notes to the financial statements.
Full Disclosure
Principle

Consistency Principle
Consistent information is prepared using the same accounting

methods for similar events and transactions over time.
Consistency allows for meaningful comparisons:
Consistency
1. Between different accounting 2. Between the financial statements Principle
periods of different companies that use
the same accounting policies
Consistency does not preclude changes in accounting policies; they are

permitted but must be justified and disclosed in the financial statements.

Consistency Principle
Example:
A company uses the LIFO (Last-in, First-out) method of inventory

valuation and has determined that the FIFO (First-in, First-out)
method is more appropriate.
Consistency
The following year, management determines that the change from
Principle
LIFO to FIFO will negatively impact net income and wants to make
the change back to LIFO.
Another change would violate the consistency principle as there is

no justifiable reason to do so.

Objectivity Principle
Under the objectivity principle, accounting records and financial

statements should be independent and free from bias (i.e. verifiable).
Financial information that is prepared objectively is more relevant and
reliable and thus more useful for users.
Example:
Objectivity
An accountant He uses amounts This violates the Principle
preparing a displayed in the consistency principle
company’s financial accounting system as information in the
statements needs to rather than the financial statements
verify accounts supporting must be
receivables. documentation. independent and
verifiable.

Usefulness of Financial Information

Session Objectives
Identify and understand the Identify and understand the

fundamental traits that characteristics that enhance the
characterize useful financial usefulness of financial
information information

Importance of Useful Financial Information
Useful financial information allows users to make informed decisions.
Fundamental Characteristics Enhancing Characteristics
For financial information to be useful, The usefulness of financial information

it must be: is enhanced if it is:
• Relevant • Comparable
• Faithfully represent what it purports • Verifiable

to
• Timely
• Understandable

Fundamental Characteristics
Relevant financial information is capable of making a difference in the decisions made by users.
Financial information can make a difference in decisions if it has predictive value and/or confirmatory
value.
Predictive Value Confirmatory Value
Information that can be used Information that provides

as an input to predict future feedback about (confirms or
outcomes. changes) previous
evaluations.

Fundamental Characteristics
Financial information is relevant if it

• Includes all things
faithfully represents the substance necessary (descriptions
of an economic event. Complete and explanations) for a
user to understand the
event being depicted
To be a faithful
representation, • Without bias in its
Neutral
financial information selection or presentation
needs to be:
• No errors or omissions in
Free From the information and the
Errors processes used to
produce it

Enhancing Characteristics
The usefulness of financial information is enhanced if it is comparable, verifiable, timely and

understandable.
1. Comparability 2. Verifiability 3. Timeliness 4. Understandability

Information that can be Different knowledgeable Having information Classifying, characterizing
compared with similar and independent available to decision- and presenting
information about other observers could reach makers in time to be information clearly and
entities and with similar similar conclusions from capable of influencing concisely makes it
information about the the same information. their decisions. understandable.
same entity for another
period.

Detailed Accounting Standards

Introduction to Accounting Standards
The objective of accounting standards is to bring uniformity and comparability to the financial
statements, which then allows them to be relied upon by investors, lenders, creditors and others.
There are two key accounting standards setting bodies in the world:
International Financial
Accounting Accounting
Standards Board Standards Board
(IASB) (FASB)
International Financial Generally Accepted Accounting

Reporting Standards (IFRS) Principles (US GAAP)

Key Accounting Standards
Accounting standards are the rules and guidelines issued by the accounting institutions that specify how
transactions and other events are to be recognized, measured, presented and disclosed in financial
statements.
Some of the key standards that are relevant to financial analysts include:
1. Leases 2. Income Taxes 3. Share-based 4. Business 5. Financing Fees &

Payments Combinations Transaction Costs
The following materials will address these topics from an IFRS perspective and will note where there are
differences with US GAAP.

Accounting For Leases

Session Objectives
Identify the criteria needed for a Understand the differences in the Calculate the initial lease liability
contract to be considered a lease accounting treatment of finance and right-of-use asset balances at
and operating leases lease commencement
Calculate amortization and

interest expenses following
commencement of the lease

Right to Control
A lease is a contract that conveys the right to control

the use of an identified asset for a period of time in
exchange for consideration.
Right to Control
Right to obtain substantially Right to direct the

all (≥ 90%) of the economic use of the asset
benefits

Accounting Treatment of Leases
IFRS US GAAP
All leases are classified as finance Leases are classified based on
VS.
leases. whether the arrangement is
effectively a purchase of the asset:
• There are exemptions for short-
term leases (< 1 year) and low- • Finance lease (control of the
value leases (< $5K approximate underlying asset is transferred to the
asset value or less). lessee)
• Operating lease (control of the

underlying asset is not transferred to
the lessee)

Financial Statement Impact
Both finance and operating leases require balance sheet recognition. The type of lease will impact how the
lease expense is recognized on the income statement.
Finance Lease Operating Lease
01. Right-of-Use Asset 01. Right-of-Use Asset

Balance Sheet
02. Lease Liability 02. Lease Liability
Income Statement 01. Interest Expense 01. Lease Expense

02. Amortization Expense
01. Principle Payments 01. Lease Payments

Cash Flow Statement
02. Interest Payments
• Lease components: included in the lease liability (e.g. basic rent)
• Non-lease components: expensed as incurred (e.g. property taxes, operating expenses on the property)

Initial Recognition of Balance Sheet Amounts
A right-of-use asset and lease liability must be recognized on the balance sheet for all leases at lease
commencement.
Lease Liability Right-of-Use Asset
= Present value of the remaining = The amount of the lease liability

lease payments, discounted at at lease commencement
either:
+ Lease payments made before the
• The rate implicit in the lease; or commencement date, less any
lease incentives received
• The lessee’s incremental
borrowing rate (IBR) + Initial direct costs incurred
*IBR = The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to
obtain an asset of a similar value to the right-of-use asset in a similar economic environment.
Initial Recognition of Balance Sheet Amounts
Example:
Company ABC enters into a 5-year lease with payments of $20,000 at the end of each year for a total of $100,000. The
rate implicit in the lease is 6%. There are no initial direct costs. What are the initial right-of-use asset and lease liability
balances?
Lease Liability Right-of-Use Asset

= PV of Lease Payments = Lease Liability
= PV of a 5-year annuity with = $84,247

payments of $20,000
= $84,247

Subsequent Recognition and Measurement
Over the lease term, the right-of-use asset must be amortized and interest expense on the lease
liability must be recorded. The income statement recognition and classification is based on how the
lease is classified.
Lease Expense
Interest Expense Amortization Expense Interest Expense Amortization Expense
Based on the outstanding Straight-line over the Based on the outstanding Difference between the
lease liability balance shorter of the lease term or lease liability balance average annual lease
the asset useful life payment and interest
expense


Interest Expense Amortization Expense Total Expenses Interest Expense Amortization Expense Lease Expense
$25,000 $25,000
$20,000 $20,000
$15,000 $15,000
$10,000 $10,000
$5,000 $5,000
$0 $0
Year 1 Year 2 Year 3 Year 4 Year 5 Year 1 Year 2 Year 3 Year 4 Year 5
• Total expenses are usually higher in earlier periods and • The total lease expense equals to the annual lease
decrease over time. payment and is constant over the lease term if the lease
payments are the same every year.
• Amortization expense remains constant during the
lease term (straight-line depreciation).
• Interest expense decreases over time as the lease

liability is reduced each year.

Example:
Continuing from the prior example, the right-of-use asset and lease liability amounts were originally both $84,247. How
much interest and amortization expense are recognized in year 1?
Lease Expense = $20,000

Interest Expense Amortization Expense
Interest Expense Amortization Expense
= $84,247 x 6% = $84,247 / 5 years = $84,247 x 6% = $20,000 - $5,055
= $5,055 = $16,849 = $5,055 = $14,945

Accounting For Income Taxes

Session Objectives
Understand the difference Understand the difference Identify the circumstances in

between accounting and taxable between carrying value and tax which taxable or deductible
income and perform a base of assets and liabilities and temporary differences arise
reconciliation between the two quantify each
Calculate temporary differences

and related deferred tax amounts
on the balance sheet

Accounting Treatment of Income Taxes
Under both IFRS and US GAAP, income tax expense includes both current and deferred components.
Income Tax Expense Current Tax Expense Deferred Tax Expense
The total amount The amount of tax due to The amount of tax due to
included on the income the tax authorities in the the tax authorities in
statement for the period current period future periods

Accounting Income Versus Taxable Income
A key element in determining income tax expense is understanding the difference between accounting
income and taxable income.
Accounting Income Taxable Income
• The profit or loss for a period before

deducting tax expense VS. • The profit or loss for a period
determined in accordance with rules
established by taxation authorities
• Income before tax on the income
statement for the period • Taxable Income on tax returns

Reconciling Accounting Income and Taxable Income
Income taxes are based on taxable income and not accounting income. Under IFRS, disclosure of a
reconciliation between tax expense and accounting income is required.
Accounting Income
+ Expenses not deductible under tax laws but recognized for accounting purposes
+ Income included under tax laws but not recognized for accounting purposes
– Expenses deductible under tax laws but not recognized for accounting purposes
– Income not included under tax laws but recognized for accounting purposes
= Taxable Income

Reconciling Accounting Income and Taxable Income
Example:
Company XYZ incurred the following during 2020:
Accounting Income $50,000
• Accounting income: $50,000
Fines and penalties paid: $500

•
+ Fines and Penalties Paid $500
Non-taxable income: $2,500
•
+ Depreciation Expense $1,000
Depreciation expense: $1,000
•
+ 2020 Bonus Provision $1,250
• Tax Depreciation: $1,500
– Tax Depreciation $1,500
Provision for the 2020 bonus: $1,250
•
– 2019 Bonus Paid in 2020 $1,100
• 2019 bonus paid in 2020: $1,100
– Non-taxable Income $2,500
Fines and penalties are not deductible for tax purposes.
Non-taxable income is not recognized for tax purposes.

= Taxable Income $47,650
Bonus are tax deductible only in the year they are paid.

Carrying Amount Versus Tax Base
Example:
An asset has an original cost of $1,000.
Carrying Amount
• Accumulated depreciation for accounting purposes: $500
• Tax depreciation to-date: $800
The net book value of an asset or
liability recorded on a company’s
Carrying Amount:
balance sheet for accounting purposes
Cost $1,000
Accumulated Depreciation ($500)
Net Book Value $500
Tax Base
Tax Base:
The amount attributed to an asset or Cost $1,000

liability for tax purposes Tax Depreciation To-Date ($800)
Tax Base $200

Temporary Differences
Temporary differences are the differences between the carrying amount of assets and liabilities for
accounting purposes and their respective tax bases.
They can also be thought of the differences between accounting income and taxable income that
eventually reverse (are eliminated).
Temporary Carrying Tax

Difference Amount Base
Permanent differences are differences between the tax and

financial reporting of revenue or expense items which will not be
reversed in the future.

General Rules Around Temporary Differences
Deductible Temporary Differences Taxable Temporary Differences
Differences that result in amounts that are Differences that result in amounts that are
deductible in determining taxable income of taxable in determining taxable income of future
future periods periods
Give rise to: Deferred Tax Assets Deferred Tax Liabilities
Generally arise when:
1. Differences result in: Taxable Income > Accounting Income Taxable Income < Accounting Income
2. Assets: Tax Base > Carrying Amount Tax Base < Carrying Amount
3. Liabilities: Carrying Amount > Tax Base Carrying Amount < Tax Base

Common Examples of Temporary Differences
Installment Sales
Capitalized
Tax Depreciation
Development Costs
> Accounting
Amortized Over
Depreciation
Accrued Unearned Time
Expenses Revenue
Taxable
Temporary
Tax Differences
Depreciation <
Tax Losses
Accounting
Depreciation Deductible
Temporary
Differences

Deferred Tax Assets and Liabilities
Deferred tax assets are the amounts of income tax recoverable in future periods.
Deferred Tax Asset Deductible Temporary Difference Tax Rate
Deferred Tax Asset Unused Tax Loss or Credit Tax Rate
Deferred tax liabilities are the amounts of income tax payable in future periods.
Deferred Tax Liability Taxable Temporary Difference Tax Rate

Temporary Differences and Deferred Taxes
Example:
Carrying Amount:
An asset has an original cost of $10,000.
Cost $10,000
• Depreciation for accounting purposes: Accounting Depreciation ($1,000)
Straight-line over 10 years Net Book Value $9,000
• Tax depreciation: $2,000 per year
• Tax rate: 30%

Tax Base:
Cost $10,000
Tax Depreciation ($2,000)
Tax Base $8,000
Taxable Temporary Difference = $9,000 – $8,000 = $1,000

Deferred Tax Liability = $1,000 x 30% = $300

Accounting For Share-based Payments

Session Objectives
Gain an understanding of the key Calculate share-based payment Calculate share-based payment
elements of share-based expenses under scenarios with expenses under scenarios with
payments service conditions only both service and performance
conditions

Introduction to Share-based Payments
Share-based payment (SBP) transactions occur when an entity receives good or services from a third-
party and grants equity instruments or cash amounts based on the value of such equity instruments as
consideration.
Share-based payment awards are common features of employee compensation for directors, senior
executives and other employees.
Key elements of share-based payments:
1. SBP 2. Grant Date 3. Vesting 4. Vesting 5. Fair Value at

Classification Conditions Period Grant Date

Share-based Payment Classification
The accounting treatment for share-based payment transactions differs depending on the classification.
Equity-settled Payments Cash-settled Payments
• Occur when transactions are settled • Occur when transactions are settled in
using an entity’s own equity instruments cash, the amount of which is based on
the value of an equity instruments
• Typical example: stock options
• Typical example: share appreciation
rights

Determination of Grant Date
Grant date is the date an entity grants the right to receive equity instruments to its employee.
The grant date occurs when all of the following have occurred:
Agreement Rights Conferred Approval
When the terms and The right to cash or The share-based

conditions are agreed equity instruments of the payment agreement has
upon and understood by entity has been received the necessary
both the entity and its conferred on the and appropriate
employee. employee. approvals.

Vesting Conditions and Vesting Period
Vesting conditions are conditions that

determine whether the entity receives Vesting Conditions
the services that entitle the employee to
receive the share-based payment.
Vesting period is the period whereby all Service Conditions Performance Conditions
the specified vesting conditions must be
satisfied.
Market Non-market
Share-based expense is recognized over Conditions Conditions
the vesting period, or if there is no
vesting period, immediately.

Determining Fair Value
The fair value of equity instruments granted to employees in share-based payment transactions is
measured at the grant date (or measurement date).
The fair value of equity instruments is not adjusted subsequent to the grant date in respect of changes
in market conditions.
1. Market Prices 2. Valuation Techniques

If market prices are available for the actual equity If market prices are not available, then fair value is
instruments granted, then the estimate of fair value estimated using a valuation technique (e.g. Black-
is based on these market prices. Scholes, binomial pricing models).

Example #1 (service condition only):

Company XYZ grants 100 share options to each of its 500 employees, which can be exercised at anytime over 3 years
subject to a 2-year service condition.
• The fair value of each option is determined to be $20 at the grant date.
• An estimated 75% of the 500 employees will complete the service condition required for receiving the options.
Employee benefit expense recognition:

Grant Date Year 1 Year 2 Year 3 Year 4 Year 5
Total employee benefit expense:
$0 + $375,000 + $375,000 = $750,000

= 100 options x 500 = 100 x 500 x 75% x
employees x 75% x $20 x 2/2 years –
$20 x 1/2 years $375,000 recognized
in Year 1
Example #2 (service and market performance conditions):

Company XYZ grants 100 share options to each of its 500 employees, exercisable over 3 years and subject to:
i) A 3-year service condition;
ii) Company XYZ’s stock price must be at least 25% higher after the 3-year period compared to at the grant date.
• 90% of employees are estimated to meet the service condition.
• The fair value of each option is determined to be $20 at the grant date.
$0 $300,000
= 100 options x 500 employees
x 90% x $20 x 1/3 years

Example #2 continued (service and market performance conditions):

At the end of Year 2, the price of Company XYZ’s stock has fallen and is 5% lower than at the grant date.
• Fewer employees left the company than expected and the revised estimate of employees that will meet the service
condition is 95%.
• The fair value of the options has fallen to $15.
(The decrease in fair value of the options does not impact the expense calculation.)
$333,333
= 100 x 500 x 95% x $20 x 2/3 years
– $300,000 recognized in Year 1

Example #2 continued (service and market performance conditions):

At the end of Year 3, the price of Company XYZ’s stock has risen and is 25% higher than at the grant date. The fair value
of the options has risen to $30. Also, 480 employees have met the service condition.
$326,667
= 100 x 480 x $20 x 3/3 years –
($300,000 + $333,333) expenses
recognized in Year 1 & 2
Total employee benefit expense = $300,000 + $333,333 + $326,667 = $960,000

Accounting For Business Combinations

Session Objectives
Identify the key criteria required Apply the general framework Understand each of the steps in
for a set to be considered a used to identify business applying the acquisition method
business combinations of accounting for business
combinations
Calculate goodwill arising from a

business combination

Introduction to Business Combinations
A business combination is a transaction or other event in which an acquirer obtains control of one or
more businesses.
Business Combination
Acquirer Acquiree
Control

Key Elements of Business Combinations
An integrated set of activities and assets that is capable of being

Business conducted and managed for the purpose of providing goods or
services to customers, generating investment income or other
income from ordinary activities
Acquisition
The date on which the acquirer obtains control of the acquiree
Date
Acquirer The entity that obtains control of the acquiree
The business or businesses that the acquirer obtains control of in a

Acquiree

General Framework For Identifying Business Combinations
Distinguishing between a business combination and an asset acquisition is important because there are
many differences between the accounting treatment for each.
Test For Inputs and

Substantive Process
(Absence of Outputs)
Test for Fair Value

Test for Outputs
Concentration
Test For Inputs and

Substantive Process
(Presence of Outputs)

Fair Value Concentration
The fair value concentration test is designed to quickly identify whether a transaction is more akin to an
asset acquisition or a business combination.
Is > 90% of the value

acquired in a single asset Ye
or group of similar assets? s Asset Acquisition
Test For Inputs and

Test for Fair Value Substantive Process
Concentration (Absence of Outputs)
Test for Outputs

No
Test For Inputs and
Substantive Process
(Presence of Outputs)

Outputs, Inputs, and Substantive Processes
Any economic resources that creates or has the ability to contribute

Inputs to the creation of outputs when one or more processes are applied
to it
Any systems, standards, protocols, conventions, or rules that

Processes when applied to inputs, creates, or has the ability to significantly
contribute to the creation of outputs
Outputs The result of inputs and processes applied to those inputs

A business needs to have an input and a substantive process that together are critical to the ability
to create outputs. There are different considerations depending on whether the set has outputs or not.
Ye
Test For Inputs and s Business Combination
Test for Outputs Substantive Process
(Absence of Outputs) Asset Acquisition

No
Test:
In the absence of outputs, an input and a substantive process are deemed to be present if:
I) There is a process critical to producing outputs, and
II) Inputs that include employees that form an organized workforce and other inputs that the workforce could
develop or convert into output.

A business needs to have an input and a substantive process that together are critical to the ability
to create outputs. There are different considerations depending on whether the set has outputs or not.
Ye
Test For Inputs and s Business Combination
Test for Outputs Substantive Process
(Presence of Outputs) Asset Acquisition

No
Test:
In the presence of outputs, an input and a substantive process are deemed to be present if there is:
I) An organized workforce with skills, knowledge or experience critical to producing outputs; or
II) An acquired contract that provides access to an organized workforce; or
III) A process(es) that cannot be replaced without significant cost, effort or delay; or
IV) A process(es) that is considered unique or scarce.

Accounting Treatment For Business Combinations
The acquisition method is used to account for business combinations

and involves four steps:
01. 02. 03. 04.

Identify the Determine the Recognize and Recognize and
Acquirer Acquisition Measure the Measure
Date Assets Goodwill
Acquired, and
the Liabilities
Assumed

Identifying the Acquirer
In a business combination, an acquirer must be identified for accounting purposes.
Acquirer Acquiree
Control
Other factors to consider include:
1. Transfer of cash / 2. Relative voting 3. Existence of a 4. Board 5. Senior

assets, exchange rights in the large minority composition of management
of equity combined entity voting interest in the combined of the
interests or the the absence of entity combined
assumption of other significant entity
liabilities voting interests

The Acquisition Date
The acquisition date is the date on which the acquirer obtains control of the acquiree.
All forms of consideration The assets acquired,

The acquirer begins
are measured at fair value, liabilities assumed, and any
consolidating the acquiree, if
and the acquirer’s equity non-controlling interests are
required.
securities are issued to the identified and measured at
seller. fair value.

Recognizing and Measuring Assets Acquired and the Liabilities Assumed
On the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets
acquired, the liabilities assumed, and any noncontrolling interest in the acquiree.
Recognition Principles Measurement Principles

Identifiable assets acquired and An acquirer is required to measure the
liabilities assumed must: identifiable assets acquired, the
liabilities assumed, and any non-
1. Meet the definition of assets and
controlling interest in the acquiree at
liabilities
their acquisition-date fair values.
2. Be part of what the acquirer and
acquiree exchanged in the

Recognizing and Measuring Goodwill
Goodwill represents the future economic benefits arising from other assets acquired in a business
combination that are not individually identified and separately recognized.
Consideration Fair Value of Net

Goodwill
Transferred Assets Acquired
The difference between Measured at fair value and includes:

consideration transferred by the
1. Assets transferred by the acquirer
acquirer to the acquiree and the
fair value of the net assets acquired 2. Liabilities incurred by the acquirer
to the former owners of the
acquiree; and
3. Equity interests issued by the

acquirer
Accounting For Financing Fees and
Transaction Costs

Session Objectives
Understand examples of and the Understand examples of and the Understand examples of and the
accounting for debt issuance accounting for share issue costs accounting for transaction costs
costs

Introduction to Financing Fees and Transaction Costs
Financing fees and transaction costs are incurred when companies undertake certain transactions such
as securing external financing or business combinations.
Financing Fees
Debt Issuance Costs Share Issue Costs Transaction Costs
The accounting treatment differs depending on the nature of the cost.

Debt Issuance Costs
Debt issuance costs are the costs incurred by a company when they raise new debt.
These costs are recognized initially on the balance sheet as a contra account under liabilities, and then
amortized over the term of the related debt liability.
Debt Issuance Costs
Registration Fees Underwriting Fees Legal and Other Directly

Accounting Fees Attributable Costs

Share Issue Costs
Share issue costs are the costs incurred by a company when they issue shares to the public.
These costs directly reduce the proceeds a company receives from an equity offering.
Share Issue Costs
Registration Fees Underwriting Fees Legal and Marketing and

Accounting Fees Administrative
Costs

Transaction Costs
Transaction costs are incurred by both acquirers and targets during the course of an M&A transaction.
Transaction costs represent services that have been rendered to and consumed by the acquirer and are
expensed as they are incurred.
Transaction Costs
Financial Advisory Legal Fees Accounting Fees Related

Administrative
Costs

Accounting Principles and Standards: For Financial Analysts

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Accounting Principles and Standards: For Financial Analysts

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Accounting Principles and Standards

For Financial Analysts

Corporate Finance Institute®

Corporate Finance Institute®

Corporate Finance Institute®

Corporate Finance Institute®

Corporate Finance Institute®

Decisions users of financial

Buying, selling, or holding Providing or settling loans Exercising rights to vote on

Corporate Finance Institute®

Accounting Principles Accounting Standards

• When accounting principles become

Corporate Finance Institute®

Ensures reliability and relevance Maintains consistency in financial

Reduces the risk of erroneous Allows for uniform comparisons

Corporate Finance Institute®

Accrual Basis Revenue Historical Matching Materiality Conservatism

Economic Going Monetary Full Consistency Objectivity

Corporate Finance Institute®

Accrual Basis of Accounting Cash Basis of Accounting

• States that the financial aspects • States that revenues and

Corporate Finance Institute®

The customer receives and

Corporate Finance Institute®

Consistent with accrual accounting, the revenue recognition principle

The company accrues

Revenue Recognized Cash Received

Services Rendered Payment

Corporate Finance Institute®

A customer subscribes to 3 The service provider will

Services Rendered Services Rendered Services Rendered

Corporate Finance Institute®

10 Years Ago Today

Land Value $1 Million $3 Million

Financial Statements $1 Million

Corporate Finance Institute®

The costs of doing business should be recorded in the same period as

Depreciation Expense Depreciation Expense Depreciation Expense

Equipment Useful Life

Financial information is material to the financial statements if it

All material financial The concept of Professional Materiality

Corporate Finance Institute®

Net Income $10 million $200 million

Loss $1 million $1 million

= 10% of net income = 0.5% of net income

Loss is material Loss is immaterial

Corporate Finance Institute®

The principle of conservatism provides guidance on how to record

Corporate Finance Institute®

The outcome of lawsuits is uncertain:

Potential Gains Potential Losses

Do not record in financial Record in financial

Corporate Finance Institute®

This principle is important in that it allows financial statement users to

Corporate Finance Institute®

The asset cannot be

Corporate Finance Institute®

Financial statements are prepared assuming that the organization will

Accrued Expenses Prepayments Depreciation of

Corporate Finance Institute®

COVID-19 has adversely Many retailers in CBL’s

In June 2020, mall owner As a result, CBL violated

Corporate Finance Institute®