GAAP Companion Guide T09

GAPT09
SELFSTUDY CONTINUING PROFESSIONAL EDUCATION
Companion to PPC's Guide to
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GAPT09
Interactive Selfstudy CPE
Companion to PPC's Guide to GAAP

TABLE OF CONTENTS
Page
COURSE 1: SELECTED GAAP TOPICS

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Lesson 1: GAAP Chapters 32 and 33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Lesson 2: GAAP Chapters 35, 26 and 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
Lesson 1: GAAP Chapters 15 and 22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Lesson 2: GAAP Chapters 25, 42, and 44 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
Lesson 1: GAAP Chapters 1, 2, and 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
Lesson 2: GAAP Chapters 7 and 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Lesson 3: GAAP Chapters 16, 24, and 37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
To enhance your learning experience, the examination questions are located throughout
the course reading materials. Please look for the exam questions following each lesson.
EXAMINATION INSTRUCTIONS, ANSWER SHEETS, AND EVALUATIONS
Course 1: Testing Instructions for Examination for CPE Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381

Course 1: Examination for CPE Credit Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
Course 1: Selfstudy Course Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384
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GAPT09
INTRODUCTION
Companion to PPC's Guide to GAAP consists of three interactive selfstudy CPE courses. These are companion
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Taking the Courses
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Examination for CPE Credit Answer Sheet or by logging on to our Online Grading System.
Qualifying Credit Hours QAS or Registry
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GAPT09
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GAPT09
vi
GAPT09 Companion to PPC's Guide to GAAP
COMPANION TO PPC'S GUIDE TO GAAP
COURSE 1
SELECTED GAAP TOPICS (GAPTG091)
OVERVIEW
COURSE DESCRIPTION: This interactive selfstudy course covers GAAP related to investments, leases,
nonmonetary transactions, intangibles, the equity method, and joint ventures.
PUBLICATION/REVISION November 2009
DATE:
RECOMMENDED FOR: Users of PPC's Guide to GAAP
PREREQUISITE/ADVANCE Basic knowledge of accounting.
PREPARATION:
CPE CREDIT: 5 QAS Hours, 5 Registry Hours
Check with the state board of accountancy in the state in which you are licensed to
determine if they participate in the QAS program and allow QAS CPE credit hours.
This course is based on one CPE credit for each 50 minutes of study time in
accordance with standards issued by NASBA. Note that some states require
100minute contact hours for self study. You may also visit the NASBA website at
www.nasba.org for a listing of states that accept QAS hours.
Note:This course material is similar to course material found in the Companion to

PPC's Guide to Nonprofit GAAP. Please consider this when determining your
reporting requirements in the same CPE reporting period.
FIELD OF STUDY: Accounting
EXPIRATION DATE: Postmark by November 30, 2010
KNOWLEDGE LEVEL: Basic
Learning Objectives:
Lesson 1 GAAP Chapters 32 and 33
Completion of this lesson will enable you to:

Identify accounting and disclosure requirements for investments in life insurance and investment in life
settlements contracts.
Determine when a lease should be classified as a capital lease.
Describe how various types of leases are accounted for by the lessee and the lessor.
Identify common types of changes to leases and how they are accounted for.
List the exceptions that apply to leases involving real estate.
Determine how to account for subleases and similar transactions.
Identify when a saleleaseback transaction is appropriate.
Lesson 2 GAAP Chapters 35, 26, and 31

Account for nonmonetary transactions.
Describe accounting for intangible assets, both goodwill and other.
Define the equity method and joint venture methods of investments.
1
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Lesson 1:GAAP Chapters 32 and 33

INVESTMENTS OTHER
INTRODUCTION
This lesson provides guidance on accounting for cost method investments and investments in insurance contracts.
Ordinarily, an investment in equity securities is accounted for using the cost method when the investor lacks the
ability to significantly influence the operating and financial policies of the investee and the fair value of the equity
securities is not readily determinable. Cost method investments are originally recorded at cost with dividends
recorded as income in the period received. If a cost method investment is otherthantemporarily impaired, its
carrying amount is reduced to fair value through a charge to current period income.
The authoritative literature on accounting for investments in life insurance and investments in life settlement
contracts offers the following guidance:
a. Premium payments on insurance policies that do not transfer risk to the insurer should be treated as
deposits.
b. The cash surrender value of an investment in life insurance should be reported as an asset. Any change
in the cash surrender value during the period should be reported as an adjustment to premiums paid.
c. An entity may choose how it classifies business interruption insurance proceeds in its income statement
so long as the presentation is not contrary to existing GAAP.
d. Investments in life settlement contracts should be accounted for using either the investment or fair value
methods.

Identify accounting and disclosure requirements for investments in life insurance and investment in life
settlements contracts.
Determine when a lease should be classified as a capital lease.
Describe how various types of leases are accounted for by the lessee and the lessor.
Identify common types of changes to leases and how they are accounted for.
List the exceptions that apply to leases involving real estate.
Determine how to account for subleases and similar transactions.
Identify when a saleleaseback transaction is appropriate.
ACCOUNTING REQUIREMENTS
GENERAL RULE
In some instances, the substance of an insurance or reinsurance contract is such that the risk of loss is not
transferred to the insurer or reinsurer. In those cases, the insured or ceding enterprise should account for the
premiums paid, less the portion of the premiums that will be kept by the insurer or reinsurer, as a deposit.
Consequently, that amount should be reported as an asset rather than as insurance expense. (SFAS 5, par. 44)
A business in a high risk industry who is unable to purchase insurance at reasonable rates may pool its risks with
other businesses by forming a mutual insurance enterprise. Each business pays premiums to the mutual insurance
enterprise and also has an equity interest in the enterprise. In such cases, risk of loss may or may not be transferred
to the insurance enterprise. Thus, whether premium payments should be treated as an expense or deposit
depends on the individual facts and circumstances involved. (SFAS 5, par. 45)
3
COST METHOD INVESTMENTS
Cost method investments include investments in equity securities that (a) do not have readily determinable fair
values and (b) do not qualify for consolidation or the equity method. The cost method is generally followed for most
investments in noncontrolled corporations, some corporate joint ventures, and occasionally unconsolidated for
eign subsidiaries. Ordinarily, the investment is originally recorded as an asset at cost. Dividends distributed from
accumulated earnings of the investee are recorded as income in the period received. Dividends in excess of
accumulated earnings are considered a return of investment and recorded as a reduction of the cost of the
investment. (FASB ASC 3252053; 32520251; 32520301; 32520351) (formerly, APB 18, paras. 56)
If a cost method investment is otherthantemporarily impaired, its carrying amount should be reduced to fair value
through a charge to current period income. However, the fair value of a cost method investment is not readily
determinable and the investor may not have developed a fair value estimate. In that case, the investor should
evaluate whether events or changes in circumstances have occurred that may have a significant adverse effect on
fair value, such as (a) a significant deterioration in the investee's financial or operating performance, (b) a significant
adverse change in the investee's regulatory, economic, or technological environment, (c) a significant adverse
change in the investee's industry or geographic market conditions, (d) a bona fide offer to purchase or sell that is
below cost, or (e) significant concerns about the investee's ability to continue as a going concern. If one or more of
those events has occurred, a fair value estimate should be developed and compared to the cost of the investment.
If an impairment exists but is considered only temporary, the cost method investment should be evaluated for
impairment each reporting period until it is either written down or no longer impaired. (FASB ASC 320103525
through 3529) (formerly, FSP FAS 1151 and FAS 1241, paras. 1012)
LIFE INSURANCE
Under certain life insurance policies, a portion of premium payments go to the insurer for its assumption of risk
while the other portion accumulates as cash value. The insured can receive the cash value of the policy by either (a)
borrowing money from the insurer and using the cash value as collateral or (b) surrendering the policy. The amount
that can be received, referred to as the policy's cash surrender value," is the policy's cash value reduced by policy
loans and surrender charges. (FTB 854, par. 5 and EITF 065, Exhibit 065B)
When a company buys a cash value policy for itself, the amount that it could receive by surrendering the policy at
the balance sheet date should be reported as an asset. Any change in the policy's cash surrender value during the
period should be reported as an adjustment of premiums paid. (FASB ASC 32530251; 32530351 and 352)
(formerly, FTB 854, par. 2) When determining the amount that could be realized under the insurance policy, any
additional amounts included in the contractual terms of the policy should be considered. (FASB ASC 32530353)
(formerly, EITF 065, par. 6) FASB ASC 3253035, Investments Other Investments in Insurance Contacts Sub
sequent Measurement (formerly EITF Issue No. 065, Accounting for Purchases of Life Insurance Determining
the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 854,") addresses various
issues relating to the realization of amounts on life insurance.
BUSINESS INTERRUPTION INSURANCE
Business interruption insurance provides coverage if an entity's business operations are suspended due to the loss
of use of property and equipment resulting from a covered loss. Such insurance coverage generally reimburses
certain costs and losses incurred during the period required to rebuild, repair, or replace the damaged property,
such as the following: (EITF 0113, par. 4)
Gross margin not earned because normal operations were suspended.
A portion of fixed charges and expenses relating to that lost gross margin.
Other expenses, such as the rent of temporary facilities and equipment, which are incurred to reduce the
loss from business interruption.
However, business interruption insurance does not cover things such as marketing costs related to the loss or use
of property. An entity may choose how to classify business interruption insurance proceeds in the income state
4
ment as long as that classification is not contrary to existing GAAP. For example, business insurance proceeds must
meet the requirements for an extraordinary item if they are to be classified as such in the income statement. (EITF
0113, par. 7)
INVESTMENTS IN LIFE SETTLEMENT CONTRACTS
An owner of a life insurance policy may enter into a contract with a thirdparty investor where the investor receives
the face value of the life insurance policy upon the death of the insured. For such contracts (referred to as life
settlement contracts) the investor does not have an insurable interest and provides consideration to the policy
owner of an amount in excess of the cash surrender value of the insurance policy. (FASB ASC 3253020) (formerly,
FSP FTB 8541, par. 2)
The investor may make an irrevocable election to account for its investments in life settlement contracts, on an
instrumentbyinstrument basis, using either the investment method or fair value method. Under the investment
method, the initial investment, plus all initial direct external and subsequent continuing costs to keep the policy in
force are capitalized by the investor. Upon the death of the insured, a gain is recognized in earnings for the
difference between the life insurance proceeds and the carrying amount of the contract. The investment should be
tested for impairment if the investor becomes aware of information that indicates the expected proceeds will be
insufficient to recover the carrying amount plus anticipated undiscounted future premiums and capitalizable direct
external costs. If an impairment loss is recognized, the investment should be written down to fair value. (FASB ASC
32530252; 32530301C; 32530358 through 3511; 32530401A) (formerly, FSP FTB 8541, paras. 57)
Under the fair value method, an investor records the initial investment at the transaction price and remeasures the
investment at fair value at each subsequent reporting period. Changes in fair value are reported in earnings when
they occur. Premiums paid and proceeds received are reported in the same financial statement line item as the
changes in fair value. (FASB ASC 32530302; 325303512; 32530454) (formerly, FSP FTB 8541, par. 8)
DISCLOSURE REQUIREMENTS
COST METHOD INVESTMENTS
As of each date for which a balance sheet is presented, an investor should disclose the following information for
cost method investments:
a. The aggregate carrying amount of all cost method investments
b. The aggregate carrying amount of cost method investments that the investor did not evaluate for
impairment
c. If applicable, the fact that the fair value of a cost method investment is not estimated if there are no identified
events or changes in circumstances that may have a significant adverse effect on fair value and the investor
does not estimate fair value under (FASB ASC 82510) (formerly, SFAS No. 107 either because (a) it is not
practicable to estimate fair value or (b) the investor is exempt from estimating fair value
LIFE INSURANCE
A policyholder should disclose the existence of contractual restrictions on the ability to surrender a life insurance
policy. (FASB ASC 32530501) (formerly, EITF 065, par. 11) EITF No. 065 also requires various transition
disclosures when the provisions of the EITF are applied.
The following disclosures are required if business interruption proceeds were received during the period: (EITF
0113, par. 7)
a. Nature of the event resulting in business interruption losses.
5
b. Aggregate amount of proceeds recognized during the period and the income statement line item in which
they are presented (including amounts reported as extraordinary items)
INVESTMENTS IN LIFE SETTLEMENT CONTRACTS
Life settlement contracts that are remeasured at fair value should be reported separately on the face of the
statement of financial position from those accounted for under the investment method. This may be accomplished
by either reporting separate line items or reporting an aggregate amount with parenthetical disclosure of the
amount of investments accounted for under the fair value method. (FASB ASC 32530451) (formerly, FSP FTB
8541, par. 9)
Investment income from investments in life settlement contracts remeasured at fair value should be reported
separately from investment method income. This may be accomplished by either reporting separate line items or
reporting an aggregate amount with parenthetical disclosure of the amount of investment income from investments
accounted for under the fair value method. (FASB ASC 32530453) (formerly, FSP FTB 8541, par. 10)
Cash receipts and payments related to life settlement contracts should be classified in the statement of cash flows
based on the nature and purpose for which the life settlements were acquired. (FASB ASC 32530455) (formerly,
FSP FTB 8541, par. 11)
The following information should be disclosed for investments in life settlement contracts:
a. The accounting policy for life settlement contracts including the classification of cash receipts and
disbursements in the statement of cash flows (FASB ASC 32530502) (formerly, FSP FTB 8541, par. 12)
b. Separately for fair value and investment method contracts, based on the remaining life expectancy for each
of the first five succeeding years from the date of the statement of financial position and thereafter, and in
the aggregate: (FASB ASC 32530504; 32530508) (formerly FSP FTB 8541, paras. 13 and 17)
(1) Number of contracts
(2) Carrying value of contracts
(3) Face value (death benefits) of the underlying life insurance policies
c. The nature of information that causes a change in the expected timing of cash proceeds, including
significant changes to the amounts above. (FASB ASC 32530506; 32530509) (formerly, FSP FTB
8541, paras. 15 and 18)
d. For investment method contracts, anticipated life insurance premiums to be paid for each of the five
succeeding fiscal years. (FASB ASC 32530505) (formerly FSP FTB 8541, par. 14)
e. For fair value contracts, the methods and significant assumptions used to estimate the fair value of
investments, including any mortality assumptions (FASB ASC 32530507) (formerly, FSP FTB 8541, par.
16)
The following should be disclosed for each income statement: (FASB ASC 325305010) (formerly, FSP FTB
8541, par. 19)
a. Gains or losses recognized on investments sold during the period.
b. Unrealized gains or losses recognized during the period for investments still held at the statement of
financial position date.
6
SELFSTUDY QUIZ
Determine the best answer for each question below. Then check your answers against the correct answers in the
following section.
1. Accounting for investments in life insurance and investments in life settlement contracts is characterized by
which of the following?
a. Premium payments on insurance policies where risk is not transferred to the insurer should be treated as
assets.
b. The cash surrender value of an investment in life insurance should be reported as a liability.
c. If the presentation is consistent with existing GAAP, an entity can choose how business interruption
insurance proceeds are classified in income statements.
d. Investments in life settlement contracts should be accounted for using only the investment method.
2. The amount that a company could receive at the balance sheet date by surrendering a cash value policy that
it buys for itself should be reported as an asset. If there is any change in the policy's cash surrender value during
the period, the change should be reported as:
a. An adjustment of premiums paid.
b. Income.
3. Business interruption insurance provides coverage when an entity's business operations are suspended as a
result of the loss of use of property and equipment due to a covered loss. Such insurance coverage normally
reimburses all the following costs and losses incurred during the period that are required to repair, rebuild, or
replace the damaged property except:
a. Expenses related to rent of temporary facilities that are incurred to reduce the loss from interruption of the
business.
b. Gross margin not earned due to suspension of normal operations.
c. A portion of fixed charges and expenses associated with lost gross margin.
d. Marketing costs related to the loss or use of property.
7
SELFSTUDY ANSWERS
This section provides the correct answers to the selfstudy quiz. If you answered a question incorrectly, reread the
appropriate material. (References are in parentheses.)
1. Accounting for investments in life insurance and investments in life settlement contracts is characterized by
which of the following? (Page 3)
a. Premium payments on insurance policies where risk is not transferred to the insurer should be treated as
assets. [This answer is incorrect. Premium payments on insurance policies where risk is not transferred
to the insurer should be treated as deposits, not assets.]
b. The cash surrender value of an investment in life insurance should be reported as a liability. [This answer
is incorrect. The cash surrender value of an investment in life insurance should be reported as an asset,
not a liability.]
c. If the presentation is consistent with existing GAAP, an entity can choose how business interruption
insurance proceeds are classified in income statements. [This answer is correct. As long as the
presentation is not contrary to existing GAAP, an entity may choose the method it will use to classify
business interruption insurance proceeds in its income statement.]
d. Investments in life settlement contracts should be accounted for using only the investment method. [This
answer is incorrect. Investments in life settlement contracts should be accounted for using either the fair
value or investment methods.]
2. The amount that a company could receive at the balance sheet date by surrendering a cash value policy that
it buys for itself should be reported as an asset. If there is any change in the policy's cash surrender value during
the period, the change should be reported as: (Page 3)
a. An adjustment of premiums paid. [This answer is correct. Since a portion of premium payments
accumulate as cash value, any subsequent change in the policy's cash surrender value would be
reported as an adjustment of premiums paid per FASB ASC 32530251; 32530351 and 352
(formerly FTB 854, par. 2).]
b. Income. [This answer is incorrect. A change in the policy's cash surrender value during the period would
not be reported as income because FASB ASC 32530251; 32530351 and 352 (formerly FTB 854, par.
2 states that any change would be reported as an adjustment of premiums that the company paid pursuant
to FASB ASC 32530251; 32530351 and 352 (formerly FTB 854, par. 2).]
3. Business interruption insurance provides coverage when an entity's business operations are suspended as a
result of the loss of use of property and equipment due to a covered loss. Such insurance coverage normally
reimburses all the following costs and losses incurred during the period that are required to repair, rebuild, or
replace the damaged property except: (Page 4)
a. Expenses related to rent of temporary facilities that are incurred to reduce the loss from interruption of the
business. [This answer is incorrect. Business interruption insurance generally reimburses expenses
related to rent of temporary facilities that are incurred in order to reduce the loss from business interruption
in accordance with EITF 0113, par. 4.]
b. Gross margin not earned due to suspension of normal operations. [This answer is incorrect. Another
reimbursable expense covered by business interruption insurance as indicated in EITF 0113, par. 4, is
gross margin that was not earned due to normal operations being suspended.]
c. A portion of fixed charges and expenses associated with lost gross margin. [This answer is incorrect.
Business interruption insurance generally covers a portion of fixed charges and expenses that are
associated with lost gross margin as detailed in EITF 0113, par. 4)
8
d. Marketing costs related to the loss or use of property. [This answer is correct. Marketing costs are
considered normal costs of doing business and, therefore, would not be covered by insurance
policies such as business interruption insurance.]
9
10
LEASES
OVERVIEW
Accounting for leases is based on the notion that a lease transferring substantially all of the risks and rewards of
ownership should be capitalized. That is, an asset and related obligation should be recorded by the lessee and a
sale or financing should be recorded by the lessor. Other leases should be accounted for as the rental of property.
CLASSIFYING LEASES
A lessee should classify a lease as a capital lease if the lease meets at least one of the following criteria: (Otherwise,
the lessee should classify the lease as an operating lease.)
a. The lease passes title to the lessee by the end of the lease term.
b. The lease contains a bargain purchase option.
c. The lease term is at least 75% of the property's estimated remaining economic life.
d. The present value of the minimum lease payments is at least 90% of the property's fair value.
The 75% and 90% tests do not apply if the lease term begins within the last 25% of the leased property's total
estimated economic life, however.
Salestype and direct financing leases are the lessor's equivalent of a capital lease. In a salestype lease, the leased
property's book value is different from its fair value, resulting in a gain or loss to the lessor. In a direct financing
lease, the leased property's book value and fair value are the same and no gain or loss results. A lessor should
classify a lease as a salestype or direct financing lease if the lease meets at least one of the tests in the preceding
paragraph and both of the following criteria: (Otherwise, the lessor should classify the lease as an operating lease.)
a. Collectibility of the minimum lease payments is reasonably predictable.
b. There are no important uncertainties about additional unreimbursed costs the lessor will incur.
A leveraged lease is a type of direct financing lease that has the following additional characteristics:
a. It involves a lessee, a lessor, and a longterm creditor.
b. The financing provided by the longterm creditor is nonrecourse to the general credit of the lessor.
c. The amount of financing provided by the longterm creditor is substantial to the transaction.
d. The lessor's net investment in the lease declines in the early years of the lease and rises during the later
years before it is finally eliminated.
e. Any investment tax credit retained by the lessor is deferred and allocated to income over the lease term.
Certain exceptions to the lessee and lessor classification criteria exist for leases involving real estate.
11
12
SELFSTUDY QUIZ
following section.
4. A lessee should classify a lease as a capital lease if it meets at least one of four criteria. Which of the following
is one of those criteria it must meet?
a. The lease passes title to the lessee no later than midway through the lease term.
b. The lease contains an option for a bargain purchase.
c. The lease term is at least 60% of the property's estimated remaining economic life.
d. The current value of the minimum lease payments is at least 75% of the property's fair value.
5. No gain or loss results with which of the following types of leases?
a. Salestype lease.
b. Direct financing lease.
13
SELFSTUDY ANSWERS
4. A lessee should classify a lease as a capital lease if it meets at least one of four criteria. Which of the following
is one of those criteria? (Page 11)
a. The lease passes title to the lessee no later than midway through the lease term. [This answer is incorrect.
The lease must pass title to the lessee by the end of the lease term, but not by midway through the lease
term.]
b. The lease contains an option for a bargain purchase. [This answer is correct. A lease transferring
substantially all of the risks and rewards of ownership should be capitalized. A lease containing a
bargain purchase option completes that transfer.]
c. The lease term is at least 60% of the property's estimated remaining economic life. [This answer is
incorrect. The lease term must be at least 75% of the property's estimated remaining economic life for the
lease to effectively transfer ownership.]
d. The current value of the minimum lease payments is at least 75% of the property's fair value. [This answer
is incorrect. The current value of the minimum lease payments must be at least 90% of the property's fair
value because substantially all of the reward of ownership must be transferred.]
5. No gain or loss results with which of the following types of leases? (Page 11)
a. Salestype lease. [This answer is incorrect. In a salestype lease, the leased property's book value is
different from its fair value, thus, a gain or loss to the lessor results.]
b. Direct financing lease. [This answer is correct. In a direct financing lease, the leased property's book
value and fair value are the same, therefore, no gain or loss results.]
14
ACCOUNTING FOR LEASES—LESSEES
A lessee should account for a capital lease as if the leased asset were purchased and the entire purchase price
were financed. As a result, the lessee should record a leased asset and lease obligation of the same amount. The
amount recorded should be the lesser of the fair value of the leased asset at the inception of the lease or the present
value of the minimum lease payments as of the beginning of the lease term. Once recorded, the leased asset
should be depreciated like any owned asset, and the lease obligation should be accounted for under the interest
method.
A lessee should account for an operating lease by charging the lease payments to expense. Generally, rent
expense under an operating lease should be recognized on a straightline basis over the lease term, however, even
if payments are not made on a straightline basis.
ACCOUNTING FOR LEASES—LESSORS
A lessor should account for a salestype lease as follows:
a. The gross investment in the lease and the present value of the gross investment in the lease should be
determined.
b. The present value of the gross investment should be recorded as a receivable and classified as current or
noncurrent like any other receivable. The difference between the gross investment and its present value
should be recorded as unearned income and amortized over the lease term using the interest method.
c. The present value of the minimum lease payments to be received should be recognized as income. The
carrying amount of the leased property, plus any initial direct costs and less the present value of the
unguaranteed residual value, should be charged against income.
A lessor should account for a direct financing lease as follows:
a. The gross investment in the lease should be determined.
b. The difference between the gross investment and the book value of the property represents unearned
interest income. The unearned interest income and any initial direct costs should be amortized to income
over the lease term using the interest method.
c. The net investment in the lease should be shown as a single line item on the balance sheet and classified
as current and noncurrent like any other receivable. The net investment consists of the gross investment
plus any unamortized initial direct costs minus the unearned interest income.
A lessor should record its net investment in a leveraged lease net of the nonrecourse debt. The total net income
over the lease term, which should only be recognized in periods in which the net investment net of deferred taxes
is positive, is determined by subtracting the original investment from total cash receipts.
When accounting for an operating lease, the lessor should continue to carry the leased asset in its balance sheet
and depreciate it according to its normal depreciation policy. Rent income should be reported as it becomes
receivable in the same way rent expense is reported by lessees. That is, it generally should be recognized on a
straightline basis.
OTHER LEASE TRANSACTIONS
Additional requirements (or variations of the preceding requirements) apply to subleases, leases involving real
estate, leases with governmental entities, moneyovermoney leases, saleleaseback transactions, and wrap
leases.
15
In general terms, a lease is a contract that provides an entity the right to use property that it does not own in
exchange for some consideration, usually for a specified period of time. Leases ordinarily involve two parties a
lessor (the one who owns the leased property and is paid rent) and a lessee (the one who pays rent). All
agreements that meet the preceding definition are considered leases, including those not specifically referred to as
leases and those that require the lessor to provide substantial services to operate or maintain the leased assets.
However, for purposes of applying GAAP, leases do not include agreements that (SFAS 13, par. 1 and EITF 018)
concern the right to explore for or to exploit natural resources such as oil, gas, minerals, and timber.
apply to intangibles, such as licensing agreements for motion picture films, plays, manuscripts, patents,
and copyrights.
apply to inventory, including equipment parts inventory.
are not dependent on the use of specified property, plant, or equipment for their fulfillment.
TYPES OF LEASES
Accounting for leases varies depending on the type of lease. Under generally accepted accounting principles,
leases are classified as one of the following types:
Lessees
Capital lease. A capital lease transfers substantially all the benefits and risks of ownership to the lessee and
is recorded as if the lessee borrowed money to purchase the leased property.
Operating lease. Operating leases are those that are not classified as capital leases. (FASB ASC
84010101) (formerly SFAS 13, par. 6) They are treated as the rental of property by the lessee from the
lessor, and their effects are recorded as consideration is paid.
Lessors
Direct financing lease. Direct financing leases and salestype leases are the lessor's equivalent of a capital
lease. In a direct financing lease, the fair value and book value of the leased asset are the same. Thus, there
is no profit involved for the lessor, and the lease is accounted for as a financing. The difference between
the total lease payments to be received and the book value of the property is assumed to be the equivalent
of interest that would have been paid had the lessee borrowed the money from the lessor to purchase the
property. (SFAS 13, par. 6)
Salestype lease. In a salestype lease, the leased property's book value is different from its fair value.
Consequently, the sale provides a profit (or loss) to the lessor. The basic accounting for salestype leases
involves recognizing both a profit element and a financing element. (SFAS 98, par. 22)
Leveraged lease. A leveraged lease is structured primarily to provide certain tax benefits to the lessor
without the lessor being entirely at risk for nonperformance by the lessee. To be classified as a leveraged
lease, a lease must meet the criteria for classification as a direct financing lease and certain other criteria
related to financing provided by a longterm creditor and the lessor's net investment.
Operating lease. An operating lease is one that does not meet the criteria for classification as a salestype
or direct financing lease by the lessor. (FASB ASC 840102543) (formerly SFAS 13, par.6) Like operating
leases of lessees, operating leases of lessors are similar to rentals of property and their effects are recorded
as consideration is received.
16
Classifying Leases Lessees
From the lessee's perspective, a lease should be considered a capital lease if it meets at least one of the following
criteria: (Otherwise, it should be considered an operating lease.) (FASB ASC 84010251 and 2529) (formerly
SFAS 13, par. 7)
a. Ownership transfer test. The lease passes title to the lessee by the end of the lease term.
b. Bargain purchase option test. The lease contains a bargain purchase option.
c. 75% test. The lease term is at least 75% of the property's estimated economic life.
d. 90% test. The present value of the minimum lease payments is at least 90% of the property's fair value.
The 75% test and 90% test should not be considered if the lease term begins within the last 25% of the leased
property's total estimated economic life, however. In addition, certain exceptions to the preceding criteria exist for
real estate leases. The flowchart in Exhibit 11 illustrates the basic lease classification criteria for a lessee.
Ownership Transfer Test. The basis for this test is fairly straightforward. If the lease transfers ownership of the
property by the end of the lease term, it effectively transfers all the benefits and risks of ownership. The following
definitions and issues should be considered when applying this test:
a. Lease term. The lease term is defined as the fixed, noncancelable portion of the lease, plus all
periods (FASB ASC 8401020) (formerly SFAS 13, par. 5)
(1) covered by bargain renewal options.
(2) for which failure to renew imposes enough of a penalty on the lessee that renewal is reasonably
assured.
(3) covered by ordinary renewal options during which a guarantee by the lessee of the lessor's debt that
is directly or indirectly related to the leased property is expected to be in effect or a loan from the lessee
to the lessor directly or indirectly related to the leased property is expected to be outstanding. (It is
assumed that the lessee will not terminate the lease if the lease payments are being used by the lessor
to pay debt related to the leased property.)
(4) covered by ordinary renewal options preceding the exercise date of a bargain purchase option. (It is
assumed that the bargain purchase option will be exercised, so it is also assumed that all renewal
options up to that date will be exercised.)
(5) representing renewals or extensions of the lease at the lessor's option.
The lease term cannot extend past the date a bargain purchase option becomes exercisable, however,
since it is assumed that the option will be exercised and the lease will end at that time. In addition, a lease
term is considered noncancelable if it may be canceled only (1) on the occurrence of some remote
contingency, (2) with the permission of the lessor, (3) if the lessee enters into a new lease with the same
lessor, or (4) if cancellation imposes enough of a penalty on the lessee that continuation of the lease
appears reasonably assured.
17
Exhibit 11
Basic Lease Classification Lessee
Lease agreement or
commitment.
Yes Ownership transfers

by the end of the lease term?
No
Yes Lease contains a

bargain purchase option?
No
Lease term begins within the last

25% of the property's estimated Yes
total economic life (including
earlier years of use)?
No
Lease term is 75% or more

Yes of the property's estimated
remaining economic life?
No
Present value of
Yes minimum lease payments
is 90% or more of the
property's fair value?
No
Classify as a Classify as an
capital lease. operating lease.
Note:Classification of real estate leases may differ.
* * *
b. Bargain renewal option. A bargain renewal option allows the lessee to renew the lease for a rental payment
significantly lower than fair rental" at the date the option becomes exercisable. A fair rental is the rental
rate for similar property under similar terms and conditions. (SFAS 13, par. 5)
c. Penalty. A penalty is anything that must be given up by the lessee or any obligation that is or can be imposed
on the lessee. It is not limited to items imposed on the lessee by the lease agreement. It can be caused by
circumstances outside of the lease agreement as well. A penalty that extends the lease term is any penalty
so significant that renewal of the lease is reasonably assured. (SFAS 98, par. 22)
18
d. Timing of the ownership transfer. The ownership transfer criterion is met if ownership is transferred at or
shortly after the end of the lease term. That includes situations in which the lessee purchases the property
at the end of the lease term for a nominal fee, such as $1. That often occurs when the lease is intended to
transfer ownership, but state law requires that some consideration be given up in order to establish a valid
contract. (FASB ASC 84010251) (formerly SFAS 13, par. 7)
Bargain Purchase Option Test. A bargain purchase option is an option for the lessee to purchase the leased
property at a price substantially below its expected fair value at the date the option is exercisable. In essence, the
bargain purchase option test is similar to the ownership transfer test. That is, the existence of a bargain purchase
option is assumed to virtually assure that ownership will be transferred. (SFAS 13, par. 5)
The 75% Test. The 75% test is met if the lease term is at least 75% of the estimated economic life of the leased
property. (SFAS 13, par. 7) The estimated economic life of the leased property is the remaining period during which
the property is expected to be economically usable, with normal repairs and maintenance, for the purpose intended
at the inception of the lease, regardless of the lease term. (SFAS 13, par. 5)
When determining the classification of a capital lease, the 75% test should not be applied as a criterion if the lease
term begins within the last 25% of the leased property's total estimated economic life, including periods of prior use.
(SFAS 13, par. 7)
The 90% Test. The 90% test is met if the present value at the beginning of the lease term of the minimum lease
payments is at least 90% of the property's fair value to the lessor at the inception of the lease. (The 90% test should
not be applied if the lease term begins within the last 25% of the leased property's total estimated economic life,
however.) The following should be considered when applying this test: (FASB ASC 8401020; 84010251;
84010255 through 257; 840102531; 840105543 and 5544) (formerly SFAS 13, paras. 5 and 7 and FTB
7912, par. 3)
a. When computing the present value of the minimum lease payments, a lessor should use the interest rate
implicit in the lease. A lessee should use its incremental borrowing rate unless it is practicable to learn the
lessor's implicit rate, and the lessor's implicit rate is lower. (The lessee has no obligation to estimate the
lessor's implicit rate if it does not know that rate.)
(1) The lessee's incremental borrowing rate is the rate the lessee would have incurred if it had borrowed
money to purchase the property rather than lease it. The lessee may use a secured borrowing rate
as the incremental rate if it is determinable, reasonable, and consistent with the financing that would
have been used if the property were purchased instead of leased.
(2) The interest rate implicit in the lease is the rate that discounts the minimum lease payments and the
unguaranteed residual value to the fair value of the property to the lessor at the inception of the lease.
The fair value used in the calculation of the implicit rate should be reduced by any investment tax credit
retained and to be used by the lessor.
b. The lessee's minimum lease payments consist of all rental payments called for during the lease term plus
any residual value guaranteed by the lessee. It includes any payment the lessee must make for not
renewing or extending the lease, including a requirement to purchase the property. The lessee's minimum
lease payments do not include the following, however:
(1) Any guarantee by the lessee of the lessor's debt
(2) The lessee's obligation (separate from rental payments) to pay executory costs (for example,
insurance, taxes, etc.) and any related profit on those costs
(3) Any penalty for which the lease term has been extended
(4) Contingent rentals (Increases in minimum lease payments occurring during the preacquisition or
construction period that result from an escalation clause in the lease are not considered contingent
rentals.)
19
If the lease contains a bargain purchase option, however, the above criteria are disregarded. In that case,
minimum lease payments consist only of the rental payments to the date the option is exercisable
(excluding executory costs and profit thereon) and the option amount.
c. The lessor's minimum lease payments are the same as the lessee's with one exception they also include
any guarantee of the residual value or lease payments beyond the lease term by a third party (provided
the third party is financially capable of meeting the obligation).
d. The fair value of the leased property is the price for which the property could be sold in an arm's length
transaction between unrelated parties. When the lessor is a manufacturer or dealer, the property's fair value
is usually its normal selling price. When the lessor is not a manufacturer or dealer, the property's fair value
at the inception of the lease is usually its cost. (Current market conditions must be considered, however,
particularly when significant time has lapsed since the construction or acquisition of the property.)
Classifying Leases Lessors
A lessor should classify a lease as a salestype lease or direct financing lease if it meets at least one of the four tests
discussed above and both of the following criteria: (FASB ASC 840102542 and 2543) (formerly SFAS 13, par. 8)
a. Collectibility of the minimum lease payments must be reasonably predictable. A lease meets this criteria
even if it is believed that not all of the minimum lease payments will be collected so long as the uncollectible
portion can be reasonably estimated based on experience with similar receivables. The minimum lease
payments are not considered reasonably predictable" when other than normal credit risks are involved,
however.
b. There are no important uncertainties about additional unreimbursed costs the lessor will incur. Important
uncertainties might relate to such items as performance guarantees beyond a typical product warranty or
commitments to replace the leased asset if it becomes obsolete.
If the lease does not give rise to profit (or loss) to the lessor (that is, if the fair value of the leased property equals its
book value), the lease is a direct financing lease. Otherwise, it is a salestype lease. Certain exceptions to the
preceding criteria exist for real estate leases. The flowchart in Exhibit 12 illustrates the basic lease classification
criteria for a lessor.
ACCOUNTING FOR LEASES—LESSEES
Capital Leases
When a lease is classified as a capital lease, it is accounted for as if the leased asset were purchased and the entire
purchase price were financed. Consequently, the lessee should record a leased asset and a lease obligation of the
same amount. The amount recorded should be the lesser of (a) the fair value of the leased asset at the inception of
the lease or (b) the present value of the minimum lease payments (excluding executory costs to be paid by the
lessor and related profit) as of the beginning of the lease term. (FASB ASC 84030301 through 303) (formerly
SFAS 13, par. 10) The present value of the minimum lease payments should be discounted using the interest rate
used to apply the 90% test. That rate is the lessee's incremental borrowing rate unless it is practicable to learn the
lessor's implicit rate, and the lessor's implicit rate is lower. (FASB ASC 840102531) (fomerly SFAS 13, par. 7)
Once recorded, the leased asset should be amortized in a manner consistent with the entity's depreciation policy,
like any owned asset. That is, it should be amortized over its estimated useful life down to its expected value to the
lessee at the end of the lease term. In a capital lease, however, the period over which the asset should be amortized,
and the value to which it should be depreciated, depends on why the lease was capitalized. (FASB ASC
84030351) (formerly SFAS 13, par. 11)
a. If the lease meets the transfer of ownership or bargain purchase option test, it is assumed that the lessee
will own the property for its full economic life. Consequently, the asset should be depreciated over its
estimated economic life down to its estimated residual value.
20
b. If the lease does not meet the transfer of ownership or bargain purchase option tests (i.e., it was capitalized
because it met the 75% or 90% test), it is assumed that the property will revert back to the lessor at the end
of the lease term. Consequently, the asset should be depreciated over the lease term down to its expected
value to the lessee. That will ordinarily be zero since the property reverts back to the lessor at the end of
the lease term. However, if the lease agreement contains a residual value guarantee and the lessee gets
no benefit from any value in excess of the guarantee, the expected value is the amount the lessee can
realize from the property, up to the amount of the guarantee.
Exhibit 12
Basic Lease Classification Lessor
Lease agreement or
commitment.
Yes Ownership transfers

by the end of the lease term?
No
Yes Lease contains a

bargain purchase option?
No
Lease term begins within the last

25% of the property's estimated Yes
total economic life (including
earlier years of use)?
No
Yes Lease term is 75% or more

of the property's estimated
remaining economic life?
No
Present value of
Yes minimum lease payments No
is 90% or more of the
property's fair value?
Collectibility of minimum No
lease payments is
reasonably predictable?
Yes
Costs to be incurred by No
lessor are reasonably
predictable?
Yes
Fair value equals No
book value?
Yes
Classify as a Classify as a Classify as an
direct financing lease. salestype lease. operating lease.
Note:Classification of real estate leases by lessors may differ.
* * *
The lease obligation should be accounted for using the interest method of accounting. Consequently, a portion of
each minimum lease payment should be allocated to interest expense, and the remainder applied to reduce the
21
obligation, so that a constant rate of interest is produced on the outstanding liability. (FASB ASC 84030356)
(formerly SFAS 13, par. 12)Contingent rental payments should be recognized as expense when accruable. (FASB
ASC 84030252) (formerly SFAS 13, par. 12)
Operating Leases
Generally, rent expense under an operating lease should be recognized on a straightline basis over the lease term,
even if payments are not made on a straightline basis. (FASB ASC 84020251) (formerly SFAS 13, par. 15)
Rent expense may be recognized using a method other than straightline if the method is systematic, rational, and
more representative of the time pattern in which the leased asset is used. Using factors such as the time value of
money, anticipated inflation, or expected future revenues to allocate scheduled rent increases to expense is not
appropriate because those factors do not relate to the time pattern of actually using the leased property. (FASB
ASC 84020251 and 252) (formerly SFAS 13, par. 15; FTB 853, par.2)
Contingent Rentals. Rent increases or decreases based on future conditions, such as future sales volume,
machine hours, interest rates, or price indexes, are considered contingent rentals. A contingent rental payment
should be recognized prior to the achievement of the specified future conditions that triggers the contingent rental
payment provided that it is probable that the specified future conditions will be achieved. (FASB ASC 840102535)
(formerly EITF 989) If it becomes probable that the specified future conditions will not be met, previously recorded
contingent rental payments should be reversed into income. (FASB ASC 84010401) (formerly EITF 989)
Right to Control the Use of the Asset Is Equivalent to Physical Use. The right to control the use of the leased
asset is considered the equivalent of physical use. Thus, whether the lessee actually uses the leased asset has no
effect on rental expense or rental revenue. (FASB ASC 84020253) (formerly FTB 881, par. 2 and 4) For example,
if an entire manufacturing building with excess capacity is leased, and the lease agreement includes escalating
rental payments in contemplation of the lessee's expected expansion and physical use of the excess capacity, the
aggregate lease payments should be recognized on a straightline basis over the lease term, regardless of whether
the excess capacity is actually used.
On the other hand, if rents escalate as the lessee gains control of the additional leased property, the additional
rental expense should be recognized as it is due, provided rental amounts are based on the relative fair value of the
additional leased property at the inception of the lease. If escalating rental payments are not based on fair value,
however, they should be reallocated between the original leased property and the additional leased property based
on the relative fair value of the property at the inception of the lease. After the reallocation, the amount of rental
expense or rental revenue attributable to the additional leased property should be proportionate to the relative fair
value of the additional property, as determined at the inception of the lease, in the periods during which the lessee
controls its use. (FASB ASC 84020254 and 255) (formerly FTB 881, par. 2)
Lease Incentives. Incentive payments include items such as upfront cash payments to the lessee to sign the
lease, payments to reimburse the lessee for specific costs such as moving costs or abandoned leasehold improve
ments, and payments to thirdparties on behalf of the lessee, such as for leasehold improvements. The lessee
should recognize incentive payments as a reduction of rental expense over the term of the lease. (FASB ASC
84020256 and 257) (formerly FTB 881, par. 7) The lessee should record receipt of the payment through a debit
to cash and a credit to a deferred lease incentive account. The deferred lease incentive account should be
amortized through a credit to rent expense over the lease term using the straightline method.
If a lessor assumes a lessee's preexisting lease with a third party, the related loss incurred by the lessor is
considered a rent incentive. The lessor and the lessee should independently estimate the loss incurred by the
lessor. An appropriate method for the lessee to estimate the lessor's loss is to base its estimate on a comparison of
the new lease with the market rental rate available for similar leased property or the market rental rate from the same
lessor without the lease assumption. (FASB ASC 84020257) (formerly FTB 881, par. 8)
Maintenance Deposits
Sometimes a lessee may make maintenance deposits to a lessor that are wholly or partially refundable if the lessee
performs specified maintenance activities. Those maintenance deposits, or portions thereof, that are refundable
22
should be accounted for as deposit assets. Amounts that are less than probable of being refunded should be
expensed. Similarly, amounts that were originally considered refundable but that subsequently become less than
probable of being refunded should be expensed. Underlying maintenance costs incurred by the lessee should be
expensed or capitalized according to the entity's maintenance accounting policy. (FASB ASC 840102539A and
39B; 84010359A) (formerly EITF 083)
ACCOUNTING FOR LEASES—LESSORS
Salestype Leases
A lease is classified as a salestype lease when the transaction is, in essence, a sale of property to the lessee that
provides a profit or loss to the lessor. A lessor should account for a salestype lease as follows:
a. The gross investment in the lease should be determined. The lessor's gross investment is equal to (1) the
total minimum lease payments to be received (net of any included executory costs and related profits to
be paid by the lessor) plus (2) any unguaranteed residual value accruing to the benefit of the lessor (that
is, the unguaranteed fair value of the leased asset to which the lessor is entitled at the end of the lease term.)
(FASB ASC 84030306) (formerly SFAS 13, par. 17)
b. The gross investment in the lease should be discounted to its present value using the interest rate implicit
in the lease. The difference between the gross investment and its present value should be recorded as
unearned income and amortized over the lease term using the interest method. (Other amortization
methods may be used if they do not produce materially different results.) The present value of the gross
investment, referred to as the net investment in the lease, should be recorded as a receivable and classified
as current or noncurrent like any other receivable. (FASB ASC 84030308 and 309: 840303522;
c. The present value of the minimum lease payments to be received (net of any included executory costs and
related profits to be paid by the lessor) should be recognized as income. The carrying amount of the leased
property, plus any initial direct costs (i.e., costs incurred by the lessor to negotiate and consummate the
lease) and less the present value of the unguaranteed residual value, should be charged against income.
(FASB ASC 84030256; 840303010) (formerly SFAS 13, par. 17)
d. The estimated residual value should be reviewed at least annually to determine whether a decline in value
has occurred. If a decline that is other than temporary has occurred, the transaction should be revised using
the new estimate. The resulting reduction in the net investment in the lease should be recognized as a loss
in the period of the decline. No adjustments should be made to increase the property's estimated residual
value including any guaranteed portion. (FASB ASC 840303525) (formerly SFAS 13, par. 17)
Direct Financing Leases
A lessor should account for a direct financing lease as follows:
a. The gross investment in the lease should be determined by adding (1) the total minimum lease payments
to be received (net of any included executory costs and related profits to be paid by the lessor) and (2) any
unguaranteed residual value accruing to the benefit of the lessor (that is, the unguaranteed fair value of the
leased asset to which the lessor is entitled at the end of the lease term.) (FASB ASC 84030306) (formerly
SFAS 13, par. 17)
b. The difference between the gross investment and the book value of the property represents unearned
interest income. The net investment in the lease consists of the gross investment plus any unamortized
initial direct costs minus the unearned interest income. The net investment should be shown as a single
line item on the balance sheet and classified as current and noncurrent like any other receivable. (FASB
ASC 840303011 and 3013; 84030454) (formerly SFAS 13, paras. 17 and 18)
c. The unearned interest income and initial direct costs should be amortized to income over the lease term
using the interest method or another method that produces a constant periodic rate of return. (FASB ASC
23
d. The estimated residual value should be reviewed at least annually to determine whether a decline in value
has occurred. If a decline that is other than temporary has occurred, the transaction should be revised using
the new estimate. The resulting reduction in the net investment in the lease should be recognized as a loss
in the period of the decline. An upward adjustment should not be made. No adjustment should be made
to increase the property's estimated residual value, including any guaranteed portion. (FASB ASC
Leveraged Leases
Basically, a leveraged lease is one that is structured primarily to provide certain tax benefits (and the temporary use
of funds due to taxes saved in the early years of the lease) to the lessor without the lessor being entirely at risk for
nonperformance by the lessee. Although technically not considered a direct financing lease, a leveraged lease
must meet the criteria for classification as a direct financing lease and also possess all of the following characteris
tics: (FASB ASC 8402543) (formerly SFAS 13, par. 42)
a. It involves at least three parties a lessee, a lessor, and a longterm creditor.
b. The financing provided by the longterm creditor is nonrecourse to the general credit of the lessor.
c. The amount of financing provided by the longterm creditor gives the lessor substantial leverage."
Substantial leverage" is commonly interpreted to mean that the financing is more than 50% of the lessor's
cost of the property.
d. The lessor's net investment in the lease declines in the early years of the lease and rises during the later
years before it is finally eliminated (although decreases and increases in the net investment balance may
occur more than once).
A lessor should include the following in its recorded investment in a leveraged lease: (FASB ASC 84030258;
a. Rents receivable, net of the portion applicable to principal and interest on the nonrecourse debt
b. A receivable for the investment tax credit to be realized on the transaction
c. Estimated residual value of the leased asset
d. Unearned and deferred income consisting of (1) the estimated pretax lease income or loss, after deducting
initial direct costs, that remains to be allocated to income over the lease term and (2) the investment tax
credit that remains to be allocated to income over the lease term
The investment in leveraged leases, less applicable deferred income taxes, represents the net investment for
purposes of computing periodic net income. Based on the original investment and the projected cash receipts and
disbursements during the term of the lease, the lessor should compute the rate of return on the net investment in
the periods in which the net investment is positive. (The rate of return is the rate that, when applied to the net
investment in the periods the net investment is positive, will distribute the net income to those periods.) The net
investment balance is increased or decreased each period by the difference between the net cash flow and the
amount of income recognized, if any. The amount of net income that should be recognized each year should
consist of the following: (FASB ASC 840303533 through 3535) (formerly SFAS 13, paras. 4344)
a. Pretax lease income or loss allocated from unearned income included in the net investment
b. Investment tax credit allocated from deferred income included in the net investment
c. The tax effect of the pretax lease income or loss recognized, which is included in tax expense for the period
24
If, at any time, projected cash receipts over the remaining term of the lease are less than the lessor's investment in
the lease, a loss should be recognized immediately. (FASB ASC 840303536) (formerly SFAS 13, par. 45) In
addition, all important assumptions affecting estimated net income from the leveraged lease, as well as the
projected timing of income tax cash flows generated by the lease, should be reviewed at least annually. (FASB ASC
25
26
SELFSTUDY QUIZ
following section.
6. When a lessor accounts for a direct financing lease, which of the following applies?
a. The lessor should determine the gross investment in the lease and its present value.
b. The lessor should record the present value of the gross investment as a receivable.
c. The lessor should recognize the present value of the minimum lease payments to be received as income.
d. The lessor should show the net investment in the lease as a single line item on the balance sheet.
7. When the lease is intended to transfer ownership at the end of the lease term by means of the lessee purchasing
the property, and state law requires consideration be given by the lessee in order to establish a valid contract,
what is the minimum consideration that must be given?
a. $1.
b. $100.
c. $200.
d. $250.
8. When a lease is classified as a capital lease, the present value of the minimum lease payments should be
discounted using the interest rate used to apply the 90% test. When the lessor's implicit rate is known and it
is lower than the lessee's incremental borrowing rate, which interest rate should be used to apply the 90% test?
a. The lessee's incremental borrowing rate.
b. The lessor's implicit rate.
9. Lessee contingent rentals are rentals where rent increases or decreases based on any of the following
conditions except:
a. Machine hours.
b. Sales history.
c. Interest rates.
d. Price indexes.
10. If projected cash receipts over the remaining term of the lease are determined to be less than the lessor's
investment in the lease, which of the following is true?
a. A loss should be recognized at the end of the lease term.
b. A loss should be recognized immediately.
c. The lessor should use professional discretion in deciding whether a loss should be recognized.
27
SELFSTUDY ANSWERS
6. When a lessor accounts for a direct financing lease, which of the following applies? (Page 15)
a. The lessor should determine the gross investment in the lease and its present value. [This answer is
incorrect. The lessor should determine the gross investment in the lease and its present value when
accounting for a salestype lease.]
b. The lessor should record the present value of the gross investment as a receivable. [This answer is
incorrect. The lessor should record the present value of the gross investment as a receivable when
accounting for a salestype lease.]
c. The lessor should recognize the present value of the minimum lease payments to be received as income.
[This answer is incorrect. The lessor should recognize the present value of the minimum lease payments
to be received as income when accounting for a salestype lease.]
d. The lessor should show the net investment in the lease as a single line item on the balance sheet.
[This answer is correct. Because the net investment in the lease is an asset, the lessor should show
the net investment in the lease as a single line item on the balance sheet when accounting for a direct
financing lease.]
7. When the lease is intended to transfer ownership at the end of the lease term by means of the lessee purchasing
the property, and state law requires consideration be given by the lessee in order to establish a valid contract,
what is the minimum consideration that must be given? (Page 17)
a. $1. [This answer is correct. A minimal fee as little as $1 is viewed by state laws as consideration
given in establishing a valid contract.]
b. $100. [This answer is incorrect. State laws do not require that $100 in consideration be given in order to
establish a valid contract when the lessee purchases the property at the end of the lease term.]
c. $200. [This answer is incorrect. It is not necessary for the lessee to provide $200 in consideration when
purchasing property in order to satisfy state law that a valid contract has been established.]
d. $250. [This answer is incorrect. State law does not specify that $250 in consideration must be given when
a lessee purchases property in order for a valid contract to be deemed to have been established.]
8. When a lease is classified as a capital lease, the present value of the minimum lease payments should be
discounted using the interest rate used to apply the 90% test. When the lessor's implicit rate is known and it
is lower than the lessee's incremental borrowing rate, which interest rate should be used to apply the 90% test?
(Page 20)
a. The lessee's incremental borrowing rate. [This answer is incorrect. The lessee's incremental borrowing
rate is generally the interest rate used to apply the 90% test, unless the lessor's implicit rate is known and
it is lower, in which case the lessor's implicit rate should be used to apply the 90% test.]
b. The lessor's implicit rate. [This answer is correct. In cases where the lessor's implicit rate is known
and it is lower than the lessee's incremental borrowing rate, the lessor's implicit rate should be used
to apply the 90% test.]
28
9. Lessee contingent rentals are rentals where rent increases or decreases based on any of the following
conditions except: (Page 22)
a. Machine hours. [This answer is incorrect. Machine hours are one of several future conditions that can
cause rent increases or decreases.]
b. Sales history. [This answer is correct. Contingent rentals are rentals where rent increases or
decreases based on future conditions. Sales history is not a future condition and would therefore
not be a condition that contingent rentals are based upon. Future sales volumes can be used to
recognize a contingent rental payment.]
c. Interest rates. [This answer is incorrect. Rent increases or decreases with contingent rentals that are based
on future conditions such as interest rates because they fluctuate over time.]
d. Price indexes. [This answer is incorrect. Because price indexes fluctuate with time, they are one of several
future conditions that rent increases or decreases are based on that correctly classifies them as contingent
rentals.]
10. If projected cash receipts over the remaining term of the lease are determined to be less than the lessor's
investment in the lease, which of the following is true? (Page 25)
a. A loss should be recognized at the end of the lease term. [This answer is incorrect. A loss should not be
recognized at the end of the lease term as indicated in FASB ASC 840303536 (formerly SFAS 13, par.
45)]
b. A loss should be recognized immediately. [This answer is correct. According to FASB ASC
840303536 (formerly SFAS 13, par. 45) if, at any time, projected cash receipts over the remaining
term of the lease are less than the lessor's investment in the lease, a loss should be recognized
immediately.]
c. The lessor should use professional discretion in deciding whether a loss should be recognized. [This
answer is incorrect. FASB ASC 840303536 (formerly SFAS 13, par. 45) does not give the lessor the option
to decide whether a loss should be recognized or not.]
29
Operating Leases
When accounting for an operating lease, the lessor should continue to carry the leased asset in its balance sheet
and depreciate it according to its normal depreciation policy. Rent income should be reported as it becomes
receivable in the same way rent expense is reported by lessees. (FASB ASC 84020251; 84020353;
84020452) ( formerly SFAS 13, par. 19) That is, it should be recognized on a straightline basis unless another
systematic and rational basis is more representative of the time pattern in which the lessor's benefits in the leased
asset are depleted. (FASB ASC 84020251) (formerly SFAS 13, par. 15) Any initial direct costs (i.e., costs incurred
by the lessor in negotiating and consummating the lease) should be deferred and allocated to income in proportion
to the recognition of rental income. (FASB ASC 840202516; 84020352) (formerly SFAS 13, par. 19)
Incentive Payments by Lessors. Incentive payments include items such as upfront cash payments to the lessee
to sign the lease and payments to reimburse the lessee for specific costs such as moving costs or abandoned
leasehold improvements. The lessor should recognize incentive payments as reductions in rental income over the
term of the lease. The lessor should record the payment as a debit to a deferred lease incentive account and a
credit to cash. The deferred lease incentive account should be amortized against rent income over the lease term
using the straightline method. (FASB ASC 84020256) (formerly FTB 881, par. 7)
If a lessor assumes a lessee's preexisting lease with a third party, the related loss incurred by the lessor is
considered a rent incentive. The lessor and the lessee should independently estimate the loss incurred by the
lessor. The lessor should estimate its loss based on the total remaining costs reduced by the expected benefits
from the sublease or use of the assumed leased property. (FASB ASC 84020257) (formerly FTB 881, par. 8)
Contingent Rentals. Rent increases or decreases based on future conditions, such as future sales volume,
machine hours, interest rates, or price indexes, are considered contingent rentals. A lessor should accrue a
contingent rental payment in the period it is incurred (generally when the future condition occurs). (FASB ASC
84020252) (formerly FTB 853, par. 12)
Losses on Operating Leases. If an operating lease involving real estate would have qualified as a salestype lease
except for the fact that it does not transfer ownership, and if the property's fair value is less than its book value, the
property should be written down to its fair value and a loss recognized at the inception of the lease. (FASB ASC
CHANGES, EXTENSIONS, AND TERMINATIONS
After a lease has been classified and recorded, it is not unusual for changes to occur prior to the end of the lease
term. Some of those changes require that adjustments be made to the amounts originally recorded under the
lease, whereas others do not. This section discusses common types of changes and how to account for them.
Changes in Lease Provisions
When the provisions of a lease are changed (other than by renewing or extending the term), and the revised
provisions would have resulted in a different classification had they existed at the inception of the lease, the revised
lease should be treated as a new agreement over its remaining term and classified accordingly. As a result, all
related accounts should be adjusted to what they would have been if the revised provisions had existed at
inception. (FASB ASC 84010354) (formerly SFAS 13, par. 9)
Lessee Accounting. For the lessee, if the provisions of a capital lease are changed, the accounting depends on
whether (a) the revised lease would have been classified as an operating lease if the revised terms had existed at
inception and (b) whether the revision changes the amount of remaining minimum lease payments.
a. If the revised lease would have been an operating lease, the transaction should be accounted for as a
saleleaseback transaction. Any profit or loss should be deferred and amortized in proportion to the gross
rent expensed over the remaining lease term. (FASB ASC 84040156) (formerly SFAS 13, par. 14)
b. If the revised lease is still a capital lease, but the revision changes the remaining minimum lease payments,
the lease obligation should be adjusted to the present value of the remaining minimum lease payments.
30
The asset should be adjusted by the same amount, and no gain or loss should be recorded. The interest
rate used to compute the present value of the remaining minimum lease payments should be the same rate
used when the lease was initially recorded. (FASB ASC 840303519) (formerly SFAS 13, par. 14)
An exception to the preceding guidance applies if the provisions of a lease are changed due to the refunding by the
lessor of taxexempt debt. In such cases, the change should be accounted for as follows: (FASB ASC 840303510)
(formerly SFAS 22, par. 12)
a. If the change results from a refunding that is accounted for as an early extinguishment of debt, the lessee
should adjust the lease obligation to the present value of the revised future minimum lease payments using
the effective interest rate applicable to the revised agreement. Any resulting gain or loss should be
recognized as gain or loss on early extinguishment.
b. If the change results from a refunding that is not accounted for as an early extinguishment of debt and the
lessee is obligated to reimburse the lessor for costs related to the refunded debt (such as unamortized
discount or issue costs or a call premium), the lessee should accrue the costs using the interest method
over the period from the date of the advance refunding to the call date of the refunded debt.
If the provisions of an operating lease are changed in a way that would have caused it to be classified as a capital
lease had the revised terms existed at inception, the revised lease is treated as a new agreement. An asset and
obligation equal to the present value of the future minimum lease payments should be recorded. (FASB ASC
84010354) (formerly SFAS 13, par.9)
Lessor Accounting. For the lessor, the lease changes that require accounting adjustments are essentially the
same as for a lessee. If a salestype, direct financing, or leveraged lease is revised, and the revised lease would
have been an operating lease had the revised terms existed at inception, the following adjustments are required:
a. The net investment in the lease should be written off.
b. The leased asset should be recorded on the lessor's books at the lower of its original cost, present fair value,
or present carrying amount (that is, the amount of the net investment in the lease).
c. Any difference in the net investment and the amount at which the asset is recorded on the lessor's books
should be recognized as a loss in the period of the change. (No gain will result because the asset cannot
be reestablished at more than the amount of the net investment.)
d. The new lease subsequently should be accounted for as any other operating lease.
If a salestype or direct financing lease is revised, the revision changes the remaining minimum lease payments,
and the revised lease would still have been a salestype or direct financing lease had the revised terms existed at
inception, the following adjustments are required: (FASB ASC 840303530) ( formerly SFAS 13, par. 17)
a. The gross investment in the lease should be adjusted to reflect the new minimum lease payments
receivable and the new estimated residual value, if affected (although the residual value estimate cannot
exceed the amount estimated originally).
b. The net adjustment should be charged or credited to unearned income.
If the provisions of an operating lease are changed in a way that would have caused it to be classified as a
salestype or direct financing lease had the revised terms existed at inception, the revised lease should be treated
as a new agreement. (FASB ASC 84010354) (formerly SFAS 13, par. 9)
Renewals and Extensions
Renewals and extensions are any actions that extend the lease beyond its original lease term. Renewals, for
example, often occur when renewal options (other than those already included in the lease term) are exercised.
31
Renewals and extensions also include situations in which the same lessee continues to rent the same property
under a new lease. Renewals and extensions of operating leases are treated as new agreements. (SFAS 13, par. 9)
Renewals and extensions of capital leases (as well as salestype and direct financing leases) can be slightly more
complex, however. Accounting for renewals and extensions of capital leases depends on (a) whether they render
a guarantee or penalty inoperative and (b) if a guarantee or penalty is not rendered inoperative, whether the
renewal or extension is classified as a capital or operating lease. (FASB ASC 840303516 and 3517;
840303523; 840303527 and 3528) (formerly SFAS 13, paras. 12 and 14)
Original Lease Contains a Guarantee or Penalty. If a lease contains a residual value guarantee or penalty for
failure to renew (other than penalties so severe that the renewal period was included in the original lease term), the
renewal or extension of the lease will nullify the guarantee or penalty. An example is the extension of a 10year lease
that would have required the lessee to purchase the property for $100,000 at the end of the original lease (which is
considered a residual value guarantee). Another example is the extension or renewal of a lease that would have
required the lessee to pay a penalty if it had not been renewed or extended (unless the penalty were so significant
that, at inception, it was assumed that the lease would be renewed and, thus, the renewal period was included in
the lease term). If a renewal or extension of a capital lease renders a guarantee or penalty inoperative, the
accounting is the same as when lease provisions are revised to change the remaining minimum lease payments,
but they do not create an operating lease. The accounting is as follows:
The lessee should adjust the lease obligation to the present value of the remaining minimum lease
payments. The asset should be adjusted by the same amount, and no gain or loss should be recorded.
The interest rate used to compute the present value of the remaining minimum lease payments should be
the rate used when the lease was initially recorded. (FASB ASC 84030358) (formerly SFAS 13, par. 12)
The lessor should adjust the gross investment to reflect the new minimum lease payments receivable and
the new estimated residual value, if affected (although the residual value estimate cannot exceed the
amount originally estimated). The net adjustment should be charged or credited to unearned income.
Original Lease Does Not Contain a Guarantee or Penalty. If renewal or extension of a capital lease does not
render a guarantee or penalty inoperative, the accounting for the renewal or extension depends on whether it is
classified as an operating lease. If the renewal or extension is classified as a capital lease, it should be accounted
for as discussed above. If it is classified as an operating lease, both the lessee and lessor should continue to
account for the lease as is" to the end of its original term. Subsequently, the lease should be accounted for as any
other operating lease. (FASB ASC 840303517) (formerly SFAS 13, par. 14)
Classifying Renewals or Extensions as Salestype Leases. Renewals or extensions of salestype or direct

financing leases may be classified as salestype leases only if they meet the criteria for such leases and occur at or
near the end of the lease term. (At or near the end" is defined as within the last few months.") Such renewals or
extensions that do not occur at or near the end of the lease term must be classified as direct financing leases.
Terminations
When a capital lease is terminated because the lessee purchases the leased asset from the lessor, the lessee
should remove the lease obligation and record the difference between the purchase price and the obligation as an
adjustment to the carrying amount of the asset. The asset would subsequently be presented and accounted for as
any other owned asset. (FASB ASC 840303514) (formerly FIN 26, par. 5)
When a capital lease is terminated other than due to the purchase of the leased asset by the lessee, the lessee
should write off the leased asset and obligation and record any difference as a gain or loss. (FASB ASC
84030401) (formerly SFAS 13, par. 14)The lessor should account for the termination in the same way as for a
change in the provisions of a salestype or direct financing lease. That is
a. the net investment in the lease should be written off,
b. the leased asset should be recorded on the lessor's books at the lower of its original cost, present fair value,
or present carrying amount, and
32
c. any difference in the net investment and the amount at which the asset is recorded on the lessor's books
should be recorded as a loss in the period of the change. (No gain will result because the asset cannot be
reestablished at more than the amount of the net investment.) (FASB ASC 84030407) (formerly SFAS 13,
par. 17)
Changes in Estimates or Circumstances
Changes in estimates, such as changes in the estimated economic life or residual value of leased assets, do not
require the classification of the lease to be reconsidered. Likewise, changes in circumstances do not require that
classification of the lease be reconsidered. (FASB ASC 84010354) ( formerly SFAS 13, par. 9)For example,
assume that a lessee's financial condition unexpectedly improves so that a required payment for failing to exercise
a renewal option is no longer considered a penalty. Had the situation existed at the inception of the lease, the lease
term would have been defined differently and the lease would not have been classified as a capital lease. That (or
any other) change in circumstances would not change the classification of the lease, however. The lease would
continue to be accounted for as a capital lease over the originally determined lease term.
TRANSFER OF LEASED PROPERTY, RENTAL PAYMENTS, OR RESIDUAL VALUE INTERESTS
Transfer of Leased Property or Rental Payments
Subject to Salestype or Direct Financing Lease. After a lease is entered into, the lessor may transfer the lease
or the property subject to the lease to a third party. In such a case, the original accounting for the lease should not
be reversed. (FASB ASC 84030408) (formerly SFAS 13, par. 20)
Receivables related to salestype and direct financing leases are made up of two components: minimum lease
payments and residual values. Transfers of those receivables should be accounted for as follows:
a. Transfers of minimum lease payments and guaranteed residual values. A transfer of minimum lease
payments receivable and residual values guaranteed at the inception of a lease in which the transferor
surrenders control, should be accounted for as a transfer of financial assets. (FASB ASC 84030408)
(formerly SFAS 13, par.20)
b. Transfers of unguaranteed residual values. Unless the sale or assignment is to a related party, a transfer of
unguaranteed residual values or residual values guaranteed after the inception of a lease is not a transfer
of financial assets. (FASB ASC 84030408) (formerly SFAS 13, par. 20) Accordingly, the difference
between the sales price and the carrying amount of the unguaranteed residual values should be
recognized at the time of the transaction as a gain or loss.
Subject to Operating Lease. A sale of property subject to an operating lease should not be recorded as a sale if
the seller (or any party related to the seller) retains substantial risks of ownership in the property. That can occur
when the seller guarantees the recovery of the buyer's investment. For example, if the lessee defaults or terminates
the lease, the seller may have a formal or informal agreement to purchase the leased property, substitute an
existing lease, or secure a new lessee under a remarketing agreement. (A remarketing agreement does not
disqualify accounting for the transaction as a sale, however, if the seller (a) receives a reasonable fee for its efforts
in securing a replacement lessee and (b) is not required to give priority to releasing the property over similar
property owned or produced by the seller.) (FASB ASC 84020403 and 404) (formerly SFAS 13, par. 21)
If the seller retains substantial risks of ownership, the transaction should be accounted for as a borrowing rather
than a sale. In essence, it is assumed that the sales proceeds are actually a borrowing by the seller" from the
buyer," and the loan" is to be repaid with the lease proceeds (even if the lease payments go directly to the buyer).
Consequently, the seller" should record the proceeds from the sale" as a liability and, if necessary, record a
portion of each payment as interest expense. Rent receipts should continue to be recorded as revenue and the
leased asset included in the seller's" balance sheet as an asset. (The term over which the asset is depreciated
should be limited to the estimated amortization period of the obligation, however.) (FASB ASC 84020354)
The preceding guidance also applies if leased property is sold to a third party that leases, or intends to lease, the
property to another party.
33
Acquisition of Residual Value Interest
The residual value of a leased asset is its value at the end of the lease. Although the residual value usually accrues
to the lessor, sometimes it is owned by a nonlessor. For example a lease broker may receive an interest in the
residual value of a leased asset as a fee for services, an interest in the residual value of a leased asset may be
purchased directly from lessors, or a lessor may sell the minimum rental payments associated with a lease and
retain an interest in the residual value of the leased asset. The following guidance applies to accounting for the
acquisition by a third party of an interest in the residual value of a leased asset: (FASB ASC 36010303 and 304;
360103514) (formerly FTB 862, paras. 46)
a. An asset should be recorded at the amount of cash disbursed, the fair value of other consideration given,
or the present value of liabilities assumed at the date the right is acquired. However, the asset should be
recorded at the fair value of the interest if that is more clearly evident than the fair value of assets
surrendered, services rendered, or liabilities assumed.
b. The asset should not be accreted. Thus, it should never be recorded at an amount greater than cost.
c. The asset's recorded value should be written down to fair value through a charge to earnings if recorded
value subsequently exceeds fair value and the decline is other than temporary. An upward adjustment
should not be made, even if fair value subsequently increases.
If a lessor sells the minimum rental payments associated with a salestype, direct financing, or leveraged lease and
retains an interest in the residual value of the leased asset, the lessor should not recognize increases in the
estimated residual value over the lease term. The retained interest is reported at its carrying amount at the date the
rental payments were sold. Subsequent impairment, if any, should be recognized in accordance with subpara
graph (c) above. If the residual value was guaranteed at the inception of the lease, however, it is considered a
financial asset and any increase in the estimated residual value should be recognized over the remaining lease
term. (FASB ASC 840303521; 840303553) (formerly FTB 862, paras. 1012)
34
SELFSTUDY QUIZ
following section.
11. If a revised lease was originally a capital lease and remains a capital lease, but the revision changes the
remaining minimum lease payments, which of the following should occur?
a. The lease obligation should remain unchanged.
b. No asset gain or loss should be recorded.
c. Use the current interest rate to determine the present value of remaining minimum lease payments.
12. Regarding lessor accounting, which of the following actions is appropriate if a direct financing lease or
salestype lease is revised, and the revised lease would have been an operating lease if the revised terms had
existed at inception?
a. The net investment in the lease should continue to be carried on the lessor's books.
b. The leased asset should always be recorded on the lessor's books at it's present fair value.
c. Any difference between net investment and the amount of the recorded asset on lessor's books should
be recognized as a loss in the period of change.
13. A renewal or extension of a lease that occurs eleven months prior to the end of the lease term must be classified
as which of the following?
a. A salestype lease only.
b. A direct financing lease.
14. Which of the following applies when a capital lease is terminated as a result of the lessee purchasing the leased
asset from the lessor?
a. The lessee should write off the leased asset and obligation, recording any difference as a gain or loss.
b. The lessor should account for the termination just as would be done for a change in the provisions of a
salestype or direct financing lease.
c. The lessee should remove the lease obligation and record the difference between the obligation and the
purchase price as an adjustment to the carrying amount of the asset.
15. When there are changes in estimates or circumstances, which statement below accurately reflects how the
classification of the lease should be handled?
a. Changes in the estimated economic life of leased assets require the classification of the lease to be
reconsidered.
b. Changes in the residual value of lease assets do not require the classification of the lease to be
reconsidered.
c. Changes in circumstances require the classification of the lease to be reconsidered.
35
16. When accounting for an interest in the unguaranteed residual value of a leased asset, which of the following
actions should not be taken regarding the asset?
a. It should be recorded at the cash disbursal amount.
b. It should be recorded at a maximum amount of 5% greater than cost.
c. It should be recorded at the fair value of other consideration given.
d. It should be recorded at the present value of liabilities assumed the date the right is acquired.
36
SELFSTUDY ANSWERS
11. For the lessee, if a revised lease was originally a capital lease and remains a capital lease, but the revision
changes the remaining minimum lease payments, which of the following should occur? (Page 30)
a. The lease obligation should remain unchanged. [This answer is incorrect. If the revision to a capital lease
changes the remaining minimum lease payments, the lease obligation must be adjusted to reflect the
present value of the remaining minimum lease payments.]
b. No asset gain or loss should be recorded. [This answer is correct. No gain or loss to the asset should
be recorded when a revision to a capital lease changes the remaining minimum lease payments
because the asset value should be adjusted by the same amount as the lease obligation.]
c. Use the current interest rate to determine the present value of remaining minimum lease payments. [This
answer is incorrect. The same interest rate that was used when the lease was initially recorded should be
used to compute the present value of the remaining minimum lease payments.]
12. Regarding lessor accounting, which of the following actions is appropriate if a direct financing lease or
salestype lease is revised, and the revised lease would have been an operating lease if the revised terms had
existed at inception? (Page 31)
a. The net investment in the lease should continue to be carried on the lessor's books. [This answer is
incorrect. The net investment in the lease should be written off, not carried on the lessor's books per FASB
ASC 84030406 (formerly SFAS 13, par. 17).]
b. The leased asset should always be recorded on the lessor's books at it's present fair value. [This answer
is incorrect. Per FASB ASC 84010354 (formerly SFAS 13, par. 9), the leased asset should be recorded
on the lessor's books at the lower of it's original cost, the amount of the net investment in the lease, or
present fair value.]
c. Any difference between net investment and the amount of the recorded asset on lessor's books
should be recognized as a loss in the period of change. [This answer is correct. Any difference
between the net investment and the amount at which the asset is recorded on the lessor's books
should be recognized as a loss in the period of change due to the fact that no gain will result since
the asset cannot be reestablished at a greater amount than the amount of the net investment.]
13. A renewal or extension of a lease that occurs eleven months prior to the end of the lease term must be classified
as which of the following? (Page 32)
a. A salestype lease only. [This answer is incorrect. According to FASB ASC 840102551 (formerly SFAS
13, par. 6), in order for a renewal or extension of a lease to be classified as a salestype lease only, it must
meet the criteria for such leases and occur within the last few months.]
b. A direct financing lease. [This answer is correct. Renewals that do not occur within the last few
months must be classified as direct financing leases as indicated in FASB ASC 840102551
(formerly SFAS 13, par. 6). A renewal or extension of a lease that occurs eleven months prior to the
end of the lease term would not meet the requirement of having occurred within the last few
months" and would, therefore, be classified as a direct financing lease.]
37
14. Which of the following applies when a capital lease is terminated as a result of the lessee purchasing the leased
asset from the lessor? (Page 32)
a. The lessee should write off the leased asset and obligation, recording any difference as a gain or loss. [This
answer is incorrect. According to FASB ASC 84030401 (formerly SFAS 13, par. 14), this action should
be taken when a capital lease is terminated other than due to the purchase of the leased asset by the
lessee.]
b. The lessor should account for the termination just as would be done for a change in the provisions of a
salestype or direct financing lease. [This answer is incorrect. This action should be taken when a capital
lease is terminated other than due to the purchase of the leased asset by the lessee.]
c. The lessee should remove the lease obligation and record the difference between the obligation and
the purchase price as an adjustment to the carrying amount of the asset. [This answer is correct.
This is the correct action according to FASB ASC 840303514 (formerly FIN 26, par. 5). The asset
would subsequently be presented as any other owned asset.]
15. When there are changes in estimates or circumstances, which statement below accurately reflects how the
classification of the lease should be handled? (Page 33)
a. Changes in the estimated economic life of leased assets require the classification of the lease to be
reconsidered. [This answer is incorrect. Changes in the estimated economic life of leased assets do not
require the classification of the lease to be reconsidered according to FASB ASC 84010354 (formerly
SFAS 13, par. 9).
b. Changes in the residual value of lease assets do not require the classification of the lease to be
reconsidered. [This answer is correct. Per FASB ASC 84010354 (formerly SFAS 13, par. 9),
reconsideration of the classification of the lease is not required due to changes in the residual value
of lease assets.]
c. Changes in circumstances require the classification of the lease to be reconsidered. [This answer is
incorrect. Changes in circumstances do not require the classification of the lease to be reconsidered
according to FASB ASC 84010354 (formerly SFAS 13, par. 9).]
16. When accounting for an interest in the unguaranteed residual value of a leased asset, which of the following
actions should not be taken regarding the asset? (Page 34)
a. It should be recorded at the cash disbursal amount. [This answer is incorrect. According to FASB ASC
36010303 and 304; 360103514 (formerly FTB 862 paras. 46), when accounting for an interest in the
unguaranteed residual value of a leased asset, the asset should be recorded in one of three ways, one
being at the cash disbursal amount.]
b. It should be recorded at a maximum amount of 5% greater than cost. [This answer is correct. The
asset should not be accreted, meaning it should never be recorded at any amount greater than cost
per FASB ASC 36010303 and 304; 360103514 (formerly FTB 862 paras. 46).]
c. It should be recorded at the fair value of other consideration given. [This answer is incorrect. Another of
the three ways to account for the asset when accounting for an interest in the unguaranteed residual value
of a leased asset is to record it at the fair value of other consideration given per FASB ASC 36010303
and 304; 360103514 (formerly FTB 862 paras. 46).]
d. It should be recorded at the present value of liabilities assumed the date the right is acquired. [This answer
is incorrect. According to FASB ASC 36010303 and 304; 360103514 (formerly FTB 862 paras. 46)
the asset can be recorded at the present value of liabilities assumed the date the right is acquired when
accounting for an interest in the unguaranteed residual value of a leased asset.]
38
LEASES INVOLVING REAL ESTATE
Although the basic principles discussed in the preceding paragraphs apply to all leases, certain exceptions exist for
leases involving real estate. Classifying real estate leases depends on whether they involve land only; land and
buildings; land, buildings, and equipment; or only part of a building. (FASB ASC 840102518) (formerly SFAS13,
par. 24)
Leases Involving Land Only
A lessee should consider only two of the capitalization tests when classifying leases of land the transfer of
ownership test and the bargain purchase option test. Thus, if a land lease does not transfer ownership by the end
of the lease term or contain a bargain purchase option, a lessee should classify it as an operating lease rather than
a capital lease. (FASB ASC 840102537) (formerly SFAS 13, par. 25)
A lessor should classify a lease involving only land as follows: (SFAS98, par. 22)
a. The lease should be classified as a salestype lease if it provides a salestype profit or loss and meets the
transfer of ownership test. (FASB ASC 840102555) (formerly SFAS 13, par. 25)
b. The lease should be classified as a direct financing or leveraged lease, whichever is applicable, if it does
not provide a salestype profit or loss but transfers ownership by the end of the lease term or contains a
bargain purchase option and meets the following criteria: (FASB ASC 840102542, 2556, and 2557)
(formerly SFAS 13, paras. 8 and 25)
(1) Collection of the minimum lease payments is reasonably predictable.
(2) There are no important uncertainties about additional unreimbursed costs the lessor will incur.
All other leases involving land only, including those that provide a salestype profit but do not meet the transfer of
ownership test, should be classified as operating leases.
Leases Involving Land and Buildings
Classifying the lease of a building and the underlying land depends on whether the lease transfers ownership or
contains a bargain purchase option and, if not, whether the fair value of the land is less than 25% of the total fair
value of the property.
Lease Transfers Ownership or Contains a Bargain Purchase Option. A lessee should classify a lease involving
land and buildings as a capital lease if it transfers ownership by the end of the lease term or contains a bargain
purchase option. The capitalized lease cost should be allocated between the land and building so that the cost
associated with the building can be depreciated. That is accomplished by (FASB ASC 840102538) (formerly
SFAS 13, par. 26)
allocating the present value of minimum lease payments based on the relative fair values of the land and
building at the inception of the lease.
recording two leased assets one for the land and one for the building. (Only one lease obligation should
be recorded, however.)
A lessor should classify a lease involving land and buildings that transfers ownership by the end of the lease term
and/or contains a bargain purchase option as follows: (FASB ASC 840102561 and 2562) (formerly SFAS 13, par.
26)
a. If the lease transfers ownership by the end of the lease term and provides a salestype profit or loss, the
lessor should classify the lease as a salestype lease. In that case, the lessor should treat the lease as a
single unit, and need not allocate the lease payments received between the land and building.
39
b. If the lease contains a bargain purchase option and provides a salestype profit or loss, the lessor should
classify the lease as an operating lease.
c. If the lease transfers ownership by the end of the lease term (or contains a bargain purchase option) and
does not provide a salestype profit or loss, the lessor should classify the lease as
(1) a direct financing or leveraged lease if collectibility of the minimum lease payments is reasonably
predictable and there are no important uncertainties about additional unreimbursed costs the lessor
will incur.
(2) an operating lease if collectibility of the minimum lease payments is not reasonably predictable or
there are important uncertainties about additional unreimbursed costs the lessor will incur.
Lease Does Not Transfer Ownership or Contain a Bargain Purchase Option. If a land and building lease does
not transfer ownership or contain a bargain purchase option, the lessor and lessee must determine whether the
land portion of the lease is material.
a. If the fair value of the land is less than 25% of the total fair value of the property at the inception of the lease,
the land is considered immaterial. Consequently, the lessee and lessor should consider the lease to be a
single unit for the purposes of applying the 75% and 90% tests and the estimated economic life of the
building should be used when applying the 75% test. If the lease meets either the 75% test or the 90%
test (FASB ASC 840102538 and 2563 through 2565) (formerly SFAS 13, par. 26)
(1) the lessee should classify the lease as a capital lease. (Otherwise, it should classify the lease as a
single operating lease.)
(2) the lessor should classify the lease as a direct financing or leveraged lease, as appropriate, if
collectibility of the minimum lease payments is reasonably predictable and there are no important
uncertainties about additional unreimbursed costs the lessor will incur. (If collectibility of the minimum
lease payments is not reasonably predictable or there are important uncertainties about additional
unreimbursed costs the lessor will incur, the lessor should classify the lease as an operating lease.)
b. If the fair value of the land is greater than or equal to 25% of the total fair value of the property at the inception
of the lease, the land is considered to be material. Consequently, the lessee and lessor should consider
the land portion and the building portion of the lease as separate leases. To determine the portion of the
minimum lease payments applicable to the land, the fair value of the land should be multiplied by the
lessee's incremental borrowing rate. The remaining payments are attributed to the building. The lessee and
lessor should account for the land and building portions of the lease as follows: (FASB ASC 840102538
and 2566 through 2568) (formerly SFAS 13, par. 26)
(1) The lessee should classify the land portion of the lease as an operating lease because the criteria for
capitalizing leases of land only are not met. The 75% and 90% test should be applied to the building
portion and, if either test is met, the building portion should be treated as a capital lease. If neither the
75% or 90% test is met, the lessee should consider the land and building as a single operating lease.
(2) The lessor should classify the land portion of the lease as an operating lease because the criteria for
capitalizing land only leases are not met. The 75% and 90% tests should be applied to the building
portion of the lease. If the 75% test or the 90% test is met, and collectibility of the minimum lease
payments is reasonably predictable and there are no important uncertainties about additional
unreimbursed costs the lessor will incur, the lessor should classify the building portion as a direct
financing or leveraged lease. If neither the 75% test nor the 90% test is met, or if collectibility of the
minimum lease payments is not reasonably predictable or there are important uncertainties about
additional unreimbursed costs the lessor will incur, the lessor should consider the land and building
as a single operating lease.
40
Leases Involving Land, Buildings, and Equipment
Some real estate leases may provide for the lease of both real estate and equipment. The real estate portions and
the equipment portions of such leases should be classified and accounted for separately. If the lease agreement
does not indicate how much of the minimum lease payments apply to real estate and how much apply to
equipment, or if the allocation is unreasonable, the lease payments should be allocated by whatever means are
appropriate in the circumstances." (FASB ASC 840102519 and 2520) (formerly SFAS 13, par. 27)
Leases Involving Only Part of a Building
Many real estate leases involve only part of a building. Examples include leases of office space in office buildings
and leases of retail space in shopping malls. The lessee and lessor's classification of those types of leases depends
on whether the cost or fair value of the leased property is objectively determinable.
a. If the lessee can objectively determine the fair value of the property, it should classify the lease as it would
any other land and building lease.
If the lessee cannot objectively determine the fair value of the property, it should apply only the 75% test
to determine the lease's classification. When applying the test, the estimated economic life of the building
in which the leased premises are located should be used rather than the estimated economic life of the
leased premises. If the 75% test is met, the lessee should classify the lease as a capital lease. Otherwise,
the lease should be considered a single operating lease. (FASB ASC 840102523; 840102539)
b. If the lessor can objectively determine both the cost and fair value of the property, it should classify the lease
as it would any otherland and building lease. If it cannot objectively determine either the cost or fair value
of the property, the lessor should classify the lease as an operating lease. (FASB ASC 840102523;
RELATED PARTY LEASES
Related parties in leasing transactions are defined as owners, parent companies, or investors who have significant
influence over the other party to the lease. Two or more otherwise unrelated companies are considered related if
they are subject to significant influence by a common entity, investors, officers, or directors (for example, brother/
sister companies). (FASB ASC 840105527 and 5529) (formerly SFAS 13, par. 5)
In some leasing arrangements, it is clear that the terms of the transactions have been significantly affected by the
fact that the parties are related. In those cases, the substance of the lease, rather than its form, should govern the
accounting for the transaction. (FASB ASC 840102526) (formerly SFAS 13, par. 29)
41
42
SELFSTUDY QUIZ
following section.
17. All leases involving land only, that provide a salestype profit but do not meet the transfer of ownership test
should:
a. Be classified as direct financing leases.
b. Be classified as operating leases.
c. Be classified as leveraged leases.
d. Be classified as salestype leases.
18. If a lease involving land and buildings that transfers ownership by the end of the lease term and/or contains
a bargain purchase option and provides a salestype profit or loss, the lessor should classify the lease as:
a. An operating lease.
b. A salestype lease.
c. A direct financing lease.
d. A leveraged lease.
19. Regarding a land and building lease that does not contain a bargain purchase option or transfer ownership,
the lessee should consider the land and building as a single operating lease if:
a. The building portion meets the 75% test.
b. The building portion meets the 90% test.
c. The building portion does not meet either the 75% or 90% test.
20. If the lease agreement does not indicate what percent of the minimum lease payments apply to equipment and
what percent apply to real estate, the lease payments should be:
a. Made under a salestype lease.
b. Made under an operating lease.
c. Made under a capital lease.
d. Allocated by whatever means are appropriate.
43
SELFSTUDY ANSWERS
17. All leases involving land only, that provide a salestype profit but do not meet the transfer of ownership test
should: (Page 39)
a. Be classified as direct financing leases. [This answer is incorrect. The lease should be classified as a direct
financing lease, as applicable, if it does not provide a salestype profit or loss but meets certain specified
criteria.]
b. Be classified as operating leases. [This answer is correct. Operating leases are those that involve
land only and/or those that provide a salestype profit but do not meet the transfer of ownership
test.]
c. Be classified as leveraged leases. [This answer is incorrect. The lease should be classified as a leveraged
lease, as applicable, if it does not provide a salestype profit or loss but meets certain specified criteria.]
d. Be classified as salestype leases. [This answer is incorrect. The lease should be classified as a salestype
lease if it provides a salestype profit or loss and meets the transfer of ownership test.]
18. If a lease involving land and buildings that transfers ownership by the end of the lease term and/or contains
a bargain purchase option and provides a salestype profit or loss, the lessor should classify the lease as:
(Page 39)
a. An operating lease. [This answer is correct. The lessor should classify the lease as an operating
lease if the lease contains a bargain purchase option and provided a salestype profit or loss.]
b. A salestype lease. [This answer is incorrect. The lessor should classify the lease as a salestype lease if
the lease transfers ownership by the end of the lease term and provides a salestype profit or loss per FASB
c. A direct financing lease. [This answer is incorrect. The lessor should classify the lease as a direct financing
lease, as applicable, if collectibility of the minimum lease payments can be likely predicted and the lessor
will not incur any important uncertainties about additional unreimbursed costs per FASB ASC
840102555 (formerly SFAS 13, par. 25).]
d. A leveraged lease. [This answer is incorrect. The lessor should classify the lease as a leveraged lease, as
applicable, if collectibility of the minimum lease payments can be likely predicted and the lessor will not
incur any important uncertainties about additional unreimbursed costs per FASB ASC 840102555
(formerly SFAS 13, par. 25).]
19. Regarding a land and building lease that does not contain a bargain purchase option or transfer ownership,
the lessee should consider the land and building as a single operating lease if: (Page 40)
a. The building portion meets the 75% test. [This answer is incorrect. If the 75% test is met, the lessee should
treat the building portion as a capital lease per FASB ASC 840102538 (formerly SFAS 13, par. 26).]
b. The building portion meets the 90% test. [This answer is incorrect. If the 90% test is met, the lessee should
treat the building portion as a capital lease per FASB ASC 840102538 (formerly SFAS 13, par. 26).]
c. The building portion does not meet either the 75% or 90% test. [This answer is correct. If the building
portion does not meet the 75% or the 90% test, the lessee should consider the land and building as
a single operating lease per FASB ASC 840102555 (formerly SFAS 13, par. 26).]
44
20. If the lease agreement does not indicate what percent of the minimum lease payments apply to equipment and
what percent apply to real estate, the lease payments should be: (Page 41)
a. Made under a salestype lease. [This answer is incorrect. Lease payments should not be made under a
salestype lease when the lease agreement does not indicate what percent of the minimum lease
payments apply to equipment and what percent apply to real estate per FASB ASC 840102519 and 2520
b. Made under an operating lease. [This answer is incorrect. Lease payments should not be made under an
operating lease when the lease agreement does not indicate what percent of the minimum lease payments
apply to equipment and what percent apply to real estate per FASB ASC 840102519 and 2520 (formerly
SFAS 13, par. 27).]
c. Made under a capital lease. [This answer is incorrect. Lease payments should not be made under a capital
lease when the lease agreement does not indicate what percent of the minimum lease payments apply
to equipment and what percent apply to real estate per FASB ASC 840102519 and 2520 (formerly SFAS
13, par. 27).]
d. Allocated by whatever means are appropriate. [This answer is correct. When the lease agreement
does not indicate what percent of the minimum lease payments apply to equipment and what
percent apply to real estate, the lease payments should be allocated by whatever means are
appropriate for the particular circumstances.]
45
SUBLEASES AND SIMILAR TRANSACTIONS
The authoritative literature related to accounting for subleases and similar transactions addresses the following
situations:
A new lessee is substituted for the original lessee under a new agreement, and the original lease agreement
is terminated.
A new lessee is substituted under the original lease agreement for the original lessee, and the new lessee
is primarily obligated for the lease (the original lessee may or may not be secondarily obligated).
The lessee releases the property and the original lease remains in effect (i.e., a sublease).
In each situation, the new lessee should classify and account for the lease as it would any other new lease. (FASB
ASC 840102532; 84010402) (formerly SFAS 13, par. 40) Classification and accounting by the original lessor
and the original lessee vary, however, depending on the circumstances as discussed in the following paragraphs.
New Lessee Substituted through a New Agreement
If a new lessee is substituted for the original lessee under a new agreement, and the original lease agreement is
terminated, the accounting is relatively straightforward. The transaction is accounted for by both the original lessee
and original lessor as a termination. (FASB ASC 84010402) (formerly SFAS 13, paras. 37 and 38) Accordingly, if
the lessee recorded the original lease of property other than real estate as a capital lease, the lessee should remove
all accounts related to the lease and record a gain or loss for the difference. Any consideration paid or received
should be included in the gain or loss. If the lessor recorded the original lease as a salestype or direct financing
lease, the lessor should remove the net investment in the lease and record the leased asset at the lower of its
original cost, present fair value, or present carrying amount and change the net adjustment to income. (FASB ASC
84030405 and 407) (formerly SFAS 13, paras. 17 and 3638)
The lessor should classify and account for the new lease agreement as a new transaction. The lessor's cost" for
purposes of classifying and accounting for the new lease is the amount at which the property was recorded upon
termination of the original lease (i.e., the lower of its original cost, present fair value, or present carrying amount).
New Lessee Substituted under the Original Agreement New Lessee Primarily Obligated
If a new lessee is substituted under the original lease agreement for the original lessee, or if the lessee sells or
transfers the lease agreement to a third party, and the new lessee is primarily obligated for the lease, the lessor's
accounting for the original lease is unchanged. (FASB ASC 840103510) (formerly SFAS 13, par. 36) The original
lessee, on the other hand, should account for the transaction as a termination. Accordingly, if the lessee recorded
the original lease as a capital lease of property other than real estate, the lessee should remove all accounts related
to the lease and record a gain or loss for the difference. Any consideration paid or received should be included in
the gain or loss. (FASB ASC 84030405) (formerly SFAS 13, par. 38)
If the lessee remains secondarily liable for the lease, the guarantee obligation should be recognized in accordance
with SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.
(FASB ASC 40520402) (formerly SFAS 13, par. 38) (FASB ASC 84030405)
If the lessee recorded the original lease as a capital lease of real estate (including integral equipment) and the
criteria for recognition of a sale are met, then the lessee should remove all accounts related to the lease and record
a gain or loss for the difference. Any consideration paid or received should be included in the gain or loss, and if the
lessee remains secondarily liable for the lease, the guarantee obligation should be recognized in accordance with
SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. (FASB
ASC 40520402) A gain may be recognized if the criteria for recognition by the full accrual method are met.
Otherwise, the gain should be recognized according to one of the other profit recognition methods. Any loss should
be recognized immediately. (FASB ASC 84030405) (formerly SFAS 13, par. 38)
46
New Lessee Substituted Under the Original Agreement Original Lessee Primarily Obligated (Sublease)
If the lessee releases the property and the original lease remains in effect (i.e., a sublease), the original lessor's and
lessee's accounting for the original lease should not change. (FASB ASC 840103510; 840303512) (formerly
SFAS 13, paras. 36 and 39) When the lessee is not relieved of the primary lease obligation, the original lessee (new
sublessor) should classify and account for the sublease as a new agreement as discussed in the following
paragraphs.
Original Lease Was an Operating Lease. If the original lease was an operating lease, the sublease should be
accounted for as an operating lease. (FASB ASC 840202514) (formerly SFAS 13, par. 39)
Original Lease Was a Capital Lease. If the original lease was a capital lease, accounting for the sublease depends
on why the original lease was capitalized: (FASB ASC 840303512) (formerly SFAS 13, par. 39)
a. If the original lease was capitalized because the lease transferred ownership or contained a bargain
purchase option, the sublease should be classified and accounted for as any other lease. The unamortized
balance of the leased asset should be considered its cost.
b. If the original lease was capitalized because it met the 75% or 90% test, the new lease should be capitalized
only if it meets the 75% test and collectibility of the minimum lease payments is reasonably predictable and
there are no important uncertainties about additional unreimbursed costs the new lessor will incur.
Losses on Subleases
Losses on subleases may be incurred by the lessee/sublessor. Generally, that occurs when
the original lease is a capital lease, the sublease is a salestype lease, and the property's book value (i.e.,
the unamortized balance of the leased property) exceeds its fair value.
the original lease is a capital lease, the sublease is a direct financing lease, and the property's book value
exceeds the total rental payments and residual value to be received.
the original lease is a capital lease, the sublease is an operating lease, and the property's book value plus
executory costs to be incurred exceed the total rental payments to be received.
the original lease and the sublease are operating leases, and the sublessor pays more under the original
lease (in rental payments and executory costs) than it receives under the sublease.
Losses on subleases should be recognized when they occur as follows:
a. For operating subleases, the amount of loss is the amount by which costs to be incurred exceed revenues
to be received over the term of the sublease. (FASB ASC 840202515) (formerly FTB 7915, par. 2)
b. For direct financing subleases, the loss is the amount by which the carrying amount of the investment in
the sublease exceeds expected rentals to be received and estimated residual value, unless the original
lessee's tax benefits are sufficient. (FASB ASC 840303514) (formerly FTB 7915, par. 2)
BUSINESS COMBINATIONS
A business combination by itself does not affect a lease's classification. Consequently, so long as its terms are not
changed as part of the combination, a lease classified as a capital lease prior to a business combination would
continue to be classified as a capital lease after the business combination. (FASB ASC 840102527; 84010355)
(formerly FIN 21, par. 12) (A lease should be classified and accounted for as a new lease if its terms are changed
and the revised terms would have resulted in a different classification if they had been in effect at the inception of
the lease.)
47
A leveraged lease acquired in a business combination should be accounted for as follows: (FASB ASC
840302510; 84303015) (formerly FIN 21, par.16)
a. The amount assigned to an investment in a leveraged lease at the date of the combination should be based
on the lease's remaining future cash flows with appropriate recognition given to the estimated tax effects
of those cash flows.
b. Once assigned, the amount should be allocated to the lease's components (that is, net rentals receivable,
estimated residual value, and unearned income) and accounted for as discussed herein.
LEASES WITH GOVERNMENTAL ENTITIES
Fiscal Funding Clauses
Some leases with governmental entities contain clauses referred to as fiscal funding clauses. Those clauses allow
the governmental entity to cancel the lease if sufficient funds are not appropriated for it to fulfill its obligations under
the lease. Questions arose as to whether fiscal funding clauses resulted in the leases being cancelable and,
consequently, preclude them from being classified as capital leases. GAAP indicates that the likelihood of cancella
tion should be assessed, and, if the likelihood is considered to be remote, the lease should be considered
noncancelable. (FASB ASC 84010253) (formerly FTB 7910, par. 5)
Property Owned by a Governmental Unit or Authority
Leases of terminal space or other airport facilities from governmental units or authorities normally are classified as
operating leases because they do not transfer ownership or contain a bargain purchase option, the estimated life
of the facility is not determinable (because the governmental unit can abandon the facility), and the concept of fair
value is not applicable (because such property is not available for sale). Typically, other leases from governmental
units or authorities (for example, leases of bus terminals) also are classified as operating leases because they
possess similar characteristics. Leases involving governmental units or authorities should be classified as operat
ing leases if all of the following conditions are met: (FASB ASC 840102525) (formerly FIN 23, par. 8 and SFAS 13,
par. 28)
a. The leased property is owned by a governmental unit or authority.
b. The leased property is operated by or on behalf of the governmental unit or authority and is part of a larger
facility, such as an airport.
c. The leased property cannot be moved to another location because it is a permanent structure or is part of
a permanent structure.
d. The governmental unit or authority has the right to terminate the lease at any time.
e. The lease does not transfer ownership to the lessee or allow the lessee to purchase or otherwise acquire
the leased property.
f. Equivalent property in the service area cannot be purchased or leased from a nongovernmental unit or
authority.
48
MONEY-OVER-MONEY LEASE TRANSACTIONS
A moneyovermoney lease transaction is one in which a company manufactures or purchases an asset, leases the
asset to the lessee, and obtains nonrecourse financing in excess of the asset's cost using the leased asset and
future lease rentals as collateral. Such transactions should be accounted for as (a) the manufacture or purchase of
an asset, (b) the leasing of the asset under an operating, direct financing, or salestype lease, and (c) the borrowing
of funds. (FASB ASC 840305519) (formerly FTB 881, par. 17) (Classification of the lease as an operating, direct
financing, or salestype lease should be based on the same criteria as for any other lease.)
In a moneyovermoney lease, the company should not offset the asset (if the lease is classified as an operating
lease) or the lease receivable (if the lease is classified as a direct financing or salestype lease) and the nonrecourse
debt unless a right of setoff exists. (FASB ASC 840305520) (formerly FTB 881, par. 17)
49
50
SELFSTUDY QUIZ
following section.
21. If a new lessee is substituted for the original lessee under a new agreement and termination of the original lease
agreement also occurs, the transaction is accounted for:
a. Only by the original lessee as a termination.
b. Only by the original lessor as a termination.
c. By both the original lessor and original lessee as a termination.
d. By both the original lessor and original lessee as a transfer.
22. If the lessee recorded the original lease as a capital lease of real estate and the criteria for recognition of a sale
are met, what action should the lessee take?
a. Remove only major accounts related to the lease and record a gain or loss for the difference.
b. Consideration paid or received from removed accounts are not included in the gain or loss.
c. A gain may be recognized if the requirements for recognition by the full accrual method are met.
d. Any loss should be recognized by the end of the reporting period.
23. Losses on subleases may be incurred by the lessee/sublessor when the original lease is a capital lease, the
sublease is a salestype lease, and:
a. The property's book value exceeds its fair value.
b. The property's book value exceeds the total rental payments and residual value to be received.
c. The property's book value plus executory costs to be incurred exceed total rental payments to be received.
d. The sublessor pays more under the original lease than it receives under the sublease.
24. Leases involving governmental units or authorities should be classified as operating leases if a number of
conditions are met. Which of the following is one of those required conditions?
a. The leased property is operated by a nongovernmental unit or authority and is part of a larger facility.
b. The leased property can be moved or relocated to another location because it is a temporary structure.
c. The lease does not allow the lessee to purchase or otherwise acquire the leased property.
d. Equivalent property in the service area cannot be purchased or leased from another governmental unit or
authority.
51
SELFSTUDY ANSWERS
21. If a new lessee is substituted for the original lessee under a new agreement and termination of the original lease
agreement also occurs, the transaction is accounted for: (Page 46)
a. Only by the original lessee as a termination. [This answer is incorrect. The transaction is not accounted
for as a termination by the original lessee only per FASB ASC 84010402 (formerly SFAS 13, paras. 37
and 38).]
b. Only by the original lessor as a termination. [This answer is incorrect. The transaction is not accounted for
as a termination by the original lessor only per FASB ASC 84010402 (formerly SFAS 13, paras. 37 and
38).]
c. By both the original lessor and original lessee as a termination. [This answer is correct. If a new
lessee is substituted for the original lessee under a new agreement and termination of the original
lease agreement also occurs, the transaction is accounted for by both the original lessor and
original lessee as a termination.]
d. By both the original lessor and original lessee as a transfer. [This answer is incorrect. The transaction is
not accounted for by both the original lessor and original lessee as a transfer per FASB ASC 84010402
(formerly SFAS 13, paras. 37 and 38).]
22. If the lessee recorded the original lease as a capital lease of real estate and the criteria for recognition of a sale
are met, what action should the lessee take? (Page 46)
a. Remove only major accounts related to the lease and record a gain or loss for the difference. [This answer
is incorrect. Per FASB ASC 84030405 (formerly SFAS 13, par. 38), the lessee should remove all accounts
related to the lease and record a gain or loss for the difference.]
b. Consideration paid or received from removed accounts are not included in the gain or loss. [This answer
is incorrect. Per FASB ASC 84030405 (formerly SFAS 13, par. 38), any consideration paid or received
should be included in the gain or loss.]
c. A gain may be recognized if the requirements for recognition by the full accrual method are met.
[This answer is correct. A gain may be recognized if the requirements for recognition by the full
accrual method are met. Otherwise, the gain should be recognized in accordance with one of the
other profit recognition methods such as the deposit method, the cost recovery method, the
installment method, the reduced profit method, and the percentageofcompletion method per FASB
d. Any loss should be recognized by the end of the reporting period. [This answer is incorrect. Any loss should
be recognized immediately according to FASB ASC 84030405 (formerly SFAS 13, par. 38).]
23. Losses on subleases may be incurred by the lessee/sublessor when the original lease is a capital lease, the
sublease is a salestype lease, and: (Page 47)
a. The property's book value exceeds its fair value. [This answer is correct. When the original lease
is a capital lease, the sublease is a salestype lease, and the property's book value exceeds its fair
value, losses on subleases may be incurred by the lessee/sublessor per FASB ASC 840202515
(formerly FTB 7915, par. 2).]
b. The property's book value exceeds the total rental payments and residual value to be received. [This
answer is incorrect. Losses on subleases may be incurred by the lessee/sublessor when the original lease
is a capital lease, the sublease is a direct financing lease, and the property's book value exceeds the total
rental payments and residual value to be received.]
c. The property's book value plus executory costs to be incurred exceed total rental payments to be received.
[This answer is incorrect. Losses on subleases may be incurred by the lessee/sublessor when the original
52
lease is a capital lease, the sublease is an operating lease, and the property's book value plus executory
costs to be incurred exceed total rental payments to be received.]
d. The sublessor pays more under the original lease than it receives under the sublease. [This answer is
incorrect. Losses on subleases may be incurred by the lessee/sublessor when the original lease and the
sublease are operating leases, and the sublessor pays more in rental payments and executory costs under
the original lease than it receives under the sublease.]
24. Leases involving governmental units or authorities should be classified as operating leases if a number of
conditions are met. Which of the following is one of those required conditions? (Page 48)
a. The leased property is operated by a nongovernmental unit or authority and is part of a larger facility. [This
answer is incorrect. Per FASB ASC 840102525 (formerly FIN 23, par. 8 and SFAS 13, par. 28), the leased
property must be owned by a governmental unit or authority.]
b. The leased property can be moved or relocated to another location because it is a temporary structure.
[This answer is incorrect. The leased property cannot be moved to another location since it is a permanent
structure or part of a permanent structure.]
c. The lease does not allow the lessee to purchase or otherwise acquire the leased property. [This
answer is correct. The lease does not transfer ownership to the lessee or allow the lessee to
purchase or acquire the leased property according to FASB ASC 840102525 (formerly FIN 23, par.
8 and SFAS 13, par. 28).]
d. Equivalent property in the service area cannot be purchased or leased from another governmental unit or
authority. [This answer is incorrect. Equivalent property in the service area cannot be purchased or leased
from a nongovernmental unit or authority according to FASB ASC 840102525 (formerly FIN 23, par. 8 and
SFAS 13, par. 28).]
53
SALE-LEASEBACK TRANSACTIONS
A saleleaseback transaction occurs when an owner sells property and then leases all or part of it back from the
new owner. (FASB ASC 84040053) (formerly SFAS 13, par. 32) The seller is referred to as the sellerlessee and the
purchaser is referred to as the purchaserlessor. Saleleaseback transactions typically are entered into as a means
of financing, for tax reasons, or both. In addition, if a property owner has accumulated significant equity in a
property, a saleleaseback transaction provides a way to realize the equity without giving up the use of the property.
Purchaserlessor Accounting
For the purchaserlessor, there is nothing very unique about accounting for a saleleaseback transaction. The
saleleaseback should simply be treated as two separate transactions the purchase of an asset and the lease of
an asset. The asset purchase should be recorded at cost and accounted for like any other purchase, and the lease
should be classified and accounted for like any other lease. The only exception is that the purchaserlessor may not
classify the leaseback as a salestype lease; it must classify the lease as either an operating or direct financing
lease. (FASB ASC 84040258) (formerly SFAS 13, par. 34)
Sellerlessee Accounting
The sellerlessee should account for the lease portion of a saleleaseback as a capital lease if it meets certain
criteria. Otherwise, it should account for the lease as an operating lease. Any profit or loss on the sale of the asset
should be deferred and amortized in proportion to the amortization of the leased asset (if the lease is classified as
a capital lease) or in proportion to the gross rental charged to expense over the lease term (if the lease is classified
as an operating lease) except in the following situations: (FASB ASC 84040252 and 253; 84040351) (formerly
SFAS 13, par. 33)
a. The sellerlessee retains the rights to only a minor portion of the remaining use of the property sold. In that
event, the sellerlessee should account for the saleleaseback as separate transactions based on their
respective terms. The lease must provide for a reasonable amount of rent based on market conditions at
the inception of the lease, however. If it does not, an appropriate amount of the profit or loss should be
deferred and amortized as described above so that the total rent for the leased property is a reasonable
amount.
b. The sellerlessee retains the rights to more than a minor portion but less than substantially all of the remaining
use of the property sold. In that event, the sellerlessee should recognize any excess profit determined at
the sale date.
If the lease is classified as an operating lease, the amount that should be recognized is the profit in excess
of the present value of minimum lease payments over the lease term. When computing that amount, the
present value of the minimum lease payments should be determined using the interest rate used to apply
the 90% test.
If the lease is classified as a capital lease, the amount that should be recognized is the profit in excess of
the recorded amount of the leased asset.
c. The fair value of the property at the time of the transaction is less than its undepreciated cost. In that event,
a loss should be recognized equal to the difference between undepreciated cost and fair value.
The sellerlessee is presumed to have retained only a minor portion of the rights to the asset's remaining use if the
present value of a reasonable amount of rental for the leaseback is 10% or less of the fair value of the asset sold.
The sellerlessee is presumed to have retained substantially all of the rights to the asset's remaining use if the
leaseback (a) covers the entire property sold and (b) meets the criteria for classification as a capital lease. (FASB
54
Saleleaseback Transactions Involving Real Estate. If a saleleaseback transaction involves real estate, the
sellerlessee should apply the saleleaseback accounting described in the preceding paragraphs only if the
transaction meets all of the following conditions: (FASB ASC 84040259) (formerly SFAS 98, par. 7)
a. The leaseback is a normal leaseback." A normal leaseback is defined as one in which the sellerlessee
actively uses the property during the lease term in exchange for payment of rent, provided any subleasing
of the property is minor, and provided there is no continuing involvement with the property on the part of
the sellerlessee. When determining whether a leaseback is a normal leaseback, the following should be
considered: (FASB ASC 8404020) (formerly SFAS 98, par. 8)
(1) To satisfy the active use requirement, the sellerlessee must occupy the property and use it in its trade
or business. The active use requirement also is satisfied in situations in which the sellerlessee only
provides services and the property is occupied occasionally or on a shortterm basis generally
transient or shortterm and is integral to the services being provided. That provision allows
saleleaseback accounting for saleleasebacks of properties such as hotels and golf courses. (FASB
ASC 8404020; 840405535 and 5536) (formerly SFAS 98, par. 8)
(2) For the leaseback to be considered a normal leaseback, any subleasing of the property must be minor.
For that purpose, minor" is determined in the same way a minor leaseback" is determined. (FASB
ASC 8404020; 840405535) (formerly SFAS 98, par. 8)
(3) If the leaseback includes rental payments that are contingent on the future operations of the
sellerlessee (for example, a percentage of the sellerlessee's gross sales), the leaseback is still
considered to be a normal leaseback, and saleleaseback accounting should be used. (FASB ASC
8404020) (formerly SFAS 98, par. 8) As discussed in item c., however, if the leaseback includes rental
payments that are contingent on the future operations of the purchaserlessor, the sellerlessee is
considered to have continuing involvement with the property, and saleleaseback accounting is
precluded. (FASB ASC 840402514) (formerly SFAS 98, par. 12)
b. Payment terms and provisions adequately demonstrate the purchaserlessor's initial and continuing
investments. The purchaserlessor's initial and continuing investment in the property must be adequate as
prescribed by FASB ASC 3602040, Property, Plant and Equipment Real Estate Sales Derecognition,
(formerly SFAS No. 66, Accounting for Sales of Real Estate). (FASB ASC 36020409 through 4020)
(fomerly SFAS 66, paras. 812)
c. The sale has been completed and the sellerlessee has no continuing involvement with the property other
than the leaseback. Continuing involvement includes situations in which the sellerlessee has a repurchase
obligation or option or the sellerlessee guarantees the purchaserlessor's investment or a specific return
on that investment. The following are specific examples of continuing involvement that preclude
saleleaseback accounting: (FASB ASC 840402513 and 2514) (formerly SFAS98, paras. 1113)
(1) The sellerlessee guarantees a specified residual value.
(2) The sellerlessee provides nonrecourse financing to the purchaserlessor for any portion of the sales
proceeds.
(3) The sellerlessee provides recourse financing in which the only recourse is to the leased asset.
(4) The sellerlessee remains obligated under any existing debt related to the property, including
secondary liability.
(5) The sellerlessee provides collateral on behalf of the purchaserlessor (other than the property directly
involved in the saleleaseback transaction).
(6) The sellerlessee guarantees the purchaserlessor's debt.
(7) A party related to the sellerlessee guarantees the purchaserlessor's debt.
55
(8) A party related to the sellerlessee guarantees a return of the purchaserlessor's investment.
(9) A party related to the sellerlessee guarantees a return on the purchaserlessor's investment.
(10) The sellerlessee's rental payment is contingent on future operations of the purchaserlessor.
(11) The sellerlessee does not sell or lease the underlying land to the purchaserlessor.
(12) A provision or circumstance allows the sellerlessee to participate in future appreciation of the property
or future profits of the purchaserlessor.
Saleleaseback transactions that do not qualify for saleleaseback accounting because of any form of continuing
involvement should be accounted for by the deposit method or as a financing (i.e., the financing method). (FASB
ASC 8402511) (formerly SFAS 98, par. 10) Under both the deposit method and financing method, the sellerlessee
should convert to saleleaseback accounting when the criteria for saleleaseback accounting are met (for example,
when continuing involvement ends). At that time, an adjustment to convert income to what it would have been if the
sale had been initially recorded should be calculated, the profit should be deferred over the remaining lease term,
and the sale and the lease should be recorded. (FASB ASC 840405555) (formerly SFAS 98, par. 31)
WRAP LEASE TRANSACTIONS
A wrap lease transaction is one in which a company purchases an asset and leases it to a lessee, obtains
nonrecourse financing using the lease rentals or the asset and lease rentals as collateral, sells the asset and
nonrecourse debt to a third party, and leases the asset back while remaining the lessor on the original lease. (FASB
ASC 8404020) (formerly FTB 881, par. 21) A wrap lease transaction is essentially a saleleaseback of property
and should be accounted for as such. If the property involved in the transaction is real estate, the guidance above
should be followed. Otherwise, the guidance for saleleaseback of other property should be followed. (FASB ASC
860405517 and 5518) (formerly FTB 881, paras. 2122)
When presenting a wrap lease transaction in the balance sheet, the subleased asset and related nonrecourse debt
should not be offset unless a legal right of setoff exists. (FASB ASC 840405521) (formerly FTB 881, par. 22)
LEASES AND ASSET RETIREMENT OBLIGATIONS
Entities should record the fair value of a liability for an asset retirement obligation in the period in which it is incurred.
If an asset retirement obligation exists in connection with leased property, a lessee should record the obligation
only if it does not meet the definition of minimum lease payments or contingent rentals. If the lessee's asset
retirement obligation meets the definition of either minimum lease payments or contingent rentals, the obligation
should be accounted for as such. (FASB ASC 41020152) (formerly SFAS 143, par.17)
GENERAL DISCLOSURES ABOUT LEASES
Authoritative literature requires the following information about leases to be disclosed:
Lessees:
a. A general description of the leasing arrangements including, but not limited to, the following: (FASB ASC
(1) Basis on which contingent rental payments are determined
(2) Existence and terms of renewal or purchase options and escalation clauses
(3) Restrictions imposed by lease agreements, such as those concerning dividends, additional debt, and
further leasing
56
b. Nature and extent of leasing transactions with related parties (FASB ASC 84010501) (formerly SFAS 13,
par. 29)
c. For capital leases: (FASB ASC 84030501) (formerly SFAS 13, par. 16)
(1) Gross amount of assets recorded under capital leases presented by major classes according to
nature or function (The information should be disclosed as of the date of each balance sheet
presented and may be combined with comparable information with owned assets.)
(2) Future minimum lease payments as of the date of the latest balance sheet presented, in the aggregate
and for each of the five succeeding fiscal years, with separate deductions from the total for the amount
representing executory costs (including any related profit) included in the minimum lease payments
and for the amount of the imputed interest necessary to reduce the net minimum lease payments to
present value
(3) Total minimum sublease rentals to be received in the future under noncancelable subleases as of the
date of the latest balance sheet presented
(4) Total contingent rentals actually incurred for each period for which an income statement is presented
(5) Assets recorded under capital leases and related accumulated depreciation should be separately
identified in the balance sheet or notes to the financial statements. Likewise, lease obligations should
be separately identified in the balance sheet or notes to the financial statements as obligations under
capital leases and classified as current or noncurrent like any other liability. (FASB ASC 84030451
and 452) (formerly SFAS 13, par. 13)
(6) Unless depreciation expense related to assets recorded under capital leases is included with
depreciation expense related to owned assets (and that fact is disclosed), depreciation expense
related to assets recorded under capital leases should be separately disclosed in the financial
statements or notes to the financial statements. (FASB ASC 84030453; 84030502) (formerly SFAS
13, par. 13)
d. For operating leases having initial or remaining noncancelable lease terms in excess of one year: (FASB
(1) Future minimum rental payments required as of the date of the latest balance sheet presented, in the
aggregate and for each of the five succeeding fiscal years
(2) Total minimum rentals to be received in the future under noncancelable subleases as of the date of
the latest balance sheet presented
e. For all operating leases, rental expense for each period for which an income statement is presented, with
separate amounts for minimum rentals, contingent rentals, and sublease rentals (Rental payments under
leases with terms of a month or less that were not renewed need not be included.) (FASB ASC 84020501)
Lessors:
a. If leasing is a significant part of business activities, a general description of the leasing arrangements (FASB
b. Nature and extent of leasing transactions with related parties (FASB ASC 84010501) (formerly SFAS 13,
par. 29)
c. If leasing is a significant part of business activities, for salestype and direct financing leases: (FASB ASC
(1) Components of the net investment in salestype and direct financing leases as of the date of each
balance sheet presented (The components of the net investment include future minimum lease
57
payments to be received, executory costs and related profit, accumulated allowance for uncollectible
minimum lease payments receivable, unguaranteed residual values accruing to the benefit of the
lessor, unearned income, and initial direct costs of direct financing leases.)
(2) Future minimum lease payments receivable for each of the five fiscal years following the date of the
latest balance sheet presented
(3) Contingent rentals included in income for each income statement presented
d. If leasing is a significant part of business activities, for operating leases: (FASB ASC 84020504) (formerly
SFAS 13, par. 23)
(1) Cost and carrying amount of property leased to lessees or held for leasing (The information should
be disclosed for each balance sheet presented and include the amounts for each major class of
property and the amount of accumulated depreciation for all such assets in total.)
(2) Minimum future rentals on noncancelable leases as of the date of the latest balance sheet presented,
in total and for each of the five succeeding fiscal years
(3) Total contingent rentals included in each income statement presented (SFAS 13, par. 23)
e. For contingent rental income (FASB ASC 84010505) (formerly EITF 989)
(1) Accounting policy for recognizing contingent rental income
(2) If the lessor accrues contingent rental income prior to the lessee's achievement of the specified target
(provided achievement of the target is probable), the impact on rental income if the lessor's
accounting policy was to defer contingent rental income until the specified target is met
LEVERAGED LEASES
A lessor's balance sheet should report an investment in a leveraged lease separately from the related deferred
taxes. (FASB ASC 84030455) (formerly SFAS 13, par. 47) If leveraged leasing activities comprise a significant part
of the lessor's revenue, net income, or assets, the components of the net investment in leveraged leases should be
disclosed. The components include the following: (FASB ASC 84030258; 840303014; 84030505) (formerly
SFAS 13, par. 47)
a. Rentals receivable, net of the portion applicable to principal and interest on the nonrecourse debt
b. Receivable for investment tax credits to be received on the transaction
c. The leased asset's estimated residual value
d. Unearned and deferred income
SALE-LEASEBACK TRANSACTIONS
In addition to the lessee disclosures above, a sellerlessee in a saleleaseback transaction should describe the
terms of the transaction, including any future commitments, obligations, provisions, or circumstances that require
or result in the sellerlessee's continuing involvement. The sellerlessee also should disclose the following if it
accounts for the transaction under the deposit method or as a financing: (FASB ASC 84040501 and 502)
(formerly SFAS 98, paras.1718)
a. Obligation for future minimum lease payments as of the date of the latest balance sheet presented
b. Total minimum sublease rentals to be received in the future under noncancelable subleases
Both of the preceding disclosures should be presented in the aggregate and for each of the five years succeeding
the latest balance sheet date.
58
SELFSTUDY QUIZ
following section.
25. When accounting for a saleleaseback transaction, the purchaserlessor may not classify the leaseback as
a. Operating lease.
b. Salestype lease.
c. Direct financing lease.
26. Under a saleleaseback transaction involving real estate, the buyerlessor's initial and continuing investment
in the property must be adequate as prescribed by:
a. FASB ASC 360 (formerly SFAS No. 66).
b. FASB ASC 840 (formerly SFAS No. 98).
c. FASB ASC 825 (formerly SFAS No. 107).
d. FASB ASC 805 (formerly SFAS No. 141(R)).
27. Which of the following is an example of continuing involvement that precludes saleleaseback accounting?
a. The sellerlessee provides recourse financing to the buyerlessor for any portion of the sales proceeds.
b. The sellerlessee provides nonrecourse financing in which the only nonrecourse is to the leased asset.
c. The sellerlessee remains obligated under any existing debt related to the property, except secondary
liability.
d. Except for property directly involved in the saleleaseback transaction, the sellerlessee provides collateral
on behalf of the buyerlessor.
28. Saleleaseback transactions that do no qualify for saleleaseback accounting should be accounted for using
the deposit method or the financing method. Which of the following statements accurately describes how
saleleaseback transactions are accounted for using either of these two methods?
a. Under the financing method, when continuing involvement ends, the sellerlessee should continue using
the financing method of accounting.
b. Under the deposit method, when continuing involvement ends, the sellerlessee should convert to
saleleaseback accounting.
59
SELFSTUDY ANSWERS
25. When accounting for a saleleaseback transaction, the purchaserlessor may not classify the leaseback as
which of the following? (Page 54)
a. Operating lease. [This answer is incorrect. The purchaserlessor may classify a leaseback as an operating
lease per SFAS 13, par. 33.]
b. Salestype lease. [This answer is correct. The purchaserlessor may not classify the leaseback as
a salestype lease when accounting for a saleleaseback transaction per SFAS 13, par. 33.]
c. Direct financing lease. [This answer is incorrect. Per SFAS 13, par. 33, there are two types of leases the
purchaserlessor may classify a leaseback as when accounting for a saleleaseback transaction, one is
a direct financing lease.]
26. Under a saleleaseback transaction involving real estate, the purchaserlessor's initial and continuing
investment in the property must be adequate as prescribed by: (Page 55)
a. FASB ASC 360 (formerly SFAS No. 66). [This answer is correct. The adequacy of the buyerlessor's
initial and continuing investment in the property is addressed in FASB ASC 360 (formerly SFAS No.
66, Accounting for Sales of Real Estate).]
b. FASB ASC 360 (formerly SFAS No. 98). [This answer is incorrect. FASB ASC 360 (formerly SFAS No. 98),
Accounting for Leases, an amendment of FASB Statements No. 13, 66, and 91 and a rescission of FASB
Statement No. 26 and Technical Bulletin No. 7911, specifies the accounting by a sellerlessee for a
saleleaseback transaction involving real estate, including real estate with equipment. In addition, this
Statement modifies the provisions of FASB Statement No. 13, Accounting for Leases, that define the lease
term, the accounting by a lessor for salestype leases of real estate that provide for the transfer of title, and
the accounting for initial direct costs of direct financing leases.]
c. FASB ASC 840 (formerly SFAS No.107). [This answer is incorrect. FASB ASC 360 (formerly SFAS No. 107),
Disclosures about Fair Values of Financial Instruments, extends existing fair value disclosure practices for
some instruments by requiring all entities to disclose the fair value of financial instruments, both assets and
liabilities recognized and not recognized in the statement of financial position, for which it is practicable
to estimate fair value. If estimating fair value is not practicable, this Statement requires disclosure of
descriptive information pertinent to estimating the value of a financial instrument.]
d. FASB ASC 805 (formerly SFAS No. 141). [This answer is incorrect. FASB ASC 805 (formerly SFAS No.
141(R)), Business Combinations, addresses financial accounting and reporting for business combinations
and supersedes APB Opinion No. 16, Business Combinations, and FASB Statement No. 38, Accounting
for Preacquisition Contingencies of Purchased Enterprises. All business combinations in the scope of this
Statement are to be accounted for using one method, the purchase method.]
27. Which of the following is an example of continuing involvement that precludes saleleaseback accounting?
(Page 55)
a. The sellerlessee provides recourse financing to the buyerlessor for any portion of the sales proceeds.
[This answer is incorrect. The sellerlessee provides nonrecourse financing to the buyerlessor for any
portion of the sales proceeds per FASB ASC 840402513 and 2514 (formerly SFAS 98, paras. 1113).]
b. The sellerlessee provides nonrecourse financing in which the only nonrecourse is to the leased asset.
[This answer is incorrect. According to FASB ASC 840402513 and 2514 (formerly SFAS 98, paras.
1113), the sellerlessee provides recourse financing in which the only recourse is to the leased asset.]
c. The sellerlessee remains obligated under any existing debt related to the property, except secondary
liability. [This answer is incorrect. The sellerlessee remains obligated under any existing debt related to
the property, including secondary liability per FASB ASC 840402513 and 2514 (formerly SFAS 98,
paras. 1113).]
60
d. Except for property directly involved in the saleleaseback transaction, the sellerlessee provides
collateral on behalf of the buyerlessor. [This answer is correct. According to FASB ASC
840402513 and 2514 (formerly SFAS 98, paras. 1113). The sellerlessee provides collateral on
behalf of the buyerlessor except for the property directly involved in the saleleaseback
transaction.]
28. Saleleaseback transactions that do not qualify for saleleaseback accounting should be accounted for using
the deposit method or the financing method. Which of the following statements accurately describes how
saleleaseback transactions are accounted for using either of these two methods? (Page 56)
a. Under the financing method, when continuing involvement ends, the sellerlessee should continue using
the financing method of accounting. [This answer is incorrect. According to FASB ASC 8402511 (formerly
SFAS 98, par.10), under the financing method, when continuing involvement ends, the sellerleasee
converts to saleleaseback accounting.]
b. Under the deposit method, when continuing involvement ends, the sellerlessee should convert to
saleleaseback accounting. [This answer is correct. Under the deposit method and the financing
method, when continuing involvement ends and the criteria have been met for saleleaseback
accounting, the sellerlessee should convert to saleleaseback accounting per FASB ASC 8402511
(formerly SFAS 98, par 10).]
61
62
EXAMINATION FOR CPE CREDIT
Lesson 1 (GAPTG091)
Determine the best answer for each question below. Then mark your answer choice on the Examination for CPE
Credit Answer Sheet located in the back of this workbook or by logging onto the Online Grading System.
1. Which of the following is incorrect regarding a business in a high risk industry that cannot purchase insurance
at reasonable rates?
a. Forming a mutual insurance enterprise allows a business to pool its risks with other businesses for reason
able insurance rates.
b. The business paying the largest premiums to the mutual insurance enterprise holds controlling interest in
it.
c. Risk of loss may or may not transfer to the insurance enterprise.
d. Depending on circumstances, premium payments by a business to the mutual insurance enterprise

should be treated as an expense or deposit.
2. Which of the following should be classified in the statement of cash flows based on the nature and purpose for
which the life settlements were acquired?
a. Life settlement contracts that are remeasured at fair value.
b. Investment income from investments in life settlement contracts remeasured at fair value.
c. Cash receipts and payments related to life settlement contracts.
d. Do not select this answer choice.
3. Regarding investments in life settlement contracts, for investment method contracts, anticipated life insurance
premiums to be paid should be disclosed for which of the following?
a. Each of the two succeeding fiscal years.
b. Each of the three succeeding fiscal years.
c. Each of the four succeeding fiscal years.
d. Each of the five succeeding fiscal years.
4. Which of the following characteristics is applicable to a leveraged lease?
a. The lessor's net investment in the lease rises in the early years of the lease and declines during the later
years before it is eliminated.
b. The lessor's net investment in the lease declines during the early years of the lease and rises during the
later years prior to being eliminated.
c. The lessor's net investment in the lease remains constant throughout the lease from the early to the late
years prior to being eliminated.
d. Investment tax credits retained by the lessor are not deferred and, therefore, are not allocated to income
over the lease term.
63
5. When determining whether to classify a lease as a capital lease, the lease term and the present value of the
minimum lease payments criteria do not apply if the lease term begins within what percent of the leased proper
ty's total estimated economic life?
a. The last 20%.
e. The last 25%.
f. The last 30%.
g. The last 35%.
6. If the lease transfers ownership of the property by the end of the lease term, which of the following is correct
regarding extension of the lease term past the date a bargain purchase option becomes exercisable?
a. The lease term can be extended for a period not to exceed 90 days after the date a bargain purchase option
becomes exercisable.
b. The lease term can be extended for a period not to exceed 120 days after the date a bargain purchase
option becomes exercisable.
c. The lease term can be extended for a period not to exceed 180 days after the date a bargain purchase
option becomes exercisable.
d. The lease term cannot extend past the date a bargain purchase option becomes exercisable because it is
assumed that the option will be exercised and the lease will end concurrently.
7. In order to meet the bargain purchase option test, the lessee must have the option to purchase the leased prop
erty at a price:
a. Slightly below its expected fair value at the date the option is exercisable.
b. Substantially below its expected fair value at the date the option is exercisable.
c. At least 40% below its expected fair value at the date the option is exercisable.
d. At least 50% below its expected fair value at the date the option is exercisable.
8. Over what period of time should a leased asset classified as a capital lease be amortized by the lessee?
a. It depends on why the lease was capitalized.
b. If the transfer of ownership or bargain purchase option test is met, depreciate over lease term down to its
expected value to lessee.
c. If the transfer of ownership or bargain purchase option test is not met, depreciate over its estimated life
down to estimated residual value.
9. How should a lessor account for a salestype lease?
a. Determine the net investment in the lease.
b. Discount the net investment in the lease to present value.
c. Recognize the present value of the minimum lease payments to be received as income.
d. Review the estimated residual value at least semiannually.
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10. A lessor should include all the following in its recorded net investment in a leveraged lease except:
a. Rents receivable, including the portion applicable to principal and interest on the nonrecourse debt.
b. A receivable for the investment tax credit that will be realized.
c. The leased asset's estimated residual value.
d. Unearned and deferred income.
11. For the lessee, if the provisions of a capital lease are changed and the revised lease would have been classified
as an operating lease, the transaction should be accounted for as a:
a. Sublease.
b. Moneyovermoney lease.
c. Saleleaseback transaction.
d. Wrap lease.
12. How should a revised operating lease be treated if the change would have caused it to be classified as either a
direct financing or salestype lease had the revised terms existed at the inception of the lease?
a. New agreement.
b. Operating lease.
c. Salestype lease.
d. Direct financing lease.
13. Which of the following is an accurate statement regarding lease renewals?
a. They result when renewal options included in the lease term are exercised.
b. They result when the same lessee continues to rent the same property under a new lease.
c. Renewals of operating leases are always treated as existing agreements.
d. Renewals of capital leases are always treated as new agreements.
14. How should transfers of minimum lease payments and guaranteed residual values be accounted for?
a. As a sale when the assignment is to a related party.
b. The original accounting for the lease should be reversed.
c. As a transfer of financial assets.
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15. Transfers of unguaranteed residual values without recourse should be recognized as:
a. A gain.
b. A loss.
c. A sale.
d. A transfer.
16. A sale of property subject to an operating lease should not be recorded as a sale in which of the following cir
cumstances?
a. The seller guarantees the recovery of the buyer's investment.
b. The seller retains minimal risks of ownership in the property.
c. A party related to the seller retains minimal risks of ownership in the property.
17. Determining how to classify the lease of a building and the underlying land is based on whether the lease trans
fers ownership or contains a bargain purchase option. If the lease does neither of these, it depends on whether
the fair value of the land is less than what percent of the total fair value of the property?
a. 90%.
b. 75%.
c. 50%.
d. 25%.
18. If a lease involving land and buildings does not transfer ownership or contain a bargain purchase option, the
lessor and lessee must determine whether the part of the lease addressing the land is material. The land is con
sidered immaterial if the fair value of the land is:
a. Less than 50% of the total fair value of the property at the inception of the lease.
b. Less than 35% of the total fair value of the property at the inception of the lease.
c. Less than 30% of the total fair value of the property at the inception of the lease.
d. Less than 25% of the total fair value of the property at the inception of the lease.
19. Which of the following would prevent the lessor from classifying the building portion of the lease as a direct
financing lease?
a. Neither the 75% test nor the 90% test are met.
b. Collectibility of the minimum lease payments is reasonably predictable.
c. The 75% test is met.
d. The 90% test is met.
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20. Regarding a real estate lease that only involves part of a building, if the lessee can objectively assess the cost
and the fair value of the property, it should classify the lease as:
b. A capital lease.
c. It would any other land and building lease.
d. A salestype lease.
21. Sometimes a new lessee is substituted for the original lessee through a new agreement. If the lessor recorded
the original lease as a direct financing or salestype lease, the lessor should not perform which of the following?
a. Retain the net investment in the lease.
b. Record the leased asset at its original cost.
c. Record the leased asset at its present fair value.
d. Record the leased asset at its present carrying amount.
22. Mr. C, the lessee, releases the property and is not relieved of the primary lease obligation. If the original lease
was an operating lease, the sublease should be accounted for by Mr. C as:
b. A salestype lease.
c. A direct financing lease.
23. If the original lease was capitalized due to the fact that it met the 75% or 90% test, the sublease should be capital
ized only if all of the following conditions exist except:
a. It meets the 75% test.
b. It meets the 90% test.
c. Collectibility of the minimum payments is reasonably predictable.
d. There are no important uncertainties concerning additional unreimbursed costs incurred by the new
lessor.
24. Following a business combination where terms are not changed as part of the combination, a lease formerly
classified as a capital lease will be classified as what type of lease after the business combination?
a. A sublease.
b. An operating lease.
c. A capital lease.
67
25. If a saleleaseback meets certain specified criteria (ownership transfer test, bargain purchase option test, 75%
test, or 90% test), the sellerlessee should account for the lease portion as what type of lease?
a. Salestype lease.
b. Capital lease.
c. Operating lease.
d. Direct financing lease.
26. The sellerlessee is presumed to have retained substantially all of the rights to the asset's remaining use if the
leaseback covers the complete property sold and meets the criteria for classification as:
a. A capital lease.
b. An operating lease.
c. A salestype lease.
d. A direct financing lease.
27. If the present value of a reasonable amount of rental for the leaseback is or less of the fair value of the
asset sold, the sellerlessee is presumed to have retained only a minor portion of the rights to the asset's remain
ing use.
a. 10%.
b. 15%.
c. 17%.
d. 20%.
28. All of the following are examples of continuing involvement that precludes saleleaseback accounting except:
a. A party related to the sellerlessee guarantees the buyerlessor's debt.
b. A party related to the sellerlessee guarantees a return of the buyerlessor's investment.
c. The sellerlessee's rental payment is contingent on future operations of the buyerlessor.
d. The sellerlessee sells or leases the underlying land to the buyerlessor.
29. A nonmonetary exchange is considered to lack commercial substance if:
a. The entity's future cash flows are not expected to change significantly due to the exchange.
b. The timing of future cash flows from the asset received significantly differs from that of the transferred asset.
c. The amount of future cash flows from the asset received significantly differs from that of the transferred
asset.
d. The entityspecific value of the asset received significantly differs from that of the transferred asset.
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30. Regarding an exchange facilitating sales to customers or lacking commercial substance, an exchange involv
ing exclusively nonmonetary assets should be based on:
a. Fair value amounts and no gain recognized.
b. Fair value amounts and all gain recognized.
c. Recorded amounts and no gain recognized.
d. Recorded amounts and minimal gain recognized.
31. Which of the following statements is accurate regarding fair value?
a. Fair value is always determinable within reasonable limits even if significant uncertainties exist about the
realizability of the value that would be assigned to the asset received in a monetary transaction that would
be accounted for at fair value.
b. Fair value is not determinable within reasonable limits if significant uncertainties exist about the realizability
of the value that would be assigned to the asset received in a monetary transaction that would be
accounted for at fair value.
c. Fair value is always determinable within reasonable limits even if significant uncertainties exist about the
realizability of the value that would be assigned to the asset received in a nonmonetary transaction that
would be accounted for at fair value.
d. Fair value may not be determinable within reasonable limits if significant uncertainties exist about the reali
zability of the value that would be assigned to the asset received in a nonmonetary transaction that would
be accounted for at fair value.
32. With regard to nonmonetary transactions, disclosure requirements include all of the following except:
a. The nature of any nonmonetary transaction.
b. Basis of accounting for transferred assets,.
c. Associated revenue and costs for any nonmonetary exchanges of inventory.
d. Recognized gains and losses.
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70
Lesson 2:GAAP Chapters 35, 26, and 31

NONMONETARY TRANSACTIONS
INTRODUCTION
Generally, a nonmonetary transaction should be recorded based on the fair values of the assets or services
involved, and any gain or loss should be recognized. Certain exceptions exist for exchanges that facilitate sales to
customers or that lack commercial substance, nonreciprocal transfers to owners, and exchanges in which fair value
is not determinable.

Account for nonmonetary transactions.
Describe accounting for intangible assets, both goodwill and other.
Define the equity method and joint venture methods of investments.
Most business transactions are monetary transactions. That is, they involve the transfer of monetary assets and
liabilities such as cash, accounts receivable, and accounts payable. Some transactions are nonmonetary, however.
They involve the transfer of assets and liabilities whose amounts are not fixed in terms of currency (by contract or
otherwise), such as property and equipment, investments in common stock, and inventories.
Nonmonetary transactions can be nonreciprocal or reciprocal. A nonreciprocal nonmonetary transaction is the

oneway transfer of nonmonetary assets or services either (a) from an entity to its owners or another entity or (b) to
an entity from its owners or another entity. Examples include the distribution of nonmonetary assets to stockholders
as dividends or the donation of nonmonetary assets to charitable organizations. A reciprocal transfer (i.e.,
exchange) of nonmonetary assets is a transaction in which each party distributes or receives nonmonetary assets.
To qualify as an exchange, transferors must not have substantial continuing involvement in the transferred asset.
Examples of nonmonetary exchanges include the exchange of inventory for other inventory and the exchange of
services for inventory. (FASB ASC 84510054 through 6; 8451020; 84510251) (formerly APB 29, paras. 3, 57)
ACCOUNTING FOR NONMONETARY TRANSACTIONS
As a general rule, nonmonetary transactions should be recorded the same as monetary transactions. That is, they
should be based on the fair values of the assets or services involved. Consequently, the amount recorded for an
asset received in a nonmonetary exchange should be the fair value of the asset given up (or the fair value of the
asset received if it is more clearly evident), and a gain or loss should be recognized on the transaction. (FASB ASC
84510301) (formerly APB 29, par. 18) (The gain or loss, if any, should be classified as part of continuing
operations, extraordinary items, etc., depending on the circumstances surrounding the transaction.) For example,
assume that a company exchanges machinery with a net book value of $25,000 for land appraised at $35,000 and
that, because of the specialized nature of the machinery, there is no readily determinable market value for it. The
exchange would be recorded through the following entry:
Land 35,000
Machinery net 25,000
Gain on exchange 10,000
Exceptions to the general rule exist for certain exchanges that facilitate sales to customers (other than the parties
to the exchange) or that lack commercial substance, nonreciprocal transfers to owners, and exchanges in which
neither the fair value of the asset given up nor the fair value of the asset received is determinable. Those exceptions
are discussed in the following paragraphs.
71
Exchanges Facilitating Sales to Customers or that Lack Commercial Substance
Exchanges that facilitate sales to customers are those in which products or property held for sale in the ordinary
course of business are exchanged for products or property to be sold in the same line of business. (FASB ASC
84510303) (formerly APB 29, par. 20)
A nonmonetary exchange of finished goods inventory for raw materials or workinprogress inventories within the
same line of business is not an exchange that facilitates sales to customers for the entity exchanging the finished
goods inventory. Thus, the inventories received should be valued at fair value if determinable within reasonable
limits and the transaction has commercial substance. All other nonmonetary exchanges of inventory within the
same line of business should be recognized at the book value of the inventory transferred. (FASB ASC
845103015 and 3016) (formerly EITF 0413)
A nonmonetary exchange is considered to lack commercial substance if the entity's future cash flows are not
expected to significantly change due to the exchange. If either of the following conditions is met, the entity's future
cash flows are considered to significantly change: (FASB ASC 84510304) (formerly APB 29, par. 21)
a. The risk, timing, or amount of future cash flows from the asset received significantly differs from that of the
transferred asset.
b. The entityspecific value of the asset received significantly differs from that of the transferred asset.
The following rules apply for exchanges that facilitate sales to customers or lack commercial substance:
a. An exchange involving only nonmonetary assets should be based on recorded amounts and no gain
recognized. (A loss should be recognized if indicated, however.) (FASB ASC 84510303) (formerly APB
29, par. 20) Thus, for example, if a truck with a book value of $20,000 were exchanged in a transaction that
lacked commercial substance for another truck, the amount recorded for the new truck would be $20,000,
and no gain or loss would be recognized.
b. If the exchange lacking commercial substance involves monetary consideration
(1) the entity receiving the monetary consideration should recognize a portion of any gain on the
transaction in the ratio of cash received to total consideration received (i.e., cash plus the fair value
of the asset received);
(2) the entity paying the monetary consideration should not recognize any gain (i.e., the new asset should
be recorded at the surrendered asset's book value plus the cash payment); and
(3) any losses on the exchange should be recognized. (FASB ASC 84510306) (formerly APB 29,
par.22)
Nonreciprocal Transfers to Owners
Generally, nonreciprocal transfers of nonmonetary assets to owners (referred to as dividendsinkind) should be

recorded at fair value (and a gain or loss on disposition of the assets recorded) if the fair value of the assets
distributed are objectively measurable and could have been realized in an outright sale at or near the time of the
distribution. However, distributions in a reorganization or liquidation (including spinoffs) or in a rescission of a prior
business combination should be based on recorded amounts less any necessary reduction for impairment of
value. (FASB ASC 845103010) (formerly APB 29, par. 25)
A prorata distribution to owners of the shares of a company that has been or is being consolidated or accounted for
under the equity method is considered to be the equivalent of a spinoff. (FASB ASC 845103010) (formerly APB
29, par. 23)
Fair Value Not Determinable
Fair value may not be determinable within reasonable limits if major uncertainties exist about the realizability of the
value that would be assigned to the asset received in a nonmonetary transaction that would be accounted for at fair
72
value. If neither the fair value of the asset given up nor the fair value of the asset received can be determined within
reasonable limits, the recorded amount of the asset transferred should be used to measure the transaction. (FASB
ASC 84510303; 84510308) (formerly APB 29, paras. 20 and 26)
1.511An entity should disclose the nature of any nonmonetary transactions that occur during the period, including
the basis of accounting for the assets transferred and gains or losses recognized. (FASB ASC 84510501)
(formerly APB 29, par. 28) That includes disclosing the amount of gross operating revenue recognized in each
period's financial statements as a result of nonmonetary transactions. (FASB ASC 84510502) (formerly EITF
008)
1.512For nonmonetary exchanges of inventory within the same line of business recognized at fair value, disclosure
should be made of the associated revenue and costs (or gains and losses). (FASB ASC 84510503) (formerly EITF
0413, par. 8)
When nonmonetary assets are distributed as dividends, the nature of the distribution, the basis of accounting for
the assets transferred, and the gains and losses recognized should be disclosed. (FASB ASC 84510501)
(formerly APB 29, par. 28)
73
74
SELFSTUDY QUIZ
following section.
29. Most business transactions are:
a. Monetary transactions.
b. Nonmonetary transactions.
30. Nonmonetary transactions can be:
a. Nonreciprocal only.
b. Nonreciprocal or Reciprocal.
75
SELFSTUDY ANSWERS
29. Most business transactions are: (Page 71)
a. Monetary transactions. [This answer is correct. Most business transactions are monetary
transactions since they generally involve the transfer of monetary assets and liabilities such as
cash, accounts receivable, and accounts payable.]
b. Nonmonetary transactions. [This answer is incorrect. Far fewer business transactions are nonmonetary
than are monetary since few business transactions involve the transfer of assets not in the form of cash,
accounts receivable, and accounts payable.]
30. Nonmonetary transactions can be: (Page 71)
a. Nonreciprocal only. [This answer is incorrect. Nonmonetary transactions can be nonreciprocal, but they
can also be reciprocal. A nonreciprocal nonmonetary transaction is the oneway transfer of nonmonetary
assets or services either (a) from an entity to its owners or another entity or (b) to an entity from its owners
or another entity.]
b. Nonreciprocal or Reciprocal. [This answer is correct. Nonmonetary transactions can be either

nonreciprocal or reciprocal. A reciprocal transfer of nonmonetary assets is a transaction in which
each party distributes or receives nonmonetary assets. To qualify as an exchange, transferors must
not have substantial continuing involvement in the transferred asset.]
76
INTANGIBLES GOODWILL AND OTHER

OVERVIEW
Assets that have no physical substance are referred to as intangible assets. Generally, the cost of intangible assets
with finite lives should be capitalized and amortized to income over their useful lives. Similar to the accounting for
depreciable assets, the estimated useful lives used to amortize intangible assets should be continually reassessed
and adjusted if necessary. In addition, if an intangible asset becomes impaired, an immediate write down of cost
through a charge to income may be required.
Goodwill should not be amortized but should be tested at least annually for impairment at the reporting unit level.
Other intangible assets with indefinite useful lives also should be assessed annually for impairment rather than
being amortized to earnings.
Accounting for website development costs depends on the stage in which they are incurred. Costs incurred in the
planning stage should be expensed as incurred. Accounting for software costs relating to developing the applica
tions and infrastructure and developing the graphics depends on whether the software is for internal use or will be
externally marketed. Costs of operating the site should be expensed as incurred.
WHAT ARE INTANGIBLE ASSETS?
Simply stated, an intangible asset is an asset that lacks physical substance. It may be purchased, such as a
franchise, or developed internally, such as a patent. In some cases, an intangible asset may be specifically
identified. That is, it has a value and identity apart from the entity itself and thus can be sold. Often, however, an
intangible asset is unidentifiable. It results from a number of factors and has no value apart from the entity itself (for
example, goodwill). Examples of intangible assets include trademarks, patents, franchises, company name, cove
nants not to compete, customer lists, copyrights, and goodwill.
Accounting for an intangible asset involves the same basic issues as for any other asset. That is, it involves:
valuing and recording the asset when it is acquired; and
amortizing the cost of the asset during its period of use.
The following paragraphs discuss those issues and present additional guidance for specific types of intangible
assets.
The guidance discussed below is based on the requirements of FASB ASC 350, Intangibles Goodwill and Other
(formerly SFAS No. 142, Goodwill and Other Intangible Assets. The discussion includes guidance that is effective
for fiscal years and interim periods within those years beginning after December 15, 2008, from the following
standards that amended SFAS No. 142:
SFAS No. 141(R), Business Combinations. Among other things, this guidance clarifies that the fair value
of intangible assets is based on the assumptions that market participants would make. In addition, it
amends the guidance on accounting for research and development costs acquired in a business
combination, including impairment testing of acquired research and development intangible assets that
the acquirer does not intend to use.
SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements This guidance clarifies that
FASB ASC 350 (formerly SFAS No. 142) does not apply to goodwill and other intangible assets recognized
upon the acquisition of a noncontrolling interest in a subsidiary in periods beginning after December 15,
2008. (After that date, acquisitions of noncontrolling interests are accounted for as equity transactions;
thus, no goodwill or other intangible assets would be recognized.) The guidance also provides
77
requirements for impairment losses when a reporting unit is less than wholly owned and amends the
disclosures about intangible assets.
ACCOUNTING FOR INTANGIBLE ASSETS
Valuing Intangible Assets
Purchased Intangibles. Intangible assets acquired individually or as part of a group of assets should be recorded
at fair value. The cost of a group of assets acquired in a transaction other than a business combination should be
allocated to the individual assets acquired based on their relative fair values, but should not result in goodwill being
recognized. (FASB ASC 35030251 and 252; 35030301) (formerly SFAS 142, par. 9)
The fair value of intangible assets is based on the assumptions that market participants would use in pricing the
asset. In addition, the requirement to price intangible assets at fair value applies even though the entity may not
intend to use the asset or may not use the asset in its highest and best use. (FASB ASC 35030301) [(formerly
SFAS 142, par. 9, as amended by SFAS 141(R), par. E27)]
Internally Developed Intangibles. In many cases, intangible assets are developed internally rather than pur
chased from another entity. For example, a company may patent a unique product that it develops or develop
goodwill through excellent business practices and superior service. The costs of internally developing, maintaining,
or restoring such intangibles (including goodwill) that are not specifically identifiable, have indeterminate lives, or
are inherent in a continuing business should be charged to expense when incurred. (FASB ASC 35020253;
Accounting for Intangible Assets
While goodwill is an intangible asset, accounting for goodwill is subject to unique considerations, which are
discussed below.
The accounting for a recognized intangible asset other than goodwill is based on its useful life. The useful life of the
intangible asset is the period over which the asset is expected to contribute directly or indirectly to the entity's future
cash flows. It is estimated by considering all relevant factors, including: (FASB ASC 35030351 through 355)
(formerly SFAS 142, par. 11, as amended by FSP FAS 1423)
a. The expected use of the asset by the entity.
b. The expected useful life of another relevant or related asset or asset group.
c. Legal, regulatory, or contractual provisions that may limit the asset's useful life.
d. The entity's own experience in renewing or extending similar arrangements or, in the absence of that
experience, the assumptions that market participants would use about renewal or extension considering
the entityspecific factors in this paragraph.
e. Effects of obsolescence, demand, competition, and other economic facts (such as the stability of the
industry, known technological advances, legislative action that results in an uncertain or changing
regulatory environment, and expected changes in distribution channels).
f. The level of maintenance expenditures required to obtain the asset's expected future cash flows (for
example, a material level of required maintenance in relation to the carrying amount of the asset may
suggest a very limited useful life).
g. Where an income approach is used to measure the fair value of an intangible asset, the period of expected
cash flows used in the valuation, adjusted for entityspecific factors in this paragraph.
If no factors limit the intangible asset's expected useful life, the asset's life is considered indefinite.
78
An entity may acquire an intangible asset that it does not intend to actively use primarily for the purpose of
preventing others from using it (for example, rights to a trade name for a product that will be discontinued). These
intangible assets, commonly referred to as defensive intangible assets, should be assigned a useful life based on
the expected benefits to be derived from the assets, that is, the direct and indirect cash flows from preventing others
from realizing any value from the assets. The useful life should be measured by estimating the period over which
the defensive intangible asset will diminish in value. It would be rare for such assets to have an indefinite life. (FASB
ASC 35030355A and 35B) (formerly EITF 087, paras. 1112) This guidance is effective for intangible assets
acquired on or after the beginning of the first annual period beginning on or after December 15, 2009. (FASB ASC
35030652) (formerly EITF 087, par. 13)
Intangible Assets Subject to Amortization. An intangible asset with a finite life should be amortized over its useful
life (or the best estimate of its useful life). The amortization method should either reflect the pattern of use or
consumption of the asset's economic benefits. If a pattern cannot be determined, the straightline method should
be used. Amortized intangible assets should be reviewed for impairment. An intangible asset should not be written
down or off during the acquisition period unless it becomes impaired during the period. (FASB ASC 35030356
and 357) (formerly SFAS 142, par. 12)
For periods beginning before December 15, 2008, intangible research and development assets with no alternative
future use (including those acquired in a business combination) should be expensed. However, for periods
beginning on or after December 15, 2008, intangible research and development assets acquired in a business
combination should be recognized and measured at fair value regardless of whether there is an alternative future
use for the assets. Intangible research and development assets with no alternative future use acquired in a
transaction other than a business combination should be expensed. (FASB ASC 35030357) [formerly SFAS 142,
par. 12, as amended by SFAS 141(R), par. E27]
The amount of the intangible asset to be amortized is the amount initially recorded less any residual value. Residual
values generally are zero, unless (a)the asset is expected to continue to have a useful life to another entity when its
useful life to the current reporting entity ends and (b) another entity has committed to purchase the asset or the
residual value can be determined in a market for the asset that is expected to exist at the end of the asset's useful
life. (FASB ASC 35030358) (formerly SFAS 142, par. 13)
The useful life should be reviewed during each reporting period to see if the remaining period of amortization
should be revised. If a revision is made, the remaining carrying amount of the intangible asset should be amortized
prospectively over the revised remaining useful life. If the useful life is subsequently determined to be indefinite, the
asset should no longer be amortized and should be tested for impairment as discussed below. (FASB ASC
35030359 and 3510) (formerly SFAS 142, par. 14)
Intangible Assets Not Subject to Amortization. An intangible asset with an indefinite useful life should not be
amortized until its remaining useful life is no longer indefinite. The remaining useful life should be reviewed each
reporting period. If the asset life is subsequently determined to be finite, the asset should be tested for impairment
as discussed below. The asset should then be amortized prospectively and accounted for as an intangible asset
subject to amortization. (FASB ASC 350303515 through 3517) (formerly SFAS 142, par. 16)
Accounting for Impairment. Intangible assets not subject to amortization should be tested for impairment at least
annually, or more frequently if there are indications that the asset is impaired. The asset should be written down and
a loss recognized in the periods when the asset's recorded value is not recoverable and the recorded value
exceeds its fair value. Subsequent reversals of recognized impairment losses are prohibited. (FASB ASC
350303518 through 3520) (formerly SFAS 142, par. 15 and par. 17)
Accounting for Goodwill
Goodwill represents future economic benefits arising from other assets acquired in a business combination that are
not individually identified and separately recognized. (FASB ASC 3502020) [formerly SFAS 142, par. F1, as
amended by SFAS 141(R), par. E27] An intangible asset should be recognized as an asset apart from goodwill if it
arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from
the acquired entity or from other rights and obligations. If it does not, it should be recognized as an asset apart from
goodwill only if it is separable (capable of being separated or divided from the acquired entity and sold, transferred,
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licensed, rented, or exchanged by itself or in combination with a related contract, asset, or liability). (FASB ASC
8052020; 805202510) (formerly SFAS 141(R), paras. A19A22)
Goodwill should not be amortized. Instead, it should be tested for impairment at the reporting unit level. (FASB ASC
Determining the Reporting Units. A reporting unit is defined as an operating segment or one level below an
operating segment, referred to as a component. A component is the reporting unit if (a) it is a business with discrete
financial information and (b) segment management regularly reviews operating results. However, two or more
components should be aggregated into a single reporting unit if the components have similar economic character
istics. An operating segment is a reporting unit if all of its components are similar, none of its components is a
reporting unit, or if it comprises a single component. (FASB ASC 3502020; 350203533 through 3536) (formerly
SFAS 142, paras. F1 and 30)
An entity must test goodwill at the reporting unit level even if it is not subject to the segment information reporting
requirements. (FASB ASC 350203538) (formerly SFAS 142, par. 31)
When performing the goodwill impairment test, an entity should assign acquired assets and assumed liabilities
(including those acquired in a business combination) to a reporting unit if the asset will be employed in or the
liability relates to the reporting unit's operations, and the asset or liability will be considered in determining the
reporting unit's fair value. If the assets or liabilities relate to multiple reporting units, a reasonable, supportable, and
consistent method for assigning such assets and liabilities to reporting units should be used. (FASB ASC
350203539 and 3540) (formerly SFAS 142, paras. 3233) Examples of items that may meet both of the criteria
and should be assigned are environmental liabilities that relate to an existing operating facility of the reporting unit,
deferred income taxes, and a pension obligation that would be included in the determination of the fair value of the
reporting unit.
All acquired goodwill should be assigned to one or more reporting units in a reasonable, supportable, and
consistent manner. The total amount of acquired goodwill can be divided among a number of reporting units.
Goodwill may be assigned to a reporting unit that is expected to benefit from the synergies created by a business
combination even if that unit has not been assigned any other acquired assets or liabilities. (FASB ASC
350203541) (formerly SFAS 142, par. 34) An entity should determine the fair value of the acquired business to be
included in the reporting unit (that is, the fair value of the assets acquired and liabilities assumed to assign to the
reporting unit). The fair value of the acquired business over the fair value of the individual assets and liabilities
assigned to the reporting unit is the goodwill assigned to the reporting unit. (FASB ASC 350203542 and 3543)
(formerly SFAS 142, par. 35, as amended by SFAS 141(R), par. E27)The allocation process used to determine the
implied fair value of goodwill is only for testing goodwill for impairment. It should not result in adjustments to the
values of recognized assets or liabilities or recognition of a previously unrecognized asset. (FASB ASC
350203544) (formerly SFAS 142, par. B121)
Twostep Goodwill Impairment Test. Assessing goodwill for impairment involves the following two steps:
a. Determine whether impairment exists. The first step of the impairment test is to determine whether
impairment exists by comparing the fair value of the reporting unit with its carrying value (including
goodwill). If fair value is greater than the recorded amount, goodwill is not impaired, and the second step
of the impairment test is not necessary. If the fair value is less than the recorded amount, impairment exists
and the second step of the test should be performed. (FASB ASC 35020354 through 356; 35020358)
The fair value of a reporting unit represents the amount that would be received to sell the unit as a whole
in an orderly transaction between market participants at the measurement date. If available, quoted market
prices in active markets should be used as the basis for fair value. However, the market price for an
individual equity security for a reporting unit might not be reflective of the fair value of the reporting unit as
a whole. For example, an acquiring entity will often pay more for equity securities in order to gain a
controlling interest. The control premium may cause the fair value of a reporting unit to exceed its market
capitalization. As a result, the quoted market price of an individual equity security may not be the only basis
for the measurement of fair value of the reporting unit. When estimating the fair value of a reporting unit,
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a valuation technique based on multiples of earnings or revenue or a similar performance measure might
be used if the approach is consistent with the objective of measuring fair value. (FASB ASC 350203522
through 3524) (formerly SFAS 142, paras. 23 and 25, as amended by SFAS No. 157)
Once the initial determination of the fair value of a reporting unit is made, that value may be carried forward
to the next year if all of the following criteria are met: (FASB ASC 350203529) (formerly SFAS 142, par.
27)
(1) The assets and liabilities that make up the reporting unit have not changed significantly since the most
recent fair value determination.
(2) The most recent fair value computation resulted in an amount that exceeded the carrying amount of
the reporting unit by a substantial margin.
(3) Based on recent events and circumstances, the likelihood is remote that the current fair value
computation would be less than the current carrying amount of the reporting unit.
b. Measure the amount of the impairment loss. The second step of the impairment test measures the amount
of the impairment loss by comparing the implied fair value of reporting unit goodwill to its carrying amount.
If the carrying amount of the reporting unit goodwill is greater than the implied fair value, an impairment
loss equal to the difference should be recognized and goodwill should be written down. (However, the loss
should not be greater than the carrying amount of goodwill.) Recognized impairment losses may not be
reversed once the measurement of that loss is completed. (FASB ASC 35020359; 350203511 through
The implied fair value of reporting unit goodwill is the excess of the fair value of the reporting unit over the
amounts assigned to the assets and liabilities. It should be measured using a methodology similar to that
used to measure the amount of goodwill resulting from a business combination. (FASB ASC 350203514
and 3516) [formerly SFAS 142, par. 21, as amended by SFAS 141(R), PM.E27]
When an entity reorganizes its reporting structure and changes reporting units, the preceding guidance should be
used to reassign assets and liabilities to the affected reporting units. Goodwill should be reassigned to the reporting
units using the relative fair value allocation approach similar to the one used when a part of a reporting unit is
disposed of as discussed below. (FASB ASC 350203545) (formerly SFAS 142, par.36)
Goodwill should be tested for impairment at least annually and should be tested more frequently if there are
indications of impairment such as the following: (FASB ASC 350203528; 350203530) (formerly SFAS 142, par.
26 and par. 28):
A significant adverse change in legal factors or the business climate
An adverse action or assessment by a regulator
Unanticipated competition
A loss of key personnel
A likely expectation that a reporting unit or a significant portion of a reporting unit will be sold or disposed
of
A significant asset group within a reporting unit is tested for recoverability under (FASB ASC 36010)
(formerly SFAS No. 144)
Recognition of a goodwill impairment loss of a subsidiary that is a component of a reporting unit
Goodwill also should be tested for impairment after a portion of goodwill has been allocated to a business to be
disposed of.
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The annual test for goodwill impairment may be performed any time during the year as long as the test is performed
at the same time every year. Different reporting units may be tested at different times. (FASB ASC 350203528)
If the second step of the impairment test is not completed before the financial statements are issued (or available
to be issued), and a goodwill impairment loss is both probable and can be reasonably estimated, the best estimate
of the loss should be recognized in the financial statements. The fact that the loss is an estimate should be
disclosed. If the amount of the loss changes when the impairment test is completed, the adjustment should be
made in the next reporting period. (FASB ASC 350203518 and 3519) (formerly SFAS 142, par. 22) If goodwill is
tested for impairment at the same time another asset is being tested for impairment, the other asset should be
tested for impairment before the goodwill impairment test is performed. (FASB ASC 350203531) (formerly SFAS
142, par.29)
Testing by a Subsidiary. Goodwill reported on a subsidiary's separate GAAP financial statements should be tested
for impairment as if the subsidiary were a standalone entity. If an impairment loss is recognized at the subsidiary
level, goodwill should also be tested at the higher consolidated level if the cause of the impairment loss at the
subsidiary level would be likely to reduce the fair value of the reporting unit below its carrying amount at the higher
consolidated level. A goodwill impairment loss should be recognized at the consolidated level only if goodwill of the
higherlevel reporting unit is impaired. (FASB ASC 350203548) (formerly SFAS 142, par. 37)
Testing When a Noncontrolling Interest Exists. Goodwill from a business combination with a continuing noncon
trolling interest (minority interest) should be tested for impairment based on how the noncontrolling interest was
measured at the acquisition date. For example, if goodwill was initially recognized based only on the controlling
interest of the parent, the fair value of the reporting unit used for testing impairment should be based only on that
controlling interest and would not reflect the fair value attributable to the noncontrolling interest. The implied fair
value of goodwill used to measure the impairment loss in the second step of the impairment test should reflect only
the parent's interest in that goodwill. (FASB ASC 350203550) (formerly SFAS 142, par. 38)
Testing after Disposal of All or a Portion of a Reporting Unit. When an entire reporting unit is disposed of, the
reporting unit's goodwill should be included in the reporting unit's carrying amount when determining the gain or
loss on disposal. When a portion of a reporting unit that is considered a business is disposed of, goodwill linked to
that business should be included in the business' carrying amount for calculating the gain or loss. Goodwill should
be allocated using the relative fair values of the disposed business and the portion of the reporting unit retained.
However, if the business to be disposed of was never integrated into the reporting unit and benefits of acquired
goodwill never realized, the current carrying amount of that acquired goodwill is included in the carrying amount of
the disposed business. When only a portion of goodwill is allocated to business to be disposed of, the goodwill left
in the remaining reporting unit should be tested for impairment using its adjusted carrying amount. (FASB ASC
350203551; 350203552 through 3554; 350203557) (formerly SFAS 142, par. 39)
If a reporting unit is less than wholly owned, any impairment loss should be attributed to the parent (if the reporting
unit includes only goodwill attributable to the parent) or to both the parent and the noncontrolling interest (if the
reporting unit includes goodwill attributable to both the parent and the noncontrolling interest). (FASB ASC
350203557) (formerly SFAS 142, par. 39A, as amended by SFAS 160, par. C10) (FASB ASC 81010) (formerly
SFAS No. 160) is effective for fiscal years and interim periods within those fiscal years beginning on or after
December 15, 2008. Early application is prohibited.
ACCOUNTING FOR WEBSITE DEVELOPMENT COSTS
While many entities use Internet websites as an advertising vehicle, an increasing number of them use websites to
conduct electronic commerce. The cost to develop and maintain a website primarily depends on the richness of its
graphics and what visitors can do at the site (commonly referred to as the site's functionality), and, in many cases,
can be significant. Accounting for website development costs depends on the stage in which they are incurred,
which consists of the following:
Planning the website
Developing the applications and infrastructure
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Developing graphics
Operating the site
Costs also may be incurred to develop content for the website. Current authoritative literature does not specifically
address accounting for the costs to develop content for websites, however.
Planning the Website
Costs incurred in the planning stage should be expensed as incurred. (FASB ASC 35050252) (formerly EITF
002, par. 4) The following are examples of development activities occurring in the planning stage: (FASB ASC
a. Developing a plan for the site. That may entail, for example, deciding whether the site will be used solely
to provide information about the entity or also to conduct electronic commerce, identifying target visitors
to the site, and budgeting costs.
b. Determining the functionality of the site. For example, a site may enable users to communicate with the
entity or specific employees via email or chat rooms, place and pay for orders, or search for information
meeting certain characteristics, such as the subject matter of articles or product specifications.
c. Identifying the hardware and software needed to operate the site. Required software applications depend
on the site's functionality. Examples of applications include
(1) interfaces with inventory and other internal systems that must be accessed to conduct electronic
commerce.
(2) registration and verification of visitors to the site, such as credit card authorizations.
(3) content management, such as updating databases of information made available to visitors.
An entity that does not use an ISP to host its website must acquire various types of hardware to operate the site.
Examples are web and application servers, Internet connection (bandwidth) routers, staging servers (for making
preliminary changes to the website in a test environment), and production servers (accessible to customers using
the site). (FASB ASC 35050153) (formerly EITF Issue No. 002) excludes hardware acquisitions from its scope.
However, generally the costs of acquiring hardware should be capitalized as incurred and amortized over the
period benefited. Given the current rate of technology advances, the amortization period may be relatively short, for
example, because servers likely will be replaced to take advantage of greater capabilities.
d. Determining that technology exists for the desired functionality. Examples include technologies required
(1) for intrusion detection, security of customer and transaction information, and electronic authorization.
(2) to meet response time expectations, such as the time it takes a customer to place an order.
(3) to display only information that meets parameters set by the visitor to the site, for example, displaying
different banner advertisements depending on the state in which the visitor is located.
e. Exploring alternatives for achieving the desired functionality. Common examples are deciding whether to
host the site or have it hosted by an ISP and whether to use licensed software or customized software.
f. Conceptually formulating and identifying graphics and content. For example, should the site provide access
to relevant articles; hyperlinks with other sites; digitized photographs of products, facilities, and key
employees; and graphical displays of results?
g. Inviting vendors to demonstrate how their web applications, service, or hardware will help accomplish the
site's functionality.
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h. Selecting consultants or vendors.
i. Identifying internal resources to help design and develop the site.
j. Identifying software needed for development purposes.
k. Addressing legal considerations such as compliance with copyright, trademark, and privacy issues.
Developing the Applications and Infrastructure
During this stage, the entity may incur costs to acquire or develop both hardware and software needed to operate
the site. All costs relating to such software should be accounted for following the guidance for internaluse software
unless a plan exists or is being developed to market the software externally. In that event, the costs should be
accounted for following the guidance for externallymarketed software. That essentially means such costs should
be expensed as incurred until technological feasibility is established. (FASB ASC 35050254) (formerly EITF 002,
par. 5 and 10) Following that guidance, costs incurred during the application and infrastructure development stage
generally should be accounted for as follows: (FASB ASC 35050553) (formerly EITF 002, par. 10)
a. Costs incurred to obtain and register an Internet domain name generally should be capitalized. (FASB ASC
(FASB ASC 35050) (formerly EITF Issue No. 002) does not address amortization of the capitalized costs.
However, generally the capitalized cost of an Internet domain name should be amortized over the shorter
of the period benefited or the period during which the entity has the exclusive right to use the domain name.
As a practical matter, since entities frequently change names, the amortization period may be relatively
short.
b. Costs incurred to develop or acquire the software tools needed for the development work (e.g., the HTML
editor, software to convert data to HTML, and multimedia software) should be capitalized. However, the cost
of such software should be charged as research and development expense as incurred if the software is
used in research and development and either (1) does not have any alternative future use or (2) is internally
developed as a pilot project or for use in a specific research and development project. (FASB ASC
c. Other costs that generally should be capitalized include those incurred to (FASB ASC 35050254)
(formerly EITF 002, par. 10)
(1) develop or acquire software needed for general website operations (such as the server operating
system, Internet server, web browser, and Internet protocol).
(2) develop or acquire (and customize) code for web applications (such as email, search engines, order
processing systems, sales tax calculations, and shipment tracking applications or interfaces).
(3) develop or acquire (and customize) database software and software to integrate applications such
as corporate databases and accounting systems into web applications.
(4) develop HTML web pages or templates.
(5) install developed applications on the web server.
(6) create initial hypertext links to other websites or other locations within the website.
(7) test the website applications, for example, to determine the effect of spikes in the number of hits.
(FASB ASC 35050153) (formerly EITF Issue No. 002) excludes hardware acquisitions from its scope. However,
generally the costs of acquiring hardware should be capitalized as incurred and amortized over the period
benefited. Given the current rate of technology advances, the amortization period may be relatively short, for
example, because servers likely will be replaced to take advantage of greater capabilities.
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If an entity uses an ISP to host its website, fees for website hosting generally should be expensed over the period
benefited. (FASB ASC 35050255) (formerly EITF 0002, par. 5)
Developing Graphics
This stage involves designing and laying out the web page using graphics such as borders, background and text
colors, fonts, frames, and buttons. The graphics generally stay consistent even when changes are made to the
site's content. Graphics are a component of software and their initial development costs should be accounted for
following the guidance for internaluse software or for externallymarketed software, as applicable. Entities should
evaluate modifications to graphics after a website is launched to determine whether they represent maintenance or
website enhancements. (FASB ASC 35050258 and 259; 35050554 and 555) (formerly EITF 002, par. 6)
Developing Content
Content that resides on the website may include information such as articles, photos, stock quotes, and maps.
Content can reside in separate databases that are integrated into the website or may be coded directly into the web
pages. (FASB ASC 35050556) (formerly EITF 002, par. 7) Accounting for content is not unique to website
development and operations and GAAP does not provide special accounting for website contents. However, costs
to input content into a website and for data conversion should be expensed as incurred. Software to integrate a
database with a website should be capitalized. (FASB ASC 350502510 through 2513) (formerly EITF 002, par.
10)
Operating the Site
The costs of operating the site, (such as for training, administration, and maintenance) should be expensed as
incurred. Enhancements to the site should be treated, in effect, as new software. Thus, for internal use software,
enhancements should be accounted for following (FASB ASC 35040) (formerly SOP 981), which requires certain
costs of enhancements to be capitalized if it is probable that they will result in added functionality. For marketed
software, enhancements should be accounted for following (FASB ASC 985) (formerly SFAS No. 86), which
requires capitalization of the costs of product enhancements that extend the software's life or significantly improve
its marketability. Whether a change to the software results in added functionality for internaluse software or a
product enhancement for externally marketed software generally depends on the specific facts and circumstances.
Internal costs for minor upgrades and enhancements that cannot be reasonably separated from maintenance
costs should be expensed as incurred. (FASB ASC 350502514 through 2516) (formerly EITF 002, par.8)
The costs of registering the website with Internet search engines are advertising costs that should be expensed as
incurred. Other website operating costs that should be expensed as incurred include: (FASB ASC 350502517
and 559) (formerly EITF 0002, par. 10)
a. training the employees that support the website.
b. performing user administration tasks.
c. upgrading site graphics without adding functionality.
d. performing routine backups.
e. creating new links.
f. verifying that links are functioning correctly and updating links.
g. routinely reviewing the security of the website and the ISP (if applicable).
h. analyzing usage.
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GOODWILL AND INTANGIBLE ASSETS
Disclosures
The following information should be disclosed for the period in which intangible assets are acquired either
individually or with a group of assets (including assets acquired in a business combination): (FASB ASC
35030501) [formerly SFAS 142, par. 44, as amended by FSP FAS 1423 and SFAS 141(R)]
a. For intangible assets subject to amortization:
(1) Total amount assigned and amount assigned to any major intangible asset class
(2) Amount of any significant residual value, in total and by major intangible asset class
(3) Weightedaverage amortization period, in total and by major intangible asset class
b. For intangible assets not subject to amortization, the total amount assigned and the amount assigned to
any major intangible asset class
c. Amount of research and development assets acquired in a transaction other than a business combination
and written off in the period and the line item in the income statement in which the amounts written off are
aggregated
d. For intangible assets with renewal or extension terms, the weighted average period prior to the next renewal
or extension (either explicit or implicit) by major asset class.
For a recognized intangible asset, information should be disclosed about the extent to which the expected future
cash flows associated with the asset are affected by the intent or ability to renew or extend the arrangement. (FASB
ASC 35030504) (formerly FSP FAS 1423)
The following information should be disclosed in the financial statements or the notes to the financial statements for
each period for which a balance sheet is presented: (FASB ASC 35020501; 35030502) [formerly SFAS 142,
par. 45, as amended by FSP FAS 1423 and SFAS 141(R)]
a. For intangible assets subject to amortization
(1) Gross carrying amount and accumulated amortization, in total and by major intangible asset class
(2) Aggregate amortization expense for the period
(3) Estimated aggregate amortization expense for each of the five succeeding fiscal years
b. For intangible assets not subject to amortization, the total carrying amount and the carrying amount for
each major intangible asset class
c. The entity's accounting policy on the treatment of costs incurred to renew or extend the term of a
recognized intangible asset
d. In the period of acquisition or renewal:
(1) The weightedaverage period prior to the next renewal or extension by major asset class
(2) If the entity capitalizes renewal or extension costs, the costs incurred in the period to renew or extend
the term of a recognized intangible asset by major asset class
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e. The changes in the carrying amount of goodwill during the period, showing separately:
(1) The gross amount and accumulated impairment losses at the beginning of the period
(2) Additional goodwill recognized during the period, except goodwill included in a disposal group that,
on acquisition, meets the criteria to be classified as held for sale
(3) Adjustments resulting from the subsequent recognition of deferred tax assets during the period
(4) Goodwill included in a disposal group classified as held for sale and goodwill derecognized during
the period without having previously been reported in a disposal group classified as held for sale
(5) Impairment losses recognized during the period
(6) Net foreign currency exchange differences arising during the period
(7) Any other changes in the carrying amounts during the period
(8) The gross amount and accumulated impairment losses at the end of the period
Entities required to report segment information should provide the information provided above about goodwill in
total and for each reportable segment. Any significant changes in the allocation of goodwill by reportable segment
should be disclosed. If any portion of goodwill has not been allocated to a reporting unit at the date the financial
statements are issued, that unallocated amount and the reasons for not allocating that amount should be dis
closed. (FASB ASC 35020501) (formerly SFAS 142, par. 45)
For each impairment loss recognized related to an intangible asset, the following information should be disclosed
in the notes to the financial statements that include the period in which the impairment loss is recognized: (FASB
ASC 35030503) (formerly SFAS142, par. 46)
a. A description of the impaired intangible asset and the facts and circumstances leading to the impairment
b. The amount of the impairment loss and the method for determining fair value
c. The caption in the income statement or the statement of activities in which the impairment loss is
aggregated
d. If applicable, the segment in which the impaired asset is reported
For each goodwill impairment loss recognized, the following information should be disclosed in the notes to the
financial statements that include the period in which the impairment loss is recognized: (FASB ASC 35020502)
(formerly SFAS142, par. 47)
a. A description of the facts and circumstances leading to the impairment
b. The amount of the impairment loss and the method of determining the fair value of the associated reporting
unit (whether based on quoted market prices, prices of comparable businesses, a present value or other
valuation technique, or a combination of those techniques)
c. If a recognized impairment loss is an estimate that has not yet been finalized, that fact and the reasons for
using an estimate and, in subsequent periods, the nature and amount of any significant adjustments made
to the initial estimate of the impairment loss
Financial Statement Presentation
Intangible Assets. At a minimum, all intangible assets (other than goodwill) should be combined and presented as
a separate line item on the balance sheet, although individual intangible assets or classes of assets may be
presented separately. Amortization expense and impairment losses for such intangibles should be presented in
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income statement line items within continuing operations. Impairment losses resulting from impairment tests
performed when it is determined that the asset should no longer be amortized or should begin to be amortized due
to a reassessment of its remaining useful life should not be recognized as a change in accounting principle. (FASB
ASC 35030451 through 453) (formerly SFAS 142, par.42)
Goodwill. The aggregate amount of goodwill should be presented as a separate line item in the balance sheet.
Aggregate goodwill impairment losses from continuing operations should be presented as a separate line item in
the income statement before income from continuing operations. Goodwill impairment losses associated with
discontinued operations should be included on a netoftax basis in the results of discontinued operations. (FASB
ASC 35020451 through 453) (formerly SFAS142, par. 43)
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SELFSTUDY QUIZ
following section.
31. Which of the following statements is accurate regarding intangible assets that are subject to amortization?
a. The straightline amortization method should be used whenever possible.
b. Amortized intangible assets need not be reviewed for impairment.
c. An intangible asset generally should be written off during the acquisition period.
d. The amount of an intangible asset to be amortized is the amount initially recorded minus any residual value.
32. Which of the following statements is accurate regarding intangible assets that are not subject to amortization?
a. They should be tested for impairment at least once every year.
b. A loss should always be recognized in the periods when the asset's recorded value is unrecoverable.
c. Reversals of recognized impairment losses are permitted under certain circumstances.
33. Goodwill should be tested for impairment more frequently than normal if which of the following indications of
impairment exists?
a. A loss of any personnel.
b. Any assessment by a regulator.
c. A reporting unit is likely to be sold.
d. Any change in the business climate.
34. In cases where a reporting unit is less than wholly owned and the reporting unit includes goodwill attributable
to both the parent and the noncontrolling interest, which of the following is true?
a. Any impairment loss should be attributed only to the parent.
b. Any impairment loss should be attributed to both the parent and the noncontrolling interest.
35. Authoritative literature does not specifically address accounting for which of the following website development
costs?
a. Developing the applications.
b. Developing graphics.
c. Developing content.
d. Operating the site.
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36. Which of the following costs should be expensed as incurred?
a. Costs incurred to obtain and register an internet domain name.
b. Costs incurred to develop HTML web pages or templates.
c. Costs incurred in operating the website.
d. Costs incurred to install developed applications on the web server.
37. Which of the following costs generally should be capitalized?
a. Performing routine backups for website.
b. Performing website user administration tasks.
c. Developing software needed for the Internet server.
d. Upgrading website graphics without adding functionality.
38. For intangible assets not subject to amortization, which of the following information should be disclosed for the
period in which intangible assets are acquired either individually or with a group of assets?
a. Weightedaverage amortization period, in total and by major intangible asset class.
b. Total amount assigned and the amount assigned to any major intangible asset class.
c. Amount of any significant residual value, in total and by major intangible asset class.
d. Weightedaverage period prior to the next renewal or extension by major asset class.
90
SELFSTUDY ANSWERS
31. Which of the following statements is accurate regarding intangible assets that are subject to amortization?
(Page 79)
a. The straightline amortization method should be used whenever possible. [This answer is incorrect. The
straightline amortization method should be used only if the pattern of use of intangible assets cannot be
determined.]
b. Amortized intangible assets need not be reviewed for impairment. [This answer is incorrect. Amortized
intangible assets should be reviewed for impairment.]
c. An intangible asset generally should be written off during the acquisition period. [This answer is incorrect.
An intangible asset should be written off during the acquisition period only when it becomes impaired
during the period.]
d. The amount of an intangible asset to be amortized is the amount initially recorded minus any
residual value. [This answer is correct. The amount of an intangible asset to be amortized is the
amount initially recorded minus any residual value. Residual values generally are zero except when
the asset is expected to continue to have a useful life to another entity when its useful life to the
current reporting entity ends and, another entity has committed to purchase the asset or the residual
value can be determined in a market for the asset that is expected to exist at the end of the asset's
useful life.]
32. Which of the following statements is accurate regarding intangible assets that are not subject to amortization?
(Page 79)
a. They should be tested for impairment at least once every year. [This answer is correct. Intangible
assets not subject o amortization should be tested for impairment at least annually, or more
frequently if there is reason to believe that the asset is impaired.]
b. A loss should always be recognized in the periods when the asset's recorded value is unrecoverable. [This
answer is incorrect. A loss should only be recognized in the periods when the asset's recorded value is
unrecoverable and the recorded value exceeds its fair value.]
c. Reversals of recognized impairment losses are permitted under certain circumstances. [This answer is
incorrect. Reversals of recognized impairment losses are prohibited.]
33. Goodwill should be tested for impairment more frequently than normal if which of the following indications of
impairment exists? (Page 81)
a. A loss of any personnel. [This answer is incorrect. One indication of impairment where goodwill should be
tested more frequently than normal is in situations where there is a loss of key personnel.]
b. Any assessment by a regulator. [This answer is incorrect. If there is an adverse action or assessment by
a regulator, goodwill should be tested for impairment more frequently than normal.]
c. A reporting unit is likely to be sold. [This answer is correct. Goodwill should be tested more
frequently than normal in cases where there is a likely expectation that a reporting unit or a
significant portion of a reporting unit will be disposed of or sold.]
d. Any change in the business climate. [This answer is incorrect. Goodwill should be tested for impairment
more frequently than at normal intervals in cases where there is a significant adverse change in legal factors
or the business climate.]
91
34. In cases where a reporting unit is less than wholly owned and the reporting unit includes goodwill attributable
to both the parent and the noncontrolling interest, which of the following is true? (Page 82)
a. Any impairment loss should be attributed only to the parent. [This answer is incorrect. Any impairment loss
should be attributed only to the parent in cases where the reporting unit includes only goodwill attributable
to the parent per FASB ASC 81010651. (formerly SFAS No. 160)]
b. Any impairment loss should be attributed to both the parent and the noncontrolling interest. [This
answer is correct. Any impairment loss should be attributed to both the parent and the
noncontrolling interest in cases where the reporting unit includes goodwill attributable to both the
parent and the noncontrolling interest per FASB ASC 81010651. (formerly SFAS No. 160)]
35. Authoritative literature does not specifically address accounting for which of the following website development
costs? (Page 82)
a. Developing the applications. [This answer is incorrect. Accounting for developing the applications and
infrastructure is one of four stages of website development costs incurred that are specifically addressed
in authoritative literature.]
b. Developing graphics. [This answer is incorrect. Accounting for developing graphics is another of the
stages of website development costs that are addressed in authoritative literature.]
c. Developing content. [This answer is correct. Although costs may also be incurred to develop
content for the website, authoritative literature does not currently address accounting for the costs
to develop content for websites.]
d. Operating the site. [This answer is incorrect. Authoritative literature addresses accounting for website
development costs based on four stages during which costs are incurred, including operating the
website.]
36. Which of the following costs should be expensed as incurred? (Page 85)
a. Costs incurred to obtain and register an internet domain name. [This answer is incorrect. Costs incurred
to obtain and register an internet domain name should be capitalized per FASB ASC 35040 (formerly SOP
981).]
b. Costs incurred to develop HTML web pages or templates. [This answer is incorrect. Costs incurred to
develop HTML web pages or templates should be capitalized per FASB ASC 35040 (formerly SOP 981).]
c. Costs incurred in operating the website. [This answer is correct. Costs incurred in operating the
website should be expensed as incurred.]
d. Costs incurred to install developed applications on the web server. [This answer is incorrect. Costs
incurred to install developed applications on the web server should be capitalized per FASB ASC 35040
(formerly SOP 981)]
37. Which of the following costs generally should be capitalized? (Page 85)
a. Performing routine backups for website. [This answer is incorrect. The costs associated with performing
routine backups for the website should be expensed as they are incurred per FASB ASC 35050 (formerly
EITF 002, par. 6)]
b. Performing website user administration tasks. [This answer is incorrect. The operating costs of performing
website user administration tasks should be expensed as incurred per FASB ASC 35050 (formerly EITF
002, par. 6)]
c. Developing software needed for the Internet server. [This answer is correct. Developing software
needed for the Internet server, the server operating system, web browser, and Internet protocol, are
costs that generally should be capitalized.]
92
d. Upgrading website graphics without adding functionality. [This answer is incorrect. Upgrading website
graphics without adding functionality are costs that should be expensed when incurred per FASB ASC
35050) (formerly EITF 002, par. 6).]
38. For intangible assets not subject to amortization, which of the following information should be disclosed for the
period in which intangible assets are acquired either individually or with a group of assets? (Page 86)
a. Weightedaverage amortization period, in total and by major intangible asset class. [This answer is
incorrect. This information should be disclosed for intangible assets that are subject to amortization.]
b. Total amount assigned and the amount assigned to any major intangible asset class. [This answer
is correct. This information should be disclosed for intangible assets not subject to amortization.]
c. Amount of any significant residual value, in total and by major intangible asset class. [This answer is
incorrect. For intangible assets subject to amortization, the amount of any significant residual value, in total
and by major intangible asset class should be disclosed for the period in which intangible assets are
acquired individually or with a group of assets.]
d. Weightedaverage period prior to the next renewal or extension by major asset class. [This answer is
incorrect. This information should be disclosed for intangible assets with renewal or extension terms.]
93
94
INVESTMENTS EQUITY METHOD AND JOINT VENTURES

OVERVIEW
The equity method is used to account for an investment if the investor (a) has the ability to significantly influence the
investee's financial and operating policies and (b) has not elected the fair value option for the investment. Under the
equity method, an investment is initially recorded at cost. Thereafter, the carrying amount of the investment is (a)
increased for the investor's proportionate share of the investee's earnings and (b) decreased for the investor's
proportionate share of the investee's losses or for dividends received from the investee. Other adjustments similar
to those made in consolidated financial statements are also made, such as the elimination of intercompany gains
and losses. The investment generally is shown in the investor's balance sheet as a single amount and earnings and
losses from the investment are shown in the investor's income statement as a single amount. Because the
investor's net income and equity at the end of the period are generally the same as if the investment had been
consolidated, the equity method is sometimes referred to as a oneline consolidation."
CRITERIA FOR USING THE EQUITY METHOD
An investor should use the equity method to account for an investment when it has the ability to significantly
influence the investee's operating and financial policies. Absent predominant evidence to the contrary, an investor
is presumed to have the ability to significantly influence an investee if it owns (directly or indirectly) 20% or more of
the investee's voting stock. (FASB ASC 32310158) (formerly APB 18, par. 17) An investor uses the equity method
to account for investments in common stock or insubstance common stock (that is, investments whose risks and
rewards are substantially similar to common stock). (FASB ASC 32310153) (formerly EITF 0214) In addition, an
investor should use the equity method to account for an investment in a corporate joint venture. (FASB ASC
32310153) (formerly APB 18, par. 1)
Authoritative literature generally looks at the percentage ownership in the investee to determine the extent of an
investor's ability to influence an investee. Consequently, the method used to account for an investment in another
company generally is determined as follows:
% of Other Company Owned Accounting Method Usually Required
Less than 20% Cost or fair value method
20% to 50% Equity method
More than 50% Consolidation
The 20% ownership criteria is intended to provide a degree of uniformity in applying the equity method rather than
absolutely require its use. An investor's ability to significantly influence an investee depends on a variety of factors,
and determining whether there is significant influence requires an evaluation of all the facts and circumstances. For
example, even if an investor does not own 20% of a company's voting stock, it may have significant influence if it is
represented on the investee's board of directors, participates in the investee's policy making process, or
exchanges management personnel. Significant influence may also exist if there are material intercompany transac
tions or the investee is technologically dependent on the investor (FASB ASC 32310156) (formerly APB 18, par.
17). On the other hand, the following circumstances may indicate that an investor does not have significant
95
influence, even if it owns 20% or more of an investee's voting stock: (FASB ASC 323101510) (formerly FIN 35,
par.4)
a. The investee files a lawsuit or complaint against the investor.
b. The investor and investee execute an agreement restricting the investor's rights as a shareholder.
c. Majority ownership of the investee is concentrated among a small group of shareholders who operate the
investee without regard to the views of the investor.
d. The investor seeks more financial information than is available to the investee's other shareholders and is
unable to obtain that information.
e. The investor tries and fails to obtain representation on the investee's board of directors.
If an entity is a variable interest entity, consolidation by an investor or other party that holds less than a 50%
ownership interest may be required.
Also, entities may choose to measure at fair value certain eligible financial instruments and specified other items
that are not otherwise currently measured at fair value under accounting rules. This choice, referred to as the fair
value option, is allowed at specified election dates. For items for which the fair value option is elected, unrealized
gains and losses are reported in earnings at subsequent reporting dates. An entity may choose the fair value
option, subject to certain conditions, for investments that would otherwise be accounted for under the equity
method as discussed in this lesson.
APPLYING THE EQUITY METHOD
Under the equity method, the investment is initially recorded at cost, then reduced by dividends and increased or
decreased by the investor's proportionate share of the investee's net earnings or loss. The investment is shown in
the investor's balance sheet as a single amount and the investor's share of earnings is reported in the investor's
income statement as a single amount. (See item d., however.) Use of the equity method generally results in the
investor's stockholders' equity and net earnings being the same as if the investor and investee were consolidated.
The following are additional considerations for applying the equity method: (FASB ASC 32310302; 32310354;
32310451) (formerly APB 18, paras. 6, 10, and 11)
a. At acquisition, any difference between the cost of the investment and the investor's proportionate equity
in the investee's net assets should be accounted for as if the investee were a consolidated subsidiary. That
is, the difference should be related to the investee's tangible and intangible assets based on their fair
values. Any difference that cannot be related to specific assets should be recognized as goodwill. (FASB
ASC 323103513) (formerly APB, 18, par. 19)
Under (FASB ASC 35020, Intangibles Goodwill and Other Goodwill) (formerly SFAS No. 142, Goodwill
and Other Intangible Assets), investors should not amortize goodwill for equity method investments. In
addition, equity method goodwill should not be tested for impairment under (FASB ASC 35020) (formerly
SFAS No. 142), but should continue to be reviewed as discussed below. (FASB ASC 323103513).
b. Contingent consideration should only be included in the initial measurement of an equity investment if
required by GAAP other than the requirements for business combinations in FASB ASC 805. If an equity
method investment agreement involves a contingent consideration agreement where the fair value of the
investor's share of the investee's net assets exceeds the initial cost, a liability should be recognized. The
liability should be measured as the lesser of (1) the maximum contingent consideration not otherwise
recognized or (2) the excess of the investor's share of the investee's net assets over the initial cost
measurement (including contingent consideration otherwise recognized) (FASB ASC 32310252A;
32310302A and 302B)
c. An investor's equity in the operating results of the investee should be based on the shares of common stock
and insubstance common stock held. (FASB ASC 32310354) (formerly APB 18, par. 18)
96
d. Intercompany profits and losses should be eliminated until realized as if the investee were consolidated.
(FASB ASC 32310357) (formerly APB 18, par. 19)
GAAP offers the following guidance on eliminating intercompany profits and losses under the equity method:
(FASB ASC 32310357, 3510, and 3511; 323105528 and 5529) (formerly AICPA Interpretation No. 1 of APB
Opinion No. 18, par. 1)
a. Only intercompany profits and losses included in assets remaining on the investor or investee's books
need be eliminated.
b. If the investor controls the investee through majority ownership and the transaction is not arm's length, no
intercompany profit should be recognized. Otherwise
(1) when the investor purchases an asset from the investee (i.e., upstream sale), the investor should
eliminate its proportionate share of the intercompany profit or loss (net of tax) from its equity in the
investee's earnings. The eliminated profit or loss should be recorded in a deferred income or loss
account or as an adjustment to the investment account and amortized over the life of the purchased
asset. (Any remaining deferred income or loss should be recognized in full if the investor subsequently
sells the asset.)
(2) when the investor sells an asset to the investee (i.e., downstream sale), the investor should eliminate
from its net income its proportionate share of the intercompany profit or loss. The eliminated profit or
loss should be recorded in a deferred income or loss account and recognized as the investee
depreciates or sells the asset.
c. An investor should report its share of an investee's extraordinary item (or prior period adjustment) as an
extraordinary item (or prior period adjustment) unless the amount is immaterial. (FASB ASC 32310452)
(formerly APB 18, par. 19) Similarly, if an investee has items of other comprehensive income, such as
unrealized holding gains and losses on investments in debt and equity securities classified as
availableforsale, the investor should adjust its investment in the investee by its share of the items and
include those amounts in other comprehensive income. (The format used by an investee to display other
comprehensive income does not affect how the investor shows its proportionate share of those amounts.
Thus, regardless of the format the investee uses to display other comprehensive income, the investor may
combine its proportionate share of those amounts with its own other comprehensive income items and
display the total of those amounts in a separate statement of comprehensive income, a single statement
of income and comprehensive income, or in the statement of changes in equity.) (FASB ASC 323103518;
32310453) (formerly SFAS No. 130, paras. 121122)
d. Capital transactions of the investee that affect the investor's share of the investee's stockholders' equity
should be accounted for on a stepbystep basis. (FASB ASC 323103515) (formerly APB 18, par. 19)
e. An investor should recognize a gain or loss on the sale of its investment equal to the difference between
the selling price and the carrying amount of the investment at the time of sale. (FASB ASC 323103535)
(formerly APB 18, par. 19)
f. An investor should recognize a loss for declines in an investment's value that are other than temporary.
g. An investor ordinarily should discontinue applying the equity method when its share of the investee's losses
reduces the investment in and advances to the investee to zero. Thereafter, the investor should not provide
for additional losses unless it has guaranteed obligations of the investee or is otherwise committed to
provide further financial support for the investee. If the investee subsequently reports net income, the
investor should resume applying the equity method only after its share of net income equals the share of
net losses not recognized during the period the equity method was suspended. However, there are
instances when the investor should continue to record its share of the investee's losses. (FASB ASC
323103520 and 3522) (formerly APB 18, par. 19i)
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h. Dividends on the investee's cumulative preferred stock should be deducted when computing the investor's
share of earnings, regardless of whether they have been declared. (FASB ASC 323103516) (formerly
APB 18, par. 19)
Exhibit 21 illustrates accounting for an investment under the equity method.
Exhibit 21
Example Equity Method Calculations
Facts:
On June 30, 20X5, ABC, Inc. purchased 40% of XYZ Company for $55,000. On that date, XYZ Company had
a total net book value of $100,000. The difference between the amount paid and 40% of XYZ Company's net
book value is attributable to goodwill.
XYZ Company reported earnings of $20,000 for the six months ended December 31, 20X5, and $45,000 for the
year ended December 31, 20X6. In addition, XYZ Company declared and paid dividends totaling $10,000
during 20X6.
During 20X6, XYZ Company recognized a profit of $10,000 on the sale of inventory to ABC, Inc. The inventory
is included in ABC, Inc.'s assets at December 31, 20X6.
XYZ Company's effective tax rate is 30%.
Accounting for the investment on ABC, Inc.'s books:
Equity in
Investment XYZ Co.'s
in XYZ Co. Earnings
Acquisition of 40% of XYZ Company $ 55,000 $

Proportionate share of XYZ Company's earnings for the six months ended
December 31, 20X5 ($20,000 40%) 8,000 8,000
December 31, 20X5 balances 63,000 $ 8,000
Proportionate share of XYZ Company's earnings for the year ended December
31, 20X6 ($45,000 40%) 18,000 $ 18,000
Dividends received ($10,000 40%) (4,000 )
Deferral of XYZ Company's profits on sale of inventory to ABC, Inc., net of
related income taxes incurred by XYZ Company [($10,000 [$10,000
30%]) 40%] (2,800 ) (2,800 )
December 31, 20X6 balances $ 74,200 $ 15,200
* * *
Accounting for Investee Losses When the Investor Has Other Investments in the Investee
If the investor (a) is not committed to provide further financial support for the investee, (b) has already reduced its
investment in and advances to the investee to zero, and (c) has other investments in the investee, the investor
should continue to report its share of the investee's losses up to the adjusted basis of those other investments.
Examples of other investments include debt securities (including mandatorily redeemable preferred stock), pre
ferred stock, or loans to the investee. (FASB ASC 323103523 and 3524) (formerly EITF 9813, par. 4) Accounting
for the investee's losses is as follows: (FASB ASC 323103526) (formerly EITF 9813, par. 5)
a. The investor's share of the investee's losses should be determined.
b. The adjusted basis of the other investments in the investee should be determined. The adjusted basis of
the other investments is the cost basis adjusted for any valuation allowances for investee loans and the
98
cumulative investee losses applied to the other investments. The cost basis is the original cost of the other
investments adjusted for other than temporary writedowns, unrealized holding gains and losses on
securities in the trading category, and amortization of discounts or premiums on debt securities or loans.
(FASB ASC 323103525) (formerly EITF 9813, par. 4)
(1) If the adjusted basis of the other investments is positive, the adjusted basis of the other investments
should be adjusted for the investor's share of the investee's losses. The losses should be applied to
the other investments based on their seniority. The adjusted basis of debt and equity securities
accounted for under (FASB ASC 32010) (formerly SFAS No. 115) becomes the securities' basis for
measuring changes in fair value.
(2) The investor's share of the investee's losses are no longer recorded once the adjusted basis of the
other investments is zero. However, the unreported investee losses should be tracked. If an other
investment is sold and its carrying value exceeds its adjusted basis, the difference between the cost
basis and adjusted basis represents unreported investee losses that also should be tracked.
c. The adjusted basis of other investments should be adjusted for any applicable accounting principles. For
example, investee loans should be adjusted for any required valuation allowances, and debt and equity
securities should be adjusted to fair value.
d. After the investor's share of investee income equals its share of previously unreported investee losses,
subsequent investee income should be recorded as adjustments to the adjusted basis of the other
investments in the reverse order of the application of the investor's share of the investee's losses. (FASB
ASC 323103525) (formerly EITF 9813, par. 4)
Exhibit 22 illustrates accounting for investee losses as adjustments to other investments.
Exhibit 22
Example Accounting for Investee Losses When

The Investor Has Other Investments in Investee
Facts:
At December 31, 20X1, XYZ Company owned 40% of ABC, Inc. Recorded investee losses reduced the
investment in ABC to zero on December 31, 20X1.
Other investments in ABC are $1,000 in ABC's preferred stock (classified as availableforsale) and a $1,000
loan. XYZ is not required to provide any additional financial support.
ABC's income and losses in the following table have been adjusted for intercompany transactions.
ABC's Carrying Value of Loan

Operating Income under FASB ASC 310 Fair Value of
For the year ended (Loss) (formerly SFAS No. 114) Preferred Stock
December 31, 20X2 $ (2,000 ) 950 900

December 31, 20X3 $ (4,000 ) 750 900
December 31, 20X4 $ 4,000 600 500
99
Accounting for the investment on XYZ's books:

Carrying Carry
Value of ing Accumu
Invest Carry Value of lated Other
ment in ing Pre Compre
Common Value ferred hensive
Stock of Loan Stock Income
December 31, 20X1 balances $ $ 1,000 $ 1,000 $
20X2 activity:
Proportionate share of ABC's loss ($2,000 40%) (800 )
Adjustment to carrying value of loan ($1,000 $950) (50 )
Adjustment to carrying value of preferred stock ($1,000
$800 $900) 700 (700 )
December 31, 20X2 balances $ 0 $ 950 $ 900 $ (700 )
At December 31, 20X2, the adjusted basis of XYZ's investment in ABC is:
Common stock $
Loan ($1,000 $50) 950
Preferred stock ($1,000 $800) 200
$ 1,150
Carrying Carry
Value of ing Accumu
December 31, 20X2 balances $ $ 950 $ 900 $ (700 )

20X3 activity:
Proportionate share of ABC's loss ($4,000 40% lim
ited to XYZ's adjusted basis) (950 )a (200 )
Adjustment to carrying value of preferred stock 200 (200 )
Note:
a Because the adjusted basis of the loan is now zero, there is no adjustment to record the reduction in carrying
value under (FASB ASC 31010) (formerly SFAS No. 114).
Common stock $
Loan ($950 $950)
Preferred stock ($200 $200)
$ 0
100
Carrying Carry
Value of ing Accumu
December 31, 20X3 balances $ $ 0 $ 900 $ (900 )

20X4 activity:
Proportionate share of ABC's earnings [(($4,000 40%)
$450 of previously unreported losses)] 950 200
Adjustment to carrying value of loan ($950 $600) (350 )
Adjustment to carrying value of preferred stock ($1,100
$500) (600 ) 600
Common stock $
Loan ($0 + $950 $350) 600
Preferred stock ($0 + $200) 200
$ 800
* * *
An investor that has suspended equity method loss recognition may subsequently increase its investment in a way
that does not result in increasing its ownership interest from one of significant influence to one of control. In such
cases, the investor should recognize previously suspended losses up to the amount of the additional investment
that represents funding of prior losses. Determining whether an additional investment represents funding of prior
losses is a matter of judgment based on the existing facts. The investor also should reevaluate whether it has
become committed to provide financial support for the investee. (FASB ASC 323103529 and 3530) (formerly
EITF 0218, paras. 911)
Factors to consider when determining whether an additional investment represents funding of prior losses include:
(FASB ASC 323103529) (formerly EITF 0218, par. 10)
Whether the additional investment is acquired directly from the investee or from a third party
Whether there is a difference between the fair value of the additional investment and the consideration paid
Whether the additional investment results in an increased ownership percentage
Whether the additional investment is subordinate to other equity of the investee
Differences in Fiscal Years
An investor may recognize its share of the investee's earnings or losses based on the most recent available
financial statements of the investee so long as the time lag in reporting periods is consistent from year to year.
(FASB ASC 32310356) (formerly APB18, par. 19) Thus, for example, if an investor and investee have different
fiscal year ends, the investor generally may compute its share of the investee's earnings or losses based on the
investee's financial statements for its fiscal year. A change in a previously existing difference in yearends should be
reported as a change in accounting principle under (FASB ASC 25010) (formerly SFAS No. 154) (FASB ASC
810104513) (formerly EITF 069)
101
Income Taxes
Accounting for an investment under the equity method may cause temporary differences between amounts
reported for financial and tax reporting. (FASB ASC 74030252) (formerly APB 23, par. 9)
Changing to or from the Equity Method
Changes in its ability to significantly influence an investee's financial and operating policies may require an investor
to change to or from the equity method. For example, an investor (or others) might buy or sell shares of the
investee's stock, changing the investor's ownership percentage and ability to influence. In such cases, the follow
ing apply:
a. When an investor loses its ability to significantly influence the investee, it should stop accruing its share of
the investee's earnings or losses and begin accounting for the investment under the cost method. The
investment's cost is its carrying amount on the date that it no longer qualifies for equity method accounting.
(FASB ASC 323103536) (formerly APB 18, par. 19) The investor's proportionate share of accumulated
other comprehensive income of the investee should be offset against the carrying amount of the investment
when significant influence is lost. If the adjustment would reduce the investment's carrying amount below
zero, the excess should be recorded in income. (FASB ASC 323103539) (formerly FSP APB 181, par.
4)
b. When an investment previously accounted for under the cost method becomes eligible for equity method
accounting, an investor should retroactively adjust its investment, results of operations, and retained
earnings on a stepbystep basis (as if the equity method had been in effect during all periods the
investment was held). For example, if ABC Company purchased 10% of DEF Company's voting stock on
January 1, 20X4, and another 15% on October 1, 20X5, its earnings for 20X5 would include (1) 10% of DEF
Company's earnings for the nine months ended September 30, 20X5, and (2) 25% of DEF Company's
earnings for the three months ended December31, 20X5. ABC Company would also restate its retained
earnings to include 10% of DEF Company's undistributed earnings for the year ended December 31, 20X4.
In addition, ABC Company should compare the cost of each purchase with the underlying net assets of
DEF Company and account for any differences as discussed previously. (FASB ASC 323103533)
(formerly APB 18, par. 19m)
Investee Capital Transactions
If an investee accounted for under the equity method issues additional shares, the investor should account for the
transaction as if it had sold a proportionate share of its investment. Any resulting gain or loss should be recognized
in earnings. (FASB ASC 32310401) (formerly EITF 086, par. 9)
An investor's financial statements should include the following disclosures about an investment accounted for
under the equity method: (FASB ASC 32310502 and 503) (formerly APB 18, par. 20)
a. Name of the investee
b. Percentage ownership of the investee's common stock
c. Investor's accounting policies with respect to investments in common stock (If an investee is 20% or more
owned but not accounted for under the equity method, the disclosure should include the name of the
investee and the reasons why the equity method is not appropriate. Conversely, if an investee is less
than20% owned but accounted for under the equity method, the disclosure should include the name of
the investee and the reasons why the equity method is being used.)
d. Difference, if any, between the carrying amount of the investment and the underlying equity in net assets,
and the accounting treatment of the difference
102
e. If a quoted market price for the investment is available, the aggregate value of the investment based on the
quoted price. (This disclosure is not required for investments in subsidiaries.)
f. If equity method investments are, in the aggregate, material to the investor's financial position or results
of operations, summarized information about the investees' assets, liabilities, and results of operations
g. Material effects on the investor of possible conversions of the investee's outstanding convertible securities,
exercises of options and warranty, or contingent issuances
When determining the extent of the disclosures, the investment's significance to the investor's financial position
and results of operations should be considered.
103
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SELFSTUDY QUIZ
following section.
39. When there is a 20% to 50% ownership in another company, the accounting method generally used to account
for the investment is:
a. Consolidation.
b. Cost or fair value method.
c. Equity method.
40. In which of the following circumstances might the investor have significant influence over an investee even if
the investor does not own 20% of a company's voting stock?
a. The investor seeks, but is unable to obtain, more financial information than is available to the investee's
other shareholders.
b. The investor participates in the investee's policy making process.
c. The investor and investee execute an agreement that restricts the investor's rights as a shareholder.
d. The investor tries and fails to obtain representation on the investee's board of directors.
41. The second action to take in applying the equity method is:
a. The investment is increased or decreased by the investor's proportionate share of the investee's net
earnings or loss.
b. The investment is recorded at cost.
c. The investment is reduced by dividends.
42. A number of disclosures concerning an investment accounted for under the equity method should be included
in an investor's financial statements. One such disclosure is the investor's accounting policies with respect to
investments in common stock. If an investee is less than 20% owned but accounted for under the equity
method, the disclosure should:
a. Include the name of the investee and the reasons why the equity method is being used.
b. Include the name of the investee and the reasons why the equity method is not appropriate.
105
SELFSTUDY ANSWERS
39. When there is a 20% to 50% ownership in another company, the accounting method generally used to account
for the investment is: (Page 95)
a. Consolidation. [This answer is incorrect. Consolidation is the accounting method generally used to
account for the investment when there is more than 50% ownership in another company.]
b. Cost or fair value method. [This answer is incorrect. The cost or fair value method generally is used to
account for the investment when there is less than 20% ownership in another company.]
c. Equity method. [This answer is correct. When there is 20% to 50% ownership in another company,
the equity method generally is used to account for the investment.]
40. In which of the following circumstances might the investor have significant influence over an investee even if
the investor does not own 20% of a company's voting stock? (Page 95)
a. The investor seeks, but is unable to obtain, more financial information than is available to the investee's
other shareholders. [This answer is incorrect. This circumstance may indicate that an investor does not
have significant influence, even if it owns 20% or more of an investee's voting stock.]
b. The investor participates in the investee's policy making process. [This answer is correct. Even if
the investor does not own 20% of a company's voting stock, the investor may still have significant
influence over an investee if they participate in the investee's policy making process.]
c. The investor and investee execute an agreement that restricts the investor's rights as a shareholder. [This
answer is incorrect. Even if the investor owns 20% or more of an investee's voting stock, it may not have
significant influence in cases where the investor and investee execute an agreement that restricts the
investor's rights as a shareholder.]
d. The investor tries and fails to obtain representation on the investee's board of directors. [This answer is
incorrect. In circumstances where the investor tries and fails to obtain representation on the investee's
board of directors, the investor may not have significant influence, even if it owns 20% or more on an
investee's voting stock.]
41. The second action to take in applying the equity method is: (Page 96)
a. The investment is increased or decreased by the investor's proportionate share of the investee's net
earnings or loss. [This answer is incorrect. This is the third action to take in applying the equity method.]
b. The investment is recorded at cost. [This answer is incorrect. This is the first action to take in applying the
equity method.]
c. The investment is reduced by dividends. [This answer is correct. This is the second action to take
in applying the equity method.]
106
42. A number of disclosures concerning an investment accounted for under the equity method should be included
in an investor's financial statements. One such disclosure is the investor's accounting policies with respect to
investments in common stock. If an investee is less than 20% owned but accounted for under the equity
method, the disclosure should: (Page 102)
a. Include the name of the investee and the reasons why the equity method is being used. [This answer
is correct. If an investee is less than 20% owned but accounted for under the equity method, the
disclosure should include the name of the investee and the reasons why the equity method is being
used.
b. Include the name of the investee and the reasons why the equity method is not appropriate. [This answer
is incorrect. The disclosure should include the name of the investee and the reasons why the equity method
is not appropriate if an investee is 20% or more owned but not accounted for under the equity method.]
107
108
Lesson 2 (GAPTG091)
33. Which of the following is an intangible asset?
a. Company headquarters building.
b. Company franchises.
c. Company vehicles.
d. Company computer server.
34. If factors do not limit an intangible asset's expected useful life, the asset's life is:
a. One calendar year.
b. Remainder of current tax year.
c. Indefinite.
d. Based on similar intangible assets.
35. An operating segment is a reporting unit in which of the following circumstances?
a. None of its components is a reporting unit.
b. The majority of its components are similar.
c. It comprises two or more components.
36. FASB ASC 350203528 (formerly SFAS No. 142, par. 26), indicates that the annual test for goodwill impairment
should be performed at the same time every year and that such impairment occur in what timeframe during
the year?
a. The first quarter.

b. The third quarter.
c. The fourth quarter.
d. Any time during the year.
37. If an investor directly or indirectly owns ________ of the investee's voting stock, the investor is presumed to have
the ability to significantly influence an investee, unless there is evidence to the contrary.
a. 20% or more.
b. 25% or more.
c. 30% or more.
d. 35% or more.
109
38. In cases where an entity is a variable interest entity, consolidation may be required by an investor or other party
that holds less than _______ ownership interest?
a. 80%.
b. 75%.
c. Twothirds.
d. 50%.
39. Capital transactions of the investee that have an impact on the investor's share of the investee's stockholders'
equity should be accounted for on a stepbystep basis using which of the following accounting methods?
a. Equity method.
b. Consolidation.
c. Cost or fair value method.
40. When an investor no longer has the ability to significantly influence the investee, it should stop accruing its share
of the investee's earnings or losses and begin accounting for the investment under which method?
a. Fair value method.
b. Consolidation.
c. Cost method.
d. Equity method.
110
GLOSSARY
Capital Lease: A lease that must be reflected on a company's balance sheet as an asset and corresponding liability.
Generally, this applies to leases where the lessee acquires essentially all of the economic benefits and risks of the
leased property.
Direct Financing Lease: A method used by lessors in capital leases when both of the following criteria for the lessor
are satisfied: (1) collectibility of minimum lease payments is assured and (2) no important uncertainties surround the
amount of unreimbursable costs yet to be incurred. In a direct financing lease, the lessor is not a manufacturer or
dealer in the item; the lessor purchases the property only for the purpose of leasing it.
Lessee: One who holds as estate by virtue of a lease.
Lessor: One who grants a lease to another, thereby transferring to him exclusive temporary right of possession of
certain property, subject only to rights expressly retained by the owner.
Leveraged Lease: A lease that involves a lender in addition to the lessor and lessee. The lender, usually a bank or
insurance company, puts up a percentage of the cash required to purchase the asset, generally more than half. The
balance is put up by the lessor, who is both the equity participant and the borrower.
Operating Lease: A type of lease, normally involving equipment, whereby the contract is written for considerably
less than the life of the equipment and the lessor handles all maintenance and servicing.
Present Value: Today's value of a future payment, or stream of payments, discounted at some appropriate
compound interest, or discount rate; also called time value of money. The presentvalue method, also called the
discounted cash flow method, is widely used in corporate finance to measure the return on a capital investment
project. In security investments, the method is used to determine how much money should be invested today to result
in a certain sum at a future time. Presentvalue calculations are facilitated by presentvalue tables, which are
compound interest tables in reverse.
Related Party Transaction: Interaction between two parties, on of whom can exercise control or significant influence
over the operating policies of the other.
Residual Value: Realizable value of a fixed asset after costs associated with the sale. Also, the amount remaining
after all allowable depreciation charges have been subtracted from the original cost of a depreciable asset.
Saleleaseback Agreement: A form of lease agreement in which a company sells an asset to another party in
exchange for cash, then contracts to lease the asset for a specified term.
Salestype Lease: Accounting by lessor in which one or more of the four criteria required for a capital lease are met
and both of the following criteria are satisfied: (1) collectibility of minimum lease payments is predictable and (2) no
important uncertainties surround the amount of unreimbursable costs yet to be incurred.
Sublease: Lease from one lessee to another lessee.
111
112
INDEX
A L
ACCOUNTING CHANGES LEASES
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Amortization and depreciation
Capital leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
ACCOUNTING POLICIES Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Equity method investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22, 30
Asset retirement obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
ASSET RETIREMENT OBLIGATIONS Bargain purchase option
Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Effect on classification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
I Effect on lease term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Effect on minimum lease payments . . . . . . . . . . . . . . . . . . . 19
INTANGIBLE ASSETS Leases involving land and buildings . . . . . . . . . . . . . . . . . . . 39
Amortizing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Leases involving land only . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Test description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 Bargain renewal option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Business combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Goodwill, accounting for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Capital leases
Goodwill, impairment after disposal . . . . . . . . . . . . . . . . . . . . . . 82 Acquired in a business combination . . . . . . . . . . . . . . . . . . . 47
Goodwill, impairment test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Amortization of leased assets . . . . . . . . . . . . . . . . . . . . . . . . . 20
Goodwill, reporting unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Changes in estimates or circumstances . . . . . . . . . . . . . . . . 33
Goodwill, subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 Changes in lease provisions . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Impairment of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79, 80 Criteria for classification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Indefinite useful life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Internally developed intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Guarantee of residual value . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Presenting in financial statements . . . . . . . . . . . . . . . . . . . . . . . . 87 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Purchased intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Land only . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Useful lives, determining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Lessee accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Website development costs Purchase of leased asset by lessee . . . . . . . . . . . . . . . . . . . 32
Accounting for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 Renewals and extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Developing graphics, costs of . . . . . . . . . . . . . . . . . . . . . . . . 85 Saleleaseback transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Development applications and infrastructure, Subleases and similar transactions . . . . . . . . . . . . . . . . . . . . 46
costs of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 Termination of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Operating costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 Changes in estimates or circumstances . . . . . . . . . . . . . . . . . . . 33
Planning stage, costs during . . . . . . . . . . . . . . . . . . . . . . . . . 83 Changes in lease provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Leases acquired in a business combination . . . . . . . . . . . . 47
INVENTORY Lessee accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Purchases or sales with the same counterparty . . . . . . . . . . . . 72 Lessor accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Classifying leases
INVESTMENTS EQUITY METHOD AND JOINT VENTURES Lessees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Applying the equity method Lessors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Accounting changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Collateral wrap lease transactions . . . . . . . . . . . . . . . . . . . . . . . . 56
Capital transactions by investee . . . . . . . . . . . . . . . . . . . . . . 96 Contingent rentals
Changes in ability to significantly influence . . . . . . . . . . . . 102 Capital leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Difference between cost and underlying equity . . . . . . . . . 96 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Differences in fiscal years . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Exclusion from minimum lease payments . . . . . . . . . . . . . . 19
Earnings, losses of investee . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Lessor accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Deferred lease incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . 22, 30
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Definitions
Intercompany transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Bargain renewal option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Investee losses when investor has other investments . . . . 98 Contingent rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Investment less than zero . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Estimated remaining economic life . . . . . . . . . . . . . . . . . . . . 19
Other than temporary declines in investment . . . . . . . . . . . 96 Fair rental . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Preferred stock of investee . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Prior period adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Initial direct costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Sale of investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Interest rate implicit in the lease . . . . . . . . . . . . . . . . . . . . . . . 19
Criteria for applying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Lease term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Lessee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Impairment of value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Lessee's incremental borrowing rate . . . . . . . . . . . . . . . . . . 19
Lessor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
INVESTMENTS OTHER Lessor's gross investment in lease . . . . . . . . . . . . . . . . . . . . 23
Cash surrender value of life insurance . . . . . . . . . . . . . . . . . . . . . 4 Lessor's net investment in lease . . . . . . . . . . . . . . . . . . . . . . 23
Cost method investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Leveraged leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Disclosures Moneyovermoney lease transactions . . . . . . . . . . . . . . . . . 49
Cost method investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Normal leaseback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Investments in life settlement contracts . . . . . . . . . . . . . . . . . 6 Penalty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Rate of return on net investment . . . . . . . . . . . . . . . . . . . . . . 24
Investments in life settlement contracts . . . . . . . . . . . . . . . . . . 5, 6 Substantial leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4, 5 Deposit method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
113
Direct financing leases Initial direct costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Land and buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Calculation of gross investment . . . . . . . . . . . . . . . . . . . . . . . 23 Maintenance deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Calculation of net investment . . . . . . . . . . . . . . . . . . . . . . . . . 23 Rate of return on net investment . . . . . . . . . . . . . . . . . . . . . . 24
Changes in estimates or circumstances . . . . . . . . . . . . . . . . 33 Rents receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Changes in lease provisions . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Residual value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Compared with leveraged leases . . . . . . . . . . . . . . . . . . . . . 24 Review of assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Criteria for lessor classification . . . . . . . . . . . . . . . . . . . . . . . . 20 Unearned income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Decline in net investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Maintenance deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Minimum lease payments
Executory costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 90% test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Gains or losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Allocating between land and building . . . . . . . . . . . . . . . . . . 40
Income determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Allocating between real estate and equipment . . . . . . . . . . 41
Initial direct costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Capital leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Land and buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Changes in lease provisions . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Lessor accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Collectibility reasonably predictable . . . . . . . . . . . . . . . . . . . 20
Moneyovermoney lease transactions . . . . . . . . . . . . . . . . . 49 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Renewals and extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Effect on lease classification . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Saleleaseback transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Exclusions from . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Unearned income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Interest rate used to calculate present value . . . . . . . . . . . . 19
Unguaranteed residual value . . . . . . . . . . . . . . . . . . . . . . . . . 23 Residual value guarantee . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Salestype leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Discount rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Moneyovermoney lease transactions . . . . . . . . . . . . . . . . . . . . 49
Escalating rental payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Net investment
Escalation clauses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Direct financing leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Exclusions from leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Salestype leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Executory costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19, 23, 47, 56 Ninety percent test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 19
Fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19, 20, 39 Normal leaseback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Financial statement presentation . . . . . . . . . . . . . . . . . . . . . . . . . 56 Offbalancesheet risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Fiscal funding clauses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Operating leases
Gains or losses Accounting for leased asset . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Changes in lease provisions . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Accounting for revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Direct financing leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Lease incentives in operating leases . . . . . . . . . . . . . . 22, 30 Changes in estimates or circumstances . . . . . . . . . . . . . . . . 33
Lessor's assumption of a preexisting lease . . . . . . . . . . . . 22 Changes in lease provisions . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Leveraged leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Contingent rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22, 30
Losses on subleases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Criteria for lessee classification . . . . . . . . . . . . . . . . . . . . . . . 17
Loss on operating leases involving real estate . . . . . . . . . . 30 Criteria for lessor classification . . . . . . . . . . . . . . . . . . . . . . . . 20
Salestype leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Subleases and similar transactions . . . . . . . . . . . . . . . . . . . . 46 Escalating rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Termination of capital leases . . . . . . . . . . . . . . . . . . . . . . . . . 32 Incentive payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Governmentowned facilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Land and buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Gross investment Land only . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Direct financing leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Lease incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Salestype leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Leases with governmental units . . . . . . . . . . . . . . . . . . . . . . . 48
Initial direct costs Lessee accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Direct financing leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Lessor accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Lessor accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Lessor accounting for initial direct costs . . . . . . . . . . . . . . . 30
Leveraged leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Losses involving real estate . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Interest expense and interest method Minimum lease payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Capital leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Moneyovermoney lease transactions . . . . . . . . . . . . . . . . . 49
Direct financing leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Moving costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22, 30
Interest rate implicit in the lease . . . . . . . . . . . . . . . . . . . . . . . 19 Renewals and extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Minimum lease payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Rental payments on unused property . . . . . . . . . . . . . . . . . . 22
Salestype leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Lease incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22, 30 Saleleaseback transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Lease payments Sale of leased property or rental payments . . . . . . . . . . . . . 33
Allocation between interest and principal . . . . . . . . . . . . . . . 21 Scheduled rent increases . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Contingent rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Subleases and similar transactions . . . . . . . . . . . . . . . . . . . . 46
Escalating rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Upfront cash payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Lease incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Ownership transfer test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Scheduled rent increases . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Payments to third parties on behalf of lessee . . . . . . . . . . . . . . 22
Leases with governmental entities . . . . . . . . . . . . . . . . . . . . . . . . 48 Penalty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 19, 31
Lease term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Purchase of leased asset by lessee . . . . . . . . . . . . . . . . . . . . . . . 32
Lessee's incremental borrowing rate . . . . . . . . . . . . . . . . . . . . . . 19 Purchase options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Leveraged leases Real estate leases
Acquired under purchase method . . . . . . . . . . . . . . . . . . . . . 48 Land and buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Calculation of net investment . . . . . . . . . . . . . . . . . . . . . . . . . 24 Land, buildings, and equipment . . . . . . . . . . . . . . . . . . . . . . 41
Changes in estimates or circumstances . . . . . . . . . . . . . . . . 33 Land only . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Part of a building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Compared with direct financing leases . . . . . . . . . . . . . . . . . 24 Qualifying as a salestype lease . . . . . . . . . . . . . . . . . . . . . . . 30
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Related parties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41, 56
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Remarketing agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Gains or losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Renewals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 19
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Renewals and extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Subleases and similar transactions

Rental concessions provided by lessor . . . . . . . . . . . . . . . . . . . 22 Accounting by new lessee . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Rental income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Accounting by original lessee . . . . . . . . . . . . . . . . . . . . . . . . 46
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Accounting by original lessor . . . . . . . . . . . . . . . . . . . . . . . . . 46
Residual value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19, 23 56 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . 46, 56
Residual value guarantee Gains or losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Effect of renewals or extensions . . . . . . . . . . . . . . . . . . . . . . 31 Losses on subleases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Effect on amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 New lessee substituted through new agreement . . . . . . . . 46
Saleleaseback transactions New lessee substituted under original
Accounting by buyerlessor . . . . . . . . . . . . . . . . . . . . . . . . . . 54 agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46, 47
Accounting by sellerlessee . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Terminations of leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Transfer of ownership
Real estate leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Leases involving land and buildings . . . . . . . . . . . . . . . . . . . 39
Wrap lease transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Leases involving land only . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Salestype leases Types of leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Calculation of investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Unearned income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
Changes in estimates or circumstances . . . . . . . . . . . . . . . . 33 Wrap lease transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Changes in lease provisions . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Criteria for lessor classification . . . . . . . . . . . . . . . . . . . . . . . . 20 N
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Executory costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 NONMONETARY TRANSACTIONS
Gain or loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Determination of fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
Initial direct costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Land and buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Exchanges facilitating sales to customers . . . . . . . . . . . . . . . . . 72
Lessor accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Exchanges that lack commercial substance . . . . . . . . . . . . . . . 72
Moneyovermoney lease transactions . . . . . . . . . . . . . . . . . 49 General accounting rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Renewals and extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Nonreciprocal transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Saleleaseback transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Nonreciprocal transfers to owners . . . . . . . . . . . . . . . . . . . . . . . . 72
Unguaranteed residual value . . . . . . . . . . . . . . . . . . . . . . . . . 23 Purchases or sales with the same counterparty . . . . . . . . . . . . 72
Scheduled rent increase based on physical use . . . . . . . . . . . . 22 Reciprocal transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Seventyfive percent test . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 19
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COURSE 2
OVERVIEW
COURSE DESCRIPTION: This interactive selfstudy course covers GAAP related to derivative instruments and
hedging activities, foreign operations and currency translation, income taxes,
research and development costs, and revenue recognition.
DATE:
PREPARATION:

KNOWLEDGE LEVEL: Overview

Identify the accounting requirements for derivatives and the various types of hedging instruments.
Identify the required disclosures for derivatives.
Determine foreign currency transactions and the accounting requirements for reporting these transactions.

Determine the primary objective of accounting for income taxes and identify temporary income tax differences.
Identify deferred tax assets and liabilities.
Determine research and development activities and describe the accounting requirements for the associated
costs.
Determine when revenue should be recognized.
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Thomson Reuters
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DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
INTRODUCTION
An entity should measure all derivative financial instruments (including certain derivatives embedded in other
contracts) at fair value and record them as assets or liabilities in the statement of financial position. Accounting for
gains and losses (i.e., changes in fair value) depends on whether the derivative is designated as a hedge and, if so,
the type of hedge. The following lists the general requirements for accounting for changes in the fair value of
derivatives:
The derivative hedges the exposure to changes in fair value of a recognized asset or liability or an
unrecognized firm commitment. The gain or loss on a derivative designated as a fair value hedge should
be recognized in earnings in the period of change together with the offsetting gain or loss due to changes
in the fair value of the hedged item attributed to the risk being hedged.
The derivative hedges the exposure to variable cash flows of a forecasted transaction. The effective portion
of the gain or loss on a derivative designated as a cash flow hedge should initially be reported in other
comprehensive income and subsequently reclassified to net income in the same period that the forecasted
transaction affects earnings. The ineffective portion of the gain or loss on the derivative should be reported
in earnings immediately.
The derivative hedges the exposure of a net investment in a foreign operation. The gain or loss on a
derivative designated as hedging the foreign currency exposure of a net investment in foreign operations
should be reported in other comprehensive income as part of the cumulative translation adjustment.
The derivative is not a hedge. Gains and losses on derivative instruments not designated as hedging
instruments should be recognized in earnings in the period of the change in fair value.
To use hedge accounting, the derivative must be designated as a hedge at the inception of the contract. In addition,
the entity must document the risk being hedged and the reason for undertaking the hedge, including the hedging
instrument, the hedged item, and how the hedging instrument's effectiveness in offsetting exposure to changes in
fair value or variability in cash flows attributable to the hedged risk will be assessed. Nonderivative instruments may
be designated as a hedge only against the change in fair value of a firm commitment attributed to foreign currency
exchange rates or against an entity's net investment in foreign operations.

Identify the accounting requirements for derivatives and the various types of hedging instruments.
Identify the required disclosures for derivatives.
Determine foreign currency transactions and the accounting requirements for reporting these transactions.
All derivative financial instruments should be measured at fair value and reported in the balance sheet as assets or
liabilities. Accounting for gains and losses (i.e., subsequent changes in fair value) depends on the intended use of
the derivative. Gains and losses on derivative instruments not designated as hedging instruments should be
recognized in earnings in the period of the change in fair value. Accounting for gains and losses on hedging
instruments depends on the type of hedge. A hedging instrument may be one of the following three types of
hedges: (FASB ASC 81510251; 81510301; 81510351 and 352; 81520351) (formerly SFAS 133, paras. 17
and 18)
Fair value hedge.
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Cash flow hedge.
Hedge of an entity's net investment in a foreign operation.
WHAT ARE DERIVATIVES?
A derivative is a financial instrument or other contract with all three of the following characteristics: (FASB ASC
815101583) (formerly SFAS 133, par.6)
a. It has at least one underlying and at least one notional amount or payment provision or both. An underlying
is a specified interest rate, security price, commodity price, foreign exchange rate or rate index, or other
variable (including the occurrence or nonoccurrence of a specified event, such as a scheduled payment
under a contract). A notional amount is a number of currency units, shares, bushels, pounds, or other units
specified in the contract. A payment provision specifies a fixed or determinable settlement to be made if
the underlying performs in a specified manner. An underlying, along with either a notional amount or a
payment provision, determines the settlement of a derivative, and, in some cases, whether or not a
settlement is required. Therefore, a derivative instrument must have at least one underlying and at least one
notional amount or payment provision (or both). (FASB ASC 815101588; 815101592 and 1593)
(formerly SFAS133, paras. 7 and 57)
b. It requires no initial net investment or an initial net investment less than required for other types of contracts
expected to respond similarly to changes in market factors. Derivative instruments either require no initial
net investment or an initial net investment less than other types of contracts that respond similarly to
changes in market factors. For example, entering into a commodity futures contract generally does not
require an initial net investment. Swap or forward contracts also generally require no initial net investment
unless the terms favor one party over the other. However, options generally require the party that has rights
under the contract to make an initial net investment (a premium). (FASB ASC 815101594 and 1595)
(formerly SFAS133, paras. 8 and 57)
c. Its terms require or allow net settlement; it can readily be settled net by a method outside the contract; or
it provides for delivery of an asset that puts the recipient in a position similar to net settlement. A contract
satisfies the net settlement requirement if its settlement provisions meet one of the following three criteria:
(FASB ASC 815101599 and 15100; 8151015110; 8151015119 and 15120) (formerly SFAS 133, par.
9)
(1) Neither party is required to deliver an asset associated with the underlying and that has a principal
amount, stated amount, number of shares, face value, or other denomination equal to the notional
amount (or equal to the notional amount plus or minus a premium or a discount). For example, the
two parties in an interest rate swap do not exchange principal.
(2) One of the parties must deliver an asset in a denomination equal to the notional amount, but a market
mechanism facilitates net settlement. For example, a party to a forward contract to buy units of foreign
currency has a mechanism to immediately sell the units bought under the forward, so that it only has
a net receipt or payment.
(3) One of the parties must deliver an asset in a denomination equal to the notional amount, but that asset
is readily convertible to cash or is itself a derivative. For example, a swaption (which is an option to
enter into a swap contract) is a derivative.
Contracts Not Subject to the Guidance in This Lesson
The following types of contracts are not subject to the requirements discussed in this lesson even though,
depending on the facts andcircumstances, they otherwise might be considered derivatives: (FASB ASC
a. Regularway" security trades. Contracts providing for delivery of a security that is readily convertible to
cash within customary timeframes established by marketplace regulations are not subject to the guidance
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in this lesson, provided there is no net settlement provision or market mechanism to facilitate net settlement
(unless the contract is required to be accounted for on a tradedate basis). (FASB ASC 815101515 and
1516) (formerly SFAS 133, paras. 10 and 58) For example, a contract to purchase a publicly traded equity
security on an exchange regulated by the Securities and Exchange Commission is considered a
regularway" security trade if the contract requires settlement within three business days (the customary
timeframe established for SEC trades). A contract to purchase such a security is not a regularway"
security trade if the contract requires settlement in five days rather than three, unless the contract is required
to be accounted for on a tradedate basis. Contracts that require delivery of securities that are not readily
convertible to cash are not subject to (FASB ASC 815) (formerly SFAS No. 133) unless a market mechanism
outside the contract facilitates net settlement. For example, delivery of a restricted security is not subject
to the requirements of (FASB ASC 815) (formerly SFAS No. 133) since the restricted security is not readily
convertible into cash. (FASB ASC 815101515, 1517, and 1518) (formerly SFAS 133, par. 58)
b. Normal purchases and sales. Contracts for the purchase or sale of something (other than financial or
derivative instruments) that will be delivered in quantities expected to be used or sold over a reasonable
period in the normal course of business are not subject to the guidance in this lesson. For example, an
agreement for a cooperative to sell grain is considered a normal sale if the contract's terms are consistent
with the terms of the cooperative's normal sales.
Forward contracts that contain net settlement provisions also are not subject to the guidance in this lesson
if it is likely that such contracts will result in the physical delivery of assets and will not settle net. The entity
should document, either by individual contract or for groups of similarly designated contracts, the basis
for determining that the contract will not settle net and will result in physical delivery. (FASB ASC
815101522; 815101537 and 1538; 815101541) (formerly SFAS 133, par.10)
c. Certain insurance contracts. Insurance policies that reimburse the holder only for losses incurred as a result
of identifiable insured events (such as traditional life insurance and property and casualty insurance
policies) are not subject to the guidance in this lesson. However, some insurance policies may include
investment features that are embedded derivatives. (FASB ASC 815101552 through 1554) (formerly
SFAS 133, par. 10)
d. Certain financial guarantee contracts. Contracts that only reimburse the guaranteed party for a loss if the
debtor fails to satisfy its required payment obligations are not subject to the guidance in this lesson.
However, contracts that provide for payment in response to changes in an underlying (such as a decrease
in a specific debtor's creditworthiness) are derivatives subject to the guidance in this lesson. For example,
a contract that requires the guarantor to make a payment if the debtor's financial condition falls below a
prescribed level is subject to the guidance in this lesson. (FASB ASC 815101558) (formerly SFAS 133,
par. 10) To qualify for exclusion from the guidance in this lesson, a financial guarantee contract must
provide payment to the guaranteed party only if the debtor is past due in meeting its payment obligations.
In addition, the guaranteed party must bear the risk of nonpayment both at the inception of the contract
and throughout its term. (FASB ASC 815101558) (formerly SFAS 133, par. 10)
e. Certain contracts that are not traded on an exchange. Contracts that are not traded on an exchange are not
subject to the guidance in this lesson if the underlying on which settlement is based is any of the
following (FASB ASC 815101559) (formerly SFAS 133, par. 10)
(1) a climatic, geological, or other physical variable (such as a forward contract for a distributor to buy
fuel oil if the total of average daily low temperatures for a month is below a specified amount),
(2) the price or value of a nonfinancial asset that is not readily convertible to cash (such as an option based
on the value of a tract of undeveloped land) or a nonfinancial liability that does not require delivery of
an asset that is readily convertible to cash (such as an option that requires payment if the amount of
outstanding service warranty claims exceeds a specified amount), or
(3) specified volumes of sales or service revenues (such as an operating lease that requires rents
contingent upon the lessee having prescribed levels of sales from the leased asset).
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f. Derivatives that prevent sales accounting. Derivative instruments that prevent one party from recognizing
a related contract as a sale or the counterparty from recognizing a purchase are not subject to the guidance
in this lesson. For example, a put option that enables the buyer of real estate to require the seller to buy
back the real estate prevents sales accounting. (FASB ASC 815101563) (formerly SFAS 133, par. 10)
g. Investments in life insurance. A policyholder's investment in a life insurance contract accounted for under
FASB ASC 32530, Investments Other Investments in Insurance Contracts (formerly FASB Technical
Bulletin No. 854, Accounting for Purchases of Life Insurance or FASB Staff Position FTB 8541, Accounting
for Life Settlement Contracts by ThirdParty Investors), is not subject to the guidance in this lesson. This
exclusion does notapply to the issuer of the life insurance contract, however. (FASB ASC 815101567)
[formerly SFAS 133, par. 10]
h. Certain investment contracts. Investment contracts accounted for under paragraph 4 of SFAS No. 110,
Reporting by Defined Benefit Pension Plans of Investment Contracts and paragraph 12 of SFAS No. 35,
Accounting and Reporting by Defined Benefit Pension Plans are not subject to the guidance in this lesson.
This exclusion applies only to the party accounting for the contract under those statements, however.
(FASB ASC 815101568) [formerly SFAS 133, par. 10]
i. Loan commitments. Potential borrowers that hold commitments to originate loans, and issuers of
commitments to originate loans (other than mortgage loans held for sale), are not subject to the guidance
in this lesson. (FASB ASC 815101569 and 1571) [formerly SFAS 133, paras. 6 and 10]
j. Registration payment arrangements. Contingent obligations to make future payments or otherwise transfer
consideration under a registration payment arrangement, whether issued as a separate agreement or
included as a provision of a financial instrument or other agreement, should be separately recognized and
measured in accordance with SFAS No. 5, Accounting for Contingencies. (FASB ASC 45020) [ formerly
SFAS 133, par. 10 and FSP EITF 00192] (FASB ASC 815101582; 82520253)
In addition to the contracts listed above, the following contracts should not be considered derivative instruments:
a. Contracts that are (1) issued or held by the reporting entity, (2)indexed to its own stock, and (3) classified
in stockholders' equity in its balance sheet. For example, a company that issues debt with a conversion
feature should not separately account for the conversion feature as a derivative instrument since a
standalone option is classified as equity. (Likewise, the holder of a privately held entity's convertible debt
should not account for the conversion feature separately since the equity securities are not readily
convertible into cash.) (FASB ASC 815101574) [formerly SFAS 133, par. 11]
b. Contracts issued by the entity in connection with stockbased compensation arrangements. For example,
performancebased stock option plans are not considered derivative instruments subject to the guidance
in this lesson. If a contract ceases to be subject to the requirements for sharebased compensation, the
terms of the contract would dictate whether it would be considered a derivative instrument. (FASB ASC
815101574) [formerly SFAS 133, par. 11]
c. Contracts between an acquirer and a seller to enter into a business combination at a future date. (FASB
ASC 815101574) [formerly SFAS 133, par. 11, as amended by SFAS 141(R)]
d. Forward contracts requiring the delivery of cash for a fixed number of the reporting entity's equity shares
that are accounted forunder SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. (FASB ASC 480, Distinguishing Liabilities from Equity) (FASB
ASC 815101574) [formerly SFAS 133, par. 11]
The preceding exceptions do not apply to the counterparty in such contracts. In addition, a contract that an entity
can or must settle by issuing its own equity instruments that is indexed (in part or in full) to an underlying other than
the entity's own stock may be a derivative for the issuer if it meets the criteria detailed above. (FASB ASC
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Embedded Derivatives
Certain contracts (such as bonds, insurance policies, and leases) that do not meet the definition of a derivative
above may contain embedded derivative instruments. Embedded derivatives affect the cash flow or value of other
exchanges required by the contract in a manner similar to a derivative instrument. (FASB ASC 8151520) (formerly
SFAS 133, par. 12) Examples of derivatives embedded in a financial instrument or other contract (the host contract)
include a feature in
a. A loan agreement that (1) permits the debtor to pay the loan prior to its maturity (a call option), (2) allows
the creditor to require the debtor to pay the loan prior to its maturity (a put option), or (3) enables either the
creditor or the debtor to require that the loan balance be converted to equity.
b. An equity instrument that permits the entity to buy back the equity interest (a call option) or the investor to
sell it back to the entity (a put option).
c. A loan agreement in which interest payments fluctuate with changes in the S&P 500 Index.
Generally, an embedded derivative is accounted for separately if all of the following criteria are met: (FASB ASC
a. The economic characteristics and risks of the embedded derivative are not clearly and closely related to
the host contract,
b. GAAP does not require the contract (the hybrid instrument) to be remeasured at fair value, with changes
in fair value reported in current earnings, and
c. It would be subject to the requirements of (FASB ASC 815) (formerly SFAS No. 133) if it were a standalone
contract.
If the underlying for an embedded derivative is an interest rate orinterest rate index and the host contract is a debt
instrument for which theunderlying alters the net interest payments required under the contract,the embedded
derivative meets the clearly and closely related criteria unless (a)the holder is required or could be forced to settle
the contract in a way that would result in the holder not recovering substantially all of its initial investment or (b) the
embedded derivative could at least double the investor's initial rate of return on the host contract and would
simultaneously result in theinvestor earning a rate of return at least twice what otherwise would be themarket
return for a similar contract. (FASB ASC 815152526) (formerly SFAS 133, par. 13)
Interestonly strips and principalonly strips are not considered derivative instruments provided they (a) represent
the right to receive only a specified proportion of the contractual interest or principal cash flows of a specific debt
instrument and (b) incorporate only terms present in the original debt instrument. Other interests in securitized
financial assets should be evaluated to identify interests that are freestanding derivatives or hybrid financial
instruments containing an embedded derivative. (FASB ASC 815101511; 815101572) (formerly SFAS 133,
paras. 14 and 14A)
An embedded foreign currency derivative should not be separated from the host contract and considered a
derivative instrument if, at inception, the host contract is not a financial instrument and it requires payments
denominated in (a) the functional or local currency of any substantial party to the contract, (b) the currency in which
the related goods or services acquired or delivered under the contract are commonly denominated in international
commerce, or (c) the currency used by a substantial party as its functional currency in a highly inflationary
economy. Also, other aspects of the embedded foreign currency derivative should be clearly and closely related to
the host contract. (FASB ASC 815151510) (formerly SFAS 133, par. 15 and DIG B04)
When a previously bifurcated conversion option in a convertible debt instrument no longer meets the criteria cited
above for separate accounting, the carrying amount of the liability for the conversion option should be reclassified
to shareholders' equity. Any debt discount recognized when the conversion option was separated from the
convertible debt instrument should continue to be amortized. (FASB ASC 81515354) (formerly EITF 067, par. 3)
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If an embedded derivative cannot be reliably identified and measured separate from the host contract, the entire
contract should be measured at fair value with gains or losses recognized in earnings. In addition, when a hybrid
financial instrument that would be separated into a host contract and embedded derivative is initially recognized,
an entity may irrevocably elect to measure the entire hybrid instrument at fair value with changes in fair value
recognized in earnings. The election can be made on an instrumentbyinstrument basis and is also available when
a previously recognized financial instrument is subject to new basis accounting. An instrument measured at fair
value in its entirety may not be designated as a hedge. (FASB ASC 81515254 and 255; 815152553;
81515301; 81515351) (formerly SFAS 133, par. 16)
Exhibit 11 provides additional guidance on applying the above criteria several types of embedded derivatives.
Exhibit 11
Application of Clearly and Closely Related Criteria to Selected Types of Embedded Derivatives
Embedded Derivative Accounted for Separately?

Inflationindexed interest payments No. Interest rates and the rate of inflation in the economic environment are
considered to be clearly and closely related.
Credit sensitive payments No. Creditworthiness of the borrower and the interest rate on the debt are
considered clearly and closely related.
Calls and puts on debt instruments No, unless the debt involves a substantial premium or discount and the put or
call option is only contingently exercisable, provided the put or call option is
clearly and closely related to the debt based on the criteria cited above.
(Contingently exercisable calls and puts are considered clearly and closely
related to the debt instrument only if they are indexed to interest rates or credit
risk. Otherwise, they should be separated and accounted for separately. Call or
put options that do not accelerate principal payments but rather require a cash
settlement equal to the option price at date of exercise are not considered
clearly and closely related to the debt instrument.)
Calls and puts on equity instruments Yes, provided (a) GAAP does not require the instrument to be remeasured at fair
value with changes in fair value reported in current earnings and (b) the put or
call would be subject to the requirements of (FASB ASC 815) (formerly SFAS
No. 133)if it were a standalone contract. However, if the issuer would classify the
put or call in equity, it is not considered a derivative and should not be
accounted for separately by the issuer. [The holder of the related equity
instrument that includes the embedded call option should account for the
derivative separately, however, if the criteria in (a) and (b) are met.]
Interest rate floors, caps, and collars No, provided the criteria for clearly and closely related herein are met.
Termextending options Yes. A contractual provision that either (a) allows one party to significantly
extend the remaining term to maturity or (b) automatically significantly extends
the remaining term to maturity if triggered by specific conditions or events is not
clearly and closely related to the host contract unless the interest rate on the
debt is reset to the approximate current market rate for the extended term and
there was not a significant discount with the initial debt instrument.
Equityindexed interest payments Yes. Changes in the fair value of an equity instrument or index are not clearly
and closely related to the interest rate based economic characteristics of debt.
Commodityindexed principal or interest Yes. Changes in the fair value of a commodity or other asset are not clearly and
closely related to the interest rate based economic characteristics of debt.
Inflationindexed rentals No. Changes in inflation and rentals for the use of leased assets are considered
to be clearly and closely related. Thus, unless the contract includes a significant
leverage factor, the inflationrelated embedded derivative should not be
accounted for separately from the lease agreement.
Contingent rentals based on sales No. The contingent rentalrelated derivative should not be accounted for
separately from the host lease contract because it is a nonexchangetraded
contract whose underlying is specified sales volumes of one of the parties to the
contract.
Contingent rentals based on a variable interest rate No. Changes in variable interest rates and changes in lease payments for the
use of a leased asset are considered to be clearly and closely related.
Convertible debt Investor Yes. Changes in the fair value of an equity interest and the interest rate
on debt are not considered to be clearly and closely related.
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Embedded Derivative Accounted for Separately?

Issuer No, if the debt is convertible into the issuers own stock, the issuer
should not account for the conversion option separately from the debt
instrument since it requires the issuance of the issuer's own stock.
Convertible preferred stock Depends. Changes in the fair value of an equity interest and the interest rate on
debt are not considered to be clearly and closely related. Determination of
whether the embedded derivative in convertible preferred stock should be
accounted for separately depends on whether the preferred stock is more
similar to a debt instrument or an equity instrument. For example, cumulative
fixedrate preferred stock that has a mandatory redemption feature is more
similar to debt while cumulative participating perpetual preferred stock is more
similar to an equity instrument.
* * *
FAIR VALUE HEDGES
A derivative instrument may be designated to hedge the exposure to changes in the fair value of a recognized asset
or liability (or an unrecognized firm commitment) due to a particular risk. A derivative instrument qualifies as a fair
value hedge if all of the following criteria are met:
a. At the inception of the hedge, the entity documents, the hedging relationship, the risk being hedged, and
the reason for undertaking the hedge, including the hedging instrument, the hedged item, and how the
hedging instrument's effectiveness (and ineffectiveness) in offsetting exposure to changes in fair value
attributable to the hedged risk will be assessed. There must be a reasonable basis for how the entity plans
to assess the hedging instrument's effectiveness. Certain components of a hedging derivative's change
in fair value may be excluded from the assessment of hedge effectiveness (for example, the change in fair
value of an option contract attributed to time value). For a fair value hedge of a firm commitment, the
documentation must include a reasonable method for recognizing in earnings the gain or loss on the
hedged firm commitment.
b. Both at the inception of the hedge and on an ongoing basis, the entity expects the hedging relationship
to be highly effective in offsetting changes in fair value attributable to the hedged risk. Effectiveness of the
hedge should be considered both prospectively and retrospectively to determine if the requirement for
highly effective offset is met. The prospective assessment should consider all reasonably possible changes
in fair value and not be limited to only likely or expected changes, although likely or expected changes can
be given more weight in the assessment. Retrospectively, the effectiveness of the hedging relationship
should be assessed when financial statements are prepared and at least every three months. If a company
issues monthly financial statements (for example, to creditors), the assessment of hedge effectiveness
should be performed on a monthly basis.
c. If a written option is designated as hedging a recognized asset or liability, or an unrecognized firm

commitment, the combination of the option and the hedged item provides at least as much potential for
gains from favorable changes in the fair value of the combined instruments as for losses from unfavorable
changes.
A nonderivative instrument (such as a Treasury note) should not be designated as a hedging instrument except for
certain foreign currency hedges. (FASB ASC 81520251; 81520253; 815202511; 815202571;
815202575; 815202579; 815202582; 815202594) (formerly SFAS No. 133, paras. 20 and 63; EITF D102
and DIG E07) Generally, a derivative instrument held for trading purposes may be designated as a hedging
instrument, prospectively, if it meets the criteria in SFAS No. 133 discussed in the preceding paragraph.
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An asset or liability can be designated as a hedged item in a fair value hedge if all of the following criteria are met:
(FASB ASC 815202512; 815202543) (formerly SFAS 133, paras. 21 and 404; DIG K03)
a. The entity specifically identifies a recognized asset or liability or an unrecognized firm commitment (or a
specific portion of an asset, liability, or firm commitment) as the hedged item. The hedged item can be a
single asset or liability (or portion) or a portfolio of similar assets or similar liabilities.
(1) If a portfolio of assets or liabilities are designated as the hedged item, the individual assets or individual
liabilities must have the same risk exposure for which they are designated as being hedged.
(2) If a specific portion of an asset or liability is designated as the hedged item, the hedged item may be
(a) a percentage of the entire asset or liability, (b) one or more selected contractual cash flows, (c) a
put or call option, including an interest rate or price cap or floor, embedded in an existing asset or
liability that is not accounted for separately as an embedded derivative, or (d) the residual value in a
lessor's net investment in a direct financing or salestype lease.
b. Exposure to changes in the fair value of the hedged item due to the hedged risk could affect reported
earnings.
c. The hedged item is not (1) an asset or liability that is remeasured at its fair value, with changes in fair value
reported in current earnings, (2) an equity method investment, (3) a noncontrolling interest in a
consolidated subsidiary, (4) an equity investment in a consolidated subsidiary, (5) a firm commitment to
enter into a business combination or acquire or dispose of an equity method investee, noncontrolling
interest, or subsidiary, (6) an equity instrument issued by the entity and reported in stockholders' equity
in its balance sheet, or (7) a component of an embedded derivative in a hybrid instrument, (8) an implicit
fixedtovariable swap perceived to be embedded in a host contract with fixed cash flows, where the entire
asset or liability is an instrument with variable cash flows, (9) a transaction with stockholders, (10) an
intracompany transaction between entities included in consolidated financial statements, or (11) the price
of stock expected to be issued under a stock option plan for which compensation expense is not based
on changes in stock prices after the grant date.
d. If the hedged item is all or part of a heldtomaturity debt security, the hedged risk is changes in fair value
attributable to credit risk, foreign exchange risk, or both. The hedged risk for a heldtomaturity security
cannot be due to changes in fair value attributable to interest rate risk.
e. If the hedged item is a nonfinancial asset or liability, the hedged risk is the risk of changes in the fair value
of the total asset or liability, not a separate component thereof. The hedged risk is not due to changes in
the fair value of a component or a similar asset in a different location.
f. If the hedged item is a financial asset or liability, a recognized loan servicing right, or a nonfinancial firm
commitment with financial components, the hedged risk is due to (1) changes in the overall fair value of
the entire hedged item, (2) changes in the designated benchmark interest rate (referred to as interest rate
risk), (3) changes in related foreign currency exchange rates (referred to as foreign exchange risk), or (4)
changes in both the debtor's creditworthiness and changes in the spread over the benchmark interest rate
with respect to the hedged item's credit sector at the hedge's inception (referred to as credit risk).
In a hedge of interest rate risk, the benchmark interest rate being hedged must specifically be identified and
documented at the hedging relationship's inception. Generally, an entity should designate the same benchmark
interest rate as the risk being hedged for similar hedges. Use of different benchmark interest rates for similar
hedges must be justified. (FASB ASC 81520256) (formerly SFAS 133, par. 21)
Accounting for Fair Value Hedges
A derivative instrument that qualifies as a fair value hedge should be reported at its fair value. The change in the
derivative's value should be added to the basis of the asset, liability, or firm commitment that it hedges. (In most
cases, a firm commitment has no basis and therefore the change in basis creates an asset or liability.) The gain or
loss on the hedging instrument and the change in fair value of the hedged item should be included in earnings in
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the period of the change. If the hedge is completely effective, earnings will not be affected because the gain or loss
on the hedged item will offset the gain or loss on the hedging instrument. However, if the hedge is not entirely
effective, the net gain or loss will affect earnings. (FASB ASC 81510301; 81525351 and 352) (formerly SFAS
133, paras. 17 and 22)
If a hedged item is otherwise measured at fair value and changes in fair value are reported in other comprehensive
income (such as an availableforsale security), the adjustment of the hedged item's carrying amount should be
recognized in earnings rather than other comprehensive income so that the change in fair value of the hedged item
will offset the gain or loss on the hedging instrument. (FASB ASC 81525356) (formerly SFAS 133, par. 23)
Adjustments to the carrying amounts of hedged assets or liabilities that are required above should be subsequently
accounted for as any other adjustment to the basis of the asset or liability. (FASB ASC 81525358) (formerly SFAS
133, par. 24)
The accounting should be discontinued for an existing hedge in the event of any of the following:
a. The derivative instrument or the hedged item no longer meets any of the criteria cited herein.
b. The derivative expires, is sold, terminated, or exercised.
c. The designation as a fair value hedge is removed by the entity.
In the instances noted above, the entity may elect to designate prospectively a new hedging relationship with a
different hedging instrument or a different hedged item or transaction. (FASB ASC 81525401 and 402) (formerly
SFAS 133, par. 25)
Hedge Ineffectiveness. The portion of the change in fair value of the derivative that is attributed to hedge
ineffectiveness is recognized in the income statement as a result of the requirement to recognize both the change
in fair value of the derivative and the change in fair value of the hedged item that is related to the hedged risk. If the
offsetting changes in fair value of the hedging instrument and the hedged item do not equal, the difference is
recognized in earnings. (FASB ASC 81525352 through 354) (formerly SFAS 133, par. 22) If the entity's periodic
assessment of hedge effectiveness indicates that the hedge is not effective, the change in the fair value of the
derivative should be recognized in earnings with no offset from changes in the fair value of the hedged item after the
last date on which the hedge was assessed as being effective. If the entity discontinues the fair value hedge of a firm
commitment because the hedged item no longer meets the definition of a firm commitment, any asset or liability
recognized related to the firm commitment should be written off and reflected in earnings. (FASB ASC 81525403;
Foreign Currency Fair Value Hedges. An entity can designate a derivative instrument (or a nonderivative financial
instrument) that results in a foreign currency transaction gain or loss as hedging changes in the fair value of an
unrecognized firm commitment attributable to foreign currency exchange rates. A derivative instrument that
hedges foreign currency exposure for an unrecognized firm commitment denominated in a foreign currency should
be measured at fair value and changes in fair value should be recognized in current earnings, if all the criteria herein
for fair value hedges are met. (FASB ASC 815202558) (formerly SFAS 133, par. 37) If a nonderivative financial
instrument is designated as hedging the changes in fair value of a firm commitment attributable to foreign
exchange rates, the foreign currency transaction gains or losses recognized in accordance with (FASB ASC 830)
(formerly SFAS No. 52) should be recognized in current earnings along with the change in the carrying amount of
the hedged firm commitment. (FASB ASC 815253516) (formerly SFAS133, par. 39)
An entity can designate a derivative instrument as hedging changes in the fair value of an availableforsale debt
security attributable to changes in foreign currency exchange rates. (However, a nonderivative financial instrument
may not be designated as the hedge of the foreign currency exposure of an availableforsale security.) If a
derivative instrument hedges foreign currency exposure for an availableforsale debt security based in a foreign
currency, the derivative should be measured at fair value and changes in the derivative's fair value should be
recognized in current earnings if all the criteria herein for fair value hedges are met. If a derivative instrument hedges
foreign currency exposure for an availableforsale equity security based in a foreign currency, the derivative should
be measured at fair value and changes in the derivative's fair value should be recognized in current earnings if all
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the criteria herein are met. In addition, the security must not be traded on an exchange in which trades are
denominated in the investor's functional currency and dividends must be denominated in the same foreign
currency as the currency expected to be received when the security is sold. The change in fair value of the hedged
availableforsale equity security attributable to foreign exchange risk should be reported in earnings rather than
other comprehensive income. (FASB ASC 815202537; 81520351) (formerly SFAS 133, par. 38)
Recognized assets or liabilities denominated in a foreign currency may be the hedged item in a foreign currency fair
value hedge since the recognition in earnings of the foreign currency transaction gain or loss on the foreigncur
rency denominated asset or liability based on changes in exchange rates is not considered to be a remeasurement
of that asset or liability. (FASB ASC 815202529) (formerly SFAS 133, par. 36) Therefore, an entity may designate
a derivative instrument as hedging the changes in the fair value of a recognized asset or liability (or a specific
portion thereof) for which a foreign currency translation gain or loss is recognized in earnings. However, a
nonderivative financial instrument may not be designated as the hedging instrument in a fair value hedge of the
foreign currency exposures of a recognized asset or liability. If a derivative instrument hedges foreign currency
exposure for a recognized foreigncurrencydenominated asset or liability for which a foreign currency transaction
gain or loss is recorded in earnings, the derivative should be measured at fair value and changes in the derivative's
fair value should be recognized in current earnings if all of the criteria herein for fair value hedges are met. (FASB
ASC 815202537; 815202571) (formerly SFAS 133, par 37A)
Illustration of Accounting for a Fair Value Hedge
Exhibit 12 illustrates the accounting for a fair value hedge.
Exhibit 12
Illustration of Accounting for a Fair Value Hedge
FACTS
1. On January 1, 20X0, ABC Company, Inc. entered into a firm commitment to purchase a piece of equipment from
a German manufacturer for delivery on July 1, 20X0. The price of the equipment will be 1,000,000 Deutsche
marks (DM1,000,000). ABC Company's functional currency is the U.S. dollar.
2. Also on January 1, 20X0, ABC Company entered into a forward contract to purchase 1,000,000 Deutsche marks
(DM1,000,000) on July 1, 20X0 for $.60 per DM1 ($600,000), which is the current forward exchange rate on
January 1, 20X0. ABC Company has designated the forward exchange contract as a hedge against the risk of
changes in the fair value of the firm commitment resulting from changes in the U.S. dollar/German mark forward
exchange rate.
3. Forward exchange rates in effect on certain key dates are as follows:
January 1, 20X0 $.60 = DM1
March 31, 20X0 $.58 = DM1
June 30, 20X0 $.57 = DM1
July 1, 20X0 $.57 = DM1
Documentation of Hedging Strategy:
Date of Designation January 1, 20X0
Hedging Instrument Forward exchange contract to purchase DM1,000,000 on July 1, 20X0 for DM1:$.60.
Hedged Item Firm commitment to purchase equipment for DM1,000,000 on July 1, 20X0.
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Hedging Strategy and Nature of Risk Being Hedged Changes in the fair value of the forward exchange
contract should perfectly offset changes in the fair value of the firm commitment due to changes in the U.S.$/DM
forward exchange rates.
Assessment of Effectiveness ABC Company, Inc. will assess effectiveness by comparing the overall changes
in the fair value of the forward exchange contract to the changes in the fair value in U.S. dollars of the firm
commitment due to changes in the U.S. dollar/German mark forward exchange rates. There is no hedge
ineffectiveness because the fair value of the firm commitment is being valued using the forward exchange rate.
The hedge qualifies as a fair value hedge.
COMPUTATIONS
1/1/X0 3/31/X0 6/30/X0
Forward Contract:
$/DM forward exchange rate (July1, 20X0
settlement) $ .60 $ .58 $ .57
Units of currency (DM) 1,000,000 1,000,000 1,000,000
Forward price of DM (in dollars) $ 600,000 $ 580,000 $ 570,000
Contract price (in dollars) (600,000 ) (600,000 ) (600,000 )
Fair Valuea $ 0 $ (20,000 ) $ (30,000 )

Change in fair value during the period $ 0 $ (20,000 ) $ (10,000 )
Firm Commitment:
$/DM forward exchange rate (July1,20X0
settlement) $ .60 $ .58 $ .57
Units of currency (DM) 1,000,000 1,000,000 1,000,000
Forward price of DM (in dollars) $ 600,000 $ 580,000 $ 570,000
Initial forward price in dollars 600,000 (600,000 ) (600,000 )
Fair Valuea $ 0 $ 20,000 $ 30,000
Change in fair value during the period $ 0 $ 20,000 $ 10,000
Note:
a Time value of money has been ignored for purposes of this illustration.
Accounting Entries:
March 31, 20X0
Earnings $ 20,000
DM forward exchange contract $ 20,000
To recognize change in fair value of forward exchange contract.
Firm commitment $ 20,000

Earnings $ 20,000
To recognize change in fair value of firm commitment.

June 30, 20X0
Earnings $ 10,000
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To recognize change in fair value of forward exchange contract.

Earnings $ 10,000
To recognized change in fair value of firm commitment.
July 1, 20X0
Equipment $ 600,000
Cash 570,000
To record purchase of equipment.

Cash $ 30,000
To record settlement of foreign exchange contract.
* * *
Impairment
Any asset or liability that has been designated as a hedged item continues to be subject to the applicable GAAP
requirements for assessing and recognizing impairment. When being assessed for impairment, the carrying
amount of the asset or liability should reflect any adjustments made to the carrying amount resulting from hedge
accounting. However, because the hedging instrument is recognized as a separate asset or liability, its fair value
and/or cash flows should not be taken into account when assessing the hedged item for impairment. (FASB ASC
CASH FLOW HEDGES
An entity may designate a derivative instrument as a cash flow hedge. Cash flow hedges are intended to hedge the
exposure to variability in expected future cash flows due to a particular risk. The exposure may relate to an existing
asset or liability (such as future interest payments on variablerate debt) or a forecasted transaction (such as a
forecasted sale). A derivative instrument qualifies as a cash flow hedge if all of the following criteria are met:
a. At the inception of the hedge, the entity documents, the hedging relationship, the risk being hedged, and
the reason for undertaking the hedge, including the hedging instrument, the hedged transaction, and how
the hedging instrument's effectiveness (and ineffectiveness) in offsetting exposure to variability in cash
flows attributable to the hedged risk will be assessed.
(1) As part of the entity's risk management strategy, portions of a specific hedging derivative's change
in fair value may be excluded from the assessment of hedge effectiveness.
(2) Documentation must include the date or time period the forecasted transaction is expected to occur,
the nature of any asset or liability involved, and the expected currency amount (for foreign currency
hedges) or quantity of the forecasted transaction (including the current price of a forecasted
transaction). The hedged transaction must be described in sufficient detail so that when the
transaction occurs, it is easy to determine whether that transaction is or is not the hedged transaction.
For example, next year's purchases" would not be sufficient detail for designation as the hedged
item. The forecasted transaction could be identified as the first 5,000 units purchased" or the first
$1,000,000 in purchases," however.
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b. Both at the inception of the hedge and on an ongoing basis, the entity expects the hedging relationship
to be highly effective in offsetting cash flows attributable to the hedged risk. Effectiveness of the hedge
should be considered both prospectively and retrospectively to determine if the requirement for highly
effective offset is met. The prospective assessment should consider all reasonably possible changes in fair
value and not be limited to only likely or expected changes, although likely or expected changes can be
given more weight in the assessment. Retrospectively, the effectiveness of the hedging relationship must
be assessed when financial statements are prepared and at least every three months. If a company issues
monthly financial statements (for example, to creditors), the assessment of hedge effectiveness should be
performed on a monthly basis.
c. If a written option is designated as hedging the variability in cash flows for a recognized asset or liability,
or an unrecognized firm commitment, the combination of the option and the hedged item provides at least
as much potential for favorable cash flows as for unfavorable cash flows.
d. A hedging instrument that is used to change interest receipts or payments related to a financial asset or
liability from one variable rate to another variable rate provides a link between an existing designated asset
with variable cash flows and an existing designated liability with variable cash flows and is highly effective
at achieving offsetting cash flows. A link exists if the basis (i.e., the index on which the interest rate is based)
of one portion of an interest rate swap equals the basis of the interest receipts for the designated asset and
if the basis of the other part of the swap equals the basis of the interest payments for the designated liability.
A nonderivative instrument (such as a treasury note) cannot be designated as a cash flow hedge. (FASB ASC
8152020; 81520253; 815202513; 815202550 and 2551; 815202575; 815202582; 815202594) (for
merly SFAS 133, paras. 4, 28, and 63; EITF D102 and DIG E07) A derivative instrument held for trading purposes
may be designated as a hedging instrument, prospectively, if it meets the criteria in (FASB ASC 815) (formerly SFAS
No. 133) discussed in the preceding paragraph.
A forecasted transaction can be designated as a hedged transaction in a cash flow hedge if all of the following
criteria are met: (FASB ASC 81520256; 815202515; 815202543) (formerly SFAS133, paras. 21 and 29)
a. The entity specifically identifies a single transaction (or group of individual transactions that share the same
risk exposure) as the forecasted transaction.
b. Occurrence of the forecasted transaction is probable.
c. The forecasted transaction is with an external party (except for certain foreign currency cash flow hedges)
and variability in cash flows for the hedged risk could affect reported earnings.
d. The forecasted transaction is not due to acquiring an asset or incurring a liability that will be remeasured
at fair value, with changes in fair value attributable to the hedged risk reported in current earnings.
e. If the forecasted transaction relates to a heldtomaturity debt security, the hedged risk is due to credit risk,
foreign exchange risk, or both. The hedged risk cannot be due to changes in cash flows attributable to
interest rate risk.
f. The forecasted transaction does not involve a business combination, a parent company's interests in
consolidated subsidiaries, a minority interest in a consolidated subsidiary, an equity method investment,
or the entity's own equity instruments.
g. If the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the hedged risk relates
to changes in cash flows attributable to changes in (1) foreign currency exchange rates or (2) the purchase
or sales price of the asset, regardless of whether that price and the related cash flows are stated in the
entity's functional currency or a foreign currency (not a similar asset in a different location).
h. If the hedged transaction is the forecasted purchase or sale of a financial asset or liability (or the interest
payments on that financial asset or liability) or the variable cash flows of an existing financial asset or liability,
the hedged risk is due to (1) overall changes in hedged cash flows related to the asset or liability (such as
131
changes in the purchase or sales price); (2) changes in cash flows attributable to changes in the designated
benchmark interest rate (referred to as interest rate risk); (3) changes in cash flows attributable to changes
in related foreign currency exchange rates, (referred to as foreign exchange risk); or (4)changes in cash
flows attributable to default, changes in the debtor's creditworthiness, and changes in the spread over the
benchmark interest rate with respect to the hedged item's credit sector at the hedge's inception (referred
to as credit risk). (The entity cannot designate prepayment risk as the risk being hedged.)
In a hedge of interest rate risk, the benchmark interest rate being hedged must be specifically identified
and documented at the hedging relationship's inception. Generally, an entity should designate the same
benchmark interest rate as the risk being hedged for similar hedges. Use of different benchmark interest
rates for similar hedges must be justified.
In a cash flow hedge of a variablerate financial asset or liability, the designated risk being hedged cannot
be due to changes in the specifically identified benchmark interest rate if the cash flows of the hedged
transaction are explicitly based on a different rate, such as a specific bank's prime rate. However, if the other
cash flow hedge criteria have been met, the hedged risk potentially could be the risk of overall changes
in the hedged cash flows related to the asset or liability.
Accounting for Cash Flow Hedges
A derivative instrument that qualifies as a cash flow hedge should be reported at its fair value. The gain or loss on
the effective portion of the hedge initially should be included as a component of other comprehensive income. The
gain or loss from the ineffective portion of the cash flow hedge should be included in earnings. If the entity's risk
management strategy excludes a portion of the gain or loss or related cash flows on the hedging instrument from
the assessment of hedge effectiveness, that portion of the gain or loss should be recognized in earnings. (FASB
ASC 81530353) (formerly SFAS 133, para. 30)
When the hedged cash flows related to the forecasted transaction affect earnings (for example, when a forecasted
sale actually occurs), the derivative gain or loss should be reclassified from accumulated other comprehensive
income into earnings. If the hedged transaction results in the entity acquiring an asset or liability, the gains or losses
in accumulated other comprehensive income are reclassified into earnings in the same period(s) in which the asset
acquired or liability incurred affects earnings. However, if the entity expects that continued reporting of a loss in
accumulated comprehensive income would result in a net loss on the combination of the derivative and the hedged
transaction in one or more future periods, a loss should be reclassified immediately into earnings for the amount
that is not expected to be recovered. (FASB ASC 815303538 through 3540) (formerly SFAS 133, par. 31)
The entity should adjust the accumulated other comprehensive income associated with a hedged transaction to a
balance that is the lesser of: (FASB ASC 81530353) (formerly SFAS 133, par. 30)
a. The cumulative gain or loss on the derivative from inception of the hedge less any portion of the derivative
excluded from assessment of hedge effectiveness and any amount previously reclassified from other
comprehensive income into earnings, or
b. The portion of the cumulative gain or loss on the derivative necessary to offset the cumulative change in
expected future cash flows on the hedged transaction from inception of the hedge less the derivative's
gains or losses previously reclassified from accumulated other comprehensive income to earnings.
In a cash flow hedge of the functionalcurrencyequivalent cash flows of a recognized foreigncurrencydenomi

nated asset or liability remeasured at spot exchange rates, the amount reclassified to or from other comprehensive
income to earnings each period depends on whether the hedging instrument is an option or nonoptionbased
contract. For nonoptionbased contracts when the assessment and measurement of effectiveness are based on
total changes in the contract's cash flows, an amount that offsets the transaction gain or loss due to the remeasure
ment should be reclassified to earnings each period. For option contracts, changes in the option's intrinsic value
that result from changes in the underlying should be reclassified to or from other comprehensive income each
period. In addition, when the assessment and measurement of effectiveness are based on total changes in the
option's cash flows, an amount to amortize the option cost on a rational basis should be reclassified to earnings
each period. (FASB ASC 81530353) (formerly SFAS 133, par. 30)
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The accounting discussed herein should be discontinued for an existing hedge in the event of any of the following:
a. The derivative instrument and the hedged item no longer meet any of the criteria herein.
b. The derivative expires, is sold, terminated, or exercised.
c. The designation as a cash flow hedge is removed by the entity.
Any net gain or loss on the derivative should remain in accumulated other comprehensive income and reclassified
into earnings in accordance with the guidance herein. In the instances noted above, the entity may elect to
designate prospectively a new hedging relationship with a different hedging instrument or a different hedged item
or transaction if the hedging relationship meets the criteria cited in previous paragraphs for a cash flow hedge or for
a fair value hedge. (FASB ASC 81530401 through 403) (formerly SFAS 133, par. 32)
A discontinued cash flow hedge's net derivative gain or loss should continue to be reported in accumulated other
comprehensive income unless it is unlikely that the hedged forecasted transaction will occur within two months
after the time designated at the hedge's inception. If the forecasted transaction will not occur by the two month
extension, the derivative gain or loss in accumulated other comprehensive income should be immediately reclassi
fied to earnings. An exception is made for certain rare cases in which the forecasted transaction will occur beyond
the additional two months due to the nature of the transaction and circumstances outside the entity's control. In that
case, the net derivative gain or loss should continue to be reported in accumulated other comprehensive income
until it is reclassified into earnings. (FASB ASC 81530404 and 405) (formerly SFAS 133, par. 33)
Foreign Currency Cash Flow Hedges. An entity may designate a derivative instrument as hedging the foreign
currency exposure to variability in the equivalent functional currency cash flows associated with a forecasted
transaction, a recognized asset or liability, an unrecognized firm commitment, or a forecasted intercompany
transaction denominated in a foreign currency. (However, a nonderivative instrument cannot be designated as a
hedging instrument in a foreign currency cash flow hedge.) The foreign currency cash flow hedge qualifies for
hedge accounting if all of the following criteria are met:
a. For consolidated financial statements, either of the following is a party to the hedging instrument:
(1) the operating unit that has the foreign currency exposure, or
(2) another member of the consolidated group that has the same functional currency as the operating
unit, as long as no intervening subsidiary has a different functional currency.
b. The hedged transaction is not denominated in the hedging unit's functional currency.
c. All of the criteria herein for cash flow hedges are met (except for the requirement above that the forecasted
transaction is with an external party).
d. If the hedged transaction is a group of individual forecasted transactions denominated in foreign currency,
forecasted foreign currency inflows cannot be included in the same group as forecasted foreign currency
outflows.
e. If the hedged item is a recognized foreigncurrencydenominated asset or liability, the effect of the hedge
eliminates all of the variability in the asset or liability's functionalcurrencyequivalent cash flows. (FASB
ASC 815202530; 815202538 and 2539; 815202571) [formerly SFAS 133, par. 40]
A derivative instrument that hedges foreign currency exposure for a forecasted future transaction denominated in
a foreign currency should be accounted for in the same way as other cash flow hedges. (FASB ASC 815202565)
Recognized assets or liabilities denominated in a foreign currency may be the hedged item in a foreign currency
cash flow hedge if the foreign currency transaction gain or loss is recognized in earnings, since such recognition in
earnings of the foreign currency transaction gain or loss on the foreigncurrency denominated asset or liability
133
based on changes in exchange rates is not considered to be remeasurement of that asset or liability. (FASB ASC
Certain internal derivatives designated as foreign currency cash flow hedges of forecasted borrowings, purchases,
or sales denominated in foreign currency or unrecognized firm commitments may be offset on a net (aggregate) or
individual basis, by thirdparty derivative contracts. An internal derivative is a foreign currency derivative contract
entered into with another member of a consolidated group (such as a treasury center). Such a derivative may be the
hedging instrument in a foreign currency cash flow hedge of a forecasted borrowing, purchase, or sale of an
unrecognized firm commitment in the consolidated financial statements only if: (FASB ASC 8152020;
815202561) (formerly SFAS 133, par. 40a)
a. the criteria for foreign currency cash flow hedge accounting herein is satisfied from the perspective of the
consolidated group member using the derivative as a hedging instrument (hedging affiliate), and
b. the member of the consolidated group not using the derivative as a hedging instrument (issuing affiliate)
(1) enters into a derivative contract with an unrelated third party to offset the exposure from the internal
derivative or (2) if all of the criteria herein are met, enters into derivative contracts with unrelated third parties
that offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal
derivatives.
If a member of the consolidated group not using the derivative as a hedging instrument (the issuing affiliate) wishes
to offset exposures from multiple internal derivatives on an aggregate or net basis, the derivatives may qualify as
cash flow hedges only if:
a. The issuing affiliate enters into a derivative contract with an unrelated third party to offset the foreign
exchange risk for multiple internal derivative contracts on a net basis for each foreign currency, and such
contract equals or closely approximates the gains and losses of the derivative contracts issued to affiliates.
b. Internal derivatives not designated as hedging instruments are not included in the calculation of foreign
currency exposure on a net basis to be offset by the thirdparty derivative, and nonderivative contracts are
not used as hedging instruments to offset exposures from internal derivative contracts.
c. Foreign currency exposure that is offset by a single net thirdparty contract arises from internal derivative
contracts maturing with the same 31day period and involving the same currency exposure as the net
thirdparty derivative. Offsetting net thirdparty derivatives related to a group of internal derivative contracts
must offset the aggregate or net foreign currency exposure, must mature within the same 31day period,
and must be entered into within 3 business days after the internal derivatives are designated as hedging
instruments.
d. The issuing affiliate monitors the exposure with the affiliated entity using the hedging instrument and
documents the linkage between internal derivative contracts and offsetting contracts with third parties.
e. The issuing affiliate does not alter or terminate the offsetting derivative with a thirdparty unless the affiliate
using the hedging instrument initiates the alteration or termination. (FASB ASC 815202562) (formerly
SFAS 133, par.40b)
An entity is not permitted to offset exposures from multiple contracts on a net basis for foreign currency cash flow
exposures related to recognized foreigncurrency denominated assets or liabilities. (FASB ASC 815202564)
(formerly SFAS 133, par. 40c)
Illustration of Accounting for a Cash Flow Hedge
Exhibit 13 illustrates the accounting for a common type of cash flow hedge.
134
Exhibit 13
Illustration of Accounting for a Cash Flow Hedge
FACTS
1. On January 1, 20X0, ABC Company, Inc. purchased for $825 ($8.25/oz. 100 oz.) an at the money call option
to purchase one hundred troy oz. of gold with a strike price of $310/oz. The option expires January 1, 20X1. The
company designates the option contract as a cash flow hedge for the forecasted purchase of one hundred troy
oz. of gold on January 1, 20X1.
2. ABC Company's policy is to assess hedge effectiveness by comparing the changes in cash flows on the hedged
transaction (based on the spot price of gold) with the change in the option's intrinsic value. Thus, changes in
the time value of the option will be reflected in current earnings.
3. The spot price of gold and the fair value of the option contract at the end of each quarter in 20X0 are as follows:
Spot Price of Fair Value of

Date Gold (per oz.) Option Contract
3/31/X0 $ 320 $ 1,750
6/30/X0 $ 290 $ 600
9/30/X0 $ 318 $ 1,100
12/31/X0 $ 320 $ 1,000
4. On February 28, 20X1, ABC Company sold the 100 oz. of gold for $345/oz.
Hedging Instrument Written call option to purchase 100 oz. of gold with a strike price of $310/oz. Option expires
January 1, 20X1.
Hedged Item The company has budgeted to purchase 100 oz. of gold by January 1, 20X1.
Hedging Strategy and Nature of Risk Being Hedged Changes in the option's intrinsic value should offset changes
in required cash flow for the forecasted transaction based on changes in the spot price of gold.
Assessment of Effectiveness The company views the changes in the time value of the purchased option as the
cost of insurance to lock in the purchase price of the forecasted purchase of gold. Because the change in the spot
price will be the same for the forecasted purchase and the option contract, the change in intrinsic value of the
option is considered to be perfectly effective as a hedge. The change in time value of the option contract will be
recognized in earnings in the same manner as an ineffective portion of a hedge. The hedge qualifies as a cash flow
hedge.
COMPUTATIONS
3/31/X0 6/30/X0 9/30/X0 12/31/X0

Ending fair value of option:
Time value $ 750 $ 600 $ 300 $ 0
Intrinsic value 1,000 a 800 1,000
Total $ 1,750 $ 600 $ 1,100 $ 1,000
Change in time value $ (75 ) $ (150 ) $ (300 ) $ (300 )

Change in intrinsic value 1,000 (1,000 ) 800 200
Total current period gain (loss) on derivative $ 925 $ (1,150 ) $ 500 $ (100 )
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3/31/X0 6/30/X0 9/30/X0 12/31/X0
Gain (loss) on derivative after adjusting to remove the

component excluded from effectiveness test:
Current period $ 1,000 $ (1,000 ) $ 800 $ 200
Cumulative $ 1,000 0 $ 800 $ 1,000
Change in expected future cash flows on hedged transac
tion:
Current period $ (1,000 ) $ 3,000 $ (2,800 ) $ (200 )
Cumulative $ (1,000 ) $ 2,000 $ (800 ) $ (1,000 )
Balance to be reflected in accumulated other comprehen
sive income:
Lesser of (in absolute amounts) the derivative's cumula
tive gain (loss) or amount necessary to offset the
cumulative change in expected future cash flows of the
hedged transaction $ 1,000 $ 0 $ 800 $ 1,000
Note:
a Because the hedging instrument is a purchased call option, its intrinsic value cannot be less than zero. (If the
price of gold is less than the option's strike price, the option is out of the money.)
Accounting Entries:
January 1, 20X0
Gold option contract $ 825

Cash $ 825
To record purchase of call option contract.
March 31, 20X0

Earnings 75
Other comprehensive income $ 1,000
To adjust derivative to fair value, other comprehensive income for effective component of change in fair
value, and earnings for change in fair value attributed to the time value of the option.
June 30, 20X0

Earnings 150
Gold option contract $ 1,150
September 30, 20X0

Earnings 300
Other comprehensive income $ 800
136
December 31, 20X0
Earnings $ 300
Other comprehensive income 200
January 1, 20X1
Gold inventory $ 32,000

Cash $ 31,000
Gold option contract 1,000
To record purchase of 100 oz. of gold.
February 28, 20X1
Cash $ 34,500
Cost of sales 32,000
Gold Inventory $ 32,000
Revenue 34,500
To record sale of gold inventory.

Cost of sales $ 1,000
To reclassify amounts related to changes in fair value of option contract from other comprehensive
income to earnings.
* * *
Impairment
Any asset or liability that gives rise to variable cash flows that have been designated as the hedged item in a cash
flow hedge continue to be subject to the applicable GAAP requirements for assessing and recognizing impairment
applicable to that type of asset. When being assessed for impairment, the carrying amount of the asset or liability
should reflect any adjustments made to the carrying amount resulting from hedge accounting. However, because
the hedging instrument is recognized as a separate asset or liability, its fair value and/or cash flows should not be
taken into account when assessing the hedged item for impairment. The gain or loss on the hedging instrument in
accumulated other comprehensive income should be accounted for as discussed herein. (FASB ASC
If an impairment loss is recognized on an asset or an additional obligation is recognized on a liability in accordance

with GAAP related to a hedged forecasted transaction, any offsetting gain related to the hedged transaction
included in accumulated other comprehensive income should be immediately reclassified into earnings. Likewise,
if a recovery is recognized on the asset or liability related to the hedged transaction, any offsetting net loss reflected
in accumulated other comprehensive income should be immediately reclassified into earnings. (FASB ASC
FOREIGN CURRENCY HEDGES OF A NET INVESTMENT IN A FOREIGN OPERATION
An entity can designate a derivative instrument (or a nonderivative financial instrument) resulting in a foreign
currency transaction gain or loss under (FASB ASC 830) (formerly SFAS No. 52) as hedging the foreign currency
137
exposure of a net investment in a foreign operation as long as specified conditions are met. (However, a nonderiva
tive instrument reported at fair value cannot be designated as the hedging instrument.) The gain or loss in fair value
on the hedging instrument should be reported in other comprehensive income as part of the cumulative translation
adjustment to the extent the instrument is effective as a hedge. The hedged net investment should be accounted for
in accordance with (FASB ASC 830) (formerly SFAS No. 52). The provisions above for recognizing gains or losses
in a fair value hedge are not applicable to the hedge of a net investment in a foreign operation. (FASB ASC
815202566; 81535351 and 352) (formerly SFAS 133, par. 42)
Exhibit 14 illustrates the accounting for a hedge of an entity's net investment in a foreign subsidiary.
Exhibit 14
Illustration of Accounting for a Net Investment Hedge
FACTS
1. ABC Company, Inc. has a Swiss subsidiary (DEF Company) that uses the Swiss franc as its functional currency.
At December 31, 20X0, its cumulative translation loss is $1,000,000, while its equity in the subsidiary is
$10,000,000 (SFr15,000,000).
2. The spot exchange rate at December 31, 20X0 is SFr1.5:$1.
3. On January 1, 20X1, ABC Company issues debt denominated in Swiss francs totaling SFr15,000,000, due on
December 31, 20X5. The company designates the SFr denominated debt as a hedge of its net investment in
the Swiss subsidiary.
4. On December 31, 20X1, DEF Company paid a dividend to ABC Company equal to its earnings for the year.
Therefore, DEF Company's equity (and ABC Company's net investment) is still SFr15,000,000.
5. The spot exchange rate at December 31, 20X1 is SFr1.25:$1.
Hedging Instrument SFr15,000,000 debt due December 31, 20X5
Hedged Item $10,000,000 net investment in DEF Company
Hedging Strategy and Nature of Risk Being Hedged Change in the fair value of the SFr denominated debt
attributable to foreign exchange risk should offset any translation gain/loss on the company's net investment in
DEF Company.
Assessment of Effectiveness The change in carrying value of the SFr15,000,000 debt on ABC Company's books
attributable to the change in the spot foreign exchange rate is a perfect hedge for the net investment in DEF
Company. There should be no hedge ineffectiveness. The hedge qualifies as a net investment hedge.
Accounting Entries:
Investment in DEF Company $ 2,000,000

Cumulative translation adjustment $ 2,000,000
To record translation gain on the net investment in DEF Company. (SFr15,000,000/$1.25 $10,000,000).
Cumulative translation adjustment $ 2,000,000

SFr denominated debt $ 2,000,000
To record the transaction loss on the SFr denominated debt as a hedge of the net investment in DEF
Company. (SFr15,000,000/$1.25 = $12,000,000 SFr15,000,000/$1.50 = $10,000,000)
138
Because the SFr denominated debt was structured as a perfect hedge of ABC Company's net investment in DEF
Company, the cumulative translation loss remains $1,000,000 at December 31, 20X1. If there had been any hedge
ineffectiveness, the component of the derivative gain or loss considered to be ineffective would be recognized in
earnings.
* * *
SPECIAL CONSIDERATIONS FOR NOT-FOR-PROFIT ENTITIES AND OTHER ENTITIES THAT DO NOT
REPORT EARNINGS
Entities that do not report earnings (such as a notforprofit organization or a pension plan) should recognize the
gain or loss on a hedging instrument (or any nonhedging derivative instrument) as a change in net assets in the
period of change. However, if the hedging instrument is designated as a hedge of a net investment in a foreign
operation, the guidance herein should be followed. Changes in the carrying amount of a hedged item in a fair value
hedge should be reported as a change in net assets in accordance with the guidance herein. Entities that do not
report earnings are prohibited from using cash flow hedge accounting. (FASB ASC 81510353; 815253519;
81530152) (formerly SFAS133, par. 43)
139
140
SELFSTUDY QUIZ
following section.
1. Which of the following reflects how the gains or losses on a hedge of an entity's net investment in a foreign
operation should be accounted for?
a. The gain or loss on the hedging instrument and the change in fair value of the hedged item should be
included in earnings in the period of change.
b. The change in fair value on the hedging instrument should be reported in other comprehensive income
as part of the cumulative translation adjustment.
c. The gain or loss from the ineffective portion of the cash flow hedge should be included in earnings.
2. Which of the following is a financial instrument which meets all the requirements of a derivative?
a. The purchase of a publicly traded stock on an exchange regulated by the SEC where the contract requires
settlement within three business days.
b. A contract based on i) physical variables including climatic or geological; ii) an option based on a tract of
undeveloped land; or iii) an operating lease where rents are contingent upon the lessee having a certain
level of sales from the leased asset.
c. A contract with all three of the following criteria: i) It has at least one underlying and at least one notional
amount or payment provision or both; ii) It requires no initial net investment less than required for other
types of contracts expected to respond similarly in market factors; and iii) It's terms require or allow net
settlement.
3. A contract to purchase a publicly traded equity security on an exchange regulated by the SEC is considered
a regularway" security trade if the contract requires settlement within how many days?
a. Three calendar days.
b. Four calendar days.
c. Three business days.
d. Five business days.
4. Generally, an embedded derivative is not accounted for separately in which of the following circumstances?
a. When the risks and economic characteristics of the embedded derivative are clearly and closely related
to the host contract.
b. When the contract is not required by GAAP to be remeasured at fair value, with changes in fair value
reported in current earnings.
c. When the embedded derivative would be subject to SFAS No. 133 requirements if it were a standalone
contract.
141
5. Which of the following is an example of an embedded derivative?
a. ModeODae has issued debt with a conversion feature.
b. Rothchild is holding a put option on several shares of Maedae stock.
c. First National Bank has made stock options available to all employees as additional compensation if
certain revenue goals are met.
d. Big Company acquired all the shares of Little Company on October 1st. On the date of acquisition, Big
Company and Little Company contract to enter into a business combination on December 31st.
6. Which of the following embedded derivatives are accounted for separately?
a. Inflationindexed interest payments.
b. Credit sensitive payments.
c. Inflationindexed rentals.
d. Equityindexed interest payments.
7. Which of the following is an accurate statement regarding derivative and nonderivative instruments?
a. A derivative instrument cannot be designated to hedge the exposure to changes in the fair value of a
recognized liability due to a particular risk.
b. A derivative instrument cannot be designated to hedge the exposure to changes in the fair value of an
unrecognized firm commitment due to a particular risk.
c. A nonderivative instrument can be designated as a hedging instrument under certain foreign currency
hedges.
d. A derivative instrument held for trading purposes cannot be designated as a hedging instrument under any
conditions.
8. An asset or liability can be designated as a hedged item in a fair value hedge if several criteria are met. Which
of the following is an inaccurate representation of one of those criteria?
a. The entity specifically identifies a recognized asset or liability or an unrecognized firm commitment, or a
specific portion of thereof, as the hedged item.
b. Exposure to changes in the fair value of the hedged item due to the hedged risk could not affect reported
earnings.
c. If the hedged item is all or part of a heldtomaturity debt security, the hedged risk is changes in fair value
attributable to credit risk, foreign exchange risk, or both.
d. If the hedged item is a nonfinancial asset or liability, the hedged risk is the risk of changes in the fair value
of the total asset or liability, not a separate component thereof.
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9. The benchmark interest rate being hedged must specifically be identified and documented at the hedging
relationship's inception in a hedge of interest rate risk. Generally, what interest rate should be used when an
entity hedges an interest rate risk?
a. A lower benchmark interest rate.
b. The same benchmark interest rate.
c. A higher benchmark interest rate.
10. The accounting should be discontinued for an existing hedge in the case of any of the following except:
a. When the derivative is held for trading purposes.
b. When the derivative is sold.
c. When the derivative is terminated.
d. When the derivative is exercised.
11. Which of the following statements regarding fair value hedges is accurate?
a. An entity cannot designate a derivative instrument as hedging changes in the fair value of an
availableforsale debt security attributable to changes in foreign currency exchange rates.
b. A nonderivative financial instrument may be designated as the hedge of the foreign currency exposure of
an availableforsale security.
c. The change in fair value of the hedged availableforsale equity security attributable to foreign exchange
risk should be reported in earnings.
d. Recognized assets or liabilities denominated in a foreign currency may not be the hedged item in a foreign
currency fair value hedge.
12. What risks are cash flow hedges intending to hedge the exposure to variability in expected future cash flows
against?
a. A prior risk.
b. A particular risk.
c. A projected risk.
13. Which of the following criteria does not apply to a forecasted transaction that can be designated as a hedged
transaction in a cash flow hedge?
a. The entity specifically identifies a single transaction or a group of individual transactions sharing the same
risk exposure as the forecasted transaction.
b. The forecasted transaction is with an external party, including all foreign currency cash flow hedges and
variability in cash flows for the hedged risk could affect reported earnings.
c. The forecasted transaction is due to acquiring an asset or incurring a liability that will be remeasured at
fair value, with changes in fair value attributable to the hedged risk reported in current earnings.
d. The forecasted transaction does not involve a business combination, a minority interest in a consolidated
subsidiary, a parent company's interests in consolidated subsidiaries, an equity method investment, or the
entity's own equity instrument.
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14. Under which statement of Financial Accounting Standard can an entity designate a derivative instrument
resulting in a foreign currency transaction gain or loss as hedging the foreign currency exposure of a net
investment in a foreign operation if specified conditions are met?
a. FASB ASC 830 (formerly SFAS No. 52).
b. FASB ASC 360 (formerly SFAS No. 66).
c. FASB ASC 840 (formerly SFAS No. 98).
d. FASB ASC 815 (formerly SFAS No. 133).
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SELFSTUDY ANSWERS
1. Which of the following reflects how the gains or losses on a hedge of an entity's net investment in a foreign
operation should be accounted for? (Page 119)
a. The gain or loss on the hedging instrument and the change in fair value of the hedged item should be
included in earnings in the period of change. [This answer is incorrect. The gain or loss on the hedging
instrument and the change in fair value of the hedged item should be included in earnings in the period
of change when accounting for fair value hedges.]
b. The change in fair value on the hedging instrument should be reported in other comprehensive
income as part of the cumulative translation adjustment. [This answer is correct. The gain or loss
on the hedging instrument should be reported in other comprehensive income as part of the
cumulative translation adjustment when accounting for hedges of an entity's net investment in a
foreign operation.]
c. The gain or loss from the ineffective portion of the cash flow hedge should be included in earnings. [This
answer is incorrect. The gain or loss from the ineffective portion of the cash flow hedge should be included
in earnings when accounting for cash flow hedges.]
2. Which of the following is a financial instrument which meets all the requirements of a derivative? (Page 120)
a. The purchase of a publicly traded stock on an exchange regulated by the SEC where the contract requires
settlement within three business days. [This answer is incorrect. This answer choice describes a
regularway" security trade.]
b. A contract based on i) physical variables including climatic or geological; ii) an option based on a tract of
undeveloped land; or iii) an operating lease where rents are contingent upon the lessee having a certain
level of sales from the leased asset. [This answer is incorrect. This answer choice describes contracts that
are not traded on an exchange. Contracts not traded on an exchange are usually not considered to be
derivatives.]
c. A contract with all three of the following criteria: i) It has at least one underlying and at least one
notional amount or payment provision or both; ii) It requires no initial net investment less than
required for other types of contracts expected to respond similarly in market factors; and iii) It's
terms require or allow net settlement. [This answer is correct. This answer choice lists all three of
the required characteristics of a derivative as promulgated by FASB ASC 815 (formerly SFAS 133).]
3. A contract to purchase a publicly traded equity security on an exchange regulated by the SEC is considered
a regularway" security trade if the contract requires settlement within how many days? (Page 120)
a. Three calendar days. [This answer is incorrect. There is a customary timeframe established for SEC trades.
That timeframe is not three calendar days.]
b. Four calendar days. [This answer is incorrect. Four calendar days is not the defined timeframe for contract
settlement in this case since it is not the customary timeframe used for SEC trades.]
c. Three business days. [This answer is correct. A contract to purchase a publicly traded equity
security on an exchange regulated by the SEC is considered a regularway" security trade if the
contract requires settlement within three business days because it is the customary timeframe
established for SEC trades.]
d. Five business days. [This answer is incorrect. A contract to purchase a publicly traded equity on an
exchange regulated by the SEC is not a regularway" security trade if the contract requires settlement in
five days rather than three unless the contract is required to be accounted for on a tradedate basis.]
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4. Generally, an embedded derivative is not accounted for separately in which of the following circumstances?
(Page 123)
a. When the risks and economic characteristics of the embedded derivative are clearly and closely
related to the host contract. [This answer is correct. An embedded derivative is not accounted for
separately if the economic characteristics and risks of the embedded derivative are clearly and
closely related to the host contract. For example, if the underlying for an embedded derivative is an
interest rate index and the host contract is a debt instrument for which the underlying alters the net
interest payments required under the contract, the embedded derivative will most likely meet the
clearly and closely related criteria.]
b. When the contract is not required by GAAP to be remeasured at fair value, with changes in fair value
reported in current earnings. [This answer is incorrect. Generally, an embedded derivative is accounted
for separately if GAAP does not require the contract to be remeasured at fair value, with changes in fair
value reported in current earnings, and two additional criteria are met.]
c. When the embedded derivative would be subject to FASB ASC 815 (formerly SFAS No. 133) requirements
if it were a standalone contract. [This answer is incorrect. Generally, an embedded derivative is accounted
for separately if it would be subject to the requirements of FASB ASC 815 (formerly SFAS No. 133) if it was
a standalone contract, and two additional criteria are met.]
5. Which of the following is an example of an embedded derivative? (Page 124)
a. ModeODae has issued debt with a conversion feature. [This answer is incorrect. Debt issued with a
conversion feature is specifically excluded as a derivative instrument by FASB ASC 815 (formerly SFAS
133).]
b. Rothchild is holding a put option on several shares of Maedae stock. [This answer is correct. FASB
ASC 815 (formerly SFAS 133) classifies both puts and calls as embedded derivatives.]
c. First National Bank has made stock options available to all employees as additional compensation if
certain revenue goals are met. [This answer is incorrect. Contracts issued by the entity in connection with
stockbased compensation arrangements are specifically excluded as derivatives under FASB ASC 815
(formerly SFAS 133).]
d. Big Company acquired all the shares of Little Company on October 1st. On the date of acquisition, Big
Company and Little Company contract to enter into a business combination on December 31st. [This
answer is incorrect. Contracts between an acquirer and a seller to enter into a business combination at a
future date are specifically excluded as derivatives under FASB ASC 815 (formerly SFAS 133).]
6. Which of the following embedded derivatives are accounted for separately? (Page 124)
a. Inflationindexed interest payments. [This answer is incorrect. Inflationindexed interest payments are not
accounted for separately. Interest rates and the rate of inflation are thought to be clearly and closely
related.]
b. Credit sensitive payments. [This answer is incorrect. Credit sensitive payments are not accounted for
separately since creditworthiness of the borrower and the interest rate on the debt are perceived to be
clearly and closely related.]
c. Inflationindexed rentals. [This answer is incorrect. Inflationindexed rentals are not accounted for
separately. Changes in inflation and rentals for use of leased assets are considered to be clearly and
closely related.]
d. Equityindexed interest payments. [This answer is correct. Equityindexed interest payments are
accounted for separately. Changes in the fair value of an equity instrument or index are not clearly
and closely related to the interest rate based economic characteristics of debt.]
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7. Which of the following is an accurate statement regarding derivative and nonderivative instruments?
(Page 125)
a. A derivative instrument cannot be designated to hedge the exposure to changes in the fair value of a
recognized liability due to a particular risk. [This answer is incorrect. A derivative instrument can be
designated to hedge the exposure to changes in the fair value of a recognized asset or liability due to a
specific risk per FASB ASC 815 (fomerly SFAS No. 133) which lists criteria required for a derivative
instrument to qualify as a fair value hedge.]
b. A derivative instrument cannot be designated to hedge the exposure to changes in the fair value of an
unrecognized firm commitment due to a particular risk. [This answer is incorrect A derivative instrument
can be designated to hedge the exposure to changes in the fair value of an unrecognized firm commitment
as a result of a particular risk per FASB ASC 815 (fomerly SFAS No. 133) which lists criteria required for
a derivative instrument to qualify as a fair value hedge.]
c. Except for certain foreign currency hedges, a nonderivative instrument should not be designated
as a hedging instrument under certain foreign currency hedges. [This answer is correct. A
nonderivative instrument should not be designated as a hedging instrument except in the case of
certain foreign currency hedges per FASB ASC 815 (fomerly SFAS No. 133).]
d. A derivative instrument held for trading purposes cannot be designated as a hedging instrument under any
conditions. [This answer is incorrect. A derivative instrument held for trading purposes may be designated
as a hedging instrument prospectively if it meets the criteria in FASB ASC 815 (formerly SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities).]
8. An asset or liability can be designated as a hedged item in a fair value hedge if several criteria are met. Which
of the following is an inaccurate representation of one of those criteria? (Page 126)
a. The entity specifically identifies a recognized asset or liability or an unrecognized firm commitment, or a
specific portion thereof, as the hedged item. [This answer is incorrect. An asset or liability can be
designated as a hedged item in a fair value hedge if six criteria are met. This is one of those six required
criteria per FASB ASC 815 (SFAS 133).]
b. Exposure to changes in the fair value of the hedged item due to the hedged risk could not affect
reported earnings. [This answer is correct. One of the criteria per FASB ASC 815 (formerly SFAS
133) that must be met is that exposure to changes in the fair value of the hedged item due to the
hedged risk could affect reported earnings.]
c. If the hedged item is all or part of a heldtomaturity debt security, the hedged risk is changes in fair value
attributable to credit risk, foreign exchange risk, or both. [This answer is incorrect. This is another of six
required criteria listed in FASB ASC 815 (formerly SFAS 133) that must be met for an asset or liability to
be designated as a hedged item in a fair value hedge.]
d. If the hedged item is a nonfinancial asset or liability, the hedged risk is the risk of changes in the fair value
of the total asset or liability, not a separate component thereof. [This answer is incorrect. This is one of the
six required criteria included in FASB ASC 815 (formerly SFAS 133) in order for an asset or liability to be
designated as a hedged item in a fair value hedge.]
9. The benchmark interest rate being hedged must specifically be identified and documented at the hedging
relationship's inception in a hedge of interest rate risk. Generally, what interest rate should be used when an
entity hedges an interest rate risk? (Page 126)
a. A lower benchmark interest rate. [This answer is incorrect. Using a lower benchmark interest rate from the
risk being hedged for similar hedges must be justified to be used per FASB ASC 815 (formerly SFAS 133).]
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b. The same benchmark interest rate. [This answer is correct. Generally, an entity should use the same
benchmark interest rate as the risk being hedged for similar hedges per FASB ASC 815 (formerly
SFAS 133).]
c. A higher benchmark interest rate. [This answer is incorrect. Per FASB ASC 815 (formerly SFAS 133),
without justification, a higher benchmark interest rate from the risk being hedged for similar hedges cannot
be used.
10. The accounting should be discontinued for an existing hedge in all of the following circumstances, except:
(Page 127)
a. When the derivative is held for trading purposes. [This answer is correct. The accounting should
be retained for an existing hedge when the derivative is held for trading purposes.]
b. When the derivative is sold. [This answer is incorrect. If the derivative is sold, the accounting should be
discontinued for an existing hedge per FASB ASC 81525358 (formerly SFAS 133, par. 24).]
c. The derivative is terminated. [This answer is incorrect. The accounting should be discontinued for an
existing hedge if the derivative is terminated per FASB ASC 81525358 (formerly SFAS 133, par. 24).]
d. The derivative is exercised. [This answer is incorrect. Once the derivative is exercised, discontinuing the
accounting for an existing hedge should occur per FASB ASC 81525358 (formerly SFAS 133, par. 24).]
11. Which of the following statements regarding foreign currency fair value hedges is accurate? (Page 127)
a. An entity cannot designate a derivative instrument as hedging changes in the fair value of an
availableforsale debt security attributable to changes in foreign currency exchange rates. [This answer
is incorrect. Per FASB ASC 815202537; 81520351 (formerly SFAS 133, par. 38), an entity can
designate a derivative instrument as hedging changes in the fair value of an availableforsale debt security
attributable to changes in foreign currency exchange rates.]
b. A nonderivative financial instrument may be designated as the hedge of the foreign currency exposure of
an availableforsale security. [This answer is incorrect. According to FASB ASC 815202537; 81520351
(formerly SFAS 133, par. 38), a nonderivative financial instrument may not be designated as the hedge of
the foreign currency exposure of an availableforsale security.
c. The change in fair value of the hedged availableforsale equity security attributable to foreign
exchange risk should be reported in earnings. [This answer is correct. The change in fair value of
the hedged availableforsale equity security attributable to foreign exchange risk should be
reported in earnings rather than other comprehensive income per FASB ASC 815202537;
d. Recognized assets or liabilities denominated in a foreign currency may not be the hedged item in a foreign
currency fair value hedge. [This answer is incorrect. Recognized assets or liabilities denominated in a
foreign currency may be the hedged item in a foreign currency fair value hedge per FASB ASC
815202537; 81520351 (formerly SFAS 133, par. 38).]
12. What risks are cash flow hedges intending to hedge the exposure to variability in expected future cash flows
against? (Page 130)
a. A prior risk. [This answer is incorrect. A prior risk has no bearing on expected future cash flows and would
not be a basis for establishing a cash flow hedge.]
b. A particular risk. [This answer is correct. Cash flow hedges are intended to hedge the exposure to
variability in expected future cash flows due to a particular risk. The exposure may relate to an
existing asset or liability or a forecasted transaction.]
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c. A projected risk. [This answer is incorrect. Cash flow hedges do not hedge the exposure to variability in
expected future cash flows due to a projected risk and are not based on risk speculation. The previous
statement makes sense because cash flow hedging decisions would not be made on projected risk but
on forecast risk. This is because a forecast risk is management's estimate of future results and a projected
risk would be the answer to a what if" question.]
13. Which of the following criteria does not apply to a forecasted transaction that can be designated as a hedged
transaction in a cash flow hedge? (Page 131)
a. The entity specifically identifies a single transaction or a group of individual transactions sharing the same
risk exposure as the forecasted transaction. [This answer is incorrect. According to FASB ASC
81520256; 815202515; 815202543 (formerly SFAS 133, paras. 21 and 29), There are eight criteria
that must be met in order for a forecasted transaction to be designated as a hedged transaction in a cash
flow hedge. One of those criteria is that the entity specifically identifies a single transaction or a group of
individual transactions sharing the same risk exposure as the forecasted transaction.]
b. The forecasted transaction is with an external party, (excluding certain foreign currency cash flow hedges)
and variability in cash flows for the hedged risk could affect reported earnings. [This answer is incorrect.
This is another of the criteria detailed in FASB ASC 81520256; 815202515; 815202543 (formerly
SFAS 133, paras. 21 and 29), that must be met for a forecasted transaction to be designated as a hedged
transaction in a cash flow hedge.]
c. The forecasted transaction is due to acquiring an asset or incurring a liability that will be remeasured
at fair value, with changes in fair value attributable to the hedged risk reported in current earnings.
[This answer is correct. This criteria does not apply. One of the criteria is that the forecasted
transaction is not due to acquiring an asset or incurring a liability that will be remeasured at fair
value, with changes in fair value attributable to the hedged risk reported in current earnings per
FASB ASC 81520256; 815202515; 815202543 (formerly SFAS 133, paras. 21 and 29.]
d. The forecasted transaction does not involve a business combination, a minority interest in a consolidated
subsidiary, a parent company's interests in consolidated subsidiaries, an equity method investment, or the
entity's own equity instrument. [This answer is incorrect. A forecasted transaction can be designated as
a hedged transaction in a cash flow hedge if the forecasted transaction does not involve a business
combination, a minority interest in a consolidated subsidiary, a parent company's interests in consolidated
subsidiaries, an equity method investment, or the entity's own equity instrument per FASB ASC
81520256; 815202515; 815202543 (formerly SFAS 133, paras. 21 and 29).]
14. Under which statement of Financial Accounting Standard can an entity designate a derivative instrument
resulting in a foreign currency transaction gain or loss as hedging the foreign currency exposure of a net
investment in a foreign operation if specified conditions are met? (Page 137)
a. FASB ASC 830 (formerly SFAS No. 52). [This answer is correct. FASB ASC 830 (formerly SFAS No.
52) addresses foreign currency translation and would be the correct pronouncement to address
foreign current transaction gain or loss.]
b. FASB ASC 360 (formerly SFAS No. 66). [This answer is incorrect. FASB ASC 360 (formerly SFAS No. 66)
addresses accounting for sales of real estate.]
c. FASB ASC 840 (formerly SFAS No. 98). [This answer is incorrect. FASB ASC 840 (formerly SFAS No. 98)
addresses accounting for leases.]
d. FASB ASC 815 (formerly SFAS No. 133). [This answer is incorrect. FASB ASC 815 (formerly SFAS No. 133)
addresses accounting for derivative instruments and hedging activities.]
149
DISCLOSURES PRIOR TO THE ADOPTION OF SFAS NO. 161
An entity that holds or issues derivatives (or nonderivatives that qualify as hedging instruments) should disclose the
following:
a. The entity's objectives for holding or issuing each type of hedging instrument, including the context needed
to understand the objectives and the entity's strategies for achieving the objectives
b. The entity's risk management policy for each type of hedge, including a description of the items or
transactions for which risks are hedged
c. The purpose of the derivative activity for derivative instruments not designated as hedging instruments
The disclosures should differentiate between (a) derivative instruments (and nonderivative instruments) designated
as fair value hedging instruments, (b)derivative instruments designated as cash flow hedging instruments,
(c)derivative instruments (and nonderivative instruments) designated as hedging instruments for hedges of the
foreign currency exposure of a net investment in a foreign operation, and (d) all other derivatives. (SFAS 133,
par.44)
In addition, the following disclosures should be made separately as part of the disclosures of accumulated other
comprehensive income: (FASB ASC 81530502) (formerly SFAS133, par. 47)
a. The beginning and ending accumulated derivative gain or loss
b. The related net change associated with current period hedging transactions
c. The net amount of any reclassification into earnings
The following disclosures should be made for derivative instruments designated and qualifying as fair value
hedging instruments (as well as nonderivative instruments that may give rise to foreign currency transaction gains
or losses) and for the related hedged items:
a. The net gain or loss recognized in earnings during the reporting period representing the amount of the
hedges' ineffectiveness and the component of the derivative instruments' gain or loss, if any, excluded from
the assessment of hedge effectiveness
b. A description of where the net gain or loss is reported in the income statement
c. The amount of net gain or loss recognized in earnings when a hedged firm commitment no longer qualifies
as a fair value hedge
The preceding disclosures must be made for each reporting period for which a complete set of financial statements
is presented. (SFAS 133, par. 45)
The following disclosures should be made for derivative instruments designated and qualifying as cash flow
hedging instruments and for the related hedged transactions:
a. The net gain or loss recognized in earnings during the reporting period representing the amount of the
hedges' ineffectiveness and the component of the derivative instruments' gain or loss, if any, excluded from
the assessment of hedge effectiveness
b. A description of where the net gain or loss is reported in the income statement
c. A description of the transactions or other events that will result in reclassifying gains and losses reported
in accumulated other comprehensive income into earnings
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d. The estimated net amount of existing gains or losses at the balance sheet date that is expected to be
reclassified into earnings within the next 12 months
e. The maximum length of time over which the company is hedging its exposure to variability in future cash
flows for forecasted transactions, excluding forecasted transactions related to payment of variable interest
on existing financial instruments
f. The amount of gains and losses reclassified into earnings as a result of the discontinuance of cash flow
hedges because it is probable that the original forecasted transactions will not occur by the end of the
originally specified time period or within the additional twomonth extension.
The preceding disclosures must be made for each reporting period for which a complete set of financial statements
is presented. (SFAS 133, par. 45) The net gain or loss on derivative instruments designated and qualifying as cash
flow hedging instruments reported in other comprehensive income should be displayed as a separate classification
within other comprehensive income. (FASB ASC 81530451) (formerly SFAS 133, par. 46)
For derivative instruments designated and qualifying as hedging instruments for hedges of the foreign currency
exposure of a net investment in a foreign operation (as well as for nonderivative instruments that may give rise to
foreign currency transaction gains or losses, the entity should disclose the net amount of gains or losses included
in the cumulative translation adjustment during the reporting period. The disclosure must be made for each
reporting period for which a complete set of financial statements is presented. (SFAS 133, par. 45)
For the period in which an embedded conversion option previously accounted for as a derivative no longer meets
the separation criteria, the following disclosures should be made: (FASB ASC 81515503) (formerly EITF 067, par.
6)
a. A description of the primary changes causing the embedded conversion option to no longer require
separation.
b. The amount of the liability for the conversion option reclassified to stockholders' equity.
A seller of credit derivatives should disclose information about its credit derivatives (and hybrid instruments with
embedded credit derivatives) that allows users of the financial statements to assess their potential effect on its
financial position, financial performance, and cash flows. For hybrid instruments with embedded credit derivatives,
the seller should disclose the required information for the entire hybrid instrument not just the embedded credit
derivatives. For each balance sheet presented, the seller of a credit derivative should disclose the following
information for each credit derivative, or each group of similar credit derivatives (even if the likelihood of the seller
having to make any payments under the credit derivative is remote): (FASB ASC 81510504K and 504L) (formerly
SFAS 133, par. 44DD, as amended by FSP FAS 1331 and FIN 454, par. A1)
a. The nature of the credit derivative, including the approximate term, the reason(s) for entering into the credit
derivative, the events or circumstances that would require the seller to perform under the credit derivative,
and the current status (as of the balance sheet date) of the payment/performance risk of the credit
derivative.
b. For internal groupings, how groupings are determined and used for managing risk.
c. The maximum potential amount of future payments (undiscounted) the seller could be required to make
under the credit derivative. (The maximum potential amount of future payments should not be reduced by
any amounts that may possibly be recovered under recourse or collateralization provisions.)
d. If applicable, the fact that the terms of the credit derivative provide for no limitation to the maximum potential
future payments under the contract.
e. If the seller is unable to develop an estimate of the maximum potential amount of future payments under
the credit derivative, the reasons why an estimate cannot be made.
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f. The fair value of the credit derivative as of the balance sheet date.
g. The nature of (1) any recourse provisions that would enable the seller to recover from third parties amounts
paid under the credit derivative and (2) any assets held either as collateral or by third parties that, upon the
occurrence of a specified triggering event or condition, the seller can obtain and liquidate to recover all or
a portion of the amounts paid under the credit derivative. If estimable, the seller should indicate the
approximate extent to which the proceeds from liquidation of those assets would be expected to cover the
maximum potential amount of future payments under the credit derivative. [In its estimate, the seller of
credit protection should consider the effect of any purchased credit protection with identical underlying(s).]
DISCLOSURES FOR PERIODS BEGINNING ON OR BEFORE NOVEMBER 15, 2008
Entities with derivative instruments (or nonderivative instruments that are designated and qualify as hedging
instruments) should disclose information that enables users to understand (a) how and why derivative instruments
are used, (b) the accounting for derivative instruments and related hedged items, and (c) how derivative instru
ments and related hedged items affect financial position, income, and cash flows. (FASB ASC 81510501)
(formerly SFAS 133, par. 44 as amended by SFAS 161, par. 3)
An entity that holds or issues derivative instruments (or nonderivative instruments that are designated and qualify
as hedging instruments) should disclose the following for each annual and interim reporting period for which a
balance sheet and income statement are presented: (FASB ASC 81510501A, 501B, 502, and 505) (formerly
SFAS 133, par. 44, as amended by SFAS 161, par. 3)
a. The entity's objectives for holding or issuing the instruments, the context needed to understand the
objectives, and the entity's strategies for achieving those objectives. (Disclosure should be made in the
context of each instrument's primary underlying risk exposure. Instruments should be distinguished
between those used for risk management purposes and those used for other purposes.)
b. For instruments designated as hedging instruments, the description in paragraph [OLDREF](a) should
distinguish between derivative (and nonderivative) instruments designated as (1) fair value hedging
instruments, (2) cash flow hedging instruments, and (3) hedging instruments of the foreign currency
exposure in a net investment in a foreign operation.
c. For derivative instruments not designated as hedging instruments, the description in paragraph
[OLDREF](a) should indicate the purpose of the derivative activity, distinguishing between derivatives used
for risk management purposes and derivatives used for other purposes.
d. Information about the volume of the entity's derivative activity.
e. If additional qualitative disclosures about the entity's overall exposures to interest rate risk, foreign currency
exchange rate risk, commodity price risk, credit risk, and equity price risk are made, a discussion of those
exposures even though the entity does not manage some of those exposures by using derivative
instruments.
For entities that hold or issue derivative instruments (and nonderivative instruments that are designated and qualify
as hedging instruments), the following should be disclosed for each annual and interim reporting period for which
a balance sheet and income statement are presented: (FASB ASC 81510504A through 4F) (formerly SFAS 133,
par. 44C, as amended by SFAS 161, par. 3)
a. The financial statement line item(s) and fair value amounts of derivative instruments reported in the balance
sheet showing:
(1) The fair value of derivative instruments presented on a gross basis, even when the derivative
instruments are subject to master netting arrangements and qualify for net presentation in the balance
sheet (associated cash collateral payables and receivables should not be netted against fair value
amounts).
152
(2) Fair value amounts presented as separate asset and liability values segregated between (a)
derivatives that are designated and qualifying as hedging instruments and (b) those that are not, with
further separate presentation by type of derivative contract within those two categories.
b. The financial statement line item(s) and amount of gains and losses reported in the income statement [or
when applicable, the balance sheet, such as for gains and losses initially recognized in other
comprehensive income (OCI)] with separate presentation of gains and losses for: [The information should
be presented separately by type of derivative contract, for example, interest rate contracts, foreign
exchange contracts, equity contracts, commodity contracts, credit contracts, other contracts, etc.]
(1) Derivative instruments designated and qualifying as hedging instruments in fair value hedges and
related hedged items designated and qualifying in fair value hedges.
(2) The effective portion of gains and losses on derivative instruments designated and qualifying in cash
flow hedges and net investment hedges that was recognized in OCI during the current period.
(3) The effective portion of gains and losses on derivative instruments designated and qualifying as
hedging instruments in cash flow hedges and net investment hedges recorded in accumulated other
comprehensive income during the term of the hedging relationship and reclassified into earnings
during the current period.
(4) The portion of gains and losses on derivative instruments designated and qualifying as hedging
instruments in cash flow hedges and net investment hedges representing (a) the amount of the
hedges' ineffectiveness and (b) the amount, if any, excluded from the assessment of hedge
effectiveness.
(5) Derivative instruments not designated or qualifying as hedging instruments.
c. For derivative instruments that are not designated or qualifying as hedging instruments, if the entity's policy
is to include those derivative instruments in its trading activities and the entity elects to not separately
disclose gains and losses, disclosure should be made of the following:
(1) The gains and losses on its trading activities (including both derivative and nonderivative instruments)
recognized in the income statement, separately by major types of items (such as fixed income/interest
rates, foreign exchange, equity, commodity, and credit).
(2) The line items in the income statement in which trading activities gains and losses are included.
(3) A description of the nature of its trading activities and related risks, and how the entity manages those
risks.
If this disclosure election is made, a footnote should be added to the required tabular information referencing this
disclosure.
If the entity holds or issues derivative instruments (or nonderivative instruments that are designated and qualify as
hedging instruments), the following should be disclosed for each annual and interim reporting period for which a
balance sheet is presented: (FASB ASC 81510504H) (formerly SFAS 133, par. 44D, as amended by SFAS 161,
par. 3)
a. The existence and nature of creditriskrelated contingent features and the circumstances in which the
features could be triggered in derivative instruments that are in a net liability position at the end of the
reporting period.
b. The aggregate fair value amounts of derivative instruments that contain creditriskrelated contingent
features that are in a net liability position at the end of the reporting period.
c. The aggregate fair value of assets that are already posted as collateral at the end of the reporting period
and (1) the aggregate fair value of additional assets that would be required to be posted as collateral and/or
153
(2) the aggregate fair value of assets needed to settle the instrument immediately, if the creditriskrelated
contingent features were triggered at the end of the reporting period.
If information on derivative instruments (or nonderivative instruments that are designated and qualify as hedging
instruments) is disclosed in more than a single footnote, a crossreference should be made from the derivative
footnote to other footnotes in which derivativerelated information is disclosed. (FASB ASC 81510504I) (formerly
SFAS 133, par. 44E, as amended by SFAS 161, par. 3)
The following should be disclosed for every annual and interim reporting period for which a balance sheet and
income statement are presented: (FASB ASC 81525501; 81530501) (formerly SFAS 133, par. 45, as amended
by SFAS 161, par. 3)
a. For derivative instruments (as well as nonderivative instruments that may give rise to foreign currency
transaction gains or losses) designated and qualifying as fair value hedging instruments and for the related
hedged items:
(1) The net gain or loss recognized in earnings during the reporting period representing (a) the amount
of the hedges' ineffectiveness and (b) the component of the derivative instruments' gain or loss, if any,
excluded from the assessment of hedge effectiveness.
(2) The amount of net gain or loss recognized in earnings when a hedged firm commitment no longer
qualifies as a fair value hedge.
b. For derivative instruments designated and qualifying as cash flow hedging instruments and for the related
hedged transactions:
(1) A description of the transactions or other events that will result in the reclassification into earnings of
gains and losses that are reported in accumulated other comprehensive income.
(2) The estimated net amount of the existing gains or losses at the reporting date that is expected to be
reclassified into earnings within the next 12 months.
(3) The maximum length of time over which the entity is hedging its exposure to the variability in future
cash flows for forecasted transactions excluding those forecasted transactions related to the payment
of variable interest on existing financial instruments.
(4) The amount of gains and losses reclassified into earnings as a result of the discontinuance of cash
flow hedges because it is probable that the original forecasted transactions will not occur by the end
of the originally specified time period or within two months, unless the transaction qualifies for an
exception due to extenuating circumstances.
154
SELFSTUDY QUIZ
following section.
15. It is not necessary for an entity that holds or issues derivatives, or nonderivatives that qualify as hedging
instruments, to disclose which of the following?
a. The entity's objectives for holding or issuing each type of hedging instrument.
b. The entity's risk management policy for each type of hedge.
c. The purpose of the derivative activity for derivative instruments designated as hedging instruments.
16. Which of the following is a complete and accurate disclosure that should be made separately as part of the
disclosures of accumulated other comprehensive income?
a. The ending accumulated derivative gain or loss.
b. The related net change associated with prior period hedging transactions.
c. The net amount of any reclassification into earnings.
155
SELFSTUDY ANSWERS
15. It is not necessary for an entity that holds or issues derivatives, or nonderivatives that qualify as hedging
instruments, to disclose which of the following? (Page 150)
a. The entity's objectives for holding or issuing each type of hedging instrument. [This answer is incorrect.
Per SFAS 133, par. 44, the entity's objectives for holding or issuing each type of hedging instrument should
be disclosed.]
b. The entity's risk management policy for each type of hedge. [This answer is incorrect. The entity's risk
management policy for each type of hedge should be disclosed per SFAS 133, par. 44.]
c. The purpose of the derivative activity for derivative instruments designated as hedging instruments.
[This answer is correct. In accordance with SFAS 133, par. 44, an entity that holds or issues
derivatives, or nonderivatives that qualify as hedging instruments should disclose the purpose of
the derivative activity for derivative instruments not designated as hedging instruments.]
16. Which of the following is a complete and accurate disclosure that should be made separately as part of the
disclosures of accumulated other comprehensive income? (Page 150)
a. The ending accumulated derivative gain or loss. [This answer is incorrect. The correct disclosure that
should be made separately as part of the disclosures of accumulated other comprehensive income is the
beginning and ending accumulated derivative gain or loss as detailed in FASB ASC 81530502 (formerly
SFAS 133, par. 47).]
b. The related net change associated with prior period hedging transactions. [This answer is incorrect. The
correct disclosure is the related net change associated with current period hedging transactions per FASB
ASC 81530502) (formerly SFAS 133, par. 47.]
c. The net amount of any reclassification into earnings. [This answer is correct. The net amount of any
reclassification into earnings is a disclosure that should be made separately as part of the
disclosures of accumulated other comprehensive income as defined in FASB ASC 815 (formerly
SFAS No. 133).]
156
FOREIGN CURRENCY MATTERS

OVERVIEW
GAAP primarily addresses two issues that entities with foreign activities must deal with when preparing their
financial statements:
a. Translating foreign currency statements to the reporting currency so that the foreign operations may be
consolidated, combined, or accounted for on the equity method
b. Accounting for and reporting foreign currency transactions
GAAP does not address translating financial statements from one currency to another for purposes other than
consolidation, combination, or the equity method. Consequently, the guidance in this lesson does not apply to, for
example, translating an entity's financial statements from its reporting currency to another currency for the conve
nience of readers familiar with the other currency.
Translating foreign currency statements to the reporting currency involves (a) adjusting the foreign currency
statements to conform to U.S. generally accepted accounting principles, (b) remeasuring the amounts presented
in the foreign currency statement into functional currency amounts, if necessary, and (c) translating functional
currency amounts into reporting currency amounts. Exchange gains and losses that result from remeasuring
foreign currency amounts into functional currency amounts are included in net income. On the other hand,
exchange gains and losses that result from translating functional currency amounts into reporting currency
amounts are not included in net income. Instead, they are reported as other comprehensive income.
A foreign currency transaction is one that must be settled in a currency other than the reporting entity's functional
currency. If the foreign currency's exchange rate changes after the sale or purchase is recorded, but before
payment is made, an exchange gain or loss results. Generally, an exchange gain or loss should be included in the
reporting entity's net income in the period the exchange rates change unless the transaction (a) hedges a net
investment in a foreign entity or (b) is an intercompany transaction of a longterm investment nature.
OBJECTIVES
A key objective in translating foreign currency statements and transactions is to preserve the financial results and
relationships measured in the foreign currency. That is accomplished by measuring assets, liabilities, and opera
tions in the foreign entity's functional currency and, if necessary, translating the functional currency to the reporting
currency. (FASB ASC 83010101 and 102) (formerly SFAS 52, par. 4)
Functional Currency
An entity's functional currency is the currency of the primary economic environment in which it generates and
expends cash. In many cases, the functional currency is the currency of the country in which the entity is located.
In other cases, it may be the currency of another country. (FASB ASC 83010452) (formerly SFAS 52, par. 5) For
example, if a foreign subsidiary's operations are (a) relatively selfcontained, (b)located within a single country, and
(c) not dependent on the parent's economic environment, the subsidiary's functional currency is the currency of the
country in which it is located. On the other hand, if a foreign subsidiary's operations are a direct and integral
component of the parent's operations (for example, if significant assets are acquired from or sold to the parent,
financing primarily is supplied by the parent, etc.), its daily operations are dependent on the parent's economic
environment and its functional currency is the parent's functional currency. (FASB ASC 83010454) (formerly
SFAS 52, paras. 8081)
157
Often, the facts will clearly identify an entity's functional currency. If they do not (for example, because the entity
conducts significant amounts of business in two or more currencies), management's judgment should be used to
determine the functional currency. (FASB ASC 83010456) (formerly SFAS 52, paras. 8 and 39) Typically, the
following are some of the factors that should be considered when determining an entity's functional currency:
a. Cash flow indicators. A foreign entity's functional currency is the foreign currency if the entity's cash flows
do not directly impact the parent's cash flows. If the foreign entity's cash flows directly impact the parent's
cash flows and are readily available for remittance to the parent, the entity's functional currency is the
parent's currency.
b. Sales price indicators. A foreign entity's functional currency is the foreign currency if its products' sales
prices primarily are determined (on a shortterm basis) by local competition or local government regulation
rather than exchange rates. If exchange rates directly influence (on a shortterm basis) product prices, the
foreign entity's functional currency is the parent's currency.
c. Sales market indicators. A foreign entity's functional currency is the foreign currency if there is an active
local market for its products (although there also may be significant amounts of exports). If sales are mostly
in the parent's country or denominated in the parent's currency, the foreign entity's functional currency is
the parent's currency.
d. Expense indicators. A foreign entity's functional currency is the foreign currency if the cost of its products
or services (for example, labor, materials, etc.) primarily are local costs (although there also may be imports
from other countries). If the entity's product or service costs, on a continuing basis, primarily are costs for
components obtained from the parent's country, its functional currency is the parent's currency.
e. Financing indicators. A foreign entity's functional currency is the foreign currency if financing primarily is
denominated in the foreign currency and the entity's operations are sufficient to service current and
normally expected debt obligations. The functional currency is the parent's currency, however, if (1)
financing primarily is from the parent or other obligations denominated in the parent's currency or (2) the
entity cannot service its debt obligations without funds from the parent.
f. Intercompany transactions. A foreign entity's functional currency is the foreign currency if there are few
intercompany transactions and little interrelationship between the parent's and foreign entity's operations.
Otherwise, the functional currency is the parent's currency.
An entity may have more than one distinct and separable operation, such as a division or branch. If conducted in
different economic environments, each operation may have a different functional currency. (FASB ASC
Changing the Functional Currency. Once a foreign entity's functional currency has been determined, it should be
used consistently unless facts and circumstances clearly indicate that the functional currency has changed.
Changes in the functional currency should be accounted for in the year of the change and prior period financial
statements should not be restated. (FASB ASC 83010457) (formerly SFAS 52, par. 9) In addition
a. if the functional currency changes from a foreign currency to the reporting currency, translation adjustments
for prior periods should remain in equity. The translated amounts for nonmonetary assets at the end of the
period prior to the change become the assets' new bases for subsequent periods.
b. if the functional currency changes from the reporting currency to a foreign currency, the adjustment needed
to translate nonmonetary assets as of the date of the change should be reported in other comprehensive
income. (FASB ASC 83010459 and 4510) (formerly SFAS52, par. 46)
158
TRANSLATING FOREIGN CURRENCY STATEMENTS
Translating foreign currency statements to the reporting currency may involve the following steps:
a. Adjust the foreign currency financial statements to conform to U.S. generally accepted accounting
principles. Foreign currency financial statements must be presented in accordance with U.S. generally
accepted accounting principles before they are translated to the functional or reporting currency.
b. Remeasure the amounts presented in the foreign currency statements into functional currency amounts. If
the foreign entity maintains its books of record in a currency other than the functional or reporting currency,
its assets, liabilities, revenues, expenses, gains, and losses must be remeasured into the functional
currency before translating amounts to the reporting currency. For example, assume a company
presenting its financial statements in U.S. dollars owns a foreign subsidiary whose functional currency is
Swiss francs. If some or all of the foreign subsidiary's records are maintained in German marks, its financial
statements must be remeasured into Swiss francs before they may be translated into U.S. dollars. (FASB
c. Translate functional currency amounts into reporting currency amounts. If the entity's functional currency
is the reporting currency, further conversion is not needed. If a foreign entity's functional currency differs
from the reporting currency, however, the functional currency amounts must be translated into reporting
currency amounts before the entity can be consolidated, combined, or accounted for on the equity method.
The following paragraphs discuss remeasuring amounts into the functional currency and translating functional
currency amounts into the reporting currency.
Remeasuring the Books of Record into the Functional Currency
The process of remeasuring foreign currency amounts into functional currency amounts is intended to produce the
same results as if the entity had kept its books of record in the functional currency. (FASB ASC 830104517)
(formerly SFAS 52, par. 10) To accomplish that, balance sheet and income statement items are remeasured into the
functional currency based on historical or current exchange rates between the functional currency and the other
currency as follows: (FASB ASC 830104517 and 4518) (formerly SFAS 52, paras. 4748)
Nonmonetary assets and liabilities should be remeasured into the functional currency using historical
exchange rates (i.e., the rates in effect when the transactions occurred). Exhibit 15 lists common
nonmonetary items that should be remeasured using historical rates.
Monetary assets and liabilities, such as cash, marketable securities carried at market, inventory carried at
other than cost, and most liabilities, should be remeasured based on current exchange rates.
Revenues and expenses related to nonmonetary items, such as cost of goods sold, depreciation, and
amortization of intangible assets, should be remeasured using the historical exchange rates that apply to
the related assets while those related to monetary items should be remeasured using current exchange
rates. Because it may be impractical to determine the exchange rate in effect on the date each revenue and
expense is recognized, however, an appropriate average exchange rate may be used. Thus, for example,
an average annual exchange rate might be used if revenues and expenses are recognized evenly
throughout the year, or average monthly or quarterly rates might be used if significant revenues and
expenses are recognized during certain periods of the year. (FASB ASC 830105510 and 5511) (formerly
SFAS 52, paras. 12, 29, and 140)
Exchange gains and losses that result from remeasuring balance sheet and income statement items into
the functional currency should be recognized as income or loss in the functional currency financial
statements.
159
Exhibit 15
Examples of Amounts to Be Remeasured into the

Functional Currency Using Historical Exchange Rates
Balance sheet items: Income statement items:

Marketable securities, at cost Cost of goods sold
Inventories, at cost Depreciation of property, plant, and equipment
Prepaid expenses such as insurance, advertising, and Amortization of intangible items such as patents and
rent licenses
Property, plant, and equipment Amortization of deferred charges or credits, except
Accumulated depreciation on property, plant, and policy acquisition costs for life insurance enter
equipment prises
Patents, trademarks, licenses, and formulas
Goodwill
Other intangible assets
Deferred charges and credits, except policy acquisi
tion costs for life insurance enterprises
Deferred income
Common stock
Preferred stock carried at issuance price
* * *
Exhibit 16 illustrates remeasuring books of record into functional currency amounts.
Exhibit 16
Remeasuring the Books of Record

Into the Functional Currency
Although Foreign Company's functional currency is the U.S. dollar, it maintains its books of record in Swiss francs.
During 20X6, the exchange rates between the Swiss franc and U.S. dollar were as follows:
Exchange rate at December 31, 20X6 1 SFr = $.82

Exchange rate at January 1, 20X6, when common stock was issued and land, machinery 1 SFr = $.70
and equipment was purchased
Weighted average exchange rate during 20X6 1 SFr = $.75
Exchange rate when inventories were purchased 1 SFr = $.80
Foreign Company's financial statements at December 31, 20X6, remeasured from Swiss francs to U.S. dollars, are
presented below:
Exchange U.S.
SFr Rate Dollars
ASSETS
Cash 8,000 .82 $ 6,560
Trade accounts receivable 18,500 .82 15,170
Inventories, at cost 46,300 .80 37,040 a
Land 150,000 .70 105,000
Machinery and equipment, net of accumulated depreciation 65,000 .70 45,500
287,800 $ 209,270
160
Exchange U.S.
SFr Rate Dollars
LIABILITIES AND
STOCKHOLDERS' EQUITY
Accounts payable 3,700 .82 $ 3,034
Notes payable 20,400 .82 16,728
Common stock 1,000 .70 700
Additional paidin capital 249,000 .70 174,300
Retained earnings 13,700 14,508
287,800 $ 209,270
SALES 335,200 .75 $ 251,400

COST OF GOODS SOLD 235,000 .80 188,000
GROSS PROFIT 100,200 63,400
EXPENSES
(excluding depreciation) 73,500 .75 55,125
DEPRECIATION 13,000 .70 9,100
REMEASUREMENT GAIN (15,333 )b
NET INCOME 13,700 14,508
RETAINED EARNINGS,
BEGINNING OF THE YEAR
RETAINED EARNINGS,
END OF THE YEAR 13,700 $ 14,508
Notes:
a The market value of inventory in U.S. dollars is assumed to exceed remeasured inventory at cost.
b The remeasurement gain is determined as follows:
U.S.
Dollars
Cash $ 6,560
Trade accounts receivable 15,170
Inventories, at cost 37,040
Land 105,000
Machinery and equipment 45,500
Accounts payable (3,034 )
Notes payable (16,728 )
Common stock (700 )
Additional paidin capital (174,300 )
Sales (251,400 )
Cost of goods sold 188,000
Expenses 55,125
Depreciation 9,100
Remeasurement gain $ 15,333
* * *
Applying Lower of Cost or Market Rules to Remeasured Inventory. Inventories should be recorded at the lower
of cost or market. Thus, when remeasuring inventories into the functional currency, remeasured cost should be
161
compared to remeasured market and the lower amount should be used. Applying the rule may result in a
writedown to market in the functional currency statements even though no writedown may have been made in the
books of record maintained in the other currency. Similarly, a writedown to market in the books of record may have
to be reversed prior to remeasuring the inventory into the functional currency if remeasured market exceeds
remeasured cost. A similar procedure should be followed when assets other than inventory are required to be
written down from historical cost. (FASB ASC 83010558) (formerly SFAS 52, par. 49)
Translating Foreign Currency Statements into the Reporting Currency
Before an investor can account for a foreign entity through consolidation, combination, or the equity method, the
foreign entity's financial statements must be stated in the investor's reporting currency. If the foreign entity's
functional currency is the reporting currency, that poses no problem. If the foreign entity's functional currency
differs from the reporting currency, however, the foreign entity's financial statements must be translated to the
reporting currency as follows: (FASB ASC 83010101) (formerly SFAS 52, par. 4)
Assets and liabilities should be translated using the current exchange rate (i.e., the exchange rate at the
foreign entity's balance sheet date). (FASB ASC 83030453) (formerly SFAS 52, par. 12) If a current
exchange rate is not available, the first exchange rate available after the balance sheet date should be used.
(An investor should consider whether it is appropriate to account for a foreign entity by consolidating,
combining, or applying the equity method if its inability to obtain an exchange rate is other than temporary.)
Revenues and expenses, including accounting allocations such as depreciation, amortization, and cost
of sales, should be translated using the exchange rate in effect on the date they are included in net income.
Since it may be impractical to separately translate each transaction, an appropriate weightedaverage
exchange rate may be used. (FASB ASC 83030453; 830105510 and 5511) (formerly SFAS 52, paras.
12 and 99)
Capital accounts should be translated using the exchange rate in effect when the foreign entity's capital
stock was acquired or issued.
Cash flows reported on the foreign entity's statement of cash flows should be translated using the exchange
rates in effect at the time of the cash flows. (An appropriate weightedaverage exchange rate may be used
if it produces similar results, however.) The effect of exchange rate changes should be presented as a
separate part of the statement of cash flows. (FASB ASC 830230451) (formerly SFAS 95, par.25)
Gains or losses on translating the functional currency into the reporting currency should not be included
in net income. Instead, they should be reported as other comprehensive income. (FASB ASC
830304512) (formerly SFAS52, par. 13). If all or part of an equity method investment in the foreign entity
is sold or liquidated, however, a pro rata portion of the accumulated translation gain or loss should be
included in the gain or loss on sale or liquidation. (FASB ASC 83030401 and 402) (formerly SFAS 52,
par.14 and FIN37, par. 2)
Exhibit 17 illustrates translating a foreign entity's functional currency statements to the reporting currency.
Exhibit 17
Translating Functional Currency Financial Statements

Into the Reporting Currency
Assume the following about USA Company's whollyowned German subsidiary:
The subsidiary's functional currency is the Deutsche mark (DM). During 20X5, the exchange rates between the
DM and USA Company's reporting currency (the U.S. dollar) were as follows:
Exchange rate at January 1, 20X5 1 DM = $.63

Exchange rate at December 31, 20X5 1 DM = $.68
Weighted average exchange rate during 20X5 1 DM = $.65
162
The subsidiary commenced operations on March 1, 20X3, when it issued 10,000 shares of common stock to
USA Company for 500,000 DM. On that date, the exchange rate between the DM and U.S. dollar was 1 DM =
$.55.
During April 20X5, the subsidiary made building improvements totaling 40,000 DM. The subsidiary paid for the
improvements by borrowing 30,000 DM from a German bank and paying 10,000 DM in cash. The exchange
rate between the DM and U.S. dollar at that time was 1 DM = $.64.
On November 1, 20X5, the subsidiary declared a dividend of 1.5DM per share. On that date, the exchange rate
between the DM and U.S. dollar was 1 DM = $.66.
The subsidiary's financial statements at December 31, 20X5, translated from DMs to U.S. dollars, follow:
Exchange U.S.
DM Rate Dollars
ASSETS
Cash 11,000 .68 $ 7,480
Trade accounts receivable 25,400 .68 17,272
Land 175,000 .68 119,000
Building and improvements, net of accumulated depreciation 455,000 .68 309,400
666,400 $ 453,152
LIABILITIES AND
Accounts payable 15,100 .68 $ 10,268
Notes payable 25,000 .68 17,000
Common stock 10,000 .55 5,500
Additional paidin capital 490,000 .55 269,500
Translation adjustments 72,614 a
666,400 $ 453,152
REVENUES 364,600 .65 $ 236,990
OPERATING EXPENSES 296,800 .65 192,920

NET INCOME 67,800 44,070
RETAINED EARNINGS, BEGINNING OF THE YEAR (assumed) 73,500 44,100
DIVIDENDS (15,000 ) .66 (9,900 )
RETAINED EARNINGS,
END OF THE YEAR 126,300 $ 78,270
CASH FLOWS FROM

OPERATING ACTIVITIES
Net income 67,800 .65 $ 44,070
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation 3,000 .65 1,950
Increase in trade accounts receivable (15,500 ) .65 (10,075 )
Decrease in accounts payable (17,300 ) .65 (11,245 )
NET CASH PROVIDED BY OPERATING ACTIVITIES 38,000 24,700
163
Exchange U.S.
DM Rate Dollars
CASH FLOWS FROM

INVESTING ACTIVITIES
Purchase of building improvements (10,000 ) .64 (6,400 )
NET CASH USED BY INVESTING ACTIVITIES (10,000 ) (6,400 )
CASH FLOWS FROM

FINANCING ACTIVITIES
Payments made on notes payable (5,000 .64 (3,200 )
Dividends paid (15,000 ) .66 (9,900 )
NET CASH USED BY FINANCING ACTIVITIES (20,000 ) (13,100 )
EFFECT OF EXCHANGE RATE CHANGES ON CASH 390
NET INCREASE IN CASH 8,000 5,590
CASH AT BEGINNING
OF YEAR 3,000 .63 1,890
CASH AT END OF YEAR 11,000 .68 $ 7,480
If USA Company were accounting for its investment in the German subsidiary under the equity method of
accounting, the following entries would be needed in 20X5:
a. Investment in German subsidiary 44,070

Equity in earnings of subsidiary 44,070
To record the subsidiary's 20X5 earnings.
b. Cash 9,900
Investment in German subsidiary 9,900
To record dividends received in 20X5.
c. Investment in German subsidiary 43,939

Translation adjustments 43,939 a
To record foreign currency translation adjustments.
Note:
a Translation adjustments are determined as follows:
U.S.
Dollars
Cash $ 7,480
Trade accounts receivable 17,272
Land 119,000
Building and improvements 309,400
Accounts payable (10,268 )
Notes payable (17,000 )
Common stock (5,500 )
Additional paidin capital (269,500 )
Retained earnings (78,270 )
164
U.S.
Dollars
Cumulative translation adjustment at end of year 72,614

Cumulative translation adjustment at beginning of year (assumed) 28,675
Current year translation adjustment $ 43,939
* * *
Foreign Entities in Highly Inflationary Economies
A highly inflationary economy is one whose cumulative inflation over a threeyear period is 100% or more. The
functional currency of a foreign entity in a highly inflationary economy is considered to be the investor's reporting
currency. Consequently, if the financial statements of a foreign entity in a highly inflationary economy are stated in
any currency other than the reporting currency, they must be remeasured into the reporting currency (i.e., the
functional currency). (FASB ASC 830104511) (formerly SFAS 52, par.11) (The subsequent translation is not
necessary since the remeasured functional currency financial statements will already be expressed in the reporting
currency.) As a result of that process, gains and losses from converting foreign currency financial statements into
reporting currency financial statements are recognized in net income rather than reported in stockholders' equity.
FOREIGN CURRENCY TRANSACTIONS
A foreign currency transaction is one that must be settled in a currency other than the reporting entity's functional
currency. Foreign currency transactions arise from the following: (FASB ASC 8301020) (formerly SFAS 52, par.
162)
a. Credit purchases or sales where the prices are denominated in a foreign currency
b. Borrowing or lending funds where the payable or receivable is denominated in a foreign currency
c. Unperformed forward exchange contracts
d. Acquisition or disposition of assets or incurrence or settlement of liabilities denominated in a foreign

currency
If the exchange rate between the foreign currency and functional currency changes after a purchase or sale is
recorded but before payment is made, a foreign currency transaction gain or loss results. (SFAS 52, par. 15) For
example, assume that a U.S. business purchased inventory on account from a British company for 100,000 pounds
when the exchange rate between the British pound and U.S. dollar was 1 pound = $1.55. The U.S. business would
record the purchase by debiting inventory and crediting account payable for $155,000 (100,000 pounds 1.55).
If the account payable was paid when the exchange rate was 1 pound = $1.65, the U.S. business would realize a
$10,000 exchange loss [$155,000 (100,000 pounds 1.65)].
Generally, foreign currency transaction gains and losses should be included in net income in the period the
exchange rate changes as follows: (FASB ASC 83020351; 83020401) (formerly SFAS 52, par. 15)
a. At the date a transaction is recognized, each asset, liability, revenue, expense, gain, or loss arising from
the transaction should be measured and recorded in the reporting entity's functional currency using the
exchange rate in effect at that time. (FASB ASC 83020251; 83020301) (formerly SFAS 52, par. 16)
b. At each balance sheet date, balances that will be settled in a foreign currency should be adjusted to reflect
the current exchange rate. (FASB ASC 83020352) (formerly SFAS 52, par. 16)
165
Transaction Gains and Losses to Be Excluded from Net Income
Gains and losses on the following foreign currency transactions should be excluded from net income and reported
as other comprehensive income: (FASB ASC 83020353) (formerly SFAS 52, par. 20)
a. Foreign currency transactions that are designated and effective economic hedges of a net investment in
a foreign entity. For example, a U.S. company with an investment in a French subsidiary may borrow French
francs in an amount equal to its investment (in French francs) in the subsidiary and designate the borrowing
as an economic hedge of its investment. By doing so, it protects itself from changes in exchange rates since
any decline in the investment due to changing exchange rates will be offset by a decline in the dollars
needed to settle the foreign currency loan.
b. Intercompany foreign currency transactions whose settlement is not anticipated in the foreseeable future.
The entities involved in the transaction must be consolidated, combined, or accounted for by the equity
method in the reporting entity's financial statements.
INCOME TAX CONSIDERATIONS
Deferred taxes generally must be provided for the future tax effects of taxable foreign currency transactions and
taxable translation adjustments. In such cases, the portion of total income tax expense attributable to amounts
reported as other comprehensive income should be allocated to other comprehensive income. (FASB ASC
ELIMINATION OF INTERCOMPANY PROFITS
When eliminating intercompany profits, the exchange rate in effect at the date of the intercompany transaction
should be used. An average or approximate rate may be used, however, if it is reasonable. (FASB ASC
Foreign operations should be fully disclosed to the extent they are significant. Foreign earnings reported beyond
amounts received in the United States (or available for unrestricted transmittal to the United States) should be
disclosed. [(Accepted Practice) ARB 43, Ch. 12, paras. 56] In addition, the following information should be
disclosed about foreign currency translations: (FASB ASC 83020501 and 502; 83030501 and 502) (formerly
SFAS 52, paras.3032 and 143)
a. Aggregate foreign currency transaction gain or loss included in net income.
b. Analysis of the changes during the period in accumulated other comprehensive income for cumulative
translation adjustments. The disclosure may be presented in a separate financial statement, in notes to the
financial statements, or as part of the statement of changes in equity. Regardless, the analysis should
include the following at a minimum: (FASB ASC 830304518 and 4520) (formerly SFAS 52, par. 31)
(1) Beginning and ending amount of cumulative translation adjustments
(2) Aggregate adjustment for the period resulting from translation adjustments and gains and losses from
hedges of a net investment in a foreign entity and longterm intercompany foreign currency
transactions
(3) Amount of income taxes for the period allocated to translation adjustments
(4) Amounts transferred from cumulative translation adjustments and included in net income as a result
of the sale or liquidation of an investment in a foreign entity
c. Exchange rate changes occurring after the balance sheet date, including their effects on unsettled foreign
currency transactions. The disclosure is not required if the effects of the subsequent rate changes are not
significant. If it is not practicable to determine the effect of the rate changes, that fact should be stated.
166
The reporting entity is encouraged to supplement the preceding disclosures with an analysis of the effects of rate
changes on the reported results of operations. The analysis might include, for example, the effect of translating
revenues and expenses at exchange rates that are different from the prior year or the effects of exchange rate
changes on selling prices, sales volume, and costs. (FASB ASC 83020503) (formerly SFAS 52, par. 144)
167
168
SELFSTUDY QUIZ
following section.
17. Translating financial statements from one currency to another for which of the following purposes, is not
addressed by GAAP?
a. In order that foreign operations may be consolidated.
b. In order that foreign operations may be combined.
c. In order that foreign operations may be accounted for on the equity method.
d. In order to accommodate readers familiar with the other currency.
18. Which of the following factors does not apply in determining an entity's functional currency?
a. Cash flow indicators.
b. Sales price indicators.
c. Expense indicators.
d. Risk indicators.
19. Which of the following is not one of the ways in which foreign currency amounts are remeasured into functional
currency amounts?
a. Nonmonetary assets and liabilities should be remeasured into the functional currency using current
exchange rates.
b. Monetary assets and liabilities should be remeasured based on current exchange rates.
c. Revenues and expenses related to nonmonetary items should be remeasured using current exchange
rates.
d. Exchange gains and losses that result from remeasuring balance sheet and income statement items into
statements.
20. Which of the following foreign entity's financial statements should be translated using the exchange rate in
effect on the date they are included in net income?
a. Assets and liabilities.
b. Revenues and expenses.
c. Capital accounts.
d. Cash flows.
169
SELFSTUDY ANSWERS
17. Translating financial statements from one currency to another for which of the following purposes, is not
addressed by GAAP? (Page 157)
a. In order that foreign operations may be consolidated. [This answer is incorrect. Translating financial
statements from one currency to another to facilitate consolidation of foreign operations is addressed by
GAAP. Guidance is found in FASB ASC 830 (formerly SFAS 52).]
b. In order that foreign operations may be combined. [This answer is incorrect. Translating financial
statements from one currency to another so that foreign operations may be combined is addressed by
GAAP. Guidance is found in FASB ASC 830 (formerly SFAS 52).]
c. In order that foreign operations may be accounted for on the equity method. [This answer is incorrect.
Translating financial statements from one currency to another in order that foreign operations may be
accounted for on the equity method is addressed by GAAP. Guidance is found in FASB ASC 830 (formerly
SFAS 52).]
d. In order to accommodate readers familiar with the other currency. [This answer is correct.
Translating financial statements from one currency to another in order to accommodate readers
familiar with the other currency is not addressed by GAAP because a key objective is to preserve
the financial results and relationships measured in the foreign currency.]
18. Which of the following factors does not apply in determining an entity's functional currency? (Page 158)
a. Cash flow indicators. [This answer is incorrect. Per FASB ASC 83010555 (formerly SFAS 52, par. 42),
Cash flow indicators should be considered when determining an entity's functional currency. If the entity's
cash flows do not directly impact the parent's cash flows, a foreign entity's functional currency is the foreign
currency. The entity's functional currency is the parent's currency if the foreign entity's cash floes directly
impact the parent's cash flows and are readily available for remittance to the parent.]
b. Sales price indicators. [This answer is incorrect. Sales price indicators should be considered when
determining an entity's functional currency according to FASB ASC 83010555 (formerly SFAS 52, par.
42). If a foreign entity's products' sales prices primarily are determined on a shortterm basis by local
competition or local government regulation rather than exchange rates, a foreign entity's functional
currency is the foreign currency. The foreign entity's functional currency is the parent's currency if
exchange rates directly influence on a shortterm basis product prices.]
c. Expense indicators. [This answer is incorrect. As indicated in FASB ASC 83010555 (formerly SFAS 52,
par. 42), expense indicators should be considered when determining an entity's functional currency. If the
cost of a foreign entity's products or services primarily are local costs, a foreign entity's function currency
is the foreign currency. If the foreign entity's product or service costs, on a continuing basis, primarily are
costs for components obtained from the parent's country, the foreign entity's functional currency is the
parent's currency.]
d. Risk indicators. [This answer is correct. Risk indicators is not listed in FASB ASC 83010555
(formerly SFAS 52, par. 42), and not one of the factors that should be considered when determining
an entity's functional currency.]
19. Which of the following is not one of the ways in which foreign currency amounts are remeasured into functional
currency amounts? (Page 159)
a. Nonmonetary assets and liabilities should be remeasured into the functional currency using current
exchange rates. [This answer is correct. Nonmonetary assets and liabilities should be remeasured
170
into the functional currency using historical exchange rates because the rates in effect when the
transactions occurred will produce the same results as if the entity had kept its books of record in
the functional currency. Examples include balance sheet items such as inventories at cost, deferred
income, and common stock. Examples also include income statement items such as the cost of
goods sold, depreciation of property, and amortization of deferred charges or credits, except policy
acquisition costs for life insurance enterprises.]
b. Monetary assets and liabilities should be remeasured based on current exchange rates. [This answer is
incorrect. Monetary assets and liabilities should be remeasured based on current exchange rates such as
cash, marketable securities carried at market, inventory carried at other than cost, and most liabilities per
FASB ASC 830104517 and 4518 (formerly SFAS 52, paras. 4748).]
c. Revenues and expenses related to nonmonetary items should be remeasured using historical exchange
rates. [This answer is incorrect. As cited in FASB ASC 830104517 and 4518 (formerly SFAS 52, paras.
4748), revenues and expenses related to nonmonetary items such as cost of goods sold, depreciation,
and amortization of intangible assets are remeasured using historical exchange rates that apply to the
related assets.]
d. Exchange gains and losses resulting from remeasuring income statement and balance sheet items into
statements. [This answer is incorrect. According to FASB ASC 830104517 and 4518 (formerly SFAS 52,
paras. 4748), exchange gains and losses that result from remeasuring income statement and balance
sheet items into the functional currency should be recognized as income or loss in the functional currency
financial statements.]
20. Which of the following foreign entity's financial statements should be translated using the exchange rate in
effect on the date they are included in net income? (Page 162)
a. Assets and liabilities. [This answer is incorrect. Assets and liabilities should be translated using the current
exchange rate per FASB ASC 83030453 (formerly SFAS 52, par. 12).]
b. Revenues and expenses. [This answer is correct. Revenues and expenses, including accounting
allocations such as cost of sales, should be translated using the exchange rate in effect on the date
they are included in net income per FASB ASC 83030453; 830105510 and 5511 (formerly SFAS
52, paras. 12 and 99.]
c. Capital accounts. [This answer is incorrect. Capital accounts should be translated using the exchange rate
in effect when the foreign entity's capital stock was acquired or issued per FASB ASC 83010101 (formerly
SFAS 52, par. 4).]
d. Cash flows. [This answer is incorrect. Cash flows reported on the foreign entity's statement of cash flows
should be translated using the exchange rates in effect at the time of the cash flows per FASB ASC
171
Lesson 1 (GAPTG092)
1. Which of the following would not qualify as a hedging instrument?
a. Hedge of an entity's net investment in a domestic operation.
b. Hedge of an entity's net investment in a foreign operation.
c. Cash flow hedge.
d. Fair value hedge.
2. A contract meets the requirement to qualify as a net settlement if its settlement provisions meet one of three
criteria. Which of the following is one of those criteria?
a. Both parties are required to deliver an asset associated with the underlying and that has a principal amount,
stated amount, face value, number of shares, or other denomination equal to the notional amount, or the
notional amount plus or minimum a premium or a discount.
b. One of the parties is required to deliver an asset associated with the underlying and that has a principal
amount, stated amount, face value, number of shares, or other denomination equal to the notional amount,
or the notional amount plus or minimum a premium or a discount.
c. Both of the parties must deliver an asset in a denomination equal to the notional amount and a market
mechanism facilitates net settlement.
d. One of the parties must deliver an asset in a denomination equal to the notional amount. However, that
asset is readily convertible to cash or is itself a derivative.
3. As defined in SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, derivatives include
a. Contracts for the purchase or sale of something that will be delivered in quantities expected to be used
or sold over a reasonable period in the normal course of business.
b. Forward contracts that contain net settlement provisions if it is likely that such contracts will result in the
physical delivery of assets and will not settle net.
c. Contracts that provide for payment in response to changes in an underlying.
d. Insurance policies that reimburse the holder only for losses incurred as a result of identifiable insured
events.
4. Of the following contracts, which would be considered a derivative instrument?
a. Contracts that are issued or held by the reporting entity.
b. Contract indexed to its own stock.
c. Contracts that result in a decrease in a specific debtor's creditworthiness.
d. Contracts classified in stockholders' equity in its balance sheet.
172
5. What portion of the contract should be measured at fair value with gains or losses recognized in earnings, if
an embedded derivative cannot be reliably identified and measured separate from the host contract?
a. A representative portion of the contract.
b. No portion of the contract.
c. The entire contract.
d. The portion varies from contract to contract.
6. Which of the following embedded derivatives are not accounted for separately?
a. Inflationindexed interest payments.
b. Calls and puts on equity instruments.
c. Termextending options.
d. Commodityindexed interest.
7. At what intervals should hedge effectiveness be assessed?
a. The same interval used by the entity for issuing financial statements.
b. At an interval selected by management, no more frequently than annually.
c. The same interval that corresponds to the commencement of the annual audit.
d. Hedge effectiveness should be assessed daily.
8. A derivative instrument qualifies as a fair value hedge if a number of criteria are met. One of the criteria is, if a
written option is designated as hedging a recognized asset or liability, or an unrecognized firm commitment,
and the combination of the option and the hedged item provides:
a. Much less potential for gains from favorable changes in the fair value of the combined instruments than
for losses from unfavorable changes.
b. Somewhat less potential for gains from favorable changes in the fair value of the combined instruments
than for losses from unfavorable changes.
c. At least as much potential for gains from favorable changes in the fair value of the combined instruments
as for losses from unfavorable changes.
d. Much greater potential for gains from favorable changes in the fair value of the combined instruments than
for losses from unfavorable changes.
9. Fair value hedges are characterized by which of the following?
a. A derivative instrument qualifying as a fair value hedge should be reported at its estimated value.
b. Any change in the derivative's value should be added to the basis of the asset or the liability that it hedges,
but not to the firm commitment that it hedges.
c. The gain or loss on the hedging instrument should be included in earnings in the period of the change.
d. It the hedge is completely effective, earnings will usually be affected since the gain or loss on the hedged
item will generally not offset the gain or loss on the hedging instrument.
173
10. When measuring the effectiveness of a hedge, where should the portion of the change in fair value of the
derivative that is attributed to the hedge ineffectiveness be measured?
a. Income statement.
b. Statement of financial position.
c. Balance sheet.
d. Tax returns.
11. Which of the following statements is not applicable for assessing and recognizing impairment on assets and
liabilities designated as hedged items?
a. Any asset that has been designated as a hedged item continues to be subject to the applicable GAAP
requirements for assessing and recognizing impairment.
b. Any liability that has been designated as a hedged item continues to be subject to the applicable GAAP
requirements for assessing and recognizing impairment.
c. The carrying amount of the asset or liability being assessed for impairment should not reflect adjustments
made to the carrying amount resulting from hedge accounting.
d. The hedging instruments' fair value and/or cash flows should not be taken into account when assessing
the hedged item for impairment.
12. A derivative instrument qualifies as a cash flow hedge if several criteria are met. Which of the following is one
of those criteria?
a. At the beginning of the hedge, the entity documents the risk that is being hedged, but need not indicate
the reason for the hedge.
b. Only at the beginning of the hedge will the entity expect the hedging relationship to be very effective in
offsetting cash flows attributable to the hedged risk.
c. If a written option is designated as hedging the variability in cash flows for a recognized asset or liability,
the combined option and hedged item provides at least as much potential for favorable cash flows as for
unfavorable cash flows.
d. A hedging instrument that is used to change interest receipts or payments related to a financial asset or
liability from one variable rate to another variable rate is most often ineffective at achieving offsetting cash
flows.
13. Which of the following does not apply to accounting for cash flow hedges?
a. A derivative instrument that qualifies as a cash flow hedge should be reported at its fair value.
b. A loss should never be reclassified immediately into earnings for an amount that is not expected to be
recovered.
c. When a forecasted sale occurs, the derivative gain or loss should be reclassified from accumulated other
comprehensive income into earnings.
d. If the entity acquires an asset or liability due to a hedged transaction, the gains or losses in accumulated
other comprehensive income are reclassified into earnings in the same period(s) in which the asset
acquired or liability incurred affects earnings.
174
14. A discontinued cash flow hedge's net derivative gain or loss should continue to be reported in accumulated
other comprehensive income unless it is unlikely that the hedged forecasted transaction will occur within two
months after the time designated at the hedge's inception. What happens if the forecasted transaction does
not occur within the two months after the time designated at the hedge's inception?
a. The derivative gain or loss in accumulated other comprehensive income should be immediately
reclassified to deferred income.
b. The derivative gain or loss in accumulated other comprehensive income should be immediately
reclassified to earnings.
c. The gain or loss on the hedging instrument in accumulated other comprehensive income should continue
to be accounted for as accumulated other comprehensive income.
d. The derivative gain or loss in accumulated other comprehensive income should be immediately
reclassified to unrealized gains and losses.
15. Disclosures by an entity holding or issuing derivatives or nonderivatives that qualify as hedging instruments
should differentiate between which of the following?
a. Only derivative instruments (excluding nonderivative instruments) designated as fair value hedging
instruments.
b. Derivative and nonderivative instruments designated as cash flow hedging instruments, fair value hedging
instruments, and hedging instruments of the foreign currency exposure of a net investment in a foreign
operation.
c. Only derivative instruments (excluding nonderivative instruments) designated as hedging instruments for
hedges of the foreign currency exposure of a net investment in a foreign operation.
d. Only certain specified derivatives not detailed above.
16. Which of the following applies to disclosures made for derivative instruments designated and qualifying as cash
flow hedging instruments and for the related hedged transactions?
a. The disclosures should be made at least once in four consecutive reporting periods for which a complete
set of financial statements is presented.
b. The disclosures should be made twice in four consecutive reporting periods for which a complete set of
financial statements is presented.
c. The disclosures must be made for each reporting period for which a complete set of financial statements
is presented.
d. There is no requirement as to how often disclosures must be made for derivative instruments designated
and qualifying as cash flow hedging instruments and for the related hedged transactions.
17. The subsidiary's functional currency is the parent's functional currency if a foreign subsidiary's operations are:
a. Relatively selfcontained.
b. Located within a single country.
c. Not dependent on the parent's economic environment.
d. Significant assets are acquired from the parent.
175
18. An entity may have as many as four different functional currencies under which of the following scenarios?
a. The entity has at least two distinct and separable operations within the same economic environment.
b. The entity has four distinct and separable operations within the same economic environment.
c. The entity has at least two distinct and separable operations in different economic environments.
d. The entity has four distinct and separable operations in different economic environments.
19. Which of the following is an example of an income statement item amount to be remeasured into the functional
currency using historical exchange rates?
a. Amortization of patents.
b. Prepaid advertising expenses.
c. Marketable securities, at cost.
d. Accumulated depreciation on property.
20. Which of the following statements regarding foreign entities and foreign currency transactions is most
accurate?
a. An economy with a highly inflationary economy is one whose cumulative inflation over a threeyear period
is 75% or more.
b. A foreign currency transaction must be determined in the reporting entity's functional currency.
c. A foreign currency transaction gain or loss results when the exchange rate between the foreign currency
and functional currency changes before a purchase is made.
d. An investor's reporting currency is the functional currency of a foreign entity in a highly inflationary
economy.
176

INCOME TAXES
INTRODUCTION
The primary objective of accounting for income taxes is to record the tax effects of events that ultimately will affect
both pretax accounting income and taxable income in the period the events occur. Authoritative literature accom
plishes that objective by requiring an asset and liability approach for accounting for income taxes. That approach,
commonly called the liability method, focuses on the balance sheet and on calculating current and deferred tax
assets and liabilities at the balance sheet date. As a result, the tax provision under the liability method is essentially
a residual amount calculated as the difference between deferred tax balance sheet amounts at the beginning and
end of the year plus the current tax provision.
The following broad principles govern the requirements for accounting for income taxes:
A current tax liability or asset should be recognized for the amount of taxes that are payable or refundable
for the year.
A deferred tax liability or asset should be recognized for the future tax effects of temporary differences and
carryforwards.
Current and deferred tax liabilities and assets should be measured based on enacted tax laws.
Deferred tax assets should be reduced by the amount of tax benefits that are not expected to be realized.

Determine the primary objective of accounting for income taxes and identify temporary income tax differences.
Identify deferred tax assets and liabilities.
Determine research and development activities and describe the accounting requirements for the associated
costs.
Determine when revenue should be recognized.
The basic tax provision calculation consists of the following steps:
a. Identify the taxable and deductible temporary differences and loss carryforwards available for tax reporting
at the end of the year.
b. Calculate the deferred tax liability by multiplying total taxable differences by the applicable tax rate.
c. Calculate the deferred tax asset by multiplying total deductible differences and loss carryforwards by the
applicable tax rate.
d. Identify the tax credit carryforwards available for tax reporting at the end of the year and record a deferred
tax asset for the total of the carryforwards.
e. Provide a valuation allowance for the portion of the deferred tax asset for which there is not more than a
50% chance that the benefit of the deductible differences and carryforwards will be realized.
f. Subtract the net deferred tax asset or liability at the end of the year from the net amount at the beginning
of the year to determine the deferred tax benefit or expense for the year. (The net deferred tax asset or
177
liability is the difference between the deferred tax liability and the deferred tax asset net of the related
valuation allowance.)
g. Add the deferred tax provision to the current tax provision to determine the total tax provision for the year.
(The current tax provision represents the income taxes for the year as reported in the tax returns.)
The flowchart in Exhibit 21 summarizes the preceding steps.
In addition to the steps listed in this paragraph, the financial statement effects of uncertainty in income taxes should
be recognized.
Exhibit 21
Computation of Annual Tax Provision
Identify temporary differences and operating

loss and tax credit carryforwards.
Multiply deductible temporary Multiply taxable

differences and operating loss temporary
carryforwards by applicable differences by
tax rate. Add tax credit applicable
carryforwards to the result. tax rate.
Deferred tax asset
Does
evidence
indicate that the
Yes deferred tax
No
asset will more
likely
than not be
realized?
Reduce deferred tax

Deferred tax asset is Deferred tax lia
asset by a valuation
amount calculated above. bility
allowance.
Net deferred tax asset

(liability) at end of year
Subtract net deferred tax

asset (liability) at
beginning of year
Deferred tax provision
Add current tax provision
Total tax provision
* * *
178
IDENTIFYING TEMPORARY DIFFERENCES
Temporary differences are differences between income tax and financial reporting that have future tax conse
quences. Specifically, they are differences between the financial and tax bases of assets and liabilities that will
result in future tax income or future tax deductions when the reported amount of the asset or liability is settled.
(FASB ASC 7401020) (formerly SFAS 109, par. 289) Temporary differences arise as a result of the following: (FASB
a. Revenues or gains that are taxable after they have been recognized in financial income (for example, an
installment sale receivable)
b. Expenses or losses that are deductible after they have been recognized in financial income (for example,
a product warranty liability)
c. Revenues or gains that are taxable before they have been recognized in financial income (for example,
subscriptions received in advance)
d. Expenses or losses that are deductible before they have been recognized in financial income (for example,
depreciation based on accelerated tax methods)
e. A reduction in the tax basis of depreciable assets because of tax credits
f. Investment tax credits accounted for by the deferral method
g. Business combinations
h. An increase in the tax basis of assets because of indexing whenever the local currency is the functional
currency
Temporary differences generally are identified by reviewing assets and liabilities for financial reporting and isolating
those with different tax bases. However, some temporary differences relate to amounts that only appear on the
income tax balance sheet and cannot be identified with a particular asset or liability for financial reporting. For
example, organization costs may be expensed for financial reporting but capitalized for tax purposes. Neverthe
less, temporary differences are still determined by calculating the difference between the financial and tax bases of
assets and liabilities. (FASB ASC 740102524 through 2526; 74010510) (formerly SFAS 109, par.15) (Whether
temporary differences relate to specific assets and liabilities for financial reporting is significant when classifying
deferred tax assets and liabilities as current and noncurrent, however.
Exhibit 22 lists examples of some of the more common temporary differences. There are exceptions to the concept
that differences between the bases of assets and liabilities for financial and tax reporting constitute temporary
differences for which deferred taxes should be provided. Deferred taxes should not be provided for differences
related to the following: (FASB ASC 74010253) (formerly SFAS 109, paras. 9, 31, and 256)
a. Unless it becomes apparent that the temporary differences will reverse in the foreseeable future:
Differences between the book and tax basis of an investment in a foreign subsidiary or a foreign
corporate joint venture that is essentially permanent in duration.
Undistributed earnings of a domestic subsidiary or corporate joint venture that is essentially

permanent in duration and arose in fiscal years beginning on or before December 15, 1992.
Tax bad debt reserves of U.S. savings and loan associations that arose in tax years beginning before
December 31, 1987.
b. Temporary differences related to deposits in statutory reserve funds by U.S. steamship enterprises.
c. Impairment of goodwill for which amortization is not deductible for tax purposes (A deferred tax liability
should be provided for temporary differences related to goodwill that is deductible for tax purposes,
however.)
179
d. Differences between the tax and financial bases of an investment in a leveraged lease
e. Intracompany differences between the tax bases of assets in the buyer's tax jurisdiction over the financial
bases of the assets as reported in the consolidated financial statements
f. Differences between the tax and financial bases of assets and liabilities that, under (FASB ASC 83010,
Foreign Currency Matters Overall) (formerly SFAS No. 52), are remeasured from the local currency into
the functional currency using historical exchange rates and that result from changes in exchange rates or
indexing for tax purposes
Deferred taxes should not be provided for the difference between the tax and financial basis of an investment in a
domestic subsidiary if the tax law provides a means of recovering the investment taxfree and the company expects
that it will use that means. (FASB ASC 74030253) (formerly APB 23, par. 10) Also, generally deferred taxes should
not be provided for the excess of cash surrender value of life insurance over premiums paid if the company intends
to hold the policy until the death of the insured since, under current federal tax law, such benefits are not taxable.
Deferred taxes should be provided for the excess, however, if management does not intend to hold the policy until
the death of the insured.
Exhibit 22
Examples of Temporary Differences
The following is a list of various examples of temporary differences based on current accounting and tax
requirements. Specific temporary differences may change as changes to generally accepted accounting principles
or income tax rules either create additional differences between the financial and tax bases of assets or liabilities or
eliminate existing differences.
Marketable Securities
Unrealized gains and losses on securities that are reported as an adjustment to income in the financial statements
based on the fair value of the securities at the balance sheet date but are not reported in the tax return until the
securities are sold
Unrealized gains and losses on securities that are reported as other comprehensive income for financial reporting
but are not recorded in the tax return until the securities are sold
Receivables
Bad debts that are recognized using the allowance method for financial reporting and the direct chargeoff method
for tax reporting
Gross profit on sales that is recognized in different periods for financial and tax reporting:
Gross profit recognized in the year of sale for financial reporting and on the installment method for tax reporting
Gross profit recognized on the cost recovery or deposit method for financial reporting and installment method
for tax reporting
Sales returns and allowances that are accrued for financial reporting but are not reported in the tax return until the
goods actually are returned
Imputed interest for financial reporting that differs from amounts for tax reporting
Longterm Construction Contracts
Revenues on longterm construction contracts that are accounted for differently for financial and tax reporting:
Percentageofcompletion method for financial reporting and completedcontract method for tax reporting
180
Percentageofcompletion based on physical completion for financial reporting and on estimated total
completed costs for tax reporting
Percentageofcompletion method for financial reporting and cash or accrual method for tax reporting
Inventories
Inventories that are recorded at the lower of cost or market for financial reporting and at cost for tax reporting
Reserves for obsolete inventory that are expensed for financial reporting and are not deductible for tax reporting
unless the inventory is actually scrapped or offered for sale at a reduced value
Inventoryrelated costs for manufacturers, wholesalers, and retailers that are expensed for financial reporting and
capitalized for tax reporting
Prepaid Expenses
Prepaid expenses that are recognized as the goods are delivered or the services are rendered for financial
reporting, but expensed for tax reporting.
Investments
Investments that are accounted for by the equity method for financial reporting and the cost method for tax
reporting
The excess of cash surrender value of life insurance over cumulative premiums paid, which is taxable if the
insurance is terminated for reasons other than death
Property and Equipment
Depreciation for financial reporting determined using estimated useful lives or methods that differ from tax reporting
Interest income that is offset against capitalized interest for financial reporting and recognized as income for tax
reporting
Assets that are recorded at fair value for financial reporting and at a different basis for tax reporting
Gains and losses on depreciable assets that are recognized for financial reporting and deferred for tax reporting
because the assets are traded in on similar assets
Gains on the appreciation of assets distributed as part of a liquidation that are recognized when liquidation is
imminent for financial reporting and on distribution for tax reporting
Leases that are capitalized for financial reporting and reported as operating leases for tax reporting
Amortizing capitalized leases over different periods for financial and tax reporting
Depletion that is based on the historical cost of the asset (cost depletion) for financial reporting and on statutory
rates (statutory depletion) for tax reporting
Intangible Assets
Intangible drilling costs that are capitalized for financial reporting and expensed for tax reporting
Amortization or impairment of intangible assets for financial reporting that differs from tax reporting
Organization costs that are expensed for financial reporting and capitalized for tax reporting
Liabilities
Debt issue costs that are amortized using the interest method for financial reporting and the straightline method for
tax reporting
181
Expenses that are accrued for financial reporting but deductible for tax reporting only when actually paid (for
example, vacation pay, certain loss contingencies, and losses on discontinued operations)
Imputed interest for financial reporting that differs from amounts for tax reporting
Deferred Revenues
Revenues received in advance that are deferred for financial reporting and recognized as income for tax reporting
(for example, subscription revenue)
Derivatives
The fair value of an interest rate swap that is included in other comprehensive income for financial reporting and
realized for tax purposes when the swap is terminated
ShareBased Compensation
Cumulative compensation cost due to sharebased awards recognized for financial reporting that is expected to be
deductible on future tax returns upon exercise of the award
* * *
Taxable versus Deductible Temporary Differences
GAAP refers to temporary differences that will result in taxable amounts in future years as taxable temporary
differences" (or taxable differences). Taxable differences create deferred tax liabilities and generally represent
expenses that have been deducted in the tax returns but that will be expensed in future financial statements, such
as depreciation deducted over shorter lives for tax purposes than permitted by GAAP. They also may represent
income recognized in the financial statements that will be taxable in future tax returns, such as use of the
percentageofcompletion method of accounting by a small contractor for financial reporting and the completed
contract method for tax reporting. (FASB ASC 7401058; 740102523)(formerly SFAS 109, par. 13)
Similarly, temporary differences that will result in deductions in future years are referred to a deductible temporary
differences" (or deductible differences). Deductible differences give rise to deferred tax assets. Generally, they
represent either (a) expenses that have been recognized in the financial statements but that will be deducted in
future tax returns, such as a provision for warranty costs, or (b) income recognized in the tax returns but deferred
for financial statement reporting, such as subscriptions received in advance. (FASB ASC 7401058; 740102523)
FASB ASC 718 (formerly SFAS No. 123(R), Compensation Stock Compensation) provides guidance on account
ing for the tax effects of sharebased compensation awards. In general, the cumulative compensation cost recog
nized for instruments classified as equity or liabilities that ordinarily will result in a future tax deduction is considered
a deductible temporary difference. The difference is based on the compensation cost recognized for financial
reporting. Guidance is also provided for situations when the amount reported on the tax return differs from the
cumulative compensation cost recognized in the financial statements.
In addition, FASB ASC 718740458 through 4512 (formerly EITF 0611) discusses the accounting treatment for
certain tax benefits of deductible dividends or dividend equivalents on awards of nonvested equity shares or
options that are part of a sharebased arrangement with dividendprotection features.
182
SELFSTUDY QUIZ
following section.
21. There are several broad principles that govern the requirements for accounting for income taxes. As a result,
which of the following should be reduced by the amount of tax benefits that are not expected to be realized?
a. A current tax liability or asset.
b. A deferred tax liability or asset.
c. Current and deferred tax liabilities and assets.
d. Deferred tax assets.
22. Which of the following does not result in a temporary income tax difference?
a. Revenues or gains that are taxable subsequent to being recognized in financial income.
b. Investment tax credits that are accounted for by the accrual method of accounting.
c. Expenses or losses that are deductible after being recognized in financial income.
d. Revenues or gains that are taxable before they have been recognized in financial income.
23. Which of the following is not an example of a temporary difference based on current accounting and tax
requirements?
a. Shortterm construction contracts.
b. Property and equipment.
c. Intangible assets.
d. Sharebased compensation.
24. Which of the following is an example of taxable temporary differences"?
a. Expenses that have been recognized in the financial statements but that will be deducted in future tax
returns.
b. Income recognized in the financial statements that will be taxable in future tax returns.
c. Income recognized in the tax return but deferred for financial statement reporting.
183
SELFSTUDY ANSWERS
21. There are several broad principles that govern the requirements for accounting for income taxes. As a result,
which of the following should be reduced by the amount of tax benefits that are not expected to be realized?
(Page 177)
a. A current tax liability or asset. [This answer is incorrect. A current tax liability or asset should be recognized
for the amount of taxes that are payable or refundable for the year.]
b. A deferred tax liability or asset. [This answer is incorrect. A deferred tax liability or asset should be
recognized for the future tax effects of temporary differences and carryforwards.]
c. Current and deferred tax liabilities and assets. [This answer is incorrect. Current and deferred tax liabilities
and assets should be measured based on enacted tax laws.]
d. Deferred tax assets. [This answer is correct. Deferred tax assets should be reduced by the amount
of tax benefits that are not expected to be realized.]
22. Which of the following does not result in a temporary income tax difference? (Page 179)
a. Revenues or gains that are taxable subsequent to being recognized in financial income. [This answer is
incorrect. Revenues or gains that are taxable subsequent to being recognized in financial income result
in temporary income tax differences such as an installment sale receivable per FASB ASC 740102520
b. An increase in the tax basis of depreciable assets as a result of tax credits. [This answer is correct.
A temporary tax difference results from a reduction in the tax basis of depreciable assets as a result
of tax credits per FASB ASC 740102520 (formerly SFAS 109, par. 11).]
c. Expenses or losses that are deductible after being recognized in financial income. [This answer is
incorrect. Expenses or losses that are deductible after being recognized in financial income result in
temporary income tax differences such as depreciation based on accelerated tax methods per FASB ASC
d. Revenues or gains that are taxable before they have been recognized in financial income. [This answer
is incorrect. Per FASB ASC 740102520 (formerly SFAS 109, par. 11), revenues or gains that are taxable
before they have been recognized in financial income result in temporary income tax differences such as
subscriptions received in advance.]
23. Which of the following is not an example of a temporary difference based on current accounting and tax
requirements? (Page 179)
a. Shortterm construction contracts. [This answer is correct. Longterm, not shortterm construction
contracts are an example of a temporary difference based on current accounting and tax
requirements.]
b. Property and equipment. [This answer is incorrect. Property and equipment are an example of a temporary
difference based on current accounting and tax requirements. One example is depreciation for financial
reporting determined using estimated useful lives or methods that are different from tax reporting per FASB
ASC 830 (formerly SFAS 52).]
c. Intangible assets. [This answer is incorrect. Intangible assets are another example of a temporary
difference based on current accounting and tax requirements. An example of intangible assets is intangible
drilling costs that are capitalized for financial reporting and expensed for tax reporting per FASB ASC 830
(formerly SFAS 52.]
184
d. Sharebased compensation. [This answer is incorrect. Sharebased compensation is another example of

a temporary difference based on current accounting and tax requirements. Sharebased compensation
is cumulative compensation cost due to sharebased awards recognized for financial reporting that is
expected to be deductible on future tax returns after the award is exercised per FASB ASC 830 (formerly
SFAS 52).]
24. Which of the following is an example of taxable temporary differences"? (Page 182)
a. Expenses that have been recognized in the financial statements but that will be deducted in future tax
returns. [This answer is incorrect. As indicated in FASB ASC 7401058; 740102523 (formerly SFAS 109,
par. 13), expenses that have been recognized in the financial statements but that will be deducted in future
tax returns is an example of deductible temporary differences."
b. Income recognized in the financial statements that will be taxable in future tax returns. [This answer
is correct. Income recognized in the financial statements that will be taxable in future tax returns is
one example of taxable temporary differences" per FASB ASC 7401058; 740102523 (formerly
SFAS 109, par. 13). Another example is depreciation deducted over shorter lives for tax purposes
than permitted by GAAP.]
c. Income recognized in the tax return but deferred for financial statement reporting. [This answer is incorrect.
Per FASB ASC 7401058; 740102523 (formerly SFAS 109, par. 13), income recognized in the tax return
but deferred for financial statement reporting is an example of deductible temporary differences."
185
MEASURING DEFERRED TAX ASSETS AND LIABILITIES
A deferred tax asset or liability should be recognized at the end of each year for all taxable and deductible
temporary differences, operating loss carryforwards for tax reporting purposes, and tax credit carryforwards. The
deferred tax liability is computed by multiplying taxable temporary differences by the applicable tax rate. The
deferred tax asset is computed by multiplying deductible temporary differences and tax operating loss carryfor
wards by the applicable tax rate and adding tax credit carryforwards. The deferred tax asset should then be
reduced by a valuation allowance if there is more than a 50% chance that all or a portion of it will not be realized.
(FASB ASC 740102529; 74010305) (formerly SFAS 109, paras. 1617)
Selecting a Tax Rate
A strict application of the asset and liability approach to measuring deferred taxes would require estimating the
incremental effect of temporary differences. That is, deferred taxes would be determined by (a) computing the
amount of taxes that will be payable or refundable in future years including carryforwards and reversing temporary
differences and (b) subtracting the amount of taxes that would be payable or refundable in future years excluding
carryforwards and reversing temporary differences. That method would be difficult, however, except in the simplest
situations. As a practical alternative, authoritative literature requires deferred taxes to be measured using the
enacted tax rate expected to apply to taxable income in the periods in which the temporary differences are
expected to reverse. (FASB ASC 74010103; 74010308) (formerly SFAS 109, paras. 18 and 87)
Current federal tax law imposes a graduated rate structure. Corporations with taxable income between $335,000
and $10 million are taxed at a flat rate of 34%. Personal service corporations and corporations with taxable income
over $18,333,333 are taxed at a flat rate of 35%. Other corporations are subject to a graduated rate structure that
imposes rates ranging from 15% to 39% on various levels of taxable income. GAAP requires deferred federal taxes
to be measured using the flat tax rate (currently 34% or 35%) unless (a) the effect of the graduated rate structure is
significant or (b)special rates apply to the temporary difference or carry forward. (FASB ASC 74010309)(formerly
SFAS 109, par. 18)
Selecting a Tax Rate When Graduated Rates Are a Significant Factor. In some situations, using a flat tax rate to
measure deferred taxes may produce significantly different results than if graduated tax rates had been used. In
those situations, deferred taxes should be computed using the average tax rate that will apply to estimated taxable
income of the years in which the temporary differences are expected to reverse. (FASB ASC 74010309) (formerly
SFAS 109, par. 18) The average graduated tax rate is calculated by dividing the tax on taxable income by taxable
income. To illustrate, assume that currently enacted tax laws require the first $50,000 of income to be taxed at 15%,
the next $25,000 to be taxed at 25%, and income above $75,000 to be taxed at 34%. A company expecting its
taxable income in year 2 to be $100,000 can expect to pay taxes of $22,250 in that year. Thus, its expected average
graduated tax rate in year 2 is 22% ($22,250$100,000).
Different average graduated tax rates may apply in different years. In most cases, however, a different average
graduated tax rate need not be computed for each year in which temporary differences and carryforwards are
expected to reverse. Since the calculation is based on expected taxable income, which is no more than an
estimate, determining a different average graduated tax rate for each future year in the reversal period is usually not
necessary. Using a single average graduated tax rate based on average estimated annual taxable income during
the reversal period usually will provide sufficient precision. To illustrate how the average graduated tax rate is
computed based on average expected taxable income, assume that a company has a taxable temporary difference
of $200,000. The difference is expected to reverse $150,000 in year 1 and $50,000 in year 2. In addition, the
company expects $60,000 of taxable income from other sources in each year. Based on those assumptions, the
company's expected taxable income will be $210,000 in year1 ($150,000 + $60,000) and $110,000 in year 2
($50,000 + $60,000), and the average taxable income per year during the reversal period will be $160,000
[($210,000+$110,000) 2]. The company should use an average graduated tax rate based on estimated annual
taxable income of $160,000. Judgment may be used to deal with unusual situations, however. Thus, in some cases,
a company may determine that more than one average graduated tax rate should be used during the reversal
period (for example, if an unusually large temporary difference will reverse in a single future year or if an abnormal
level of taxable income is expected for a single future year). (FASB ASC 7401055138) (formerly SFAS 109,
par.236)
186
Selecting a Tax Rate When Special Rates Apply. Certain types of taxable income may be taxed at different rates.
For example, prior to the Tax Reform Act of 1986, federal tax law imposed a maximum tax rate of 28% on excess net
longterm capital gains. If special tax rates apply and they differ significantly from the regular rate that would
ordinarily be used, the deferred tax effect of temporary differences that will not be taxed as ordinary income should
be measured using the special rates. (FASB ASC 74010309) (formerly SFAS 109, par. 18)
Special Considerations When Tax Losses Are Expected during the Reversal Period. Future taxable losses
cannot be considered to avoid providing a deferred tax liability for existing taxable differences. Taxable differences
that reverse in a year in which a tax loss is expected reduce the tax loss. Similarly, deductible differences that
reverse in a year in which a tax loss is expected increase the tax loss. As a result, they reduce (or increase) the tax
benefits that will be received from the carryback or carryforward of the tax loss. The deferred tax liability or asset is
measured using the tax rate that is expected to apply to the loss carryforward or carryback. If the loss carryforward
or carryback is not expected to be realized, deferred tax assets and liabilities should be measured using the lowest
graduated tax rate rather than an estimated average graduated tax rate of zero. (FASB ASC 740105523;
7401055129 through 55135) (formerly SFAS 109, paras. 233235)
Should Federal Alternative Minimum Tax Rates Be Considered? Current federal income tax law requires
corporations to compute taxes under the regular and alternative minimum tax (AMT) systems. The larger of the two
calculations is the tax due for the year. When the AMT exceeds the regular tax, the excess (referred to as the AMT
credit) may be carried forward indefinitely to offset the excess of the regular tax over the AMT in future years. The
FASB views the AMT as having only a temporary effect. AMT will almost always be recovered through the use of
AMT credit carryforwards. Therefore, over the entire life of an entity, cumulative income will be taxed under the
regular tax system. Consequently, deferred taxes should be measured using regular tax rates, and AMT tax rates
should not be considered. (FASB ASC 740103010 through 3011; 740105531 and 5532) (formerly SFAS 109,
paras. 19, 9091, and 238239) AMT credit carryforwards are considered in calculating deferred tax assets.
Changes in Future Tax Rates. Deferred taxes should be measured using the tax rate expected to apply to
estimated taxable income in the periods in which temporary differences are expected to reverse. Thus, deferred tax
calculations should consider future changes in tax rates. The calculations should only consider those changes
prescribed by tax laws that are enacted at the balance sheet date, however. Changes in tax rates that are enacted
subsequent to the balance sheet date should not be considered. As a result, the effects of changes in tax rates are
recognized in the year the changes in tax law are enacted. (FASB ASC 74010308 and 309; 74010354;
740104515) (formerly SFAS 109, paras. 18 and 27)
Considering the Need for a Deferred Tax Asset Valuation Allowance
The deferred tax asset should be reduced by a valuation allowance if it is likely that all or a portion of it will not be
realized. In other words, a deferred tax asset should be recognized only if there is more than a 50% chance that it
will be realized. (FASB ASC 74010305) (formerly SFAS 109, par. 17) The need for a valuation allowance should
be reevaluated each year based on current circumstances. Changes in the valuation allowance from yeartoyear
should be included in the deferred tax provision in the year of the change. (FASB ASC 740104520) (formerly
SFAS 109, par. 26)
Whether a deferred tax asset will be realized requires considerable judgment. The potential effects of both positive
and negative evidence should be weighed. If negative evidence exists, it may be difficult to conclude that a
valuation allowance is not needed for at least a portion of the deferred tax asset. The existence of negative evidence
does not always indicate that a valuation allowance is needed, however. In some cases, positive evidence may exist
that outweighs the negative evidence, and a conclusion can be reached that a valuation allowance is not neces
sary. (FASB ASC 740103023) (formerly SFAS 109, par. 25) The following are examples of negative and positive
evidence that should be considered (the list is not allinclusive): (FASB ASC 740103021 through 3023) (formerly
Negative evidence
Cumulative losses in recent years
A history of operating loss or tax credit carryforwards expiring unused
187
Losses expected in early future years by a presently profitable entity
Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit
levels on a continuing basis in future years
A carryback, carryforward period that is so brief that it would limit realization of tax benefits if (a) a significant
deductible temporary difference is expected to reverse in a single year or (b) the enterprise operates in a
traditionally cyclical business
Positive evidence
Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the
deferred tax asset based on existing sales prices and cost structures
An excess of appreciated asset value over the tax basis of the entitys net assets in an amount sufficient
to realize the deferred tax asset
A strong earnings history exclusive of the loss that created the future deductible amount (tax loss
carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for
example, an unusual, infrequent, or extraordinary item) is an aberration rather than a continuing condition
Whether a deferred tax asset will be realized ultimately depends on whether there will be sufficient taxable income
of the appropriate character (such as ordinary income or capital gain) within the carryback, carryforward period
available under the tax law. The following sources of taxable income should be considered when determining the
need for a valuation allowance: (FASB ASC 740103018 and 3019) (formerly SFAS 109, paras. 2122)
a. Future reversals of existing taxable temporary differences (Future reversals of taxable differences for which
a deferred tax liability has not been recognized should not be considered, however.)
b. Future taxable income exclusive of reversing temporary differences and carryforwards (Future distributions
of future earnings of a subsidiary or corporate joint venture should not be considered except to the extent
that a deferred tax liability has been recognized for existing undistributed earnings or earnings have been
remitted in the past.)
c. Taxable income in prior carryback years if carryback is permitted under the tax law
d. Taxplanning strategies (A taxplanning strategy should be considered as a source of future taxable income
only if (1) it is prudent and feasible, (2) it is one that management ordinarily might not take, but would take
to prevent an operating loss or tax credit carryforward from expiring unused, and (3) it would result in the
realization of deferred tax assets.)
CALCULATING THE INCOME TAX PROVISION
The income tax provision consists of the following components:
a. Current tax expense or benefit. The current income tax expense or benefit represents the income taxes paid
or payable (or refundable) for the year determined by applying the provisions of enacted tax law to taxable
income. (FASB ASC 7401020) (formerly SFAS 109, par. 289) Generally, it may be determined by
aggregating the tax liabilities as reported in the tax returns for all tax jurisdictions, net of applicable tax
credits, but before considering any estimated tax payments or prepayments.
b. Deferred tax expense or benefit. Under the liability method of accounting for income taxes, the deferred tax
provision is a residual amount that equals the change in deferred tax liabilities and assets between the
beginning and end of the period. (FASB ASC 74010304) (formerly SFAS 109, par. 16) Consequently, it
is calculated as follows:
(1) Aggregate the deferred tax assets and liabilities for all tax jurisdictions at the beginning of the year.
188
(2) Aggregate the deferred tax assets and liabilities for all tax jurisdictions at the end of the year.
(3) Record the difference between the amounts calculated in a. and b. as the deferred tax expense or
benefit for the year.
Exhibit 23 presents a comprehensive example of calculating deferred tax assets, liabilities, and the deferred tax
provision.
Exhibit 23
Example Tax Provision Calculation
Facts:
ACE Incorporated began operations in 20X5 and has reported the following amounts in its income statements
and tax returns: (This exhibit uses the terms pretax income" to refer to amounts reported in the company's
income statements and taxable income" to refer to amounts reported in its tax returns.)
Non
Pretax deductible Taxable
Income Expenses Income
Actual losses
20X5 $ (299,900 ) $ 5,000 $ (326,300 )
20X6 (245,000 ) 2,500 (305,000 )
Estimated future income
20X7 24,400 3,000 4,900
20X8 20,500 4,000 7,000
20X9 15,600 3,500 34,300
20Y0 18,800 4,000 33,200
20Y1 22,000 2,500 29,900
20Y220Z1 (estimated amount per year) 37,600 3,400 49,700
ACE Incorporated had the following temporary differences at the end of 20X5 and 20X6:
GAAP
Expense Over
GAAP Tax Deductible (Tax (Under) Tax
Basis Basis able) Difference Expense
Accumulated depreci
ation
20X5 $ 25,000 $ 71,400 $ (46,400 ) $ (46,400 )
20X6 75,000 193,900 (118,900 ) (72,500 )
Inventory
20X5 $ 350,000 $ 365,000 $ 15,000 $ 15,000
20X6 370,000 395,000 25,000 10,000
The company is subject only to federal income taxes. Current tax calculations assume that the regular tax
exceeds the alternative minimum tax and are based on the following rate table:
If taxable income is: The tax is:

$1 to $50,000 15% of taxable income
$50,001 to $75,000 $7,500 plus 25% of the amount over $50,000
189
There are no tax credits.
Graduated tax rates are not considered to have a significant effect on deferred tax calculations. Therefore,
deferred taxes are provided at 34%.
Tax Calculation for 20X6:
Current provision
Pretax income (loss) $ (245,000 )

Nondeductible expenses 2,500
Temporary differences
Depreciation (72,500 )
Inventory 10,000
Taxable income (loss) (305,000 )

Loss carryforward from 20X5 (326,300 )
Loss carryforward available at end of 20X6 $ (631,300 )
Deferred provision
Deferred
Tax
Liability Asset Net
Net deferred tax asset at end of 20X5

Depreciation $ (46,400 ) $
Inventory 15,000
Loss carryforward 326,300
(46,400 ) 341,300
Tax rate 34 % 34 %
Deferred tax asset
(liability) $ (15,776 ) $ 116,042 $ 100,266
Deferred tax asset
valuation allowance a
Net deferred tax asset at end of 20X5 $ 100,266
Net deferred tax asset at end of 20X6
Depreciation $ (118,900 ) $
Inventory 25,000
Loss carryforward 631,300
(118,900 ) 656,300
Tax rate 34 % 34 %
Deferred tax asset
(liability) $ (40,426 ) $ 223,142 $ 182,716
Deferred tax asset
valuation allowance (8,500 )a
Net deferred tax asset at end of 20X6 174,216
Deferred tax asset at end of 20X5 100,266
Deferred benefit for 20X6 $ 73,950
Total provision
Current benefit $
190
Deferred
Tax
Liability Asset Net
Deferred benefit 73,950
$ 73,950
Note:
a The illustration assumes that a deferred tax asset valuation allowance was not considered necessary at the
end of 20X5. A deferred tax asset valuation allowance is needed at the end of 20X6, however, since there is
more than a 50% probability that ACE Incorporated will not realize the tax benefits of the deductible difference
and operating loss carryforward. That conclusion was reached through the following analysis:
Estimated future taxable income during the carryforward period 20X7 through 20Z1
(Future taxable income includes the reversals of the existing taxable and deductible
temporary differences) $ 606,300
Operating loss carryforward (631,300 )
Operating loss carryforward in excess of future taxable income (25,000 )

34 %
$ (8,500 )
When determining the need for a valuation allowance, taxable income in prior carryback years and available
taxplanning strategies that would generate future taxable income also should be considered. In this
illustration, however, there is no available taxable income in prior carryback years and, for simplicity, it is
assumed that there are no taxplanning strategies available to ACE Incorporated.
* * *
FINANCIAL STATEMENT PRESENTATION
Classifying Deferred Tax Assets and Liabilities
When classified balance sheets are presented, deferred tax assets and liabilities should be segregated into current
and noncurrent components. The method used to classify deferred tax assets and liabilities depends on whether
they relate to assets and liabilities for financial reporting as follows: (FASB ASC 74010454; 74010459) (formerly
SFAS 109, par. 41)
a. Deferred tax assets and liabilities associated with particular assets and liabilities for financial reporting.
Deferred tax assets and liabilities that can be identified with particular assets and liabilities for financial
reporting should be classified the same as those assets and liabilities. For example, a deferred tax asset
related to trade accounts receivable would be classified as current since it relates to a current asset. On
the other hand, a deferred tax asset related to property and equipment would be classified as noncurrent
since it relates to a noncurrent asset.
b. Deferred tax assets and liabilities not associated with particular assets or liabilities for financial reporting.
Some temporary differences are associated with deferred taxable income or deductions and only appear
on tax basis balance sheets. Those differences, as well as loss and tax credit carryforwards, cannot be
easily identified with a particular asset or liability for financial reporting. Deferred tax assets or liabilities that
are not associated with an asset or liability for financial reporting should be classified as current or
noncurrent according to the reversal dates of the temporary differences or carryforwards. In other words,
the portion of those deferred tax assets and liabilities that will reverse during the next year should be
classified as current, and the portion that will reverse after the next year should be classified as noncurrent.
191
The deferred tax asset valuation allowance for a particular tax jurisdiction should be allocated ratably between
current and noncurrent deferred tax assets for that jurisdiction. (FASB ASC 74010455) (formerly SFAS 109, par.
41) Accordingly, if there is only one deferred tax asset, the valuation allowance would be classified the same as that
asset. If there is more than one deferred tax asset, the valuation allowance would be allocated ratably between all
deferred tax assets. For example, assume that a company has the following deductible temporary differences at the
end of the year:
Accounts receivable $ 35,500

Investment in partnership 15,000
$ 50,500
Assume further that the company determines that a deferred tax asset valuation allowance of $8,500 is necessary
at the end of the year. The valuation allowance would be allocated between current and noncurrent deferred tax
assets as follows:
% of Allocated
Total Amount
Current:
Deferred tax asset related to accounts receivable
($35,500 34%) $ 12,070 70 % $ 5,950
Noncurrent:
Deferred tax asset related to
investment in partnership
($15,000 34%) 5,100 30 % 2,550
$ 17,170 100 % $ 8,500
At the end of the year, the company's balance sheet would show a current deferred tax asset of $6,120
($12,070$5,950) and a noncurrent deferred tax asset of $2,550 ($5,100$2,550).
Offsetting Assets and Liabilities. All current deferred tax assets and liabilities should be offset and presented as
a single amount and all noncurrent deferred tax assets and liabilities should be offset and presented as a single
amount. Income tax assets and liabilities should not be offset or netted unless a legal right of setoff exists, however.
Thus, current deferred tax assets and current deferred tax liabilities or noncurrent deferred tax assets and noncur
rent tax liabilities should only be offset if they relate to the same tax jurisdictions deferred (e.g., federal taxes) and
to the same taxpaying entity (e.g.,the parent if a parent and subsidiary file separate tax returns). (FASB ASC
74010456) (formerly SFAS 109, par. 42) For example, a tax asset for federal income taxes may not be offset
against a tax liability for state or local income taxes.
Intraperiod Tax Allocation
Intraperiod tax allocation refers to the mechanics of allocating income taxes within a period to income from
continuing operations and to other components of net income and other comprehensive income. Income taxes (tax
benefits) for the year should be allocated to the following components: (FASB ASC 74020052; 74020452)
a. Continuing operations
b. Discontinued operations
c. Extraordinary items
d. Other comprehensive income
e. Items charged or credited directly to stockholders' equity
192
The intraperiod tax allocation method focuses on continuing operations. Income tax expense is calculated on
income from continuing operations and total pretax income to arrive at income tax attributable to continuing
operations and total income tax expense for the period. The difference between those two amounts is allocated to
income from sources other than continuing operations. The amount attributable to continuing operations is the tax
effects of income or loss from continuing operations, plus or minus the following: (FASB ASC 74020458)
(formerly SFAS109, par. 35)
a. Changes in circumstances that cause a change in judgment about the realization of deferred tax assets
in future years
b. Changes in tax laws or rates
c. Changes in tax status
d. Taxdeductible dividends paid to shareholders (except for dividends paid on unallocated shares held by
an employee stock ownership plan or any other stock compensation arrangement)
Certain tax effects should be charged or credited to other comprehensive income or equity rather than the
components of net income, however, since they relate to items charged or credited directly to other comprehensive
income or equity. Examples include the tax effects of the following: (FASB ASC 740204511) (formerly SFAS 109,
par. 36 and EITF 9410)
a. Gains and losses excluded from net income but included in other comprehensive income, such as the
following:
(1) Changes in the fair value of marketable securities classified as available for sale securities
(2) Adjustments from recognizing certain additional pension liabilities
(3) Foreign currency translation adjustments
(4) The effective portion of gains or losses on cash flow hedges
b. Adjustments of the opening balance of retained earnings for certain changes in accounting principles on
the correction of an error
c. An increase or decrease in contributed capital (for example, deductible expenditures reported as a

reduction of the proceeds from issuing capital stock)
d. Expenses for employee share options recognized differently for financial reporting and tax purposes
e. Dividends that are paid on unallocated shares held by an ESOP and that are charged to retained earnings
f. Deductible temporary differences and carryforwards that existed at the date of a quasireorganization
g. Changes in tax bases of assets and liabilities caused by transactions among or with shareholders
(including the effect of valuation allowances initially required upon recognition of the related deferred tax
assets)
Amounts remaining after allocating the tax provision to continuing operations and stockholders' equity are allo
cated to the other components of net income. If there are two or more other components, the remaining tax
provision should be allocated to each item in proportion to their individual effects on net income. The total of the
separately calculated, individual effects of each item may not equal the amount of expense or benefit that remains
after the allocation to continuing operations and equity, however. In those situations, the remaining amount should
be allocated as follows: (FASB ASC 740204514) (formerly SFAS 109, par. 38)
a. Determine the effect on income tax expense or benefit for the year of the total net loss for all net loss items.
193
b. Calculate the effect on income tax expense or benefit of each loss item, and apportion the tax benefit
determined in a. ratably to each loss item in the following ratio:
Tax benefit of each loss category

Total tax benefit for all losses individually
c. Determine the amount that remains, that is, the difference between the amount to be allocated to all items
other than continuing operations and the amount calculated in step a. to obtain the amount to be allocated
to all net gain items.
d. Calculate the effect on income tax expense or benefit of each gain item, and apportion the tax expense
determined in step c. ratably to each gain item in the following ratio:
Tax effect of each gain category

Total taxes for all gains individually
Allocating the Tax Benefits of Loss Carrybacks and Carryforwards. In most cases, the tax benefits of loss
carryforwards or carrybacks should be reported in the same manner as the source of the income or loss in the
current year rather than (a) the source of the operating loss carryforward or taxes paid in a prior year or (b) the
source of expected future income that will result in realization of the loss carryforward's tax benefits. However, the
following are exceptions to that general rule: (FASB ASC 74020453) (formerly SFAS 109, par. 37)
e. The tax effects of deductible differences and carryforwards related to (1) contributed capital, (2) expenses
for employee share options, and (3) dividends paid on unallocated shares held by an ESOP that are
charged to retained earnings should be allocated to the related components of equity.
f. The tax effects of deductible differences and operating losses as of the date of a quasireorganization that
are subsequently recognized generally are reported as an addition to contributed capital.
SPECIAL AREAS
Change in Tax Status
A change in a company's tax status generally occurs when (a) a corporation elects or terminates S corporation
status, (b) a proprietorship or partnership incorporates, or (c) a corporation converts to a partnership or a propri
etorship. If an entity's tax status changes from taxable to nontaxable, existing deferred tax assets and liabilities
should be eliminated through a charge or credit to income tax expense for the period. On the other hand, if an
entity's tax status changes from nontaxable to taxable, deferred tax assets and liabilities should be recorded for the
tax effects of any temporary differences that exist on the date of the change. The effects of a change in tax status
should be recognized in the financial statements at the date the entity either becomes taxable or ceases to be
taxable. A change in tax status resulting from a change in tax law should be recognized in the period the law is
enacted. (For federal tax purposes, that is the date the President signs the law.) A voluntary change in tax status
should be recognized on the date the change is approved by the taxing authority or on the date of filing the election
for change if approval is not necessary. (FASB ASC 740102532 through 2534; 74010406; 740104519)
Multiple Tax Jurisdictions
Deferred taxes should be provided for the tax effects of all federal, state, local, and foreign income taxes to which
the entity is subject. If state or local taxable income is based on taxable income for federal reporting, temporary
differences generally are the same for each jurisdiction. Some state and local laws require taxable income to be
determined differently than for federal tax reporting. For example, they may permit deductions for bad debts based
on the allowance method or require depreciation to be computed differently than for federal reporting. In such
cases, temporary differences and carryforwards may not be the same for each jurisdiction. If the differences are
significant, separate deferred tax computations will be necessary. (FASB ASC 740103012) (formerly SFAS 109,
par. 19)
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Discounting Deferred Taxes
Deferred taxes should not be discounted to reflect the time value of money. (FASB ASC 74010308) (formerly APB
10, par. 6)
Temporary Differences Whose Reversal Is Indefinite
Deferred tax assets and liabilities should not be recognized for the following types of temporary differences unless
it becomes apparent that they will reverse in the foreseeable future: (The exemptions should not be applied to
analogous types of temporary differences.) (FASB ASC 74010253; 74030154) (formerly SFAS 109, par. 31)
a. Temporary difference related to an investment in a foreign subsidiary or foreign corporate joint venture that
is essentially permanent in duration
b. Undistributed earnings of a domestic subsidiary or a domestic corporate joint venture that is essentially
permanent in duration that arose in fiscal years beginning on or before December15,1992
c. Bad debt reserves for tax purposes of U.S. savings and loan associations (and other qualified thrift lenders)
that arose in tax years beginning before December 31, 1987
d. Policyholders' surplus of stock life insurance companies that arose in fiscal years beginning on or before
December 15, 1992
Income Taxes on Intercompany Profits
If the affiliated group files a consolidated tax return (and there are no temporary differences between book and tax
basis), consolidated income is the basis for determining the income tax expense reported on the financial state
ments and on the tax return. Since all intercompany profits and losses are eliminated to arrive at consolidated
income, there is no need to make further adjustments for the tax effect of intercompany transactions. That is, the tax
effects of intercompany transactions may be ignored if a consolidated tax return is filed.
If a parent and subsidiary file separate tax returns rather than a consolidated tax return, the parent or subsidiary's
accounts may include income taxes that were paid on intercompany profits. In such cases, the income taxes
should be deferred, or the intercompany profits eliminated in consolidation should be appropriately reduced.
(FASB ASC 81010458) (formerly ARB 51, par. 17)
Separate Financial Statements of a Subsidiary
Consolidated income tax expense may be allocated among the affiliated entities so that each of the affiliates may
record its share of the consolidated income tax expense on its own books. (The allocation is necessary if separate
financial statements will be prepared for the affiliates.) The allocation method used should be systematic, rational,
and consistent with the liability method of accounting for income taxes. Methods that are not consistent (and thus
prohibited) include the following: (FASB ASC 740103027 and 3028) (formerly SFAS 109, par. 40)
a. A method that allocates only current taxes payable to a member of the group that has taxable temporary
differences
b. A method that allocates deferred taxes to a member of the group using a method fundamentally different
from the asset and liability method
c. A method that allocates no current or deferred tax expense to a member of the group that has taxable
income because the consolidated group has no current or deferred tax expense
A method that allocates current and deferred taxes to members of the group by applying the liability method to
each member as if it were a separate taxpayer is acceptable even though the sum of the individual tax provisions
may not equal the consolidated amount. That is because the difference between the consolidated provision and
the total of the amounts allocated to the separate entities is a result of consolidation and has no effect on the
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consolidated statements. (FASB ASC 740103027) (formerly SFAS 109, par. 40) Exhibit 24 illustrates acceptable
methods of allocating consolidated income tax expense to members of an affiliated group.
Exhibit 2-4
Allocating Consolidated Income Tax Expense to Affiliates
Assume the following:
During 20X5, Parent Company and its wholly owned subsidiary, Sub Co., had pretax income of $250,000 and
$100,000, respectively.
The companies had no deferred tax assets or liabilities at the beginning or end of 20X5.
On December 31, 20X5, Parent Company has inventory on hand that it purchased in 20X5 from Sub Co. at a
profit to Sub Co. of $20,000.
Parent Company and Sub Co. file a consolidated tax return.
Assuming a tax rate of 30%, consolidated income tax expense would be computed as follows:
Reported income from operations before income taxes:

Parent Company $ 250,000
Sub Co. 100,000
350,000
Less intercompany profit in ending inventory (20,000)
Consolidated income before income taxes $ 330,000
Consolidated income tax expense ($330,000 30%) $ 99,000
The following methods of allocating consolidated income tax expense to Parent Company and Sub Co. would be
acceptable: (Other methods that meet the criteria in paragraph would also be acceptable.)
Example Allocation A
An acceptable method would be to allocate current and deferred income taxes to members of the group by
applying the provisions of FASB ASC 740 (formerly SFAS No. 109) to each member as if it were a separate taxpayer.
Under that approach, Parent Company and Sub Co. would record the following amounts of income tax expense on
their books:
Parent Company ($250,00030%) $ 75,000

Sub Co. ($100,000 30%) 30,000
$ 105,000
The difference between the total amounts recorded by the affiliates ($105,000) and consolidated income tax
expense ($99,000) relates to the tax effect of intercompany profits eliminated in consolidation and would be
eliminated by the following entry:
Income taxes payable 6,000

Income tax expense 6,000
To eliminate income taxes on intercompany profit.
Example Allocation B
Another acceptable method would be to apportion the $99,000 consolidated tax provision in the ratio of the income
taxes computed separately for each affiliate as follows:
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Taxes Allocated
Computed Percent Tax
Separately of Total Amount
Parent Company $ 75,000 71.4 % $ 70,686

Sub Co. 30,000 28.6 % 28,314
$ 105,000 100.0 % $ 99,000
* * *
Interim Period Financial Statements
The basic premise underlying GAAP for interim periods is that interim periods are an integral part of an annual
period, and annual results should be allocated to interim periods. (Certain revenues and expenses directly related
to a specific interim period, including items such as significant unusual or infrequently occurring items, extraordi
nary items, and discontinued operations, should be reported in the interim period in which they occur rather than
prorated over the balance of the fiscal year, however.) Under that view, interim income tax provisions related to
ordinary income or loss (that is, income or loss from continuing operations before income taxes, excluding unusual
or infrequently occurring items) are determined using an estimated annual effective tax rate (or tax benefit rate) that
is based on estimated annual results. And the tax effects of unusual or infrequently occurring items, extraordinary
items, and discontinued operations are recorded in the period they occur. (FASB ASC 740270252; 740270302
through 304) (formerly APB 28, par. 19 and FIN 18, par. 6) Interim tax effects of ordinary income or loss are
determined as follows: (FASB ASC 740270305 and 306) (formerly FIN 18, paras. 89)
a. Estimate ordinary income or loss for the year and calculate the related income tax provision.
b. Determine the estimated annual effective tax rate (or tax benefit rate) by dividing the estimated income tax
provision for the year by estimated ordinary income or loss for the year.
c. Determine the yeartodate tax provision or benefit by multiplying yeartodate ordinary income or loss by
the estimated annual effective tax rate.
d. Subtract the tax provision related to ordinary income or loss through the preceding interim period from the
provision calculated in step c. to determine the tax effect to report in the current interim period.
Certain limitations apply when an ordinary loss is expected for the year, however. The following must be considered
when calculating interim income taxes and an ordinary loss is expected for the year: (FASB ASC 7402703026 and
3028) (formerly FIN 18, paras.1213)
a. If there is yeartodate ordinary income, yeartodate taxes are calculated by multiplying the yeartodate
ordinary income by the estimated annual tax benefit rate.
b. If there is a yeartodate ordinary loss that is less than the estimated ordinary loss for the year, a deferred
tax asset should be recognized at the interim date if the tax benefits of the loss are expected to be
recognizable as a deferred tax asset at the end of the year. That limitation is accomplished by reflecting the
tax effect of the expected yearend valuation allowance in the effective tax rate.
c. If there is a yeartodate ordinary loss that exceeds the estimated ordinary loss for the year, the yeartodate
tax benefit is the lesser of (1) the amount calculated by applying the estimated annual tax benefit rate to
the yeartodate ordinary loss or (2) the tax benefit obtained by applying the estimated annual tax benefit
rate to ordinary income for the remainder of the year that is more likely than not plus the tax benefit of the
excess loss that can be carried back to taxable income of prior years and the tax benefit of any remaining
excess loss that is recognizable as a deferred tax asset at the end of the year. That limitation is
accomplished by substituting the yeartodate ordinary loss for the estimated annual ordinary loss.
Changes in Tax Rates or New Tax Legislation. Deferred tax assets and liabilities in both annual and interim
financial statements should be adjusted for the effects of changes in tax laws or rates in the period that includes the
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enactment date, that is, for federal tax purposes, the period in which the President signs the legislation and it
becomes law. (FASB ASC 740270255) (formerly APB 28, par. 20) (For example, the President signed the
Revenue Reconciliation Act of 1993 on August 10, 1993. Although many provisions of the Act were effective
retroactively to the beginning of 1993, deferred tax assets and liabilities should have been adjusted for the effects
of the change in tax law during the period that included August 10, 1993.) Thus, in any interim period that includes
a change, the tax provision or benefit generally should be computed by (a)recomputing the estimated annual
effective tax rate based on the newly enacted laws, (b) computing the yeartodate tax provision or benefit based on
the new estimated annual effective tax rate, and (c) subtracting the yeartodate tax provision or benefit from the
provision or benefit reported through the end of the preceding interim period.
Uncertainty in Income Taxes. If a tax position does not initially meet the morelikelythannot threshold for
recognition, it should be recognized in the first interim period that any of the described criteria noted in that
paragraph are met. A change in judgment that results in the subsequent recognition, derecognition, or change in
measurement of a tax position taken in a prior interim period within the same fiscal year should be accounted for.
FASB ASC 74010258; 740270356) (formerly FIN 48, paras. 10 and 14)
Accounting for Investment Tax Credits
Two methods of accounting for investment tax credits (ITC) are commonly used the flowthrough method, in
which the benefits of ITC are recognized in income in the period the qualifying property is acquired, and the deferral
method, in which the benefits of ITC are amortized over the life of the qualifying property. Although the flowthrough
method is conceptually more consistent with GAAP for accounting for income taxes, either method may be used.
Uncertainty in Income Taxes
Tax positions represent positions taken in a previously filed return or expected to be taken in a future return that are
reflected in current or deferred income tax assets and liabilities. As a result of a tax position, taxes payable might be
permanently reduced, a current payable may be deferred to a future year, or the realizability of a deferred tax asset
may be changed. A tax position might also include (FASB ASC 7401020) (formerly FIN 48, par. 4)
a. How income is characterized or the decision to exclude income in a tax return
b. Decisions to classify transactions, entities, or other positions as tax exempt
c. Allocations or shifts of income between jurisdictions
d. Decisions not to file a return
e. Status as a passthrough entity or a taxexempt notforprofit entity
Passthrough entities and taxexempt notforprofit entities may have tax positions that require evaluation of uncer
tainty. For example, a tax position might be the entity's status as a passthrough entity. Another tax position could
be the determination of whether the passthrough entity has nexus in jurisdictions where it has income. For
taxexempt entities, a tax position might involve unrelated business income subject to income taxes. For such
entities, accounting for uncertainty depends on whether the laws and regulations of the tax jurisdiction attribute
income taxes to the entity or its owners (i.e., that consideration affects whether related tax effects should be treated
as taxes of the entity or transactions with owners). (FASB ASC 7401055223 through 55228)
Accounting Standards Update 200906, Implementation Guidance on Accounting for Uncertainty in Income Taxes
and Disclosure Amendments for Nonpublic Entities, amended the FASB Accounting Standards Codification to
provide the preceding guidance on uncertainty in income taxes for passthrough and taxexempt notforprofit
entities. The guidance was effective for periods ending after September 15, 2009, for entities that have already
adopted the accounting requirements for uncertain tax positions. For nonpublic entities that have not adopted the
accounting requirements for uncertain tax positions, the guidance is effective for fiscal years beginning after
December 15, 2008 (concurrent with the adoption of those accounting requirements).
198
The financial statement effect of a tax position should be recognized when it is more likely than not that the position
will be sustained upon examination by a taxing authority, including the resolution of related appeals or litigation. A
likelihood of more than 50 percent should be applied to the meaning of more likely than not. This determination
should be based on the technical merits of the tax position and the facts, circumstances, and information available
as of the reporting date. (FASB ASC 74010256) (formerly FIN 48, par. 6) Tax positions that meet the morelikely
thannot recognition threshold should be initially and subsequently measured at the largest amount of tax benefit
that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the taxing authority.
(FASB ASC 74010307) (formerly FIN 48, par. 8)
If a tax position is not recognized in the period taken or expected to be taken because it does not meet the
morelikelythannot recognition threshold, it should be recognized in the first period in which one of the following
three conditions is met: (FASB ASC 74010258) (formerly FIN 48, par. 10)
a. The morelikelythannot threshold is met by the reporting date;
b. The tax position is effectively settled through examination, negotiation, or litigation; or
c. The statute of limitations has expired.
When determining whether a tax position is effectively settled, the following conditions should be evaluated: (FASB
ASC 740102510) (formerly FIN 48, par. 10A)
a. The taxing authority has completed its examination procedures, including appeals and administration
reviews, which are required and expected to be performed for the tax position.
b. The entity does not intend to appeal or litigate any aspect of the tax position that was part of the examination.
c. The possibility of examination or reexamination of the tax position by the taxing authority is remote.
When an entity becomes aware that a taxing authority may examine, reexamine, appeal, or litigate a tax position
that was previously considered to be effectively settled, the tax position should be reevaluated. (FASB ASC
74010403) (formerly FIN 48, par. 10B)
A tax position should be derecognized in the period when it no longer meets the morelikelythannot threshold. A
valuation allowance cannot be used as a replacement for derecognition. (FASB ASC 74010402) (formerly FIN 48,
par. 11)
If interest would be paid on any tax underpayment that might result from a tax position, the interest should be
accrued starting in the first period it would begin accruing under the tax law. The amount that should be recognized
is computed by multiplying the applicable interest rate times the difference between the recognized tax benefit and
the position taken or expected to be taken in the tax return. Similarly, if a position not sustained would result in
assessment of a penalty, an expense for the statutory amount of the penalty should be recognized in the period in
which the entity claims or expects to claim the tax position. If a change in judgment, including a change in
determining whether the position meets the morelikelythannot threshold, occurs that affects the amount of
interest or penalty that should be recognized, the amount should be adjusted in the period in which the change
occurs. Interest may be classified as either income taxes or interest expense. Penalties may be classified as either
income taxes or another expense. The classification is an accounting policy decision that should be disclosed.
(FASB ASC 740102556 and 2557; 740103029; 74010353; 74010405; 740104525) (formerly FIN 48,
paras. 13, 15, 16, and 19)
A liability should be recognized (or a net operating loss carryforward or refund reduced) for unrecognized tax
benefits of a tax position. The amount should be classified as a current liability if payment is expected within one
year. A recognized tax position may affect the tax bases of assets and liabilities and the resulting temporary
differences. A liability should not be classified as a deferred tax liability unless it arises from a taxable temporary
difference. (FASB ASC 740102516 and 2517; 740104512) (formerly FIN 48, paras. 1718)
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The following information about income taxes should be disclosed:
Accounting policies
a. Types of temporary differences and carryforwards that result in significant portions of deferred tax assets
or liabilities (Public companies must disclose the approximate tax effect, before allocation of valuation
allowances, of each type.) (FASB ASC 74010506; 74010508) (formerly SFAS 109, par.43)
b. For a public company not subject to income taxes because its income is taxed directly to its owners, that
fact and the net difference between the tax and financial bases of its assets and liabilities (FASB ASC
c. Method of accounting for the investment tax credit (if applicable) and amounts involved (when material)
Deferred tax assets and liabilities (FASB ASC 74010502; 74030502; 942740501; 944740501;
995740502) (formerly SFAS 109, paras. 4344)
d. Total of all deferred tax liabilities
e. Total of all deferred tax assets
f. Total valuation allowance recognized for deferred tax assets
g. Net change during the year in the total valuation allowance
h. If a deferred tax liability is not recognized because of the exceptions discussed above
(1) a description of the types of temporary differences for which a deferred tax liability has not been
recognized and the types of events that would cause the temporary differences to become taxable
(2) the cumulative amount of each type of temporary difference
(3) the amount of the unrecognized deferred tax liability for temporary differences related to investments
in foreign subsidiaries and foreign corporate joint ventures that are essentially permanent in duration
if determination of that liability is practicable (or a statement that determination is not practicable)
(4) the amount of the unrecognized deferred tax liability for temporary differences related to undistributed
domestic earnings, the baddebt reserve for tax purposes of a U.S. savings and loan association or
other qualified thrift lender, the policyholders' surplus of a life insurance enterprise, and the statutory
reserve funds of a U.S. steamship enterprise
Income tax expense (FASB ASC 74010509 and 5010; 740105012 and 5013) (formerly SFAS 109,
paras. 4547)
i. Significant components of income tax expense attributable to continuing operations for each year
presented, including, for example
(1) current income tax expense or benefit
(2) deferred tax expense or benefit (excluding the effects of other components listed below)
(3) investment tax credits
(4) government grants (to the extent recognized as a reduction of income tax expense)
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(5) benefits of operating loss carryforwards
(6) tax expense that results from allocating certain tax benefits directly to contributed capital
(7) adjustments of deferred tax assets or liabilities for enacted changes in tax laws or rates or a change
in a company's tax status
(8) adjustments of the beginningoftheyear balance of a valuation allowance because of a change in

circumstances that causes a change in judgment about the realizability of the related deferred tax
asset in future years
j. For each year presented, income tax expense or benefit allocated to (1) continuing operations, (2)
discontinued operations, (3) extraordinary items, (4) other comprehensive income, and (5) items charged
or credited directly to stockholders' equity
k. Significant reconciling items between income tax expense attributable to continuing operations for the year
and the amount of income tax expense that would result from applying domestic federal statutory rates to
pretax income from continuing operations (Public companies must present a numerical reconciliation
using either percentages or dollar amounts.)
Other disclosures
l. Amounts and expiration dates of operating loss and tax credit carryforwards for tax purposes (FASB ASC
m. Any portion of the valuation allowance for deferred tax assets for which subsequently recognized tax
benefits will be credited directly to contributed capital (FASB ASC 74010503) (formerly SFAS 109, par.
48)
n. In the separately issued financial statements of an entity that is part of a group that files a consolidated tax
return (FASB ASC 740105017) (formerly SFAS 109, par. 49)
(1) the aggregate amount of current and deferred tax expense for each income statement presented
(2) the amount of any taxrelated balances due to or from affiliates as of the date of each balance sheet
presented
(3) the principal provisions of the method by which the consolidated amount of current and deferred tax
expense is allocated to members of the group
(4) the nature and effect of any changes in the method of allocating current and deferred tax expense to
members of the group and in determining the related balances due to or from affiliates during each
year for which the disclosures in (1) and (2) are presented
o. Policy for classifying interest and penalties recognized in the financial statements that are associated with
tax positions (FASB ASC 740105019) (formerly FIN 48, par. 20)
p. At the end of each annual reporting period (FASB ASC 740105015) (formerly FIN 48, par. 21)
(1) For public entities a tabular reconciliation of the total amounts of unrecognized tax benefits at the
beginning and end of the period, including at a minimum the gross increases and decreases as a
result of tax positions taken during a prior period, the gross increases and decreases as a result of
tax positions taken during the current period, the decreases relating to settlements with taxing
authorities, and reductions as a result of a lapse of the applicable statute of limitations
(2) For public entities the total amount of unrecognized tax benefits that, if recognized, would affect the
effective tax rate
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(3) The total amounts of interest and penalties recognized in the statement of operations and statement
of financial position
(4) For positions for which it is reasonably possible that the total amounts of unrecognized tax benefits
will significantly increase or decrease within 12 months of the reporting date, the nature of the
uncertainty, the nature of the event that could occur in the next 12 months that would cause the
change, and an estimate of the range of the reasonably possible change or a statement that such an
estimate cannot be made
(5) A description of tax years that remain subject to examination by major tax jurisdictions
q. If application of the accounting requirements for uncertain tax positions has been deferred by a nonpublic
entity, that fact and the accounting policy for evaluating uncertain tax positions for each set of financial
statements where the deferral applies (FASB ASC 74010651) (formerly FSP FIN 483, par. 10)
r. Nature and effect of any other significant matters affecting comparability of information for all periods
presented, if not otherwise apparent from the preceding disclosures (FASB ASC 740105014) (formerly
SFAS 109, par. 47)
s. For nonpublic entities that used the minimum value method in SFAS No. 123, the amount of a material
income tax benefit realized from the exercise of employee stock options that is credited to equity but not
presented as a separate line item in the statement of cash flows or in the statement of changes in
stockholders' equity (Grandfathered) (formerly EITF 0015)
t. Any change in the accounting policy for income tax benefits of dividends on sharebased payment awards
when adopting the requirement to treat such benefits as an increase in additional paidin capital (FASB ASC
718740501) (formerly EITF 0611)
u. A change in the entity's tax status that becomes effective after yearend but before the financial statements
are issued or available to be issued. (FASB ASC 74010504) (formerly QA 109, par. 11)
In addition, the statement of cash flows should disclose the amount of income taxes paid during the period (a) as
a separate class of operating cash payments if the direct method of reporting cash flows from operating activities
is used or (b) as a separate item outside the statement if the indirect method of reporting cash flows from operating
activities is used. (FASB ASC 230104525; 23010502) (formerly SFAS 95, paras. 27 and 29)
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SELFSTUDY QUIZ
following section.
25. A deferred tax asset or liability should be recognized at the end of each year for all the following except:
a. All taxable and nondeductible temporary differences.
b. All taxable and deductible temporary differences.
c. Operating loss carryforwards for tax reporting purposes.
d. Tax credit carryforwards.
26. Currently, personal service corporations with taxable income over $18,333,333 are taxed at:
a. A flat rate of 34%.
b. A flat rate of 35%.
c. A flat rate of 36%.
d. A graduated rate of 15% to 39%.
27. Corporations are required by current federal income tax law to compute taxes under the regular and alternative
minimum tax (AMT) systems. The tax due for the year is based on which of the following?
a. The smaller of the two calculations.
b. The larger of the two calculations.
c. Whichever of the two calculations the corporation chooses to use.
28. Which of the following actions should be taken regarding changes in future tax rates?
a. Deferred tax calculations do not need to consider future changes in tax rates.
b. Deferred tax calculations should consider changes in tax rates enacted after the balance sheet date.
c. The effects of changes in tax rates should be recognized in the year tax law changes are enacted.
29. Which of the following calculations is invalid in determining deferred tax expense or benefit?
a. Aggregate the deferred tax assets and liabilities for all tax jurisdictions at the beginning of the year.
b. Aggregate the deferred tax assets and liabilities for all tax jurisdictions at midyear.
c. Aggregate the deferred tax assets and liabilities for all tax jurisdictions at the end of the year.
d. Record the difference between the amounts calculated as the deferred tax expense or benefit.
30. Deferred tax assets and liabilities associated with particular assets and liabilities for financial reporting should
be:
a. Classified the same as those assets and liabilities.
b. Classified as current according to the reversal dates of the temporary differences or carryforwards.
c. Classified as noncurrent according to the reversal dates of the temporary differences or carryforwards.
203
31. Intraperiod tax allocation, the mechanics of allocating income taxes within a period, focuses on which of the
following?
a. Items charged or credited directly to stockholders' equity.
b. Other comprehensive income.
c. Continuing operations.
d. Extraordinary items.
32. The tax effects of which of the following should not be charged or credited to other comprehensive income or
equity instead of to the components of net income?
a. Gains and losses excluded from net income but included in other comprehensive income.
b. An increase or decrease in contributed capital.
c. Dividends that are paid on allocated shares that are held by an ESOP and that are changed to retained
earnings.
d. Expenses for employee share options recognized differently for financial reporting and tax purposes.
33. Generally, the tax benefits of loss carryforwards or carrybacks should be reported in the same manner as:
a. The source of expected future income that will result in realization of the loss carryforward's tax benefits.
b. The source of the income or loss in the current year.
c. The source of the operating loss carryforward or taxes paid in a prior year.
34. Deferred taxes should be provided for the tax effects of to which the entity is subject.
a. All federal income taxes.
b. All federal and state income taxes.
c. All federal, state, and local income taxes.
d. All federal, state, local, and foreign income taxes.
35. Deferred tax assets and liabilities should be recognized for which of the following types of temporary
differences?
is generally permanent in duration.
permanent in duration that arose in fiscal years beginning on or before December 15, 1992.
c. Bad debt reserves for tax purposes of U.S. savings and loan associations, including other qualified thrift
lenders, that arose in tax years beginning January 1, 1988.
d. Policy holders' surplus of stock life insurance companies that arose in fiscal years beginning on or before
December 15, 1992.
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36. Consolidated income tax expense may be allocated among the affiliated entities so that each affiliate may
record its share of the consolidated income tax expense on its own books. Which of the following allocation
methods is consistent with the liability method of accounting for income taxes?
differences.
from the asset and liability method.
c. A method that allocates current and deferred taxes to members of the group by applying the liability
method to each member as if it were a separate taxpayer.
d. A method that allocates no current or deferred tax expense to a member of the group that has taxable
income because the consolidated group has no current or deferred tax expense.
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SELFSTUDY ANSWERS
25. A deferred tax asset or liability should be recognized at the end of each year for all the following except:
(Page 186)
a. All taxable and nondeductible temporary differences. [This answer is correct. A deferred tax asset
or liability should not be recognized at the end of each year for nondeductible temporary differences
according to FASB ASC 740102529; 74010305 (formerly SFAS 109, paras. 1617).]
b. All taxable and deductible temporary differences. [This answer is incorrect. Per FASB ASC 740102529;
74010305 (formerly SFAS 109, paras. 1617), a deferred tax asset or liability should be recognized at
the end of each year for all taxable and deductible temporary differences.]
c. Operating loss carryforwards for tax reporting purposes. [This answer is incorrect. A deferred tax asset or
liability should be recognized at the end of each year for operating loss carryforwards for tax reporting
purposes per FASB ASC 740102529; 74010305 (formerly SFAS 109, paras. 1617).]
d. Tax credit carryforwards. [This answer is incorrect. Tax credit carryforwards is an example of a deferred tax
asset or liability that should be recognized at the end of each year per FASB ASC 740102529;
74010305 (formerly SFAS 109, paras. 1617).]
26. Currently, personal service corporations with taxable income over $18,333,333 are taxed at: (Page 186)
a. A flat rate of 34%. [This answer is incorrect. Corporations with taxable income between $335,000 and $10
million are taxed at a flat rate of 34% as cited in FASB ASC 74010309 (formerly SFAS 109, par. 18).]
b. A flat rate of 35%. [This answer is correct. Personal service corporations and corporations with
taxable income over $18,333,333 are taxed at a flat rate of 35% per FASB ASC 74010309 (formerly
SFAS 109, par. 18.]
c. A flat rate of 36%. [This answer is incorrect. Current federal tax law does not have a flat rate of 36% per FASB
ASC 74010309 (formerly SFAS 109, par.18).]
d. A graduated rate of 15% to 39%. [This answer is incorrect. Other corporations are subject to a graduated
rate structure that imposes rates ranging from 15% to 39% on various levels of taxable income per FASB
27. Corporations are required by current federal income tax law to compute taxes under the regular and alternative
minimum tax (AMT) systems. The tax due for the year is based on which of the following? (Page 187)
a. The smaller of the two calculations. [This answer is incorrect. When a corporation computes taxes under
the regular and AMT systems, the tax due for the year is not the smaller of the two calculations based on
current tax law.]
b. The larger of the two calculations. [This answer is correct. Income tax law requires a corporation
to use whichever calculation (regular or AMT) is the larger of the two in determining the tax due for
the year.]
c. Whichever of the two calculations the corporation chooses to use. [This answer is incorrect. A corporation
cannot choose whichever of the two calculations (regular or AMT system) they wish to use to determine
the tax due for the year pursuant to current federal income tax law.]
206
28. Which of the following actions should be taken regarding changes in future tax rates? (Page 187)
a. Deferred tax calculations do not need to consider future changes in tax rates. [This answer is incorrect.
Deferred tax calculations should consider future changes in tax rates in accordance with FASB ASC
74010308 and 309; 74010354; 740104515 (formerly SFAS 109, paras. 18 and 27).]
b. Deferred tax calculations should consider changes in tax rates enacted after the balance sheet date. [This
answer is incorrect. Deferred tax calculations should not consider changes in tax rates enacted after the
balance sheet date per FASB ASC 74010308 and 309; 74010354; 740104515 (formerly SFAS 109,
paras. 18 and 27).]
c. The effects of changes in tax rates should be recognized in the year tax law changes are enacted.
[This answer is correct. The effects of changes in tax rates should be recognized in the year tax law
changes are enacted since deferred tax calculations are based on tax law changes enacted at the
balance sheet date as detailed in FASB ASC 74010308 and 309; 74010354; 740104515
(formerly SFAS 109, paras. 18 and 27.]
29. Which of the following calculations is invalid in determining deferred tax expense or benefit? (Page 188)
a. Aggregate the deferred tax assets and liabilities for all tax jurisdictions at the beginning of the year. [This
answer is incorrect. Per FASB ASC 74010304 (formerly SFAS 109, par. 16), aggregate the deferred tax
assets and liabilities for all tax jurisdictions at the beginning of the year is one of the calculations necessary
to determine the deferred tax expense or benefit.]
b. Aggregate the deferred tax assets and liabilities for all tax jurisdictions at midyear. [This answer is
correct. The difference between the amounts calculated as the deferred tax expense or benefit for
the year determines the deferred tax expense or benefit. Deferred tax assets and liabilities at
midyear will not facilitate such a calculation per FASB ASC 74010304 (formerly SFAS 109, par.
16.]
c. Aggregate the deferred tax assets and liabilities for all tax jurisdictions at the end of the year. [This answer
is incorrect. Aggregate the deferred tax assets and liabilities for all tax jurisdictions at the end of the year
is another of the calculations necessary to determine the deferred tax expense or benefit per FASB ASC
d. Record the difference between the amounts calculated as the deferred tax expense or benefit. [This answer
is incorrect. Once the deferred tax assets and liabilities for all tax jurisdictions have been aggregated, the
difference between the two amounts determines the deferred tax expense or benefit as cited in FASB ASC
30. Deferred tax assets and liabilities associated with particular assets and liabilities for financial reporting should
be: (Page 191)
a. Classified the same as those assets and liabilities. [This answer is correct. Deferred tax assets and
liabilities associated with particular assets and liabilities for financial reporting should be classified
the same as those assets and liabilities per FASB ASC 74010454; 74010459 (formerly SFAS 109,
par. 41).]
b. Classified as current according to the reversal dates of the temporary differences or carryforwards. [This
answer is incorrect. Deferred tax assets and liabilities associated with particular assets and liabilities for
financial reporting should be classified as current, as applicable, according to the reversal dates of the
temporary differences or carryforwards per FASB ASC 74010454; 74010459 (formerly SFAS 109, par.
41).]
c. Classified as noncurrent according to the reversal dates of the temporary differences or carryforwards.
[This answer is incorrect. Deferred tax assets and liabilities associated with particular assets and liabilities
for financial reporting should be classified as noncurrent, as applicable, according to the reversal dates
207
of the temporary differences or carryforwards per FASB ASC 74010454; 74010459 (formerly SFAS
109, par. 41).]
31. Intraperiod tax allocation, the mechanics of allocating income taxes within a period, focuses on which of the
following? (Page 192)
a. Items charged or credited directly to stockholders' equity. [This answer is incorrect. Interperiod tax
allocation does not focus on items charged or credited directly to stockholders' equity. However tax
benefits for the year should be allocated to a number of components, one example is items charged or
credited directly to stockholders' equity per FASB ASC 740204511 (formerly SFAS 109, par. 36).]
b. Other comprehensive income. [This answer is incorrect. Interperiod tax allocation does not focus on other
comprehensive income, although other comprehensive income is one of several components that income
taxes for the year should be allocated to per FASB ASC 74020458 (formerly SFAS 109, par. 35).]
c. Continuing operations. [This answer is correct. The interperiod tax allocation method focuses on
continuing operations. Income tax expense is determined based on income from continuing
operations and total pretax income to determine income tax attributable to continuing operations
and total income tax expense for the period. The difference between those two amounts is
distributed to income from other sources besides continuing operations.]
d. Extraordinary items. [This answer is incorrect. Extraordinary items are not the component that the
intraperiod tax allocation method focuses on per FASB ASC 74020458 (formerly SFAS 109, par. 35).
They are, however, one of several component that income taxes (tax benefits) for the year should be
allocated to.]
32. The tax effects of which of the following should not be charged or credited to other comprehensive income or
equity instead of to the components of net income? (Page 193)
a. Gains and losses excluded from net income but included in other comprehensive income. [This answer
is incorrect. Tax effects of gains and losses excluded from net income but included in other comprehensive
income should be charged or credited to other comprehensive income or equity. One example is foreign
currency translation adjustments per FASB ASC 740204511 (formerly SFAS 109, par. 36).]
b. An increase or decrease in contributed capital. [This answer is incorrect. Tax effects of an increase or
decrease in contributed capital should be charged or credited to other comprehensive income or equity,
for example, deductible expenditures reported as a reduction of the proceeds from issuing capital stock
per FASB ASC 740204511 (formerly SFAS 109, par. 36).]
c. Dividends that are paid on allocated shares that are held by an ESOP and that are changed to
retained earnings. [This answer is correct. Dividends that are paid on allocated shares that are held
by an ESOP and that are charged to retained earnings should be charged or credited to other
comprehensive income or equity instead of to the components of net income. Dividends that are
paid on unallocated shares should be charged to retained earnings per FASB ASC 740204511
d. Expenses for employee share options recognized differently for financial reporting and tax purposes. [This
answer is incorrect. Tax effects of expenses for employee share options recognized differently for financial
reporting and tax purposes should be charged or credited to other comprehensive income or equity per
FASB ASC 740204511 (formerly SFAS 109, par. 36).]
33. Generally, the tax benefits of loss carryforwards or carrybacks should be reported in the same manner as:
(Page 194)
a. The source of expected future income that will result in realization of the loss carryforward's tax benefits.
[This answer is incorrect. Per FASB ASC 74020453 (formerly SFAS 109, par. 37) there are exceptions,
but in most cases the tax benefits of loss carryforwards or carrybacks should not be reported in the same
208
manner as the source of expected future income that will result in realization of the loss carryforward's tax
benefits.]
b. The source of the income or loss in the current year. [This answer is correct. The general rule is that
the tax benefits of loss carryforwards or carrybacks should be reported in the same manner as the
source of the income or loss in the current year. One exception to that general rule is when
deductible differences and operating losses as of the date of a quasireorganization that are
subsequently recognized generally are reported as an addition to contributed capital per FASB ASC
c. The source of the operating loss carryforward or taxes paid in a prior year. [This answer is incorrect.
Although, under certain circumstances, the tax benefits of loss carryforwards or carrybacks may be
reported in the same manner as the source of expected future income that will result in realization of the
loss carryforward's tax benefit, generally it will not as indicated in FASB ASC 74020453 (formerly SFAS
109, par. 37).]
34. Deferred taxes should be provided for the tax effects of to which the entity is subject.
(Page 194)
a. All federal income taxes. [This answer is incorrect. Deferred taxes should be provided for the tax effects
of more than just all federal income taxes to which the entity is subject per FASB ASC 740103012
b. All federal and state income taxes. [This answer is incorrect. Deferred taxes should be provided for the tax
effects of more than just all federal and state income taxes to which the entity is subject per FASB ASC
c. All federal, state, and local income taxes. [This answer is incorrect. Deferred taxes should be provided for
the tax effects of more than just all federal, state, and local income taxes to which the entity is subject per
FASB ASC 740103012 (formerly SFAS 109, par. 19).]
d. All federal, state, local, and foreign income taxes. [This answer is correct. Deferred taxes should be
provided for the tax effects of all federal, state, local, and foreign income taxes to which the entity
is subject as cited in FASB ASC 740103012 (formerly SFAS 109, par. 19).]
35. Deferred tax assets and liabilities should be recognized for which of the following types of temporary
differences? (Page 195)
is generally permanent in duration. [This answer is incorrect. Per FASB ASC 74010253; 74030154
(formerly SFAS 109, par. 31), deferred tax assets and liabilities should not be recognized for temporary
difference related to an investment in a foreign subsidiary or foreign corporate joint venture that is generally
permanent in duration.]
permanent in duration that arose in fiscal years beginning on or before December 15, 1992. [This answer
is incorrect. Per FASB ASC 74010253; 74030154 (formerly SFAS 109, par. 31), deferred tax assets and
liabilities should not be recognized for undistributed earnings of a domestic subsidiary or a domestic
corporate joint venture that is essentially permanent in duration that arose in fiscal years beginning on or
before December 15, 1992.]
c. Bad debt reserves for tax purposes of U.S. savings and loan associations, including other qualified
thrift lenders, that arose in tax years beginning December 31, 1987. [This answer is correct. Per
FASB ASC 74010253; 74030154 (formerly SFAS 109, par. 31), deferred tax assets and liabilities
should be recognized for bad debt reserves for tax purposes of U.S. savings and loan associations,
including other qualified thrift lenders, that arose in tax years beginning December 31, 1987.]
209
d. Policy holders' surplus of stock life insurance companies that arose in fiscal years beginning on or before
December 15, 1992. [This answer is incorrect. Deferred tax assets and liabilities should not be recognized
for policy holders' surplus of stock life insurance companies that arose in fiscal years beginning on or
before December 15, 1992 per FASB ASC 74010253; 74030154 (formerly SFAS 109, par. 31).]
36. Consolidated income tax expense may be allocated among the affiliated entities so that each affiliate may
record its share of the consolidated income tax expense on its own books. Which of the following allocation
methods is consistent with the liability method of accounting for income taxes? (Page 195)
differences. [This answer is incorrect. A method that allocates only current taxes payable to a member of
the group that has taxable temporary differences is not consistent with the liability method of accounting
for income taxes per FASB ASC 740103027 and 3028 (formerly SFAS 109, par. 40).]
from the asset and liability method. [This answer is incorrect. A method that allocates deferred taxes to a
member of the group using a method fundamentally different from the asset and liability method is not
consistent with the liability method of accounting for income taxes per FASB ASC 740103027 and 3028
c. A method that allocates current and deferred taxes to members of the group by applying the liability
method to each member as though it were a separate taxpayer. [This answer is correct. A method
that allocates current and deferred taxes to members of the group by applying the liability method
to each member as though it were a separate taxpayer is acceptable even though the sum of the
individual tax provisions do not always equal the consolidated amount per FASB ASC 740103027
and 3028 (formerly SFAS 109, par. 40).]
d. A method that allocates no current or deferred tax expense to a member of the group that has taxable
income because the consolidated group has no current or deferred tax expense. [This answer is incorrect.
Per FASB ASC 740103027 and 3028 (formerly SFAS 109, par. 40), a method that allocates no current
or deferred tax expense to a member of the group that has taxable income because the consolidated group
has no current or deferred tax expense is not consistent with the liability method of accounting for income
taxes.]
210
RESEARCH AND DEVELOPMENT

OVERVIEW
Research and development costs should be charged to expense when incurred. If an entity obtains funding for its
research and development through arrangements with others, the nature of its obligation under the arrangement
determines the accounting. To the extent the entity is obligated to repay the other parties, it should record a liability
for its obligation to repay and charge research and development costs to expense as they are incurred. If the entity
is not obligated to repay the other parties, regardless of the results of the research and development, its obligation
under the arrangement should be accounted for as a contract to provide research and development services for
others.
DEFINITION OF RESEARCH AND DEVELOPMENT ACTIVITIES
Research is defined as an entity's efforts to discover information that will be useful in developing a new product,
service, process, or technique or in significantly improving an existing product or process. Development involves
converting research into a plan to create or significantly improve a product, service, process, or technique.
Development activities include conceptualizing, designing, and testing product alternatives, constructing proto
types, and operating pilot plants. They do not include routine improvements to existing products and operations,
however, nor do they include market research activities. (FASB ASC 73010154) (formerly SFAS 2, par. 8)The
following activities typically are considered research and development activities: (FASB ASC 73010551) (formerly
SFAS 2, par. 9 and SFAS 86, par. 50)
a. Laboratory research aimed at discovering new knowledge
b. Searching for ways to apply new research findings or other knowledge
c. Conceptualizing and designing product or process alternatives
d. Evaluating product or process alternatives
e. Modifying the concept or design of a product or process
f. Designing, constructing, and testing preproduction prototypes and models
g. Designing tools, jigs, molds, and dies involving new technology
h. Designing, constructing, and operating a pilot plant (so long as the plant is not of a scale that is
economically feasible to the entity for commercial production)
i. Engineering activity to advance the product's design to the point of manufacture
j. Tools used to facilitate research and development or components of a product or process undergoing
research and development
Conversely, the following activities usually are not considered research and development activities: (FASB ASC
a. Engineering followthrough in an early phase of commercial production
b. Quality control during commercial production
c. Troubleshooting in connection with breakdowns during commercial production
211
d. Routine efforts to improve the quality of an existing product
e. Adapting an existing capability to a specific requirement or customer need as part of a continuing

commercial activity
f. Seasonal or periodic changes to existing products
g. Routine design of tools, jigs, molds, and dies
h. Constructing, relocating, rearranging, or starting facilities or equipment other than pilot plants or facilities
or equipment whose sole use is for a particular research and development project
i. Legal work in connection with patent applications, patent defense, or patent sale or licensing
ACCOUNTING FOR RESEARCH AND DEVELOPMENT COSTS
Research and development costs include the following:
a. Intangibles purchased from others
b. Materials, equipment, and facilities acquired or constructed for a particular research and development
project
c. Salaries and related costs of personnel engaged in research and development activities
d. Services performed by others in connection with research and development
e. Reasonable allocations of indirect costs (except general and administrative costs not clearly related to
research and development activities)
Generally, research and development costs should be charged to expense when incurred rather than recorded as
inventory, elements of overhead, or otherwise deferred to future periods. However, materials, equipment, and
facilities should be capitalized and depreciated over their useful lives if they have alternative future uses (including
use in other research and development projects). Depreciation expense related to capitalized research and
development costs should be considered a research and development cost. (FASB ASC 73010251 and 252)
(formerly SFAS 2, paras.1112) Intangibles purchased from others for use in research and development that have
alternative future uses should be capitalized and amortized over their useful lives or not amortized if their lives are
indefinite. (FASB ASC 73010252) (formerly SFAS 2, par. 11)
Research and development assets acquired in a business combination or in an acquisition of a business or

nonprofit activity by a notforprofit entity should be recorded at fair value using the acquisition method. Intangible
research and development assets should be accounted for as indefinitelived intangibles until the related research
and development efforts are completed or abandoned. During that period, the assets should not be amortized but
should be tested for impairment at least annually. When the research and development efforts are completed or
abandoned, the costs should be written off or amortized according to their useful life. (FASB ASC 350303517A
and 3518) (formerly SFAS 142, paras. 1617)
Computer Software Costs
Generally, the guidelines above apply to the cost of software developed or purchased for internal use or for sale to
others. The following paragraphs provide additional guidance on applying those guidelines.
Software Purchased or Developed for Internal Use. The guidance above should be followed when accounting
for the cost of computer software purchased or developed for internal use. That is, if the software is used in research
and development activities, its cost is a research and development cost and should be accounted for as follows:
a. Costs incurred to purchase software from others should be charged to expense when incurred unless it
has an alternative future use. In that case, it should be capitalized and amortized over its useful life.
212
b. Costs incurred to internally develop software, including costs incurred during all phases of development,
should be charged to expense when incurred. (The alternative future use test described above applies only
to intangibles purchased from others. Consequently, none of the cost of software developed internally for
research and development activities should be capitalized.) (FASB ASC 73010253 and 254) (formerly
FASBI 6, paras. 5 and 8)
Software Purchased or Developed to Be Sold, Leased, or Otherwise Marketed. Costs incurred to establish the
technological feasibility of software to be sold, leased, or otherwise marketed are research and development costs
and should be charged to expense when incurred. (FASB ASC 98520251) (formerly SFAS 86, par. 3) Software
development costs incurred after technological feasibility has been established are not research and development
costs.
RESEARCH AND DEVELOPMENT ARRANGEMENTS
Research and development may be partially or entirely funded by others through a research and development
arrangement. For example, in a typical arrangement, an entity might form a limited partnership through which
research and development will be conducted. The entity acts as general partner, managing the research and
development activities, and limited partners provide all or a part of the funds needed to complete the research
project. Normally, the entity performs the research under a contract with the limited partnership, and the limited
partnership retains the rights to the results of the research and development. The entity may purchase the results
from the partnership or pay a royalty to the partnership for the rights to use the results, however. Accounting for
such arrangements depends on the nature of the obligation the entity incurs when it enters into the arrangement.
(FASB ASC 73020052, 054, and 055; 73020252) (formerly SFAS 68, paras. 4, 17, 19, and 20)
Obligation Is a Liability to Repay the Other Parties
If the entity is obligated to repay all of the funds provided by the other parties, regardless of the outcome of the
research and development, the financial risks associated with the research and development arrangement have
not been transferred to others. In such cases, the entity should estimate and accrue the liability to repay others and
charge research and development costs to expense as incurred.
In some instances, written agreements or contracts may not require the entity to repay the funds provided by the
other parties, but circumstances indicate that it is probable the entity will repay the funds. In that event, the entity is
presumed to have incurred a liability to repay. Examples of circumstances that may indicate that the entity will repay
funds provided by others include the following:
a. The entity has indicated that it intends to repay the funds provided by others regardless of the success of
the research and development.
b. The entity would suffer a severe economic penalty if it failed to repay the funds. For example, an entity that
provided proprietary information to a limited partnership formed to conduct research and development
may have to purchase the partnership's interest in the research to recover the proprietary information or
prevent it from being transferred to others.
c. At the time the entity enters into the research and development arrangement, a significant related party
relationship exists between the entity and a party providing the funding.
d. The entity has essentially completed the research and development before entering into the arrangement.
If the entity is obligated to repay some but not all of the funds provided by other parties, it should charge its portion
of research and development costs to expense as the liability is incurred. (FASB ASC 73020253 through 257)
(formerly SFAS 68, paras. 59)
Obligation Is to Perform Contractual Services
If the entity is not obligated to repay any of the funds provided by the other parties or if repayment depends solely
on the results of the research having some future economic benefit, the financial risks associated with the research
213
and development arrangement have been transferred to others. In such cases, the entity should account for the
arrangement as a contract to perform research and development for others. Consequently, any research and
development costs incurred should be capitalized as inventory and charged to cost of sales when revenue is
recognized. (FASB ASC 73020258) (formerly SFAS 68, par.10)
If the entity's obligation is to perform research and development for others and it subsequently decides to purchase
the other parties' interests in the arrangement or to obtain the rights to use the research results, the purchase of the
interest or rights should be accounted for in accordance with existing GAAP. (FASB ASC 73020259 and 2510)
Other Issues
Loans or Advances to the Other Parties. The entity may loan funds to the other parties, the repayment of which
depends solely on the future economic benefits of the research and development. For example, the loan may be
repaid by reducing the price the entity must pay to purchase the results of the project or by reducing the royalties
the entity must pay to use the results of the project. Such loans should be charged to research and development
expense unless they specifically relate to another activity, such as marketing or advertising. (FASB ASC
Issuance of Warrants or Similar Instruments. If the entity issues stock purchase warrants or similar instruments
in connection with a research and development arrangement, a portion of the funds received from the other parties
should be recorded as additional paidin capital. The amount that should be recorded is the fair value of the
instruments on the date of the arrangement. (FASB ASC 730202512) (formerly SFAS 68, par. 13)
Acquiring the Results of a Research and Development Arrangement by Issuing Stock. The entity should
record stock issued to acquire the results of a research and development arrangement at its fair value or the fair
value of the consideration received, whichever is more clearly evident. Fair value should be determined at the date
the entity exercises its option to purchase the results of the arrangement, if delivery is probable because of
sufficiently large disincentives for nondelivery. Otherwise, fair value should be measured when the results are
delivered. [FASB ASC 50550306, 3011, and 3012] [formerly SFAS 123(R), par. 7 and EITF 9618]
The total research and development costs charged to expense should be disclosed for each period for which an
income statement is presented. (FASB ASC 73010501) (formerly SFAS 2, par. 13) In addition, an entity that
accounts for a research and development arrangement as a contract to provide research and development
services for others should disclose the following:
a. Terms of significant agreements under the arrangement (including royalty agreements, purchase
provisions, license agreements, and commitments to provide additional funding) as of the date of each
balance sheet presented
b. Amount of compensation earned and costs incurred under such contracts for each period for which an
income statement is presented (FASB ASC 73020501) (formerly SFAS 68, par. 14)
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SELFSTUDY QUIZ
following section.
37. Generally, research and development costs should be:
a. Charged to expense when incurred.
b. Recorded as inventory.
c. Recorded as elements of overhead.
d. Deferred to future periods
38. If computer software is purchased or developed for internal use in research and development activities, which
of the following statements is accurate concerning costs incurred to internally develop software, including costs
incurred during all phases of development?
a. Costs should be charged to expense when incurred.
b. Costs should be charged to expense when incurred unless it has an alternative future use (applies only
to intangibles purchased from others).
c. If there is an alternative future use, costs should be capitalized and amortized over its useful life.
215
SELFSTUDY ANSWERS
37. Generally, research and development costs should be: (Page 211)
a. Charged to expense when incurred. [This answer is correct. In most cases, research and
development costs should be charged to expense when incurred, that is, at the time the research
is being conducted per FASB ASC 73010551 (formerly SFAS 2, par. 9).]
b. Recorded as inventory. [This answer is incorrect. Research and development costs should not be recorded
as inventory per FASB ASC 73010551 (formerly SFAS 2, par. 9).]
c. Recorded as elements of overhead. [This answer is incorrect. Research and development costs are not
overhead costs and should not be recorded as elements of overhead per FASB ASC 73010551 (formerly
SFAS 2, par. 9).]
d. Deferred to future periods. [This answer is incorrect. Research and development costs should not be
deferred to future periods. However, materials, facilities, and equipment should be capitalized and
depreciated over their useful lives if they have alternative uses in the future, including being used in other
research and development projects as cited in FASB ASC 73010551 (formerly SFAS 2, par. 9).]
38. If computer software is purchased or developed for internal use in research and development activities, which
of the following statements is accurate concerning costs incurred to internally develop software, including costs
incurred during all phases of development? (Page 212)
a. Costs should be charged to expense when incurred. [This answer is correct. Costs incurred to
internally develop software, including costs incurred during all phases of development, should be
charged to expense when incurred per FASB ASC 73010251 and 252 (formerly SFAS 2, paras.
1112). None of the cost of software developed internally for research and development activities
should be capitalized.]
b. Costs should be charged to expense when incurred unless it has an alternative future use (applies only
to intangibles purchased from others). [This answer is incorrect. This method of charging costs applies
to purchase of software from others per FASB ASC 73010251 and 252 (formerly SFAS 2, paras. 1112).]
c. If there is an alternative future use, costs should be capitalized and amortized over its useful life. [This
answer is incorrect. If there is an alternative future use for the software purchased from others, then costs
should be capitalized and amortized over its useful life per FASB ASC 73010251 and 252 (formerly SFAS
2, paras. 1112).]
216
REVENUE RECOGNITION
OVERVIEW
Generally, revenue should be recognized (and an appropriate provision for uncollectible amounts should be made)
when a transaction is completed. When the buyer has the right to return the merchandise sold, revenue should be
recognized only if certain criteria are met. Revenue and cost of sales recognized when a right of return exists should
be reduced for estimated returns, and expected costs or losses related to sales returns should be accrued.
Multiple deliverable arrangements should be divided into separate units of accounting based on certain criteria.
Revenue should be allocated to the separate units of accounting based on their relative fair values. (For fiscal years
beginning on or after June 15, 2010, the allocation should be based on each deliverable's relative selling price.)
Each unit of accounting should be considered separately to determine when to recognize the revenue from that
unit.
Revenue related to separately priced extended warranty and product maintenance contracts should be deferred
and generally recognized over the life of the contracts on a straightline basis. Costs directly related to the
acquisition of the contracts should be charged to expense in proportion to the revenue recognized. All other costs,
including costs associated with performing services under the contracts, should be charged to expense as
incurred.
Companies that act as agents should use judgment to determine whether to recognize revenue based on the gross
amount billed or the net amount retained. Relevant facts and circumstances, including the evaluation of certain
indicators, should be considered in making this determination.
When a nonmonetary asset is involuntarily converted to a monetary asset, any gain or loss resulting from the
difference between the carrying amount of the nonmonetary asset and the monetary asset received should be
recognized, even if the company reinvests in a similar nonmonetary asset.
Revenue and expense related to barter transactions in which companies exchange rights to place advertisements
with each other should be recognized at fair value, if determinable. If fair value is not determinable, the barter
transaction should be recorded based on the carrying amount of the advertising surrendered, most likely zero.
A vendor should recognize cash consideration (including a sales incentive) given to a customer as a reduction
of revenue in the vendor's income statement. However, the consideration should be reported as an expense if
certain conditions are met. A vendor should recognize the cost of a sales incentive that can be used or becomes
exercisable as a result of a single exchange transaction, and that will not result in a loss on the sale of the product
or service, at the later of the date the related revenue is recognized by the vendor or the date the sales incentive is
offered. A vendor should recognize a rebate or refund of a specified amount of cash consideration that is redeem
able only if the customer completes a specified cumulative level of revenue transactions or remains a customer for
a specified time period as a reduction of revenue based on a systematic and rational allocation of the cost of
honoring rebates or refunds earned and claimed to each of the underlying revenue transactions that result in
progress by the customer toward earning the rebate or refund.
Construction contractors should use the percentageofcompletion method to account for revenues from longterm
construction contracts if they can make reasonably dependable estimates of costs to complete and the extent of
progress toward completion. Under the percentageofcompletion method, income generally is recognized based
on the ratio of costs incurred to date to estimated total costs.
If dependable estimates are not available or if inherent hazards cause forecasts to be doubtful, construction
contractors should recognize revenue from longterm construction contracts using the completedcontract
method. Under that method, income is not recognized until the contract is substantially completed.
217
(FASB ASC 60510251) (formerly Statement of Financial Accounting Concepts No. 5, Recognition and Measure
ment in Financial Statements of Business Enterprises), states that revenue is recorded in financial statements when
the following conditions are met:
a. Amounts are realized or realizable (that is, they are converted or convertible into cash or claims to cash).
b. Amounts are earned (that is, activities prerequisite to obtaining benefits have been completed).
Thus, as a general rule, revenue from selling products should be recognized at the date of sale, and revenue from
rendering services should be recognized when the services have been performed and are billable. In addition, an
appropriate allowance for uncollectible amounts should be provided.
Ordinarily, the preceding conditions occur when the transaction is completed. As a result, recognizing revenue
under the installment method (which recognizes a portion of the transaction's profit as revenues are collected)
generally is not acceptable. In some exceptional cases, however, the terms of a transaction are such that receiv
ables are collectible over an extended period of time and their collectibility cannot be reasonably estimated. Under
those conditions, the installment method or costrecovery method may be used to recognize revenue. (When the
costrecovery method is used, no profit is recognized until all costs have been recovered.) In addition, specific
standards, such as those dealing with sales of real estate or construction contractors, may permit the use of the
installment, costrecovery, or percentageofcompletion method. (FASB ASC 60510253 and 254) (formerly APB
10, par.12)
Various pronouncements discuss recognizing revenue related to specific transactions or industries. This lesson
discusses general revenue recognition requirements, including those concerning recognizing revenue when the
buyer has the right to return the merchandise, recognizing revenue from multiple deliverable arrangements, and
recognizing revenue related to warranty and maintenance contracts.
RECOGNIZING REVENUE WHEN A RIGHT OF RETURN EXISTS
A customer may be allowed to return merchandise for refund, credit, or exchange during a specified period
following the sale. In such cases, ownership essentially has not been transferred from the seller to the buyer.
Consequently, the sale has not been completed and revenue generally should not be recognized. Revenue may be
recognized at the time of sale when a right of return exists, however, if all of the following conditions are met:
a. The seller's price to the buyer is substantially fixed or determinable at the date of sale.
b. The buyer has paid the seller or is obligated to pay the seller and the obligation is not contingent on reselling
the merchandise.
c. The buyer's obligation to the seller would not change if the merchandise were stolen, damaged, or
destroyed.
d. The buyer has economic substance. (That is, the buyer is not a front established by the seller primarily to
recognize sales revenue.)
e. The seller has no significant obligation to help the buyer resell the merchandise.
f. The amount of returns can be reasonably estimated.(FASB ASC 60515251) (formerly SFAS 48, par. 6)
The guidance herein on accounting for revenues when the right of return exists generally applies to all transactions
except
revenue in service industries that may be returned under cancellation privileges,
transactions involving real estate, and
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customer rights to return defective goods, such as under warranty provisions.
If all of the preceding conditions are met and sales revenue is recognized, a contingency exists for the costs or
losses that may occur from merchandise returns. The contingency should be accrued through a reduction to sales
and cost of sales if
a. information available before the financial statements are issued or available to be issued indicates it is
probable that an asset has been impaired or a liability incurred as of the balance sheet date and
b. the amount of the loss can be reasonably estimated. (FASB ASC 45020252; 60515252) (formerly SFAS
5, par.8 and SFAS 48, par. 7)
The ability to reasonably estimate the amount of future returns depends on a variety of factors that change from one
case to the next. Factors that may impair a seller's ability to reasonably estimate returns include the following:
Susceptibility of the merchandise to external factors such as changes in demand or technological

obsolescence
Right of return period that lasts for a relatively long time
Lack of experience with similar types of sales or products
Volume of relatively homogeneous transactions that is too small
Inability to apply prior experience due to changes in marketing policies or customer relationships (FASB
REVENUE FROM MULTIPLE DELIVERABLE ARRANGEMENTS
Periods beginning before June 15, 2010. A multiple deliverable arrangement exists when a company enters into
an agreement to perform multiple revenuegenerating activities. For example, a company may enter into a sales
agreement to provide delivery, installation, and activation services for certain equipment. All deliverables in such an
arrangement should be evaluated at inception and upon delivery to determine whether they require separate
accounting. A deliverable is a separate unit of accounting if:
it is sold separately by any vendor or could be separately resold by the customer,
the fair value of the undelivered items can be objectively and reliably determined, and
when a general right of return exists for the delivered item(s), delivery or performance of the undelivered
items is probable and within the control of the vendor. (FASB ASC 60525255) (formerly EITF 0021, par.
9)
Any deliverables that do not qualify as separate units of accounting should be combined into one accounting unit.
Consideration received under multiple deliverable arrangements should be allocated to the separate units of
accounting based on their relative fair values. Each unit of accounting should be considered separately to deter
mine when to recognize the revenue from that unit. (FASB ASC 60525252; 60525256) (formerly EITF 0021,
paras. 10 and 12)
If there is evidence of the fair value of undelivered items under an arrangement, but no evidence of the fair value of
the delivered item(s), the residual method should be used to allocate consideration. Under the residual method, the
amount allocated to the delivered item(s) is equal to the total arrangement consideration less the fair value of the
undelivered items. (FASB ASC 60525302 and 303) (formerly EITF0021, par. 12)
Periods Beginning On or After June 15, 2010. A multiple deliverable arrangement exists when a company enters
into an agreement to perform multiple revenuegenerating activities. For example, a company may enter into a
sales agreement to provide delivery, installation, and activation services for certain equipment. All deliverables in
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such an arrangement should be evaluated at inception and upon delivery to determine whether they require
separate accounting. A deliverable is a separate unit of accounting if both of the following apply:
The deliverable has standalone value to the customer; in other words, it is sold separately by vendors or
could be separately resold by the customer.
When a general right of return exists for the delivered item(s), delivery or performance of the undelivered
items is probable and within the control of the vendor. (FASB ASC 60525254 and 255, as amended by
ASU 200913)
Any deliverables that do not qualify as separate units of accounting should be combined into one accounting unit.
Consideration received should be allocated at inception of the arrangement to all deliverables based on their
relative selling price. Relative selling price should be determined using vendorspecific objective evidence of selling
price, if available. If not available, third party evidence of selling price should be used. If neither exists, the best
estimate of selling price should be used. (FASB ASC 60525256 and 60525302, as amended by ASU 200913)
If any separate unit of accounting is required by other GAAP to be recorded at fair value, the amount allocated to
that unit will be fair value. (FASB ASC 60525304, as amended by ASU 200913)
The amount allocated to a delivered unit of accounting is limited to an amount that is not contingent on delivering
other items or meeting other performance conditions. (FASB ASC 60525305, as amended by ASU 200913)
SEPARATELY PRICED EXTENDED WARRANTY AND PRODUCT MAINTENANCE CONTRACTS
Many retailers offer a separately priced service contract when products are sold. The contract covers a stated
period and may entitle the customer to warranty protection, routine periodic maintenance services, or both.
Revenue from separately priced extended warranty and product maintenance contracts should be deferred at the
point of sale and recognized on a straightline basis over the life of the contract. Revenues may be recognized over
the contract period in proportion to costs, however, if sufficient historical evidence indicates that the costs of
performing services under the contracts are incurred on other than a straightline basis. (FASB ASC 60520253)
(formerly FTB 901, par. 3)
Incremental direct acquisition costs (that is, those directly related to the acquisition of the contract that would not
have been incurred if the contract had not been acquired) should also be deferred and charged to expense in
proportion to the revenue recognized. Other costs related to the contracts, including the costs of services per
formed under the contract, general and administrative expenses, advertising expenses, and costs associated with
the negotiation of a contract that is not consummated, should be charged to expense when incurred. (FASB ASC
60520254) (formerly FTB 901, par. 4)
If the expected costs of providing services under separately priced extended warranty and product maintenance
contracts plus unamortized acquisition costs exceed the related unearned revenue, a loss should be recognized.
The loss should first be recognized by charging any unamortized acquisition costs to expense. A liability should be
recognized for any loss that is greater than the unamortized acquisition costs. (FASB ASC 60520256) (formerly
FTB 901, par. 5)
REPORTING REVENUE GROSS AS A PRINCIPAL VERSUS NET AS AN AGENT
Companies that act as an agent rather than a principal (for example, companies that sell goods or services over the
Internet or with transactions related to advertisements, mailing lists, event tickets, travel tickets, auctions, magazine
subscription brokers, and catalog, consignment, or specialorder retail sales) often question whether they should
recognize revenue based on the gross amount billed to a customer or the net amount retained. How the revenue
is recognized is a matter of judgment that depends on the relevant facts and circumstances, including the
evaluation of certain indicators. (FASB ASC 60545451) (formerly EITF No.9919)
Indicators of gross revenue reporting include whether the company:
Is the primary obligor in the arrangement.
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Has general inventory risk.
Has latitude in establishing price.
Changes the product or performs part of the service.
Has discretion in supplier selection.
Is involved in the determination of product or service specifications.
Has physical loss inventory risk.
Has credit risk. (FASB ASC 60545453 through 4514) (formerly EITF 9919)
Indicators of net revenue reporting include:
The supplier, not the company, is the primary obligor in the arrangement.
The amount the company earns is fixed.
The supplier has credit risk. (FASB ASC 605454515 through 4518) (formerly EITF 9919)
INVOLUNTARY CONVERSIONS OF NONMONETARY ASSETS TO MONETARY ASSETS
A nonmonetary asset may involuntarily be converted to a monetary asset. (For example, a building may be totally
or partially destroyed by fire or other disaster.) In such cases, the involuntary conversion should be considered a
monetary transaction and a gain or loss recognized even if the entity reinvests in a similar nonmonetary asset. The
gain or loss recognized on the conversion is the difference between the carrying amount of the nonmonetary asset
and the monetary assets received, if any. (FASB ASC 60540252) (formerly FIN 30, par. 10)
The preceding guidance does not apply to the involuntary conversion of a LIFO inventory layer at an interim
reporting date (and thus a gain should not be recognized) if the proceeds are reinvested in replacement inventory
by the end of the fiscal year. If the proceeds are not reinvested in replacement inventory by the end of the fiscal year,
a gain still should not be recognized so long as no gain is recognized for tax reporting. (FASB ASC 60540253)
(formerly FIN 30, par. 2)
ADVERTISING BARTER TRANSACTIONS
Revenue and expense from advertising barter transactions should be recorded at fair value only if the fair value of
the surrendered advertising can be determined based on the entity's practice of receiving cash (or other consider
ation readily convertible to cash) for similar advertising from buyers unrelated to the current buyer. (Advertising is
considered similar if it is in the same media, delivered by the same advertising vehicle, and of the same quantity or
volume.) If fair value cannot be determined, revenue and expense should be based on the carrying amount of the
advertising surrendered, which likely will be zero. (FASB ASC 605202515; 605202517) (formerly EITF No.
9917)
CONSIDERATION GIVEN BY A VENDOR TO A CUSTOMER
Vendors of products or services may offer customers (including resellers of the vendors' products or entities that
purchase the vendors' products from resellers) sales incentives in the form of discounts, coupons, rebates, free"
products or services, or arrangements labeled as slotting fees, cooperative advertising, or buydowns. The incen
tives may be given to direct or indirect customers at any point along the distribution line. (FASB ASC 60550051;
Cash Consideration
A vendor should recognize cash consideration (including a sales incentive) given to a customer as a reduction
of revenue in the vendor's income statement following the guidance below. However, the consideration should be
reported as an expense if both of the following conditions are met:
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a. The vendor receives, or will receive, an identifiable benefit (goods or services) in exchange for the
consideration. The benefit must be sufficiently separable from the recipient's purchase of the vendor's
products such that the vendor could have entered into an exchange transaction with a party other than a
purchaser of its products or services in order to receive that benefit.
b. The vendor can reasonably estimate the fair value of the benefit. Any excess of the consideration paid by
the vendor over the estimated fair value of the benefit received should be reported as a reduction of
revenue, however, following the guidance below. (FASB ASC 60550452) (formerly EITF 019)
In addition, consideration other than cash (or equity instruments) should be recognized as an expense. (FASB ASC
An amount reported as a reduction of revenue should not be recharacterized as an expense unless characteriz
ing it as a reduction of revenue results in negative revenue for a specific customer on a cumulative basis (that is,
since the inception of the overall relationship between the vendor and the customer). In that case, the amount of the
cumulative shortfall may be recharacterized as an expense. (FASB ASC 60550457) (formerly EITF 019)
Sales Incentive Offered as a Result of a Single Exchange Transaction with a Customer
A vendor may voluntarily, and without charge, offer a sales incentive to a customer that can be used or becomes
exercisable as a result of a single exchange transaction, and that will not result in a loss on the sale of the product
or service. The vendor should recognize the cost of the sales incentive at the later of the following:
a. The date the related revenue is recognized by the vendor
b. The date the sales incentive is offered (which would be the case when the sales incentive offer is made after
the vendor has recognized revenue; for example, when a manufacturer issues coupons offering discounts
on a product that it already has sold to retailers) (FASB ASC 60550253) (formerly EITF 019)
If the sales incentive entitles the customer to claim a refund or rebate subsequent to making the purchase, a
vendor should recognize a liability (deferred revenue) for the sales incentives at the later of (a) or (b) above, based
on the estimated amount of refunds or rebates that will be claimed by customers. However, if the amount of future
rebates or refunds cannot be reasonably and reliably estimated, a liability (deferred revenue) should be recognized
for the maximum potential amount of the refund or rebate. The following factors may impair a vendor's ability to
make a reasonable and reliable estimate:
a. Rebate or refund claim period lasts for a relatively long time
b. Lack of experience with similar types of sales incentives with similar products or inability to apply such
experience because of changing circumstances
c. Volume of relatively homogeneous transactions is too small (FASB ASC 60550257) (formerly EITF 019)
If the sales incentive will result in a loss on the sale of a product or service, the vendor should not recognize a
liability for the sales incentive before the date the related revenue is recognized. (FASB ASC 60550255) (formerly
EITF 019)
Contingent Sales Incentive
A vendor may offer a customer a rebate or refund of a specified amount of cash consideration that is redeemable
only if the customer completes a specified cumulative level of revenue transactions or remains a customer for a
specified time period. The vendor should recognize the rebate or refund obligation as a reduction of revenue based
on a systematic and rational allocation of the cost of honoring rebates or refunds earned and claimed to each of the
underlying revenue transactions that result in progress by the customer toward earning the rebate or refund. The
total rebate or refund obligation should be measured based on the estimated number of customers that will
ultimately earn and claim rebates or refunds under the offer, if it can be reasonably estimated. If the amount of future
rebates or refunds cannot be reasonably estimated, a liability should be recognized for the maximum potential
222
amount of the refund or rebate. The factors listed above may impair a vendor's ability to make a reasonable
estimate. (FASB ASC 60550257) (formerly EITF 019)
CONSTRUCTION CONTRACTORS
Revenue recognition issues for construction contractors are different from those for most other commercial entities.
Generally, commercial companies recognize revenue when a product is delivered to a customer at the conclusion
of a sale. If construction contractors followed that general rule, however, revenue would not be recognized until the
construction project is completed and delivered at the conclusion of the construction process. Under generally
accepted accounting principles, construction contractors should recognize revenues from construction contracts
under either the percentageofcompletion or the completedcontract method.
Percentageofcompletion Method
The percentageofcompletion method recognizes income in each accounting period as the contract progresses to
completion. The recognized income should be the estimated total income multiplied by either: (FASB ASC
605352551 and 2552) (formerly ARB 45, par. 4)
the percentage of incurred costs to date to the most recently estimated total completion costs, or
a percentage indicated by some other measure of progress toward completion that is appropriate with
regard to the work performed.
Particularly in the early stages of a contract, costs may include items such as materials and subcontracts that distort
the project's percentage of completion. (For example, materials may be purchased in the early stages of construc
tion but not used until much later.) Such costs may be excluded from the percentageofcompletion calculation if
that would result in a more meaningful allocation of periodic income. (FASB ASC 605352553) (formerly ARB 45,
par. 4)
Completedcontract Method
The completedcontract method recognizes income only when the project is complete (or substantially complete
if no significant costs remain). Accordingly, costs of contracts in process and current billings are accumulated but
there are no charges or credits to income (other than provisions for losses) prior to completion. (FASB ASC
605352588) (formerly ARB 45, par. 9 and SOP 811, par. 30)
When the completedcontract method is used, it may be appropriate to allocate general and administrative
expenses to contract costs rather than to periodic income if a better matching of costs and revenues would result,
particularly in years when no contracts are completed. If the contractor is engaged in numerous projects, however,
it may be preferable to charge general and administrative expenses to periodic income as incurred. (FASB ASC
605352599) (formerly ARB 45, par. 10)
Selection of Method
The percentageofcompletion and completedcontract methods are not alternatives from which a contractor may
select. Instead, GAAP specifies when each method should be used. In general, the percentageofcompletion
method should be used when estimates of costs to complete and extent of progress toward completion of
longterm contracts are reasonably dependable. The completedcontract method may be used, however, if lack of
dependable estimates causes forecasts to be doubtful. (FASB ASC 60535251; 605352556; 605352590)
(formerly ARB 45, par. 15 and SOP 811, paras. 21 and 23)
Contract Claims
A contractor should recognize additional revenue resulting from claims to collect amounts in excess of agreed
upon contract prices only if the amount of the claim can be reliably estimated and it is probable that the contractor
will collect such amounts. Those requirements are met if all of the following conditions exist:
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a. There is a legal basis for the claim either in the contract provisions or from a legal opinion.
b. Additional costs incurred were unforeseen when the contract was initiated and are not due to deficiencies
in the contractor's performance.
c. The costs are reasonable and identifiable or otherwise determinable.
d. The evidence to support the claim is objective and verifiable.
Revenue should be recognized only to the extent that costs attributable to the claim have been incurred. Such costs
should be treated as costs of the contract when incurred. Alternatively, revenues from claims may be recognized
only when they have been received or awarded. (FASB ASC 605352530 and 2531) (formerly SOP 811, paras.
6566)
Provision for Anticipated Losses
Regardless of the revenue recognition method used by a contractor, GAAP requires a loss to be accrued whenever
it becomes apparent that the total estimated contract costs (costs incurred to date plus estimated costs to
complete) will materially exceed the total estimated contract revenue. If a loss on a particular contract is expected
after comparing the total estimated contract revenue to the total estimated contract costs, the full loss should be
charged to a special loss account and credited to a corresponding liability account. The contractor should accrue
the full amount of the estimated loss in the period it is determined, and the accrued liability should be disclosed
separately in the balance sheet, if material. If there is a close relationship between profitable and unprofitable
contracts (for example, if the contracts are part of the same project), they may be considered as a group when
determining whether a loss provision is necessary. FASB ASC 605352545 and 2546; 60535255; 60535451
and 452) (formerly ARB 45, par. 6 and SOP 811, paras. 24, 85, 88, and 89)
Balance Sheet Accounts
Under the percentageofcompletion method, current assets may include an account for costs and recognized
income not yet billed with respect to some contracts, and current liabilities may include an account for billings in
excess of costs and recognized income with respect to other contracts. (FASB ASC 60535453) (formerlyARB45,
par. 5) Under the completedcontract method, current assets may include an account for an excess of accumulated
costs over related billings, and current liabilities may include an account for an excess of accumulated billings over
related costs. (FASB ASC 60535454 and 455) (formerly ARB 45, par. 12)
If costs exceed billings on some contracts and billings exceed costs on others, the contracts should usually be
segregated so that assets include only those contracts on which costs exceed billings, and liabilities include only
those on which billings exceed costs. (FASB ASC 60535454) (formerly ARB 45, par. 12)
Generally accepted accounting principles do not require specific disclosures about revenues in general, revenues
recognized when a right of return exists, or revenues related to separately priced warranty and maintenance
contracts.
A company should disclose its policy for recognition of revenue from multipledeliverable arrangements, and the
description and nature of such arrangements, including performance, cancellation, termination, or refund provi
sions. (FASB ASC 60525501) (formerly EITF 0021)
224
If shipping or handling costs are significant and not included in cost of sales, a company should disclose both the
amount of the costs and the line item(s) in the income statement that include them. (FASB ASC 60545502)
(formerly EITF 0010)
A company should disclose its policy for presenting taxes assessed by governmental authorities that are imposed
on and concurrent with specific revenueproducing transactions (e.g., sales, use, valueadded, etc.). For taxes
reported gross, the amounts of those taxes should be disclosed for each period for which an income statement is
presented. Such disclosure can be made on an aggregate basis. (FASB ASC 60545503 and 504) (formerly EITF
063)
225
226
SELFSTUDY QUIZ
following section.
39. Revenue is recorded in financial statements when certain conditions are met. Which of the following is not one
of those required conditions?
a. Amounts are converted into cash or claims to cash.
b. Amounts are convertible into cash or claims to cash.
c. Activities required prior to obtaining benefits are pending.
40. Revenue may be recognized at the time of sale when a right of return exists, if a number of conditions are met.
Which of the following is one of those required conditions?
a. The seller's price to the buyer is indeterminable at the date of sale.
b. The buyer's obligation to pay the seller is contingent on reselling the merchandise.
c. The buyer's obligation to the seller would not change if the merchandise were damaged.
d. The seller is fully obligated to assist the buyer in reselling the merchandise.
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SELFSTUDY ANSWERS
39. Revenue is recorded in financial statements when certain conditions are met. Which of the following is not one
of those required conditions? (Page 218)
a. Amounts are converted into cash or claims to cash. [This answer is incorrect. Revenue is recorded in
financial statements when amounts are realized per FASB ASC 60510251 (formerly SFAC No. 5).]
b. Amounts are convertible into cash or claims to cash. [This answer is incorrect. Revenue is recorded into
financial statements when amounts are realizable per FASB ASC 60510251 (formerly SFAC No. 5).]
c. Activities required prior to obtaining benefits are pending. [This answer is correct. Revenue is
recorded into financial statements when amounts are earned such that activities that are required
prior to obtaining benefits have been completed per FASB ASC 60510251 (formerly SFAC No. 5).]
40. Revenue may be recognized at the time of sale when a right of return exists, if a number of conditions are met.
Which of the following is one of those required conditions? (Page 218)
a. The seller's price to the buyer is indeterminable at the date of sale. [This answer is incorrect. The seller's
price to the buyer is substantially fixed or can be determined at the date of sale per FASB ASC 60515251)
b. The buyer's obligation to pay the seller is contingent on reselling the merchandise. [This answer is
incorrect. The buyer's has paid the seller or is obligated to pay the seller and the obligation is not contingent
on reselling the merchandise per FASB ASC 60515251 (formerly SFAS 48, par. 6).]
c. The buyer's obligation to the seller would not change if the merchandise were damaged. [This
answer is correct. The buyer's obligation to the seller would not change if the merchandise were
stolen, damaged, or destroyed per FASB ASC 60515251 (formerly SFAS 48, par. 6).]
d. The seller is fully obligated to assist the buyer in reselling the merchandise. [This answer is incorrect. The
seller has no significant obligation to help the buyer resell the merchandise per FASB ASC 60515251
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Lesson 2 (GAPTG092)
21. Which of the following is not one of the steps in the basic tax provision calculation?
a. Identify the taxable and deductible temporary differences and loss carryforwards available for tax reporting
at the end of the year.
b. Identify the tax credit carryforwards applicable for tax reporting at the beginning of the year and record a
carryforward tax liability for the total of the carryforwards.
c. Calculate the deferred tax liability by multiplying total taxable differences by the applicable tax rate.
d. Calculate the deferred tax asset by multiplying total deductible differences and loss carryforwards by the
applicable tax rate.
22. Deferred taxes should be provided for differences related to which of the following?
a. Impairment of goodwill for which amortization is not deductible for tax purposes.
b. A reduction in the tax basis of depreciable assets because of tax credits.
c. Differences between the tax and financial bases of an investment in a leveraged lease.
d. Differences between the tax and financial bases of assets and liabilities that will be recovered or settled
in a taxfree transaction.
23. Lucy Newby, staff accountant with Newby Ship Builders is reviewing assets and liabilities for financial reporting
and isolating those with different tax bases. She is unable to reconcile all the differences. What is Lucy failing
to recognize?
a. Deductible temporary differences represent expenses that have been recognized in the financial
statements but will be deducted in future tax returns.
b. Some temporary differences are not traceable to a particular asset or liability because they may be
expensed for financial reporting but capitalized for tax purposes.
c. Taxable temporary differences represent expenses that have been deducted in the tax returns but will be
expenses in future financial statements.
d. Deductible reversals are reversals of deductible differences and taxable reversals are reversals of taxable
differences.
24. Deductible differences result in which of the following?
a. Deferred tax liabilities.
b. Deferred tax assets.
c. Taxable temporary differences.
d. Taxable reversals.
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25. Which of the following represents the formula used at year end to recognize a deferred tax asset?
a. (taxable temporary differences X the tax rate).
b. (taxable reversals X the tax rate).
c. [(deductible temporary differences + tax operating loss carryforwards) X the tax rate] + tax credit
carryforwards.
d. [(taxable reversals + tax operating loss carryforwards) X the tax rate] + tax credit carryforwards.
26. In some situations, deferred taxes should be computed using the average tax rate that will apply to estimated
taxable income of the years in which the temporary differences are expected to reverse. Assume that current
tax laws require the first $50,000 of income to be taxed at 15%, the next $25,000 to be taxed at 25%, and income
above $75,000 to be taxed at 34%. If a company's taxable income in year 2 is expected to be $130,000, what
will its expected average graduated tax rate be in year two?
a. 22%.
b. 23%.
c. 24%.
d. 25%.
27. Which of the following statements is appropriate regarding federal AMT rates?
a. When the AMT exceeds the regular tax, the AMT credit may be carried forward for up to five years to offset
the excess of the regular tax over the AMT in future years.
b. AMT is considered by the FASB as having a permanent effect on corporate tax calculations.
c. AMT will be recovered through the use of AMT credit carryforwards approximately 50% of the time.
d. Over the life of the entity, cumulative income will be taxed under the regular tax system.
28. Sources of taxable income that should be considered when determining the need for a valuation allowance
include all of the following except:
a. Future reversals of taxable differences for which a deferred tax liability has not been recognized.
b. Future reversals of existing taxable temporary differences.
c. Future taxable income exclusive of reversing temporary differences and carryforwards.
d. Taxable income in prior carryback years if carryback is permitted under the tax law.
29. Which of the following is not applicable when determining current tax expense or benefit?
a. Aggregating the tax liabilities as reported in the tax returns for all tax jurisdictions, net of applicable tax
credits.
b. Aggregating the tax liabilities as reported in the tax returns for all tax jurisdictions, after considering any
estimated tax payments or prepayments.
c. Aggregating the tax liabilities as reported in the tax returns for all tax jurisdictions, but before considering
any estimated tax payments.
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d. Aggregating the tax liabilities as reported in the tax returns for all tax jurisdictions, but before considering
any estimated prepayments.
30. A tax asset for federal income taxes may be offset against a tax liability for which of the following?
a. A tax liability for federal income taxes.
b. A tax liability for federal or state income taxes.
c. A tax liability for state income taxes.
d. A tax liability for federal, state, or local income taxes.
31. All of the following affect the intraperiod tax allocation. From the following scenarios identify those that have
a positive or negative effect on income taxes from continuing operations.
I. Gandolf Corporation has a deferred tax asset calculated over the years using the current corporate tax rate of
35%. The U.S. Congress passes a law to increase the corporate tax rate to 38%.
II. Howell Corporation, a C corporation, elects S Corporation status in the current year.
III. Ingrid Corporation accrued state income tax based on current state tax laws. The state Supreme Court has ruled
that a taxpayer in similar circumstances did not have nexus and therefore owes no state income tax.
IV. During the current year Jones Corporation elects not to pay dividends to shareholders.
a. Positive effect: Scenarios I, II, III and IV.
b. Negative effect: Scenarios I, II, III and IV.
c. Positive effect: Scenarios II and III.
d. Negative effect: Scenarios II and III.
32. Sharon, staff accountant of Shipshape Ship Builders is performing the intraperiod tax allocation. The income
statement for Shipshape Ship Builders has five components of net income. Sharon has allocated the tax
provision to continuing operations and stockholder's equity and has an amount remaining. How should Sharon
handle the remaining amount?
a. Allocate the remaining amount to the other components of net income in proportion to their individual
effects on net income.
b. Calculate the effect on income tax provision of each loss item and apportion the tax benefit determined
ratably to each loss item.
c. Calculate the effect on income tax provision of each gain item and apportion the tax benefit determined
ratably to each gain item.
d. Sharon should not allocate any remaining amount, it should be recorded as a deferred tax benefit (or loss)
carryforward (or carryback).
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33. When there is a change in a company's tax status, which of the following actions is appropriate based on the
circumstances described?
a. If an entity's tax status changes from taxable to nontaxable, existing deferred tax assets should be retained.
b. If an entity's tax status changes from nontaxable to taxable, deferred tax assets and liabilities should be
eliminated by means of a charge or credit to income tax expense for the period.
c. The effects of a change in tax status should be recognized in the financial statements at the end of the tax
year in which the change occurs.
d. A change in tax status resulting from a change in tax law should be recognized in the period the law is
enacted.
34. Which of the following statements is accurate regarding discounting deferred taxes?
a. They should be discounted to reflect the time value of money.
b. They should not be discounted to reflect the time value of money.
c. Do not select this answer choice.
35. Which of the following statements regarding how penalties are to be classified in income taxes is accurate?
a. Penalties may be classified as only income taxes.
b. Penalties may be classified as either income taxes or interest expense.
c. Penalties may be classified as either income taxes or penalty expense.
d. Penalties may be classified as either income taxes or another expense.
36. Which of the following requires a disclosure due to a change in accounting policy?
a. A deferred tax liability is not recognized because the cumulative effect of each type of temporary difference
requires a disclosure.
b. The owners of a public company are taxed directly and the net difference between the tax and the financial
bases of its assets and liabilities should be disclosed.
c. The continuing benefit of an operating loss carryforward is significant to the company's continuing
operations and is disclosed in the financial statements.
d. For tax purposes, the amounts and expiration dates of operating losses and tax credit carryforwards are
disclosed.
37. Listed below are several activities. Select the one that is not considered research and development.
a. Sam is testing three prototypes of a new airplane wing.
b. Susan is constructing prototypes of a new type of offset printing press.
c. Alan is operating a pilot plant that will build a fuel efficient car.
d. Arman is participating in a routine effort to improve the quality of an existing product.
232
38. Which of the following is not considered a category of development activities?
a. Market research activities.
b. Conceptualizing product alternatives.
c. Constructing prototypes.
d. Operating pilot plants.
39. Accounting for revenues when the right of return exists generally applies to which of the following transactions?
a. Customer rights to return defective goods, such as under warranty provisions.
b. Customer rights to return merchandise for refund, credit or exchange.
c. Transactions involving real estate.
d. Revenue in service industries that may be returned under cancellation privileges.
40. There are several indicators of net revenue reporting including:
a. The company is the primary obligor in the arrangement.
b. The supplier is a secondary obligor.
c. The amount the company earns is variable.
d. The supplier has credit risk.
233
234
GLOSSARY
Accumulated Depreciation: In accounting, the amount of depreciation expense that has been claimed to date.
Amortization: Reduction of a debt by periodic charges to assets or liabilities. In accounting statements, the
systematic wroteoff of costs incurred to acquire an intangible asset, such as patents, copyrights, goodwill,
organization, and expenses.
Cash Flow Hedge: A cash flow hedge is a hedging relationship in which the variability of the hedged item's cash
flow is offset by the cash flows of the hedging instrument. In addition, the hedged item is a forecasted transaction
or balance sheet item with variable cash flows.
Deferred Taxes: Taxes extended over a period of time or put off to a future date.
Derivative Instrument: A derivative instrument (or simply derivative) is a financial instrument which derives its value
from the value of some other financial instrument or variable.
Exchange Rate: The price at which one country's currency can be converted into another's. Most exchange rates
float freely and change slightly each trading day; some rates are fixed and do not change as a result of market forces.
Fair value Hedge: A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset, or
liability, or of an unrecognized firm commitment attributable to a particular risk.
Functional Currency: The legal tender of the primary economic environment in which a company operates. Usually,
it is the country where a company generates and expends most of its cash.
Hedge: A strategy used to offset business or investment risk. A perfect hedge is one eliminating the possibility of
future gain or loss.
Lessee: One who holds an estate by virtue of a lease.
Lessor: One who grants a lease to another, thereby transferring to him exclusive temporary right of possession of
certain property, subject only to rights expressly retained by the owner.
Leveraged Lease: A lease that involves a lender in addition to the lessor and lessee. The lender, usually a bank or
insurance company, puts up a percentage of the cash required to purchase the asset, generally more than half. The
balance is put up the lessor, who is both the equity participant and the borrower.
Marketable Securities: Securities that are easily sold. On a corporation's balance sheet, they are assets that can
be readily converted into cash, such as government securities, banker's acceptances, and commercial paper.
Notional Amount: A number of currency units, shares, bushels, pounds, or other units specified in the contract.
Operating Lease: A type of lease, normally involving equipment, whereby the contract is written for considerably
less than the life of the equipment and the lessor handles all maintenance and servicing.
Right of Return: The option of the purchaser to give goods back to the seller for full credit.
Underlying Amount: A specified interest rate, security price, commodity price, foreign exchange rate or rate index,
or other variable (including the occurrence or nonoccurrence of a specified event, such as a scheduled payment
under a contract).
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236
INDEX
A Functional currency
Changing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
ACCOUNTING CHANGES Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Changes in functional currency . . . . . . . . . . . . . . . . . . . . . . . . . 158 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Factors in determining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
ACCOUNTING POLICIES Highly inflationary economies . . . . . . . . . . . . . . . . . . . . . . . 165
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Management judgment in determining . . . . . . . . . . . . . . . . 158
Remeasuring books of record into . . . . . . . . . . . . . . . . . . . 159
C Gains and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Gains and losses on translation . . . . . . . . . . . . . . . . . . . . . . . . . 162
CONSTRUCTION CONTRACTORS Gains and losses to be excluded from net income . . . . . . . . . 166
Balance sheet presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224 Hedge contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Completedcontract method . . . . . . . . . . . . . . . . . . . . . . . 223, 224 Highly inflationary economies . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Contract claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 Income tax considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Disclosure requirements Intercompany profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Provision for anticipated losses . . . . . . . . . . . . . . . . . . . . . . 224 Inventories, applying lower of cost or market rule . . . . . . . . . . 161
Percentageofcompletion method . . . . . . . . . . . . . . . . . . 223, 224 Liquidation of investment in a foreign entity . . . . . . . . . . 162, 166
Provision for anticipated losses . . . . . . . . . . . . . . . . . . . . . . . . . 224 Objective of translation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Revenue recognition methods Remeasuring books of record into functional currency . . . . . 159
Completedcontract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 Sale of investment in a foreign entity . . . . . . . . . . . . . . . . 162, 166
Percentageofcompletion . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Selection of method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 Statement of changes in equity . . . . . . . . . . . . . . . . . . . . . . . . . 166
Stockholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
D Translating foreign currency statements . . . . . . . . . . . . . . . . . . 159
Translating foreign currency statements into
DERIVATIVES AND HEDGING reporting currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Cash flow hedges Translation gains and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Accounting for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132 Weightedaverage exchange rates . . . . . . . . . . . . . . . . . . . . . . 162
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 I
Foreign currency cash flow hedges . . . . . . . . . . . . . . . . . . 133
Impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 INCOME STATEMENT
Definition of derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Discontinued operations
Disclosure changes after the adoption of SFAS No. 161 . . . . 152 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Disclosures prior to the adoption of SFAS No. 161 Extraordinary items
Cash flow hedges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Conversion option in a convertible debt instrument
that no longer meets separation criteria . . . . . . . . . . . . . . . 151 INCOME TAXES
Fair value hedges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Accounting policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
General disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Adjustments of the opening balance of
Hedges of net investment in foreign operations . . . . . . . . 151 retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
Sellers of credit derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . 151 Allocating consolidated tax provision to subsidiaries . . . . . . . 195
Embedded derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 Allocation of income tax expense or benefit
Entities that do not report earnings . . . . . . . . . . . . . . . . . . . . . . 139 Assets acquired by a pooling of interest . . . . . . . . . . . . . . 193
Excluded contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Foreign currency translation adjustment . . . . . . . . . . . . . . 193
Fair value hedges Pretax income/loss from continuing operations . . . . . . . . 192
Accounting for . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 Stockholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . 192, 193
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 Tax benefits of loss carrybacks . . . . . . . . . . . . . . . . . . . . . . 194
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150 Alternative minimum tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
Foreign currency fair value hedges . . . . . . . . . . . . . . . . . . . 127 Balance sheet classification of deferred taxes . . . . . . . . . . . . . 191
Hedge ineffectiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Calculation of basic tax provision . . . . . . . . . . . . . . . . . . . . . . . . 177
Foreign currency cash flow hedges . . . . . . . . . . . . . . . . . . . . . . 133 Change in tax laws or rates . . . . . . . . . . . 187, 193, 194, 197, 200
Foreign currency hedge of net investment in Change in tax status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193, 200
foreign operation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Current income tax expense or benefit . . . . . . . . . . . . . . . . . . . 188
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151 Deductible temporary differences . . . . . . . . . . . . . . . . . . . . . . . 182
Internal derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 Deferred income tax expense or benefit . . . . . . . . . . . . . . . . . . 188
Notforprofit entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Deferred tax assets/liabilities
Pension plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Classifying in a balance sheet . . . . . . . . . . . . . . . . . . . . . . . 191
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
F Discounting not appropriate . . . . . . . . . . . . . . . . . . . . . . . . . 195
Foreign income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
FOREIGN OPERATIONS AND CURRENCY TRANSLATION Graduated rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
Changing the functional currency . . . . . . . . . . . . . . . . . . . . . . . 158 Local taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
Current exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166 Multiple tax jurisdictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166 Offsetting assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . 192
Elimination of intercompany profits . . . . . . . . . . . . . . . . . . . . . . 166 Selecting a tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
Exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162, 166 State taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
Foreign currency transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Definitions
Foreign currency translations . . . . . . . . . . . . . . . . . . . . . . 162, 166 Deductible temporary differences . . . . . . . . . . . . . . . . . . . . 182
Foreign entities in highly inflationary economies . . . . . . . . . . . 165 Intraperiod tax allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
237
Taxable temporary differences . . . . . . . . . . . . . . . . . . . . . . . 182 Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199

Temporary differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 Morelikelythannot threshold . . . . . . . . . . . . . . . . . . . . . . . 199
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Valuation allowance . . . . . . . . . . . . . . . . . 177, 186, 187, 192, 200
Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . 192, 200
Employee stock ownership plan (ESOP) . . . . . . . . . . . . . . . . . 193 INTERIM REPORTING
Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192, 200 Calculating tax provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
Financial statement presentation of deferred taxes . . . . . . . . 191 Determining tax effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
Foreign earnings repatriation . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Government grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 INVENTORY
Income taxes on intercompany profits . . . . . . . . . . . . . . . . . . . 195 Foreign currency translation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Income tax provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188, 200
Interim period financial statements . . . . . . . . . . . . . . . . . . . . . . 197 N
Changes in tax rates or new tax regulation . . . . . . . . . . . . 197
Uncertainty in income taxes . . . . . . . . . . . . . . . . . . . . . . . . . 198 NONMONETARY TRANSACTIONS
Intraperiod tax allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192 Involuntary conversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Allocating the tax benefit of loss carrybacks and
carrforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 P
Investment tax credit (ITC) . . . . . . . . . . . . . . . . . . . . . . . . 198, 200
Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 PRIORPERIOD ADJUSTMENTS
Loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . 177, 186, 200 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Measuring deferred tax assets and liabilities
Changes in future tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . 187 R
Considering alternative minimum tax rates . . . . . . . . . . . . 187
Considering need for a valuation allowance . . . . . . . . . . . 187 RESEARCH AND DEVELOPMENT
General rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186 Accounting requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
Selecting a tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186 Acquired in a business combination . . . . . . . . . . . . . . . . . . . . . 212
Tax losses expected during reversal period . . . . . . . . . . . . 187 Computer software costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
Multiple tax jurisdictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
Offsetting tax assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . 192 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 Examples of activities typically excluded . . . . . . . . . . . . . . . . . 211
Priorperiod adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Examples of activities typically included . . . . . . . . . . . . . . . . . . 211
Proprietorships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 Research and development arrangements
Public company disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Circumstances that may indicate obligation . . . . . . . . . . . 213
Quasireorganization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Related parties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Example of arrangement . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
S corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 Issuance of warrants or similar instruments . . . . . . . . . . . . 214
Separate financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Loans or advances to other parties . . . . . . . . . . . . . . . . . . . 214
Separate financial statements of a subsidiary . . . . . . . . . . . . . 195 Obligation is a liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
Statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202 Obligation to perform contractual services . . . . . . . . . . . . 213
Stockholders' equity, allocating taxes to . . . . . . . . . . . . . 192, 200 Purchase of other parties' interest in arrangements . . . . . 214
Taxable temporary differences . . . . . . . . . . . . . . . . . . . . . . . . . . 182 Stock issued to acquire results of . . . . . . . . . . . . . . . . . . . . 214
Tax credit carryforwards . . . . . . . . . . . . . . . . . . . . . . . 177, 186, 200 Software purchased or developed for internal use . . . . . . . . . 212
Tax planning strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 Software to be sold, leased, or otherwise marketed . . . . . . . . 213
Tax provision, calculating . . . . . . . . . . . . . . . . . . . . . . . . . 177, 188 Types of costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
Tax rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
Temporary differences REVENUE RECOGNITION
Business combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 Barter transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 Conditions for recording revenue . . . . . . . . . . . . . . . . . . . . . . . . 218
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Costrecovery method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Identifying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 Extended warranty and product maintenance contracts . . . . 220
Investment in foreign subsidiary . . . . . . . . . . . . . . . . . . . . . 195 General rule for revenue recognition . . . . . . . . . . . . . . . . . . . . . 218
Multiple tax jurisdictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 Installment method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Policyholders' surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195 Involuntary conversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Reversal is indefinite . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195 Multiple deliverable arrangements . . . . . . . . . . . . . . . . . . 219, 224
Situations that give rise to . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 Reporting gross vs. net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
Taxable versus deductible . . . . . . . . . . . . . . . . . . . . . . . . . . . 182 Right of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
Tax bad debt reserves of savings and loan Sale of real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
associations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
Undistributed earnings of a domestic subsidiary . . . . . . . 195 S
Uncertainty in income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198 STOCK OPTIONS AND OTHER SHAREBASED PAYMENTS
Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Employee stock ownership plans (ESOPs)
Interest and penalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 Accounting for tax effects . . . . . . . . . . . . . . . . . . . . . . 193, 194
238
COURSE 3
OVERVIEW
COURSE DESCRIPTION: This interactive selfstudy course covers a variety of GAAP topics including
accounting policies, changes and error corrections, financial statement
presentation, the balance sheet, the income statement, the cash flows statement,
comprehensive income, and earnings per share.
DATE:
PREPARATION:

KNOWLEDGE LEVEL: Basic

Describe various accounting requirements and identify disclosure requirements both for accounting changes
and for when previously issued priorperiod financial statements are adjusted.
Discuss the hierarchy of accounting literature and the required disclosures for accounting policies within
financial statements.
Identify attributes of current assets and liabilities and discuss the requirements and disclosures of offsetting
assets and liabilities in the financial statements.
239

Identify the accounting requirements and basic elements of the statement of cash flows.
List what is included in operating activities and describe the various formats for presenting cash flows from
operations.
Explain cash flows from investing activities including capital expenditures, investments, and loans.
Identify the cash flows from financing activities, the noncash investing and financing activities, and the
disclosures required for the cash flows statement.
Explain comprehensive income, its components and how it is reported.

Explain basic earnings per share and diluted earnings per share and how each are calculated.
Describe how different types of securities affect earnings per share and the disclosure requirements for
earnings per share.
Identify items related to the income statement and the presentation of each item including revenue, expenses,
extraordinary items, and unusual or infrequent items.
Explain the financial presentation of discontinued operations, going concerns and disposing of a component
of an entity.
Thomson Reuters
240

INTRODUCTION
This lesson will be discussing accounting changes and error corrections, accounting policies, and the balance
sheet. All three broad categories of accounting changes will be described. Applying generally accepted accounting
principles often involves choosing from a number of acceptable accounting principles and methods. Selecting one
alternative over another may result in significantly different financial results. Consequently, all accounting policies
should be disclosed with financial statements are presented. A discussion of classified balanced sheets will be
included as the last part of this lesson.

Describe various accounting requirements and identify disclosure requirements both for accounting changes
and for when previously issued priorperiod financial statements are adjusted.
Discuss the hierarchy of accounting literature and the required disclosures for accounting policies within
Identify attributes of current assets and liabilities and discuss the requirements and disclosures of offsetting
assets and liabilities in the financial statements.
ACCOUNTING CHANGES AND ERROR CORRECTIONS
OVERVIEW
There are three broad categories of accounting changes:
a. changes in an accounting principle,
b. changes in an accounting estimate, and
c. changes in the reporting entity.
Corrections of errors are not accounting changes.
An overall presumption in financial statement preparation is that the accounting principles adopted by an entity will
be applied consistently from period to period. However, entities sometimes change accounting principles to use a
preferable method of accounting. Changes in accounting principles are generally recorded through retrospective
application to prior year financial statements. In some cases, changes may be recorded on a prospective basis.
Disclosures are required in the year of the change. (However, when a change is required by a new accounting
standard that prescribes specific transition guidance, those requirements should be followed when accounting for
and reporting the change.)
Changes in accounting estimates are common in practice and result from new events or occur as a company gains
more experience or obtains additional information. Changes in estimates are reported in the period the estimate is
revised or in both the current and future periods if the change affects future periods.
A change in reporting entity is a change that results in financial statements that are, in effect, the statements of a
different entity. Changes in reporting entity are generally limited to changes in the companies or subsidiaries that
are included in combined or consolidated financial statements. Changes in reporting entity are accounted for by
retrospective application to financial statements of prior periods.
When an error is discovered in previously issued prior period financial statements, an adjustment to correct the
error, referred to as a prior period adjustment," may be necessary. The balance of retained earnings at the
241
beginning of the period should be restated for the effects of prior period adjustments. In addition, if the financial
statements of the affected prior periods are presented, the components of net income, retained earnings, and other
affected accounts of those prior periods should be restated. Certain disclosures about the adjustments and their
effects on prior period net income are required in the year in which the adjustments are made.
FASB ASC 250, Accounting Changes and Error Corrections (formerly SFAS No. 154, Accounting Changes and Error
Corrections), addresses the accounting and reporting for changes in accounting principle, accounting estimate,
and reporting, entity along with corrections of errors in previously issued financial statements.
The retrospective application method is required for all voluntary changes in accounting principle and those
changes required by an accounting standard that does not provide specific transition provisions. (New authorita
tive standards often provide detailed transition guidance on how to apply the provisions of the standard. That
guidance may mandate one or more methods to adopt the standard. Furthermore, the transition guidance may
require certain disclosures that are unique to the adoption of the standard. In such cases, the detailed transition
guidance provided in the standard should be followed.)
How accounting changes are reported depends on whether the change is a change in accounting principle,
accounting estimate, or reporting entity. Exhibit 11 presents a flowchart that summarizes the accounting for each
type of change. Exhibit 12 summarizes the accounting, reporting, and disclosure requirements for accounting
changes. The remaining paragraphs discuss each type of accounting change in more detail.
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Exhibit 11
Accounting Changes
Change
Change Change
to preferable
in in reporting
accounting
estimate entity
principlea
Is the
change in
Yes principle insepara
ble from a change
in estimate?
No
Is it
practicable
to apply the Yes
change to all
prior periods
presented?
Retrospective
No application to
all prior
periods
Can the
cumulative
effect be deter Yes
mined, but not
the periodspe
cific effects?
No
Apply in income Apply prospec Apply cumulative effect
statements of cur tively as of the to opening balances of
rent and prospec earliest date the earliest period
tive periods practicable practicable
Note:
a The change may be voluntary or required by a new accounting standard that does not specify transition
requirements. If transition requirements are provided by a new accounting standard, those specific
requirements should be followed for the accounting change.
* * *
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Exhibit 12
Summary of Accounting and Disclosure Requirements Accounting Changes
Type of
Accounting Accounting Disclosure
Change Treatment Accounting Requirements Requirements
Change in Accounting Principle
Change in Retrospective application to all Report current period operating (1) Disclose the nature and
Accounting prior periods presented results using the new account reason for the change and why
Principle ing method. it is preferable.
(generalrule)
Determine cumulative effect of (2) Disclose the method of
the change as if the different applying the change, including a
accounting principle had always description of prior period
been used for periods not information adjusted, the effect
presented and apply to the on financial statement line items
opening assets and liabilities of and per share amounts for the
the earliest period presented. current and prior periods
Offset is to retained earnings. adjusted, and the cumulative
effect on retained earnings of
Adjust prior financial statements the earliest period presented.
presented to reflect the period
specific effects of applying the (3) Describe any indirect effects
new principle. recognized and the amounts
attributable to each period
presented.
Change in Accounting Princi Retrospective application to Determine cumulative effect of The disclosures above, where
ple (impracticable to deter earliest period practicable the change and apply to the applicable, and the reasons and
mine periodspecific effects opening assets and liabilities of description of the alternative
on all prior periods) the earliest period practicable. method used to report the
Offset is to retained earnings. change.
Beginning with the earliest

period practicable, adjust prior
financial statements presented
to reflect the periodspecific
effects of applying the new
principle.
Change in Accounting Princi Prospective application as of the Report operating results using The disclosures above, where
ple (impracticable to deter earliest date practicable the new accounting method applicable, and the reasons and
mine cumulative effect of from the earliest date practica description of the alternative
applying the change to any ble. method used to report the
prior period) change.
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Type of
Accounting Accounting Disclosure
Change Treatment Accounting Requirements Requirements
Changes in Estimate and Reporting Entity
Change in Current and prospective periods Record in income statements of (1) For a change that affects
Estimate current and future periods. several future periods and for
material changes in estimates
Report current and future finan made each period in the ordi
cial statements on the new nary course of accounting,
basis. disclose the effect on income
from continuing operations and
net income of the current period,
Present prior period financial
and related per share amounts.
statements as previously pre
sented.
(2) For changes in accounting
estimate that have been effected
by changing an accounting
principle, make the change in
accounting principle disclo
sures.
(3) When a change has no

material effect in the change
period, but is reasonably certain
to have a material effect in later
periods, describe the change
whenever the financial state
ments of the change period are
presented.
Change in Retrospective application Restate the financial statements For the period of the change
Reporting Entity for all prior years presented. disclose
Determine operating results of (1) the nature and the reason for
prior years based on the new the change.
reporting entity.
(2) the effect on income before
extraordinary items, net income,
and related per share amounts
for all periods presented.
* * *
CHANGE IN ACCOUNTING PRINCIPLE
Definition of a Change in Accounting Principle
A change in accounting principle is generally defined as a change from one acceptable principle to another or a
change in the method of applying an acceptable accounting principle. (FASB ASC 2501020) (formerly SFAS 154,
par. 2) A change to an unacceptable method, including the use of a tax or cash method of accounting for an item
in GAAP financial statements, results in a GAAP departure. A change from an unacceptable method to an accept
able method is a correction of an error and not a change in accounting principle as defined by GAAP. (FASB ASC
2501020) (formerly SFAS No. 154, par. 2)
Circumstances That Are Not Changes in Accounting Principle. The following events or circumstances are not
considered to be accounting changes:
a. Adoption of an accounting principle for new events or transactions, substantially different events or
transactions, or material events or transactions that previously were immaterial (FASB ASC 25010451)
b. Changes in classification
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c. A change in accounting principle for income tax purposes only
Change in Components of Inventory Cost. Under generally accepted accounting principles, inventory is stated
at cost. Generally, inventory costs include the cost of raw materials, direct labor, purchased finished goods, and
allocated indirect costs. A change in inventory cost components (for example, to allocate insurance costs to
inventory) is considered a change in accounting principle. (FASB ASC 25010551) (formerly FIN 1, par. 5)
Changes Prescribed by New or Existing Accounting Standards. An entity may change an accounting principle
because it is required by a new accounting standard. Accounting standards typically provide specific transition
requirements. In some cases, a new or existing standard will permit alternative accounting principles and will
provide requirements for changing from one alternative to the other. When the standards specify transition require
ments, that transition or other adoption guidance should be followed. If standards do not provide specific transition
guidance, the change in accounting principle should be reported as discussed in this lesson. (FASB ASC
Justifying Changes in Accounting Principles. Changes in accounting principle are permitted only if an entity
justifies the use of an alternative acceptable accounting principle on the basis that it is preferable. (FASB ASC
250104512) (formerly SFAS 154, par. 13) For example, if there are acceptable alternative methods of accounting
for certain items, entities may change among those alternative methods. However, a company should not change
an accounting principle unless the proposed new principle is in conformity with GAAP and management believes
that the new principle is preferable in the circumstances.
New authoritative accounting standards that either create new accounting principles, interpret existing principles,
express a preference for accounting principles, or reject specific accounting principles are sufficient support for
changes in accounting principles. (FASB ASC 250104513) (formerly SFAS 154, par. 14) The entity is responsible
for justifying other changes in accounting principle.
Accounting Treatment of a Change in Accounting Principle
Changes in accounting principle (as well as adoption of new standards that lack transition guidance) should be
reported through retrospective application to all prior periods unless it is impracticable to do so. (FASB ASC
Notwithstanding the general rule stated above, there may be circumstances when GAAP provides different transi
tional guidance. The following summarizes the various methods that may be used to account for changes in
accounting principles:
a. Retrospective application
(1) Retrospective application to all prior periods should be used for all voluntary changes in accounting
principle and those situations where an accounting standard does not provide specific transition
guidance, unless it is impracticable to do so.
b. Prospective change
(1) In certain situations when it is impracticable to apply a change in accounting principle retrospectively,
prospective application is used.
(2) New standards that specify transition guidance may allow prospective accounting.
In some cases, a new accounting standard may provide more than one transition method. For example, when
issued, FASB ASC 718, (formerly SFAS No. 123(R)), ShareBased Payment specified three different transition
methods modified prospective, modified retrospective, and prospective depending on which method of
accounting for sharebased compensation was used prior to the effective date of the statement.
Prior to FASB ASC 250 (formerly SFAS No. 154), accounting rules generally required that the cumulative affect of
a change in accounting principle be reported in the income statement between the captions extraordinary items"
246
and net income." FASB ASC 250 (formerly SFAS No. 154) has superseded that guidance. The cumulative effect is
now ordinarily reported as an adjustment of beginning retained earnings.
The accounting and reporting requirements for changes in accounting principles are discussed in the following
paragraphs.
Retrospective Application
Method of Application. Retrospective application is the application of a different accounting principle to previously
issued financial statements (or to the opening balances of the current statement of financial position) as if the
different principle had always been used. (FASB ASC 2501020) (formerly SFAS 154, par. 2) The following general
steps should be performed when applying a change in accounting principle retrospectively: (FASB ASC
a. Adjust the carrying amounts of assets and liabilities as of the beginning of the first period presented to
reflect the cumulative effect of the change to the new accounting principle. The offsetting adjustment is
made to the opening balance of retained earnings for that period.
b. Restate the financial statements for each period presented to reflect the periodspecific effects of applying
the new accounting principle.
When applying the retrospective method, only the direct effects of the change in accounting principle (including
related income tax effects) should be included. Indirect effects that would have been recognized if the accounting
principle had been followed in previous years should not be included in the retrospective application. Indirect
effects that are actually incurred should be reported in the period in which the accounting change is made. (FASB
ASC 25010458) (formerly SFAS 154, par. 10) For example, a change in a nondiscretionary profit sharing or royalty
payment based on reported revenues or net income is considered an indirect effect. (FASB ASC 2501020)
Impracticability. A change in accounting principle should be retrospectively applied unless it is impracticable to do

so. If any of the following conditions exist, retrospective application is considered impracticable: (FASB ASC
a. The entity is unable to apply the retrospective application after making every reasonable effort.
b. Retrospective application would require assumptions about management's intent in a prior period that
cannot be independently supported.
c. Significant estimates of amounts are required and it is impossible to objectively determine which
information currently available about those estimates (1) provides evidence of circumstances that existed
on the dates the amounts would have been recognized, measured, or disclosed, and (2) would have been
available at the time the prior period financial statements were issued.
If it is impracticable to apply a change in accounting principle retrospectively to all prior periods presented, the
following guidance applies: (FASB ASC 25010456 and 457) (formerly SFAS 154, paras. 89)
a. If the cumulative effect of applying the change can be determined for all prior periods, but determining the
periodspecific effects on all prior periods presented is impracticable, the cumulative effect should be
applied to carrying amounts of assets and liabilities as of the beginning of the earliest period to which the
new accounting principle can be applied. The offset should be made to the opening balance of retained
earnings for that period.
b. If it is impracticable to determine the cumulative effect of applying the change to any prior period, the new
accounting principle should be applied prospectively as of the earliest date practicable.
A change from the firstin, firstout (FIFO) method of inventory valuation to the lastin, firstout (LIFO) method might
be an example of a change in accounting principle where it is impracticable to determine the cumulative effect of
applying the change to one or more prior periods.
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Changes in Depreciation Methods
Adopting a New Depreciation Method. A change in the depreciation, amortization, or depletion method for
longlived assets should be accounted for as a change in accounting estimate as discussed below. The change in
depreciation methods is considered to be a change in accounting estimate that is effected by a change in
accounting principle. Consequently, the change may only be made if the new accounting principle (i.e., depreci
ation method) is justifiable on the basis that it is preferable. (FASB ASC 250104518 and 4519) (formerly SFAS
154, paras. 2021)
Distinguishing between a change in accounting principle and a change in accounting estimate is often difficult. For
example, a change in depreciation methods is often predicated on new information about the remaining future
benefits to be derived from the assets and the patterns of consumption. The effect of the change in accounting
principle and the change in accounting estimate are often inseparable. Since such changes arise from the process
of reviewing new information and revising estimates that were previously made, the change is considered a change
in estimate.
Since a change in depreciation methods is a change in accounting estimate that is effected by a change in
accounting principle, the disclosures required for a change in accounting principle apply in addition to those
required for a change in accounting estimate. (FASB ASC 25010504) (formerly SFAS 154, par. 22)
Planned Change in Depreciation Method. Since declining balance methods do not depreciate to zero, some
companies adopt a policy of using a declining balance method until depreciation drops below what straightline
depreciation would have been and then switch to straightline depreciation. The book value of the asset when the
change is made is depreciated on a straightline basis over the asset's remaining useful life. For example, a
company may establish a policy that for a certain type of asset, it will use the double declining balance method for
the first two years (assuming two years is the breakeven point), then switch to the straightline method. The policy
is acceptable for GAAP and would actually reflect the economic decline in value of many assets. GAAP specifically
states that the consistent application of a policy to change to the straightline method at a specific point in the
service life of an asset does not constitute a change in accounting principle. (FASB ASC 250104520) (formerly
SFAS 154, par. 21)
Changes in Interim Periods
For interim financial statements, a change in an accounting principle occurs if an accounting principle or the
method of applying a principle differs from that used in the preceding interim period, the prior annual period, or the
comparable interim period of the prior year. (FASB ASC 270104512) (formerly APB 28, par. 23) Changes in
accounting principle made in interim periods should be recognized by using the retrospective application method
for prior interim periods. An entity may decide it is impracticable to apply the retrospective method to prior interim
periods of the current year. For example, an entity may not be able to distinguish between the cumulative effects of
the change on prior years and the effects on prior interim periods of the year of change. In these rare instances, the
change can only be made as of the beginning of a subsequent year. (FASB ASC 250104514) (formerly SFAS 154,
par. 15)
CHANGE IN ACCOUNTING ESTIMATE
A change in accounting estimate results from additional information or new developments. Such changes adjust
the carrying amounts or alter the subsequent accounting for existing or future assets or liabilities. Examples of
accounting estimates that periodically change are allowances for bad debts, useful lives or salvage values of
depreciable assets, and inventory obsolescence. (FASB ASC 2501020) (formerly SFAS 154, par. 2) The effects of
changes in estimates should be reported in the period of change and subsequent periods. Restatement or
retrospective adjustment of prior periods is not appropriate. Also, reporting pro forma amounts is not permitted.
(FASB ASC 250104517) (formerly SFAS 154, par. 19) For example, a change in the estimated useful lives of
assets would be accounted for by adjusting depreciation expense in the current and future periods to depreciate
the carrying value of assets at the date of the change over their remaining (new) useful lives.
Changes in estimates that are inseparable from changes in accounting principle, such as a change from deferring
and amortizing a cost to expensing it as incurred because of a reassessment of future benefits, should be
248
accounted for as changes in accounting estimates. (FASB ASC 250104518) (formerly SFAS 154, par. 20)
However, a change in accounting estimate that is effected by a change in accounting principle should only be
made if the change is justifiable on the basis that it is preferable. In addition, the disclosures for a change in
accounting principle would apply. (FASB ASC 250104519; 25010504) (formerly SFAS 154, paras. 2122)
Change in Salvage Value and Estimated Useful Life
Changes in salvage value and estimated useful life are normally changes in estimates caused by, for example,
changing market conditions or better information. (FASB ASC 2501020) (formerly SFAS 154, par. 2) Prior period
financial statements should not be adjusted for changes in estimates. Instead, the dollar amount of the change
should be recorded entirely in current year earnings or current and future earnings if the change affects both. (FASB
To illustrate, assume that a repair shop buys a press for $12,000 and estimates that it will have a useful life of five
years. However, at the end of the fourth year, management believes it can use the press for four more years. Using
the original estimate, annual depreciation was $2,400 ($12,000 5), but using the revised estimate, annual
depreciation should have been $1,500 ($12,000 8). As a result, there is an overstatement of depreciation of $900
($2,400 $1,500) for each of the first four years (for a total of $3,600), which should be spread over depreciation
of years five through eight. The undepreciated cost at the time of the change in estimate of $2,400 ($12,000
$9,600) should be allocated to the remaining four years at $600 per year as follows.
Year Depreciation
1 $ 2,400
2 2,400
3 2,400
4 2,400
5 600
6 600
7 600
8 600
$ 12,000
The catchup" method, which would reduce depreciation in the preceding example by $3,600 in the year of
change, is a departure from GAAP.
CHANGE IN REPORTING ENTITY
Definition of a Change in Reporting Entity
A change in reporting entity refers to a change that results in financial statements that are, in effect, the statements
of a different reporting entity. Typically, such changes are limited to changes in the companies or subsidiaries that
are included in combined or consolidated financial statements. (FASB ASC 2501020) (formerly SFAS 154, par. 2)
Changes in the legal form of businesses, for example, sole proprietorship to corporation, are not changes in the
reporting entity.
Identifying a Change in Reporting Entity
Determining when a change in reporting entity occurs is important because it should be accounted for by retro
spectively adjusting the financial statements of prior periods to show financial information for the new reporting
entity for all periods. (FASB ASC 250104521) (formerly SFAS 154, par. 23) A change in reporting entity takes
place when the following occurs: (FASB ASC 2501020) (formerly SFAS 154, par. 2)
a. Consolidated or combined statements are presented in place of the statements of individual companies.
b. Specific subsidiaries comprising the group of companies for which consolidated financial statements are
presented change.
249
c. Entities included in combined financial statements change.
Neither a business combination nor the consolidation of a variable interest entity constitutes a change in reporting
entity. (FASB ASC 2501020) (formerly SFAS 154, par. 2) Financial statements that include a business combination
should not be retrospectively adjusted.
In all cases, the key issue in deciding whether a change qualifies as a change in reporting entity is to determine if
the change results in financial statements that are, in effect, those of a different reporting entity. (FASB ASC
2501020) (formerly SFAS 154, par. 2) The concept of a different reporting entity differs from that in which the
reporting entity is the same but whose mix of assets and liabilities has changed. The latter situation does not
constitute a change in reporting entity.
PRIOR PERIOD ADJUSTMENTS
Profits and losses related to the correction of an error in prior period financial statements should not be included in
currentperiod net income. (FASB ASC 250104522) (formerly SFAS 16, par. 11) Instead, the prior period's
financial statements (and beginning retained earnings of the current period) should be retroactively adjusted to
correct the error. (FASB ASC 250104524) (formerly APB 9, par. 18) An error may result from any of the following:
Making a mathematical mistake
Using an accounting principle that is not in conformity with GAAP (This differs from a change in accounting
principle, which is a change from one acceptable principle to another or a change from one acceptable
method of applying a principle to another acceptable method. A change in accounting principle is not
considered an error.)
Applying a GAAP principle incorrectly
Disregarding or misusing facts that existed at the date the financial statements were prepared (This differs
from a change in accounting estimate, which results from new information or developments that did not
exist at the time the financial statements were prepared.)
A prior period adjustment is made by adjusting the current period's beginning retained earnings balance for the
error's effect on prior years' earnings. In addition, balance sheets and income statements of the affected prior
periods, if presented as comparative statements, should be restated to show the correct amounts. (FASB ASC
250104524) (formerly APB 9, par. 18)
To illustrate correcting an error in prior period financial statements, assume that a company determined in 20X2 that
its inventories were understated by $190,000 at the end of 20X1 and $120,000 at the beginning of 20X1. As a result,
20X1 income before taxes was understated by $70,000 ($190,000 $120,000), and net income after taxes
(assuming a 30% tax rate) was understated by $49,000 [$70,000 ($70,000 30%)]. The company would adjust
its 20X1 balance sheet and income statement to reflect the proper balances of inventory, retained earnings, cost of
sales, and income tax expense, and present a statement of retained earnings similar to the following:
20X2 20X1
RETAINED EARNINGS AT BEGINNING

OF YEAR
As previously reported $ 1,711,000 $ 1,374,000
Adjustment for understatement of inventories (net of applicable income taxes of

$57,000 in 20X2 and $36,000 in 20X1) 133,000 84,000
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20X2 20X1
Balance at beginning of year, as restated 1,844,000 1,458,000
Net income (as restated in 20X1) 419,000 386,000
RETAINED EARNINGS
AT END OF YEAR $ 2,263,000 $ 1,844,000
Adjustment Related to Prior Interim Periods of the Current Fiscal Year
GAAP requires prior interim periods of the current fiscal year to be restated for the adjustment or settlement of (a)
litigation or similar claims, (b)income taxes (excluding the effects of retroactive tax legislation), (c) renegotiation
proceedings, or (d) utility revenues subject to a ratemaking process. Prior interim periods may only be adjusted for
those items, however, if all of the following criteria are met:
The adjustment or settlement is material to income from continuing operations of the current fiscal year (or
to the trend of income from continuing operations) or is material as measured by other appropriate criteria.
All or part of the settlement is specifically identifiable with prior interim periods of the current fiscal year. (This
criterion is not met solely because of incidental effects such as interest on a settlement.)
The settlement amount could not be reasonably estimated prior to the current interim period but becomes
reasonably estimable in the current interim period. (This criterion normally is met by the occurrence of an
event whose effects can be currently measured, such as a final decision on a rate order.)
Prior interim periods should not be restated for normal or recurring corrections that result from the use of estimates.
Consequently, prior interim periods should not be restated for adjustments to the provision for doubtful accounts
even if the adjustments result from litigation or similar claims. (FASB ASC 250104525; 270104517) (formerly
SFAS 16, par. 13)
When adjusting interim periods of the current fiscal year, any settlement related to prior fiscal years should be
included in the first interim period's income. Otherwise, the interim periods of the current fiscal year that are affected
by the adjustment should be restated. (FASB ASC 250104526; 270104518) (formerly SFAS 16, par. 14) For
example, net income of the second and third quarters of the current fiscal year would be restated if a settlement
occurring in the fourth quarter relates to the business activities of the second and third quarters.
ACCOUNTING CHANGES
The following is a summary of disclosure requirements for accounting changes:
a. Changes in accounting principles. In the period in which the change is made, disclosure should be made
of the following [Except as indicated in a.(1), financial statements for subsequent periods are not required
to repeat the disclosures in a.(1)(3)]
(1) The nature and reason for the change, including an explanation of why it is preferable. (When a change
has no material effect in the change period, but is reasonably certain to have a material effect in later
periods, this disclosure is required whenever the financial statements of the change period are
presented.) (FASB ASC 25010501) (formerly SFAS 154, par. 17)
(2) The method of applying the change including: (FASB ASC 25010501 and 502) (formerly SFAS 154,
par. 17)
A description of any prior period information that has been retrospectively adjusted
251
The effect of the change on income from continuing operations, net income, and any other
affected financial statement line item (and for public companies, related per share amounts) for
the current period and prior periods retrospectively adjusted
The cumulative effect of the change on retained earnings (or other components of equity) as of
the beginning of the earliest period presented
The reasons and a description of the alternative method used to report the change when
retrospective application to all prior periods is impracticable
(3) If the indirect effects of a change in accounting principle are recognized: (FASB ASC 25010501)
A description of the indirect effects of the change, including amounts that have been recognized
in the current period (and for public companies, related per share amounts)
The amount of the total recognized indirect effects of the accounting change (and for public
companies, related per share amounts) that are attributable to each prior period presented,
unless impracticable
Generally, effect of applying the guidance in FASB ASC 105, Generally Accepted Accounting Principles (formerly
SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting
Principles) should be reported as a change in accounting principle or correction of an error. In addition to the
preceding disclosures, an entity should also disclose the accounting principles used before and after adopting the
guidance in FASB ASC 105 and the reasons why a change in accounting principle or correction of an error resulted.
With certain limited exceptions, SFAS No. 168 is effective for interim and annual periods ending after September 15,
2009. Prior to the guidance introduced by SFAS No. 168, SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles, contained the same requirements regarding the effect of its application. SFAS No. 162 was
effective as of November 15, 2008. SFAS No. 168 replaced SFAS No. 162.
b. Changes in accounting estimates. Disclosure should be made of the following
(1) For a change in estimate that affects several future periods, the effect on income from continuing
operations and net income (and for public companies, related per share amounts) of the current
period (FASB ASC 25010504) (formerly SFAS 154, par. 22)
(2) The effect, if material, on income from continuing operations and net income (and for public
companies, related per share amounts) for changes in estimates made each period in the ordinary
course of accounting for items such as uncollectible accounts or inventory obsolescence (FASB ASC
(3) For changes in accounting estimate that have been effected by changing an accounting principle, the
disclosures in item a. (FASB ASC 25010504) (formerly SFAS 154, par. 22)
(4) When a change in estimate has no material effect in the change period, but is reasonably certain to
have a material effect in later periods, a description of the change whenever the financial statements
of the change period are presented (FASB ASC 25010504) (formerly SFAS 154, par. 22)
c. Changes in reporting entity. In the period in which the change is made, disclosure should be made of the
following [Except as indicated in c.(1), financial statements for subsequent periods are not required to
repeat the disclosures in c.(1)(2)]
(1) The nature of the change and the reason for it. (When a change has no material effect in the change
period, but is reasonably certain to have a material effect in later periods, this disclosure is required
whenever the financial statements of the change period are presented.) (FASB ASC 25010506)
252
(2) For all periods presented, the effect of the change on income before extraordinary items, net income,
and other comprehensive income (and for public companies, related per share amounts). (FASB ASC
Accounting Changes Interim Periods
The following disclosures should be made for accounting changes in interim periods:
a. For changes in accounting principle made in the interim period, the disclosures in the above paragraph,
item a. (FASB ASC 25010502) (formerly SFAS 154, par. 17)
b. For interim periods subsequent to the date of adoption in the fiscal year of the change in accounting
principle, the effect of the change on income from continuing operations and net income (and for public
companies, on related per share amounts) for the post change interim periods (FASB ASC 25010503)
c. For changes in accounting estimate made in an interim period, the disclosures in the above paragraph,
item b., if the effect is material in relation to any period presented. Disclosure should be made in current
and subsequent interim periods and continue to be reported in the interim financial information of the
subsequent year for as many periods as necessary to avoid misleading comparisons. (FASB ASC
270104514) (formerly APB 28, par. 26)
d. For changes in reporting entity made in the interim period, the disclosures noted in the above paragraph,
item c. Also, previously issued interim statements should be presented on a retrospective basis (FASB ASC
Future Accounting Changes
When the accounting principles currently being followed are acceptable, an entity does not have to implement an
accounting standard prior to its effective date. However, entities that have not yet implemented, due to a future
effective date, a recently issued accounting standard that will require retrospective application and is expected to
have a material effect on results of operations or financial position should consider whether disclosure of the
following is necessary for adequate disclosure:
a. A brief discussion of the new standard, the date that implementation is required, and the date that the entity
plans to implement the standard
b. A discussion of the effect that implementation of the accounting standard is expected to have on the
financial statements or, if the effect is not known or is not reasonably estimable, a statement to that effect
If the estimated effect of implementing a new accounting standard is material, disclosure may be made by
supplementing the financial statements with pro forma information as if the adjustment had occurred as of the
balance sheet date. The information may be presented in the notes to the financial statements, in a column
alongside the statements, or in separate pro forma statements following the financial statements.
PRIOR PERIOD ADJUSTMENTS
The following disclosures are required when previously issued priorperiod financial statements are adjusted:
Correction of an Error
When a company restates priorperiod financial statements (and beginning retained earnings of the current period)
by recording the correction of an error, the following information should be disclosed:
a. Nature of the error (FASB ASC 25010507) (formerly SFAS 154, par. 26)
b. For single period financial statements, the effect of restatement (gross and net of tax) on beginning retained
earnings and on net income of the preceding period (FASB ASC 25010508 and 509) (formerly APB 9,
par. 26)
253
c. For comparative financial statements, the effect of restatement (gross and net of tax) on net income for each
period presented (FASB ASC 25010508 and 509) (formerly APB 9, par. 26)
d. The amount of income tax applicable to each prior period adjustment (FASB ASC 25010509) (formerly
APB 9, par. 26)
e. If a restated historical financial summary (commonly 5 or 10 years) is presented, disclosure of the

restatements in the first summary published after the restatements (FASB ASC 250104528) (formerly
APB 9, par. 27)
f. A disclosure that the previously issued financial statements have been restated (FASB ASC 25010507)
g. The effect of the correction on each financial statement line item for all prior periods restated (and for public
companies, related per share amounts that have been affected) (FASB ASC 25010507) (formerly SFAS
154, par. 26)
h. The cumulative effect of the change on retained earnings (or other appropriate components of equity) as
of the beginning of the earliest period presented (FASB ASC 25010507) (formerly SFAS 154, par. 26)
Adjustment Related to a Prior Interim Period of the Current Fiscal Year
When a company restates prior interim periods of the current fiscal year, the following information should be
disclosed:
a. The effect on income from continuing operations and net income (and for public companies, related per
share amounts) for each prior interim period of the current fiscal year (FASB ASC 250105011) (formerly
SFAS 16, par. 15)
b. Income from continuing operations and net income (and for public companies, related per share amounts)
for each restated prior interim period (FASB ASC 250105011) (formerly SFAS 16, par. 15)
Generally, financial statements of periods subsequent to the period in which the adjustment occurred need not
repeat the disclosures. (FASB ASC 250105010) (formerly SFAS 154, par. 26)
If a corrected error is only material to the interim period, but is not material to the estimated income for the full fiscal
year or to the trend of earnings, the change should be separately disclosed in the interim period. (FASB ASC
250104527) (formerly APB 28, par. 29)
254
SELFSTUDY QUIZ
following section.
1. Which of the following statements is accurate regarding accounting changes?
a. Changes in accounting principles are always recorded through retrospective application to prior year
b. Changes in accounting estimates generally are uncommon in practice.
c. Changes in accounting estimates are not always reported in the period the estimate is revised.
d. Changes in reporting entity are recorded on a prospective basis.
2. Regarding accounting changes, a change in estimate should be applied in which of the following ways?
a. Apply by retrospective application to all prior periods.
b. Apply in income statements of current and prospective periods.
c. Apply prospectively as of the earliest date practicable.
d. Apply cumulative effect to opening balances of the earliest period practicable.
3. A newspaper publishing company purchases a new printing press for $6,000 and estimates its useful life to be
five years. After four years of use, it is estimated that the printing press still has a useful life of four more years.
Under the original estimated useful life, annual depreciation was $1,200. Using the revised estimated useful
life, annual depreciation should have been $750. Thus, there is an overstatement of depreciation of $450 for
each of the first four years that should be spread over depreciation of years five through eight. The
undepreciated cost at the time of the change in estimate should be allocated to the remaining four years at
which of the following amounts per year?
a. $300.
b. $600.
c. $1,200.
d. $2,400.
4. Of the following statements, which one is inaccurate regarding when a change in reporting entity takes place?
a. Entities change that is included in combined financial statements.
b. Consolidated or combined statements are presented in addition to the statements of individual

companies.
c. Specific subsidiaries change that comprise the group of companies for which consolidated financial
statements are presented.
5. According to SFAS 154, par. 2, (FASB ASC 2501020), an error may result from any of the following actions
except:
a. An accounting principle being used that is not in conformity with GAAP.
255
b. Making a mathematical error.
c. Incorrectly applying a GAAP principle.
d. A change in accounting principle.
6. If certain criteria are met, GAAP requires prior interim periods of the current fiscal year to be restated for the
adjustment or settlement of a number of actions. Which of the following is not one of those actions that require
prior interim periods of the current fiscal year to be restated?
a. Utility revenues for which a ratemaking process applies.
b. Litigation or claims of a similar nature.
c. Income taxes that result from retroactive tax legislation.
d. Renegotiation proceedings.
256
SELFSTUDY ANSWERS
1. Which of the following statements is accurate regarding accounting changes? (Page 241)
a. Changes in accounting principles are always recorded through retrospective application to prior year
financial statements. [This answer is incorrect. Changes in accounting principles are generally recorded
through retrospective application to prior year financial statements; however, in some instances, changes
may be recorded on a prospective basis.]
b. Changes in accounting estimates generally are uncommon in practice. [This answer is incorrect. Changes
in accounting estimates are common in practice and result from new events or may occur as a company
obtains additional information or gains more experience.]
c. Changes in accounting estimates are not always reported in the period the estimate is revised. [This
answer is correct. Changes in accounting estimates are reported in the period the estimate is
revised or in both the current and future periods, if the change affects future periods.]
d. Changes in reporting entity are recorded on a prospective basis. [This answer is incorrect. Changes in
reporting entity are accounted for by retrospective application to financial statements of prior periods.]
2. Regarding accounting changes, a change in estimate should be applied in which of the following ways?
(Page 243)
a. Apply by retrospective application to all prior periods. [This answer is incorrect. A change in reporting
entity, not a change in estimate, should be applied by retrospective application to all prior periods.]
b. Apply in income statements of current and prospective periods. [This answer is correct. The effects
of changes in estimates should be reported in the period of change and subsequent periods.
Restatement or retrospective adjustment of prior periods is not appropriate.]
c. Apply prospectively as of the earliest date practicable. [This answer is incorrect. Depending on the
circumstances, a change to preferable accounting principle should be applied prospectively as of the
earliest date practicable.]
d. Apply cumulative effect to opening balances of the earliest period practicable. [This answer is incorrect.
Depending on the circumstances, a change to preferable accounting principle should be applied using
the cumulative effect to opening balances of the earliest period practicable.]
3. A newspaper publishing company purchases a new printing press for $6,000 and estimates its useful life to be
five years. After four years of use, it is estimated that the printing press still has a useful life of four more years.
Under the original estimated useful life, annual depreciation was $1,200. Using the revised estimated useful
life, annual depreciation should have been $750. Thus, there is an overstatement of depreciation of $450 for
each of the first four years that should be spread over depreciation of years five through eight. The
undepreciated cost at the time of the change in estimate should be allocated to the remaining four years at
which of the following amounts per year? (Page 249)
a. $300. [This answer is correct. This is the result of the undepreciated cost at the time of the change
in estimate of $1,200 ($6,000 $4,800). This amount should be allocated to the remaining four years
at $300 per year. Depreciation in the first four years is $1,200 per year, plus $300 per year for the
remaining four years, for a total of $6,000.]
b. $600. [This answer is incorrect. $600 would be the undepreciated cost at the time of the change in estimate
that should be allocated per year to the remaining four years if the purchase price of the new printing press
was $12,000.]
c. $1,200. [This answer is incorrect. $1,200 would be the undepreciated cost at the time of the change in
estimate that should be allocated per year to the remaining four years if the purchase price of the new
printing press was $24,000.]
257
d. $2,400. [This answer is incorrect. $2,400 would be the undepreciated cost at the time of the change in
estimate that should be allocated per year to the remaining four years if the purchase price of the new
printing press was $48,000.]
4. Of the following statements, which one is inaccurate regarding when a change in reporting entity takes place?
(Page 249)
a. Entities change that are included in combined financial statements. [This answer is incorrect. A change
in reporting entity does take place when entities that are included in combined financial statements
change.]
b. Consolidated or combined statements are presented in addition to the statements of individual

companies. [This answer is correct. When consolidated or combined statements are presented in
place of the statements of individual companies, a change in reporting entity takes place.]
c. Specific subsidiaries change that comprise the group of companies for which consolidated financial
statements are presented. [This answer is incorrect. A change in reporting entity occurs when specific
subsidiaries comprising the group of companies for which consolidated financial statements are
presented change.]
5. According to (FASB ASC 2501020), (formerly SFAS 154, par. 2), an error may result from any of the following
actions except: (Page 250)
a. An accounting principle being used that is not in conformity with GAAP. [This answer is incorrect. When
an accounting principle is being used that is not in conformity with GAAP an error may result.]
b. Making a mathematical error. [This answer is incorrect. Making a mathematical error is one example of an
action that may result in an error.]
c. Incorrectly applying a GAAP principle. [This answer is incorrect. According to SFAS 154, par. 2, incorrectly
applying a GAAP principle may result in an error.]
d. A change in accounting principle. [This answer is correct. A change in accounting principle, which
is a change from one acceptable method of applying a principle to another acceptable method or
a change from one acceptable principle to another, is in conformity with GAAP and is therefore not
considered an error.]
6. If certain criteria are met, GAAP requires prior interim periods of the current fiscal year to be restated for the
adjustment or settlement of a number of actions. Which of the following is not one of those actions that require
prior interim periods of the current fiscal year to be restated? (Page 251)
a. Utility revenues for which a ratemaking process applies. [This answer is incorrect. When certain specified
criteria are met, GAAP requires prior interim periods of the current fiscal year to be restated for the
adjustment or settlement of utility revenues subject to a ratemaking process.]
b. Litigation or claims of a similar nature. [This answer is incorrect. Litigation or similar claims are one example
of an action that GAAP requires the prior interim periods of the current fiscal year to be restated for the
adjustment or settlement of, when certain criteria are met.]
c. Income taxes that result from retroactive tax legislation. [This answer is correct. Adjustment or
settlement of income taxes require that prior interim periods of the current fiscal year be restated;
however income taxes that result from retroactive tax legislation are not included in this
requirement.]
d. Renegotiation proceedings. [This answer is incorrect. Prior interim periods of the current fiscal year are
required by GAAP to be restated for the adjustment or settlement of the adjustment or settlement of
renegotiation proceedings when specified criteria are met.]
258
ACCOUNTING POLICIES
OVERVIEW
Applying generally accepted accounting principles often involves choosing from a number of acceptable account
ing principles and methods. For example, the LIFO, FIFO, specific identification, or average cost methods may be
used to value inventory. Selecting one alternative over another may result in significantly different financial results.
Consequently, all significant accounting policies should be disclosed when a balance sheet, income statement, or
statement of cash flows is presented.
SOURCES OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES FOR PERIODS ENDING AFTER

SEPTEMBER 15, 2009
The FASB Accounting Standards Codification represents the source of authoritative accounting principles under
U.S. GAAP for nongovernmental entities. SEC registrants must also follow the rules and interpretive releases of the
Securities and Exchange Commission. All guidance contained within the Codification has the same level of
authority.
If the accounting treatment for a transaction or event is not specified within a source of authoritative GAAP, an entity
should first consider accounting principles for similar transactions or events within a source of authoritative GAAP
and then consider nonauthoritative guidance from other sources. Nonauthoritative sources of guidance and
literature include practices widely recognized or generally prevalent or in industry, FASB Concepts Statements,
AICPA Issues Papers, International Financial Reporting Standards (IFRSs) of the International Accounting Stan
dards Board (IASB), pronouncements of other professional associations or regulatory agencies, Technical Informa
tion Service Inquiries and Replies included in AICPA Technical Practice Aids, and accounting textbooks,
handbooks, and articles.
Grandfathered Guidance
Certain exceptions exist to the GAAP hierarchy discussed above. If an entity has and continues to follow an
accounting treatment that was in categories (c) or (d) under the previous GAAP hierarchy as of March 15, 1992, it
is not required to change to an accounting treatment in a higher category [(b) or (c)] if the effective date was before
March 15, 1992.
Accounting standards permit the ongoing application of certain superseded standards for transactions that have
an ongoing effect on the financial statements. Although the Codification does not contain these instances of
superseded guidance, the guidance remains authoritative for the applicable transactions.
The following list, while not comprehensive, represents examples of the grandfathered items discussed above:
Pooling of interests in a business combination described in SFAS No. 141, Business Combinations,
paragraph B217.
Pension transition assets or obligations described in SFAS No. 87, Employer's Accounting for Pensions,
paragraph 77
Employee stock ownership plan shares purchased and held as of December 31, 1992, as described in
AICPA SOP 936, Employers' Accounting for Employee Stock Ownership Plans, paragraphs 97 and 102.
Loans restructured in a troubled debt restructuring before the effective date of SFAS No. 114, Accounting
by Creditors for Impairment of a Loan, described in SFAS No. 118, Accounting by Creditors for Impairment
of a Loan Income Recognition and Disclosures, paragraph 24.
Stock compensation for nonpublic and other entities described in SFAS No. 123 (R), ShareBased
Payment, paragraph 83.
The deferral of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes," for electing
nonpublic companies.
259
For business combinations with an acquisition date before the first annual reporting period beginning on
or after December 15, 2008, SFAS No. 141 and related standards.
Pooling of interests under APB Opinion No. 16 for notforprofit entities until the effective date of SFAS No.
164, NotforProfit Entities: Mergers and Acquisitions.
For goodwill and intangible assets from certain notforprofit business combinations until the effective date
of SFAS No. 164, APB Opinion No. 16, Business Combinations, and APB Opinion No. 17, Intangible Assets.
FASB ASC 105, Generally Accepted Accounting Principles (formerly SFAS No. 168, The FASB Accounting Stan
dards Codification and the Hierarchy of Generally Accepted Accounting Principles), identifies the sources of
accounting principles, including the FASB Accounting Standards Codification, and the framework for selecting the
principles to be used in the preparation of financial statements of nongovernmental entities in conformity with U.S.
GAAP. SFAS No. 168 replaces SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS
No. 168 represents the last Statement of Financial Accounting Standards prior to the effective date of the FASB
Accounting Standards Codification. The guidance provided by SFAS No. 168, as codified in FASB ASC 105, is
effective for interim and annual periods ending after September 15, 2009. (Special transition rules exist for certain
revenue arrangements.) On the effective date, all existing nonSEC accounting and reporting standards, other than
those grandfathered and certain recently issued standards not codified, are superseded. All other accounting
literature not included in the Codification is considered nonauthoritative. The Codification was issued on July 1,
2009.
SOURCES OF GENERAL ACCEPTED ACCOUNTING PRINCIPLES FOR PERIODS ENDING ON OR BEFORE

SEPTEMBER 15, 2009
For periods ending on or before September 15, 2009, the sources of accounting principles that are generally
accepted are categorized in descending order of authority as follows:
a. FASB Statements of Financial Accounting Standards (SFAS) and Interpretations (FIN), FASB Statement
133 Implementation Issues, FASB Staff Positions (FSP), and AICPA Accounting Research Bulletins (ARB)
and Accounting Principles Board Opinions (APB) that are not superseded by actions of the FASB.
b. FASB Technical Bulletins (FTB) and, if cleared by the FASB, AICPA Industry Audit and Accounting Guides
(AAG) and Statements of Position (SOP).
c. AICPA Accounting Standards Executive Committee Practice Bulletins (PB) that have been cleared by the
FASB, consensus positions of the FASB Emerging Issues Task Force (EITF), and the Topics discussed in
Appendix D of EITF Abstracts (EITF DTopics).
d. Implementation guides (Q&As) published by the FASB staff, AICPA Accounting Interpretations, AICPA
Industry Audit and Accounting Guides and Statements of Position not cleared by the FASB, and practices
that are widely recognized and prevalent either generally or in the industry.
If the accounting treatment for a transaction or event is not specified by a pronouncement in category (a), an entity
shall consider whether the accounting treatment is specified by an accounting principle from a source in another
category and, if so, follow the accounting treatment specified by the source in the highest category for example,
follow category (b) treatment over category (c) treatment.
If the accounting treatment for a transaction or event is not specified by a pronouncement or established in practice
as described in categories (a)(d), an entity shall first consider accounting principles for similar transactions or
events within categories (a)(d) and then other accounting literature that is relevant and specific to the circum
stances and issued by an issuer or author that is recognized as an authority. Other accounting literature includes
FASB Concepts Statements, AICPA Issues Papers, International Financial Reporting Standards (IFRSs) of the
International Accounting Standards Board (IASB), pronouncements of other professional associations or regula
tory agencies, Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids, and
accounting textbooks, handbooks, and articles. FASB Concepts Statements would normally be more influential
than other sources in this category.
260
SFAS No. 162, The Hierarchy of Generally Accepted Accounted Principles, identifies the sources of accounting
principles and the framework for selecting the principles to be used in the preparation of financial statements of
nongovernmental entities that are presented in conformity with GAAP. Prior to the effective date of the guidance in
FASB ASC 105 (formerly SFAS No. 168.) SFAS No. 162 was effective as of November 15, 2008.
Like FASB ASC 105, the GAAP hierarchy in SFAS No. 162 generally applies with respect to pronouncements that
are effective or principles that are initially applied after March 15, 1992. Entities that have and continue to follow an
accounting treatment that was in category (c) or (d) as of March 15, 1992, need not change to an accounting
treatment in a higher category [(b) or (c)] if its effective date was before March 15, 1992.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
General Requirements
Accounting policies are the specific accounting principles and methods of applying those principles that an entity
uses to prepare its financial statements. (FASB ASC 23510053) (formerly APB 22, par. 6) An entity is required to
disclose its significant accounting policies whenever it issues one or more of the basic financial statements (that is,
a balance sheet, income statement, or statement of cash flows). An accounting policy is significant if it materially
affects the determination of financial position, cash flows, or results of operations. In particular, accounting prin
ciples and methods that involve any of the following should be disclosed: (FASB ASC 23510501 and 503)
(formerly APB 22, paras. 8 and 12)
A selection from existing acceptable alternatives
Industry peculiarities
Unusual or innovative application of GAAP
The format, including the location, of the disclosure is flexible. However, it is preferable to title the information
Summary of Significant Accounting Policies" and present it in a separate summary preceding the notes or in the
first note to the financial statements. (FASB ASC 23510506) (formerly APB 22, par. 15)
Applying the General Requirements
Often, a specific accounting standard will require an accounting policy to be disclosed when acceptable alternative
policies exist. Also, authoritative literature frequently provides guidance on accounting policies peculiar to specific
industries. However, there is little guidance on disclosing unusual or innovative applications of GAAP. In general,
financial statement preparers should assume that readers have a fundamental, but not expert, knowledge of
accounting principles. That means, for example, that the accounting treatment of changes in a company's tax
status might be considered unusual and should be disclosed.
Accounting policies disclosures need not duplicate information presented elsewhere in the financial statements.
Consequently, in some instances it may be appropriate for the accounting policies note to refer to information that
may be found in other parts of the financial statements. (FASB ASC 23510505) (formerly APB 22, par. 14)
Specifically Required Accounting Policy Disclosures
Authoritative standards often require an entity to disclose a specific accounting policy. For example, accounting
policies related to the following are specifically required to be disclosed:
a. Inventory. Basis for stating inventories and the method of determining cost. (FASB ASC 21010501;
23510504; 33010501) (formerly ARB 43, Ch. 3A, par. 9 and Ch. 4, Statement 8; APB 22, par. 13)
b. Depreciation. General description of the methods used to compute depreciation for major classes of
depreciable assets. (FASB ASC 36010501) (formerly APB 12, par. 5)
261
c. Cash and cash equivalents. Policy used to determine whether a shortterm investment is treated as a cash
equivalent in the statement of cash flows. (FASB ASC 23010501) (formerly SFAS 95, par. 10)
d. Accounting by creditors for impairment of a loan. Method used to recognize interest income related to
impaired loans, including how cash receipts are recorded. (FASB ASC 310105015) (formerly SFAS 114,
par. 20)
e. Shipping and handling costs. Policy for classifying shipping and handling costs. (If shipping and handling
costs are significant and are not included in cost of sales, the amount of the costs and the line item on the
income statement that includes the costs should also be disclosed.) (FASB ASC 60545502) (formerly
EITF 0010)
f. Trade and notes receivable. Regarding receivables: (FASB ASC 31010502; 31010506; 31010509)
(formerly SOP 016, par. 13)
(1) Basis for accounting for loans, trade receivables, and lease financings, including those classified as
held for sale.
(2) Method used to determine the lower of cost or fair value of nonmortgage loans held for sale.
(3) Classification and method of accounting for interestonly strips, loans, other receivables, or retained
interests in securitizations that can be contractually prepaid or otherwise settled in a way that the entity
would not recover substantially all of its recorded investment.
(4) Method used to recognize interest income on loan and trade receivables, including the entity's policy
for treatment of related fees and costs (including its method of amortizing net deferred fees or costs).
(5) Method used to estimate allowances for loan losses and doubtful accounts, liabilities for
offbalancesheet credit losses, and related charges, including a description of the factors influencing
management's judgment.
(6) Policies for placing loans and trade receivables on nonaccrual status, recording payments on
nonaccrual receivables, and resuming accrual of interest.
(7) Policy for charging off uncollectible loans and trade receivables.
(8) Policy for determining when receivables are past due or delinquent (that is, based on contractual
terms or how recently payments have been received).
g. Sharebased employee compensation. Method used for measuring compensation cost from sharebased
payment arrangements with employees. (FASB ASC 71810502) [formerly SFAS 123(R), par. A240]
h. Derivatives. Policy for reporting cash flows from derivatives accounted for as hedges, when the cash flows
are reported in the same category (that is, operating, investing, or financing) as the cash flows from the item
being hedged. (FASB ASC 230104527) (formerly SFAS 95, par. 14)
i. Product warranties. Guarantor's accounting policy and methodology for product warranty liabilities. (FASB
ASC 46010508) (formerly FIN 45, par. 14)
j. Revenue arrangements with multiple deliverables. Policy for recognizing revenue from multipledeliverable
arrangements. (FASB ASC 60525501) (formerly EITF 0021)
k. Presentation of sales and similar taxes. Policy for presenting taxes (i.e., at either gross or net) assessed by
governmental authorities that are imposed on and concurrent with specific revenueproducing
transactions (e.g., sales, use, valueadded, etc.). (FASB ASC 60545503) (formerly EITF 063)
l. Life settlement contracts. Policy for life settlement contracts including the classification of cash receipts and
cash disbursements in the statement of cash flows. (FASB ASC 32530502) (formerly FSP FTB 8541,
par. 12)
262
m. Interest and penalties on tax positions. Policy for classification of interest and penalties associated with tax
positions. (FASB ASC 740105019) (formerly FIN 48, par. 20)
n. Offsetting amounts under master netting arrangements. Policy to offset or not offset fair value amounts
recognized for the right to reclaim or return cash collateral arising from derivative instruments recognized
at fair value under master netting arrangements. (FASB ASC 81510507) (formerly FIN No. 39, par. 10B)
o. Income tax benefits of certain dividends. Any change in the policy for income tax benefits of dividends on
sharebased awards when adopting the requirement to treat such benefits as an increase in additional
paidin capital. (FASB ASC 718740501) (formerly EITF 0611)
p. Collaborative arrangements. For fiscal years beginning after December 15, 2008, and interim periods within
those years, the policy for collaborative arrangements. (FASB ASC 80810501) (formerly EITF 071)
q. Intangible assets. For fiscal years beginning after December 15, 2008 and interim periods within those
years, the policy for the treatment of costs incurred to renew or extend the term of a recognized intangible
asset. (FASB ASC 35030502) (formerly SFAS 142, par. 45)
r. Investment tax credit. Policy for recognizing the investment tax credit and the amounts involved (i.e. the
deferral or the flowthrough method. (FASB ASC 740105020) (formerly APB 4, par. 11)
In addition, the basis of consolidation and method of recognizing profit on longterm constructiontype contracts
are examples of accounting policies that typically should be disclosed. (FASB ASC 23510504) (formerly APB 22,
par. 13)
263
264
SELFSTUDY QUIZ
following section.
7. Which of the following is correct regarding the sources of GAAP for periods ending after September 15, 2009?
a. The FASB Accounting Standards Codifications is multilayered and a user must determine what layer the
accounting policy will fall in before understanding its application.
b. If an accounting standard is not included in the Codification, then the guidance is no longer relevant and
not valid.
c. The source of authoritative accounting principles under U.S. GAAP for nongovernmental entities is the
FASB Accounting Standards Codification.
d. The FASB Accounting Standards Codification was issued on July 1, 2009 and all financials distributed after
that date must adhere to its guidance.
8. When an entity issues basic financial statements, it is required for them to disclose their significant accounting
policies used to complete the financial statements. Which of the following is correct about the disclosure
requirements?
a. The disclosure must be placed in the footnotes to the financial statements so that the reader knows where
the information will be located.
b. An entity only has to disclose their accounting method when there are industry anomalies within the
financial statements being presented.
c. A preparer can assume that the users of financial statements have a specialized knowledge of accounting
principles; so many disclosures are not needed.
d. If the information is presented other places in the financial statements, then the information does not have
to be duplicated in the disclosures.
265
SELFSTUDY ANSWERS
7. Which of the following is correct regarding the sources of GAAP for periods ending after September 15, 2009?
(Page 260)
a. The FASB Accounting Standards Codifications is multilayered and a user must determine what layer the
accounting policy will fall in before understanding its application. [This answer is incorrect. All guidance
contained within the Codification has the same level of authority, so its user does not have to discern which
policies are more important than another.]
b. If an accounting standard is not included in the Codification, then the guidance is no longer relevant and
not valid. [This answer is incorrect. The Codification does not contain the ongoing application of certain
superseded standards for transaction that have an ongoing effect on financial statements. Although it is
not contained, the guidance does remain authoritative for applicable transactions and user can still follow
the guidance.]
c. The source of authoritative accounting principles under U.S. GAAP for nongovernmental entities is
the FASB Accounting Standards Codification. [This answer is correct. The FASB Accounting
Standards Codification represents the source of authoritative accounting principles under U.S.
GAAP for nongovernmental entities. SEC registrants must also follow the rules and interpretive
releases of the Securities and Exchange Commission. If an accounting treatment for a transaction
or event is not specified within a source of authoritative GAAP, like the Codification, then an entity
should first consider accounting principles for similar transactions or events within a source of
authoritative GAAP and then consider nonauthoritative guidance from other sources.]
d. The FASB Accounting Standards Codification was issued on July 1, 2009 and all financials distributed after
that date must adhere to its guidance. [This answer is incorrect. While the Codification was issued on July
1, 2009, the SFAS No. 168, which includes the FASB Accounting Standards Codification, is effective for
interim and annual periods after September 15, 2009. After September 15, 2009, all other accounting
literature not included in the Codification is considered nonauthoritative. So, financial statements do not
have to be issued in compliances with the Codification until after September 15, 2009.]
8. When an entity issues basic financial statements, it is required for them to disclose their significant accounting
policies used to complete the financial statements. Which of the following is correct about the disclosure
requirements? (Page 261)
a. The disclosure must be placed in the footnotes to the financial statements so that the reader knows where
the information will be located. [This answer is incorrect. The format and location of the disclosure is flexible
within the financial statements and can be decided upon by the preparer. However, it is preferable to title
the information Summary of Significant Accounting Policies" and present it in a separate summary
preceding the notes or in the first note to the financial statements.]
b. An entity only has to disclose their accounting method when there are industry anomalies within the
financial statements being presented. [This answer is incorrect. An entity should disclose the accounting
policy if it is significant and if it materially affect the determination of the financial position, cash flows or
results of operations. In particular, accounting principles and methods that involve a selection from existing
acceptable alternatives, an unusual or innovative application of GAAP or industry peculiarities should be
disclosed.]
c. A preparer can assume that the users of financial statements have a specialized knowledge of accounting
principles, so many disclosures are not needed. [This answer is incorrect. Financial statement preparers
should assume that readers have a fundamental, but not expert, knowledge of accounting principles and
should tailor the disclosures in the financial statements based on that assumption. The preparer should
disclose unusual or innovative application of GAAP, in addition to required disclosures for added
comprehension.]
266
d. If the information is presented other places in the financial statements, then the information does
not have to be duplicated in the disclosures. [This answer is correct. Accounting policies
disclosures need not duplicate information presented elsewhere in the financial statements since
the information is already available to the reader. It would be appropriate for a note to be placed in
the disclosure referring to where the information can be found in the other parts of the financial
statements.]
267
BALANCE SHEET
OVERVIEW
Classified balance sheets should present current assets and current liabilities separately from other assets and
liabilities. Current assets are those that will be realized in cash, sold, or used within one year (or operating cycle, if
longer). Current liabilities are obligations that will be liquidated by using current assets or creating other current
liabilities.
Current liabilities also include noncurrent obligations that are callable and noncurrent obligations expected to be
refinanced.
Related assets and liabilities may be offset and presented in the balance sheet as a net amount if a right of setoff
exists. Generally, a right of setoff exists if four conditions, established by FASB ASC 21020 (formerly FASB
Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts"), are met. Certain exceptions to that
general rule exist, however, for fair value amounts of derivative instruments executed with the same counterparty
under a master netting arrangement.
CURRENT ASSETS AND CURRENT LIABILITIES
Classified balance sheets distinguish current assets and current liabilities from other assets and liabilities. They are
presumed to be more useful than unclassified balance sheets because they present information that owners,
lenders, and investors frequently use to measure a company's liquidity. For example, to assess a company's ability
to meet obligations when they are due, financial statement users often compute a company's working capital
(current assets less current liabilities), current ratio (current assets divided by current liabilities), and quick ratio
(cash and assets convertible into cash divided by current liabilities).
Classified balance sheets are useful for manufacturing, trading, and some service entities. However, in some
industries, for example, savings and loan associations and real estate, presenting an unclassified balance sheet is
accepted practice because the working capital distinction is not relevant.
Current Assets
Current assets are cash and those assets that are reasonably expected to be realized in cash or sold or consumed
within one year or within a business's normal operating cycle if it is longer. (FASB ASC 2101020) (A business
whose operating cycle is not clearly defined should classify assets as current based on a one year time period.) A
business's normal operating cycle is the time needed to convert cash first into materials and services, then into
products, then by sale into receivables, and finally by collection back into cash. For most businesses, that period
is less than one year or not recognizable. For some businesses, however, such as shipbuilders, distillers, logging
companies, and others with extended production processes, the operating cycle may be longer than one year.
(FASB ASC 21010453)
Generally, current assets include the following:
Cash and cash equivalents available for current operations
Marketable securities representing the investment of cash available for current operations, including
investments in debt and equity securities classified as trading securities
Inventories
Trade accounts receivable
Notes and other receivables that are expected to be collected within one year (or operating cycle, if longer)
Prepaid expenses such as insurance, interest, rents, taxes, etc. (Although prepaid expenses will not be
converted into cash, they are considered current assets because they would have required the use of
268
current assets had they not been paid in advance.) (FASB ASC 21010451 and 452) (formerly ARB 43,
Ch. 3A, par. 4)
The following are not current assets, however, since they generally are not expected to be converted into cash
within one year (or operating cycle, if longer):
Cash restricted or designated for special purposes other than current operations. (Restricted cash may be
classified as a current asset if it is considered to offset maturing debt that has been properly classified as
a current liability, however.)
Longterm investments
Receivables from unusual transactions not expected to be collected within one year (or operating cycle,
if longer)
Cash surrender value of life insurance policies
Land and other natural resources
Depreciable assets
Prepayments or deferred charges that will not be charged to operations within one year (or operating cycle,
if longer) (FASB ASC 21010454) (formerly ARB 43, Ch. 3A, par. 6)
Current Liabilities
Current liabilities are obligations whose liquidation is reasonably expected to require (a) the use of current assets
or (b) the creation of other current liabilities. (FASB ASC 2101020) Current liabilities include the following:
Payables for materials and supplies
Amounts collected before goods or services are delivered
Accruals for wages, salaries, commissions, rents, royalties, and taxes
Other obligations, including portions of longterm obligations, that are expected to be liquidated within one
year (or operating cycle, if longer) (FASB ASC 2101020; 21010458 and 459) (formerly ARB 43, Ch. 3A,
par. 7)
Current liabilities do not include longterm notes, bonds, and obligations that will be liquidated through accounts
not classified as current assets. (FASB ASC 210104512) (formerly ARB 43, Ch. 3A, par. 8)
In some cases, authoritative literature specifically states how certain assets and liabilities are to be classified. For
example, FASB ASC 740 (formerly SFAS No. 109, Accounting for Income Taxes), provides specific guidance for
classifying deferred tax assets and liabilities, and FASB ASC 32010 (formerly SFAS No.115, Accounting for Certain
Investments in Debt and Equity Securities), specifies how investments in debt and equity securities are to be
classified.
OFFSETTING ASSETS AND LIABILITIES
Assets and liabilities should not be offset in a statement of financial position (i.e., reported at a net amount) unless
a right of setoff exists. (FASB ASC 21020051) (formerly APB 10, par. 7) The right of setoff exists when a debtor has
a legal right, by contract or otherwise, to discharge all or a portion of the debt owed to another party by applying
against the debt an amount that the other party owes to the debtor. (FASB ASC 2102020) (formerly FIN 39, par. 5)
A right of setoff exists when all of the following conditions are met:
a. Each of two parties owes the other a determinable amount.
269
b. The reporting party has the right to set off the amount it owes against the amount owed by the other party.
c. The reporting party intends to set off.
d. The right of setoff is legally enforceable. (FASB ASC 21020451) (formerly FIN 39, par. 5)
When determining whether assets and liabilities may be offset, accountants should note the following:
The reporting party must actually intend to set off amounts owed. Thus, even though the ability to offset
may exist, assets and liabilities should not be offset if the reporting party does not intend to set off. (FASB
Because the right of setoff must be enforceable at law, situations involving state laws and the U.S.
Bankruptcy Code may modify or restrict the reporting party's right of set off. (FASB ASC 21020458)
(formerly FIN 39, par. 6)
Assets and liabilities need not be denominated in the same currency or bear interest at the same rates to
be offset. If an asset and liability have different maturities, however, only the party with the earlier maturity
may offset since the party with the longer maturity must settle in the manner the other party selects at the
earlier maturity date. (FASB ASC 21020453) (formerly FIN 39, par. 4)
Offsetting Securities against Taxes Payable
Generally, a government's securities should not be offset against taxes and other liabilities owed to it. The only
exception to that rule is when it is clear that the security purchase is, in effect, an advance payment of taxes that will
be owed in the near future (for example, if a government issues securities that it designates as acceptable for the
payment of taxes). (FASB ASC 21020456 and 457) (formerly APB 10, par.7)
Offsetting Derivative Instruments
Questions have been raised about offsetting derivative instruments that are measured at fair value rather than
notional amounts or amounts to be exchanged. GAAP clearly states that the carrying amount for such instruments
is fair value. Thus, so long as the conditions to offset are met, the fair value of contracts in a loss position may be
offset against the fair value of contracts in a gain position. (FASB ASC 81510454) (formerly FIN 39, par. 8)
Master Netting Arrangements. Under a master netting arrangement, individual contracts are effectively consoli
dated into a single agreement between the parties. Failure to make one payment under the master netting
arrangement entitles the other party to terminate the entire arrangement and demand the net settlement of all
contracts. Such arrangements typically do not meet the conditions for offsetting because the right to set off is
conditional (i.e., a party must default). However, because the FASB believes that presenting aggregate fair values
of the individual contracts does not provide information that is more useful than presenting net amounts, GAAP
provides an exception to the general rule. It allows an entity to offset the fair value amounts recognized for derivative
instruments and amounts recognized for the right to reclaim cash collateral or the obligation to return cash
collateral arising from derivative instruments recognized at fair value with the same counterparty under a master
netting arrangement. The fair value recognized for some of these contracts may include an accrual component for
the periodic unconditional receivables and payables that result from the contract. This accrual component may
also be offset. (FASB ASC 81510455) (formerly FIN 39, par. 10)
The exception applies only to fair value amounts recognized for derivative instruments and fair value amounts
recognized for the right to reclaim cash collateral or the obligation to return cash collateral arising from derivative
instruments recognized at fair value with the same counterparty under a master netting arrangement. It does not
apply to other contracts not recorded at fair value (for example, repurchase agreements and reverse repurchase
agreements) that are executed under master netting arrangements. (FASB ASC 81510455) (formerly FIN 39, par.
10) The gross amounts recorded for such assets and liabilities provide useful information about the timing and
amount of future cash flows that would be lost if the amounts were offset. Thus, such contracts may not be offset
solely because they are executed under a master netting arrangement; they may be offset only if they meet the
conditions discussed previously.
270
Entities are required to make an accounting policy decision to offset the fair value amounts discussed above. The
choice to offset or not must be consistently applied. A reporting entity cannot offset fair value amounts for derivative
instruments recognized at fair value under master netting arrangements without also offsetting the fair value
amounts recognized for the right to reclaim or obligation to return cash collateral. (FASB ASC 81510456)
(formerly FIN 39, par. 10A)
Offsetting Receivables and Payables from Repurchase and Reverse Repurchase Agreements
Amounts recognized as payables under repurchase agreements may (but are not required to) be offset against
amounts recognized as receivables under reverse repurchase agreements if all of the following conditions are met:
(FASB ASC 210204511; 210204514 through 4517) (formerly FIN 41, paras. 3 and 4)
a. The repurchase and reverse repurchase agreements are executed with the same counterparty.
b. The repurchase and reverse repurchase agreements have the same explicit settlement date specified at
the inception of the agreement.
c. The repurchase and reverse repurchase agreements are executed in accordance with a master netting
arrangement.
d. The securities underlying the agreements exist in book entry" form and can be transferred only by means
of entries in the records of the transfer system operator or securities custodian.
e. The agreements will be settled on a securities transfer system that requires the security's owner of record
to initiate the transfer by notifying its custodian to transfer the security. In addition, an associated banking
arrangement is in place that requires each party to maintain available cash on deposit only for the amount
of any net payable unless it fails to instruct its securities custodian to transfer securities to its counterparty.
It must be probable that the associated banking arrangement will provide sufficient daylight overdraft or
other intraday credit at the settlement date for each of the parties.
f. The reporting entity intends to use the same account at the clearing bank or other financial institution at
the settlement date to transact both (1) the cash inflows from settlement of the reverse repurchase
agreement and (2) the cash outflows from settlement of the offsetting repurchase agreement.
The reporting party may offset related receivables and payables regardless of whether it actually intends to set off
the amounts. Thus, the requirements provide an exception to the general rule discussed above.
Circumstances Not Covered by FASB ASC 21020 (formerly FASB Interpretation No. 39)
FASB ASC 21020 (formerly FASB Interpretation No. 39) does not apply to offsetting cash balances on deposit in
banks and other financial institutions because it states that amounts on deposit should not be considered to be
amounts owed to the depositor. Accordingly, the condition that each of two parties owes the other a determinable
amount is not met.
In addition, derecognition or nonrecognition of assets or liabilities is not addressed. Derecognition is the removal
of a recognized asset or liability, for example, by sale of the asset or extinguishment of the liability, and generally
results in a gain or loss. Nonrecognition, on the other hand, involves not recognizing assets or liabilities (commonly
known as offbalancesheet financing) and, therefore, results in no gain or loss. Offsetting relates solely to the
display of a recognized asset or liability, in contrast to derecognition or nonrecognition, which relates to the
measurement of assets or liabilities. (FASB ASC 21020152) (formerly FIN 39, par. 5)
FASB ASC 21020 (formerly FASB Interpretation No. 39) does not modify other pronouncements that require a
particular accounting treatment that results in offsetting or is similar to offsetting in specific circumstances. (FASB
271
CURRENT ASSETS AND CURRENT LIABILITIES
Classified balance sheets should contain totals for current assets and current liabilities. (FASB ASC 21010455)
(formerly SFAS 6, par. 15) In addition, any allowance (such as those for uncollectible receivables or depreciation)
should be deducted from the related asset and disclosed. (FASB ASC 31010454; 31010504) (formerly APB 12,
par. 3)
OFFSETTING ASSETS AND LIABILITIES
A reporting entity should disclose the policy to offset fair value amounts recognized for derivative instruments and
fair value amounts recognized for the right to reclaim or obligation to return cash collateral arising from derivative
instruments recognized at fair value under master netting arrangements. (FASB ASC 81510507) (formerly FIN 39,
par. 10B)
A reporting entity should disclose the following regarding offsetting fair value amounts recognized for derivative
instruments under master netting arrangements at the end of each reporting period: (FASB ASC 81510455;
81510508) (formerly FIN 39, paras. 10 and 10B)
a. If an accounting policy decision to offset fair value amounts has been made, separately disclose amounts
recognized for the right to reclaim cash collateral or the obligation to return cash collateral that have (i) been
offset against net derivative positions under master netting arrangements that are eligible for offsetting and
(ii) not been offset against net derivative positions under master netting arrangements.
b. If an accounting policy decision to not offset fair value amounts has been made, separately disclose
amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral under
master netting arrangements.
272
SELFSTUDY QUIZ
following section.
9. On the balance sheet, which of the following would be classified as a current asset?
a. Accounts receivable for trade accounts.
b. Land.
c. Longterm bonds.
d. Salary accrual.
10. The controller of Big Rig Industries in offsetting some assets and liabilities on their financial statements. In which
scenario would Big Rig be able to take advantage of the right to offset?
a. Big Rig meets all the criteria for the right of set off with a supplier, Truck Parts, Inc, but Truck Parts is not
intending to offset on their financial statements. Big Rig and Truck Parts both purchase from each other.
b. Big Rig purchases government securities in lieu of a payment of taxes to the government that is owed by
year end.
c. Big Rig owes Gas Plus money, but Gas Plus does not owe Big Rig any funds nor has any outstanding
contracts with Big Rig.
11. Which of the following is true about master netting arrangements?
a. Master netting arrangements is eligible for offsetting in the financial statements.
b. If one party does not make a payment, the agreement is modified in favor of the other party.
c. Under GAAP, the reporting exception is allowed for all contracts.
d. A master netting arrangement is when contracts are netted against all outstanding contracts, regardless
of the parties involved.
273
SELFSTUDY ANSWERS
9. On the balance sheet, which of the following would be classified as a current asset? (Page 268)
a. Accounts receivable for trade accounts. [This answer is correct. Current assets are cash and those
assets that are reasonable expected to be realized in cash or sold or consumed within one year or
within a business's normal operating cycle. Trade accounts receivable is considered a current
asset, along with cash, cash equivalents, inventory and some prepaid expenses.]
b. Land. [This answer is incorrect. Land would not be considered a current asset since it cannot be converted
into cash within one year or an operating cycle, whichever is longer for the entity.]
c. Longterm bonds. [This answer is incorrect. Longterm bonds are not classified as current assets. They
are also not classified as current liabilities because they will be liquidated through accounts not classified
as current assets.]
d. Salary accrual. [This answer is incorrect. Accruals for wages, salaries, commissions, rents, royalties and
taxes are classified as current liabilities.]
10. The controller of Big Rig Industries in offsetting some assets and liabilities on their financial statements. In which
scenario would Big Rig be able to take advantage of the right to offset? (Page 270)
a. Big Rig meets all the criteria for the right of set off with a supplier, Truck Parts, Inc, but Truck Parts is not
intending to offset on their financial statements. Big Rig and Truck Parts both purchase from each other.
[This answer is incorrect. Even if the ability to offset may exist, the reporting party must actually intend to
set off amounts owed. Otherwise, the assets and liabilities should not be offset.]
b. Big Rig purchases government securities in lieu of a payment of taxes to the government that is
owed by year end. [This answer is correct. Generally, a government's securities should not be offset
against taxes and other liabilities owed to it. The only exception to that rule is when it is clear that
the security purchase is, in effect, an advance payment of taxes that will be owed in the near future.]
c. Big Rig owes Gas Plus money, but Gas Plus does not owe Big Rig any funds nor has any outstanding
contracts with Big Rig. [This answer is incorrect. The right to set off does not exist in this situation. The right
of set off exists when a debtor has a legal right, by contract or otherwise, to discharge all or a portion of
the debt owed to another party by applying against the debt an amount that the other party owes to the
debtor. Since Gas Plus owes no money and has no outstanding contracts with Big Rig, the qualification
for offsetting has not been met and there is nothing for Big Rig to offset against.]
11. Which of the following is true about master netting arrangements? (Page 270)
a. Master netting arrangements is eligible for offsetting in the financial statements. [This answer is
correct. Although master netting arrangements do not typically meet the conditions for offsetting
because the right to set off is conditional GAAP allows an exception to the general rule and allows
an entity to offset the fair value amounts recognized for derivative instruments and amounts
recognized for the right to reclaim cash collateral or the obligation to return cash collateral arising
from derivative instruments recognized at fair value with the same counterparty under a master
netting arrangement.]
b. If one party does not make a payment, the agreement is modified in favor of the other party. [This answer
is incorrect. Failure to make one payment under the master netting arrangement entitles the other party
to terminate the entire arrangement and demand the net settlement of all contracts.]
c. Under GAAP, the reporting exception is allowed for all contracts. [This answer is incorrect. The GAAP
exception applies only to fair value amounts recognized for derivative instruments and fair value amounts
274
recognized for the right to reclaim cash collateral or the obligation to return cash collateral arising from
derivative instruments recognized at fair value with the same counterparty under a master netting
arrangement. It does not apply to other contracts not recorded at fair value that are executed under master
netting arrangements, for example, repurchase agreements and reverse repurchase agreements.]
d. A master netting arrangement is when contracts are netted against all outstanding contracts, regardless
of the parties involved. [This answer is incorrect. A master netting agreement is when individual contracts
with a single counterparty are effectively consolidated into a single agreement.]
275
Lesson 1 (GAPTG093)
1. Which of the following are not accounting changes?
a. Changes due to corrections of errors.
b. Changes in an accounting estimate.
c. Changes in the reporting entity.
d. Changes in an accounting principle.
2. Which of the following circumstances is considered a change in accounting principle?
a. A change in classification.
b. A change in the method of applying an acceptable accounting principle.
c. A change in accounting principle for income tax purposes only.
d. Adoption of an accounting principle for new events or transactions.
3. ABC Company has inventory stated at cost in 20X1. In 20X2, ABC Company decides to allocate insurance costs
to their inventory. Is such action considered a change in accounting principle?
a. Yes.
b. No.
4. Which of the following is typically considered a change in reporting entity?
a. Changes in the legal form of businesses such as a sole proprietorship to a corporation.
b. Changes in the subsidiaries or companies that are included in combined financial statements.
5. Which of the following constitutes a change in reporting entity?
a. A business combination.
b. Consolidation of a variable interest entity.
c. Both a. and b.
d. Neither a. nor b.
276
6. Which of the following statements is accurate regarding an entity's actions in cases where the accounting
principles currently being followed are acceptable?
a. An entity need not implement an accounting standard prior to its effective date.
b. Implementation of an accounting standard by an entity should always occur prior to its effective date.
7. Prior to the FASB Accounting Standard Codification, which of the following authoritative literature had the
greatest influence over accounting policies?
a. FASB Implementation Guides.
b. Technical Bulletins published by the FASB.
c. FASB Statements of Financial Accounting Standards.
d. FASB Emerging Issues Task Force consensus positions.
8. If a preparer is disclosing the company's policy or method used to recognize interest income on loans, the
policies for writing off uncollectible trade receivables and the basis of accounting for lease financing, they are
detailing the specific required accounting policy disclosures for:
a. Accounting by creditors for the impairment of a loan.
b. Trade and notes receivables.
c. Cash and cash equivalents.
d. Inventory.
9. Assets that within one year will be settled into cash, sold or used should be classified as current assets.
a. True.
b. False.
10. Which of the following is a characteristic of a current liability?
a. Its liquidation will create a current asset.
b. It will be consumed within one year.
c. Its liquidation will require the use of a current asset.
d. It should be realized in cash within the business's normal operating cycle.
277
11. Which of the following is correct about the offsetting of receivables and payables in reverse repurchase
agreements?
a. The master netting agreement must be implemented for the repurchase and reverse repurchase
agreements.
b. The repurchase and reverse repurchase agreements must have different settlement dates that are detailed
in the original agreement.
c. Different accounts must be set up at different banks for the cash inflows from the repurchase and reverse
repurchase agreements.
d. A bank official must initiate the transfer of the securities specified in the agreement for the repurchase and
reverse repurchase agreement.
278

INTRODUCTION
This lesson discusses the cash flows statement and the features of comprehensive income. A statement of cash
flows shows the changes in an entity's cash and cash equivalents during a period. It is required to be presented a
part of a full set of financial statements prepared in accordance with generally accepted accounting principles.
Comprehensive income is the change in an entity's equity during a period from transactions and events other than
those resulting from investments by and distributions to owners. Comprehensive income and its components are
required to be reported when an entity presents a full set of generalpurpose financial statements.

Identify the accounting requirements and basic elements of the statement of cash flows.
List what is included in operating activities and describe the various formats for presenting cash flows from
operations.
Explain cash flows from investing activities including capital expenditures, investments, and loans.
Identify the cash flows from financing activities, the noncash investing and financing activities, and the
disclosures required for the cash flows statement.
Explain comprehensive income, its components and how it is reported.
CASH FLOWS STATEMENT

OVERVIEW
A statement of cash flows is required to be presented as part of a full set of financial statements prepared in
accordance with generally accepted accounting principles. The statement shows a company's cash receipts and
payments during a period, classified by principal sources and uses. The cash receipts and payments are catego
rized as operating, investing, and financing activities. In addition, noncash transactions that affect financial position
must be disclosed.
A statement of cash flows must be included for each period that an income statement is presented along with a
balance sheet. If a balance sheet or income statement is presented separately, a statement of cash flows is not
required.
WHEN SHOULD THE STATEMENT BE PRESENTED?
A statement of cash flows shows the changes in an entity's cash and cash equivalents during a period. (FASB ASC
23010454) (formerly SFAS 95, par. 7) It should be presented as a basic financial statement when each of the
following conditions is met:
a. The entity is a profitoriented business enterprise or nonprofit organization. Individuals are not required to
present the statement. (FASB ASC 23010152; 958205454) (formerly SFAS 95, par. 3 and SFAS 117,
par. 6)
b. The financial statements are prepared in accordance with generally accepted accounting principles. A
statement of cash flows is not required if the financial statements are prepared on a basis of accounting
other than GAAP.
c. Both financial position and results of operations are presented. (A statement of cash flows should be
provided for each period for which results of operations are presented.) (FASB ASC 23010153) (formerly
SFAS 95, par. 3)
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Authoritative literature does not prohibit presenting a statement of cash flows when the preceding requirements are
not met. Thus, for example, a company could present a statement of cash flows and not present a balance sheet
or income statement.
The following entities are exempt from the requirement to present a statement of cash flows, however:
a. Defined benefit pension plans and employee benefit plans presenting financial information similar to that
of defined benefit pension plans (FASB ASC 23010154; 960205455; 962205459) (formerly SFAS
102, par. 5)
b. If the following conditions are met, investment companies subject to the requirements of the Investment
Company Act of 1940 (and those with essentially the same characteristics as those subject to the Act) and
common trust funds, variable annuity accounts, or similar funds maintained by a trustee, administrator, or
guardian (FASB ASC 23010154) (formerly SFAS 102, paras. 67)
(1) Substantially all investments during the period were highly liquid.
(2) Substantially all investments are carried at market value.
(3) The entity had little or no debt, based on average debt outstanding during the period, in relation to
average total assets.
(4) The entity presents a statement of changes in net assets.
All other entities meeting the requirements above are required to present a statement of cash flows regardless of
their legal form (for example, partnership, proprietorship, limited liability company, S corporation, or C corporation)
or whether they normally classify their assets and liabilities as current and noncurrent. In addition, the requirement
to present a statement of cash flows applies to both interim and annual financial statements.
DEFINITION OF CASH AND CASH EQUIVALENTS
The statement of cash flows presents information about changes in cash and cash equivalents. That is, the net
effect of cash flows on cash and cash equivalents during the period should be shown in a manner that reconciles
beginning and ending cash and cash equivalents. Cash includes currency on hand and demand deposits with
banks or other financial institutions. It also includes other accounts that have the general characteristics of demand
deposits in that the customer may deposit or withdraw funds at any time without prior notice or penalty. (FASB ASC
2301020; 23010454) (formerly SFAS 95, par. 7) Examples of cash include certificates of deposit (unless
penalties or terms associated with them effectively restrict withdrawal of funds), money market accounts, and
repurchase agreements that have the preceding characteristics.
Cash equivalents are shortterm, highly liquid investments that (a) are readily convertible to known amounts of cash
and (b) are so near to their maturity that they present an insignificant risk of changes in value because of changes
in interest rates. Examples include Treasury bills, commercial paper, money market accounts that are not classified
as cash, and other shortterm investments whose original maturity is three months or less. (FASB ASC 2301020)
(formerly SFAS 95, paras. 89) (Equity securities never meet the definition of cash equivalents.)
Only investments that meet the preceding criteria and mature three months or less from the date they were
purchased qualify as cash equivalents. For example, a threemonth Treasury bill and a threeyear Treasury note
purchased three months from maturity both qualify as cash equivalents. A Treasury note purchased three years
ago does not become a cash equivalent when its remaining maturity is three months, however.
The statement of cash flows should use descriptive terms such as cash or cash and cash equivalents rather than
ambiguous terms such as funds. The total amount of cash and cash equivalents at the beginning and end of the
period shown in the statement of cash flows should be the same as similarly titled line items or subtotals in the
balance sheet. Throughout this lesson, the term cash includes cash equivalents.
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BASIC ELEMENTS OF THE STATEMENT OF CASH FLOWS
A statement of cash flows has five basic elements:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Net change in cash during the period
Supplemental disclosure of noncash investing and financing activities
Accordingly, all cash receipts and payments should be classified as operating, investing, or financing activities, and
noncash transactions involving investing and financing activities, such as acquiring assets by assuming liabilities,
should be disclosed separately rather than within the body of the statement. (FASB ASC 23010451;
230104510; 23010503) (formerly SFAS 95, paras. 6, 14, and 32) When a cash receipt or cash payment qualifies
for more than one classification, it should be included in the category that represents the predominant source of
cash flows for the item. (FASB ASC 230104522) (formerly SFAS 95, par. 24) The measurement of eligible items at
fair value under the fair value option does not change the way its related cash flows should be categorized in the
cash flow statement. (FASB ASC 82510453) (formerly SFAS 159, par. 16)
Generally, cash receipts and disbursements should be classified in the statement of cash flows without regard to
whether they stem from an item intended as a hedge. For example, the proceeds from a borrowing should be
classified as a financing activity even though the debt is considered a hedge of an investment, and the purchase or
sale of a futures contract should be classified as an investing activity even though the contract is considered a
hedge of a firm commitment to purchase inventory. However, cash flows from derivative instruments accounted for
as fair value or cash flow hedges may be classified in the same category as the cash flows from the hedged item
(provided that the derivative instrument does not include an otherthaninsignificant financing element at inception)
so long as the accounting policy is disclosed. If hedge accounting is discontinued for an instrument that hedges an
identifiable transaction or event, any cash flows subsequent to the date of discontinuance should be classified
consistent with the nature of the derivative instrument. (FASB ASC 230104527) (formerly SFAS 95, par. 14) Exhibit
21 shows how a typical company's transactions would be classified into operating, investing, and financing
activities.
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Exhibit 21
Types of Cash Flows
STATEMENT OF CASH FLOWS NONCASH INVESTING AND

OPERATING INVESTING FINANCING FINANCING TRANSACTIONS
CASH RECEIPTS FROM: CASH RECEIPTS FROM: CASH RECEIPTS FROM: Acquiring nonoperating assets, e.g.,
Sale of goods and services Sale of property and Shortterm borrowings property and equipment or a subsidiary, by
Short and longterm notes receiv equipment Longterm borrowings assuming liabilities
able from customers arising from Sale of availablefor Issuance of equity Issuing stock in exchange for subscriptions
sales of goods or services sale or held to matu instruments receivable or other noncash consideration
Interest and dividends rity securities Derivatives that Converting debt to equity or one class of
Other cash receipts not arising Collections on loans include a financing stock to another, e.g., common to preferred
from investing or financing activi Insurance proceeds element Stock dividends or distributions of property
ties, such as amounts received to relating to transac as dividends
settle lawsuits or refunds from tions classified as Converting notes receivable to investments

suppliers investing Settling liabilities by transferring noncash
Sale or maturity of trading securi Sale or maturity of assets or issuing shares
ties acquired for operating pur trading securities
poses acquired for investing
purposes
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CASH PAYMENTS FOR: CASH PAYMENTS FOR: CASH PAYMENTS FOR:

Inventory Property and equip Dividends and other
Short and longterm notes payable ment (including capi distributions to own
to suppliers for materials or goods talized interest) ers
Wages Availableforsale or Repayment of
Other operating expenses heldtomaturity secu amounts borrowed,
General and administrative rities e.g., shortterm debt,
expenses Loans to others longterm debt, and
Interest (excluding amounts Purchase of trading capital lease obliga
capitalized) securities acquired for tions
Taxes investing purposes Repurchase or
Other cash payments not related redemption of shares,
to investing or financing activities, e.g., treasury stock
such as cash contributions and and mandatorily
cash refunds to customers redeemable stock
Purchase of trading securities Distributions to coun
acquired for operating purposes terparties of deriva
tives that include a
financing element
GAPT09
Debt issue costs
Presenting Gross and Net Cash Flows
As a general rule, cash flows from investing and financing activities should be reported in gross rather than net
amounts. The presumption is that gross cash receipts and disbursements are more relevant than net amounts.
(FASB ASC 23010457) (formerly SFAS 95, par. 11) Thus, for example, both proceeds from sales of assets and
cash payments for capital expenditures should be shown in the cash flows statement rather than the net change in
property and equipment. In addition, both proceeds from shortterm debt and payments to settle shortterm debt
should be shown rather than the net change in shortterm debt.
While the general rule calls for reporting gross cash flows, net cash flows may be reported from the following
activities:
a. Cash receipts and payments from purchasing and selling cash equivalents (FASB ASC 23010457)
b. Cash receipts and payments related to investments that are not cash equivalents, loans receivable, and
debt when the original maturity of the asset or liability is three months or less (Amounts due on demand
and credit card receivables of financial services operations are generally considered to have maturities of
three months or less are considered to be loans.) (FASB ASC 23010459) (formerly SFAS 95, par. 13)
c. Cash receipts and payments from agency transactions (that is, transactions for which the company is
holding or disbursing cash on behalf of its customers) (FASB ASC 23010458) (formerly SFAS 95, par.
12)
d. For banks, savings institutions, and credit unions, cash receipts and payments related to:
(1) Deposits placed with other financial institutions
(2) Customer time deposits
(3) Loans made to customers (FASB ASC 942230451) (formerly SFAS 95, par. 13A)
Although GAAP permits reporting net cash flows from the preceding activities, netting is not required. Presenting
gross cash flows for those activities may be preferable in some instances. For example, it may create an unneces
sary recordkeeping burden to segregate cash flows from investments with a maturity of three months or less from
those of investments with longer maturities.
Should cash flows from revolving lines of credit be presented on a gross or net basis? A difference of opinion exists
among CPAs in practice. Some firms have taken the position that there must be a series of 90day notes for the cash
flows to be presented net. If the borrower signs a single note with a term of more than three months for the
maximum amount of the line of credit, they believe that GAAP requires gross amounts to be presented. Others,
however, present all cash flows related to revolving lines of credit net.
CASH FLOWS FROM OPERATING ACTIVITIES
What Is Included?
Cash flows from operating activities are defined by exception; operating activities include all transactions and
events that are not investing or financing activities. (FASB ASC 2301020) (formerly SFAS 95, par. 21) Generally,
however, operating activities meet the following three criteria:
a. The amounts represent the cash effects of transactions or events.
b. The amounts result from a company's normal operations for delivering or producing goods for sale and
providing services.
c. The amounts are derived from activities that enter into the determination of net income.
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Thus, cash flows from operating activities include cash received from sales of goods or services and cash used in
generating the goods or services, such as for inventory, personnel, and administrative and other operating costs.
Cash receipts from both short and longterm notes receivables from customers arising from sales of goods or
services are also classified as operating activities. Similarly, principal payments on customers' accounts and both
short and longterm notes payable to suppliers for materials or goods also should be classified as operating
activities. In addition, interest and dividend income and interest expense are considered to be operating activities
even though they are not precisely consistent with the preceding criteria. (FASB ASC 230104516 and 4517)
FASB ASC 230104517 (formerly EITF Issue No. 026, Classification in the Statement of Cash Flows of Payments
Made to Settle an Asset Retirement Obligation within the Scope of FASB Statement No. 143"), states that a cash
payment made to settle an asset retirement obligation should be classified as an operating activity in the statement
of cash flows.
Cash flows from operating activities exclude (a) amounts not derived from cash receipts and cash payments (for
example, accruals, deferrals, and allocations such as depreciation), and (b) amounts considered to be derived
from investing or financing activities rather than from operations (for example, cash receipts and payments related
to property and equipment and dividends paid).
Formats for Presenting Cash Flows from Operations
Cash flows from operations may be presented in either of two basic formats: the direct method or the indirect
method. The following paragraphs describe both methods.
Direct Method. The direct method begins with gross cash receipts and deducts gross cash payments for operating
costs and expenses, individually listing the cash effects of each major type of operating activity. At a minimum, the
following categories of cash receipts and cash payments are required to be presented:
Cash collected from customers, including lessees and licensees
Interest and dividends received
Other operating cash receipts, if any
Cash paid to employees and other suppliers of goods or services, including suppliers of insurance and
advertising
Interest paid
Income taxes paid and, separately, the cash that would have been paid for income taxes if excess tax
benefits attributable to sharebased payment arrangements were not present
Other operating cash payments, if any (FASB ASC 230104525) (formerly SFAS 95, par. 27)
Cash outflows from operating activities and cash inflows from financing activities include excess tax benefits
attributable to sharebased payment transactions. Excess tax benefits represent realized tax benefits from deduct
ible compensation costs on an employer's tax return that exceed those recognized for financial reporting purposes.
Because the direct method shows only cash receipts and payments, no adjustments are necessary for noncash
expenses such as depreciation or deferred income taxes. The following illustrates how cash flows from operating
activities would be presented using the direct method:

Cash received from customers $ 435,000
Interest received 2,450
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437,450
Cash paid to suppliers and employees 274,000

Cash paid to settle lawsuit 15,000
Interest paid 3,475
Income taxes paid 12,000
304,475
NET CASH PROVIDED BY
OPERATING ACTIVITIES 132,975
If the direct method is used, a reconciliation of net income to net cash flows from operating activities is required to
be presented in a separate schedule showing all major classes of operating items, including, at a minimum,
changes in receivables and payables related to operating activities and changes in inventory. (FASB ASC
230104529 and 4530) (formerly SFAS 95, paras. 29 and 30)
Proponents of the direct method believe it is preferable because it shows the actual sources and uses of cash from
operations. In addition, some accountants believe the statement of cash flows is easier to understand because
there is no need to adjust for noncash items such as depreciation. The direct method may be preferable to the
indirect method in the following circumstances:
Information required for the direct method is readily available or can be obtained without significant cost.
There are numerous reconciling items between net income and cash flows from operations making the indirect
presentation cluttered and cumbersome to analyze.
Management or banks with which the company obtains financing find the relationship of specific cash receipts and
payments to cash flows from operations useful for making decisions.
Generally, it will take more time to prepare a statement using the direct method than using the indirect method.
Additional time is necessary because a separate reconciliation of net income to operating cash flows is required,
thus presenting operating cash flows both directly and indirectly.
Indirect Method. The indirect method starts with net income and adjusts for (a) noncash items such as depreci
ation and deferred income taxes and (b) changes during the period in operating current assets and liabilities. The
reconciliation should show all major classes of operating items, including, at a minimum, changes in receivables
and payables related to operating activities and changes in inventory. Changes in current assets and liabilities
arising from investing or financing activities (for example, shortterm loans or notes receivable or payable not
related to sales of goods or services) should be shown as investing or financing activities, as appropriate, however.
In addition, accounts payable may have aspects of financing or investing activities, for example, dividends payable
or equipment purchased on account. In such cases, it would not be appropriate to include the net change in
payables as an adjustment in arriving at cash flows from operations. (FASB ASC 230104528 and 4529) (formerly
Although GAAP literally requires presenting changes in receivables, payables, and inventory separately in the
reconciliation, some accountants believe that amounts could be combined if they would affect a single line item
under the direct method, such as increase in accounts payable and accrued expenses.
Items reconciling net income to net cash flows from operating activities may be presented in the statement of cash
flows or in a separate schedule. (FASB ASC 230104531) (formerly SFAS 95, par. 30) The following illustrates
presenting the reconciliation in the statement of cash flows:

Net income $ 223,000
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation 29,400
Gain on sale of equipment (6,700 )
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(Increase) decrease in:

Trade accounts receivable (10,200 )
Inventories 26,450
Prepaid expenses 4,100
Increase (decrease) in:
Trade accounts payable 37,250
Accrued liabilities (9,500 )
Income taxes payable 4,300
OPERATING ACTIVITIES 298,100
If the reconciling items were presented in a separate schedule, the cash flow statement would show a single line
item for cash flows from operations such as the following:
Net cash flows from operating activities $ 298,100
Agency Transactions. Changes in certain current assets and liabilities do not flow through net income and,
therefore, theoretically do not affect cash provided from operations. For example, some companies collect funds
such as sales tax from third parties and remit them to a separate entity or otherwise hold or disburse cash on behalf
of a customer. Operating activities include all transactions and events not defined as investing and financing
activities, however, and are not limited to the cash effects of transactions that are reported in the income statement.
Thus, the cash effects of agency transactions are operating activities. It is generally acceptable to report only the
net changes in those assets and liabilities because knowledge of gross amounts generally is not essential to
understanding the company's operating, investing, and financing activities. (FASB ASC 23010458) (formerly
SFAS 95, par. 12)
Extraordinary Items and Discontinued Operations
Extraordinary items or discontinued operations need not be separately disclosed in cash flow statements. Thus, the
criteria for classifying transactions and events as operating, investing, or financing also would apply to extraordi
nary items and discontinued operations. (FASB ASC 230104524) (formerly SFAS 95, par. 26)
The following are some best practices for presenting extraordinary items and discontinued operations in the
statement of cash flows:
Extraordinary items. Cash flows related to extraordinary items should be appropriately classified as
operating, investing, or financing activities. Thus, for example, cash payments to settle a lawsuit probably
would be classified as an operating activity, while cash received from disposing assets following a business
combination probably would be classified as an investing activity, and cash paid to extinguish debt
probably would be classified as a financing activity. Noncash extraordinary items should be treated in the
same manner as other noncash items. That is, noncash extraordinary items would not be presented under
the direct method of reporting cash flows from operations since cash flows from operations consist only
of cash receipts and payments. Under the indirect method, however, net income should be adjusted to
arrive at the cash effects of operating activities by adding the noncash elements of extraordinary losses to
net income and subtracting the noncash elements of extraordinary gains from net income.
Discontinued operations. Net operating cash flows from discontinued operations need not be reported
separately as a single line item within the operations section of the cash flow statement. However, that
information could be disclosed in the statement itself or in a separate schedule if it is considered relevant.
When separate disclosure is made, the disclosures should be presented for all periods affected, including
periods that may be affected long after the sale or liquidation of the operation. (FASB ASC 230104524)
Although not required, cash flows from investing and financing activities may be allocated to continuing
and discontinued operations if that information is relevant. The information may be presented (a) in a
separate schedule, (b) on the face of the cash flow statement under captions such as Continuing
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operations" and Discontinued operations," or (c) on the face of the cash flow statement identified by a
caption such as Proceeds from disposal of property and equipment discontinued operations."
The FASB has issued an exposure draft that would amend the accounting and disclosure requirements for
discontinued operations. The proposed standards would require disclosure of the major classes of cash flows
(operating, investing, and financing) from discontinued operations on the face of the financial statements or in the
notes in the period in which a component of an entity either has been disposed of or is classified for sale. The
standards are expected to be final in 2009. The status of this project can be monitored on the FASB's website at
www.fasb.org.
Other Adjustments to Arrive at Net Cash Flows from Operating Activities
Other adjustments to arrive at net cash flows from operating activities are necessary when the indirect method is
used to present cash flows from operations. The objective of the adjustments is to present net cash flows generated
by operating activities by adding noncash expenses to and subtracting noncash revenues from net income. (FASB
ASC 230104528) (formerly SFAS 95, par. 28) Examples of those adjustments include
a. Noncash entries to current operating assets and liabilities, such as recording a provision for bad debts or
providing a reserve for inventory obsolescence
b. Amortization of intangible assets or deferred charges such as copyrights and trademarks
c. Increases in the cash value of life insurance, net of any premiums paid
d. Deferred income taxes
e. Deferred revenue
f. Depletion
g. Depreciation
h. Gains or losses associated with the disposal of noncurrent assets
i. Operating items purchased with a business (Such items should be shown as cash outflows from investing
activities.)
j. Longterm installment sale receivables
k. Earnings on longterm investments in common stock accounted for under the equity method
l. Unrealized gains and losses on marketable securities
m. The cash that would have been paid for income taxes if excess tax benefits attributable to sharebased
payment arrangements were not present (Such amount should be shown as a cash inflow from financing
activities.)
The adjustments should be reflected either in the statement itself or in a separate schedule. (FASB ASC
230104529; 230104531 and 4532) (formerly SFAS 95, paras. 2930)
When the direct method is used, the noncash reconciling items listed previously ordinarily should be excluded from
the statement of cash flows because the direct approach only reflects cash receipts and payments. However, the
items would be shown in the reconciliation of net income to net cash provided by operating activities. An exception
is that item (m) should be included in the statement of cash flows under both the direct and indirect methods.
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CASH FLOWS FROM INVESTING ACTIVITIES
Investing activities include the following: (FASB ASC 2301020; 230104512 and 4513) (formerly SFAS 95, paras.
1517)
Lending money and collecting on loans
Acquiring and selling or disposing of availableforsale or heldtomaturity securities (Trading securities are
classified based on the nature and purpose for which the securities were acquired.)
Acquiring and selling or disposing of productive assets that are expected to generate revenue over a long
period of time
Investing activities exclude acquiring and disposing of cash equivalents and acquiring and disposing of certain
loans or other debt or equity instruments that are acquired specifically for resale. (FASB ASC 230204512 and
4513; 230104521) (formerly SFAS 95, paras. 1617 and SFAS 102, par. 9)
Exhibit 21 lists examples of cash flows provided by and used in investing activities. The following paragraphs
discuss how to handle cash flows from investing activities in the statement of cash flows.
Noncash Investing Activities
Certain investing activities, such as acquiring assets by assuming liabilities or exchanging assets, are noncash
transactions that do not involve cash receipts or payments. Nevertheless, GAAP requires investing activities that do
not involve cash to be reported separately so that information is provided on all investing activities. (FASB ASC
23010503 through 505) (formerly SFAS 95, par. 32)
Capital Expenditures
Purchases. Cash outlays for acquiring productive assets (including capitalized interest, if any) should be reported
as a cash outflow from investing activities. The amount to be reported in a statement of cash flows generally should
consist of (a) assets purchased for cash and (b) down payments for assets purchased by assuming liabilities.
(FASB ASC 230104513) (formerly SFAS 95, par. 17) Payments of liabilities, including capital lease obligations,
and tradein allowance and other noncash aspects of the transaction should be excluded from the amounts
reported as investing activities.
Purchase and sale or disposal of longlived assets generally are classified as investing activities. However, some
times it may be appropriate to classify such transactions as operating activities (for example, when longlived
assets are acquired or produced to be a direct source of a company's revenues, such as assets rented to others for
a short period of time and then sold).
Investing cash flows only should include advance payments, the down payment, or other amounts paid at the time
productive assets are purchased or shortly before or after. Subsequent principal payments on an installment loan
should be classified as financing activities. (FASB ASC 230104513) (formerly SFAS 95, par. 17) The noncash
aspects of the transaction (equipment acquired by assuming liabilities, net of the tradein allowance) should be
disclosed separately.
Sales. Proceeds from sales of productive assets should be shown as cash inflows from investing activities. (FASB
Investments
Shortterm Investments versus Cash Equivalents. If a company has amounts that do not meet the definition of
cash, it must decide whether to account for them as cash equivalents or as other shortterm investments. [Cash
equivalents are defined as shortterm, highly liquid investments that (a) are readily convertible to known amounts
of cash and (b) are so near to their maturity that they present an insignificant risk of changes in value because of
changes in interest rates.] GAAP allows a company to establish policies concerning which shortterm, highly liquid
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investments with original maturities of three months or less are considered cash equivalents and which are to be
reported as shortterm investments. (A company should disclose its policy in its financial statements.) Once
established, the policy should be consistently followed. A change in the type of investments that are classified as
cash equivalents is a change in accounting principle that requires priorperiod financial statements presented for
comparative purposes to be restated. (FASB ASC 23010456; 23010501) (formerly SFAS 95, par. 10)
Purchases and sales of investments that are classified as cash equivalents are part of a company's cash manage
ment rather than part of its operating, investing, and financing activities. Thus, the net change in cash equivalents
should be included in the net change in cash and cash equivalents shown in the statement of cash flows, in other
words, purchases and sales of cash equivalents need not be reported separately. (FASB ASC 23010455)
Investments That Are Not Cash Equivalents. Purchases and sales of investments in debt or equity securities that
are not cash equivalents should be classified as operating or investing activities as follows:
a. Purchases and sales of trading securities should be shown in cash flow statements, based on the nature
and purpose for which the securities were acquired. (Receipts and payments for other securities or assets
should be classified as operating activities if they are acquired specifically for resale and carried at market
value and in a trading account.) (FASB ASC 230104518 through 4520; 320104511) (formerly SFAS
102, par. 8)
b. Purchases and sales of availableforsale securities and heldtomaturity securities should be shown as
investing activities. (FASB ASC 230104511; 320104511) (formerly SFAS 102, par. 8 and SFAS115, par.
18)
Interest and Dividend Income. Receipts from interest and dividends should be classified as cash flows from
operating activities rather than cash flows from investing activities. (FASB ASC 230104516) (formerly SFAS 95,
par. 22)
Making Loans
Making loans (notes and loans receivable) is an investment activity. Accordingly, the principal amount of the loan
should be shown as cash used for investing activities, and principal collected on the loans should be shown as
cash provided by investing activities. (FASB ASC 230104512 and 4513) (formerly SFAS 95, par. 1617) Interest
collected on the loans should be shown as an operating activity. Cash flows relating to investments or loans
receivable with original maturities of three months or less may be reported net. (FASB ASC 23010459) (formerly
SFAS 95, par. 13) (Where loans are specifically originated or purchased for resale, held for short periods of time,
and carried at market value or the lower of cost or market, the associated cash receipts and payments should be
classified as operating activities.) (FASB ASC 230104521) (formerly SFAS 102, par. 9)
Purchase (Sale) of a Business
When a company is purchased or sold, cash flow statements should report the cash paid to acquire the company
(or cash proceeds from sale) as an investing activity. (FASB ASC 230104513) (formerly SFAS 95, par. 17) For
example, if a company pays $90,000 to acquire another business with working capital (other than cash) of $30,000
and net noncurrent assets of $60,000, cash flows from investing activities would be presented as follows:

Acquisition of ABC Company
(net of cash acquired) $ 90,000
The fair values of assets obtained and liabilities assumed should be disclosed as noncash investing and financing
activities.
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CASH FLOWS FROM FINANCING ACTIVITIES
Financing activities include the following:
Obtaining resources from owners and providing them with a return on, and a return of, their investment
Borrowing money and repaying amounts borrowed, or otherwise settling the obligation
Obtaining and paying for other resources from creditors on longterm credit (FASB ASC 2301020;
Exhibit 21 lists examples of cash flows provided by financing activities. The following paragraphs discuss how to
handle cash flows from financing activities in the statement of cash flows.
Noncash Financing Activities
Certain financing activities do not involve cash receipts or payments (for example, issuing stock in exchange for
noncash consideration such as property and equipment). Financing activities that do not involve cash should be
reported separately so that information is provided on all financing activities. (FASB ASC 23010503 through 505)
Cash Dividends
Financing activities include providing owners with a return on their investment, and, thus, cash dividends paid
should be shown as a cash outflow from financing activities. (FASB ASC 230104515) (formerly SFAS 95, par. 20)
Dividends declared but not paid and stock dividends are noncash transactions. Accordingly, they should not be
shown in the cash flow statement itself. Rather, they should be disclosed as noncash investing and financing
activities.
Issuing Stock
Proceeds from issuing stock should be reported as cash inflows from financing activities. (FASB ASC
The following transactions relating to issuing stock do not affect cash flows and should be disclosed as noncash
investing and financing activities:
Stock issued for receivables or other noncash consideration such as property and equipment
Stock issued to settle debt
Stock issue costs that have not been paid in cash during the period
Shortterm and Longterm Debt
Cash receipts from both shortterm and longterm borrowings should be shown as cash inflows from financing
activities. The reduction of shortterm and longterm obligations should be reported as a separate cash outflow
from financing activities, except for cash flows related to loans with original maturities of three months or less, which
may be reported net. (FASB ASC 23010459; 230104514 and 4515) (formerly SFAS 95, paras. 13 and 1920)
The following are best practices for presenting shortterm and longterm debt in the statement of cash flows:
Debt issue costs. Generally, debt issue costs are capitalized as an asset and amortized over the term of
the related debt. Cash payments for debt issue costs should be classified as financing activities. (FASB ASC
230104515) (formerly EITF 9513) It is ordinarily preferable to present the payments as cash outflows
rather than netting them against related debt proceeds.
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Life insurance policies. Loans against life insurance policies should be treated as longterm borrowings
if the loans will be repaid. If the loans are considered to be permanent, however, the proceeds can be
treated as distributions rather than loans.
Repurchase or Redemption of Shares
The cash paid to acquire a company's own stock should be reported as a cash outflow from financing activities.
Subsequent reissuance of treasury stock for cash should be reported as a cash inflow from financing activities,
similar to the treatment for issuing stock. (FASB ASC 230104514 and 4515) (formerly SFAS 95, paras. 1920)
Payments to holders of mandatorily redeemable stock should be reported separately from payments to other
creditors. (FASB ASC 48010452) (formerly SFAS 150, par. 19)
Derivatives That Include a Financing Element
For derivatives that include an otherthaninsignificant financing element at inception (other than a financing
element inherently included in an atthemarket derivative instrument with no prepayments), all cash inflows and
outflows at inception and over the term of the derivative are reported by the borrower as cash flows from financing
activities. (FASB ASC 230104514 and 4515) (formerly SFAS 95, paras. 1920)
Excess Tax Benefits Under Sharebased Payment Arrangements
Cash retained as a result of excess tax benefits attributable to sharebased payment arrangements is included in
the definition of cash inflows from financing activities. Excess tax benefits represent realized tax benefits from
deductible compensation costs on an employer's tax return that exceed those recognized for financial reporting
purposes. The excess tax benefits result from changes in the fair value of an entity's shares after the measurement
date for financial reporting. The same amount is reported as a cash outflow from operating activities. (FASB ASC
NONCASH INVESTING AND FINANCING ACTIVITIES
Investing and financing activities that do not involve cash receipts and payments during the period should be
excluded from the cash flow statement and reported separately. That can either be done in a supplemental
schedule on the face of the cash flows statement (usually at the bottom of the statement) or in the notes to the
financial statements. (FASB ASC 23010503) (formerly SFAS 95, par. 32)
Assets Acquired by Assuming Liabilities
Assets acquired by assuming liabilities, including capital lease obligations, are noncash transactions that should
be disclosed separately. Seller financing, as well as thirdparty financing, is considered a noncash transaction that
must be disclosed. (FASB ASC 23010504) (formerly SFAS 95, par. 32)
The traditional form of this transaction is for the lender to send a check to the seller or for the buyer to assume debt.
In some situations, the form of the transaction is such that the buyer actually receives the proceeds of the borrowing
and then sends those proceeds to the seller. The following are common examples:
The lender deposits the proceeds of the loan into the company's checking account, and the company
drafts a check to the vendor.
The company drafts restricted cash accounts to pay the vendor, for example, cash restricted under the
terms of an industrial development bond or cash restricted under a construction draw arrangement.
The company draws against a preestablished line of credit to pay the vendor.
The substance of each of those situations is the same; the company acquires an asset by incurring a liability. The
company is in the same position as if the lender sent a check to the vendor. Accordingly, each can be reported as
a noncash investing and financing activity.
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Converting Debt to Equity
Converting debt to equity is a financing transaction since longterm financing is capitalized; however, the transac
tion does not involve cash. Thus, the debt reduction should be disclosed in the financial statements in a separate
schedule or otherwise. (FASB ASC 23010504) (formerly SFAS 95, par. 32)
Converting Stock
Converting one class of stock to another, such as preferred to common, is treated in a manner similar to converting
debt to equity. An amount equal to the par value of the preferred stock and any related additional paidin capital that
is converted should be disclosed as a noncash financing transaction.
Liabilities Settled by Transferring Assets or Issuing Shares
Obligations that must be settled by issuing a variable number of shares are classified as liabilities in the statement
of financial position. However, the settlement of those obligations does not involve cash. Similarly, mandatorily
redeemable stock and other obligations to redeem or repurchase the issuer's equity shares may be settled by
transferring assets other than cash. Liabilities settled by issuing shares or transferring assets other than cash are
noncash transactions that should be disclosed separately.
Noncash Dividends
GAAP requires the fair value of property that is distributed as a dividend to be charged to retained earnings. At the
date property dividends are declared, the company should recognize a gain or loss for the difference between the
carrying value and the fair value of the assets that are distributed. (FASB ASC 84510301; 845103010) (formerly
APB 29, paras. 18 and 23) For example, if property with a cost of $85,000 and a fair value of $150,000 is distributed
as a dividend, the company would recognize a gain of $65,000 ($150,000 $85,000) when the dividend is
declared. The gain would be subtracted from net income to arrive at cash flows from operations, and the transac
tion would be shown in the schedule of noncash investing and financing activities as follows:
Property dividends
Fair value of property distributed $ 150,000
as dividends
Cost (85,000 )
Gain on distribution $ 65,000
Purchase (Sale) of a Business
When a company is purchased or sold, the cash paid to acquire the company (or cash proceeds from sale of the
company) should be shown as cash used (or provided) by investing activities. The fair value of assets acquired and
the fair value of liabilities assumed should be disclosed as a noncash transaction. For example, the fair value of
assets acquired and liabilities assumed may be reported in a schedule of noncash investing activities as follows:
Acquisition of ABC Company

Working capital other than cash $ 17,000
Equipment and leasehold improvements 120,000
Intangibles and other assets 30,000
Longterm debt assumed (90,000 )
Cash paid to acquire ABC Company $ 77,000
CASH FLOW PER SHARE
Because cash flow per share data is susceptible to misinterpretation (for example, it may imply that cash flow is
equivalent or superior to earnings as a measure of performance or that an amount representing cash flow per share
292
is available for distribution to stockholders), cash flow per share should not be presented. (FASB ASC 23010453)
EXAMPLE STATEMENT OF CASH FLOWS
Exhibit 22 presents example balance sheets and an income statement and illustrates how a related statement of
cash flows may be presented using the direct and indirect methods.
Exhibit 22
Illustrative Cash Flow Statement
ACE MANUFACTURING, INC.

BALANCE SHEETS
December 31
20X7 20X6
ASSETS
CURRENT ASSETS
Cash $32,450 $ 56,250
Accounts receivable 112,800 121,600
Notes receivable stockholder 27,800 11,400
Accrued interest receivable 1,450 800
Inventory 149,500 183,300
TOTAL CURRENT ASSETS 324,000 373,350
PROPERTY AND EQUIPMENT

Land 60,000 60,000
Building 320,000 320,000
Shop equipment 55,000 40,000
Furniture 18,500 18,500
Autos and trucks 11,000 23,500
464,500 462,000
Accumulated depreciation (195,850 ) (185,000 )
268,650 277,000
OTHER ASSETS
Cash value of life insurance 22,950 19,350
Deposits 1,350 2,700
24,300 22,050
TOTAL ASSETS $ 616,950 $ 672,400
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Notes payable $ 40,000 $ 50,000
Current portion of longterm debt 72,000 67,500
Accounts payable 170,850 179,400
Accrued expenses
Compensation 11,000 8,150
Interest 1,850 1,400
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20X7 20X6
Payroll taxes 1,300 950
Income taxes 4,350 2,250
TOTAL CURRENT LIABILITIES 301,350 309,650
LONGTERM DEBT, less current portion 180,500 242,500
Common stock 20,000 20,000
TOTAL STOCKHOLDERS' EQUITY 135,100 120,250
TOTAL LIABILITIES AND

STOCKHOLDERS' EQUITY $ 616,950 $ 672,400

STATEMENT OF INCOME
Year Ended December 31, 20X7
REVENUE
Sales $ 737,200
Gain on sale of truck 250
Interest income 2,400
739,850
COST OF SALES
Raw materials 315,200
Direct labor 32,900
Freight 16,700
364,800
GROSS PROFIT 375,050
SELLING AND ADMINISTRATIVE EXPENSES

Officers' salaries 89,600
Sales salaries 48,400
Office salaries 51,600
Payroll taxes 18,650
Rent 27,200
Office expense 10,800
Officers' life insurance 4,200
Professional fees 5,900
Telephone 4,700
Utilities 9,350
Repairs and maintenance 6,700
Insurance 14,300
Provision for bad debts 20,000
Depreciation 18,850
Other taxes 3,200
Interest expense 14,650
348,100
INCOME BEFORE INCOME TAXES 26,950
294
INCOME TAXES 8,100
NET INCOME 18,850
BEGINNING RETAINED EARNINGS 100,250

Dividends paid (4,000 )
ENDING RETAINED EARNINGS $ 115,100
ADDITIONAL FINANCIAL INFORMATION FOR ACE MANUFACTURING, INC.
The company's principal stockholder repaid $3,600 of his $11,400 receivable during 20X7. At December 31,
20X7, the stockholder borrowed an additional $20,000.
The company purchased machinery in exchange for a $5,000 down payment and a $10,000 equipment note.
The first payment on the equipment note is due in 20X8.
A truck with an original cost of $12,500 and accumulated depreciation of $8,000 was sold for $4,750.
Notes payable shown as a current liability have original maturities of three months or less.

STATEMENT OF CASH FLOWS INDIRECT METHOD

Net income $ 18,850 a
Depreciation 18,850 b
Gain on sale of truck (250 )c
Cash value of officers' life insurance (3,600 )d
Provision for bad debts 20,000 e
Trade accounts receivable (11,200 )e
Interest receivable (650 )f
Inventories 33,800 f
Deposits 1,350 g
Trade accounts payable (8,550 )f
Accrued liabilities 5,750 f
NET CASH PROVIDED BY OPERATING ACTIVITIES 74,350

Purchase of equipment (5,000 )h
Proceeds from sale of equipment 4,750 i
Loans made (20,000 )j
Collection of loans 3,600 k
NET CASH USED BY INVESTING ACTIVITIES (16,650 )
CASH FLOWS FROM FINANCING ACTIVITIES

Debt reduction:
Shortterm (10,000 )l
295
Longterm (67,500 )m
Dividends paid (4,000 )n
NET CASH USED BY FINANCING ACTIVITIES (81,500 )
NET DECREASE IN CASH (23,800 )
CASH AT BEGINNING OF YEAR 56,250
CASH AT END OF YEAR $ 32,450
SUPPLEMENTAL DISCLOSURESo
Operating activities reflect interest paid of $14,200 and income taxes paid of $6,000.
Noncash investing and financing transactions:

Acquisition of equipment
Cost of equipment $ 15,000
Equipment loan (10,000 )
Cash down payment for equipment $ 5,000
Notes:
a When the indirect method is used to prepare the statement of cash flows, cash flows from operating activities
begin with net income of $18,850, as reported in the income statement.
b Depreciation is a noncash expense. Thus, it is added back to net income in arriving at cash flows from
operations.
c Gain on the sale of the truck (amounting to $250) is subtracted from net income to arrive at cash flows from
operating activities. Proceeds from sales of noncurrent assets are shown as investing activities.
d Increases in cash value of life insurance ($22,950 $19,350) that are allowed to accumulate are included in
net income as a reduction of insurance expense. Since the increases do not provide cash, however, they
should be subtracted from net income in arriving at cash flows from operations.
e The net change in trade accounts receivable should be adjusted for the provision for bad debts that is
presented separately in the statement of cash flows. The change in accounts receivable is determined as
follows:
Net decrease in accounts receivable $ (8,800 )

Add back provision for bad debts 20,000
Net increase attributable to cash amounts $ 11,200
f When cash flows from operations are presented using the indirect method, net income should be adjusted for
changes during the period in operating current assets and liabilities to approximate actual cash receipts and
payments attributed to operations. If there are no material noncash entries posted to operating current assets
and liabilities, the net change would be as follows:
296
Net
20X7 20X6 Change
Interest receivable $ 1,450 $ 800 $ 650

Inventories 149,500 183,300 (33,800 )
Trade payables (170,850 ) (179,400 ) 8,550
Accrued expenses (18,500) (12,750) (5,750 )
Total $ (38,400) $ (8,050) $ (30,350 )

g Refunds of deposits paid for leased storage facilities are shown as cash flows from operating activities.
h A cash down payment for equipment amounting to $5,000 is shown as cash used by investing activities.
i Proceeds from the sale of the truck are shown as cash flows from investing activities.
j An additional stockholder loan in the amount of $20,000 is shown as cash used by investing activities.
k Cash collections of a stockholder loan are shown as cash flows from investing activities.
l Repayment of notes payable ($50,000 $40,000) is shown as cash used by financing activities. (The net
change is shown because the original maturities of the notes are three months or less.)
m Payment of the current portion of longterm debt is shown as cash used by financing activities.
n Dividends paid are shown as cash used by financing activities.
o Alternatively, the supplemental disclosures could be made in the notes to the financial statements rather than
on the face of the cash flow statement.

STATEMENT OF CASH FLOWS DIRECT METHOD

Collections from customers $ 726,000 a
Interest collected 1,750 a
Cash paid to suppliers and employees (634,550 )a
Deposits refunded 1,350
Interest paid (14,200 )a
Income taxes paid (6,000 )a
NET CASH PROVIDED BY OPERATING ACTIVITIES 74,350 b
CASH FLOWS FROM INVESTING ACTIVITIESc

Purchase of equipment (5,000 )
Proceeds from sale of equipment 4,750
Loans made (20,000 )
Collection of loans 3,600
NET CASH USED BY INVESTING ACTIVITIES (16,650 )
CASH FLOWS FROM FINANCING ACTIVITIESc

Debt reduction:
Shortterm (10,000 )
297
Longterm (67,500 )
Dividends paid (4,000 )
NET CASH USED BY FINANCING ACTIVITIES (81,500 )
NET DECREASE IN CASH (23,800 )
CASH AT BEGINNING OF YEAR 56,250
CASH AT END OF YEAR $ 32,450
SUPPLEMENTAL DISCLOSURESc
Noncash investing and financing transactions:

Acquisition of equipment
Cost of equipment $ 15,000
Equipment loan (10,000 )
Cash down payment for equipment $ 5,000
Notes:
a Under the direct method, revenues and expenses presented in the income statement are adjusted for accrued
amounts at the beginning and ending of the period and are grouped into categories. Noncash revenues and
expenses are excluded. Amounts for Ace Manufacturing, Inc. are calculated as follows:
Collections from customers:

Sales per income statement $ 737,200
Increase in accounts receivable (11,200 )
$ 726,000
Interest collected:
Interest income $ 2,400
Increase in accrued interest receivable (650 )
$ 1,750
Cash paid to suppliers and employees:

Cost of sales $ 364,800
Selling and administrative expenses 348,100
Less interest expense presented separately (14,650 )
Less noncash items:
Depreciation (18,850 )
Increase in cash value of life insurance 3,600
Bad debt provision (20,000 )
Decrease in inventory (33,800 )
Decrease in trade payables 8,550
Increase in accrued compensation and payroll taxes (3,200 )
$ 634,550
Interest paid:
Interest expense per income statement $ 14,650
Increase in accrual interest payable (450 )
$ 14,200
298
Income taxes paid:

Income tax provision per income statement $ 8,100
Increase in accrued income taxes payable (2,100 )
$ 6,000
b If Ace Manufacturing, Inc., prepared its cash flow statement using the direct method, it also would be required
to present a separate schedule that reconciles net income to net cash provided by operating activities, such
as the following:
RECONCILIATION OF NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES

Net income $ 18,850
Depreciation 18,850
Gain on sale of truck (250 )
Cash value of officers' life insurance (3,600 )
Provision for bad debts 20,000
Trade accounts receivable (11,200 )
Interest receivable (650 )
Inventories 33,800
Deposits 1,350
Trade accounts payable (8,550 )
Accrued liabilities 5,750

OPERATING ACTIVITIES $ 74,350
c Cash flows from investing activities, cash flows from financing activities, and the schedule of noncash
investing and financing activities are presented in the same manner as under the indirect method.
* * *
The following are required disclosures related to statements of cash flows: (Many of the requirements listed are
presentation matters rather than disclosures and are discussed in the Accounting Requirements section of this
lesson. Those requirements have been summarized and repeated in this section, however, so that the primary
considerations for statements of cash flows may be quickly identified.)
a. Descriptive terms such as cash or cash and cash equivalents should be used rather than terms such as
funds.
b. Cash receipts and cash payments should be classified by operating, investing, and financing activities.
c. Generally, cash inflows and outflows from investing and financing activities should be reported at gross
amounts (for example, outlays for acquisitions should be reported separately from sales or other
dispositions of property and equipment). Cash receipts and payments pertaining to investments (other
than cash equivalents), loans receivable, and debt with original maturity of three months or less may be
reported net, however.
d. The net effect of cash flows on cash and cash equivalents during the period should be shown in a manner
that reconciles beginning and ending cash and cash equivalents.
e. A reconciliation of net income and net cash flows from operating activities that reports all major classes of
reconciling items separately, including, at a minimum, changes during the period in receivables and
299
payables pertaining to operating activities and in inventory, should be presented. (If the indirect method
is used, the reconciliation may be presented in a separate schedule or in the statement itself.)
f. The following classes of operating cash receipts and payments should be shown separately, at a minimum,
when the direct method is used:
(1) Cash collected from customers, including lessees, licensees, and the like
(2) Interest and dividends received
(3) Other operating cash receipts
(4) Cash paid to employees and other suppliers of goods or services, including suppliers of insurance,
advertising, and the like
(5) Interest paid
(6) Income taxes paid and, separately, the cash that would have been paid for income taxes if excess tax
benefits attributable to sharebased payment arrangements were not present
(7) Other operating cash payments
g. The total amount of cash and cash equivalents at the beginning and end of the period shown in the
statement of cash flows should be the same as similarly titled line items or subtotals in the balance sheet.
h. The accounting policy for determining which items are treated as cash and cash equivalents should be
disclosed. (FASB ASC 23010456; 23010501) (formerly SFAS 95, par.10)
i. Noncash investing and financing transactions should either be disclosed in narrative form or summarized
in a schedule and should relate any cash aspects of the transaction. If there are only a few noncash
transactions, it may be convenient to include them on the face of the cash flows statement. If the
transactions are reported elsewhere in the financial statements, they should be clearly referenced to the
statement of cash flows. (FASB ASC 23010503; 23010506) (formerly SFAS 95, paras. 32 and 74)
j. If the indirect method of reporting cash flows from operating activities is used, the amounts of interest paid
(net of amounts capitalized) and income taxes paid during the period should be disclosed. (FASB ASC
23010502) (formerly SFAS 95, par. 29) (The disclosures may be made on the face of the cash flows
statement or in the notes. When included in the notes, they may be added to the existing longterm debt
and income tax notes or disclosed in a separate note of supplemental cash flow disclosures.)
k. If cash flows from derivative instruments accounted for as fair value or cash flow hedges are classified in
the same category as cash flows from the item being hedged, the fact that it is the entity's policy to present
such cash flows in that manner should be disclosed. (FASB ASC 230104527 (formerly SFAS95, par. 14)
l. Payments to holders of mandatorily redeemable stock should be reported separately from payments to
other creditors.
300
SELFSTUDY QUIZ
following section.
12. Is a statement of cash flows required by Mellow Industries under the following circumstances?
a. Yes, if Mellow is presenting only the statement of financial position and it is prepared using GAAP
b. Yes, if Mellow is presenting financial statements prepared on a basis of accounting other than GAAP.
c. Yes, if Mellow is presenting both financial position and results of operations prepared in accordance with
GAAP.
13. There are four types of cash flows: operating, investing, financing, and noncash investing and financing. Which
type of cash flow would the following be? LM Inc., a manufacturing company, collected $120,000 on loans over
the course of the year.
a. Operating.
b. Investing.
c. Financing.
d. Noncash Investing.
14. Cash flows from investing and financing activities should generally be reported in _______ amounts rather than
______ amounts?
a. Gross; net.
b. Net; gross.
15. Cash flows must meet certain criteria to be considered cash flows from operating activities. What is one of those
criteria?
a. The amounts represent the cash effects of plant and equipment.
b. The amounts represent the cash effects of dividends paid.
c. The amounts represent the cash effects of events.
d. The amounts represent the effects of accruals, deferrals, and allocations.
16. Which extraordinary item listed below should be classified as a financing activity?
a. Following a business combination, cash was received from disposing of assets.
b. Extinguishing long term debt with cash payout.
c. Settling a lawsuit by paying cash.
301
17. Which statement below concerning purchases and sales of capital items is most accurate?
a. Principal payments on an installment loan used to purchase productive assets should be classified as
financing activities.
b. Amounts received from selling productive assets should be reported as operating activities.
c. Tradein allowances should be reported as investing activities.
d. Assets rented to others for a short period of time and then sold should be classified as investing activities.
18. Which statement below concerning disclosures is most accurate?
a. The terms cash, cash equivalents or funds can be used interchangeably on the statement of cash flows.
b. A reconciliation of net income and cash flows from operating activities may be presented in a separate
schedule if the direct method is used.
c. Disclosure of the accounting policy for determining cash and cash equivalents is not required.
d. The amounts of interest paid during the period should be disclosed if the indirect method of reporting cash
flows from operating activities is used.
19. Which statement below is correct for classifying the cash flows of investments that are not cash equivalents on
the statement of cash flows?
a. Interest and dividends from investments should be classified as cash flows from investing activities.
b. If securities are acquired specifically for resale and are held in a trading account at market value, the
receipts should be classified as operating activities.
c. Sales of availableforsale securities should be shown as operating activities.
d. Investments in debt or equity securities that are purchased and sold must always be classified as
investment activities.
20. What is the best treatment of the proceeds from a loan against a life insurance policy?
a. If the loan will be repaid, treat it as longterm borrowings.
b. If the loan is considered permanent, treat it as longterm borrowings.
302
SELFSTUDY ANSWERS
12. Is a statement of cash flows required by Mellow Industries under the following circumstances? (Page 279)
a. Yes, if Mellow is presenting only the statement of financial position and it is prepared using GAAP. [This
answer is incorrect. Mellow is not required to present a statement of financial position because both
financial position and results of operations are not being presented. If only results of operations were being
presented, Mellow should present the statement of cash flows for each if those periods.]
b. Yes, if Mellow is presenting financial statements prepared on a basis of accounting other than GAAP. [This
answer is incorrect. One of the conditions that must be present for a statement of cash flows to be required
in the presentation is that the financial statements are prepared in accordance with GAAP.]
c. Yes, if Mellow is presenting both financial position and results of operations prepared in accordance
with GAAP. [This answer is correct. Because all three required conditions are present, Mellow is
required to present a statement of cash flows. The three requirements Mellow meets is that it is a
for profit business, preparing its financial statements in accordance with GAAP, and it is presenting
both financial position and results of operations.]
13. There are four types of cash flows: operating, investing, financing, and noncash investing and financing. Which
type of cash flow would the following be? LM Inc., a manufacturing company, collected $120,000 on loans over
the course of the year. (Page 282)
a. Operating. [This answer is incorrect. Operating types of cash flows might include sale of goods and
services as well as interest and dividends. Loan receipts are not part of the operations of LM Inc, a
manufacturing company.]
b. Investing. [This answer is correct. Collections on loans are considered an investing type of cash
flow because the loan itself was an investment that earned interest.]
c. Financing. [This answer is incorrect. Financing types of cash flows would come from short or longterm
borrowings, not loan collections.]
d. Noncash Investing. [This answer is incorrect. The $120,000 was a cash inflow. An example of noncash
investing cash flow would be acquiring nonoperating property by assuming a loan.]
14. Cash flows from investing and financing activities should generally be reported in _______ amounts rather than
______ amounts? (Page 283)
a. Gross; net. [This answer is correct. The presumption is that gross cash receipts and disbursements
are more relevant than net amounts.]
b. Net; gross. [This answer is incorrect. Because there is more relevancy in gross cash receipts and
disbursements than net amounts, cash flows from investing and financing activities should generally be
reported in net amounts. An example would be both proceeds from sales of assets and cash payments
for capital expenditures should be shown in the cash flows statement rather than just the net change in
property and equipment.]
15. Cash flows must meet certain criteria to be considered cash flows from operating activities. What is one of those
criteria? (Page 283)
a. The amounts represent the cash effects of plant and equipment. [This answer is incorrect. Cash receipts
and payments related to property and equipment are considered to be derived from investing operations.]
303
b. The amounts represent the cash effects of dividends paid. [This answer is incorrect. Cash payments of
dividends are considered to be derived from financing operations.]
c. The amounts represent the cash effects of events. [This answer is correct. Generally, operating
activities meet the these three criteria: The amounts represent the cash effects of transactions or
events; the amounts result from a company's normal operations for delivery or producing goods for
sale and providing services; or the amounts are derived from activities that enter in the
determination of net income.]
d. The amounts represent the effects of accruals, deferrals, and allocations. [This answer is incorrect.
Amounts not derived from cash receipts and cash payments, such as accruals, deferrals, and allocations
such as depreciations, are excluded from cash flows from operating activities.]
16. Which extraordinary item listed below should be classified as a financing activity? (Page 286)
a. Following a business combination, cash was received from disposing of assets. [This answer is incorrect.
This would be classified as an investing activity because the business combination is an investment.]
b. Extinguishing long term debt with cash payout. [This answer is correct. This would be classified as
a financing activity because loans are used for financing the business.]
c. Settling a lawsuit by paying cash. [This answer is incorrect. Because settling a lawsuit is neither an
investing activity nor a financing activity, it would be classified as an operating activity.]
17. Which statement below concerning purchases and sales of capital items is most accurate? (Page 288)
a. Principal payments on an installment loan used to purchase productive assets should be classified
as financing activities. [This answer is correct. Investing cash flows only should include advance
payments, the down payment, or other amounts paid at the time productive assets are purchased
or shortly before or after. The subsequent principal payments should be classified as financing
activities.]
b. Amounts received from selling productive assets should be reported as operating activities. [This answer
is incorrect. The proceeds should be shown as cash inflows from investing activities per FASB ASC
c. Tradein allowances should be reported as investing activities. [This answer is incorrect. Payments of
liabilities, such as capital lease obligations and tradein allowances should be excluded from the amounts
reported as investing activities.]
d. Assets rented to others for a short period of time and then sold should be classified as investing activities.
[This answer is incorrect. Although purchases and sales or disposal of longlived assets generally are
classified as investing activities, longlived assets acquired to be a direct source of revenues, such as
assets rented to others for a short period of time and then sold, should be classified as operating activities.]
18. Which statement below concerning disclosures is most accurate? (Page 288)
a. The terms cash, cash equivalents or funds can be used interchangeably on the statement of cash flows.
[This answer is incorrect. The term funds should not be used, but instead descriptive terms such as cash
or cash and cash equivalents should be used.]
b. A reconciliation of net income and cash flows from operating activities may be presented in a separate
schedule if the direct method is used. [This answer is incorrect. If the indirect method is used, the
reconciliation may be presented in a separate schedule or in the statement itself.]
c. Disclosure of the accounting policy for determining cash and cash equivalents is not required. [This
answer is incorrect. This disclosure is required per FASB ASC 23010456; 23010501 (formerly SFAS
95, par. 10).]
304
d. The amounts of interest paid during the period should be disclosed if the indirect method of
reporting cash flows from operating activities is used. [This answer is correct. The disclosure may
be made on the face of the cash flow statement or in the notes.]
19. Which statement below is correct for classifying the cash flows of investments that are not cash equivalents on
the statement of cash flows? (Page 289)
a. Interest and dividends from investments should be classified as cash flows from investing activities. [This
answer is incorrect. Receipts from interest and dividends should be classified as cash flows from operating
activities, rather than cash flows from investing activities.]
b. If securities are acquired specifically for resale and are held in a trading account at market value,
the receipts should be classified as operating activities. [This answer is correct. Purchases and
sales of trading securities should be shown in cash flow statements, based on the nature and
purpose of which the securities were acquired.]
c. Sales of availableforsale securities should be shown as operating activities. [This answer is incorrect. The
proper treatment is to show purchases and sales of availableforsale and heldtomaturity securities as
investing activities per(FASB ASC 230104511; 320104511 (formerly SFAS 102, par. 8 and SFAS 115,
par. 18).]
d. Investments in debt or equity securities that are purchased and sold must always be classified as
investment activities. [This answer is incorrect. There are rules specified for classifying purchases and
sales of these investments as operating or investing activities.]
20. What is the best treatment of the proceeds from a loan against a life insurance policy? (Page 290)
a. If the loan will be repaid, treat it as longterm borrowings. [This answer is correct. Loans against life
insurance policies should be treated as longterm borrowings if the loans will be repaid. Show the
cash receipt as cash inflows from financing activities.]
b. If the loan is considered permanent, treat it as longterm borrowings. [This answer is incorrect. The
proceeds can be treated as a distribution rather than a loan, if there is no intent of repayment. Do not show
the cash receipt as cash inflows from financing activities.]
305
FEATURES OF COMPREHENSIVE INCOME

OVERVIEW
those resulting from investments by and distributions to owners. Comprehensive income and its components are
required to be reported when an entity presents a full set of generalpurpose financial statements. All items that are
recognized as comprehensive income are required to be reported in a financial statement that is displayed with the
same prominence as other financial statements (such as the balance sheet, income statement, and statement of
cash flows). However, a separate statement of comprehensive income is not required.
An entity is required to (a) classify components of comprehensive income by their nature and (b) display the
accumulated balance of other comprehensive income separately from retained earnings and additional paidin
capital in the equity section of the balance sheet.
WHAT IS COMPREHENSIVE INCOME?
those resulting from investments by and distributions to owners. (FASB ASC 2201020; 22010553) (formerly
SFAS 130, par. 8) Comprehensive income includes net income and other changes in assets and liabilities not
reported in net income, but instead reported as a separate component of stockholders' equity (referred to as other
comprehensive income).
The term comprehensive income is used to refer to all components of comprehensive income, including net
income. The term other comprehensive income refers to revenues, expenses, gains and losses that, under GAAP,
are included in comprehensive income, but excluded from net income. Although GAAP does not require an entity
to use the terms comprehensive income and other comprehensive income in its financial statements, those terms
are commonly used in practice. (FASB ASC 22010154; 2201020; 22010452) (formerly SFAS 130, par. 10)
Under current accounting standards, other comprehensive income includes the following:
Foreign currency items (FASB ASC 22010552) (formerly SFAS 130, paras.17 and 39)
Foreign currency translation adjustments
Gains and losses on intercompany foreign currency transactions whose settlement is not planned or
anticipated in the foreseeable future, when the entities involved in the transactions are reported in the
financial statements through consolidation, combination, or the equity method
Gains and losses on foreign currency transactions designated (and effective) as hedges of a net investment
in a foreign entity
Unrealized gains and losses and other-than-temporary impairments on investments (FASB ASC
22010552) (formerly SFAS 130, paras.17 and 39)
Unrealized holding gains and losses on availableforsale securities (or debt securities transferred
from the heldtomaturity category to the availableforsale category)
Temporary increases or decreases in the fair value of availableforsale securities that occur after the
securities were written down as impaired
For periods ending after June 15, 2009, otherthantemporary impairments related to factors other than
credit loss for debt securities classified as availableforsale or heldtomaturity when the entity does not
306
intend to sell the security (and it is not more likely than not the entity will be required to sell the security
before recovery of its amortized cost less any currentperiod credit loss.
Cash flow hedges (FASB ASC 22010552) (formerly SFAS 133, par. 18)
The effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash
flow hedge
Gains or losses, prior service costs or credits, and transition assets or obligations associated with
pension or other postretirement benefits (FASB ASC 22010552) (formerly SFAS 130, par.17)
Comprehensive income does not include the following items, even though current GAAP requires them to be
recorded directly to equity and they do not always appear to result from transactions with owners:
a. Unearned ESOP shares. GAAP requires unearned ESOP shares to be recorded as a reduction of
stockholders' equity. While such transactions have equity characteristics, it could be argued that they
should be included in comprehensive income since they will eventually be recognized as compensation
expense. However, FASB has decided to treat reductions in equity due to unearned ESOP shares as equity
transactions and exclude them from comprehensive income. (FASB ASC 22010553) (formerly SFAS 130,
paras. 110112)
b. Taxes not payable in cash. A reorganized entity may pay minimal amounts of income taxes as a result of
operating losses incurred prior to reorganization. Nevertheless, GAAP requires the entity to report a full
tax rate" on its pretax income and record the portion of taxes that will not be paid in cash as an increase
to paidin capital rather than as a liability. Although the taxes not payable in cash is not a transaction with
an owner, the credit to paidin capital is necessary to adjust equity transactions recorded upon
reorganization it does not result from the currentperiod debit to income tax expense. Consequently,
taxes not payable in cash should not be included in comprehensive income. (FASB ASC 22010553)
c. Net cash settlement from a change in the value of a contract. Net cash settlements due to the change in
value of a contract, where the contract allows a settlement either in cash or shares, are treated as changes
in the value of an equity instrument and not as items of comprehensive income. (FASB ASC 22010553)
d. Other transactions affecting paidin capital or other nonincome equity. GAAP may require transactions other
than those listed in the preceding paragraphs to be recorded as direct adjustments of paidin capital or
other nonincome equity accounts. An example of a transaction that affects paidin capital is sharebased
compensation in which the actual tax deduction exceeds cumulative compensation cost recognized for
financial reporting. The excess tax benefit is recognized as additional paidin capital. Such transactions
should not be included in comprehensive income. (FASB ASC 22010553) (formerly SFAS 130, par. 119)
REPORTING COMPREHENSIVE INCOME
An entity [other than a nonprofit entity following FASB ASC 958205, NotforProfit Entities Presentation of Finan
cial Statements (formerly SFAS No. 117, Financial Statements of NotforProfit Organizations)] must report compre
hensive income and its components when it (a) has items of other comprehensive income and (b) presents a full set
of financial statements that report financial position, results of operations, and cash flows. Investment companies,
defined benefit pension plans, and other employee benefit plans that are exempt from the requirement to provide
a statement of cash flows are not exempt from the requirement to report comprehensive income. (FASB ASC
When required to be reported, comprehensive income and its components must be presented in a financial
statement that is displayed with the same prominence as the other financial statements. That does not mean that
a separate statement of comprehensive income must be presented, however. Comprehensive income may be
reported in a single statement of income and comprehensive income, in a separate statement of comprehensive
income, or in a statement of changes in equity that includes comprehensive income. Regardless of the method
307
used, the statement displaying comprehensive income must include net income, the components of other compre
hensive income, and a total comprehensive income amount. (FASB ASC 22010455; 22010458) (formerly SFAS
130, paras. 14 and 22) The following are additional considerations for reporting comprehensive income:
a. Items included in other comprehensive income must be classified according to their nature. For example,
under current accounting standards, other comprehensive income should be classified as unrealized
gains and losses on certain investments in debt and equity securities, foreign currency items, net gains or
losses on derivative instruments designated and qualifying as cash flow hedges, gains and losses
associated with pension or other postretirement benefits, prior service costs or credits associated with
pension or other postretirement benefits, and transition assets or obligations associated with pension or
other postretirement benefits. (FASB ASC 220104513; 22010552; 81530451) (formerly SFAS 130,
par. 17 and SFAS 133, par 46)
b. Reclassification adjustments may be necessary to avoid double counting items displayed in the current
period's net income that previously were reported as other comprehensive income. For example, realized
gains and losses on availableforsale marketable securities reported in current year net income may have
been reported previously in other comprehensive income as unrealized holding gains or losses.
Reclassification adjustments should be calculated for each classification of other comprehensive income
and reported on the face of the financial statement that reports comprehensive income or in the notes to
the financial statements. (Reclassification adjustments related to foreign currency translation adjustments
are not required unless the translation gains and losses were realized upon the sale or substantially
complete liquidation of the investment in the foreign entity.) Thus, an entity may either
(1) display the gross amount of each component of other comprehensive income on the face of the
financial statement and add or subtract any related reclassification adjustment for that component;
or
(2) display each component of other comprehensive income net of related reclassification adjustments
and disclose the gross change in the notes to the financial statements. (FASB ASC 220104515
through 4517) (formerly SFAS 130, paras. 1820)
For periods ending after June 15, 2009, reclassification adjustments for amounts recognized in other
comprehensive income related to otherthantemporary impairments of heldtomaturity debt securities
should only be determined when the loss is realized as a result of selling the security or an additional credit
loss occurs. (FASB ASC 220104516A) (formerly SFAS 130, par. 19A)
Exhibit 23 and Exhibit 24 illustrate how reclassification adjustments are calculated.
c. Components of comprehensive income may be presented net of related tax effects or before related tax
effects with one amount displayed for the aggregate income tax expense or benefit related to total other
comprehensive income. Regardless, the amount of income tax expense or benefit allocated to each
component of comprehensive income (and related reclassification adjustments) must be disclosed either
on the face of the financial statements or in the notes to the financial statements. (FASB ASC 220104511
and 4512) (formerly SFAS 130, paras. 2425)
Exhibit 25 to Exhibit 28 illustrate alternatives for reporting comprehensive income.
Exhibit 23
Computation of Reclassification Adjustment For Realized Gains

on an Investment in Availableforsale Equity Securities
Facts:
1. On December 31, 20X7, ABC Company, Inc. purchased 1,000 shares of equity securities at $50 per share.
2. The fair value of the securities at December 31, 20X8, and June 30, 20X9, was $75 and $65 per share,
respectively.
308
3. No dividends were declared on the securities, which were sold on June 30, 20X9.
4. Assumed tax rate is 40%
Computation of Holding Gain (Loss)
Before Income Tax Net of

Tax (Benefit) Tax
Holding gains (losses) recognized in other comprehensive
income:
Year ended December 31, 20X8 $ 25,000 $ 10,000 $ 15,000
Year ended December 31, 20X9 (10,000 ) (4,000 ) (6,000 )
Total gain $ 15,000 $ 6,000 $ 9,000
Amounts Reported in Net Income and Other Comprehensive Income

for the Years Ended December 31, 20X8 and December 31, 20X9
20X8 20X9
Net income:
Gain on sale of securities $ $ 15,000
Income tax expense (6,000 )
Net realized gain 9,000
Other comprehensive income:

Holding gain (loss) arising during the period, net of tax 15,000 (6,000 )
Reclassification adjustment, net of tax (9,000 )
Net gain (loss) recognized in other comprehensive
income 15,000 (15,000 )
Total impact on comprehensive income $ 15,000 $ (6,000 )
* * *
Exhibit 24
Computation of Reclassification Adjustment For Realized Losses

on an Investment in Availableforsale Debt Securities
Facts:
1. On December 31, 20X7, ABC Company, Inc. purchased $1,500,000 (face value) of 8% bonds for $1,609,500
(6.5% effective yield) and classified them as availableforsale.
2. The fair value of the bonds on December 31, 20X8 and December 31, 20X9 was $1,441,500 and $1,383,000
respectively.
3. ABC Company, Inc. sold the bonds on December 31, 20X9.
4. Assumed tax rate is 40%.
5. The securities are not considered to be otherthantemporarily impaired.
309
Computation of Costbased Carrying Amount,

Interest Income, and Premium Amortization
(a) (b) (c) (d) (e)

Cash
Interest Interest Premium Ending
Beginning Received Income Amortiza Carrying
Carrying [8% [(a) tion Value
Year Value par] 6.5%] [(b) (c)] [(a) (d)]
20X7 $ 1,609,500
20X8 $ 1,609,500 $ 120,000 $ 104,618 $ 15,382 1,594,118
20X9 1,594,118 120,000 103,618 16,382 1,577,736
Computation of Holding Loss (Before Tax)
(a) (b) (c) (d) (e)

Ending Ending Change in Holding
Carrying Fair Fair Premium Loss
Year Value Value Value Amortization [(c) + (d)]
20X7 $ 1,609,500 $ 1,609,500 $ $ $
20X8 1,594,118 1,441,500 (168,000 ) 15,382 (152,618 )
20X9 1,577,736 1,383,000 (58,500 ) 16,382 (42,118 )
Netoftax Holding Losses
Before Income Tax Net of

Tax (Benefit) Tax
Holding losses recognized in
other comprehensive income:
Year ended December 31, 20X8 $ (152,618 ) $ (61,047 ) $ (91,571 )
Year ended December 31, 20X9 (42,118 ) (16,847 ) (25,271 )
Total loss $ (194,736 ) $ (77,894 ) $ (116,842 )
Amounts Reported in Net Income and Other Comprehensive Income for the Years Ended December 31,
20X8 and December 31, 20X9
20X8 20X9
Net income:
Loss on sale of securities $ $ (194,736 )
Income tax expense (benefit) (77,894 )
Net realized loss (116,842 )
Other comprehensive income:

Holding loss arising during period,
net of tax (91,571 ) (25,271 )
Reclassification adjustment, net of tax 116,842
310
20X8 20X9
Net gain (loss) recognized in other comprehensive income (91,571 ) 91,571
Total impact on comprehensive income $ (91,571 ) $ (25,271 )
* * *
Exhibit 25
Single Statement of Income and Comprehensive Income
DEF INCORPORATED
STATEMENT OF INCOME AND COMPREHENSIVE INCOME
SALES $ 11,000,000
COST OF SALES 6,000,000
GROSS PROFIT 5,000,000
SELLING, GENERAL
AND ADMINISTRATIVE 3,000,000
OTHER OPERATING EXPENSES 750,000
OPERATING INCOME 1,250,000
OTHER INCOME (EXPENSE)

Interest income 10,000
Interest expense (250,000 )
Gain on sale of securities 50,000
Other, net (25,000 )
(215,000 )
INCOME BEFORE TAXES 1,035,000
INCOME TAX EXPENSE 414,000
NET INCOME 621,000
OTHER COMPREHENSIVE INCOMEa

Cash flow hedges 75,000
Foreign currency translation
adjustments 100,000
Unrealized gains on securities:
Unrealized holding gains arising during the periodb $ 250,000
Less: reclassification adjustment for gains included in net income (50,000 ) 200,000
Defined benefit pension plans:
Prior service cost arising during period (16,000 )
Net loss arising during period (10,000 )
Less: amortization of prior service cost included in periodic pension cost 1,000 (25,000 )
350,000
Income tax expense related to other comprehensive income (140,000 )
311
OTHER COMPREHENSIVE INCOME 210,000
TOTAL COMPREHENSIVE INCOME $ 831,000
Notes:
a Exhibit 25 demonstrates presenting components of comprehensive income before tax with one amount
shown for aggregate income tax expense. Alternatively, they could be displayed net of tax, as in Exhibit 26. In
either case, the tax effects applicable to each component of other comprehensive income should be disclosed
either parenthetically on the face of the financial statements or in the notes to the financial statements.
b Alternatively, the entity could display the components of other comprehensive income net of reclassification
adjustments on the face of the financial statements as long as the gross amount and the reclassification
adjustments are disclosed in the notes to the financial statements.
* * *
Exhibit 26
Separate Statement of Comprehensive Income
DEF INCORPORATED
STATEMENT OF COMPREHENSIVE INCOME
NET INCOME $ 621,000
OTHER COMPREHENSIVE INCOME, NET OF TAX:a

Cash flow hedges 45,000
Foreign currency translation adjustments 60,000
Unrealized holding gains arising during the periodb $ 150,000
Less: reclassification adjustment for gains included
in net income (30,000 ) 120,000
Prior service cost arising during period (9,700 )
Net loss arising during period (6,000 )
Less: amortization of prior service cost included in
periodic pension cost 700 (15,000 )
OTHER COMPREHENSIVE INCOME 210,000
TOTAL COMPREHENSIVE INCOME $ 831,000
Notes:
a Exhibit 26 demonstrates presenting components of comprehensive income net of tax. Alternatively, they
could be displayed before tax with one amount shown for aggregate income tax expense as in Exhibit 25. In
either case, the tax effects applicable to each component of other comprehensive income should be disclosed
either parenthetically on the face of the financial statements or in the notes to the financial statements.
312
b Alternatively, the entity could display the components of other comprehensive income net of reclassification
adjustments on the face of the financial statements so long as the gross amount and the reclassification
adjustments are disclosed in the notes to the financial statements.
* * *
Reporting Noncontrolling Interests
Comprehensive income amounts attributable to the parent and the noncontrolling interest in a less than wholly
owned subsidiary should be reported on the face of the financial statement where consolidated comprehensive
income is presented. (FASB ASC 22010455) (formerly SFAS 130, par. 14) Exhibit 27 illustrates an abbreviated
presentation of comprehensive income where a noncontrolling interest in a less than whollyowned subsidiary
exists.
Exhibit 27
Reporting Comprehensive Income for Noncontrolling Interests
Net income $ 1,000

Other comprehensive income, net of tax:
Unrealized holding gain on availableforsale securities: 50
Total other comprehensive income 1,050
Comprehensive income attributable to the noncontrolling interest (105 )
Comprehensive income attributable to XYZ Company $ 945
* * *
Entities that consolidate a less than whollyowned subsidiary should also report the components of other compre
hensive income attributable to the parent and noncontrolling interest as part of the entity's statement of changes in
equity or other equity reconciliation. (FASB ASC 81010501A) (formerly ARB 51, par. 38)
Interim Reporting
Public companies that report condensed interim financial information also should report total comprehensive
income at interim dates. (FASB ASC 220104518) (formerly SFAS 130, par. 27)
313
Exhibit 28
Statement of Changes in Equity
DEF INCORPORATED
Statement of Changes in Equity
Accumulated
Additional Other
Common Paidin Retained Comprehensive
Stock Capital Earnings Income Total
BALANCE AT BEGINNING OF YEAR $ 1,000,000 $ 2,000,000 $ 4,250,000 $ 675,000 $ 7,925,000
COMPREHENSIVE INCOME
Net income 621,000 621,000
Other comprehensive income, net of tax:a
Derivatives designated as hedges of forecasted inventory purchases 45,000 45,000

Foreign currency translation adjustments 60,000 60,000
Unrealized holding gains arising during the period 150,000 150,000
Less: reclassification adjustment (30,000 ) (30,000 )
314
Prior service cost arising during period (9,000 ) (9,000 )

Net loss arising during period (6,000 ) (6,000 )
210,000 210,000
TOTAL COMPREHENSIVE INCOME 831,000
ISSUANCE OF COMMON STOCK 250,000 500,000 750,000
DIVIDENDS DECLARED (250,000 ) (250,000 )
BALANCE AT END OF YEAR $ 1,250,000 $ 2,500,000 $ 4,621,000 $ 885,000 $ 9,256,000
Note:
a The tax effects applicable to each component of other comprehensive income should be disclosed either parenthetically on the face of the financial
statements or in the notes to the financial statements.
* * *
GAPT09
REPORTING ACCUMULATED COMPREHENSIVE INCOME IN THE BALANCE SHEET
The accumulated balance of other comprehensive income should be reported as a component of equity, separate
from retained earnings and additional paidincapital, and labeled with a descriptive title such as accumulated other
comprehensive income. Accumulated balances for each component of other comprehensive income should be
displayed on the face of the balance sheet, the statement of changes in stockholders' equity, or disclosed in the
notes to the financial statements. The classifications of accumulated other comprehensive income should corre
spond to the classifications for components of other comprehensive income used elsewhere in the financial
statements. (FASB ASC 220104514) (formerly SFAS 130, par. 26)
The following are required presentation and disclosure items related to comprehensive income:
a. Components of comprehensive income and total comprehensive income for the period should be
presented either in a separate statement of comprehensive income that begins with net income, in the
income statement below the total for net income, or in the statement of changes in equity. (FASB ASC
22010455; 22010458) (formerly SFAS 130, paras. 14 and 22)
b. If not displayed on the face of the financial statement in which comprehensive income is presented,
reclassification adjustments (discussed previously) should be disclosed in the notes to the financial
c. If not disclosed on the face of the financial statements, the amount of income tax expense or benefit
allocated to each component of comprehensive income (including reclassification adjustments) should be
disclosed in the notes to the financial statements. (FASB ASC 220104512) (formerly SFAS 130, par. 25)
d. If not disclosed in the balance sheet or a statement of changes in equity, the accumulated balance for each
classification of accumulated comprehensive income should be disclosed in the notes to the financial
315
316
SELFSTUDY QUIZ
following section.
21. Comprehensive income includes which of the following?
a. Taxes not payable in cash.
b. Sharebased compensation tax deduction that exceeds cumulative compensation.
c. The unrealized holding gains and losses associated with availableforsale securities.
d. Unearned ESOP share.
22. An entity must report comprehensive income when it presents a full set of financial statements that report
financial position, results of operations and cash flows and when it has items of other comprehensive income.
Which of the following is accurate regarding reporting comprehensive income?
a. The amount of income tax expense related to each component of comprehensive income does not have
to be disclosed, it should just be included in comprehensive income.
b. Comprehensive income items must be classified according to their nature.
c. Comprehensive income should be shown in the financial statements as a gross amount, with tax expense
shown in expenses on the income statement.
d. Comprehensive income can only be reported in a separate statement of income.
317
SELFSTUDY ANSWERS
21. Comprehensive income includes which of the following? (Page 306)
a. Taxes not payable in cash. [This answer is incorrect. GAAP requires an entity to report a full tax rate" on
its pretax income and record the portion of taxes that will not be paid in cash as an increase to paidin
capital rather than as a liability.]
b. Sharebased compensation tax deduction that exceeds cumulative compensation. [This answer is
incorrect. GAAP requires that transactions that affect paidin capital be recorded as direct adjustments of
paidin capital or other nonincome equity accounts. An example of a transaction that affects paidin capital
is sharebased compensation in which the actual tax deduction exceeds cumulative compensation cost.]
c. The unrealized holding gains and losses associated with availableforsale securities. [This answer
is correct. Unrealized gain and losses on investments are including in other comprehensive income.
Examples of investments included in this category are the unrealized gain and losses on
availableforsale securities, or debt securities transferred from the heldtomaturity category to the
availableforsalecategory.]
d. Unearned ESOP share. [This answer is incorrect. GAAP requires unearned ESOP shares to be recorded
as a reduction of stockholders' equity.]
22. An entity must report comprehensive income when it presents a full set of financial statements that report
financial position, results of operations and cash flows and when it has items of other comprehensive income.
Which of the following is accurate regarding reporting comprehensive income? (Page 307)
a. The amount of income tax expense related to each component of comprehensive income does not have
to be disclosed, it should just be included in comprehensive income. [This answer is incorrect. The amount
of income tax expense or benefit allocated to each component of comprehensive income must be
disclosed either on the face of the financial statements or in the notes to the financial statements.]
b. Comprehensive income items must be classified according to their nature. [This answer is correct.
Items that are included in other comprehensive income must be classified according to their nature.
For example, other comprehensive income should be classified as unrealized gains and losses on
certain investments in debt and equity securities, foreign currency items, net gain or losses on
derivative instruments designated and qualifying as cash flow hedges and gain and losses
associated with pension or other postretirement benefits.]
c. Comprehensive income should be shown in the financial statements as a gross amount, with tax expense
shown in expenses on the income statement. [This answer is incorrect. Components of comprehensive
income may be presented net of related tax effects or before related tax effects with one amount displayed
for the aggregate income tax expense or benefit related to total other comprehensive income.]
d. Comprehensive income can only be reported in a separate statement of income. [This answer is incorrect.
Comprehensive income may be reported in a single statement of income and comprehensive income, in
a separate statement of comprehensive income, or in a statement of changes in equity that includes
comprehensive income.]
318
Lesson 2 (GAPTG093)
12. Who is not required to present a statement of cash of cash flows?
a. ABC Furniture, a business operating for profit.
b. XYZ Charity, a nonprofit organization.
c. Rich Mack, an individual working as an attorney.
d. 123 Texas, an entity presenting GAAP financial statements.
13. Match the type of cash flow with the cash payments.
1. Operating i. Heldtomaturity securities

2. Investing ii. Selling liabilities by issuing shares of stock
3. Financing iii. General and administrative expenses
4. Noncash Investing and Financing iv. Cash refunds to customers
Transactions
v. Repurchase shares of stock
vi. Capitalized interest on equipment
a. 1 iii; 2 vi; 3 iv and i; 4 ii and v
b. 1 i and iv; 2 v; 3 vi; 4 ii and iii
c. 1 iv and v; 2 i and ii; 3 iv; 4
d. 1 iii and iv; 2 i and vi; 3 v; 4 ii
14. Generally, investing and financing activity cash flows are reported at gross, but there are times when net cash
flows may be reported. Which of the following scenarios is one of those times?
a. Cash receipts and payments related to investments that are not cash equivalents.
b. Cash receipts and payments from agency transactions.
c. Cash receipts and payments for capital assets such as property and equipment.
15. In the statement of cash flows, a cash payment to settle an asset retirement obligation should be classified as
a(an):
a. Operating activity.
b. Investing activity.
c. Financing activity.
319
16. Utter Surprise Inc's statement of cash flows begins with net income and adjusts for noncash items and changes
during the period in operating current assets and liabilities. What format does Utter Surprise use to present their
cash flows from operations?
a. Direct.
b. Indirect.
17. Which statement concerning shortterm investments versus cash equivalents is most accurate?
a. GAAP has clear requirements concerning when to report shortterm, highly liquid investments with original
maturities of three month or less as cash equivalents and when to report them as shortterm investments.
b. Sales of investments classified as cash equivalents are part of a company's operating or financing activities
depending on their use.
c. A company must restate priorperiod financial statements presented for comparative purposes after a
change in the type of investments that are classified as cash.
d. Purchases and sales of cash equivalents should be reported separately in the statement of cash flows.
18. The principal amount of a note receivable should be shown as cash used for _______ activities, and principal
collected on the loans should be shown as cash provided by ________ activities. The collected interest on the
note should be shown as a(n) ________ activity.
a. Investing, investing, operating.
b. Financing, investing, financing.
c. Financing, financing, operating.
d. Investing, financing, investing.
19. Which financing activity needs to be excluded from the cash flow statement and reported separately?
a. Proceeds from issuing stock.
b. Cash dividends paid.
c. Stock dividends.
d. Reissuance of treasury stock for cash.
20. These classes of operating cash receipts and payments should be shown separately when the ________
method is used: cash collected from customers, interest and dividends received, cash paid to employees.
a. Indirect.
b. Direct.
320
21. Where should comprehensive income be reported in the balance sheet?
a. As a component of stockholders' equity.
b. As a section of paidin capital.
c. With retained earnings.
d. As a current asset.
22. Which of the following is an accurate disclosure that is required for comprehensive income?
a. There are no disclosures required for comprehensive income since it is part of the basic financial
statements.
b. The accumulated balance for each classification of accumulated comprehensive income should be
communicated in the notes to the financial statements if it is not disclosed in the balance sheet.
c. If the disclosure is presented on the face of the financial statements, then a reclassification adjustment
should located in the notes to the financial statements.
d. The income tax expense or benefit distributed to each component of comprehensive income should be
disclosed in the notes to the financial statement if it is not disclosed on the face of the financial statements.
321
322

INTRODUCTION
This lesson discusses earnings per share, the income statement, and the presentation of financial statements.
Generally, all public companies must disclose earnings per share information whenever an income statement or
summary of earning is presented. Calculations are presented in this lesson. The income statement is one of the
basic financial statements necessary to present a company's financial position and results of operations in confor
mity with GAAP. The statement of income and the statement of retained earnings are designed to reflect, in a broad
sense, results of operations. The lesson concludes with a discussion of presentation of financial statements to
include accounting requirements, discontinued operations, going concern, and disclosure requirements.

Explain basic earnings per share and diluted earnings per share and how each are calculated.
Describe how different types of securities affect earnings per share and the disclosure requirements for
earnings per share.
Identify items related to the income statement and the presentation of each item including revenue, expenses,
extraordinary items, and unusual or infrequent items.
Explain the financial presentation of discontinued operations, going concerns and disposing of a component
of an entity.
EARNINGS PER SHARE

OVERVIEW
Generally, all public companies must disclose earnings per share information whenever an income statement or
summary of earnings is presented. Pershare information related to income from continuing operations and net
income should be shown on the face of the income statement for all periods presented. Entities that report a
discontinued operation or an extraordinary item should present pershare information for those items either on the
face of the income statement or in the notes to the financial statements.
Companies with simple capital structures (that is, those with only common stock or no potentially dilutive securities)
should make a single earnings per share presentation (referred to as basic earnings per share) based on the
weighted average number of shares of common stock outstanding during the period.
Companies with complex capital structures should make two earnings per share presentations one showing
basic earnings per share and another showing diluted earnings per share. Diluted earnings per share should be
based on the weighted average number of shares of common stock and all other potential common stock
outstanding during the period. Potential common stock consists of securities such as options, warrants, convertible
securities, or contingent stock agreements.
Call options and warrants (and their equivalents) are incorporated into the diluted earnings per share calculation
under the treasury stock method. Under that method, stock options and warrants are assumed to have been
exercised at the beginning of the period (or when they were issued, if later). Contracts that require the entity to
repurchase its own stock (such as written put options and forward purchase contracts) are incorporated into the
diluted earnings per share calculation under the reverse treasury stock method.
Convertible securities are included in earnings per share calculations under the ifconverted method. Under that
method, the securities are assumed to have been converted into common stock at the beginning of the period (or
when they were issued, if later). In addition, income available for common stockholders is determined by adjusting
income to remove interest payments on the converted debt (and other nondiscretionary adjustments based on
income), net of taxes, and dividends on the converted preferred stock.
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Earnings per share is a measure of the income available to common shareholders. It must be presented in financial
statements of all entities that issue common stock or potential common stock (such as options, warrants, convert
ible securities, or contingent stock agreements) if those securities are traded in a public market. (A public market
is a domestic or foreign stock exchange or overthecounter market, including local or regional markets.) In
addition, entities that have made a filing or are in the process of making a filing with a regulatory agency to prepare
for the sale of securities in a public market must also present earnings per share. Earnings per share need not be
included in the financial statements of investment companies that comply with the requirements of FASB ASC 946,
Financial Service Investment Companies (formerly the AICPA Audit and Accounting Guide, Investment Compa
nies), or wholly owned subsidiaries. If an entity is not required to present earnings per share information but elects
to do so anyway, the information should be presented following the requirements discussed in this lesson. (FASB
ASC 26010152 and 153) (formerly SFAS 128, par. 6)
Most nonpublic entities are not required to present earnings per share in their financial statements unless they have
made a filing to offer common stock or potential common stock that will be traded in the public market.
Companies with simple capital structures (that is, companies with only common stock outstanding) must present
basic earnings per share, while companies with more complex capital structures must present both basic and
diluted earnings per share. Per share amounts must be reported for net income and income from continuing
operations and, if applicable, discontinued operations and extraordinary items. (FASB ASC 26010452 and 453)
(formerly SFAS 128 paras. 3637)
A company may disclose in the notes to the financial statements other pershare information, such as the pershare
gain on the sale of real estate. While not required to be disclosed, such other pershare information, if presented,
should be computed based on the guidance in this lesson. Such disclosure should indicate whether the pershare
amounts are pretax or net of tax. (FASB ASC 26010455) (formerly SFAS 128, par. 37) Cash flow per share should
not be reported, however. (FASB ASC 23010453) (formerly SFAS 95, par. 33)
BASIC EARNINGS PER SHARE
Basic earnings per share is computed by dividing available earnings by the weighted average number of shares of
common stock outstanding during the period. When making that calculation, the following should be considered:
a. Income available to common stockholders is income less claims of preferred stockholders on income.
Thus, dividends declared on noncumulative preferred stock (whether or not paid) should be deducted from
income before computing earnings per share, and dividends on cumulative preferred stock should be
deducted even if they have not been declared. (Preferred dividends that are cumulative only if earned
should be deducted only to the extent they are earned, however.) (FASB ASC 260104511) (formerly SFAS
128, par. 9)
b. For fiscal years and interim periods within those years beginning on or after December 15, 2008, when
computing earnings per share (whether basic or diluted) in consolidated statements, the income
attributable to noncontrolling interests in subsidiaries should be excluded from income from continuing
operations and net income. (FASB ASC 260104511A) (formerly SFAS 128, par. 9)
c. Stock dividends and stock splits (including reverse stock splits) should be recognized on a retroactive
basis. That is, they should be treated as though they occurred on the first day of the earliest period
presented. Also, if stock dividends and stock splits occur after the balance sheet date but before the
financial statements are issued, (or available to be used) earnings per share calculations should be based
on the new number of shares since financial statement users are primarily concerned with earnings per
share based on the corporation's current capitalization. (FASB ASC 260105512) (formerly SFAS 128, par.
54)
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d. If shares are issued to acquire a company in a business combination, the earnings per share calculation
should treat the new shares as outstanding only from the acquisition date. (FASB ASC 260105517)
e. Shares to be issued for little or no cash when certain specified conditions are met (i.e. contingently issuable
shares) should be considered outstanding on the date all the necessary conditions were satisfied.
Contingently returnable shares should be treated in same manner as contingently issuable shares.
(Contingent shares are discussed further in this lesson.) (FASB ASC 260104513) (formerly SFAS 128,
par. 10)
f. If the corporation has issued rights whose exercise price is less than the fair value of the stock, the rights
issue contains a bonus element similar to a stock dividend. If the rights issue including the bonus element
is offered to all existing shareholders, basic earnings per share should be retroactively adjusted for the
bonus element for all periods presented. However, if the ability to exercise the rights is contingent on an
event other than the passage of time, basic earnings per share should not be adjusted for the bonus
element until that contingency is resolved. (FASB ASC 260105513) (formerly SFAS 128, par. 55)
To restate basic earnings per share for the bonus element, the number of shares used in the calculation
should be the number of shares outstanding prior to the rights issue multiplied by the following factor:
Fair value per share immediately prior to exercise of the rights
Theoretical exrights fair value per share
Theoretical exrights fair value is computed as

Aggregate fair value of shares immediately prior to the rights
exercise plus the proceeds expected from the exercise of the rights
Number shares outstanding after exercise of the rights
If the rights themselves will be publicly traded separate from the shares prior to their exercise, fair value
should be determined as of the last day the shares and rights traded together. (FASB ASC 260105514)
g. The entity may have issued common stock that is partially paid and entitled to dividends in proportion to
the amount paid. In such cases, the common share equivalent of the partially paid shares should be
reflected in the denominator of the basic earnings per share calculation to the extent the shares were
entitled to participate in dividends. (FASB ASC 260105523) (formerly SFAS 128, par. 64)
h. The entity may have issued mandatorily redeemable common shares or entered into a contract requiring
repurchase of a fixed number of its common shares for cash. In such cases, the common shares to be
redeemed or repurchased should be excluded from the denominator of the basic (and diluted) earnings
per share calculation. In addition, any amounts attributable to accumulated dividends and participation
rights that have not been recognized as interest expense should be deducted from income before
computing earnings per share, consistent with the twoclass method. (FASB ASC 48010454) (formerly
SFAS150, par. 25)
An Exposure Draft, Earnings per Share, would amend FASB ASC 260, Earnings per Share (formerly SFAS No. 128),
by requiring shares to be issued upon conversion of certain mandatorily convertible securities to be included in the
computation of basic earnings per share from the date the conversion becomes mandatory. The proposed
standards also would make certain changes in the calculation of diluted earnings per share. Additional discussions
on the earnings per share project are expected to occur in late 2009.
In addition, the Board's continuing project on financial instruments with characteristics of equity has an overall
objective that would lead to a comprehensive standard on accounting and reporting for financial instruments that
have characteristics of equity. The first phase of the project resulted in the issuance of FASB ASC 480 (formerly
SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity). In
addition, a preliminary views document was issued in November 2007. Although that document did not address
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earnings per share implications of various possible approaches for distinguishing equity from liabilities and assets,
it is expected there will be an effect on the calculation of earnings per share. The Board is continuing to deliberate
a classification model for distinguishing between equity and liabilities. An exposure draft is expected in late 2009.
Exhibit 31 illustrates computing basic earnings per share.
Exhibit 31
Computing Basic Earnings per Share
Facts:
1. At the beginning of the year, ABC Company had 100,000 shares of common stock and 2,000 shares of
noncumulative, nonconvertible preferred stock issued and outstanding.
2. An additional 25,000 shares of common stock were issued on June 30, 20X6.
3. On September 5, 20X6, the company declared a 2for1 stock split for common stockholders effective
September 30, 20X6.
4. ABC Company purchased 24,000 shares of treasury stock on December 1, 20X6.
5. ABC Company reported net income of $750,000 for 20X6 and declared and paid dividends totaling $100,000
to preferred stockholders.
Weighted average number of shares of common stock outstanding during 20X6:
Shares Effect of Adjusted

Originally 2for1 Shares Months Weighted
Outstand Stock Outstand Outstand Average
ing Split ing ing Shares
Beginning
balance 100,000 2 200,000 12/12 200,000
Stock issue 25,000 2 50,000 6/12 25,000
Treasury purchase 24,000 1 24,000 1/12 (2,000 )
223,000
Earnings per share calculation:
Income available to common stockholders

($750,000 100,000) $ 650,000
Weighted average number of common shares outstanding 223,000
Earnings per share $ 2.92
* * *
DILUTED EARNINGS PER SHARE
General Rules
Corporations that issue dilutive potential common stock generally must disclose diluted earnings per share in
addition to basic earnings per share. Potential common stock consists of securities such as options, warrants,
convertible securities and contingent stock agreements that allow the holder to obtain common stock during or
after the end of the period.
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The diluted earnings per share calculation is similar to the calculation of basic earnings per share it divides
available income by the weighted average number of shares outstanding. Unlike the computation of basic earnings
per share, however, diluted earnings per share is calculated by acting as if certain dilutive potential common stock
had been issued. The denominator is adjusted to reflect the issuance of potential common stock, and the numera
tor is adjusted to add back:
a. any dividends on convertible preferred stock;
b. interest expense (net of tax) on convertible debt recognized during the period; and
c. any other changes in net income resulting from the assumed conversion of potential common stock. (FASB
ASC 26010102; 260104516) (formerly SFAS 128, par. 11)
Diluted earnings per share should be calculated using the most advantageous conversion rate or exercise price
from the standpoint of the security holder. In addition, previously reported diluted earnings per share should not be
restated for subsequent conversions or changes in the stock's market price. (FASB ASC 260104521) (formerly
SFAS 128, par. 12)
No Antidilution. Securities that have an antidilutive effect on earnings per share should not be included in the
computation of diluted earnings per share. When determining whether a security is dilutive or antidilutive, each
issue or series of issues of potential common stock should be considered individually (rather than in the aggre
gate). (FASB ASC 260104517) (formerly SFAS 128, par. 13) Because some convertible securities may be dilutive
on their own, but antidilutive when included with other potential common stock, each issue (or series of issues)
should be considered in sequence from the most dilutive to the least dilutive to reflect maximum dilution. (That is,
dilutive potential common stock with the lowest earnings per incremental share should be included in diluted
earnings per share before those with higher earnings per incremental share). (FASB ASC 260104518) (formerly
SFAS 128, par. 14) Exhibit 32 illustrates sequencing issues of potential common stock to determine whether they
are dilutive or antidilutive.
Exhibit 32
Determining Whether Potential Common

Stock Is Antidilutive
Facts:
1. ABC Company has income available to common stockholders of $1,000,000 for the year 20X7.
2. 500,000 shares of common stock were outstanding the entire year 20X7.
3. If converted, ABC Company's potential common shares outstanding during the 20X7 would have had the
following effect on income and common shares:
Increase in Earnings
Number of per
Increase in Common Incremental
Income Shares Share
Options 3,000
Convertible preferred stock $ 400,000 160,000 $ 2.50
Convertible debentures $ 300,000 200,000 $ 1.50
Computing Diluted Earnings per Share:
Income Common
Available Shares Per Share
Basic earnings per share $ 1,000,000 500,000 $ 2.00

Options 3,000
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Income Common
Available Shares Per Share
503,000 $ 1.99 Dilutive
Convertible debentures 300,000 200,000
1,300,000 703,000 $ 1.85 Dilutive
Convertible preferred stock 400,000 160,000
$ 1,700,000 863,000 $ 1.97 Antidilutive
Based on the preceding analysis, only options and convertible debentures would be included in the diluted
earnings per share calculation. Convertible preferred stock would not because its effect is antidilutive.
* * *
If the company reports a discontinued operation or an extraordinary item, income from continuing operations
(adjusted for preferred dividends as discussed previously in the lesson) should be used as the control number to
determine whether potential common shares are dilutive or antidilutive. In other words, the number of potential
common shares used to compute diluted earnings per share for continuing operations should be used to compute
all other diluted pershare amounts even if those amounts would be antidilutive to their respective basic pershare
amounts. (FASB ASC 260104518) (formerly SFAS 128, par. 15)
For example, assume ABC Company has income from continuing operations of $10,000, a loss from discontinued
operation of ($15,000), a net loss of ($5,000), and 5,000 common shares and 1,000 potential common shares
outstanding. Basic pershare amounts would be $2.00 for continuing operations, ($3.00) for discontinued opera
tions, and ($1.00) for the net loss. The 1,000 potential common shares should be included in the denominator for
determining diluted pershare results from continuing operations because the resulting $1.67 pershare amount is
dilutive. The 1,000 potential common shares also should be included when determining the pershare amounts for
loss from discontinued operations and net loss even though the resulting per share amounts [($2.50) for loss from
discontinued operations and ($.83) for net loss)] are antidilutive when compared to the comparable basic pershare
amounts.
For fiscal years and interim periods within those years beginning on or after December 15, 2008, income from
continuing operations (adjusted for preferred dividends as discussed previously) that is used as the control number
for determining whether potential common shares are dilutive or antidilutive should exclude income from continu
ing operations attributable to noncontrolling interests. (FASB ASC 260104518) (formerly SFAS 128, par. 15)
Including potential common shares in the denominator when computing the pershare amount for continuing
operations is always antidilutive if the company reports a loss for continuing operations. (or a loss from continuing
operations available to common shareholders after preferred dividend deductions) If the company has a loss from
continuing operations, no potential common shares should be included in the denominator when computing any
pershare amounts, even if the company reports net income. (FASB ASC 260104519) (formerly SFAS 128, par.
16)
A company may report income from continuing operations but have a loss from continuing operations available to
common stockholders (for example, as a result of deducting preferred dividends as discussed previously). In such
cases, no potential common shares should be included in any pershare computations because they would be
antidilutive to the pershare amount reported for continuing operations.
In addition, if the company has income for the current quarter, but a yeartodate loss, potential common shares
should be included in the pershare computations for the quarter, but not for yeartodate because they would be
antidilutive to the yeartodate amounts. However, yeartodate income from continuing operations should be the
basis for determining whether or not dilutive potential common shares not included in one or more quarterly
calculations of diluted earnings per share should be included in the calculation of yeartodate diluted earnings per
share. For example, inthemoney stock options may be excluded from the quarterly computation of diluted
earnings per share if their effect is antidilutive. However, such options should be included in the yeartodate
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computation of diluted earnings per share if their effect is dilutive. (FASB ASC 26010553A and 553B) (formerly
EITF D62)
Options, Warrants, and Their Equivalents
Generally, stock options, warrants, and their equivalents (such as nonvested stock granted to employees, stock
purchase contracts, and partially paid stock subscriptions) that have a dilutive effect should be reflected in diluted
earnings per share using the treasury stock method. (FASB ASC 260104522) (formerly SFAS 128, par. 17) Under
the treasury stock method, earnings per share is computed as if
a. the options or warrants were converted to common shares at the beginning of the period (or at the time
they were issued, if later),
b. proceeds that would have been received were used to purchase common stock at the average market price
during the period, and
In other words, under the treasury stock method, the incremental number of shares issued (that is, the difference
between the number of shares assumed to be issued and the number of shares assumed to be purchased) is
included in the denominator when computing diluted earnings per share. (FASB ASC 260104523) (formerly
SFAS 128, par. 17) Under the treasury stock method, options and warrants are dilutive only when the average
market price of common stock during the period is greater than the exercise price of the options and warrants. The
company should not restate previously reported earnings per share information as a result of changes in the market
price of the common stock. (FASB ASC 260104525) (formerly SFAS 128, par. 18)
To illustrate using the treasury stock method, assume ACE Company (a) has 1,000 warrants outstanding that may
be exercised at $25 per share and (b) the average market price of the company's common stock during the period
was $40. If the 1,000 warrants were exercised, the company would receive $25,000 (1,000 $25), which would be
sufficient to buy 625 shares of its stock on the open market ($25,000 $40). The company would then have to
issue 375 additional shares of common stock (1,000 625) to convert all of the outstanding warrants. Thus, 375
shares should be added to outstanding common shares when computing diluted earnings per share.
When computing the number of incremental shares for quarterly earnings per share, the average market price of
the company's stock for the three months included in the reporting period should be used. When computing
yeartodate diluted earnings per share, the company should use a yeartodate weighted average of the incremen
tal number of shares included in each quarterly diluted earnings per share calculation. (FASB ASC 26010553)
Using a simple average of weekly or monthly closing prices usually is adequate when computing the average
market price of a company's stock. However, if prices fluctuate widely, an average of the high and low prices for the
period would result in a more representative price. Regardless, the method used should be applied consistently
from period to period unless it is no longer representative due to changed conditions.
When computing average shares outstanding, the most precise average would be the sum of shares determined
on a daily basis divided by the number of days in the reporting period. However, less precise methods (such as an
average of the shares outstanding at each month end in the reporting period) are acceptable as long as they are
reasonable.
Some option or warrant contracts may require that any proceeds received from exercise be used to retire debt or
other securities issued by the company. In such cases, diluted earnings per share should be computed assuming
the proceeds were used to purchase the debt (or other securities) at its average market price instead of to purchase
common stock under the treasury stock method. (The treasury stock method should be applied to any excess
proceeds, however.) The numerator should be adjusted to add back any interest (net of tax) on the debt assumed
to be purchased. In addition, the numerator should be adjusted for any other nondiscretionary adjustments (net of
tax). (FASB ASC 260105510) (formerly SFAS 128, par. 52)
Dilutive options or warrants issued, canceled, or exercised during the period should be reflected in the calculation
of diluted earnings per share for the period they were outstanding. Common shares issued when options or
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warrants are exercised should be included in the denominator subsequent to the exercise date. (FASB ASC
Written Put Options. Written put options and forward purchase contracts are agreements that require the corpora
tion to repurchase its own stock, and should be included in the determination of dilutive earnings per share if they
are dilutive. If their exercise price is above the average market price for the period, the potential dilutive effect
should be computed using the reverse treasury stock method. The reverse treasury method assumes (FASB ASC
a. the corporation issued a sufficient number of shares at the beginning of the period (at the average market
price for the period) to raise enough cash proceeds to satisfy the contract, and
b. the proceeds were used to satisfy the contract (i.e. repurchase the number of shares specified in the
contract).
Thus, the incremental number of shares (shares assumed issued minus shares repurchased) should be included
in the denominator in the diluted earnings per share calculation under both the treasury and reverse treasury stock
methods.
Purchased Options. Purchased put options and purchased call options (options held by the corporation on its
own stock) should not be included when computing diluted earnings per share because their effect would be
antidilutive. (FASB ASC 260104537) (formerly SFAS 128, par. 25)
Options and Warrants to Purchase Convertible Securities. When computing diluted earnings per share, the
company should assume options or warrants to purchase convertible securities were exercised whenever the
average price of both the convertible security and the common stock obtainable upon conversion are above the
exercise price of the options or warrants. Their exercise should not be assumed, however, unless it is assumed that
similar convertible securities already outstanding were exercised. The incremental number of shares should be
calculated using the treasury stock method. (FASB ASC 26010556) (formerly SFAS 128, par. 49)
Debt or Other Securities Tendered as Payment of Option Price. Some options or warrants may permit (or
require) the security holder to pay all or a portion of the option price by tendering debt or other securities issued by
the company. When computing diluted earnings per share, the debt or other securities should be assumed to be
tendered unless the contract permits the tendering of cash and doing so would be more advantageous to the
option holder. (In that case, the treasury stock method should be applied.) If debt is assumed to have been
tendered, interest (net of tax) should be added back to the numerator. The numerator also should be adjusted for
any other nondiscretionary adjustments to income (net of tax) that would have resulted from the conversion (for
example, an adjustment of bonus expense based on net income). The treasury stock method should be applied for
any cash proceeds assumed to be received. (FASB ASC 26010559) (formerly SFAS 128, par. 51)
Convertible Debt and Convertible Preferred Stock
The calculation of diluted earnings per share should take into account the dilutive effect of convertible debt and
convertible preferred stock using the ifconverted method. Under the ifconverted method: (FASB ASC
a. dividends applicable to convertible preferred stock should be added back to the numerator.
b. interest expense (net of tax) applicable to convertible debt outstanding should be added back to net
income. In addition, the numerator should be adjusted for any other changes (nondiscretionary
adjustments) in net income (net of tax) resulting from assumed conversion (such as bonus expense that
is based on net income).
c. the denominator should be adjusted as if the convertible preferred stock or convertible debt was converted
as of the beginning of the period (or when the convertible security was issued, if later).
If conversion options lapse, convertible preferred stock is redeemed, convertible debt is extinguished, or convert
ible securities were converted during the period, the dilutive effect of the convertible securities should be included
330
in the denominator for the period they were outstanding. Common shares issued upon conversion of the securities
should be included in the denominator subsequent to the exercise date. (FASB ASC 260104542) (formerly SFAS
128, par. 28)
Convertible securities that permit or require the payment of cash at conversion should be treated as warrants. When
computing diluted earnings per share, the treasury stock method should be applied to any cash proceeds
assumed to be received and the ifconverted method should be applied to the convertible security. (FASB ASC
Contracts That May Be Settled in Stock or Cash
A company may issue a contract that can be settled in stock or cash at the election of the company or the holder.
Generally, it should be assumed that the contract will be settled in common stock and the resulting potential
common shares should be included in diluted earnings per share if the effect is more dilutive. However, if past
experience or stated policy provides a reasonable basis to assume the contract will be settled partially or wholly in
cash, the presumption that the contract will be settled in common stock may be overcome. If it is assumed the
contract will be settled in common stock, an adjustment to the numerator may be necessary for any changes in net
income or loss that would result if the contract had been treated as an equity instrument instead of an asset or
liability (similar to the adjustment for convertible debt discussed previously). (FASB ASC 260104545 and 4546)
Contingently Issuable Shares
An agreement may call for the company to issue additional shares of common stock if certain conditions are met.
Generally, the effects of such agreements should be considered in earnings per share calculations (basic and
diluted) if the conditions for issuing the additional stock have been met and issuance of the stock depends solely
on the passage of time. If all contingencies have not been satisfied by the end of the period, however, the number
of contingently issuable shares included in diluted earnings per share should be based on the number of shares (if
any) that would be issuable if the end of the reporting period were the end of the contingency period (for example,
the number of shares that would be issuable based on currentperiod earnings or the endofperiod market price)
and that would have a dilutive effect on the calculation. For interim earnings per share computations, the shares
should be included in the denominator at the beginning of the period (or the date of the contingent stock
agreement, if later). For yeartodate computations, the contingent shares should be weighted for the interim
periods in which they were included in the diluted earnings per share computations. (FASB ASC 260104548 and
4549) (formerly SFAS 128, par. 30) Further considerations follow.
a. Shares that must be issued if a specified level of earnings is met or maintained. If the specified level of
earnings has been attained, the additional shares should be included in the calculation of diluted earnings
per share. The calculation of diluted earnings per share should include those shares that would be issued
assuming that the current amount of earnings will remain unchanged until the end of the agreement
(however, only if the effect would be dilutive). Basic earnings per share should not reflect such contingently
issuable shares because all conditions for issuance have not been satisfied due to the fact earnings may
change in future periods. (FASB ASC 260104551) (formerly SFAS 128, par. 31)
b. Shares that must be issued if the stock's market price reaches a specified amount. Earnings per share
calculations should consider the number of shares that would be issuable based on the stock's market
price at the end of the period. If the contract is based on an average market price over some time period,
the average for that time period should be used. Basic earnings per share should not reflect such
contingently issuable shares because all conditions for issuance have not been satisfied due to the fact the
market price may change in future periods. (FASB ASC 260104552) (formerly SFAS128, par. 32)
c. Shares contingently issuable based on future earnings and on the stock's future market price. Only shares
that are issuable based on conditions existing at the end of the period should be reflected in diluted
earnings per share. Thus, such contingently issuable shares would be included in diluted earnings per
share calculations only if both conditions are met at the end of the reporting period and the effect of
including them is dilutive. (FASB ASC 260104553) (formerly SFAS 128, par. 33)
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In some cases, shares may be issued contingent on conditions other than earnings or market price of the
company's stock (for example, based on opening a certain number of retail locations by a certain date). In such
cases, the contingently issuable shares should be included in diluted earnings per share computations based on
the assumption that the current status of the condition will remain unchanged until the end of the contingency
period. (FASB ASC 260104554) (formerly SFAS 128, par. 34)
The conditions in the preceding paragraph also should be considered when determining whether contingently
issuable potential common shares (such as contingently issuable options or warrants) should be included in
diluted earnings per share. If the company determines the potential common shares should be included, computa
tion of diluted earnings per share, the relevant guidance for options and warrants, for convertible securities, or for
contracts that may be settled in stock or cash should be followed. In any event, exercise or conversion of
contingently issuable potential common stock should not be assumed unless exercise or conversion of similar
outstanding potential common shares that are not contingently issuable is also assumed. (FASB ASC 260104555
through 4557) (formerly SFAS 128, par. 35)
For example, if the company has entered into contracts that require the issuance of stock options when certain
specified conditions are met, those contingently issuable potential common shares should not be included in the
computation of diluted earnings per share unless similar outstanding options (that are not contingently issuable)
are also assumed to be exercised.
Exhibit 33 illustrates the computation of earnings per share when a company has entered into contracts for
contingently issuable shares.
Exhibit 33
Effect of Contingently Issuable Shares on

Earnings per Share Computations
Facts:
1. ABC Company, Inc. had 1,000,000 shares of common stock outstanding during the year ended December 31,
20X8.
2. In connection with the acquisition of a subsidiary, ABC Company entered into a contingent stock agreement
on January 1, 20X8. The terms are as follows:
20,000 common shares must be issued for each new longterm contract entered into exceeding
$1,000,000 in annual revenues.
500 additional common shares must be issued for each $1,000 of consolidated net income (after tax) in
excess of $1,000,000 for the year ended December 31, 20X8.
3. ABC Company was awarded two new longterm contracts exceeding $1,000,000 in annual revenues during
20X8 one on May 1, 20X8 and one on August 1, 20X8.
4. ABC Company's consolidated, yeartodate net income (after tax) was:
$750,000 as of March 31, 20X8.
$1,250,000 as of June 30, 20X8.
$900,000 as of September 30, 20X8.
$1,500,000 as of December 31, 20X8.
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Computing Basic Earnings per Share:
First Second Third Fourth Full

Quarter Quarter Quarter Quarter Year
Numerator $ 750,000 $ 500,000 $ (350,000 ) $ 600,000 $ 1,500,000

Denominator:
Common shares outstanding 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Contract
contingency 13,333 a 33,333 b 40,000 21,666 c
Earnings
contingencyd
Total shares 1,000,000 1,013,333 1,033,333 1,040,000 1,021,666
Basic earnings
per share $ .75 $ .49 $ (.34 ) $ .58 $ 1.47
Notes:
a 20,000 shares related to the May contract outstanding for twothirds of the quarter (20,000 2/3).
b 20,000 shares related to the May contract + 20,000 shares related to the August contract that were
outstanding for twothirds of the quarter.
c 20,000 shares outstanding since May 1, 20X8 (20,000 8/12) + 20,000 shares outstanding since August 1,
20X8 (20,000 shares 5/12).
d No effect on basic earnings per share because it is not certain the contingency has been satisfied until the end
of the year.
Computing Diluted Earnings per Share:
First Second Third Fourth Full

Quarter Quarter Quarter Quarter Year
Numerator $ 750,000 $ 500,000 $ (350,000 ) $ 600,000 $ 1,500,000

Denominator:
Common shares outstanding 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Contract contingency 20,000 a 40,000 a 40,000 a 25,000 b
Earnings contingency 125,000 c 250,000 d 93,750 b
Total shares 1,000,000 1,145,000 1,040,000 1,290,000 1,118,750
Diluted earnings per share $ .75 $ .44 $ (.34 )e $ .47 $ 1.34
Notes:
a Contingent shares are included as of the beginning of the period when computing diluted earnings per share
for interim periods.
b When computing yeartodate diluted earnings per share, contingent shares are included on a weightedaver
age basis. In this example, the weighted average number of shares outstanding is determined by totalling the
shares outstanding each quarter and dividing that total by four.
c [($1,250,000 $1,000,000) $1,000] 500 shares.
d [($1,500,000 $1,000,000) $1,000] 500 shares.
333
e In the example, loss for the quarter is assumed to be due to discontinued operations, therefore, the antidilution
rules discussed previously do not apply.
* * *
Contingently Returnable Shares. Contingently returnable shares should be treated in the same manner as
contingently issuable shares. (FASB ASC 260104513) (formerly SFAS 128, par. 10) Contingently returnable
shares include shares issued or placed in escrow that must be returned in total or in part if specified conditions are
not met.
Rights Issues
If the corporation has issued rights whose exercise price is less than the fair value of the stock, the rights issue
contains a bonus element that is similar to a stock dividend. If the rights issue including the bonus element is
offered to all existing shareholders, diluted earnings per share should be retroactively adjusted for the bonus
element for all periods presented. If the ability to exercise the rights is contingent on an event other than the
passage of time, however, diluted earnings per share should not be adjusted for the bonus element until the
contingency is resolved. (FASB ASC 260105513) (formerly SFAS 128, par. 55)
When restating earnings per share as a result of a rights issue, the number of shares used in computing basic and
diluted earnings per share is the number of shares outstanding prior to the rights issue multiplied by the following
factor:
Fair value per share immediately prior to exercise of the rights
Theoretical exrights fair value per share
Theoretical exrights fair value is computed as follows:

Aggregate fair value of shares immediately prior to the rights
exercise plus the proceeds expected from the exercise of the rights
Number shares outstanding after exercise of the rights
If the rights themselves will be publicly traded (separate from the shares) prior to their exercise, fair value should be
determined as of the last day that the shares and rights trade together. (FASB ASC 260105514) (formerly SFAS
128, par. 56)
Sharebased Compensation Plans
Awards of share options and nonvested shares [defined in FASB ASC 71820, Compensation Stock Compensa
tion (formerly SFAS No. 123(R), Sharebased Payment)] issued to an employee in accordance with a sharebased
compensation plan (or sharebased awards issued to a nonemployee in exchange for goods or services) should be
treated as options when computing diluted earnings per share. Sharebased awards should be considered to be
outstanding at the grant date (even though the holder may not be able to exercise them until they are vested) and
included in the diluted earnings per share calculation if they have a dilutive effect (even though the employee may
not receive or be able to sell the stock until some future date). The treasury stock method (discussed previously)
should be used to determine the dilutive effect of sharebased compensation awards. (FASB ASC 260104528
and 4528A) (formerly SFAS 128, par. 20) In addition
a. when applying the treasury stock method, the proceeds from exercising the share awards is the sum of (1)
the amount the employee must pay, (2) compensation related to future services and not yet charged to
expense, and (3) the amount of any excess tax benefit to be credited to capital. Assumed proceeds should
not include amounts considered compensation for past services. (FASB ASC 260104529) (formerly
SFAS 128, par. 21)
b. generally, if a sharebased compensation agreement allows the employee or corporation to elect whether
payment is in stock or cash, it should be presumed that the contract will be settled in common stock and
334
the resulting potential common shares should be included in the diluted earnings per share calculation if
the effect is more dilutive. If past experience or stated policy provides a reasonable basis to assume the
contract will be settled wholly or partially in cash, however, the presumption that the contract will be settled
in stock may be overcome. (FASB ASC 260104530; 260104545 and 4546) (formerly SFAS 128, par.
22 and par. 29)
c. if the corporation has tandem stock plans that allow the entity or employee to make an election that involves
two or more types of instruments, diluted earnings per share for the period should be computed based on
the terms used to compute compensation for the period. (FASB ASC 260104530) (formerly SFAS 128,
par. 22)
d. if the corporation has issued awards with a market condition, performance condition, or combinations of
both, the contingent share provisions should be followed when determining whether they are included in
diluted earnings per share. (FASB ASC 260104531) (formerly SFAS 128, par. 23)
Example Calculation
Exhibit 34 illustrates calculating diluted earnings per share.
Exhibit 34
Computing Diluted Earnings per Share
Facts:
1. ABC Company, Inc. had income from continuing operations of $2,000,000 (net of tax) and a loss from
discontinued operations of ($500,000) (net of tax) for the year ended December 31, 20X8.
2. At January 1, 20X8, the company had 1,500,000 shares outstanding. An additional 250,000 shares were issued
for cash on February 28, 20X8.
3. Threepercent convertible bonds with a principal amount of $10,000,000 were sold for cash (at par) during the
fourth quarter of 20X7. Each $1,000 bond is convertible into 25 shares of common stock. No bonds were
converted during 20X8.
4. 100,000 shares of convertible preferred stock were issued in 20X7. Each share of preferred stock is entitled to
a cumulative dividend of $2 per share and is convertible to three shares of common stock. No preferred stock
was converted during 20X8.
5. Options to buy 150,000 shares of common stock at $50 per share for a period of 10 years were issued on July
1, 20X3. All options were exercised on June 30, 20X8. The average market price of the stock between January
1, 20X8 and June 30, 20X8 was $65 per share.
6. Warrants to buy 100,000 shares of common stock at $55 per share were outstanding during all of 20X8. Average
stock price for the year was $70 per share.
7. ABC Company's effective tax rate was 40% in 20X8.
Computation of Weighted Average Shares Outstanding:
Weighted
Shares Fraction Average
Dates Outstanding Outstanding of Period Shares
January 1February 28 1,500,000 2/12 250,000
Issuance of common stock on February 28 250,000
1,750,000 4/12 583,333
Exercise of options on June 30 150,000
335
1,900,000 6/12 950,000
Weightedaverage shares 1,783,333
Computation of Basic Earnings per Share:
Income from continuing operations $ 2,000,000

Less: Preferred dividends (200,000 )
Income available to common shareholders 1,800,000
Loss from discontinued operations (500,000 )
Net income available to common shareholders $ 1,300,000
Basic earnings per share:
Income from continuing operations ($1,800,000 1,783,333) $ 1.01
Loss from discontinued operations ($500,000 1,783,333) $ (.28 )
Net income ($1,300,000 1,783,333) $ .73
Computation of Diluted Earnings per Share:
Income available to common shareholders $ 1,800,000

Add impact of assumed conversion:
Preferred stock dividends $ 200,000
Interest on convertible bonds (net of tax) 180,000 380,000
Income from continuing operations available to common shareholders plus assumed conversions 2,180,000
Net income available to common shareholders plus assumed conversions $ 1,680,000
Weighted average shares 1,783,333

Add incremental shares from assumed conversion:
Convertible preferred stock 300,000
Options 17,308 a
Warrants 21,429 b
3% convertible bonds 250,000
Dilutive potential common shares 588,737
Adjusted weighted average shares 2,372,070
Diluted earnings per share:

Income from continuing operations ($2,180,000 2,372,070) $ .92
Loss from discontinued operations ($500,000 2,372,070) $ (.21 )
Net income ($1,680,000 2,372,070) $ .71
Notes:
a [($65 $50) $65] 150,000 6/12
b [($70 $55) $70] 100,000
* * *
336
OTHER CONSIDERATIONS
Participating Securities and Twoclass Common Stock
A corporation may issue securities that participate in undistributed earnings (e.g., securities that participate in
dividends with common stockholders or a class of common stock with different dividend rates from another class
of common stock). If the effect of their conversion would be dilutive, the ifconverted" method (discussed pre
viously) should be used for those securities that are convertible into common stock. For securities not convertible
into common stock, the twoclass method should be used to calculate earnings per share. (For the computation of
basic earnings per share using the twoclass method, all participating securities regardless of whether they are
convertible, nonconvertible, or potential common stock securities should be included.) Under the twoclass
method (FASB ASC 260105559A through 5560B) (formerly SFAS 128, paras.6061 and EITF 036)
a. dividends declared in the current period for each class of stock and unpaid cumulative dividends (or
contractual interest on participating bonds) should be deducted from income from continuing operations
(or net income). The remaining earnings (undistributed earnings) should be allocated to common stock
and the participating securities to the extent that each security may share in earnings.
b. for each security, the undistributed earnings allocated in step a. should be added to the amount allocated
to the security for dividends to determine the total earnings allocated to each security.
c. The amount in b. should be divided by the total outstanding shares for each security to which earnings were
allocated to arrive at earnings per share for the security.
Basic and diluted earnings per share should be presented for each class of common stock.
In essence, the twoclass method determines earnings per share for each class of common stock and participating
security using an allocation formula based on dividends declared (or accumulated) and participation rights in
undistributed earnings. The twoclass method does not require presentation of basic and diluted earnings per
share for securities other than common stock.
Unforfeitable rights to dividends or dividend equivalents on unvested sharebased payment awards are participat
ing securities should be included in the computation of basic earnings per share using the twoclass method.
(FASB ASC 260104561A) (formerly FSP EITF 03061, par. 6)
Exhibit 35 illustrates the computation of basic earnings per share under the twoclass method.
Exhibit 35
Computing Basic Earnings per Share

Under the Twoclass Method
Facts:
1. ABC Company had 1,000,000 shares of common stock and 500,000 shares of nonconvertible preferred stock
outstanding as of December 31, 20X8.
2. The preferred stock is entitled to a $3 per share noncumulative dividend before any dividends are paid on
common stock.
3. After common stock is paid a dividend of $1 per share, the preferred stock participates in any additional
dividends paid on a 25:75 per share ratio with common shareholders.
4. Net income for 20X8 was $10,000,000.
5. Preferred shareholders were paid $1,625,000 ($3.25 per share) in 20X8.
337
6. Common shareholders were paid $1,750,000 ($1.75 per share) in 20X8.
Computation of Undistributed Earnings:
Net income $ 10,000,000

Less dividends paid:
Preferred $ 1,625,000
Common 1,750,000 3,375,000
Undistributed earnings $ 6,625,000
(A)
(B) (A) (B) Undistrib
Shares Dividend uted
Outstand Sharing Equivalent Earnings
ing Ratio Shares Allocationa
Preferred 500,000 25 % 125,000 $ 946,429

Common 1,000,000 75 % 750,000 5,678,571
100 % 875,000 $ 6,625,000
Note:
a Undistributed earnings are allocated based on the percentage of each class of stock's equivalent shares to
total equivalent shares.
Total allocated earnings:
Undistrib
Distributed uted
Earnings Earnings Total
Preferred $ 1,625,000 $ 946,429 $ 2,571,429

Common 1,750,000 5,678,571 7,428,571
$ 3,375,000 $ 6,625,000 $ 10,000,000
Basic earnings per share:
Preferred ($2,571,429 500,000) $ 5.14

Common ($7,428,571 1,000,000) $ 7.43
* * *
Securities of Subsidiaries
A subsidiary may issue options, warrants, or convertible securities that allow holders to obtain common stock of the
subsidiary or the parent company. The following guidelines should be applied when computing consolidated
diluted earnings per share of a company with subsidiaries that have issued common stock or potential common
stock to parties other than the parent: (FASB ASC 260105520) (formerly SFAS 128, par. 62)
a. If the subsidiary issues securities enabling holders to obtain common stock of the subsidiary, those
securities should be included in the subsidiary's diluted earnings per share computation. The subsidiary's
resulting per share earnings should then be included in the consolidated company's earnings per share
computation based on the consolidated group's holding of the subsidiary's securities.
338
b. Securities issued (or held) by the subsidiary that allow the holder to obtain the parent's common stock
should be considered potential common shares when computing the parent's diluted earnings per share.
If the parent company issues shares that are convertible into common stock of the subsidiary or an equity method
investee, the ifconverted method should be used to determine the effect on earnings per share. Under that
method, the numerator of the earnings per share calculation should be adjusted so that it equals the parent's
earnings that would have been reported if the securities had been converted to the subsidiary's common stock.
(That includes the parent's portion of adjustments to the subsidiary's earnings resulting from the assumed conver
sion.) No adjustments to the denominator are necessary, however, because the number of parent company shares
outstanding would not change from the assumed conversion. (FASB ASC 260105522) (formerly SFAS 128, par.
63)
Prior Period Adjustments
GAAP may require the results of operations of a prior period to be restated. In such cases, earnings per share data
for the prior period (or periods) also should be restated. Earnings per share should be computed following the
provisions of this lesson as if the restated income or loss had been originally reported for the prior period or
periods. The effect of the restatement (in per share terms) should be disclosed in the period of restatement. (FASB
ASC 260105515 and 5516) (formerly SFAS 128, paras. 5758)
Public companies with simple capital structures must present basic earnings per share while those with complex
capital structures must present basic and diluted earnings per share. Earnings per share data should be presented
for all periods for which an income statement or summary of earnings is presented. Companies required to present
diluted earnings per share must do so for all periods presented even if it equals basic earnings per share. (If they
are the same, however, basic and diluted earnings per share may be reported as one line item on the income
statement.) (FASB ASC 26010452; 26010457) (formerly SFAS 128, paras. 36 and 38)
Pershare amounts for net income and income from continuing operations should be presented on the face of the
income statement. Pershare amounts for discontinued operations or extraordinary items (when those items are
present) should be reported on the face of the income statement or disclosed in the notes to the financial
statements. (FASB ASC 26010452 and 453) (formerly SFAS 128, paras. 3637) In addition, the financial state
ments should include the following disclosures for each period for which an income statement is presented:
a. A reconciliation of the numerators and denominators of the basic and diluted earnings per share
computations for income from continuing operations. (Income and share amounts for all securities that
affect earnings per share should be provided in the reconciliation.)
b. The effect of preferred dividends on the income available to common shareholders amount used in the
basic earnings per share calculation.
c. Any securities (including those that could be issued under contingent stock agreements) that could
potentially dilute basic earnings per share, but were not included in the diluted earnings per share
computation because their effect was antidilutive for the periods presented. (Disclosure of the terms and
conditions of those securities is required even if a security is not included in diluted earnings per share in
the current period.)
d. Any transactions occurring after the end of the period, but before the financial statements are issued (or
available to be issued), that would have a material effect on the number of common shares or potential
common shares outstanding at the end of the period. (For example, issuance or purchase of common
shares, issuance of options, warrants, or convertible securities, the resolution of a contingency specified
in a contingent stock agreement, and the conversion or exercise of potential common shares outstanding
at the end of the period.) (FASB ASC 26010501 and 502) (formerly SFAS 128, paras. 4041)
e. If applicable, the fact that per share amounts have been adjusted as a result of stock dividends, stock splits,
or reverse stock splits. (FASB ASC 260105512) (formerly SFAS 128, par. 54)
339
f. If earnings per share amounts have been restated as the result of a prior period adjustment, the effects of
the restatement (in per share amounts). (FASB ASC 260105515) (formerly SFAS 128, par. 57)
g. If per share amounts other than those required to be presented are disclosed, whether the per share
amounts are net of tax. (FASB ASC 26010455) (formerly SFAS 128, par. 37) Note that GAAP prohibits
presenting cash flow per share. (FASB ASC 26010456) (formerly SFAS 128, par. 37)
h. For public companies, if stockbased employee compensation awards are outstanding and accounted for
under the intrinsic value method during any period for which an income statement is presented, a tabular
reconciliation of basic and diluted earnings per share as reported to pro forma basic and diluted earnings
per share as if the fair value method had been used for all awards. [SFAS 123(R), par. 84]
Exhibit 36 illustrates how the more common disclosures could be presented in the notes to the financial state
ments.
Exhibit 36
Example Disclosure of Reconciliation of Numerators

And Denominators for Basic and
Diluted Earnings per Share Computations
NOTE H EARNINGS PER SHARE
Basic earnings per share are computed by dividing earnings available to common stockholders by the weighted
average number of common shares outstanding during the period. Diluted earnings per share reflect per share
amounts that would have resulted if dilutive potential common stock had been converted to common stock. The
following reconciles amounts reported in the financial statements:
For the Year Ended 20X8

Income Shares
(Numera (Denomina Pershare
tor) tor) Amount
Income from continuing operations $ 2,000,000

Less preferred stock dividends (400,000 )
Income available to common stockholders basic earnings per

share 1,600,000 500,000 $ 3.20
Effect of dilutive securities

Options 3,000
5% convertible debentures 300,000 200,000
Income available to common stockholders diluted earnings per

share $ 1,900,000 703,000 $ 2.70
During 20X8, the corporation had 80,000 shares of convertible preferred stock (entitled to a $5 per share cumulative
dividend) outstanding. Each share of preferred stock is convertible into one share of common stock. The
convertible preferred stock was not included in the computation of diluted earnings per share because the effect of
conversion would be antidilutive. The convertible preferred stock was still outstanding at December 31, 20X8.
* * *
340
SELFSTUDY QUIZ
following section.
23. The measure of income available to common shareholders is the earnings per share. Which of the following
is correct for earnings per share?
a. Publicly traded companies must present basic and diluted earnings per share.
b. The pershare gain on real estate should be disclosed by public companies.
c. All companies must communicate earnings per share in the financial statements.
d. If an entity is in the process of filing with a regulatory agency to sell securities in a public market, then
earnings per share must be presented.
24. The computation for basic earnings per share is dividing available earnings by the weighted average number
of shares of common stock outstanding during the period. Which of the following is an issue that a preparer
would need to consider when doing the calculation?
a. If common shares will be repurchased for cash, they should be excluded from the denominator of the basic
earnings per share calculation.
b. Only shares that have been fully paid should be used when calculating earnings per share.
c. Paid claims to preferred stockholders should be deducted from income before calculating earnings per
share.
d. Stock dividends and stock splits should be recognized on the day of the dividend or split, when deciding
the new number of shares for earnings per share calculation.
25. The Smith Foundation is reporting a loss on a discontinued operation for 2009. Here is addition information from
the 2009 financials:
Income from continuing operations $ 25,000

Net Loss (10,000 )
Shares of common stock 5,000
Potential common shares outstanding 1,000
What are the diluted earnings per share from continuing operations for The Smith Foundation for 2009?
a. ($7.00).
b. ($2.00).
c. $4.17.
d. $5.00.
341
26. Which of the following is accurate about dilutive earnings per share?
a. Diluted earnings per share should be calculated using the most advantageous conversion rate for the
company.
b. Potential common shares should only be used when computing diluted earnings per share for continuing
operations and discontinued operations if they are not antidilutive.
c. All securities should be included when computing the diluted earnings per share.
d. If a company reports a loss for continuing operations, the per share amount for continuing operations will
always be antidilutive if they include the potential common share in the denominator.
27. Which of the following is included when computing earnings per share under the treasury stock method?
a. Income that would be received is used to purchase common stock at the current market price during the
period.
b. The conversion of options or warrants was completed at the beginning of the period.
c. The incremental number of shares issued is included in the numerator when computing diluted earnings
per share under the treasure stock method.
28. When calculating the diluted earnings per share, the dilutive effect of convertible debt and convertible preferred
stock should use the ifconverted method. One aspect of the ifconverted method is:
a. The numerator should be adjusted based on if the convertible preferred stock or convertible debt was
translated as of the beginning of the period.
b. Net income should not include the interest expense applicable to convertible debt that is outstanding.
c. Net income, prior to any adjustments, should be used as the numerator in the ifconverted method.
d. The numerator should include the dividends applicable to the convertible preferred stock.
29. Sally is working on calculating the interim earnings per share for Food Market, Inc. The company has an
agreement for contingently issuable shares if certain conditions are met, which have for the current year. Which
of the following information would help Sally calculate the interim earnings per share for Food Market, Inc.,
including the contingently issuable shares?
a. The contingently issuable share would be included in the denominator of the earnings per share
calculation, as of the beginning of the period.
b. The number of contingently issuable shares is based on the number of shares that would be issuable at
the end of the reporting period.
c. To be included in the diluted earnings per share computation, the contingent shares should be weighted
for the interim periods.
d. The number of contingently issuable shares that would be included in the computation is based on the
current status and that the number of shares will remain unchanged until the end of the contingency period.
342
30. When computing diluted earnings per share, how should sharebased compensation awards be treated?
a. Diluted earnings per share should be retroactively adjusted for the sharebased compensation awards.
b. The awards should be treated as options and should be considered outstanding at the grant date.
c. The awards should be treated as in the same manner as contingently issuable shares.
d. The treasury method should be applied when computing the diluted earnings per share for sharebased
compensation awards.
31. Toyco, Inc. recently acquired a new subsidiary, Brand New Toys, Co. The stockholders of each company have
been issued securities that allows them to purchase common stock in the parent company or the subsidiary.
How should these securities be factored into the computation of earnings per share for either Toyco or Brand
New Toys?
a. The twostock method should be used when determining the effect on earnings per share if the parent
company issues convertible shares in the subsidiary.
b. Securities issued by Brand New Toys allowing stockholders to purchase common stock of the company
should not be included in the diluted earnings per share of the company.
c. If stockholders of Brand New Toys hold options for Toyco, the shares should be considered potential
common shares in Toyco for the parent company's computation.
32. What are the disclosure requirements for earnings per share for public companies?
a. The effect of preferred dividends on common stock does not have to be detailed in the income statement.
b. The net income and continuing operations per share amounts should be presented on the face of the
income statement.
c. If basic earnings per share and diluted earnings per share are the same, then only basic earnings per share
has to be reported.
d. All public companies must show both basic earnings per share and diluted earnings per share for each
period that an income statement is presented.
343
SELFSTUDY ANSWERS
23. The measure of income available to common shareholders is the earnings per share. Which of the following
is correct for earnings per share? (Page 324)
a. Publicly traded companies must present basic and diluted earnings per share. [This answer is incorrect.
Companies with a simple capital structure must present basic earnings per share, while companies with
more complex capital structure must present both basic and diluted earnings per share.]
b. The pershare gain on real estate should be disclosed by public companies. [This answer is incorrect. A
company may chose to disclose other pershare information, such as pershare gain on the sale of real
estate, but it is not required. Cash flow per share should not be reported.]
c. All companies must communicate earnings per share in the financial statements. [This answer is incorrect.
Earnings per share must be presented in the financial statements of all entities that issue common stock
or potential common stock, if those securities are traded in a public market. If a company is nonpublic, they
are not required to present earnings per share in their financial statements.]
d. If an entity is in the process of filing with a regulatory agency to sell securities in a public market,
then earnings per share must be presented. [This answer is correct. Entities that have made a filing
or are in the process of making a filing with a regulatory agency to prepare for the sale of securities
in a public market must also present earnings per share.]
24. The computation for basic earnings per share is dividing available earnings by the weighted average number
of shares of common stock outstanding during the period. Which of the following is an issue that a preparer
would need to consider when doing the calculation? (Page 324)
a. If common shares will be repurchased for cash, they should be excluded from the denominator of
the basic earnings per share calculation. [This answer is correct. The entity may have issued
mandatorily redeemable common shares or entered into a contract requiring repurchase of a fixed
number of its common shares for cash. In such cases, the common shares to be redeemed or
repurchased should be excluded from the denominator of the basic earnings per share calculation.]
b. Only shares that have been fully paid should be used when calculating earnings per share. [This answer
is incorrect. An entity may have issued common stock that is partially paid and entitled to dividends in
proportion to the amount paid. If so, the common share equivalent of the partially paid share should be
reflected in the denominator of the basic earnings per share calculation to the extent the shares were
entitled to participate in dividends.]
c. Paid claims to preferred stockholders should be deducted from income before calculating earnings per
share. [This answer is incorrect. Income available to common stockholders is income less claims of
preferred stockholders on income. Dividends declared on noncumulative preferred stock, whether or not
paid, should be deducted from income before computing earnings per share and dividends on cumulative
preferred stock should be deducted even if they have not been declared.]
d. Stock dividends and stock splits should be recognized on the day of the dividend or split, when deciding
the new number of shares for earnings per share calculation. [This answer is incorrect. Stock dividends
and stock splits should be recognized on a retroactive basis. Also, if stock dividends and stock splits occur
after the balance sheet date, but before the financial statements are issued, earnings per share calculations
should be based on the new number of shares.]
344
25. The Smith Foundation is reporting a loss on a discontinued operation for 2009. Here is addition information from
the 2009 financials:
Income from continuing operations $ 25,000

Net Loss (10,000 )
Shares of common stock 5,000
Potential common shares outstanding 1,000
What is the diluted earnings per share from continuing operations for The Smith Foundation for 2009?
(Page 328)
a. ($7.00). [This answer is incorrect. The per share amount for discontinued operations would be ($7.00). This
is calculated by taking the loss from discontinued operations and dividing it by the shares of common
stock.]
b. ($2.00). [This answer is incorrect. This is the per share amount for the net loss for The Smith Foundation.
The net loss per share is calculated by taking the total net loss and dividing it by the total shares of common
stock.]
c. $4.17. [This answer is correct. The diluted per share amount is calculated by taking the total income
from continuing operations and dividing it by total share that could be outstanding, the common
stock shares plus the potential common shares outstanding.]
d. $5.00. [This answer is incorrect. This is the basic per share amount. This is the income from continuing
operations divided by the shares of common stock.]
26. Which of the following is accurate about dilutive earnings per share? (Page 328)
a. Diluted earnings per share should be calculated using the most advantageous conversion rate for the
company. [This answer is incorrect. Diluted earnings per share should be calculated using the most
advantageous conversion rate or exercise price from the standpoint of the security holder. In addition,
previously reported diluted earnings per share should not be restated for subsequent conversions or
changes in the stock's market price.]
b. Potential common shares should only be used when computing diluted earnings per share for continuing
operations and discontinued operations if they are not antidilutive. [This answer is incorrect. The number
of potential common shares used to computer diluted earnings per share for continuing operations should
be used to compute all other pershare amounts even if those amounts would be antidilutive to their
respective basic pershare amounts.]
c. All securities should be included when computing the diluted earnings per share. [This answer is incorrect.
Securities that have an anitdilutive effect on earnings per share should not be included in the computation
of diluted earnings per share.]
d. If a company reports a loss for continuing operations, the per share amount for continuing
operations will always be antidilutive if they include the potential common share in the denominator.
[This answer is correct. Including potential common shares in the denominator when computing the
pershare amount for continuing operations is always antidilutive if the company reports a loss for
continuing operations. If the company has a loss from continuing operations, no potential common
shares should be included in the denominator when computing any pershare amounts, even if the
company reports net income.]
345
27. Which of the following is included when computing earnings per share under the treasury stock method?
(Page 329)
a. Income that would be received is used to purchase common stock at the current market price during the
period. [This answer is incorrect. Any proceeds that are received and was used to purchase common stock
should be purchased at the average market price during the period.]
b. The conversion of options or warrants was completed at the beginning of the period. [This answer
is correct. When using the treasury stock method to compute earnings per share, the options or
warrants that were converted to common shares should be done at the beginning of the period.]
c. The incremental number of shares issued is included in the numerator when computing diluted earnings
per share under the treasure stock method. [This answer is incorrect. Under the treasury stock method,
the incremental number of shares issued (the difference between the number of shares assumed to be
issued and the number of shares assumed to be purchased), is included in the denominator when
computing diluted earnings per share.]
28. When calculating the diluted earnings per share, the dilutive effect of convertible debt and convertible preferred
stock should use the ifconverted method. One aspect of the ifconverted method is: (Page 330)
a. The numerator should be adjusted based on if the convertible preferred stock or convertible debt was
translated as of the beginning of the period. [This answer is incorrect. When applying the ifconverted
method, the denominator should be adjusted as if the convertible preferred stock or convertible debt was
converted as of the beginning of the period.]
b. Net income should not include the interest expense applicable to convertible debt that is outstanding. [This
answer is incorrect. When using the ifconverted method, any interest expense, net of tax that is applicable
to convertible debt outstanding should be added back to the net income.]
c. Net income, prior to any adjustments, should be used as the numerator in the ifconverted method. [This
answer is incorrect. In the ifconverted method, the numerator should be adjusted for any changes to net
income, net of tax, resulting from the assumed conversion. An example of an adjustment is bonus expense
that is based on net income.]
d. The numerator should include the dividends applicable to the convertible preferred stock. [This
answer is correct. Under the ifconverted method, dividends applicable to the convertible preferred
stock should be added back to the numerator.]
29. Sally is working on calculating the interim earnings per share for Food Market, Inc. The company has an
agreement for contingently issuable shares if certain conditions are met, which have for the current year. Which
of the following information would help Sally calculate the interim earnings per share for Food Market, Inc.,
including the contingently issuable shares? (Page 331)
a. The contingently issuable share would be included in the denominator of the earnings per share
calculation, as of the beginning of the period. [This answer is correct. When calculating the interim
earnings per share, Sally should include all of the shares in the denominator at the beginning of the
period, or the date of the contingent stock agreement, whichever is a later date.]
b. The number of contingently issuable shares is based on the number of shares that would be issuable at
the end of the reporting period. [This answer is incorrect. If all contingencies have not been satisfied by
the end of the period, the number of contingently issuable shares included in diluted earnings per share
should be based on the number of shares (if any) that would be issuable if the end of the reporting period
were the end of the contingency period.]
c. To be included in the diluted earnings per share computation, the contingent shares should be weighted
for the interim periods. [This answer is incorrect. If Sally was computing the yeartodate computation, then
the contingent shares would be weighted for the interim periods in which they would be included in the
diluted earnings per share computation.]
346
d. The number of contingently issuable shares that would be included in the computation is based on the
current status and that the number of shares will remain unchanged until the end of the contingency period.
[This answer is incorrect. If the shares were issued contingent on conditions other than earnings or market
price of the company's stock (for example, based on the opening a certain number of retail locations by
a certain date), then the contingently issuable shares should be included in diluted earnings per share
computations is based on the assumption that the current status of the condition will remain unchanged
until the end of the contingency period.]
30. When computing diluted earnings per share, how should sharebased compensation awards be treated?
(Page 334)
a. Diluted earnings per share should be retroactively adjusted for the sharebased compensation awards.
[This answer is incorrect. Diluted earnings per share should be retroactively adjusted for any bonus
elements, not sharebased compensation awards that are present for all periods.]
b. The awards should be treated as options and should be considered outstanding at the grant date.
[This answer is correct. Awards of share options and nonvested shares issued to an employee in
accordance with a sharebased compensation plan should be treated as options when computing
diluted earnings per shares. Sharebased awards should be considered to be outstanding at the
grant date.]
c. The awards should be treated as in the same manner as contingently issuable shares. [This answer is
incorrect. Contingently returnable shares should be treated in the same manner as contingently issuable
shares. Contingently returnable shares include shares issued or placed in escrow that must be returned
in total or part if specified conditions are not met.]
d. The treasury method should be applied when computing the diluted earnings per share for sharebased
compensation awards. [This answer is incorrect. The treasury method should not be applied to
sharebased compensation awards, but should be applied, along with the ifconverted method, when any
cash proceeds are received in relation to convertible securities.]
31. Toyco, Inc. recently acquired a new subsidiary, Brand New Toys, Co. The stockholders of each company have
been issued securities that allows them to purchase common stock in the parent company or the subsidiary.
How should these securities be factored into the computation of earnings per share for either Toyco or Brand
New Toys? (Page 338)
a. The twostock method should be used when determining the effect on earnings per share if the parent
company issues convertible shares in the subsidiary. [This answer is incorrect. If the parent company
issues shares that are convertible into common stock of the subsidiary, the ifconverted method should
be used to determine the effect on earnings per share.]
b. Securities issued by Brand New Toys allowing stockholders to purchase common stock of the company
should not be included in the diluted earnings per share of the company. [This answer is incorrect. If the
subsidiary issues securities enabling holders to obtain common stock of the subsidiary, those securities
should be included in the subsidiary's diluted earnings per share computation. The subsidiary's resulting
per share earnings should then be included in the consolidated company's earnings per share
computation based on the consolidated group's holding of the subsidiary's securities.]
c. If stockholders of Brand New Toys hold options for Toyco, the shares should be considered potential
common shares in Toyco for the parent company's computation. [This answer is correct. Securities
issued (or held) by the subsidiary that allow the holder to obtain the parent's common stock should
be considered potential common shares when computing the parent's diluted earnings per share.]
347
32. What are the disclosure requirements for earnings per share for public companies? (Page 339)
a. The effect of preferred dividends on common stock does not have to be detailed in the income statement.
[This answer is incorrect. The effect of preferred dividends on the income available to common
stockholders amount used in the basic earnings per share calculation should be disclosed for each period
in which an income statement is presented.]
b. The net income and continuing operations per share amounts should be presented on the face of
the income statement. [This answer is correct. Pershare amounts for net income and income from
continuing operations should be presented on the face of the income statement. Pershare amounts
for discontinued operations or extraordinary items should be reported on the face of the income
statement or disclosed in the notes to the financial statements.]
c. If basic earnings per share and diluted earnings per share are the same, then only basic earnings per share
has to be reported. [This answer is incorrect. Companies are required to present diluted earnings per share
even if it equals basic earnings per share. However, if they are the same, they may be reported as one line
item on the income statement.]
d. All public companies must show both basic earnings per share and diluted earnings per share for each
period that an income statement is presented. [This answer is incorrect. Public companies with simple
capital structures must present basic earnings per share, while those with complex capital structures must
present basic and diluted earnings per share for each period in which an income statement is presented.]
348
INCOME STATEMENT
OVERVIEW
The income statement is one of the basic financial statements necessary to present a company's financial position
and results of operations in conformity with generally accepted accounting principles. The statement of income and
the statement of retained earnings (separately or combined) are designed to reflect, in a broad sense, results of
operations.
Each income statement item may be categorized as either a revenue, expense, gain, or loss. Although there are few
strict rules for presenting those items in the income statement, generally accepted accounting principles require
the following to be presented separately:
Extraordinary items
Unusual or infrequent items
Discontinued operations of a component of an entity
Equity in operations of investees
Goodwill impairment losses
Those items should be presented in the income statement in the following order:
a. Income from continuing operations, including, if applicable, unusual or infrequently occurring items, equity
in operations of investees, and goodwill impairment losses
b. Discontinued operations of a component of an entity, including, if applicable, goodwill impairment losses
c. Extraordinary items
An entity may choose how to classify business interruption insurance proceeds in the income statement as long as
that classification is not contrary to existing GAAP. In addition, costs incurred and expenses generated from
transactions with third parties in collaborative arrangements should be reported in each participant's separate
income statement. Payments between participants should be presented in the income statement according to their
nature.
COMPONENTS OF NET INCOME AND BASIC PRINCIPLES
Net income should include all items of profit and loss recognized during the period except for error corrections.
(FASB ASC 22510451) (formerly APB 9, par. 17) According to Statement of Financial Accounting Concepts
(SFAC) No. 6, Elements of Financial Statements, each item presented in the income statement may be categorized
according to one of the following four components of net income:
Revenues actual or expected cash inflows (or the equivalent) that have occurred or will eventuate as a
result of an entity's major or central operations
Expenses outflows or other using up of assets or incurrences of liabilities (or a combination of both) from
delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's
ongoing major or central operations
Gains increases in equity (net assets) from peripheral or incidental transactions of an entity and from all
other transactions and other events and circumstances affecting the entity except those that result from
revenues or investments by owners
349
Losses decreases in equity (net assets) from peripheral or incidental transactions of an entity and from
all other transactions and other events and circumstances affecting the entity except those that result from
expenses or distributions to owners
Classifying amounts as revenues, expenses, gains, or losses varies among companies depending on the nature of
each company's operations. Events or circumstances that are sources of revenues for one company may be gains
for another. The primary differences between revenues and gains and between expenses and losses are that (a)
revenues and expenses result from an entity's ongoing major or central operations such as producing or delivering
goods or rendering services, while gains and losses result from incidental or peripheral events or circumstances
and (b) revenues and expenses usually are recorded at their gross amounts while gains and losses usually are
recorded at net amounts.
Recognizing Revenues, Expenses, Gains, and Losses
Revenues. SFAC No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that
revenue is recorded in financial statements when the following conditions are met:
a. Amounts are realized or realizable, i.e., converted or convertible into cash or claims to cash.
b. Amounts are earned, i.e., activities that are prerequisite to obtaining benefits have been completed.
Thus, as a general rule, revenue from selling products is recognized at the date of sale, and revenue from rendering
services is recognized when the services have been performed and are billable.
SFAC No. 5 provides the following additional guidelines on recognizing revenue:
If sale or cash receipt (or both) precedes production and delivery (for example, magazine subscriptions),
revenues may be recognized as earned by production and delivery.
If product is contracted for before production, revenues may be recognized by a percentageofcompletion

method as earned as production takes place provided reasonable estimates of results at completion
and reliable measures of progress are available.
If services are rendered or rights to use assets extend continuously over time (for example, interest or rent),
reliable measures based on contractual prices established in advance are commonly available, and
revenues may be recognized as earned as time passes.
If products or other assets are readily realizable because they are salable at reliably determinable prices
without significant effort (for example, certain agricultural products, precious metals, and marketable
securities), revenues and some gains or losses may be recognized at completion of production or when
prices of the assets change.
If product, services, or other assets are exchanged for nonmonetary assets that are not readily convertible
into cash, revenues or gains or losses may be recognized on the basis that they have been earned and
the transaction is completed. Recognition in both kinds of transactions depends on the provision that the
fair values involved can be determined within reasonable limits.
If collectibility of assets received for product, services, or other assets is doubtful, revenues may be
recognized on the basis of cash received.
Various pronouncements provide specific guidance on revenue recognition for certain transactions or in certain
industries.
Expenses. The term matching sometimes is used to describe the process of recognizing expenses in the same
accounting period as the revenues associated with those costs. SFAC No. 5 describes the following broad expense
recognition principles:
Costs and revenues that result directly and jointly from the same transaction or event are recognized in the
same accounting period, such as sales revenue, cost of goods sold, and certain selling expenses.
350
Costs that are incurred to obtain benefits that are exhausted in the period in which the costs are incurred
are recognized in that period, for example, salesmen's monthly salaries and utilities.
Costs that provide benefits over several periods are allocated to those periods, for example, prepaid
insurance and depreciation. Costs are generally allocated to accounting periods when no direct
relationship between revenues and costs exists, and the costs cannot be identified with a particular
accounting period.
Gains and Losses. SFAC No. 6 indicates that gains and losses generally result from one of the following events or
circumstances:
a. Netting costs and proceeds of incidental transactions, such as sales of investments in marketable
securities or equipment
b. Nonreciprocal transfers other than those between the company and its owners, for example, donations,
winning a lawsuit, or thefts
c. Holding assets or liabilities while their values change, for example, causing inventory to be written down
from cost to market
d. Environmental factors, such as damage or destruction of property by fire or flood
EXTRAORDINARY ITEMS
Extraordinary items are events or transactions that meet both of the following criteria: (FASB ASC 2252020;
22520452) (formerly APB 30, par. 20)
a. Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be
of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity,
taking into account the environment in which the entity operates. (An event or transaction is not considered
to be unusual merely because it is beyond the control of management.)
b. Infrequency of occurrence. The underlying event or transaction should be of a type that would not
reasonably be expected to recur in the foreseeable future, taking into account the environment in which
the entity operates.
However, the following item should be recognized as an extraordinary item regardless of whether those criteria are
met: (FASB ASC 22520152) (formerly APB 30, par. 20)
a. The net effect of discontinuing the application of FASB ASC 980, Regulated Operations (formerly SFAS No.
71, Accounting for the Effects of Certain Types of Regulation)
Accounting standards allowed extraordinary treatment for certain other transactions prior to the effective date of
SFAS No. 141(R), Business Combinations, which is codified in FASB ASC 805. That guidance is effective for
business combinations for which the acquisition date is on or after the beginning of the first annual reporting period
beginning on or after December 15, 2008. Prior to the effective date, the following items are also recognized as
extraordinary items regardless of whether they meet the criteria described previously:
The remaining excess of fair value of acquired net assets over cost (negative goodwill).
Goodwill resulting from initial measurement of the assets, liabilities, and noncontrolling interests of a newly
consolidated variable interest entity at fair values, if the variable interest entity is not a business.
An event or transaction should be classified as extraordinary only in rare circumstances. A presumption underlying
the definition of extraordinary items is that an event or transaction should be considered ordinary and usual unless
evidence clearly supports its classification as extraordinary. (FASB ASC 22520451) (formerly APB 30, par. 19) The
environment in which a company operates, including the characteristics of its industry, the geographical location of
351
its operations, and the nature and extent of governmental regulation, should be a primary consideration when
determining whether an event or transaction is extraordinary (FASB ASC 22520551) (formerly APB 30, par. 21).
Thus, as a general rule, particular events or transactions do not, of themselves, require classification as extraordi
nary items, and an event or transaction considered an extraordinary item for one company may not be considered
an extraordinary item for another.
Although the definition of an extraordinary item embodies infrequency of occurrence, infrequency alone does not
imply that an event or transaction should be classified as extraordinary. The past occurrence of an event for a
particular entity provides evidence to assess the probability of recurrence in the foreseeable future. The probability
of recurrence should take into account the environment in which the particular entity operates. (FASB ASC
22520552) (formerly APB 30, par. 22)
The materiality of an event or transaction should be considered when deciding whether to present it as an
extraordinary item. Materiality should be considered as it relates to individual items, except that the effects of a
series of related transactions from a single specific and identifiable event or plan of action should be considered in
the aggregate. (FASB ASC 22520453) (formerly APB 30, par. 24)
Examples of Items That Are Not Extraordinary Items
Some events or transactions may either be unusual in nature or occur infrequently but not both, and thus do not
meet the criteria for classification as extraordinary items. Examples of such items generally include the following:
Writedown or writeoff of receivables, inventories, equipment leased to others, or intangible assets
Gains or losses from sale or abandonment of property, plant, or equipment used in the business
Gains or losses from exchange or translation of foreign currencies including those relating to major
devaluations and revaluations
Effects of a strike, including those against competitors and major suppliers
Adjustments of accruals on longterm contracts
Disposals of a component of an entity
A discussion presenting items that are unusual or occur infrequently in further detail later in this lesson.
Costs Incurred to Defend Against a Takeover
Costs incurred to defend against a takeover attempt or to pay a stockholder for a standstill" agreement (i.e., an
agreement in which the former stockholder agrees not to purchase additional shares of the corporation) do not
meet the criteria for classification as extraordinary items and should be charged to expense when incurred since
they do not provide future economic benefits. (FASB ASC 22520554) (formerly FTB 856, par. 7)
Income Statement Presentation
Extraordinary items should be separately presented in the income statement, net of any related income tax effect.
Preferably, the applicable income taxes should be disclosed on the face of the income statement. Individual
extraordinary items should be presented (preferably on the face of the income statement, if practicable) using
descriptive captions following income from continuing operations. If the income statement includes discontinued
operations, extraordinary items should be presented following discontinued operations. (Pershare amounts may
be presented on the face of the income statement or in the related notes.) (FASB ASC 205204510 through 4512)
(formerly APB 30, par. 11 and SFAS 144, par. 43) Exhibit 37 illustrates presenting extraordinary items in the income
statement.
352
Exhibit 37
Example Income Statement Presentation of Extraordinary Items
INCOME FROM CONTINUING OPERATIONS 437,000
DISCONTINUED OPERATIONS
Income from operations of discontinued division (less applicable income taxes of $14,000) 33,000
Loss on disposal of division (less applicable income taxes of $21,000) (49,000 )
(16,000 )
INCOME BEFORE EXTRAORDINARY ITEM 421,000
EXTRAORDINARY ITEM Loss on expropriation of assets by foreign government (less

applicable income tax benefit of $12,600) (29,400 )
* * *
Adjustment of Priorperiod Extraordinary Items
In many circumstances, amounts reported as extraordinary items are based on estimates and require adjustments
in subsequent periods. In those cases, unless the adjustments meet the criteria for prior period adjustments, they
also should be reported as extraordinary items. (FASB ASC 225204513 and 4514) (formerly APB 30, par. 25)
UNUSUAL OR INFREQUENT ITEMS
Events or transactions that are either unusual or infrequent, but not both (and therefore, do not meet the criteria for
extraordinary items), should be presented in the income statement as separate elements of income from continuing
operations. The income statement presentation should not imply that the amounts are extraordinary items; for
example, they should not be presented net of tax as separate line items following income from continuing
operations. The nature and effects of the events or transactions should be disclosed on the face of the income
statement or in the notes to the financial statements. (FASB ASC 225204516) (formerly APB 30, par.26)
Examples of items that may be considered unusual or infrequent, but not both, are listed previously. Captions such
as Nonrecurring items" or Unusual items" may be used if the unusual or infrequent event or transaction is
disclosed in the notes to the financial statements.
The following income statement presentation illustrates an unusual or infrequent item. The example assumes that
the warehouse closing represents discontinuance of part of a line of business rather than of a component of an
entity.
NET SALES $ 350,000

COSTS AND EXPENSES
Cost of sales 165,000
Selling and administrative 95,000
Closing of Eastern warehouse 83,000
343,000
INCOME BEFORE INCOME TAXES 7,000
Business interruption insurance provides coverage if an entity's business operations are suspended due to the loss
of use of property and equipment resulting from a covered loss. Such insurance coverage generally reimburses
353
certain costs and losses incurred during the period required to rebuild, repair, or replace the damaged property,
such as the following: (FASB ASC 2253020; 22530052) (formerly EITF 0113, par. 4)
Gross margin lost or not earned because normal operations were suspended.
A portion of fixed charges and expenses relating to that lost gross margin.
Other expenses, such as the rent of temporary facilities and equipment, which are incurred to reduce the
loss from business interruption.
An entity may choose how to classify business interruption insurance proceeds in the income statement as long as
that classification is not contrary to existing GAAP. For example, business insurance proceeds must meet the
requirements for an extraordinary item if they are to be classified as such in the income statement. (FASB ASC
COLLABORATIVE ARRANGEMENTS
A collaborative arrangement is a contractual arrangement for a joint operating activity not primarily conducted
through a separate legal entity that involves two or more parties who are both: (FASB ASC 8081020; 80810154)
(formerly EITF 071, paras. 5 and 6)
a. Active participants in the activity, and
b. Exposed to significant risks and rewards dependent on the commercial success of the activity
In a collaborative arrangement, costs incurred and revenues generated from transactions with third parties should
be reported in each entity's separate income statement. The collaborative arrangement participant that is the
principal participant for a transaction should record the transaction on a gross basis; other participants may record
the transaction on a net basis. Payments between participants should be presented in the income statement
according to their nature. The equity method of accounting should not be applied to activities of collaborative
arrangements. (FASB ASC 80810451 through 453) (formerly EITF 071, paras. 1619)
The following paragraphs describe the required disclosures for extraordinary items, unusual or infrequent items,
business interruption insurance, and collaborative arrangements.
EXTRAORDINARY ITEMS
In addition to the presentation requirements discussed previously, the following disclosures about extraordinary
items are required:
The nature of the event or transaction and the principal items entering into determination of the
extraordinary gain or loss (FASB ASC 225204511) (formerly APB 30, par. 11)
The year of origin and nature of each adjustment in the current period of an element of an extraordinary
item that was reported in a prior period (The adjustment should be presented separately in the current
period income statement as an extraordinary item.) (FASB ASC 22520502) (formerly APB 30, par. 25)
UNUSUAL OR INFREQUENT ITEMS
The gain or loss from events or transactions that are either unusual or infrequent, but not both should be presented
as a separate component of income from continuing operations. In addition, the nature and financial effects of each
event should be disclosed (on the face of the income statement or in the notes). (FASB ASC 22520503) (formerly
APB 30, par. 26)
354
The following information should be disclosed in the period in which business interruption insurance recoveries are
recognized: (FASB ASC 22530501) (formerly EITF 0113, par. 7)
a. The nature of the event resulting in business interruption losses
b. The aggregate amount of business interruption insurance recoveries recognized during the period and the
line items in the income statement in which those recoveries are reported
COLLABORATIVE ARRANGEMENTS
Participants to collaborative arrangements should disclose the following for the initial period and all annual periods
thereafter, with amounts for individually significant collaborative arrangements disclosed separately: (FASB ASC
a. Accounting policy for collaborative arrangements
b. Information about the nature and purpose of collaborative arrangements
c. The participant's rights and obligations under the arrangement
d. The income statement classification and amounts attributable to transactions between the participants
under the arrangements for each period an income statement is presented
Upon initial application of 808, Collaborative Arrangements (formerly EITF 071), an entity should disclose a
description of any priorperiod information that has been retrospectively adjusted, and the effect on revenue and
operating expenses (or any other appropriate caption) and on any other financial statement line item. If retrospec
tive application is impracticable, disclose both the reasons why reclassification was not made and the effect of the
reclassification on the current period. (FASB ASC 80810651) (formerly EITF 071, paras. 2223) The guidance on
collaborative arrangements in 808 (formerly EITF 071) is effective for fiscal years beginning after December 15,
2008 and interim periods within those years.
355
356
SELFSTUDY QUIZ
following section.
33. There are four components of net income that are presented in the income statement. Which category includes
increases in equity from incidental transactions in an entity?
a. Losses.
b. Revenues.
c. Expenses.
d. Gains.
34. Truss Ties, Inc. builds saws to build trusses for new construction. A truss manufacturing facility orders a new
saw and it takes Truss Ties approximately 90 days to build the new saw and deliver it to the customer. The
customer signs a contract for the saw and gives 25% deposit so that Truss Ties will begin fabrication of the saw.
How can Truss Ties recognize the revenue of a new saw that was purchased by a customer?
a. Truss Ties can recognize revenue on the percentageofcompletion method as the production takes place.
b. Since Truss Ties received a contract from the customer, it can recognize revenue based on the passing
of time in the calendar year.
c. Truss Ties can recognize the revenue at the date of the sale.
d. The revenue can be recognized by Truss Ties when the cash is received from the customer.
35. In which of the following scenarios would the event or transaction be classified as an extraordinary item?
a. The flight attendants for Fly Right Airlines strike for two weeks while renegotiating their contracts with the
airline. The company had large salary expense for this time period, due to bringing in extra help to keep
their flights from being cancelled.
b. Trojan Industries decides that they are going to have to write off a large receivable, due to a major customer
declaring bankruptcy.
c. Castor Oil, Inc. acquired Deep Drill Company in 2009. At the time of purchase, Castor Oil paid less for Deep
Drill's assets than the fair value. They are planning on writing off the negative goodwill at the end of the year.
d. Video Now has decided that they are no longer going to produce VHS tapes to sell to suppliers, since most
of the market has moved to CDs and DVDs. The equipment that was used to purchase the VHS tapes is
going to be written off on the financial statements.
357
36. Melissa, the controller at Flirty Fashions, has decided to buy business interruption insurance for her company.
The insurance will provide coverage if the company's business operations are suspended due to the company
not being able to use their property or equipment in certain situations. In which of the following situations would
the business interruption insurance be likely to cover a loss for Flirty Fashions?
a. Flirty Fashions has one of its large sewing machines break down. This machine is one of ten that the
company utilizes on a rotation basis, so the break down does not change production for the company.
b. The large presser that the company uses to press the clothing before it is shipped breaks down. The
company is unable to ship any product for four days while waiting for a part to fix the presser and loses
a significant amount of revenue due to the halt in production, and still has expenses related to the time
period.
c. A hurricane is set to hit the city where Flirty Fashions is located. The company decides for the welfare of
their employees to shut down for two days. Luckily, neither Flirty Fashions building nor equipment is
harmed in the storm.
d. Due to a slowdown in the economy, Flirty Fashions decides it is going to manufacture four days a week
instead of five for the month of August. This will result in a loss in gross margin, but will also save expenses.
358
SELFSTUDY ANSWERS
33. There are four components of net income that are presented in the income statement. Which category includes
increases in equity from incidental transactions in an entity? (Page 349)
a. Losses. [This answer is incorrect. Losses are one of the four components of net income, but it includes
decreases in equity from peripheral or incidental transactions in an entity and from all other transactions
and other events and circumstances affecting the entity, except those that result from expenses or
distributions to owners.]
b. Revenues. [This answer is incorrect. Revenues consist of actual or expected cash inflows that have
occurred or will eventuate as a result of an entity's major or central operations.]
c. Expenses. [This answer is incorrect. One of the four components of net income is expenses, but they are
defined as outflows or other using up of assets or incurrence of liabilities from delivering and producing
goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or
central operations.]
d. Gains. [This answer is correct. Gains in net income are described as increases in equity from
peripheral or incidental transactions of an entity and from all other transactions and other events
and circumstances affecting the entity except those that result from revenues or investments by
owners.]
34. Truss Ties, Inc. builds saws to build trusses for new construction. A truss manufacturing facility orders a new
saw and it takes Truss Ties approximately 90 days to build the new saw and deliver it to the customer. The
customer signs a contract for the saw and gives 25% deposit so that Truss Ties will begin fabrication of the saw.
How can Truss Ties recognize the revenue of a new saw that was purchased by a customer? (Page 350)
a. Truss Ties can recognize revenue on the percentageofcompletion method as the production takes
place. [This answer is correct. If a product is contracted for before production begins, as in the case
of the saw with Truss Ties, then revenues may be recognized by a percentageofcompletion method
as earned. As production takes place, revenue is recognized by the company, as long as reasonable
estimates of results at completion and reliable measures of progress are available.]
b. Since Truss Ties received a contract from the customer, it can recognize revenue based on the passing
of time in the calendar year. [This answer is incorrect. Revenue may be recognized based on the passing
of time when services are rendered or rights to use assets extend over a continuous time period and reliable
measures based on contractual prices established in advance are commonly available. This is applicable
to interest and rent.]
c. Truss Ties can recognize the revenue at the date of the sale. [This answer is incorrect. While the general
rule for recognizing revenue from selling products is that it is recognized at the date of the sale, SFAC No.
5 provides additional guidance on recognizing revenue in different situations.]
d. The revenue can be recognized by Truss Ties when the cash is received from the customer. [This answer
is incorrect. If the collectability of the assets received for products, services, or other assets is doubtful, the
company should recognize revenue based on when the cash is received from the customer. There is no
indication of this in the question.]
359
35. In which of the following scenarios would the event or transaction be classified as an extraordinary item?
(Page 351)
a. The flight attendants for Fly Right Airline strike for two weeks while renegotiating their contracts with the
airline. The company had large salary expense for this time period, due to bringing in extra help to keep
their flights from being cancelled. [This answer is incorrect. While a strike would be considered to occur
infrequently, but it would not be considered unusual and therefore, does not meet both criteria needed for
an extraordinary item.]
b. Trojan Industries decides that they are going to have to write off a large receivable, due to a major customer
declaring bankruptcy. [This answer is incorrect. Writing off of a receivable would not be considered
unusual, even if the company would say that it occurs infrequently. This does not qualify as an extraordinary
item.]
c. Castor Oil, Inc. acquired Deep Drill Company in 2009. At the time of purchase, Castor Oil paid less
for Deep Drill's assets than the fair value. They are planning on writing off the negative goodwill at
the end of the year. [This answer is correct. According to FASB ASC 805 [formerly SFAS No. 141(R)],
for acquisitions occurring after December 15, 2008, negative goodwill is considered an
extraordinary item, regardless if they meet the criteria for an extraordinary item.]
d. Video Now has decided that they are no longer going to produce VHS tapes to sell to suppliers, since most
of the market has moved to CDs and DVDs. The equipment that was used to purchase the VHS tapes is
going to be written off on the financial statements. [This answer is incorrect. While the loss from the
abandonment of equipment used in business would be considered infrequent, it would not be unusual,
and would not qualify as an extraordinary item.]
36. Melissa, the controller at Flirty Fashions, has decided to buy business interruption insurance for her company.
The insurance will provide coverage if the company's business operations are suspended due to the company
not being able to use their property or equipment in certain situations. In which of the following situations would
the business interruption insurance be likely to cover a loss for Flirty Fashions? (Page 353)
a. Flirty Fashions has one of its large sewing machines break down. This machine is one of ten that the
company utilizes on a rotation basis, so the break down does not change production for the company.
[This answer is incorrect. Although the company had equipment that needed to be repaired, it did not affect
the normal operations of the company so business interruption insurance would not cover the breakdown
of the machine.]
b. The large presser that the company uses to press the clothing before it is shipped breaks down. The
company is unable to ship any product for four days while waiting for a part to fix the presser and
loses a significant amount of revenue due to the halt in production, and still has expenses related
to the time period. [This answer is correct. Business interruption insurance covers the loss incurred
during a period of time required to rebuild, repair, or replace damaged property. It can cover the
gross margin not earned, a portion of fixed charges and expense related to the lost gross margin,
and other expenses, such as rent.]
c. A hurricane is set to hit the city where Flirty Fashions is located. The company decides for the welfare of
their employees to shut down for two days. Luckily, neither Flirty Fashions' building nor equipment is
harmed in the storm. [This answer is incorrect. While there is an interruption in normal operations of Flirty
Fashions, business interruption insurance would not cover the loss since the parameters of the insurance
have not been fulfilled.]
d. Due to a slowdown in the economy, Flirty Fashions decides it is going to manufacture four days a week
instead of five for the month of August. This will result in a loss in gross margin, but will also save expenses.
[This answer is incorrect. Closing the plant due to the economy is a business decision and would not be
covered by business interruption insurance.]
360
PRESENTATION OF FINANCIAL STATEMENTS

OVERVIEW
Comparative presentations enhance the usefulness of financial statements. Therefore, although not required, it
ordinarily is desirable for financial statement presentations to include the financial statements of two or more years.
Discontinued operations should be separately presented in the income statement, net of any related tax effect. The
results of discontinued operations should be presented after results from continuing operations but before extraor
dinary items.
When preparing financial statements, management should assess the reporting entity's ability to continue as a
going concern. Disclosure is required whenever there is substantial doubt about the entity's ability to continue as
a going concern.
COMPARATIVE FINANCIAL STATEMENTS
Current year financial statements are presumed to be more useful if financial statements for one or more prior years
are presented with them for comparative purposes. Although GAAP does not require such presentations, compara
tive financial statements often help readers more clearly understand the nature and trends of current changes
affecting an entity. Furthermore, they help emphasize that the business is an ongoing entity and the current period
is just one of a number of periods in its history. (FASB ASC 20510451) (formerly ARB 43, Ch. 2A, par. 1)
Normally, it is preferable to present a balance sheet, income statement, and statement of changes in equity for one
or more prior years when current year financial statements are presented. (FASB ASC 20510452) (formerly ARB
43, Ch. 2A, par. 2) [If both a balance sheet and income statement are presented, the presentation also should
include a statement of cash flows for each year for which an income statement is presented. (FASB ASC
23010153) (formerly SFAS 95, par. 3)] To the extent they continue to be significant, notes to prior year financial
statements should be repeated, or at least referred to, in the comparative presentation. (FASB ASC 20510454)
(formerly ARB 43, Ch. 2A, par. 2)
Prior year figures included in comparative financial statements should be comparable to those shown in the current
year. Any exceptions to comparability should be clearly described as discussed previously. (FASB ASC
20510453) (formerly ARB 43, Ch. 2A, par. 3)
Disposal of a Component of an Entity
The results of continuing operations must be reported separately from discontinued operations. Discontinued
operations should be separately presented in the income statement, net of any related tax effect. They should be
presented after results from continuing operations but before extraordinary items. (FASB ASC 20520453) (for
merly SFAS 144, par. 43) Exhibit 38 illustrates presenting discontinued operations in the income statement.
Exhibit 38
Example Income Statement Presentation

of Discontinued Operations
Income from continuing operations before income taxes $ 625,000

Income taxes 188,000
INCOME FROM CONTINUING OPERATIONS 437,000
361
Income from operations of discontinued division (less applicable income taxes of $14,000) 33,000
Loss on disposal of division (less applicable income taxes of $21,000) (49,000 )
(16,000 )
INCOME BEFORE EXTRAORDINARY ITEM 421,000
EXTRAORDINARY ITEM Loss on expropriation of assets by foreign government (less

applicable income tax benefit of $12,600) (29,400 )
* * *
The operating results of a component of an entity that is classified as held for sale or that has been disposed of is
presented in discontinued operations if the operations and cash flows of the component will be (or have been)
eliminated from the ongoing operations of the entity and the entity will not have any significant continuing involve
ment in the component's operations. (FASB ASC 20520451) (formerly SFAS 144, par. 42) A component of an
entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial
reporting purposes, from the other operations and cash flows of the entity. (FASB ASC 2051020) (formerly SFAS
144, par. 41)
A component of an entity may be a reportable segment or an operating segment as defined in FASB ASC 280,
Segment Reporting (formerly SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information),
a reporting unit as defined in FASB ASC 350, Intangibles Goodwill and Other (formerly SFAS No. 142), a
subsidiary, or an asset group. (FASB ASC 2051020) (formerly SFAS 144, par. 41)
The following events or transactions generally would not be considered disposals of a component of an entity
(although they may qualify as unusual or infrequent items as discussed previously in this lesson):
a. Disposal of assets that are part of a larger cashflowgenerating group, even though those assets constitute
a separate physical facility or are segregated by geographic location.
b. Shifting production or marketing activities for a particular line of business from one location to another.
c. Disposal of two or more unrelated assets that individually do not constitute a component of an entity.
Disposal of a separate line of business that does not constitute a component of an entity should not be reported as
discontinued operations even if the gain or loss on disposal is material.
To illustrate determining whether an event or transaction constitutes a disposal of a component of an entity, assume
that a company manufactures men's and women's clothing and accessories through separate divisions and
distributes them through manufacturers' representatives and companyowned retail stores. The division (i.e.,
clothing or accessories) is the lowest level at which the operations and cash flows can be clearly distinguished. The
authors believe the company would not be considered to have disposed of a component in any of the following
circumstances:
a. The company closes all of its retail stores in the state of Oklahoma.
b. The company discontinues the manufacture and sale of women's clothing, but not men's clothing.
c. The company discontinues distributing through marketing representatives.
d. The company discontinues a highend brand of mens and womens accessories but retains its other
brands.
e. The company outsources the manufacture of clothing and sells the related physical facilities.
362
If the company were to shut down its clothing division and only sell accessories, however, reporting income or loss
from discontinued operations for the clothing division would be appropriate.
The operating results of a component classified as held for sale should be reported in discontinued operations in
the period in which they occur. The amount reported in discontinued operations should include any gain or loss
recognized. (FASB ASC 20520453) (formerly SFAS 144, par. 43) The entity should disclose the gain or loss on
disposal either on the face of the income statement or in the notes to the financial statements. (FASB ASC
In determining whether the operations and cash flows of the disposed component will be (or have been) eliminated
from the ongoing operations of the entity, an evaluation should be made of whether continuing direct or indirect
cash flows are expected to be (or have been) generated. If continuing direct cash flows are significant, the
operations should not be presented as a discontinued operation. (FASB ASC 20520554 and 555) (formerly EITF
0313, par. 4) Direct cash flows are those expected to be recognized by the ongoing entity as a result of (a) a
migration of revenues (or costs) from the disposed component after the disposal, or (b) the continuation of activities
between the ongoing entity and the disposed component. (FASB ASC 20520557) (formerly EITF 0313, par. 6)
The significance of the cash flows is a matter of judgment to be determined by comparing the expected continuing
cash flows of the ongoing entity after the disposal to the expected cash flows that would have been generated by
the disposed component if the transaction had not occurred. (FASB ASC 205205514) (formerly EITF 0313, par.
8)
If the continuing cash flows are indirect, or if continuing direct cash flows are not significant, an evaluation should
be made of whether the ongoing entity will have significant continuing involvement in the operations of the
disposed component. Continuing involvement in operations typically exists if the ongoing entity has the ability to
influence the operating or financial policies of the disposed component. Key considerations include the retention of
risk or the ability to obtain benefits associated with the ongoing operations of the disposed component. If continu
ing involvement exists, a determination of its significance should be made based on quantitative and qualitative
assessments from the perspective of the disposed component. (FASB ASC 205205515 and 5516) (formerly EITF
0313, paras. 910)
If a significant event or circumstance occurs in a oneyear period after the disposal that may impact the assessment
of the criteria discussed previously, the ongoing entity should reassess whether the criteria will be met by the end
of the oneyear period. If the criteria will not be met, the component's operations should not be presented as
discontinued operations. In certain cases, the assessment period may extend beyond one year after the disposal.
(FASB ASC 205205522 and 5523) (formerly EITF 0313, paras. 1314)
Adjustments to amounts previously reported in discontinued operations that relate directly to the disposal of a
component of an entity in a prior period should be separately classified in discontinued operations in the current
period. Circumstances in which those types of adjustments may arise include resolution of contingencies and
settlement of employee benefit plan obligations related directly to the disposal transaction. (FASB ASC 20520454
and 455) (formerly SFAS 144, paras.43 and 44)
In September 2008, FASB issued an Exposure Draft, Amending the Criteria for Reporting a Discontinued Operation.
In that exposure draft, a discontinued operation is defined as a component of an entity that is: (FASB ASC
80510XX)
a. an operating segment as defined in FASB ASC 280, Segment Reporting (formerly SFAS No. 131,
Disclosures about Segments of an Enterprise and Related information), that has either been disposed or
is classified as held for sale, or
b. a business as defined in FASB ASC 805, Business Combinations [formerly SFAS No. 141(R), Business
Combinations], that meets the criteria to be classified as held for sale on acquisition.
LongLived Asset or Disposal Group Held for Sale
A longlived asset that is classified as held for sale should be presented separately in the balance sheet. The assets
and liabilities of a disposal group classified as held for sale should be presented separately in the asset and liability
363
sections of the balance sheet and should not be offset and presented as a single amount. The major classes of
assets and liabilities classified as held for sale should be disclosed separately, either on the face of the balance
sheet or in the notes to financial statements. (FASB ASC 205204510; 20520502) (formerly SFAS 144, par. 46)
GOING CONCERN
Uncertainty about a company's ability to continue as a going concern relates to its ability to continue to meet its
obligations as they become due without substantial disposition of assets outside the ordinary course of business,
restructuring of debt, externally forced revisions of its operations, or similar actions. Thus, it is more than an
evaluation of whether recorded assets and liabilities are recoverable and properly classified. When preparing
financial statements, management should assess the reporting entity's ability to continue as a going concern for a
reasonable period of time not to exceed one year beyond the balance sheet date.
An outstanding exposure draft of a proposed standard would provide guidance on management's responsibility to
evaluate a reporting entity's ability to continue as a going concern. The proposed guidance essentially moves to
the accounting standards the going concern guidance that currently resides in the auditing standards. However,
the proposed guidance changes the time horizon for management's evaluation from a reasonable period of time
not to exceed one year" to a period that is at least, but is not limited to, 12 months" from the end of the reporting
period.
The Board is currently in redeliberations and is considering broadening the scope of the project to enhance
disclosures on shortterm and longterm risks for which there is a morethanremote likelihood of occurrence. In
addition, the Board plans to address (1) defining substantial doubt in terms of the entity's ability to continue as a
going concern and (2) when it would be appropriate to apply the liquidation basis of accounting. Accountants can
monitor the status of this project at www.fasb.org. The FASB project plan indicates a final standard is expected in
2010.
COMPARATIVE FINANCIAL STATEMENTS
Reclassifications or other changes may cause items for two or more periods to no longer be comparable. Changes
affecting comparability should be disclosed. (FASB ASC 20510501) (formerly ARB 43, Ch. 2A, par. 3)
FASB ASC 250, Accounting Changes and Error Corrections (formerly SFAS No. 154), requires retrospective
application and restatement of prior period financial statements for most voluntary changes in accounting principle
and changes in the reporting entity, as well as for the correction of errors in previously issued financial statements.
Thus, statements for all periods presented are comparable. Prior period financial statements also may be restated
to conform to changes in the way amounts are classified in current year financial statements (for example, to
present interest income as a separate line item rather than as a part of other income). In such cases, the fact that
prior year amounts have been reclassified should be disclosed.
Disposal of a Component of an Entity
The following disclosures should be made when a component of an entity has been disposed of or classified as
held for sale:
a. For current and prior periods, results of operations of the component in discontinued operations, including
any gain or loss on disposal and less applicable income taxes, if any, reported as a separate component
of income before extraordinary items. A gain or loss recognized on the disposal can be disclosed either
on the face of the income statement or the notes to the financial statements. (FASB ASC 20520453)
b. The nature and amount of any adjustments to amounts previously reported in discontinued operations that
are directly related to the disposal of a component of the entity in a prior period (Such adjustments should
364
be classified separately in the current period in discontinued operations.) (FASB ASC 20520454;
For each discontinued operation that generates continuing cash flows, the following information should be dis
closed in the notes to the financial statements: (FASB ASC 20520504) (formerly EITF 0313, par. 17)
a. The nature of the activities
b. The period of time continuing cash flows are expected to be generated
c. The principal factors that were used to conclude that the expected continuing cash flows are not direct cash
flows of the disposed component
For ongoing entities that will engage in a continuation of activities with a disposed component after its disposal, the
following information should be disclosed: (FASB ASC 20520506) (formerly EITF 0313, par. 17)
a. For all periods presented, any intercompany amounts that were eliminated in consolidation prior to the
disposal that relate to the continuing revenues and expenses
b. In the period in which the operations are initially classified as discontinued, the types of continuing
involvement that the entity will have after the disposal
Assets Sold or Held for Sale
The following information should be disclosed in the notes to the financial statements that cover the period in which
a longlived asset either has been sold or is classified as held for sale: (FASB ASC 20520501) (formerly SFAS 144,
par. 47)
a. Description of the facts and circumstances leading to the expected disposal, the expected manner and
timing of that disposal, and, if not separately presented on the face of the balance sheet, the carrying
amounts of the major classes of assets and liabilities included in the disposal group
b. Loss recognized for any initial or subsequent writedown to fair value less cost to sell (or gain recognized
for subsequent increases in fair value to the extent of such losses) and, if not presented separately on the
face of the income statement, the caption in that statement that includes the gain or loss
c. If applicable, amounts of revenue and pretax profit or loss reported in discontinued operations
d. Business segments in which the longlived asset is reported, if applicable
Assets and liabilities held for sale should be presented separately in the asset and liability sections of the balance
sheet, with the major classes of such assets and liabilities separately disclosed either on the face of the statement
or in the notes. (FASB ASC 20520502) (formerly SFAS 144, par. 46)
If a decision was made during the period not to sell a longlived asset previously classified as held for sale, a
description of the circumstances leading to the decision and the effect of the decision on the results of operations
for all periods presented should be disclosed in the notes to financial statements that include the period of that
decision. (FASB ASC 20520503) (formerly SFAS 144, par. 48)
GOING CONCERN
If there is substantial doubt about a company's ability to continue as a going concern for a period of time not to
exceed one year beyond the balance sheet date, the following information should be disclosed:
a. Pertinent conditions and events giving rise to the assessment of substantial doubt about the company's
ability to continue as a going concern for a period of time not to exceed one year from the balance sheet
date
365
b. Possible effects of the conditions and events
c. Management's evaluation of the significance of those conditions and events and any mitigating factors
d. Possible discontinuance of operations
e. Management's plans, including relevant prospective financial information
f. Information about the recoverability or classification of recorded asset amounts or the amounts or
classification of liabilities (AU 341.10)
If the substantial doubt about the company's ability to continue as a going concern is alleviated, the following
information should be disclosed:
a. Conditions and events that initially caused the substantial doubt
b. Possible effects of the conditions and events
c. Mitigating factors, including management's plans (AU 341.11)
An outstanding exposure draft of a proposed standard would provide guidance on management's responsibility to
evaluate a reporting entity's ability to continue as a going concern. The proposed guidance essentially moves to
the accounting standards the going concern guidance that currently resides in the auditing standards. In addition
to the previous disclosures, the proposed guidance would add disclosure requirements applicable when financial
statements are not prepared on a going concern basis. In that case, the entity would disclose that fact, together
with the basis on which the financial statements were prepared and the reason why the entity is not considered a
going concern. The Board is currently in redeliberations and is considering broadening the scope of the project to
enhance disclosures on shortterm and longterm risks for which there is a morethanremote likelihood of occur
rence. Accountants can monitor the status of this project at www.fasb.org. The FASB project plan indicates a final
standard is expected in 2010.
366
SELFSTUDY QUIZ
following section.
37. Which of the following is a disposal of a component of an entity?
a. Electronic World has always included home theater systems in each of their stores. They carried all the
products, and provided installation and repair for the line of business. They have decided that it is not
profitable and are pulling home theater systems out of each store. They currently classify each product
line as a separate operational unit in their financial statements.
b. Frank's Frozen Foods has production plants in six cities in Florida. They recently opened a new plant in
Orlando and are going to shift all the production of their ice cream from the Tampa location to the new plant
in Orlando since the new plant has a better layout and equipment for the production of ice cream. They
have no plans at this time to close the Orlando production plant.
c. US Apparel currently manufactures a clothing line for men, women and children and accessories for
women. They have decided to discontinue the manufacturing of children's clothing, but will continue the
men's and women's line and the accessories in the company. All clothing is kept in one operating segment.
38. How are the continuing cash flows of a disposed component of an entity managed in the financial statements
of the entity?
a. If the continuing cash flows are significant to the entity, the operations should be presented as a
discontinued operation.
b. The significance of cash flows is a formula determined by adding the migration of revenues within the
company with the continuation of activities between the ongoing entity and the disposed component.
c. If the continuing cash flows are determined to not be significant, the ongoing entity will have significant
involvement, a significant event occurs within the first year and all criteria are not met, then the component's
operations should not be presented as discontinued operations.
39. How should the major classes of assets and liabilities of a disposal group that are held for sale be disclosed
in the financial statements?
a. In the notes to the financial statements or the balance sheet.
b. Presented separately on the income statement.
c. Offset in the asset and liabilities section.
d. Grouped with all other assets and liabilities on the balance sheet.
40. Which of the following is not a required disclosure in the notes to the financial statements for longlived assets
that have either been sold or are classified as held for sale?
a. A description of the facts and circumstances that led to the decision to dispose of the longlived asset.
b. The business segment that reports the longlived asset that will be disposed.
c. The amounts of expense reported in the discontinued operations.
d. Any loss that will be recognized for a subsequent writedown to fair value less cost to sell.
367
SELFSTUDY ANSWERS
Which of the following is a disposal of a component of an entity? (Page 362)
a. Electronic World has always included home theater systems in each of their stores. They carried all
the products, and provided installation and repair for the line of business. They have decided that
it is not profitable and are pulling home theater systems out of each store. They currently classify
each product line as a separate operational unit in their financial statements. [This answer is correct.
Since the component of the business can be clearly distinguished, both operationally and for
financial reporting purposes, it would be considered the disposal of a component of the entity.]
b. Frank's Frozen Foods has production plants in six cities in Florida. They recently opened a new plant in
Orlando and are going to shift all the production of their ice cream from the Tampa location to the new plant
in Orlando since the new plant has a better layout and equipment for the production of ice cream. They
have no plans at this time to close the Orlando production plant. [This answer is incorrect. Although the
production of a product line is moved from one location to another, shifting production or marketing
activities for a particular line of business is not considered a disposal of a component of an entity.]
c. US Apparel currently manufactures a clothing line for men, women and children and accessories for
women. They have decided to discontinue the manufacturing of children's clothing, but will continue the
men's and women's line and the accessories in the company. All clothing is kept in one operating segment.
[This answer is incorrect. Since the children's clothing is not separately identifiable and is not clearly
distinguishable in the financial statements, disposing of the line does not constitute a disposal of a
component of an entity.]
How are the continuing cash flows of a disposed component of an entity managed in the financial statements
of the entity? (Page 363)
a. If the continuing cash flows are significant to the entity, the operations should be presented as a
discontinued operation. [This answer is incorrect. If an evaluation is made and the continuing cash flows
are determined to be significant to the entity, the operations should not be presented as a discontinued
operation.]
b. The significance of cash flows is a formula determined by adding the migration of revenues within the
company with the continuation of activities between the ongoing entity and the disposed component. [This
answer is incorrect. The significance of cash flows is a matter of judgment to be determined by comparing
the expected continuing cash flows of the ongoing entity after the disposal to the expected cash flows that
would have been generated by the disposed component if the transaction had not occurred.]
c. If the continuing cash flows are determined to not be significant, the ongoing entity will have
significant involvement, a significant event occurs within the first year and all criteria are not met,
then the component's operations should not be presented as discontinued operations. [This answer
is correct. If continuing cash flows are indirect, and evaluation should be made of whether the
ongoing entity will have significant continuing involvement in the operations of the disposed
component. If there is continuing involvement in the operations and a significant event occurs in a
oneyear period after the disposal, the ongoing entity should reassess whether the criteria will be
met by the end of the oneyear period. If the criteria will not be met, the components operations
should not be presented as discontinued operations.]
How should the major classes of assets and liabilities of a disposal group that are held for sale be disclosed
in the financial statements? (Page 363)
a. In the notes to the financial statements or the balance sheet. [This answer is correct. The major
classes of assets and liabilities classified as held for sale should be disclosed separately, either on
the face of the balance sheet or in the notes to the balance sheet.]
368
b. Presented separately on the income statement. [This answer is incorrect. A longlived asset that is
classified as held for sale should be presented separately on the balance sheet.]
c. Offset in the asset and liabilities section. [This answer is incorrect. The assets and liabilities of a disposal
group classified as held for sale should be presented separately in the asset and liabilities sections of the
balance sheet and should not be offset and presented as a single amount.]
d. Grouped with all other assets and liabilities on the balance sheet. [This answer is incorrect. The major
classes of assets and liabilities classified as held for sale should be disclosed separately.]
Which of the following is not a required disclosure in the notes to the financial statements for longlived assets
that have either been sold or are classified as held for sale? (Page 365)
a. A description of the facts and circumstances that led to the decision to dispose of the longlived asset. [This
answer is incorrect. One of the disclosures required is a description of the facts and circumstances leading
to the expected disposal, the expected manner and timing of the disposal, and if not separately presented
on the face of the balance sheet, the carrying amount of the major classes of assets and liabilities included
in the disposal group.]
b. The business segment that reports the longlived asset that will be disposed. [This answer is correct. A
required disclosure in the note to the financial statement is the business segment in which the longlived
asset is reported, if applicable.]
c. The amounts of expense reported in the discontinued operations. [This answer is correct. The
expense is not required to be disclosed, but if applicable, the amount of revenue and pretax profit
or loss reported in discontinued operations should be disclosed in the notes to the financial
statements for longlived assets that have either been sold or is classified as held for sale.]
d. Any loss that will be recognized for a subsequent writedown to fair value less cost to sell. [This answer
is incorrect. The loss recognized for any initial or subsequent writedown to fair value less cost to sale the
longlived asset is a required disclosure items. Also, if the loss if not presented separately on the face of
the income statement, then the caption in that statement should include the loss.]
369
Lesson 3 (GAPTG093)
23. If there is a bonus element to the value of stock due to a corporation that has issued rights whose exercise price
is less than the fair value of the stock, how should the earnings per share be calculated if the rights will not be
publicly traded?
a. Fair value per share as of the last day the shares and rights are traded together divided by the theoretical
exrights fair value per share.
b. Aggregate fair value of shares immediately prior to the rights exercise plus the proceeds expected from
the exercise of the rights divided by the number of share outstanding after the exercise of the rights.
c. Fair value per share immediately prior to exercise of rights divided by the theoretical exrights fair value per
share.
d. Available earnings divided by the weighted average number of shares of common stock outstanding
during the period.
24. Use the information in question 24 for question 24 and 25.
On January 1, 2009, Big Bear Company had 50,000 shares of common stock and 5,000 shares of
noncumulative, nonconvertible preferred stock issued and outstanding. An additional 10,000 share of common
stock were issued on July 1, 2009. On September 1, 2009, Big Bear Company declared a 2for1 stock split
for common stockholders, effective September 30, 2009. On December 1, 2009, Big Bear purchased 6,000
share of treasury stock. What is the weighted average of the common stock that is outstanding in 2009 for Big
Bear Company?
a. 54,000 shares.
b. 104,000 shares.
c. 109,500 shares.
d. 110,500 shares.
25. Big Bear Company reported net income of $500,000 for 2009 and declared and paid dividends totaling $50,000
to preferred stockholders. What is the earnings per share for 2009?
a. $4.09 per share.
b. $4.11 per share.
c. $4.55 per share.
d. $4.56 per share.
26. Which of the following does not adjust the numerator when calculating diluted earnings per share?
a. The issuance of any common stock.
b. Any interest expense on convertible debt that was recognized during the period.
c. Changes to net income caused by the assumed conversion of the potential common stock.
d. Dividends issued on convertible preferred stock.
370
27. Based on the information below, which of the following are considered diluted earnings per share?
Income Common Per

Available Shares Share
Basic earnings per share $ 1,200,000 600,000 $ 2.00
Options 4,500
604,500 $ 1.99
Convertible debentures 600,000 400,000
1,800,000 1,004,500 $ 1.79
Convertible preferred stock 800,000 320,000
$ 2,600,000 1,324,500 $ 1.96
a. Options only.
b. Options and convertible debentures.
c. Options, convertible debentures and convertible preferred stock.
d. Convertible preferred stock only.
28. Born to be Wild Motorcycle company has 1,500 warrants outstanding that may be exercised at $50 per share.
The average market price of the company's common stock during the period is $75. How many additional
shares of common stock would the company have to issue to convert all of the outstanding warrants?
a. 0.
b. 500.
c. 1,000.
d. 1,500.
29. What are agreements that demand a corporation to repurchase their own stock?
a. Contingently Issuable Shares.
b. Convertible Preferred Stock.
c. Rights Issues.
d. Written Put Options.
371
30. Use the information listed below to answer questions 30 and 31.
Hartman Electrics, Inc. had 1,000,000 shares of common stock outstanding during the year ended December
31, 2008. On January 1, 2009, Hartman entered into an agreement to purchase a subsidiary that included the
following contingent stock agreement:
10,000 common shares must be issued for each net longterm contract entered into exceeding $4,000,000
in annual revenues.
Hartman Electrics, Inc was awarded two new longterm contracts exceeding $4,000,000 in annual revenues
during 2009, one on February 1, 2009 and one on July 1, 2009.
The consolidated, yeartodate net income for 2009 for the company was $4,500,000.
What are the basic earnings per share at the end of 2009 for Hartman Electrics, Inc.?
a. $4.35
b. $4.43
c. $4.44
d. $4.47
31. What are the diluted earnings per share at the end of 2009 for Hartman Electric, Inc.?
a. $4.35
b. $4.43
c. $4.44
d. $4.47
32. Leghorn Construction issues two different types of stock each type pays a different dividend rate to the
stockholder. One of the stocks is not convertible into common stock. What method should Leghorn use to
calculate the earnings per share on the nonconvertible stock?
a. Ifconverted" method.
b. Treasury stock method.
c. Twoclass method.
d. Weighted average method.
33. Which of the following should be presented first in the income statement?
a. Discontinued operations of a component of an entity.
b. Income from continuing operations.
c. Extraordinary items.
d. Goodwill impairment losses applicable to a discontinued operation.
372
34. What is the process of recognizing expenses in the same accounting period as the revenues related with those
costs referred to as?
a. Materiality.
b. Collaborative agreement.
c. Unusual nature.
d. Matching.
35. What should be a primary consideration when deciding whether an event or transaction should be classified
as extraordinary?
a. The company's operating environment.
b. The frequency in which the event or transaction occurs.
c. The degree of abnormality that the event or transaction occupies.
d. The net effect the classification would have on the financials.
36. Where should unusual or infrequent items be presented in the financial statements?
a. Charged to an expense in the income statement, since they do not provide future economic benefit.
b. In the income statement as separate elements of income from continuing operations.
c. In the income statement, following discontinued operations.
37. Where should the gain or loss from the disposal of a component of an entity be reported in the financial
statements?
a. After any extraordinary items in the income statement.
b. It should not be reported, just included in revenue and expenses for the period.
c. Presented separately as a line on the balance sheet.
d. On the face of the income statement or the notes to the financial statements.
38. A company's ability to continue as a going concern should be reported in the financial statements if the time
period:
a. Exceeds two years beyond the balance sheet date.
b. Does not exceed six months from the balance sheet date.
c. Does not exceed one year beyond the balance sheet date.
d. Exceeds one year beyond the balance sheet date.
373
39. For discontinued operations that generate cash flows, which of the following does not have to be disclosed in
the financial statements?
a. The time period that the continuing cash flows are expected to be produced.
b. The concluding facts that the expected continuing cash flows are not of the disposed component.
c. The nature of the activities in the discontinued operations.
d. The intercompany amounts that were eliminated due to the discontinued operations.
40. If a company had decided it had substantial doubt of its ability to be a going concern, but then their concerns
were eased, what information should be disclosed?
a. Management's plans for the company, including relevant prospective financial statements.
b. The reasons that the company initially had a substantial doubt about their ability to continue.
c. The possibility of discontinuing operations.
d. The ability to recover recorded asset amounts.
374
GLOSSARY
Accounting Changes: There are three broad categories of accounting changes: a) changes in an accounting
principle, b) changes in an accounting estimate, and c) changes in the reporting entity.
Accounting Policies: The specific accounting principles and methods of applying those principles that an entity
uses to prepare its financial statements.
Basic Earnings Per Share: Computed by dividing available earnings by the weighted average number of shares
of common stock outstanding during the period.
Business Interruption Insurance: Provides coverage if an entity's business operations are suspended due to the
loss of use of property and equipment resulting from a covered loss.
Cash: Includes currency on hand and demand deposits with banks or other financial institutions. Also includes
accounts that have the general characteristics of demand deposits in that the customer may deposit or withdraw
funds at any time without prior notice or penalty.
Cash Equivalents: Shortterm, highly liquid investments that (a) are readily convertible to known amounts of cash
and (b) are so near to their maturity that they present an insignificant risk of changes in values because of changes
in interest rates.
Cash Flows Statement: Shows a company's cash receipts and payments during a period, classified by principal
sources and uses.
Change in Accounting Principle: A change from one acceptable principle to another or a change in the method
of applying an acceptable accounting principle.
Change in Reporting Entity: A change that results in financial statements that are, in effect, the statements of a
different entity.
Classified Balance Sheet: Presents current assets and current liabilities separately from other assets and liabilities.
Collaborative Arrangements: A contractual arrangement for a joint operating activity not primarily conducted
through a separate legal entity that involves two or more parties who are both active participants in the activity, and
exposed to significant risks and rewards dependent on the commercial success of the activity.
Comprehensive Income: The change in an entity's equity during a period from transactions and events other than
those resulting from investments by and distributions to owners.
Current Assets: Assets that will be realized in cash, sold, or used within one year (or operating cycle, if longer).
Current Liabilities: Obligations that will be liquidated by using current assets or creating other current liabilities.
Dilutive Earnings Per Share: Divides available income by the weighted average number of shares outstanding.
Diluted earnings per share is calculated by acting as if certain dilutive potential common stock had been issued.
Direct Method: One format of cash flows from operations presentation which begins with gross cash receipts and
deducts gross cash payment for operating costs and expenses, individually listing the cash effects of each major
type of operating activity.
Earnings Per Share: A measure of the income available to common shareholders.
Extraordinary Items: Events or transactions that meet both criteria of being unusual in nature and in frequent in
occurrence.
FASB Accounting Standards Codification: The source of authoritative accounting principles under U.S. GAAP for
nongovernmental entities. All guidance contained within the Codification has the same level of authority.
375
Financing Activities: Include obtaining resources from owners and providing them with a return on, and a return
of, their investment; borrowing money and repaying amounts borrowed, or otherwise settling the obligation, and
obtaining and paying for other resources from creditors on longterm credit.
Income Statement: Presents a company's financial position and results of operations in conformity with GAAP.
Indirect Method: One format of cash flows from operations presentation which begins with net income and adjusts
for (a) noncash items such as depreciation and deferred income taxes and (b) changes during the period in operating
current assets and liabilities.
Infrequency of Occurrence: The underlying event or transaction should be of a type that would not reasonably be
expected to recur in the foreseeable future, taking into account the environment in which the entity operates.
Investing Activities: Include lending money and collecting on loans, acquiring and selling or disposing of
availableforsale or heldtomaturity securities, and acquiring and selling or disposing of productive assets that are
expected to generate revenue over a long period of time.
Master Netting Arrangements: Individual contracts are effectively consolidated into a single agreement between
the parties. Failure to make one payment under the master netting arrangement entitles the other party to terminate
the entire arrangement and demand the net settlement of all contracts.
Matching: The process of recognizing expenses in the same accounting period as the revenues associated with
those costs.
Noncash Financing Activities: Financing activities that do not involve cash receipts or payments such as issuing
stock in exchange for property and equipment.
Noncash Investing Activities: Investing activities that do not involve cash receipts or payments such as acquiring
assets by assuming liabilities or exchanging assets.
Operating Activities: Defined by exception; transactions and events that are not investing or financing activities.
Prior Period Adjustment: Tan adjustment to correct an accounting error discovered in previously issued prior period
Retrospective Application: The application of a different accounting principle to previously issued financial
statements (or to the opening balances of the current statement of financial position) as if the different principle had
always been used.
Treasury Stock Method: The incremental number of shares issued is included in the denominator when computing
diluted earnings per share.
Unusual in Nature: The underlying event or transaction should possess a high degree of abnormality and be of a
type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking in to
account the environment in which the entity operates.
Written Put Options and Forward Purchase Contracts: Agreements that require the corporation to repurchase
its own stock and should be included in the determination of dilutive earnings per share if they are dilutive.
376
INDEX
A C
ACCOUNTING CHANGES CASH FLOWS STATEMENT

Change in accounting estimate Agency transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283, 286
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251 Basic elements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249 Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . 280, 299
Interim periods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248 Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
Change in accounting principle Cash flow per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Accounting treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 Change in policy for cash equivalents . . . . . . . . . . . . . . . . . . . 288
Change in components of inventory cost . . . . . . . . . . . . . . 246 Classification of cash receipts and payments
Changes prescribed by new or existing accounting Financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
pronouncements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 Investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Circumstances that are not accounting changes . . . . . . . 245 Operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245, 248 Debt issue costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251 Defined benefit pension plans . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Justification for change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 Derivatives that include a financing element . . . . . . . . . . . . . . 291
Prospective change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 Direct method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284, 299
Retrospective application . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
Change in depreciation methods Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
Adopting a new depreciation method . . . . . . . . . . . . . . . . . 248 Excess tax benefits under sharebased payment
Planned change in depreciation method . . . . . . . . . . . . . . 248 arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284, 287, 291
Change in reporting entity Exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Business combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249 Financing activities
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251 Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
When a change in reporting entity occurs . . . . . . . . . . . . . 249 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
Disclosure of future accounting changes . . . . . . . . . . . . . . . . . 253 Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
Disclosure requirements Excess tax benefits under sharebased arrangements . . 291
Change in accounting estimate . . . . . . . . . . . . . . . . . . . . . . 251 Issuing stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
Change in accounting principle . . . . . . . . . . . . . . . . . . . . . . 251 Noncash financing activities . . . . . . . . . . . . . . . . . . . . . . . . . 290
Change in reporting entity . . . . . . . . . . . . . . . . . . . . . . . . . . 251 Repurchase or redemption of shares . . . . . . . . . . . . . . . . . 291
Interim periods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 Shortterm and longterm debt . . . . . . . . . . . . . . . . . . . . . . . 290
Impracticability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 Gross and net cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
Inventory valuation, change in . . . . . . . . . . . . . . . . . . . . . . . . . . 246 Indirect method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285, 299
Retrospective application Investing activities
Impracticability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Method of application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Making loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
ACCOUNTING POLICIES Noncash investing activities . . . . . . . . . . . . . . . . . . . . . . . . . 288
Cash flows statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299 Purchase (sale) of a business . . . . . . . . . . . . . . . . . . . . . . . 289
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261 Investment companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
General disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . 261 Issuing stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
Specifically required disclosures . . . . . . . . . . . . . . . . . . . . . . . . 261 Noncash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Noncash investing and financing activities
B Assets acquired by assuming liabilities . . . . . . . . . . . . . . . 291
Converting debt to equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Converting stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
BALANCE SHEET Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Derivatives that include a financing element . . . . . . . . . . . 291
Classified balance sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Liabilities settled by transferring assets or
Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 issuing shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 Noncash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Purchase (sale) of a business . . . . . . . . . . . . . . . . . . . . . . . 292
Definitions
Nonprofit organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Operating activities
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
Operating cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Direct method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
Indirect method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Purchase (sale) of a business . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
Longterm investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Purchases and sales of trading securities . . . . . . . . . . . . . . . . 289
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Shares, repurchase or redemption of . . . . . . . . . . . . . . . . . . . . 291
Noncurrent assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Offsetting assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 269 COMPARATIVE FINANCIAL STATEMENTS
Operating cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Changes affecting comparability . . . . . . . . . . . . . . . . . . . . . . . . 364
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Disclosures for preferable financial statements . . . . . . . . . . . . 361
Quick ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Scope of accounting requirements . . . . . . . . . . . . . . . . . . . . . . 361
Restricted cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Unclassified balance sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 COMPENSATION See COMPENSATED ABSENCES;
Working capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 DEFERRED COMPENSATION ARRANGEMENTS
377
COMPREHENSIVE INCOME EQUITY

Balance sheet presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315 Financial instruments with characteristics of liabilities
Cash flow hedges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 and equity
Components of comprehensive income . . . . . . . . . . . . . . . . . . 306 Mandatorily redeemable shares . . . . . . . . . . . . . . . . . . . . . . 324
Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 Redeemable preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
Financial statement presentation . . . . . . . . . . . . . . . . . . . 307, 315 G
Foreign currency items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
Interim reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313 GOING CONCERN
Items associated with pension or other postretirement Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
Reclassification adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307 Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
Unrealized gains and losses on investments . . . . . . . . . . . . . . 306
I
CONSOLIDATION
Variable interest entities INCOME STATEMENT
Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351 Basic principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
Business interruption insurance . . . . . . . . . . . . . . . . . . . . . . . . . 353
D Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
Collaborative arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
DERIVATIVES AND HEDGING
Disclosure requirements
Derivatives that include a financing element . . . . . . . . . . . . . . 291
Business interruption insurance . . . . . . . . . . . . . . . . . . . . . . 355
Offsetting derivative instruments . . . . . . . . . . . . . . . . . . . . . . . . 270
Collaborative arrangements . . . . . . . . . . . . . . . . . . . . . . . . . 355
Master netting arrangements . . . . . . . . . . . . . . . . . . . . . . . . 270
Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
Unusual or infrequent items . . . . . . . . . . . . . . . . . . . . . . . . . 354
DISCONTINUED OPERATIONS Discontinued operations
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364, 365 Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
Disposal of a component of an entity Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364 Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349, 350
Longlived asset or disposal group held for sale . . . . . . . . . . . 363 Extraordinary items
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365 Costs incurred to defend against a takeover . . . . . . . . . . . 352
Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
E Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
EARNINGS PER SHARE Discontinuation of regulated operations . . . . . . . . . . . . . . . 351
Antidilution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324 Examples that do not meet criteria . . . . . . . . . . . . . . . . . . . 352
Example calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326 Infrequent in occurrence . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
Contingently issuable shares . . . . . . . . . . . . . . . . . . . . . . . . . . . 331 Initial measurement of variable interest entity . . . . . . . . . . 351
Contingently returnable shares . . . . . . . . . . . . . . . . . . . . . . . . . 334 Materiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
Convertible debt and convertible preferred stock . . . . . . . . . . 330 Negative goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
Diluted earnings per share Presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
Contingently issuable shares . . . . . . . . . . . . . . . . . . . . . . . . 331 Priorperiod adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Contracts that may be settled in stock or cash . . . . . . . . . 331 Unusual in nature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
Convertible debt and convertible preferred stock . . . . . . . 330 Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349, 351
Example calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 Infrequent items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
General rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326 Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349, 351
No antidilution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349, 350
Options, warrants, and their equivalents . . . . . . . . . . . . . . 329 Unusual items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Rights issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334 Unusual or infrequent items
Stockbased compensation plans . . . . . . . . . . . . . . . . . . . . 334 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339 Presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Extraordinary items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
Ifconverted method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 INVENTORY
Mandatorily redeemable shares, effect on . . . . . . . . . . . . . . . . 324 Balance sheet classification . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Options, warrants, and their equivalents Cost components
Accounting requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 Change in components of inventory cost . . . . . . . . . . . . . . 246
Debt or other securities tendered as payment of
option price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 O
Options and warrants to purchase convertible
securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 OFFSETTING ASSETS AND LIABILITIES
Purchased options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 Circumstances not covered by FASBI No. 39 . . . . . . . . . . . . . 271
Treasury stock method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 Derecognition of assets or liabilities . . . . . . . . . . . . . . . . . . . . . 271
Written put options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
Participating securities and twoclass common stock . . . . . . 337 General rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
Prior period adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339 Nonrecognition of assets or liabilities . . . . . . . . . . . . . . . . . . . . 271
Public companies, definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324 Offsetting derivative instruments . . . . . . . . . . . . . . . . . . . . . . . . 270
Rights issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334 Offsetting receivables and payables from repurchase and
Securities of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338 reverse repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . 271
Stockbased compensation plans . . . . . . . . . . . . . . . . . . 334, 339 Offsetting securities against taxes payable . . . . . . . . . . . . . . . 270
Treasury stock method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 Right of setoff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
378
P Change in estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Comparative financial statements . . . . . . . . . . . . . . . . . . . . . . . 253
PRIORPERIOD ADJUSTMENTS Correction of errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250, 253
Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 Cumulative effect on retained earnings . . . . . . . . . . . . . . . . . . . 253
Adjustment of prior interim periods in current year . . . . 251, 254 Disclosure requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
Change from unacceptable to acceptable accounting Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 Errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
Change in accounting principle . . . . . . . . . . . . . . . . . . . . . . . . . 250 Exclusion from net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
379
Historical financial summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 Accounting changes

Illustration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 Changes in estimated useful life . . . . . . . . . . . . . . . . . . . . . 249
Restatement of opening retained earnings . . . . . . . . . . . . . . . . 250 Changes in salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
Restatement of prior period financial statements . . . . . . . . . . 250 Estimated useful life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
Salvage value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
PROPERTY, PLANT, AND EQUIPMENT
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GAPT09

SELFSTUDY CONTINUING PROFESSIONAL EDUCATION

Companion to PPC's Guide to

Fort Worth, Texas

Copyright 2009 Thomson Reuters/PPC

Practitioners Publishing Company is registered with the National

Practitioners Publishing Company is registered with the National

Interactive Selfstudy CPE

Companion to PPC's Guide to GAAP

COURSE 1: SELECTED GAAP TOPICS

EXAMINATION INSTRUCTIONS, ANSWER SHEETS, AND EVALUATIONS

Course 1: Testing Instructions for Examination for CPE Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381

Taking the Courses

Qualifying Credit Hours QAS or Registry

Obtaining CPE Credit

Retaining CPE Records

PPC InHouse Training

COMPANION TO PPC'S GUIDE TO GAAP

SELECTED GAAP TOPICS (GAPTG091)

Note:This course material is similar to course material found in the Companion to

Lesson 1 GAAP Chapters 32 and 33

Completion of this lesson will enable you to:

Lesson 2 GAAP Chapters 35, 26, and 31

Completion of this lesson will enable you to:

TO COMPLETE THIS LEARNING PROCESS:

Lesson 1:GAAP Chapters 32 and 33

Completion of this lesson will enable you to:

COST METHOD INVESTMENTS

BUSINESS INTERRUPTION INSURANCE

Gross margin not earned because normal operations were suspended.

INVESTMENTS IN LIFE SETTLEMENT CONTRACTS

a. The aggregate carrying amount of all cost method investments

BUSINESS INTERRUPTION INSURANCE

a. Nature of the event resulting in business interruption losses.

INVESTMENTS IN LIFE SETTLEMENT CONTRACTS

(1) Number of contracts

(2) Carrying value of contracts

a. Gains or losses recognized on investments sold during the period.

a. An adjustment of premiums paid.

b. Gross margin not earned due to suspension of normal operations.

d. Marketing costs related to the loss or use of property.

b. The lease contains a bargain purchase option.

a. Collectibility of the minimum lease payments is reasonably predictable.

a. It involves a lessee, a lessor, and a longterm creditor.

b. The lease contains an option for a bargain purchase.

5. No gain or loss results with which of the following types of leases?

b. Direct financing lease.

ACCOUNTING FOR LEASES—LESSEES

ACCOUNTING FOR LEASES—LESSORS

A lessor should account for a salestype lease as follows:

A lessor should account for a direct financing lease as follows:

a. The gross investment in the lease should be determined.

OTHER LEASE TRANSACTIONS

apply to inventory, including equipment parts inventory.

Classifying Leases Lessees

(1) covered by bargain renewal options.

(5) representing renewals or extensions of the lease at the lessor's option.

Basic Lease Classification Lessee

Yes Ownership transfers

Yes Lease contains a

Lease term begins within the last

Lease term is 75% or more

Note:Classification of real estate leases may differ.

(1) Any guarantee by the lessee of the lessor's debt

SELFSTUDY CONTINUING PROFESSIONAL EDUCATION

Interactive Selfstudy CPE

PPC InHouse Training

Note:This course material is similar to course material found in the Companion to

a. It involves a lessee, a lessor, and a longterm creditor.

A lessor should account for a salestype lease as follows:

Note:Classification of real estate leases may differ.

Note:Classification of real estate leases by lessors may differ.

a. It involves at least three parties a lessee, a lessor, and a longterm creditor.

Classifying Renewals or Extensions as Salestype Leases. Renewals or extensions of salestype or direct

a. A salestype lease only.

d. Be classified as salestype leases.

a. Made under a salestype lease.

(1) The sellerlessee guarantees a specified residual value.

(6) The sellerlessee guarantees the purchaserlessor's debt.