CMA Part 1 Textbook Section A

2022 Edition
CMA
Preparatory Program
Part 1
Section A
Financial Planning,
Performance, and Analytics
Brian Hock, CMA, CIA

and
Lynn Roden, CMA
HOCK international books are licensed only for individual use and may not be
lent, copied, sold, or otherwise distributed without permission directly from
HOCK international.
If you did not download this book directly from HOCK international, it is not a
genuine HOCK book. Using genuine HOCK books assures that you have complete,
accurate and up-to-date materials. Books from unauthorized sources are likely outdated
and will not include access to our online study materials or access to HOCK teachers.
Hard copy books purchased from HOCK international or from an authorized

training center should have an individually numbered orange hologram with the
HOCK globe logo on a color cover. If your book does not have a color cover or does
not have this hologram, it is not a genuine HOCK book.
HOCK international, LLC
P.O. Box 6553
Columbus, Ohio 43206
(866) 807-HOCK or (866) 807-4625

(281) 652-5768
www.hockinternational.com
cma@hockinternational.com
Published October 2021
Acknowledgements
Acknowledgement is due to the Institute of Certified Management Accountants for

permission to use questions and problems from past CMA Exams. The questions and
unofficial answers are copyrighted by the Certified Institute of Management Accountants
and have been used here with their permission.
The authors would also like to thank the Institute of Internal Auditors for permission to
use copyrighted questions and problems from the Certified Internal Auditor Examinations
by The Institute of Internal Auditors, Inc., 247 Maitland Avenue, Altamonte Springs,
Florida 32701 USA. Reprinted with permission.
The authors also wish to thank the IT Governance Institute for permission to make use
of concepts from the publication Control Objectives for Information and related
Technology (COBIT) 3rd Edition, © 2000, IT Governance Institute, www.itgi.org.
Reproduction without permission is not permitted.
© 2021 HOCK international, LLC
No part of this work may be used, transmitted, reproduced or sold in any form or by any
means without prior written permission from HOCK international, LLC.
ISBN: 978-1-934494-68-4
Thanks
The authors would like to thank the following people for their assistance in the
production of this material:
§ Kekoa Kaluhiokalani for his assistance with copyediting the material,

§ All of the staff of HOCK Training and HOCK international for their patience in the
multiple revisions of the material,
§ The students of HOCK Training in all of our classrooms and the students of HOCK
international in our Distance Learning Program who have made suggestions,
comments and recommendations for the material,
§ Most importantly, to our families and spouses, for their patience in the long hours
and travel that have gone into these materials.
Editorial Notes
Throughout these materials, we have chosen particular language, spellings, structures

and grammar in order to be consistent and comprehensible for all readers. HOCK study
materials are used by candidates from countries throughout the world, and for many,
English is a second language. We are aware that our choices may not always adhere to
“formal” standards, but our efforts are focused on making the study process easy for all
of our candidates. Nonetheless, we continue to welcome your meaningful corrections and
ideas for creating better materials.
This material is designed exclusively to assist people in their exam preparation. No

information in the material should be construed as authoritative business, accounting or
consulting advice. Appropriate professionals should be consulted for such advice and
consulting.
CMA Part 1 Table of Contents
Table of Contents
Introduction to CMA Part 1 ................................................................................................1
Section A – External Financial Reporting Decisions ......................................................2

Study Unit 1: A.1. The Financial Statements, The Balance Sheet ..................................2
Users of Financial Information 2
The Financial Statements 3
Differences Between IFRS and U.S. GAAP 3
1) The Balance Sheet (Statement of Financial Position) 4
Study Unit 2: A.1. The Income Statement ...................................................................... 12
2) The Income Statement 12
Study Unit 3: A.1. The Statement of Comprehensive Income ...................................... 17
3) Statement of Comprehensive Income 17
Study Unit 4: A.1. Statement of Owners Equity and Notes to FS ................................. 22
4) Statement of Changes in Stockholders’ Equity 22
Notes to Financial Statements 22
Study Unit 5: A.1. Statement of Cash Flows – Introduction ......................................... 24
5) The Statement of Cash Flows (SCF) 24
Preparation of the Statement of Cash Flows 26
Study Unit 6: A.1. The Indirect Method........................................................................... 33
Study Unit 7: A.1. Investing and Financing Activities, SCF Disclosures .................... 39
Investing and Financing Activities 39
Statement of Cash Flows Disclosures 40
Study Unit 8: A.1. Integrated Reporting ......................................................................... 42
Introduction to Integrated Reporting 42
The International <IR> Framework 44
Sustainability Accounting Standards Board (SASB) 53
Study Unit 9: A.2. Accounts Receivable......................................................................... 54
Valuing Accounts Receivable 55
Discounts and Initial Recording of the Accounts Receivable 55
Credit Losses on Receivables 58
Sales Returns and Allowances 67
Factoring: Using Receivables as an Immediate Source of Cash 68
Study Unit 10: A.2. Inventory and Inventory Tracking Methods .................................. 69
Valuing the Inventory When It Is Purchased 69
Which Goods Are Included in Inventory? 70
Costs Included in Inventory 71
Determining Which Item Is Sold: Cost Flow Assumptions 71
© HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. i
Table of Contents CMA Part 1
Effect of the Different Methods 76

The Frequency of Determining Inventory Balances 76
Study Unit 11: A.2. Inventory Count, Errors, and Valuation ......................................... 81
The Physical Inventory Count 81
Errors in Inventory 82
Recognizing Permanent Declines in Inventory Values 83
Study Unit 12: A.2. Investments Overview, Debt Securities ......................................... 89
Investments Overview 89
Investments in Debt Securities – Methods 1, 2, and 3 91
Credit Losses on Debt Securities 93
The Fair Value Option for Investments in Debt Securities 95
Study Unit 13: A.2. Equity Investments .......................................................................... 96
Investments in Equity Securities – Methods 3, 4, 5, and 6 96
Equity Securities Where the Investor Does Not Have Significant Influence 96
Long-Term Investments Where the Investor Has Significant Influence or Control 101
Changes in Level of Ownership or Degree of Influence 104
Study Unit 14: A.2. Business Combinations and Consolidations .............................. 106
Consolidated Financial Statements – Method 6 106
Study Unit 15: A.2. Recording Fixed Assets ................................................................ 109
Initial Recording of the Fixed Asset 109
Depreciation 110
Net Book Value of Fixed Assets 110
Study Unit 16: A.2. Depreciation of Fixed Assets and Impairment ............................ 111
Calculation of Depreciation 111
Depreciation Methods 111
Depreciation for Tax Purposes 115
Which Method of Depreciation is Best? 117
Impairment of Long-Lived Assets to be Held and Used 117
Study Unit 17: A.2. Intangible Assets ........................................................................... 120
Initial Recording of Intangible Assets 120
Amortization and Accounting Treatment of Intangibles 120
Impairment of Limited-Life Intangible Assets 121
Impairment of Indefinite-Lived Intangible Assets Other Than Goodwill 122
Goodwill and the Impairment of Goodwill 123
Study Unit 18: A.2. Reclassification of Short-Term Liabilities ................................... 126
Study Unit 19: A.2. Warranties ...................................................................................... 127
1) Accounting for Assurance-Type Warranties 128
2) Accounting for Service-Type Warranties 130
Study Unit 20: A.2. Accounting for Income Taxes ...................................................... 132
Deferred Taxes and Temporary Timing Differences 133
ii © HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.
CMA Part 1 Table of Contents
Tax Cuts and Jobs Act of 2017 and Its Effect on Accounting for Income Taxes 136
Presentation of Income Taxes on the Income Statement 141
Presentation of Deferred Tax Assets and Liabilities on the Balance Sheet 143
Permanent Differences 143
Treatment of Net Operating Losses 145
Valuing Deferred Tax Assets with a Valuation Allowance 145
Study Unit 21: A.2. Leases ............................................................................................ 146
Definition of a Lease 146
The Two Categories of Leases for Lessees 147
Study Unit 22: A.2. Owners’ Equity and Retained Earnings ....................................... 150
Corporate Shareholders’ Equity 151
Study Unit 23: A.2. Common Stock .............................................................................. 152
Study Unit 24: A.2. Preferred Stock .............................................................................. 157
Retained Earnings 158
Study Unit 25: A.2. Treasury Stock and Classification of Shares .............................. 160
Treasury Stock 160
Classification of Shares 160
Study Unit 26: A.2. Revenue Recognition .................................................................... 162
Contract Assets and Liabilities 162
Five Steps to Revenue Recognition 164
Study Unit 27: A.2. Right of Return and Consigned Goods ....................................... 169
Study Unit 28: A.2. Long-Term Contracts .................................................................... 171
Netting Contract Assets and Contract Liabilities on the Balance Sheet 182
Disclosures for Revenue Recognition 183
Study Unit 29: US GAAP / IFRS Differences ................................................................ 184
Study Unit 30: A.2. Income Measurement .................................................................... 184
Expense Recognition 184
Gains and Losses 184
Gains and Losses on the Disposal of Fixed Assets 185
Presentation of Gains and Losses on the Income Statement 187
Involuntary Disposals 187
Comprehensive Income 188
© HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. iii
Table of Contents CMA Part 1
(This page intentionally left blank.)
iv © HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.
CMA Part 1 Introduction to CMA Part 1
Introduction to CMA Part 1

The CMA Part 1 Exam has six sections in the ICMA’s Learning Outcome Statements:1
A. External Financial Reporting Decisions: 15%
B. Planning, Budgeting and Forecasting: 20%
C. Performance Management: 20%
D. Cost Management: 15%
E. Internal Controls: 15%
F. Technology and Analytics: 15%
The Learning Outcome Statements (LOS) for both exam parts are available to download on the IMA’s web-
site at www.imanet.org.
The questions on the exams focus on understanding, in-depth thinking on business strategy, and problem-
solving ability, not just number crunching. To be able to think through the questions on the exam, candi-
dates will need to understand the concepts and be able to apply the concepts to new situations. These study
materials provide the tools for understanding the concepts, but they cannot teach in-depth thinking and
problem solving. Your ability to put the knowledge you gain into practice to pass the CMA exam will depend
on you and the effort you put into preparing for the exam.
Section A, External Financial Reporting Decisions, represents 15% of the exam. Section A covers external
financial reporting from the perspective of its use in decision-making only, which is what is tested on the
Part 1 exam. A knowledge of external financial reporting is assumed as a prerequisite to preparing for the
CMA exams.
Section B, Planning, Budgeting and Forecasting, represents 20% of the exam and includes strategic plan-
ning, budgeting, forecasting, and top-level planning and analysis.
Section C, Performance Management, is 20% of the exam. Section C covers variance analysis and respon-
sibility accounting as well as financial performance measures. For variances, it is important to be able to
calculate the variances and interpret the information provided by variance analysis. Therefore, in addition
to memorizing the variance formulas, candidates will need to be able to understand and interpret the results
of each variance calculation.
Section D, Cost Management, is 15% of the exam. Section D focuses on costing systems and covers several
methods of allocating costs and overheads. It also covers supply chain management and business process
improvement.
Section E, Internal Controls, represents 15% of the exam. The technicalities of internal controls are im-
portant to know, especially the relevant laws businesses are subject to and the related guidance that has
been published. The Sarbanes-Oxley Act has had far-reaching effects and candidates should be familiar
with its requirements.
Section F, Technology and Analytics, is 15% of the exam and covers information systems including account-
ing information systems, data governance, technology, and data analytics.
The exam will consist of 100 multiple-choice questions and 2 essay scenarios, each with several questions.
The multiple-choice questions will not be presented in order according to sections. Thus, an exam might
begin with a sales variance question, then follow that with an inventory question, and so forth.
Only candidates who score a minimum of 50% correct on the multiple-choice portion of the exam will be
eligible to take the essay section of the exam.
1
The Learning Outcome Statements are published by the Institute of Certified Management Accountants (ICMA), the
examining body for the CMA exams. The Learning Outcome Statements provide in detail the information candidates need
to know and things they need to be able to do in order to pass the CMA exams.
© HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. 1
Study Unit 1: A.1. The Financial Statements, The Balance Sheet CMA Part 1
Section A – External Financial Reporting Decisions

Study Unit 1: A.1. The Financial Statements, The Balance Sheet
Note: References to the relevant sections of the FASB’s Accounting Standards Codification® and to other
publications of the FASB are provided throughout Section A. The references are supplied for candidates
who wish to do further research on the topics. Candidates are not expected to memorize the relevant
reference numbers.
Financial accounting is the process of reporting the results and effects of the financial transactions a busi-
ness undertakes. The objective of financial reporting is to provide useful financial information about the
entity for decision-making. Those using the financial information to make decisions include present and
potential equity investors, lenders, and other creditors who need to make decisions about providing re-
sources to the entity. The decisions relate to buying, selling, or holding debt or equity instruments and
providing credit. The investors, lenders, and other creditors need information that will help them assess the
amount of, timing of, and prospects for future net cash inflows to the entity to make their decisions.2 Other
users who may or may not be providing capital to the firm—such as management, employees, financial
analysts, and regulators—may find financial statements useful as well.
The types of decisions potential investors, lenders, and other creditors are making are numerous and varied.
It is not possible for accounting information to provide all the information that all users need to make their
decisions. Users need to access information from other sources as well, such as economic forecasts, the
political climate, and industry outlooks.3 However, the financial statements do attempt to provide as much
useful information as possible.
Users of Financial Information

Published financial information must comply with the established accounting standards because outside
users will rely on it to make a variety of decisions. Accounting standards are in place to protect outside
users by ensuring that the information is accurate and useful and can be understood by everyone.
Because so many people are using financial information for so many diverse purposes, the reasons people
need the financial information are also diverse, such as:
• Making investment decisions.
• Extending or withholding credit.
• Assessing areas of strength and weakness within the company.
• Evaluating management performance.
• Determining whether or not the company is complying with regulatory requirements.
Users of financial information can be classified by various distinctions:
Direct and Indirect Users. Direct users are directly affected by the results of a company. Direct users
include investors and potential investors, employees, management, suppliers, and creditors. Direct users
stand to lose money if the company has financial problems.
Indirect users are people or groups who represent direct users. They include financial analysts and advisors,
stock markets, and regulatory bodies.
2
FASB Statement of Financial Accounting Concepts No. 8, Conceptual Framework for Financial Reporting, September
2010, Chapter 1, paragraph OB3.
3
Ibid.
2 © HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.
Section A Study Unit 1: A.1. The Financial Statements, The Balance Sheet
Internal and External Users. Internal users make decisions within the firm. External users make deci-
sions from outside of the firm about whether or not to begin a relationship, continue a relationship, or
change their relationship with the firm.
Note: Users of financial statements are assumed to have a reasonable knowledge of business and
economic activities and to be willing to study the information with reasonable diligence. Those as-
sumptions are important because they mean that, in the preparation of financial statements, a
reasonable level of competence on the part of users can be assumed. Someone who has a “reasonable
understanding” of business, accounting, and economic activities should be able to read the financial
information and understand it.
The Financial Statements

The five financial statements used by business entities under U.S. Generally Accepted Accounting Principles
(GAAP) are:
1) Balance sheet (also called the statement of financial position)
2) Income statement
3) Statement of comprehensive income
4) Statement of changes in stockholders’ equity
5) Statement of cash flows
Note: The notes to financial statements are also considered an integral part of the financial statements
but are not an actual financial statement. The purpose of the notes is to provide informative disclosures
required by U.S. GAAP.
Note: A company can also prepare prospective financial statements. Prospective financial state-
ments are financial statements based on a set of assumptions that present projected information about
a future period. Whenever prospective financial statements are prepared, the significant accounting
policies and significant assumptions used need to be disclosed.
Differences Between IFRS and U.S. GAAP

IFRS stands for “International Financial Reporting Standards,” a widely accepted set of accounting
principles used in many countries around the world. IFRS is primarily a principles-based set of accounting
standards with few practical examples and limited interpretative guidance. Neither acting as a tax standard
nor applying to government organizations, IFRS is intended for multiple countries with different cultural,
legal, and commercial standards.
IFRS’s main objective is to be more open and flexible; therefore, the standard-setters leave interpretation
to companies and their auditors, resulting in greater flexibility. As a result, companies and their auditors
can interpret IFRS differently. The significance of these differences in interpretation will vary from company
to company, depending on factors such as the nature of the company’s operations, the industry in which it
operates, and the accounting policies it chooses.
U.S. GAAP, on the other hand, is largely a rules-based body of standards with extensive interpretive
guidance for individual industries and specific examples for auditors and practitioners. It applies to United
States-based entities and foreign companies that participate in the U.S. financial markets. In addition, the
standard-setters actively interpret the standards. This active participation often results in a proscriptive
approach in U.S. GAAP that reflects the strong regulatory environment in the United States.
Because many of the countries in the world have adopted IFRS, think of IFRS as “International” GAAP
compared to “U.S.” GAAP. Despite their differences, the general principles, conceptual framework, and
accounting results between U.S. GAAP and IFRS are often very similar, if not the same, because the two
standards are more alike than different for most common transactions.
For the exam, candidates need to know what IFRS is and some specific differences between U.S. GAAP and
IFRS. These specific differences appear in orange boxes following the related U.S. GAAP coverage
of the topic.
1) The Balance Sheet (Statement of Financial Position)

Note: Guidance in the Accounting Standards Codification® on presentation of the balance sheet is in
ASC 210.
The balance sheet, also called a statement of financial position, provides information about an entity’s
assets, liabilities, and owners’ equity at a point in time (usually the end of a reporting period). The balance
sheet shows the entity’s resource structure—the major classes and amounts of its assets—and its financing
structure—the major classes and amounts of its liabilities and equity. The balance sheet provides a basis
for computing rates of return4, evaluating the capital structure of the business, and predicting a company’s
future cash flows. It helps users to assess the company’s liquidity, financial flexibility, solvency, and risk.
• Liquidity refers to the time expected to elapse until an asset is converted into cash or until a
liability needs to be paid. The greater a company’s liquidity is, the lower will be its risk of failure.
• Financial flexibility is the ability of a business to take actions to alter the amounts and timing of
its cash flows that enable the business to respond to unexpected needs and take advantage of
opportunities.
• Solvency refers to the company’s ability to pay its long-term obligations when they are due. A
company with a high level of long-term debt relative to its assets has lower solvency than a com-
pany with a lower level of long-term debt.
• Risk refers to the unpredictability of future events, transactions and circumstances that can affect
the company’s cash flows and financial results.
The statement of financial position can also be used in financial statement analysis to assess a company’s
ability to pay its debts when due and its ability to distribute cash to its investors to provide them an adequate
rate of return.
A balance sheet is not intended to show the value of a business. However, along with other financial state-
ments and other information, a balance sheet should provide information that will be useful to someone
who wants to make his or her own estimate of the business’s value.5
Balance sheet accounts are permanent accounts. Balance sheet accounts are not closed out at the end
of each accounting period as income statement accounts are, but rather their balances are cumulative.
They keep accumulating transactions and changing with each transaction, year after year.
4
A rate of return is an income amount divided by an asset amount. Thus, though the balance sheet does not present
income information, it provides a basis for computing rates of return because it presents the asset amounts that are
used in the computation of the rate of return.
5
FASB Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of
Business Enterprises, December 1984, paragraph 27.
Elements of the Balance Sheet

Elements of the balance sheet include assets, liabilities, and stockholders’ (or owners’) equity.
Assets are probable future economic benefits that have been obtained or are controlled by an entity as a
result of past transactions or events. Thus, an asset:
• Arose from a past transaction

• Is presently owned by the company
• Will provide a probable future economic benefit to the company
Note that the preceding definition encompasses three time periods: the past, the present owned, and the
future.
Liabilities are probable future sacrifices of economic benefits due to present obligations of an entity to
transfer assets or provide services in the future, resulting from past transactions or events.6 Thus, a liability:
• Arose from a past transaction

• Is presently owed by the company
• Will lead to a probable future sacrifice of economic benefits by the company
As with the definition of an asset, the definition of a liability encompasses the past, the present and the
future.
Equity represents the entity’s net assets, or the residual (remaining) interest in the assets of the entity
after deducting its liabilities from its assets. For a business entity, equity is the ownership interest.
Current and Non-Current Classification of Assets and Liabilities

On the balance sheet, assets and liabilities are classified as either current or non-current. Generally,
current assets and liabilities are short-term and non-current assets and liabilities are long-term, but the
more correct terminology is “current” and “non-current” for both assets and liabilities. Whether an asset or
liability is classified as current or non-current depends on the time frame in which the entity expects an
asset to be converted into cash or a liability to be settled.
Current Assets
Current assets are cash and other assets or resources that are reasonably expected to be realized in cash
or sold or consumed during the normal operating cycle of the business.
Note: The operating cycle is defined in the Master Glossary in the FASB’s Accounting Standards Cod-
ification® as the average time between the acquisition of materials or services and their final cash
realization.
Per ASC 210-10-45-3, a one-year time period is to be used as the basis for the segregation of current
assets when an entity has several operating cycles occurring within a year. However, if the period of an
entity’s operating cycle is greater than twelve months, for example as in the tobacco, distillery, and
lumber businesses, the longer period is used as the entity’s operating cycle. If an entity has no clearly
defined operating cycle, the one-year rule governs.
6
FASB Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements of Business Enterprises,
December 1985, paragraph 35.
Current assets are perhaps the easiest of the various sections of the balance sheet to identify. They include:
• Cash available for current operations, including coins, currency, undeposited checks (checks that
have been received but have not yet been deposited in the bank), money orders and drafts, and
demand deposits.
• Cash equivalents. Short-term, highly liquid investments that are convertible to known amounts
of cash without a significant loss in value and have maturities of 3 months or less from the date of
purchase.
• Marketable securities classified as current assets. Marketable debt and equity securities that
represent the investment of cash available for current operations.7 Marketable securities classified
as trading securities are almost always current assets. Marketable securities other than trading
securities may or may not be classified as current assets, depending on management’s intention.
Marketable debt securities classified as available-for-sale are current assets if they are considered
working capital available for current operations, regardless of their maturity dates. Marketable debt
securities classified as held-to-maturity are current assets only if their maturity is within one year
or the length of the firm’s operating cycle, whichever is longer. Marketable equity securities may
or may not be classified as current assets, depending on management’s intention.
• Receivables. Trade accounts receivable, notes receivable, and acceptances receivable. Receiva-
bles from officers, employees, affiliates and others are also current assets if they are collectible in
the ordinary course of business within one year or the firm’s operating cycle.
• Contract assets classified as current assets. Under the revenue recognition standard, ASC
606, contract assets represent an entity’s right to consideration in exchange for goods or services
that the entity has transferred to a customer when that right is conditional on something other
than the passage of time, for example the entity’s future performance, before the entity can invoice
the customer. Contract assets may be current assets or non-current assets or both, depending on
the facts and circumstances such as when receipt of payment is expected, based on the agreement
with the customer. Contract assets are explained in the Revenue Recognition topic in this volume.
• Short-term notes receivable if they conform generally to normal trade practices and terms
within the business.
• Inventories. Merchandise on hand and available for sale and, for a manufacturer, raw materials
and work-in-process as well as finished goods. Operating supplies and ordinary maintenance ma-
terial and parts are also inventories.
• Prepaid expenses. Amounts paid in advance for the use of assets such as rent paid at the begin-
ning of a rental period or amounts paid for services to be received at a future date. An insurance
premium paid at the beginning of a policy period for insurance coverage to be received during the
portion of the future policy period that will occur during the coming operating cycle is a current
prepaid expense. Prepaid expenses are not convertible to cash, but they are classified as current
assets because they would have required the use of current assets during the coming operating
cycle if the expenses had not been prepaid.
• Funds that are restricted for current purposes. If cash or cash equivalents are being held for
a current purpose, such as for payment of current obligations due within a year or the operating
cycle, whichever is longer, or as a compensating balance to support short-term borrowing, the
cash should be reported on a separate line in the current assets section of the balance sheet.
7
Per ASC 210-10-45-1f.
Non-Current Assets
Non-current assets are assets or resources other than those that are reasonably expected to be realized
in cash or sold or consumed during the normal operating cycle of the business.
Non-current assets include:
• Cash and claims to cash that are restricted as to withdrawal or use for other than current opera-
tions, that are designated for the acquisition or construction of non-current assets, or that are
segregated for the liquidation of long-term debts. The restricted cash should be reported on a
separate line in the investments or other assets section as non-current assets.
• Marketable securities, including stocks, bonds, and long-term notes receivable that do not repre-
sent the investment of cash available for current operations. Even though a security may be readily
marketable, if management does not intend to convert it to cash within one year or the company’s
operating cycle, whichever is longer, it should be classified as a non-current asset. An available-
for-sale debt security with a maturity date that would otherwise cause it to be classified as a current
asset should also be classified as a non-current asset if management does not consider it to be
available for current operations. A held-to-maturity debt security is normally classified as a non-
current asset until its maturity date is within one year or the length of the firm’s operating cycle,
whichever is longer.
• Long-term investments or advances, whether marketable or not, made for the purpose of obtaining
control, for affiliation, or other continuing business advantage.
• Property, plant, and equipment.
• Right-of-use assets obtained under lease agreements.
Note: The FASB has not specified whether right-of-use assets obtained under lease agreements
are to be considered tangible or intangible assets.
• Intangible long-term assets.

• Other long-term assets such as long-term prepaid expenses, prepaid pension cost, and receivables
arising from unusual transactions not expected to be collected within twelve months.
• Contract assets under ASC 606 that are not expected to be converted to cash within one year or
the operating cycle, whichever is longer.
• Net deferred tax assets.
• The cash surrender value of life insurance policies on the lives of key employees.
• Other non-current assets not included in other categories, such as non-current receivables, long-
term prepayments, and restricted cash or securities or assets in special funds.
Property, Plant, and Equipment (Fixed Assets)

Property, plant, and equipment (PP&E) are tangible assets used in operations that will continue to be used
beyond the end of the current period. When the fixed assets are purchased, they are recorded at their cost,
including shipping-in and installation costs needed to bring the asset to usable condition. The cost is then
expensed over the life of the asset through depreciation, amortization, or depletion (except for land, which
is not depreciated).
Examples of property, plant, and equipment include:
• Land, buildings, machinery, furniture, equipment, and vehicles
• Leasehold improvements, or improvements made to leased property at the lessee’s expense
• Assets obtained by means of a lease agreement
• Natural resources, such as gas, minerals, or timberland
Natural resources other than land are depleted; property, plant, and equipment other than land are depre-
ciated; and leasehold improvements are amortized. Land is not depreciated, amortized, or depleted because
land is not used up and does not wear out.
Intangible Long-term Assets

Intangible assets do not have physical substance, but they provide benefit to the firm. Intangible assets
may be either purchased or developed internally. However, because an asset recorded on the balance sheet
comes about only by means of a prior transaction, internally generated intangible assets are not recorded
on the balance sheet.8
Examples of intangible assets are copyrights, patents, goodwill, trademarks, and franchises. An intangible
asset with a limited life is amortized over its useful life. An intangible asset with an indefinite life, such as
goodwill, is assessed periodically for impairment.
Current Liabilities
Current liabilities are obligations that will be settled through the use of current assets or by the creation of
other current liabilities.
Examples of current liabilities include:
• Accounts payable and trade notes payable due to suppliers for purchase of goods and services.
• Cash dividends payable.
• Contract liabilities representing an entity’s obligation under ASC 606, the revenue recognition
standard, to transfer goods or services to a customer for which the entity has received considera-
tion from the customer. Contract liabilities may be current liabilities or non-current liabilities or
both, depending on the facts and circumstances such as when the entity expects to satisfy its
performance obligations and how it satisfies its performance obligations—over time or at a point
in time.
• Other deposits received from customers such as a security deposit on a lease.
• Agency collections such as employee tax withholdings and sales taxes, where the company acts as
agent for another party (the government) and is obligated to remit the payments.
• Obligations due on demand according to their terms, such as demand notes.
• Short-term (30-, 60-, 90-day) notes.
• Current portions of long-term debt and lease liabilities (the portions of the principal due within the
operating cycle, usually twelve months).
• Taxes payable, wages payable, and other accruals.
• Long-term obligations callable at the balance sheet date due to some violation by the company
such as a violation of a loan covenant.9
• Assurance-type warranties10 for which the term of the warranty extends only into the next ac-
counting period or the portion of a longer-term warranty that extends only into the next period.
8
For an internally developed patent, the costs of registration fees and legal fees for filing the patent (only) may be
capitalized and amortized because the costs of research and development are expensed as they are incurred.
9
A covenant is a condition or a requirement in a loan agreement or in a bond indenture. (A bond indenture is the legal,
binding contract between a bond issuer, the borrower, and the bondholders, who are the lenders.) Covenants may restrict
the actions of the borrower or require that the borrower meet certain requirements such as maintaining certain financial
statement ratios. If the borrower fails to meet the requirements of the loan agreement, the loan becomes in default, just
as if the borrower had failed to make scheduled loan payments, and the full principal and any accrued interest becomes
immediately due and payable.
10
An assurance-type warranty is a manufacturer’s warranty given along with the sale of the product that provides
assurance only that the product meets agreed-upon specifications in the contract at the time it is sold, without any
additional payment being required from the customer.
Current liabilities do not include:
• Debts to be paid by funds in accounts classified as non-current.
• The portion of a short-term obligation intended to be refinanced by a long-term obligation, subject

to fulfilling requirements as noted below.
Note: If the company can demonstrate that it has the intent and the ability to refinance an obliga-
tion that is coming due in the next twelve months, it may reclassify that obligation on the balance
sheet as a non-current liability. Having a commitment from a bank for long-term financing of the
obligation is an example of a way to demonstrate the ability to refinance it.
For example, when a company can show that it has the intent and the ability to refinance an obligation
that is due in nine months, the company can show the obligation on its balance sheet as a non-current
liability because management knows it will use the funds received from the future long-term financing
to settle the existing debt. The company is replacing one kind of debt with another kind of debt.
Bank Overdrafts: An Item That Could Be Reported by Netting Against the Current Asset “Cash” or by
Adding to the Current Liability “Accounts Payable”
Bank overdrafts are amounts by which a company’s checking account is in a negative position due to checks
written that exceed the amount in the account. The management of the bank has discretion over whether
a non-sufficient funds check will be honored, allowing the overdraft, or whether the non-sufficient funds
check will be returned to the payee unpaid. If the bank honors the check and allows the overdraft in the
payor’s account, the overdraft amount should be added to the payor’s accounts payable and reported as a
current liability, unless the payor has cash in an amount greater than the overdraft in another
account in the same bank. If enough cash is present in another account in the same bank, the net
amount of cash available (the positive balance minus the negative balance) in that bank should be reported
as part of cash, a current asset.
Non-current Liabilities
Non-current liabilities are liabilities that will not be settled within one year or the operating cycle if the
operating cycle is longer than one year.
Examples of non-current liabilities are:
• Contract liabilities classified as non-current.
• Long-term notes or bonds payable.
• The long-term portions of long-term debt and lease liabilities (the portions of the principal due
after the operating cycle (usually twelve months).
• Pension obligations.
• Net deferred tax liabilities.
• The non-current portion of assurance-type warranties for which the term of the warranty extends
beyond the next accounting period.
Note: Most long-term debt is subject to various covenants and restrictions, requiring a great deal of
disclosure in the financial statements.
Equity
Equity is the remaining balance of assets after the subtraction of all liabilities. Equity is the portion of the
company’s assets owned by and owed to the owners. If the company were to be liquidated, equity repre-
sents the amount that would theoretically be distributable to the owners.
All business enterprises have owners’ equity, but the types of accounts in owners’ equity will differ depend-
ing on the type of the entity. The following discussion focuses on corporations, so the elements of owners’
equity discussed here are the elements of a corporation’s equity.
Owners’ equity for corporations is split into six different categories:
• Capital stock. The par or stated value of the shares issued.
• Additional paid-in capital. The excess of amounts contributed by owners from the sale of shares
over and above the par or stated value of the shares issued.
• Retained earnings. Net income of the company that has not been distributed as dividends.
• Accumulated other comprehensive income items. Specific items that are not included in the
income statement but are included in equity and adjust the balance of equity, even though they
do not flow to equity by means of the income statement as retained earnings do.
• Non-controlling interest. A portion of the equity of subsidiaries that the reporting entity owns
but does not own wholly.
• Treasury stock. Either the amount paid for shares that have been repurchased or the par value
of shares that have been repurchased.11 Treasury stock is a contra-equity account that reduces
equity on the balance sheet.
Note: When a corporation repurchases shares of its own stock from the market, the repurchased shares
are called treasury shares or treasury stock. Treasury shares purchased reduce owners’ equity,
because those shares are no longer outstanding.
Benefits of the Balance Sheet
• Because the balance sheet provides information on assets, liabilities, and stockholders’ equity, it pro-
vides a basis for computing rates of return, evaluating the capital structure of the business, and
predicting a company’s future cash flows.
• The balance sheet helps users to assess the company’s liquidity, financial flexibility, solvency, and
risk. The statement of financial position can also be used in financial statement analysis to assess the
company’s ability to pay its debts when due and its ability to distribute cash to its investors to provide
them an adequate rate of return.
11
Treasury stock can be accounted for under the cost method, the par value method, or the constructive retirement
method. Under the cost method, the full amount paid to repurchase the treasury stock is debited to the treasury stock
account. Under the par value method, the par value of the repurchased shares is debited to the treasury stock account
and the remaining purchase price is debited to the additional paid-in capital account. Under the constructive retirement
method, the par value of the repurchased shares is debited directly to the common stock account and the remaining
purchase price is debited to the additional paid-in capital account. The methods of accounting for treasury stock are
covered in more detail in any accounting textbook.
Limitations of the Balance Sheet
• A statement of financial position (balance sheet) provides only a partial picture of liquidity or financial
flexibility unless it is used in conjunction with at least a statement of cash flows.12
• A balance sheet reports a company’s financial position at one point in time, but it does not report the
company’s true value, for the following reasons:
• Many assets are not reported on the balance sheet, even though they have value and will
generate future cash flows, such as employees, human resources, internally generated intangible
assets, processes and procedures, and competitive advantages.
• Values of certain assets are measured at historical cost, or the price the company paid to
acquire the asset—not the asset’s market value, replacement cost, or value to the firm. For exam-
ple, property, plant, and equipment (PP&E) are reported on the balance sheet at historical cost
minus accumulated depreciation, although the assets’ value in use may be significantly greater.
• Judgments and estimates are used to determine the value of many items reported in the
balance sheet. For example, estimates of the balance of receivables the company will collect are
used to value accounts receivable; the expected useful life of fixed assets is used to determine the
amount of depreciation; and the company’s liability for future warranty claims is estimated by
projecting the number and the cost of the future claims.
• Most liabilities are valued at the present value of cash flows discounted at the rate that
was current when the liability was incurred, not at the present value of cash flows discounted
at the current market interest rate. If market interest rates increase, a liability with a fixed interest
rate that is below the market rate increases in its value to the company. If market rates decrease,
a liability with a fixed interest rate that is higher than the market interest rate sustains a loss in
value. Neither of these changes in values is recognized on the balance sheet.
Note: To counter the limitations related to valuation, fair value is used to measure many items pre-
sented on the balance sheet. “Fair value” is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement date. U.S.
GAAP has increasingly called for the use of fair value to measure financial instruments. For example,
many items such as derivatives, which previously were not reported on the balance sheet at all, are now
being reported at fair value. Entities have an option to measure most financial assets and liabilities at
fair value.
12
FASB Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of
Business Enterprises, paragraph 24.a.
Study Unit 2: A.1. The Income Statement CMA Part 1
Study Unit 2: A.1. The Income Statement

2) The Income Statement
Guidance in the Accounting Standards Codification® on presentation of the income statement is in ASC
225.
The income statement reports the results of a company’s operations during a given period of time. The
income statement provides users with information to help them predict the amounts, timing, and uncer-
tainty of (or prospects for) future cash flows.
The income statement is created using the accrual method of accounting as applied to historical transac-
tions. The income statement gives the results of operations for a period of time and is like a movie,
recording the monetary effect of business transactions for that period of time. The income statement is
different from the balance sheet because the balance sheet provides information specific to one moment
in time, like a photograph.
The accounts used to record revenues, expenses, gains, and losses are temporary accounts. They are
closed to retained earnings, a permanent account on the balance sheet at the end of each fiscal
year. At the beginning of each fiscal year, the balances in the income statement accounts are zero.
Certain types of events are classified and reported separately on the income statement. The standard mul-
tiple-step income statement format includes the following sections:
Revenues $XXXXX
Cost of goods sold XXXX
Gross profit $XXXXX
Selling, general, and administrative expenses XXX
Operating income $XXXXX
Interest and dividend income XXX
Interest expense XXX
Non-operating gains/(losses) XXXX
Income from continuing operations before income taxes $XXXXX
Provision for income taxes on continuing operations XXXX
Income from continuing operations $ XXXX
Discontinued operations:
Gain/(loss) from operations of discontinued Component X
(including gain/[loss] on disposal of $XXX) XXXX
Income tax benefit or (income tax expense) XXX
Income (loss) on discontinued operations XXXX
Net Income $ XXXX
Note: In addition to income information, information regarding Earnings per Share (EPS) must also
be presented on the face of the income statement.
Section A Study Unit 2: A.1. The Income Statement
Note: “Income from continuing operations” on a multi-step income statement is not the same as “op-
erating income.”
Operating income includes revenues and expenses generated by the company’s core business. Operating
income does not include financial income (interest and dividend income) or financial expense (interest
expense), nor does it include non-operating gains and losses or the provision for income taxes on con-
tinuing operations.
Income from continuing operations, on the other hand, does include financial income, financial expense,
non-operating gains and losses, and income taxes on continuing operations, in addition to revenues and
expenses generated by the company’s core business.
Income from continuing operations refers to gain or loss that the company generated on all its activities
that are expected to continue in the future. It is called income from continuing operations to distinguish
it from gains and losses on discontinued operations. Income from continuing operations does not include
income from discontinued operations because income from discontinued operations represents income
or loss that is not expected to continue in the future. The potential buyer of a company should look at
income from continuing operations instead of net income because income from continuing operations
will continue in the future.
The line “Income from continuing operations” appears on an income statement only if the firm
is reporting results of discontinued operations.
A single-step income statement that has only two groupings, revenues and expenses, may also be used.
Total expenses are subtracted from total revenues to determine the net income or loss. The single-step
form of income statement is simpler and eliminates potential classification problems.
Elements of the Income Statement

The income statement is made up of four elements: revenues, gains, expenses, and losses.
• Revenues represent inflows or other enhancements to assets or settlements of liabilities13 (or a

combination of both) that result from delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or central operations. Under ASC 606, revenue
is to be recognized in the accounting period in which the performance obligation is satisfied, that
is, when the customer obtains control of the asset, which is the good or service that is transferred
to the customer. Revenue is recognized to depict the transfer of goods or services to customers in
an amount that reflects the consideration the company expects to be entitled to in exchange for
the goods or services.
Note: The revenue recognition principle requires revenues to be recognized in the account-
ing period in which the performance obligation is satisfied.
• Gains are increases in equity resulting from transactions that are not part of the company’s main
or central operations and do not result from revenues or investments by the owners of the entity.
• Expenses are outflows or other using-up of assets or the incurrence of liabilities that result from
delivering goods or providing services that are the entity’s main or central operations.
Note: The expense recognition principle, or the matching principle, states that recogni-
tion of expenses is related to net changes in assets and the earning of revenues. Expenses
should be recognized when the work or product contributes to revenue.
13
Settlement of a liability creates revenue, for example, when the company has received a deposit from a customer for
an order to be delivered in the future. The deposit is a contract liability when received. When the performance obligation
in the contract has been satisfied, the contract liability is debited to reduce it by the amount of the deposit, and the
amount of the deposit is credited to revenue.
• Losses are decreases in equity that result from transactions that are not part of the company’s
main or central operations and that do not result from expenses or distributions made to owners
of the entity.
The difference between revenues and gains and between expenses and losses depends on what the com-
pany’s typical activities are. For example, the sale of a product as part of a company’s normal operations
constitutes revenue. However, the sale of a fixed asset is not part of the company’s regular operations, so
the excess of the amount received for the asset over its net book value is a gain, not revenue.
Other Income Statement Items

Unusual Gains and Losses
Unusual gains and losses are gains and losses the firm considers to be of an unusual nature or of a type
that indicates infrequency of occurrence or both. Some examples of unusual losses are losses on inventory
or other assets damaged in a fire and restructuring charges. So that users can better predict the amounts,
timing, and uncertainty of future cash flows, unusual losses may require separate presentation on the
income statement.
Per ASC 220-20-45-1, unusual gains and losses are part of income from continuing operations (in contrast
to discontinued operations). Unusual gains and losses are generally reported as non-operating gains and
losses within income from continuing operations. Unusual gains or losses of a similar nature that are not
individually material should be aggregated, that is, combined on one line. Unusual gains or losses that are
material should be presented as separate line items or, alternatively, disclosed in the notes to financial
statements.
Discontinued Operations
Guidance in the Accounting Standards Codification® on presentation of discontinued operations in finan-

cial statements is in ASC 205-20.
A discontinued operation is any component14 of an entity that has been or will be eliminated from the
operations of the company. A discontinued operation is defined as a disposal of a component or group of
components either disposed of or held for sale that represents a strategic shift that has or will have a
major effect on the entity’s operations and financial results. A strategic shift that has or will have a major
effect on operations and financial results could include disposing of operations in a major geographical area
or disposing of a major line of business, a major equity investment, or other major parts of the entity.
All gains or losses incurred by the discontinued component are reported net of tax in the period in
which the gain or loss occurred. The gain or loss from operations of the discontinued component and
the gain or loss from the disposal, when the disposal takes place, are combined and reported on one line,
followed by the income tax effect on the next line, either a tax benefit (for a loss) or a tax expense (for a
gain), followed by the after-tax income or loss on discontinued operations. The gain/loss, the tax expense
or tax benefit associated with the gain or loss of the discontinued component, and the net income or loss
on discontinued operations should be reported below income from continuing operations, as follows.15
14
A component is defined as operations and cash flows that can be clearly distinguished from the rest of the entity
both operationally and for financial reporting purposes.
15
ASC 205-20-45-3A.
Section A Study Unit 2: A.1. The Income Statement
Income from continuing operations before income taxes $XXXX

Income taxes XXX
Income from continuing operations $XXXX
Discontinued operations:
Gain/(loss) from operations of discontinued Component X
(including gain/[loss] on disposal of $XXX) XXXX
Income tax benefit or (income tax expense) XXX
Income (loss) on discontinued operations XXXX
Net Income $XXXX
Disposal of a component or group of components that represent a strategic shift must be reported as
discontinued operations when any of the following three items occurs:
1) The component or group of components meets the criteria in ASC 205-20-45-1E to be classified
as held for sale. ASC 205-20-45-1E requires the held-for-sale classification in the period in which
all the following criteria are met:
• Management commits to a plan to sell the entity.
• The entity to be sold is available for immediate sale.
• An active program to locate a buyer or buyers and other actions required to complete the plan
to sell the entity have been initiated.
• The sale is probable within one year, unless events beyond the entity’s control occur.
• The entity is being actively marketed at a reasonable price in relation to its fair value.
• Actions required to complete the plan to sell the entity make it unlikely that the plan will be
withdrawn or significantly changed.
2) The component or group of components is sold.
3) The component or group of components is disposed of in a manner other than by sale, such as by
abandonment or by distribution to owners in a spinoff.16
In addition to reporting the discontinued entity’s results of operations in the current period, the company
should also reclassify to discontinued operations the net income or loss from the discontinued
operations in the prior period income statements presented as comparisons. Reclassification of prior
period operating results is done so that the prior period financial statements are comparable to the current
period financial statements.
In other words, all gains and losses from the component to be discontinued should be removed from income
from continuing operations so users of the financial statements can see what income from continuing op-
erations is without the operations of the component disposed of or to be disposed of.
Companies use the line “Income from continuing operations” on the income statement only when gains
or losses on discontinued operations occur.
16
A spinoff is a form of corporate divestiture. It results in a subsidiary or a division of the company becoming an
independent company. Usually, shares in the new company are distributed to the shareholders of the parent company
on a pro-rata basis.
Intra-period Tax Allocation

The income tax effect of discontinued operations needs to be reported on the income statement separately
from income taxes applicable to continuing operations, and discontinued operations are reported on the
income statement net of their applicable taxes. Therefore, taxes must be allocated on the income
statement between income from continuing operations and income from discontinued opera-
tions.
In addition, any items reported on the balance sheet in accumulated other comprehensive income are to
be reported net of tax. Allocation of tax among income from continuing operations, discontinued operations,
and accumulated other comprehensive income is called intra-period tax allocation (allocation within one
period).
The income tax due should be allocated first to income from continuing operations. The remaining tax due
should be allocated to gains/losses from discontinued operations and items reported in accumulated other
comprehensive income according to each one’s proportion of the total other taxable items.
Benefits of the Income Statement
The income statement helps to predict future cash flows, as follows:

• It helps users to evaluate the company’s past performance and to compare it to the performance of
its competitors.
• It provides a basis for predicting future performance.
• It helps users assess the risk or uncertainty of achieving future cash flows.
Limitations of the Income Statement
Most of the limitations of the income statement are caused by the periodic nature of the income state-
ment. At any particular financial statement date, buying and selling will be in process and some
transactions will be incomplete. Therefore, net income for a period necessarily involves estimates that
affect the company’s performance for the period.
Limitations that reduce the usefulness of the income statement for predicting amounts, timing, and un-
certainty of cash flows include:
• Net income is an estimate that reflects a number of assumptions.
• Income numbers are affected by the accounting methods used. For example, differences in methods
of depreciation can cause differences in the amount of depreciation expense during each year of an
asset’s life. A lack of comparability between and among companies results from these differences in
accounting methods.
• Income measurement requires judgment. For example, the amount of depreciation expense recog-
nized during a period is dependent on estimates regarding the useful lives of the assets being
depreciated.
• Items that cannot be measured reliably are not reported in the income statement. For instance,
increases in value due to brand recognition, customer service, and product quality are not reflected
in net income.
• The income statement is limited to reporting events that produce reportable revenues and expenses.
Some transactions are not reported immediately on the income statement.
Section A Study Unit 3: A.1. The Statement of Comprehensive Income
Study Unit 3: A.1. The Statement of Comprehensive Income

3) Statement of Comprehensive Income
Guidance in the Accounting Standards Codification® on presentation of the statement of comprehensive
income is in ASC 220.
U.S. Generally Accepted Accounting Principles (GAAP) are based on comprehensive income. Comprehensive
income includes all transactions of the company except for transactions made with the owners of the
company (such as distribution of dividends or the sale or repurchase of shares).
Thus, comprehensive income is the change in equity (net assets) of an entity from non-owner sources that
arise during a period from transactions and other events. It includes all changes in equity during a period
except those resulting from investments by owners and distributions to owners.
Comprehensive income includes everything on the income statement plus some specific items that do not
appear on the income statement that are called “other comprehensive income.” Therefore, it is more inclu-
sive than traditional net income. In other words, net income is a part of comprehensive income, but it is
not all of comprehensive income.
Net income flows to retained earnings in equity when the year-end close is performed, so net income ends
up in equity. However, certain specific items are not presented on the income statement. Instead, they go
straight to equity by means of the accumulated other comprehensive income account. Accumulated
other comprehensive income is a line in the equity section of the balance sheet that includes these items
that are not reflected on the income statement.
The word “other” in “accumulated other comprehensive income” refers to the specific items that are other
than income statement transactions and that flow to equity by means of the accumulated other compre-
hensive income account. Even though those items are not on the income statement, those items, along
with net income, are also comprehensive income. Those items are called other comprehensive income
items because they are reported not in net income (and remember, net income is a part of comprehensive
income) but directly in equity. They are other comprehensive income.
Of these specific items, the ones that would increase net income if they were reported on the income
statement are credited to accumulated other comprehensive income, and the ones that would decrease
net income if they were reported on the income statement are debited to accumulated other comprehen-
sive income.
The word “accumulated” in “accumulated other comprehensive income” means that the balance in the
account keeps accumulating. Since accumulated other comprehensive income is a balance sheet account,
it is a permanent account. It is never closed out, and the balance in it keeps accumulating just like any
other balance sheet account. The accumulated other comprehensive income balance in the account may be
referred to as AOCI.
The amount of change in the AOCI account from the beginning of the year to the end of the year is the
net amount of other comprehensive income items that were recorded during the year. The amount of
change in the AOCI account during a period is called simply “other comprehensive income,” or OCI.
“Total comprehensive income” or just “comprehensive income” for a year includes net income for the year
plus other comprehensive income for the year, that is, the net of the other comprehensive income items
that were reported in AOCI during the year.
Study Unit 3: A.1. The Statement of Comprehensive Income CMA Part 1
Note: Comprehensive income for a period is the period’s net income plus or minus the amount of
change during the period in the accumulated other comprehensive income account.
Comprehensive Income
Other Comprehensive
Net Income Income, equal to the
Part of amount of change in AOCI
ComprehensiveIncome Part of
Note: Definitions to know and understand:
• Accumulated Other Comprehensive Income (AOCI) is the name of the balance sheet account
in the equity section of the balance sheet where certain items that are not reported in Net Income
are recorded. The balance in the AOCI account accumulates and is never closed out because it is a
permanent account.
• Other Comprehensive Income (OCI) is the amount of change in the Accumulated Other Com-
prehensive Income account during a period. Other Comprehensive Income is also the net of all the
debit and credit transactions in the AOCI account during the period. When the income statement
covers a one-year period, Other Comprehensive Income for the year is the amount of change in the
Accumulated Other Comprehensive Income account during the year.
• Comprehensive Income is the total of Net Income for the year (or other period such as a quarter)
plus Other Comprehensive Income for the same period.
• The Statement of Comprehensive Income reports both Net Income and Other Comprehensive
Income.
The Statement of Comprehensive Income

According to ASC 220-10-45-1, a company has the option to report comprehensive income, including net
income and other comprehensive income (other comprehensive income is the net of all the transactions
for the year in the accumulated other comprehensive income account) either in a single continuous financial
statement or in two separate but consecutive financial statements.
• If the company chooses to present a single continuous financial statement, it must present it in
two sections: net income and other comprehensive income. It must present:
o Total net income along with the components that make up net income; and
o A total amount for the other comprehensive income along with the components that make up
other comprehensive income.
• If the company chooses to present two separate but consecutive financial statements, it must
present:
o Total net income and the components of net income in the statement of net income; and
o Total other comprehensive income and the components of other comprehensive income in a
statement of comprehensive income that immediately follows the statement of net income.
The statement of comprehensive income must begin with net income.
The items that are considered other comprehensive income items are not reported on the income statement
but instead are reported as a component of equity in the accumulated other comprehensive income account.
They are expressly stated in the standards (ASC 220-10-45-10A). The items currently in this group include:
1) Foreign currency translation adjustments.
2) Gains and losses on foreign currency transactions that are designated as, and are effective as,
economic hedges of a net investment in a foreign entity, commencing as of the designation date.
3) Gains and losses on intra-entity foreign currency transactions that are of a long-term investment
nature (that is, settlement is not planned or anticipated in the foreseeable future), when the enti-
ties to the transaction are consolidated, combined, or accounted for by the equity method in the
reporting entity’s financial statements.
4) Gains and losses on derivative instruments that are designated as, and qualify as, cash flow
hedges.
5) For derivatives that are designated in qualifying hedging relationships, the difference between
changes in fair value of the excluded components and the initial value of the excluded components
recognized in earnings under a systematic and rational method.
6) Unrealized holding gains and losses on available-for-sale debt securities.
7) Unrealized holding gains and losses that result from a debt security being transferred into the
available-for-sale category from the held-to-maturity category.
8) Gains or losses associated with pension or other postretirement benefits that are not recognized
immediately as a component of net periodic benefit cost.
9) Prior service costs or credits associated with pension or other postretirement benefits.
10) Transition assets or obligations associated with pension or other postretirement benefits that are
not recognized immediately as a component of net periodic benefit cost.
11) Changes in fair value attributable to instrument-specific credit risk of liabilities for which the fair
value option is elected.
The items above may each be shown as either net of tax or before related tax effects with one amount
shown for the aggregate income tax expense or benefit related to the total of other comprehensive income.
Study Unit 3: A.1. The Statement of Comprehensive Income CMA Part 1
If a company does not have any items of other comprehensive income in any period presented, it is not
required to prepare a statement of other comprehensive income.
A company must report the accumulated balance of the items of other comprehensive income on the
balance sheet as an element of owners’ equity. Accumulated other comprehensive income should be
reported separately from stock, additional paid-in capital (APIC) and retained earnings.
However, the components of accumulated other comprehensive income may not be presented only as part
of the statement of changes in stockholders’ equity. They must also be reported as described above in a
separate statement of comprehensive income.
Exam Tip: It is possible for a company to have none of these items. However, candidates need to be
able to identify the items that are included as accumulated other comprehensive income items.
An example of a single continuous financial statement presenting net income followed by other comprehen-
sive income follows.
HOCK international books are licensed only for individual use and may not be lent,
copied, sold, or otherwise distributed without permission directly from HOCK
international.
If you did not download this book directly from HOCK international, it is not a
genuine HOCK book. Using genuine HOCK books assures that you have complete, accurate,
and up-to-date materials. Books from unauthorized sources are likely outdated and will not
include access to our online study materials or access to HOCK teachers.
Hard copy books purchased from HOCK international or from an authorized training
center should have an individually numbered orange hologram with the HOCK globe
logo on a color cover. If your book does not have a color cover or does not have this
hologram, it is not a genuine HOCK book.
STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

In thousands, except per share amounts
Year Ended Year Ended

Dec. 31, Dec. 31,
20X3 20X2
Revenues:
Net revenues $10,400 $11,100
Cost of goods sold 3,200 3,400
Gross profit $ 7,200 $ 7,700
Operating expenses:
Research and development $ 3,000 $ 1,800
Selling, general and administrative 1,500 1,700
Total operating expenses $ 4,500 $ 3,500
Operating income $ 2,700 $ 4,200
Non-operating gains/(losses):
Realized gains/(losses) - equity securities 300 500
Unrealized gains/(losses) - equity securities 100 200
Realized gains/(losses) – available-for-sale debt securities ( 44) 290
Financial income and expense:

Interest and dividend income 177 129
Interest expense ( 400) ( 400)
Income before income taxes $ 2,833 $ 4,919

Provision for income taxes ( 708) ( 1,230)
Net income $ 2,125 $ 3,689
Other comprehensive income/(loss) net of tax:

Unrealized gains/(losses) on available-for-sale debt securities
(net of income taxes of $52 in 20X3 and $114 in 20X2) 97 211
Unrealized gain on debt securities reclassified from held-to-maturity to
available-for-sale preparatory to selling (net of income tax of $153)1 283
Reclassification adjustment for gains included in net income
(net of income tax of $153)1 ( 283)
Other comprehensive income/(loss) net of income tax $ 97 $ 211
Comprehensive income $ 2,222 $ 3,900
Basic earnings per common share $ 1.26 $ 2.21

Diluted earnings per common share $ 1.26 $ 2.20
Weighted average common shares outstanding 1,680 1,667
Weighted average common shares outstanding assuming dilution 1,680 1,672
Cash dividends paid per common share $ 0.30 $ 0.60
1 Gross amount included in net security gains on the income statement for
20X2 was $436.
Study Unit 4: A.1. Statement of Owners Equity and Notes to FS CMA Part 1
Study Unit 4: A.1. Statement of Owners Equity and Notes to FS

4) Statement of Changes in Stockholders’ Equity
The statement of changes in stockholders’ equity reports the changes in each account in the stockholders’
equity section of the balance sheet and in total stockholders’ equity during the year and reconciles the
beginning balance in each account with the ending balance. Since stockholders’ equity accounts are per-
manent accounts that keep on accumulating their balances from year to year, information about the sources
of changes in the separate accounts is required to make the financial statements sufficiently informative.
The statement of changes in stockholders’ equity is prepared in columnar form, with a column for each
individual account and a column for total stockholders’ equity. The first line contains the beginning balances;
the sources of the changes are on lines below and identified in the leftmost column; and the final line
contains the ending balances in each account. A statement of changes in stockholders’ equity should be
prepared for every year that comparative financial statements are presented. One statement can be pre-
pared for all the years to be presented, showing beginning balances, activity, and ending balances for each
year. The ending balance for each year becomes the beginning balance for the subsequent year.
Following is an example of a statement of changes in stockholders’ equity.
Statement of Changes in Stockholders’ Equity

Accumu-
Additional lated Other
Preferred Common Paid-in Retained Comprehen-
Stock Stock Capital Earnings sive Income Total
Balance, December 31, 20X1 100 1,650 5,310 3,540 0 10,600
Net income 3,689 3,689
Preferred dividends declared (5) (5)
Common dividends declared (1,023) (1,023)
Issuance of common stock 20 260 280
Other comprehensive income ____ ______ _______ _______ 325 325
Net income 2,125 2,125
Preferred dividends declared (5) (5)
Common dividends declared (528) (528)
Issuance of common stock 15 210 225
Other comprehensive income ____ ______ _______ _______ 149 149
Notes to Financial Statements

Note: Guidance in the Accounting Standards Codification® on presentation of notes to financial state-
ments is in ASC 235.
For an item to be recognized in the main body of an entity’s financial statements, it must meet the definition
of a basic element, be measurable with sufficient certainty, and be relevant and reliable, per SFAC 5. Items
that do not meet those four criteria but are nevertheless integral to the financial statements and essential
to a user’s understanding of items presented within the main body of the financial statements are presented
in the notes to financial statements. Notes are used to amplify or explain the items presented in the main
body of the financial statements.
A complete set of financial statements requires notes to financial statements to present a thorough picture
of a company’s financial position and the results of its operations. The notes are used to explain the items
Section A Study Unit 4: A.1. Statement of Owners Equity and Notes to FS
presented in the main body of the financial statements and the methods used to determine the amounts
reported. For example, if a company recognized a loss in the income statement due to impairment of a
fixed asset, a note is a way to explain how the asset became impaired. The notes can also provide further
breakdown and analysis of certain accounts that are deemed important, such as an analysis of depreciation
recorded for the period. Disclosures in the notes can provide additional relevant information that can be
important to fully understanding the financial statements.
Accounting Policies
The first note is a summary of significant accounting policies, such as what method of depreciation is being
used or how inventories are valued and what cost flow assumption is being used. Accounting policies are
the principles a company uses and considers appropriate to present fairly its financial statements. Disclosure
of accounting policies is used to identify and describe the principles of accounting being followed by the
reporting entity and the methods used for applying the principles that materially affect the determination
of the company’s financial position, cash flows, or results of operations.
Companies should present a disclosure of significant accounting policies used as the first note to the financial
statements or in a separate summary of significant accounting policies section preceding the notes to fi-
nancial statements. The disclosure needs to include important judgments regarding the principles and
methods that involve any of the following:
• A selection from acceptable alternatives available
• Any principles or methods that are unique to the industry in which the company operates, even if
those principles and methods are commonly followed in that industry
• Any unusual or innovative applications of generally accepted accounting principles.
Specific disclosures are addressed in the FASB’s Accounting Standards Codification® within the appropriate
topics. However, ASC 235-10-50-4 does include examples of accounting policy disclosures that are com-
monly required, as follows:
• The basis of consolidation used,
• Depreciation method(s) used,
• Information on amortization of intangibles,
• Inventory pricing,
• Recognition of revenue from contracts with customers, and
• Recognition of revenue from leasing operations.
The summary of significant accounting policies can suggest to the user whether the company is using liberal
or conservative accounting policies. Liberal accounting policies are policies that lead to higher current in-
come, such as longer-then-usual estimated lives for depreciable assets. Conservative accounting policies
lead to lower current income, for example the use of the LIFO inventory cost flow assumption when prices
are rising.
Study Unit 5: A.1. Statement of Cash Flows – Introduction CMA Part 1
Limitations of Financial Statements in General
• Measurements are made in terms of money, so qualitative aspects of a firm are not included. Only
transactions recorded in the accounting records are in the financial statements.
• Information supplied by financial reporting involves estimation, classification, summarization, judg-
ment, and allocation.
• Financial statements primarily reflect transactions that have already occurred; consequently, many
aspects of them are based on historical cost.
• Only transactions involving the entity being reported on are reflected in that entity’s financial reports.
However, transactions of other entities, such as competitors, may be very important.
• Financial statements are based on the going-concern assumption.17 If the going-concern assumption
is invalid and the business is facing liquidation, the appropriate attribute for measuring financial state-
ment items is liquidation value. If a business will be liquidated, it is not appropriate to use historical
cost, fair value, net realizable value, or any other valuation measure for a going-concern’s financial
statements.
Study Unit 5: A.1. Statement of Cash Flows – Introduction

5) The Statement of Cash Flows (SCF)
Guidance in the Accounting Standards Codification® on preparation of the Statement of Cash Flows is in
ASC 230.
Note: This Study Unit contains an overview of the statement of cash flows. Specific information on how
to prepare a statement of cash flows follows it in Study Units 6 and 7.
The statement of cash flows is one of the three main financial statements presented by companies (the
other two are the balance sheet and income statement). The statement of cash flows must be presented
by all businesses, for-profit and non-profit, public and private, whenever the company presents either a
balance sheet and income statement or just an income statement. Thus, if a company presents income
statements only and no balance sheets for prior periods, it must also present the statement of cash flows
for each of the prior periods.
The primary purpose of the statement of cash flows is to provide information regarding receipts and uses
of cash, cash equivalents, restricted cash, and restricted cash equivalents for the company during
a period of time.
17
The going-concern assumption is an assumption that the entity will continue in operational existence for the foresee-
able future.
Section A Study Unit 5: A.1. Statement of Cash Flows – Introduction
Classification Within the Statement of Cash Flows
Note: The term “cash” is used in the context of the statement of cash flows to refer to the total of cash,
cash equivalents, restricted cash, and restricted cash equivalents. The four classifications are combined
for purposes of reporting activities on the statement of cash flows.
The statement of cash flows presents all the receipts and uses of cash of the company during the period.
For the purposes of presentation and usefulness, the cash activities are broken down into three categories
of activities in the statement of cash flows. These three categories are:
1) Operating activities
2) Investing activities
3) Financing activities
Benefits of the Statement of Cash Flows
• The statement of cash flows provides the most information about cash and how the company receives
and spends cash. It helps users to assess the ability of the company to generate positive future cash
flows to meet its obligations as they come due and to pay dividends.
• It helps users to assess the reasons for differences between net income and net cash inflows and
outflows.
• It helps users to assess the effect of investing and financing transactions on the company’s financial
position.
• It helps users to assess the company’s need for external financing. A negative operating cash flow
and a positive financing cash flow indicate the company is financing its operations with either debt or
equity. An examination of the financing section of the statement will reveal whether debt or equity is
being used.
• Lenders can use it to assess the ability of a company to repay a loan.
• Investors can use it to determine if the company will be able to continue to pay its current level of
dividends in the future or whether it might even be able to increase its dividend.
Limitations of the Statement of Cash Flows
• The statement of cash flows shows only how much cash was received and paid out for operating,
investing, and financing activities. For the information on a statement of cash flows to be fully utilized,
it often needs to be interpreted in the context of other information in the other financial statements.
For example, a positive operating cash flow may have been achieved by not paying the payables when
due, an important thing for users to know. For users to recognize the existence of past due payables,
they need to use the balance sheet and income statement.
• The indirect method (covered in detail later) of preparing the operating cash flows section of the SCF
does not show the sources and uses of operating cash individually but shows only adjustments to
accrual-basis net income, a limitation that can cause a user to have difficulty in using the information
presented.
Preparation of the Statement of Cash Flows
Overview of the Preparation of the Statement of Cash Flows

One of the good things about the SCF is that the net cash flow from all three sources combined—operating
activities, investing activities, and financing activities—is known before the statement is prepared. The total
of the net cash flows from operating, investing, and financing activities must be equal to the amount of
change in the balance of cash from the beginning of the period to the end of the period. Because the cash
balances for the prior period and the current period are on the balance sheets, the total increase or decrease
in cash for the period can be easily calculated.
What Is “Cash” on the Statement of Cash Flows?

On the statement of cash flows, “cash” is the total of cash, cash equivalents, restricted cash, and
restricted cash equivalents, even though some of those or all of those four classifications of cash may
be reported on separate lines on the balance sheet. The amount of change in “cash” on the statement of
cash flows is the amount of change in the total of the four classifications.
A cash equivalent is a highly liquid, short-term investment that is easily converted into a known amount
of cash without significant loss in value. Common examples of cash equivalents are money market funds,
commercial paper and Treasury Bills. The definition of cash equivalents usually includes only those invest-
ments that have a maturity of 3 months or less from the date the company acquires the
investment.
Note: Cash or cash equivalents could be restricted for various reasons, such as cash that has been set
aside for future capital investment, retirement of a long-term debt, or compensating balances required
by a lender to support existing borrowing arrangements. “Restricted cash” and “restricted cash equiva-
lents” are specifically not defined in the Accounting Standards Codification®.
Example: A company purchases a 20-year Treasury bond two months before it matures. That Treasury
bond will be classified as a cash equivalent on the company’s balance sheet.
However, if the company had instead acquired the same 20-year Treasury bond two years before its
maturity date, that Treasury bond would never be classified as a cash equivalent on the company’s
balance sheet, even when the financial statement date is 3 months before the Treasury bond’s maturity
date. The Treasury bond’s maturity date was not within 3 months of the date it was acquired, so that
Treasury bond will be classified as an investment on the company’s balance sheet until it matures.
In the preparation of the statement of cash flows, cash equivalents, restricted cash, and restricted cash
equivalents are all considered to be cash. The statement of cash flows must explain the amount of
change during the period in the total of the four classifications of cash. The total of the four classifications
should be used when reconciling the beginning-of-period and end-of-period total amounts shown on the
statement of cash flows.
Note: Movements of cash between and among the cash, cash equivalents, restricted cash, and restricted
cash equivalents classifications are not considered cash flows from operating activities, investing activ-
ities, or financing activities, since those transactions simply exchange one form of “cash” (as cash is
defined for the SCF) for another form of “cash.”
The individual line items and amounts of cash, cash equivalents, restricted cash, and restricted cash equiv-
alents are to be presented on the face of the statement of cash flows or disclosed in the notes to financial
statements. The disclosure may be in either narrative form or tabular form.
Furthermore, in the statement of cash flows, the four classifications of cash are to be described specifically
using descriptive terms such as cash, cash equivalents, and restricted cash, not using ambiguous terms
such as “funds.”
Format of the Statement of Cash Flows

The format for a statement of cash flows is as follows (in this specific order):
Name of Company
Statement of Cash Flows
For the Year Ended XXXX XX, 20XX
Cash flows from operating activities

…… $XXXX
…… XXXX
…… XXXX
Net cash provided by operating activities $XXXXX
Cash flows from investing activities

…… $XXXX
…… XXXX
Net cash provided by investing activities $XXXXX
Cash flows from financing activities

…… $XXXX
…… XXXX
Net cash provided by financing activities $XXXXX
Net increase in cash, cash equivalents, and restricted cash $ XXXX
Cash, cash equivalents, and restricted cash at beginning of year $XXXXX
Cash, cash equivalents, and restricted cash at end of year $XXXXX
Supplemental schedule of noncash investing and financing activities:

• XXXXX
• XXXXX
Note: When the indirect method is used to prepare the cash flows from operating
activities section of the Statement of Cash Flows, a supplemental schedule showing the
amount of cash paid for interest and the amount of cash paid for income taxes must also
be disclosed.
The supplemental schedules of noncash investing and financing activities and the amount of
cash paid for interest and income taxes are disclosures, and they are covered later in this topic
in “Statement of Cash Flows Disclosures” along with other required disclosures.
Cash Inflows and Cash Outflows Presented Separately

Cash inflows and cash outflows for investing and financing activities are to be presented separately from
each other. (Cash flows from operating activities are more complex and are reported differently.)
Example: Cash used for the purchase of fixed assets (cash outflows) should be reported on a separate
line from cash received from the sale of fixed assets (cash inflows), although both are reported as cash
flows from investing activities.
However, if a question asks for net cash flows from a particular activity or for a particular category of
activities, both the inflows and the outflows for that activity must be netted together. If outflows are greater
than inflows, then the net amount will be negative.
Cash Flows in Foreign Currencies

For cash flows in foreign currencies, the exchange rate that was in effect at the time of the cash flow should
be used. However, if the average exchange rate gives a similar result, the average may be used.
Classification of Items Within the Statement of Cash Flows

The SCF presents all the company’s receipts of cash and uses of cash during the period. For the purposes
of presentation and usefulness, the cash activities are broken down into three main categories of activ-
ities:
1) Operating activities
2) Investing activities
3) Financing activities
The sum of the cash flows from the three categories above must equal the net increase or decrease in cash
during the period. The net increase or decrease in cash is also reported in the SCF.
A discussion of what cash flows are included each of the three categories of activities follows.
Note: Candidates should know the specific items listed under each of the three categories, operating
activities, investing activities, and financing activities.
Cash Flows from Operating Activities

Cash flows from operating activities are cash inflows and cash outflows that result from the company’s main
business activities and central operations. In general, any item not classified as either an investing or a
financing activity is an operating activity.
Transactions that cause gains or losses are generally not considered operating activities. Gains and losses
arise from events that do not involve the main business operations of the company. There are a few excep-
tions to this rule, but they are outside the scope of the exam.
The following specific items are classified as operating activities according to the FASB’s Accounting Stand-
ards Codification®, Topic 230, “Statement of Cash Flows”:
• Cash received from customers and cash paid to suppliers in the course of the company’s primary
business activity. Cash paid to suppliers includes principal payments on accounts and on both
short- and long-term notes payable to suppliers.
• Interest paid on bonds and other debt such as loans, finance leases, and mortgages, net of any
amounts capitalized.
• Interest received and dividends received from investments in debt and equity instruments.
• Cash paid to governments for taxes, duties, fines, and other fees or penalties and cash
received back from governments as refunds.
• Payments for the settlement of interest on zero-coupon18 debt instruments.
18
Zero-coupon bonds are sold by the issuer at a price significantly less than the face value. At the maturity date, the
issuer pays the face value of the bond to the investor. The issuer’s interest expense over the term of the bond is the
difference between the face value of the bond and the discounted amount the issuer received for the bond’s sale. The
issuer recognizes a portion of the interest expense each period throughout the term of the bond, but the issuer does not
pay any cash interest until the bond matures. The advantage to the issuer is that it does not need to make any cash
• Cash paid to settle an asset retirement obligation.19
• Cash payments made by an acquirer to settle a contingent consideration liability that are not
made soon after a business combination and that are in excess of the amount of the liability rec-
ognized at the acquisition date.
• Other cash receipts and cash payments that do not stem from transactions defined as investing
or financing activities.20
• Cash receipts and cash payments resulting from purchases and sales of securities classified as
trading securities (debt and equity) are to be classified based on the nature and purpose for
which the securities were acquired.21 Usually, purchases and sales of trading securities are classi-
fied as operating activities.
In addition, certain cash flows related to leases are classified within operating activities according to ASC
842, “Leases,” as follows. (Leases are covered later in this volume.)
Lessees, ASC 842-20-45-5:
• Finance leases: Lessees classify payments of the interest on finance leases according to require-
ments for interest paid in Topic 230, Statement of Cash Flows, generally within operating activities.
(Payments made that reduce the principal portion of the lease liability for a finance lease are
classified by lessees as financing activities.)
• Operating leases: Lessees classify all cash payments arising from operating leases within op-
erating activities as cash outflows from operating activities on the SCF, except to the extent that
those payments represent costs to bring another asset to the condition and location necessary for
its intended use, which should be classified within investing activities.
Lessors, ASC 842-30-45-5 and 45-7:
• Sales-Type and Direct Financing leases: Lessors that are not financial institutions (normally,
dealers or manufacturers) classify the full amount of cash received from sales-type and direct
financing leases—both interest and principal receipts—within operating activities on the SCF. Les-
sors that are financial institutions classify cash receipts from the interest portion only of sales-
type and direct financing leases within operating activities. (Receipts for the principal portion of
sales-type and direct financing leases are classified by financial institution lessors within investing
activities.)
• Operating leases: All lessors classify all cash receipts from operating leases within operating activ-
ities on the SCF.22
outlay for the payment of interest during the life of the bond. However, the issuer is liable for repayment of the full-face
value of the bond at its maturity date.
19
An asset retirement obligation (ARO) is a liability that is established to cover future costs associated with the disman-
tling of an asset when the asset is taken out of production.
20
Per ASC 230-10-45-16 and 45-17.
21
Per ASC 230-10-45-19. Trading securities are defined in the Accounting Standards Codification® as “securities that
are bought and held principally for the purpose of selling them in the near term and therefore held for only a short period
of time. Trading generally reflects active and frequent buying and selling, and trading securities are generally used with
the objective of generating profits on short-term differences in price.” Trading securities may be either debt securities or
equity securities. Trading securities will generally be reported primarily by entities whose primary business is trading,
such as broker-dealers making trades for their own direct market gain, called “proprietary trading.” According to ASC
940-320-45-7, broker-dealers are required to report their trading securities activities in the operating section of the
statement of cash flows.
22
Per ASC 842-30-45-5 and 45-7.
Cash Flows from Investing Activities

Investing activities are activities the company undertakes to generate a future profit from investments.
Common events that are classified as investing activities in the Accounting Standards Codification® (ASC
230-10-45-11 through 45-13) are:
• Purchasing and selling property, plant, and equipment (fixed assets).
• Making and collecting loans to other parties or the sale of loans acquired as investments and, for
financial institutions that are lessors, the principal portion of lease payments received from les-
sees on sales-type and direct financing leases.23
• Acquiring and disposing of available-for-sale or held-to-maturity debt securities.
• Acquiring and disposing of equity instruments other than certain equity instruments carried in a
trading account.
• Payments made by an acquirer to settle a contingent consideration liability that are made soon
after a business combination are investing cash outflows.
• Cash proceeds from the settlement of corporate-owned life insurance policies and other in-
surance settlements that are directly related to investments such as the proceeds of insurance
on a building that was damaged or destroyed are investing cash inflows.
Cash Flows from Financing Activities

Financing activities are activities a company undertakes to raise capital to finance the business and the
repayment of the same. Common events that are financing activities according to the Accounting Standards
Codification® include:
• Proceeds from issuance of stock.
• Treasury stock transactions. (Treasury stock is shares that have been issued and then later re-
purchased by the issuer. Treasury stock is covered later in this volume.)
• Paying cash dividends (note that dividends paid are a financing activity, but dividends received
are an operating activity).
Note: A stock dividend (a dividend paid in shares of company stock) is not included in the
statement of cash flows because a stock dividend does not represent a cash transaction. Stock
dividends are explained in more detail in the Equity Transactions topic in this volume.
• Proceeds from issuing debt such as bonds, mortgages, notes, and payments for debt issuance
costs and repayment of principal on debt obligations.
• Obtaining a loan and repaying the principal of the loan. (The interest portion of loan payments
made is classified within cash flows from operating activities.)
• Debt prepayment or debt extinguishment costs, including call premiums paid and fees paid
to lenders or third parties that are directly related to the debt prepayment or debt extinguishment,
excluding accrued interest.
• Payments not made soon after the acquisition date of a business combination by an acquirer to
settle a contingent consideration liability, up to the amount of liability recognized at the
acquisition date.
• Payments for the settlement of the principal of zero-coupon debt instruments.24
23
Per ASC 842-30-45-5 and ASC 942-230-45-4.
24
Per ASC 230-10-45-14 and 45-15.
• A lessee classifies repayment of the principal portion (lease liability) of finance lease payments
as a financing activity. (The interest portion of payments on finance leases is classified within
operating activities.)25
Net Cash Provided by Operating Activities: Two Methods

Cash flows from operating activities may be calculated and presented in either of two ways: the direct
method and the indirect method.
• The direct method essentially adjusts each line of the income statement to make it a cash number
instead of an accrual number. For example, revenue is adjusted to become cash received.
• The indirect method begins with net income and adjusts the net income figure to remove any
income or expense items that are investing or financing activities and to present the cash flows
from operations instead of the accrual-basis net income.
The direct method and the indirect method are both acceptable under U.S. GAAP for preparing the net cash
flows from operating activities section of the statement of cash flows, but a company must consistently use
the same method each period.
Note: The direct and indirect methods differ only in their presentations of cash flows from oper-
ating activities. Despite the difference in presentations, the end total of net cash flows from operating
activities will be exactly the same under both methods. The difference between the two methods relates
only to the presentation of the information, not to the results.
Overview of the Two Methods
Note: The ICMA’s Learning Outcome Statements for the CMA exams state that candidates need to be
able to prepare a statement of cash flows using the indirect method of determining cash flow from
operating activities. Therefore, preparation of the operating activities section under the indirect method
only will be covered in detail. Preparation of the operating activities section under the direct method will
be described briefly, however, so that candidates can understand how it differs from the indirect method.
25
Per ASC 842-20-45-5a and 45-5b.
The Direct Method

The direct method shows separately each operating activity that caused cash to be spent or received, such
as cash paid to suppliers or cash collected from customers. The direct method presentation is very similar
to the income statement in the lines in the presentation. Three sets of adjustments need to be made to the
income statement line items.
1) Each line on the income statement that represents an operating activity is adjusted to reflect the
cash flows of that item, instead of the accrual accounting amount. For example, revenue is adjusted
to be cash received from customers and cost of goods sold is adjusted to be cash paid to suppliers.
Example: Sales revenue for the year 20X5 was $1,500,000. Beginning accounts receivable (at
year-end 20X4) on the balance sheet was $100,000. Ending accounts receivable (at year-end
20X5) was $125,000.
Cash received from customers during 20X5 was $1,500,000 + $100,000 − $125,000 =
$1,475,000.
The beginning A/R balance is added to the sales revenue for the period because it is assumed
that the amount outstanding in A/R at the beginning of the current period (from sales made
during the previous period) was collected during the current period. The ending A/R balance is
subtracted because that represents sales made during the current period for which the amount
receivable was not collected during the current period.
2) Some income statement items are noncash revenues or expenses, and noncash items are elimi-
nated. Depreciation expense is an example of a noncash income statement item. Even though
depreciation expense is reported on the income statement, the expense does not represent cash
that was paid out during the current period.
3) Some lines on the income statement represent transactions for activities other than operating
activities. For example, the gain or loss on the sale of fixed assets is related to an investing activity
but it is included in net income. The cash received from the sale, which includes any gain or loss
on the sale, will be shown on the statement of cash flows as part of cash provided by investing
activities. Therefore, gains and losses recognized in net income must be excluded from net cash
provided by operating activities so that they are not included twice on the statement of cash flows.
The actual process for preparing the statement of cash flows using the direct method to develop the net
cash flows from operating activities section is outside the scope of the CMA exam and so is not presented
here.
Section A Study Unit 6: A.1. The Indirect Method
Study Unit 6: A.1. The Indirect Method

The Indirect Method
The CMA Part 1 exam requires candidates to be able to prepare a statement of cash flows using the indirect
method for cash flows from operating activities.
Under the indirect method of preparing the cash flows from operating activities section of the statement of
cash flows, all adjustments are made to the net income figure from the income statement. The adjust-
ments for the indirect method are the same as those for the direct method, with adjustments for changes
in balance sheet accounts and the elimination of noncash and non-operating activity transactions. However,
the adjustments are made to the figure on the net income line instead of to the figures on the various
individual lines on the income statement.
Begin with net income as the top line of the operating activities section of the SCF and then adjust net
income by reversing noncash and non-operating items that are included in net income.
Net income is adjusted for four types of items, as follows:
1) Eliminate noncash income and expense items such as depreciation expense that are included in
the income statement. Add items that reduced net income and deduct items that increased net
income.
2) Eliminate investing and financing activity events whose results are included in the income state-
ment, for example gains and losses on the income statement.
3) Include the effect of any operating activities that were not included in net income but that did have
a cash effect. Exclude (eliminate) the effect of any events that are included in net income but that
did not have a cash effect. Examples of these adjustments are those that must be made for changes
in receivables, payables, inventory, and other assets and liabilities.
4) Cash flows from the purchase or sale of trading securities (either debt or equity) will usually be
classified as operating activities, not investing activities. If those cash flows are classified as oper-
ating activities on the SCF, those cash flows must be included as an adjustment to reconcile net
income to net cash from operating activities.
1) Eliminate Noncash Income Statement Items

Perhaps the most obvious example of the required adjustments, and one of the easiest, is the elimination
of depreciation and amortization that has been expensed. Net income will have been reduced by
depreciation and amortization expense, but the company did not pay out any cash related to those ex-
penses. Therefore, the amount of depreciation and amortization expense charged against net income will
need to be added back to net income to determine the net cash from operating activities.
Any other noncash items on the income statement must be eliminated as well. Another type of non-cash
adjustment to net income that needs to be reversed is unrealized gains and losses on securities that have
been recognized in net income. Unrealized gains and losses on securities arise because of changes in the
fair value of securities that are held, and unrealized gains and losses on those securities are charged to net
income in the period in which they occur. However, the unrealized gains and losses do not represent any
cash activity since the securities have not beensold, and therefore they need to be reversed. Unrealized
gains that increase net income should be deducted from net income and unrealized losses that decrease
net income should be added back to net income.
2) Eliminate Investing and Financing Activity Events Included in the Income Statement
The income statement reports the results of all income-generating and expense-generating transactions
the company entered into during the period. However, some of those events are not operating activities.
In calculating cash flows from operating activities using the indirect method, eliminate all the items in the
income statement that do not relate to operating activities. The events that need to be eliminated as non-
Study Unit 6: A.1. The Indirect Method CMA Part 1
operating activities are usually identified on the income statement as gains and losses. Gains and losses
arise from secondary business activities and are therefore not operating activities.
The most common realized gains and losses on the income statement that are eliminated in determining
cash flow from operating activities are:
• Realized gains or losses from the sale of equipment or other fixed assets
• Realized gains or losses on the sale of securities
Note: Unrealized investment holding gains and losses reported on the income statement also need to
be eliminated from net income, as referenced in item 1) above. Since they are noncash transactions,
though, they are not investing or financing activities.
To eliminate realized gains and losses on the income statement from cash flows from operating activities in
the preparation of cash flows from operating activities using the indirect method, gains are subtracted
from net income and losses are added back to net income.
Each investing or financing activity event that gave rise to a realized gain or loss must be included in the
SCF in either the investing or financing activities section. However, each event will be included at the cash
amount of the transaction, not at the amount of the gain or loss from the transaction.
3) Individual Account Adjustments

After taking out the noncash items and investing and financing activity items, the company next needs to
adjust net income for changes in individual asset and liability accounts that are related to operating activi-
ties. The following adjustments are all made to net income.
Net Accounts Receivable
An adjustment needs to be made to net income for the change in the net accounts receivable26 balance
over the period.
If net accounts receivable increases during the period, it means that customers bought a greater value
of goods that they have not yet paid for than customers who bought goods in the previous period and paid
for them in the current period. Therefore, the increase in net accounts receivable means that cash collec-
tions during the period were lower than the revenue recognized during the period. The amount of the
increase in net accounts receivable will need to be subtracted from net income because not all the cash
corresponding to the amount of revenue recognized during the period was received during the period.
On the other hand, if the net accounts receivable balance decreases during the period, it means that
the company collected more cash from the previous period’s sales (for example, sales made in December
of last year) than it failed to collect from the current period’s sales (for example, sales made this December).
The decrease in net accounts receivable over the period will therefore need to be added to net income to
properly calculate the cash received from operating activities during the period.
Note: When the operating activities section is being prepared according to the indirect method, always
use the amount of change in net accounts receivable, not the amount of change in gross accounts
receivable.
Note: Any other receivable account that affected net income will need a similar adjustment made for it.
26
Net accounts receivable is gross accounts receivable less the balance in the allowance for credit losses on receivables
account, since the allowance for credit losses account is a valuation account that decreases the balance in accounts
receivable to a level the company thinks is collectible.
Inventory
An increase in inventory during the period indicates that the company has paid cash for inventory items
that have not yet been expensed as cost of goods sold. Therefore, the amount of increase in the inven-
tory account needs to be subtracted from net income.
Similarly, a decrease in the inventory account needs to be added to net income.
Note: Just because the inventory account has increased, that does not mean cash was paid for the
purchased inventory. However, if the company did not yet pay for some of the purchased inventory, the
company will have an increase in payables that will also be an adjustment in calculating net cash flows
from operating activities, as covered in the next topic.
Accounts Payable
As with accounts receivable, an adjustment will also need to be made to reflect the change in the accounts
payable balance during the period.
Accounts payable are related to the “cost of goods sold” line on the income statement because cost of goods
sold on the income statement is calculated using, among other things, the amount of inventory purchased
during the year. If the company purchased inventory but did not pay for it during the year, its accounts
payable balance will be higher at the end of the year. The company has recognized an increase in an asset
account (inventory), which is considered a decrease in cash, but the company has not yet actually paid for
some of it. Similarly, if the company has made other purchases that are period costs such as selling, general
and administrative items that it has not yet paid for but has recognized as expenses, the income statement
will include expenses that have not yet actually been paid for.
Therefore, any increase in accounts payable must be added back to net income because it represents
increases in assets and expenses for which the cash has not yet been paid.
On the other hand, a decrease in accounts payable means that the company paid for items this year that it
purchased during the previous year and thus were expensed during the previous year. To create the equiv-
alent of a cash basis net income, the amount of the decrease in accounts payable will need to be
subtracted from net income.
Example: If a company started in business on December 30 and its only activity during the year was to
buy $100 of inventory on credit, the cash flows for the year would be $0. Also, the company’s net income
would be $0. Additionally, the company’s inventory account will have increased by $100 and accounts
payable will have increased by $100.
Based on the needed adjustments above, a deduction of $100 would need to be made from net income
because of the increase in inventory. An addition of $100 would also need to be made to net income
because of the increase in accounts payable. These two adjustments net to $0, which would be the net
cash from operating activities for the company.
Note: Any other payable (for example, salaries payable) or other liability account that affected net
income will need a similar adjustment made for it.
General Rules for Operating Activity Asset and Liability Accounts

The following rules should be used to adjust net income by the amount of change in operating activity asset
and liability accounts when calculating net cash flows from operating activities using the indirect method.
Operating Asset Accounts
 The amount of an increase in an asset account should be deducted from net income.
 The amount of a decrease in an asset account should be added to net income.
Operating Liability Accounts
 The amount of an increase in a liability account should be added to net income.
 The amount of a decrease in a liability account should be deducted from net income.
The rule is that assets adjust net income to cash flow in the opposite direction from the direction of
change in the account balance. Liabilities adjust net income to cash flow in the same direction as the
account balance changes.
Bond Discount or Premium Adjustments 27

A bond discount decreases the valuation of the related bond on the balance sheet, whether the bond
discount is a contra-asset (that is, contra to a bond carried as an investment asset) or a contra-liability
(that is, contra to a bond issued by the company as debt and carried as a liability). Regular amortization
of the discount increases the net carrying value of the related asset or liability.
• For an investor, amortization of a discount increases reported interest income.
• For an issuer of a bond (the debtor), amortization of a discount increases the reported interest
expense.
A bond premium works in the opposite way. The premium increases the valuation of the bond on the
balance sheet. As the premium is amortized, the amortization results in a decrease to the net carrying
value of the asset or liability.
• For an investor, amortization of a premium decreases reported interest income.
• For an issuer of a bond (the debtor), amortization of a premium decreases reported interest ex-
pense.
Thus, transactions recorded in bond discount and premium accounts to amortize the discount or premium
represent noncash transactions that nonetheless affect the income statement. Changes in bond discount
and premium accounts require adjustments to the net income figure just as do changes to other assets and
liabilities.
The required adjustments to net income for amortization of bond discounts and premiums when calculating
net cash flow from operating activities are as follows:
For a bond that is held as an investment:
• Amortization of a discount increases the asset and increases the amount of interest income
reported (and thus increases net income) and so the amount of the amortization—the amount of
change in the bond discount account on the balance sheet—is deducted from net income.
• Amortization of a premium decreases the asset and decreases the amount of interest in-
come reported (and thus decreases net income) and so the amount of the amortization—the
amount of change in the bond premium account on the balance sheet—is added to net income.
27
For full information on the process of accounting for debt securities and amortization of discounts and premiums by
both the issuer and the investor, please see any intermediate accounting textbook.
For a bond that has been issued as debt:
• Amortization of a discount increases the liability and increases the amount of interest ex-
pense reported (and thus decreases net income) and so the amount of the amortization—the
amount of change in the bond discount account on the balance sheet—is added to net income.
• Amortization of a premium decreases the liability and decreases the amount of interest
expense reported (and thus increases net income) and so the amount of the amortization—the
amount of change in the bond premium account on the balance sheet—is deducted from net
income.
4) Cash Flows from the Purchase and Sale of Trading Securities

Trading securities may be either debt securities or equity securities. Trading securities are defined in the
Accounting Standards Codification® Glossary as “securities that are bought and held principally for the
purpose of selling them in the near term and therefore held for only a short period of time. Trading generally
reflects active and frequent buying and selling, and trading securities are generally used with the objective
of generating profits on short-term differences in price.”
Cash flows from the purchase and sale of trading securities are classified based on the nature and purpose
for which the securities were acquired.28
Trading securities will generally be reported only by entities whose primary business is securities trading,
such as broker-dealers making trades for their own direct market gain, called “proprietary trading.” Accord-
ing to ASC 940-320-45-7, broker-dealers are required to report their trading securities activities in the
operating section of the statement of cash flows. Other entities that carry securities in a trading account
should classify their cash flows on the SCF as either operating activities or as investment activities, accord-
ing to management’s judgment as to the nature and purpose for which the securities were acquired.
If cash received from the sale of trading securities or cash paid for the purchase of trading securities is
classified on the SCF within operating activities, those cash flows will be another adjustment to reconcile
net income to net cash from operating activities.
Remember that in calculating cash flows from operating activities under the indirect method, realized gains
or losses on the sale of all securities (including trading securities) are backed out of net income in Item 2,
Eliminate Investing and Financing Activity Events Included in the Income Statement. The entire cash inflow
from any sale of trading securities (not just the gain) and the entire cash outflow for any purchases of the
same need to be included in cash flows from operating activities (not investment activities) if it is appropri-
ate to report cash flows from trading securities activities as operating activities.
Summary: The Indirect Method

Below is a summary of the steps to prepare the operating activities section under the indirect method. They
are presented to show how all the items discussed above fit together.
1) Add all depreciation and amortization expense back to net income.
2) Add all non-operating losses on the income statement back to net income.
3) Subtract all non-operating gains on the income statement from net income.
4) Add and subtract the changes in balance sheet accounts that are related to operating
activities: net accounts receivable, accounts payable, inventory, other payables and receivables,
28
Trading securities will generally be reported only by entities whose primary business is trading, such as broker-dealers
making proprietary trades. Trading securities are securities bought and held principally for the purpose of selling them
in the near term with the objective of generating profits on short-term differences in price. Trading securities are therefore
held for only a short period of time, sometimes only minutes or seconds.
bond discount or premium amortization, and other assets and liabilities. All these items are ad-
justments to net income in accordance with the rules set out in the General Rules for Operating
Activity Asset and Liability Accounts above.
5) If purchases and sales of trading securities are to be classified as operating activities, subtract
cash used for purchasing trading securities and add cash received for trading securities that were
sold.
6) In addition to the above adjustments, the cash amounts for income taxes paid and interest
paid need to be disclosed in a supplemental schedule.
Exam Tip: If an exam problem requires the use of the indirect method and does not give the amount
of net income for the period, net income can usually be calculated by analyzing the amount of change in
retained earnings from one year end to the next year end. Retained earnings are increased by net income
and reduced by any dividends declared during the period. Therefore, by using the beginning and ending
retained earnings balances and the total dividends declared, if any, the amount of net income for the
period can be calculated.
Example: Beginning retained earnings equal $200,000. Ending retained earnings equal $350,000. Div-
idends were declared in the amount of $60,000 during the period. What was net income during the
period?
Beginning retained earnings + Net income – Dividends declared = Ending retained earnings
$200,000 + Net income – $60,000 = $350,000
Net income = $210,000
The Two Methods Compared and Contrasted

Both the direct method and the indirect method of preparing the operating activities section of the SCF
produce the same result for net cash provided by operating activities because the same adjustments are
made under both methods to the amounts on the income statement. The difference is that under the direct
method each individual line on the income statement is adjusted and each individual type of operating
cash flow is presented, whereas under the indirect method the net income figure is adjusted and only the
net operating cash flow is presented.
Disclosures differ between the two methods, as well, and those are covered in the next unit.
Section A Study Unit 7: A.1. Investing and Financing Activities, SCF Disclosures
Study Unit 7: A.1. Investing and Financing Activities, SCF Disclosures

Investing and Financing Activities
Cash Flows from Investing Activities

The cash inflows and outflows from investing activities are those related to the items included in investing
activities.
Exam Tip: Exam questions on the statement of cash flows often center on the sale of fixed assets.
Usually, some of the information needed to answer the question will be provided as “Other Additional
Information.”
The main issue in calculating net cash provided by investing activities will probably be the purchase or sale
of property, plant, or equipment. Remember that the amount reported in the investing activities section of
the statement of cash flows is the amount of cash received or paid.
• For an asset purchase, the amount paid for the asset is reported in the SCF.
• For the sale of an asset, the amount of cash received for the asset is reported in the SCF.
Information regarding the gain or loss on the sale of the asset is not the amount that is used in calculating
cash flows from investing activities, nor is the book value of the asset sold used, although the book value
of the asset and the gain or loss on the sale are used to calculate the amount of cash received from the
sale. However, neither the book value nor the gain or loss are used individually, and they should not be
included in the statement of cash flows.
Note: Any gain or loss on the sale of fixed assets included in net income needs to be eliminated from
net income when calculating net cash flows from operating activities using the indirect method.
An exam question may not directly give the amount received for the sale of an asset. Instead, the amount
received may need to be calculated using the book value and gain or loss on the sale.
Example: Knox Co. sold a fixed asset that had an original cost of $20,000 and accumulated depreciation
of $12,000 at the time of the sale. Knox realized a gain of $5,000 on the sale.
Although the amount of cash received on the sale is not provided, it can be calculated from the infor-
mation that is provided, as follows.
At the time of the sale, the asset had a net book value of $8,000: $20,000 cost less $12,000 accumulated
depreciation. Since the asset was sold at a $5,000 gain, Knox must have received $5,000 more than the
book value of $8,000, or $13,000, for the sale. The $13,000 cash received from the sale of the equipment
is presented on the statement of cash flows as a cash inflow from investing activities.
In addition, the $5,000 gain will be an adjustment to net income in calculating net cash flows from
operating activities when the statement of cash flows is prepared using the indirect method, which begins
with net income. The gain is included in net income, but it is not an operating cash flow. Therefore, the
$5,000 gain must be deducted from net income when calculating net cash flow from operating activities
because it is included instead in investing activities in the $13,000 cash received from the sale of the
fixed asset.
Study Unit 7: A.1. Investing and Financing Activities, SCF Disclosures CMA Part 1
Cash Flows from Financing Activities

Cash flows from financing activities are calculated in the same manner as those for investing activities.
Again, only the amount of cash in the transaction is used. For example, only the amount of cash paid
to redeem an outstanding bond issue before its maturity date, including any premium paid due to the early
redemption, is reported in the SCF, not the book value of the bond on the date of the redemption nor the
gain or loss on the early extinguishment of the debt. However, as was the case with investing activities,
the information on the book value and the gain or loss may be needed to calculate the amount of cash
actually paid to redeem the bond.
Note: In reporting investing and financing activities, do not net together cash paid and cash re-
ceived amounts, even when they are for the same classification of items. For example, the statement
of cash flows should have separate lines for “Cash paid to purchase equipment” and “Cash received from
the sale of equipment.”
Statement of Cash Flows Disclosures
Noncash Investing and Financing Activities
Note: Noncash investing and financing activities are reported in a schedule below the SCF. While it is
not really a fourth category of cash activities, think of it as a fourth category of the SCF. Do not forget
about these noncash transactions if a problem requires the preparation of a complete SCF.
Some investing and financing activities are not included on the face of the statement of cash flows (meaning
within the statement itself) because they are noncash investing or financing transactions. Examples of
noncash investing and financing transactions are:
• Debt converted to equity.

• Borrowing money to purchase a fixed asset when the lender pays the loan proceeds directly to the
seller of the asset to make sure the loan proceeds are used as intended, or when the seller provides
the financing.
• Obtaining a right-of-use asset in exchange for a lease liability.
• Buying or selling fixed assets for something other than cash (for example, stock).
• Obtaining a building or other item by gift.
• Exchanging noncash assets or liabilities for other noncash assets or liabilities.
Even though no cash is involved in these transactions, they need to be disclosed in the statement of cash
flows if they affect recognized assets or liabilities.
Disclosure of noncash investing or financing activities is required because these events may be very im-
portant for a potential investor to know about. For example, if the company makes a practice of issuing
new shares to acquire fixed assets, the disclosure of that fact will let the potential investor know that his or
her ownership share will be diluted as the company buys fixed assets.
Noncash investing or financing activities may be presented as either a narrative or summarized in a sched-
ule.
Note: A stock dividend (a dividend paid in shares of company stock) is not included in the statement of
cash flows because a stock dividend does not represent a cash transaction. It is also not disclosed as a
non-cash transaction on the statement of cash flows, because it does not affect recognized assets or
liabilities. A stock dividend affects the components of equity only. Stock dividends are explained in more
detail in the Equity Transactions topic in this volume.
Section A Study Unit 7: A.1. Investing and Financing Activities, SCF Disclosures
Cash Equivalents Policy Disclosure

The company must disclose how it determines which items are treated as cash equivalents, and if that
policy is changed, it is to be accounted for as a change in accounting principle that is put into effect by
restating financial statements for any earlier years that are presented for comparison purposes.
Cash Interest and Income Taxes Paid Disclosure

When the indirect method is used to prepare the operating activities section of the SCF, two items must
be disclosed:
1) the amount of cash paid for interest (net of amounts capitalized), including the portion of the
payments made to settle zero-coupon debt instruments attributable to accreted interest related to
the debt discount or the portion of payments made to settle other debt instruments with coupon
interest rates that are insignificant in relation to the effective interest rate attributable to accreted
interest related to the debt discount, and
2) the amount of cash paid for income taxes during the period.
The disclosures are required because when the indirect method is used to prepare the operating activities
section, the cash paid for interest and income taxes will not be reported separately in the SCF, and users
need to know the individual item amounts. The disclosures are made at the end of the SCF as a supple-
mental schedule.
When the direct method is used to prepare the operating activities section, cash paid for interest and cash
paid for income taxes are reported within the statement of cash flows and need not be separately disclosed.
Reconciliation of Net Income to Net Cash Flow from Operating Activities Required
A reconciliation of net income and net cash flow from operating activities is required regardless of whether
the direct or indirect method of reporting net cash flow from operating activities is used, although it may
be presented differently under the direct and the indirect methods.
• When the operating activities section of the SCF is prepared using the direct method, a reconcili-
ation between net income and net cash flows from operating activities must be provided in a
separate schedule.
• When the indirect method is used, the reconciliation may be reported within the statement of
cash flows, or it may be provided in a separate schedule with the statement of cash flows report-
ing only the net cash flow from operating activities.
Note: An Excel spreadsheet is posted in My Studies containing an example of a statement of cash flows
prepared using the indirect method. The Excel file contains worksheets for three years of balance sheets,
three years of income statements, and two years of statements of cash flows. The amounts in the state-
ments of cash flows have been calculated using formulas that show where in the balance sheets and
income statements the numbers come from.
Study Unit 8: A.1. Integrated Reporting CMA Part 1
Study Unit 8: A.1. Integrated Reporting

Introduction to Integrated Reporting
“Integrated reporting” is the most recent development in a movement that emphasizes corporate reporting
on non-financial information relating to an organization’s corporate citizenship. An integrated report incor-
porates non-financial information along with the financial information provided in financial reports and
shows how the financial information is influenced by the non-financial information over the short, medium,
and long term.
What is Non-financial Information and Why Report It?

The public has come to perceive corporations as prospering at the expense of the broader community,
thereby causing social, environmental, and economic problems, and that is not an incorrect perception.
Corporations have in the past caused many problems for themselves and others because they have viewed
value creation narrowly, as optimizing short-term financial performance for the benefit of their sharehold-
ers. This short-term focus on wealth-building for shareholders has caused corporations to overlook the
broader influences that determine their long-term success. The result has been long-term problems such
as depletion of natural resources that will be vital to their businesses in the future, a lack of caring about
the economic viability of their suppliers, and economic distress in their communities due to having shifted
more and more of their production activities to lower-wage locations.
According to Michael E. Porter and Mark R. Kramer in The Big Idea: Creating Shared Value, the problems
caused by corporations’ short-term focus can be addressed by generating “shared value,” that is, creating
economic value for the company and its shareholders in a way that also creates value for society. Porter
and Kramer define “shared value” as policies and operating practices that enhance the competitiveness of
a company while simultaneously advancing the economic and social conditions in the communities in which
it operates. Through shared value creation, a corporation can link its operations to generating long-term
value both for its shareholders and for society while reducing the corporation’s negative impacts on society.
Thus, shared value is a new way of achieving economic success. A corporation that is creating shared value
defines its success in terms of both internal financial returns and external social and economic results.29
Along with this change in focus, corporate reporting needs to change, as well. Financial statements alone
cannot communicate the full value of a corporation because they report historical financial performance
only. They cannot provide information about the long-term value-creation potential of a corporation.
The Movement to Report Non-Financial Information

The movement to report on non-financial information actually originated in the 1950s to early 1960s in
response to the needs of information users, later called “stakeholders,” for information beyond what was
presented in financial statements to better explain the value-creation process of the organization as well as
its material non-financial risks.
An organization’s stakeholders include all those who are affected by its actions and include its employees,
managers, owners, customers, suppliers, society, government, and creditors. According to stakeholder the-
ory, business can be understood as a system of how value is created for stakeholders—in contrast to the
idea that a corporation’s sole responsibility is to maximize value for its shareholders. The stakeholder
worldview connects business and capitalism with ethics.30
Over the years, two separate but compatible concepts have emerged, one becoming “corporate social re-
sponsibility” and the other becoming “sustainable development.” Corporate social responsibility focuses on
29
Michael E. Porter and Mark R. Kramer, The Big Idea: Creating Shared Value, Harvard Business Review, January-
February 2011. https://hbr.org/2011/01/the-big-idea-creating-shared-value
30
The concept of stakeholders and stakeholder theory was introduced by R. Edward Freeman in Strategic Management:
A Stakeholder Approach, Pitman Publishing, Boston (1984).
Section A Study Unit 8: A.1. Integrated Reporting
organizations’ impacts on society, and sustainable development focuses on organizations’ meeting the
needs of the present without compromising the ability of future generations to meet their own needs.
ISO 26000, Guidance on Social Responsibility, is an international standard that was introduced in 2010 and
aids organizations in structuring, evaluating, and improving their social responsibility, including their stake-
holder relationships and community impacts. It sets forth society’s expectations about what constitutes
socially responsible behavior.
ISO 26000’s definition of social responsibility incorporates sustainable development under the umbrella of
social responsibility. According to ISO 26000, social responsibility is an organization’s responsibility for the
impacts of its decisions and activities on society and the environment through transparent and ethical
behavior that:
1) Contributes to sustainable development, including the health and welfare of society,
2) Takes into account the expectations of stakeholders,
3) Complies with applicable law and is consistent with international norms of behavior, and
4) Is integrated throughout the organization and practiced in its relationships.
ISO 26000 provides guidance on how an organization can be socially responsible, but it does not provide a
framework for reporting on social responsibility. The earliest framework for reporting on social responsi-
bility and sustainable development activities was introduced by the Global Reporting Initiative (GRI). GRI
is a non-governmental organization (NGO), founded in the U.S. in Boston, Massachusetts in 1997 to support
economic, environmental, and social sustainability. Since 2002, GRI has been headquartered in Amsterdam,
The Netherlands. The first GRI reporting guidelines, Sustainability Reporting Guidelines on Economic, Envi-
ronmental, and Social Performance, were launched in 2000, and GRI has updated them several times since.
The GRI framework has become an international standard for reporting on environmental and social re-
sponsibility, including sustainability, and economic performance.
Reporting Requirements
The U.S. has no mandatory non-financial reporting requirements other than some required disclosures
about mine safety and conflict minerals. However, many of the largest U.S. companies prepare non-financial
reports on a voluntary basis.
Many countries outside the U.S. have mandatory non-financial reporting requirements. Some examples
follow but are not exhaustive.
In 2014, the European Commission issued a Directive (Directive 2014/95/EU) on disclosure of non-financial
and diversity information by large, public-interest entities (listed companies, banks, insurance companies,
and other companies designated as such by authoritative bodies) and generally having more than 500
employees. Each EU-member country was required to adopt the Directive into its own legislative require-
ments, though member countries were allowed some flexibility in adapting the terms. Affected companies
were required to apply the Directive under the terms legislated by their own countries as of 2018 for fiscal
years beginning on or after January 1, 2017.
Covered EU companies are required to report on policies, risks, and program outcomes related to environ-
mental protection, social responsibility, treatment of employees, respect for human rights, and
anticorruption and bribery matters. Companies licensed to trade securities must also issue a diversity report
containing information about age, gender, and professional and educational backgrounds at different man-
agement levels. Non-financial statements may be presented to stakeholders either in the company’s annual
report or as a separate report published alongside the annual report or within six months of the balance
sheet date. The Directive requires a statutory auditor or an audit firm to verify that the required non-
financial disclosures have been published, but it does not require an auditor’s assurance report with respect
to the content.
South Africa was the first country to include integrated reporting in its official reporting requirements. The
King Code of Governance for South Africa 2009 (King III) stated that “the board should appreciate that
strategy, risk, performance, and sustainability are inseparable” and recommended that companies prepare
an integrated report including non-financial information along with financial information. The principles of
King III were incorporated into the listing requirements of the Johannesburg Stock Exchange (JSE), and
listed companies are required to prepare an integrated report or explain why they are not doing so. How-
ever, King III did not contain guidelines on how the report should be structured or what it should include.
The reporting requirement coupled with the dearth of guidelines led to the birth of the Integrated Reporting
Committee (IRC) of South Africa, a national body that brought together accountants, companies, internal
auditors, directors, institutional investors, the JSE, and others with an interest in corporate reporting. The
IRC of South Africa developed a framework for an integrated report in 2011, and that framework was used
as a starting point for the development of the International Integrated Reporting Council’s (IIRC) Interna-
tional <IR> Framework, which was issued in 2013.
The International <IR> Framework

The International Integrated Reporting Council was founded in August 2010 as the International Integrated
Reporting Committee, bringing together a cross-section of representatives from the corporate, investment,
accounting, securities, regulatory, academic, and standard-setting sectors as well as civil society. The IIRC’s
stated purpose was to create a globally accepted framework for a process that results in communications
by an organization about value creation over time.31 The group’s work product, the International <IR>
Framework, was published in December 2013.
According to its website, today the International Integrated Reporting Council (IIRC) is a global coalition of
regulators, investors, companies, standard setters, the accounting profession, and non-governmental or-
ganizations (NGOs). The coalition promotes communication about value creation as the next step in
the evolution of corporate reporting.32 Value creation is defined in the Framework as “the process that
results in increases, decreases, or transformations of the capitals33 caused by the organization’s business
activities and outputs.”34
• The IIRC’s mission is “to establish integrated reporting and thinking within mainstream business
practice as the norm in the public and private sectors.”
• The IIRC’s vision is “to align capital allocation and corporate behavior to wider goals of financial
stability and sustainable development through the cycle of integrated reporting and thinking.”
• The IIRC’s objective is “to change the corporate reporting system so that integrated reporting
becomes the global norm.”35
31
Per https://www.iasplus.com/en/resources/sustainability/iirc, accessed February 5, 2019.
32
Per http://integratedreporting.org/the-iirc-2/, accessed February 5, 2019.
33
“Capitals” are the resources organizations use in the production of goods or the provision of services. Capitals are
discussed in detail later in this topic.
34
The International Integrated Reporting Committee (IIRC), The International <IR> Framework, December 2013, Glos-
sary, p. 33, http://integratedreporting.org/resources/, accessed January 24, 2019.
35
Per http://integratedreporting.org/the-iirc-2/, accessed February 5, 2019.
The International <IR> Framework introduces the concept of reporting non-financial information as an
integral part of the annual report that may be read by all stakeholders. Originally, an organization’s
stakeholders included those who could be expected to be significantly affected by the organization’s busi-
ness activities. The IIRC expanded the definition of stakeholders in the Framework to include those whose
actions can be expected to significantly affect the organization and also expanded the list of those groups
identified as stakeholders, as follows:
[Stakeholders are] Those groups or individuals that can reasonably be expected to be sig-
nificantly affected by an organization’s business activities, outputs or outcomes, or whose
actions can reasonably be expected to significantly affect the ability of the organ-
ization to create value over time [emphasis added]. Stakeholders may include providers
of financial capital, employees, customers, suppliers, business partners, local communities,
NGOs, environmental groups, legislators, regulators, and policymakers.
Integrated Report, Integrated Reporting, Integrated Thinking, and Their Relationships

The Framework builds on the concepts of corporate social responsibility and sustainable development, but
it also introduces new and enhanced concepts.
An integrated report is defined by the IIRC in the Framework as:
A concise communication about how an organization’s strategy, governance, performance

and prospects, in the context of its external environment, lead to the creation of value over
the short, medium, and long term.
Integrated reporting is defined in the Framework as:
A process founded on integrated thinking that results in a periodic integrated report by an

organization about value creation over time and related communications regarding aspects
of value creation.
Integrated thinking is defined in the Framework as:
The active consideration by an organization of the relationships between its various oper-
ating and functional units and the capitals [see next topic] that the organization uses or
affects. Integrated thinking leads to integrated decision-making and actions that consider
the creation of value over the short, medium, and long term.
Integrated thinking is an important concept in integrated reporting. When integrated thinking is a part of
all of an entity’s activities, management reporting will naturally incorporate the non-financial information
into its management reporting, analysis, and decision-making. Information systems will be better integrated
and better able to support both internal and external reporting and communication.36
The “Capitals”
Organizations depend on various forms of capital for success. “Capitals” are the resources an organization
uses in producing and providing products and services. The capitals are stocks of value that are increased,
decreased, or transformed by the activities and outputs of the organization. The Framework discusses six
capitals:
Financial capital is the pool of funds available to an organization to use in the production of goods or the
provision of services. It is funds obtained through financing activities such as debt, equity, or grants or
generated through the reinvestment of funds obtained from operations or investments. Financial capital is
increased when a corporation earns a profit or obtains additional financing.
36
<IR> Framework, Glossary, p. 33.
Manufactured physical capital is manufactured physical objects available to an organization for use in
the production of goods or the provision of services. Manufactured capital includes property, plant, and
equipment that belong to the organization, but it includes much more, as well. It includes external manu-
factured assets or infrastructure available to the organization such as roads, bridges, and waste and water
treatment plants. It also includes assets manufactured by the reporting organization for sale or for retention
by the organization for its own use.
Intellectual capital results from employees’ efforts that generate intangible assets. Thus, it is intellectual
property such as patents, copyrights, software, rights, and licenses. It is also “organizational capital” such
as knowledge, systems, procedures, and protocols.
Human capital is the skills, capabilities, and experiences of people. It includes employees’ motivations to
innovate, their alignment with and support for the organization’s governance framework, approach to risk
management, and ethical values; their ability to understand, develop and implement the organization’s
strategy; and their loyalties and motivations for improving processes, goods, and services. It also includes
their ability to lead, manage, and collaborate. The quality of a company’s human capital is improved when
employees become better trained.
Social and relationship capital derives from the relationship between a company and the society from
which it secures its license to operate. It is the institutions as well as the relationships within and between
communities, groups of stakeholders, and the ability to share information to enhance individual and collec-
tive well-being. It includes intangibles associated with the brand recognition and reputation that an
organization has developed and the willingness to engage that the organization has with external stake-
holders.
Natural capital is renewable and non-renewable natural and environmental resources such as air, water,
land, forests, and minerals that provide goods or services supporting the past, current, or future prosperity
of an organization. Natural capital also includes the health and biodiversity of the ecosystem.
The capitals serve as part of the theoretical underpinning for the concept of value creation within the
Framework.37
The Purpose and Goals of Integrated Reporting

An integrated report is a single report that presents both financial and non-financial information in a manner
that emphasizes the whole picture and the interdependence of its parts. It communicates how an organi-
zation's strategy, governance, performance, and prospects lead to the creation of value in the context of
its external environment in the short, medium, and long term.
The primary purpose of an integrated report is to explain to providers of financial capital how an organi-
zation creates value over time. An integrated report also benefits all stakeholders that are interested in the
organization’s ability to create value, including employees, suppliers, business partners, local communities,
legislators, regulators, and policymakers.38
The IIRC’s goal is a world in which integrated thinking is embedded within mainstream business practice in
the public and private sectors. The IIRC sees integrated reporting as facilitating that vision. Thus, the goals
of integrated reporting are to:
• Improve the quality of information available to providers of financial capital to enable more efficient
and productive allocation of capital.
• Promote a more cohesive and efficient approach to corporate reporting that draws on different
reporting strands and communicates the full range of factors that materially affect the ability of an
organization to create value over time.
37
<IR> Framework, §2C, pp. 11-12.
38
<IR> Framework, p. 4.
• Enhance accountability and stewardship for the broad base of capitals (financial, manufactured,
intellectual, human, social and relationship, and natural) and promote understanding of their in-
terdependencies.
• Support integrated thinking, decision-making, and actions that focus on the creation of value over
the short, medium, and long term.39
Value Creation for the Organization and Others

Value creation is the process of creating outputs that are more valuable than the inputs used to create
them. An organization’s business activities and outputs create value over time. An organization’s ability to
create value for itself enables financial returns to the providers of its financial capital.
The value created is manifested by increases, decreases, or transformations of the capitals. The
value is created for
• the organization, enabling financial returns to the providers of financial capital, and
• others, including all stakeholders and society at large.
Note: The value created by the organization for itself is interrelated with the value it creates for stake-
holders and society at large. The ability of an organization to create value for itself is dependent
on the value it creates for others.
An organization creates value through making sales, which creates changes in financial capital. However, a
wide range of other activities, interactions, and relationships also create value. Those other activities, in-
teractions, and relations include but are not limited to:
• Effects of the organization’s business activities and outputs on customer satisfaction,

• Suppliers’ willingness to trade with the organization and the terms under which they do it,
• Initiatives the organizations’ business partners agree to undertake with the organization, and
• The imposition of supply chain conditions or legal requirements.
An integrated report should include the other interactions, activities, and relationships to the degree that
they are material to the organization’s ability to create value.
Note: Value is created when the benefit derived from its use of capitals is greater than the capitals used.
Value is preserved when it is maintained through continuous improvement, superior quality, superior
service, and customer satisfaction. Value is diminished when poor strategy or poor execution causes
goals not to be achieved. Value is created, preserved, and diminished by management decisions in all
areas, from strategy setting to daily operations.
An integrated report should include the extent of the effects on capitals that are not owned by the organi-
zation, or externalities. Externality is primarily an economics term. An externality is a positive or
negative consequence of an economic activity that is received or paid for by unrelated third parties that are
external to the transaction.
• The effect of a well-educated labor force on the productivity of a company is an example of a

positive externality. The person who pays for and gets a degree receives benefits because people
with more education generally earn more than do people with less education. However, employers,
society, and the economy also benefit from highly educated people because the work force is more
versatile and productive.
• Pollution emitted by a factory that injures the health of nearby residents is an example of a neg-
ative externality because the residents pay the cost of the emissions as they suffer the
39
consequences of the pollution. Another example of a negative externality can occur when a mining
company builds a dam to contain waste from the mine. Such dams can and do fail, causing toxic
sludge or water to invade inhabited areas, killing residents and destroying property. Periodically
another such incident is reported in the news media.
A positive externality may ultimately result in a net increase to the value embodied in the capitals, while a
negative externality may ultimately result in a net decrease. Therefore, providers of financial capital need
information about externalities to the company that are material in order to assess their effects and allocate
resources accordingly.
Value is created over different time horizons and for different stakeholders by means of different capitals.
Over the long term, value is not likely to be created by maximizing one capital, such as financial capital, to
the exclusion of the others.40
The Value Creation Process

The value creation process is central to integrated reporting. The objective of an integrated report is to
communicate how an organization creates value over time. The value creation process is influenced by the
organization’s external environment, its governance, and its business model. An organization’s business
model draws on various capitals as inputs and, through its business activities, converts the inputs to out-
puts. The outputs are products, services, by-products, and waste. The organization’s activities and its
outputs lead to outcomes, which are their effects on the capitals.41
An integrated report should include insights about:
• The external environment affecting the organization.
• The resources and relationships used and affected by the organization: its financial, manufactured,
intellectual, human, social and relationship, and natural capitals.
• How the organization interacts with the external environment and the capitals to create value over
the short, medium, and long term.42
40
<IR> Framework, §2.8-2.9, p. 11.
41
<IR> Framework, §2D, p. 13.
42
The graphic from the Framework depicts the value creation process and is explained following:
The elements of the graphic are as follows.
• The six capitals are the inputs to the value creation process, and they enter the process at the
left side of the graphic.
• The external environment (for example, economic conditions, technological change, societal is-
sues, and environmental challenges) creates the context within which the organization operates.
The external environment is the background of the graphic.
• The organization’s mission and vision (at the top of the graphic) identifies the organization’s
purpose and intentions.
o Monitoring and analysis of the external environment in the context of the organization’s mission
and vision is needed to identify risks and opportunities (on the top left of the circle).
o The organization’s strategy identifies the way it plans to mitigate or manage risks and max-
imize opportunities. Strategic objectives are implemented through resource allocation plans
(on the top right of the circle).
• Governance (at the top center of the circle) involves creating an oversight structure that supports
the organization’s ability to create value. Governance includes all the means by which an organi-
zation is directed and controlled, including the rules, regulations, processes, customs, policies,
procedures, institutions, and laws that affect the way the organization is administered. Governance
spells out the rules and procedures to be followed in making decisions. Governance also involves
the relationships among the various participants and stakeholders within the organization, such as
the board of directors, the shareholders, the chief executive officer (CEO), and the managers.
Governance is the joint responsibility of the board of directors and management.
• The business model (in the center of the graphic) is at the core of the organization. A company’s
business model is the organization’s system of using its business activities to transform inputs (the
capitals) into outputs and outcomes to fulfill the organization’s strategic purposes and create value
over the short, medium, and long term. The business model encompasses the various capitals
(inputs, at the center far left) and the organization’s business activities (center left) that convert
the inputs to outputs (center right), which include products, services, by-products, and waste.
• The organization’s business activities and outputs lead to outcomes (center far right). The out-
comes are the internal and external consequences, both positive and negative, for the capitals that
result from the organization’s business activities and outputs. The value creation process may
preserve, increase, or decrease the organization’s capitals over time.
• The outcomes are transformed capitals that are depicted in the graphic emerging from the right
side of the process.
• The outcomes—the transformed capitals—become inputs to the ongoing value creation process.
• Information about performance (on the bottom left of the circle) is required for decision-making.
Performance is monitored through setting up measurement and monitoring systems.
• Regular review of each component of the value creation process and its interactions with other
components and a focus on the organization’s outlook (on the bottom right of the circle) lead to
revisions and refinement to make improvements.43
The Content of an Integrated Report

An integrated report should include the following eight content elements [not necessarily in this order],
which parallel the items in the graphic depicting the integrated reporting process.
1) Organizational overview and external environment: What does the organization do, and what
are the circumstances under which it operates? The report should provide information about the
company’s use of and effects on the capitals and how the organization’s strategy relates to its
ability to create value in the short, medium, and long term, and significant factors affecting the
external environment and the organization’s response to it. It should also include quantitative
information such as number of employees, revenue, countries in which the organization operates,
and changes from prior periods.
2) Governance: How does the organization’s governance structure support its ability to create value
in the short, medium, and long term? The report should provide information about how regulatory
requirements and the skills and diversity of the organization’s leadership structure influence the
design of the governance structure. It should include information on
a. The organization’s attitude toward risk,
b. Methods of addressing integrity and ethical issues,
c. How the organization’s culture, ethics, and values are reflected in its use of and effects on the
capitals and on its relationships with key stakeholders, and
d. How compensation and incentives are linked to value creation and to the organization’s use of
and effects on the capitals in the short, medium, and long term.
3) Business model: What is the organization’s business model? An integrated report should describe
the business model, including key inputs, business activities, outputs, and outcomes.
4) Risks and opportunities: What are the risks and opportunities that affect the organization’s
ability to create value over the short, medium, and long term, and how is the organization dealing
with them?
5) Strategy and resource allocation: Where does the organization want to go and how does it
intend to get there? The report should identify the organization’s short-, medium-, and long-term
43
<IR> Framework, §2D, pp. 13-14.
strategic objectives, how it intends to achieve them, how it plans to allocate resources to imple-
ment its strategy, and how it will measure achievements and outcomes for the short, medium, and
long term.
6) Performance: To what extent has the organization achieved its strategic objectives for the period,
and what are its outcomes in terms of effects on the capitals? The report should contain qualitative
and quantitative information about performance, such as a discussion of quantitative indicators,
the organization’s positive and negative effects on the capitals, the state of key stakeholder rela-
tionships, and linkages between past and current performance and between current performance
and the organization’s future outlook.
7) Outlook: What challenges and uncertainties is the organization likely to encounter in pursuing its
strategy, and what are the implications for its business model and future performance? The report
should highlight anticipated changes, the organization’s expectations about the external environ-
ment it expects to face in the short, medium, and long term, how it will affect the organization,
and how the organization is equipped to respond to the challenges and uncertainties likely to arise.
8) Basis of presentation: How does the organization determine what matters to include in the in-
tegrated report, and how are those matters quantified or evaluated? The report should provide a
summary of the frameworks and methods used to quantify or evaluate material matters and a brief
description of the process used to identify relevant matters, evaluate their importance, and narrow
them down to material matters.44
Guiding Principles for Preparation and Presentation of an Integrated Report

The following seven principles are the guiding principles for preparing an integrated report:
1) Strategic focus and future orientation: The report should provide information about the or-
ganization’s strategy and the way it relates to the organization’s ability to create value in the short,
medium, and long term, and to its use and effects on the capitals.
2) Connectivity of information: The report should present a holistic45 picture of the combination,
interrelatedness, and dependencies between and among the factors that affect the organization’s
ability to create value over time.
3) Stakeholder relationships: An integrated report should provide information about the nature
and quality of the organization’s relationships with its key stakeholders. The report should include
how and to what extent the organization understands, takes into account, and responds to stake-
holders’ legitimate needs and interests.
4) Materiality: The information disclosed in an integrated report should be about material matters,
that is, matters that substantively affect the organization’s ability to create value over the short,
medium, and long term. The materiality determination process involves identifying relevant mat-
ters, evaluating their importance, prioritizing the matters, and determining what information to
disclose about material matters.
5) Conciseness: An integrated report should be concise.46 It should include context that is sufficient
to understand the organization’s strategy, governance, performance, and prospects without in-
cluding less relevant information.
6) Reliability and completeness: The report should include all material matters, both positive and
negative, in a balanced way and without material error.
44
<IR> Framework, §4, pp. 24-32.
45
“Holistic” means the parts of a whole are intimately interconnected and are understandable only as parts of the whole.
46
“Concise” means brief but comprehensive, giving a lot of information clearly and in a few words.
7) Consistency and comparability: The information in the report should be presented on a basis
that is consistent over time, meaning reporting policies are followed consistently from one period
to the next unless a change is needed to improve the quality of information reported. The infor-
mation should also be presented in a way that enables comparison with other organizations to the
extent it is material to the organization’s own ability to create value over time.47
Benefits of Adopting Integrated Reporting
• Integrated reporting can impose a form of discipline on a company’s reporting by ensuring that the
company concisely reports material information that shows how well it is performing in non-financial
areas that affect the company’s strategies and their execution. The result is greater clarity about the
relationship between financial and non-financial performance and how value creation is affected.
• Integrated reporting can help managers gain a better understanding of the relationship between
financial performance and non-financial performance. Managers are forced to think about when and
under what conditions trade-offs and interdependencies between financial and non-financial perfor-
mance arise. Better internal decision-making may result.
• Internal measurement and control systems for producing reliable and timely non-financial information
are improved. Adopting integrated reporting forces organizations to increase the quality of their in-
formation systems, internal controls, and monitoring systems so that the integrated report can meet
standards for independent assurance by external auditors.
• Greater employee engagement may result.
• Integrated reporting can lower an organization’s reputational risk.
• Customers who care about sustainability may be more committed.
• Better communication about the organization’s performance, position, vision, and mission in both
financial and non-financial terms can result in deeper engagement and improved relationships with
shareholders and stakeholders.
• Integrated reporting can communicate a company’s vision of the future and how it addresses non-
financial challenges and opportunities, enhancing confidence of long-term investors in the company’s
leadership and its ability to build sustainable value.
47
<IR> Framework, §3, pp. 16-23.
Challenges of Adopting Integrated Reporting
• Adopting integrated reporting requires support of the board of directors and the CEO.
• Non-financial information does not have the same established reporting standards as financial infor-
mation has. The information covers more diverse topics and varies by industry. Quantitative
disclosures are not usually measured in monetary units.
• Understanding what is a material issue that should be reported is very challenging. Management
needs to determine what information its providers of financial capital will want to know. The judgment
of what matters are relevant and important is firm-specific, and each organization needs to develop
a process for how relevant and important matters are defined, which stakeholders will be addressed,
how input will be obtained from them, and the relative weights to assign to issues and audience
members.
• An assurance opinion is necessary to establish the reliability and comparability of integrated reports,
and it should be in the form of “positive” assurance, for example, “the company has fairly presented
the necessary information” (in the U.S.) or “the necessary information presents a true and fair view”
(internationally).48
• Internal controls over non-financial data are not as effective as controls over financial data. Thus, a
lack of data quality may prevent reporting of some non-financial information, and data quality pre-
sents a challenge to the independent auditor when attempting to provide positive assurance on non-
financial information.
• Preparation of an integrated report requires collecting and analyzing structured and unstructured
data, which entails investments in new information systems and data, new processes and control
systems, dedicating resources, and obtaining assurance from third parties.
• Specialists with analytical skills will need to be brought in to make sense of the data and incorporate
it into financial reporting.
• Integrated reporting may cause disclosure of proprietary information and revelation of competitive
information.49
Sustainability Accounting Standards Board (SASB)

Sustainability is an important part of integrated reporting. In November 2018, the Sustainability Accounting
Standards Board (SASB) launched a set of industry-specific sustainability accounting standards that cover
financially material issues. The SASB standards comprise specific recommendations for 77 industries about
the factors most likely to have financially material impacts on a typical company in each industry.
The codified standards may be a resource that individual organizations can use in their determination of
what items are material enough to be included in an integrated report. According to the SASB’s announce-
ment, the standards can help businesses to better focus on the sustainability issues that matter to their
financial performance and to communicate their performance on those issues to providers of capital.
The Sustainability Accounting Standards Board Foundation is an independent, nonprofit standard-setting

organization that develops and maintains reporting standards that enable businesses to identify, manage,
and communicate financially material sustainability information to their investors. Information about the
SASB is available at www.sasb.org. Any of the 77 industry-specific standards can be downloaded there, as
well.
48
“Positive assurance” is in contrast to “negative assurance.” Negative assurance means the auditor states that he or
she is not aware of any material modifications that should be made to the report. Negative assurance is not adequate
for an auditor’s statement regarding an integrated report.
49
IMA, 2016. Statements on Management Accounting – Integrated Reporting, pp. 8-11.
Study Unit 9: A.2. Accounts Receivable CMA Part 1
Study Unit 9: A.2. Accounts Receivable

Following are specific topics relating to recognition, measurement, valuation, and disclosure in the financial
statements that candidates need to be familiar with:
1) Assets
a. Accounts receivable
b. Inventory
c. Investments
d. Property, plant, and equipment (fixed assets)
e. Intangible assets
2) Liabilities
a. Reclassification of short-term debt
b. Warranty liabilities
c. Off-balance sheet financing
d. Accounting for income taxes
e. Leases
3) Equity transactions
4) Income statement
a. Revenue recognition
b. Income measurement
1) Asset Valuation
1a) Accounts Receivable
Guidance in the Accounting Standards Codification® on accounting for receivables is in ASC 310.
Receivables arise when a company makes a sale but does not collect the cash at the time of the sale.
According to ASC 606, a company recognizes revenue when it satisfies its performance obligation by trans-
ferring control of the good or service sold to the customer. When all the performance obligations in the
contract have been satisfied, if the customer has not yet paid, the company recognizes an account receiv-
able because the amount due is consideration the entity expects to be entitled to in exchange for satisfying
its performance obligations.
Such a sale is called a credit sale. Instead of cash, the company receives a promise from the customer to
pay later. This promise is an asset that must be recorded on the books at the time of the transaction. As is
done with other assets, accounts receivable must be valued at the end of each period to make sure that
they are not overstated on the balance sheet.
The main issues with respect to receivables are:
1) Valuing the accounts receivable on the balance sheet.
2) Calculating the allowance for credit losses.
3) Understanding the factoring of receivables with and without recourse.
Section A Study Unit 9: A.2. Accounts Receivable
Valuing Accounts Receivable

For financial statement presentation, short-term receivables are valued and reported at the net amount
expected to be collected. The amount of consideration a company expects to receive from an individual
customer in exchange for transferring goods or services is the transaction price. The net amount the firm
expects to receive in cash may be different from the amount legally receivable at any given time due to
future returns and allowances, other variable consideration, and credit losses on receivables.
Therefore, determining the net amount expected to be collected on accounts receivable involves estimation
of (1) expected credit losses on receivables and (2) any returns or allowances to be granted, or (3) other
variable consideration expected. Variable consideration is the term used to refer to prices of goods or
services that are dependent on future events.
Discounts and Initial Recording of the Accounts Receivable

Receivables should initially be recorded at the net amount of cash the company expects to be entitled to
receive in exchange for the goods or services transferred to the customer. Therefore, any trade discounts
that are given or any other discounts that the company expects its customers to take should be subtracted
before recording the receivable in the books. This reduced amount is also the amount that should be rec-
ognized as revenue on the income statement.
Two types of discounts may be given: trade discounts and cash discounts (also called prompt payment
or sales discounts).
Note: Discounts are applied only to the cost of the product that is purchased. If the seller pays for the
shipping costs and then charges them to the customer, the discount is not applied to the shipping costs.
Trade Discounts
Trade discounts are discounts given for large purchases, to repeat customers, or for a special offer. It does
not matter why the discount was given, simply that it was given.
Accounting for Trade Discounts

Accounting for trade discounts is fairly straightforward since the trade discount is a simple reduction of the
selling price. A trade discount may be given to good, long-term customers, purchasers of large amounts,
or as an incentive to win new clients.
When a trade discount is extended, the sales revenue and the receivable are recorded at the discounted
price. If more than one trade discount is given (for example, a discount for being a long-standing customer
and an additional discount for a large order), it does not matter which discount is calculated first because
the ending discounted sales amount will be the same no matter which discount is calculated first. What is
important, though, is that the second discount is not applied to the entire sale amount, but rather to the
reduced amount after the application of the first discount.
Cash Discounts (Sales Discounts or Prompt Payment Discounts)

A cash discount, also called a sales discount or a prompt payment discount, is a discount given when
a customer pays a receivable in full before a set date. The purpose of a cash discount is to encourage early
payment of the amount due by giving a discount if the payment is made before the final due date.
A cash or sales discount offered is noted on the invoice the customer receives. For example, an invoice
might say “Terms: 2/10, n/30.” Terms noted like that mean that if the customer pays within 10 days of the
invoice date, the customer can pay 2% less than the invoiced amount, and the invoice will be considered
paid in full. However, if the customer does not pay within 10 days, the full un-discounted amount is due
within 30 days. The preceding is only an example, and any combination of days and percentages is possible.
Businesses frequently take cash/sales discounts, because the amount of the discount usually translates to
a substantial benefit when the difference between the full invoiced amount and the discounted amount is
regarded as an interest charge on the discounted amount—as an interest charge for taking a few more days
to pay (such as 20 additional days in the example above).
Accounting for Cash (or Sales) Discounts

Prompt payment discounts are variable, and the receivables should reflect management’s estimate of the
balance of discounts that will be taken based on its experience with the customer, with similar customers,
or with similar transactions.
There are two possible accounting treatments for cash discounts given. The company can either record
receivables at the full amount (the gross method) or record them at the discounted amount (the net
method). The gross method is used more frequently in practice.
Gross Method
Under the gross method, the company recognizes a receivable and revenue equal to the full (gross) amount
of the sale. When receivables are paid within the discount time period (and thus less than the full amount
is paid), an adjusting entry is made to account for the fact that less than the full amount is paid.
If the customer does not pay within the discount period but rather pays in full by the due date, the account-
ing is very simple because the company records the receivable at its full amount and that is also the amount
of cash that is collected. The two journal entries will be as follows:
Dr Accounts receivable........................................................ 100
Cr Sales revenue ...................................................................100
To record the sale.
Dr Cash ............................................................................ 100

Cr Accounts receivable ...........................................................100
To record the receipt of cash for the sale.
However, if the customer pays within the time frame required for the discount and takes the discount, the
journal entries to record the sale and the receipt of cash will be more involved and will look like the following:
Dr Accounts receivable ........................................................ 100
Cr Sales revenue ...................................................................100
To record the sale.
Dr Cash .............................................................................. 98
Dr Cash discounts (or sales discounts) given ............................. 2
To record the receipt of cash and also to recognize that only $98 was received.
Even though the full amount of the receivable was not paid, the entire receivable must be removed from
the books, since the customer owes no more money. The $2 discount amount is debited to an account
called cash discounts (or sales discounts) given, which is a contra-revenue account. The amount of the
discount taken will reduce the revenue account on the income statement, but the adjustment is made to
the discounts given contra-revenue account instead of to the revenue account itself to enable analysis.
Allowance for Discounts – Under the Gross Method

However, rather than debiting income each time a discount is taken, proper expense recognition under the
gross method requires that the company reasonably estimate the expected discounts to be taken and set
up an allowance account for discounts. The allowance account is a valuation account and a contra-asset
account that carries a negative balance and reduces the reported receivables on the balance sheet. The
other side of the entry is estimated expense for discounts taken, and that debit goes to the contra-revenue
account, discounts given.
The company uses the allowance to properly value the receivables on the balance sheet at the end of the
period and to avoid overstating them. The allowance that is set up should be equal to the balance of
discounts the company expects its customers to take in the future for sales already made. The net of the
accounts receivable balance and the balance in the allowance account for discounts should be equal to the
amount the company expects its customers to pay.
When a customer takes the discount, the debit for the discount amount is made to the allowance account
instead of to the contra-revenue account.
The process of estimating the discounts to be taken and setting up and using the allowance for discounts
is very similar to the process for the allowance for credit losses on receivables, covered later in this topic.
Net Method
The net method of accounting for cash/sales discounts recognizes the amount of the potential discount at
the time of sale, and each receivable is recorded at its net amount (after the discount), assuming the
customer will take the discount. If the outstanding balance is not paid within the discount period, the lost
discount is recognized in a separate account such as cash discounts (or sales discounts) forfeited,
which is a revenue account on the income statement. Under the net method, the journal entries for the sale
and the customer’s payment are as follows.
Dr Accounts receivable .......................................................... 98
Cr Sales revenue .................................................................... 98
To record the revenue and the receivable at the net amount.
When the discount period passes for each sale, an additional journal entry is required to increase accounts
receivable and income by the discount amount forfeited, as follows:
Dr Accounts receivable ............................................................ 2
Cr Cash discounts (or sales discounts) forfeited ........................... 2
To record sales discount forfeited on receivable that has passed the discount period.
When the receivable is collected, the following journal entry is recorded:

Dr Cash ............................................................................ 100
To record receipt of the gross amount of the receivable.
The cash discounts forfeited account is a revenue account and will increase the revenue reported on the
income statement as each sale passes its discount period.
According to ASC 606-10-32-2, the transaction price is the amount of consideration the company expects
to be entitled to in exchange for transferring the promised goods or services to a customer. Therefore,
technically the net method is called for by the revenue recognition standard. However, the net method
may not be practical for most companies because it is quite labor-intensive, requiring analysis and
bookkeeping time to calculate and record sales discounts forfeited on each receivable that has passed its
discount period. If collection periods are fairly short, any differences between the revenues and receivables
that result from the gross method and the net method will probably be immaterial.
Credit Losses on Receivables

Note: Guidance in the Accounting Standards Codification® on accounting for credit losses on financial
instruments, including trade receivables, is in ASC 326.
Unfortunately, some of a company's receivables will not actually be collected. A credit loss may occur on a
receivable because a customer goes bankrupt, an amount is disputed, or the customer simply fails to pay
for some other reason. Because an asset recorded on the balance sheet should reflect the amount of future
benefit the company expects to receive, it is essential that a company makes sure that its assets are not
overstated. The company accomplishes this by valuing the receivables at each reporting date by esti-
mating the balance of outstanding receivables that it will be able to collect in the future. This expected
amount is what the company should present on the balance sheet.
Credit losses on accounts receivable and most financial assets other than those accounted for at fair value
through net income are accounted for using the current expected credit loss (CECL) model. The model
is based on expected losses and should be a forward-looking estimate of
• expected credit loss when a financial asset is first recorded, and
• increases or decreases in expected credit losses on existing financial assets.
The measurement of expected credit losses is based on relevant information about past events including
historical experience but also information about current conditions and reasonable and supportable fore-
casts that affect the collectability of the outstanding balances. Considerations that a company valuing its
receivables should use in its measurement of expected credit losses include the following:
• The quality of the company’s credit review system and management’s experience,
• The company’s credit policies
• Environmental factors affecting the company’s customers and the areas in which the company’s
receivables are concentrated, such as:
o The regulatory, legal, or technological environment
o Changes and expected changes in the general market condition of the geographical area or the
industry to which the company has exposure
o Changes and expected changes in international, national, regional, and local economic and
business conditions, including the condition and expected condition of various market seg-
ments.
The CECL model is particularly applicable to loans held by financial institutions and leases held by lessors,
but for all entities, it applies to trade receivables because they are financial assets.50
A valuation account, Allowance for Credit Losses-Trade Receivables, is used to report the portion of the
receivables that management estimates will not be collectible. The valuation allowance decreases the car-
rying amount of the receivables on the balance sheet in recognition of the fact that not all of them will be
collected as cash. Thus, the allowance account should always have a negative (credit) balance, and, when
combined with the gross accounts receivable account (which carries a positive, or debit, balance), the
valuation account serves to decrease the value of net accounts receivable reported on the balance sheet.
The valuation account usually follows the accounts receivable account in the general ledger. The positive
accounts receivable account balance and the negative valuation account balance combined equal the re-
ceivable amount estimated to be collectible. The estimated collectible amount is called “net receivables”
and usually only the net receivables amount is presented on the balance sheet.
50
The CECL model also applies to investments in debt securities measured at amortized cost and notes receivable.
The estimate must be updated at each reporting date. A related credit loss expense is recorded in net
income and is equal to the amount needed to adjust the allowance account to management’s current esti-
mate of expected credit losses on the financial assets.51
A company can use various measurement approaches to estimate expected credit losses such as discounted
cash flow methods, loss-rate methods, roll-rate methods, probability-of-default methods, methods utilizing
aging analysis, and the value of collateral.
• Discounted cash flow methods use projections of principal and interest cash flows over the life
of the asset, discounted at the financial asset’s effective interest rate.52
• Loss-rate methods use historical loss rates as a starting point, but then the historical rate must
be adjusted for differences between conditions expected to exist in the future and conditions that
existed during the historical charge-off period used.
• Roll-rate methods involve predicting credit losses by segmenting a portfolio of financial assets
according to factors such as delinquency or risk rating. The financial industry uses several different
models and no one model is prescribed, but most of the models are based on similar principles.
• Probability-of-default methods estimate the probability that financial assets (generally loans)
with specific risk ratings will default, using different historical default rates for different risk-strat-
ified segments.
• Aging analysis methods utilize aging reports that categorize receivables according to the length
of time payments have been past due. Aging analysis is used to determine the effectiveness of
credit and collections processes as well as for estimating potential credit losses. An aging report
will contain columns for the unpaid totals classified by past due status. For example, the report
may have one column for the balance of receivables that are current, one column for receivable
balances 1-30 days past the due date, one column for receivables 31-60 days past due, one column
for receivables 61-90 days past due, and one column for receivables that are 91 days or more past
the due date.
• Collateral-value methods may be used for receivables that are highly dependent on collateral.
If foreclosure of a collateral-dependent receivable is probable, the creditor is required to remeasure
the expected credit loss based on the fair value of the collateral adjusted by the undiscounted costs
to sell if it intends to sell the collateral rather than operate it.53
Regardless of the method used, the estimate of current expected credit losses should reflect all available
information that is relevant, including past events, current conditions, reasonable and supportable fore-
casts, qualitative factors, and quantitative factors, and their effects on expected credit losses. Historical
charge-off rates can be used as a starting point, but the company must also evaluate how its current
expectations of future conditions may differ from conditions that existed during the historical charge-off
period.
Because of the subjective nature of the estimate, ASC 326 does not require any specific approach or ap-
proaches to developing the estimate of expected credit losses. A company should use judgment in
developing estimation techniques, should apply them consistently over time, and should faithfully estimate
the collectability of the financial assets. The estimation techniques used should be practical and relevant to
the circumstance, the type of financial asset, the company’s ability to predict the timing of cash flows, and
information available.54
51
Per ASC 326-20-30-1.
52
Per ASC 326-20-30-4.
53
Per ASC 326-20-35-4 and 35-5.
54
Per ASC 326-20-55-7.
Financial assets that share similar risk characteristics should be evaluated on a collective, or pool, basis. If
an individual receivable does not share risk characteristics with the other receivables, that receivable should
be evaluated individually for expected credit losses.55
Regardless of how the company develops its estimate of expected credit losses, it will do all of the following:
1) Estimate the balance of receivables that will not be collected in the future, in other words,
that will become credit losses,
2) Determine the credit loss expense the company needs to recognize on the income statement in
the current period, and
3) Record a debit to an expense account called Credit Loss Expense-Trade Receivables and a bal-
ancing credit to the Allowance for Credit Losses-Trade Receivables account.
The purpose of valuing accounts receivable is to recognize anticipated credit loss expense before the write-
offs occur and to reduce the accounts receivable balance reported to the amount the company realistically
thinks it will be able to collect.
The company focuses on making the balance in the valuation account be whatever it needs to be to create
a net accounts receivable figure that represents the outstanding balance of receivables the company esti-
mates are collectible. It values the ending receivables by estimating the outstanding balance of receivables
that will not be collected in the future. The amount of credit loss expense the company recognizes is
whatever amount is needed to change the unadjusted balance in the Allowance for Credit Losses-Trade
Receivables account to a balance that will create the correct net accounts receivable figure when the allow-
ance account is combined with the accounts receivable account. A certain amount of “working backwards”
is necessary in calculating the credit loss expense. The credit loss expense on the income statement be-
comes the balancing figure.
The Direct Write-off Method is Not Acceptable Under U.S. GAAP

Another method that may be used to value receivables is the Direct Write-off Method. Under this method,
receivables are written off to expense only when they specifically go bad. However, the direct write-off
method is not acceptable under U.S. GAAP because it is not consistent with accrual accounting since it
does not match the revenues and expenses of the company. For this reason, the direct write-off method is
not satisfactory and should not be used for external financial reporting purposes. However, it may be re-
quired for tax purposes. If so, it results in temporary tax differences that will result in deferred tax assets
and liabilities (deferred taxes are discussed later in this volume).
The Allowance for Credit Losses-Trade Receivables T-Account

When an allowance is recorded, the Allowance for Credit Losses-Trade Receivables account (the val-
uation account) is credited and Credit Loss Expense-Trade Receivables is debited for the amount by
which the valuation account is being adjusted.
Three types of journal entries affect the allowance account. These journal entries are:
1) To record the credit loss expense for the period.
2) To write off a specific receivable when it becomes uncollectible.
3) To collect a previously written-off receivable.
Because the allowance account is a valuation account, it is used to reduce the balance of receivables shown
on the balance sheet (similar to the way accumulated depreciation reduces fixed assets). Therefore, the
allowance account must carry a credit balance because it is not likely that a company will collect more from
55
Per ASC 326-20-30-2 and ASC 326-20-55-5.
its customers than the customers owe them. If the details of the net accounts receivable are presented on
the balance sheet, they will be presented as follows:
Accounts receivable $100,000

Less: Allowance for credit losses 3,750 $96,250
The $96,250 is the net accounts receivable, that is, gross accounts receivable less the allowance for credit
losses-trade receivables.
Exam Tip: A good way to solve problems relating to the valuation of receivables is to set up a T-account
for the allowance account. The T-account contains five items, and generally an exam question will provide
all of the numbers except for two (the items in bold below are usually given). The candidate will need to
calculate one of the two amounts not given and then, having calculated one of the missing amounts,
solve for the final missing amount. Setting these questions up in a T-account makes answering them
much easier.
The T-account for the allowance for credit losses and the five elements in it are:
Allowance for Credit Losses-Trade Receivables
Dr Cr
(1) Beginning balance
(2) Amount written off as credit losses for the
(3) Collection of previously written-off credit
period
losses.
(4) Amount charged as credit loss expense
(5) Ending balance
Usually items numbered 1, 2, and 3 will be given in the problem. Alternatively, sometimes a question will
give the ending balance in the allowance account before it is adjusted for the period’s credit loss expense.
In this second instance, the balance given includes the beginning balance adjusted by amounts written off
during the period and by amounts collected of previously written-off credit losses. The question will most
likely ask for the amount for item 4 or 5. Candidates will need to calculate one of these two items (item 4
or 5) using information given in the problem, and then it is simply a matter of solving an algebraic equation
for the final amount (or “backing into” it).
Allowance Account Journal Entries

Following are the five items recorded in the allowance account and the journal entries for each.
1) The beginning balance of the allowance for credit losses-trade receivables account
The beginning balance in the allowance account is usually given. The beginning balance is the
previous period’s ending balance. The account should always be adjusted at the end of each re-
porting period, and the beginning balance should always be a credit balance because the allowance
account is an asset valuation account that reduces the balance of the asset, accounts receivable.
2) Writing off a receivable deemed to be a credit loss
When an account finally becomes uncollectible and thus the customer that is not going to pay
becomes known, that individual receivable must be written off. The receivable is written off with
the following journal entry:
Dr Allowance for credit losses-trade receivables ......................... X
Cr Accounts receivable .............................................................. X
Note: The journal entry above is item (2) in the preceding T-account.
The journal entry above does not record an expense because the expense was already recognized
when the allowance account was set up and the credit loss expense account was debited. In fact,
writing off an account that has been deemed a credit loss does not even change the net accounts
receivable balance. The debit balance in the gross accounts receivable account and the credit bal-
ance in the valuation contra-asset account are each decreased by the same amount by the write-
off, so the net of the two accounts is unchanged.
3) Collecting a Previously Written-off Receivable
Occasionally, a company collects a receivable that it had previously written off. When a previously
written-off receivable is collected, the company makes two journal entries. The first entry is made
to reverse the entry that was made in 2) above that previously wrote off that receivable, as follows:
Dr Accounts receivable – Company A ........................................ X
Cr Allowance for credit losses-trade receivables ........................... X
The journal entry above puts the receivable back on the books so that its receipt can be recorded
and increases the credit balance in the allowance account. The credit balance in the allowance
account must be increased because the receivable that was thought to be one that would be a
credit loss has in fact been collected. Therefore, it must be a different receivable that will be a
credit loss, and so the allowance is put back into the allowance account so it will be available for
the other receivable.
The second journal entry records the collection of the cash. It is:
Dr Cash ................................................................................ X
Cr Accounts receivable .............................................................. X
Both entries above involve the accounts receivable account, the first one a debit to accounts re-
ceivable and the second one a credit to accounts receivable, and they are for the same amount.
Therefore, if the accounting system permits, the two journal entries can be combined into one
journal entry as follows:
Dr Cash ................................................................................ X
Note: The journal entry above is item (3) in the preceding T-account.
4) Amount charged as credit loss expense-trade receivables
At the end of each period a journal entry needs to be made to record the current expected credit
loss expense for the period. Credit loss expense-trade receivables is debited and the allowance for
credit losses-trade receivables account is credited. The journal entry is:
Dr Credit loss expense-trade receivables ................................... X
Note: The above journal entry is item (4) in the preceding T-account.
The allowance account is in essence a holding account. The company’s management knows that
some customer is not going to pay, but since they do not yet know which customer that is, man-
agement is not able to credit (reduce) any specific customer’s receivable account to write off the
credit loss. Therefore, the expected credit loss is “held” in the allowance account until time passes
and the company knows which customer will not be paying.
The required ending balance in the allowance for credit losses account is an estimate of the balance
of outstanding receivables that will not be collected and will become credit losses. The ending
balance is item 5 in the allowance T-account. The amount of the credit to the allowance account
(Item 4 in the allowance T-account) is whatever amount is required to adjust the ending balance
in the allowance account to what it needs to be. The debit to the credit loss expense-trade receiv-
ables account is the other side of the entry.
5) The ending balance in the allowance for credit losses-trade receivables account
Note: The ending balance in the allowance account is item (5) in the preceding T-account.
The ending balance in the allowance for credit losses-trade receivables account will reduce the
ending net accounts receivable balance shown on the balance sheet to the amount expected to be
received. The ending balance in the allowance account must be a credit balance because it must
reduce accounts receivable, not increase accounts receivable.
However, the pre-closing ending balance (just before the credit losses adjustment is made) may
be given in the problem. And if so, that balance may be a debit balance if accounts written off
during the period (which are debits to the allowance account) have exceeded the credit balance in
the account at the beginning of the period. When that occurs, the debit balance in the allowance
account must be adjusted to a credit balance at the financial statement date by recording a credit
to the allowance account that (1) adjusts the debit balance to zero and (2) creates the required
credit balance in the allowance account. Thus, when the allowance account has a debit balance
before adjustment, the credit transaction to adjust the allowance account will need to be the
amount of the debit balance plus the ending balance required in the allowance account.
Usually only net accounts receivable (gross accounts receivable minus the balance in the allowance
account) is reported on the balance sheet.
The ending balance required in the allowance account is determined using any one or more of
several acceptable methods. From this required ending balance, the credit loss expense is deter-
mined for the period to be whatever amount is needed to change the pre-closing ending balance
in the allowance account to the required ending balance. The credit loss expense-trade receivables
account is debited for the same amount as the credit to the allowance account.
Note: On the exam, for any allowance-related question, the easiest way to solve the problem is to set
up a T-account for the allowance account and then put the numbers into that structure.
The journal entry looks like the following:

Dr Credit loss expense-trade receivables ................................... Y
Cr Allowance for credit losses-trade receivables ........................... Y
Where Y = the amount of change needed in the allowance account to create

the required ending credit balance in the account.
Note: If the credit balance in the allowance that is required at the end of a reporting period is less than
the pre-closing credit balance in the allowance account, the credit loss expense recognized for the period
will actually be a reduction of credit loss expense or a gain (a credit to the credit loss expense-trade
receivables account instead of a debit) and the other side of the entry is a debit instead of a credit to
the allowance for credit losses-trade receivables account.
The credit balance in the allowance account at the end of the period and before adjustment could be
greater than required if previous estimates of credit losses on receivables were too high and the company
actually collected more of its receivables than anticipated.
Steps to Calculating Credit Loss Expense

The steps in calculating the credit loss expense are:
1) Calculate the required ending balance in the allowance account—what the balance should be—
using any of the acceptable methods that reflect all available, relevant information, including his-
torical information, current conditions, and reasonable and supportable forecasts.
A common method used for accounts receivable involves use of an aging report combined with
other relevant information such as economic conditions. The required ending balance in the allow-
ance account is calculated as a weighted average of the various amounts on the accounts
receivable aging report, using as the weights the estimated percentages that will be uncollectible
for each classification of balances on the aging report.
Example: Using all available information, a company estimates that 1% of its receivables aged
0-30 days will be uncollectible, 2% of receivables aged 31-60 days will be uncollectible, 3% of
receivables aged 61-90 days will be uncollectible, and 10% of receivables aged 91 days and
over will be uncollectible. All those amounts are calculated and then the results are summed to
calculate the required ending credit balance in the allowance account.
2) Determine what the “plug figure” in the allowance account needs to be to adjust the ending balance
in the allowance account to the amount calculated in Step 1. This “plug figure” is the credit loss
expense for the period.
3) Record the journal entry to debit credit loss expense-trade receivables and credit the allowance for
credit losses-trade receivables account using the credit loss expense figure calculated in Step 2.
Exam Tip: The balance at the end of the period in the allowance for credit losses-trade receiv-
ables account is the accumulated balance of all the transactions in the allowance account. The
required ending balance in the allowance account is what is calculated, and the amount of the
credit to the allowance account is a function of the needed ending balance. It is the difference
between the balance in the account and the balance needed in the account, that is, the amount
of the transaction needed to change the current balance to the needed balance. The other side
of the entry is an adjustment to credit loss expense-trade receivables.
Note: Usually, a credit transaction will be required to adjust the balance in the allowance account to the
required balance and the other side of the transaction will be a debit to the credit loss expense account.
However, occasionally the credit balance in the allowance account may be higher than it needs to be, for
instance if previous estimates of credit losses on receivables were too high and the company has actually
collected more of its receivables than anticipated. In that event, the allowance for credit losses account
will be debited to reduce the credit balance in the allowance account to what it needs to be. The credit
loss expense account will be credited for the same amount, resulting in a reversal of credit loss ex-
pense on the income statement.
Individually Evaluated Receivables

If an individual receivable no longer exhibits risk characteristics that are similar to those of other receivables
in the portfolio, that receivable should be evaluated on an individual basis, and adjustments to the accounts
may be needed at other than reporting dates because of new information.
Examples
Example of an individually evaluated receivable: ABC Company evaluates its trade receivables for
expected credit losses according to its aging analysis along with other factors. However, it has been
evaluating its $100,000 receivable from XYZ Company on an individual basis because the receivable is
over 120 days past due. As of December 31, 20X1, ABC Company has established an allowance for credit
losses on the XYZ receivable of $60,000.
On February 15, 20X2, XYZ files for bankruptcy and, as an unsecured creditor, ABC Company deems the
entire balance will be a credit loss. Therefore, on February 15, 20X2, ABC increases the allowance for
credit losses on XYZ’s receivable to the full $100,000 due and then writes off the entire receivable, as
follows:
Credit loss expense–trade receivables .................................. $40,000

Allowance for credit losses-trade receivables .......................... $40,000
Allowance for credit losses-trade receivables ....................... $100,000
Accounts receivable ........................................................... $100,000
Example of a portfolio of receivables: Anita’s Supply Co. values its accounts receivable by using its
accounts receivable aging report and taking into consideration available information such as current
conditions, reasonable and supportable forecasts, and qualitative and quantitative factors and their ef-
fects on expected credit losses. Anita’s prepared the following aging schedule as of December 31, 20X9
and estimated the proportion of each receivables aging level that would become credit losses based on
the ages and the other relevant information:
Outstanding % Estimated
Age of Accounts Balances Credit Losses
Under 60 days $925,000 2%
61-90 days 115,000 5%
91-120 days 56,000 10%
Over 120 days 44,000 30%
On December 31, 20X9 before recording the year-end adjustment for the allowance account, Anita’s had
a debit balance of $5,000 in its allowance for credit losses account.
By multiplying each aging category’s receivable balance by its estimated credit loss percentage and
summing the results, the accounts receivable manager calculated that the balance in the allowance
account needed to be a credit balance of $43,050, as follows:
($925,000 × 0.02) + ($115,000 × 0.05) + ($56,000 × 0.10) + ($44,000 × 0.30) = $43,050
To adjust the debit balance of $5,000 to a credit balance of $43,050, a credit transaction in the amount
of $48,050 ($43,050 + $5,000) will need to be recorded in the allowance account as of December 31,
20X9. The other side of the transaction will be a debit of $48,050 to credit loss expense-trade receivables.
Note: If the balance before adjustment in the allowance account had been a credit balance of $5,000
instead of a debit balance of $5,000, the necessary credit to the allowance account to adjust its balance
to a credit balance of $43,050 would have been $38,050 ($43,050 − $5,000), and the debit to credit
loss expense-trade receivables would have been $38,050.
Percentage of Sales Method

A percentage of sales made during the current period may be used as a starting point for developing an
estimate of expected credit losses. Applying a percentage to current credit sales has the advantage of
recognizing current expected credit loss expense in the same period as current revenue from credit sales is
recognized, consistent with the matching principle.
However, the ending balance in the allowance account that would result from calculating the credit loss
expense as a percentage of current credit sales must be evaluated by management before using a percent-
age of sales alone as the amount by which to adjust the allowance account, because the allowance account
balance that would result may not be reasonable. For example, write-offs during the current period may
have exceeded the amount of the allowance causing it to have a debit balance instead of a credit balance
before adjustment, and correction of that would need to be included in the adjustment. Furthermore, future
expectations related to other considerations such as economic and environmental factors must be consid-
ered and might require additional adjustment.
ASC 326-20-35-1 states the following:
“At each reporting date, an entity shall record an allowance for credit losses on financial assets . . . An
entity shall report in net income (as a credit loss expense or a reversal of credit loss expense) the amount
necessary to adjust the allowance for credit losses for management’s current estimate of ex-
pected credit losses on financial asset(s).”
Thus, if the balance in the allowance for credit losses account that results from using a percentage of current
sales as the credit loss expense for the period is not reasonable in management’s estimation, the amount
of credit loss expense (or the amount of any reversal of credit loss expense) recognized and the adjustment
to the allowance account for the period will need to be revised so that the allowance for credit losses fairly
represents the amount the company expects to lose from its outstanding trade receivables.
Example: A wholesaler has the following information available for use in determining its credit loss
expense for the period.
Beginning Balances:
Accounts receivable $10,000
Allowance for credit losses (750)
Accounts receivable, net $ 9,250
Transactions during the period:

Credit sales $60,000
Collections on credit sales 55,000
During the period, accounts receivable totaling $1,000 were written off as credit losses. This brought the
balance in the allowance account to a debit balance of $250. By using an aging analysis along with other
relevant considerations, the retailer has determined that 6% of its outstanding receivables are expected
to be credit losses.
The required ending balance in the allowance for credit losses account and the amount to be charged to
credit loss expense for the period are calculated as follows.
Required ending balance in the allowance for credit losses account
The accounts receivable balance at the end of the period is $14,000, calculated as follows: $10,000
beginning A/R balance + $60,000 credit sales − $55,000 collections on credit sales − $1,000 written off
= $14,000 ending A/R balance.
Since balances equal to 6% of ending accounts receivable are deemed credit losses, the ending balance
in the allowance account needs to be $14,000 × 0.06, which equals $840. The allowance account needs
to have a credit balance of $(840).
(Continued)
Credit loss expense for the period
The balance in the allowance account before the credit loss expense for the year is recorded is the
beginning credit balance of ($750), adjusted for a $1,000 debit for the account written off, equals an
ending balance of $250, a debit balance. The balance in the allowance account needs to be a credit
balance of ($840). Therefore, the credit to the allowance account needs to be a credit of $250 + $840,
or $1,090.
The credit loss expense is the other side of the entry, or a debit to credit loss expense of $1,090.
The T-account for the Allowance for Credit Losses account, including the ending balance after recording
the credit loss expense, is as follows:
Allowance for Credit Losses-Trade Receivables
Dr Cr
(1) Beginning balance: 750.
(2) Amount actually written off as credit
(3) Collection of previously written-off credit
losses for the period: 1,000.
losses: 0.
(4) Amount to be charged as credit loss ex-

pense for the period (residual figure): 1,090.
(5) Ending balance: 840.
Sales Returns and Allowances

A company needs to recognize that customers will return a certain amount of sold merchandise, or the
company may grant an allowance on the sales price if the customer is dissatisfied. Estimated returns and
allowances are recognized as sales are made.
Two valuation accounts are used: sales returns and allowances and allowance for sales returns and
allowances.
• Sales returns and allowances is a contra-revenue account. It carries a debit balance and re-
duces sales revenue on the income statement.
• Allowance for sales returns and allowances is a contra-asset account. It carries a credit bal-
ance and reduces accounts receivable on the balance sheet.
The sales returns and allowances account and the allowance for sales returns and allowances account are
used to show the estimated amount of refunds and allowances the company expects to grant in the future.
Both sales revenue and accounts receivable are reduced to the amount the company expects to receive.
Factoring: Using Receivables as an Immediate Source of Cash

At times a company will need to convert its receivables to cash immediately. One of the company’s options
is to “sell” its accounts receivable.56 Receivables are sold by selling them to a “factor,” a type of commercial
finance company. The factor essentially makes a loan to the seller of the receivables that is guaranteed
(collateralized) by the receivables.
Receivables can also be used as a source of cash by assigning or pledging them as security for a loan.
Pledging receivables as security for a loan does not actually involve selling them.
However, selling its accounts receivable differs for the seller from borrowing money and pledging the re-
ceivables as collateral in two ways:
• After it sells its receivables to the factor, the seller of the receivables no longer owns the receiva-
bles, so the receivables are removed from the seller’s balance sheet.
• The seller also does not report a loan outstanding on its balance sheet for the funds received in
the sale of the receivables.
The factor notifies the seller’s customers to begin remitting their payments directly to the factor, and the
factor receives repayment of its “loan” as it collects the receivables.
The two forms of factoring are called “without recourse” and “with recourse.”
Traditionally, factoring is without recourse, which means the factor assumes the risk of any credit losses
on the receivables. If a receivable the factor purchased proves to be uncollectible, the factor has no recourse
against the seller of the receivable—the loss is the factor’s loss. Some companies factor their receivables
without recourse to transfer the credit loss risk in this manner. However, the greater the risk of credit
losses, the less cash the selling company will receive from the factor.
Note: If the receivables are sold without recourse, any credit loss expense and balance in the allowance
for credit losses account already recorded by the seller for the receivables needs to be reversed.
Sometimes the sale is with recourse. In a sale of receivables with recourse, if a customer does not pay
the receivable, the seller of the receivable is liable to the factor for the credit loss. Therefore, when a factor
purchases receivables with recourse, the factor’s risk of credit losses is limited. Because of the lower level
of risk to the factor, it will pay more when buying receivables with recourse.
Note: If receivables are factored with recourse, the seller will carry a liability, called recourse liability
or recourse obligation, on its balance sheet for the estimated amount of any expected credit losses.
The recourse liability is very similar in process to the allowance for credit losses account used by a
company that collects its own receivables and bears the risk of the associated credit losses.
A company will not be able to sell its receivables for the full amount of their face value, however. The factor
takes some of the value of the receivables as fees for its service provided. Furthermore, if the factor pur-
chases the receivables without recourse and thus assumes the risk of credit losses, the amount the selling
company will receive for its receivables will be even more reduced.
56
A company can sell a receivable or receivables only if the receivables to be sold have not already been assigned to
another lender as security for a borrowing arrangement.
Section A Study Unit 10: A.2. Inventory and Inventory Tracking Methods
Study Unit 10: A.2. Inventory and Inventory Tracking Methods
1b) Inventory
Guidance in the Accounting Standards Codification® on accounting for inventory is in ASC 330.
Inventory is a critical asset. It is one of the most important and possibly largest items on the balance sheet
for a company that either produces or sells goods. Inventory is not only reported on the balance sheet as
an asset, but it is also an important item used to calculate the cost of goods sold on the income statement.
For a merchandising company, cost of goods sold is usually one of the largest expense items on the income
statement.
A retailer or a wholesaler will have merchandise inventory. Retailers and wholesalers do not manufacture
the inventory they sell. They buy their inventory and resell it without doing any production.
Note: A manufacturing company has three different classifications of inventory: raw materials, work-in-
process, and finished goods. The production process, the allocation of costs in the production process,
and accounting for raw materials, work-in-process and finished goods inventory by a manufacturer are
covered in Section D, Cost Management, in Volume 2.
In this Study Unit, the focus is on accounting for finished goods by a merchandising company or a
reseller, in other words a company that buys finished products and resells them to a wholesale company
or to the consumer without doing any production.
In contrast to a manufacturing company, a retailer or wholesaler has only one type of inventory: finished
goods.
Important issues to be familiar with in regard to inventory include:
1) The valuation of the inventory when it is purchased and recorded
2) The determination of which specific items of inventory are included in inventory at year end
3) The recognition of permanent declines in the value of the inventory
Valuing the Inventory When It Is Purchased

Inventory should be recorded in the books at an amount that includes all the costs paid for the inventory
and for getting the inventory ready and available for sale. Costs include the cost of the inventory,
shipping costs to receive the inventory, insurance while the inventory is in transit, taxes and tariffs, duties,
and any other costs without which the company could not receive the inventory to sell to the customer.
Costs of receiving the inventory are called landing costs.
The journal entry to record the purchase of inventory is as follows:

Dr Inventory .................................................... all costs required
Cr Cash ............................................................. all costs required
Note: If more than one type of inventory is purchased for only one purchase price, the cost needs to be
allocated among the different inventories purchased using a pro rata distribution based on the fair val-
ues of the different items purchased.
If a company receives any discounts related to the purchase of the inventory, the discounted price it
pays is the amount that should be recorded as the value of the inventory.
Study Unit 10: A.2. Inventory and Inventory Tracking Methods CMA Part 1
Which Goods Are Included in Inventory?

Which items should be included in ending inventory at the reporting date? Which items belong to someone
else and therefore should be included in that entity’s ending inventory? These questions refer to items that
are in transit, consigned, out on approval, or obsolete. The treatment of these different categories of
goods is discussed below.
In-Transit Goods
In-transit goods are goods that have been shipped prior to the financial statement date but had not yet
been received by the buyer as of the financial statement date. The owner of the goods is determined by
the terms of shipping.
• Goods sent FOB Shipping Point belong to the buyer from the moment the seller gives them to
the shipping company. Thus, while the goods are in transit they belong to the buyer because title
was transferred at the shipping point. Therefore, goods that have been shipped FOB Shipping Point
by the end of the period should be included in the buyer’s ending inventory even though the buyer
may not have received them by the end of the period. The goods should not be included in the
seller’s ending inventory.
• Goods sent FOB Destination belong to the seller until the buyer receives them. While the goods
are in transit, they belong to the seller and title is transferred at the destination point only when
the buyer receives them. Goods shipped FOB Destination near the end of the period that have not
been delivered to the buyer by the end of the period should be excluded from the ending inventory
of the buyer and included in the ending inventory of the seller.
Note: The issue of the owner of goods in transit is also connected to accounts receivable. For the seller,
any individual shipment made near the end of a period should be reported on the period-end balance
sheet as either inventory or as a receivable (or cash if the sale was a cash sale).
For example, a shipment shipped FOB Destination on December 30 that arrives on January 3 will be
inventory on the seller’s books until January 3. On January 3, the seller’s accounts receivable is debited
for the full amount of the sale and revenue is credited for the same amount; and cost of sales is debited
for the cost of the sale while inventory is credited for the same amount. That shipment should never be
shown on the seller’s books as both inventory and a receivable.
For the buyer, the item will be either 1) both inventory and a payable or 2) neither inventory nor a
payable.
Consigned Goods
Consigned goods are given by one company (the consignor) to another company (the consignee) for the
consignee to sell to the end consumer. Goods may be consigned because the consignee is physically closer
to the consumer or because consignment enables the consignor to get a wider distribution of goods than
the company could achieve on its own.
Ownership never transfers to the consignee when goods are consigned. Instead, title passes di-
rectly from the consignor to the end consumer. Therefore, the consignee never bears the risk of loss unless
a contract passes that risk to it. Consigned goods should be reported as inventory on the records of the
consignor because it bears the risk of loss.
Goods out on consignment belong in the inventory of the consignor company because the ownership never
transfers to the consignee. The goods should be carried on the consignor’s balance sheet at the cost the
consignor paid for the goods plus any shipping costs the consignor paid to get the goods to the consignee
company that will sell the goods. The shipping costs to the consignee are costs of making the goods available
for sale to the customer and thus are “inventoriable” costs.
Goods held on consignment do not belong to the company that holds them (that is, the consignee) and
therefore should not be included in the consignee’s inventory.
Note: Accounting for and revenue recognition connected to goods out on consignment are covered in
this volume in the topic Revenue Recognition.
Goods Out on Approval

Goods out on approval are goods that are currently in the possession of a potential customer but have not
yet been purchased by the customer. The customer physically has the product and has a stated period in
which to decide either to purchase it or return it. Goods-out-on-approval items should be included in the
seller’s inventory at their original cost until either the customer accepts the goods or the time to return the
goods expires. Only when either of these events occurs will the sale be recognized and the cost of the goods
removed from the seller’s inventory and transferred to cost of goods sold. If instead the customer returns
the goods, no transaction is necessary.
Obsolete Inventory
Obsolete inventory items are items that can no longer be sold and thus their cost should not be included
in the inventory balance on the balance sheet. Items may become obsolete for several reasons: tech-
nological advancement that makes the product useless, market loss, new features in newer products, or
the item is used with another product that is no longer available for sale. Any inventory that becomes
obsolete should be written off as a loss in the period in which it is determined to be obsolete.
Costs Included in Inventory

Product costs are included in inventory, so they are called inventoriable costs. Product costs are costs
that are attached to each unit of inventory. They are all the costs directly incurred to bring the goods in
and, for a manufacturer, to convert them to a product that can be sold. They include the cost of the product
itself, freight charges on the incoming shipments, other direct costs to acquire the product, and, for a
manufacturer, production costs incurred in production of a salable product. For a manufacturer, production
costs include direct materials, direct labor, and manufacturing overhead. Product costs are held in inventory
on the balance sheet until the items they are attached to are sold, and then they are expensed as cost of
goods sold.
Although costs of purchasing and storing the inventory could be considered product costs, usually those are
not included in product costs because of the difficulty of allocating them to specific units. Instead, those
costs are usually considered period costs. Period costs, as opposed to product costs, are costs not directly
related to acquiring or producing goods. Period costs include general and administrative expenses and
selling costs, including outgoing freight on shipments to customers. Period costs are expensed as incurred.
Determining Which Item Is Sold: Cost Flow Assumptions

Because the inventory on hand that a company holds is purchased at different times, the prices paid for
individual units of the same item are different. The cost of the specific unit of inventory that is sold impacts
both the balance sheet (through reduction of the inventory account) and the income statement (through
increase of the cost of goods sold).
Therefore, the company must have a method of determining exactly which unit of inventory is sold for each
and every sale. The company must essentially determine if the sold unit was the oldest in inventory (that
is, purchased a long time ago), the newest unit (the most recently purchased), or some “average” unit of
inventory.
The different methods for determining which units have been sold are called cost flow assumptions. The
four main cost flow assumptions are:
1) First in First Out (FIFO), in which it is assumed that the item sold to the customer is the earliest
unit purchased by the seller that has not yet been sold (that is, the oldest item in inventory).
2) Last in First Out (LIFO), in which it is assumed that the item sold to the customer is the latest
unit purchased by the seller (that is, the newest item in inventory).
3) Average Cost, in which the costs paid for all the individual units of a given item in inventory are
summed and divided by the number of units purchased to find the average cost for each unit.
4) Specific Identification, in which each unit of inventory is individually tracked. The specific iden-
tification method is used for low quantity, high value inventory items, such as merchandise in a
jewelry store or serialized electronic merchandise where inventory records are kept by serial num-
ber.
IFRS Note: Under IFRS, LIFO is prohibited.
Whichever cost flow assumption is used, the resulting cost of a sold unit becomes the cost used as the cost
of goods sold for that sale.
The three most common methods are FIFO, LIFO, and average cost, which will all be discussed below.
Specific identification will be covered only briefly because it is simple to determine the value of what was
sold and what remains on hand at the end of a reporting period since a cost record is maintained for each
individual piece of inventory. For example, many accounting systems provide the ability to track serialized
inventory such as electronic equipment according to serial number, and the actual cost of each specific unit
is attached to that item in inventory. When an item of serialized inventory is sold, the cost attached to that
specific item is removed from inventory and transferred to cost of goods sold.
1) First in First Out (FIFO)

Under FIFO, the most recently purchased inventory items are included in ending inventory on the balance
sheet. The assumption is that the oldest item in inventory is always the item sold, whether or not that is
actually what happens. In addition, it is assumed the most recently purchased items are still in inventory
at the end of the period.
An example of the FIFO method is a fruit stand. When someone buys an apple, the seller will try to sell the
oldest apple first because if it spoils before its sale it will become “obsolete,” creating a loss for the fruit
stand.
However, unless inventory is highly perishable as apples are, it does not matter whether or not the actual
earliest item stocked is the item sold. Whether it is or not, the assumption is made that the earliest item
stocked is the item sold each time a sale occurs.
In a period of rising costs, using FIFO will result in a higher ending inventory balance and a lower COGS
(and therefore higher operating income) when compared to LIFO, which will be covered next. This occurs
because the newest, highest-cost units of each inventory item are still on hand at year-end (higher ending
inventory) and the oldest, lowest-cost units of each inventory item were sold during the year (lower cost of
goods sold).
Note: Under FIFO, ending inventory is essentially valued at current cost (or replacement cost), and cost
of goods sold is reported at an older, historical cost. Therefore, the balance sheet has “current” figures
because the inventory is valued at the more current costs.
In a period of rising prices, FIFO looks like the following:
Cost of a Unit of
Price
Inventory-FIFO
Ending
Inventory
COGS
Time
Benefits of FIFO
• In a period of rising prices, cost of goods sold will be lower with FIFO than with other cost flow
assumptions because the oldest, lowest-cost inventory will be assumed sold for each sale. Conse-
quently, reported net income will be higher than it would be with other cost flow assumptions, which
may be of benefit to some companies.
• When FIFO is used, inventory on hand will reflect more-current market prices than would be the case
under other cost flow assumptions because the inventory on the balance sheet will be reported at the
cost of the most recently purchased items.
• In the U.S., FIFO is the only inventory cost flow assumption that is not restricted in its usage for
income tax purposes by the IRS.
Limitations of FIFO
• Although reported net income is higher under FIFO than under other cost flow assumptions, net cash
flow will probably be lower. In a period of rising prices, taxable income will be higher, and higher
taxable income means higher income taxes paid, which decreases net cash flow.
• Use of FIFO when prices are rising creates short-term, overstated operating income that is not sus-
tainable due to lower-cost units purchased long ago being the ones expensed as cost of goods sold.
Last in First Out (LIFO)

When LIFO is used, the assumption is made that each time a unit is sold it is the one that was purchased
most recently—the newest item in inventory. Therefore, the oldest inventory items (and the lowest-cost
items, assuming rising prices) will be included in ending inventory on the balance sheet.
In a period of rising prices LIFO will create a lower ending inventory balance and a higher COGS (and
therefore lower operating income) when compared to FIFO. At year end, the oldest, lowest-cost items
are still in inventory and the newest, highest cost units have been sold and are expensed on the income
statement as cost of goods sold.
The LIFO inventory method can be compared to an elevator. Assume a crowd of people stepping onto an
elevator and heading to the same floor together. The last person who steps on is often the first person
stepping off because that person is closest to the door.
Note: Under LIFO, cost of goods sold is valued at the current cost (or replacement cost) of the inventory.
Inventory is recorded on the balance sheet at an older, historical cost. Therefore, the income statement
has “current” figures on it because cost of goods sold is valued at the current costs.
LIFO in a period of rising prices is shown below:
Cost of a Unit of
Inventory-LIFO
Price
COGS
Ending
Inventory
Time
Whenever a sale takes place, the newest, highest-cost item of inventory is considered sold and is reported
as cost of goods sold expense while the oldest, lowest cost unit is assumed to remain in ending inventory.
LIFO Layers and LIFO Liquidations

When LIFO is being used, each purchase of merchandise for sale is a separate layer in inventory, and each
layer has its own cost per unit. Selling 100% of a particular layer is called liquidating that layer. The layers
are liquidated in the reverse order of their purchase. The most recent layer is liquidated before the next
most recent layer is liquidated, and so forth.
When prices are rising, the price per unit of the older layers is lower than the price per unit of layers
purchased more recently. Therefore, liquidating any layer means that the next sale must come from the
next oldest layer, and the cost of the next sale will be lower because the inventory was purchased earlier
at a lower price.
Therefore, liquidating last-in, first-out layers of inventory when prices have been increasing will lead to an
increase in net income because the cost of the sales made from earlier layers of inventory will be lower, so
net income will be higher.
Benefits of LIFO
• LIFO is sometimes the best match for the way goods physically flow into and out of inventory. When
new inventory is received and displayed for sale, items may be placed in front of the existing inventory
unless a concerted effort is made to position newer items behind older ones. If newer items are
consistently placed in front of older ones, the newest units are always the units sold.
• LIFO better matches current costs against current revenues and therefore provides a better measure
of current earnings. When prices are rising, use of LIFO leads to better quality earnings.
• The primary advantage of LIFO is that when prices are rising the use of LIFO for tax reporting results
in a higher cost of goods sold and a lower taxable income. Lower taxable income leads to lower
income taxes and higher cash flow.
Limitations of LIFO
• If a company uses LIFO for its tax reporting to gain the advantage of lower taxes, tax law in the U.S.
requires that the company also use LIFO for its financial reporting. Therefore, the company’s reported
earnings will be lower than they would be under the other cost flow assumptions, assuming rising
prices. Tax law does not have a similar requirement for other inventory cost flow assumptions.
• Since the items reported as inventory on the balance sheet will be the earliest items purchased, when
prices rise inventory will be valued too low on the balance sheet.
• If sales exceed purchases of inventory, layers of old inventory will be liquidated. The old costs will be
matched against current revenues and will cause an increase in reported income for the period in
which the liquidation occurs.
• A company using LIFO may be able to manipulate its net income by altering its purchasing pattern at
year end.
• Accounting under LIFO can be complex because of the LIFO cost layers.
• Using LIFO for inventory valuation is not permitted if a company is using IFRS.
Average Cost
The average cost method attempts to create a balance between FIFO and LIFO by using an average cost
for the calculation of ending inventory and COGS. For each sale, the average cost per unit is calculated by
dividing the total cost paid for all the units on hand (before the sale took place) by the number of units on
hand. When average cost is used, the ending balance for inventory and the amount of cost of goods sold,
and thus net income, will be somewhere in between what they would have been under FIFO and LIFO.
The IRS does not permit the average cost method to be used on a company’s tax return. If a company
chooses to use the average cost method for financial reporting, it can use only FIFO for income tax report-
ing. Using the average cost method for financial reporting and LIFO for income tax reporting is not an
option, because, as noted above (in “Limitations of LIFO”), if LIFO is used on the income tax return, tax
regulations in the U.S. state that LIFO must be used for financial reporting as well.
Effect of the Different Methods

The different cost flow assumptions have different impacts on ending inventory and cost of goods sold,
depending on whether prices are rising or falling, as follows:
Ending Inventory Cost of Goods Sold Gross Profit
Rising Prices FIFO Higher LIFO Higher FIFO Higher
Falling Prices LIFO Higher FIFO Higher LIFO Higher
In general, LIFO is preferable when:
• Selling prices and revenues are increasing faster than costs and thus distorting net income
• LIFO has traditionally been used, such as in department stores and in industries where a fairly
constant core inventory remains on hand, such as refining, chemicals, and glass.
LIFO is probably less preferable or even inappropriate when:
• prices tend to lag behind costs
• specific identification is needed, such as with automobiles, farm equipment, serialized electronic
equipment, art, and antique jewelry
• unit costs tend to decrease as production increases, which would nullify any tax benefit that LIFO
might provide because the most recently produced units would be in inventory at lower costs than
inventory produced earlier because the lower-cost units would be the units sold
• prices tend to decrease, for example in electronics where prices are high when a new technology
is introduced and prices for the same item typically decrease as time passes.
The Frequency of Determining Inventory Balances

Management must decide not only which inventory cost flow assumption (FIFO, LIFO, or Average Cost) to
use, but it must also decide how frequently it will make the necessary inventory calculations. Two systems
are used for determining the frequency of making inventory entries: the periodic method and the perpet-
ual method. The difference between the two systems lies in how often a company makes the calculation of
its ending inventory and cost of goods sold.
1) Periodic System
Under the periodic system, entries and calculations are made only at the end of a period (every month,
quarter, or year). The effects of the periodic method on the three main methods of tracking physical units
of inventory are as follows.
FIFO in the Periodic System

At the end of the period, the company determines the total number of units of inventory it had available
for sale during the period (beginning inventory plus inventory purchased during the period) and the cost of
each of the units in beginning inventory and those purchased during the period. The cost of the units sold
is the cost of the units in beginning inventory and, if sales exceeded the units in beginning inventory, the
cost of the earliest units purchased during the period up to the total number of units sold. Ending inventory
consists of the most recently purchased units or those purchased toward the end of the period that had not
been sold before the end of the period. The value of the ending inventory is determined only at the end of
the period.
LIFO in the Periodic System

LIFO in the periodic system is similar to FIFO in the periodic system except for the determination of which
units are included in ending inventory and which units were sold during the period.
At the end of the period, the company determines the number of units of inventory it had available for sale
during the period (beginning inventory plus inventory purchased during the period) and the cost of each of
the units in beginning inventory and the units purchased during the period. The cost of the units sold is
assumed to be the cost of the units most recently purchased during the period. If the number of units sold
during the period is greater than the number of units purchased during the period, some units are sold from
the beginning inventory at their cost in beginning inventory, using the most recently purchased units in the
beginning inventory. Ending inventory consists of the oldest units on hand.
• If inventory increased during the period, the ending inventory for the period is made up of the
units that were in beginning inventory plus the units purchased closest to the beginning of the
period.
• If inventory decreased during the period, the ending inventory for the period consists of the re-
maining units in beginning inventory that are still unsold at the end of the period. All units that
were purchased during the period are sold by the end of the period.
Again, the value of the ending inventory is determined only at the end of the period.
Average Cost in the Periodic System: A Weighted Average

In the periodic system, average cost is called the weighted average method. At the end of the period,
the company determines the total number of units it had available for sale during the period (beginning
inventory plus inventory purchased during the period) and the total cost it paid for all the units available
for sale. By dividing the total cost by the total units available for sale, the company determines an average
cost for each unit of inventory available for sale during the period. The average cost per unit is applied to
the units on hand at the end of the period as well as to the units sold to calculate ending inventory and
COGS, respectively. The calculation of the weighted average cost in the periodic system is done only at the
end of the period.
2) Perpetual System
Under the perpetual system, the calculation of the cost of the unit of inventory sold is made after each
individual sale. For LIFO and the average cost methods, the perpetual system leads to a larger number of
calculations. While the calculations are not difficult, it is important to keep track of all the necessary infor-
mation for these types of questions. The effects of the perpetual method on the three main methods of
tracking physical units of inventory are outlined below.
FIFO in the Perpetual System

Under FIFO, the periodic and the perpetual methods result in the same numbers because according
to FIFO the oldest unit is sold first.
Example: FIFO in a perpetual system can be illustrated using birth order of children in a family. No
matter how many children are born, the oldest child is always the oldest child. Regardless of whether
more children are still being born or all of the children are born in the family, the oldest always remains
the oldest. The same idea can be applied to inventory. Regardless of when the oldest unit is determined,
it will always be the oldest unit until it is sold.
Note: Remember that under FIFO, the FIFO periodic and the FIFO perpetual methods produce
the same result. Knowing this equivalence may help save time in the calculations of a large inventory
question.
LIFO in the Perpetual System

With perpetual LIFO, it is slightly more difficult to calculate the ending inventory because the LIFO inventory
is in LIFO layers.
A LIFO layer arises when a company purchases more inventory before it sells all of its previously purchased
inventory. The assumption underlying LIFO—the most recently purchased (newest) inventory item is always
the first unit sold—leads to many different individual prices for the units in ending inventory. Each time the
company buys more inventory before selling all the inventory it previously had on hand, a layer is added.
The graph that follows contains a presentation of LIFO perpetual in which inventory layers are created. To
simplify the presentation, assume that the company counts its inventory twice a year rather than after
every purchase. Also assume that in both the first and second half of the year the company purchased more
units of inventory than it sold. Therefore, at the end of the year the company will have the ending inventory
and COGS shown on the graph.
Once a LIFO layer is created, it will remain in place until the company reaches a period when it sells more
units than it purchased during the period. When the company sells more units than it has purchased, one
or more LIFO layers may be eliminated, a process called a “LIFO Liquidation.”
If an exam problem deals with a company’s purchases and sales over a one-month period, it is best to write
down the different purchases and sales and mark out which units are sold and which units remain after
each sale.
LIFO Perpetual Method

Price
Cost of a Unit of
Inventory
COGS
Ending
Inventory
COGS
Ending
Inventory
Time
Each layer will remain in inventory until it is “liquidated.” The liquidation of a layer occurs when the company
sells all of the most recently purchased inventory plus some “older” inventory before purchasing more.
However, keep in mind that the liquidated layer will be the newest, most recently formed layer. Therefore,
the first units of each inventory item that a company purchased could theoretically still be in the company’s
inventory 50 or more years later.
Average Cost in the Perpetual System: A Moving Average

When the average cost method is performed on a perpetual basis, the method is called the moving aver-
age method because the average applied to ending inventory and COGS is constantly changing because
of calculating a new average cost after each purchase of inventory.
The process of using average cost in a perpetual system is slightly difficult mathematically because of the
need to keep track at all times of the current inventory in respect to both units and total cost. Each time a
new purchase is made, a new average cost must be calculated, and this new average cost is then used as
the cost per unit for all sales made afterwards until the next purchase is made, at which point a new average
cost will be calculated.
Note: The perpetual system provides a more accurate reflection of inventory transactions than the pe-
riodic system, but it requires extensive time and effort to collect, input, and process the data.
For the exam, candidates may need to make the various calculations under FIFO, LIFO, and average cost
(weighted average or moving average) methods. These calculations include ending inventory, cost of goods
sold, and gross profit from sales.
Example: Below are the March inventory purchase and sales transactions for Medina Company. Note
that prices are rising.
Units Cost Per Unit
Beginning Inventory 1,000 $5.00
March 3 Purchase 1,500 6.00
March 7 Sale 900
March 11 Sale 700
March 20 Purchase 1,000 7.00
March 21 Sale 600
March 29 Sale 200
Ending Inventory 1,100
Calculate the ending inventory and COGS using FIFO periodic, FIFO perpetual, LIFO periodic, LIFO per-
petual, weighted average periodic, and moving average perpetual methods.
Before answering these questions, it is useful to look at the number of units the company had available
for sale during the period and determine how many were sold (and will be in cost of goods sold) and how
many units are in ending inventory.
The number of units sold is 2,400. The company had 3,500 units available to sell during the period (the
1,000 units in beginning inventory plus the 2,500 units purchased), and ending inventory contains 1,100
units. Therefore, 2,400 units must have been sold (3,500 – 1,100). The units sold in each of the four
individual sales during the month can also be summed: 900 + 700 + 600 + 200 = 2,400.
The total value of goods available for sale during the month is $21,000: (1,000 × $5) + (1,500 × $6) +
(1,000 × $7). The total of ending inventory and cost of goods sold must therefore be $21,000 under all
methods. When one of those amounts (inventory or cost of goods sold) is known, the other can be
determined by looking at the difference between the total goods available for sale (here, $21,000) and
the known amount, as shown in the explanations below.
FIFO Periodic
When FIFO is being used, it is usually easier to calculate ending inventory. Once ending inventory is
calculated, subtract the ending inventory from the total cost of all units available for sale, which in this
example is $21,000, to calculate COGS. Since 1,100 units are in ending inventory and FIFO is being
used, the units in ending inventory are the units most recently purchased. Therefore, ending inventory
consists of 1,000 units that cost $7 each and 100 units that cost $6 each for a total of $7,600. If ending
inventory is $7,600, then the COGS sold is $13,400 ($21,000 − $7,600).
FIFO Perpetual
For FIFO, the periodic and perpetual methods yield the same answers. The answers to the FIFO perpetual
method are the same as the answers to the FIFO periodic method.
(Continued)
LIFO Periodic
The values of ending inventory and COGS can be calculated in a manner very similar to the FIFO periodic
method, except that the 1,100 units in ending inventory are the oldest units purchased. Thus, ending
inventory includes 1,000 units that cost $5 each and 100 units that cost $6 each, which equals $5,600.
If ending inventory is equal to $5,600, then COGS is equal to $15,400 ($21,000 − $5,600).
LIFO Perpetual
With LIFO perpetual, it is necessary to determine the COGS after each individual sale of inventory. After
determining the total COGS amount, subtract it from $21,000 to calculate the ending inventory amount.
For each of the sales, the units sold and their costs are as follows:
March 7 900 units sold. The units sold are from the March 3 purchase for $6: $6 × 900 =
$5,400 COGS.
March 11 700 units sold. 600 units are from the March 3 purchase for $6 and 100 units are from
beginning inventory at $5: ($6 × 600) + ($5 × 100) = $4,100 COGS.
March 21 600 units sold. The units are from the March 20 purchase for $7: $7 × 600 = $4,200
COGS.
March 29 200 units sold. The units are from the March 20 purchase for $7: $7 × 200 = $1,400
COGS.
The sum of $5,400 + $4,100 + $4,200 + $1,400 = $15,100 for cost of goods sold during March.
Therefore, ending inventory must be equal to $5,900 ($21,000 − $15,100). The units in ending inven-
tory include 900 from beginning inventory ($5 each for a total of $4,500) and 200 from the March 20
purchase ($7 each for a total of $1,400).
Weighted Average (Periodic Average Cost)

For the weighted average method, calculate an average cost for all the units available for sale during the
period. The total cost was $21,000 and 3,500 units were available for sale. $21,000 divided by 3,500
equals an average cost of $6 per unit. The $6 per unit average cost is multiplied by the 1,100 units in
ending inventory to calculate the ending inventory balance of $6,600 and by the 2,400 units that were
sold to calculate cost of goods sold of $14,400.
Moving Average (Perpetual Average Cost)

For the moving average method, after each purchase it is necessary to calculate a new average cost per
unit. This calculation of average cost per unit is shown in the table below for each of the sales and
purchases made during March.
Cost Total Units Total Cost Avg. Cost
Date Units per Unit in Inventory in Inventory per Unit COGS Calculation
Mar 1 Beg. Inv. 1,000 $ 5,000 $5.00
Mar 3 Buy 1,500 $6 2,500 $14,000 $5.60
Mar 7 Sell 900 1,600 $ 8,960 $5.60 900 × 5.60 = $5,040
Mar 11 Sell 700 900 $ 5,040 $5.60 700 × 5.60 = $3,920
Mar 20 Buy 1,000 $7 1,900 $12,040 $6.34 *
Mar 21 Sell 600 1,300 $ 8,238 $6.34 600 × 6.34 = $3,802
Mar 29 Sell 200 1,100 $ 6,971 $6.34 200 × 6.34 = $1,267
* This average cost per unit and the following two average cost per unit amounts all have small rounding
differences. The calculated averages are $6.337, and each has been rounded up to $6.34.
The sum of the COGS items is $14,029 ($5,040 + $3,920 + $3,802 + $1,267). The ending inventory is
from the table and is the “Total Cost in Inventory” value from the last row, or $6,971.
(Continued)
Section A Study Unit 11: A.2. Inventory Count, Errors, and Valuation
Summary:
Ending
Inventory COGS Total
FIFO Periodic $7,600 $13,400 $21,000
FIFO Perpetual $7,600 $13,400 $21,000
LIFO Periodic $5,600 $15,400 $21,000
LIFO Perpetual $5,900 $15,100 $21,000
Weighted Average Periodic $6,600 $14,400 $21,000
Moving Average Perpetual $6,971 $14,029 $21,000
Note: In a period of rising prices, LIFO yields the highest cost of goods sold and thus the lowest net
income of all the methods, while FIFO results in the lowest cost of goods sold and the highest net income.
If prices are falling, the opposite will be true.
The resulting cost of goods sold and operating income from the average cost method (weighted or mov-
ing) will always be in between LIFO and FIFO.
Study Unit 11: A.2. Inventory Count, Errors, and Valuation

The Physical Inventory Count
At the end of each year, a company undertakes a physical inventory count to determine the number of
units on hand of each item as of the year-end. Once the company knows how many units are physically on
hand, it will use its inventory method (FIFO or LIFO, for example) to determine the cost of those units. The
result of the calculation is recorded in the financial statements because it is the actual inventory balance.
After the inventory count is made, the company will need to make an adjusting journal entry so that the
balance sheet reflects the true inventory balance.
If the actual count of inventory is less than the accounting records indicate, the journal entry to write down
inventory is:
Dr Inventory loss ................................................................... X
Cr Inventory ............................................................................ X
If the physical count of inventory is greater than the amount recorded in the accounting records, the value
of the inventory needs to be written up. The journal entry is:
Dr Inventory .......................................................................... X
Cr Inventory gain ..................................................................... X
Note: A physical count is required by U.S. GAAP for annual reporting purposes. Under GAAP, a
physical count of the inventory must be done each year regardless of which inventory cost flow method
is being used. A physical count is not required for interim financial statements, however.
Study Unit 11: A.2. Inventory Count, Errors, and Valuation CMA Part 1
Errors in Inventory
Candidates need to be able to assess the way an error in one or more of the inventory amounts (beginning
or ending inventory or purchases) affects the balance of any of the other components of the inventory
calculation, such as ending inventory or cost of goods sold.
In questions about inventory errors, it is best to make two calculations. The first is based on the amounts
actually used (with the mistakes) in the accounting and the second is with the amounts that should have
been used. The difference between these two numbers will be the effect of the error.
The two most common questions about errors are “What was the effect on ending inventory?” and
“What was the effect on cost of goods sold?” The relevant formulas are below.
If the question is about ending inventory, the formula is:
Beginning inventory
+ Purchases
= Cost of goods available for sale
− Cost of goods sold
= Ending inventory
If the question is about cost of goods sold, the formula is:
Beginning inventory
+ Purchases
= Cost of goods available for sale
− Ending inventory
= Cost of goods sold
Note: When COGS (an expense) is overstated, operating income is understated. Conversely, when COGS
is understated, operating income is overstated.
Example: Medina Company completed its physical inventory count at the end of 20X8 and adjusted the
accounting records accordingly. After the adjustment, on January 1, 20X9, the company’s beginning
inventory was $150,000. During 20X9, Medina purchased $525,000 of inventory and had an ending
inventory of $100,000.
However, management later discovered that at the end of 20X8, the company failed to count $30,000
of inventory. Medina also discovered that the purchases for 20X9 were overstated by $18,000 because
some purchases had been recorded twice. Finally, the ending inventory count at the end of 20X9 was
overstated by $15,000.
The best way to determine the total effect of these errors is to set up two COGS calculations: the first
determines what Medina did and the second determines what it should have done.
What Medina DID What Medina SHOULD HAVE DONE
Beginning inventory $150,000 $180,000
+ Purchases 525,000 507,000
− Ending inventory (100,000) ( 85,000)
= Cost of goods sold $575,000 $602,000
Through these two calculations, it is easy to see that the cost of goods sold was understated as a result
of these errors. If the company had recorded everything correctly, the cost of goods sold would have
been $602,000 instead of the recorded $575,000.
On the exam, candidates are strongly encouraged to set up these two columns to use to answer a
question about the effect of an inventory error or errors.
A self-correcting error is one that corrects itself in time, even if it is not discovered. The miscounting of
inventory is a self-correcting error. While the error in ending inventory will affect two balance sheets and
two income statements, if inventory is correctly counted at the end of the next year, then no further errors
will be caused by the original miscounting.
Recognizing Permanent Declines in Inventory Values

Inventories are initially recorded at their cost. However, the value of inventory may decline over time. If
the inventory becomes obsolete, is damaged, or is impacted by market conditions, the benefit the company
can expect to receive from its sale may decline to a level below its cost, leading to inventory being over-
stated on the balance sheet.
Because inventory is an asset, it is important not to overvalue it on the balance sheet. If the inventory’s
value declines, it should be written down. Therefore, at the end of each period a company must evaluate
its inventory to make sure the carrying amount is actually less than or equal to the amount of benefit the
company will receive from it in the future. The process of valuing inventory is similar to the processes of
valuing accounts receivable through the allowance for credit losses and determining impairment of fixed
assets and intangible assets.
Under U.S. GAAP, the way inventory valuation is done depends upon what inventory method the company
is using.
• For inventories measured using any method other than LIFO or the Retail Method, the inventory
should be measured at the lower of cost or net realizable value (LCNRV). Net realizable value
is defined as the estimated selling price in the ordinary course of business, minus reasonably pre-
dictable costs of selling, including costs of completion, disposal, and transportation.
• Measurement for inventory measured using LIFO or the Retail Method (including all cost flow as-
sumptions when the Retail Method is used) is at the lower of cost or market (LCM).
The evaluation is done by comparing the cost of the inventory (under whichever cost flow assumption or
inventory valuation method the company is using) to either its net realizable value or its designated market
value, as appropriate. The value of the inventory reported on the balance sheet should be the lower of its
cost or its net realizable value or the lower of its cost or its designated market value.
If the net realizable value or the designated market value (whichever is appropriate, depending on the
inventory method being used) is lower than the historical cost of the inventory, the difference (loss) must
be written off. U.S. GAAP does not specify what account should be debited for the write-down. Two accounts
are acceptable: COGS or a loss account. Methods of recording inventory losses are covered later in this
topic.
The Lower of Cost or NRV for FIFO, Average Cost, or Specific Identification Methods
Inventories measured using any method other than LIFO or the Retail Method 57—including FIFO, Average
Cost, or Specific Identification—are measured at the lower of cost or net realizable value (LCNRV).
Net realizable value is defined as the estimated selling price in the ordinary course of business, minus
reasonably predictable costs of completion, disposal, and transportation.
An example follows.
Example: Plumbing Wholesale uses FIFO to value its inventory. The company sells several inventory
items. Four items and the calculation of their lower of cost or net realizable values are:
Hist. Sell Cost to Lower of

Cost Price Sell NRV Cost or NRV
S 7.00 10.00 1.00 9.00 7.00
T 8.00 10.00 1.00 9.00 8.00
U 14.00 19.00 1.00 18.00 14.00
V 16.00 20.00 1.00 19.00 16.00
For each item, the value in the far-right column, the lower of its historical cost under FIFO or its net
realizable value, is the valuation that should be reported.
Note: Lower of cost or net realizable value can be applied to the entire inventory as one group, to groups
or pools of inventory items, or to each item individually. Applying it to each item individually will
provide the lowest amount for ending inventory. When each item is calculated separately, any
decrease in value will be recorded. However, when groups, or pools, of inventory are used a decline in
the value of one item may be offset by an increase in the value of another item.
57
The Retail Method is a method of estimating inventory cost that is often used by department stores and other busi-
nesses that label their inventory with price tags when it is received and keep records of both the cost paid and the retail
value (selling price) of the inventory. The retailer makes the physical inventory count at the end of the period but
compiles the ending inventory at retail prices instead of at cost. To determine the cost of the ending inventory (which
is what must be reported on the balance sheet), the retail value of the ending inventory is multiplied by a cost/retail
ratio (C/R ratio). The Retail Method is not tested on the CMA exams, so it is not covered further in these study materials.
The Lower of Cost or Market for Inventories Measured Using LIFO or the Retail Method
For inventories valued using either LIFO or the Retail Method (including all cost flow assumptions when the
Retail Method is used), the inventory should be measured at the lower of cost or market (LCM).
Notes:
(1) LIFO inventories can be valued at the lower of cost or market for financial reporting, but tax regula-
tions prohibit the use of LCM with LIFO for tax reporting. According to 26 CFR 1.472-2(b),
Requirements Incident to Adoption and Use of LIFO Inventory Method, “The inventory shall be taken
at cost regardless of market value.”
(2) When the Retail Method is being used, LCM is calculated according to that method. It is not calculated
according to the information that follows that uses a designated market value.
(3) For a reseller that buys merchandise and resells it, “market” refers to the market in which the reseller
purchases the inventory, not the market in which it sells the inventory. For a manufacturer, “mar-
ket” refers to the cost to reproduce the inventory.
Thus, for both resellers and manufacturers, “market” essentially means the cost to replace or repro-
duce the inventory.
LIFO and LCM

When the LIFO cost flow assumption is used, the “market” value used in the LCM calculation is a “designated
market value.”
The cost of the inventory is its historical cost, determined using LIFO.
The market value used is called the designated market value and it is the middle value of the following
three numbers, as follows:
1) Ceiling, also called the Net Realizable Value or NRV. The net realizable value is the item’s
estimated normal selling price minus reasonable costs to complete and dispose of the item.
Net realizable value is the maximum value for the designated market value of the inventory.
Net Realizable Value = Selling Price minus the Cost to Complete and Dispose
2) Current replacement cost, or the cost to purchase the inventory currently. The current replace-
ment cost will usually be given in any LCM problem.
3) Floor, or the minimum value that will be used as the designated market value for the inventory.
The floor is the net realizable value minus a normal profit margin.
Floor = Net Realizable Value (Ceiling) minus a Normal Profit Margin
If the replacement cost is higher than the net realizable value, the net realizable value will still serve as the
ceiling (the maximum value) for the designated market value.
Exam Tips: Compare the cost of the inventory to the middle value of the three values (not the
average of the three amounts) to determine the lower of cost or market. Current replacement cost and
other necessary amounts will be given in the problem, and they must be used correctly in the formulas.
Since the middle value is used, the designated market value of the inventory will never be either above
the ceiling or below the floor.
Example: Plumbing Wholesale sells several inventory items and values its inventory using LIFO. Four
of the items and the calculation of their lower-of-cost-or-market values are as follows (the columns
containing the two amounts to be compared for each item to determine its lower of cost or market are
marked with arrows):
Hist. Sell Cost to Normal Norm. Profit Repl. NRV−Norm. Designated

Cost Price Sell Profit % Amount Cost NRV Profit Market LCM
S 7.00 10.00 1.00 30% 3.00 7.50 9.00 6.00 7.50 7.00
T 8.00 10.00 1.00 27% 2.70 7.25 9.00 6.30 7.25 7.25
U 14.00 19.00 1.00 26% 5.00 19.50 18.00 13.00 18.00 14.00
V 16.00 20.00 1.00 20% 4.00 14.00 19.00 15.00 15.00 15.00
For each item, the designated market value is the middle value of the replacement cost, the NRV, and
the NRV minus Normal Profit. That designated market value is compared with the item’s historical cost.
The lower of the two amounts is the LCM.
Note: The LCM Method can be applied to the entire inventory as one group, to groups or pools of
inventory items, or to each item individually. Applying it to each item individually will provide the
lowest amount for ending inventory. When each item is calculated separately, any decrease in value
will be recorded. However, when groups, or pools, of inventory are used a decline in the value of one
item may be offset by an increase in the value of another item.
If the designated market value is lower than the cost of the inventory, the difference (the loss) must be
written off.
LIFO and LCM for Taxes

U.S. GAAP does not prescribe rules for applying the LIFO cost flow assumption in valuing inventory. Instead,
IRS regulations provide the rules. As noted above, LCM may not be used with a LIFO cost flow as-
sumption under IRS regulations. If a company uses LIFO for tax purposes, the IRS requires it to also
use LIFO for its financial reporting. However, the company is not required to use the same LIFO applications
for its tax reporting and its financial reporting. A company may use different LIFO applications for tax
reporting and financial reporting. The use of lower of cost or market with LIFO costing is an example of this
flexibility.
Although IRS regulations do not permit the use of LCM with LIFO on the income tax return, LCM is applied
with LIFO for financial reporting purposes. However, when prices are rising, the instances in which inventory
is written down will be fewer under LIFO than they will be under the other inventory cost flow assumptions
because the historical cost of the inventory on the books will be lower. It will be more likely that the
historical cost will be lower than the designated market value when LIFO is being used than it is when cost
flow assumptions for which inventory is valued at the lower of cost or net realizable value are being used.
If inventory is written down to its designated market value under LIFO, the application of LCM with LIFO
for financial reporting but not for tax purposes will cause a temporary difference between book income and
taxable income, leading to deferred taxes. Deferred taxes are covered in the topic Accounting for Income
Taxes in this section.
Exam Tip: Any exam questions about inventory write-downs will generally be very straightforward and
the only thing necessary will be to take the information in the question and put it into the calculations
to determine either the net realizable value or the designated market value of the inventory. In reality,
most inventory will be carried at cost. However, on any exam questions, usually more than half of the
inventory items must be written down to either their net realizable value or their market value, whichever
applies to the inventory cost flow assumption being used.
Note: The Retail Method and the use of LCM with it is covered in any intermediate accounting book. The
Retail Method is not tested on the CMA exam, so it is not discussed further in these study materials.
Recording Inventory Write-downs

If the market value (for inventories measured under LIFO or the Retail Method) or the net realizable value
(for all other methods of measuring inventory) is lower than the cost of the inventory, the difference (or
loss) must be written off to a loss account that will be reported on the income statement as a reduction of
income in that period. The journal entry will be:
Dr Inventory loss or cost of goods sold ..................................... X
Cr Inventory ............................................................................ X
U.S. GAAP does not specify what account should be debited for the write-down. The loss may be recorded
on the income statement in either of two ways. Both ways are acceptable.
1) The loss method debits a loss account such as loss on inventory write-down. The loss is identified
separately on the income statement. The loss is an operating loss, so the loss account is in the
administrative expense area of the income statement.58
2) The cost-of-goods-sold method debits cost of goods sold for the inventory write-down. If the
loss is simply debited to cost of goods sold, though, it is not identified separately on the income
statement. It is buried in cost of goods sold. Furthermore, the income statement lacks represen-
tational faithfulness because cost of goods sold does not represent what it purports to represent.
The cost-of-goods-sold method is permitted if the difference is not material. However, most managements
would find it preferable to debit a loss account. Furthermore, ASC 330-10-50-2 states that a substantial
and unusual loss should be disclosed in the financial statements. A substantial and unusual inven-
tory loss could be disclosed on a separate line in the administrative expense area on the income statement,
but it may also need to be explained in a note to the financial statements.
Instead of decreasing the inventory account directly for inventory write-downs, most companies credit a
valuation account on the balance sheet, an allowance account such as allowance to reduce inventory to
market or net realizable value. The historical cost of the inventory remains in the inventory account while
the net realizable value reported for the inventory is the net of the inventory and the allowance account
balances. Use of an allowance account keeps subsidiary inventory ledgers in correspondence with the con-
trol account.
However, if the inventory that has been written down has been sold and thus its historical cost has been
transferred from the inventory account to cost of goods sold, the allowance account should be closed out
to cost of goods sold. The company then establishes a “new” allowance account for any inventory valuation
required going forward.
In practice, many companies leave the allowance account on the books and at each year-end they adjust
the balance in the allowance account to agree with the amount of valuation reduction needed for the in-
ventory on the books at year-end. The other side of the adjusting entry is to cost of goods sold.
An example follows.
58
Inventory write-downs that are done in order to report inventory at the lower of cost or net realizable value (or the
lower of cost or market for LIFO or Retail Method inventories) are operating losses because they are specifically required
by accounting standards. Inventory should be evaluated for potential write-downs whenever financial statements are
issued, and any losses resulting from that evaluation are operating expenses. If an inventory loss occurs due to an
unusual or infrequent event such as a fire, hurricane, or other unusual occurrence, that would usually be reported as a
non-operating loss.
Example: Inventory that cost $200,000 is valued at $150,000, a $50,000 loss. The loss is recorded as
follows:
Dr Inventory loss ........................................................... 50,000

Cr Allowance to reduce inventory ....................................... 50,000
The inventory is sold for $150,000. The sale is recorded as a receivable and the historical cost of the
inventory in the inventory account is transferred to cost of goods sold:
Dr Accounts receivable .................................................. 150,000
Dr Cost of goods sold .................................................... 200,000
Cr Sales revenue ............................................................ 150,000
Cr Inventory .................................................................. 200,000
Before the allowance account is closed out, the gross loss on the sale is $50,000: $150,000 sales revenue
less $200,000 cost of goods sold.
The allowance account is closed out by crediting cost of goods sold:

Dr Allowance to reduce inventory ..................................... 50,000
Cr Cost of goods sold ........................................................ 50,000
The company now has neither a gross profit nor a gross loss on the sale because the sale is at breakeven:
$150,000 sales revenue less $150,000 cost of goods sold.
The inventory write-down of $50,000 remains in the inventory loss account and is reported in the income
statement as an inventory loss.
Inventory Write-downs on Interim Financial Statements

ASC 270-10-45-6 states that inventory losses from write-downs are not to be deferred beyond the interim
period in which the decline occurs. If the value of the same inventory (unsold) recovers in later interim
periods of the same fiscal year, the recovered amount is to be recognized as a gain in the later interim
period, up to the amount of previously recognized interim losses. However, the standard further states that
if a decline in the value of the inventory is expected to be restored by the end of the fiscal year, such a
temporary decline does not need to be recognized at the interim date since no loss is expected to be incurred
during the fiscal year.
Thus, recognition of interim inventory losses is a matter of management’s judgment.
Note: Under U.S. GAAP, recording inventory recoveries in value to the extent of previously recognized
losses is limited to reporting within a single fiscal year. Inventory write-downs reported on an an-
nual financial statement may not be restored in a later annual period.
IFRS Notes:
1) Under IFRS, all inventory is valued at the lower of cost or net realizable value. In U.S. GAAP,
inventories measured using any method other than LIFO or the Retail Method are also be measured
at the lower of cost or net realizable value. However, in U.S. GAAP, inventory valued using LIFO or
the Retail Method is valued at the lower of cost or market instead of the lower of cost or net realizable
value.
2) Under IFRS, previous write-downs of inventory may be recovered up to the original cost of the
inventory. Gains cannot be recognized on appreciated inventory, but previous losses can be reversed.
Reversal of previous inventory write-downs in annual financial statements is not permitted in a later
annual period under U.S. GAAP (although inventory write-downs in interim financial statements may
be reversed up to the original cost of the inventory within the same fiscal year).
Section A Study Unit 12: A.2. Investments Overview, Debt Securities
1c) Investments
Study Unit 12: A.2. Investments Overview, Debt Securities
Guidance in the Accounting Standards Codification® on accounting for investments in debt and equity
securities is in ASC 320, 323, and 325.
Investments Overview
Firms hold various types of investments for various purposes. Investments may be equity securities or debt
securities. The securities may be marketable (such as publicly traded on secondary markets) or not mar-
ketable (such as privately held). Securities may be held as an investment for unused funds until they are
needed, or they may be held for the purpose of controlling the other company.
Debt securities are bonds or notes issued by corporations or governmental authorities that generally are
traded on secondary markets, although some are privately placed and are not traded on secondary markets.
They represent loans made to the issuer by investors in the securities.
Equity securities represent ownership interests in other companies. Equity securities may be those for
which the investor does not have significant influence over the investee, those for which the investor does
have significant influence over the investee, or those for which the investor has control over the investee
and consolidates the operations of the investee with its own financial statements.
Both debt and equity investments may or may not be traded on secondary markets. If securities are traded
in active markets, their fair values can easily be determined under normal circumstances.59
• Marketable debt securities are accounted for according to whether they are classified as held-
to-maturity or available-for sale, as follows:
o Marketable debt securities that management has both the positive intent and the ability to hold
until maturity are classified as held-to-maturity and accounted for at their amortized cost.
o Marketable debt securities are classified as available-for-sale and accounted for at fair value
unless management has both the positive intent and the ability to hold them until maturity.
• Equity securities where the investor exercises significant influence or control over the in-
vestee, whether publicly or privately held, are accounted for under the equity method or by
consolidation, as follows:
o Significant influence is usually assumed when the investor owns between 20% and 50% of
the investee’s voting stock, and the equity method of accounting for the investment is required.
o Control is usually assumed when the investor owns over 50% of the investee’s voting shares,
and consolidation is required.
• Equity securities where the investor does not exercise significant influence or control over the
operations of the investee are accounted for according to whether they are publicly held or privately
held, as follows:
o Publicly held equity securities are securities traded on secondary markets, including over-the-
counter markets. They are accounted for at fair value.
o Privately held equity securities are securities not traded on secondary markets, and they are
accounted for at cost less impairment, adjusted for observable price changes.
59
The FASB has established a fair value hierarchy to provide priority for fair value valuation techniques. The fair value
hierarchy has three levels. Level 1 is quoted prices in active markets. Level 2 is inputs other than quoted prices that are
observable. Level 3 is unobservable inputs such as a company’s own data or assumptions. If a valuation method in Level
1 is not available, a method from Level 2 should be used. Level 3 is used only if the options in Levels 1 and 2 are not
available.
Study Unit 12: A.2. Investments Overview, Debt Securities CMA Part 1
Six different methods are used to account for investments.
• Four methods are used to account for debt securities and for equity securities other than those for
which the investor has significant influence or consolidates the financial statements.
• Two additional methods are used to account for equity securities when the investor has significant
influence over or controls the other entity.
The table below lists the six types of investment accounting and when each is used.
Method Guideline
1. Amortized cost Used for debt securities classified as held-to-maturity ONLY.
2. Fair value through OCI Used for debt securities classified as available-for-sale ONLY.
3. Fair Value through income Used for both debt and equity investments classified as trading
statement securities.
Used also for equity securities when the investor does not have
significant influence, usually indicated by up to 20% ownership of
the voting stock, when the investment has a readily determinable
fair value (usually publicly owned securities that are traded on an
active secondary market).
4. Cost less impairment, if Used for equity securities when the investor does not have sig-
any, adjusted for observable nificant influence, usually indicated by up to 20% ownership of the
price changes voting stock, when the investment does not have a readily deter-
minable fair value (usually privately held and not traded on an
active secondary market).
5. Equity method Used for equity securities when the investor has significant in-
fluence, usually indicated by between 20% and 50% ownership
of the voting stock.
6. Consolidation Used when the investor controls the other entity, usually when
the investor owns greater than 50% of the voting stock of the in-
vestee.
Investments in Debt Securities – Methods 1, 2, and 3

Note: Guidance in the Accounting Standards Codification® on accounting for debt securities is in ASC
320.
Debt securities are classified into three different categories for accounting and presentation in the financial
statements.
Accounting
Category Description Method Used
Held-to-Maturity Debt securities that are purchased with the intent and #1
the ability to hold them to maturity. Amortized Cost
Available-for-Sale Debt securities not classified as either trading or held- #2

to-maturity. Fair Value
Through OCI
Trading Debt securities bought and held principally for the #3

purpose of selling them in the near term and therefore Fair Value Through
held for only a short period of time, with the objective Income Statement
of generating profits from short-term price changes.
Trading securities will generally be reported only by
entities whose primary business is trading, such as
broker-dealers making proprietary trades.
A company should classify an investment in a debt security as held-to-maturity only if it has both the
positive intent and the ability to hold the security to maturity. If the investing company anticipates that
a sale of the security may be necessary before its maturity, the security should be classified as available-
for-sale.
Held-to-Maturity Debt Securities – Method 1

Debt securities classified as held-to-maturity are accounted for at amortized cost and presented at the
net amount expected to be collected using an allowance for credit losses as a valuation account de-
ducted from the amortized cost basis. See the next topic, Credit Losses on Debt Securities, for more
information.
Premiums and discounts are amortized as adjustments to interest income. If management has the intent
and the ability to hold the securities to their maturity date, changes in the fair value (market value) of the
securities during the holding period are not relevant, so the securities are not adjusted to fair value during
the holding period. Interest income (including adjustments for amortization of premiums and dis-
counts) and realized gains and losses are reported in net income.
Note: A discount is amortized to the maturity date of the debt security. A premium is amortized to the
debt security’s maturity date unless the debt security is callable prior to its maturity.
If the debt security has an explicit, noncontingent call feature and is callable at a fixed price on a preset
date, to the extent that the amortized cost basis of the callable debt security exceeds the amount re-
payable by the issuer at the earliest call date, the excess (the premium) must be amortized to the
earliest call date. After the earliest call date, if the call option is not exercised, the investor resets the
effective yield using the payment terms of the debt security.60
Available-for-Sale Debt Securities – Method 2

Available-for-sale debt securities are accounted for at fair value. Similar to held-to-maturity debt securi-
ties, they are presented at the net amount expected to be collected using an allowance for credit losses
as a valuation account deducted from the amortized cost basis. See the next topic, Credit Losses on Debt
Securities, for more information.
Interest and realized gains and losses are reported in net income. Premiums and discounts on available-
for-sale debt securities are amortized, the same as premiums and discounts on held-to maturity debt se-
curities. However, unlike held-to-maturity debt securities, available-for-sale debt securities’ values on the
balance sheet are also adjusted to their fair values at the end of each reporting period. Fair value adjust-
ments are debited and credited to a fair value adjustment (valuation) account for available-for-sale debt
securities. The balance in the valuation account is the difference between the fair value of the debt securities
and their amortized cost. The amount of the unrealized gain or loss each period is whatever amount is
required to adjust the valuation account to the balance needed to maintain it as the difference between the
fair value and the amortized cost. Unrealized holding gains and losses are reported in equity in accumulated
other comprehensive income.
Note: As with held-to-maturity debt securities, a discount is amortized to the security’s maturity date
and a premium is amortized to the security’s maturity date unless the security is callable by means
of an explicit, noncontingent call feature at a fixed price on a preset date. If the security is
callable and it has an explicit, noncontingent call feature at a fixed price on a preset date, however, the
premium is amortized to the earliest call date. After the earliest call date, if the call option is not
exercised, the investor resets the effective yield using the payment terms of the debt security.
Trading Debt Securities – Method 3

Trading debt securities are debt securities that are bought and held principally for the purpose of selling
them in the near term and therefore held for only a short period of time. Trading generally reflects active
and frequent buying and selling, and trading securities are generally used with the objective of generating
profits on short-term differences in price. Trading debt securities will generally be reported by entities whose
primary business is trading, such as broker-dealers making proprietary trades.
Trading debt securities are accounted for at fair value, with interest, realized gains and losses, and unre-
alized holding gains and losses reported in net income. Fair value adjustments during the holding period
are debited and credited to a fair value adjustment account (a valuation account) for trading debt securities.
60
Per ASC 310-20-35-33.
Reassessment of Classification Required

Per ASC 320-10-35-5, at each reporting date the investor company must reassess the classifications of its
investments in debt securities for their continued appropriateness. For example, if the company no longer
has the ability to hold debt securities to maturity, it would not be appropriate to continue to classify them
as held-to-maturity.
Credit Losses on Debt Securities

Note: Guidance in the Accounting Standards Codification® on accounting for credit losses on financial
instruments is in ASC 326.
Estimated credit losses are recorded as valuation allowances on debt securities classified as held-to-ma-
turity and available-for-sale, but they are determined differently for HTM and AFS securities.
Credit Losses on Held-to-Maturity Debt Securities
Note: Guidance on accounting for credit losses on held-to-maturity debt securities that are measured
at amortized cost is in ASC 326-20.
Credit losses on held-to-maturity debt securities measured at amortized cost are accounted for using the
current expected credit loss (CECL) model and presented at the net amount expected to be col-
lected.
The model is based on expected losses and should be a forward-looking estimate of expected credit loss
that is recognized when an asset is first recorded.
The estimate of current expected credit losses should include some measurement of the risk of credit loss,
even if the risk is remote. Only if the expectation of nonpayment is zero—such as for U.S. Treasury securi-
ties—are entities not required to measure expected credit losses.61
A valuation account, Allowance for Credit Losses-HTM Securities, is used to report the portion of the amor-
tized cost basis of the assets that the entity estimates will not be collectible because of a credit loss. The
estimate must be updated at each reporting date. A related credit loss expense is recorded in net income
and is equal to the amount needed to adjust the allowance account to management’s current estimate of
expected credit losses on the financial assets.62
Note: The CECL model is particularly pertinent to loans held by financial institutions and leases held by
lessors, but it is also applicable to investments in held-to-maturity debt securities measured at amortized
cost and accounts receivable that are held by other types of entities.
If the entity holds several securities with similar risk characteristics such as an internal or third-party credit
rating, risk rating, type of financial asset, collateral, size, term, effective interest rate, and other factors,
these securities should be aggregated, and the expected credit losses should be evaluated on a collective
(pool) basis. If an individual security does not share risk characteristics with the other financial assets, that
security should be evaluated individually for expected credit losses.63
61
Per ASC 326-20-30-10.
62
Per ASC 326-20-30-1.
63
Per ASC 326-20-30-2 and ASC 326-20-55-5.
In making the estimates, entities should consider internal and external information including:
• Past events
• Current conditions
• Reasonable and supportable forecasts
• Qualitative factors
• Quantitative factors.64
The Accounting Standards Codification® does not prescribe any specific method for estimating expected
credit losses. As described in the topic Credit Losses on Receivables in this volume, an entity can use various
measurement approaches to estimate expected credit losses such as discounted cash flow methods, loss-
rate methods, roll-rate methods, probability-of-default methods, methods utilizing aging analysis, and the
value of collateral. An entity may use more than one method.
There is no requirement to reconcile the estimate developed to an estimate developed using a discounted
cash flow method.65 But regardless of the method or methods that are used, management is expected to
maintain backup that supports how the selected method or methods fit with the standard and result in
realistic estimates of future losses.
Credit Losses on Available-for-Sale Debt Securities
Note: Guidance on accounting for credit losses on available-for-sale debt securities that are measured
at fair value is in ASC 326-30.
Similar to the way held-to-maturity securities are presented, available-for-sale securities are also presented
at the amount expected to be received and a valuation account, Allowance for Credit Losses-AFS Securities,
is used to reduce their reported fair value to that amount if a credit loss is estimated. However, the amount
of the allowance for credit losses is limited to the amount by which the fair value is below the
amortized cost, because classification as AFS is based on an investment strategy that recognizes that the
investment could be sold at fair value.
Furthermore, available-for-sale securities are specifically excluded from using the CECL model.
Instead, available-for-sale securities are evaluated for impairment.
An AFS investment is impaired if its fair value is less than its amortized cost basis. Impairment is assessed
at the individual security level. If the fair value of an AFS security is below its amortized cost basis, the
entity must determine whether the decline in fair value is due to a credit loss or due to other factors, such
as an increase in market interest rates.
To determine whether a credit loss exists, the entity compares the present value of cash flows it expects to
collect from the security with the amortized cost basis of the security. If the present value of the expected
cash flows, discounted at the effective interest rate implicit in the security at the date of acquisition, is less
than the amortized cost basis, a credit loss exists.66
Note: An estimate of an expected credit loss is required for an AFS debt security only when the fair
value of the security is below its amortized cost. The maximum amount of the credit loss is the
amount by which the fair value is lower than the security’s amortized cost.
64
Per ASC 326-20-30-7.
65
Per ASC 326-20-30-3.
66
Per ASC 326-30-35-1 through 35-10.
Other factors to consider in determining whether a credit loss exists include:
• The extent to which the fair value is less than the amortized cost basis
• Adverse conditions related to the security, an industry, or geographic area
• The payment structure of the debt security and, if the payments are scheduled to increase in the
future, the likelihood of the issuer being able to make the increased future payments
• Failure of the issuer to make scheduled interest or principal payments
• Changes to the rating of the security by a rating agency
• Information relevant to the security’s collectability, including the remaining payment terms, pre-
payment speeds, the issuer’s financial condition, expected defaults, and the value of the collateral
• Industry analyst reports and forecasts
• Credit ratings
• Other relevant market data and how other credit enhancements can affect the security’s expected
performance.67
An Allowance for Credit Losses-AFS Securities is recorded for the credit loss, limited by the amount by
which the security’s fair value is less than its amortized cost basis. The Allowance account serves
as a valuation account to decrease the reported balance to the present value of the amounts the entity
expects to receive from the investment. A related Credit Loss Expense-AFS Securities is recorded in net
income and is equal to the amount needed to adjust the allowance account to the required amount. The
impairment is evaluated at each reporting date, and changes in the allowance are recorded in the period of
the change as either credit loss expense or reversal of credit loss expense.
Impairment is assessed at the individual security level. Thus, providing a general allowance for an uniden-
tified impairment in a portfolio of debt securities is not appropriate.
Unrealized losses that are due to factors other than credit losses are reported in accumulated other com-
prehensive income net of applicable taxes.68 The valuation account used is Fair Value Adjustment-AFS
Securities.
The Fair Value Option for Investments in Debt Securities

Note: Guidance in the Accounting Standards Codification® on the application of the fair value option is
in ASC 825.
If a debt security is one that would normally not be reported at fair value through the income statement,
an investor may choose to report that specific debt security using the fair value option, with all unrealized
gains and losses related to changes in its fair value reported on the income statement. The debt security
is carried in a separate account and its fair value is increased or decreased as appropriate (a valuation
account is not used)
• Available-for-sale debt securities are customarily reported at fair value with unrealized gains and
losses reported in accumulated other comprehensive income in equity. If the fair value option is
chosen for a specific AFS debt security, that debt security will still be reported at fair value on the
balance sheet, but unrealized gains and losses on that security will be reported in income instead
of in equity.
• Held-to-maturity debt securities are customarily reported at amortized cost and unrealized gains
and losses on them are not reported. If the fair value option is chosen for a specific HTM debt
67
Per ASC 326-30-55-1 through 55-4.
68
Per ASC 326-30-35-1 through 35-10.
Study Unit 13: A.2. Equity Investments CMA Part 1
security, that debt security will be reported at fair value on the balance sheet and unrealized gains
and losses on that security will be reported in income.
Note: Whenever an available-for-sale or held-to-maturity debt security is accounted for at fair value,
any discount or premium on the debt security must still be amortized. The amortized cost at
each reporting date is used to determine the amount of unrealized holding gain or loss each period and
if the security is sold, the amortized cost at the date of sale is used to determine the amount of the
realized gain or loss.
The fair value option is applied to a specific instrument on an instrument-by-instrument basis. The choice
to report at fair value a specific instrument that would otherwise not be reported at fair value is
available only when the investor first purchases the financial asset. If an investor chooses the fair
value option, it must apply that option consistently for as long as it continues to own that security.
Example: A company invests in a debt security that it classifies as held-to-maturity. Instead of reporting
the security at its amortized cost, the investor company chooses to report that security using the fair
value option with all gains and losses related to changes in its fair value during the holding period re-
ported on the income statement. When an investor chooses the fair value option for a specific security,
it must continue reporting that security at its fair value until it sells the security.
A valuation account is not used for that security because the fair value option applies to only that HTM
security. Instead, the security is carried in a separate account and the value of the security is increased
or decreased directly in the account, as appropriate. The unrealized gain or loss is reported in earnings.
Nevertheless, the investor also continues to record amortization of any purchase discount or
premium on that debt security. The amortized cost at each reporting date is used to determine the
amount of unrealized holding gain or loss each period. When the security matures, the discount or
premium will be fully amortized and if the investor receives the face value of the debt security at its
maturity, the investor will have no realized gain or loss.
Study Unit 13: A.2. Equity Investments

Investments in Equity Securities – Methods 3, 4, 5, and 6
Investments in equity securities may be investments where the investor does not have significant influence,
investments where the investor does have significant influence, or investments where the investor company
controls the other entity and is required to consolidate the investee subsidiary’s financial statements.
Equity Securities Where the Investor Does Not Have Significant Influence
Note: Guidance in the Accounting Standards Codification® on accounting for equity securities where the
investor does not have significant influence is in ASC 321.
Equity securities other than those accounted for by the equity method or by consolidation are those where
the investor does not have significant influence or control. Such equity securities may or may not have
readily determinable fair values.
Usually, a lack of significant influence is indicated by ownership of up to 20% of the voting stock, although
it is possible to lack significant influence with ownership of 20% or more of the voting stock.
The way an equity security where the investor does not have significant influence or control is accounted
for depends on whether the security has a readily determinable fair value.
Section A Study Unit 13: A.2. Equity Investments
Accounting
Category Description Method Used
Equity securities Sales prices or bid-and-asked quotations are currently #3

that do have read- available on a securities exchange or in the over-the- Fair Value Through
ily determinable counter market and are publicly reported. A security Income Statement
fair values may also be included in this classification if it is a mu-
tual fund or similar investment vehicle that determines
and publishes the fair value per share and that fair
value is the basis for current transactions.
Equity securities Securities that are privately held and not traded on #4
that do not have any securities exchange or in the over-the-counter Cost Less
readily determina- market and thus sales prices or bid-and-asked quota- Impairment, ad-
ble fair values tions are not available. justed for observable
price changes69
Equity Securities with Readily Determinable Fair Values – Method 3

The fair value through the income statement method is used for equity securities when the investor does
not have significant influence over the investee and the investment has a readily determinable fair
value, usually because it is traded in active secondary markets. Little or no influence is usually indicated
by a holding of less than 20% of the investee’s outstanding common stock.
When an equity investment that will be accounted for under the fair value through the income statement
method is purchased, it is recorded at the cost of acquisition. Then, each time financial statements are
prepared, the investments will be valued at their fair value at the balance sheet date.
Equity securities may be classified on the balance sheet as trading equity securities. As with trading debt
securities, trading equity securities will generally be reported only by entities whose primary business is
trading, such as broker-dealers making proprietary trades. Trading equity securities are accounted for in
the same manner as any other equity securities, at fair value through the income statement. The reporting
difference exists only in their presentation in the statement of cash flows. Broker-dealers are to report their
trading securities activities in the operating section of the statement of cash flows, not in the investing
section.70
Gains and Losses on Equity Securities with Readily Determinable Fair Values
Unrealized Gain or Loss
As the fair value of the equity security changes during its holding period, the unrealized gain or loss is
reported on the income statement as an unrealized holding gain or loss.
In the case of an increase in the fair value, the journal entry will be:
Dr Fair value adjustment (valuation account) ........................................ X
Cr Unrealized holding gain (on income statement) ................................ X
69
If the entity identifies an observable price change in an orderly transaction for the identical or a similar investment of
the same issuer, the carrying value of the security is measured at fair value as of the date the transaction occurred, per
ASC 321-10-35-2 and 35-3. An “observable price change” can be a subsequent purchase of the same security or a similar
security of the same issuer made by the entity itself if its purchase transaction represents the fair value of the security,
or it can be any other purchase of the same or a similar security of the same issuer made by another investor.
70
Per ASC 940-320-45-7.
For a decrease in fair value, the entry will be as follows:

Dr Unrealized holding loss (on income statement) .............................. X
Cr Fair value adjustment (valuation account) .......................................... X
Realized Gain or Loss

When a security that has been carried at fair value (and adjusted to fair value at each reporting date with
unrealized gains and losses recognized in the financial statements) is sold, the realized gain or loss is
calculated as the amount received for the sale minus the original cost of the security. The full amount
of the realized gain or loss is reported as realized gain or loss on the income statement as of the sale date.
For example, if the security has increased in value while being held, the realized gain on the sale is recorded
as follows:
Dr Cash (including costs of the transaction) .................. sales price
Cr Investment account.............................. original acquisition price
Cr Gain .......................................................................... balance
Note that the realized gain or loss is calculated as follows:
Amount received for the sale

− Acquisition cost (original cost of the security)
= Realized gain or loss
It is not necessary to reverse on the sale date any previously recognized unrealized gains or losses on the
security that has been sold. When an investment has been sold, it will simply not be included in calculating
the fair value of all the remaining investments in the portfolio at the end of the reporting period. The
adjustment to the fair value valuation account that is made at the end of the reporting period for the
remaining investments in the portfolio will have the effect of reversing any unrealized gains or losses that
had been recognized in previous periods on investments that have been sold during the current period.
The actual calculation of the adjustment amount that is done at the end of each reporting period is outside
the scope of the exam.
Equity Securities Without Readily Determinable Fair Values – Method 4

When an equity security is privately held and is not traded on secondary exchanges and if there is not an
available practical expedient method to estimate fair value as outlined in ASC 820, Fair Value Measure-
ment,71 the equity investment should be carried at cost and assessed each period for impairment.
To assess impairment, the company must perform a qualitative assessment. If the situation and information
about the investment indicate that it is impaired, the company must recognize a loss for the difference
between the investment’s assessed fair value and its carrying value.
Additionally, if the investor identifies an observable price change in an orderly transaction for the identical
or similar investment of the same issuer, the carrying value of the security should be measured at fair value
as of the date the observable transaction occurred.72 An “observable price change” can be a subsequent
purchase of the same security or a similar security of the same issuer made by the entity itself if its purchase
71
The practical expedient is available only to investment companies for their holdings, and it permits the reporting entity
to use the net asset value per share if the net asset value per share is calculated in a manner consistent with the
measurement principles of Topic 946, Financial Services – Investment Companies.
72
Per ASC 321-10-35-2 and 35-3.
transaction represents the fair value of the security, or it can be any other purchase of the same or a similar
security of the same issuer made by another investor.
Note: Because preferred shares have no voting rights, investments in preferred stock are always ac-
counted for as investments in which the investor does not have significant influence. Even if an investor
owns 100% of the preferred shares outstanding of a company, the investor has no opportunity to exert
influence over the investee because the investor cannot vote.
Therefore, preferred shares are accounted for using the fair value method if the shares have a readily
determinable fair value or, if they do not have a readily determinable fair value, at cost less impairment
adjusted for observable price changes.
Accounting for Dividends When the Investor Does Not Have Significant Influence
Dividends received on equity securities where the investor does not have significant influence or control
and does not consolidate the investment as a subsidiary are accounted for the same way whether the equity
securities do or do not have readily determinable fair values.
Dividends Received
Cash Dividends
Dividend income for equity securities both with and without a determinable fair value is recognized for any
cash dividends declared on common or preferred stock. The following entry is made on the date of record
when the company has a legal right to the dividend.
Dr Dividend receivable ............................................................ X
Cr Dividend income .................................................................. X
When the dividend is received, the journal entry is:

Dr Cash ................................................................................ X
Cr Dividend receivable .............................................................. X
Stock Dividends
Stock dividends do not give rise to any journal entry for the investor. Because only additional shares are
received in a stock dividend while the investor’s cost is unchanged, only a memorandum entry is used to
record the receipt of the additional shares and the fact that the investor’s cost per share is now proportion-
ately less. This means that no revenue is recognized from the receipt of a stock dividend.
Note: Stock splits that result in the receipt of additional shares also do not result in a journal entry for
the investor.
Liquidating Dividends
A liquidating dividend is a dividend that the payer company pays from a source other than retained earnings.
A liquidating dividend is considered a return of the investor’s capital, rather than a return on the investor’s
capital.
If the dividend payer pays a dividend out of any source other than retained earnings, such as from paid-in
capital, the payer must inform its shareholders of how much of the dividend paid for each share should be
considered a liquidating dividend. Each shareholder can then record the dividend appropriately. Each share-
holder reduces its investment account by the portion of the dividend that is a liquidating dividend, as
follows.73
Dr Cash X
Cr Investment ......................................................................... X
However, no shareholder can reduce the carrying value for an investment below zero. Therefore, if a liqui-
dating dividend received would reduce a particular shareholder’s carrying value for the investment below
zero, then the shareholder reduces the carrying value of its investment in the stock to zero and records the
excess of the liquidating dividend as a realized gain.
Example: ABC Company and DEF Company each own 100 shares of XYZ Company common stock. ABC
and DEF purchased their holdings in XYZ at different times and at different prices. ABC Company’s cost
for its 100 shares of the stock was $500, and DEF Company’s cost for its 100 shares of the stock was
$1,100.
ABC and DEF each receive a $10 per share dividend from XYZ Company, for a total of $1,000. XYZ
provides information to shareholders that $3 per share of the dividend is being paid from earnings and
$7 per share of the dividend is a partially liquidating dividend. For each shareholder, $300 is a dividend
received from earnings and $700 is a partially liquidating dividend.
ABC Company:
Since ABC cannot reduce the carrying value of its investment in XYZ Company below its $500 cost for
the stock, ABC records a credit to its investment in XYZ in the amount of $500 and records the amount
of the partially liquidating dividend received in excess of its cost for the stock as a realized gain, as
follows. (The journal entry is shown on the cash basis for simplicity, but a dividend receivable would be
recorded on the date of record and cash would be debited and the receivable credited when the dividend
was actually received.)
Dr Cash ($10×100 sh.) ............................................................... 1,000
Cr Dividend revenue ($3×100 sh.) ...................................................300
Cr Investment – XYZ Company common stock ($5×100 sh.) ...............500
Cr Realized gain on XYZ Company common stock ($2×100 sh.) ...........200
After recording the partially liquidating dividend, ABC’s carrying value for the XYZ common stock is zero.
If ABC receives another liquidating dividend from XYZ in the future, ABC will record all of it as a realized
gain.
DEF Company:
Since DEF Company’s carrying value for the XYZ common stock was $1,100 before receipt of the partially
liquidating dividend, DEF Company credits the full $7 per share of the partially liquidating dividend to its
investment in XYZ, reducing DEF’s carrying value for the stock to $400 ($1,100 − $700). DEF Company
records the $1,000 it receives as follows:
Dr Cash ($10×100 sh.) ............................................................... 1,000

Cr Dividend revenue ($3×100 sh.) ...................................................300
Cr Investment – XYZ Company common stock ($7×100 sh.) ...............700
If DEF receives another liquidating dividend from XYZ Company in the future, DEF will record up to its
$400 carrying value for the XYZ stock as a reduction to the stock’s carrying value and will record as a
realized gain any amount of the liquidating dividend received in excess of the stock’s carrying value.
73
The journal entry is shown on the cash basis for simplicity, but a dividend receivable would be recorded on the date
of record and cash would be debited and the receivable credited when the dividend was actually received.
Long-Term Investments Where the Investor Has Significant Influence or Control
The Equity Method – Method 5
Note: Guidance in the Accounting Standards Codification® on accounting for long-term investments
under the equity method is in ASC 323.
The equity method can be called a “one-line consolidation,” because the net result on the investor’s income
of accounting for an investment using the equity method is the same as the result of using full consolidation.
However, instead of reporting its share of each separate component of income (sales, cost of sales, oper-
ating expenses, and so forth) in its income statement, the investor includes only its share of the investee’s
net income in a single line on its income statement.
When to Use the Equity Method

The equity method is used when the investor has significant influence over operating and financial poli-
cies of the investee, usually as a long-term investor. Owning between 20% and 50% of the outstanding
voting stock usually indicates significant influence.
Note: It is important to remember that the rules governing the equity method and consolidation
are based on influence and control, not the percentage of ownership. The percentages of ownership
are only guidelines. If a company owns 80% of another company but does not have significant influence
over the other company, the investment is accounted for using the fair value method or, if the investment
does not have a readily determinable fair value, at cost less impairment, adjusted for observable price
changes.
ASC 323-10-15-6 provides indicators of “significant influence,” in addition to the percentage of ownership,
as follows:
• The investor is represented on the board of directors of the investee.
• The investor participates in the policy-making processes of the investee.
• There are material intra-entity transactions.
• There is an interchange of managerial personnel between the investor and the investee.
• There is technological dependency between the entities, for example using the same systems.
Acquisition of the Equity Method Investment

The investment is initially recorded at cost.
Dr Investment ...................................................................... X
Cr Cash .................................................................................. X
Post-Acquisition Events
After acquisition, the investment account will be adjusted for the amount of the earnings or losses that
“belong to” the investor and for a few other events.
Investee’s Earnings
Because the investor owns some percentage of the investee company, some percentage of the earnings of
the investee actually “belong” to the investor, even if they are not distributed. Also, because the investor
has significant influence over the investee company, the investor is in a position to determine when a
dividend is declared or not declared, and how large the dividend is. If the fair value or cost less impairment
adjusted for observable price changes method were used to account for the investment, the investor could
“smooth” its own income by declaring or not declaring dividends (see the next topic, Cash Dividends).
Therefore, to prevent this smoothing of income, each year the investor will recognize its share of the in-
vestee’s earnings by debiting the investment account on its balance sheet to increase it and crediting an
income statement account, either investment income or equity in investee’s income, even if dividends are
not declared.
Note: If the investee has preferred stock outstanding, the calculation of the investor’s share of the
earnings is made after the deduction of preferred dividends earned or declared.
Positive investee earnings (profits) increase the balance in the investment account.
Dr Investment ....................................................................... X
Cr Investment income (or equity in investee’s income) ................. X
If the investee has a loss, the investor must also report its share of the loss, thereby decreasing the
investment account on its balance sheet.
Cash Dividends
When dividends on the common shares are declared, the dividends are recorded by the investor as a re-
duction of its investment account (because a portion of the investor’s share of the investee’s earnings has
now been distributed) and an increase to the investor’s cash or dividends receivable. The declaration and
receipt of dividends does not affect the investor’s income statement because the investor has already rec-
ognized that income as part of its share in the investee’s earnings. For the investor, the dividend receipt
represents a transfer from one asset account to another asset account.
Dr Cash (or dividends receivable) ............................................. X
Cr Investment account.............................................................. X
Equity Method Summary

Following is a T-account summary of the events that are recorded in the investment account under the
equity method.
Equity Investment Account
Original cost of investment
Share of investee’s income since acquisition Share of investee’s losses since acquisition
Share of investee’s dividends declared
Disposal of investee stock
Ending Balance in Investment
Stock Dividends and Stock Splits

When an investor receives shares via a stock dividend or a stock split, the investor makes no journal
entry. There is no change in the percentage of the investor’s ownership in the investee, and there is no
distribution of earnings of the company. Only a memorandum entry is made that increases the number of
shares held and reduces the book value of each individual share of stock held in the investee.
Intercompany Profits and Losses

The investor’s pro rata share of profits or losses on transactions between the investor and the investee
should be eliminated for any items not yet sold to an outside party at the financial statement date. These
profits or losses, which are still inside the companies, are eliminated through the investment and investment
income accounts. It is unlikely that an exam question will ask about intercompany profits and losses under
the equity method.
Intercompany Receivables and Payables

Intercompany receivables and payables are not eliminated under the equity method of accounting, but
receivables and payables from companies that are accounted for using the equity method should be dis-
closed separately.
Other Considerations
Goodwill
If the investor pays more for the shares than the proportionate net worth of the company purchased, the
difference between these two amounts is equity method goodwill. The amount of goodwill is calculated
as the difference between the price paid (the fair value of everything given up) and the fair value of the net
assets acquired (based on the percentage of ownership).
However, equity method goodwill is not recognized as a separate line-item asset. It is simply included in
the investment account with all other net assets.
Note: A notational reference to the amount of goodwill will probably be recorded, but it is not separately
listed in the journal entry.
Financial Statement Presentation

The investment account is shown in one line on the balance sheet, and the earnings or losses from the
investment are shown on the income statement as part of net income, but not as operating income. They
are presented as part of the non-operating gains and losses line on the income statement below net oper-
ating income, and the components of that line on the income statement are disclosed in the notes to
financial statements.
Disposal of an Equity Investment

When an investment that was accounted for under the equity method is disposed of, a gain or loss is
recognized for the difference between the carrying amount and the selling price.
Changes in Level of Ownership or Degree of Influence
Changing from the Fair Value or Cost Less Impairment Method to the Equity Method
When an investment accounted for at fair value or cost less impairment adjusted for observable price
changes qualifies as an equity method investment because of an additional investment made, the investor
adds the cost of the additional investment to the basis of the previously held interest and adopts the equity
method of accounting as of the date the investment qualifies for equity method accounting. No retroactive
adjustment is made.74
However, the current basis of the investor’s previously held interest in the investee must be remeasured to
fair value immediately before recording the additional investment, and the investor recognizes a gain or
loss in earnings on the change in fair value of its previous holdings.
• If the equity security has a readily determinable fair value (that is, it is traded on an active
secondary market), the fair value is the current market value.
• If the equity security does not have a readily determinable fair value and the investor has
been estimating its fair value at its cost minus impairment adjusted for observable price changes
in accordance with ASC 321-10-35-2, that paragraph provides that if the investor identifies an
observable price change in an orderly transaction for the same or a similar investment of the same
issuer, the investor measures the equity security at fair value as of the date the observable trans-
action occurred. The investor’s own purchase of the additional investment is an observable
transaction if the investor determines that the price it paid per share represents the fair value of
the security.
Therefore, before recording its purchase of the additional shares, ASC 323-10-35-33 provides that
the investor remeasures the current basis of its previously held interest in the investee according
to the fair value per share as established by its own subsequent purchase (assuming the investor
determines that the price it paid represents the fair value) and recognizes a gain or loss in earn-
ings.75
The investor then proceeds to record its subsequent purchase at its purchase price and then applies
the equity method of accounting to its entire investment in the investee.
Changing from the Equity Method to the Fair Value or Cost Less Impairment Method
Accounting for an equity method investment may need to be changed to the fair value method or the cost
less impairment adjusted for observable prices changes method because the investor has sold some of its
holdings in the investee and no longer has significant influence.
When an equity investment is changed to the fair value or cost less impairment adjusted for observable
price changes method, the cost basis that should be used for the newly classified investment is the carrying
value of the equity investment at the time of the change. However, several adjustments to that value
are needed first.
1) The investor’s investment account needs to be adjusted so it is current as of the date of the event
that caused the change in accounting methods. The investor’s share of net income or loss in the
investee for the period up to the event should be recorded.
2) If the event that gave rise to the change in method was a partial sale, the gain or loss on the sale
can be computed after the accounts have been adjusted for the investor’s share of net income or
loss in the investee for the period up to the sale. The investor’s gain or loss is equal to the difference
at the time of the sale between the selling price and the investor’s carrying amount of the stock
74
Per ASC 323-10-35-33.
75
Per ASC 323-10-35-33, in accordance with to ASU 2020-01, effective December 16, 2020.
sold. The gain (loss) is reported on the investor’s income statement in the non-operating
gains/losses section.
3) The remaining holdings are remeasured to fair value immediately after recording the partial sale
and a gain or loss is recorded in earnings.
o If the equity security accounted for under the equity method has a readily determinable
fair value (that is, it is traded on an active secondary market), the fair value is the current
market value.
o If the equity security accounted for under the equity method does not have a readily deter-
minable fair value and the investor estimates its fair value at its cost minus impairment
adjusted for observable price changes in accordance with ASC 321-10-35-2, the investor’s own
sale of a portion of its investment is an observable transaction if the investor determines that
the price it received per share represents the fair value of the security.
Therefore, after recording the sale and the gain or loss on the sold shares, if the security does
not have a readily determinable fair value, the investor remeasures its remaining holdings at
fair value based on the price it received per share for the shares it sold (assuming the investor
determines that the price it received represents the fair value) and recognizes a gain or loss
on the remaining shares.76
The adjusted carrying value of the retained portion of the investment at the time of the change becomes
the cost basis for the remaining investment under the fair value or cost less impairment adjusted for ob-
servable price changes method.
Although the change represents a change in accounting principle, the investment account is not adjusted
retroactively. Going forward, the investor accounts for the retained portion of the investment at fair value
or cost less impairment adjusted for observable price changes, as appropriate. The investor records future
dividends received as dividend income, although any dividends received in excess of the investor’s share of
the investee’s post-disposal net income are considered a return of capital and are credited to the investment
rather than to income.
The Fair Value Option for Equity Method Investments

For a specific security that would otherwise be reported using the equity method, an investor may choose
the fair value option instead, with all gains and losses related to changes in its fair value reported on the
income statement. The option is applied to a specific instrument on an instrument-by-instrument basis and
is available only when the investor first purchases the financial asset. If an investor chooses the fair value
option, the investor must apply the fair value method consistently as long as they own the security.
If the fair value option is used for an equity investment where the investor has significant influence, the
investor does not report its proportionate share of the investee’s income or loss, and dividends received by
the investor are credited to dividend income and do not reduce the investments account. The equity invest-
ment is carried in a separate account and its fair value is increased or decreased as appropriate to reflect
unrealized gains and losses. The other side of the entry is an unrealized gain or loss on the income state-
ment.
76
Per ASC 323-10-35-36, in accordance with to ASU 2020-01, effective December 16, 2020.
Study Unit 14: A.2. Business Combinations and Consolidations CMA Part 1
Study Unit 14: A.2. Business Combinations and Consolidations

Consolidated Financial Statements – Method 6
Guidance in the Accounting Standards Codification® on accounting for consolidations is in ASC 810.
Consolidated financial statements are usually required for a fair presentation when one of the companies in
a group of companies directly or indirectly has a controlling interest in a subsidiary or subsidiaries and the
parent and subsidiary or subsidiaries are operated as separate legal entities. Consolidated financial state-
ments present the financial statements of the consolidated companies (the parent and subsidiary or
subsidiaries) as if the companies were a single economic entity.
Two models are used for assessing “controlling interest” and determining whether consolidation of financial
statements is appropriate:
1) The voting interest model. When an acquirer has a controlling financial interest in the acquiree,
the financial statements of the acquirer and the acquiree should be consolidated. The usual condi-
tion for a controlling financial interest is ownership by one reporting entity (directly or indirectly)
of more than 50% of the outstanding voting shares of the acquiree.
Although control is normally demonstrated by ownership of more than 50% of the voting stock of
a company, it is possible for an owner to have control with a smaller ownership percentage or to
have no control with a higher ownership percentage. For example, if non-controlling shareholders77
have substantive participating rights, the majority shareholder does not have a controlling financial
interest and therefore the financial statements should not be consolidated.
Note: A majority-owned subsidiary should not be consolidated if control does not rest with
the majority owner. For example, if the subsidiary is in legal reorganization or bankruptcy, or
if it operates under foreign restrictions, controls, or other governmentally imposed uncertainties
so strict that they cast significant doubt on the parent's ability to control the subsidiary, the
parent may not have control.
2) The variable interest entity (VIE) model. A “variable interest entity” is a legal entity that is
financially controlled by one or more entities that do not hold a majority voting interest. The entity
holding the majority of the financial control is called the VIE’s primary beneficiary. The definition
of a “parent” in a consolidation includes a VIE’s primary beneficiary, and the definition of “subsid-
iary” includes a VIE that is consolidated by its primary beneficiary.
This assessment of the VIE and determination of the primary beneficiary needs to be made on an
ongoing basis.
According to ASC 810-10, the financial statements of VIE’s that have a primary beneficiary must
be consolidated with the financial statements of the primary beneficiary, regardless of the amount
of ownership held in the VIE by the primary beneficiary.
The Consolidation Process

The income or loss of the consolidated company is calculated by including the income or the loss of the
purchased company only for the period after the purchase. The revenues and expenses of the acquired
company are included in the combined financial statements, again, only for the period after the acquisition.
At the end of each period, a consolidation worksheet is prepared. The balance sheets and income statements
of the companies to be consolidated are prepared in a columnar format, and an additional column is created
on the worksheet for adjusting or eliminating entries. The main exercise in the consolidation is eliminating
77
When a parent company owns a controlling interest in a subsidiary but does not own 100% of its voting stock, the
owner(s) of the remainder of the voting stock are called non-controlling interests or non-controlling shareholders.
Section A Study Unit 14: A.2. Business Combinations and Consolidations
intercompany transactions. An event that gives rise to an asset for one company and a liability for the
other company must be eliminated from the consolidated balance sheet to prevent double counting of the
event. Similarly, income statement events (buying and selling) carried out between two consolidated com-
panies need to be eliminated from the consolidated income statement.
The main adjustments are:
1) Eliminating intercompany receivables and payables
2) Eliminating the effect of intercompany sales of inventory
3) Eliminating the effect of intercompany sales of fixed assets
4) Eliminating the parent’s investment account
1) Eliminating Intercompany Receivables and Payables

Because it is not possible for a company to owe money to itself, when the consolidated financial statements
are prepared any payables or receivables between the consolidated companies need to be eliminated.
If intercompany payables and receivables were not eliminated, the balance sheet would be “grossed” up
because payables and receivables would be overstated. The amounts of intercompany payables and receiv-
ables to eliminate should be equal to each other since if one of the consolidated parties has a related party
receivable then another of the consolidated parties must have a related party payable.
2) Eliminating the Effect of Intercompany Sales of Inventory

When an inventory sale takes place between consolidated companies, several adjustments need to take
place.
• The inventory sold by one consolidated company to another consolidated company must be re-
ported in the consolidated financial statements at the value recorded by the original purchaser
of the inventory. If the inventory sold to the related party included some profit for the seller, the
buyer of the inventory will have recorded it at an amount higher than the seller’s purchase price.
Because it is necessary to show all of these companies as if they were one company, the inventory
must be reported at the value at which it was purchased by the “group.” If the inventory is still on
the books of the company that purchased it, the inventory account must be written down to the
cost that was paid when the consolidated group of companies first acquired the inventory.
• Furthermore, any profit recognized by one member of the consolidated group on inter-company
sales of inventory not yet sold to an unrelated third party by the group must be eliminated because
the company cannot make a profit simply by selling inventory to itself.
• If the buyer of the inventory has sold it to an unrelated third party, the consolidated reported profit
will be the sale price received by the company that ultimately sold the inventory to the unrelated
third party minus the inventory’s cost to the original purchasing company.
3) Eliminating the Effect of Intercompany Sales of Fixed Assets

The following adjustments must also be made if an intercompany sale of fixed assets has taken place:
• The carrying value of the asset needs to be adjusted to the amount it would have been if the fixed
asset had never been sold within the group. The historical cost on the consolidated balance sheet
needs to be the amount the selling company paid for the asset.
• The intercompany gain on the sale is unrealized until the asset is sold to an outside party, so the
gain recorded by the seller must be eliminated. This adjustment must be made every year.
• Since the unrealized gain is eliminated from the valuation of the asset, the gain element must be
eliminated from the related depreciation expense in the consolidated income statement. The de-
preciation expense on the consolidated income statement should be what it would have been if the
asset had not been sold to the related party.
Study Unit 14: A.2. Business Combinations and Consolidations CMA Part 1
• The accumulated depreciation needs to be the amount it would have been if the asset had not been
sold. This adjustment must be made every year.
• The retained earnings of the selling company need to be reduced to eliminate the gain that was
recognized by the selling company on the sale of the fixed asset.
4) Eliminating the Parent’s Investment Account

Because the parent company owns shares of the subsidiary, it has an investment in subsidiary account on
its balance sheet that represents its investment in the subsidiary. Because the subsidiary’s balance sheet
is added to the parent’s balance sheet in the consolidation, the parent would be double counting that in-
vestment unless an adjustment is made. The adjustment eliminates the investment account on the parent’s
books against the equity accounts on the subsidiary’s books. (Candidates do not need to worry about the
details of the elimination, other than to know that it happens.)
Other Eliminations
Any other intercompany transactions also need to be eliminated. Intercompany transactions could be re-
lated to bonds, loans, notes payable or anything similar.
Non-controlling Interests
Non-controlling interests are the claims to the net assets of the subsidiary that are held by investors other
than the parent company. Non-controlling interests arise when the parent does not own 100% of the sub-
sidiary. If the parent does own 100% of the subsidiary, then no non-controlling interests can exist.
In the consolidation, the balance sheet of the subsidiary is added to the balance sheet of the parent. For
example, if the parent owns only 90% of the subsidiary, technically it should include only 90% of the assets
and liabilities of the subsidiary because 90% is all it owns. However, the parent will prepare the consolida-
tion worksheet as though it owned 100% of the subsidiary. The parent then sets up a balance sheet account
called non-controlling interests that represents the claims on the subsidiary’s net assets by the non-
controlling shareholders.
• In the consolidated balance sheet, the offsetting credit amount for the portion that does not belong
to the parent company is shown as a separate caption in the stockholders’ equity section.
• Accumulated other comprehensive income of the subsidiary is also apportioned between the parent
and the non-controlling interest and the amounts are shown separately in the equity section.
• In the income statement, the amount of net income belonging to the parent and to the non-con-
trolling interests are consolidated, but they must be separately identified. Net income of the parent
and 100% of the subsidiary, including the income attributable to the non-controlling interest, is
shown first. That is followed by a line identified as net income (or net loss) attributable to the non-
controlling interest, and the net income (net loss) attributable to the non-controlling interest is
subtracted from (added to) the consolidated net income. The remainder is net income attributable
to the parent.
Section A Study Unit 15: A.2. Recording Fixed Assets
Study Unit 15: A.2. Recording Fixed Assets
1d) Property, Plant, and Equipment

Except as noted, guidance in the Accounting Standards Codification® on accounting for property, plant,
and equipment is in ASC 360.
Property, plant, and equipment—also called fixed or capital assets—includes land, buildings, and equipment
acquired for operations and not for resale. Fixed assets are long-term assets that possess physical sub-
stance, and they are usually depreciated.
For many companies, “Property, Plant, and Equipment” constitutes the largest asset classification on the
balance sheet, especially for production companies with large production facilities. Therefore, it is an im-
portant that the company correctly value and account for fixed assets.
Initial Recording of the Fixed Asset

Fixed assets should be initially recorded in the accounting records at historical cost, which is the amount
paid for the asset and all other costs necessary to get the asset ready for use.
It is important to be familiar with the costs included in the different classes of fixed assets. Below are some
of the major classifications of assets and the items specific to each classification.
• Buildings. The purchase price, costs of renovating or preparing the building, cost of permits, any
taxes assumed by the purchaser, insurance paid during the construction of the building, and mate-
rials, labor, and overhead of construction.
• Machinery and equipment. The cost of the machine, freight-in, handling, taxes, testing the ma-
chinery, installation, and any other costs of getting the machinery ready for its intended use. Partial
destruction of property can be included if, for example, a wall needs to be torn down to install
machinery onto a factory floor. If a wall needs to be torn down to install the machinery, the costs
of the demolition and rebuilding the wall are included in the cost of the machinery.
• The cost of improvements made to equipment after its acquisition should be added to the asset’s
historical cost if the improvements will provide future benefits.
• Land. The land purchase price, including any mortgages the purchaser assumed, transaction costs,
site preparation costs, the costs of purchasing and razing (destroying) an existing structure, the
amount of any delinquent real estate taxes assumed by the purchaser, permanent improvements,
and other costs necessary to prepare the land for its intended use. The costs of destroying an
existing building are included in the land cost because the land is not ready for its intended use
until the building is removed.
Any proceeds from the sale of an asset resulting from preparing the land for use should be treated
as a reduction in the cost of the land, not income. For example, if trees are cleared and the
timber sold, the proceeds from the sale of the wood are accounted as a reduction in the cost of the
land.
Note: When a company constructs fixed assets for its own use, it will often need to obtain some financing
to pay for the costs of the construction. In some cases, the company can capitalize some of the interest
it incurs on that external financing. Capitalization of interest is covered in any intermediate accounting
textbook, and since it is not tested on the CMA exam, it is not discussed further in these study materials.
Study Unit 15: A.2. Recording Fixed Assets CMA Part 1
Depreciation
Depreciation is the systematic and rational allocation of the costs of a fixed asset over its expected useful
life. In other words, depreciation matches the cost of acquiring the asset with the revenues the asset will
generate over its useful life by spreading the recognition of the acquisition cost over the time period during
which the asset will be useful (provide revenue) to the company. Depreciation is a method of cost allocation.
It is a purely mathematical process of dividing in some manner the cost of the asset among the periods in
which it will be used.
IFRS Note: Under U.S. GAAP, no attempt is made to report fixed assets at their fair value during their
life because the value of the asset may fluctuate and changes in fair value are difficult to measure
objectively. In contrast, IFRS permits revaluation of fixed assets to fair value if the revaluation is per-
formed on a regular basis and the policy is applied consistently to all assets in the asset class.
Net Book Value of Fixed Assets

Each year, depreciation is usually recorded by debiting depreciation expense (or an inventory account for
manufacturing depreciation) and crediting accumulated depreciation. Accumulated depreciation is a val-
uation account that decreases the carrying value of fixed assets, recorded at their historical cost, to their
book value. The book value is the cost of the fixed assets minus the accumulated depreciation. The historical
cost recorded in the fixed asset account at the time of acquisition will remain unchanged until disposal
unless subsequent expenditures for that asset are capitalized.
The journal entry to record depreciation expense below has the same form, no matter which depreciation
method is used. The calculation that is made for depreciation expense determines the amount that is rec-
orded in the following journal entry:
Dr Depreciation expense (or factory overhead control)78 ............. x

Cr Accumulated depreciation ..................................................... x
The accumulated depreciation account is presented on the balance sheet as a reduction or valuation of the
fixed assets account. In the example that follows, $76,250 is the carrying value or book value of the com-
pany’s fixed assets.
Fixed assets $100,000

Less: Accumulated depreciation (23,750) $76,250
Note: The fixed asset account itself is not reduced as an asset is depreciated.
78
If the depreciation being recorded is depreciation of manufacturing facilities, the depreciation is a fixed overhead cost
and is debited to factory overhead control instead of to depreciation expense. The depreciation becomes a part of the
inventory cost of the items manufactured and flows to cost of goods sold along with the other costs of production as the
items are sold.
Section A Study Unit 16: A.2. Depreciation of Fixed Assets and Impairment
Study Unit 16: A.2. Depreciation of Fixed Assets and Impairment

Calculation of Depreciation
Four methods are used to calculate the amount of depreciation to record each period. Some general infor-
mation is needed before depreciation can be calculated under any of the methods. The needed information
and the definitions of the terms are:
• Estimated useful life. Also known as “service life,” “estimated useful life” refers to the length of
time an asset is expected to be useful and the period of time over which depreciation is recognized.
At the end of its useful life, the asset should have a book value equal to the estimated salvage
value.
• Estimated salvage value. Also known as “residual value,” “estimated salvage value” refers to
the value an asset is expected to have at the end of its useful life. The book value may not be
depreciated below the salvage value. However, some companies have an accounting policy that
salvage value is always $0.
• Depreciable amount or depreciable base. The depreciable base is the amount to be depreciated
over the asset’s useful life. It is equal to the capitalized amount (that is, the cost of the asset)
minus its salvage value.
Note: Land is never depreciated because the useful life of land is unlimited.
Depreciation Methods
The annual depreciation charge can be calculated in four main ways. No matter which depreciation method
is used, the journal entry on the previous page is the same. The following four methods are simply different
ways of calculating the value of “X” in the journal entry.
1) Straight-line Depreciation
Straight-line depreciation (STL) results in an equal amount of depreciation taken each period:
Depreciable Base
Periodic Depreciation =
Estimated Useful Life
The depreciable base is the asset’s initial cost (including all costs required to purchase the asset and
make the asset ready for use, such as sales or value-added taxes, shipping-in costs, and installation costs)
minus the anticipated salvage value.
Note: Straight-line depreciation is the easiest depreciation method to calculate. As such, it is the depre-
ciation method that will usually appear in questions that include depreciation but are not specifically
questions about depreciation.
All other depreciation methods result in greater depreciation in the early years of an asset’s life and lesser
depreciation in the latter years. All the other depreciation methods are called accelerated depreciation
methods.
Study Unit 16: A.2. Depreciation of Fixed Assets and Impairment CMA Part 1
2) Double Declining Balance

The annual depreciation rate in the double declining balance (DDB) method is two times the percentage
that would be recognized under the straight-line method, but that percentage is applied to the net book
value of the asset at the beginning of each year instead of to its depreciable base, as in straight-line
depreciation.
Example: If the useful life of the asset is 10 years, take a depreciation charge each year equal to 20%
of the asset’s book value at the beginning of the year. Twenty percent is used because 20% is twice
the 10% that would have been used each year under the straight-line method.
However, the 20% is applied to the net book value of the asset at the beginning of each year, whereas
with straight-line depreciation, the 10% would have been applied to the depreciable base each year.
The annual depreciation to be recorded is calculated as follows:
Double declining rate × book value of the asset at the beginning of the year
Note: In the double-declining balance method, the depreciation charge is calculated using the book
value at the beginning of the period, not the original depreciable base.
Salvage value is not taken into account when calculating the periodic depreciation charge. However, the
anticipated salvage value is used. Near the end of the asset’s useful life, it is important not to depreciate
the asset below its salvage value. Therefore, the final year’s depreciation amount needs to be ad-
justed so that the asset’s net book value after the final year’s depreciation has been recorded
will be equal to its salvage value.
Note: Many companies use DDB for the first few years of an asset’s life and then switch to straight-line
for the remaining years.
Example: A company buys an asset costing $100,000 that has an estimated salvage value of $10,000.
The estimated useful life is 4 years.
The depreciable base is $90,000 (calculated as the cost less the salvage value). Given a 4-year useful
life, the annual depreciation recorded under the straight-line method would be 25% of the depreciable
base. Under the DDB method, the annual depreciation is two times 25%, or 50% of the asset’s begin-
ning book value. The depreciation charge for Year 1 must be calculated before calculating the
depreciation charge for Year 2 in order to know the book value at the beginning of Year 2, and so on.
Year 1: $100,000 book value × 50% = $50,000 depreciation recorded
Year 2: $50,000 BV ($100,000 − $50,000 depreciation recorded in Year 1) × 50% = $25,000 depre-
ciation recorded
Year 3: $25,000 BV ($100,000 − $50,000 depreciation recorded in Year 1 − $25,000 depreciation

recorded in Year 2) × 50% = $12,500 depreciation recorded
Year 4: $12,500 BV ($100,000 − $50,000 depreciation recorded in Year 1 − $25,000 depreciation

recorded in Year 2 − $12,500 depreciation recorded in Year 3) × 50% = $6,250. However, recording
the entire $6,250 as depreciation in Year 4 would reduce the asset’s book value below its $10,000 salvage
value. Thus, the Year 4 depreciation recorded is only $2,500 ($12,500 BV − $2,500 depreciation =
$10,000 BV after the Year 4 depreciation is recorded).
The total depreciation recorded during Years 1 through 4 is $90,000, the amount of the depreciable base
($50,000 + $25,000 + $12,500 + $2,500), and at the end of 4 years the net book value of the asset
will be its salvage value of $10,000.
Note: The double declining balance method uses 200% of, or two times, the straight-line amount. Other
forms of declining balance depreciation can be used as well, using different percentages such as 150%
of the straight-line amount.
Note: With all the other methods of depreciation, the depreciation recorded can be calculated for any
year of the asset’s life independent of the other, earlier years. However, when the declining balance
method is used, to calculate the depreciation recorded for Year 2, for example, it is necessary to first
calculate the depreciation recorded for Year 1 in order to know the book value to use in calculating the
Year 2 depreciation. And before calculating Year 3’s depreciation, depreciation needs to be calculated for
Years 1 and 2, and so forth.
In contrast, under the straight-line, sum-of-the-years’-digits and units-of-production methods (the last
two are discussed next), depreciation for any year subsequent to the first year can be calculated without
first calculating any of the preceding years’ depreciation amounts.
3) Sum-of-the-Years’-Digits
In the sum-of-the-years’-digits (SYD) method, the amount of depreciation to be recorded for any given
period is calculated using fractions based on the estimated useful life of the asset.
Under the SYD method, the depreciable base (cost less estimated salvage value) is multiplied by a fraction
that is determined using the useful life of the asset. The denominator of the fraction is a sum of all of the
asset’s estimated years of useful life. For example, if the asset has a useful life of 5 years, the denominator
is the sum of the useful years: 5 + 4 + 3 + 2 + 1 = 15. The numerator is the number of years remaining
in its life, including the year for which depreciation is being calculated. Thus, for a 5-year asset, the depre-
ciation recorded in the first year is 5/15 of the depreciable base. In the second year, the depreciation
recorded will be 4/15 of the depreciable base, in the third year 3/15, and so on.
If the number of years is too great to sum easily, the sum-of-the-years’-digits, or the denominator of the
fraction, can be calculated using the following formula, where n represents the total number of years of
useful life for the asset:
n(n + 1)
Sum-of-the-Years’-Digits =
2
For example, the SYD to use for the denominator for an asset with a five-year useful life is:
Sum-of-the-Years’-Digits = 5(5 + 1) = 5×6 = 15

2 2
The above sum-of-the-years’-digits can also be achieved through the following summation: 1 + 2 + 3 + 4
+ 5 = 15.
Example: A company buys an asset costing $100,000 that has an estimated salvage value of $10,000.
The estimated useful life is 4 years.
The depreciable base is $90,000 (calculated as the cost less the salvage value). This depreciable base
of $90,000 will be depreciated over the asset’s 4-year useful life. With a useful life of 4 years, the sum
of the year’s digits is 10 (1 + 2 + 3 + 4 = 10). Therefore, in Year 1, the company will record depreciation
equal to 4/10 of the depreciable base, or $36,000. The calculation for each of the 4 years is below:
Year 1: $90,000 × 4/10 = $ 36,000

Year 2: $90,000 × 3/10 = 27,000
Year 3: $90,000 × 2/10 = 18,000
Year 4: $90,000 × 1/10 = 9,000
Total $ 90,000
The total depreciation recorded over the life of the asset is equal to the depreciable base, and the final
book value equals the salvage value.
IFRS Note: Under IFRS, if individual components of a fixed asset have different usage patterns and
useful lives, then the individual components must be depreciated separately. For example, if the engine
on a machine has a 5-year life while the rest of the machine has a 15-year life, the engine must be
depreciated over 5 years and the remaining cost of the machine must be depreciated over 15 years.
Under U.S. GAAP, component depreciation is allowed but not required.
4) Units-of-Production Method
The preceding depreciation methods are based on time. The units-of-production method is based on
actual physical usage of the asset during a given period.
Under the units-of-production method, an estimate is made of the number of units the asset will be able to
produce over its useful life. The depreciation rate per unit produced is calculated as the cost less the esti-
mated salvage value divided by the estimated number of units to be produced over the asset’s estimated
useful life.
Cost Less Salvage Value

Depreciation Rate =
Estimated number of units to be produced
by the asset over its estimated useful life
The depreciation recorded for any period is the depreciation rate multiplied by the number of units actually
produced during the period.
Example: A new piece of equipment is purchased for $2,000,000. The equipment is expected to produce
1,000,000 units over its estimated useful life and to have a $200,000 salvage value. The depreciation
rate is ($2,000,000 − $200,000) ÷ 1,000,000, or $1.80 per unit produced.
During its first year of operation, the equipment produces 120,000 units. The amount of depreciation
recorded for the first year of operation is $1.80 × 120,000, or $216,000.
Depreciation for Tax Purposes

In the U.S., the Internal Revenue Service prescribes the method of depreciation to be used on a company’s
tax return, and the method is specific for tax purposes.
MACRS, or Modified Accelerated Cost Recovery System, is the most common type of depreciation required
by the U.S. tax laws, although it is not the only acceptable method a company can use on its tax return.
The depreciable base for tax purposes, is always 100% of the cost of the asset and the other costs required
to make it ready for use. Therefore, any anticipated salvage value at the end of the asset’s life is never
subtracted from the original cost when calculating depreciation for tax purposes or when calculating the tax
basis (book value for tax purposes) when the asset is sold.
Furthermore, U.S. tax laws require that a portion of a year’s depreciation be taken in the year the asset is
acquired and a portion of a year’s depreciation be taken in the year the asset is disposed of. The most
common portion used is one-half year’s depreciation in both the first and the last year, regardless of the
actual date the asset was purchased. Taking one-half year’s depreciation in the first and last year is called
the half-year convention.
For example, if an asset is being depreciated over a three-year period for tax purposes, that three-year
period begins in the middle of the fiscal year in which the asset is acquired (July 1 if the company is using
a calendar year as its fiscal year) and it ends in the middle of the year in which the asset is completely
depreciated and/or disposed of. Thus, a three-year asset purchased in 20X1 when the company’s fiscal year
is the same as the calendar year will be depreciated over four calendar years as follows:
20X1 ½ of one year’s depreciation

20X2 1 year’s depreciation
20X3 1 year’s depreciation
20X4 ½ of one year’s depreciation
Note that the above depreciation schedule works out to three full years of depreciation, even though the
depreciation is taken over a period of four tax years.
The U.S. Internal Revenue Service (IRS) provides MACRS tables that give the percentage of the original
cost to be depreciated each year. There are several tables, each incorporating a given convention, and the
half-year convention is the most commonly used. The percentages for the first and last year in the half-
year convention table have already been adjusted to reflect one-half year’s depreciation in those years.
Therefore, when calculating annual depreciation amounts using the MACRS tables, the percentages should
be used as given.
For example, for an asset that is being depreciated over three years using MACRS and the half-year con-
vention, here are the percentages given in the tables:
Year 1 33.33%
Year 2 44.45%
Year 3 14.81%
Year 4 7.41%
Total 100.0%
The first year’s depreciation in the schedule above is 33.33% of the asset’s total cost. If one full year’s
depreciation were recorded in the first year, the full year amount would be 66.67% of the asset’s total cost.
One-half of that is 33.33%. The final year’s depreciation is adjusted similarly.
Exam Tip: Knowledge of these percentages are not necessary for the exam. If MACRS is to be
used on the exam, the percentages will be given in the question.
Example: The amount of depreciation to be taken for each year for an asset with an original cost of
$90,000 that is being depreciated as three-year property using MACRS and the half-year convention will
be as follows:
Year 1 33.33% $29,997
Year 2 44.45% 40,005
Year 3 14.81% 13,329
Year 4 7.41% 6,669
Totals 100.00% $90,000
Straight-Line Depreciation When Used for Tax Purposes

Straight-line depreciation can be used for tax purposes. However, straight-line depreciation for tax purposes
is different from straight-line depreciation used for financial reporting under U.S. GAAP. If straight-line
depreciation is used for tax purposes, do not subtract the salvage value to determine the depreciable base
for the depreciation to be reported on the tax return, even though for financial reporting under U.S. GAAP
the salvage value would be subtracted. The depreciable base for tax purposes is always 100% of the
asset’s cost.
The U.S. Internal Revenue Service generally requires assets depreciated on the straight-line basis on the
tax return to be depreciated monthly. If an exam question specifies that a company uses straight-line
depreciation for tax purposes, it will usually state that the asset was purchased on either January 1 or on
June 30/July 1.
1) If the asset was purchased on January 1, take a full year of depreciation in the year acquired. A
three-year asset will be depreciated over only three tax years, not four tax years.
2) If the asset was purchased on June 30 or July 1, take one-half year of the annual straight-line
depreciation amount in the year acquired and leave one-half year of depreciation for the final year.
A three-year asset will be depreciated over four tax years.
If the asset was purchased on any date other than January 1, June 30, or July 1, calculate the monthly
straight-line depreciation for the first year and the final year of the asset’s life as needed. The asset will be
depreciated over one tax year more than its life. For example, a three-year asset that was purchased on
October 1 will be depreciated for three months in the first tax year it is owned and for nine months in the
fourth tax year.
Note: When the tax depreciation method is different from the depreciation method used for financial
statement purposes, the company’s depreciation expense for financial reporting purposes will be different
from its depreciation expense for tax purposes. This is a temporary timing difference and a deferred tax
issue. Deferred taxes are covered in this book in Accounting for Income Taxes.
Which Method of Depreciation is Best?

The depreciation method a company should use is the one that best matches the recognized depreciation
charge with the revenue management expects to receive from the asset. The method of depreciation should
not be selected to result in a desired net income amount. Considerations for which depreciation method
should be used include:
• If the revenues that management expects to receive from the use of the asset will be constant
over its useful life, straight-line depreciation should be used so that the costs are also constant
over the asset’s useful life.
• If revenues from the use of the asset will be higher at the beginning of the asset’s life, then an
accelerated method of depreciation should be used. If an accelerated method of depreciation is
used, depreciation recorded will be higher and net income and net assets will be lower in the early
years of the asset’s life (and vice versa in the later years of the asset’s life) than they would be if
straight-line depreciation were used.
• If revenues from the asset will be lower at the beginning of the asset’s life, the amount of depre-
ciation recorded in the early years should be lower than the amount recorded in later years. Lower
depreciation in the beginning of the asset’s life can usually be achieved by using the units of pro-
duction method. Depreciation recorded will be lower and net income and net assets will be higher
in the early years of the asset’s life (and vice versa in the later years of the asset’s life) than they
would be if straight-line depreciation were used.
If the company can reliably estimate the timing of revenues to be received from the use of the asset,
selecting the depreciation method that best matches the cost with the revenues will provide the most useful
information to financial statement users for assessing future cash flows from the asset.
Note: More information on depreciation and accounting for fixed assets is available in any intermediate
accounting textbook.
Impairment of Long-Lived Assets to be Held and Used

Under U.S. GAAP, fixed assets are not written up to recognize any increase in the fair value of the asset
over time. However, according to ASC 360-10-35-17, a company must write a fixed asset (or asset group)
down if the carrying value of the asset is not recoverable and the carrying value exceeds the asset’s fair
value.
Note: A long-lived asset’s carrying value is not recoverable if it exceeds the sum of the undiscounted
cash flows expected to result from the use and eventual disposition of the asset or asset group.
A long-lived asset or asset group is tested for recoverability whenever something happens that may cause
the carrying amount of the asset or asset group to not be recoverable. For example, recoverability testing
should be done in the event that:
• The market price of the long-lived asset or asset group decreases significantly;
• The extent or way in which a long-lived asset or asset group is being used or its physical condition
changes adversely;
• Legal factors or the business climate change in a way that could adversely affect the long-lived
asset or asset group’s value, including an adverse action or assessment by a regulator.
• Accumulated costs for the acquisition or construction of a long-lived asset or asset group increase
so that they are significantly greater than the amount originally expected;
• Operating or cash flow losses associated with the use of a long-lived asset or asset group occur
and/or are forecasted;
• Management expects that it is more likely than not (more than a 50 percent likelihood) that a long-
lived asset or asset group will be sold or otherwise disposed of significantly before the end of its
previously estimated useful life.79
To determine if the carrying value of an asset or asset group is recoverable, the company compares the
carrying amount of the asset or asset group with the sum of the estimated future undiscounted cash flows
(cash inflows minus associated cash outflows) expected to result directly from the use and ultimate dispo-
sition of the asset or asset group.
• If the sum of the estimated future undiscounted cash flows associated with the asset or asset group
is greater than the asset’s carrying value, it is not impaired and no write-down is needed, even if
the carrying value of the asset or asset group is greater than its fair value.
• If the carrying value of the asset or asset group is greater than the sum of the estimated future
undiscounted cash flows associated with it, the asset or asset group is impaired. The impaired
asset or asset group must be written down to its fair value and an impairment loss must be
recognized.
This comparison is called a recoverability test, and it is used as a screening tool only, not as a method
of establishing the asset or asset group’s fair value.
The recoverability test may need to include a review of depreciation estimates and method. Any revision to
the remaining useful life of the asset that results from that review should be included in developing the
estimates of future cash flows that are used in testing the asset for its recoverability.
Note: The fair value of the asset or asset group is determined according to the market price if an active
market for the asset or asset group exists. If the asset or asset group has no active market, its fair value
is the present value of the expected future net cash flows expected to result directly from the use and
ultimate disposition of the asset or asset group.
The amount by which an impaired asset is written down is reported as a current period loss.
The journal entry to record an impairment loss is:

Dr Impairment loss................................................................. X
Cr Accumulated depreciation ..................................................... X
No entry is made to the fixed asset account. After the impaired asset has been written down, the adjusted
book value of the asset (that is, the original cost in the fixed asset account less the adjusted balance
attributed to the asset in the accumulated depreciation account) becomes its new cost basis. Future depre-
ciation is recognized based on the new cost basis and the asset’s remaining useful life, which may have
changed as a result of the recoverability test.
An impairment loss for a fixed asset that is to be held and used is included in income from continuing
operations before income taxes.
If an impaired asset subsequently recovers its value, the recovery of the previously written off value is not
recognized. Once an asset is impaired, under U.S. GAAP, it may not be written up in value if its value
subsequently recovers.
Note: If the sum of the estimated future undiscounted cash flows from the asset is less than the
asset/asset group’s carrying value, write the asset down to its fair value.
If the sum of the estimated future undiscounted cash flows from the asset is greater than the asset/as-
set group’s carrying value, the asset is not impaired, and no write-down is needed.
79
Per ASC 360-10-35-21.
Note: The process of writing down impaired fixed assets to their fair value is similar to the processes
for valuing accounts receivable through the allowance for credit losses and for valuing inventory with the
lower of cost or net realizable value or lower of cost or market. The objective in all these processes is to
make certain that assets are not overvalued.
Example: In a company’s review of long-lived assets to be held and used, an asset with a cost of
$10,000 and accumulated depreciation of $5,500 was determined to have a fair value of $3,500. Two
different scenarios using different estimated future operating cash flows follow.
Scenario no. 1: The estimated future operating cash flows associated with the asset are $3,000 at the
end of one year and $1,500 at the end of two years. At the end of two years, the company estimates
the asset will be sold for $500.
The recoverable amount is the sum of the estimated future undiscounted cash flows, which is $5,000
($3,000 + $1,500 + $500). The recoverable amount is greater than the asset’s carrying value of $4,500
($10,000 cost minus accumulated depreciation of $5,500), so there is no impairment loss even though
the $4,500 carrying value is greater than the asset’s fair value of $3,500.
Scenario no. 2: The estimated future operating cash flows associated with the asset are $1,500 at the
end of one year and $1,000 at the end of two years. At the end of two years, the company estimates
the asset will be sold for $500.
The recoverable amount is the sum of the estimated future undiscounted cash flows, which is $3,000
($1,500 + $1,000 + $500). The recoverable amount is less than the asset’s carrying value of $4,500,
so the company needs to recognize an impairment loss. The asset’s carrying value of $4,500 is written
down to its fair value of $3,500 by recognizing an impairment loss of $1,000.
The journal entry to record the impairment loss is:

Dr Impairment loss........................................................... 1,000
Cr Accumulated depreciation ............................................... 1,000
The new carrying value of the asset after the write-down is $3,500 ($10,000 cost minus accumulated
depreciation of $6,500). Future depreciation of the asset will be based on the asset’s carrying value of
$3,500 and the fact that its estimated remaining useful life is two years.
IFRS Notes:
1) The impairment process in IFRS is a one-step process. The carrying value of the asset is compared
to the recoverable amount. The recoverable amount is the higher of 1) the fair value of the asset,
if sold, minus any costs of sale, or 2) its value in use, which is the present value of the future net
cash flows expected to be received from the asset or cash-generating unit, discounted at the current
market risk-free rate of interest. (U.S. GAAP uses undiscounted future cash flows.)
2) Under IFRS, a company may increase the carrying the value of its fixed assets (called “writing
them up”) if the fair value of that class of assets is materially different from the class’s carrying value.
The increase in the value is recognized in accumulated other comprehensive income and carried
in the equity section of the balance sheet as a revaluation surplus.
3) If the revaluation is the recovery of a previously recognized loss when the asset was impaired, the
revaluation gain is reported on the income statement.
4) A decrease due to impairment is recognized on the income statement unless the loss to impairment
is a write-down of a previous increase in the asset because of an increase in its fair value.
Study Unit 17: A.2. Intangible Assets CMA Part 1
Study Unit 17: A.2. Intangible Assets
1e) Intangible Assets

Except as noted, guidance in the Accounting Standards Codification® on accounting for intangible assets
is in ASC 350, Intangibles-Goodwill and Other. Guidance on accounting for the intangible asset goodwill
acquired in a business combination is in ASC 350 and also in ASC 805, Business Combinations.
Intangible assets are assets that are not physical or that cannot be touched. The accounting for intangibles
is very similar to that for property, plant & equipment with many of the same issues:
1) Initial recording of the intangible asset
2) Amortization of the cost of the intangible asset (for intangibles, amortization is equivalent to de-
preciation of tangible assets)
3) Adjusting the value of the asset to recognize any permanent decreases in its value (impairment)
Initial Recording of Intangible Assets

Like fixed assets, intangible assets are recorded at the cost paid to acquire them including expenditures
required to make the assets ready for their intended use.
Note: Value attributed to internally generated assets such as patents (other than registration fees and
legal fees for filing the patent) or customer goodwill are not recorded on the balance sheet because they
do not meet the definition of asset. An asset is something that has arisen from a past transaction.
Internally generated value attributed to assets such as patents and customer goodwill did not arise from
a past transaction.
Research and development costs are generally expensed as incurred and thus they are not capitalized
and amortized. For example, a patent that results from research and development activities would not
lead to an asset on the books of the company that developed it, although registration fees and legal fees
paid for filing the patent may be capitalized on the balance sheet and amortized.
Amortization and Accounting Treatment of Intangibles

After the intangible asset has been recorded, it must be properly valued as time passes.
• If the asset has a finite life—a determinable, limited life—it is amortized over that useful life.
The amount amortized for a limited-life intangible asset is its cost minus any residual value. How-
ever, usually the residual value will be zero unless the intangible asset has value to another
company and thus can be sold. The amount of amortization expense recognized each period should
be based on the pattern in which the asset will be used up, if that is determinable. When the
amortization expense is recognized, the expense should be debited to an amortization expense
account and the credit should be either to the appropriate intangible asset account or to a separate
accumulated amortization account.
If the estimated life of a limited-life intangible asset changes, the remaining carrying amount at
the time of the change should be amortized prospectively over the revised remaining useful life.
• If the asset has an indefinite life, the asset is not amortized, but it must be tested regularly for
impairment and written down to its fair value if it is found to be impaired.
• All intangibles, including amortized intangibles, should be evaluated regularly for impairment.
An impairment loss should be recognized if the evaluation indicates that the carrying amount of
the intangible asset is not recoverable.
Section A Study Unit 17: A.2. Intangible Assets
The following are common types of purchased intangibles that have determinable useful lives:
• Purchased patents. A patent is the right of exclusive use granted by a government. Patents in
the U.S. are valid for 20 years and if purchased, they are amortized over the shorter of two possible
time frames: either the patent’s legal life or the economic useful life of the patent. It is very possible
that the economic useful life of a patent will be shorter than its legal life because of changing
technologies. A purchased patent should be recorded on the books as an asset at the purchase
price, which is also the amount that should be amortized over its useful life.
Note: For internally developed patents, the capitalized and amortized amount is limited to
registration fees and legal fees for filing the patent. This accounting treatment is consistent with
the accounting treatment of research and development costs, which are generally expensed as
incurred and thus cannot be capitalized and amortized.
• If a company successfully defends a patent in court, the cost of the legal defense is added to
the intangible asset account and is amortized over the patent’s remaining useful life. However, if
the company is unsuccessful in its defense, the remaining book value of the patent as well as the
legal costs of the defense must be expensed immediately because the court ruling has essentially
stated that the company has no patent or patent rights. Without a patent and patent rights, the
company has no asset.
• Franchises are contractual agreements that allow a franchisee to operate a specific business using
the franchisor’s name. The franchisee should capitalize the costs of acquiring the franchise and
amortize them over the franchise’s useful life. A franchise with an indefinite life should be carried
at cost and should not be amortized but should be tested at least annually for impairment.
• Leasehold improvements are additions a lessee makes to a building or property that the lessee
cannot remove when the lease period is over. For example, if a lessee installs an air conditioning
system in a leased building, the air conditioning system is considered a “leasehold improvement”
and cannot be uninstalled and taken away once the lease expires.
The cost of leasehold improvements should be amortized over the shorter of the remaining
lease term or the useful life of the improvements. The remaining term of the lease includes
any options to extend the term of the lease that the lessee expects to exercise.
• A trademark (®) or trade name is a distinctive sign, word, or symbol. In the U.S., trademarks
can be registered for 20 years and renewed for longer time periods. The costs that should be
capitalized include legal and registration fees, design costs, and any cost of successfully defending
the name. A trademark should be amortized over its useful life, but the amortization period should
not exceed 40 years.
• A copyright (©) is granted for intellectual property consisting of original works and is effective for
the life of the author plus 70 years. A purchased copyright is recorded at its purchase price. An
internally generated copyright can be recorded only at its registration costs.
Because it is difficult to assess the useful life of a copyright, companies usually write off amounts
capitalized for copyrights over a fairly short period of time.
Impairment of Limited-Life Intangible Assets

If at any time it is determined that the carrying amount of an intangible asset with a finite life that is
being amortized (for example, a patent) is not recoverable and exceeds its fair value, an impairment loss
is recognized. The carrying amount is not recoverable if it exceeds the sum of the undiscounted cash flows
expected to result from its use and ultimate disposition.
The company should evaluate an intangible asset whenever there is any indication that the asset’s carrying
amount may not be recoverable. The evaluation and the calculation of any write-down is a two-step process.
1) The company performs the recoverability test by comparing the undiscounted sum of the future
cash flows from the asset’s expected use and its eventual disposal with the book value of the asset.
If the book value is greater than this undiscounted sum, the asset is impaired.
2) If the asset is determined to be impaired, it is written down to its fair value. The fair value is the
present value of the future net cash flows, discounted at the company’s market rate of interest.
(Note that the undiscounted sum of the future cash flows used in Step 1 is not used in Step 2.)
The loss is the amount by which the book value is greater than the fair value.
Any loss must be written off in the period the asset is determined to be impaired. The loss is part of income
from continuing operations and is reported on a separate line from any goodwill impairment.
Impairment of Indefinite-Lived Intangible Assets Other Than Goodwill

Intangible assets with indefinite lives are not amortized, but they may become impaired. Intangible assets
should be tested for impairment annually and between annual tests if circumstances change. The impair-
ment test and subsequent write-down if necessary for intangible assets with indefinite lives is a 2- or 3-
step process.
1) The first step is optional. Qualitative factors are used to determine if it is more likely than not
(meaning a probability greater than 50%) that the asset is impaired. Examples of factors that could
impact indefinite-lived intangible assets include increases in raw materials or labor that could have
a negative effect on the fair value of the asset, financial performance such as negative or declining
cash flows, economic factors, competition, regulatory issues, issues related to technology, and any
other relevant events or circumstances that could affect the fair value of the asset.
If the company determines that the probability is 50% or less that the asset is impaired, it does
not need to proceed any further. This qualitative assessment should be performed at least annually
for each indefinite-lived intangible asset that is not amortized.
If the company determines that the probability is greater than 50% that the asset is impaired (or
if the company chooses not to perform the first step), the company performs the next step.
2) The next step (or Step 1, if the company does not perform the optional first step) is a quantitative
assessment called a fair value test. The fair value of the intangible asset is calculated and com-
pared with the asset’s book value (carrying amount). The calculated fair value of the intangible
asset is determined by considering the same types of events and circumstances listed in Step 1
that affect the fair value: cost factors, financial performance, environmental factors, management
changes, legal, regulatory, political, business or other factors, and macroeconomic conditions. Not
only negative events and circumstances should be considered, but positive events and circum-
stances should be considered, as well.
If the fair value is more than the book value, then the asset is not impaired, and no further action
is necessary.
3) If the calculated fair value is less than the book value, the next step is to write the asset down to
its fair value and recognize a loss. Any impairment loss is part of income from continuing operations
and is reported on a separate line from any goodwill impairment.
The optional qualitative assessment can be performed just on certain intangible assets or on all of them.
Alternatively, the company can skip the qualitative test and perform the quantitative, fair value, test.
A previously recognized impairment loss may not be reversed.
Note: The optional qualitative assessment allows the company to not have to test every intangible asset
for impairment every year. However, a company also has the option to bypass the qualitative assessment
for any indefinite-lived intangible asset and proceed with the quantitative, fair value test.
Goodwill and the Impairment of Goodwill

Guidance in the Accounting Standards Codification® on accounting for the intangible asset goodwill ac-
quired in a business combination is in ASC 350 and also in ASC 805, Business Combinations. Guidance
on accounting for the impairment of goodwill is in ASC 350-20-35-1 through 35-61.
Goodwill is defined in ASC 805-30-20 (Glossary) as “an asset representing the future economic benefits
arising from other assets acquired in a business combination or an acquisition by a not-for-profit entity that
are not individually identified and separately recognized.”
Goodwill is the amount by which the payment a purchaser has made for a company exceeds the fair value
of the net identifiable assets (identifiable assets less identifiable liabilities) purchased. Purchased goodwill
must be reported as a separate line item on the balance sheet separate from other intangible
assets. Generally, other intangibles are combined and reported as one figure on the balance sheet.
Goodwill is recognized as an asset only by the acquirer of a business and only when the acquirer pays
more for the acquired business than the fair value of its net assets. The amount of goodwill purchased in
an acquisition is equal to the difference between the purchase price paid for a business and the fair
value of the net identifiable assets (identifiable assets less identifiable liabilities) received.
Note: Goodwill as reported on the balance sheet cannot be purchased by itself apart from an acquisition,
nor can it be developed internally. Internally generated goodwill is not recognized as an asset because
it does not meet the definition of an asset. An asset is defined as a probable future economic benefit
obtained or controlled by an entity as a result of past transactions or events.
Internally generated customer goodwill is not an asset because there is no past transaction in which it
was acquired. In addition, because internally generated customer goodwill was not acquired in a mone-
tary transaction and thus has no historical cost, internally generated goodwill cannot be valued. Even if
a company contracts for and pays for a public relations program or an institutional advertising program,
the cost of the program is not the value of any “goodwill” that results.
Thus, production costs for advertising and public relations are expensed as incurred, while media costs
for advertising and public relations programs are expensed the first time the public is exposed to the
advertising, whether it is broadcast, published, or distributed to the public in some other way. The ac-
counting treatment for internally generated customer goodwill in the form of an advertising or public
relations program is similar to that for research and development costs.
If a company that has internally generated customer goodwill is sold to another company, the sale
transaction provides the basis for the valuation of the purchased goodwill that the buyer may record
on its balance sheet.
A company should record goodwill purchased in an acquisition on the books as an asset at the amount paid
for it. Goodwill is considered to have an indefinite life, and therefore it should not be amortized. However, at
least annually, the company must assess its goodwill to determine if it has been impaired during the year.
Note: If the price paid for a business is less than the value of the net identifiable assets, the purchase
is called a bargain purchase. The acquirer must first reassess its review of the identifiable tangible and
intangible assets acquired and liabilities assumed to determine whether all the items have been correctly
identified and valued and make any necessary corrections. Any additional assets or liabilities identified
in that reassessment should be recognized.
After the reassessment has been done, if the purchase price is still less than the fair value of the net
assets received, the acquirer recognizes a gain on the purchase equal to the amount by which the
purchase price is less than the value of the net assets received. The gain is recognized in income from
continuing operations as of the acquisition date.
Because some companies might attempt to make an intentional error in measuring the net assets ac-
quired in order to book such an immediate gain, the nature of the gain must be disclosed in the financial
statements so users of the financial statements can evaluate it.
The costs of developing goodwill or maintaining purchased goodwill are expensed as they are in-
curred. Examples of these costs are training and hiring employees from the purchased company.
Impairment of Goodwill
Note: Guidance in the Accounting Standards Codification® on accounting for the impairment of goodwill
is in ASC 350-20.
Impairment of goodwill is the condition that exists when the carrying amount of a reporting unit that in-
cludes goodwill exceeds the reporting unit’s fair value. In the event of impairment, a goodwill impairment
loss is recognized for the amount by which the carrying amount of a reporting unit, including the goodwill,
exceeds its fair value, limited to the total amount of goodwill allocated to that reporting unit. Any effect on
deferred income taxes related to tax-deductible goodwill must be included in the measurement of the good-
will impairment loss.80
Like other indefinite-lived intangibles, goodwill is not amortized but it must be assessed at least annually
for impairment or whenever changes in circumstances indicate that the carrying amount of the asset may not
be recoverable. The assessment should be made at the reporting unit level. The reporting unit level is
the operating segment (also called a component) level or one level below the operating segment
level. Thus, the overall goodwill should be broken down into categories at the component level or one level
below; it should not all be treated as one overall amount of goodwill for the purposes of impairment as-
sessment.
The steps for testing for impairment of goodwill are:
Step 1 (optional): As with other intangible assets that are not being amortized, the company has the
option to first perform a qualitative assessment to determine whether it is more likely than not (having
a greater than 50% probability) that the fair value of the reporting unit is less than its net carrying amount,
including the goodwill.81
Examples of events and circumstances that may lead to a determination that it is more likely than not that
the fair value of the reporting unit is less than its net carrying amount including the goodwill include (but
are not limited to):
• Macroeconomic conditions such as a deterioration in general economic conditions, limitations on

accessing capital, fluctuations in foreign exchange rates, or other negative developments in equity
and credit markets.
80
ASC 350-20-35-2.
81
ASC 350-20-35-3A.
• Industry and market considerations such as a deterioration in the environment in which the com-
pany operates, increased competition in the industry, a decline in market values, a change in the
market for the company’s products or services, or regulatory or political changes.
• Cost increases in inputs such as raw materials or labor or other costs that have a negative effect
on earnings and cash flow.
• Deteriorating overall financial performance.
• Changes in management, key personnel, strategy, or customers; litigation; an expectation of sell-

ing or disposing of the reporting unit; contemplation of bankruptcy.
• If applicable, a sustained decrease in share price.82
If the company concludes that it is not more likely than not that the fair value of a reporting unit is less
than its net carrying amount, then there is no impairment, and no further action is necessary.
If the company concludes that it is more likely than not that the fair value of the reporting unit is less than
its net carrying amount, the company proceeds to the quantitative goodwill impairment test. If the quan-
titative impairment test is necessary, it is used to identify goodwill impairment and measure the amount of
a goodwill impairment loss to be recognized, if any. 83
Step 2 (or Step 1 if the optional first step is not performed): The company compares the fair value
of the reporting unit whose purchase gave rise to the goodwill, including the goodwill, with the reporting
unit’s carrying amount (assets minus liabilities), also including the goodwill. The fair value of a reporting
unit is the price that would be received to sell the unit in an orderly transaction between market participants
at the measurement date.
• If the fair value of the reporting unit, including the goodwill that arose from its purchase, is greater
than the reporting unit’s carrying amount, the goodwill of the reporting unit is not impaired, and
no further action is necessary.
• If the carrying amount of the reporting unit’s net assets including the goodwill that arose from its
purchase exceeds its fair value including the goodwill, an impairment loss is recognized in an
amount equal to the excess, up to the amount of goodwill allocated to the reporting unit.84
Note: The goodwill impairment loss recognized cannot be greater than the carrying amount of
the goodwill.
A goodwill impairment loss is presented on a separate line in the continuing operations section of the income
statement unless the goodwill impairment is associated with a discontinued operation, in which case it is
presented in the discontinued operations section of the income statement.
Subsequent reversal of a goodwill impairment loss is prohibited once the measurement of the loss has been
recognized.85
Note: As with other indefinite-lived intangible assets, the company has the option to bypass the quali-
tative assessment for goodwill and proceed with the quantitative, fair value test.
82
ASC 350-20-35-3C.
83
ASC 350-20-35-3.
84
ASC 350-20-35-8 and 35-8B.
85
ASC 350-20-35-13.
Study Unit 18: A.2. Reclassification of Short-Term Liabilities CMA Part 1
IFRS Notes:
1) Under IFRS, internal development costs of intangible assets are capitalized when the technological
and economic feasibility of the project can be demonstrated. Under U.S. GAAP, internal development
costs are usually expensed as incurred. They may be capitalized only if a specific U.S. GAAP standard
allows capitalization for that asset.
2) Under IFRS, a previously recognized impairment loss on an intangible asset may be reversed if the
estimates of the recoverable amount have changed.
3) If the intangible asset has a specific, active market, the intangible asset may be written up in value
to that fair value under IFRS. (Note: Goodwill may not be written up.)
2) Valuation of Liabilities
Study Unit 18: A.2. Reclassification of Short-Term Liabilities
2a) Reclassification of Short-Term Debt

When a company expects to refinance some or all of its short-term liabilities by means of new long-term
debt or by issuing equity, the amount of the liability to be refinanced should not be classified as a current
liability. Rather, the amount of the short-term liability that will be refinanced is reclassified as a
non-current liability on the balance sheet.
Note: Reclassification of short-term debt to long-term debt if the liability will be refinanced after the
balance sheet date is an example of the correct treatment of subsequent events, or events that take
place after the financial statement date but before the financial statements are issued. Subse-
quent events are covered in ASC 855. Issuers of financial statements are required to evaluate subsequent
events through the date the financial statements are issued. If an event is significant enough that the
financial statements would be misleading without its disclosure, the company should recognize the event
in the financial statements.
For a company to reclassify its short-term obligations as long-term obligations, it must both:
• Have the intent to refinance them, and
• Be able to demonstrate the ability to refinance them.
The ability to refinance the short-term debt can be demonstrated by either:
• Completing the refinancing transaction and converting the short-term obligations to long-term
obligations after the end of the year but before the financial statements are issued or are available
to be issued, or
• Entering into a financing agreement with another party after the end of the year but before the
financial statements are issued or are available to be issued that will enable the refinancing to
occur. If this requirement is met, the company also must be able to show the ability to actually
perform the agreement.86
Note: If some of the short-term obligations that were intended for refinancing are actually settled
(paid) in the following year before the issuance of the financial statements by using short-term assets,
the balance of the obligations that were settled must be shown as short-term obligations on the year-
end balance sheet.
86
See ASC 470-10-45-14.
Section A Study Unit 19: A.2. Warranties
Note: If the company refinances only part of its short-term obligations, it must continue to show the
short-term obligations that were not refinanced as current liabilities.
Study Unit 19: A.2. Warranties
2b) Warranty Liabilities

A warranty is a promise a company makes to a buyer to repair or replace a product if it proves to be
defective during a specific time period. Warranties can be of two types:
1) An assurance-type warranty is a manufacturer’s warranty given along with the sale of the prod-
uct that provides assurance only that the product meets agreed-upon specifications in the contract
at the time it is sold, without any additional payment being required from the customer. An assur-
ance-type warranty is included with the product price, and the consideration received from the
transaction includes the warranty.
Assurance-type warranties that cover only the compliance of the product with agreed-upon speci-
fications do not constitute a separate performance obligation87 under ASC 606, Revenue
Recognition, and are accounted for as liabilities under ASC 460, Guarantees.
2) A service-type warranty is an extended warranty that is usually sold separately from the prod-
uct. Service-type warranties provide a service in addition to product assurance. A service-type
warranty may offer protection against wear and tear or certain types of damage. A service-type
warranty may be offered by the manufacturer but also may be offered by either the reseller or by
a third party.
When a warranty, or a part of a warranty, provides a service in addition to the assurance that the
product complies with agreed-upon specifications, the promised service is a performance obliga-
tion. The seller should allocate the revenue from the sale between the product and the service.
Service-type warranties constitute a separate performance obligation under ASC 606, Revenue
Recognition, and a portion of the consideration received from the transaction is allocated to the
warranty and recognized as revenue over the warranty period. ASC 606 is discussed in detail later.
Classification of Warranties
A warranty that is not sold separately may nevertheless represent a separate performance obli-
gation under ASC 606 if it provides any service beyond assuring that the product complies with agreed-
upon specifications. A single warranty can have elements of both an assurance-type and a service-type
warranty. If a warranty includes elements of both and the company cannot reasonably account for them
separately, the company should account for both of the warranties together as a single performance obli-
gation.88
All warranties need to be carefully assessed to determine whether they should be accounted for as liabilities
under ASC 460 or whether they need to be accounted for as separate performance obligations under ASC
606, or both. To assess whether a warranty provides a customer with a service in addition to the assurance
that the product complies with agreed-upon specifications, the company should consider the following fac-
tors:
87
A performance obligation is a promise made in a contract with a customer to transfer to the customer either (a) a
good or service (or a bundle of goods and services) that is distinct or (b) a series of distinct goods or services that are
substantially the same and that have the same pattern of transfer to the customer.
88
ASC 606-10-55-34.
Study Unit 19: A.2. Warranties CMA Part 1
1) Is the warranty required by law? A warranty required by law should be accounted for as an assur-
ance warranty.89 It is not a performance obligation under ASC 606.
2) What is the length of the warranty coverage period? The longer the coverage period, the more
likely it is that the promised warranty is a performance obligation because it is more likely that it
provides a service in addition to the assurance that the product complies with the agreed-upon
specifications. For example, a “lifetime warranty” provided at no extra charge with purchase of a
product that promises to repair or replace the product at any time for any reason is likely a separate
performance obligation that needs to be accounted for under ASC 606, even though it is not pur-
chased separately.
3) What is the nature of the tasks that the company promises to perform? Specified tasks performed
to provide the assurance that a product complies with agreed-upon specifications, such as provid-
ing a return shipping service for defective products, probably do not give rise to performance
obligations under ASC 606.90 However, referring again to a “lifetime warranty,” a promise to repair
or replace the product for any reason at any time during the life of the product goes beyond simply
assuring that the product complies with agreed-upon specifications and tends to indicate a separate
performance obligation.
Example: A manufacturer of pet accessories promises that its products are guaranteed for life “even if
chewed.” For instance, if a dog chews on its leash and destroys it at any time, no matter how long it has
been in use, the manufacturer will replace it with a new one with no questions asked. The lifetime
guarantee is a service in addition to the assurance that the product complies with specifications, so it is
a service-type warranty even though it is not sold separately. It should be accounted for as a separate
performance obligation, and a portion of the consideration from each sale should be allocated to the
warranty.
1) Accounting for Assurance-Type Warranties

Guidance in the Accounting Standards Codification® on accounting for assurance-type warranties is in
ASC 460.
Warranties that represent assurances that the product meets agreed-upon specifications are assurance-
type warranties and are accounted for as liabilities under ASC 460.
Per ASC 460-10-25-5, because of the uncertainty surrounding claims under warranties, warranty obligations
are considered contingencies and losses are to be accrued if the conditions in ASC 450-20-25-2 are met,
specifically:
• If it is probable that an obligation has been incurred due to a transaction that occurred on or
before the date of the financial statements, and
• If the amount of the obligation can be reasonably estimated.
Assurance-type warranties may be current liabilities, or they may be partly current liabilities and partly
non-current liabilities.
• If the term of the warranty extends only into the next accounting period, a current liability is
recorded.
• If the term of the warranty extends beyond the next period, the estimated liability must be sepa-
rated into a current portion and a non-current portion.
89
ASU 2014-09, Section C (Background Information and Basis for Conclusions), Implementation Guidance, Paragraph
BC377.
90
ASC 606-10-55-33.
Because the company does not know exactly how many units will break, or exactly how much it will cost to
fix or replace those units, warranty expense under assurance-type warranties is an estimate.
At the end of each period, the company must make a calculation of the amount of expected warranty claims
that will be received in all future periods. This calculation can be based on a percentage of sales, a cost per
unit sold, or can be calculated in some other manner. No matter which method is used for calculating the
amount of the estimated warranty expense, the journal entry to record the liability and the expense for
warranties is:
Dr Assurance-type warranty expense ........................ as calculated
Cr Assurance-type warranty liability ........................... as calculated
This entry will match the expense of the future warranty claims with revenues that were recognized
from the sale of those items.
When a warranty claim is received, the company will reduce the liability. It will not recognize an expense
because the expense was already recognized in the period when the sale was made. The entry to record
actual cost incurred is:
Dr Assurance-type warranty liability .........................cost incurred
Cr Cash, inventory, accrued payroll, as appropriate ...... cost incurred
At the end of each period the company must evaluate the balance in the assurance-type warranty liability
account to make certain that it is appropriate. If the credit balance in the account is estimated to be too
low or if the balance has become a debit balance because of warranty claims during the period that have
exceeded the estimated liability, additional expense and liability are recognized using the first entry above.
If it is determined that the liability is greater than necessary, a portion of the first entry is reversed to bring
the assurance-type warranty liability account down to its proper estimated value.
Note: As each assurance-type warranty period expires, the company will need to remove any remaining
estimated warranty liability balance attributable to that warranty period by reversing any remaining
amount of the first entry above.
Candidates should be able to calculate both the warranty expense for a period and the remaining war-
ranty liability.
• The assurance-type warranty expense is a simple percentage of sales (or other calculation) and
does not take into account the amount of cost actually incurred for warranty claims.
• The assurance-type warranty liability is the total assurance-type warranty expenses recognized
in the past (as debits to assurance-type warranty expense and credits to assurance-type warranty
liability) minus all costs incurred on warranty claims.
Reporting Assurance-Type Warranties on the Balance Sheet

Assurance-type warranties are classified as current or non-current liabilities on the balance sheet based on
the remaining time period that the warranty is valid.
1) If the warranty term extends only into the next accounting period, a current liability is recorded.
2) If the warranty term extends beyond the next period, the estimated liability must be separated
into a current portion and a long-term portion.
The warranty liability on the balance sheet is calculated as:
Total warranty expenses recognized (accrued) in the past on warranties that are still open
− All costs that have been incurred on warranty claims on those warranties
= Warranty liability on the balance sheet
Study Unit 19: A.2. Warranties CMA Part 1
2) Accounting for Service-Type Warranties

Guidance in the Accounting Standards Codification® on accounting for service-type warranties is in ASC
606, Revenue Recognition.
When a warranty such as an optional extended warranty is sold separately from the product, the warranty
is a distinct service because the company promises to provide the service to the customer in addition to the
product. The option to purchase the warranty separately provides evidence that the warranty is a service
in addition to the product. A service-type warranty is a separate performance obligation under ASC 606.
However, a warranty does not need to be sold separately in order to be a separate performance obligation.
The company should assess all warranties to determine whether they are assurance-type or service-type
warranties. A warranty could even have elements of both assurance and service.
The seller of a service-type warranty should account for the promised warranty as a performance obligation
in accordance with ASC 606-10-25-14 through 25-22. A portion of the transaction price of each sale should
be allocated to that performance obligation.
The recognition of revenue for the consideration allocated to a service-type warranty is deferred and is
usually recognized on a straight-line basis over the life of the warranty contract. However, if historical
evidence indicates that costs under the contracts are incurred on some basis other than a straight-line
basis, then the revenue should be recognized over the contract period in proportion to the ex-
pected costs. If the extended warranty picks up after the manufacturer’s warranty expires, recognition of
the extended warranty revenue does not begin until after the manufacturer’s warranty has expired.
Since service-type warranty revenue is recognized throughout the term of the contract, expenses incurred
in fulfilling the contracts should be expensed as period costs when incurred.
Thus, consideration received for a service-type warranty is a contract liability on the balance sheet ac-
cording to ASC 606, representing the seller’s performance obligation over the term of the contract. The
name of the liability account may be contract liability or it may be more descriptive, such as service-type
warranty liability.
Dr Cash or accounts receivable ...................... Consideration allocated to warranty
Cr Service-type warranty liability ....................... Consideration allocated to warranty
The consideration received for the service-type warranty is transferred to revenue as the contract is per-
formed. Estimated future costs of service-type warranties are not accrued as liabilities. Actual costs are
expensed as they are incurred.
Example: A manufacturer that sells direct to consumers offers a one-year assurance-type warranty
against defects for its products and an extended 4-year service-type warranty for an additional cost.
When the extended warranty is purchased along with the product, the $5,200 consideration received for
both is allocated $5,000 to the product and $200 to the service-type warranty. The consideration allo-
cated to the product includes the assurance-type warranty that covers the product for the first year, and
the extended, service-type warranty covers the product from Year 2 through Year 5. The manufacturer’s
entry on the date of the sale for each unit sold is:
Dr Cash .......................................................................... 5,200
Cr Sales revenue ................................................................ 5,000
Cr Service-type warranty liability ............................................200
On the sale date, the manufacturer also estimates that its liability for the assurance-type warranty will
be $100 for each sale during Year 1, the period covered by the assurance-type warranty, and records its
liability for the assurance-type warranty as follows:
Dr Assurance-type warranty expense .................................... 100
Cr Assurance-type warranty liability ........................................100
The manufacturer processes a claim against the assurance-type warranty during Year 1 that involves
one hour of labor at $20 and parts costing $60:
Dr Assurance-type warranty liability ....................................... 80
Cr Parts inventory .................................................................. 60
Cr Accrued payroll .................................................................. 20
The manufacturer evaluates the balance in the assurance-type warranty liability account at each report-
ing date and adjusts it according to its estimated remaining liability. The other side of the adjusting entry
is either a debit or a credit to assurance-type warranty expense.
Since the product is under the assurance-type warranty for the first year, the service-type warranty
covers years 2 through 5 (4 years).
At the end of Year 2 following the sale (after expiration of the assurance-type warranty) and for each of
the three following years, the manufacturer recognizes one-fourth of the revenue for the service-type
warranty on a straight-line basis. Entries at the ends of Years 2, 3, 4, and 5 to recognize the revenue
from the service-type warranty for each sale are:
Dr Service-type warranty liability ........................................... 50
Cr Service-type warranty revenue ............................................ 50
Costs for repairing or replacing items covered by the service-type warranty during years 2, 3, 4 and 5
are expensed as incurred, as follows:
Dr Service-type warranty expense ...................... Amount incurred
Cr Salaries and wages payable ............................. Amount incurred
Cr Parts inventory .............................................. Amount incurred
Study Unit 20: A.2. Accounting for Income Taxes CMA Part 1
Study Unit 20: A.2. Accounting for Income Taxes
2c) Accounting for Income Taxes

Guidance in the Accounting Standards Codification® on accounting for income taxes is in ASC 740.
Every company makes two separate calculations of income during a period. The first calculation is financial
income, which is calculated using the rules of generally accepted accounting principles (GAAP) and is based
on accrual accounting. Financial income is the income in the financial statements. It is reported as income
before tax, and then the provision for income tax is deducted to calculate net income. From the perspective
of the reporting company, financial income is the “correct” income because it is calculated according to
GAAP, which is the system under which they keep their financial records and report to their shareholders.
The second calculation of income is made for the company’s taxable income. “Taxable income” is a tax
term that refers to the amount of income on which the company’s income tax due to the government is
computed. Taxable income must be calculated according to the relevant tax laws of the country in which
the company operates. In the U.S., taxable income is calculated according to the laws codified in the Inter-
nal Revenue Code. Tax-deductible expenses are deducted from taxable revenue to calculate taxable income.
Taxable income determines the amount of money the company must pay the government as income taxes
for the period.
Financial income and taxable income are two different perspectives on the same two things: 1) the
amount of income that should be taxed, and 2) when that income should be taxed. Some differences be-
tween financial income and taxable income are permanent because some revenues and gains are never
taxable, and some expenses and losses are never deductible, on the tax return. However, many differences
between financial income and taxable income are only temporary, meaning that while one of the two in-
comes will be higher in Year 1, the other will be higher in a future year. A temporary difference arises from
timing differences between when revenues or gains are recognized on the income tax return and when they
are recognized in financial income, and between when expenses or losses are deducted on the tax return
and when they are recognized in financial income.
Note: If permanent differences are ignored, the total financial income and the total taxable income over
the life of a company will be equal to each other. The financial income and taxable income may not be
equal to each other in any individual year, but over the life of the company, the TOTAL financial and
TOTAL taxable income will be equal to each other. Again, this assumes that there are no permanent
differences. Permanent differences are discussed later in this topic.
The income tax due based on financial income is the amount a company wants to pay in taxes because
it is calculated on the “correct” amount of income—meaning the financial income the company reports for
a period (regardless of when the taxing authorities say the tax is due). By means of the laws codified in the
tax code, the government determines how the company must calculate the taxable income on which the
income tax it has to pay for the same period is based.
Even when a company uses accrual accounting for calculating both financial income and taxable income,
there will still be differences between its financial income and its taxable income due to the different treat-
ments of certain specific items required by the two authorities: the taxing authorities and the accounting
standard setters.
• Certain specific revenues and gains and expenses and losses are recognized at different times in
financial income and in taxable income. Those are temporary timing differences.
• Certain specific revenues and gains and expenses and losses are recognized in financial income
but are never recognized on the tax return. Those are permanent differences.
Section A Study Unit 20: A.2. Accounting for Income Taxes
Financial income can be reconciled to taxable income as follows:
Pretax financial income (loss): $X,XXX

Plus: Excess of taxable revenues over financial revenues XXX
Less: Excess of deductible expenses over financial expenses (XXX)
Less: Excess of financial revenues over taxable revenues (XXX)
Plus: Excess of financial expenses over deductible expenses XXX
Taxable income (loss): $X,XXX
The difference between financial income and taxable income caused by temporary timing differences
gives rise to deferred taxes, which are used to account for the temporary timing differences.
Note: It is important to remember that accountants report a company’s financial income in accordance
with GAAP. Therefore, the amount of tax a company wants to pay and when it wants to pay it is “correct”
according to GAAP income, although it frequently is different from the taxes the government says the
company has to pay.
Deferred Taxes and Temporary Timing Differences

When an item is recognized in taxable income in a different period from its recognition in financial income,
the item is a temporary timing difference.
For an item to be a temporary timing difference, the item must be recognized at some point in both
financial income and taxable income, though not in the same period. Timing differences are temporary
because they will “reverse” over time.
Example: A revenue item is reported on the income tax return currently but is recognized in financial
income in a future period. Therefore, current taxable income is higher than current financial income, and
future financial income will be higher than future taxable income by the same amount.
The reversal of temporary differences over time means that over the life of a business any differences
between its total financial income and its total taxable income will be caused by permanent differences only.
Four potential events will cause a temporary difference between taxable income and financial income:
1) A revenue or gain is recognized on the income tax return before it is recognized in financial income.
2) A deductible expense or loss is recognized on the income tax return after it is recognized in financial
income.
3) A revenue or a gain is recognized on the income tax return after it is recognized in financial income.
4) A deductible expense or a loss is recognized on the income tax return before it is recognized in
financial income.
Example: For tax purposes, certain receipts are recognized as taxable when they are received in cash.
However, the receipts are recognized as revenue in financial income only when the performance obliga-
tion they represent is satisfied, which can be in a future period.
Advance rent received is an example. Rent received in advance when the use of the rented asset will
take place in the following year will be included in taxable income and taxed in the year it is received.
However, in the accounting records it will not be recognized as revenue until the following year when
the renter uses the asset. Advance rent received is recorded as a liability on the balance sheet until the
renter has received the use of the rented asset.
As a result, in the following year when the consideration received is recognized as rental revenue in
financial income, it will not be reported as a taxable revenue on that year’s tax return. The rental income
is not taxable in the following year since it was already taxed in the year it was received. Thus, the
income tax as calculated for financial income will be higher in the next period than the tax actually
payable to the government for that year.
Or looking at it another way, after the first year (when the taxes were actually paid) the company has
an asset because, from the perspective of the accounting records, it prepaid some of the taxes that
would be due only in the following year according to the financial statements. The tax paid in the first
year is in essence a prepaid tax.
Note: Unfortunately, if the enacted tax rate is scheduled to change before the deferred tax item will
reverse, the amount of the “prepaid tax” asset recognized on the balance sheet in the period the tax is
paid (called a deferred tax asset) will be different from the amount actually paid in the earlier year. The
difference is recognized in income tax expense for the earlier year, as will be explained later in this topic.
However, with respect to the amount of the temporary difference, the total financial income and total
taxable income of the company over time will be the same, except for the impact of any permanent
differences (discussed later in this topic).
The Asset-Liability Method

Deferred income tax accounting is an inter-period income tax allocation: allocating income tax expense
to the correct period in the financial statements. The effect of inter-period income tax allocation is to rec-
ognize a deferred tax asset or deferred tax liability on the company’s accrual-based financial
statements to recognize the future tax consequences of events that represent temporary differences be-
tween financial income and taxable income that exist at the financial statement date.
Using deferred tax assets and deferred tax liabilities to account for temporary timing differences and to
allocate the income tax expense to the correct period is called the asset-liability method.91
• A deferred tax asset is an estimate of the amount of tax that will not need to be paid in the
future because of current differences between financial income and taxable income that will re-
verse in the future. It arises when an item causes current taxable income to be higher than
current financial income. This same item will cause future taxable income to be lower than
future financial income. When it increases future financial income, the income tax on it will have
already been paid. The income tax expense will be recognized in future financial income even
though the tax will not need to be paid in the future since it was already paid.
91
According to ASC 740-10-25-2b, “a deferred tax liability or asset shall be recognized for the estimated future tax
effects attributable to temporary differences and carryforwards.” The justification for the asset-liability method is that
timing differences lead to assets and liabilities for the company due to essentially prepaying taxes to the government or
deferring taxes payable to a future period. These assets and liabilities need to be recognized in the financial statements.
• A deferred tax liability is an estimate of the amount of tax that will need to be paid in the
future because of current differences between financial income and taxable income that will re-
verse in the future. It arises when an item causes current taxable income to be lower than
current financial income. Again, the income tax expense provision on the higher financial income
is recognized in the current period’s financial income as a tax expense even though that amount
will be greater than the amount the company actually needs to pay in taxes currently. This item
will cause future financial income to be lower than future taxable income, so that in the future,
the company will have to pay income taxes on a taxable income that is higher than its financial
income. The company will have already benefited from a lower taxable income and lower taxes. It
still owes an amount of tax and will need to pay it at the later date, although the company will not
recognize the income tax expense in financial income at that time since it was already recognized
in the earlier period.
As a very simplified example, if the tax the company “wants to pay” based on its financial income is $90
but the amount it “has to pay” based on its taxable income is $100, taxes would be recorded as follows:
Dr Income tax expense (want to pay – based on financial income) ........... 90
Dr Deferred tax asset ........................................................................ 10
Cr Cash or tax payable (have to pay – based on taxable income) ............. 100
In the preceding example, the company essentially makes a prepayment of taxes because it must pay the
larger amount that the taxing authorities require. Hence, the prepayment of taxes is recognized as a de-
ferred tax asset on the balance sheet of its financial statement according to GAAP.
In a later year, the company will recognize in its financial income the item that gave rise to the deferred
tax asset. It will recognize the related income tax expense in its financial income at that time, but it will not
need to actually pay the income tax on that item at that time because it will have reported the item on its
tax return and paid the tax on it in the earlier year. Thus, the amount the company “wants to pay” based
on its financial income in the later period will be higher than the amount it “has to pay” in that period based
on its taxable income. Using $100 as the amount the company “wants to pay” and $90 as the amount the
company “has to pay” in the later period, the difference will reverse and the deferred tax asset will be
eliminated, as follows:
Dr Income tax expense (want to pay – based on financial income) ......... 100
Cr Deferred tax asset........................................................................... 10
Cr Cash or tax payable (have to pay – based on taxable income) ............... 90
On the other hand, if the amount the company “has to pay” in the earlier period is $90 but the amount it
“wants to pay” is $100, the company has not paid all the tax due according to its financial income and the
company essentially has a tax payable, which is recorded on the balance sheet as a deferred tax liability:
Dr Income tax expense (want to pay – based on financial income) ......... 100
Cr Cash or tax payable (have to pay – based on taxable income) ............... 90
Cr Deferred tax liability ....................................................................... 10
In the later period, the company will “want to pay” $90 according to its financial income, but it will “have
to pay” $100 according to its taxable income, and the difference will reverse. The journal entry will be as
follows:
Dr Income tax expense (want to pay – based on financial income) ........... 90
Dr Deferred tax liability ..................................................................... 10
Cr Cash or tax payable (have to pay – based on taxable income) ............. 100
Note: The journal entries above are very simplified because the examples assume that the tax rate in
the future when the item reverses will be the same as the current tax rate. If the future tax rate will be
different from the current tax rate, the transaction is recorded differently, as will be explained later.
The following table provides a few examples of the amounts calculated under GAAP, the tax code, and the
deferred tax effect (assuming the future tax rate will be the same as the current tax rate).
Taxes company wants Taxes company must pay

to pay under GAAP under tax code Deferred tax status
(the Debit) (the Credit) (the balancing amount)
$10,000 $ 5,000 $5,000 Liability
$ 5,000 $10,000 $5,000 Asset
$12,000 $12,000 No Effect
Note: If an income or expense item is recognized only in financial income or only on the tax return but
not both, it is a permanent difference. Permanent differences do not give rise to deferred tax assets
or liabilities.
Tax Cuts and Jobs Act of 2017 and Its Effect on Accounting for Income Taxes
The U.S. Tax Cuts and Jobs Act of 2017 (TCJA) changed corporate income tax rates significantly. Corporate
tax rates prior to its enactment were graduated, meaning the tax rate changed as total taxable income
increased.92 The Tax Cuts and Jobs Act changed the corporate income tax rate to a flat 21%, effective
January 2018.
The TCJA also made changes to the reporting of revenue for tax purposes to align it more closely with the
FASB’s ASC 606, the revised Revenue Recognition accounting standard for financial reporting. The align-
ment between tax reporting and financial reporting is called “book-tax conformity.” As a result, some
items that may have given rise to deferred tax assets or liabilities in the past no longer do so.
The Act amended the Internal Revenue Code, Section 451, “General Rule for Taxable Year of Inclusion.”
The amendments include the following:
• Most revenue items must be recognized on the income tax return no later than the same tax year
in which the items are included in revenue for financial accounting purposes.93 In some cases, that
requirement could potentially cause tax reporting of some revenue items to be accelerated to a
period earlier than the traditional “all-events test”94 would otherwise require their reporting, be-
cause under ASC 606 they are recognized in financial income and thus they are required by I.R.C.
§ 451 to be recognized also in taxable income. There is no temporary timing difference and no
deferred tax consequence.
92
Until 2018, the graduated federal income tax rates for corporations in the U.S. were 15% on the first $50,000 of
taxable income; 25% on taxable income from $50,000 to $75,000; 34% on taxable income from $75,000 to $100,000;
and so forth.
93
I.R.C. § 451(b).
94
The “all-events test” is the IRS’s requirement that all events that fix an accrual-method taxpayer’s right to receive
income or incur expense must occur before the taxpayer reports an item of income or expense on its tax return. According
to § 451(b)(1)(A), the “all events test” is met with respect to any item of gross income upon the earlier of (i) when the
item is taken into account on the taxpayer’s applicable financial statement (generally an annual report or an SEC filing),
or (ii) when the item would have been recognized as income under the traditional all events test, which states that
income is taxable if all the events have occurred that fix the right to receive such income and the amount of such income
can be determined with reasonable accuracy.
Example: ASC 606 created a class of assets called conditional contract assets. Conditional
contract assets represent an entity’s right to receive consideration for which it has satisfied one
of, or some of, the performance obligations in a contract, but the entity must satisfy another
performance obligation or obligations before it can invoice the customer, so the entity does not
yet have a receivable representing the contract. The entity recognizes revenue in its financial
income and, instead of a receivable, it recognizes a contract asset for the performance obli-
gations it has satisfied.
The TCJA requires the revenue to be recognized in taxable income in the same year it is recog-
nized in financial income, even though the customer has not yet been invoiced, because the
revenue must be recognized in taxable income no later than it is recognized in financial income.
Thus, a contract asset does not lead to a deferred tax consequence.
• The ability is now codified to elect to defer reporting certain advance payments received until the
following taxable year. The taxability of some advance payments received may therefore be de-
ferred until the same year the revenue is recognized in financial income. As a result, some advance
payments received the year before the performance obligation they represent is satisfied may be
reported on the tax return and in financial income in the same tax year (the year following their
receipt) and thus will not give rise to deferred tax assets.
The information and examples that follow are consistent with the TCJA and the Internal Revenue Code
amendments.
Deferred Tax Assets and Future Deductible Amounts

A deferred tax asset arises when an item causes taxable income (and thus income tax due) in the current
period to be greater than financial income (and income tax due according to financial income) in the current
period, and the item will cause the reverse in a future period. Because taxable income is higher than finan-
cial income, the company has needed to pay more in taxes for the current year than its financial income
indicates it owes for that year. However, in the future the item will be deductible from taxable income and
will reduce taxes paid at the future tax rate to an amount below what that future year’s financial income
would indicate is owed that year.
A deferred tax asset is similar to a prepaid tax, but it is different because the amount of the deferred tax
asset is the estimated amount of reduction in the future tax. Therefore, the amount of the deferred
tax asset is based on the future enacted tax rate which may be different from the current year’s tax rate.
Note: When the enacted tax rate for the year in which a deferred tax asset will reverse differs from the
current tax rate, the amount of the deferred tax asset will be different from the amount of tax that has
been prepaid for the related item.
An item that will cause future taxable income (and thus the tax due in the future) to be lower than future
financial income is called a future deductible amount.
A deferred tax asset is created by any of the following types of items:
1) An item that is recognized first as revenue or a gain on the income tax return before it is
recognized in financial income in a later period.
For example, an advance payment received from a customer before the company has satisfied the
performance obligation to the customer represented by the payment may give rise to a deferred
tax asset.95 The receipt may be taxable as revenue when received but reported in the financial
95
I.R.C. § 451(c). § 451(c)(4)(B) includes a list of advance payment items that are excluded from the ability to defer
reporting as taxable income, including rent, certain insurance premiums, and other items. Thus, for example, the report-
ing of advance rent receipts may not be deferred and the receipt of rent in one year for use of the asset that will take
place in the following year will give rise to a deferred tax asset.
statements as a liability until the performance obligation has been satisfied and control has trans-
ferred to the buyer, at which time it is recognized as revenue for financial income purposes.
Note: Deferred tax assets resulting from revenues recognized as taxable before they are rec-
ognized in financial income are limited in the U.S., as per the Tax Cuts and Jobs Act of 2017.
The U.S. Internal Revenue Code provides that a company may elect to defer reporting certain
types of advance payments received until the year following their receipt.96 If because of that
election, the company recognizes a particular advance payment received as both taxable income
and financial income in the year following its receipt, that item will not result in a temporary
timing difference or a deferred tax asset.
However, if that election is not permitted by the Internal Revenue Code, or if the revenue
related to an advance payment received will not be recognized in financial income for an ex-
tended period of time (beyond the following tax year), then a temporary timing difference and
a deferred tax asset may result.
Year 1 Year 2
Income Tax Income Tax
Statement Return Statement Return
Revenues Revenues Revenues Revenues

(Expenses) (Expenses) (Expenses) (Expenses)
Financial Taxable Financial Taxable
Income Income Income Income
Taxable income higher in Year 1. Financial income higher in Year 2.
2) An item that is recognized first as an expense or loss that reduces financial income before
it is recognized as a deductible expense or loss on the income tax return in a later period. For
example:
• Assurance-type warranty expense:97 Assurance-type warranty expense is recognized as

an expense in financial income when revenue from the associated product sales is recognized.
However, the warranty expense is not a deductible expense on the tax return until claims are
made under the warranty by buyers and warranty costs are actually paid.
• Estimated liabilities for loss contingencies: If a contingent loss is probable in the future
and the amount can be reasonably estimated (for example, a loss expected due to a pending
lawsuit), an expense is recognized in financial income for the amount of the estimated loss. On
the tax return, however, the loss is deductible only when cash is actually paid.
• Estimated credit losses: Estimated credit loss expense related to sales is recognized imme-
diately in financial income as the sales are made. However, credit losses are deductible on the
tax return only when accounts are actually charged off as credit losses.
• Unrealized losses on trading securities and equity securities: Unrealized (holding) losses
on trading securities and equity securities are recognized in financial income when the fair
value of the securities held decreases. However, a loss is deductible on the tax return only if
and when the securities are sold at a loss.
96
I.R.C. § 451(c)(1)(B), codified by the Tax Cuts and Jobs Act of 2017.
97
An assurance-type warranty is a manufacturer’s warranty given along with the sale of the product that provides
assurance only that the product meets agreed-upon specifications in the contract at the time it is sold, without any
additional payment being required from the customer for the warranty.
3) A net operating loss that is carried forward to a future tax year to offset future taxable income
also creates a deferred tax asset. Tax loss carryforwards are covered later.
Year 1 Year 2

Taxable income higher in Year 1. Financial income higher in Year 2.
Note: An item that gives rise to a deferred tax asset is a future deductible amount because it will
cause future taxable income to be lower than future financial income.
Deferred Tax Liabilities and Future Taxable Amounts

A deferred tax liability arises when an item causes taxable income in the current period to be lower than
financial income in the current period, and the item will cause the reverse in a future period. Because
taxable income is lower than financial income, the company does not pay as much in taxes as its financial
income indicates it should pay for that year. However, in the future the item will be taxable at the future
tax rate and will increase taxes paid above what that future year’s financial income would indicate is owed
that year.
A deferred tax liability is similar to a tax payable, but it is different because the amount of the deferred tax
liability is the estimated amount of the future tax. Therefore, the amount of the deferred tax liability is
based on the future tax rate which may be different from the current year’s tax rate.
Note: When the enacted tax rate for the year in which a deferred tax liability will reverse differs from
the current tax rate, the amount of the deferred tax liability will be different from the amount of tax
that has been postponed for the related item.
An item that will cause future taxable income (and thus the tax due in the future) to be higher than future
financial income is called a future taxable amount.
A deferred tax liability is created by any of the following types of items:
1) An item that is recognized first as revenue or a gain in financial income before it is recog-
nized on the income tax return in a later period. For example:
• Undistributed earnings of a subsidiary accounted for in the parent’s financial income

through consolidation or undistributed earnings of an investment accounted for in the investor’s
financial income by the equity method are not reported as taxable income until they are trans-
ferred to the parent.
• Unrealized (holding) gains on trading securities and equity securities are recognized in
financial income but are taxable only if and when the securities are sold at a gain.
• If real property is sold at a gain and the seller finances the sale, the seller must recog-
nize the full amount of the gain immediately in its financial income. However, the seller may
report the sale on its tax return as an installment sale and recognize the gain proportionately
over the term of the financing.
Note: Sales of inventory and securities may not be reported on the tax return (or in financial
income) as installment sales. Only sales of real property may be reported on the tax return as
installment sales.
Year 1 Year 2

Financial income higher in Year 1. Taxable income higher in Year 2.
2) An item that is recognized as an expense or loss that is deductible on the income tax
return before it is recognized as an expense or loss that reduces financial income.
The most common example of an expense deductible on the tax return before it is recognized in
financial income is the use of an accelerated depreciation method such as MACRS (Modified Accel-
erated Cost Recovery System) on the income tax return while using straight-line depreciation for
financial income. A deferred tax liability originates gradually during the early years of the asset’s
life and reverses gradually in the later years of the asset’s life.
Year 1 Year 2

Financial income higher in Year 1. Taxable income higher in Year 2.
Note: An item that gives rise to a deferred tax liability is a future taxable amount because it will cause
future taxable income to be higher than future financial income.
Table of Temporary Differences and Their Results

Examples of the situations that cause temporary timing differences and the deferred tax assets and liabilities
arising from each are shown in the following table.
Summary – Temporary Differences and Their Results
Revenues and Gains Expenses and Losses
Deferred Tax Liability

Deferred Tax Asset More accelerated
Reported in taxable income first depreciation used for tax
Rent received in advance
purposes than for
financial income
Deferred Tax Liability

Real property sold at a gain
and reported in financial in- Deferred Tax Asset
Reported in financial income come as an immediate gain
first Estimated assurance-type
and on the tax return as an
warranty expense
installment sale with gain rec-
ognized proportionately as
payments are received
Presentation of Income Taxes on the Income Statement

Two tax expense items are used in determining income tax expense recognized on the income statement:
1) Current Income Tax Expense. Current income tax expense is the tax amount due to the gov-
ernment. It is based on current taxable income and the current tax rate.
2) Deferred Income Tax Expense or Benefit. The deferred income tax expense or benefit is the
tax effect of timing differences between financial income and taxable income in the current period.
A deferred tax expense increases income tax expense, while a deferred tax benefit reduces income
tax expense on the income statement.
3) Items 1) and 2) combined equal the total income tax expense on the income statement.
Current income tax expense and deferred income tax expense or benefit, taken together, equal total in-
come tax expense on the income statement according to GAAP.
Note: Another name for the total income tax expense on the income statement is the provision for
income taxes.
Calculation of Current Income Tax Expense

The current income tax expense is the amount actually due to the government in taxes for the year based
on taxable income. If the tax rate is graduated, that is, calculated at an increasing rate based on the level
of taxable income,98 the tax rate to use for general planning purposes is the average effective tax rate
applicable to the estimated annual taxable income for the year. When an average effective income tax rate
is being used, current income tax expense is:
Current Income Tax Expense = Taxable Income × Income Tax Rate
The journal entry to record the current income tax expense is:
Dr Current income tax expense ................................................ X
Cr Income taxes payable ........................................................... X
It is possible for a company to have a taxable loss rather than taxable income. If the company has a
taxable loss, the amount of its current income tax expense will be zero and the loss may be carried forward
and used to offset taxable income in a future year. A tax loss carryforward is accounted for as a deferred
tax asset. Accounting for a tax loss carryforward is discussed later.
98
Until 2018 in the U.S., the graduated federal income tax rates for corporations were 15% on the first $50,000 of
taxable income; 25% on taxable income from $50,000 to $75,000; 34% on taxable income from $75,000 to $100,000;
and so forth. Effective January 2018, the federal income tax rate for corporations was changed to a flat 21%.
Calculation of Deferred Income Tax Expense or Benefit

The deferred tax expense or benefit that is included in income tax expense on the income statement is the
amount of change in the net deferred tax asset or liability position of the company during the year. The
amount of change in the net deferred tax position is calculated by comparing the beginning and ending net
deferred tax positions.
Note: The net deferred tax position and whether it is to be presented as an asset or a liability is deter-
mined by subtracting the deferred tax liability amounts from the deferred tax asset amounts. If the net
result is positive (a debit), the net amount is reported on the balance sheet as a non-current asset. If
the net result is negative (a credit), the net amount is reported on the balance sheet as a non-current
liability. (See the next topic, Presentation of Deferred Tax Assets and Liabilities on the Balance Sheet,
for more information.)
• If the company is in a better position at the end of the year than at the beginning of the year
(meaning it has a smaller net deferred tax liability or a larger net deferred tax asset), then the
amount of the improvement is a deferred tax benefit. A deferred tax benefit reduces income
tax expense on the income statement. The deferred tax benefit is subtracted from current tax
expense to calculate the total income tax expense shown on the income statement.
• If the company is in a worse position at the end of the year (meaning it has a smaller net deferred
tax asset or a larger net deferred tax liability than it had at the beginning of the year), then the
amount of the change in its deferred tax position will be a deferred tax expense. A deferred tax
expense increases income tax expense on the income statement. The deferred tax expense is
added to the current tax expense to calculate the total income tax expense shown on the income
statement.
Calculation of Income Tax Expense on the Income Statement

Income tax expense on the income statement, also called the provision for income taxes, is current income
tax expense (tax payable currently) plus the deferred tax expense for the period or minus the deferred tax
benefit for the period.
• An increase to a net deferred tax liability or a decrease to a net deferred tax asset is a deferred
tax expense.
• An increase to a net deferred tax asset or a decrease to a net deferred tax liability is a deferred
tax benefit.
In other words, total income tax expense on the income statement is the combination of the current income
tax expense (tax due on current taxable income) and the amount of change in the net deferred tax asset
or liability position during the period.
Current Income Tax Expense (tax payable based on taxable income)

+ Deferred Income Tax Expense OR
− Deferred Income Tax Benefit
= Total Income Tax Expense on the Income Statement
Presentation of Deferred Tax Assets and Liabilities on the Balance Sheet

All deferred tax assets and liabilities, as well as any related valuation allowance, 99 are classified as non-
current on the statement of financial position (balance sheet).
For a particular tax-paying component of an entity and within a particular taxing jurisdiction, all deferred
tax assets, related valuation allowance, and deferred tax liabilities are to be offset and classified as either
a net non-current asset or a net non-current liability. However, deferred tax assets, valuation allow-
ance, and deferred tax liabilities attributable to different tax-paying components of the entity or to different
taxing jurisdictions are not to be offset.100
Note: A company that operates in multiple tax jurisdictions must net together the deferred tax position
for each tax jurisdiction separately. This will mean that a company may have more than one deferred
tax position that will need to be presented (most likely with the jurisdiction detail disclosed in the notes).
The net amount and whether it is to be presented as an asset or a liability is determined by subtracting the
deferred tax liability amounts and any valuation allowance from the deferred tax asset amounts. If the net
result is positive (a debit), the net amount is reported on the balance sheet as a non-current asset. If the
net result is negative (a credit), the net amount is reported on the balance sheet as a non-current liability.
Note: All deferred tax assets, any related valuation allowance, and deferred tax liabilities are presented
as a net non-current asset or liability on the statement of financial position (balance sheet).
Example: As of December 31, 20X9, XYZ Corporation had the following deferred tax assets, deferred
tax asset valuation allowance, and deferred tax liabilities:
Deferred tax assets $ 70,000

Valuation allowance – deferred tax assets (30,000)
Deferred tax liabilities (50,000)
Net deferred tax assets $ (10,000)
Because the net result is negative (a credit), the net amount is reported on the balance sheet as a non-
current liability. XYZ presented a net non-current deferred tax liability of $10,000 on its December 31,
20X9 balance sheet.
Note: The deferred tax benefit or expense for the company is the amount of change in the deferred
tax asset or liability position for the company (or for each tax-paying component or each taxing jurisdic-
tion) during the year.
Permanent Differences
Permanent differences are items that cause differences between taxable income and financial income but
do not reverse over time. Permanent differences do not give rise to deferred tax assets or liabilities
because a permanent difference will be recognized for either financial income purposes or tax purposes,
but not for both.
In an exam question, candidates may need to be able to identify which items in a list are temporary differ-
ences and give rise to deferred tax assets or liabilities and which are permanent differences that do not
give rise to deferred tax assets or liabilities. The most commonly tested examples of permanent differences
are municipal bond interest and the dividends-received deduction. Those items will be discussed individually
below, and then other, less common, examples of permanent differences are listed.
99
A valuation allowance for deferred tax assets is discussed later in this topic, in Valuing Deferred Tax Assets With a
Valuation Allowance.”
100
Per ASC 740-10-45-4 and 45-6.
Municipal Bond Interest

The most common example of a permanent difference is municipal bond interest received (or any other
tax-exempt interest received from a state or local government entity). A municipal bond, or muni-bond, is
a bond issued by a local government. In the U.S., the federal government does not tax interest earned on
municipal bonds. The fact that muni-bond interest is tax-exempt means that the income it generates will
be recognized in financial income in the year it is earned, but it will never be included in taxable income
for federal income taxes because it is excluded from the definition of federal taxable income. Therefore, it
is a permanent difference that does not reverse.
The Dividends-Received Deduction

The dividends-received deduction is applicable when a U.S. corporation owns shares in another qualifying
U.S. corporation.101 According to the Tax Cuts and Jobs Act of 2017:
• When an investor company owns less than 20% of the qualifying investee company, 50% of the
dividends received are not taxable to the investor company.
• When the investor company owns between 20% and 80% of the qualifying company, 65% of the
dividends received are not taxable to the investor.
• When the investor company owns more than 80% of the qualifying company, 100% of the divi-
dends received are not taxable.
Because in many cases some of the dividend will still be taxable, the dividends-received deduction is only
partially a permanent difference.
Other Permanent Differences

Other examples of items that lead to permanent differences are:
• Expenses incurred in the process of earning tax-exempt income are not deductible for tax
purposes but will be deducted from net income for financial income purposes.
• Life insurance premiums paid by the corporation are never deductible expenses for tax pur-
poses if the corporation is the beneficiary. However, for financial income purposes the premiums
are an expense.
• Life insurance proceeds received by the corporation are never taxable, but they will be recog-
nized as financial income.
• Expenses incurred as a consequence of violating the law, including penalties and inter-
est, are not tax deductible.
• Certain other expenses such as client entertainment and excessive employee compensation
are not deductible for tax purposes according to the tax law, but they are expenses that reduce
financial income. All compensation over $1 million paid to any one employee and all costs to en-
tertain clients are non-deductible.102
101
The criteria for being a qualified corporation are outside the scope of this exam. For the exam candidates need to
know how the dividends received deduction works, not what qualifies for the dividends received deduction.
102
Per the Tax Cuts and Jobs Act of 2017. Previous to the enactment of the TCJA, Section 162(m) of the U.S. Internal
Revenue Code prohibited publicly held companies from deducting more than $1 million per year in compensation paid
per employee, but commissions and performance-based pay were exempted from that limitation and could be deducted
from taxable income. Many companies took advantage of the exemption and offered base pay of $1 million to their senior
executives plus virtually unlimited incentive pay, so that all the compensation paid to their senior executives could be
deducted from taxable income. The Tax Cuts and Jobs Act amended Section 162(m) to eliminate the exemption for
commission-based and performance-based pay. The Tax Cuts and Jobs Act also eliminated all deductions for entertain-
ment expenses.
Treatment of Net Operating Losses

When an entity has a taxable loss for a year, it can apply that loss to offset taxable income in another
period. For tax years beginning after December 31, 2017, the U.S. Tax Cuts and Jobs Act (TCJA) permits
the loss to be carried forward indefinitely, subject to a limitation: the amount of the loss used to offset
taxable income in a future period is limited to a maximum of 80% of that future period’s taxable income
(without regard to the NOL deduction).
A two-year net operating loss carryback is also permitted for certain farming losses. In addition, property
and casualty insurance companies may carry a net operating loss back for two years and forward for a
maximum of twenty years, similar to the pre-TCJA-enactment provisions for net operating losses.
Prior to the enactment of the Tax Cuts and Jobs Act, all corporations were permitted to carry a loss back
two years and receive a refund of taxes paid previously or to carry the loss forward for a maximum of
twenty years, or both.
Any net operating losses that arose prior to 2018 remain subject to the previous law. They are not subject
to the 80% limitation in the TCJA, and they remain subject to the prior carryback rules and the 20-year
limitation on carrying the loss forward.
If a company is permitted to carry a net operating loss back, it does so by filing an amended tax return
for the affected previous tax year(s) and will receive a cash refund from the IRS for the amount of previously
paid income taxes covered by the loss.
If the loss will be carried forward to offset future taxable income, the company needs to recognize a
deferred tax asset in the year of the loss for the amount of the loss that will be carried forward multi-
plied by the enacted tax rate for the future tax year in which the loss is expected to be used to
decrease future taxable income. The deferred tax asset will be reported on the balance sheet and the income
tax benefit from the loss carryforward is recognized on the income statement similar to the way a loss
carryback is recognized but is identified as “income tax benefit due to loss carryforward.”
Valuing Deferred Tax Assets with a Valuation Allowance

A deferred tax asset is recognized for all deductible temporary differences and tax loss carryforwards. As
with other assets, a deferred tax asset must be evaluated regularly to determine whether a valuation al-
lowance is needed and if so, the amount.
Whether or not a valuation allowance is needed depends on whether or not the company expects to have
enough taxable income in the future to be able to use the deferred tax asset to offset income tax expense
on the future income. If the company does not expect to have enough future taxable income to owe income
taxes in the future, then it will not be able to benefit from the deferred tax asset. A history of operating
losses is an indication that the deferred tax asset may not be able to be realized, either partially or fully.
If, based on all available evidence, management determines that it is more likely than not (a likelihood
of more than 50%) that the company will not be able to realize some or all of the deferred tax asset, it
should establish a valuation allowance for the deferred tax asset. The valuation allowance is a contra-asset
account that carries a credit balance and reduces the deferred tax asset to its expected realizable value,
that is, the amount management expects to be able to realize.
The journal entry used to establish the allowance will increase total income tax expense in the current
period and the valuation allowance established will decrease the carrying amount of the deferred tax
asset.
If management expects the company to have adequate taxable income in the future to be able to use the
deferred tax asset, then a valuation allowance is not needed.
Study Unit 21: A.2. Leases CMA Part 1
2d) Accounting for Leases

Study Unit 21: A.2. Leases
Guidance in the Accounting Standards Codification® on accounting for leases is in ASC 842.
All leases create an asset (the right to use the asset) and a liability (the liability to make lease payments)
for the lessee, so the basic principle of Topic 842 is that a lessee should recognize the assets and
liabilities that arise from leases.
• A lessee should recognize a right-of-use asset representing its right to use the leased asset for the
term of the lease and
• A lessee should also recognize the liability to make lease payments over the lease term.
The lessee amortizes the right-of-use asset.
Each lease payment made by the lessee will include a payment of interest and a payment representing a
reduction of the lease liability.
Note: The lease liability is defined as the lessee’s obligation to make the lease payments arising from
a lease, measured on a discounted basis.103 Measurement on a “discounted basis” means the lease
liability is generally analogous to the outstanding principal balance on a loan.
Definition of a Lease
A lease is an agreement between a lessor and a lessee. The lessor is the owner of the asset. The lessor
leases the asset to the lessee, the one who is going to control the use of the asset and make payments to
the lessor for the right to use the asset. According to ASC 842-10-20, a lease is:
“A contract, or part of a contract, that conveys the right to control the use of identified
property, plant, or equipment (an identified asset) for a period of time in exchange for
consideration.”
A contract is a lease or contains a lease if it conveys the right to control the use of the property, plant, or
equipment for a period of time in exchange for consideration.
Control over the use of an identified asset means that the lessee has both:
1) The right to obtain substantially all the economic benefits from the use of the asset, and
2) The right to direct the use of the asset.104
103
ASC 842-10-20 (Glossary).
104
Per ASC 841-10-15-3 and 15-4.
Section A Study Unit 21: A.2. Leases
The Two Categories of Leases for Lessees

For lessees, there are two different types of leases for financial accounting purposes, and both require the
lessee to recognize a right-of-use asset and a lease liability. The two types are: 1) finance leases and 2)
operating leases.105
For the lessee, a finance lease is one that meets one or more of the following five criteria:
1) The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2) The lease grants the lessee an option to purchase the underlying asset, and the lessee is reasonably
certain to exercise the option to purchase.
3) The lease term is for a major part of the remaining economic life of the asset, unless the com-
mencement date of the lease falls at or near the end of the underlying asset’s economic life.
4) The present value of the sum of the lease payments and any residual value guaranteed 106 by the
lessee not already reflected in the lease payments is equal to or greater than substantially all of
the fair value of the underlying asset.
5) The underlying asset is of such a specialized nature that it is expected to have no alternative use
to the lessor at the end of the lease term.107
Note: The FASB has stated, in ASC 842-10-55-2, that one reasonable approach to assessing items 3)
and 4) in the finance lease classification criteria would be to conclude that
• A “major part” of the remaining economic life of the asset is seventy-five percent or more.
• A “commencement date that falls at or near the end of the asset’s economic life” refers to a com-
mencement date that falls within the last 25 percent of the total economic life of the asset.
• “Substantially all of the fair value of the underlying asset” is ninety percent or more of the asset’s
fair value.
The FASB has also stated, in ASC 842-10-55-3, that in some cases, it may not be practicable to determine
the fair value of the underlying asset referred to in item 4) of the finance lease classification criteria. If
it is not practicable to determine the fair value of the underlying asset, lease classification should be
determined without consideration of item 4).
If the lessee decides to use any of the firm guidelines above, the lessee should apply them consistently
to the classification of all its leases.
When none of the criteria for a finance lease are met, the lessee classifies the lease as an operating lease.
105
A third type of lease may not require the recognition of a right-of-use asset and a lease liability. For short-term
leases, defined as leases having a term of 12 months or less, the lessee may make an accounting policy election, by
class of underlying asset, to not recognize lease assets and lease liabilities.
106
Per ASC 842-10-20 (Glossary), a guaranteed residual value is a guarantee made by a lessee to the lessor that the
value of the underlying asset returned to the lessor at the end of the lease will be at least a specified amount. When
there is a guaranteed residual value, the lessor transfers to the lessee the risk of loss if the value of the underlying asset
is less than the specified amount. Per ASC 842-10-55-35, if the lessor has the right to require the lessee to purchase the
underlying asset by the end of the lease term, the stated purchase price is included in the lease payments and that
amount is a guaranteed residual value.
107
Per ASC 842-10-25-2.
Study Unit 21: A.2. Leases CMA Part 1
Lease Recognition by the Lessee

Finance Lease Recognition by the Lessee
For a finance lease, the lessee is required to:
1) Recognize a right-of-use asset and a lease liability at the commencement date of the lease 108 in
the lessee’s statement of financial position (balance sheet).
a. The initial value of the right-of-use asset is its cost, which includes the initial amount of the
lease liability plus any lease payments made either before commencement of the lease or at
the lease commencement date (minus any lease incentives received) plus any initial direct
costs incurred by the lessee.109
b. The initial value of the lease liability is the present value of the lease payments not yet paid,
discounted at the discount rate for the lease. The discount rate for the lease is the rate im-
plicit in the lease (see Note below) if that rate is readily determinable by the lessee. If the
rate implicit in the lease is not readily determinable, the lessee uses its incremental borrow-
ing rate (see Note below) as the discount rate for the lease obligation.110
Note: The rate implicit in the lease is the rate of interest that, for the lessor, causes the
aggregate present value of (a) the lease payments and (b) the amount the lessor expects to
derive from the underlying asset following the end of the lease term to be equal to the sum of
(1) the fair value of the underlying asset minus any related investment tax credit retained and
expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. 111
The rate implicit in the lease is determined by the lessor.
The lessee’s incremental borrowing rate is the rate of interest the lessee would have to pay
to borrow on a collateralized basis over a similar term an amount equal to the lease payments
in a similar economic environment.112
2) Recognize interest expense incurred after the commencement date on the lease liability and
separately recognize amortization of the right-of-use asset in the lessee’s income statement
and statement of comprehensive income (income statement).113
3) Recognize any variable lease payments114 not included in the lease liability in the period when the
obligation for those payments is incurred.115
4) Recognize any impairment of the right-of-use asset.116
5) In the statement of cash flows, recognize repayments of the principal portion of the lease liability
as cash flows from financing activities and payments of interest on the lease liability and any
variable lease payments as cash flows from operating activities.
108
Per ASC 842-20-25-1.
109
Per ASC 842-20-30-5.
110
Per ASC 842-20-30-1 through 30-3.
111
Per ASC 10-20 (Glossary).
112
Per ASC 842-10-20 (Glossary).
113
Per ASC 842-20-25-5a.
114
Per ASC 842-20-20 (Glossary), variable lease payments are payments made by a lessee to a lessor for the right to
use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date
of the lease, other than the passage of time. Variable lease payments may be based on an index or rate, such as an
escalator based on the Consumer Price Index, or they may be based on performance or usage of the asset. However,
only variable lease payments that are based on an index or rate are included in the calculation of the lease payments
that determine the measurement of the lease liability and affect the lease classification, per ASC 842-10-30-5 and 30-6.
The variable lease payments should be included at the level of the index or rate at the commencement date of the lease.
Any differences in the future payments due caused by changes in the index or rate are expensed in the period incurred.
115
Per ASC 842-20-25-5b.
116
Per ASC 842-20-25-5c.
Section A Study Unit 21: A.2. Leases
Note: The amount of interest that is expensed on the income statement each period by the lessee is
based on the balance of the lease liability (analogous to the principal balance on a loan) that is outstand-
ing during the period. Therefore, each time a lease payment is made, part of the payment represents
interest and part of the payment represents a reduction of the lessee’s lease liability. The lease liability
on which the calculation of the next interest amount is based will therefore be lower, so the portion of
the next payment that represents interest will be lower and (assuming a level payment) the portion of
the next payment that represents reduction of the lease liability will be greater.
Operating Lease Recognition by the Lessee

For an operating lease, the lessee is required to:
1) Recognize a right-of-use asset and a lease liability at the commencement date of the lease in the
lessee’s statement of financial position (balance sheet). The right-of-use asset and the lease lia-
bility are measured the same way as they are measured for a finance lease.
2) Recognize a single lease cost after the commencement date, calculated so that the total cost of
the lease is allocated on a generally straight-line basis over the term of the lease.117 The total cost
of the lease includes amortization of the cost of the right-of-use asset and interest expense on the
lease liability.
3) Recognize any variable lease payments not included in the lease liability in the period when the
obligation for those payments is incurred.118
4) Recognize the full amount of payments made on operating leases as cash flows from operating
activities in the statement of cash flows.119
Short-term Leases
For leases having a term of 12 months or less, the lessee may make an accounting policy election, by
class of underlying asset, to not recognize lease assets and lease liabilities. If a lessee makes such an
election, it should recognize the lease payments as expenses on a generally straight-line basis over the
lease term.120
However, the lease term used to determine qualification as a short-term lease may be longer than the initial
lease term. The lease term is defined in the Accounting Standards Codification® as:
The noncancelable period for which a lessee has the right to use an underlying asset, together
with all of the following:
• Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that
option
• Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exer-
cise that option
• Periods covered by an option to extend (or not to terminate) the lease in which exercise of the
option is controlled by the lessor.121
Therefore, according to the definition of the lease term, if the lease includes an option to extend the
term of the lease that is reasonably certain of exercise by the lessee or an option to terminate it prior to its
termination date that is reasonably certain not to be exercised by the lessee, those options are included in
the lease term used to determine whether or not the lease qualifies as a short-term lease.
117
Per ASC 842-20-25-6a.
118
Per ASC 842-20-25-6b.
119
Per ASC 842-20-45-5.
120
Per ASC 842-20-25-2.
121
Per ASC 842-10-20 (Glossary).
Study Unit 22: A.2. Owners’ Equity and Retained Earnings CMA Part 1
Example: A one-year lease that includes a renewal option that the lessee is reasonably certain to exer-
cise cannot qualify as a short-term lease, and the lessee must record a right-of-use asset and a lease
liability.
IFRS Notes:
Lease Classification by Lessees: Under U.S. GAAP, lessees classify leases as either finance leases or
operating leases based on meeting any one of five criteria. Under IFRS, no formal classification between
finance leases and operating leases exists for lessees.
Measurement of the right-of-use asset by lessees: Under U.S. GAAP, the right-of-use asset at the
commencement of the lease is measured as the historical cost of the right-of-use asset to the lessee.
The historical cost does not change during the term of the lease, although it is amortized. Under IFRS,
alternative measurement bases are allowed for the right-of-use asset, including the revaluation model
as permitted by IAS 16, Property, Plant, and Equipment.
Study Unit 22: A.2. Owners’ Equity and Retained Earnings
3) Equity Transactions
Guidance in the Accounting Standards Codification® on accounting for owners’ equity is in ASC 505.
Owners’ equity, or shareholders’ equity, is the “balancing” element of the balance sheet. Assets represent
what the company owns, liabilities represent what the company owes to outside parties, and owners’ equity
represents what the company owes to the owners of the company. Regardless of the business’s form or the
total number of owners, those owners will most likely have a claim on some of the assets of the company,
represented by the owners’ equity on the balance sheet. More formally, owners’ equity is defined as the
residual interest in the assets of an entity after deducting its liabilities. In theory, if the owners were to
liquidate the business, the owner’s equity represents the amount due to them after all the assets are liqui-
dated and external debts are paid. However, assets are recorded at their historical value but would be
liquidated at the market value, and these two amounts are almost never the same.
The specific accounts a company has in the owners’ equity section of its balance sheet will depend upon the
form of the company. A sole proprietorship will have one capital account for the owner, whereas a partner-
ship will have a capital account for each partner.
Note: On the exam, “owners’ equity,” “stockholders’ equity,” and “shareholders’ equity” may be used
interchangeably. Additionally, “equity” may be used without the word “owners’” or “stockholders’” or
“shareholders’” preceding it.
Section A Study Unit 22: A.2. Owners’ Equity and Retained Earnings
Corporate Shareholders’ Equity

The corporate balance sheet includes two main classifications of owners’ equity: contributed capital and
retained earnings.
1) Contributed capital consists of the assets put into the company by the owners in return for their
share of ownership of the company. The fair value of what is received in exchange for the shares,
whether cash or another asset, is recorded in two different equity accounts:
• The capital stock account records the stated, or par, value of shares that have been sold. The
company will have different capital stock accounts for each different type of share that it has
issued.
• The additional-paid-in-capital (APIC) account consists of the value received for the shares
that was over and above the stated, or par, value. A company may have a number of different
APIC accounts for either specific types of shares or specific transactions.
2) Retained earnings represent the undistributed profits of the company that were reinvested in
the company. These may also be called undistributed earnings.
Note: Owners’ equity also includes the balance of accumulated other comprehensive income, treasury
stock, and any non-controlling interests.
Accumulated other comprehensive income represents the accumulated balance of several specific types
of transactions that are not included in the income statement but are included in equity and adjust the
balance of equity, even though they do not flow to equity by means of the income statement as do
retained earnings.
Treasury stock represents issued shares that have been repurchased by the issuing corporation. The
accumulated balance in the Treasury Stock account is either the amount paid for issued shares that have
been repurchased or the par value of issued shares that have been repurchased. The treasury stock
account is a contra-equity account that carries a debit balance and reduces equity on the balance sheet.
Non-controlling interests arise when a company owns more than 50% of the outstanding common stock
of another company and therefore consolidates the financial statements of the subsidiary company with
its own but does not own 100% of the acquired company. The fair values of the partially owned subsid-
iary’s assets are recorded in the asset section of the consolidated balance sheet at 100% of their fair
values. The ownership interests held by owners other than the parent are called non-controlling in-
terests. Non-controlling interests are recorded in the equity section of the balance sheet, separately
from the parent’s equity, and they represent the claims that the non-controlling interests have on the
equity of the subsidiary.
Study Unit 23: A.2. Common Stock CMA Part 1
Study Unit 23: A.2. Common Stock

Corporations may sell two general types of stock: common stock or preferred stock.122 The form and
type of stock depends upon the way in which the company registered the stock and the characteristics the
company has given to it.
Common Stock
Types of Common Stock

Common stock is classified according to whether or not it has a “par” value. Par value is the stated value
of each share of stock, although the par value does not impact the selling price of the stock. The par value
is assigned to the shares when they are registered and does not need to be any specific amount. In fact,
par value is usually a small amount.
The par value of all shares issued represents the legal or stated capital of a company. Legal capital is the
portion of contributed capital that is required by statute to be retained in a business, and it cannot be
distributed as dividends. Because of the restriction against distribution of its legal capital, companies often
choose to have a very low par value on their stock.
When shares are first issued and sold, the par value of the shares is credited to the common stock account
and the rest of the cash received is credited to the additional paid-in capital-common stock (APIC-CS)
account.
The two types of common shares based on the existence or non-existence of a par value are:
• Par (or Stated) Value. When stock has a par value, its par value is the maximum amount of a
shareholder’s personal liability to the creditors of the company. As long as the par value has been
paid to the corporation by the shareholders for their purchase of the original issue of the stock, the
shareholders obtain the benefits of limited liability, and their potential for loss is limited to the
amount they paid for their shares.
If stock is originally issued at less than its par value (at a discount), the owners of the stock may
be called upon to pay in the amount of the discount to creditors if the corporation is subsequently
liquidated and the creditors would have losses.
Note: In most states a corporation is not permitted to issue shares at less than par value.
• No-Par Value. If stock has no par value, the legal capital is the total amount that is received when
the shares are issued, and the whole amount received is credited to the common stock account.
Issuing Common Stock

When common shares are issued for cash, the journal entry for the issuance of common or preferred shares
is:
Dr Cash .............................................................. cash received
Cr Common shares ............................... par value of shares issued
Cr Additional paid-in capital – common shares .... balancing amount
The entry above is the basic journal entry for all sales of stock, including preferred shares. For preferred
shares, the names of the accounts are changed from “common shares” to “preferred shares” and from
“additional paid-in capital-common shares” to “additional paid-in capital-preferred shares.”
122
It is possible for a company to have some type or class of stock that does not fall exactly into one of these two
categories.
Section A Study Unit 23: A.2. Common Stock
It does not matter if the sales price of the shares is above or below the fair value of the shares. Cash is
debited for the amount of cash received and the amount received is allocated between common shares and
APIC. The only amount that will ever go into the common shares or preferred shares account is
the par value of the shares sold.
Dividends
Dividends are the distribution of current profits or of the retained earnings of the company to its owners.
The declaration of cash dividends or property dividends reduces total stockholders’ equity by means of
either the distribution of an asset (cash or other property) or the incurrence of a liability (dividends payable
if the dividend is not immediately distributed).
Dividends can be paid in various forms, but the most common form is cash. Whichever form the dividend
takes, some asset of the company is distributed to the shareholders.
1) Cash Dividends
A cash dividend is the most common form of dividend, and the journal entries for cash dividends are simpler
than those for other types of dividends. One of the important areas related to dividends is the dates gov-
erning payment because those dates determine when journal entries are made. The three dates related to
the payment of a cash dividend are listed below:
1) The date of declaration is the day the board of directors formally declares the dividend. The
board also announces the date of record and the date of payment. On the date the dividend is
declared, the retained earnings account is debited, thus reducing the retained earnings balance,
and a liability, “dividends payable,” is credited. The amount of the journal entry is an estimated
amount because the exact number of shares to which the dividend will be paid may change be-
tween the date of declaration and the date of record.
The declaration of a dividend reduces working capital123 because the entry increases the com-
pany’s current liabilities.
The journal entry at the date of declaration is:

Dr Retained earnings .............................................................. X
Cr Dividends payable ................................................................ X
2) The date of record is the date used to determine who actually will receive the dividend. Anyone
who owns shares on the date of record receives the dividend when it is paid. Theoretically, no
journal entry is made on the date of record because the entry on the date of declaration recognized
the liability and the reduction in retained earnings. However, a company may need to make an
entry on the date of record to adjust the estimate that was made on the date of declaration re-
garding the calculated total of dividends payable.
3) The date of payment is the date on which the dividend is paid. When the dividend is paid the
liability is eliminated, and the cash account is decreased. The journal entry is:
Dr Dividends payable .............................................................. X
Cr Cash ................................................................................... X
123
Working capital is calculated as current assets minus current liabilities.
Note: A fourth date is also important, though it does not require any journal entry to be made by the
company paying the dividend.
The ex-dividend date is important to shareholders who either buy or sell shares in the days immediately
preceding the date of record because time is required to process stock trades. The date when a stock
begins selling without the purchaser having the right to the dividend is called the ex-dividend date.
Investors buying the stock on or after the ex-dividend date do not receive the subsequent dividend—
the prior owner does.
Currently, the established standard in the U.S. for the ex-dividend date is one business day prior to the
date of record. In order to receive the dividend, a buyer of the stock must purchase the stock before
one business day prior to the date of record, because as of one day prior to the date of record, the stock
goes “ex-dividend.” In other words, to receive the dividend, the investor must already own the stock on
the ex-dividend date, and the ex-dividend date is one business day before the date of record. For exam-
ple, if the date of record is Thursday, January 11, the ex-dividend date is Wednesday, January 10, and
the investor must purchase the stock no later than Tuesday, January 9 to receive the dividend.
Therefore, the ex-dividend date, not the record date, determines which shareholders will receive the
dividend. However, the ex-dividend date is based on the record date.
2) Liquidating Dividends
Liquidating dividends are dividends that are a return of capital rather than a return on capital. A liqui-
dating dividend occurs when the dividend distributed is greater than the balance in retained earnings. Any
dividend or portion of a dividend paid that would exceed the balance in retained earnings is classified as a
liquidating dividend because it is not a distribution of profits.
If the balance in the retained earnings account is zero or less than zero because the company has cumulative
losses when the dividend is declared, the APIC account is reduced for the full amount of the liquidating
dividend. The journal entry for a dividend that is totally liquidating at the declaration date is:
Dr APIC ........................................................ amount of dividend
Cr Dividends payable ....................................... amount of dividend
When the dividend is paid, dividends payable is debited and cash is credited.
A dividend may be a partially liquidating dividend. When there is a balance in retained earnings but the
dividend declared is larger than that balance, the portion of the dividend in excess of the balance in retained
earnings is a liquidating dividend. The part of the dividend that is available in retained earnings is a normal
dividend and takes the retained earnings balance to zero. The portion that is liquidating is a reduction to
APIC. The declaration date journal entry is shown below:
Dr Retained earnings ...................................................... to zero
Dr APIC .........................................................liquidating amount
Cr Cash .......................................................... amount of dividend
If a company pays a dividend from a source other than retained earnings, the company must inform its
shareholders of how much of the dividend for each share should be considered a liquidating dividend.
3) Property Dividends
When a company distributes a property dividend, it is distributing an asset other than cash as the dividend.
For example, the company may distribute inventory, fixed assets, or shares in another company that it
holds. The fact that a company declares a property dividend does not mean that a company does not have
cash. A property dividend may be declared because the company is using its cash to finance an expansion
or some other investment opportunity.
Section A Study Unit 23: A.2. Common Stock
When a company declares a property dividend, it restates to fair value as of that date the property it will
distribute and recognizes a gain or loss for the difference between the property’s fair value and its carrying
value.
Example: On July 1, Lemond Company declared a dividend consisting of common stock it owned in
Devery Corporation. The carrying value of the Devery stock on July 1 was $1,000,000 and the market
value of the stock on that date was $1,250,000. Lemond Company records the following journal entry
to recognize the gain and the property dividend declaration:
Dr Equity investments................................................... 250,000

Cr Gain ......................................................................... 250,000
Dr Retained earnings ................................................. 1,250,000
Cr Property dividends payable....................................... 1,250,000
When the property dividend is distributed on August 1, Lemond records the distribution as follows:
Dr Property dividends payable .................................... 1,250,000
Cr Equity investments .................................................. 1,250,000
Note: The net result of the property dividend on owners’ equity will be that owners’ equity will decrease
by the book value of the property distributed. In the preceding example, retained earnings will decrease
on the declaration date by the appreciated value of the property dividend ($1,250,000), and then when
the unrealized holding gain is closed to retained earnings, retained earnings will increase by the amount
of the gain ($250,000). The net result is that retained earnings decreases by the book value of the
property distributed ($1,000,000).
Property Dividends for the Shareholder

When the shareholder receives the assets distributed in the property dividend (not when it is declared),
the shareholder recognizes dividend income at the fair value of the asset or assets received. The journal
entry is:
Dr Asset received ........................................................ fair value
Cr Dividend income ....................................................... fair value
4) Stock Dividends and Stock Splits
Guidance in the Accounting Standards Codification® on accounting for stock dividends and stock splits
is in ASC 505-20.
Stock Dividends
A stock dividend occurs when the company distributes a dividend in the form of additional shares. The
journal entry to record the stock dividend will transfer some amount from retained earnings to the common
stock and APIC accounts. The transfer from retained earnings is necessary because even though no cash is
distributed to the shareholders, some of the earnings of the company are now “owed” to the shareholders
in the form of the shares issued in the stock dividend. Also, the company now has more shares outstanding,
and the increased number of shares outstanding needs to be recognized and recorded. Recognition and
recording are accomplished by reducing retained earnings and increasing common stock and APIC. Because
all the changes take place within the equity section of the balance sheet, the total value of the company’s
equity is not changed by a stock dividend, although the amounts in the various equity accounts are redis-
tributed.
The journal entry required depends on the size of the dividend.
Small Stock Dividend

A small stock dividend is usually less than 20-25% of the total shares outstanding.124
Shares issued in a small stock dividend are valued at the fair value of the shares on the date of decla-
ration:
Dr Retained earnings ................... fair value of shares to be issued
Cr Common shares – issuable as a dividend ....... par value of shares
Cr Additional paid-in capital – common shares ...... balancing amount
The journal entry above is recorded on the date of declaration and no adjustment to the amount is
made for any change in the fair value of the shares between the declaration date and the date of
issuance.
Note: Even if the shares of stock will be distributed at a later date, no dividend payable is set up for
a stock distribution. Rather, the credit is to an account called common shares – issuable as a divi-
dend in the equity section of the balance sheet or some similar name. Thus, no liability is recorded on
the balance sheet for a stock dividend.
On the date the stock is issued and the small stock dividend is distributed, the following entry is recorded:
Dr Common shares – issuable as a dividend ..... par value of shares
Cr Common stock ............................................ par value of shares
Large Stock Dividend

A large stock dividend is usually more than 20-25% of the total shares outstanding. If the stock dividend
is a large stock dividend, the journal entry is based on the par value of the shares:
Dr Retained earnings ..................................... par value of shares
Cr Common shares – issuable as a dividend ....... par value of shares
When the stock is issued, the common shares issuable as a dividend account is debited and the common
stock account is credited for the par value of the shares issued.
Stock Splits
A company generally splits its stock because its price per share has become too high and investors may be
hesitant to buy it. To reduce the market price per share and make the stock more attractive as an invest-
ment, the company essentially cuts its shares into smaller pieces. As a result, more shares are outstanding,
and each share is worth a lower market price. For example, in a 2-for-1 stock split, the owner of each share
becomes the owner of twice as many shares, but each share will have a market price that is half what it
was before the split. Thus, the total fair value of each investor’s holdings will be essentially unchanged after
the split.
In a stock split, the par value of each share of the stock is also reduced in the same ratio. For example,
if before any split the company had 1,000,000 shares outstanding with a par value of $1 each, the balance
in the company’s common stock account would have been $1,000,000. After a 2-for-1 stock split, the
balance in the common stock account would remain $1,000,000, but it would instead represent 2,000,000
shares with a par value of $0.50 each.
124
Per ASC 505-20-25-3, “The point at which the relative size of the additional shares issued becomes large enough to
materially influence the unit market price of the stock will vary with individual entities and under differing market condi-
tions and, therefore, no single percentage can be established as a standard for determining when capitalization of retained
earnings in excess of legal requirements is called for and when it is not. Except for a few instances, the issuance of
additional shares of less than 20 or 25 percent of the number of previously outstanding shares would call for treatment
as a stock dividend . . .”
Section A Study Unit 24: A.2. Preferred Stock
When a company splits its stock, no journal entry is made. Instead, a memo entry is made to demonstrate
that, for a 2-for-1 split, for example, twice as many shares are now outstanding and the par value of each
share is half what it was before. The balances in all the shareholders’ equity accounts on the balance sheet
remain unchanged.
Note: A company can also perform a reverse stock split. In a reverse stock split, the company con-
solidates its shares so that it has fewer shares. As a result, each share is worth more. In a 1-for-2 reverse
stock split, for example, the owner of two shares becomes the owner of one share, but the fair value of
that one share will be twice as much as the fair value of one share was before the reverse stock split,
and the investor’s total market value will be unchanged.
A company might perform a reverse stock split if the market price of its shares has dropped so low that
its stock is in danger of being de-listed from the stock exchange or exchanges on which it trades. The
reverse stock split doubles the market price of a share of the stock.
Study Unit 24: A.2. Preferred Stock

Preferred Stock
The most important difference between preferred stock and common stock is that owners of preferred
shares do not have the right to vote, whereas owners of common stock do have voting rights. However,
preferred shares have three preferences over common stock that distinguish them from common shares.
These items that make the preferred stock “preferred” are:
• Preference in the claims to assets in a liquidation.
• Preference in the payment of dividends.
• A difference in how dividends are calculated. Preferred shares usually have a higher par value
than common shares, and the dividend that is paid is usually a percentage of that par (or stated)
value. Therefore, the preferred dividend is more of a fixed amount than the common dividend
because the common dividend is dependent on earnings and management decisions.
There are two ways that dividends can be distributed to preferred shareholders. The type of dividend that
a share receives is stated in the share itself.
Note: Under both types of dividends, preferred dividends are usually a percentage of the par value of
the stock.
Cumulative Preferred Dividends

If preferred stock is cumulative, its dividend is earned each year by the preferred share. This does not
mean that company necessarily distributes the dividend each period, just that the shareholder has earned
the dividend and has a right to receive that dividend in the future. The declaration and payment of a
cumulative preferred dividend is accounted for in the same way as any other cash dividend.
For those years when the dividend is not paid, the amount that is not paid is “in arrears.” “In arrears”
means that the company is behind schedule in respect to preferred, cumulative dividends and has missed
at least one payment of dividends that should have been made. These dividends in arrears must be
paid in full at some point in the future before any common dividends can be paid.
A journal entry for cumulative preferred dividends is made only when the dividend is declared.
No liability is recorded on the books unless the dividend is actually declared. Once the dividend is declared,
the journal entry is the same as it is for a cash dividend as described earlier.
Cumulative dividends in arrears must be paid in full before any common dividends can be paid. Dividends
in arrears are not recognized as a liability but are disclosed in a note to the financial statements.
This disclosure is necessary so that a prospective buyer of the common shares can know whether or not
Study Unit 24: A.2. Preferred Stock CMA Part 1
the company will be able to pay dividends on its common stock in the future. Large cumulative dividends
in arrears indicates that the company will not be able to pay common dividends until those preferred divi-
dends in arrears are paid.
Noncumulative Preferred Dividends

Dividends that are noncumulative (the second type of dividends) are “lost” if they are not declared for any
given year. Noncumulative preferred dividends are simply dividends that are payable at the discretion of
the company. The journal entry for these dividends is the same as for common dividends.
Exam Tip If an exam question does not specify whether preferred shares are cumulative or noncumu-
lative, assume they are noncumulative.
Retained Earnings
The retained earnings account is the final destination for all income statement (revenue and expense)
accounts. The retained earnings account represents the accumulated undistributed income of the corpora-
tion from its inception.
In the year-end close, net after-tax income for the year is moved to retained earnings, so retained earnings
increases by the amount of the after-tax net income. The retained earnings account is decreased when
dividends are paid. Retained earnings is a permanent balance sheet account, so the balance in it accumu-
lates from year to year.
The balance in the retained earnings account represents all the profits of the company since it started minus
any dividends declared and amounts transferred into paid-in-capital accounts.
Appropriated Retained Earnings

All retained earnings start out classified as unappropriated retained earnings. The term “unappropri-
ated” simply means that the retained earnings are available to be distributed to shareholders in the form
of dividends. Occasionally, however, a company does not want to distribute its retained earnings and its
intention to not distribute a portion of or all of its retained earnings can be communicated to shareholders
(and potential shareholders) through the process of appropriating retained earnings.
Appropriation of retained earnings is accomplished by means of a resolution approved by the corporation’s

board of directors. The appropriation of a portion of or all of retained earnings informs the users
of the financial statements that the appropriated retained earnings are not available for distri-
bution as dividends.
A company may decide to appropriate retained earnings for several reasons. Among them are:
• Creating a reserve to build a plant.
• Acquisitions.
• Debt reduction.
• Meeting the requirements of a bond or a restriction on the payment of dividends imposed by a loan
covenant.
• Providing for research and development or new product development.
• Marketing campaigns.
• As a reserve against an expected loss.
• Simply providing for the future.
Section A Study Unit 24: A.2. Preferred Stock
The board of directors can de-appropriate the retained earnings at any time. Once the purpose for which
the retained earnings have been reserved has been fulfilled, the appropriation is closed and the segregated
retained earnings are returned to the main retained earnings account.
Appropriated retained earnings may also be referred to as a “reserve” for something such as bond retire-
ment or as “restricted retained earnings.”
Accounting for Appropriated Retained Earnings

Retained earnings are appropriated in the financial statements by debiting the retained earnings account
and crediting the appropriated retained earnings account, as follows:
Dr Retained earnings .............................................................. X
Cr Appropriated retained earnings .............................................. X
A company may have several separate appropriated retained earnings accounts if its retained earnings are
being reserved for multiple purposes at the same time.
When the need for the appropriation no longer exists, the account is simply closed back to retained
earnings by reversing the original entry made to record the appropriation. Thus, only two entries
are made that involve the appropriated retained earnings account. The first entry, the one above, is made
when the appropriation is created. The second entry is made when the appropriation is closed and the
retained earnings are again free to be distributed to owners, as follows:
Dr Appropriated retained earnings ............................................ X
Cr Retained earnings ................................................................ X
Note: The purpose and effect of appropriating retained earnings is to let shareholders know that the
appropriated retained earnings will not be distributed as a dividend.
Study Unit 25: A.2. Treasury Stock and Classification of Shares CMA Part 1
Study Unit 25: A.2. Treasury Stock and Classification of Shares

Treasury Stock
Guidance in the Accounting Standards Codification® on accounting for treasury stock is in ASC 505-30.
Treasury stock is shares of a company that have been sold to investors and later reacquired by the company.
The company has become a holder of its own shares and may either retire the shares or hold them for sale
at a later time. Treasury stock is the reacquired shares that have not yet been reissued or retired.
A company may purchase treasury shares for a number of reasons:
• To temporarily provide a market for its shares.
• To reconsolidate ownership.
• As an investment if the company thinks its shares are undervalued.
• To use the shares for a stock dividend, to re-sell them, or to use them as share-based payment.
Treasury stock is not an asset, nor is it a liability or equity. When a company purchases treasury
stock, it recognizes the treasury stock in its financial statements by reducing owners’ equity. Owners’ equity
may be reduced by debiting an account called treasury stock, a contra-equity account. Alternatively, own-
ers’ equity may be reduced by debiting the common stock account directly. The specific account debited
depends upon the method of accounting being used.
Classification of Shares
On the balance sheet and in more detail in the notes to financial statements, shares will be disclosed by
giving the number of shares authorized, issued, and outstanding.
Authorized Shares
The number of authorized shares is the maximum number of shares the company can issue. The number
of authorized shares is initially specified in the company’s charter or articles of incorporation and can be
changed only by filing an amendment to the articles of incorporation with the state where the company is
incorporated. Such an amendment normally requires prior shareholder approval. Authorized shares can be
issued or unissued, outstanding or not outstanding. Generally, a company has a much greater number of
shares authorized than are issued or outstanding, which gives the company flexibility to issue more stock
as needed.
The number of authorized shares is not affected by stock dividends, stock splits, or treasury share
transactions. If a company wants to issue new stock, split its stock, declare a stock dividend, or issue
stock to its senior management under stock option grants, and if the number of resulting new shares would
exceed the number of authorized but unissued shares, the company must seek shareholder approval to
increase the number of authorized shares and then file the necessary amendment to its articles of incorpo-
ration.
Issued Shares
The number of issued shares is the number of shares that have been sold to investors at any point in the
past and that have not been retired. Issued shares may currently be held either by others or by the company
itself as treasury shares. The number of issued shares is increased by both stock splits and stock
dividends. The number of issued shares is not affected by treasury share transactions. Treasury
stock, that is, shares that have been issued and later repurchased by the issuer, continue to be issued
shares, although they are not outstanding shares. Thus, treasury shares are issued but not outstanding
shares.
Section A Study Unit 25: A.2. Treasury Stock and Classification of Shares
Outstanding Shares
The number of outstanding shares is the number of shares that are currently owned by other parties.
Outstanding shares will be equal to the number of issued shares minus the number of shares held as
treasury shares by the company itself. The number of shares outstanding is increased by both stock
splits and stock dividends, decreased by treasury share purchases, and increased if treasury
shares are subsequently re-sold to investors.
The following table summarizes which classifications of shares stock splits, stock dividends, and treasury
shares affect.
Stock Split Stock Dividend Treasury Shares
Authorized No No No
Issued Yes Yes No
Outstanding Yes Yes Yes
Note: Treasury shares do not receive dividends, do not get to vote and are not classified as
outstanding. Treasury shares are shares that are issued but are not outstanding. If they are later
resold, those shares will again become issued and outstanding.
Note: Treasury stock held by the company is stock that is authorized and issued but is not outstand-
ing. Stock that has been retired by the company is authorized but is not issued and is not
outstanding.
Thus, both treasury stock and retired shares are authorized shares that are not outstanding. The differ-
ence between treasury stock and stock that has been retired is that treasury stock is included in issued
shares (though it is not presently outstanding), whereas retired stock is not included in issued shares;
it is unissued shares.
Study Unit 26: A.2. Revenue Recognition CMA Part 1
Study Unit 26: A.2. Revenue Recognition
4) Income Statement
4a) Revenue Recognition
Note: Guidance in the Accounting Standards Codification® on revenue recognition is in ASC 606.
The Objective
The objective of the revenue recognition standard in ASC 606 is to provide a single, comprehensive
revenue recognition model for all contracts with customers to improve comparability across industries,
jurisdictions, and capital markets.
The Principle
The revenue recognition principle is to recognize revenue in the accounting period in which the perfor-
mance obligation is satisfied. A performance obligation is satisfied when the customer obtains control of
the asset, and the asset is the good or service transferred to the customer. Therefore, revenue should
be recognized to depict the transfer of goods or services to customers in an amount that reflects the
consideration that the company expects to be entitled to in exchange for those goods or services. 125
The revenue recognition standard is principles-based rather than rules-based. That means its ap-
plication will require management judgment regarding how to handle specific situations. However, once the
judgments relating to specific situations have been made, they must be applied consistently within and
across different units of the company. They may not vary according to the judgment of an individual ac-
countant or operating unit within the company.
Contract Assets and Liabilities

The revenue model focuses on recognizing revenue when control transfers to the buyer. The model is
based on an asset and liability approach that recognizes revenue based on changes in control of assets
and liabilities.
Contract Assets
Contract assets are either unconditional or conditional.
Unconditional contract assets are unconditional rights to receive consideration because the company
has satisfied its performance obligation to a customer and thus recognizes revenue. Unconditional rights to
receive consideration should be reported as receivables on the balance sheet.
Dr Accounts receivable ......................................... Amount of sale
Cr Sales revenue ................................................... Amount of sale
At the same time, the company records cost of goods sold:

Dr Cost of goods sold .................................... Cost of product sold
Cr Inventory .................................................. Cost of product sold
125
ASC 606-10-05-3.
Section A Study Unit 26: A.2. Revenue Recognition
Conditional contract assets are conditional rights to receive consideration because the company has
satisfied one of, or some of, the performance obligations in the contract and thus recognizes revenue for
the performance obligations that are satisfied, but it must satisfy another performance obligation or obli-
gations before it can invoice the customer. Conditional rights to receive consideration should be reported
on the balance sheet as contract assets.
Dr Contract asset ............................ Price of obligation A satisfied
Cr Sales revenue ............................... Price of obligation A satisfied
When the company satisfies its complete performance obligation, invoices the customer, and reports the
remainder of the performance obligation satisfied as revenue, it also reduces the contract asset and reports
the full contract obligation as a receivable:
Dr Accounts receivable ....................... Price of obligations A and B
Cr Contract asset ........................................... Price of obligation A
Cr Sales revenue ............................................ Price of obligation B
Contract Liabilities
A contract liability arises when a company receives consideration from the customer before it transfers
goods or services. The contract liability represents the company’s obligation to transfer the goods or ser-
vices. The consideration received in advance of fulfillment is recorded as a contract liability.
Dr Cash .......................................................... Amount received
Cr Contract liability ............................................. Amount received
When the performance obligation is satisfied, the company records the revenue:
Dr Contract liability .......................................... Amount received
Cr Sales revenue ................................................ Amount received
The company also records cost of goods sold at the same time as it records the revenue:
Dr Cost of goods sold .................................... Cost of product sold
Cr Inventory .................................................. Cost of product sold
Names for Contract Assets and Contract Liabilities

ASC 606 refers to “contract assets” and “contract liabilities.” However, a company may use other terms for
contract assets and contract liabilities in its statement of financial position, as appropriate, as long as the
terms used provide sufficient information to enable a user of the financial statements to distinguish between
receivables (unconditional contract assets) and contract assets that are conditional.126
126
ASC 606-10-45-5.
Five Steps to Revenue Recognition

The new revenue recognition standard includes five steps:
1) Identify the contract with a customer.
2) Identify the separate performance obligations in the contract.
3) Determine the transaction price.
4) Allocate the transaction price to the separate performance obligations in the contract.
5) Recognize revenue when or as each performance obligation is satisfied.
A particular transaction may not require all five steps to be completed, and the steps may not always need
to be applied in the order above. The revenue standard is not organized according to the five steps, but the
five steps are provided as a methodology for companies to use to determine how to account for a given
transaction.
Following are each of the steps of the revenue recognition process in more detail.
1) Identify the Contract

Identifying a contract means assessing whether the contract is within the scope of ASC 606 and whether it
meets the criteria for contracts to be accounted for under the Standard.
ASC 606 applies to all revenue transactions as long as a valid contract exists, with the exception of several
items listed in ASC 606-10-15-2, including leases, insurance contracts, various types of financial instru-
ments such as investment securities and derivatives, and some nonmonetary exchanges. Therefore, the
first requirement is to determine whether the contract is within the scope of Topic 606 or whether it is
excluded. After determining that a contract is not specifically excluded, the company determines whether
the contract meets the criteria for a contract to be accounted for under the Standard.
The FASB Accounting Standards Codification® Glossary in ASC 606-10-20 defines a contract as “an agree-
ment between two or more parties that creates enforceable rights and obligations.” A company should
account for a contract under ASC 606 only when the contract
1) creates enforceable rights and obligations and
2) meets all of the following criteria:
a. The parties have approved the contract and are committed to perform their obligations under
the contract. The approval may be oral, in writing, or in accordance with other customary
business practices.
b. The rights of each party regarding the goods or services to be transferred can be identified.
c. The payment terms for the goods or services to be transferred can be identified.
d. The contract has commercial substance (that is, the risk, timing, or amount of future cash
flows of the company will change because of the contract).
e. It is probable127 that the company will be able to collect substantially all the consideration that
it is entitled to receive for the goods or services that will be transferred to the customer under
the contract. This assessment of collectability must include an assessment of the customer’s
credit risk—the customer’s ability to pay and intent to pay. The assessment of the customer’s
credit risk is an important part of determining whether a contract is valid.128
127
U.S. GAAP defines “probable” as “likely to occur,” generally meaning a 75% to 80% probability of occurrence.
128
ASC 606-10-25-1.
Note: A valid contract to be accounted for under ASC 606 exists only if it creates enforceable rights and
obligations and meets the five conditions above.
It is important to understand that the revenue recognition guidance in ASC 606 is not limited to business
transacted under formal written contracts, nor is it limited to long-term contracts. Business such as long-
term construction of an asset is usually transacted based on a formal contract that involves progress pay-
ments made by the customer, but a valid contract can be written, oral, or simply implied by the entity’s
customary business practices. The performance obligations in a contract can be satisfied at a point in time
or over time. For example:
• A valid contract can be represented when a customer approaches a cashier in a retail establishment
and pays for a purchase. The performance obligation in such a contract is satisfied at a point in
time.
• A valid contract can be represented by an order for goods to be shipped that is received from a
customer through any of a variety of means and includes payment by credit card, on account after
receiving the invoice, or by some other method such as cash.
• A valid contract can be represented by a long-term contract, which can be satisfied at a point in
time or over time. Long-term contracts can be construction contract but can also be, for example,
contracts to provide services for an extended period. If the customer obtains control of the asset
as the asset is being constructed, the performance obligations in the contract are satisfied over
time. If the customer obtains control of the asset only at the completion of the contract, the per-
formance obligation is satisfied at a point in time.
2) Identify the Separate Performance Obligations in the Contract

A performance obligation is a promise in a contract with a customer to transfer a good or service to that
customer. A contract may contain only one performance obligation, or it may contain multiple separate and
distinct performance obligations. Each distinct performance obligation needs to be identified within the
contract.
Identifying the performance obligation or obligations involves two parts:
1) Identify the promises in the contract, including all promised goods or services or bundles of
goods or services. A written or oral contract may contain both explicit promises and implicit prom-
ises. Promises can be implied by the customary business practices of the industry, the entity’s
published policies, the company’s marketing materials, or oral representations made by the com-
pany, if those implied promises create a reasonable expectation on the part of the customer that
the entity will transfer a good or service to the customer. A customer’s expectation may include
things like customer loyalty points granted or other promises made such as a period of free mainte-
nance offered by a car dealership with the purchase of a new car.
2) Identify the contract’s performance obligations by determining which of the promises are
performance obligations that should be accounted for separately. If a promised good or service is
distinct, it represents a separate performance obligation.
A distinct good or service is (a) one the customer can benefit from either on its own or together
with other resources readily available to the customer and (b) one for which the company’s promise
to transfer the good or service to the customer is separately identifiable from other promises in
the contract. For instance, if the contract is a retail sales transaction, each of the items purchased
by the customer that is separately identifiable is a separate performance obligation. Free items
promised are also performance obligations. However, administrative tasks such as activating a
membership or enrolling a customer for a purchased service are not performance obligations. 129
129
ASC 606-10-25-14 through 25-22.
3) Determine the Transaction Price

The transaction price is the amount of consideration that the company expects to be entitled to receive in
exchange for transferring the promised goods or services to the customer, and it can include fixed amounts,
variable amounts, or both. The transaction price may be significantly different from the contractual price.
For example, the transaction price excludes any amounts that the company collects on behalf of other
parties such as sales tax, if the company makes an accounting policy election to exclude from the meas-
urement of the transaction price all taxes assessed by a governmental authority that are collected by the
company from a customer and complies with the accounting policy disclosure requirements in ASC 235-10-
50-1 through 50-6.130
The company should take into account the effects of any of the following that exist:
• Variable consideration. Variable consideration refers to revenue for goods or services that is
dependent on future events. Whenever any part of or all of the consideration is variable, the com-
pany must estimate the amount it actually expects to be entitled to receive, and that amount may
be different from the contract price. For instance:
o A portion of the consideration may be variable because it is dependent on meeting a require-

ment such as a deadline to receive a performance bonus.
o The amount of consideration the company expects to be entitled to could also be variable
because the company expects to accept an amount that is less than the price stated in the
contract. In other words, the company may expect that it will offer the customer a price
concession outside of its initial contract terms.
The variable consideration can be estimated by either of two methods:
o The expected value method: The sum of the probability-weighted amounts within a range of
possible amounts.
o The most likely amount method: The single most likely amount within the range of possible
amounts.
The company recognizes the variable consideration only to the extent it is probable that a signifi-
cant reversal in the amount of revenue recognized will not occur when the uncertainty associated
with the variable consideration is resolved. Furthermore, at the end of each accounting period, the
company must update the estimated transaction price to represent any changes in circum-
stances.131
• Any significant financing components. If the customer will make payment over a period greater
than one year, the consideration includes a financing component that should be accounted for
using time value of money concepts and the transaction price should be adjusted. 132 When the
contract includes a significant financing component, revenue from the contract and a loan receiv-
able should be presented in the financial statements. The revenue amount should be the
present value of the consideration, discounted at an interest rate that reflects inflation and
the credit risk, including the credit characteristics of the buyer and any secondary repayment
sources.
o The contract revenue is recognized once a performance obligation is satisfied.
o The interest income on the financing component is recognized separately in the income state-
ment as interest income over the financing period.133
130
ASC 606-10-32-2 and 32-2A.
131
ASC 606-10-32-5 through 32-10 and 606-10-32-14.
132
ASC 606-10-32-15.
133
ASC 606-10-32-15 through 32-20.
• Noncash consideration. Any noncash consideration such as goods, services, or common stock
that has been promised as payment should be measured at its fair value. If the fair value of the
consideration varies, for example because the market price of the common stock the company is
entitled to receive varies, the measurement date for the noncash consideration is the date of the
contract inception, that is, the date at which all the criteria for a valid contract are met.
If the company is not able to determine the fair value of the noncash consideration that has been
promised, it should estimate the selling price of the noncash consideration and use that amount
as the revenue from the noncash consideration.
Noncash consideration may be materials, equipment, or labor that the customer provides to facil-
itate the company’s fulfillment of the contract. If such consideration is provided by the customer,
the company accounts for the contributed goods or services as noncash consideration if the com-
pany obtains control of the contributed goods or services.134
4) Allocate the Transaction Price to the Performance Obligations

After the contract has been identified and the performance obligations and amount of consideration have
been determined, the company must allocate the transaction price to the individual performance obligations
if the contract contains more than one performance obligation.
The allocation is based on the fair value of each performance obligation, and the best indicator of the fair
value of each performance obligation is its standalone selling price. Therefore, the company shall allocate
the transaction price to each performance obligation identified in the contract by determining the standalone
price for each individual performance obligation and then allocating the contract price over those obligations
based on the relative standalone price of each component.
If a discount is offered to the customer, for example when a bundle of goods or services is sold at a lower
price than the total price of the individual items in the bundle, the discount should be allocated proportion-
ally based on the relative standalone selling prices of the individual goods or services in the bundle.
If, during the performance of the contract, the price of the contract changes, the change in the price should
be allocated to the individual components on the same basis as the contract price was originally allocated,
even if standalone selling prices of one or more of the performance obligations have changed.135
Note: Returning to the matter of shipping and handling activities from Step 2: When goods are shipped
FOB Shipping Point, the goods belong to the customer from the moment the seller gives them to the
shipping company, and thus the customer obtains control of them at the shipping point. Thus, the ship-
ping and handling activities will be performed after the customer obtains control of the goods, so the
shipping and handling activities are promises to the customer and may be separate and distinct perfor-
mance obligations. The company can account for the shipping and handling activities as separate
performance obligations, or the company can make a policy decision to account for all shipping and
handling activities as fulfillment activities.
If management chooses to account for the shipping and handling activities as separate performance
obligations, a portion of the revenue received from each sale is allocated to the shipping and handling
activities.
134
ASC 606-10-32-21 through 32-24. Recall that the criteria for a valid contract are that it creates enforceable rights
and obligations and in addition meets all the following requirements: (1) The parties to the contract have approved the
contract and are committed to its performance; (2) The entity can identify each party’s rights regarding the goods or
services to be transferred; (3) The entity can identify the payment terms for the goods or services to be transferred; (4)
The contract has commercial substance; and (5) It is probable that the entity will collect substantially all the consideration
to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
135
ASC 606-10-32-31 through 32-41.
Example: ABC Industries ships an order FOB Shipping Point for 1,000 widgets to XYZ Corporation on
December 31, the end of ABC’s fiscal year. ABC charges $1,000 for the widgets and does not add a
charge for shipping them to XYZ (in other words, shipping is “free” to the customer).
If ABC accounts for shipping services for goods shipped FOB Shipping Point as separate performance
obligations, ABC must allocate the $1,000 revenue from the sale between the widgets and the shipping
services. The portion of the revenue allocated to the widgets is recognized on December 31, because
that is when control is transferred to the customer. However, the portion of the revenue allocated to the
shipping will be recognized as the services occur (that is, as the performance obligation is satisfied),
most likely over the days the product is in transit. Since shipping occurred on the last day of the fiscal
year, most of the revenue allocated to shipping will be revenue of the next fiscal year. The shipping costs
paid by ABC will be costs of the next fiscal year.
If ABC makes a policy decision to account for shipping services for goods shipped FOB Shipping Point as
fulfillment activities rather than as promised services and performance obligations, then ABC recognizes
the entire amount of the $1,000 revenue to which it is entitled when the product is shipped on December
31. The company also needs to accrue its costs related to the shipping as of December 31.
Probably most companies will choose to make the policy decision to recognize shipping and handling activ-
ities performed after the customer obtains control of the goods (that is, when the goods are shipped FOB
Shipping Point) as fulfillment activities and thus will recognize revenue for the shipping when the product
is shipped.
Note that whenever goods are shipped FOB Destination, shipping and handling activities are always fulfill-
ment activities and revenue for the shipping and handling is recognized upon shipment, so no policy election
is needed.
5) Recognize Revenue When or As Each Performance Obligation is Satisfied

Revenue should be recognized when or as the entity satisfies a performance obligation. Generally, a per-
formance obligation is considered satisfied when the promised good or service (that is, an asset) has
been transferred to the customer. An asset is transferred when or as the customer obtains control of
the asset.
A customer has control of an asset when it has the ability to
1) direct the use of the asset, and
2) obtain substantially all the remaining benefits of the asset.
Section A Study Unit 27: A.2. Right of Return and Consigned Goods
Study Unit 27: A.2. Right of Return and Consigned Goods

Several special situations are covered by ASC 606. The situations covered that are relevant for the CMA
Exam are:
• Contract with a Right of Return
• Consigned Goods
• Long-term Contracts
A. Contract with a Right of Return

If a contract with a customer provides for the right to return goods for a refund or to obtain a refund for
services, the contract consideration is variable and the contract’s transaction price should exclude the
consideration related to products expected to be returned or amounts expected to be refunded. The com-
pany should recognize revenue from the contract at the amount it expects to be entitled to receive, which
is the revenue only for goods or services not expected to be returned and refunded.136
Rather than adjusting the journal entry recording sales revenue, accounts receivable, cost of goods sold,
and inventory for each individual sale, companies usually record revenue and accounts receivable for such
sales at their gross amounts and record returns when they occur without reference to any adjustments. At
the end of each reporting period, they analyze the accounts and record adjusting entries to reflect estimated
returns and allowances. At the end of the next reporting period, they reverse the previous adjusting entries
and recalculate and record the needed adjusting entries for that reporting period. That simplifies the process
while still achieving the FASB’s objective of reporting accounts receivable and sales revenue at the amount
the company is entitled to receive while reflecting in cost of goods sold and the reduction to inventory the
costs related only to sales revenue the company estimates it is entitled to receive.
B. Consigned Goods
Consigned goods were covered in Topic 1c) Inventory. In that topic, the coverage focused on what goods
are included in inventory. Here, the revenue recognition issues of consigned goods are covered.
Consignment involves an entity shipping goods to a distributor while retaining control of the goods until a
predetermined event occurs. Because control has not passed to the consignee, the consignor does not
recognize revenue upon shipment or delivery to the consignee. The consignor recognizes revenue only when
control transfers. Usually, the transfer of control occurs and thus the revenue is recognized when the goods
are sold to the final customer.
The two main points in respect to revenue recognition and consigned goods are:
1) The consignor recognizes revenue for the entire selling price for which the consignee sells
the goods, even if some of it is paid to the consignee as a commission.
2) The consignee recognizes as revenue any commission that it is entitled to receive only when the
goods are sold. The commission will be treated as a selling expense by the consignor.
Following are the journal entries that both the consignor and consignee will record in respect to the con-
signed goods.
136
ASC 606-10-32-10.
Study Unit 27: A.2. Right of Return and Consigned Goods CMA Part 1
Accounting by the Consignor

When the goods are sent to the consignee the consignor makes the following entry:
Dr Goods out on consignment137 ............................... original cost

Cr Inventory ............................................................. original cost
Freight costs paid by the consignor to transfer the goods to the consignee are inventoriable costs. The entry
to record the shipping charges is:
Dr Costs out on consignment ..................................... freight cost
Cr Cash ..................................................................... freight cost
The next entry the consignor makes will be made after a good is sold and the cash is received from the
consignee. At this point, the consignor needs to make the following entry:
Dr Cash ............................................................... cash received
Dr Commission expense (if applicable) ....................... commission
Dr Cost of goods sold ............................................ inventory cost
Cr Revenue from consignment sales ............... the selling price
Cr Goods out on consignment .................................. inventory cost
Note that the revenue and cost of goods sold are recognized only after the item has been sold to the final
customer.
Accounting by the Consignee

The consignee makes entries only when it sells some of the product held on consignment. At that time, the
consignee recognizes the cash received from the buyer, a payable to the consignor, and any commission
revenue that it is entitled to receive.
Dr Cash ............................................................... total received
Cr Payable to consignor ........................ to be remitted to consignor
Cr Commission revenue .............................. commission entitled to
When the amount due to the consignor is paid, the payable is reduced.
Dr Payable to consignor .............................. remitted to consignor
Cr Cash ...................................................... remitted to consignor
Note: The main point to remember in respect to revenue recognition and consigned goods is that the
amount of revenue recognized by the consignor is equal to the total sales price. Any commission or other
fees are treated as an expense, not as a reduction of the revenue from the sale.
137
“Goods out on consignment” is essentially a second inventory account and its balance is reported as a current asset.
Section A Study Unit 28: A.2. Long-Term Contracts
Study Unit 28: A.2. Long-Term Contracts

C. Accounting for Long-Term Contracts
Some contracts include performance obligations that require a period of time to satisfy. Under ASC 606,
the obligation is satisfied when or as the customer obtains control of the asset. In some cases, the customer
obtains control of the asset at a point in time, usually when all the performance obligations in the contract
have been satisfied, even though the contract requires time to perform. In other cases, the customer ob-
tains control over time, as the performance obligations in the contract are being satisfied.
The most common situation for long-term contracts is construction contracts, but long-term contracts also
include government contracts (such as for the military), contracts for the construction of very large items
such as airliners and space exploration equipment, or contracts for a group of assets such as office furniture
to be delivered over a period of time.
Recall that according to Topic 606, a company satisfies a performance obligation over time and recognizes
the revenue (and costs) over time if at least one of the following three criteria is met:
1) The customer simultaneously receives and consumes the benefits provided by the company’s per-
formance as the company is performing its obligations under the contract.
Example: An annual contract to provide a service such as office cleaning or grounds mainte-
nance. If the benefits of the contract are transferred to the customer on a straight-line basis
throughout the contract, the customer is invoiced periodically and the revenue is recognized as
the invoices are issued, usually monthly. Costs are recognized as they are incurred.
2) The company’s performance creates or enhances an asset such as work in process that the cus-
tomer controls as the work is being done.
Example: A contract to build a structure on land the customer already owns. Invoices for pro-
gress payments are usually issued to the customer, but the amounts of the progress billings do
not necessarily represent the progress toward satisfaction of the performance obligations in the
contract.
3) The company’s performance does not create an asset with an alternative use to the company, and
the company has an enforceable right to payment for performance completed to date.138
Example: Any asset manufactured or built to the customer’s specifications that could not be
sold to another customer without significant loss to the company if the customer terminates the
contract prior to its completion for any reason other than the failure of the company to perform.
In situations 2) and 3) above, the accounting is done in a manner similar to what was called the percentage-
of-completion method in legacy GAAP, although that term is not used in ASC 606. The current term is “over
time.”139
138
ASC 606-10-25-27.
139
The term “percentage-of-completion” may be used if that methodology conforms to the determination of transfer of
control and complete satisfaction of the performance obligation in accordance with ASC 606. However, the term “per-
centage-of-completion” is no longer codified in U.S. GAAP.
Study Unit 28: A.2. Long-Term Contracts CMA Part 1
Note: There are important differences between over-time revenue and profit recognized on a long-term
contract and the legacy percentage-of-completion method. For example, a contract might be 50% com-
plete as to costs but less than 50% complete with respect to the elements in the contract to be satisfied.
Since ASC 606 is principles-based rather than rules-based, it may not be appropriate to record 50% of
the contract revenue as would typically be done under use of the percentage-of-completion method in
legacy GAAP. Management judgment is necessary.
If the long-term contract does not meet any one of the three criteria for recognizing revenue over time, the
company recognizes revenue and gross profit only when the performance obligation or obligations in the
contract have been satisfied and the customer has obtained control of the asset or assets, in other words,
at a point in time. The accounting is similar what was formerly called the completed contract method,
though again, that term is not used in ASC 606. The current term is “point in time.”
Point-in-Time Recognition
When a long-term contract does not meet any of the criteria for over-time recognition, the contract is
recognized on the company’s balance sheet as it is being satisfied, but the revenue, cost, and gross profit
are recognized at a point in time—when the customer has obtained control of the asset. The amount of
gross profit recognized when the customer obtains control of the asset equals the difference between the
contract price (the revenue) and the total cost to complete the project.
However, if a loss is projected on the contract at any point as it is being satisfied, that loss must be recog-
nized in full immediately, consistent with guidance in ASC 450-20, Loss Contingencies.
Recognition of Losses
At the end of each reporting period, the company determines the final estimated gross profit or loss on the
contract as follows:
Contract price
− Costs actually incurred to date
− Costs estimated to be incurred in the future
= Estimated profit (loss) on the project
If the cost and gross profit estimates made at the end of the reporting period indicate that a loss on the
entire contract will result, the company must recognize the entire estimated contract loss in the
current period.
Note: When point-in-time revenue is recognized on a contract:
• No revenue or profit is recognized until the performance obligation is satisfied.
• However, an estimated loss on the whole contract (projected to the point at which the customer will
obtain control of the asset) should be recognized in the period when it becomes known.
The journal entry for recognizing an estimated loss on a point-in-time contract is covered later in this topic.
Recognizing the Incurrence of Contract Costs

The costs of construction incurred during the work-in-process period are debited as they are incurred to a
contract assets account, construction in process (CIP). The CIP account is used whether the costs are
paid for in cash, on account, as accrued wages, or other types of costs.
Dr Construction in process (CIP) .............................................. x
Cr Cash (or accounts payable or accrued wages, as appropriate) ... x
The CIP asset account is in some ways similar to a work-in-process inventory account in a manufactur-
ing company. However, the CIP account is different from a work-in-process inventory account in an
important way: the costs in the CIP account do not move to finished goods and then to cost of goods sold
as the costs in a WIP inventory account do. Instead, the CIP account is a temporary “holding” account.
Note: For a given contract, the CIP asset account may be a current asset or a non-current asset, or
both, depending on the facts and circumstances of the contract with the customer.
Recognizing Invoice Issuance

Invoices are generally sent periodically to the client as work progresses on the contract because progress
payments are usually required even though the revenue will not be recognized until the point in time when
the customer obtains control of the asset. The journal entry to record an invoice issued is:
Dr Accounts receivable ........................................................... x
Cr Billings on construction in process (BCP) ................................ x
The BCP account is not a revenue account because revenue is not recognized when invoices are issued.
Rather, the BCP account is a contract liability account because once an invoice is issued and the client
pays the invoice, the company constructing the asset owes the customer a building or whatever is being
constructed. The BCP account may also be a contra-asset to the CIP account in the general ledger.
Note: For a given contract, the BCP liability or contra-asset account may be current or non-current, or
both, depending on the facts and circumstances such as when the entity expects to satisfy its perfor-
mance obligations under the contract.
Reporting a Point-in-Time Contract on the Balance Sheet

Even though no revenue or gross profit will be recognized until the customer obtains control of the asset,
the point-in-time contract must be recognized on the balance sheet to the extent that it represents a net
contract asset or a net contract liability.
In the CIP and BCP journal entries, the company has created both an asset and a liability for each contract:
the CIP account is the asset and the BCP account is the liability. For each contract, the BCP contract liability
account is netted together with the CIP contract asset account for presentation on the balance sheet. The
difference between the construction in process (CIP) asset account and the billings on construction in
process (BCP) liability account is reported on the balance sheet as either a net contract asset or a net
contract liability.
• If CIP > BCP, the difference is reported as a net contract asset. The line item used is called costs
of in-process point-in-time contracts in excess of related billings or something similar.
• If CIP < BCP the difference is reported as a net contract liability. The line item used is called
billings on in-process point-in-time contracts in excess of related costs or something sim-
ilar.
Note: If the balance in the CIP contract asset account is greater than the balance in the BCP contract
liability account, the term “inventory” is sometimes used to refer to the amount reported on the balance
sheet as an asset, that is, the costs of in-process point-in-time contracts in excess of related billings.
However, the term “inventory” is used in that context only descriptively. The line item, costs of in-
process point-in-time contracts in excess of related billings, represents only what it purports to repre-
sent: costs of construction in process (CIP) in excess of billings on construction in process (BCP). The
line item does not function the same way inventory functions in other types of businesses.
Note: If a company has several projects in process at the same time, costs will exceed billings on some
contracts and billings will exceed costs on other contracts. On its balance sheet, the contractor presents
total net contract assets separately from total net contract liabilities, rather than a net position for all
contracts with customers. In other words, total contract assets and total contract liabilities are not to
be presented net on the balance sheet. However, total net contract assets and total net contract liabil-
ities are summed for presentation on the balance sheet.
The contractor segregates the contracts on the balance sheet according to whether each individual con-
tract represents a net asset or a net liability. The asset side of the balance sheet should include only
contracts on which the CIP contract asset is greater than the BCP contract liability, and the liability side
should include only contracts on which the BCP contract liability is greater than the CIP contract asset.
Furthermore, some net contract assets may be current and some may be non-current, and some net
contract liabilities may be current and some may be non-current.
Recognizing an Estimated Loss

When an estimated loss on a point-in-time contract is anticipated, the amount of the estimated loss
must be recognized immediately. Recognizing the estimated loss is relatively straightforward because no
revenue, expense, or gross profit will have yet been recognized on the contract. The journal entry to record
the estimated loss is:
Dr Loss on long-term contract (income statement) .. amount of loss
Cr Construction in process (reduces the asset).......... amount of loss
In subsequent periods, losses on the point-in-time contract will be recognized only to the extent that the
total estimated loss on the contract exceeds losses that have been previously recognized on the contract.
Closing Out a Point-in-Time Contract

When the performance obligations in the contract have been satisfied and the customer has obtained control
of the asset, contract revenue is recognized by closing out the billings on construction in process (BCP)
liability account to revenue on point-in-time contracts, and contract expense is recognized by closing out
the construction in process (CIP) asset account to construction expense, as follows:
Dr Billings on construction in Process (BCP) ................ total billings
Cr Revenue on point-in-time contracts ......................... total billings
Dr Construction expense .......................... total construction costs

Cr Construction in process (CIP) ................. total construction costs
Over-Time Recognition
When a contract meets any one of the three criteria for recognizing revenue over time, the contract reve-
nue, cost of sales, and gross profit are recognized as the company makes progress toward satisfaction
of its performance obligations on the project. The criteria are:
1) The customer simultaneously receives and consumes the benefits provided by the company’s per-
formance as the company is performing its contract obligations.
2) The company’s performance creates or enhances an asset such as work in process that the cus-
tomer controls as the work is being done.
3) The company’s performance does not create an asset with an alternative use to the company, and
the company has an enforceable right to payment for performance completed to date.140
140
ASC 606-10-25-27.
If the contract is a service contract with revenue recognized on a generally straight-line basis and costs
expensed as incurred, it is simple to account for. Invoices are issued periodically throughout the term of
the contract as the service is provided and revenue is recognized as the invoices are issued.
However, if the progress toward full satisfaction of the performance obligations depends on construction
progress, for instance on a building constructed on land owned by the client, the accounting is more com-
plex.
The construction in process (CIP) contract asset account is used to accumulate costs and the billings on
construction in process (BCP) contract liability account is used for invoices, similar to the way the costs and
invoices are accounted for on point-in-time contracts. However, revenue, costs, and gross profit are also
recognized on the income statement as the contract progresses. In addition, the amount of gross profit
recognized each period is debited to the construction in process (CIP) asset account along with
the construction costs incurred, thereby increasing it.
Three calculations must be made at the end of each period to determine the revenue, cost, and gross
profit to be recognized for the period:
1) The amount of the total estimated gross profit on the whole contract as of the reporting date.
2) What percentage of the performance obligation has been satisfied.
3) How much revenue, cost, and gross profit on the contract should be recognized in the current
period.
1) Calculation of Estimated Gross Profit

The first calculation is to determine the estimated gross profit on the whole contract through com-
pletion, as of the reporting date.
Contract price
− Costs actually incurred to date
− Estimated costs to be incurred in the future
= Estimated gross profit (loss)
The estimated gross profit (loss) is the amount of gross profit or loss the company expects from the entire
contract as of the reporting date. However, because the performance obligation in the contract is not yet
completely satisfied, the entire amount of the estimated gross profit should not be recognized in the current
period, nor should the percentage of the estimated gross profit represented by the percentage satisfied be
recognized in the current period, if some has already been recognized. The amount to recognize in the
current period is determined by the percentage of the performance obligation that has been satisfied less
any amounts recognized during previous periods.
2) Calculation of the Progress Toward Satisfaction of the Performance Obligation

The second calculation measures the extent of the entity’s progress as of the reporting date toward com-
plete satisfaction of the performance obligation in the contract. Methods that can be used to determine the
extent of this progress include output measures and input measures. The best method to use depends on
the circumstances and choosing the most appropriate method requires judgment.
• Output measures recognize revenue according to direct measurements of the value to the
customer of the goods or services transferred to the customer to date, relative to the remaining
goods or services promised. Examples are surveys of performance to date, milestones reached,
and appraisals of results achieved such as number of units produced or delivered. When the con-
tract is for a long-term construction project, an engineering estimation or other method may be
used to make the determination.
• Input measures measure the efforts or inputs expended—for example, resources consumed,
costs incurred, labor hours expended, time elapsed, or machine hours used—toward satisfying a
performance obligation relative to the remaining goods or services promised under the contract.
Note: The cost-to-cost method as presented in the following pages is an example of an input method
and exemplifies the basic calculations only. If an output measure is used, the calculations would be based
on the output measure instead.
The Cost-to-Cost Input Method

When the cost-to-cost method is used to determine the extent of a company’s progress toward complete
satisfaction of a contract, the percentage satisfied is the ratio between the actual cost incurred to date on
the contract and the total cost estimated for the contract. The total cost estimated for the contract is the
actual cost incurred to date plus the estimated cost to complete as of the reporting date.
The calculation for the percentage satisfied using the cost-to-cost method is as follows:
Cost Incurred to Date (including prior periods)

= Percentage Satisfied
Cost Incurred to Date + Estimated Cost to Complete
Note: The denominator of the formula, Cost Incurred to Date + Estimated Cost to Complete, is the total
estimated cost for the contract as of that date.
If an exam question gives the cost incurred to date and the estimated cost to complete, candidates will
need to sum the two amounts to calculate the denominator of the formula. However, an exam question
might simply give the total estimated cost for the contract as of the relevant date. If so, no calculation
of the denominator of the formula will be required. The information given as the total estimated cost
should just be used in the denominator of the formula as given.
3) Calculation of the Gross Profit to Recognize This Period

Using the estimated gross profit calculated in Step 1 and the percentage satisfied calculated in Step 2, the
company can now calculate the amount of gross profit that should be recognized in total to date. The
formula is:
Estimated Gross Profit
× Percentage Satisfied
= Total Gross Profit to be Recognized to Date
However, the company has not yet calculated the amount of gross profit that should be recognized as
income this period. The “total gross profit to be recognized to date” is the amount of gross profit the
company should have recognized in all periods that the contract has been in process. The amount of gross
profit to recognize in this period is the total gross profit to be recognized to date minus gross profit previ-
ously recognized, as follows.
Total Gross Profit to be Recognized to Date
− Profit Previously Recognized
= Gross Profit to Recognize This Period
Unless the previously recognized gross profit is eliminated, the profit from previous periods will be recog-
nized twice (or several times) as the project progresses.
All the preceding calculations and formulas can be combined into one formula for the calculation of gross
profit to recognize in the current period under the cost-to-cost method, as follows:
Costs Incurred to Date

Profit Profit to
Total Costs Incurred × Estimated Profit − Previously = Recognize This
to Date + Estimated Recognized Period
Costs to Complete
Note: The preceding formula can be used for all over-time contracts to determine the amount of gross
profit to recognize in a given period. Even when there are losses (discussed below), the formula can be
used as long as it is remembered that losses are always 100% complete.
In a situation where the level of estimated profit falls from one period to the next, it is possible that the
above formula will result in a negative number. This negative number is the loss that the company needs
to recognize in the current period. If the contract in total is not expected to result in a loss, however, the
loss in the current period does not eliminate all profit recognized to date on the contract. The whole contract
can remain profitable, even when there is a loss in the current period. If the contract remains profitable,
by recording a loss in the current period the company is simply “de-recognizing” some of the profit that
was recognized in a previous period or periods.
Recognition of Losses
At any point during the contract’s fulfillment, the company may estimate that the entire contract will result
in a loss by its completion because costs on the whole contract will be greater than revenue from the whole
contract. Any estimated loss on an entire project is recognized in full in the period when it be-
comes apparent that there will be a loss.
Candidates can still use the formula that is given above for the profit (or rather, loss) to recognize in the
current period, if they remember that if a loss is estimated for the whole contract, it is as if the performance
obligations in the contract are 100% satisfied.
The actual calculation of the loss to recognize this period will be
Total Estimated Loss − Profit Previously Recognized = Loss to Recognize This Period
For example, if the total estimated loss from the contract (Contract Price − Estimated Total Cost) is
$(100,000) and $150,000 of gross profit has been previously recognized, the loss to recognize this period
is
$(100,000) − $150,000 = $(250,000)
The above formula works as long as the negative numbers are used correctly in the calculation. The same
loss amount can be calculated more simply without using negative numbers, as follows:
Total Estimated Loss + Profit Previously Recognized = Loss to Recognize This Period
Using the same example, the loss to recognize is
$100,000 + $150,000 = $250,000
Note: If in the early years of an over-time contract it is estimated that there will be a profit, a percentage
of that profit will have been recognized previously. If, however, in later years the amount of estimated
profit decreases or becomes an estimated loss, previously recognized profit will need to be de-recog-
nized. The company does this by recognizing a large loss in the period when the estimated loss becomes
known.
Journal Entries
A contract with over-time performance obligations uses the same journal entries as a point-in-time contract
to recognize the following:
• Incurrence of costs
• Issuance of invoices
The following transactions are recognized differently under the two methods:
• Estimated losses
• Revenue, expense, and gross profit
Recognizing the Incurrence of Construction Costs

As is done for a point-in-time contract, the costs of construction are debited as they are incurred to a
contract asset account called construction in process (CIP). The CIP account is used whether the costs
are paid for in cash, on account, as accrued wages, or other types of costs. The journal entry to record the
incurrence of construction costs is the same as the journal entry for a point-in-time contract.
Dr Construction in process (CIP) .............................................. x
Cr Cash (or accounts payable or accrued wages, as appropriate) ... x
As with a point-in-time contract, the CIP account is a temporary “holding” account. However, when the
contract is an over-time contract where revenue and expenses are recognized as the contract progresses,
the CIP account “holds” not only the costs for construction-in-process but it also “holds” the amount of
accumulated gross profit or loss recognized to date on the contract.
The CIP account may be a current asset or a non-current asset, or both, depending on the facts and cir-
cumstances of the contract with the customer.
Recognizing Invoice Issuance

As with a point-in-time contract, invoices for progress payments on an over-time contract are sent period-
ically to the client as construction progresses. The journal entry to record the issuance of an invoice is:
Dr Accounts receivable ........................................................... x
Cr Billings on construction in process (BCP) ................................ x
Recall that the BCP account is not a revenue account because revenue is not recognized when invoices are
issued. It is a contract liability account, or it may be a contra-asset account following the contract
asset account, CIP. For a given contract, the BCP liability account may be current or non-current, or both,
depending on the facts and circumstances such as when the entity expects to satisfy its performance obli-
gations under the contract.
Recognizing Revenue, Expense, and Gross Profit

In addition to the journal entries to record the incurrence of costs and issuance of invoices, on over-time
contracts the company also needs to recognize the amount of revenue, expense, and gross profit each
period as calculated above.
Similar to the way it is done for point-in-time contracts, the costs are debited to the construction in process
(CIP) contract asset account as they are incurred.
However, when revenue and gross profit are recognized over time, the gross profit recognized each report-
ing period will be added to the construction in process (CIP) account along with the costs incurred.
In addition to debiting the CIP account for costs incurred, costs incurred are recognized as expenses by
also debiting an income statement account called construction expense. If the contract is projected to
be profitable, the amount of the debit to construction expense each period is the actual incurred costs for
the period, the same amount of costs incurred debited to the CIP asset account for the period.
Revenue is recognized on the income statement each period in an amount that will result in the correct
gross profit amount when construction expense is subtracted from revenue. Thus, the income statement
includes the current period revenue and expense for the over-time contract, and the excess of recognized
revenue over recognized expense is the gross profit that is recognized.
The entry that results in recognizing the gross profit for the period is:
Dr Construction expense .......................... actual incurred costs for the period
Dr Construction in process (CIP) ........ profit for period as calculated above
Cr Revenue on over-time contracts.............................see ‡ below for calculation
‡ The amount of revenue to be recognized on over-time contracts is calculated by multiplying
the contract price (total revenue expected on the contract) by the contract’s percentage sat-
isfied and then subtracting any revenue recognized in earlier periods. When the cost-to-cost
method is used, the percentage satisfied is based on costs incurred to date as a percentage
of total estimated costs. The process is similar to the way gross profit to be recognized this
period is calculated, except that instead of gross profit, the contract price and revenue pre-
viously recognized are used.
Contract price × percentage satisfied
− Revenue previously recognized
= Revenue to recognize this period
The journal entry above will balance if the amounts have been calculated correctly because the basis for
calculating revenue will be the percentage of the over-time contract that has been satisfied. Under the cost-
to-cost method, the percentage satisfied is based on actual costs incurred to date as a percentage of total
estimated costs. The amount of construction expense recognized will also be based on the actual costs
incurred. If the entry does not balance, then something is wrong in the calculations.
Note: The CIP contract asset account will have two items in it for an over-time contract: the costs of
the construction incurred to date and any gross profit (revenue less expense) that has been recognized
to date during the construction.
Note also that the costs incurred and the gross profit recognized will appear in the financial statements
in two places:
• The costs incurred to date and the gross profit recognized to date will be accumulated on the balance
sheet as a contract asset (CIP).
• The current costs incurred and the current gross profit recognized will be reported on the income
statement each period while the contract is in process.
That is the way it should be, and the apparent duplication will be eliminated when the performance
obligations in the contract have been satisfied and the contract is closed out.
Recording Losses on Over-Time Contracts

When a company realizes that an over-time contract will produce an overall loss, the amount of the esti-
mated loss must be recognized immediately in the period in which it arises, just as it is for a point-in-time
contract.
However, because gross profit may have already been recognized on the contract in previous periods, the
journal entry is different from the journal entry used to recognize an estimated loss on a point-in-time
contract because for a point-in-time contract, no profit will have been previously recognized. When an over-
time contract is estimated to be ultimately unprofitable, not only does the ultimate loss (the total estimated
loss for the whole contract) need to be recognized immediately, but any previously recognized gross
profit on the contract needs to be reversed, as well. Therefore, if the company has recognized any
gross profit during the contract’s earlier periods, the amount of the loss to recognize in the period when the
estimated loss arises will be larger than the estimated loss on the whole contract because the company
needs to de-recognize all the profit recognized earlier and then recognize the total estimated loss.
The journal entry used is also different from the journal entry used when an ultimate profit is estimated on
an over-time contract because the construction in process (CIP) account needs to be credited (to reduce it)
instead of debited (to increase it).
The journal entry to record an ultimate loss on an over-time contract when revenue and gross profit have
been recorded previously as the performance obligation is satisfied is:
Dr Construction expense........................................ balancing amount
Cr Construction in process ...... reversal of previous profit + total estimated loss on contract
Cr Revenue on over-time contracts..................................................... revenue for period
Revenue is recognized in the current period even though the contract is estimated to be ultimately unprof-
itable. The revenue to be recognized for the period is calculated in the same way it is calculated when a
gross profit is being recognized: the total revenue for the contract (the contract price) multiplied by the
percentage satisfied (cost incurred to date divided by [cost incurred to date plus estimated cost to com-
plete]) less revenue recognized in previous periods.
Contract price × percentage satisfied
− Revenue previously recognized
= Revenue to recognize this period
Note: When using the cost-to-cost method to estimate the progress toward completion of the project,
if a loss is expected, the percentage satisfied will be affected by the increase in estimated costs
that has caused a loss to be projected for the contract. The project’s percentage satisfied will be lower
due to the increase in total estimated cost than it would have been if the total estimated cost had not
increased.
The gross loss for the period is recognized by recognizing expense for the period that is greater than the
revenue recognized for the period. Thus, the debit to construction expense will be greater than the actual
costs incurred for the period. The expense recognized for the period will be equal to the amount of revenue
recognized for the period plus the amount of gross profit recognized previously plus the total estimated
loss on the whole contract. In other words, it will appear as the balancing amount in the journal entry.
Revenue recognized for the period
+ Gross profit previously recognized
+ Total estimated loss on the contract
= Construction expense for the period
Reporting Over-Time Contracts on the Balance Sheet

Just as is done for point-in-time contracts, an over-time contract must be recognized on the balance sheet
to the extent that it represents a net contract asset or a net contract liability.
The contract asset is the CIP account and contract liability is the BCP account. The difference between the
construction in process (CIP) and the billings on construction in process (BCP) accounts is reported on the
balance sheet as either a net contract asset or a net contract liability. Thus, the BCP liability account is
netted together with the CIP asset account for presentation on the balance sheet.
• If CIP > BCP, the difference is reported as a net contract asset. The line item used is called costs
and estimated earnings of in-process over-time contracts in excess of related billings or
something similar.
• If CIP < BCP the difference is reported as a net contract liability. The line item used is called
billings on in-process over-time contracts in excess of related costs and estimated earn-
ings or something similar.
Note: In an exam question, candidates may need to simply calculate the amount of profit to be recog-
nized in a period. However, it may also be necessary to use the formulas to solve for the amount of costs
incurred, estimated costs to be incurred, revenue to recognize in a period, or the contract price. To solve
for each of these items, simply use the formulas but solve for a different variable.
Netting Contract Assets and Contract Liabilities on the Balance Sheet

The FASB’s Topic 606 (Revenue Recognition) does not provide any guidance on netting contract assets and
contract liabilities on the balance sheet. Therefore, the FASB’s guidance on netting comes from ASC 210-
20-45 (Balance Sheet/Offsetting/Other Presentation Matters). According to ASC 210-20-45-1, a right of
setoff of assets and liabilities between two parties exists when all the following conditions are met:
1) Each of the two parties owes the other determinable amounts.
2) The reporting party has the right to set off the amount owed with the amount owed by the other
party.
3) The reporting party intends to set off.
4) The right of setoff is enforceable at law.
If offsetting is permitted, the company should offset a contract asset and a contract liability for each
individual customer. If a contractor has several contracts in process at the same time, costs will exceed
billings on some contracts and billings will exceed costs on other contracts.
The contractor segregates the contracts on its balance sheet according to whether each individual contract
represents a net asset or a net liability. The asset section of the balance sheet should include only contracts
on which the CIP contract asset is greater than the BCP contract liability (a net contract asset), and the
liability section of the balance sheet should include only contracts on which the BCP contract liability is
greater than the CIP contract asset (a net contract liability).
Thus on its balance sheet, the contractor presents total net contract assets separately from total net con-
tract liabilities, rather than a net position for all contracts with customers. In other words, total contract
assets and total contract liabilities are not to be presented net on the balance sheet. However, total net
contract assets and total net contract liabilities are summed for presentation on the balance sheet.
Note: Some net contract assets may be current and some may be non-current, and some net contract
liabilities may be current and some may be non-current, depending on when each contract will be com-
plete.
Example: A contractor has four contracts in process for four different customers, as follows.
Customer Customer Customer Customer

A B C D Totals
Contract Assets $200,000 $ 100,000 $ 300,000 $ 400,000
Contract Liabilities (150,000) (250,000) (200,000) (600,000)
Net Contract Assets $ 50,000 $ 100,000 $ 150,000
Net Contract Liabilities $(150,000) $(200,000) $(350,000)
The contractor reports on its balance sheet total net contract assets of $150,000 and total net contract
liabilities of $350,000.
The net contract assets of $150,000 include the net contract assets of Customer A and Customer C. The
net contract asset amount for each customer incorporates the individual customer’s contract assets mi-
nus its contract liabilities.
The net contract liabilities of $350,000 include the net contract liabilities for Customer B and Customer
D. The net contract liability amount for each customer incorporates the individual customer’s contract
assets minus its contract liabilities.
However, the contractor may not net those total net contract assets and total net contract liabilities
together and report one single net contract liability of $200,000 ($150,000 − $350,000).
Closing Out an Over-Time Contract When the Performance Obligation is Satisfied

Recall that profit recognized each period is debited to the CIP contract asset account as the over-time
contract progresses. The included profit increases the value of the CIP account so that, by the end of the
contract, the debit balance in the CIP account will be equal to the total revenue from the contract (expenses
+ profit = revenue). At the end of the contract, the credit balance in the BCP account will also be equal to
the total revenue from the contract because the BCP account accumulates progress billings, and the pro-
gress billings should be equal to the total contract revenue by the end of the contract.
Thus, the final balances in both the CIP account and the BCP account should be equal to the total revenue
on the contract and equal to each other.
At the end of the contract, then, the BCP liability and the CIP asset accounts are closed out against each
other by debiting BCP for its accumulated credit balance and crediting CIP for its accumulated debit balance,
as follows:
Dr Billings on construction in process ........... total contract amount
Cr Construction in process .............................total contract amount
Since the balance in the CIP account is closed out against the balance in the BCP account, the CIP account
does not behave like a work-in-process inventory account. Its balance does not flow to cost of goods sold
the way WIP inventory flows to finished goods inventory and then to cost of goods sold in a manufacturing
company.
Disclosures for Revenue Recognition

According to ASC 606-10-50-1, disclosures about revenue recognition should provide sufficient information
to enable users of the financial statements to understand the nature, amount, timing, and uncertainty of
revenue and cash flows arising from contracts with customers. To achieve that objective, quantitative and
qualitative information should be disclosed. The items noted below are not all inclusive and will vary de-
pending on the nature of the company’s business.
The company is required to provide information about:
1) Revenue recognized from contracts with customers, including the disaggregation of revenue into
appropriate categories, presentation of opening and closing balances in contract assets and con-
tract liabilities, and significant information related to performance obligations in the contracts.
2) The significant judgments made and changes in the judgments made in applying the guidance in
ASC 606 to contracts, including judgments that affect the determination of the transaction price,
the allocation of the transaction price, and the determination of the timing of the revenue.
3) Any assets recognized from the costs to obtain or fulfill a contract with a customer, including the
closing balances of assets recognized to obtain or fulfill a contract, the amount of amortization
recognized, and the method used for amortization.
If the company has elected to exclude from the measurement of the transaction price all taxes assessed by
a governmental authority that are both imposed on and concurrent with a specific revenue-producing trans-
action and collected by the company from a customer per ASC 606-10-32-2 and 32-2A (for example, sales
tax, use tax, value added tax, and some excise taxes), that accounting policy election shall be disclosed in
accordance with accounting policy disclosure requirements in ASC 235-10-50-1 through 50-6.
Study Unit 29: US GAAP / IFRS Differences CMA Part 1
Study Unit 29: US GAAP / IFRS Differences

The differences between US GAAP and IFRS are covered throughout Section A. Orange Note boxes are used
to highlight the differences.
4b) Income Measurement

Study Unit 30: A.2. Income Measurement
Income is revenues and gains less expenses and losses, reduced by provision for income taxes. The various
classifications on a multiple-step income statement are covered in this volume in the topic The Income
Statement.
Expense Recognition
The expense recognition principle, commonly called the matching principle, states that recognition of
expenses is related to net changes in assets and the earning of revenues. Expenses should be recognized
during a period that result from transferring control of goods or services to customers and recognizing the
associated revenue during that period. Thus, expenses should be recognized when the work or product
contributes to revenue. The expense recognition principle is implemented by matching efforts (or expenses)
with accomplishments (revenues).
Expenses are recognized based on one of the following three methods:
1) Cause and effect: the cost of an item sold is recognized as cost of goods sold when the sale of the
item contributes to revenue.
2) Systematic and rational allocation such as depreciation, related to net changes in assets.
3) Immediate recognition: if an expense will not provide future benefit, it is immediately recognized.
Gains and Losses

Gains are increases in equity resulting from transactions that are not part of the company’s main or central
operations and that do not result from revenues or investments by the owners of the entity.
Losses are decreases in equity resulting from transactions that are not part of the company’s main or
central operations and that do not result from expenses or distributions made to owners of the entity.
The difference between revenues and gains and between expenses and losses depends on the company’s
typical activities. For example, the sale of a product as part of a company’s normal operations constitutes
revenue. However, the sale of a fixed asset formerly used in the company’s operations is not part of the
company’s regular operations, so the excess of the amount received for the asset over its net book value
is a gain, not revenue. If the amount received for the asset is less than its net book value, the deficit is a
loss, not an expense.
Section A Study Unit 30: A.2. Income Measurement
Gains and Losses on the Disposal of Fixed Assets

According to ASC 360-10-45-9, long-lived assets or asset disposal groups141 should be reclassified from
held-for-use to held-for-sale when all the following criteria are met:
• Management commits to a plan to sell the asset or disposal group.
• The asset or disposal group to be sold is available for immediate sale.
• An active program to locate a buyer or buyers and other actions required to complete the plan to
sell the asset or disposal group have been initiated.
• The sale is probable within one year unless events beyond the entity’s control occur.
• The asset or disposal group is being actively marketed at a reasonable price in relation to its fair
value.
• Actions required to complete the plan to sell the asset or disposal group make it unlikely that the
plan will be withdrawn or significantly changed.
Per ASC 360-10-35-43, when an asset or a disposal group is reclassified as held-for-sale, it should be
measured at the lower of its carrying amount or its fair value less cost to sell.142 If a write-down is
necessary, an impairment loss is recognized for the write-down to fair value less cost to sell. While a long-
lived asset or disposal group is classified as held-for-sale, it is not to be depreciated.
If the asset or disposal group being held for sale increases in its fair value less cost to sell during the period
before it is sold, a gain should be recognized but only to the extent of cumulative losses previously recog-
nized for that asset or disposal group. In other words, the asset or disposal group cannot be written up to
a book value greater than the last book value it had when it was classified as held-and-used.
Assets in the disposal group classified as held-for-sale should be presented on the balance sheet as held
for sale. If any liabilities associated with the held-for-sale assets will be transferred along with the assets,
the liabilities should be presented separately on the balance sheet as liabilities held-for-sale. The assets
and liabilities should not be netted and presented on the same line.
When the sale of the long-lived asset or asset disposal group takes place, any gain or loss not previously
recognized that results from the sale should be recognized at the date of sale.
141
A disposal group represents long-lived assets to be disposed of, by sale or otherwise, together as a group in a single
transaction. If liabilities associated with those assets will be transferred in the transaction, those liabilities are also part
of the disposal group.
142
Costs to sell are costs that result directly from the sale transaction that would not have been incurred if the decision
to sell had not been made. They include broker commissions, legal fees, title transfer fees, and closing costs that must
be incurred before title can be transferred.
Study Unit 30: A.2. Income Measurement CMA Part 1
Example: Archer Company provides contracting services. It owns thirty 8,000-watt generators for con-
struction sites. Management has decided the 8,000-watt generators are insufficient for its needs and has
replaced them with new, 12,000-watt generators. Archer is actively seeking a buyer or buyers for the
used generators and meets all of the criteria to reclassify the generators from held-for-use equipment
to held-for-sale equipment. The carrying value of the used generators is $40,000, presently recorded in
the accounting system as follows:
Held-for-use equipment $65,000
Less: Accumulated depreciation - equipment (25,000)
At the time Archer decides to sell the generators, management determines that the fair value less selling
costs of the used generators is $30,000. Archer records the following journal entry to transfer the gen-
erators to the held-for-sale category and record the $10,000 loss:
Dr Held-for-sale equipment ............................................. 30,000
Dr Accumulated depreciation – equipment ......................... 25,000
Dr Loss on decline of fair value – held-for-sale equipment ... 10,000
Cr Held-for-use equipment ................................................ 65,000
The loss is a loss from continuing operations. While Archer seeks a buyer or buyers for the used 8,000-
watt generators and completes their sale, it will not record any further depreciation on the 8,000-wat
generators.
Three months later, Archer completes the sale of the 8,000-watt generators for $28,000 less the broker’s
fee of $1,000. Archer records the sale as follows:
Dr Cash ........................................................................ 27,000
Dr Loss on sale of equipment ............................................. 3,000
Cr Held-for-sale equipment ............................................... 30,000
If a fixed asset is sold while it is still classified as held-and-used (an asset that has not been previously
reclassified as held-for-sale), the journal entry to record the disposal for cash and to recognize any gain or
loss is as follows:
Dr Cash .......................................................... amount received
Dr Accumulated depreciation ............................ amount on books
Dr/Cr Loss/gain on disposal ......................................................balance
Cr Fixed assets ........................................... historical cost of asset
Section A Study Unit 30: A.2. Income Measurement
Presentation of Gains and Losses on the Income Statement

A gain or loss on an asset or a disposal group that is not a discontinued component should be included in
income from continuing operations before taxes. Gains and losses are not part of operating income because
they do not arise from the company’s main or central operations. However, if the company also has discon-
tinued operations, a gain or a loss that is not part of the discontinued component should be included on the
income statement in income from continuing operations (but below operating income) to distinguish it from
gains or losses from discontinued operations. For more information on the format of the income statement,
please see The Income Statement in this volume.
All gains or losses incurred by a discontinued component are reported net of tax in the period in which the
gain or loss occurred. The gain or loss from operations of the discontinued component and the gain or loss
from the disposal, when the disposal takes place, are combined and reported on one line, followed by the
income tax effect on the next line, either a tax benefit (for a loss) or a tax expense (for a gain). The
gain/loss and the tax expense or tax benefit associated with the gain or loss of the discontinued component
should be reported below income from continuing operations, as follows.
Income from continuing operations

+/− Gain/(loss) from operations of discontinued Component X
including gain/(loss) on disposal of $XXXX
+/− Income tax benefit or (income tax expense) on discontinued Component X
Net Income
In other words, all gains and losses from the discontinued component and their related tax effects should
be removed from income from continuing operations so users of the financial statements can see what
income from continuing operations is without the operations of the component that was or is to be disposed
of.
More information on discontinued operations is included in this volume in the topic A.1. Financial State-
ments, 2) The Income Statement.
Involuntary Disposals
An involuntary disposal, or an involuntary conversion, occurs when an asset is stolen or otherwise
destroyed, condemned, or seized by the government for a public purpose. The condemnation settlement or
insurance settlement, if any, constitute the proceeds received for the asset, just as if the asset had been
sold.
If the condemnation settlement or insurance proceeds are greater than the carrying value of the asset, a
gain will be recognized on the disposal. If the settlement or insurance proceeds are less than the carrying
value of the asset, a loss will be recognized. The subsequent use of the funds received, whether or not they
are used to purchase a replacement asset, does not impact the gain or loss that is recognized on the
involuntary disposal of the fixed asset.
The entire gain or loss is recognized in the period in which the conversion occurred. The journal entry to
record the involuntary disposal is the same as the journal entry for a voluntary disposal.
Study Unit 30: A.2. Income Measurement CMA Part 1
Note: The costs of cleanup and removal of an asset as well as any costs associated with determining
the fair value of condemned property or the condemnation agreement itself are added to the book
value of the old asset in determining the gain or loss on the involuntary disposal.
Any costs associated with the search for and purchase of a replacement asset are included in the capi-
talized cost of the new asset, to be depreciated over its estimated useful life.
Comprehensive income (that is, total comprehensive income) is the change in equity (net assets) of an
entity from non-owner sources that arise during a period from transactions and other events. It includes
all changes in equity during a period except those resulting from investments by owners and distributions
to owners.
Net income (loss) for a period is closed to retained earnings at the end of the reporting period, so net
income (loss) increases (decreases) equity. Comprehensive income includes everything on the income
statement plus the amount of change during the period in accumulated other comprehensive income
(AOCI), another equity account. The specific items reported on the accumulated other comprehensive in-
come line in equity are covered in this volume in the topic A.1. Financial Statements, 3) Statement of
Comprehensive Income.
As covered in more detail in that study unit, total comprehensive income for a year includes everything on
the income statement (that is, net income for the year) plus the net transactions for the year in the accu-
mulated other comprehensive income account, called other comprehensive income. The accumulated other
comprehensive income account is a permanent balance sheet account, so it is not closed out at the end of
each year the way the temporary income statement accounts are. Therefore, total comprehensive income
for a year is net income plus other comprehensive income, which is the amount of change during the year
in the accumulated other comprehensive income account.
Comprehensive Income (Loss) = Net Income (Loss) + Other Comprehen-

sive Income (∆ in Accumulated OCI)
• If the balance in the accumulated OCI account increases during a period (a net credit), compre-
hensive income will be greater than net income for the period.
• If the balance in the accumulated OCI account decreases during a period (a net debit), compre-
hensive income will be less than net income for the period.
Comprehensive income (loss) is more inclusive than net income. In other words, net income (loss) is a part
of comprehensive income (loss), but it does not constitute the whole of comprehensive income (loss).

CMA Part 1 Textbook Section A

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CMA Part 1 Textbook Section A

Uploaded by

Copyright:

Available Formats

2022 Edition

Brian Hock, CMA, CIA

Hard copy books purchased from HOCK international or from an authorized

(866) 807-HOCK or (866) 807-4625

Published October 2021

Acknowledgement is due to the Institute of Certified Management Accountants for

© 2021 HOCK international, LLC

§ Kekoa Kaluhiokalani for his assistance with copyediting the material,

Throughout these materials, we have chosen particular language, spellings, structures

This material is designed exclusively to assist people in their exam preparation. No

Introduction to CMA Part 1 ................................................................................................1

Section A – External Financial Reporting Decisions ......................................................2

Effect of the Different Methods 76

(This page intentionally left blank.)

Introduction to CMA Part 1

A. External Financial Reporting Decisions: 15%

B. Planning, Budgeting and Forecasting: 20%

C. Performance Management: 20%

D. Cost Management: 15%

E. Internal Controls: 15%

F. Technology and Analytics: 15%

Section A – External Financial Reporting Decisions

Users of Financial Information

• Making investment decisions.

• Extending or withholding credit.

• Assessing areas of strength and weakness within the company.

• Evaluating management performance.

• Determining whether or not the company is complying with regulatory requirements.

Users of financial information can be classified by various distinctions:

The Financial Statements

1) Balance sheet (also called the statement of financial position)

3) Statement of comprehensive income

4) Statement of changes in stockholders’ equity

5) Statement of cash flows

Differences Between IFRS and U.S. GAAP

1) The Balance Sheet (Statement of Financial Position)

Elements of the Balance Sheet

• Arose from a past transaction

• Arose from a past transaction

Current and Non-Current Classification of Assets and Liabilities

Non-current assets include:

• Intangible long-term assets.

Property, Plant, and Equipment (Fixed Assets)

Examples of property, plant, and equipment include:

• Land, buildings, machinery, furniture, equipment, and vehicles

• Leasehold improvements, or improvements made to leased property at the lessee’s expense

• Assets obtained by means of a lease agreement

• Natural resources, such as gas, minerals, or timberland

Intangible Long-term Assets

Examples of current liabilities include:

Current liabilities do not include:

• Debts to be paid by funds in accounts classified as non-current.

• The portion of a short-term obligation intended to be refinanced by a long-term obligation, subject

Examples of non-current liabilities are:

• Contract liabilities classified as non-current.

• Long-term notes or bonds payable.

• Net deferred tax liabilities.

Owners’ equity for corporations is split into six different categories:

• Capital stock. The par or stated value of the shares issued.

Benefits of the Balance Sheet

Limitations of the Balance Sheet

Study Unit 2: A.1. The Income Statement

Elements of the Income Statement

• Revenues represent inflows or other enhancements to assets or settlements of liabilities13 (or a