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CHAPTER FOUR

Financial Statement Reporting: The Balance Sheet

ON THE BALANCE sheet, the CFO is concerned with the accounting for and reporting of assets, liabilities, and stockholders’ equity.

ASSETS

How are assets recorded?

An asset is recorded at the price paid plus the cost of putting the asset in service (e.g., freight, insurance, installation). If an asset is acquired in exchange for a liability, the asset is recorded at the discounted values of the future payments.

Unearned discounts (except for quantity or cost), finance charges, and interest included in the face of receivables should be deducted to arrive at the net receivable.

Some of the major current and noncurrent assets are accounts receivable, inventory, fixed assets, and intangibles.

ACCOUNTS RECEIVABLE

What is an assignment of accounts receivable?

When accounts receivable are assigned, the owner of the receivables borrows cash from a lender in the form of a note payable. The accounts receivable serves as security. New receivables substitute for receivables collected. The assignment of accounts receivable usually involves a financing charge and interest on the note.

The transferor’s equity in the assigned receivables equals the difference between the accounts receivable assigned and the balance of the line (e.g., $50,000). When payments on the receivables are received, they are remitted by the company to the lending institution to reduce the liability. Customers are not notified of the assignment. Assignment is with recourse, meaning the company has to make good for uncollectible accounts.

How does factoring of accounts receivable work?

When factoring accounts receivable, the receivables are sold to a finance company. The factor buys the accounts receivable at a discount from face value (typically a discount of 6 percent). Customers are usually notified. The factoring arrangement is usually without recourse, where the risk of uncollectability of the customer’s account rests with the financing institution. Billing and collection is typically done by the factor. The factor charges a commission ranging from 0.75 percent to 1.5 percent of the net receivables acquired. The entry is:

Cash (proceeds)

Loss on sale of receivables

Due from factor (proceeds kept by factor to cover possible adjustments such as sales discounts, sales returns, and allowances)

Accounts receivable (face amount of receivables)

Factoring is usually a continual process. The seller of merchandise receives orders and transmits them to the factor for acceptance; if approved, the goods are shipped; the factor advances the money to the seller; the buyers pay the factor when payment is due; and the factor periodically remits any excess reserve to the seller of the goods. There is a continual circular flow of goods and money among the seller, the buyers, and the factor. Once the agreement is in effect, funds from this source are spontaneous.

What if receivables are transferred with recourse?

A sale is recorded for the transfer of receivables with recourse if all three of these conditions are met:

When the transfer is treated as a sale, gain or loss is recognized for the difference between the selling price and the net receivables. The selling price includes normal servicing fees of the transferor and probable adjustments (e.g., debtor’s failure to pay on time, effects of prepayment, and defects in the transferred receivable). Net receivables equals gross receivables plus finance and service charges minus unearned finance and service charges.

If the selling price varies during the term of the receivables because of a variable interest rate provision, the selling price is estimated with the use of an appropriate going market interest rate at the transfer date. Subsequent changes in the rate result in a change in estimated selling price, not in interest income or interest expense.

If one of the aforementioned criteria is not met, a liability is recognized for the amount received.

Footnote disclosure includes amount received by transferor and balance of the receivables at the balance sheet date.

INVENTORY

Inventory may be valued at the lower of cost or market value. Specialized inventory methods may be used such as retail, retail lower of cost or market; retail last-in, first-out (LIFO); and dollar value LIFO. Losses on purchase commitments should be recognized in the accounts.

If ending inventory is understated, cost of sales is overstated, and net income is understated. If beginning inventory is understated, cost of sales is understated, and net income is overstated.

How does the lower-of-cost-or-market value method work?

Inventories are recorded at the lower of cost or market value for conservative purposes applied on a total basis, category basis, or individual basis. The basis selected must be used consistently.

If cost is less than market value (replacement cost), cost is selected. If market value is below cost, we start with market value. However, market value cannot exceed the ceiling, which is net realizable value (selling price less costs to complete and dispose). If it does, the cost is used. Furthermore, market value cannot be less than the floor that is net realizable value less a normal profit margin. If market value is less than the floor, floor value is chosen. Of course, market value is used when it lies between the ceiling and floor. (See Exhibit 4.1.)

How does the retail method work?

Some large retail concerns use the retail method. These businesses may carry inventory items at retail selling price. The retail method is used to estimate the ending inventory at cost by employing a cost-to-retail (selling price) ratio. The ending inventory is first determined at selling price and then converted to cost. Markups and markdowns are both considered in arriving at the cost-to-retail ratio, resulting in a higher ending inventory than the retail lower of cost or market value method.

Retail Lower-of-Cost-or-Market Value Method (Conventional Retail)

This is a modification of the retail method and is preferable to it. In computing the cost-to-retail ratio, markups but not markdowns are considered, resulting in a lower inventory figure.

Example 4.6 illustrates the accounting difference between the retail method and the retail lower of cost or market value method.

Retail LIFO

In computing ending inventory, the mechanics of the retail method are basically used. Beginning inventory is excluded, and both markups and markdowns are included in computing the cost-to-retail ratio. A decrease in inventory during the period is deducted from the most recent layer and then subtracted from layers in the inverse order of addition. A retail price index is used in restating inventory.

What are the mechanics of the dollar-value LIFO method?

Dollar-value LIFO is an extension of the historical cost principle. The method aggregates dollars rather than units into homogeneous groupings. The method assumes that an inventory decrease came from the last year.

The procedures under dollar-value LIFO are:

• Restate ending inventory in the current year into base dollars by applying a price index.
• Subtract the year 0 inventory in base dollars from the current year’s inventory in base dollars.
• Multiply the incremental inventory in the current year in base dollars by the price index to obtain the incremental inventory in current dollars.
• Obtain the reportable inventory for the current year by adding to the year 0 inventory in base dollars the incremental inventory for the current year in current dollars.

Losses on Purchase Commitment

Significant net losses on purchase commitments should be recognized at the end of the reporting period.

Inventory Valuation Problems

Although the basics of inventory cost measurement are easily stated, difficulties exist in cost allocation. For example, idle capacity costs and abnormal spoilage costs may have to be written off immediately in the current year rather than being allocated as a component of inventory valuation. Furthermore, general and administrative expenses are inventoryable when they are directly related to production.

As per Financial Accounting Standards Board (FASB) Statement No. 151, Inventory Costs, freight and handling charges are expensed as incurred.

Inventory Stated at Market Value in Excess of Cost

In unusual cases, inventories may be stated in excess of cost. This may arise when there is no basis for cost apportionment (e.g., in the meat-packing industry). Market value may also be used when there is immediate marketability at quoted prices (e.g., certain precious metals or agricultural products). Disclosure is necessary when inventory is stated above cost.

FIXED ASSETS

How do we account for fixed assets?

A fixed asset is recorded at its fair market value or the fair market value of the consideration given, whichever is more clearly evident.

The cost of buying an asset includes all costs required to place that asset into existing use and location, including freight, installation, insurance, taxes, and break-in costs (e.g., instruction).

The additions to an existing building (such as constructing a new garage) are capitalized and depreciated over the shorter of the life of the addition or the life of the building. Rearrangement and reinstallation costs are deferred when future benefit exists. If not, they should be expensed. Obsolete fixed assets should be reclassified from property, plant, and equipment to other assets and shown at salvage value, recognizing a loss.

When two or more assets are purchased for one price, cost is allocated to the assets based on their relative fair market values. If an old building is demolished to make way for the construction of a new building, the costs of demolishing the old building are capitalized to land.

Self-constructed assets are recorded at the incremental costs to build assuming idle capacity. However, they should not be recorded at more than the outside price.

A donated fixed asset should be recorded at fair market value. The entry is to debit fixed assets and credit contribution revenue.

Land improvements (e.g., driveways, sidewalks, fencing) are capitalized and depreciated over useful life. Land held for investment purposes or for a future plant site should be classified under investments and not fixed assets.

Ordinary repairs (e.g., tune-up for a car) are expensed because they have a benefit period of less than one year.

Extraordinary repairs are deferred since they benefit a period of more than one year. An example is a new motor for a car. Extraordinary repairs increase the life of an asset or make the asset more useful. Capital expenditures improve the quality or quantity of services to be derived from the asset.

What is depreciation, and how is it accounted for?

Depreciation is the allocation of the historical cost of a fixed asset into expense over the period benefited to result in matching expense against revenue.

Fractional-year depreciation is computing depreciation when the asset is bought during the year. A proration is needed.

What are the group and composite depreciation methods?

Group and composite depreciation methods involve similar accounting. The group method is used for similar assets, whereas the composite method is used for dissimilar assets. Both methods are generally accepted. There is one accumulated depreciation account for the entire group. The depreciation rate equals:

Depreciation expense for a period equals:

The depreciation life equals:

When an asset is sold in the group, the entry is:

Upon sale of a fixed asset in the group, the difference between the cash received and the cost of the fixed asset is plugged to accumulated depreciation. No gain or loss is recognized upon the sale. The only time a gain or loss is recognized is if all the assets were sold.

When is interest deferred?

Disclosure should be made of the interest capitalized and expensed. Interest incurred on borrowed funds is expensed. However, interest on borrowed funds is deferred to the asset and then amortized in the following instances:

• Self-constructed assets for the company’s own use: To justify interest capitalization, a time period must exist for assets to be prepared for use.
• Assets for sale or lease constructed as discrete, individual projects (e.g., real estate development).
• Assets purchased for the entity’s own use by arrangements requiring a down payment and/or progress payments.

Interest is not capitalized for:

• Assets in use or ready for use
• Assets not in use and not being prepared for use
• Assets produced in large volume or on a recurring basis

Interest capitalized is based on the average accumulated expenditures for that asset. The interest rate used is either:

• Interest rate on the specific borrowing
• Weighted-average interest rate on corporate debt

How are exchanges of assets accounted for?

Nonmonetary transactions covered under Accounting Standards Codification (ASC) No. 845-10-05, Nonmonetary Transactions: Overall (Financial Accounting Standard [FAS] No. 153, Exchanges of Nonmonetary Assets) deal primarily with exchanges or distributions of fixed assets.

Fair market value in a nonmonetary exchange may be based on:

• Quoted market price
• Appraisal
• Cash transaction for similar items

As per ASC No. 845-10-05, the asset received in a nonmonetary exchange is recorded at fair market value when the transaction has commercial substance. Commercial substance exists when future cash flows change because of the transaction arising from a change in economic positions of the two parties. A gain or loss is recorded for the difference between the book value of the asset given up and the fair market value of the asset received. However, if commercial substance does not exist, the exchange is recorded based on book values with no gain or loss recognized.

What footnote disclosure is required?

Footnote disclosure should be made of the nature of the exchange transaction, method to account for transferred assets, and gain or loss on the exchange.

What happens if a fixed asset is damaged?

There may be an involuntary conversion of nonmonetary assets into monetary assets, followed by replacement of the involuntarily converted assets (e.g., a building is destroyed by a fire, and the insurance recovery is used to buy a similar building). Gain or loss is recognized for the difference between the insurance recovery and the book value of the destroyed asset.

How do we reflect the impairment or disposal of long-lived assets?

ASC No. 205-20-45-3, Presentation of Financial Statements: Discontinued Operations (FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets) applies to a company’s long-term assets to be retained or to be disposed of.

With regard to long-term assets to be retained and used, an impairment occurs when the fair market value of the long-term asset group is less than its book (carrying) value. The impairment loss is recognized only when the carrying value of the asset group is not recoverable and exceeds its fair value. There is a lack of recoverability when the carrying value of the asset group exceeds the total undiscounted cash flows anticipated from the use and ultimate disposition of the asset group. The impairment loss equals the carrying value of the asset group less its fair value.

What should be footnoted for an impairment loss?

Footnote disclosure for an impairment loss is:

• The business segment associated with the impaired asset
• Description of the impaired asset along with impairment circumstances
• Method used to derive fair value
• Amount of impairment loss and where such loss is included in the income statement

How are asset retirement obligations accounted for?

ASC No. 410-20-05, Asset Retirement and Environmental Obligations: Asset Retirement Obligations (FAS No. 143, Accounting for Asset Retirement Obligations) requires companies to record at fair value a liability when a retirement obligation is incurred, provided that fair value can be reasonably estimated, even though it is years prior to the asset’s planned retirement. The asset retirement obligation has to be measured and recorded along with its associated asset retirement cost. Asset retirements may be from sale, recycling, abandonment, or disposal.

When the initial obligation occurs, the company records a liability and defers the cost to the long-term asset for the same amount. After the initial recognition, the liability will change over time, so that the obligation must be accreted to its present value each year. The long-term asset’s capitalized cost is depreciated over its useful life. When the liability is settled, the company either settles the liability for the amount recorded or will have a settlement gain or loss.

Any incremental liability incurred in a later year is an additional layer of the initial obligation. Each layer is measured at fair value.

DISCLOSURE

What footnote disclosures are provided for fixed assets?

Footnote disclosures for fixed assets include:

• Idle fixed assets
• Fixed assets subject to pledges, liens, or other commitments
• Fully depreciated assets still in use
• Fixed assets held to be disposed of and anticipated losses
• Contractual agreements to purchase new fixed assets
• Description of depreciation method and estimates
• Fixed assets by major category

How do we account for intangible assets?

Intangible assets have a life of one year or more and lack physical substance (e.g., goodwill), or represent a right granted by the government (e.g., patent) or another company (e.g., franchise fee). ASC No. 350-20-55, Intangibles—Goodwill and Other: Goodwill (FAS 142, Goodwill and Other Intangible Assets) covers accounting for intangible assets, whether purchased or internally developed. The costs of intangibles acquired from others should be reported as assets. The cost equals the cash or fair market value of the consideration given. The individual intangibles that can be separately identified must be costed separately. If not separately identified, the intangibles are assigned a cost equal to the difference between the total purchase price and the cost of identifiable tangible and intangible assets. Note that “goodwill” does not include identifiable assets.

The cost of developing and maintaining intangibles should be charged against earnings if the assets are not specifically identifiable, have indeterminate lives, or are inherent in the continuing business (e.g., goodwill). An example of internally developed goodwill that is expensed are the costs incurred in developing a name (e.g., Cuisinart).

As per ASC No. 350-20-55, intangibles have either a limited useful life or an indefinite useful life. An intangible with a limited life is amortized into expense over its useful life. Examples are trade names, trademarks, patents, licenses, franchises, and copyrights. A loss on impairment is recognized on a limited-life intangible asset when its carrying value exceeds its fair market value. After the impairment is recognized, the reduced carrying amount is its new cost basis. An intangible asset with an indefinite life is not amortized but rather is subject to a yearly impairment test. An example is goodwill.

The factors in estimating useful lives for limited-life intangibles include:

• Legal, contractual, and regulatory provisions
• Renewal or extension provisions (if a renewal occurs, the life of the intangible may be increased)
• Obsolescence and competitive factors
• Product demand
• Service lives of key employees within the company

For example, an intangible may be enhanced owing to a strong public relations staff.

Footnote disclosure should be made of the amortization period and method.

When the purchase of assets results in goodwill, the subsequent sale of a separable part of the entity acquired requires a proportionate reduction of the goodwill account.

In a business combination accounted for under the purchase method, goodwill is recorded only when the cost to the acquirer exceeds the fair market value of the net assets acquired. Goodwill may be determined by an individual appraiser, a purchase audit done by the acquiring company’s public accounting firm, and so on. Goodwill is then subject to an annual impairment test. If the cost to the acquirer is less than the fair market value of the net assets acquired, a credit arises. This credit represents negative goodwill, which is proportionately allocated as a reduction of the acquired assets except for certain deferred assets (e.g., deferred pension and tax assets). If these assets are reduced to zero, the credit balance remaining is recorded as an extraordinary gain.

Goodwill is theoretically equal to the discounted value of future excess earnings of a company over other companies in the industry. However, it is difficult to forecast the years in which superior earnings will occur.

In acquiring a new business, goodwill must be estimated. Two possible methods to value goodwill are (1) capitalization of earnings and (2) capitalization of excess earnings.

Internally generated costs to derive a patented product, such as research and development incurred in developing a new product, are expensed. The patent is recorded at the registration fees to secure and register it, legal fees in successfully defending it, and the cost of acquiring competing patents. The patent is amortized over its useful life not exceeding its nonrenewable legal life of 20 years. If an intangible asset is worthless, it should be written off immediately as a loss.

Trademarks and trade names have legal protection for 10 years and may be renewed an indefinite number of times. Franchises and licenses with limited lives should be amortized over their useful lives. Copyrights are granted for the life of the creator plus 70 years. Registration fees and successful legal fees are deferred to the intangible asset.

Leaseholds are rent paid in advance and are amortized over the life of the lease.

What disclosures are made for goodwill and other intangible assets?

The footnote disclosures for goodwill and other intangible assets are:

• Description of impaired intangible assets and the reasons for such impairment
• Amortization period for limited-life intangibles and expected amortization expense for the next five years
• Method to compute fair value
• Amount of any significant residual value
• Amount of goodwill included in the gain or loss on disposal of all or a part of a reporting unit

What should be disclosed about recognized intangible assets?

Companies must disclose information about how recognized intangible assets would aid financial statement users to determine how a company’s ability to renew or extend an arrangement impacts the company’s anticipated cash flows associated with the asset.

Disclosure should be made of:

• Weighted-average period at acquisition or renewal before the next renewal or extension
• Accounting policy for costs incurred to renew or extend an intangible asset’s term
• In the event renewal or extension costs are capitalized, the total cost incurred to renew or extend the term of a recognized intangible asset

LIABILITIES

How do we account for and report liabilities?

In accounting for liabilities, the CFO must consider many reporting and disclosure responsibilities:

• Bonds payable may be issued between interest dates at a premium or discount.
• Bonds may be amortized using the straight-line method or effective interest method.
• Debt may be extinguished prior to the maturity date when the company can issue new debt at a lower interest rate.
• Estimated liabilities must be recognized when it is probable that an asset has been impaired or liability has been incurred by year-end, and the amount of loss can be reasonably estimated.
• An accrued liability may be recognized for future absences (e.g., sick leave or vacation time).
• Special termination benefits such as early retirement may also be offered to and accepted by employees.
• Short-term debt may be rolled over to long-term debt, requiring special reporting.
• A callable obligation by the creditor may exist.
• Long-term purchase obligations have to be disclosed.

How are bonds payable handled?

The cost of a corporate bond is expressed in terms of yield. Two types of yield are:

When a bond is issued at a discount, the yield (effective interest rate) exceeds the nominal (face, coupon) interest rate.

When a bond is issued at a premium, the yield is below the nominal interest rate.

The two methods of amortizing bond discount or bond premium are:

In the early years, the amortization amount under the effective interest method is lower relative to the straight-line method (either for discount or premium).

Bonds payable is presented on the balance sheet at its present value in this manner:

Bond issue costs are the expenditures in issuing the bonds such as legal, registration, and printing fees. Bond issue costs are preferably deferred and amortized over the life of the bond. They are shown under deferred charges.

In computing the price of a bond, the face amount is discounted using the present value of $1 table. The interest payments are discounted using the present value of an ordinary annuity of $1 table. The yield serves as the discount rate.

What if bonds are converted to stock?

In converting a bond into stock, three alternative methods may be used: book value of bond, market value of bond, and market value of stock. Under the book value of bond method, no gain or loss on bond conversion arises because the book value of the bond is the basis to credit equity. This method is preferred. Under the market value methods, gain or loss will result because the book value of the bond will be different from the market value of bond or market value of stock, which is the basis to credit the equity accounts.

How do we handle an inducement offer to convert debt to equity?

ASC No. 470-20-05, Debt: Debt with Conversion and Other Options (FAS No. 84, Induced Conversions of Convertible Debt) requires that if convertible debt is converted to stock due to an inducement offer where the debtor changes the conversion privileges (e.g., conversion price), the debtor records an expense. The amount of expense equals the fair market value of the securities transferred in excess of the fair market value of the securities issuable based on the original conversion terms. The fair market value is measured at the earlier of the conversion date or agreement date. If the additional inducement consists of stock, the market value of the stock is credited to common stock at par value, with the excess over par credited to paid-in capital and with the offsetting debit to debt conversion expense. If the additional inducement is assets, the market value of the assets is credited with an offsetting charge to debt conversion expense. For example, the inducement may be in the form of cash or property.

How do we account for the extinguishment of debt?

Long-term debt may be retired when new debt can be issued at a lower interest rate. It can also occur when the company has excess cash and wants to avoid paying interest and having the debt on its balance sheet. The gain or loss on the extinguishment of debt is an ordinary item. Extraordinary classification occurs whether the extinguishment is early, at scheduled maturity, or later.

Debt may be considered extinguished if the debtor is relieved of the principal liability and it is probable the debtor will not have to make future payments.

Footnote disclosures regarding extinguishment of debt include description of extinguishment transaction including the source of funds.

As per ASC No. 860-10-05, Transfers and Servicing: Overall (FAS No. 76, Extinguishment of Debt), if the debtor puts cash or other assets in a trust to be used only for paying interest and principal on debt on an irrevocable basis, there should be disclosure of the particulars, including a description of the transaction and the amount of debt extinguished.

How is recognition given to estimated liabilities?

A loss contingency should be accrued if both of these criteria exist:

• At year-end, it is probable (likely to occur) that an asset was impaired or a liability was incurred.
• The amount of loss can be reasonably estimated.

The loss contingency is booked based on conservatism. The entry for a probable loss is:

Expense (Loss)
	Estimated liability

A probable loss that cannot be estimated should be footnoted.

If a loss contingency exists at year-end but no asset impairment or liability incurrence exists (e.g., uninsured equipment), footnote disclosure can be made.

A probable loss occurring after year-end but before the audit report date only requires subsequent event disclosure.

Examples of probable loss contingencies are warranties, lawsuits, claims, and assessments, casualties, catastrophes (e.g., fire), and expropriation of property by a foreign government.

If the amount of loss is within a range, the accrual is based on the best estimate within that range. However, if no amount within the range is better than any other amount, the minimum amount (not maximum amount) of the range is booked. The exposure to additional losses should be disclosed.

There is no accrual for a reasonably possible loss (more than remote but less than likely). However, footnote disclosure is required of the nature of the contingency and the estimate of probable loss or range of loss. If an estimate of loss is not possible, that fact should be noted.

A remote contingency (slight chance of occurring) is usually ignored, and no disclosure is made. There are exceptions when a remote contingency would be disclosed in the case of guarantees of indebtedness, standby letters of credit, and agreements to repurchase receivables or properties.

General (unspecified) contingencies are not accrued. Examples are self-insurance and catastrophic losses. Disclosure and/or an appropriation of retained earnings can be made for general contingencies. To be booked as an estimated liability, the future loss must be specific and measurable, such as parcel post and freight losses.

Gain contingencies cannot be recognized because such recognition violates conservatism. However, footnote disclosure can be made.

ACCOUNTING FOR COMPENSATED ABSENCES

Compensated absences include sick leave, holiday, and vacation time. ASC 710-10-15, Compensation—General: Overall (FAS No. 43, Accounting for Compensated Absences) is not applicable to severance or termination pay, postretirement benefits, deferred compensation, stock option plans, and other long-term fringe benefits (e.g., disability, insurance).

The employer accrues a liability for employees’ compensation for future absences if all of these conditions are satisfied:

• Employee services have already been performed.
• Employee rights have vested.
• Probable payment exists.
• Amount of estimated liability can reasonably be determined.

The accrual for sick leave is required when the employer allows employees to take accumulated sick leave days off regardless of actual illness. The accrual is not required if employees may take accumulated days off only for actual illness, since losses for these are usually insignificant.

What if there is a special termination benefit?

An expense is accrued when an employer offers special termination benefits to an employee, the employee accepts the offer, and the amount can be estimated reasonably. The amount equals the current payment plus the discounted value of future payments.

When it can be measured objectively, the effect of changes on the employer’s previously accrued expenses applicable to other employee benefits directly associated with employee termination should be included in measuring termination expense.

ENVIRONMENTAL OBLIGATIONS

How do we account for environmental liabilities?

In determining a loss contingency to accrue for environmental liabilities, these points should be considered:

• Name and extent of hazardous waste at a site
• Remedial steps
• Level of acceptable remediation
• Other responsible individuals or entities and their degree of liability

The present value of payments associated with a liability may be recognized only when the future cash flows are reliably determinable in amount and timing.

Disclosure is required of environmental difficulties, how environmental liabilities are determined, important factors applicable to the environment as it impacts the business, future contingencies, compliance issues, and contamination.

What if short-term debt is rolled over into long-term debt?

A short-term obligation shall be reclassified as a long-term liability in either of two cases:

• The agreement does not expire within one year.
• No violation of the agreement exists.
• The parties are financially able to meet the requirements of the arrangement.

The proper classification of the refinanced item is under long-term debt and not stockholders’ equity, even if equity securities were issued in substitution of the debt. When short-term debt is excluded from current liabilities, a footnote should describe the financing agreement and the terms of any new obligation.

If the amounts under the agreement for refinancing vary, the amount of short-term debt excluded from current liabilities will be the minimum amount expected to be refinanced based on conservatism. The exclusion from current liabilities cannot be greater than the net proceeds of debt or security issuances, or amounts available under the refinancing agreement.

Once cash is paid for the short-term debt, even though the next day long-term debt of a similar amount is issued, the short-term debt is presented under current liabilities since cash was paid.

What if the creditor has the right to call the bond?

A long-term debt callable by the creditor is presented as a current liability because of the debtor’s violation of the agreement except if one of these conditions exist:

• The creditor waives or has lost the right to demand repayment for a period in excess of one year from the balance sheet date.
• There is a grace period in which the debtor may correct the violation that makes it callable, and it is probable that the violation will be so rectified.

What footnote information should be presented for long-term purchase commitments?

An unconditional purchase obligation provides funds for goods or services at a determinable future date. An example is a take-or-pay contract in which the buyer must pay specified periodic amounts for products or services. Even if the buyer does not take delivery of the goods, periodic payments still must be made.

When unconditional purchase obligations are recorded in the balance sheet, disclosure is made of payments for recorded unconditional purchase obligations and maturities and sinking fund requirements for long-term borrowings.

Unconditional purchase obligations not reflected in the balance sheet should be disclosed if they meet these conditions:

• Noncancelable; however, it may be cancellable upon a remote contingency
• Negotiated to arrange financing to provide contracted goods or services
• A term exceeding one year

The disclosures for unconditional purchase obligations when not recorded in the accounts are:

• Nature and term
• Fixed and variable amounts
• Total amount for the current year and for the next five years
• Purchases made under the obligation for each year presented

Optional disclosure exists of the amount of imputed interest required to reduce the unconditional purchase obligation to present value.

EXIT OR DISPOSAL ACTIVITIES

How do we account for the costs and obligations associated with exit or disposal activities?

ASC No. 420-10-05-3, Exit or Disposal Cost Obligations: Overall (FAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities) applies to costs (e.g., costs to consolidate facilities or relocate workers, one-time termination benefits to current workers, operating lease termination costs) applicable to a restructuring, plant closing, discontinued operation, or other exit or disposal activity. These costs are recognized as incurred (not at the commitment date to an exit plan) based on fair value along with the related liability. The best indication of fair value is quoted market prices in active markets. If fair value cannot reasonably be estimated, we must postpone recognizing the liability until it can.

The initiation date of an exit or disposal activity is that date when management obligates itself to a plan to do so or otherwise dispose of a long-lived asset and if the activity includes worker termination.

What footnote disclosures are made for exit or disposal activities?

These points should be footnoted:

• Description of exit or disposal activity and the anticipated completion date
• For each major type of cost applicable to the exit activity, the total anticipated cost, the amount incurred in the current year, and the cumulative amount to date
• If a liability for a cost is not recorded because fair value is not reasonably estimated, along with the reasons
• Where exit or disposal costs are presented in the income statement

FAIR VALUE MEASUREMENTS

What are fair value measurements about?

ASC No. 820-10-05, Fair Value Measurements and Disclosures: Overall (FAS No. 157, Fair Value Measurements) states that a fair value measurement reflects current market participant assumptions about future inflows of the asset and future outflows of the liability. A fair value measurement incorporates the attributes of the particular asset or liability (e.g., location, condition). In formulating fair value, consideration is given to the exchange price, which is the market price at the measurement date in an orderly transaction between the parties to sell the asset or transfer the liability. The focus is on the price that would be received to sell the asset or would be paid to transfer the liability (exit price), not the price that would be paid to buy the asset or would be received to assume the liability (entry price).

The asset or liability may be by itself (e.g., financial security, operating asset) or a group of assets or liabilities (e.g., asset group, reporting unit).

What about the fair value hierarchy?

A hierarchy list of fair value distinguishes between (1) assumptions based on market data from independent outside sources (observable inputs) and (2) assumptions by the company itself (unobservable inputs). The use of unobservable inputs allows for situations in which there is minimal or no market activity for the asset or liability at the measurement date. Valuation methods used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable ones.

What about risk and restrictions?

An adjustment for risk should be made in a fair value measurement when market participants would include risk in the pricing of the asset or liability. Nonperformance risk of the obligation and the entity’s credit risk should be noted. Further, consideration should be given to the effect of a restriction on the sale or use of an asset that impacts its price.

What is the difference between the principal market and the most advantageous market?

In a fair value measurement, we assume that the transaction occurs in the principal (main) market for the asset or liability. This is the market in which the company would sell the asset or transfer the liability with the greatest volume. If a principal market is nonexistent, then the most advantageous market should be used. This is the market in which the business would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability after taking into account any transaction costs. The fair value measurement should incorporate transportation costs for the asset or liability.

What valuation approaches may be used?

In fair value measurement, valuation techniques based on the market, income, and cost approaches may be used. The market approach uses prices for market transactions for identical or comparable assets or liabilities. The income approach uses valuation techniques to discount future cash flows to a present value amount. The cost approach is based on the current replacement cost, such as the cost to buy or build a substitute comparable asset after adjusting for obsolescence. Input availability and reliability related to the asset or liability may impact the choice of the most suitable valuation method.

A single- or multiple-valuation technique may be needed based on the situation. For example, a single-valuation method would be used for an asset having quoted market prices in an active market for identical assets. A multiple-valuation method would be used to value a reporting unit.

What are the three levels of fair value hierarchy?

The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. Level 1, the highest priority, assigns quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 3, the lowest priority, is assigned for unobservable inputs for the assets or liabilities.

Level 2 inputs are those except quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include:

• Quoted price for similar assets or liabilities in active markets
• Quoted prices for similar or identical assets or liabilities in markets that are not active, such as markets with few transactions, noncurrent prices, limited public information, and where price quotations show substantial fluctuation
• Inputs excluding quoted prices that are observable for the asset or liability, such as interest rates observable at often quoted intervals and credit risks
• Inputs obtained primarily from observable market information by correlation or other means

In the case of Level 3, unobservable inputs are used to measure fair value to the degree that observable inputs are not available. Unobservable inputs reflect the reporting company’s own assumptions about what market participants consider (e.g., risk) in pricing the asset or liability.

What should be disclosed?

Quantitative disclosures in a tabular format should be used for fair value measurements in addition to qualitative (narrative) disclosures about the valuation methods. Emphasis should be placed on the inputs used to measure fair value and the effect of fair value measurements on profit or change in net assets. Any change in valuation techniques should be noted.

FAIR VALUE OPTION FOR FINANCIAL ASSETS AND FINANCIAL LIABILITIES

ASC No. 825-10, Financial Instruments: Overall (FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities) permits business entities to choose to measure most financial instruments and some other items at fair value. Many provisions of the pronouncement apply only to businesses that select the fair value option. The eligible items for the fair value measurement option are:

ASC No. 825-10 allows a business to select to measure eligible items at fair value at specified election dates. Included in earnings at each reporting date are the unrealized (holding) gains and losses on items for which the fair value option has been elected.

The fair value option is irrevocable (except if a new election date occurs) and is applied solely to entire instruments (not parts of those instruments or specified risks or specific cash flows). The fair value option may be applied in most cases instrument by instrument including investments otherwise accounted for under the equity method.

FASB No. 159’s amendment to ASC No. 805-10 (FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities) relates to all companies with trading and available-for-sale securities.

Up-front costs and fees associated to items for which the fair value option is chosen are expensed as incurred.

Electing the Fair Value Option

A business entity may select the fair value option for all eligible items only on the date that one of the following occurs:

The fair value option typically does not have to be applied to all financial instruments issued or bought in a single transaction. An investor in stocks or bonds, for example, may apply the fair value option to only some of the stock shares or bonds issued or acquired in a single transaction. In this situation, an individual bond is considered the minimum denomination of that debt security. A financial instrument that is a single contract cannot be broken down into parts when using the fair value option. However, a loan syndication may be in multiple loans to the same debtor by different creditors. Each of the loans is a separate instrument, and the fair value option may be selected for some of the loans but not others.

An investor in an equity security may select the fair value option for its entire investment in that security including any fractional shares.

Balance Sheet

Companies must present assets and liabilities measured at the fair value option in a manner that separates those reported fair values from the book (carrying) values of similar assets and liabilities measured with a different measurement attribute. To accomplish this, a company must either:

• Report the aggregate fair value and nonfinancial fair value amounts in the same line items in the balance sheet and in parentheses disclose the amount measured at fair value included in the aggregate amount
• Report two separate line items to display the fair value and non–fair value carrying amounts

STATEMENT OF CASH FLOWS

Companies must classify cash receipts and cash payments for items measured at fair value based on their nature and purpose.

Disclosures

Disclosures of fair value are mandated in annual and interim financial statements.

When a balance sheet is presented, these six points must be disclosed:

When an income statement is presented, these four points must be disclosed:

Other disclosures include the methods and assumptions used in fair value estimation. Qualitative information concerning the nature of the event as well as quantitative information including the impact on earnings of initially electing the fair value option for an item should also be disclosed.

Eligible Items at Effective Date

A company may elect the fair value option for eligible items at the effective date. The difference between the book (carrying) value and the fair value of eligible items related for the fair value option at the effective date must be removed from the balance sheet and included in the cumulative-effect adjustment. These differences include (1) valuation allowances (e.g., loan loss reserves); (2) unamortized deferred costs, fees, discounts, and premiums; and (3) accrued interest associated with the fair value of the eligible item.

A company that selects the fair value option for items at the effective date must provide in financial statements that include the effective date these five issues:

AVAILABLE-FOR-SALE AND HELD-TO-MATURITY SECURITIES

Available-for-sale and held-to-maturity securities held at the effective date are eligible for the fair value option at that date. In the event that the fair value option is selected for any of those securities at the effective date, cumulative holding (unrealized) gains and losses must be included in the cumulative-effect adjustment. Separate disclosure must be made of the holding gains and losses reclassified from accumulated other comprehensive income (for available-for-sale securities) and holding gains and losses previously unrecognized (for held-to-maturity securities).

How is stockholders’ equity accounted for?

In accounting for stockholders’ equity, consideration is given to preferred stock characteristics, conversion of preferred stock to common stock, stock retirement, appropriation of retained earnings, treasury stock, quasi-reorganization, dividends, fractional share warrants, stock options, stock warrants, and stock splits.

The stockholders’ equity section of the balance sheet includes major categories for:

• Capital stock (stock issued and stock to be issued)
• Paid-in capital
• Retained earnings
• Accumulated other comprehensive income
• Treasury stock

What are the types and provisions of preferred stock?

Participating preferred stock is rare. If it does exist, it may be partially or fully participating. In partially participating stock, preferred stockholders participate in excess dividends over the preferred dividend rate proportionately with common stockholders up to a maximum additional rate. For example, a 6 percent preferred stock may allow participation up to 11 percent, so that an extra 5 percent dividend may be added. In fully participating stock, a distribution for the current year is at the preference rate plus any cumulative preference. Furthermore, the preferred stockholders’ share in dividend distributions in excess of the preferred stock rate on a proportionate basis using the total par value of the preferred stock and common stock. For example, a 12 percent fully participating preferred stock will get the 12 percent preference rate plus a proportionate share based on the total par value of the common and preferred stock of excess dividends once common stockholders have obtained their matching 12 percent of par of the common stock.

Cumulative preferred stock means that if dividends are not paid, the dividends accumulate and must be paid before any dividends can be paid to noncumulative stock.

The liquidation value of preferred stock means that in corporate liquidation, preferred stockholders will receive the liquidation value (sometimes stated as par value) before any funds may be distributed to common stockholders.

Disclosure for preferred stock includes liquidation preferences, call prices, and cumulative dividends in arrears.

When preferred stock is converted to common stock, the preferred stock and paid-in capital accounts are eliminated, and the common stock and paid-in capital accounts are credited. If a deficit results, retained earnings would be charged.

What is done for retired shares?

A company may retire its stock. If common stock is retired at par value, the entry is:

If common stock is retired for less than par value, the entry is:

Common stock
	Cash
	Paid-in capital

If common stock is retired for more than par value, the entry is:

Common stock
Paid-in capital (original premium per share)
Retained earnings (excess over original premium per share)
	Cash

What is done if retained earnings must be restricted?

Appropriation of retained earnings means setting aside retained earnings and making them unavailable for dividends. Examples include appropriations for plant expansion, debt retirement, sinking fund, and general contingencies (e.g., self-insurance).

How is treasury stock accounted for and reported?

Treasury stock is issued shares bought back by the company. The two ways to account for treasury stock are:

An appropriation of retained earnings equal to the cost of the treasury stock on hand is required. Treasury stock is presented as a contra account to the common stock it applies to under the capital stock section of stockholders’ equity.

What is a quasi-reorganization?

A quasi-reorganization provides a fresh start for a financially troubled firm with a deficit in retained earnings. A quasi-reorganization occurs to avoid bankruptcy. A revaluation of assets is made.

• Stockholders and creditors must consent to the quasi-reorganization. Net assets are reduced to fair market value. If fair value is not readily determinable, then conservative estimates of such value may be made.
• Paid-in capital is reduced to eliminate the deficit in retained earnings. If paid-in capital is insufficient, then capital stock is charged.
• Retained earnings becomes a zero balance. Retained earnings will bear the quasi-reorganization date for 10 years after the reorganization.

The retained earnings account consists of these components:

Retained earnings—Unappropriated
Dividends	Net income
Appropriations
Prior-period adjustments
Quasi-reorganization

The entry for the quasi-reorganization is:

Paid-in capital
Capital stock (if necessary)
	Assets
	Retained earnings

How are dividends accounted for?

Dividends are distributions by the company to stockholders. After the declaration date is the record date. A person is qualified to receive a dividend only if he or she is the registered owner of the stock on the date of record. Several days before the date of record, the stock will be selling “ex-dividend.” This is done to alert investors that those owning the stock before the record date are entitled to receive the dividend and that those selling the stock prior to the record date will lose their rights to the dividend.

A dividend is typically in cash or stock. A dividend is based on the outstanding shares (issued shares less treasury shares).

A property dividend is payable in assets other than cash. When the property dividend is declared, the company restates the distributed asset to fair market value, recognizing any gain or loss as the difference between the fair market value and carrying value of the property at the declaration date.

A stock dividend is issued in the form of stock. Stock dividend distributable is shown in the capital stock section of stockholders’ equity. It is not a liability. If the stock dividend is less than 20 to 25 percent of outstanding shares at the declaration date, retained earnings is reduced at the market price of the shares. If the stock dividend is in excess of 20 to 25 percent of outstanding shares, retained earnings is charged at par value. Between 20 and 25 percent is a gray area.

A liability dividend (scrip dividend) is payable in the form of a liability (e.g., notes payable). This type of dividend sometimes occurs when a company has financial difficulties.

A liquidating dividend can be deceptive, for it is not actually a dividend. It is a return of capital and not a distribution of earnings. The entry is to debit paid-in capital and credit dividends payable. The recipient of a liquidating dividend pays no tax on it.

How is a stock split handled?

In a stock split, the shares are increased, and the par value per share is decreased. However, total par value is the same.

Only a memo entry is made.

How are stock options accounted for and reported?

A stock option gives a company’s officers and other employees the right to buy shares of the company’s stock, at a stated price, within a specified time period. A stock option is typically in the form of compensation or an incentive for employee services.

Noncompensatory plans are not primarily designed to give employees compensation for services. Compensation expense is not recognized. A noncompensatory plan has all four of these characteristics:

The objective of a noncompensatory plan is to obtain funds and to reduce widespread ownership in the company among employees.

Accounting for a noncompensatory stock plan is one of simple sale. The option price is the same as the issue price.

A compensatory plan exists if any one of the above four criteria is not met. Consideration received by the firm for the stock equals the cash, assets, or employee services.

ASC No. 718-10-05, Compensation—Stock Compensation: Overall (FAS No. 123(R), Share-Based Payment) eliminates the intrinsic method to account for stock option plans.

ASC No. 718-10-05 mandates that the total compensation cost that should be recognized for stock-based compensation plans be equal to the grant-date fair value of all share options that vest with employees. This amount is then allocated over the service years based on the amount of service performance that has been, or will be, performed by workers. At the date of grant, the fair value of the share options locks and cannot be changed to later changes in stock prices. Typically the service period is the vesting period, which is the time from the grant date to the vesting date. The company must estimate the number of share options that will be given to workers based on services rendered. Compensation cost should be recognized only if performance by the employee is likely to take place. Thus, compensation cost cannot be accrued if it is unlikely that employee performance will occur. An example is an expected resignation. If at a later date it is ascertained that the initial estimate of the number of share options that are likely to be earned by workers was incorrect, a revision must be made. It is required under ASC No. 718-10-05 that the cumulative effect on current and previous years of a change in the estimated number of share options for which service is expected to be, or has been, performed should be recognized as compensation in the year of the change.

The mathematical models used to measure the fair value of share options do so at a single period in time, usually the grant date. The assumptions underlying the fair value measurement are a function of available information at the time the measurement is made. Models used to value share options include the Black-Scholes-Merton option pricing model and the Lattice-based models.

Footnote disclosure for a stock option plan includes the number of shares under option, status of the plan, option price, number of shares exercisable, and the number of shares issued under the option plan during the year.

What if a bond is issued along with warrants?

If bonds are issued along with detachable stock warrants, the portion of the proceeds applicable to the warrants is credited to paid-in capital. The basis for allocation is the relative values of the securities at the time of issuance. If the warrants are not detachable, the bonds are accounted for only as convertible debt with no allocation of the proceeds to the conversion right.

How are fractional shares accounted for?

Fractional share warrants can be issued.

With respect to stockholders’ equity, disclosure should be made of the following:

• Unusual voting rights
• Call features
• Participation rights
• Dividend and liquidation preferences
• Dividends in arrears
• Sinking fund provisions
• Conversion terms
• Agreements to issue additional shares