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CHAPTER SIX

Accounting and Disclosures

THIS CHAPTER DISCUSSES the accounting involved in changes in principle, estimate, and reporting entity. Corrections of errors are also presented. In a troubled debt situation, the debtor wants relief from the creditor. Non–interest-bearing notes and futures contracts are presented. Disclosure about financial instruments with off-balance-sheet risk is discussed.

This chapter also presents disclosures for accounting policies; development-stage company reporting and disclosures; disclosures for capital structure, related parties, inflation, and business interruption insurance; and environmental reporting and disclosures.

ACCOUNTING CHANGES

The types of accounting changes as per Accounting Standards Codification (ASC) No. 250-10-05, Accounting Changes and Error Corrections: Overall (Financial Accounting Standard [FAS] No. 154, Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3) are principle, estimate, and reporting entity.

What do we do if an accounting principle is changed?

ASC No. 250-10-05 mandates retroactive application to previous years’ financial statements of changes in accounting principle. This approach is the application of a different accounting method to previous years as if that new method had always been used. If it is impractical to ascertain either the year-specific impact or the cumulative effect of the change, the newly adopted accounting method must be applied to the beginning balances of assets or liabilities of the earliest year for practical retrospective application. Further, a corresponding adjustment must be made to the beginning balance of retained earnings for that year. If the cumulative dollar effect of applying an accounting principle change to previous years is impractical, the new accounting principle must be applied as if it were adopted prospectively from the earliest practical date.

A change in depreciation, depletion, or amortization must be accounted for as a change in estimate effected by a change in principle.

What is presented in the retained earnings statement?

The retained earnings statement after a retroactive change for a change in accounting principle follows:

A footnote discloses the nature and justification of a change in principle, including an explanation of why the new principle is preferred. Justification may be a new Financial Accounting Standards Board pronouncement, new tax law, new American Institute of Certified Public Accountants statement of position or industry audit guide, or a change in circumstances, or to more readily conform to industry practice.

If an accounting change in principle is immaterial in the current year, but it is expected to be material in the future, disclosure is needed.

These are not considered a change in accounting principle:

• A principle adopted for the first time on new or previously immaterial events or transactions
• A principle adopted or changed because of events or transactions clearly different in substance

A change in composition of the cost elements (e.g., material, labor, and overhead) of inventory qualifies as an accounting change.

What if an estimate is revised?

A change in accounting estimate results from new circumstances, such as a change in salvage value or bad debt experience. A change in accounting estimate is recognized prospectively over current and future years. There is no restatement of past years. A footnote describes the nature of a material change.

If a change in estimate is coupled with a change in principle and the effects cannot be distinguished, it is accounted for as a change in estimate. For example, there may be a change from deferring and amortizing a cost to expensing it because future benefits are uncertain. This should be accounted for as a change in estimate.

How do we account for and report when the makeup of the entity is changed?

A change in reporting entity (e.g., two previously separate companies merge) is accounted for by restating previous years’ financial statements as if both companies were always combined. The restatement helps to show trends in comparative financial statements and historical summaries. The effect of the change on income before extraordinary items, net income, and per share amounts is reported for all periods presented. The restatement does not have to go back more than five years. Footnote disclosure should be made of the nature of and reason for the change in reporting entity only in the year of change. Examples of changes in reporting entity are:

• Presenting consolidated statements rather than statements of individual companies
• Including change in subsidiaries in consolidated statements or combined statements

How is a prior-period adjustment handled?

The two types of prior-period adjustments are:

When a single year is presented, prior-period adjustments adjust the beginning balance of retained earnings. The presentation follows (1/1 represents the beginning of the period; 12/31 represents the end):

Errors may arise from mathematical mistakes, misapplication of accounting principles, or misuse of facts existing when the financial statements were prepared. Furthermore, a change in principle from one that is not generally accepted accounting principle (GAAP) to one that is GAAP is an error correction. Disclosure should be made of the nature of the error and the effect of correction on profit.

When comparative statements are prepared, a retroactive adjustment for the error is made to prior years. The retroactive adjustment is disclosed by showing the effects of the adjustment on previous years' earnings and component items of net income.

What policies should be disclosed?

Accounting policies are the specific accounting principles and methods of applying them that are selected by management. Accounting policies should be those that are most appropriate in the circumstances to fairly present financial position and operating results. Accounting policies can relate to reporting and measurement methods as well as disclosures. They include:

• A selection from GAAP or unusual applications thereof
• Practices peculiar to the industry

The first footnote or a section preceding the notes to the financial statements should describe the accounting policies used.

The application of GAAP requires the use of judgment when alternative acceptable principles exist and when there are varying methods of applying a principle to a given set of facts. Disclosure of these principles and methods is essential to the full presentation of financial position and operations.

Examples of accounting policy disclosures are inventory pricing method, depreciation method, consolidation bases, and amortization period for intangibles.

Some types of financial statements do not have to describe the accounting policies that are followed. Examples are quarterly unaudited statements when there has not been a policy change since the last year-end and statements only for internal use.

What if the debtor has trouble paying?

In a troubled debt restructuring, the debtor has financial problems and is relieved of part or all of the obligation. The concession arises from the debtor–creditor agreement or law. It also applies to foreclosure and repossession. The types of troubled debt restructurings are:

• Debtor transfers to creditor receivables from third parties or other assets.
• Debtor gives creditor equity securities to satisfy the debt.
• The debt terms are modified, including reducing the interest rate, extending the maturity date, or reducing the principal of the obligation.

The debtor records an extraordinary gain (net of tax) on the restructuring while the creditor recognizes a loss. The loss may be ordinary or extraordinary, depending on whether the arrangement is unusual and infrequent. Typically, the loss is ordinary.

Debtor

The gain to the debtor equals the difference between the fair value of assets exchanged and the book value of the debt, including accrued interest. Furthermore, there may arise a gain on disposal of assets exchanged equal to the difference between the fair market value and the book value of the transferred assets. The latter gain or loss is not a gain or loss on restructuring but rather an ordinary gain or loss in connection with asset disposal.

A debtor may give the creditor an equity interest. The debtor records the equity securities issued based on fair market value, not the recorded value of the debt extinguished. The excess of the recorded payable satisfied over the fair value of the issued securities constitutes an extraordinary item.

A modification in terms of an initial debt contract is accounted for prospectively. A new interest rate may be determined based on the new terms. This interest rate is then used to allocate future payments to lower principal and interest. When the new terms of the agreement result in the sum of all the future payments to be less than the carrying value of the payable, the payable is reduced, and a restructuring gain is recorded for the difference. The future payments only reduce principal. Interest expense is not recorded.

A troubled debt restructuring may result in a combination of concessions to the debtor. This may occur when assets or an equity interest are given in partial satisfaction of the obligation and the balance is subject to a modification of terms. There are two steps.

Direct costs, such as legal fees, incurred by the debtor in an equity transfer reduce the fair value of the equity interest. All other costs reduce the gain on restructuring. If there is no gain, they are expensed.

The debtor should disclose in the footnotes:

• Terms of the restructuring agreement
• The aggregate and per share amounts of the gain on restructuring
• Amounts that are contingently payable, including the contingency terms

Creditor

The creditor's loss is the difference between the fair value of assets received and the book value of the investment. When terms are modified, the creditor recognizes interest income to the degree that total future payments are greater than the carrying value of the investment. Interest income is recognized using the effective interest method. Assets received are reflected at fair market value. When the book value of the receivable is in excess of the aggregate payments, an ordinary loss is recognized for the difference. All cash received in the future is accounted for as a recovery of the investment. Direct costs of the creditor are expensed.

The creditor does not recognize contingent interest until the contingency is removed and interest has been earned. Furthermore, future changes in the interest rate are accounted for as a change in estimate.

The creditor discloses in the footnotes:

• Loan commitments of additional funds to financially troubled companies
• Loans and/or receivables by major type
• Debt agreements in which the interest rate has been downwardly adjusted, including an explanation of the circumstances
• Description of the restructuring provisions

What if a note does not provide for interest?

If the face amount of a note does not represent the present value of the consideration given or received in the exchange, imputation of interest is needed to avoid the misstatement of profit. Interest is imputed on noninterest-bearing notes, notes that provide for an unrealistically low interest rate, and when the face value of the note is substantially different from the “going” selling price of the property or market value of the note.

If a note is issued only for cash, the note should be recorded at the cash exchanged regardless of whether the interest rate is reasonable. The note has a present value at issuance equal to the cash transacted. When a note is exchanged for property, goods, or services, there is a presumption that the interest rate is reasonable. Where the stipulated interest rate is unreasonable, the note is recorded at the fair value of the merchandise or services or at an amount that approximates fair value. If fair value is not ascertainable for the goods or services, the discounted present value of the note is used.

The imputed interest rate is the one that would have resulted if an independent borrower or lender had negotiated an arm’s-length transaction. For example, it could be the prevailing interest rate the borrower would have paid for financing. The interest rate is based on economic circumstances and events.

The factors to be taken into account in deriving an appropriate discount rate include:

• Prime interest rate
• Going market rate for similar-quality instruments
• Collateral
• Issuer's credit standing
• Restrictive covenants and other terms in the note agreement
• Tax effects of the arrangement

ASC No. 835-30-05, Interest: Imputation of Interest (Accounting Principles Board No. 21, Interest on Receivables and Payables) applies to long-term payables and receivables. Short-term payables and receivables are typically recorded at face value. The pronouncement is not applicable to:

• Receivables or payables occurring within the ordinary course of business
• Security deposits
• Amounts that do not require repayment
• Transactions between parent and subsidiary

The difference between the face value of the note and its present value represents discount or premium that has to be accounted for as an element of interest over the life of the note. Present value of the payments of the note is based on an imputed interest rate.

The interest method is used to amortize the discount or premium on the note. The interest method results in a constant rate of interest. Under the method, amortization equals:

Interest expense is recorded for the borrower, whereas interest revenue is recorded for the lender. Issuance costs are treated as a deferred charge.

The note payable and note receivable are presented in the balance sheet in this way:

FUTURES CONTRACTS

Should you engage in futures contracts?

A futures contract is a legal arrangement between the purchaser or seller and a regulated futures exchange in the United States or overseas. Futures contracts involve:

• A buyer or seller receiving or making a delivery of a commodity or financial instrument (e.g., stocks, bonds, commercial paper, mortgages) at a specified date. Cash settlement rather than delivery typically exists (e.g., stock index future).
• The elimination of a futures contract before the delivery date by engaging in an offsetting contract for the particular commodity or financial instrument. For example, a futures contract to buy 200,000 pounds of a commodity by December 31, 2X11, may be canceled by entering into another contract to sell 200,000 pounds of that same commodity on December 31, 2X11.
• Regular (e.g., daily) settlement changes in value of open contracts. The usual contract provides that when a decrease in the contract value occurs, the contract holder has to make a cash deposit for such a decline with the clearinghouse. If the contract increases in value, the holder may withdraw the increased value.

The change in the market value of a futures contract involves a gain or loss that should be recognized in earnings. An exception exists that for certain contracts the timing of income statement recognition relates to the accounting for the applicable asset, liability, commitment, or transaction. This accounting exception applies when the contract is designed as a hedge against price and interest rate fluctuation. When the criteria discussed in the next section are satisfied, the accounting for the contract relates to the accounting for the hedged item. Thus, a change in market value is recognized in the same accounting period that the effects of the related changes in price or interest rate of the hedged item are reflected in income.

What is a hedge?

A hedge exists when both of these criteria are met:

A change in market value of a futures contract that meets the hedging criteria of the related asset or liability adjusts the carrying value of the hedged item. For example, a company has an investment in a government bond that it expects to sell in the future. The company can reduce its susceptibility to changes in fair value of the bonds by entering into a futures contract. The changes in the market value of the futures contract adjusts the book value of the bonds.

A change in market value of a futures contract that is for the purpose of hedging a firm commitment is included in measuring the transaction satisfying the commitment. An example is when the company hedges a firm purchase commitment by using a futures contract. When the acquisition takes place satisfying the purchase commitment, the gain or loss on the futures contract is an element of the cost of the acquired item. Assume ABC Company has a purchase commitment for 30,000 pounds of a commodity at $2 per pound, totaling $60,000. At the time of the consummation of the transaction, the $60,000 cost is decreased by any gain (e.g., $5,000) arising from the “hedged” futures contract. The net cost is shown as the carrying value (e.g., $55,000).

A futures contract may apply to transactions the company expects to carry out in the ordinary course of business. It is not obligated to do so. These expected transactions do not involve existing assets or liabilities, or transactions applicable to existing firm commitments. For example, perhaps your company anticipates buying a commodity in the future but has not made a formal purchase commitment. The company may minimize risk exposure to price changes by making a futures contract. The change in market value of this anticipatory hedge contract is included in measuring the subsequent transaction. The change in market value of the futures contract adjusts the cost of the acquired item. The next four criteria must be satisfied for anticipatory hedge accounting. (Note that items 1 and 2 are the same as the criteria for regular hedge contracts related to existing assets, liabilities, or firm commitments.)

Probability of occurrence depends on:

• Monetary commitment
• Time period
• Financial soundness to conduct the transaction
• Frequency of previous transactions of a similar nature
• Adverse operational effects of not engaging in the transaction
• Possibility that other types of transactions may be undertaken to accomplish the desired objective

How do we account for and disclose hedge-type contracts?

The accounting for a hedge-type futures contract related to an expected asset acquisition or liability incurrence should be consistent with the company’s accounting method used for those assets and liabilities. For example, the company should recognize a loss for a futures contract that is a hedge of an expected inventory acquisition if the amount will not be removed from the sale of inventory.

If a hedged futures contract is closed before the expected transaction, the accumulated value change in the contract should be carried forward in measuring the related transaction. If it is probable that the quantity of an expected transaction will be less than the amount initially hedged, the company should recognize a gain or loss for a pro rata portion of futures results that would have been included in the measurement of the subsequent transaction.

A hedged futures contract requires disclosure of:

• Nature of assets and liabilities
• Accounting method used for the contract, including a description of events resulting in recognizing changes in contract values
• Expected transactions that are hedged with futures contracts
• Firm commitments

What footnote information should be presented for financial instruments?

Disclosure is required of information about financial instruments with off-balance-sheet risk and financial instruments with concentrations of credit risk. A financial instrument is defined as cash, evidence of an ownership interest in another entity, or a contract that both (1) imposes on one entity a contractual obligation to deliver cash or another financial instrument to a second entity, or to exchange financial instruments on unfavorable terms, and (2) conveys to the second entity a contractual right to receive cash, another financial instrument, or exchange financial instruments on favorable terms with the first entity. Examples of financial instruments include letters of credit or loan commitments written, foreign currency or interest rate swaps, financial guarantees written, forward or futures contracts, call and put options written, and interest rate caps or floors written.

The company must disclose information about financial instruments that may result in future loss but have not been recognized in the accounts as liabilities and are thus not reported in the income statement or balance sheet. A financial instrument has an off-balance-sheet risk of accounting loss if the risk of loss exceeds the amount recognized as an asset (if any), or if the ultimate obligation may exceed the amount recognized as a liability.

These points must be footnoted:

• The face amounts of the financial instruments
• The extent, nature, and terms of the financial instruments, including any cash requirements
• The entity’s policy for requiring security on financial instruments it accepts
• Identification and description of collateral
• A discussion of credit risks associated with financial instruments because of the failure of another party to perform
• A discussion of market risk that will make a financial instrument less valuable, including future changes in market prices caused by foreign exchange and interest rate fluctuations
• Information about a region, activity, or economic factor that may result in a concentration of credit risk
• The potential loss from the financial instrument if a party fails to perform under the contract
• The entity’s accounting policies for financial instruments

VARIOUS DISCLOSURES

What environmental reporting and disclosures are required?

CFOs must be cognizant of compliance regulations with respect to environmental matters. Failure to adhere to environmental laws could result in penalties and fines. The CFO must be assured that the company is following relevant accounting, reporting, and disclosures for environmental issues.

Depending on the circumstances, a liability and/or footnote disclosure may be required for pollution, waste disposal, radiation, ocean dumping, corrosion and leakage, oil spills, and hazardous materials and chemicals. Examples of footnote disclosures are:

• Water or air pollution
• Contamination resulting in health or safety hazards
• Information on site remediation projects
• Legal and regulatory compliance issues (e.g., cleanup responsibility)

Actual environmental costs should be compared to what was budgeted with variances determined. Environmental cost trends should be noted.

What capital structure information should be disclosed?

As per ASC No. 505-10-50, Equity: Overall (FAS No. 129, Disclosure of Information about Capital Structure), companies must disclose the rights and privileges of common and preferred stockholders, such as conversion terms, sinking fund provisions, redemption requirements, participation rights, liquidation preferences, voting rights, and terms for additional issuances.

What related party disclosures are required?

According to ASC No. 850-10-05, Related Party Disclosures: Overall (FAS No. 57, Related Party Disclosures), related party relationships and transactions must be disclosed. Related party transactions include parent–subsidiary relationships, activities between affiliates, joint ventures, and transactions between the company and its principal owners. Related party transactions take place when a transacting party can materially influence or exercise control of another transacting party owing to a financial, common ownership, or familial relationship. They may also occur when a nontransacting party can significantly affect the policies of two other transacting parties.

Related party transactions may include sales, purchases, services, loans, rentals, and property transfers.

It is presumed that related party transactions are not at arm’s length. Examples are services billed at higher-than-usual rates, a loan at a very low interest rate, unusual pledges or guarantees, a very low rental, and merchandise purchased at unusually low prices.

Related party disclosures include:

• Transaction terms and amounts
• Nature and substance of the relationship
• Year-end balances due or owed
• Control relationships

What should be disclosed for business interruption insurance?

Disclosure should be made of the event resulting in losses from business interruption, including the total amount received from insurance and where such amounts are presented in the income statement.

What inflation information should be disclosed?

As per ASC No. 255-10-50, Accounting Changes and Error Corrections: Overall (FAS No. 89, Financial Reporting and Changing Prices), a company can voluntarily disclose inflation data so that management and financial statement users can better appraise inflationary impact on the company. Selected summarized financial data may be presented in both current costs and constant purchasing power (Consumer Price Index adjusted). Inflation disclosures may be for revenue, expenses, income from continuing operations, cash dividends per share, market price of stock, inventory, fixed assets, and liabilities.

What are the reporting, presentation, and disclosure requirements for development-stage companies?

A development-stage company must follow the same GAAP as an established company. A balance sheet, income statement, and statement of cash flows are presented. The balance sheet shows the cumulative net losses as a deficit. The income statement presents both cumulative and current-year figures for revenue and expenses. The statement of cash flows discloses cumulative cash receipts and cash payments. The stockholders’ equity statement presents for each equity security from inception the date and number of shares issued and dollar figures per share for cash and noncash consideration. The financial statements must be headed “Development-Stage Company.” A footnote should disclose the development-stage activities. In the first year the business is out of the development stage, it should disclose that in prior years it was in the development stage.