1   ASC 105 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

Perspectives and Issues

What is GAAP?

Definitions of Terms

Concepts, Rules, and Examples

History of GAAP

Pre Codification GAAP Hierarchy

Other sources

GAAP Codification

Standards-setting Process

Emerging Issues Task Force

Accounting Standards Updates

Maintenance Updates

American Institute of Certified Public Accountants

Researching GAAP Problems

Codification Structure

Research Procedures

Step 1: Identify the Problem

Step 2: Analyze the Problem

Step 3: Refine the Problem Statement

Step 4: Identify Plausible Alternatives

Step 5: Develop a Research Strategy

Step 6: Search Authoritative Literature

Step 7: Evaluation

Search Authoritative Literature (Step 6)—Further Explanation

Researching Wiley GAAP

Researching nonpromulgated GAAP

Internet-based research sources

The Concept of Materiality

The Conceptual Framework

Components of the conceptual framework

CON 8: Conceptual Framework for Financial Reporting

CON 8—Chapter 1: The Objective of General Purpose Financial Reporting

CON 8—Chapter 3: Qualitative Characteristics of Useful Financial Information.

CON 5: Recognition and Measurement in Financial Statements of Business Enterprises

CON 6: Elements of Financial Statements

Definitions of terms

Elements of not-for-profit financial statements

CON 7: Using Cash Flow Information and Present Value in Accounting Measurements

How CON 7 measures differ from previously utilized present value techniques

Measuring liabilities

Interest method of allocation

Accounting for changes in expected cash flows

Application of present value tables and formulas

Example of the relevance of present values

Practical matters

PERSPECTIVES AND ISSUES

What Is GAAP?

The FASB Accounting Standards Codification™ (ASC) is the

In the absence of authoritative guidance, the FASB Codification (the Codification) offers the following approach.

The Codification lists some possible nonauthoriative sources:

• Practices that are widely recognized and prevalent either generally or in the industry
• FASB Concepts Statements
• American Institute of Certified Public Accountants (AICPA) Issues Papers
• International Financial Reporting Standards of the International Accounting Standards Board
• Pronouncements of professional associations or regulatory agencies
• Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids
• Accounting textbooks, handbooks, and articles.

  (ASC 105-10-05-3)

GAAP establishes

• The measurement of economic activity,
• The time when such measurements are to be made and recorded,
• The disclosures surrounding this activity, and
• The preparation and presentation of summarized economic information in the form of financial statements.

GAAP develops when questions arise about how to best accomplish those items. In response to those questions, GAAP is either prescribed in official pronouncements of authoritative bodies empowered to create it, or it originates over time through the development of customary practices that evolve when authoritative bodies fail to respond. Thus, GAAP is a reaction to and a product of the economic environment in which it develops. As such, the development of accounting and financial reporting standards has lagged the development and creation of increasingly intricate economic structures and transactions.

There are two broad categories of accounting principles—recognition and disclosure. Recognition principles determine the timing and measurement of items that enter the accounting cycle and impact the financial statements. These are quantitative standards that require economic information to be reflected numerically.

Disclosure principles deal with factors that are not always numeric. Disclosures involve qualitative information that is an essential ingredient of a full set of financial statements. Their absence would make the financial statements misleading by omitting information relevant to the decision-making needs of the reader. Disclosure principles complement recognition principles by explaining assumptions underlying the numerical information and providing additional information on accounting policies, contingencies, uncertainties, etc., which are essential to fully understand the performance and financial condition of the reporting enterprise.

DEFINITIONS OF TERMS

(Source: ASC 105-10-20 Glossary)

Nongovernmental Entity. An entity that is not required to issue financial reports in accordance with guidance promulgated by the Governmental Accounting Standards Board or the Federal Accounting Standards Advisory Board.

Nonpublic Entity. Any entity that does not meet any of the following conditions:

1. Its debt or equity securities trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally.
2. It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
3. It files with a regulatory agency in preparation for the sale of any class of debt or equity securities in a public market.
4. It is required to file or furnish financial statements with the Securities and Exchange Commission.
5. It is controlled by an entity covered by criteria (a) through (d).

CONCEPTS, RULES, AND EXAMPLES

History of GAAP

From time to time, the bodies given responsibility for the promulgation of GAAP have changed, and indeed more than a single such body has often shared this responsibility. In response to the stock market crash of 1929, the AICPA appointed the Committee on Accounting Procedure. This was superseded in 1959 by the Accounting Principles Board (APB) created by the AICPA. Because of operational problems, in 1972 the profession replaced the APB with a three-part organization consisting of the Financial Accounting Foundation (FAF), Financial Accounting Standards Board (FASB), and the Financial Accounting Standards Advisory Council (FASAC). Since 1973 the FASB has been the organization designated to establish standards of financial reporting.

FASB is recognized as authoritative by the SEC, reaffirmed through the Sarbanes-Oxley Act of 2002, and by the AICPA through Rule 203 of the AICPA Code of Professional Conduct. FASB is an independent body relying on the FAF for selection of its members and approval of its budgets. FASB is supported by the sale of its publications and by fees assessed on all public companies based on their market capitalizations as mandated by the Sarbanes-Oxley Act.

From its inception through the mid-2009 implementation of the Accounting Standards Codification, FASB issued several types of pronouncements and used the following GAAP hierarchy (FAS 162, The Hierarchy of Generally Accepted Accounting Principles).

Pre Codification GAAP Hierarchy

Other sources.

Not all GAAP has resulted from the issuance of pronouncements by authoritative bodies. For example, depreciation methods such as straight-line and declining balance have both long been acceptable. There are, however, no definitive pronouncements that can be found to state this. Furthermore, there are many disclosure principles that evolved into general accounting practice because they were originally required by the SEC in documents submitted to them. Even much of the content of statements of financial position and income statements has evolved over the years in the absence of adopted standards.

GAAP Codification

FASB completed its project to codify GAAP in 2009. On July 1, 2009, the Codification became the single official source of authoritative, nongovernmental US generally accepted accounting principles. It superseded all nongrandfathered (see ASC105-10-70-2 for a list of grandfathered guidance), non-SEC accounting guidance, that is, extant FASB, AICPA, EITF, and related literature. After that date, only one level of authoritative GAAP existed, excluding the guidance issued by the Securities and Exchange Commission (SEC). All other literature is nonauthoritative. In effect, therefore, all former Category A-D GAAP was compressed to two levels.

The Codification did not change GAAP, but rather introduced a new structure—one that is organized into an easily accessible, user-friendly online research system. The Codification reorganizes the large number of discrete US GAAP pronouncements into roughly 90 accounting Topics, and displays all Topics using a consistent structure.

Also included in the Codification is relevant SEC guidance, which follows the same topical structure, used throughout the Codification. This represents a departure from past practice, since it was not previously included in official GAAP guidance (although it obviously was binding on publicly held reporting entities, and was to be given some consideration as “category E” hierarchy literature even by nonissuers). To increase the utility of the Codification for public companies, relevant portions of authoritative content issued by the SEC and selected SEC staff interpretations and administrative guidance are being included for reference in the Codification. The sources include:

• Regulation S-X,
• Financial Reporting Releases (FRR)/Accounting Series Releases (ASR),
• Interpretive Releases (IR), and
• SEC staff guidance in:
  • Staff Accounting Bulletins (SAB),
  • EITF Topic D and SEC Staff Observer comments.

The Codification does not, however, incorporate the entire population of SEC rules, regulations, interpretive releases, and staff guidance, such as content related to matters outside of the basic financial statements, including Management's Discussion and Analysis (MD&A), or to auditing or independence matters.

Standards-setting Process

The FASB has long adhered to rigorous “due process” when creating new guidance. The goal is to involve constituents who would be affected by the newly issued guidance so that the standards created will result in information that reports economic activity as objectively as possible without attempting to influence behavior in any particular direction. Ultimately, however, the guidance is the judgment of the FASB, based on research, public input, and deliberation. The FASB's due process procedures are described below.

The FASB receives requests for new standards from all parts of its diverse constituency, including auditors, industry groups, the EITF, and the SEC. Requests for action include both suggestions for new topics and suggestions for reconsideration of existing pronouncements. In consultation with the FASB Members and others, and subject to FAF oversight, the FASB Chairman decides whether or not to add a project to the technical agenda. The FASB begins by appointing an advisory group, which may be a task force or advisory committee of outside experts. Care is taken to ensure that various points of view are represented in the advisory group. The group meets with and advises the Board and staff on the definition and scope of the project and the nature and extent of any additional research that may be needed. The FASB and its staff then debate the significant issues in the project and arrive at tentative conclusions. As it does so, the FASB and its staff study existing literature on the subject and conduct or commission any additional research as needed. The advisory group meetings and the Board meetings are open to public observation, and a public record is maintained. Many of these proceedings are also available by live or archived audio Webcast as well as via telephone. The basis of discussion for the meetings may be a Discussion Paper or an Exposure Draft.

Any individual or organization may request to speak at the public hearing, which is conducted by the FASB and the staff assigned to the project. Public observers are welcome. After each individual speaks, the FASB and staff ask questions. Questions are based on written material submitted by the speakers prior to the hearing as well as on the speaker's oral comments. In addition to the hearing, the staff analyzes all the written comments submitted. The FASB members study this analysis and read the comment letters to help them reach conclusions. The hearing transcript and written comments become part of the public record.

After the comment letters and oral presentations responding to the discussion document are considered, formal deliberations begin. (If the accounting problem is not as complex and no discussion document was issued, the due process begins at this point.) The FASB deliberates at meetings that are open to public observation, although observers do not participate in the discussions. The agenda for each meeting is announced in advance. Prior to each Board meeting, the staff presents a written analysis and recommendations of the issues to be discussed. During the meeting, the staff presents orally a summary of the written materials and the Board discusses each issue presented. The Board meets as many times as is necessary to resolve the issues.

When the Board has reached tentative conclusions on all the issues in the project, the staff prepares an Exposure Draft. The Exposure Draft sets forth the Board's conclusions about the proposed standards of financial accounting and reporting, the proposed effective date and method of transition, background information, and an explanation of the basis for the Board's conclusions. The Board reviews, and if necessary, revises, the Exposure Draft. Then, a vote is taken about whether the Exposure Draft can be published for public comment. A majority of the Board members must vote to approve an Exposure Draft for issuance for comment. If four votes are not obtained, the FASB holds additional meetings and redrafts the Exposure Draft.

Any individual or organization can provide comments about the conclusions in the Exposure Draft during the exposure period, which is generally sixty days or more. The Board may also decide to have a public hearing to hear constituents' views. At the conclusion of the comment period, all comment letters and oral presentations are analyzed by the staff, and the Board members read the letters and the staff analysis. Then, the Board is ready to re-deliberate the issues, with the goal of issuing final accounting standards.

All Board meetings are open to the public. During these meetings, the Board considers the comments received and may revise their earlier conclusions. If substantial modifications are made, the Board will issue a revised Exposure Draft for additional public comment. If so, the Board also may decide that another public hearing is necessary. When the Board is satisfied that all reasonable alternatives have been adequately considered, the staff drafts the proposed provisions. The Board deliberates the provisions and, if approved, the Board issues an Accounting Standards Update describing amendments to the Accounting Standards Codification. Once issued, the provisions become GAAP after the stated effective date.

Emerging Issues Task Force.

The Emerging Issues Task Force (EITF) was formed in 1984 by the FASB to assist the Board in identifying current or emerging issues and implementation problems before divergent practices become entrenched. The guidance provided has often been restricted to narrow issues that were of immediate interest and importance. Task Force members are drawn primarily from public accounting firms but also include individuals who would be aware of issues and practices that should be considered by the group.

For each EITF agenda item, an issues paper is developed by members, their firms, or the FASB staff. These issues may be in especially narrow areas having little broad-based interest. Occasionally, FASB may include a narrow issue in the scope of a broader project and reaffirm or supersede the work of the Task Force. After discussion by the Task Force, a consensus may be reached on the issue, in which case the consensus is referred to the FASB for ratification. If the EITF consensus is approved by the FASB, it amends the FASB Codification through an ASU.

Accounting Standards Updates.

Accounting Standards Updates (ASUs) are composed of:

• A summary of the key provisions of the project that led to the changes,
• The specific changes to the Codification, and
• The Basis for Conclusions.

The title of the combined set of new guidance and instructions is Accounting Standards Update YYXX, where YY is the last two digits of the year and XX is the sequential number for each update. For example, the combined numbers would be 13-01, 13-02, etc. All authoritative GAAP issued by the FASB is issued in this format.

The FASB organizes the content of ASUs using the same Section headings as those used in the Codification. The ASU instructions display marked changes to the pertinent sections of the Codification. ASUs are not deemed authoritative in their own right; instead, they serve only to update the Codification and provide the historical basis for conclusions.

As with former practice, when certain standards and other guidance were issued with delayed effective dates, the Codification includes materials that may not yet be mandatorily effective. The content from updates that is not yet fully effective for all reporting entities appears in the Codification as boxed text and is labeled as pending content. The pending content text box includes the earliest transition date and a link to the related transition guidance, also found in the Codification.

For reference purposes, the Codification permits backward tracing to the actual literature from which the Codification was derived. Accounting Standards Updates add to or amend the Codification only, and no stand-alone FASB Statements or other guidance are promulgated. (ASC 105-10-0505)

Maintenance Updates.

As with any publishing practice, irregularities occur. To make necessary corrections, the FASB staff issues Maintenance Updates. These are not addressed by the Board and contain non substantive editorial changes and link-related changes.

American Institute of Certified Public Accountants.

Although it currently plays a greatly reduced standards-setting role, the American Institute of Certified Public Accountants (AICPA) has authorized the Financial Reporting Executive Committee (FinREC) to determine the AICPA's policies on financial reporting standards and to speak for the AICPA on accounting matters. FinREC, formerly the Accounting Standards Executive Committee (AcSEC), is the senior technical committee at the AICPA. It is composed of sixteen volunteer members, representative of industry, analysts, and both national and regional public accounting firms. All FinREC members are CPAs and members of the AICPA.

Researching GAAP PROBLEMS

The research procedures presented here are intended to serve as a general model for approaching research on accounting issues or questions you may have. These procedures should be refined and adapted to each individual fact situation.

Codification Structure.

The FASB has compiled the Codification into a Web site, located at http://asc.fasb.org/home. The site is intended to be easily searchable for research purposes. This section provides an overview of the site's contents and search functionality.

Areas. On all pages of the site, all categories of the Codification are listed down the vertical menu bar on the left side of the page, revealing the following Areas, and the numbering series for each one:

• General Principles (100) (Establishes the Codification as the source of GAAP.
• Presentation—(200) (Topics in this area relate only to presentation matters; they do not address recognition, measurement, and derecognition matters. Examples of these topics are income statement, balance sheet, and earnings per share.)
• Assets (300).
• Liabilities (400).
• Equity (500).
• Revenue (600).
• Expenses (700). (Clusters all types of expense-related GAAP into five broad categories, which are cost of goods sold, research and development, compensation, income taxes, and other expenses).
• Broad Transactions (800). (Contains the major transactional topics, such as business combinations, derivatives, and foreign currency matters.)
• Industry (900). (Itemizes GAAP for specific industries, such as entertainment, real estate, and software.)
• Master Glossary.

Topics. The Codification content is arranged by Area and then further divided by Topics, Subtopics, Sections, and Subsections. FASB has developed a classification system specifically for the Codification. The following is the structure of the classifications system: XXX-YY-ZZ-PP, where XXX = topic, YY = subtopic, ZZ = section and PP = paragraph. An “S” preceding the section number denotes SEC guidance. At the most granular level of detail, the Codification has a two-digit numerical code for a standard set of categories.

The numbering series indicated next to each bullet point above shows the three-digit number assigned to each topic. For example, the Presentation topic contains a number of subtopics, all indexed with numbers in the 200 range; the Balance Sheet subtopic is numbered 210, while the Interim Reporting subtopic is numbered 270. These index numbers become more apparent while perusing the submenus attached to each primary topic. For example, the submenu for the Presentation topic reveals 15 subcategories, numbered from 205 (for Presentation of Financial Statements) to 280 (for Segment Reporting). Below are the Codification Topics by Area. The entire numbering system is noted in the Codification Taxonomy section that precedes Chapter 1.

Codification Topics

General Principles

105 Generally Accepted Accounting Principles

Presentation

205 Presentation of Financial Statements

210 Balance Sheet

215 Statement of Shareholder Equity

220 Comprehensive Income

225 Income Statement

230 Statement of Cash Flows

235 Notes to Financial Statements

250 Accounting Changes and Error Corrections

255 Changing Prices

260 Earnings per Share

270 Interim Reporting

272 Limited Liability Entities

274 Personal Financial Statements

275 Risks and Uncertainties

280 Segment Reporting

Assets

305 Cash and Cash Equivalents

310 Receivables

320 Investments—Debt and Equity Securities

323 Investments—Equity Method and Joint Ventures

325 Investments—Other

330 Inventory

340 Other Assets and Deferred Costs

350 Intangibles—Goodwill and Other

360 Property, Plant, and Equipment

Liabilities

405 Liabilities

410 Asset Retirement and Environmental Obligations

420 Exit or Disposal Cost Obligations

430 Deferred Revenue

440 Commitments

450 Contingencies

460 Guarantees

470 Debt

480 Distinguishing Liabilities from Equity

Equity

505 Equity

Revenue

605 Revenue Recognition

Expenses

705 Cost of Sales and Services

710 Compensation—General

712 Compensation—Nonretirement Postemployment Benefits

715 Compensation—Retirement Benefits

718 Compensation—Stock Compensation

720 Other Expenses

730 Research and Development

740 Income Taxes

Broad Transactions

805 Business Combinations

808 Collaborative Arrangements

810 Consolidation

815 Derivatives and Hedging

820 Fair Value Measurement

825 Financial Instruments

830 Foreign Currency Matters

835 Interest

840 Leases

845 Nonmonetary Transactions

850 Related Party Disclosures

852 Reorganizations

855 Subsequent Events

860 Transfers and Servicing

Industry

905 Agriculture

908 Airlines

910 Contractors—Construction

912 Contractors—Federal Government

915 Development Stage Entities

920 Entertainment—Broadcasters

922 Entertainment—Cable Television

924 Entertainment—Casinos

926 Entertainment—Films

928 Entertainment—Music

930 Extractive Activities—Mining

932 Extractive Activities—Oil and Gas

940 Financial Services—Broker and Dealers

942 Financial Services—Depository and Lending

944 Financial Services—Insurance

946 Financial Services—Investment Companies

948 Financial Services—Mortgage Banking

950 Financial Services—Title Plant

952 Franchisors

954 Health Care Entities

958 Not-for-Profit Entities

960 Plan Accounting—Defined Benefit Pension Plans

962 Plan Accounting—Defined Contribution Pension Plans

965 Plan Accounting—Health and Welfare Benefit Plans

970 Real Estate—General

972 Real Estate—Common Interest Realty Associations

974 Real Estate—Real Estate Investment Trusts

976 Real Estate—Retail Land

978 Real Estate—Time-Sharing Activities

980 Regulated Operations

985 Software

995 U.S. Steamship Entities

Subtopics. Subtopics represent subsets of a topic and are typically identified by type or by scope. For example, operating leases and capital leases are two separate subtopics of the leases topic. Each topic contains an overall subtopic that generally represents the pervasive guidance for the topic, which includes guidance that applies to all other subtopics. Each additional subtopic represents incremental or unique guidance not contained in the overall subtopic.

Sections. Sections represent the nature of the content in a subtopic—for example, recognition, measurement, and disclosure. The sectional organization for all subtopics is the same. In a manner similar to that used for topics, sections correlate closely with sections of individual International Accounting Standards. Sections are further broken down into subsections, paragraphs, and subparagraphs, depending on the specific content of each section.

Finding Information. By drilling down through the various topics and subtopics in the sidebar of the online Codification, a researcher can eventually locate the relevant GAAP information. However, there are other ways to access GAAP information through the Codification site that may prove to be easier.

• Cross-referencing. If the researchers know the reference number of an original GAAP source document, such as an EITF consensus or a FASB Staff Position, then they can enter this information through the Cross-Reference tab, which is located at the top center of the Codification home page. A By Standard search box will appear, where the researchers can select from a drop-down menu containing three-digit abbreviations for all of the various GAAP source documents. For example, FSP represents the FASB Staff Positions, while APB represents the Accounting Principles Board Opinions. After making a selection from this menu, the available list of all corresponding documents will appear next to it, in the Standard Number drop-down menu. Selecting a document from this list will bring up the corresponding topic, subtopic, section, and paragraph number in the Codification, as well as a hyperlink to the underlying text.
• Codification search. If the researchers are searching for specific words or phrases, then the best search tool is the Codification search bar, which is located in the upper right corner of any page on the site. To use it for a precision search, enter quotes around the search text; for a less precise search that returns individual words within the search text, do not use quotes.

Codification Terminology. With issuance of the Codification, the FASB standardized on the term “entity” to replace terms such as company, organization, enterprise, firm, preparer, etc. So, too, the Codification uses “shall” throughout to replace “should,” “shall,” “is required to,” “must,” etc. The FASB believes these terms all represent the same concept—the requirement to apply a standard. “Would” and “should” are used to indicate hypothetical situations. To reduce ambiguity, the Codification also eliminated qualifying terminology, such as usually, ordinarily, generally, and similar terms

Research Procedures

Step 1: Identify the problem.

It has been observed that the mere act of defining a problem contributes mightily to solving the problem. This certainly applies to the domain of researching financial reporting issues, as well. Most often it is found that incorrect answers (e.g., regarding the proper way to report revenue-producing activities) flow from improper definition of the actual question to be resolved. Provisional definitions of problems should be vigorously challenged before attempting to search for solutions. The process to be employed is to

• Gain an understanding of the problem or question.
• Challenge the tentative definition of the problem and revise, as necessary.
• Problems and research questions can arise from new authoritative pronouncements, changes in a firm's economic operating environment, or new transactions, as well as from the realization that the problem had not been properly defined in the past.
• If proposed transactions and potential economic circumstances are anticipated, more deliberate attention can be directed at finding the correct solution, and certain proposed transactions having deleterious reporting consequences might be avoided altogether or structured more favorably.
• If little is known about the subject area, it may be useful to consult general reference sources (e.g., Journal of Accountancy, CPA Journal, Bloomberg Businessweek, Wall Street Journal) to become more familiar with the topic, that is, the basic what, why, how, when, who, and where. Web-based research vastly expands the ability to gather useful information.
• Ensure that you have sufficiently determined whether the issue you are researching is a GAAP issue or is an auditing issue so that your search is directed to the appropriate literature.

Step 2: Analyze the problem.

• Identify critical factors, issues, and questions that relate to the research problem.
• What are the options? Brainstorm possible alternative accounting treatments.
• What are the goals of the transaction? Are these goals compatible with full and transparent disclosure and recognition?
• What is the economic substance of the transaction, irrespective of the manner in which it appears to be structured?
• What limitations or factors can impact the accounting treatment?

Step 3: Refine the problem statement.

• Clearly articulate the critical issues in a way that will facilitate research and analysis.

Step 4: Identify plausible alternatives.

• Plausible alternative solutions are based upon prior knowledge or theory.
• Additional alternatives may be identified as Steps 5-7 are completed.
• The purpose of identifying and discussing different alternatives is to be able to respond to key accounting issues that arise out of a specific situation.
• The alternatives are the potential methods of accounting for the situation from which only one will ultimately be chosen.
• Exploring alternatives is important because many times there is no single cut-and-dried financial reporting solution to the situation.
• Ambiguity often surrounds many transactions and related accounting issues and, accordingly, the accountant and business advisor must explore the alternatives and use professional judgment in deciding on the proper course of action.

Step 5: Develop a research strategy.

• Determine which literature to search. This requires access to, and an understanding of, the Accounting Standards Codification™ promulgated by FASB. The topic-based organization of this material should facilitate conducting such research, allowing the user to zero in on a detailed-level issue by beginning with a broad topic definition.
• Generate keywords or phrases that will form the basis of an electronic search.
• Consider trying a broad search to
  • Assist in developing an understanding of the area,
  • Identify appropriate search terms, and
  • Identify related issues and terminology.
• Consider trying very precise searches to identify whether there is authoritative literature directly on point.

Step 6: Search authoritative literature (described in additional detail below).

This step involves implementation of the research strategy through searching, identifying, and locating applicable information.

• Research published GAAP.
• Research using Wiley GAAP.
• Research other literature.
• Research practice.
• Use theory.
• Find analogous events and/or concepts that are reasonably similar.

Step 7: Evaluation.

• Analyze and evaluate all of the information obtained.
• This evaluation should lead to the development of a solution or recommendation. Again, it is important to remember that Steps 3–7 describe activities that will interact with each other and lead to a more refined process in total, and a more complete solution. These steps may involve several iterations.

Search Authoritative Literature (Step 6)—Further Explanation

The following sections discuss in more detail how to search authoritative literature as outlined in Step 6.

Researching Wiley GAAP.

This publication can assist in researching GAAP for the purpose of identifying technical answers to specific inquiries. You can begin your search in one of two ways: by using the contents page at the front of this book to determine the chapter in which the answer to your question is likely to be discussed, or by using the index at the back of this publication to identify specific pages of the publication that discuss the subject matter relating to your question. The path chosen depends in part on how specific the question is; an initial reading of the chapter or relevant section thereof will provide a broader perspective on the subject. However, if one's interest is more specific, it might be better to search the index, because securitizations are a very specialized type of transaction involving receivables and are addressed in only a few pages of the text.

Each chapter in this publication is organized in the following manner:

• A chapter table of contents on the first page of the chapter
• Perspective and Issues, providing an overview of the chapter contents (noting any current controversy or proposed GAAP changes affecting the chapter's topics) and a list of major topics and subtopics in the FASB Accounting Standards Codification relevant to the chapter's topics.
• Definition of Terms, defining any specialized terms unique to the chapter's subject matter
• Concepts, Rules, and Examples, setting forth the detailed guidance and examples.

After reading the relevant portions of this publication, the list of major topics and subtopics in the Codification can be used to find the sections in the Codification that are related to the topic, so that these can be appropriately understood and cited in documenting your research findings and conclusions. Readers familiar with the professional literature can use the Codification Taxonomy that precedes this chapter to quickly locate the pages in this publication relevant to each specific pronouncement. The reader can therefore locate more detail on each topic covered in this publication, and also be aware of those few, highly specialized topics and pronouncements not covered within this publication.

Researching nonpromulgated GAAP.

Researching nonpromulgated GAAP consists of reviewing pronouncements in areas similar to those being researched, reading accounting literature mentioned in ASC 105-10-05-3 and earlier in this chapter as “other sources,” and careful reading of the relevant portions of the FASB Conceptual Framework (summarized later in this chapter). Understanding concepts and intentions espoused by accounting experts can give the essential clues to a logical formulation of alternatives and conclusions regarding problems that have not yet been addressed by the standard-setting bodies.

Both the AICPA and FASB publish a myriad of nonauthoritative literature. FASB publishes the documents it uses in its due process: Discussion Papers, Invitations to Comment, Exposure Drafts, and Preliminary Views as well as minutes from its meetings. It also publishes research reports, newsletters, and implementation guidance. The AICPA publishes Technical Practice Aids, Issues Papers, Technical Questions and Answers, Audit and Accounting Guides, as well as comment letters on proposals of other standard-setting bodies, and the monthly periodical, Journal of Accountancy. Technical Practice Aids are answers published by the AICPA to questions about accounting and auditing standards. AICPA Issues Papers are research documents about accounting and reporting problems that the AICPA believes should be resolved by FASB. They provide information about alternative accounting treatments used in practice.

The Securities and Exchange Commission issues Staff Accounting Bulletins and makes rulings on individual cases that come before it. These rulings create and impose accounting standards on those whose financial statements are to be submitted to the Commission. The SEC, through acts passed by Congress, has been given broad powers to prescribe accounting practices and methods for all statements filed with it.

Governmental agencies such as the Government Accountability Office, the Federal Accounting Standards Advisory Board, and the Cost Accounting Standards Board have certain publications that may assist in researching written standards. Also, industry organizations and associations may be other helpful sources.

Certain publications are helpful in identifying practices used by entities that may not be promulgated as standards. The AICPA publishes an annual survey of the accounting and disclosure policies of many public companies in GAAP Financial Statements – Best Practices in Presentation and Disclosure (formerly, Accounting Trends and Techniques) and offers an online version which contains a library of financial statements that can be accessed through a computerized search. EDGAR (Electronic Data Gathering, Analysis, and Retrieval) publishes the SEC filings of public companies, which includes the companies' financial statements. Through selection of keywords and/or topics, these services can provide information on how other entities resolved similar problems.

Internet-based research sources.

There has been and continues to be an information revolution affecting the exponential growth in the volume of materials, authoritative and nonauthoritative, that are available on the Internet. A listing of just a small cross-section of these sources follows:

The Concept of Materiality

Materiality as a concept has great significance in understanding, researching, and implementing GAAP. Disputes over financial statement presentations often turn on the materiality of items that were, or were not, recognized, measured, and presented in certain ways.

Materiality is defined by the FASB in Statement of Financial Concepts 2 (CON 2), Qualitative Characteristics of Accounting Information, as:

This is in conformity with the U.S. Supreme Court. The Supreme Court has held that a fact is material if there is –

However, due to its inherent subjectivity, the FASB definition does not provide specific or quantitative guidance in distinguishing material information from immaterial information. The individual accountant must exercise professional judgment in evaluating information and concluding on its materiality. Materiality as a criterion has both quantitative and qualitative aspects, and items should not be deemed immaterial unless all potentially applicable quantitative and qualitative aspects are given full consideration and found not relevant.

Quantitatively, materiality has been defined in relatively few pronouncements, which is a testament to the great difficulty of setting precise measures for materiality. For example, in ASC 280-10-50, which addresses segment disclosures, a material segment or customer is defined in ASC 280-10-50-12 as representing 10% or more of the reporting entity's revenues (although, even given this rule, qualitative considerations may cause smaller segments to be deemed reportable). The Securities and Exchange Commission has, in several of its pronouncements, defined materiality as 1% of total assets for receivables from officers and stockholders, 5% of total assets for separate balance sheet disclosure of items, and 10% of total revenue for disclosure of oil and gas producing activities.

Although materiality judgments have traditionally been primarily based on quantitative assessments, the nature of a transaction or event can affect a determination of whether that transaction or event is material. For example, a transaction that, if recorded, changes a profit to a loss or changes compliance with ratios in a debt covenant to noncompliance would be material even if it involved an otherwise immaterial amount. Also, a transaction that might be judged immaterial if it occurred as part of routine operations may be material if its occurrence helps meet certain objectives. For example, a transaction that allows management to achieve a target or obtain a bonus that otherwise would not become due would be considered material, regardless of the actual amount involved. So, too, offers to buy or sell assets for more or less than book value, litigation proceedings against the company pursuant to price-fixing or antitrust allegations, and active negotiations regarding their settlement can have a material impact on the enterprise's future profitability and, thus, are all examples of items that would not be capable of being evaluated for materiality based solely upon numerical calculations.

Another factor in judging materiality is the degree of precision that may be attained when making an estimate. For example, accounts payable can usually be estimated more accurately than a possible loss from the incurrence of an asset retirement obligation. An error amount that would be material in estimating accounts payable might be acceptable in estimating the retirement obligation.

The SEC in SAB Topics 1.M (Staff Accounting Bulletin 99) and 1.N (SAB 108), provides useful discussions of this issue. Although not strictly applicable to nonpublic preparers of financial statements, this guidance is worthy of consideration by all accountants and auditors. Among other things, Topic 1.M notes that deliberate application of nonacceptable accounting methods cannot be justified merely because the impact on the financial statements is deemed to be immaterial. Topic 1.N also usefully reminds preparers and others that materiality has both quantitative and qualitative dimensions, which must both be given full consideration. Topic 1.N has added to the literature of materiality with its discussion of considerations applicable to prior period restatements.

The Conceptual Framework

FASB has issued eight pronouncements (five of which remain extant) called Statements of Financial Accounting Concepts (CON). The conceptual framework is designed to prescribe the nature, function, and limits of financial accounting and reporting and to be used as a guideline that will lead to consistent standards. These conceptual statements do not establish accounting standards or disclosure practices for particular items and are not enforceable under the AICPA Code of Professional Conduct. Since GAAP may be inconsistent with the principles set forth in the conceptual framework, the FASB expects to reexamine existing accounting standards. Until that time, a CON does not require a change in existing GAAP. CON do not amend, modify, or interpret existing GAAP, nor do they justify departing from GAAP based upon interpretations derived from them.

FASB's conceptual framework is intended to serve as the foundation upon which the Board can construct standards that are both sound and internally consistent. The fact that the framework was intended to guide FASB in establishing standards is embodied in the preface to CON 8, which states

The conceptual framework is also intended for use by the business community to help understand and apply standards and to assist in their development. This goal is also mentioned in the preface to CON 8:

The FASB Special Report, The Framework of Financial Accounting Concepts and Standards (1998), states that the conceptual framework should help solve complex financial accounting or reporting problems by

• Providing a set of common premises as a basis for discussion;
• Providing precise terminology;
• Helping to ask the right questions;
• Limiting areas of judgment and discretion and excluding from consideration potential solutions that are in conflict with it; and
• Imposing intellectual discipline on what traditionally has been a subjective and adhoc reasoning process.

Components of the conceptual framework.

The components of the conceptual framework for financial accounting and reporting include objectives, qualitative characteristics, elements, recognition, measurement, and disclosure concepts.

Elements of financial statements are the components from which financial statements are created. They include assets, liabilities, equity, investments by owners, distributions to owners, comprehensive income, revenues, expenses, gains, and losses. In order to be included in financial statements, an element must meet criteria for recognition and possess a characteristic that can be reliably measured.

Reporting or display considerations are concerned with what information should be provided, who should provide it, and where it should be displayed. How the financial statements (financial position, earnings, and cash flow) are presented is the focal point of this part of the conceptual framework project.

Of the five extant Concepts Statements, the fourth, Objectives of Financial Reporting by Nonbusiness Organizations, is not covered here due to its specialized nature. Because the topics in CON 8 are foundational, this discussion begins with CON 8.

CON 8: CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING
Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information (A Replacement of FASB Concepts Statements No. 1 and No. 2)

CON 8 is a result of a joint FASB/IASB project to improve and converge their frameworks. Chapter 1 of CON 8 replaced CON 1, and Chapter 2 of CON 8 is being reserved for a chapter on the Reporting Entity, a replacement of CON 3. The current status of the project can be found on FASB.org.

CON 8—Chapter 1: The Objective of General Purpose Financial Reporting

Chapter 1 identifies the objective of financial reporting and indicates that this objective applies to all financial reporting. It is not limited to financial statements. The objective is to provide information that is useful in making decisions about providing resources to the entity. Users of financial information are identified as existing and potential investors, lenders, and other creditors. Chapter 1 is directed at general-purpose external financial reporting by a business enterprise as it relates to the ability of that enterprise to generate favorable cash flows. Investors and creditors need financial reports that provide understandable information that will aid in predicting the future cash flows of an entity. The expectation of cash flows affects an entity's ability to meet the obligations of loans and other forms of credit and to pay interest and dividends, which in turn affects the market price of that entity's stocks and bonds.

To assess cash flows, financial reporting should provide information relative to an enterprise's economic resources, the claims against the entity, and the effects of transactions, events, and circumstances that change resources and claims to resources. A description of these informational needs follows:

• Economic resources, claims against the entity, and owners' equity. This information provides the users of financial reporting with a measure of future cash flows and an indication of the entity's strengths, weaknesses, liquidity, and solvency.
• Economic performance and earnings. Past performance provides an indication of an entity's future performance. Furthermore, earnings based upon accrual accounting provide a better indicator of economic performance and future cash flows than do current cash receipts and disbursements. Accrual basis earnings are a better indicator because a charge for recovery of capital (depreciation/amortization) is made in determining these earnings. The relationship between earnings and economic performance results from matching the costs and benefits (revenues) of economic activity during a given period by means of accrual accounting. Over the life of an enterprise, economic performance can be determined by net cash flows or by total earnings since the two measures would be equal.
• Liquidity, solvency, and funds flows. Information about cash and other funds flows from borrowings, repayments of borrowings, expenditures, capital transactions, economic resources, obligations, owners' equity, and earnings may aid the user of financial reporting information in assessing a firm's liquidity or solvency.
• Management stewardship and performance. The assessment of a firm's management with respect to the efficient and profitable use of the firm's resources is usually made on the basis of economic performance as reported by periodic earnings. Because earnings are affected by factors other than current management performance, earnings may not be a reliable indicator of management performance.
• Management explanations and interpretations. Management is responsible for the efficient use of a firm's resources. Thus, it acquires knowledge about the enterprise and its performance that is unknown to the external user. Explanations by management concerning the financial impact of transactions, events, circumstances, uncertainties, estimates, judgments, and any effects of the separation of the results of operations into periodic measures of performance enhance the usefulness of financial information.

CON 8—Chapter 3: Qualitative Characteristics of Useful Financial Information

The purpose of financial reporting is to provide decision makers with useful information. Individuals or standard-setting bodies should make accounting choices based upon the usefulness of that information to the decision-making process. CON 8 – Chapter 3 identifies the qualities or characteristics that make information useful in the decision-making process. It also establishes a terminology to provide a greater understanding of the characteristics.

Usefulness for decision. This is the most important characteristic of information. Information must be useful to be beneficial to the user. To be useful, accounting information must both be relevant and faithfully represent what it claims to represent. Both of these fundamental qualitative characteristics are affected by the completeness of the information.

Relevance. Information is relevant to a decision if it makes a difference to the decision maker in his/her ability to predict events or to confirm or correct expectations. Relevant information will reduce the decision maker's assessment of the uncertainty of the outcome of a decision even though it may not change the decision itself. Information is relevant if it provides knowledge concerning

• Past events (confirmatory value). Disclosure information is relevant because it provides information about past events.
• Future events (predictive value) and if it is timely. The predictive value of accounting information does not imply that such information is a prediction. The predictive value refers to the utility that a piece of information has as an input into a predictive model.

An item of information is material and should be reported if it is significant enough to have an effect on the decision maker. Materiality is entity specific. It is dependent upon the relative size of an item and nature of the item. Because materiality is evaluated in the context of an individual entity's financial report, the FASB could not offer quantitative standards of materiality.

Faithful representation. Financial statements are an abstraction of the activities of a business enterprise. They simplify the activities of the actual entity. To be faithfully representative, financial statements must portray the important financial relationships of the entity itself. Information is faithfully representative if it is

• Complete,
• Neutral, and
• Free from errors.

A complete representation contains all the information that would enable users to understand the information. In addition to quantitative information, a particular item may need to include a description and explanation.

Neutrality. Neutrality means that accounting information should serve to communicate without attempting to influence behavior in a particular direction. This does not mean that accounting should not influence behavior or that it should affect everyone in the same way. It means that information should not favor certain interest groups.

Free from error does not mean perfectly accurate. However, it does mean that a description is

• Accurately described,
• The explanation of the phenomenon are explained, and
• No errors have been made in selecting and reporting the process.

Information that is relevant and faithfully represented can be enhanced by

• Comparability,
• Verifiability,
• Timeliness, and
• Understandability.

Comparability. To be useful, accounting information should be comparable. The characteristic of comparability allows the users of accounting information to assess the similarities and differences either among different entities for the same time period or for the same entity over different time periods. Comparisons are usually made on the basis of quantifiable measurements of a common characteristic. Therefore, to be comparable, the measurements used must be reliable with respect to the common characteristic. Noncomparability can result from the use of different inputs, procedures, or systems of classification.

Related to comparability, consistency is an interperiod comparison that requires the use of the same accounting principles from one period to another. Although a change of an accounting principle to a more preferred method results in inconsistency, the change is acceptable if the effect of the change is disclosed. Consistency, however, does not insure comparability. If the measurements used are not representationally faithful, comparability will not be achieved.

Verifiability means that several independent measures will obtain the same accounting measure. An accounting measure that can be repeated with the same result (consensus) is desirable because it serves to detect and reduce measurer bias. Cash is highly verifiable. Inventories and depreciable assets tend to be less verifiable because alternative valuation methods exist. The direct verification of an accounting measure would serve to minimize measurer bias and measurement bias. The verification of the procedures used to obtain the measure would minimize measurer bias only. Finally, verifiability does not guarantee representational faithfulness or relevance.

Timeliness. Although timeliness alone will not make information useful, information must be timely to be useful.

Understandability. Financial reports must be understandable for users who have a “reasonable knowledge of business and economic activities and who review and analyze the information diligently” (Con 8, QC 32).

Trade-offs. Although it is desirable that accounting information contain the characteristics that have been identified above, not all of these characteristics are compatible. Often, one characteristic may be obtained only by sacrificing another. The trade-offs that must be made are determined on the basis of the relative importance of the characteristics. This relative importance, in turn, is dependent upon the nature of the users and their particular needs.

Cost constraint. The qualitative characteristics of useful accounting information are subject to constraint: the relative cost benefit of that information. Associated with the benefits to the user of accounting information is the cost of using that information and of providing it to the user. Information should be provided only if its benefits exceed its cost. Unfortunately, it is difficult to value the benefit of accounting information. It is also difficult to determine whether the burden of the cost of disclosure and the benefits of such disclosure are distributed fairly.

CON 5: Recognition and Measurement in Financial Statements of Business Enterprises

CON 5 indicates that financial statements are the principal means of communicating useful financial information. A full set of such statements contains

• Financial position at end of the period
• Earnings for the period
• Comprehensive income for the period
• Cash flows during the period
• Investments by and distributions to owners during the period.

Financial statements result from simplifying, condensing, and aggregating transactions. Therefore, no one financial statement provides sufficient information by itself and no one item or part of each statement can summarize the information.

A statement of financial position provides information about an entity's assets, liabilities, and equity. Earnings are a measure of entity performance during a period. Earnings are similar to net income but exclude accounting adjustments from earlier periods such as cumulative effect changes in accounting principles. Comprehensive income comprises all recognized changes in equity other than those arising from investments by and distributions to owners. A statement of cash flows reflects receipts and payments of cash by major sources and uses including operating, financing, and investing activities. The investments by and distributions to owners reflect the capital transactions of an entity during a period.

Income is determined by the concept of financial capital maintenance which means that only if the money amount of net assets increases during a period (excluding capital transactions) is there a profit. For recognition in financial statements, subject to both cost benefit and materiality constraints, an item must meet the following criteria:

1. Definition—Meet the definition of an element in financial statements
2. Measurability—Have a relevant attribute measurable with sufficient reliability
3. Relevance
4. Reliability.

Items reported in the financial statements are based on historical cost, replacement cost, market value, net realizable value, and present value of cash flows. Price level changes are not recognized in these statements and conservatism guides the application of recognition criteria.

CON 6: Elements of Financial Statements

CON 3 was replaced by CON 6. CON 6 carried forward essentially all of the concepts in CON 3 and added the elements unique to the financial statements of not-for-profit organizations. CON 6 defines ten interrelated elements that are used in the financial statements of business enterprises.

1. Assets—Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
2. Liabilities—Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
3. Equity (Net Assets)—The residual interest in the assets that remains after deducting its liabilities. In a business enterprise, equity is the ownership interest.
4. Revenues—Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major and central operations.
5. Expenses—Outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major and central operations.
6. Gains—Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners.
7. Losses—Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners.
8. Comprehensive Income—The change in equity of a business enterprise during a period from transactions and other events and circumstances from sources other than investments by owners or distributions to owners.
9. Investments by Owners—Increases in equity of a particular business enterprise resulting from transfers to it for the purpose of increasing ownership interests.
10. Distributions to Owners—Decreases in the equity of a particular business enterprise resulting from transferring assets, rendering services, or incurring liabilities to owners.

The various elements articulate; that is, a change in one type of element causes an offsetting change in items of the other type. For example, a purchase of a building for cash and a mortgage note increases an asset (building), decreases another asset (cash), and increases a liability (mortgage note).

Definitions of Terms.

CON 6 also defines several significant financial accounting and reporting terms that are used in the Concepts Statements (and FASB pronouncements issued after the Concepts Statements). An event is a happening of consequence to an entity. It can be an internal event (the use of raw materials) or an external event with another entity (the purchase of labor) or with the environment in which the business operates (a technological advance by a competitor). A transaction is a particular kind of event. It is an external event that involves transferring something of value to another entity. Circumstances are a condition, or set of conditions, that create situations that might otherwise have not occurred and might not have been anticipated. Accrual is the accounting process of recognizing the effects of future cash receipts and payments in the current period. Accrual accounting attempts to record the financial effects on an entity of transactions and of other events and circumstances that have consequences for the entity in the periods in which those transactions, events, and circumstances occur rather than in the periods in which cash is received or paid by the entity. Thus, accrual accounting is based not only on cash transactions but also on credit transactions, bartering, changes in prices, changes in the form of assets or liabilities, and other transactions, events and circumstances that involve no current cash transfers but will have cash consequences in the future. Deferral is the accounting process of recognizing a liability resulting from a current cash receipt or an asset resulting from a current cash payment. Realization is the process of converting noncash assets into cash. Recognition is the process of formally incorporating a transaction or other event into the financial statements. Matching is the simultaneous recognition of the revenues and expenses that result directly and jointly from the same transaction or other event. Allocation is the process of assigning expenses to periods when the transactions or events that cause the using up of the benefits cannot be identified or when the cause can be identified but the actual amount of benefit used up cannot be reliably measured.

Elements of not-for-profit financial statements.

CON 6 also discusses the elements used in the financial statements of not-for-profit organizations. Of the ten elements, seven are used by not-for-profit organizations. The three elements omitted are investments by owners, distributions to owners, and comprehensive income. They are omitted because not-for-profit organizations do not have owners. The seven remaining elements are defined for not-for-profit organizations the same as they are for business enterprises. The net assets (equity) of not-for-profit organizations is divided into three classes—unrestricted, temporarily restricted, and permanently restricted—based on the existence or absence of donor-imposed restrictions.

CON 7: Using Cash Flow Information and Present Value in Accounting Measurements

CON 7 provides a framework for using estimates of future cash flows as the basis for accounting measurements either at initial recognition or when assets are subsequently remeasured at fair value (fresh-start measurements). It also provides a framework for using the interest method of amortization. It provides the principles that govern measurement using present value, especially when the amount of future cash flows, their timing, or both are uncertain. However, it does not address recognition questions, such as which transactions and events should be valued using present value measures or when fresh-start measurements are appropriate.

Fair value is the objective for most measurements at initial recognition and for fresh-start measurements in subsequent periods. At initial recognition, the cash paid or received (historical cost or proceeds) is usually assumed to be fair value, absent evidence to the contrary. For fresh-start measurements, a price that is observed in the marketplace for an essentially similar asset or liability is fair value. If purchase prices and market prices are available, there is no need to use alternative measurement techniques to approximate fair value. However, if alternative measurement techniques must be used for initial recognition and for fresh-start measurements, those techniques should attempt to capture the elements that when taken together would comprise a market price if one existed. The objective is to estimate the price likely to exist in the marketplace if there were a marketplace—fair value.

CON 7 states that the only objective of using present value in accounting measurements is fair value. It is necessary to capture, to the extent possible, the economic differences in the marketplace between sets of estimated future cash flows. A present value measurement that fully captures those differences must include the following elements:

1. An estimate of the future cash flow, or in more complex cases, series of future cash flows at different times
2. Expectations about possible variations in the amount or timing of those cash flows
3. The time value of money, represented by the risk-free rate of interest
4. The risk premium—the price for bearing the uncertainty inherent in the asset or liability
5. Other factors, including illiquidity and market imperfections.

How CON 7 measures differ from previously utilized present value techniques.

Previously employed present value techniques typically used a single set of estimated cash flows and a single discount (interest) rate. In applying those techniques, adjustments for factors 2 through 5 described in the previous section are incorporated in the selection of the discount rate. In the CON 7 approach, only the third factor listed (the time value of money) is included in the discount rate; the other factors cause adjustments in arriving at risk-adjusted expected cash flows. CON 7 introduces the probability-weighted, expected cash flow approach, which focuses on the range of possible estimated cash flows and estimates of their respective probabilities of occurrence.

Previous techniques used to compute present value used estimates of the cash flows most likely to occur. CON 7 refines and enhances the precision of this model by weighting different cash flow scenarios (regarding the amounts and timing of cash flows) by their estimated probabilities of occurrence and factoring these scenarios into the ultimate determination of fair value. The difference is that values are assigned to the cash flows other than the most likely one. To illustrate, a cash flow might be $100, $200, or $300, with probabilities of 10%, 50%, and 40%, respectively. The most likely cash flow is the one with 50% probability, or $200. The expected cash flow is $230 [=($100 × .1) + ($200 × .5) + ($300 × .4)].

The CON 7 method, unlike previous present value techniques, can also accommodate uncertainty in the timing of cash flows. For example, a cash flow of $10,000 may be received in one year, two years, or three years, with probabilities of 15%, 60%, and 25%, respectively. Traditional present value techniques would compute the present value using the most likely timing of the payment—two years. The example below shows the computation of present value using the CON 7 method. Again, the expected present value of $9,030 differs from the traditional notion of a best estimate of $9,070 (the 60% probability) in this example.

Measuring liabilities.

The measurement of liabilities involves different problems from the measurement of assets; however, the underlying objective is the same. When using present value techniques to estimate the fair value of a liability, the objective is to estimate the value of the assets required currently to (1) settle the liability with the holder or (2) transfer the liability to an entity of comparable credit standing. To estimate the fair value of an entity's notes or bonds payable, accountants look to the price at which other entities are willing to hold the entity's liabilities as assets. For example, the proceeds of a loan are the price that a lender paid to hold the borrower's promise of future cash flows as an asset.

The most relevant measurement of an entity's liabilities should always reflect the credit standing of the entity. An entity with a good credit standing will receive more cash for its promise to pay than an entity with a poor credit standing. For example, if two entities both promise to pay $750 in three years with no stated interest payable in the interim, Entity A, with a good credit standing, might receive about $630 (a 6% interest rate). Entity B, with a poor credit standing, might receive about $533 (a 12% interest rate). Each entity initially records its respective liability at fair value, which is the amount of proceeds received—an amount that incorporates that entity's credit standing.

Present value techniques can also be used to value a guarantee of a liability. Assume that Entity B in the above example owes Entity C. If Entity A were to assume the debt, it would want to be compensated $630—the amount that it could get in the marketplace for its promise to pay $750 in three years. The difference between what Entity A would want to take the place of Entity B ($630) and the amount that Entity B receives ($533) is the value of the guarantee ($97).

Interest method of allocation.

CON 7 describes the factors that suggest that an interest method of allocation should be used. It states that the interest method of allocation is more relevant than other methods of cost allocation when it is applied to assets and liabilities that exhibit one or more of the following characteristics:

1. The transaction is, in substance, a borrowing and lending transaction.
2. Period-to-period allocation of similar assets or liabilities employs an interest method.
3. A particular set of estimated future cash flows is closely associated with the asset or liability.
4. The measurement at initial recognition was based on present value.

Accounting for changes in expected cash flows.

If the timing or amount of estimated cash flows changes and the asset or liability is not remeasured at a fresh-start measure, the interest method of allocation should be altered by a catch-up approach. That approach adjusts the carrying amount to the present value of the revised estimated future cash flows, discounted at the original effective interest rate.

Application of present value tables and formulas.

Present value of a single future amount. To take the present value of a single amount that will be paid in the future, apply the following formula, in which PV is the present value of $1 paid in the future, r is the interest rate per period, and n is the number of periods between the current date and the future date when the amount will be realized.

In many cases the results of this formula are summarized in a present value factor table.

Present value of a series of equal payments (an annuity). Many times in business situations a series of equal payments paid at equal time intervals is required. Examples of these include payments of semiannual bond interest and principal or lease payments. The present value of each of these payments could be added up to find the present value of this annuity, or alternatively a much simpler approach is available. The formula for calculating the present value of an annuity of $1 payments over n periodic payments, at a periodic interest rate of r is

The results of this formula are summarized in an annuity present value factor table.

Caution must be exercised when payments are not to be made on an annual basis. If payments are on a semiannual basis n = 8, but r is now 3%. This is because r is the periodic interest rate, and the semiannual rate would not be 6%, but half of the 6% annual rate. Note that this is somewhat simplified, since due to the effect of compound interest 3% semiannually is slightly more than a 6% annual rate.

Example of the relevance of present values.

A measurement based on the present value of estimated future cash flows provides more relevant information than a measurement based on the undiscounted sum of those cash flows. For example, consider the following four future cash flows, all of which have an undiscounted value of $100,000:

1. Asset A has a fixed contractual cash flow of $100,000 due tomorrow. The cash flow is certain of receipt.
2. Asset B has a fixed contractual cash flow of $100,000 due in twenty years. The cash flow is certain of receipt.
3. Asset C has a fixed contractual cash flow of $100,000 due in twenty years. The amount that ultimately will be received is uncertain. There is an 80% probability that the entire $100,000 will be received. There is a 20% probability that $80,000 will be received.
4. Asset D has an expected cash flow of $100,000 due in twenty years. The amount that ultimately will be received is uncertain. There is a 25% probability that $120,000 will be received. There is a 50% probability that $100,000 will be received. There is a 25% probability that $80,000 will be received.

Assuming a 5% risk-free rate of return, the present values of the assets are

1. Asset A has a present value of $99,986. The time value of money assigned to the one-day period is $14 [$100,000 × .05/365 days]
2. Asset B has a present value of $37,689 [$100,000/(1 + .05)²⁰]
3. Asset C has a present value of $36,181 [(100,000 × .8 + 80,000 × .2)/(1 + .05)²⁰]
4. Asset D has a present value of $37,689 [($120,000 × .25 + 100,000 × .5 + 80,000 × .25)/(1 + .05)²⁰]

Although each of these assets has the same undiscounted cash flows, few would argue that they are economically the same or that a rational investor would pay the same price for each. Investors require compensation for the time value of money. They also require a risk premium. That is, given a choice between Asset B with expected cash flows that are certain and Asset D with cash flows of the same expected amount that are uncertain, investors will place a higher value on Asset B, even though they have the same expected present value. CON 7 says that the risk premium should be subtracted from the expected cash flows before applying the discount rate. Thus, if the risk premium for Asset D was $500, the risk-adjusted present values would be $37,500 {[($120,000 × .25 + 100,000 × .5 + 80,000 × .25) − 500]/(1 + .05)²⁰}.

Practical matters.

Like any accounting measurement, the application of an expected cash flow approach is subject to a cost-benefit constraint. The cost of obtaining additional information must be weighed against the additional reliability that information will bring to the measurement. As a practical matter, an entity that uses present value measurements often has little or no information about some or all of the assumptions that investors would use in assessing the fair value of an asset or a liability. Instead, the entity must use the information that is available to it without undue cost and effort when it develops cash flow estimates. The entity's own assumptions about future cash flows can be used to estimate fair value using present value techniques, as long as there are no contrary data indicating that investors would use different assumptions. However, if contrary data exist, the entity must adjust its assumptions to incorporate that market information.