Amortizable Life for Portions Built at Different Times

Costs that have been capitalized for a portion of a cable television system that is in the prematurity period, and that are clearly distinguishable on the basis of differences in timing between construction of that portion and the rest of the system are amortized over the same depreciation period used by the main cable plant.

Installation Revenues and Costs

A cable television system recognizes initial hookup revenue to the extent of the direct selling costs associated with that revenue. Any excess over the direct selling costs is deferred and amortized to income over the average period that subscribers are expected to be connected to the system.

Initial installation costs are capitalized and depreciated over a period that does not exceed the period used to depreciate the cable plant. After the initial installation, any costs incurred to disconnect or reconnect subscribers are charged to expense as incurred.

Franchise Application Costs

A cable television franchise is a right granted by a municipality to provide service to its residents. The treatment of franchise application costs depends upon whether or not the application is successful. If successful, the application costs are capitalized and amortized as intangible assets over the life of the franchise agreement. If unsuccessful or abandoned, all application costs are charged to expense.

Impairment

Capitalized plant and amortizable intangible assets are subject to the impairment provisions outlined in ASC 360 (discussed in detail in the chapter on ASC 360). Any of the system's intangible assets deemed to have an indefinite life are tested for impairment at least annually under the provisions of ASC 350. A separate evaluation is made for portions of the cable television system that are in their prematurity period. If total capitalized costs reach the maximum recoverable amount, capitalization continues. However, the provision to record an impairment loss to reduce capitalized costs to recoverable value is increased.

Persuasive Evidence of an Arrangement

This condition is met solely by documentary evidence that sets forth, at a minimum, the following terms: (1) the license period, (2) the film or films covered by the agreement, (3) a description of the rights transferred, and (4) the consideration to be exchanged. If the agreement is ambiguous regarding the parties' rights and obligations, or if there is significant doubt as to the ability of either party to perform under the agreement, revenue is not recognized. Acceptable documentary evidence must be verifiable (e.g., a contract, a purchase order, or an online authorization). (ASC 926-605-25-4 and 25-5)

Delivery

The delivery condition may be satisfied by an arrangement providing the customer with immediate and unconditional access to a film print held by the entity. The customer may also receive a lab access letter that authorizes it to order a film laboratory to make the film immediately and unconditionally available for its use. Under these conditions, the delivery condition is satisfied if the film is complete and available for immediate delivery. (ASC 926-605-25-7)

Some licensing arrangements require the entity to make significant changes to the film after it becomes initially available. Significant changes are changes that are additive to the film and that result from the entity creating additional content after the film becomes initially available. The changes can consist of the reshooting of selected scenes or adding additional special effects. When such changes are required to be made to the film, the arrangement does not meet the delivery condition. The costs incurred for these significant changes are added to film costs and subsequently recorded as expense when the related revenue is recognized.

Changes that are not considered to be significant changes include insertion or addition of preexisting film footage, addition of dubbing or subtitles to existing footage, removal of offensive language, reformatting to fit a broadcaster's screen dimensions, or adjustments to allow for the insertion of television commercials. Such insignificant changes do not alter the film's qualification to meet the delivery condition. The expected costs of these insignificant changes are accrued and charged directly to expense by the entity at the time that revenue recognition commences even if they have not yet been incurred. (ASC 926-605-25-8 and 25-9)

Commencement of Exploitation

Some arrangements impose on the customer a release date or street date before which the film may not be exhibited or sold. Such a date defines the commencement date of the exploitation rights. The entity does not begin to recognize revenue on the arrangement until this restriction has expired.

Fixed or Determinable Arrangement Fee

When there is a flat fee that covers a single film, the amount of the fee is, of course, considered fixed and determinable and the entity recognizes the entire license fee as revenue when all of the conditions set forth above have been satisfied. (ASC 926-605-25-11)

If the flat fee applies to multiple films, some of which have not been produced or completed, the entity allocates the fee to each individual film by market or territory based on relative fair values of the rights to exploit each film under the licensing arrangement. The entity bases the allocations to a film or films not yet produced or completed on the amounts that would be refundable if the entity did not ultimately complete and deliver the films to the customer. The entity allocates the remaining flat fee to completed films based on the relative fair values of the exploitation rights to those films under the arrangement. These allocations may not be adjusted subsequently even if better information becomes available. (ASC 926-605-25-12 and 25-13) After making the allocations described above, the entity recognizes revenue for each film when all of the above conditions are met with respect to that film by market and territory. If the entity is not able to determine relative fair values for the exploitation rights, then the fee is not fixed or determinable and the entity may not recognize revenue until such a determination can be made and it meets all five of the conditions.

An entity's arrangement fees may be variable based on a percentage of the customer's revenue from exploitation of the film. When all five conditions have been met, the entity commences revenue recognition as the customer exploits or exhibits the film. (ASC 926-605-25-18)

Certain variable fee arrangements include a nonrefundable minimum guarantee whereby the customer guarantees to pay the entity a nonrefundable minimum amount that is applied against the variable fees on a film or group of films that are not cross-collateralized. In applying the revenue recognition conditions, the amount of the nonrefundable minimum guarantee is considered to be fixed and determinable and is recognized as revenue when all of the other conditions have been met. If the nonrefundable minimum guarantee is applied against variable fees from a group of films on a cross-collateralized basis, the amount of the minimum guarantee attributable to each individual film cannot be objectively determined. In this situation, the entity recognizes revenue as described in the preceding paragraph (i.e., when all five of the conditions have been met as the customer exhibits or exploits each film). Under this scenario, if there is a remaining portion of the nonrefundable minimum guarantee that is unearned at the end of the license period, the entity recognizes the remaining guarantee as revenue by allocating it to the individual films based on their relative performance under the arrangement. (ASC 926-605-25-19 through 25-21)

Returns and price concessions can affect whether the arrangement fee meets the condition of being fixed and determinable. The factors to consider include the provisions of the arrangement between the entity and its customer and the entity's policies and past actions related to granting concessions or accepting product returns. If the arrangement includes a right-of-return provision or if its past practices allow for such rights, the entity must meet all of the conditions in ASC 605 in order for it to recognize revenue. Among those conditions is a requirement that the entity be able to reasonably estimate the amount of future returns. ASC 605 is discussed in detail in the chapter on ASC 605.

Barter Revenue

If an entity licenses programming to television stations in exchange for a specified amount of advertising time on those stations, the exchange is accounted for as a nonmonetary exchange in accordance with ASC 845. See the discussion of nonmonetary transactions in the chapter on ASC 845.

Modifications of Arrangements

If, during the term of a licensing arrangement, the entity and its customer agree to extend an existing arrangement for which all of the revenue recognition conditions have been met, the accounting follows the same rules cited above for flat-fee arrangements, variable fee arrangements, and variable fee arrangements with minimum guarantees.

For modifications that are not extensions of an existing arrangement, the modification is accounted for as a new arrangement and a termination of the former arrangement. At the time the former arrangement is terminated, the entity accrues and expenses all costs associated with the arrangement or reverses previously reported revenue to reflect refunds and concessions that result from the new arrangement. In addition, the entity adjusts accumulated film cost amortization and accrued participation costs attributable to the excess revenue. The new arrangement fee is accounted for by applying the provisions of the standard.

Product Licensing

Any revenue from licensing arrangements to market film-related products is deferred until the release date of the film.

Present Value

Revenue that an entity recognizes in connection with licensing arrangements is recorded at the present value of the license fee computed in accordance with ASC 835 as of the date that the entity first recognizes the revenue. A discounted cash flows model is often used to estimate fair value. FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, provides guidance on the traditional and expected cash flow approaches to present value measurements.

Film Costs

Film costs are presented separately on the entity's statement of financial position. They consist of direct negative costs, production overhead, and production period interest capitalized in accordance with ASC 835-20. Direct negative costs include costs to acquire the rights to intellectual property (e.g., film rights to books or stage plays, or original screenplays); the cost of adaptation or development of the property; compensation of the cast, directors, producers, extras, and other staff members; costs of set construction and operations, wardrobe and accessories; costs of sound synchronization; on-location rental facilities; and postproduction costs such as music, special effects, and editing. Production overhead includes allocation of costs of individuals or departments with exclusive or significant responsibility for the production of films. However, production overhead does not include general and administrative expenses, the costs of certain overall deals, or charges for losses on properties sold or abandoned. If the entity presents a classified statement of financial position, unamortized film costs are presented as a noncurrent asset. The amortization of film costs is explained later in this section.

Participation Costs

Participation costs are contingent compensation paid to creative talent such as actors or writers, or to entities from whom the distribution rights are licensed, such as the publisher of a novel on which a screenplay is based (these recipients are referred to as participants). The costs are computed (accrued) based on contractual formulas (participations) and by contingent amounts due under provisions of collectively bargained union agreements (residuals). The accrual of these costs is discussed later in this section.

Exploitation Costs

Exploitation costs are the direct costs associated with the film's distribution. The advertising cost component of exploitation costs is accounted for in accordance with ASC 340-20. All other exploitation costs, including marketing costs, publicity, promotion, and other distribution expenses, are expensed as incurred.

Manufacturing Costs

The cost of making theatrical film prints is charged to expense over the period benefited. The cost of manufacturing and/or duplication of products to be held for sale such as videocassettes and digital video discs is charged to expense on a unit-specific basis when the related product revenue is recognized. Unsold inventories are to be evaluated at the date of each statement of financial position, for net realizable value and obsolescence.

Ultimate Revenue

In general, ultimate revenue to be included in the denominator of the fraction includes estimates of revenue to be recognized by the entity from the exploitation, exhibition, and sale of a film in all markets and territories. There are, however, certain limitations that apply to the determination of ultimate revenue:

1. The period over which ultimate revenue for a film may be estimated is limited to ten years following the date of the film's initial release.
2. For previously released films acquired as part of a film library, the period over which ultimate revenue may be estimated is limited to twenty years from the date of acquisition of the library. A film must have been initially released at least three years prior to the acquisition date of the film library in order to be categorized as part of the library for the purposes of applying this limitation.
3. Ultimate revenue includes estimates of revenue for a market or territory only if persuasive evidence exists that the revenue will be earned, or if an entity can demonstrate a history of earning revenue in that market or territory. Ultimate revenue includes estimates of revenue from newly developing territories only if an existing arrangement provides persuasive evidence that the entity will realize the revenue.
4. Ultimate revenue includes estimates of revenue from licensing arrangements with third parties to market film-related products only if there is persuasive evidence that the revenue from that arrangement will be earned for that particular film (e.g., a signed contract to receive a nonrefundable minimum guarantee or nonrefundable advance) or if the entity can demonstrate a history of earning revenue from that form of arrangement.
5. Ultimate revenue includes estimates of the portion of the wholesale or retail revenue from an entity's sale of peripheral items (such as toys and apparel) attributable to the exploitation of themes, characters, or other contents related to a particular film only if the entity can demonstrate a history of earning revenues from that form of exploitation in similar kinds of films. Under this limitation, the amount of revenue to be included in ultimate revenue is an estimate of the amount that would be earned by the entity if rights for such a form of exploitation had been granted under licensing arrangements with third parties. Thus, the entity's estimate of ultimate revenue does not include the entire gross wholesale or retail revenue from the sale of peripheral items, but rather, the amount that it would realize in net license fees from the sales.
6. Ultimate revenue excludes estimates of revenue from unproven or undeveloped technologies.
7. Ultimate revenue excludes estimates of wholesale promotion or advertising reimbursements to be received from third parties. These reimbursements are accounted for as an offset against exploitation costs.
8. Ultimate revenue excludes estimates of amounts related to the sale of film rights for periods after those identified in 1 and 2 above.

With respect to episodic television series, the following rules apply:

1. The period over which ultimate revenue for an episodic television series may be estimated is limited to ten years from the date of delivery of the first episode or, if the series is still in production, five years from the date of delivery of the most recent episode, if later.
2. Ultimate revenue includes estimates of secondary market revenue (revenue from syndication of the series to markets other than the initial market) for produced episodes only if the entity can demonstrate through its experience or industry norms that the number of episodes already produced, plus those for which a firm commitment exists and the entity expects to deliver, can be licensed successfully in the secondary market.
3. Ultimate revenue excludes estimates of amounts related to the sale of rights for periods after those identified in 1 above.

Ultimate revenue is a gross undiscounted amount and does not include amounts representing projections of future inflation. The portion of ultimate revenue that is expected to be received in a foreign currency is valued at current spot rates.

Ultimate Participation Costs

The estimate of unaccrued ultimate participation costs to be used in the individual-film-forecast-computation method is made using assumptions consistent with the entity's estimates of film costs, exploitation costs, and ultimate revenue subject to the limitations set forth above. If, at the date of any statement of financial position, the recognized participation costs liability exceeds the estimated unpaid ultimate participation costs for an individual film, the excess liability is first applied to reduce unamortized film costs with any remaining excess credited to income. If the entity continues to incur participation costs after the film costs have been fully amortized, the participation costs are accrued and expensed as the related revenues are recognized.

Subsequent Events

When evidence of the possible need for a write-down of unamortized film costs arises after the date of the statement of financial position but before the entity issues its financial statements, a rebuttable presumption had existed that the conditions leading to the write-off existed at the statement of financial position date. When this situation arose, whether the film was released before or after the date of the statement of financial position, the entity used this subsequent evidence to compute the adjustment necessary to record a change in estimate in its financial statements. ASU 2012-07 removed this rebuttable presumption. The relevant guidance is now ASC 820, Fair Value, and ASC 855, Subsequent Events. This aligns the guidance for film with the guidance on fair value measurements in other instances, including the impairment testing of other assets.

Accounting by Licensors

Accounting by Licensees

When a licensee pays a minimum guarantee in advance, the guarantee is recorded as an asset and then amortized to expense according to the terms specified in the license agreement. If it later appears that the minimum guarantee is not fully recoverable through use of the rights received under the agreement, then the unrecoverable portion is charged to expense. (ASC 928-340-35-3)

Fees for which the amount is indeterminable before the agreement expires are sometimes stipulated in the license agreement. An example is a fee charged to a recording club for free recordings beyond a certain number given away. The licensee must estimate the amount of such fees and accrue them on a license-by-license basis.

Justifying a Change in Accounting Principle

The following sources are preferred for depository and lending institutions that must justify a change in accounting principle:

1. ASC 942, Financial Services—Depository and Lending
2. ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality.

Acquisition of a Depository or Lending Institution

The following discussion applies not only to the acquisition of a savings and loan association, but also to acquisition of savings and loan holding companies, commercial banks, mutual savings banks, credit unions, and other depository institutions with assets and liabilities of the same type.

Bad-Debt Reserves

Both stock and mutual savings and loan associations are required by regulatory authorities to place a portion of their earnings into a general reserve as protection for depositors. Savings and loan associations are allowed by the IRS to maintain a bad-debt reserve and to deduct any additions to their reserve in determining taxable income. Since this method differs from the method for determining bad debt expense, pretax accounting income and taxable income will differ.

Accounting by Creditors for Impairment of a Loan

A persistent practice problem has been in the proper determination of loan loss provisions. Since such reserves are necessarily matters of judgment, the possibility of manipulation (by either understatement or overstatement) in order to manage reported earnings or otherwise bias perceptions about the thrift's or bank's performance has always existed. In more recent years, this has received greater attention, first by the issuance of a detailed standard on accounting for impaired loans (ASC 310-10-35), and later by several FASB, SEC and banking regulatory authority policy announcements.

The SEC has noted in 310-10-S99-4 that a registrant engaged in lending activities should create a formal loan loss allowance methodology that incorporates the use of internal and external factors impacting loan collectability, lending risks, and current collateral values. An entity's management should also periodically review and update this methodology in order to yield the best possible estimate of the allowance for loan losses. An entity should also maintain supporting documentation of related internal controls, policies and procedures, loan grading systems, and changes to the loan loss allowance process.

For additional information on impairment of loans and nonrefundable loan fees and costs, see the Chapter on ASC 310.

Accounting for Loans Acquired by Transfer

Banks commonly acquire loans originated by other financial intermediaries. In some cases, these are impaired when first acquired. That is, due to changes in the borrowers' credit risks since loan inception, the expected cash flows from the purchased loans may not equal the contractual cash flows. (Note that the differences in expected cash flows versus contractual cash flows arising from changes in interest rates during the interval from loan inception to loan acquisition are a separate issue; the resulting discount or premium would be amortized by the effective yield method over the expected term of the loan.)

ASC 310-30 addresses the accounting for the differences between contractual and expected future cash flows of acquired loans when these differences are attributable, at least in part, to credit quality.

Under the provisions of ASC 310-30, purchased loans are to be displayed at the initial investment amount on the statement of financial position. The amount of any discount is not to be displayed in the statement of financial position nor should the acquirer carry over an allowance for loan losses established by the seller. This prohibition applies equally to standalone purchases of loans and to those which occur as part of purchase business combinations.

For additional information on accounting for loans acquired by transfer, see the Chapter on ASC 310.

Conforming Practice by All Financial Institutions

ASC 942, Financial Services—Depository and Lending, reconciled and conformed the accounting and financial reporting provisions of the former AICPA AAG applicable to banks and saving institutions, credit unions, and finance companies. It furthermore added mortgage companies and corporate credit unions to the scope of coverage. The standard applies, additionally, to all entities which finance other entities, even via normal trade credit arrangements, and thus directs the accounting to be employed by manufacturers, retailers, wholesalers, and other business enterprises.

ASC 942 provides revised accounting guidance for sales of loan servicing rights, in order to comply with the revenue recognition model set forth in ASC 860-50-40. It also adopts the basis allocation approach set forth in ASC 860.

ASC 942 requires that, to the extent management has the intent and the ability to hold them for the foreseeable future or until maturity or payoff, loans should be reported on the statement of financial position at the amount of outstanding principal adjusted for any charge-offs, the allowance for loan losses, any deferred fees or costs on originated loans, and any unamortized premiums or discounts on purchased loans. Nonmortgage loans held for sale should be reported at the lower of cost or fair value. When a decision is made to sell loans not previously held for sale, those loans should be reclassified as held-for-sale and carried at the lower of cost or fair value.

With regard to credit losses, these are to be deducted from the allowance. Loan balances should be charged off in the periods in which the loans are deemed uncollectible. Recoveries of amounts previously charged off should be recorded when received. Credit losses on off-balance-sheet instruments should be reported separately from valuation accounts for recognized instruments.

Under ASC 942, standby commitments to purchase loans are reported in one of two ways, depending on whether the settlement date is within a reasonable time and whether the entity has the intent and ability to accept delivery without selling assets. If both conditions are met, the entity should record the loans purchased at cost, net of the standby commitment fee received, on the settlement date. If one or both conditions are not met, or if the entity does not have the intent and ability to take delivery without selling assets, the standby commitment fee (which is essentially a written put option premium) should be reported as a liability. Thereafter, the liability should be reported at the greater of the initial standby commitment fee or the fair value of the written put option, with the unrealized gains or losses included in current operations.

A transfer of servicing rights should only be accounted for as a sale if the transfer qualifies as a sale under ASC 860-50-40, and if (1) the seller has written approval from the investor (if required), (2) the buyer is a currently approved seller/servicer, (3) if a seller-financed sale, the nonrefundable down payment is large enough to demonstrate the buyer's commitment to complete the transaction, and (4) the transferor receives adequate compensation for any temporary servicing it performs. Sales of servicing rights previously sold should be recognized in income consistent with this provision and the requirements under ASC 860.

ASC 942 also addresses a number of other issues. Thus, Federal Home Loan Bank and Federal Reserve Bank stock is to be classified as a restricted investment security, carried at cost, and evaluated for impairment. Also, any delinquency fees are to be recognized in income when chargeable, assuming collectibility is reasonably assured. Prepayment fees are not recognized in income until the loans or trade receivables are prepaid, except as set forth by ASC 310-20. Finally, accrual of interest income should not be affected by the possibility that rebates may be calculated using a method different than the interest method, except as set forth in ASC 310-20.

With regard to financial statement disclosures, ASC 942 requires that the summary of significant accounting policies state the basis of accounting for loans, trade receivables, and lease financings; the method used to determine the lower of cost or market of nonmortgage loans held for sale, the classification and method of accounting for interest-only strips, loans, and other receivables or retained interests in securitizations; and the method for recognizing interest income on loan and trade receivables, including the method of amortizing net deferred fees or costs. The accounting policies note should also describe the criteria for placing loans on nonaccrual status, for charging off uncollectible loans and trade receivables, and for determining past due or delinquency status.

The financial statement notes should include a description of the accounting policies and methodology used to estimate the allowance for loan losses, and any liability for off-balance-sheet credit losses, as well as the related charges for loan, trade receivable, or other credit losses. Aggregate gains or losses on sales of loans or trade receivables should be presented separately in the financial statements or disclosed in the notes thereto. Major categories of loans or trade receivables should be presented separately either in the statement of financial position or in the notes, as should the allowance for credit losses, the allowance for doubtful accounts, and any unearned income. Receivables held for sale should be separately reported.

ASC 942 also requires that foreclosed and repossessed assets be reported separately on the statement of financial position or disclosed in the notes. The recorded investment in loans and trade receivables on nonaccrual status should be disclosed, as should the amount of loans and trade receivables past due ninety days or more and still accruing.

The amount of securities deposited with state regulatory authorities (if required) should be disclosed. The carrying amount of loans, trade receivables, securities, and financial instruments that serve as collateral for borrowings should also be disclosed.

ASC 815 requires disclosure of the extent, nature, terms, and credit risk of financial instruments, not limited to derivatives with off-balance-sheet credit risk.

Previously, GAAP for banks and savings institutions did not require disclosure of capital requirements for branches of foreign banks, because those branches do not have capital. However, branches are subject to requirements to maintain certain levels of capital-equivalent deposits and may be required to maintain other specified reserves. Since failure to comply with those requirements potentially has an adverse impact on the reporting entity, disclosures about the balance requirements and a branch's compliance are required under ASC 942. Similarly, capital requirements for trust operations are unpublished, are subject to variations of interpretation as between regulatory agencies, and may not be uniformly applied to the trust operations of all institutions. Nonetheless, to the extent that an institution has been advised of an expectation that certain trust-related capital levels be maintained, its compliance with those expectations should be disclosed.

Servicing Assets and Liabilities

Financial institutions often acquire, or retain, servicing rights to financial assets, such as for loans originated and subsequently sold to other institutions or to qualified special-purpose entities. ASC 860-50-35 contains guidance on the accounting for retained or acquired servicing rights, which are to be recorded, at acquisition, at fair value. If the contractually expected fees and other revenues are expected to exceed the cost of providing the servicing, a servicing asset is recorded; if a shortfall of revenue is expected, a liability is recognized. Subsequent accounting for servicing assets and liabilities can be either by the amortization or the fair value method, with the option to elect one or the other for a given class of financial asset being serviced.

Cash Flow Statement

Banks, savings institutions, and credit unions are not required to report gross cash receipts and payments for the following:

1. Deposits placed with other financial institutions
2. Withdrawals of deposits
3. Time deposits accepted
4. Repayments of deposits
5. Loans made to customers
6. Principal collections of loans.

If an enterprise is part of a consolidated enterprise, net cash receipts and payments of the enterprise should be reported separate from the gross cash receipts and payments of the consolidated enterprise.

Other Accounting Guidance

ASC 310-20-35-13 concluded that, for situations where a lender allows a borrower to make larger payments for some number of periods (at least twelve payments), after which the borrower is then relieved of any remaining obligation, the loss related to the forgiven portion should be accrued over the period of the larger payments.

ASC 860-10-55-60 stated that forward commitment GNMA dollar rolls should be marked to market.

In some instances, a reporting entity may sell a loan but retain a share in the interest income, as well as the servicing rights for that loan. ASC 860-50-40-10 mandated that a gain should be recognized upon the sale of mortgage service rights that include participation in the future interest stream of the loans. On another related topic, ASC 860-50-35-18 states that servicing fee rates set by secondary market makers (GNMA, FHLMC, FNMA) should be considered normal for transactions with those agencies.

ASC 860-50-40-7 addresses events in which a mortgage loan servicer (transferor) transfers the servicing rights and related risks to an unaffiliated enterprise (transferee), which then makes a subservicing agreement whereby the transferor services the loans for a fixed fee. Income recognition should be deferred, and treatment as a sale or a financing depends on the circumstances surrounding the transaction. However, this consensus does not apply to temporary subservicing agreements. In addition, a loss should be recognized currently if loan prepayments may result in future servicing losses. When there is such a sale of mortgage servicing rights with a subservicing agreement, ASC 860-50-40 through 860-50-40-10 states that this should be accounted for as a sale if substantially all the risks and rewards of ownership have been transferred to the buyer. If substantially all the risks and rewards have not been transferred, then the transaction must be accounted for as a financing.

Normal servicing fee rates for mortgage loans are those set by federally sponsored secondary market makers (GNMA, FHLMC, FNMA). For transactions with those agencies or for mortgage loans sold to private sector investors where the seller retains servicing rights, normal servicing rates should be considered. In the latter case, a stated servicing fee rate that differs from the normal rate requires adjustment to the sales price to yield the normal rate. In either case, according to ASC 860-50-35-17 through 860-50-35-18, a loss should be accrued if expected servicing costs exceed anticipated fees based on the stated servicing fee rate. If the servicer refinances a mortgage loan and actual prepayments differ from any anticipated payments, then the servicing asset must be adjusted.

ASC 805 states that when a mutual savings and loan association converts to stock ownership and pools with another S&L, its EPS should be excluded from the restated combined EPS for years before the date of conversion. The method of presentation must be disclosed.

ASC 815 addressed equity certificates of deposit, stating that contingent interest expense resulting from equity certificates of deposit be recognized concurrently with gains relating to the assets upon which the equity is given.

Any goodwill resulting from the acquisition of a bank or thrift institution is to be amortized according to ASC 350, prohibiting amortization of goodwill but requiring annual impairment testing.

ASC 260 mandates that neither equity commitment notes nor equity contract notes should be included in earnings per share computations.

ASC 605-20-25-9 holds that a guarantor should recognize loan guarantee fees as revenue over the term of the guarantee. Any direct costs related to the guarantee must be recognized in the same manner. If material, footnote disclosure is required, and the probability of loss should be continually assessed. ASC 460 requires that a liability be recognized, at the inception of a guarantee, for the fair value of the obligation undertaken by the guarantor.

Regarding distribution fees paid by mutual funds not having front-end charges (loads), the cost deferral method should be employed. Under this method, fees expected to be received over some future period should be recognized upon receipt. Deferred incremental direct costs are amortized while indirect costs are expensed as incurred.

RAP basis accounting is no longer used in general-purpose financial statements. ASC 942-740-45-1 states that the Comptroller's Banking Circular 202, which limits the net deferred tax debits allowable on a bank's statement of condition, applies only for regulatory purposes and does not affect GAAP financial statements.

ASC 310-10-25-7 addressed purchased credit card portfolios involving premiums paid to the seller. It held that the excess of the purchase price of a credit card portfolio including cardholder relationships over the amounts due should be allocated between the credit card loans acquired and the cardholder relationships acquired. The premium related to cardholder relationships is an identifiable intangible asset and is amortized over the period of benefit. The premium related to the loans is amortized over the life of the loans.

ASC 942-405-55-1 holds that the savings accounts deposited in a credit union must be unequivocally listed as a liability if the financial statements of the credit union are to comply with the (now superseded) AICPA Credit Union Guide. The statement of financial condition must present savings accounts either as the first item in the liabilities and equity section or as a separate subtotal before total liabilities.

Lending institutions often utilize what traditionally were referred to as special-purpose entities (SPEs), and which now may or may not qualify as qualified SPEs (QSPEs) or might be simply variable interest entities (VIEs). A fairly common transaction involves securitizations of credit card receivables, which sometimes have a feature called a removal of accounts provision (ROAP) that allows certain accounts to be withdrawn and replaced by other receivables. ASC 860 concluded that credit card securitizations with such a provision should be recognized as sales transactions as long as the removal meets any specified terms, doesn't reduce the interests of the investor in the pool, and doesn't reduce the seller's percentage interest below a contractually specified level. The accounting implications of a ROAP depend on whether it results in the transferor maintaining effective control over the transferred assets. Unconditional ROAPs and those conditioned on a transferor's decision would preclude sale accounting when the receivables are transferred.

On a related topic, ASC 310-20-25-18 stipulated that credit card origination costs that qualify for deferral should be netted against the credit card fee charged, if any, and the net amount should be amortized on a straight-line basis over the term of the credit card or one year, depending on the significance of the fee.

Additionally, for both purchased and originated credit cards, the accounting policies, the net amount capitalized, and the amortization period should be disclosed.

Additional disclosure requirements relative to securitizations, which will impact financial reporting by banks and many other financial institutions that sponsor such arrangements, are detailed in the chapter on ASC 310.

Technical Alert

In May 2015, the FASB issued ASU 2015-09, Financial Services—Insurance (Topic 944): Disclosures about Short-Duration Contracts.

The ASU's objective is to enhance disclosures about short-duration insurance contracts. The new requirements focus on providing users of financial statements with more transparent information about an insurance entity's

• Incurred and paid claims development of information by accident year
• Reconciliation of incurred and paid claims development information to the aggregate carrying amount of the liability for unpaid claims and claim adjustment expenses
• For each accident year presented, total of incurred-but-not-reported liabilities and quantitative information about claim frequency along with a qualitative description of methodologies used
• Except for health insurance claims, average annual percentage of payout of insured claims by age.

These disclosures should increase transparency for short-duration contracts, but will require entities to aggregate and disaggregate new and different groupings of data by insurers from what is currently captured.

The ASU has the following effective dates:

• For public entities, financial statements issued for fiscal years beginning after December 15, 2015
• For all other entities, financial statements issued for fiscal years beginning after December 15, 2016 and for interim periods within fiscal years beginning after December 15, 2017.

Early adoption is permitted.

Premium Income

Premium income is recognized differently for short and long duration contracts. For short-duration contracts, premium income is recognized over the contract term in proportion to the amount of insurance provided. In the case of long duration contracts, revenue is accrued as the premiums become due from policyholders, except for contracts that provide benefits over a term longer than the premium payment term (such as twenty-year life policies), in which case income is recognized over the longer period during which benefits may be provided.

Claim Cost Recognition

Costs of benefits are recognized when insured events such as property damage occur. Estimated costs are accrued for as claims incurred but not yet reported. For long-duration contracts, the present values of estimated future benefits are accrued, net of the present values of future net premiums to be collected. Accrual of these benefit obligations generally involves actuarial determinations. Accountants may be dependent on the services of specialists in such cases, as they are in computing costs related to defined benefit pension plans. Recognition of other expenses is governed by the matching concept. For example, costs that vary with acquisition activity are capitalized and amortized over the period during which premium income is earned. Catastrophic losses (as from natural disasters such as hurricanes) are accrued under the guidelines of ASC 450: when impairment of the asset or incurring of a liability is probable and the amount is reasonably estimable.

Investments

The other major concern of GAAP for insurance enterprises relates to the presentation of investments held. ASC 320 contains the accounting requirements for investments in debt and marketable equity securities. Briefly, those investments must be categorized as being either held-for-trading, available-for-sale, or held-to-maturity. Investments falling within the first two categories should be reported at fair value, with value changes affecting the trading securities portfolio being reflected in income, while changes in the available-for-sale portfolio are reported in a separate equity account. Securities to be held to maturity are accounted for at amortized historical cost, absent a permanent decline in value. Equity securities that do not meet the definition of “marketable” are also to be reported at fair value, with gains or losses reported in stockholders' equity. In addition, real estate acquired in settling mortgage guaranty and title insurance claims is to be reported at fair value. Insurance entities are subject to the disclosure requirements of ASC 942-320-50.

Deferred Income Taxes

GAAP requires that deferred income taxes be provided for temporary differences. An exception was previously provided under the indefinite reversal criterion, for stock life insurance companies only, for differences designated as policyholders' surplus. However, ASC 740 holds that deferred taxes must be provided, consistent with the accounting prescribed for all other temporary differences.

Other Matters

Nontraditional Long-Duration Contracts

ASC 944 also addresses the classification and valuation of liabilities as well as disclosures for nontraditional annuity and life insurance contracts issued by insurance enterprises. The requirements under this standard are set forth in the following paragraphs.

The portion of separate account assets representing contract holder funds are to be measured at fair value and reported in the insurance enterprise's financial statements as a summary total, with an equivalent summary total for related liabilities, if the separate account arrangement meets all the specified criteria. If the arrangement does not meet the criteria, assets representing contract holder funds should be accounted for as general account assets, and any related liability should be accounted for as a general account liability.

Assets underlying an insurance enterprise's proportionate interest in a separate account do not represent contract holder funds, and thus are not to be separately reported and valued. If a separate account arrangement meets the criteria in ASC 944 and (1) the terms of the contract allow the contract holder to invest in additional units in the separate account, or (2) the insurance enterprise is marketing contracts that permit funds to be invested in the separate account, the assets underlying the insurance enterprise's proportionate interest in the separate account should be accounted for in a manner consistent with similar assets held by the general account that the insurance enterprise may be required to sell.

If the enterprise's proportionate interest in the separate account is less than 20% of the separate account, and all of the underlying investments of the separate account meet the definition of securities under the Master Glossary, or the definition of cash and cash equivalents, the enterprise may report its portion of the separate account value as an investment in equity securities classified as trading under ASC 320.

Assets transferred from the general account to a separate account should be recognized at fair value to the extent of third-party contract holders' proportionate interest in the separate account if the separate account arrangement meets the criteria set forth in the codification. Any gain related to the third-party contract holder's proportionate interest should be recognized immediately in earnings of the general account of the insurance enterprise, if the risks and rewards of ownership have been transferred to contract holders using the fair value of the asset at the date of the contract holder's assumption of risks and rewards. A guarantee of the asset's value or minimum rate of return or a commitment to repurchase the asset would indicate that the risks of ownership have not been transferred, and no gain can be recognized. If the separate account arrangement does not meet the criteria in the codification, the transfer generally should have no financial reporting effect (that is, general account classification and carrying amounts should be retained). In certain situations loss recognition may be appropriate.

The basis for determining the balance that accrues to the contract holder for a long-duration insurance or investment contract that is subject to ASC 944 is the accrued account balance. The accrued account balance equals:

1. Deposit(s) net of withdrawals;
2. Plus amounts credited pursuant to the contract;
3. Less fees and charges assessed;
4. Plus additional interest (for example, persistency bonus); and
5. Other adjustments, such as appreciation or depreciation recognized under the codification, to the extent not already credited.

For contracts that have features that may result in more than one potential account balance, the accrued account balance should be the highest contractually determinable balance that will be available in cash or its equivalent at contractual maturity or the reset date, without reduction for future fees and charges. The accrued account balance should not reflect any surrender adjustments (for example, fair value annuity adjustments, surrender charges, or credits). For contracts in which amounts credited as interest to the contract holder are reset periodically, the accrued balance should be based on the highest crediting rate guaranteed or declared through the reset date.

For a contract not accounted for under ASC 815 that provides a return based on the total return of a contractually referenced pool of assets either through crediting rates or termination adjustments, the accrued account balance should be based on the fair value of the referenced pool of assets (or applicable index value) at the date of the statement of financial position, even if the related assets are not recognized at fair value.

To determine the accounting under ASC 944 for a contract that contains death or other insurance benefit features, the enterprise should first determine whether the contract is an investment or universal-life-type contract. If the mortality or morbidity risks are other than nominal and the fees assessed or insurance benefits are not fixed and guaranteed, the contract should be classified as an ASC 944 universal-life-type contract. A rebuttable presumption is that a contract has significant mortality risk where the additional insurance benefit would vary significantly in response to capital markets volatility. The determination of significance should be made at contract inception, other than at transition, and should be based on a comparison of the present value of expected excess payments (that is, insurance benefit amounts and related incremental claim adjustment expenses in excess of the account balance) to be made under insurance benefit features to the present value of all amounts expected to be assessed against the contract holder (revenue).

For contracts classified as insurance contracts that have amounts assessed against contract holders each period for the insurance benefit feature that are assessed in a manner that is expected to result in profits in earlier years and subsequent losses from that insurance benefit function, a liability should be established in addition to the account balance to recognize the portion of such assessments that compensates the insurance enterprise for benefits to be provided in future periods in accordance with the guidance in the codification.

If a reinsurer assumes the insurance benefit feature, it should assess the significance of mortality and morbidity risk within the reinsurance contract according to the guidance in ASC 944, regardless of whether there is an account balance. The reinsurer should determine the classification of the reinsurance contract as an investment contract or as an insurance contract at the inception of the reinsurance contract. For reinsurance contracts, the mortality or morbidity risk could be deemed other than nominal even if the original issuer did not determine mortality or morbidity to be other than nominal. Similarly, the issuer of a contract that provides only an insurance benefit feature that wraps a noninsurance contract, for example, a guaranteed minimum death benefit related to a mutual fund balance, should evaluate its contract in the same manner. A reinsurer or issuer of the insurance benefit features of a contract should calculate a liability for the portion of premiums collected each period that represents compensation to the insurance enterprise for benefits that are assessed in a manner that is expected to result in current profits and future losses from the insurance benefit function. That liability should be calculated using the methodology described in ASC 944.

Contracts may provide for potential benefits in addition to the account balance that are payable only upon annuitization, such as annuity purchase guarantees, guaranteed minimum income benefit (GMIB), and two-tier annuities. Insurance enterprises should determine whether such contract features should be accounted for under the provisions of ASC 815. If the contract feature is not accounted for under the provisions of ASC 815, an additional liability for the contract feature should be established if the present value of expected annuitization payments at the expected annuitization date exceeds the expected account balance at the expected annuitization date in accordance with the guidance in ASC 944.

Sales inducements provided to the contract holder, whether for investment or universal-life-type contracts, should be recognized as part of the liability for policy benefits over the period for which the contract must remain in force for the contract holder to qualify for the inducement or at the crediting date, if earlier, in accordance with the codification. No adjustments should be made to reduce the liability related to the sales inducements for anticipated surrender charges, persistency, or early withdrawal contractual features.

Sales inducements that are recognized as part of the liability under ASC 944, that are explicitly identified in the contract at inception, and that meet the criteria specified in the codification should be deferred and amortized using the same methodology and assumptions used to amortize capitalized acquisition costs.

The financial statements of an insurance enterprise should disclose information about the following:

1. Separate account assets and liabilities; the nature, extent, and timing of minimum guarantees related to variable contracts; and the amount of gains and losses recognized on assets transferred to separate accounts.
2. An insurance enterprise's accounting policy for sales inducements, including the nature of the costs capitalized and the method of amortizing those costs; the amount of costs capitalized and amortized for each of the periods presented; and the unamortized balance as of the date of each statement of financial position presented.
3. The nature of the liabilities and methods and assumptions used in estimating any contract benefits recognized in excess of the account balance pursuant to the codification.

Costs Associated with Acquiring or Renewing Insurance Contracts

ASC 944-30-25-1A specifies that only the following costs incurred in the acquisition of insurance contracts can be capitalized and subsequently amortized:

• Incremental direct costs of successfully acquiring or renewing insurance contracts; these are costs that would not have been incurred if the contract acquisition had not occurred.
• Costs directly related to underwriting, policy issuance, medical and inspection, and sales force contract selling for successfully acquired or renewed insurance contracts.

All other costs, such as market research, training, administration, and product development, should be treated as period costs. You should treat all administrative expenses as period costs.

Capitalized acquisition costs should be charged to expense in proportion to premium revenue recognized under ASC 944-605. (ASC 944-30-35-3A)

Deferred Acquisition Costs for Insurance Contract Modifications or Exchanges

ASC 944-30 addresses the accounting for deferred acquisition costs related to the internal replacement of selected insurance and investment contracts. An internal replacement is a modification of an insurance product's benefits, features, rights, or coverages (described hereafter as benefits) by a variety of means, including the extinguishment and replacement of a contract.

If an internal replacement occurs and the rights and obligations of the parties are essentially unchanged, then the replacement contract is considered a continuation of the replaced contract. In this case, the replaced contract's unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets should continue to be recognized as part of the replacement contract. Also, costs incurred in connection with such a replacement are charged to expense as incurred.

A contract change must meet all of the following criteria in order to be considered a continuation of the replaced contract—if any condition is not met, the change is treated as a substantially changed contract:

1. The insured event, risk, or period of coverage has not changed.
2. The contract holder's investment return rights have not changed.
3. Either there is no change in the insurance premium, or a premium reduction is matched by a corresponding reduction in benefits.
4. Net of distributions, there is no net reduction in contract value.
5. There is no change in contractual participation or dividend features.
6. There is no change in the contract's amortization method or revenue classification.

If benefits replacement results in a substantially changed contract, then the replaced contract is considered extinguished, in which case unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets from the replaced contract should not be deferred as part of the replacement contract.

If a contract is accounted for as a long-duration participating contract, the estimated gross profit of the replacement contract is treated as a revision of the replaced contract's gross profit when determining the amortization of deferred acquisition costs, deferred sales inducement assets, and the recognition of unearned revenues. If a contract is accounted for as nonrefundable fees, the cash flows of the replacement contract revise the cash flows of the replaced contract for purposes of calculating the interest rate amortization of unamortized deferred acquisition costs and deferred sales inducement assets.

This standard does not apply to contract modifications resulting from an election by the contract holder that was within the original contract, as long as (1) the election followed the terms of the original contract, (2) the election is not subject to any underwriting, (3) the insurance provider cannot decline the coverage or adjust contract pricing, and (4) the benefit had been accounted for since the contract inception. The standard also does not apply if a contract feature is nonintegrated (it provides coverage that is priced solely for the incremental benefits coverage, and does not alter other components of the contract), in which case it should be accounted for as a separately issued contract.

Other Accounting Guidance

ASC 944-20-S99 notes that industry practice is to amortize the present value of future profits (PVP) using an interest method with accrual of interest added to the unamortized balance. In the past, there has been some diversity in the application of this method in practice, and so the codification mandates that the interest rate used to amortize PVP should be the liability or contract rate. It also states that changes in estimates of future gross profits on contracts should be accounted for as a catch-up adjustment. And finally, PVP and any related liability should be subject to the premium deficiency test required in ASC 944-60.

ASC 944-20 includes criteria for the recognition and amounts of assets and liabilities by the assuming and ceding enterprises, respectively, and accounting for changes in coverage during the reinsurance period. A number of conditions are identified, satisfaction of which is necessary for a contract to be treated as reinsurance, and in their absence such contracts are to be accounted for by the deposit method.

ASC 944-20-25 addresses how enterprises other than insurance companies should account for contracts with insurance companies covering various types of risks such as product and environmental liability risks. ASC 944-20 also addresses pooled risk contracts and reinsurance contracts entered into by a captive insurer. In order for a contract to be considered insurance it must indemnify the insured party as this would result in a transfer of risk. If no transfer of risk exists, then the contract is not considered insurance, and the balance of the premium less any amount to be retained by the insurer should be accounted for as a deposit.

ASC 325-20 provided guidance on the accounting for those formerly mutual insurance companies that have undergone demutualization transactions and converted to stock enterprises. In order to effect a demutualization, a company may be required to issue consideration, often in the form of stock, to existing participating policyholders in exchange for their current membership interests. The receipt of such stock has no direct effect on the policyholders' contractual interests of their insurance policies (for example, it does not alter the cash surrender value of their life insurance policies). However, the governance of the mutual insurance company and, in particular, the participating policyholders' interest in that governance are modified. Thus, stock received from a demutualization should be accounted for at fair value with a gain recognized in income from continuing operations.

ASC 944-605 addressed the lack of uniformity of practices among foreign reinsurers, and in particular how U.S. insurers were to account for property and liability reinsurance assumed from foreign companies.

ASC 944-505-55 illustrates disclosures for insurance enterprises that have received permission by the insurance department in their domiciliary states to use accounting practices other than those prescribed by state laws, regulations, and rules and by the National Association of Insurance Commissioners (NAIC).

ASC 944 provides guidance in accounting for mutual life insurance contracts. Capitalization and amortization of acquisition costs are discussed. Premiums are to be reported as revenue when due from policyholders. Death and surrender benefits are reported as expenses, and annual dividends are reported separately as expenses. The calculation of estimated gross margin and liability for future policy benefits is described.

ASC 405-30 addresses the diversity in practice of accounting for assessments made by government agencies against insurance activities such as workers' compensation second injury funds, this standard imposed accrual accounting requirements and set forth the conditions that must be met before a liability may be recognized.

ASC 340-30 provides guidance on how to account for insurance and reinsurance contracts that do not have the effect of transferring insurance risk. It applies to all entities and all types of insurance or reinsurance contracts, other than long duration life and health insurance contracts. The method prescribed by this standard is deposit accounting.

ASC 944-805 provides necessary guidance to the proper accounting for demutualization transactions and also for the formation of mutual insurance holding companies.

ASC 944-605-25 states that recognition of an unearned revenue liability representing amounts that have been assessed to compensate insurers for services to be performed over future periods is a requirement under ASC 944. Importantly, this liability is not to be used to inappropriately level or smooth out gross profit over the term of the contract or produce a level gross profit from the mortality benefit over the life of the contract.

The staff of the SEC's Division of Corporate Finance has issued guidance in its “Current Accounting and Disclosure Issues” publication regarding the proper disclosures required of publicly held property-casualty insurance companies. The disclosure about the policies and methodologies for estimating the liability for unpaid claims and claim adjustment expenses should (1) separately address each material line of business, (2) identify and describe the actuarial method used, (3) describe any policy for adjusting the liability for unpaid claims and claim adjustment expenses to an amount differing from the amount calculated by its actuaries, and (4) describe any difference in the annual and interim procedures for determining the liability for unpaid claims and claim adjustment expenses. Further, the disclosure of the reasons for incurred claims and claim adjustment expenses in the current income statement that are attributed to insured events in prior years should (1) quantify the amount by line of business and by accident year within each line, (2) describe the new events or information obtained since the last reporting period that led to any changes in estimate, and (3) explain why recognition occurred in the current period, rather than in earlier periods.

The SEC staff also requires disclosure about reserving assumptions. For each material line of business, disclosure should include (1) the key assumptions affecting the estimate of liability for unpaid claims and claim adjustment expenses, and (2) a quantification of any material assumption changes from the preceding period. Finally, registrants should disclose whether the liability for claims and claim adjustment expenses is likely to change in the future. This disclosure should include, for each material line of business, (1) the identification of key assumptions that are reasonably likely to change, (2) an explanation of why management believes each change is likely, and (3) quantification of the effect that these changes may have on future financial position, liquidity, and results of operations.

Accounting Policies

The accounting policies for an investment company result from the company's role as a vehicle through which investors can invest as a group. These policies are largely governed by the SEC, Small Business Administration, and specific provisions of the Internal Revenue Code relating to investment companies.

Investment companies report investment securities at fair value in accordance with the guidance in ASC 825. (ASC 946-10-15-2)

Security purchases and sales are generally recorded at the trade date; therefore, the effects of all securities trades entered into by the investment company to the date of the financial statements are included in the financial report. (ASC 946-320-25-1)

Investment companies record dividend income on the ex-dividend date, not on the later record or payable date. The rationale for this treatment is that the market price of market securities may be affected by the exclusion of the declared dividend. Additionally, investment companies record a liability for dividends payable on the ex-dividend date because mutual fund shares are purchased and redeemed at prices equal to or based on net asset value. If investors purchase shares between the declaration and ex-dividend dates they are entitled to receive dividends; however, investors purchasing shares after the ex-dividend date are not entitled to receive dividends. (ASC 946-320-25-4)

Open-end investment companies often employ the practice of equalization. This theory states that the net asset value of each share of capital stock sold comprises the par value of the stock, undistributed income, and paid-in capital and other surplus. When shares are sold or repurchased, the investment company calculates the amount of undistributed income available for distribution to its shareholders. Based on the number of shares outstanding, the investment company determines the per share amount; this amount is credited to an equalization account when shares are sold. Conversely, the equalization account is charged when shares are repurchased.¹³

Accounting for High-Yield Debt Securities

The accounting by creditors for investments in step interest and payment in kind (PIK) debt securities, if these qualify as high-yield securities, is addressed by the ASC 946. Step interest bonds are generally unsecured debentures that pay no interest for a specified period after issuance, then pay a stipulated rate for a period, then a higher rate for another period, etc., until maturity. Thus, they combine some of the characteristics of zero-coupon bonds with some features of current interest bonds. PIK bonds pay some or all interest in the form of other debt instruments (baby or bunny bonds), which in turn may also pay interest in the form of baby bonds. All babies mature at the due date of the parent bond.

The interest method should be used for step interest bonds; to the extent that interest income is not expected to be realized, a reserve against the income should be established. For PIK bonds, the interest method is also required.

Exemptions from the Requirement to Provide a Statement of Cash Flows

The following conditions must be met for an investment company to be exempted from providing a statement of cash flows:

1. The entity's investments are carried at fair value and classified as Level 1 or Level 2 measurements per ASC 820.
2. The entity had little or no debt, based on average debt outstanding during the period, in relation to average total assets.
3. The entity provides a statement of changes in net assets.

   (ASC 230-10-15-4)

Taxes

Investment companies that distribute all taxable income and taxable realized gains qualifying under Subchapter M of the Internal Revenue Code are not required to record a provision for federal income taxes. If the investment company does not distribute all taxable income and taxable realized gains, a liability should be recorded at the end of the last day of the taxable year. The rationale for recording on the last day of the year is that only shareholders of record at that date are entitled to credit for taxes paid.¹⁴

Commodity Pools

ASC 946-210 stipulates that investment partnerships which are commodity pools subject to regulation by the Commodity Exchange Act of 1934 are subject to its guidance. Thus, notwithstanding the rapid turnover common among such pools, the financial statements must include a schedule of investments. (ASC 946-210-50-4)

Other Accounting Guidance

ASC 946-320 concludes that for PIK and step bonds,

1. the interest method should be used to determine interest income;
2. a reserve against income should be established for interest income not expected to be realized;
3. the cost plus any discount should not exceed undiscounted future cash collections.

   (ASC 946-320-35-10 and 35-11)

For defaulted debt securities, any interest receivable written off that had been recognized as income constitutes a reduction of income. Write-offs of purchased interest increase the cost basis and represent an unrealized loss until the security is sold. (ASC 946-320-35-17 and 35-18) Capital infusions are accounted for as an addition to the cost basis, while related “workout expenditures” are recorded as unrealized losses. Any ongoing expenditures to protect the value of the investment are recorded as operating expenses. (ASC 946-320-35-14 through 16)

In ASC 946-830, it was concluded that transactions denominated in a foreign currency must originally be measured in that currency. Reporting exchange rate gains and losses separately from any gain/loss on the investment due to changes in market price is allowable but not required.

ASC 946-210-50 pertains to investment partnerships that are exempt from SEC registration under the Investment Company Act of 1940. Specifically, the statement requires that the financial statements include a condensed schedule of securities that categorizes investments by type, country or geographic region, and industry; discloses pertinent information concerning investments comprising greater than 5% of net assets; and aggregates any securities holdings less than the 5% of net assets threshold. The statement of operations for nonpublic investment companies shall be presented in conformity with requirements for public investment companies per the AAG so as to reflect their comparable operations. The financial statements shall also present management fees and disclose their computation.

ASC 946-20 requires investment companies with enhanced 12b-1 plans or board-contingent plans for which the board has committed to pay costs to recognize a liability and the related expense, for the amount of excess costs. This liability should be discounted at an appropriate current rate if the amount and timing of cash flows are reliably determinable and if distribution costs are not subject to a reasonable interest charge. Excess costs are recorded as a liability as the fund has assumed an obligation to pay the 12b-1 fee after the termination of the plan to the extent that the distributor has excess costs.

In a related matter, ASC 946-605 specifies the accounting for cash received from a third party for a distributor's right to future cash flows relating to distribution fees for previously sold shares. Revenue recognition is deemed proper when cash is received from a third party if the distributor has no continuing involvement or recourse; any deferred costs related to the sale of shares is to be expensed concurrently. It further defines absence of continuing involvement and recourse.

ASC 946-210 affects the required display of certain contracts held by investment companies if these are fully benefit-responsive. Both the fair values of the contracts, segregated between guaranteed investment contracts and so-called wrapper contracts, and the contract (guaranteed) values, must be displayed in the investment company's statement of financial position.

A contract is deemed fully benefit-responsive if all five conditions set forth by the ASC are met. These conditions are defined as:

1. The contract is negotiated directly between the fund and the issuer, and it prohibits the fund from assigning or selling the contract or its proceeds to another party without the consent of the issuer.
2. Either (a) the repayment of principal and interest credited to participants in the fund is guaranteed by the issuer of the investment contract, or (b) the fund provides for prospective interest crediting rate adjustments to participants in the fund on a designated pool of investments held by the fund, provided that the terms of the agreement with participants in the fund specify that the crediting interest rate cannot be less than zero. The risk of decline in the interest crediting rate below zero must be transferred to a financially responsible third party through a wrapper contract. If an event (e.g., decline in creditworthiness of the contract issuer or wrapper provider) has occurred that may affect the realization of full contract value for a particular investment contract, the contract no longer is to be considered fully benefit-responsive.
3. The terms of the contract require all permitted participant-initiated transactions with the fund to occur at contract value with no conditions, limits, or restrictions. Permitted participant-initiated transactions are those transactions allowed by the underlying defined-contribution plan, such as withdrawals for benefits, loans, or transfers to other funds within the plan.
4. Events that limit the ability for the fund to transact at contract value with the issuer (e.g., premature termination of the contracts by the plan, plant closings, layoffs, plan termination, bankruptcy, mergers, and early retirement incentives) must be probable of not occurring.
5. The fund itself must allow participants reasonable access to their funds.

   (ASC 946-210-20)

This standard requires that statements of financial position of investment companies report separately investments, including guaranteed investment contracts, at fair value, and wrapper contracts, also at fair value. The statement of financial position must also display an additional account to bring the total assets being reported to contract amounts—that is, the amounts at which participants can transact with the fund. (ASC 946-210-45-15)

Additionally, the following information must be disclosed in footnotes to the financial statements for each investment contract, and be reconciled to corresponding line items on the statement of financial position:

1. The fair value of the wrapper contract and the fair value of each of the corresponding underlying investments;
2. Adjustment from fair value to contract value (if the investment contract is fully benefit-responsive); and
3. Major credit ratings of the issuer or wrapper provider.

   (ASC 946-210-45-18)

Other expanded disclosures are mandated for investment companies having fully benefit-responsive contracts, as follows:

1. A description of the nature of the investment contracts, how they operate, and the methodology for calculating the crediting interest rate, including the key factors that could influence future average crediting interest rates, the basis for and frequency of determining credit interest-rate resets, and any minimum crediting interest rate under the terms of the contracts. This disclosure should explain the relationship between future crediting rates and the amount reported on the statement of financial position representing the adjustment of the portion of net assets attributable to fully benefit-responsive investments from fair value to contract value.
2. A reconciliation between the beginning and ending balance of the amount presented on the statement of financial position that represents the difference between net assets at fair value and net assets for each period in which a statement of changes in net assets is presented. This reconciliation should include:
   1. The change in the difference between the fair value and contract value of all fully benefit-responsive investment contracts, and
   2. The increase or decrease due to changes in the fully benefit-responsive status of the fund's investment contracts.
3. The average yield earned by the entire fund (without regard to the interest rate credited to participants in the fund) for each period for which a statement of financial position is presented.
4. The average yield earned by the entire fund with an adjustment to reflect the actual interest rate credited to participants in the fund covering each period for which a statement of financial position is presented.
5. Two different sensitivity analyses:
   1. The effect on the weighted-average crediting interest rates calculated at the latest date of a statement of financial position and the next four reset dates, under two or more scenarios where there is an immediate hypothetical increase or decrease in interest rates, with no change to the duration of the underlying investment portfolio and no contributions or withdrawals. These scenarios should include, at a minimum, immediate hypothetical changes in market yields equal to one-quarter and one-half of the current yield.
   2. The effect on the weighted-average crediting interest rates calculated at the latest date of a statement of financial position and the next four reset dates, under two or more scenarios where there are the same immediate hypothetical changes in market yields in the first analysis, combined with an immediate hypothetical 10% decrease in the net assets of the fund due to participant transfers, with no change to the duration of the portfolio.
6. A description of the events which limit the ability of the fund to transact at contract value with the issuer (for example, premature termination of the contracts by the plan, plant closings, layoffs, plan termination, bankruptcy, mergers, and early retirement incentives), including a statement that the occurrence of such events is probable or not probable.
7. A description of the events and circumstances that would allow issuers to terminate fully benefit-responsive investment contracts with the fund and settle at an amount different from contract value.

   (ASC 946-210-50-14)

In order to be considered within the scope of the guidance in ASC 946-210-45-15 through 45-18, any portion of the net assets of the investment company that is not held by participants in qualified employer-sponsored defined-contribution plans as of the effective date are not permitted to increase due to gross contributions, loan repayments, or transfers into the fund. (ASC 946-210-45-18A)

Mortgage Banking Activities

A mortgage banking entity (MBE) acts as an intermediary between borrowers (mortgagors) and lenders (mortgagees). MBE activities include purchasing and originating mortgage loans for sale to permanent investors and performing servicing activities during the period that the loans are outstanding. The mortgage loans offered for sale to permanent investors may be originated by the MBE (in-house originations); purchased from realtors, brokers, or investors; or converted from short-term, interim credit facilities to permanent financing. The common technique used by the MBE to market and sell the loans is referred to as securitization because the mortgage loans receivable are pooled and converted to mortgage-backed securities and sold in that form.

MBEs customarily retain the rights to service the loans that they sell to permanent investors in exchange for a servicing fee. The servicing fee, normally a percentage of the mortgage's outstanding principal balance, compensates the MBE for processing of mortgagor payments of principal, interest and escrow deposits, disbursing funds from the escrow accounts to pay property taxes and insurance on behalf of the mortgagor, and remitting net proceeds to the permanent investor along with relevant accounting reports.

Servicing Mortgage Loans

Rights to service mortgage loans for others are recognized as separate assets by an MBE. If the entity acquires such rights through purchase or origination of mortgage loans and retains them upon sale or securitization, the total cost of the mortgage loans must be allocated between the rights and the loans (without the rights) based on their relative fair values. If it is impossible to determine the fair value of the mortgage servicing rights apart from the mortgage, the MBE/transferor records the mortgage servicing rights at zero value. (ASC 860) Otherwise, mortgage servicing rights are capitalized at their fair value and recognized as a net asset if the benefits of servicing the mortgage are expected to be more than adequate compensation to the servicer for performing the duties. If the benefits of servicing the mortgage are not expected to adequately compensate the servicer, the servicer recognizes a liability. The asset, mortgage servicing contract rights, is initially measured at its fair value. Subsequent impairment is recognized as follows:

1. The mortgage servicing assets are stratified based on predominant risk characteristics.
2. Impairment is recognized through a valuation allowance for an individual stratum. The amount of impairment equals the carrying amount for a particular stratum minus its fair value.
3. The valuation allowance is adjusted to reflect changes in the measurement of impairment after the initial measurement of impairment.

Repurchase Financing

A repurchase financing involves the transfer of a previously transferred financial asset back to the lender as collateral for a financing between the borrower and the lender. The lender usually returns the financial asset to the borrower when the financing is repaid. The borrower and lender cannot separately account for an asset transfer and related repurchase financing unless the two transactions have a valid business purpose for being entered into separately, and the repurchase financing does not result in the lender retaining control over the financial asset. If a transaction meets these criteria, then evaluate the initial transfer without the repurchase financing to see if it meets the requirements for sale accounting. (ASC 860) If the transaction does not meet these criteria, then the arrangement is probably a forward contract.

Sales to Affiliated Entities

When mortgage loans or mortgage-backed securities are sold to an affiliated entity, the carrying amount of the assets must be adjusted to lower of cost or market as of the date that management decides that the sale will occur. This date is evidenced by formal approval by a representative of the affiliated entity (purchaser), issuance of a purchase commitment, and acceptance of the purchase commitment by the seller. Any adjustment is charged to income.

If a group of (or all) mortgage loans are originated specifically for an affiliate, then the originator is an agent of the affiliated entity. In this case, the loans are transferred at the originator's cost of acquisition. This treatment does not apply to right of first refusal or similar contracts in which the originator retains all risks of ownership. (ASC 948-310-30-1 and 30-2)

Issuance of GNMA Securities

An issuer of GNMA securities who elects the internal reserve method must pay one month's interest cost to a trustee. This cost is capitalized (at no greater than the present value of net future servicing income) and amortized. (ASC 948-310-25-1)

Loan and Commitment Fees and Costs

Mortgage bankers may pay or receive loan and commitment fees as compensation for various loan administration services. These fees and costs are accounted for as described in the following paragraphs.

Reporting

An MBE must, on its statement of financial position, distinguish between mortgage loans and mortgage-backed securities that are held for sale and those that are held for long-term investment. The notes to the financial statements are to disclose whether the MBE used the aggregate method or the individual-loan method to determine the lower of cost or market.

ASC 942, Financial Services—Depository and Lending, contains specific capital disclosure requirements including, at a minimum:

1. A description of the minimum net worth requirements related to:
   1. Secondary market investors, and
   2. State-imposed regulatory mandates.
2. The actual or possible material effects of noncompliance with those requirements.
3. Whether the entity is in compliance with the regulatory capital requirements including, as of the date of each statement of financial position presented, the following measures:
   1. The amount of the entity's required and actual net worth
   2. Factors that may significantly affect adequacy of net worth such as potentially volatile components of capital, qualitative factors, or regulatory mandates
4. If the entity is not in compliance with capital adequacy requirements as of the date of the most recent statement of financial position, the possible material effects of that condition on amounts and disclosures in the financial statements.
5. Loan servicers with net worth requirements imposed by more than one source are to disclose the new worth requirements of:
   1. Significant servicing covenants with secondary market investors with commonly defined servicing requirements,
   2. Any other secondary market investor where violation of the net worth requirement would have an adverse effect on the business, and
   3. The most restrictive third-party agreement if not already included in the above disclosures.

The standard points out that noncompliance with minimum net worth requirements may trigger substantial doubt about the entity's ability to continue as a going concern.

Acquisition Costs

The cost of constructing a title plant includes the cost of obtaining, organizing, and summarizing historical information pertaining to a particular tract of land. Costs incurred to assemble a title plant are to be capitalized until the record is usable for conducting title searches. Costs incurred to construct a backplant (a title plant that predates the time span of an existing title plant) must also be capitalized. However, an entity may capitalize only those costs that are directly related to and traceable to the activities performed in constructing the title plant or backplant. (ASC 950-350-30-1)

The purchase of a title plant or backplant, or an undivided interest therein (the right to its joint use) is recorded at cost as of the date acquired. If the title plant is acquired separately, it is recorded at the fair value of consideration given. (ASC 950-350-30-2)

Capitalized title plant costs are not amortized or depreciated unless an impairment in the carrying amount of the title plant occurs. The following events or changes in circumstances can indicate that the carrying amount may not be recoverable. An impairment may be indicated by the following circumstances (not intended to be an exhaustive list):

1. Changing legal or statutory requirements
2. Economic factors, such as changing demand
3. Loss of competitive advantage
4. Failure to maintain an up-to-date title plant
5. Circumstances that indicate obsolescence, such as abandonment of title plant.

   (ASC 950-350-35-1 through 35-3)

The provisions of ASC 360 apply to any such impairment. See chapter on ASC 360 for a complete discussion of this topic.

Operating Costs

Costs of title plant maintenance and of conducting title searches are required to be expensed currently. A title plant is maintained through frequent, often daily, updating which involves adding reports on the current status of specific real estate titles and documentation of security or other ownership interests in such land. A title search entails a search for all information or documentation pertaining to a particular parcel of land. This information is found in the most recently issued title report.

Once a title plant is operational, costs may be incurred to convert the record from one storage and retrieval system to another or to modify the current storage and retrieval system. These costs may not be capitalized as title plant. However, they may be separately capitalized and amortized using a systematic and rational method.

Reporting Title Plant Sales¹⁶

The sale of a title plant is to be reported separately. The amount to be reported is determined by the circumstances surrounding the sale as follows:

Note that in the last instance the amount reported is simply the amount received. In this case, no cost is allocated to the item sold unless the title plant's value drops below its adjusted cost as a result of the sale. (ASC 950-350-40-1)

Overview

Franchising has become a popular growth industry with many businesses seeking to sell franchises as their primary income source and individuals seeking to buy franchises and become entrepreneurs. How to recognize revenue on the individual sale of franchise territories and on the transactions that arise in connection with the continuing relationship between the franchisor and franchisee are prime accounting issues.

Franchise fees are governed by ASC 952, Franchisors.

Franchise Sales

Franchise operations are generally subject to the same accounting principles as other commercial entitiess. Special issues arise out of franchise agreements, however, which require the application of special accounting rules.

Revenue is recognized, with an appropriate provision for bad debts, when the franchisor has substantially performed all material services or conditions. Only when revenue is collected over an extended period of time and collectibility cannot be predicted in advance would the use of the cost recovery or installment methods of revenue recognition be appropriate. Substantial performance means:

1. The franchisor has no remaining obligation to either refund cash or forgive any unpaid balance due.
2. Substantially all initial services required by the agreement have been performed.
3. No material obligations or conditions remain.

Even if the contract does not require initial services, the pattern of performance by the franchisor in other franchise sales will impact the time period of revenue recognition. This can delay such recognition until services are either performed or it can reasonably be assured they will not be performed. The franchisee operations will be considered as started when such substantial performance has occurred.

If initial franchise fees are large compared to services rendered and continuing franchise fees are small compared to services to be rendered, then a portion of the initial fee is deferred in an amount sufficient to cover the costs of future services plus a reasonable profit, after considering the impact of the continuing franchise fee.

Area Franchise Sales

Sometimes franchisors sell territories rather than individual locations. In this event, the franchisor may render services to the area independent of the number of individual franchises to be established. Under this circumstance, revenue recognition for the franchisor is the same as stated above. If, however, substantial services are performed by the franchisor for each individual franchise established, then revenue is recognized in proportion to mandatory service. The general rule is that when the franchisee has no right to receive a refund, all revenue is recognized. It may be necessary for revenue recognition purposes to treat a franchise agreement as a divisible contract and allocate revenue among existing and estimated locations. Future revisions to these estimates will require that remaining unrecognized revenue be recorded in proportion to remaining services expected to be performed.

Other Relationships

Franchisors may guarantee debt of the franchisee, continue to own a portion of the franchise, or control the franchisee's operations. Revenue is not recognized until all services, conditions, and obligations have been performed.

In addition, the franchisor may have an option to reacquire the location. Accounting for initial revenue is to consider the probability of exercise of the option. If the expectation at the time of the agreement is that the option is likely to be exercised, the entire franchise fee is deferred and not recognized as income. Upon exercise, the deferral reduces the recorded investment of the franchisor.

An initial fee may cover both franchise rights and property rights, including equipment, signs, and inventory. A portion of the fee applicable to property rights is recognized to the extent of the fair value of these assets. However, fees relating to different services rendered by franchisors are generally not allocated to these different services because segregating the amounts applicable to each service could not be performed objectively. The rule of revenue recognition when all services are substantially performed is generally upheld. If objectively determinable separate fees are charged for separate services, then recognition of revenue can be determined and recorded for each service performed.

Franchisors may act as agents for the franchisee by issuing purchase orders to suppliers for inventory and equipment. These are not recorded as sales and purchases by the franchisor; instead, consistent with the agency relationship, receivables from the franchisee and payables to the supplier are reported on the statement of financial position of the franchisor. There is, of course, no right of offset associated with these amounts, which are to be presented gross.

Continuing Franchise and Other Fees

Continuing franchise fees are recognized as revenue as the fees are earned. Related costs are expensed as incurred. Regardless of the purpose of the fees, revenue is recognized when the fee is earned and receivable. The exception is when a portion of the fee is required to be segregated and used for a specific purpose, such as advertising. The franchisor defers this amount and records it as a liability. This liability is reduced by the cost of the services received.

Sometimes, the franchisee has a period of time where bargain purchases of equipment or supplies are granted by the contract. If the bargain price is lower than other customers pay or denies a reasonable profit to the franchisor, a portion of the initial franchise fee is deferred and accounted for as an adjustment of the selling price when the franchisee makes the purchase. The deferred amount is either the difference in the selling price among customers and the bargain price, or an amount sufficient to provide a reasonable profit to the franchisor.

Costs

Direct and incremental costs related to franchise sales are deferred and recognized when revenue is recorded. However, deferred costs cannot exceed anticipated future revenue, net of additional expected costs.

Indirect costs are expensed as incurred. These usually are regular and recurring costs that bear no relationship to sales.

Repossessed Franchises

If, for any reason, the franchisor refunds the franchise fee and obtains the location, previously recognized revenue is reversed in the period of repossession. If a repossession is made without a refund, there is no adjustment of revenue previously recognized. However, any estimated uncollectible amounts are to be provided for and any remaining collected funds are recorded as revenue.

Business Combinations

Business combinations where the franchisor acquires the business of a franchisee are accounted for in accordance with the requirements of ASC 805.

No adjustment of prior revenue is made since the financial statements are not retroactively consolidated in recording a business combination. Care must be taken to ensure that the purchase is not a repossession. If the transaction is deemed to be a repossession, it is accounted for as described in the above section.

Overview

Not-for-profit entities have several characteristics that distinguish them from business entities. First, and perhaps foremost, not-for-profit entities exist to provide goods and services without the objective of generating a profit. Rather than obtaining resources by conducting exchange transactions at a profit or from capital infusions from owners, a not-for-profit organization obtains most resources from others that share its desire to serve a chosen mission—an educational, scientific, charitable, or religious goal. Although not-for-profit organizations can be “owned” or controlled by another, the ownership interest is unlike that of business entities because the “owner” cannot remove resources from the entity for personal use or gain; the resources must be used for a mission-related purpose. Examples of not-for-profit entities are: churches and religious entities, colleges and universities, health care entities, libraries, museums, performing arts entities, civic or fraternal entities, federated fund-raising entities, professional and trade associations, social clubs, research entities, cemeteries, arboretums, and zoos.

Specifically excluded from the list of not-for-profit entities are entities that exist to provide dividends, lower costs, or other economic benefits directly and proportionately to their members, participants, or owners, such as mutual insurance companies, credit unions, farm or utility cooperatives, and employee benefit plans. Further, some not-for-profit entities are governmental and are required to follow the standards of the Governmental Accounting Standards Board (GASB). Governmental entities are outside of the scope of this publication. Readers instead should refer to Wiley GAAP for Governments 2012.

All authoritative pronouncements in the FASB codification apply to not-for-profit entities unless the pronouncement specifically excludes not-for-profit entities from its scope. Certain standards apply specifically to not-for-profit entities. Because those standards are particularly relevant to the transactions of not-for-profit entities they are discussed in this chapter.

ASC 958, Not-for-Profit Entities, applies specifically to not-for-profit entities that are nongovernmental entities. (ASC 958-10-05-01) It requires not-for-profit entities to depreciate their long-lived assets and to disclose balances for the major classes of assets, depreciation for the period, accumulated depreciation, and the organization's policy for computing depreciation.

ASC 958-605 establishes standards for recognition and display of contributions received and contributions made. It requires all contributions received and made to be measured at fair value and recognized in the period the gift is made. It applies to any contribution of assets, including contributions of cash, securities, supplies, long-lived assets, use of facilities or utilities, services, intangible assets, or unconditional promises to give those items in the future.

ASC 958-205 establishes standards for the general-purpose financial statements issued by not-for-profit entities. It defines a complete set of financial statements for most entities as a statement of financial position, a statement of activities, a statement of cash flows, and accompanying notes. It requires an organization's net assets and its revenues, expenses, gains, and losses to be classified based on the existence or absence of restrictions imposed by donors.

ASC 958-320 establishes standards for investments held by not-for-profit entities. It requires equity securities with readily determinable fair values and debt securities to be reported at fair value with the resulting holding gains and losses reported in the statement of activities. It also establishes standards for reporting investment return, including losses on donor-restricted endowment funds.

ASC 958-20 establishes standards for transfers of assets to a not-for-profit organization or a charitable trust that raises or holds contributions for others. Although it primarily affects federated fund-raising entities, community foundations, and institutionally related foundations, all entities are subject to its standards because they can be the beneficiaries of the contributions raised by those entities.

Combinations in which the acquiring entity is a not-for-profit organization, unlike combinations in which the acquiring entity is a business entity, cannot be assumed to be an exchange of commensurate value. Acquired not-for-profit entities lack owners who are focused on receiving a return on and return of their investment. Moreover, the parent or governing body of an acquired organization may place its mission effectiveness ahead of achieving maximum price when negotiating a combination agreement. Thus, when two not-for-profit entities combine, it will be necessary to determine if there was an exchange of commensurate value (in which case, standards similar to ASC 850 would be applied) or if there is a contribution inherent in the transaction that would be reported in accordance with ASC 958-605.

If there is a contribution inherent in the transaction, it would be measured as the excess of the net fair values of the identifiable assets acquired and the liabilities assumed over the fair value of the consideration exchanged. If the acquired entity is a business enterprise, the contribution inherent in a combination would be measured as the excess of the fair value of the acquired business enterprise over the cost of that business enterprise. The primary difference is that no goodwill would be recognized in most contributions of not-for-profit entities, although it would be in the contributions of business entities.

In the rare cases in which the sum of the fair values of the liabilities assumed exceeds the sum of the fair values of the identifiable assets acquired, the acquiring organization would initially recognize that excess as an unidentifiable intangible asset (goodwill).

ASC 954 applies to providers of health care services, including hospitals, nursing homes, medical clinics, continuing care retirement communities, health maintenance entities, home health agencies, and rehabilitation facilities. It discusses the aspects of financial statement preparation and audit particularly relevant to the entities within its scope.

ASC 958-805, Not-for-Profit Entity—Business Combinations, establishes standards for determining whether a combination of not-for-profit entities is a merger or an acquisition, describes the carryover method of accounting (for a merger) and the acquisition method of accounting (for an acquisition), and notes related disclosures.

ASC 958-810 establishes standards for consolidation by not-for-profit entities of investments in for-profit entities and other not-for-profit entities. It also describes the disclosures required when related entities are not consolidated because the relationship does not meet the criteria of control and economic benefit.

ASC 958-720 establishes standards for the functional classification of expenses incurred in activities that combine program or management and general components with fund-raising. It requires that all costs of the combined activity be classified as fund-raising expenses unless three criteria—purpose, audience, and content—are met.

ASC 954-815 clarifies that the performance indicator required to be reported in the financial statements of a not-for-profit health care organization is analogous to income from continuing operations of a business (for-profit) enterprise.

This chapter contains a highly summarized discussion of accounting and reporting standards for not-for-profit entities. Readers who desire a more in-depth discussion should refer to Wiley Not-for-Profit GAAP.

The Reporting Entity

Not-for-profit entities are exempted from the provisions of ASC 850 and ASC 350. Consequently the financial statement preparer must consider the applicability of ASC 958-810 in determining the reporting entity. It provides guidance on reporting investments in majority-owned for-profit subsidiaries, investments in common stock in which the not-for-profit organization owns a 50% or less voting interest, and certain relationships with other not-for-profit entities.

If a not-for-profit organization has a controlling financial interest in a for-profit organization (generally a majority voting interest), it follows the standards in ASC 810. Control of a related, but separate, not-for-profit entity in which the reporting entity has an economic interest may take forms other than a majority ownership interest, sole corporate membership, or majority voting interest in the board of the other entity. For example, control may be through contract or affiliation agreement. In circumstances such as these, consolidation is permitted but not required. Consolidation is, however, encouraged if both the following criteria are met:

1. The reporting entity controls a separate not-for-profit entity that it has an economic interest in, and that control is not control through either of the following means:
   1. A controlling financial interest in the other not-for-profit through direct or indirect ownership of a majority voting interest
   2. A majority voting interest in the board of the other not-for-profit.
2. Consolidation would be meaningful.

ASC 810 does, however, include an antiabuse provision that provides that the scope exemption does not apply if the not-for-profit organization is being used by a business enterprise in a manner similar to a variable interest entity in order to circumvent ASC 810. Variable interest entities are discussed at length in the chapter on ASC 810.

If a not-for-profit organization has significant influence over the operating and financial policies of the investee (generally owns 20% or more but less than 50% of the voting stock), it either follows the standards in ASC 323 or reports the investment at fair value.

Different combinations of control and economic interest determine the appropriate accounting for relationships with other not-for-profit entities, as shown in the following table. Control is defined for this purpose as the direct or indirect ability to determine the direction of management and policies through ownership, contract, or otherwise. Economic interest is defined as an interest in another entity that exists if (1) the other entity holds or utilizes significant resources that must be used for the purposes of the reporting organization, either directly or indirectly by producing income or providing services, or (2) the reporting organization is responsible for the liabilities of the other entity.

Certain disclosures are necessary if consolidated statements are not presented. If consolidated statements are not presented when consolidation is permitted, but not required, the not-for-profit organization must disclose the identity of the other organization, the nature of the relationship, and summarized financial data in addition to the information required by ASC 850. If consolidation is prohibited, the not-for-profit organization must disclose the information required by ASC 850.

Complete Set of Financial Statements

Financial statements are intended to help donors, creditors, and others who provide resources to a not-for-profit organization assess the services provided by the not-for-profit organization and its ability to continue to provide those services. The statements should also help them assess whether management has properly discharged its stewardship responsibilities and whether it has performed satisfactorily in its other management duties.

ASC 958, Not-for-Profit Entities, requires all not-for-profit entities to present a statement of financial position, a statement of activities, a statement of cash flows, and notes to the financial statements any time it purports to present a complete set of financial statements. In addition, voluntary health and welfare entities are required to present a statement of functional expenses as an additional basic financial statement. In most ways, the content and format of those financial statements are similar to the financial statements prepared by business enterprises.

However, three major differences between not-for-profit entities and business enterprises cause differences in the content and format of financial statements of not-for-profit entities. First, there is no profit motive in the nonprofit sector, and thus no single indicator of performance comparable to a business enterprise's net income or bottom line. In fact, the best indicators of the performance of a not-for-profit organization are generally not measurable in dollar amounts but rather in the reader's qualitative judgment about the effectiveness of the organization in achieving its mission. Nevertheless, dollars are the language of financial reporting. Information to help assess performance is provided in financial statements (1) by reporting revenues and expenses gross rather than net, and (2) by classifying expenses based on the mission-related programs and supporting activities they sustain, rather than by their natural classifications (salaries, utilities, depreciation, etc.).

Second, because the bottom line of a not-for-profit organization's statement of activities is not a performance measure, but simply a change in net assets for the reporting period, there is no need for not-for-profit entities to distinguish between components of comprehensive income as business enterprises do. All revenues, expenses, gains, and losses are reported in a single statement rather than being divided between an income statement and a statement of other comprehensive income.

Third, not-for-profit entities receive contributions, a type of transaction that is without counterpart in business enterprises. Those contributions often are subject to donor-imposed restrictions which can affect the types and levels of service that a not-for-profit organization can offer. Because donor-imposed restrictions are prevalent, recurring, and, in some cases, permanent, financial reporting by not-for-profit entities needs to reflect the nature and extent of donor-imposed restrictions and changes in them that occur during the reporting period.

If the reporting entity is a not-for-profit health care organization, the standard requires it to include within its statement of activities an intermediate subtotal called a performance indicator. ASC 954-815 clarifies that the performance indicator is analogous to income from continuing operations of a business (for-profit) enterprise, and thus would exclude items that are required to be reported in or reclassified from other comprehensive income, the effect of discontinued operations, the cumulative effect of accounting changes, transactions with owners acting in that capacity, and equity transfers from entities that control the reporting entity, are controlled by the reporting entity, or are under common control with the reporting entity. The performance indicator also excludes restricted contributions, contributions of and reclassifications related to gifts of long-lived assets, unrealized gains and losses on investments not restricted by donors or law (except for investments classified as trading), and investment returns restricted by donors.

Net Assets and Changes in Net Assets

The nature and extent of donor-imposed restrictions are reported in the statement of financial position by distinguishing between the portions of net assets that are permanently restricted, temporarily restricted, and unrestricted. Separate line items on the face of that statement or details in the notes to the financial statements are used to meet the requirement to disclose the amounts for different types of permanent and temporary restrictions.

Changes in donor-imposed restrictions are reported in the statement of activities. The organization's revenues, expenses, gains, and losses for the period are classified into the three classes of net assets so that the statement of activities reports amounts for the change in permanently restricted net assets, the change in temporarily restricted net assets, and the change in unrestricted net assets, as well as the change in net assets in total. Transactions and events that do not change the net assets of the organization as a whole, but only their classification, are reported separately as reclassifications. Reclassifications are events that simultaneously increase one class of net assets and decrease another. For example, unrestricted net assets increase and temporarily restricted net assets decrease when the purchase of a long-lived asset fulfills a donor-imposed restriction to acquire long-lived assets with the gift (sometimes referred to as a release of restrictions).

Not-for-profit entities often use fund accounting as a tool for tracking compliance with donor-imposed restrictions and internal designations. Fund accounting is a system of recording resources whose use is limited either by donors, granting agencies, governing boards, law, or legal covenants. A separate fund (a self-balancing group of accounts composed of assets, liabilities, and net assets) is maintained for each purpose limitation. For external reporting, a fund may be classified entirely in one net asset class or it may need to be allocated among two or three classes. (For an example of the allocations necessary to restate a fund balance to net asset classes, see the discussion of endowment funds in “Investments” in this section.)

Reporting Revenues

Revenues are reported in the statement of activities as increases in unrestricted net assets unless the use of the resources received is subject to a donor-imposed restriction. Thus, contribution revenues increase unrestricted net assets, temporarily restricted net assets, or permanently restricted net assets, depending on the existence and nature of donors' restrictions. Revenues from most exchange transactions (such as sales of goods or services) are classified as unrestricted.

Revenues from exchange transactions only increase restricted net asset classes if a preexisting donor-imposed restriction limits the use of the resources received. For example, if a donor contributes a car to the local library and requires that the proceeds from the sale of the car be used to purchase children's books, the proceeds from the sale of the car (an exchange transaction) increase temporarily restricted net assets. Investment income and gains (which are also exchange transactions) increase unrestricted net assets unless a donor required that the gift be invested and the investment return used for a restricted purpose. For example, assume a donor contributes securities worth $85,000 to a zoo, requires that all dividends and gains be retained and reinvested until the accumulated value is $100,000, and states that the $100,000 must be maintained as a permanent endowment fund, the income of which is to be used for the purchase of animals. In the early years of the endowment, before the accumulated value reaches $100,000, investment income and gains increase permanently restricted net assets. Investment income and gains earned after the accumulated value of the fund reaches $100,000 increase temporarily restricted net assets with the restriction expiring upon use of those funds to purchase animals.

ASC 958-605, Not-For-Profit Entities—Revenue Recognition, requires contributions to be recognized as revenue at the time of the gift and measured at the fair value of the contributed assets regardless of the form of the assets contributed. Donor-imposed restrictions do not change the timing of recognition of a contribution. Donor-imposed restrictions, or the absence of them, affect only a contribution's classification as an increase in permanently restricted net assets, temporarily restricted net assets, or unrestricted net assets. Donor-imposed conditions, however, affect the timing of recognition. Because a contribution is an unconditional transfer, a transfer of assets subject to donor-imposed conditions is not a contribution yet, although it may become one at a future date. Conditional transfers are not recognized as contribution revenues until the conditions are substantially met. Thus, the distinction between donor-imposed restrictions and donor-imposed conditions is very important to the timing of recognition. If a donor's stipulations do not clearly state whether a gift depends on meeting a stated stipulation and the ambiguity cannot be resolved by communicating with the donor or by examining the circumstances surrounding the gift, a transfer is presumed to be conditional.

Unconditional promises to give cash or other assets are recognized in financial statements when the promise is made and received, provided that there is sufficient evidence in the form of verifiable documentation (written, audio, or video). If payments of the promises are due in future periods, the promise has an implied time restriction that expires on the date the payment is due. Thus, unless circumstances surrounding the receipt of the promise indicate that the donor intended the gift to support the current period's activities, unconditional promises increase temporarily restricted net assets. A present value technique is used to measure unconditional promises to give, although short-term promises (due in less than one year) may be reported at net realizable value. Conditional promises are not recognized as revenue until the conditions are substantially met; however, they are required to be disclosed in notes to the financial statements.

In a manner similar to recognizing promises to give, a beneficiary recognizes contributions held on its behalf by an agent, trustee, or intermediary. For example, if the assets held by the agent were transferred subject to a condition that is not yet met, the beneficiary does not recognize its potential rights to the assets held by the agent. If a beneficiary has an unconditional right to receive cash flows from a charitable trust or other pool of assets, the beneficiary recognizes its rights when the beneficial interest is created and measures the rights using the present value of the estimated expected cash flows. However, if the beneficiary and the agent, trustee, or intermediary are financially interrelated entities, the beneficiary reports its rights to the assets held using a method similar to the equity method of accounting for investments. (For further discussion, see “Transfers Received as an Agent, Trustee, or Intermediary” in this section.)

The value of volunteer services received by the organization is recognized in certain circumstances. Contributed services that create or improve a nonfinancial asset (such as building a shed or replacing a roof) are recognized as revenue as contributions either by valuing the hours of service received or by measuring the change in the fair value of the nonfinancial asset created or improved. Other contributed services are recognized only if they meet all three of the following criteria: (1) they require specialized skills, (2) they are provided by persons possessing those skills, and (3) they would typically need to be purchased if not provided by donation. If volunteer services neither meet those three criteria nor create or improve nonfinancial assets, they cannot be recognized in the organization's financial statements. However, entities are required to describe the programs or activities for which contributed services are used, the nature and extent of services received for the period (regardless of whether those services are recognized), and disclose the amount recognized as revenues.

An organization that maintains works of art, historical treasures, and similar assets in collections, as defined, does not recognize gifts of items that are added to its collections unless it also capitalizes its collections. However, gifts that are not added to collections or items given to entities that do not maintain collections in accordance with the definition are recognized as revenues and measured at the fair value of the assets received.

Reporting Expenses

Expenses are recognized in the statement of activities as decreases in unrestricted net assets. Financing an expense with donor-restricted resources does not make the expense restricted; instead, it releases the restriction on the restricted resources, causing a reclassification to be reported in the statement of activities.

Expenses must be reported by functional classifications either on the face of the statement of activities or in the notes to the financial statements. The functional classifications describe the major classes of program services and supporting activities of an organization. Program services are the mission-related activities of the organization that result in goods and services being distributed to clients, customers, or members. They are the activities that are the major purpose of and the major output of the organization. For example, a not-for-profit organization with the mission of enhancing the lives of the community's senior citizens might have senior center, home visits, transportation services, and home maintenance as its program expense classifications. Supporting activities are all activities of a not-for-profit organization other than program services. Fund raising expenses and management and general are two common supporting activity classifications.

ASC 958-205 encourages, but does not require, most not-for-profit entities to provide an analysis of expenses by natural classification. Information about expenses by natural expense classifications (salaries, benefits, rent, depreciation, and so forth) can help readers of the financial statements understand the mix of fixed and discretionary costs incurred by the organization. Only voluntary health and welfare entities are required to report information about expenses by both functional and natural classification. Those entities must provide that information in a matrix format in a statement of functional expenses. (ASC 958-205-45-6)

ASC 958-360, Not-for-Profit Entities—Property, Plant, and Equipment, requires the depreciation of land, buildings, and equipment used by not-for-profit entities. An exception to that requirement is provided for certain works of art, historical treasures, and similar assets. If a not-for-profit organization can demonstrate both (1) that an asset individually has cultural, historical, or aesthetic value worth maintaining in perpetuity, and (2) that the organization has the ability to protect and preserve that value essentially undiminished and is doing so, depreciation need not be recognized. Depreciation expense is a natural expense classification that must be allocated to programs and supporting activities in reporting expenses by functional classification.

Many not-for-profit entities solicit contributions as part of conducting activities that also serve their program or management and general functions. For example, an organization that has a mission of reducing the incidence of cancer might conduct a direct mail campaign and include in an envelope a listing of lifestyle changes that will lessen the risks of cancer and a request for contributions. When a fund-raising activity is conducted in conjunction with an activity that serves a program or other support purpose, the activity is referred to as a joint activity. Users of the financial statements of not-for-profit entities are particularly interested in the extent to which the organization is able to minimize its fund-raising and management and general costs. Because neither of these types of costs directly benefit the beneficiaries of the organization's programs, successful entities attempt to minimize them as a percent of the organization's support and revenue. Since the effectiveness of the management of a not-for-profit organization is often judged on operating metrics of this nature, there is a natural incentive for management to maximize the portion of the costs of these joint activities that is characterized as program expenses.

ASC 958-720 established standards for reporting the costs of joint activities. It begins with the presumption that the costs of a joint activity are reportable as fund-raising expenses. To overcome that presumption, three criteria must be met: purpose, audience, and content. If all three of the criteria are met, the costs of a joint activity are to be charged as follows:

• Costs identifiable with a particular function are charged to that function.
• Joint costs are allocated between fund-raising and the appropriate program or management and general function.

Joint costs are the costs of conducting joint activities that are not directly identifiable with a particular component of the activity. Joint costs might include the costs of salaries, professional fees, paper, printing, postage, event advertising, telephones, broadcast airtime, and facility rentals.

Determining whether all three criteria are met is complicated because the purpose and audience criteria have additional tests within them. The purpose test includes a call to action test, a compensation or fees test, a similar scale and same medium test, and another evidence test. The audience criterion includes a prior donor test, an ability and likelihood to contribute test, and a need to use or reasonable potential for use test. Failure of one of the additional tests often causes the activity to fail the criterion.

If any of the three criteria is not met, all costs of the joint activity must be reported as fund-raising expense. “All costs” includes the costs that would have been considered program or management and general if they had been incurred in a different activity. There is an exception to the rule that all costs are charged to fund-raising expense if one or more of the criteria is not met. The costs of goods or services provided in an exchange transaction (sometimes referred to as a quid pro quo contribution) that is part of the joint activity are charged to cost of goods sold rather than fund-raising expense. For example, the costs of direct donor benefits, such as the value of items sold at a fund-raising auction or meals served at a fund-raising dinner, are not charged to fund-raising expenses.

ASC 958-720 requires that the method used to allocate the joint costs be rational and systematic and that it result in a reasonable allocation of costs. The method selected is to be applied consistently given similar facts and circumstances. No particular method of allocation is required by the standard, but three allocation methods are illustrated: the physical units method, the relative direct cost method, and the standalone joint-cost-allocation method.

Entities that allocate joint costs are required to disclose the types of activities in which joint costs have been incurred, a statement that the costs have been allocated, and the total amount of joint costs allocated, and the portion of joint costs allocated to each functional expense category. The standard also encourages disclosure of the amount of joint costs for each type of joint activity.

Transfers Received as an Agent, Trustee, or Intermediary

ASC 958-20 and ASC 958-605 establish standards for transactions in which a donor makes a contribution by using an agent, trustee, or intermediary. (Agents, trustees, and intermediaries are referred to as recipient entities.) The donor transfers assets to the recipient organization. The recipient organization accepts the assets from the donor and agrees to use the assets on behalf of or transfer the assets, their investment return, or both to another entity—the beneficiary—named by the donor. It also establishes standards for transactions that take place in a similar manner but are not contributions because the transactions are revocable, repayable, or reciprocal. It does not set standards for recipient entities that are trustees.

In general, a recipient organization reports a liability if it accepts assets from a donor and agrees to use those assets on behalf of or transfer those assets to another organization or individual specified by the donor. When it subsequently spends the assets on behalf of the beneficiary or transfers the assets, their return, or both to the beneficiary, the nonprofit organization reduces the liability it recorded earlier. If the assets received from the donor are donated materials, supplies, or other nonfinancial assets, the recipient organization may choose either to (1) report the receipt of the assets as liability to the beneficiary concurrent with recognition of the assets received, or (2) not to report the transaction at all. The choice is an accounting policy that must be applied consistently from period to period and disclosed in the notes to the financial statements.

If the donor explicitly grants the recipient organization variance power, the recipient organization, rather than the beneficiary, recognizes contribution revenue. Variance power is the unilateral power to direct the transferred assets to an entity other than the specified beneficiary. Unilateral power means that the recipient organization does not have to contact the donor, the beneficiary, or any other interested party in order to substitute a different beneficiary. Variance power must be granted by the instrument transferring the assets.

If the recipient organization and the specified beneficiary are financially interrelated entities, the recipient organization reports contribution revenue and the specified beneficiary recognizes its interest in the net assets of the recipient organization using a method similar to the equity method of accounting for investments in common stock. Entities are financially interrelated if the relationship between them has both of the following characteristics: (1) one organization has the ability to influence the operating and financial decisions of the other, and (2) one organization has an ongoing economic interest in the net assets of the other. The ability to influence the operating and financial decisions of the other can be demonstrated in several ways: (1) the entities are affiliates as defined in ASC 850, Related-Party Disclosures, (2) one organization has considerable representation on the governing board of the other, (3) the charter or bylaws of one organization limit its activities to those that are beneficial to the other, or (4) an agreement between the entities allows one organization to actively participate in the policymaking processes of the other. An ongoing economic interest in the net assets of another is a residual right to the other organization's net assets that results from an ongoing relationship. A common example of financially interrelated entities is a foundation that exists to raise, hold, and invest assets for a specific beneficiary that it supports.

In addition to establishing standards for contributions transferred to beneficiaries via agents, trustees, and intermediaries, ASC 958-20 sets standards for transfers that take place in a similar manner but are not contributions because the terms of the transfer or the relationships between the parties make the transfer revocable, repayable, or reciprocal. Transfers are recognized by the recipient organization as liabilities if one or more of the following situations are present: (1) the transfer is subject to the transferor's right to redirect the transferred assets to another beneficiary, (2) the transfer is accompanied by the transferor's conditional promise to give, (3) the transferor controls the recipient organization and specifies an unaffiliated beneficiary, or (4) the transferor specifies itself or its affiliate as the beneficiary of a transfer that is not an equity transaction. An equity transaction is a transfer that has all of the following terms: (1) the transferor specifies itself or its affiliate as beneficiary, (2) the transferor and the recipient organization are financially interrelated entities, and (3) neither the transferor nor its affiliate expects payment of the transferred assets (although payment of investment return is allowable). Equity transactions are reported by the recipient organization as a separate line item in the statement of activities.

Investments and Endowment Funds

ASC 958-320 requires investments in equity securities with readily determinable fair values and all debt securities to be reported at fair value. Although the standard applies to the same securities that ASC 320 covers for business enterprises, accounting for the resulting gains and losses is different than specified by that standard. Gains and losses (both realized and unrealized) are reported in a not-for-profit organization's statement of activities.

ASC 958 establishes standards for reporting other investments. The appropriate standards to apply depend on whether the not-for-profit organization is a college or university, a voluntary health and welfare organization, a health care organization, or another type of not-for-profit organization. Most entities have the option of reporting their other investments at either cost or at the lower of cost or market.

Not-for-profit health care entities are required to apply the provisions of ASC 815 in the same manner as business enterprises, including the provisions pertaining to cash flow hedge accounting. The gain or loss items that affect a business enterprise's income from continuing operations similarly affect the not-for-profit health care organization's performance indicator, and the gain or loss items that are excluded from a business enterprise's income from continuing operations (such as items reported in other comprehensive income) are to be excluded from the performance indicator.

Many of the investments held by not-for-profit entities are held as the investments of endowment funds. Endowment funds generally are established by gifts from donors who desire to provide support for the organization permanently (a permanently restricted endowment fund) or for a specified period of time (a term endowment fund). In addition, a governing board may determine that certain resources be invested and that only the return generated be spent by the organization. These board-designated amounts are referred to as quasi-endowment funds or funds functioning as endowment. The net assets of an endowment fund are classified in accordance with the restrictions placed on the resources by donors, if any. Because a donor can place different restrictions on each source of the net assets (original gift, investment gains and losses, and investment income), each source must be examined separately to achieve the proper classification.

Each source is unrestricted unless its use is temporarily or permanently restricted by the donor or by a law that extends the donor's restriction to the source. Thus, the net assets of an endowment fund created by the governing board from a large unrestricted bequest (or from unrestricted net assets) are classified as unrestricted because no donor was involved in the transaction of creating the endowment fund and all amounts transferred to that fund are free of donor-imposed restrictions.

In contrast, assume that a donor contributes $50,000 to a museum and stipulates that the gift be invested in perpetuity and the investment income be used to purchase works of art. The donor further stipulates that any gains on the investment be added to the original gift and invested in perpetuity. The donor's original gift ($50,000) increases permanently restricted net assets because of the stipulation that the gift be invested in perpetuity. The income earned by the investment of the gift increases temporarily restricted net assets. When works of art are purchased, the restriction on net assets resulting from the income is fulfilled and the net assets are reclassified to unrestricted net assets. The realized and unrealized gains from investment of the gift increase permanently restricted net assets because the donor required that those gains also be reinvested in perpetuity.

In most cases, the classification of the original gift and the investment income is straightforward because donors explicitly state the time and purpose restrictions on them. Classification of gains and losses on the investments is not as clearly determinable unless the donor explicitly states how gains are to be used and whether losses must be restored immediately from other sources, from future gains on the investments, or not at all. However, donors are often silent in their agreements about those matters.

In the absence of explicit donor restrictions, the law in most states provides some direction about the restrictions on investment gains of donor-restricted endowment funds. The Uniform Management of Institutional Funds Act (UMIFA) extends certain donor restrictions to the net appreciation (accumulated net gains) of donor-restricted endowment funds. In states that have adopted UMIFA, net appreciation is expendable unless the donor states otherwise. UMIFA provides that the net appreciation can be spent for the uses and purposes for which the endowment fund was established. Thus, unless the donor specifies otherwise, gains increase unrestricted net assets if the endowment's income is not restricted by the donor, and gains increase temporarily restricted net assets if the endowment's income is temporarily restricted by the donor. Assume in the earlier example of the $50,000 gift to the museum that the donor was silent about the use of gains earned by investing the original gift. In a state that has adopted UMIFA, the accumulated gains on the endowment fund would be restricted to the purchase of artwork because the law requires that the donor's restriction be extended to those gains. The restrictions on those temporarily restricted net assets expire when the museum purchases works of art even if the money to purchase the work of art is not withdrawn from the fund. Thus, this single endowment fund can be composed of permanently restricted net assets (the original $50,000 gift), temporarily restricted net assets (the gains on which restrictions have not yet been met), and unrestricted net assets (the gains on which restrictions have been met).

ASC 958-205 has expanded certain disclosure requirements applicable to endowment funds. It stipulates that not-for-profit entities that are subject to an enacted version of the Uniform Prudent Management of Institutional Funds Act of 2006 (UPMIFA, a modernized version of the Uniform Management of Institutional Funds Act of 1972 [UMIFA], the model act on which 46 states and the District of Columbia had based their primary laws governing the investment and management of donor-restricted endowment funds by not-for-profit entities) are required to classify a portion of a donor-restricted endowment fund that are of a perpetual duration as being permanently restricted net assets. The amount that is to be classified as permanently restricted should be the amount of the fund (1) that is required to be permanently retained due to an explicit stipulation by the donor, or (2) that in the absence of such donor stipulations, the organization's governing board determines must be permanently restricted to comply with applicable laws.

Losses incurred on the investments of the funds should not reduce the portion of the donor-restricted endowment fund that is to be classified as permanently restricted net assets, unless this is a requirement of the donor. Furthermore, the amount of permanently restricted net assets is not to be reduced by an organization's appropriations from the fund.

A not-for-profit organization should classify the portion of the funds that are not classified as permanently restricted net assets as temporarily restricted net assets until they are appropriated for expenditure by the organization, unless the gift instrument states otherwise. This is in accordance with the stipulation in subsection 4(a) of UPMIFA that requires, “unless stated otherwise in the gift instrument, the assets in an endowment fund are donor-restricted assets until appropriated for expenditure by the institution.”

According to ASC 958-205, a not-for-profit organization, whether or not subject to UPMIFA, is to disclose information that will enable users of its financial statements to understand the net asset classification, net asset composition, changes in net asset composition, spending policies, and related investment policies of its endowment funds. Therefore, at a minimum, the following disclosures should be made:

1. A description of the governing board's interpretation of the law that supports the organization's net asset classification of donor-restricted endowment funds.
2. A description of the organization's endowment spending policies.
3. A description of the organization's endowment investment policies.
4. The make-up of the organization's endowment by net asset class at the end of the period. These amounts should be presented in total, as well as by endowment fund and should separately show donor-restricted endowment funds from board-designated endowment funds.
5. A reconciliation of the beginning and ending balance of the organization's endowment, in total and by net asset class.
6. Information about the net assets of its endowment funds such as:
   1. The nature and types of any permanent restrictions or temporary restrictions.
   2. The aggregate amount of the deficiencies for all donor-restricted endowment funds where the fair value of the assets at the reporting date is less than the level required in the donor stipulations or law.

ASC 958-320 requires that losses on the investments of an endowment fund reduce temporarily restricted net assets to the extent that temporary restrictions on net appreciation have not yet been met before the loss occurs. The remainder of the loss, if any, reduces unrestricted net assets. If the losses reduce the value of the fund below the level required by the donor or by law, future gains that restore the value to the required level are classified as unrestricted net assets.

Expanding on the earlier example, assume that several years after the fund was established, the assets of the fund have increased in value to $65,000. Assume also that the classification of the net assets in the fund is: $50,000 permanently restricted (the original gift), $10,000 temporarily restricted (accumulated gains on which the restrictions have not been met), and $5,000 unrestricted (gains on which the restriction was met by purchasing a work of art with unrestricted funds in years after the inception of the fund). A market correction causes the value of the investments to fall to $58,000. The $7,000 loss decreases temporarily restricted net assets from $10,000 to $3,000. Assume that a further market correction reduces the value of the investments another $9,000 from $58,000 to $49,000. The $9,000 loss reduces temporarily restricted net assets by $3,000 (the amount remaining after the $7,000 loss decreased the original $10,000) and reduces unrestricted net assets by $6,000. After recording the loss, the classification of the $49,000 value of the endowment fund would be: $50,000 permanently restricted (the original gift) and ($1,000) deficit in unrestricted net assets. A not-for-profit organization is required to disclose the amount by which the value of the endowment fund is less than the level required by the donor.

Continuing the example, assume that the next year the value of the investments increases from $49,000 to $53,000. The $4,000 gain increases unrestricted net assets by $1,000 (the restoration of the deficit) and increases temporarily restricted net assets by $3,000. After the gain, the net assets of the endowment fund are $50,000 permanently restricted (the original gift) and $3,000 temporarily restricted for the purchase of works of art.

Collections

Not-for-profit entities are allowed an exception to the normal requirement to capitalize purchases of property, plant, and equipment. If a not-for-profit organization maintains collections of works of art, historical treasures, or similar assets in the manner defined in the Master Glossary, it can choose whether it will capitalize and report those collections in its statement of financial position. To qualify for the exception, an organization must (1) hold the items for public exhibition, education, or research in service to the public rather than for financial gain, (2) protect the items, keep them unencumbered, care for them, and preserve them, and (3) use the proceeds from the sale of any items to acquire other items for the collection. If an organization meets those criteria, it can choose one of the following policies: (1) capitalize its collections, (2) capitalize only collection items acquired after the adoption of ASC 958-605, or (3) not capitalize any collections. An organization cannot selectively choose to capitalize only certain collections.

If an organization does not capitalize its collections, transactions involving collection items must be reported separately on the face of its statement of activities. Similarly, if an organization chose to capitalize its collections prospectively when it adopted ASC 958-605, it would separately report transactions involving collection items not previously capitalized. Descriptions of the collections, including information about stewardship policies and items deaccessed (removed from the collection), must be included in notes to the financial statements by entities that do not capitalize their collections or that capitalize them prospectively.

Capitalization is required of works of art, historical treasures, and similar assets that are not collection items, even if those items are held by entities that regularly maintain collections. Thus, if a museum does not capitalize its collections and it is given a work of art that it does not to add to its collection (perhaps because it duplicates other collection items), the museum would recognize that contribution and report the asset in its statement of financial position as a work of art held for sale.

Split-Interest Agreements

A split-interest agreement is an arrangement in which a donor transfers assets to a not-for-profit organization or to a charitable trust and requires that the benefits of ownership of those assets be split among two or more beneficiaries. Charitable gift annuities, annuity trusts, charitable remainder unitrusts, charitable lead trusts, and pooled (or life) income funds are examples of split-interest agreements. ASC 958 provides guidance for reporting the initial gifts that create these funds and the annual adjustments necessary to report them properly. Accounting for split-interest gifts is a complex area; the following discussion is highly summarized and overly simplified.

Not-for-profit entities are required to report their interests in irrevocable split-interest agreements. If another party, such as a bank, holds the assets, a not-for-profit organization recognizes its interest as an asset and contribution revenue and measures its interest at fair value, usually based on the present value of the cash flows to be received. If the not-for-profit organization holds the assets and is also a beneficiary of the agreement, it reports the fair value of the assets received from the donor as its assets and reports the actuarially computed present value of the payments to be made to other beneficiaries as its liability. The difference between the two amounts is the contribution received by the not-for-profit organization. Each year thereafter, the liability to the beneficiaries is recomputed based on revaluations of the amounts to be paid, the expected lives of the beneficiaries, and other relevant actuarial assumptions.

The net assets resulting from most split-interest agreements are classified as temporarily restricted because they are subject to time restrictions and purpose restrictions. The net assets are time-restricted either because the distributions are not yet due (when amounts are held by a third party) or because the contribution amount cannot be used by the not-for-profit organization until the death of the beneficiary or some other future specified date. However, the net assets are classified as permanently restricted if the donor has permanently restricted the organization's use of the assets. (For example, the donor requires that the not-for-profit organization use the remaining assets to create a permanent endowment fund at the end of the agreement.) Similarly, if upon the establishment of the agreement the organization can immediately spend the contribution portion without restriction, as is the case for some gift annuities, the net assets would be classified as unrestricted. (ASC 958-30-45-2)

Revocable split-interest agreements are not recorded unless the not-for-profit organization holds the assets. Assets received by a not-for-profit organization that acts as trustee under a revocable agreement are recognized as refundable advances at their fair value.

Mergers and Acquisitions

ASC 958-805 establishes standards for determining whether a combination of not-for-profit entities is a merger or an acquisition, describes the carryover method of accounting (for a merger) and the acquisition method of accounting (for an acquisition), and notes related disclosures.

In many not-for-profit mergers and acquisitions, there is no transfer of consideration, so there is no fair value exchange to record. Because of this issue, different accounting methods are applied to a merger of not-for-profit entities and an acquisition by a not-for-profit entity.

In a merger, where two or more not-for-profit entities cede control to a new entity, the carryover method is used. (ASC 958-05-25-3) Under this method, the initial financial statements of the combined entities carry forward the assets and liabilities of the combining entities, measured at their carrying amounts, less the effects of any intra-entity transactions. There is no recognition of changes in fair value. The financial history of the new entity created by the merger begins on the merger date—it does not report the prior financial results of the preceding merged entities. Key merger disclosures include the reasons for the merger, the amounts of any significant adjustments made to conform the individual accounting policies of the merged entities, and the amounts of any intra-entity balance eliminations.

An acquisition by a not-for-profit entity is accounted for using the acquisition method, which was described in detail earlier in this chapter. If this method is used, there are a few exceptions to the recognition principle in ASC 805. The acquirer cannot recognize an acquired donor relationship as an intangible asset. So, too, if the not-for-profit acquirer has a policy of not capitalizing collections (works of art, historical treasures, or similar assets), then the acquirer does not recognize those items as assets at acquisitions added to the collection. Instead, the acquirer recognizes the cost of the collection items purchased as a decrease in the appropriate class of net assets in the statement of activities and as a cash outflow for investing activities and does not recognize the fair value of collection items contributed. For conditional promises to give, the not-for-profit acquirer recognizes either:

• The conditional promise only if the conditions on which it depends are substantially met as of the acquisition date, or
• A transfer of assets with a conditional promise to contribute them as a refundable advance unless the conditions have been substantially met as of the acquisition date.

Key acquisition disclosures include the reasons for the acquisition, the factors that make up either goodwill recognized or the equivalent amount charged to expense, and the fair value of consideration transferred.

If an acquirer expects the operations of the acquiree to be supported primarily by contributions and returns on investments, then it should recognize as an expense on the acquisition date the amount that would otherwise be recognized as a goodwill asset. This situation arises when an acquiree's contributions and returns on investments are expected to significantly exceed all other sources of revenue.

In an acquisition, there is an inherent contribution received, because the acquirer receives net assets from the acquiree without any corresponding transfer of consideration.

Complete Set of Financial Statements

The primary objective of a plan's financial statements is to provide the information necessary to assess the plan's ability to pay benefits when due. Thus, financial statements are to include information about the plan's resources, the results of transactions and events that changed the plan's resources, the stewardship of management over the plan's resources, and any other facts necessary to understand the information provided.

A complete set of financial statements includes a statement of net assets available for benefits as of the end of the plan year (statement of financial position equivalent), a statement of changes in net assets available for benefits for the plan year ended (income statement equivalent), and notes to the financial statements. In addition, defined benefit plans must include information about the actuarial present value of accumulated benefits and changes in the accumulated benefits. That information can appear either as additional financial statements or in the notes to financial statements.

ASC 230-10-15 exempts defined benefit pension plans from the requirement that a statement of cash flows be provided. Other employee benefit plans are also exempted if they report similar to defined benefit pension plans, including ASC 960's requirement to report plan investments at fair value. Although not required, presentation of a statement of cash flows is encouraged if it would provide useful information about the plan's ability to pay future liabilities, as would be the case if the plan either holds illiquid investments or purchases investments using borrowed funds.

ASC 220-10-15 requires that changes in equity other than transactions with owners be reported in financial statements in the period in which they are recognized. The statement of changes in net assets available for benefits is a comprehensive income statement because all changes in net assets available for benefits are reflected in that statement. Thus, although it did not specifically exempt employee benefit plans from its provisions, the codification did not change the reporting for employee benefit plans.

Statement of Net Assets Available for Benefits

Most investments of the plan are reported at fair value. If there is an active market, quoted market prices are used. If market quotations are not available, investments are valued “in good faith” by the plan's trustees and administrator. The selling price of similar investments or discounted cash flows can be useful in estimating fair value. The use of an independent expert may be necessary for the valuation of certain investments. Investment contracts with an insurance company, bank, or other financial institution are reported at fair value. Only insurance contracts—contracts that incorporate mortality or morbidity risk (defined benefit pension plans) or that are fully benefit-responsive (defined contribution plans and health and welfare plans)—may be reported at contract value, and then only if the plan reports at contract value in its annual report filed with government agencies. The financial statements are to identify plan investments by type of investment and indicate how fair value was determined. It is not necessary to disclose the original cost of investments in the basic financial statements. Plans are to disclose in the notes to the financial statements any investments representing 5% or more of the net assets available for benefits as of the end of the year.

Contributions receivable include those due as of the reporting date from participants, employers, withdrawing employers of a multiemployer plan, and other sources (such as a state or federal government in the case of a grant or subsidy). Receivables arise from formal commitments of an employer, legal requirements, or contractual requirements. The receivables are to be reduced by an allowance for uncollectible amounts if warranted.

Long-lived assets (such as buildings, equipment, furniture and fixtures, and leasehold improvements) that are used in the plan's operations are presented at cost less accumulated depreciation or amortization.

Statement of Changes in Net Assets Available for Benefits

The statement of changes in net assets available for benefits is a comprehensive income statement that includes all recognized transactions and events that change the net assets available for benefits. At a minimum, the statement is to include separate amounts for:

1. Contributions from
   1. Employer(s)—separating cash from noncash contributions
   2. Participants, including those transmitted by the plan sponsor
   3. Other identified sources.
2. Net appreciation or depreciation (realized and unrealized amounts may be combined) in fair value for each significant class of investment, presented by:
   1. Investments measured by quoted market prices
   2. Investments measured by some other means.
3. Investment income (not including appreciation or depreciation in fair value).
4. Payments to plan participants for benefits, excluding amounts paid by insurance contracts that are not included in plan assets.
5. Payments to insurance companies to purchase contracts that are excluded from plan assets.
6. Administrative expenses.
7. Other changes, if necessary, with appropriate description(s).

Transactions with Related Parties (ASC 850)

Transactions between a plan sponsor and its employee benefit plans are subject to the disclosure requirements of ASC 850, Related-Party Disclosures.

Risks and Uncertainties

Employee benefit plans must disclose the information required by ASC 275, Risks and Uncertainties. Risks that are unique to employee benefit plans include:

1. A significant industry downturn that could cause employees to retire early in order to avoid being laid off, especially if the plan's participants are concentrated within a particular industry or with a single employer.
2. Likelihood that an employer will significantly increase pension or health and welfare benefits in order to avoid a union walkout.
3. A planned downsizing that is expected to offer early retirement to employees.
4. Investments in the stock of the employer.

Defined Benefit Plans

In addition to the statement of net assets available for benefits and the statement of changes in net assets available for benefits, defined benefit pension plans must provide information about the actuarial present value of accumulated plan benefits and changes in the actuarial present value of accumulated plan benefits. The information can be included as separate financial statements or as schedules in the notes to the financial statements.

Accumulated plan benefits include the present value of future benefits to retired or terminated employees or their beneficiaries, to beneficiaries of deceased employees, and to present employees or their beneficiaries. Whenever possible, plan provisions are to govern the measurement of accumulated plan benefits. If the benefits earned in each year are not determinable from the plan's provisions, a formula for measurement is provided in ASC 960. When calculating accumulated plan benefits, an ongoing plan is to be assumed, analogous to the going concern assumption used in preparing GAAP financial statements of other types of entities. Thus, interest rates used for discounting expected future payments are based on rates of return on investments for the benefit deferral period, and employee turnover and employee mortality are considered.

At a minimum, the information provided in the financial statements for accumulated plan benefits is to include:

1. Vested benefits of participants currently collecting benefits
2. Other vested benefits
3. Nonvested benefits.

Either a reconciliation or a narrative description is to identify significant factors affecting the accumulated plan benefits from the beginning of the year to the end. The information is to include:

1. Effects of plan amendments
2. Changes in the nature of the plan, such as a merger or a spin-off
3. Changes in actuarial assumptions
4. Benefits accumulated during the year
5. Benefits paid during the year
6. Interest component (from amortizing the discount)
7. Other changes.

The last four items can be combined into a single “other changes” category.

If the provisions of the defined benefit plan include a postretirement medical benefit component that is funded in accordance with IRC §401(h), ASC 965-205-05 specifies the accounting and disclosure rules with respect to the §401(h) component. These specialized rules are necessary due to legal requirements regarding the separate accounting for and funding of these arrangements.

Defined Contribution Plans

The three general types of defined contribution plans are profit-sharing plans, money purchase pension plans, and stock bonus plans. A profit-sharing plan is a plan that is neither a pension plan, as defined in the Internal Revenue Code, nor a stock bonus plan. Employer contributions to a profit-sharing plan are to be either discretionary or based on a fixed formula. Although the plan is called a profit-sharing plan, the contributions need not be made from the profits of the plan sponsor. A money purchase plan is a benefit plan that bases employer contributions on a fixed formula that is unrelated to profits. A stock bonus plan is a plan that makes its distributions to participants in the stock of the employer unless the participant chooses otherwise. Within these three categories of plans are more specialized plans, such as 401(k) plans, 403(b) plans, savings plans, employee stock ownership plans, target benefit plans, and Keogh plans.

The three primary attributes that distinguish a defined contribution plan from a defined benefit plan are:

1. Employer contributions are determined at the discretion of the employer or according to a contractual formula, rather than being actuarially determined.
2. Individual accounts are maintained for each plan participant, rather than a single account in which all participants partake.
3. Benefits are determined based on the amount accumulated in a participant's account at the time he or she retires or withdraws from the plan, rather than being defined in the plan agreement. If vested, the account's value is either paid to the participant or used to purchase an annuity for the participant.

The liabilities of a defined contribution plan include accounts payable, amounts owed for securities purchases, and borrowings. The liabilities are not to include amounts that have not been paid to withdrawing participants. Those amounts are included in net assets available for benefits (representing the participants' equity in the plan net assets) and disclosed in the notes to the financial statements. Because those amounts are liabilities for regulatory purposes, a note to reconcile the financial statements to the Form 5500 may be necessary to comply with the Employee Retirement Income Security Act of 1974 (ERISA), as amended.

ASC 946-210-45 specifies that, if the net assets of an investment company contain fully benefit-responsive investment contracts, those assets shall be reported at their contract values, because that is the amount participants in the fund would receive if they were to initiate withdrawals under the terms of the plan. An asset is considered fully benefit-responsive if (1) the investment contract is between the fund and the issuer and prohibits the fund from assigning or selling the contract without issuer permission, (2) the issuer is obligated to repay principal and interest, or a financially responsible third party assures that the interest rate will not drop below zero, (3) all permitted participant-initiated transactions occur at contract value, and (4) an event that would limit the fund's ability to transact at contract value with the issuer is not probable. The codification also specifies disclosure requirements for this scenario.

Employee Health and Welfare Benefit Plans

Defined benefit health and welfare plans stipulate a determinable benefit amount, which may take the form of a payment directly to the participant or a payment to a third party (such as a service provider or an insurance company) on the participant's behalf. These benefits may be provided upon retirement of the participant or during the postemployment period between termination of employment and retirement. Factors such as length of employment, age, and salary level determine the level of benefits to be provided. The contributions from the employer may be determined actuarially, by actual claims paid, or by a formula established by the plan sponsor. Regardless of the manner in which the plan is funded, the plan is a defined benefit health and welfare plan if its purpose is to provide a defined benefit.

Like defined benefit pension plans, defined benefit health and welfare plans must include information in their financial statements about the actuarial present value of benefit obligations earned by having performed past service. A benefit obligation exists if all of the following conditions are met:

1. The participants' rights to receive benefits are attributable to services already rendered.
2. The participants' benefits vest or accumulate.
3. Payment of benefits is probable.
4. The amount can be reasonably estimated.

If conditions 1 and 2 are not met, the obligation exists if the event that gives rise to the liability has already occurred and the amount can be reasonably estimated. The benefit obligations are measured as of the end of the plan year and include the actuarial present value of:

1. Claims payable
2. Claims incurred but not reported (IBNR)
3. Insurance premiums due
4. Accumulated eligibility credits and postemployment benefits, net of amounts currently payable
5. Postretirement benefits for retired participants and their beneficiaries, other plan participants who are eligible to receive benefits, and participants who are not yet eligible to receive benefits.

Benefit obligations of defined benefit health and welfare plans, similar to accumulated plan benefits of defined benefit pension plans, do not appear as liabilities on the statement of net assets available for benefits. Instead, they are presented either as a separate financial statement, on the face of another financial statement, such as the statement of net assets available for benefits, or in the notes to the financial statements. Regardless of the location selected, the information about benefit obligations is required to be presented in its entirety in the same location.

A reconciliation, presented as a separate statement, on the face of another financial statement, or in the notes to the financial statements, is to identify significant factors comprising the change in the benefit obligation from the beginning of the year to the end. The changes are classified into at least three categories: (1) amounts currently payable, which includes claims payable, claims IBNR, and premiums due insurance companies, (2) accumulated eligibility credits and postemployment benefits, net of amounts currently payable, and (3) postretirement benefit obligations, net of amounts currently payable and claims IBNR. The information for each category is to include, at a minimum, the effects of:

1. Plan amendments
2. Changes in the nature of the plan, such as a merger or a spin-off
3. Changes in actuarial assumptions
4. Benefits accumulated during the year
5. Benefits paid during the year
6. Interest component (from amortizing the discount)
7. Other changes.

The last four items can be combined into a single “other changes” line.

ASC 965-205-50 requires the following additional disclosures:

1. The weighted-average assumed discount rate used to measure the obligation for postemployment benefits.
2. Investments representing 5% or more of the net assets available for benefits as of the end of the plan year, and
3. The portion of the plan's estimated cost of providing postretirement benefits that is funded by contributions from retirees.

Defined contribution health and welfare plans, like other defined contribution plans, maintain an account for each participant that determines the amount of benefits that the participant will eventually receive. The terms of a defined contribution health and welfare plan agreement determine the contribution that will be made by the employer or participant into each account. Defined contribution health and welfare plans do not report information about benefit obligations because a plan's obligation is limited to the amounts accumulated in the participants' accounts.

Government Regulations

Pursuant to the requirements of ERISA, the federal government oversees the operating and reporting practices of employee benefit plans. ERISA establishes minimum standards for participation, vesting, and funding. It defines the responsibilities of plan fiduciaries and standards for their conduct. It requires plans to annually report summarized plan information to plan participants.

The Department of Labor (DOL) and the Internal Revenue Service (IRS) are authorized to issue regulations establishing reporting and disclosure requirements for employee benefit plans that are subject to ERISA. Each year, plans are required to report certain information to the DOL, the IRS, and the Pension Benefit Guaranty Corporation (if applicable). For many plans, the information is reported using Form 5500, which includes financial statements prepared in conformity with GAAP and additional supplementary financial schedules.

Various provisions of the Internal Revenue Code apply to employee benefit plans. If an employee benefit plan qualifies under Section §401(a) of the Code, certain favorable tax treatments apply. For example, if a plan is qualified, the plan sponsor receives current deductions for contributions to the plan, and the plan participants do not pay income taxes on those contributions or the accumulated earnings on them until benefits are distributed to them. In addition, plan participants may receive favorable tax treatment on the distributions. Qualified plans are exempt from income taxes, except for taxes on unrelated business income. Nonqualified plans, which generally provide benefits selectively only to a few key employees, are not entitled to those favorable treatments.

Terminating Plans

If the liquidation of a plan is imminent before the end of the plan year, the plan is a terminating plan, even if another plan will replace the terminated plan. A terminating plan may continue to operate for as long as necessary to pay accrued benefits. Prominent disclosure of the relevant circumstances is necessary in all financial statements issued by the plan after the decision to terminate is made. Financial statements of a terminating plan are prepared on the liquidation basis of accounting for plan years ending after the determination that the termination is imminent. The liquidation basis for accumulated plan benefits (defined benefit pension plans) and benefit obligations (defined benefit health and welfare plans) may differ from the actuarial present value of benefits for an ongoing plan. For example, certain or all benefits may become vested upon plan termination.

Preacquisition Costs

Payments are generally capitalized if they relate to an option to obtain the real property or if all of the following conditions are met:

1. Costs are directly identified with the property.
2. Costs would be capitalized if the property already were acquired.
3. Acquisition of the option or property is probable. The purchaser wants the property and believes it to be available for sale and has the ability to finance its acquisition.

Once capitalized, these costs are project costs that, if not receivable in the future, or if the property is not acquired, are to be recognized as expense.

Taxes and Insurance

Real estate taxes and insurance are capitalized as property costs only when the property is undergoing activities necessary to get the property ready for its intended use. After the property is substantially complete and ready for its intended use such items are expensed.

Project Costs

Costs that are identifiable and clearly associated with acquisition, development, and construction of a real estate project are capitalized as a cost of the project.

Indirect costs that relate to several projects are capitalized and allocated to these projects. Overhead costs that do not clearly relate to any project (i.e., general and administrative expenses) are expensed as incurred.

Amenities

The costs in excess of anticipated proceeds of amenities that are to be sold or transferred in connection with the sale of individual units are treated as common costs of the project.

The costs of amenities that are to be sold separately or retained by the developer are capitalized with those costs in excess of estimated fair value treated as common costs. Fair value is determined as of the expected date of substantial physical completion and the amounts allocated to the amenity are not to be revised later. The sale of the amenity results in a gain or loss when the selling price differs from the fair value less accumulated depreciation.

Costs of amenities are allocated among land parcels benefited for which development is probable. The fair value of a parcel is affected by its physical characteristics, its highest and best use, and the time and cost required to make such use of the property. Before completion and availability for use, operating income or loss is an adjustment to common costs. After such date, operating income or loss is included in the income statement.

Incidental Operations

Revenue from incidental operations is netted with the costs of such operations and any excess of incremental revenue over incremental costs reduces capitalized project costs. If such costs exceed revenues, the excess is recognized as expense as incurred.

Allocation of Costs

Capitalized costs are allocated by specific identification. If this is not feasible, then costs prior to construction are allocated by the relative fair value of each parcel before construction and construction costs are allocated by the relative sales value of each unit.

If estimation of relative values is impractical, allocation may be based on square footage or another area method, or by using other appropriate methods.

Revisions of Estimates

Estimates made and cost allocations are to be reviewed at least annually until the project is substantially complete and available for sale. Costs are revised and reallocated as required for changes in current estimates.

Abandonment and Change in Use

Abandonment of a project requires all capitalized costs to be expensed and not reallocated to other components of the project or other projects. Real estate dedicated to governmental units is not deemed abandoned and its costs are treated as project common costs.

Changes in use require that costs incurred and expected to be incurred that exceed the estimated value of the required project (when substantially complete and ready for intended use) be charged to expense. If no formal plan for the project exists, then project costs in excess of current net realizable value are expensed.

Selling Costs

Costs incurred to sell are capitalized if they are:

1. Reasonably expected to be recovered from sale of the project or from incidental operations, and
2. Incurred for tangible assets used directly throughout the selling period to assist the selling process or incurred for services required to obtain regulatory approval of sales.

Other costs may be capitalized as prepaid expenses if directly associated with sales, cost recovery is reasonably expected from sales, and the full accrual method cannot be used.

All other costs are expensed in the period incurred. Capitalized costs are expensed in the period in which the related revenue is earned.

Rental Costs

Costs related to and reasonably expected to be recoverable from future rental operations are capitalized. This excludes initial direct costs as defined and described in accounting for leases. Costs that do not qualify for capitalization are expensed as incurred.

Capitalized costs are amortized over the term of the lease, if directly related to a specific operating lease, or over the period of expected benefit. Amortization begins when the project is substantially completed and available for occupancy. Estimated unrecoverable amounts are expensed when it is probable that the lease will be terminated.

A project is substantially completed and available for occupancy when tenant improvements are completed or after one year from the end of major construction activity. Then normal operations take place with all revenues and costs (including depreciation and other amortized costs) recognized in the income statement. If part of a project is occupied but other parts are not yet complete, completed portions are considered separate projects.

Impairment and Recoverability

As discussed in the chapter on ASC 360, real estate projects must be evaluated, when warranted by events and circumstances, to determine whether their carrying value is recoverable from estimated future cash flows. ASC 360 provides guidance on grouping assets that are being held and used into “asset groups” and assets being held for sale into “disposal groups” for the purpose of the evaluation of recoverability and impairment computations. ASC 360 applies to real estate held for development and sale, property to be developed in the future, and property currently undergoing development.

Generally, under ASC 360, recoverability is evaluated at the “lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities.” If a project has identifiable elements with separate cash flows such as residential and commercial, or houses and condominiums, then each element is evaluated separately and not combined for the whole project. Projects are not combined in order to avoid recognizing impairment of one of the components.

Once impairment losses are recognized on property, similar to inventory, a new cost basis is adopted and future recoveries in value are not recognized.

Real estate special assessments. The laws of various states permit the formation of Tax Increment Financing Entities (TIFEs). Although their structure and characteristics differ between jurisdictions, TIFEs are generally special taxing districts established to finance and operate infrastructure owned by the municipality, such as roads, water mains, electric lines, sewers, and the like. These infrastructure improvements are used to revitalize a discrete geographic area by facilitating the private development of adjoining residential and commercial real estate. The TIFE or, absent a TIFE, the municipality typically issues bonds to finance the construction of the infrastructure improvements. The bonds may offer investors favorable after-tax yields by qualifying for tax-exempt status under IRC §141. Generally, the bonds are repaid from special assessments specifically designated for this purpose by the TIFE (or the municipality) such as user fees, tolls, sales taxes, real estate taxes, hotel bed taxes, and the like.

Besides paying for the debt service, these special assessments also fund ongoing operating costs, such as routine infrastructure repairs and maintenance. The infrastructure improvements made with the bond proceeds directly benefit the adjoining property owners and, in fact, the terms of these arrangements are often jointly negotiated between residential and commercial real estate developers and the municipality as an inducement to the developers to invest in a local development project.

Depending on an analysis of the specific facts and circumstances, including the relevant statute, ordinance, bond indenture, and other legal documents, the property owner or developer may potentially be required to record:

1. A liability for a special assessment by the TIFE or municipality if that assessment is levied on each individual property owner at an amount that is fixed or determinable and that covers a determinable period of time. (ASC 970-470)
2. A guarantee liability under ASC 460 if, for example, it has:
   1. Contractually agreed to cover all or a portion of any shortfalls in the required annual debt service of the bond obligations of the issuing TIFE or municipality.
   2. Pledged company assets as collateral for the bond obligations.
   3. Provided a letter of credit or other credit enhancements to support all or a portion of the bond obligations.

Other Guidance to Accounting for Real Estate Operations

ASC 970-360 holds that when a seller of real estate agrees to make up any rental shortfalls for a period of time, payments to and receipts from the seller are adjustments to the cost of the property and will affect future depreciation charges.

ASC 974-323-25 addresses the accounting by a REIT in a service corporation (SC). In determining a REIT's accounting for its investment in an SC, the SC must be evaluated as a potential VIE under ASC 810. If the SC is subject to ASC 810, this codification section does not apply to the determination of the REIT's accounting. If, however, the SC is not subject to ASC 810, this section continues to apply to the determination of the method of accounting that the REIT should use to record its investment (consolidation, equity method, or cost method). The codification includes a list of factors that indicate that the equity method of accounting is to be used. Regardless of the method of accounting used by a REIT for its investment in an SC, the SC is not considered an independent third party for the purpose of capitalizing lessor initial direct costs under ASC 310-20. Consequently, leasing costs capitalized by a REIT as initial direct costs may not exceed the amounts allowable if the REIT had incurred the costs directly.

As noted in the preceding section of this chapter, ASC 978 addresses the accounting for time-share operations. ASC 978 also establishes accounting requirements for incidental operations. In particular, rental and other operations during holding periods, including sampler programs and minivacations, are to be accounted for as incidental operations. The excess, if any, of revenue over costs of such operations is to be recorded as a reduction of inventory costs.

Real Estate Sales Other than Retail Land Sales

Methods of Accounting for Real Estate Sales other than Retail Land Sales

Profit Recognition on Retail Land Sales

A single method of recognizing profit is applied to all consummated sales transactions within a project.

Accounting for Time-Share Transactions

ASC 978 provides guidance for a seller's accounting for real estate time-sharing transactions, including:

1. Fee simple transactions in which nonreversionary title and ownership of the real estate pass to the buyer or an SPE
2. Transactions in which title and ownership of all or a portion of the real estate remain with the seller
3. Transactions in which title and ownership of all or a portion of the real estate pass to the buyer and subsequently revert to the seller or transfer to a third party
4. Transactions by a time-share reseller.

The major conclusions of this very detailed, specialized section of the ASC are as follows:

Profit Recognition

A time-share seller should recognize profit on time-sharing transactions as set forth by the provisions of ASC 978 that specify the accounting for other than retail land sales. In order to justify recognizing profit, nonreversionary title must be transferred. If title transfer is reversionary, on the other hand, the seller must account for the transaction as if it were an operating lease.

For a time-sharing transaction to be accounted for as a sale, it must meet the following criteria:

1. The seller transfers nonreversionary title to the time-share;
2. The transaction is consummated;
3. The buyer makes cumulative payments (excluding interest) of at least 10% of the sales value of the time-share; and
4. Sufficient time-shares would have been sold to reasonably assure that the units will not become rental property.

Effect of Sales Incentives

The codification requires that certain sales incentives provided by a seller to a buyer to consummate a transaction are to be recorded separately, by reducing the stated sales price of the time-share by the excess of the fair value of the incentive over the amount paid by the buyer. For purposes of testing for buyer's financial commitment as set forth under ASC 978, the seller must reduce its measurement of the buyer's initial and continuing investments by the excess of the fair value of the incentive over the stated amount the buyer pays, except in certain situations in which the buyer is required to make specific payments on its note in order to receive the incentive.

Reload Transactions

A reload transaction is considered to be a separate sale of a second interval, and the second interval is accounted for in accordance with the profit recognition guidance of ASC 978. For an upgrade transaction, that guidance is applied to the sales value of the new (upgrade) interval, and the buyer's initial and continuing investments from the original interval are included in the profit recognition tests related to the new interval.

Uncollectibles

The term uncollectibles is used in ASC 978 to include all situations in which, as a result of credit issues, a time-share seller collects less than 100% of the contractual cash payments of a note receivable, except for certain transfers of receivables to independent third parties by the seller. An estimate of uncollectibility that is expected to occur should be recorded as a reduction of revenue at the time that profit is recognized on a time-sharing sale recorded under the full accrual or percentage-of-completion method. Historical and statistical perspectives are used in making such a determination of anticipated uncollectible amounts. Subsequent changes in estimated uncollectibles should be recorded as an adjustment to estimated uncollectibles and thereby as an adjustment to revenue. Under the relative sales value method, the seller effectively does not record revenue, cost of sales, or inventory relief for amounts not expected to be collected. There generally is no accounting effect on inventory when, as expected, a time-share is repossessed or otherwise reacquired.

Cost of Sales

The seller should account for cost of sales and time-sharing inventory in accordance with the relative sales value method.

Costs Charged to Current Period Expense

All costs incurred to sell time-shares would be charged to expense as incurred except for certain costs that are:

• Incurred for tangible assets used directly in selling the time-shares;
• Incurred for services performed to obtain regulatory approval of sales; or
• Direct and incremental costs of successful sales efforts under the percentage-of-completion, installment, reduced profit, or deposit methods of accounting.

Incidental operations. Rental and other operations during holding periods, including sampler programs and minivacations, should be accounted for as incidental operations. This requires that any excess of revenue over costs be recorded as a reduction of inventory costs.

VIEs and other complex structures. The accounting treatment for more complex time-sharing structures such as time-sharing special-purpose entities (variable interest entities [VIEs], which were formerly known as special-purpose entities, or SPEs), points systems, and vacation clubs should be determined using the same profit recognition guidance as for simpler structures, provided that the time-sharing interest has been sold to the end user. For statement of financial position presentation purposes, a VIE should be viewed as an entity lacking economic substance and established for the purpose of facilitating sales if the VIE structure is legally required for purposes of selling intervals to a class of nonresident customers, and the VIE has no assets other than the time-sharing intervals and has no debt. In those circumstances, the seller should present on its statement of financial position as time-sharing inventory the interests in the VIE not yet sold to end users.

Continuing Involvement by Seller or Related Entities

If the seller, seller's affiliate, or related party operates an exchange, points, affinity, or similar program, the program's operations constitute continuing involvement by the seller, and the seller should determine its accounting based on an evaluation of whether it will receive compensation at prevailing market rates for its program services.

Licensing vs. Sales

Standards setters were concerned that transfers of rights to software by licenses rather than by outright sales (a technique widely employed to provide vendors with legal recourse when others engage in unauthorized duplication of their products) were being accounted for differently. The standard setters concluded that any legal distinction between a license and a sale should not cause revenue recognition to differ.

Product May Not Equate with Delivery of Software

Arrangements to deliver software, whether alone or in conjunction with other products, often include services. Services to be provided in such contexts commonly involve significant production, modification, or customization of the software. Thus, physical delivery of the software might not constitute the delivery of the final product contracted for, absent those alterations, resulting in the requirement that such arrangements be accounted for as construction-type or production-type contracts in conformity with ASC 605-35. However, if the services do not entail significant production, modification, or customization of the software, the services are accounted for as a separate element.

Delivery is the key Threshold Issue for Revenue Recognition

This is consistent with the principles set forth in CON 5, Recognition and Measurement in Financial Statements of Business Enterprises, which states that:

An entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues…[t]he two conditions (being realized or realizable and being earned) are usually met by the time the product or merchandise is delivered…to customers, and revenues…are commonly recognized at time of sale (usually meaning delivery).

Revenue Must be Allocated to all Elements of the Sales Arrangement, with Recognition Dependent Upon Meeting the Criteria on an Element-by-Element Basis

Under prior GAAP, the accounting for vendor obligations remaining after delivery of software was dependent upon whether or not the obligation was deemed to be significant. Under ASC 985-605-25, however, all obligations are accounted for and revenue is allocated to each element of the arrangement, based on vendor-specific objective evidence (VSOE) of the fair values of the elements. Revenue associated with a particular element is not recognized until the revenue-recognition conditions established by the ASC are met, as the earnings process related to that element will not be considered complete until that time.

Fair Values for Revenue Allocation Purposes Must be Vendor-Specific

When there are multiple elements of an arrangement, revenue is generally recognized on an element-by-element basis as individual elements are delivered. Revenue is allocated to the various elements in proportion to their relative fair values. Under ASC 985-605-25, this allocation process requires that VSOE of fair value be employed, regardless of any separate prices stated in the contract for each element, since prices stated in a contract may not represent fair value and, accordingly, might result in an unreasonable allocation of revenue. If an element is not yet being sold separately, then the price established by management is acceptable as a substitute. Separate transaction prices for the individual elements comprising the arrangement, if they are also being sold on that basis, would be the best such evidence, although under some circumstances (such as when prices in the arrangement are based on multiple users rather than the single user pricing of the element on a standalone basis) even that information could conceivably be invalid for revenue allocation purposes. Relative sales prices of the elements included in the arrangement are to be used whenever possible.

The Earnings Process is Not Complete if Fees are Subject to Forfeiture

Even when elements have been delivered, if fees allocated to those elements are subject to forfeiture, refund, or other concession if the vendor does not fulfill its delivery responsibilities relative to other elements of the arrangement, those fees are not treated as having been earned. The potential concessions are an indication that the customer would not have licensed the delivered elements without also licensing the undelivered elements. For that reason, there must be persuasive evidence that fees allocated to delivered elements are not subject to forfeiture, refund, or other concessions before revenue recognition can be justified. Thus, for example, in determining the persuasiveness of the evidence, the vendor's history of making concessions that were not required by the provisions of an arrangement is more persuasive than are terms included in the arrangement that indicate that no concessions are required.

Exclusions

The ASC provides that software revenue recognition guidance does not apply when a tangible product contains software and non-software components that function together to deliver its essential functionality. Further, an entity should always exclude hardware components of a tangible product from software revenue guidance. The exclusion also applies to any software contained within a tangible product, and which is essential to its functionality (including essential software sold with the product). An example of a tangible product that would be excluded from software revenue recognition guidance is a computer sold with an included operating system. Conversely, an example of a tangible product that would not be excluded from software revenue recognition guidance is a computer sold with a bundle of software productivity software; this software is not essential to the operation of the computer, and so is not excluded from the software revenue recognition guidance.

Consider the following factors when deciding if a specific scenario is governed by these exclusions:

• Infrequent sales of the tangible product without the software elements indicate that the software elements are essential to the product's functionality.
• If an entity sells multiple similar products that primarily differ only in the presence or absence of a software component, then consider them the same for the purposes of reviewing the exclusion applicability.
• The separate sale of software that is also contained within a tangible product does not necessarily mean that the software is not essential to the tangible product.
• A software element may be considered essential to a tangible product even it is not embedded within the product.
• The non-software elements of a tangible product must substantially contribute to its functionality.
• If there is an undelivered element of a deliverable that can be subdivided into elements that are excluded from and applicable to software revenue guidance, then bifurcate them into software and non-software deliverable.