Accounting & Reporting

CHAPTER 1

SOURCES OF GAAP AND BASIC FRAMEWORK AND CONCEPTS

Hierarchy of Sources (BOIS)

B Accounting Research Bulletins (ARBs)

O Accounting Principles Board Opinions (APBOs)
I FASB Interpretations
S FASB Statements of Financial Accounting Standards (not concepts)

Hierarchy of Accounting Qualities

Pervasive constraints - Benefits > Cost, materiality

Decision Usefulness
Primary Decision-Specific Qualities – Relevance and Reliability
Relevance (PFT) – Predictive Value, Feedback Value, & Timeliness
Reliability (NRFV) – Neutrality, Representational Faithfulness, &
Verifiability.
Passing Feels Terrific & Nobody Relies on Financials unless Verified

Secondary and Interactive Qualities – Comparability & Consistency

REPORTING NET INCOME

(IDEA)

I Income from continuing operations (gross then net of tax) (operating and non
operating)
D Income from discontinued operations (net of tax)
E Extraordinary item (net of tax)
A Accounting Principle change (to R/E net of tax)

Discontinued Operations

1. Accounting for discontinued operations item can consist of gain or loss on current
year’s operations, gain/loss on sale and impairment loss. Any of these must be reported
as part of discontinued operations in the same year as they occurred. If the operations are
being “held for sale,” they are treated as discontinued.

2. Assets within the component are no longer depreciated or amortized.

3. If impairment is recognized and in a subsequent period there is an increase in fair

value, a gain is recognized for any subsequent increase in fair value minus the costs to
sell (but not in excess of the previously recognized cumulative loss)
 Example:
Book Value 1,000
Market Value 800
Loss 200

Subsequent MV increase from 800 to 1300, write back up to 1,000.

4. Anticipated future gains or losses are not recorded until they occur.

5. Subsequent directly related expenses are classified in the period they occur as
discontinued operations. Must demonstrate cause-and-effect relationship and occur no
later than one year after the date of disposal (unless circumstances beyond the control of
the entity exist).

Extraordinary Items

Extraordinary items must be unusual and infrequent. Material in nature.

‘Unusual’ requires the event be unrelated to the typical business activities of the firm.
‘Infrequent’ means the event is not expected to occur again in the foreseeable future.
They are shown “net of tax”. Ex. Expropriation of a plant by the government.

Unusual or infrequent items are reported within the ‘upper’ (I) part of the income
statement and before tax (other gains/losses). Ex. Gain or loss on sale of available-for-
sale securities, losses form major strike by employees, write downs.

Accounting Changes

1. Changes in estimate, such as the useful life of a plant asset, are incorporated into
the accounting records for the current and future periods. No change in
estimate has any implications for prior financial statement periods.

2. Changes in principle (or method) involve switching from one acceptable method
to another. The cumulative effect is the change in retained earnings that results
from restating prior years from the ‘old’ method to the ‘new’ method at the
beginning of the year. The cumulative effect is reported in the statement of
retained earnings. (GAAP to GAAP)

Changes in principle: the exception:

When it is impracticable to estimate the changes in retained

earnings that would result form restating the prior years financial
statements, the change in method is applied prospectively (as for changes
in estimate). In this case, no restatement of prior years occurs and there is
no cumulative effect reported in the statement of retained earnings: e.g.,
changing to LIFO from any other inventory method.

Change in Depreciation method is treated as a change in estimate –

prospectively.
 ALL DEPRECIATION CHANGES (USEFUL LIFE OR PRINCIPAL)
ARE TREATED PROSPECTIVELY.

3. Change in entity requires restatement of prior year’s financial statements to

conform with the new accounting entity when the prior financials are presented
comparatively.

Prior Period Adjustments (Corrections of errors)

Report net of tax in the statement of retained earnings.

Single Step Income Statement

In the single step income statement presentation of income from continuing operations,
total expenses (including income tax expense) are subtracted from total revenues: thus,
the income statement has a single step. The benefits of a single step income statement are
its simple design and the fact that the presentation of types of revenues or expenses do
not appear to the user to be classified as more important than others.

Multiple Step Income Statement

The multiple step income statement reports operating revenues and expenses separately
from non-operating revenues and expenses and other gains and losses. The benefit of the
multiple step income statement is enhanced user information (because the line items
presented often provide the user with readily available data with which to calculate
various analysis ratios.

Cost Categories

1. Inventory Cost Purchase price, freight in

2. Selling Expense Freight out, salaries and commissions, advertising
3. General & Administrative Officers’ salaries, accounting and legal, insurance
4. Non-operating Auxiliary activities, interest expense
 COMPREHENSIVE INCOME

1. Comprehensive Income includes all changes in owners’ equity other than

transactions with owners. The formula shows that comprehensive income must
include all of net income plus/minus other changes in owners’ equity not resulting
from transactions with owners. These other changes are known as other
comprehensive income

2. Other Comprehensive Income ‘PUFE’

Pension minimum liability adjustment
Unrealized gains and losses (available for sale securities)
Foreign currency translation items
Effective portion of cash flows hedges

3. Accumulated other comprehensive income is a cumulative sum of all of the

individual components of other comprehensive income. Accumulated
comprehensive income is an owners’ equity item. Must be reported.

4. 3 acceptable ways to present the statement of comprehensive income.

Single Statement Approach – displays other comprehensive income below
the income statement and totals them for comprehensive.
Two-Statement Approach – displays comprehensive income as a separate
statement that begins with net income.
Component within the statement of owners’ equity –displayed as a
separate column in the statement of owners’ equity.

BALANCE SHEET AND DISCLOSURES OVERVIEW

Summary of Significant Accounting Policies reflects the methods and policies employed
by the firm.

INTERIM FINANCIAL REPORTING

Interim financial reporting uses the same GAAP as do annual financial reports.
Timeliness is emphasized over reliability and income taxes are estimated each quarter
based on the estimated average tax rate for the whole year.

SEGMENT REPORTING

1. A reportable segment exists if it meets one of three tests:

10% of combined revenues to internal and external parties.
10% of reported profit or loss (as an absolute amount) You should be familiar
with the definition of operating profit: Segment revenues from sales to
internal and external customers less directly traceable costs and also less
reasonably allocated costs equals segment operating profit (loss).
10% of the combined assets of all operating segments.
2. The ‘75% reporting sufficiency test’ is a ‘catch all’ requirement that may
require identification of additional segments to attain the 75% level.

3. The ‘90% single industry dominance test’ means if one segment individually
contains 90% or more of the firm’s revenues, profits and assets, then the segment
reporting requirement is waived for that firm.

4. Transactions between the segments of an enterprise are not eliminated as in

consolidation between the parent company and subsidiaries.

5. Segment Reporting applies to Public Companies ONLY.

DEVELOPMENT STAGE ENTERPRISES

1. These firms have not yet started their primary operations or have generated
insignificant revenues to date.
2. Development stage enterprises use ‘regular GAAP’ with a couple of differences
regarding labeling and summation of cumulative reporting.

Financial Accounting & Reporting

CHAPTER 2

TIMING ISSUES; MATCHING CORRECTING AND ADJUSTING

1. Assets are probable future economic benefits obtained as a result of a past event
and liabilities are probable future sacrifices or economic benefits. Revenue is
recognized when earned and expenses when incurred and these two need to be
matched in their appropriate period.

2. Deferrals, such as unearned or prepaid accounts, push recognition of revenue and

expense to future periods (after the related cash flow). Accruals (receivables and
payables) recognize revenues and expenses before the related cash flow.

3. Franchise fees, initial and continuing, are revenues to the franchisor and expense
to the franchisee depending on the circumstances.
- the present value of any contract amounts relating to future services (to be
performed by the franchisor) should be recorded as unearned revenue.
- the franchisor should report revenue from initial franchise fees when all material
conditions of the sale have been “substantially performed.” (usually the
franchisee’s first day of operations)
- the initial franchisee fee is capitalized by the franchisee and amortized over the
expected period of benefit of the franchise. (expected life of franchise)
- continuing franchise fees should be recorded as an expense to the franchisee and
revenue to the franchisor in the proper period.
 INTANGIBLE ASSETS

1. Some intangibles are identifiable [copyrights and patents, e.g.] while one is
unidentifiable [goodwill]. Purchased identifiable intangible assets should be
recorded at cost plus additional expenditures necessary to purchase.

2. Amortizing identifiable intangibles with finite lives is done over the shorter of the
estimated economic and legal life. Goodwill and identifiable intangibles with
infinite lives are no longer amortized and are subject to impairment testing.

3. The cost of intangible assets developed internally and not specifically identifiable
(or having indeterminate lives) should be expensed when incurred.
- exception: Cost that can be capitalized: Legal fees and other costs related to a
successful defense of the asset, registration or consulting fees, design costs (ex.
Of a trademark) and other direct costs to secure the asset.

4. Expenses that increase the useful life of the intangible asset will require an
adjustment to the calculation of the annual amortization.

5. patent is amortized over the shorter of its estimated life or remaining legal life.

START-UP COSTS

In financial accounting, start-up costs are expensed as incurred. [Note: tax rules permit
these costs to be capitalized.] These costs are expensed due to conservatism It is not
definite the new entity will be a success.

RESEARCH & DEVELOPMENT COSTS

R & D include cost incurred prior to tech feasibility for developed software that is to
be sold, leased, or marketed.

GAAP requires research & development expenditures be expensed as incurred.

1. Assets with alternative future uses can be expensed over time. (over useful life)
- the depreciation expense on the asset is charged to R&D as expense.
2. When parties’ contract for R&D services to be performed by another firm, the
buyer of R&D will expense amounts as paid to the provider. The seller will
expense costs as cost of goods sold.
3. Items not considered R&D.
- Routine periodic design changes to old products or trouble shooting in production
stage (these are manufacturing costs)
- Marketing research
- Quality control testing
- Reformulation of a chemical compound
 COMPUTER SOFTWARE DEVELOPMENT COSTS

1. If to be sold, leased or licensed, the timeline in notes is the key. Expense

development costs from concept to achieving technological feasibility. Capitalize
costs from technological feasibility through the start of selling activity. Resume
expensing further development costs after selling has started. [matching]
a. Costs capitalized between technological feasibility and the start of selling
are amortized using one of two methods: percentage of revenue or straight
–line. Use the GREATER of the two methods.

TECHNOLOGICAL
FEASIBILITY RELEASE PRODUCT
IDEA ESTABLISHED FOR SALE

Program design, Producing product

planning, masters, including Duplicate
coding, testing additional coding/testing packaging
AMORTIZATION INVENTORY
EXPENSE CAPITALIZE EXPENSE BEGINS COGS

2. If to be used internally, the development costs need to be amortized on the

straight-line basis.
- Expense costs incurred for the preliminary project state and costs incurred for
training and maintenance
- Capitalize costs incurred after the preliminary project state and for upgrades and
enhancements, including: direct costs of materials and services, costs of
employees directly associated with project, and interest costs incurred for the
project.

IMPAIRMENTS

Think of this as two impairment tests: recoverability and calculating the impairment loss.

1. Meet the recoverability test if the asset’s carrying value > the sum of future
undiscounted net cash flows
2. Then, if the asset’s carrying value > the asset’s fair market value, the excess is the
impairment loss.

LONG-TERM CONSTRUCTION CONTRACTS

1. Completed contract method recognizes income upon completion of job; it does

not match revenues and expenses over long term.

2. Percentage of completion method recognizes revenue as job is in progress based

upon estimated profitability and cost estimates following a four-step process.
Step1: compute gross profit of completed contract: Contract Price
(Estimated total cost)
GROSS PROFIT

Step 2: comport “% of completion” Total cost to date

Total estimated cost of contract

Step3: compute gross profit earned (profit to date): Step 1 * Step 2 = PTD

Step 4: compute gross profit earned for the current year: PTD at current FYE
(PTD at beginning of period)
Current year-to-date GP

3. Both methods recognize estimated losses immediately. General rule for losses
with a few exceptions.

INSTALLMENT SALES & COST RECOVERY (not GAAP)

1. Installment sale method is used when collectibility cannot be reasonably

estimated. Revenue is recognized as cash is collected based on gross profit rate at
time of sale.
FORMULAS:
1. Gross Profit = Sale –COGS
2. Gross Profit Percentage = Gross Profit/Sales Price
3. Earned Revenue = Cash Collections * Gross Profit Percentage
4. Deferred Revenue = Installment Receivable * Gross Profit Percentage

2. Cost recovery method is more conservative than the installment method and is
used when collectibility is more doubtful. Revenue is not recognized until the cost
of the asset sold is recovered. Profit is recorded as Deferred gross profit (contra-
receivable)
Cr Sales
Cr Deferred Gross Profit
DR COGS
DR AR

ACCOUNTING FOR NONMONETARY EXCHANGES

1. Exchanges having commercial substance affect future cash flows

a. Recognize gains/losses in the exchange based on the ‘old’ asset’s carrying
value in comparison to ‘old’ asset’s fair value.
b. New’ asset’s carrying amount will always equal its fair value.
DR New asset (FMV of consideration given)
DR Accumulated depreciation of asset given up
DR Cash received
DR Loss (if any)
CR Old asset at historical cost
CR Cash given
CR Gain (if any)

2. Exchanges lacking commercial substance do not affect future CF

a. Recognize no gain or loss in these exchanges.
b. The carrying value of the ‘old’ becomes the costs basis of the ‘new’ asset.
Boot paid out will increase the cost basis of the ‘new’ asset. Boot received
will decrease the cost basis of the ‘new’ asset.
c. No gain is recognized & basis of new asset = FMV of asset given +/- cash

PARTNERSHIPS

1. Contributions by a partner to a partnership are recorded at fair value less the

present value of liabilities assumed by partnership.

2. Admission of new partners may be by the exact, bonus or goodwill method. The
bonus method adjusts the partners’ capital accounts for any difference and the
goodwill method adjusts the assets for the difference.

- Exact Method:
Total new equity= existing equity + new partners % (new equity)
- Bonus Method: (current equity Balance controls the calculation)
Bonus will be credited in the following manner
Existing partners – when new partner pays more than NBV
New partners – when new partner pays less than NBV
- Goodwill:
Going in investment (dollars) controls capital account allocation &
goodwill calculation.

3. Withdrawals of partners also use the bonus and goodwill methods.

4. When a partnership is liquidated, assets are sold, gains or losses are allocated to
partners, liabilities are paid and the partners are entitled to receive the balance in
their capital account. Partners who wind up with debit (overdrawn) balances owe
that deficiency to the partnership and the other partners.
 Financial Accounting & Reporting
CHAPTER 3

MARKETABLE SECURITIES

SFAS 115 - Investments

Classification Balance Unrealized Cash
Sheet Reported Gain/Loss Flow
Trading Current Fair Value Income Stmt Operating
Available for Sale Current or Noncurrent Fair Value OCI (PUFE) Investing
Held-to-Maturity Current or Noncurrent Amortized Cost None Investing

Summary of Transfers between Categories

FROM TO TRF UNREALIZED
ACCT FOR HOLDING GAIN/LOSS

It's already been

recognized inincome so no
Trading Any other FMV adjustment is necessary.
Recognized in current
Any Other Trading FMV earnings

Held-to-Maturity Record in Other

(Debt Securities) Available-for-Sale FMV Comprehensive Income
Amortize gain or loss form
Other Comprehensive
Income with any bond
Available for Sale premium/discount
(Debt Securities) Held-to-Maturity FMV amortization

Marketable securities have readily determinable fair values. These include equity and/or
debt securities.

1. There are as many as three marketable securities portfolios: trading securities,

available-for-sale securities and debt securities intended to be held until maturity.

2. The trading securities portfolio can contain debt and/or equity securities intended
for active trading. The portfolio itself is carried at cost and is reported at fair value
in the financial statements through the use of a valuation account. Unrealized
gains or losses are reported on the income statement.

3. The available-for-sale securities portfolio can contain debt and /or equity
securities that do not fit into either of the other two portfolios. The portfolio itself
is carried at cost and is reported at fair value in the financial statements through
the use of a valuation account. Unrealized gains or losses are reported in Other
Comprehensive Income (the ‘U’ in PUFE). Should be reported as either current
assets or noncurrent assets, depending on the intent.

Sale of Available –for-sale Security

DR Cash
DR Unrealized gain on available-for-sale security (PUFE) remove
CR Available-for-sale security
CR Realized gain on available-for-sale security (IDEA) add
4. The debt securities held-to maturity portfolio can contain only debt securities
where the investor has the ability and intent to hold to maturity. The portfolio
itself is reported in the financial statements as amortized cost.

5. Special rules apply to reclassifications and impairment. Reported as current or

noncurrent based on their time to maturity.

a. Available for Sale & Held to Maturity

If the decline in fair value is other than temporary, the cost basis of the
individual security is written down to fair value as the new cost basis and
the amount of the write down is accounted for as a realized loss and
included in earnings – The new cost basis shall not be changed for
subsequent recoveries in fair value.

Subsequent increases and decreases in the FMV of available for sale

securities is accounted for as unrealized gain/loss in OCI.

DETERMINING THE CORRECT METHOD TO USE

1. Use cost method when investor cannot exercise significant influence over investee
– generally ownership of less than 20% of outstanding shares.

2. Use equity method when investor can exercise significant influence (generally
from 20% to 50% of ownership of outstanding shares).

3. Usually consolidate when “control” is present – 50+% ownership.

4. Special circumstances may affect significant influence or control.

5. Stock dividends are not accounted for under the Cost and Equity Methods. Only a
memo is made.

THE COST METHOD

(Available-for-sale Method)
(Fair Value Method)

1. Record the investment at cost. Generally, dividends received by the investor are
treated as dividends revenue. Dividends in excess of earnings, or liquidating
dividends, reduce the investment account. “Return of Capital” The basis is
adjusted to FMV as required for marketable equity securities using a valuation
account. The “Investment in Investee” is not adjusted for investee earnings.

2. Sale of a cost method investment merely involves comparing the proceeds with
the cost basis of the securities sold to determine the realized gain/loss. [Note
liquidating dividends lower the cost basis.]
 THE EQUITY METHOD

1. Record the investment at cost. Generally, dividends received from the investee
reduce the Investment account and the investor “picks up” its share of investee’s
earnings by increasing the Investment account and recognizing the earnings on its
income statement. Under the equity method, the Investment account is similar to a
“bank account.”

- B: Beginning Balance
- A: Add: Investee’s earnings (like bank interest; it is income when earned, not
when taken out).
- S: Subtract: Investee’s dividends (like bank withdrawals; and it is not
income)
- E: Ending Balance

2. Differences between the price paid for and investment and the book value of the
investee’s net assets are allocated first to the FMV of assets and then to Goodwill.
Excess asset FMV is depreciated, while the excess value of Land and Goodwill
are not amortized.

3. In a step-by-step acquisition, Goodwill is computed separately for each

transaction. When significant influence is obtained, the equity method may be
applied retroactively to prior periods when the cost method was applicable.
Increased ownership may also require changing the investment classification form
available-for-sale to equity. See example on page 20

However, when the equity method is applied retroactively it is applied to the

percentage of ownership at that time.

Goodwill Excess =$
FMV X% =$
NBV X% =$
Purchase
Price
 DO NOT CONSOLIDATE
COST METHOD EQUITY METHOD

Purchase Price Purchase Price

DR inv in investee DR inv in investee
CR cash CR cash

comply with sfas 115 BALANCE add: Investee Income

SHEET
"accounting for
investments "Investment DR inv in investee
inmarketable equity Account" CR equity in earnings
securities
sub: Amortize FMV>NBV
DR equity in earnings
CR investment in
investee

sub: Investee dividends

DR cash
CR investment in
investee

Investee dividends Investee Income

DR cash DR inv in investee
CR dividend income INCOME STMT CR equity in earnings
"Reportable
Income" Amortize FMV>NBV
DR equity in earnings
CR investment in
investee

Goodwill
not amortized
not impaired

CONSOLIDATED FINANCIAL STATEMENTS [ownership over 50%]

1. The purchase is recorded for the fair value of any consideration paid. Direct
expenses are added to cost and securities issuance costs reduce Additional Paid-In
Capital.

2. The purchase begins as the date of acquisition, unlike pooling, which is accounted
for as if the combinor and the combinee(s) had always been together.

3. If the purchase price exceeds the fair value of the net identifiable assets acquired,
the excess is goodwill. Any goodwill is implicitly part of the Investment account.
4. If the purchase price is smaller than the fair value of the net identifiable assets
acquired, the shortfall is used to reduce proportionately the fair values of non-
current assets acquired (other than non-current investments).

5. If these non-current assets acquired have been reduced to zero without having
used up the shortfall entirely, the remaining shortfall is treated as an extraordinary
gain.

The consolidating journal entry eliminates the owners’ equity accounts of the
subsidiary (common stock, A.P.I.C. and retained earnings), eliminates the Investment
account, recognizes the minority interest (MI percent ownership of subsidiary’s
equity), adjust acquired assets to their fair values and recognizes goodwill in the
consolidated balance sheet. The mnemonic CARIMAG is used for the elements of the
eliminating journal entry. When later years’ balance sheets are shown, it is necessary
to adjust RE back to purchase date. See example on page 25 & 30

The Consolidating Workpaper

Eliminating Journal Entry

C DR Common stock - Sub XX

A DR APIC - Sub XX
R DR Retained earnings - Sub XX
I CR Investment in Subsidiary XX
M CR Minority interest XX
A DR Adjust - Balance sheet (of Sub) to FMV (Paid) XX
G DR Goodwill XX

INTERCOMPANY TRANSACTIONS

1. Eliminate 100% regardless of whether there is a minority interest.

2. Eliminate all intercompany accounts. Examples: (a) interest revenue and interest
expense, (b) interest receivable and interest payable.
3. Intercompany inventory transactions require the elimination of the intercompany
sales account and any intercompany profit that remains in ending inventory of the
buying entity (through cost of goods sold).
4. Intercompany bond transactions require the elimination of the Bonds Payable
account from the issuer’s balance sheet and the Investment in Bonds account from
the balance sheet of the investor. Do not assume the issuer sold these bonds
directly to the investor.
5. Intercompany transactions involving land require an elimination making the
consolidated financial statements look as though the transaction had not even
occurred. Put the Land account back to the value that had been in the seller’s
books and also eliminate the gain/loss.
DR Intercompany gain on sale of land
CR Land
 6. Intercompany transactions involving depreciable assets involve essentially the
same steps as for land with two complications. There is an Accumulated
Depreciation account that has to be put back where it was at the time of the
intercompany transaction, and depreciation expense after the sale must be
adjusted back to what it would have been had the transaction never occurred.

COMBINED FINANCIAL STATEMENTS

Companies are under common control or companies are under common management

Intercompany transactions and balances among these companies eliminated.

Minority interest, etc. be treated like consolidated financial statements
Capital stock and retained earnings by “added across,” “not eliminated.”
Income statements be “added across.”

PUSH DOWN ACCOUNTING

The subsidiary’s books are adjusted to reflect the fair values of assets and liabilities as
seen by the parent firm by “pushing down” the consolidation adjustments to the financial
statements of the subsidiary. If goodwill was implicit in the purchase price, the goodwill
is recorded explicitly in the subsidiary’s books. The owners’ equity accounts of the
subsidiary are adjusted to make the sub’s book balance after these adjustments. The SEC
requires push down accounting for all “substantially owned” subsidiaries.

The Pooling of Interests method of accounting for ownership is no longer GAAP;

however, it may still be used for entities that qualified for the treatment prior to June 30,
2001.

Financial Accounting & Reporting

CHAPTER 4

WORKING CAPITAL AND ITS COMPONENTS AND RELATED ISSUES

1. Working Capital is a measure of the solvency of an entity. The Current Ratio and
Quick Ratio are used for analysis purposes.

WORKING CAPITAL= Current Assets – Current Liabilities

CURRENT RATIO = Current Assets / Current Liabilities
QUICK RATIO = Cash + Net Receivables + Marketable Securities/Current Liab.
(Asset test ratio)

2. Current assets and liabilities generally must meet the one year test or normal
operating cycle if longer.
 CASH AND CASH EQUIVALENTS

1. Cash must be readily available. Cash equivalents are debt securities with maturity
dates within 90 days of date purchased. The only occasion when time to maturity
matters is at the purchase date.
a. Restricted cash must be segregated from other cash.

2. Bank reconciliations reconcile ending balances per bank and book adding and
subtracting items causing differences between the two balances. Outstanding
items are adjustments on the ‘bank side’ and ‘adjusting journal entry information’
are adjustments on the ‘book side’.

ACCOUNTS RECEIVABLE

1. Valuing accounts receivable requires reductions for expected ‘bad debts’,

expected sales returns & allowances and expected sales discounts. This results in
a net accounts receivable balance approximating cash expected to be collected.
a. Sales discounts are offered to encourage earlier payment by customers.
Sales and related receivables can be recorded either using the gross or
theoretically preferred net method.
b. Trade discounts are applied sequentially and receivables are recorded net
of any trade discount.

2. Estimating Uncollectibles
a. Direct write-off method, used for tax, is not GAAP
b. Allowance method is GAAP. The allowance for uncollectible accounts is
a contra-asset. Percentage of sales method (income statement approach)
determines bad debt expense as a percentage of sales or credit sales for the
period. In the balance sheet approach (aging method) the ending balance
in the allowance account must equal an amount determined by an analysis
of the aged A/R schedule.
c. In the allowance method, writing off an account receivable involves
debiting the allowance and crediting accounts receivable.
d. When collecting an account previously written off, restore the account
receivable and the allowance into the accounts and then record the
collection in the normal way. (reverse write-off JE and record collection)

3. Factoring receivables can be done with or without recourse. With recourse means
the transferor retains the risk of uncollectibility. Factoring without recourse is a
sale of the receivable and the assignee assumes the risk of loss.

4. Pledging (Assignment) – the process whereby the company uses existing accounts
receivable as collateral for a loan. The company retains title to the receivables but
“pledges” that it will use the proceeds to pay the loan.

5. Transfers and servicing financial assets requires accounting at the component

level. There are three tests to determine if control has been surrendered and there
 has been a “sale.” If control has not been surrendered, or if there is some
continuing involvement, different treatments apply.

NOTES RECEIVABLE

1. Discounting notes receivable involves transferring the note to a third party usually
for cash. This transfer can be with or without recourse If done with recourse a
contingent liability is created for the transferor.

2. Determining the proceeds to be received requires deducting the banker’s discount

interest from the maturity value of the note. Discount is calculated using maturity
value, discount rate and time left to maturity.

a. Compute the maturity value of the note by adding the interest to the face
amount of the note
Face value of the note
Interest on note to maturity
Payoff value of note at maturity

b. Compute the bank discount on the payoff value at maturity

Payoff value of note at maturity * bank discount % = bank discount

c. Determine the amount paid by the bank for the note

Payoff value of note at maturity

Less: Bank’s discount
Amount paid by bank for note

d. Derive the interest income (or expense) by subtracting the face value of
the note from the amount paid by the bank for the note

Amount paid by bank for the note

Less: Face value of the note
Interest income

INVENTORIES

1. All inventories owned by an entity should be included in the inventory account.

FOB shipping terms can be used to establish when a purchase or sale has
occurred. Sales with a right of return still cont as a sales if returns are estimable.
Consigned goods belong to the consignor.
2. Shipment of non-conforming goods
If the seller ships the wrong goods, the title reverts to the seller upon
rejection by the buyer. Thus, the goods should not be included in the
buyer’s inventory, even if the buyer possesses the goods prior to their
return to the seller.
3. Inventory account valuations should include all the costs necessary to make ready
for intended use (sale).
- Lower-of-cost-or-market is a departure from cost basis caused by some
decline in the inventory’s utility. When the inventory’s replacement cost is
lower than cost basis, a current period inventory write down may be
indicated based on the relationship with the market “ceiling” and “floor.”
i. Market Value: median of an inventory item’s replacement costs, its
market ceiling, and its market floor.
ii. Replacement Cost: Replacement cost is the cost to purchase the
item of inventory as of the valuation date.
iii. Market Ceiling: Market Ceiling is item’s net selling price less the
costs to complete and dispose (called the net realizable value).
iv. Market Floor: market floor is the market ceiling less a normal
profit margin.

4. Perpetual and periodic inventory systems control how we account for purchases
and sales of inventory.
- Perpetual system records purchases with a debit to inventory. Periodic
system records purchases with a debit to purchases.
- Perpetual system records inventory sales in two journal entries. The
periodic system only records the receivable and revenue at time of sale.
The inventory account is updated at the end of the period after taking a
physical count.

5. Inventory methods include first-in, first-out (FIFO), last-in, first-out (LIFO) and
weighted average. These methods may apply to both periodic and perpetual
systems. Since FIFO values inventory at most recent costs, it will generally result
in a higher net income than other methods in a period of rising prices. Weighted
average is called “moving average” in perpetual.

6. The gross profit and retail inventory methods attempt to estimate ending
inventory based on the historical gross profit or cost complement percentage.
With perpetual inventory systems there is generally no need to estimate ending
inventory.

7. Non-GAAP Inventory Cost Flow Assumptions

- Base Stock Method- the base stock method replenishes any reduction in
LIFO layers with the old cost, not the replacement cost.
- Next In, First Out (NIFO) Method – values cost of goods sold at the
replacement cost
8. Firm purchase commitments may require current loss recognition.

9. Period Costs:
Marketing costs, Freight out, Re-handling costs, Abnormal Spoilage, Idle plant
capacity costs.
 FIXED ASSETS

1. Fixed assets are valued at historic cost to acquire and put into use with few
exceptions. Donated fixed assets are recorded at fair value and a gain or revenue
is recognized equal to that value.

2. Additions or improvements increase the cost basis of the fixed assets.

3. Accounting for replacements depends on how the accounting records have been
kept for the asset being replaced.
- If the carrying value of the old asset is known, remove it and recognize any gain
or loss. Capitalize the cost of the improvement/replacement to the asset account
- If the carrying value of the old asset is unknown, and:
o The asset’s life is extended, debit accumulated depreciation for the cost of
the improvement/replacement.
o The usefulness (utility) of the asset is increased, capitalize the cost of the
improvement/replacement to the asset account.

4. Ordinary repairs “maintain” the asset and should be expensed. Extraordinary

repairs, such as overhauls or major replacements, should be capitalized.
DR Accumulated Depreciation
CR Cash/accounts payable

Cost of equipment Summary Chart

Reduce
Accumulated
Expense Capitalize Depreciation
Additions: increase quantity X

Increase life X
Improvement/Replacement:
Increase Usefulness X

Ordinary Repair: X

Increase life X
Extraordinary repair:
Increase Usefulness X

5. Land should be recorded to reflect all the costs necessary to make the land ready
for its intended use. Land improvements have finite lives and should be
depreciated.
When preparing the land for the construction of a building:
Land cost – filling in a hole or leveling
Building cost – digging a hole for the foundation
“Basket Purchase” of land and Building
Allocate the purchase price based on the ration of appraised values of
individual items.

6. Constructed fixed assets should include capitalized interest on weighted average

expenditures. Incurred during the construction period.
 -Only capitalize interest on money actually spent, not on the total amount
borrowed.
-The amount of capitalized interest is the lower of:
Actual interest cost incurred, or
Computed capitalized interest (avoidable interest)

Summary of interest incurred for construction project

Before During After

Summary Construction Construction Construction

Borrowed Funds (not used) Expense Expense Expense

Borrowed Funds (weighted average of
accumulated expense) N/A Capitalize Expense
Excess (above amount borrowed)
Expenditures (weighted average interest
rate) N/A Capitalize Expense

7. The composite (dissimilar assets) and group (similar assets) depreciation methods
depreciate an entire class of assets over a single life
- The straight-line, sum-of-the-years’ digits and declining balance methods
are the three major methods of depreciation.

Average composite life= total depreciable cost(net of salvage)/total annual depreciation

Average composite rate = Total annual depreciation/ total cost

Straight Line Method = cost-salvage/useful life

Sum-of-the-years’-digits = (1+2+3+4/1+2+3+4+5)*(cost – salvage)
Declining-Balance = the first year’s depreciation rate is double the straight-line
rate. The same depreciation rate is applied to the remaining book value
each year. It is the only method that ignores salvage value in the annual
calculation of depreciation, Salvage value is only used as the limitation on
total depreciation.

8. Units-of-production method is similar to the straight-line method except that the

life is defined in number of units expected to be produced.
Units-of-production (Productive Output) = Cost-Salvage value = rate/unit or hr
Estimated units or hours

Rate per unit * #of units produced (or hrs worked) = depreciation expense
9. Depletion is similar to the units-of-production method except the former is
applied to ‘wasting’ assets. Restoration costs should be included.

1. calculate the depletion base (REAL)

Depletion base= cost of land + extraction/development costs + anticipated
restoration costs – residual value
2. calculate unit depletion
Unit depletion rate = Depletion base/ Estimated removal units
Total depletion = unit depletion rate * number of units extracted
IMPAIRMENT
 1. The recoverability test is met when the carrying value of the assets exceeds the
sum of the undiscounted future operating net cash flows.

2. Having met the recoverability test, the impairment test is met if the carrying value
of the asset exceeds its fair value.

3. If the impaired asset is held for use, the asset is written down to fair value and
subsequent depreciation is based on that fair value. If the fair value were to
subsequently ‘rebound’, no restoration is permitted.

4. If the asset is held for disposal, depreciation is discontinued. If the fair value were
to partially recover prior to sale, a restoration is permitted. This restoration result
is similar to discontinued operations items in F1.

Total Impairment
DR Accumulated depreciation
DR Loss due to impairment
CR Asset

Partial Impairment
DR Loss on impairment
CR Accumulated depreciation

Remember:
Determining impairment- use undiscounted future net cash flows
Amount of impairment – use present value future net cash flows (PV net cash
flows = FMV)
 Undiscounted future net cash flows
(Net carrying value)

Positive Negative

No Impairment Impairment

Loss
Assets held Assets held
for use for disposal

FMV/PV net cash flows FMV/PV net cash flows

(Net carrying value) (Net carrying value)
Impairment Loss Impairment Loss
"+ Cost of disposal
1. Write asset down Total Impairment Loss
2. Depreciated new cost
3. Restoration not
permitted 1. Write asset down
2. No depreciation
taken
3. Restoration is
permitted

Financial Accounting & Reporting

CHAPTER 5

PRESENT VALUES AND ANNUITIES

1. Present value of $1 (Capital lease buyout at end of lease (Bargain Purchase) &
Bond principal payout at end)
2. Future value of $1 (Like a bank account)
3. Present value of an ordinary annuity. (Annuity in Arrears) (used for periodic lease
pmts & periodic bond interest pmts).
4. Future value of an ordinary annuity. (investing in an IRA)
5. Present value of an annuity due, and
6. Future value of an annuity due.

3 Payments of $1,000 Each

Ordinary Annuity

vs. 10 00 10 00 10 00 0

Annuity Due

10 00 10 00 10 00 0
Conversion
 Present value of an ordinary annuity for 3 periods at 8% 2.577
Plus: 1:00 1.000
Present value of an annuity, due for 4 periods at 8% 3.577

ACCOUNTING FOR OPERATING LEASES

1. Operating leases are essentially ‘rentals’ and all cash flows have to be straight-
lined over the lease period as the periodic expense to the lessee and as lease
revenue to the lessor (matching principle). Cash payments intended to be
returned to the lessee are excluded from the expense/revenue calculation and are
treated as deposits.

2. Lease Bonus (Prepayment) for future expenses should be classified as an asset

(deferred charge) and amortized using the straight-line method over the life of the
lease.

Operating Lease with Lease Bonus

Lessee Expense Lessor Income

Monthly Rentals Monthly Rentals

Plus: lease bonus
Plus: lease bonus amortization amortization
Less: Depreciation
Expense for leased asset Income from leased asset

3. Leasehold improvements by a lessee must be capitalized and expensed over the

shorter of the remaining lease term or the life of the improvement

4. Rent Kicker (ex. Percentage rent) – A premium rent payment required for
specific events – Record as period expense.

5. Refundable Security Deposit – Is reported as an asset on the lessee’s books until

refunded by the lessor. Thus, it is recorded as a liability (unearned revenue) by the
lessor.

6. Free or Reduction Rent Consideration

If consideration (free rental months or reduced rental charge at beginning)
is part of package, lessee must take total rent expense to be paid for the
entire lease term and divide it evenly over each period (matching
principle).
 Free or reduced rent consideration
Operating Lease Journal Entries

LESSEE LESSOR

During each free month

D
DR Accrued rent exp R Accrued rent receivable
C
CR Accrued rent payable R Accrued rental income

Remaining Months
D
DR Rent expense R Cash
C
DR Accrued rent payable R Rental Income
C
CR Cash/rent payable R Accrued rent receivable

1. The more disclosed the better, but most commonly tested,

Minimum future rental payments: in total, and for each of the next five
years.

CAPITAL LEASES AND LESSEES

1. Lessees account for capital leases as though purchased if one or more of 4 (owns)
tests is met:
a. Ownership transfers to lessee at end of lease
b. Written bargain purchase option exists [PO<estimated fair value]
c. Ninety percent of the leased property’s fair value is less than or equal to
the present value of the minimum lease payments.
d. Seventy-five percent of the asset’s economic life will be consumed in the
lease term.

2. Lessees record the capital leased asset and the lease liability at the present value
of the minimum lease payments, not to exceed fair value of asset. Lesser of cost
or FMV.
DR Fixed asset- leased property
CR Liability – obligation under capital lease.

3. Minimum lease payments include the required periodic payments and the
bargain purchase and/or guaranteed residual value (if any). Executory costs
(maintenance, insurance, taxes, etc.) are excluded.

4. The interest rate used is the lesser of the rate implicit in the lease (if known) or
the lessee’s incremental borrowing rate. The lease liability is amortized using the
effective interest method.
 5. Depreciation is based on the lease term unless the lease has a bargain purchase
option or ownership transfers to lessee at end of the term.

Capitalized lease assets

(Salvage value)
Depreciable Basis
/Periods of Benefit
Depreciation Expense (per period)

Lessee Capitalization Rule summary

CAPITALIZE DEPR. LIFE

Ownership = PV of payments and required buyout Asset life
Written = PV of payments and bargain buyout Asset life
Ninety % FMV = PV of payments (ignore option) Lease Life
Seventy-five % life = PV of payments (ignore option) Lease Life

6. The more disclosed the better, but most commonly tested,

Future minimum lease payments in the aggregate and for each of the next
five years, showing deductions for executory costs, including any profit
thereon, and the amount of imputed interest to reduce the net minimum
lease payments to present value.

7. Asset Retirement Obligation (ARO) – obligation for other – than – temporary

removal of a tangible long-lived asset from service.
- Qualifies for recognition when it meets the definition of a liability: Duty
of responsibility, little or no discretion to avoid, and obligating event.
- Uncertainty about whether performance will be required does into defer
the recognition of a retirement obligation
- Recognized once a reasonable estimate of fair value can be made

CAPITAL LEASES AND LESSORS

1. Lessors with capital leases may have sales type or direct financing leases.
Lessors have capital leases when meeting one of the 4 OWNS tests as described
for lessees above. In addition, there can be no material uncertainties about
collectibility or unreimbursable costs.

Lessor (seller) must have all LUC to capitalize a lease:

L: Lessee “ownes” the leased property (meets any one of the four lessee’s criteria)
U: Uncertainties do not exist regarding any unreimbursable costs to be incurred
by the lessor.
C: Collectibility of the lease payments is reasonably predictable.
 2. Sales type leases recognize a dealer profit or gross margin at lease inception. As
payments are received, interest revenue will also be recognized by the effective
interest method.

Lessor Accounting Lessor Accounting

Sales-Type Lease Calculations Sales-Type Lease
(with unguaranteed residual value) Journal Entry

1 Gross Investment (lease receivable) DR Lease receivable

Lease payment CR Unearned interest income

+ Unguaranteed residual value CR Sales revenue

Gross Investment
DR Cost of Goods Sold
2 Net Investment CR Inventory (asset sold)

Gross Investment (#1)

x P.V. factor
Net Investment

3 Unearned Interest Revenue

(contra-Lease Receivable)

Gross investment (#1)

(Net Investment #2)
Unearned Interest Revenue

4 Cost of Goods Sold

Cost of Asset
((PV Unguaranteed Residual)
Cost of Goods Sold

5 RULE FOR SALES-TYPE LEASE

SALES REVENUE
(exclude unguaranteed residual value)
Cost
+ Profit
PV = Selling Price = FMV

Journal Entry
DR Lease payments receivable #1
DR Cost of Goods Sold #4
CR Sales #5
CR Equipment given
CR Unearned interest revenue #3
3. In a direct-financing type lease, the lessor acts essentially as a finance company
and does not recognize gross profit on sale; Interest revenue is recognized by the
effective interest method.
4.
Lessor Accounting
Direct Financing Lease Calculations
(with unguaranteed residual value)

1 Gross Investment (lease receivable)

Lease payment
+ Unguaranteed residual value

Gross Investment

2 Net Investment

Gross Investment (#1)

x P.V. factor
Net Investment

3 Unearned Interest Revenue

(contra-Lease Receivable)

Gross investment (#1)

(Net Investment #2)
Unearned Interest Revenue

RULE FOR DIRECT FINANCING LEASE

SALES REVENUE
(exclude unguaranteed residual value)

PV = Carrying amt of receivable = Cost of asset

sold

Journal Entry
DR Lease Receivable (gross investment) #1
CR Equipment (at cost or FMV) given
CR Unearned interest revenue #3

SALES AND LEASEBACKS

1. If the seller/lessee retains substantially all (90+ %) of the rights, any gain is to be
deferred over the leased asset.

2. “Minor” (<10%) retention allows full recognition of any gain, while mid-range
(10%-90%) requires a separate calculation.
 Excess Profit on Sale - Leaseback

Operating Lease Capital Lease

(Rent Back) ("OWNS' Back)

Sale price Sale price

(Asset NBV) (Asset NBV)
Tentative Gain Tentative Gain GAIN
(GIVE
(PV min lease pmts) (Leaseback asset) BACK)
Excess Gain Excess Gain KEEP

SALE-LEASEBACK : SUMMARY
Major Middle Minor
90% or more 90% - 10% 10% or less
Defer All Defer
GAIN (up to PV of leaseback) No Deferral
(Amortize over leaseback) (Amortize over leaseback)
LOSS (NBV > FMV)
(real economic Recognize Recognize Recognize
losses) Immediately Immediately Immediately
OTHER LOSSES
(artificial loss) Defer All Defer All Recognize
(Amortize over leaseback) (Amortize over leaseback) Immediately

SUBLEASES
1. Sublease classification by sub-lessee
- same category as original lease
2. Sublease classification by sub-lessor
-if original lease was an operating lease, then as an operating lease
-if original lease was a capital lease, by:
-O or W, sublease is a capital lease
-N or S, sublease is an operating lease unless is meet the req. for cap lease.

LONG-TERM LIABILITIES AND BONDS PAYABLE

Stated (Nominal) Interest Rate – (coupon rate)- rate specified on the bond contract
Market (Effective yield) Interest Rate – rate actually earned by the bond holder, caused
by discount or premium.

Discount – market rate is higher than stated rate

Premium – stated rate is higher than market rate

Bond interest (check amount) = coupon rate * face value

Principal payoff is always the full face amount

FMV Bond = PV of future interest pmts (at market rate) + PV of principle (at market
rate)
Carrying value of bond = FACE +/- (unamortized premium/discount)

1. Bonds are long-term debt instruments issued by an entity. Debentures are

unsecured. Bonds may also be convertible into common stock and may have
detachable warrants. Typically the face value of individual bonds will be
$1,000. Interest at the coupon rate may be payable annually or semiannually and
bond prices are quoted as 100’s (% of face value). The market will adjust the
price paid for the bond to reflect the market, or effective, interest rate.

2. Bond selling price is the sum of the present value of the total face value of the
bond plus the present value of future interest payments, both discounted at the
effective (market) interest rate. In general, when the bond coupon rate exceeds
the market rate the bond will sell at a premium. If the bond coupon rate is below
the market, the market will adjust and the bond will sell at a discount.

3. Bonds can be issued for more or less than their face amounts. If sold above the
100 face value, the excess is premium. If sold below 100, the difference is
discount. Premium and discount result from market interest rate fluctuations and
they are amortized to interest expense using the straight-line or effective interest
(preferred) method. Unamortized discount or premium is a component of the
carrying value of a bond. Carrying value is eventually face value at the maturity
of the bond and it is used to calculate the interest expense when using the
effective interest method of premium/discount amortization.

a. Straight Line Method results in a constant dollar amount of interest each

period.
i. Premium or discount/number of periods bond outstanding = amor.
ii. Interest expense = (face value * stated interest rate) minus
premium amortization or plus discount amortization
iii. Check Amount +/- amortization = interest expense.
JE is the same every period
b. Effective Interest Method

EFFECTIVE INTEREST METHOD SUMMARY

I/S Net Carrying Value * Effective interest rate = Interest expense

B/S Bond face * Coupon rate = (Interest paid)

DIFF AMORTIZATION

4. Bond issue costs are amortized using the straight-line method. The bond issue
costs are recorded as an asset and amortized over the bond life.
DR Cash
 DR Discount
DR Bond Issue Cost (Asset)
CR Bonds Payable

5. When bonds are issued between interest payment dates, the selling price includes
the accrued interest to date. (use coupon rate to determine accrued interest)

6. Interest is accrued at year-end form the last interest payment date.

7. Bond Sinking Funds are created to avoid a cash shortage at the time of debt
repayment. It is generally a non-current (restricted) asset. Determining how much
to invest in a sinking fund is like an IRA. Use the FV of an ordinary annuity to
figure out how much to deposit each period (pg50).

8. Serial Bonds (alternative to sinking funds) have principals that mature in

installments. Amortization methods:

a. Effective interest method (same as for term bonds)

b. Bonds outstanding method (like sum of the years digits)

Example
BONDS OUTSTANDING METHOD SUMMARY
(1) (2) (3) (4) (5) (6)
FRACTION OF PRE / DIS INTEREST INTEREST
OUTSTANDIN AMORTIZATIO
G TOTAL BONDS N PAYMENT EXPENSE
(coupon% * col. (col. 5 -
PERIOD VALUE OUTSTANDING (pre/dis * Col.3) 2) col.4)

1/1/yr1 200,000 200000/300000

1/1/yr2 100,000 100000/300000
300,000

9. Convertible bondholders (non detachable warrants) have the option of converting

the bonds into common equity. Everything goes to the bond at issue. The two
accounting methods for conversion are Book Value and Market Value. The
Market Value method can result in a gain or loss on conversion.
a. Book Value Method (GAAP): No I/S impact. Common Stock and APIC
Only
Convertible Bond/ Book Value Method
Bond Premium Cash Common Stock
face total premium cash/stock Par value
* amt exercised * % exercised * amt exercised * amt exercised
total par
APIC SQUEEZE
Premium
Amt
Amt Converted + Converted + Cash Paid = TOTAL
 b. Market Value Method (not GAAP): I/S impact, recognize gain/loss
Convertible Bond/ Market Value Method
Bond Premium Cash Common Stock APIC GAIN/LOSS
face total premium cash/stock Par value Stock FMV
* amt exercised * % exercised * amt exercised * amt exercised - Par value
Premium Difference
* amt exercised
Amt Converted + Amt Converted + Cash Paid = Total Par Amt + Total APIC + PLUG

10. Detachable stock purchase warrants have a value separate from the bond and the
value of the warrants is part of stockholders’ equity. The warrant gives the
bondholder the right to buy stock at a fixed price within a specific time. At issue
date allocate bond proceeds between the bond and the warrants. The warrants
only or market value method may be used.
a. Warrants only method – used if only the fair market value of the
warrants is known.
Detachable Warrants/ Warrants Only Method
Bond Premium/Dis. Warrants Cash Common Stock
face pre/dis Total Warrant Amt cash per share Stock Par
*0 *0 * % exercised * amt exercised * amt exercised
total par
APIC SQUEEZE
0 + 0 + Amt Converted + Total Cash paid = Total CS
BOND STILL HELD DETACHABLE

b. Market Value Method – market value of both the warrants and bonds is
known.
Detachable Warrants Market Value Method
To record purchase of convertible bonds with detachable warrants
DR Cash
CR Bonds Payable
CR APIC-Warrants
DR/CR Discount/Premium PLUG
To record exercise of warrants
DR Cash (additional received)
DR APIC-Warrants
CR Common stock (at par)
CR APIC in excess of par

11. Extinguishment of debt can occur at maturity or earlier (if the issuer calls the
bond). Early extinguishment can cause and extraordinary item if it is both
unusual and infrequent.
(gain) or loss = Reacquisition price- Net carrying amount
 Net Carrying amount = face value +/- unamortized premium/discount –
unamortized issue costs.

Reacquisition price > Net carrying amount = loss

Reacquisition price < Net carrying amount = gain

TROUBLED DEBT RESTRUCTURING

1. A troubled debt restructuring will generally involve a creditor giving

concessions to a debtor that would not be likely under normal circumstances. The
debtor will recognize a gain in the excess of the carrying amount of the payable
(including accrued interest) over the fair value of the assets given up. The
restructuring gain may be an extraordinary item if it meets the requirements for
such treatment. An ordinary gain or loss may result from the difference between
the FMV and the NBV of the asset transferred.

TROUBLE DEBT RESTRUCTURINGS (impaired

loans)
TRANSFER OF ASSETS
Recognize ordinary gain/loss on:
FMV asset transferred
(NBV asset transferred)
Ordinary gain/loss

Recognize [possible extraordinary] gain on:

Face of payable
+ accrued interest
Total obligation

(FMV asset transferred)

GAIN

2. If an equity interest is transferred, there may be a gain to the extent that the FMV
of the equity transferred exceeds the face of the payable. This gain may also be
classified as extraordinary if it meets the requirements.

3. If there is a modification of terms, the debtor does not change the carrying
amount of the debt unless it exceeds the face of the payable. This gain may also
be classified as extraordinary if it meets the requirements.

4. If there is a modification of terms, the debtor does not change the carrying amount
of the debt unless it exceeds the total future cash payments under the new terms.

5. A restructuring may involve a combination of asset transfers, equity transfers and

modification of terms.
6. From the creditor’s standpoint, these loans are treated as impaired and a loss
accrual may be necessary.

DR Bad debt expense

CR Allowance for credit losses

Financial Accounting & Reporting

CHAPTER 6

EMPLOYER ACCOUNTING FOR PENSION PLANS

1. Pension plans can be broken out into defined benefit and defined contribution.
The CPA exam has emphasized defined benefit plans in which an employer
provides an employee with defined retirement benefits in exchange for current or
past services. As employees work, the pension benefits accumulate and actuarial
computations are necessary to determine the present value of the future payments
due. A pension plan and the sponsoring company are two separate legal entities.
The CPA exam and GAAP for pensions addressed in this chapter are concerned
with how the sponsor company accounts for the plan.

Accounting for pension plans is concerned primarily with determining the amount of
- Pension expense that appears on the sponsoring company’s income
statement,
- Any related pension accounts (asset, liability, and/or contra-equity
accounts) that appear on the sponsor company’s balance sheet.

2. The fundamental accounting done by the employer involves a pension expense

and, perhaps, a cash payment to the pension plan. Any difference between these
two amounts will cause the pension plan to ‘over funded’ or ‘under funded’. Over
funded means the firm’s balance sheet will show an asset, prepaid pension cost,
and under funded plans will show and accrued pension liability.

3. The Accumulated Benefits Obligation (ABO) is the actuarial present value of

benefits based on current and past compensation levels. The Projected Benefit
Obligation (PBO) will be higher since it factors in future (generally higher)
compensation levels. The PBO will increase by interest costs and the plan assets
will be invested to achieve an expected return.

4. Periodic pension expense (SIRAGE) is the net of six components:

INCOME STATEMENT
PENSION EXPENSE FORMULA

S CURRENT SERVICE COST (normal service costs)

I INTEREST COST
R (EXPECTED RETURN ON PLAN ASSETS)
A +/- AMORTIZATION OF PRIOR SERVICE COST (retroactive benefits)
G (GAINS) LOSSES
 +/- AMORTIZATION OF EXISTING NET OBLIGATION OR NET ASSET
E (at implementation of plan)
NET PENSION EXPENSE
The “PBO” is the “GREATER” of the two amounts and is used in all “SIR-AGE”.

1970 1980 1990 2000 2010

PAST SERVICE
COSTS NORMAL SERVICE COST RETIREMENT YEARS

Employee Company Starts Valuation Date New Employee Actuarial

starts work Pension Benefit or Increase Retires Death
PRIOR SERVICE COSTS

Six components:
I. Current Service Cost = PV of all benefits earned this period or the increase in
the PBO.
II. Interest Cost = increase in PBO during the current period due to passage of
time.
BEGINNING OF PERIOD PBO
SETTLEMENT RATE
INTEREST COST

III. (Expected Return on Plan Assets)

BEGINNING FV OF PLAN ASSETS
EXPECTED RATE OF RETURN ON PLAN ASSETS
EXPECTED RETURN ON PLAN ASSETS

Differences between actual and expected return is reflected in (gains) and

losses (unrecognized)

DETERMINING THE ACTUAL RETURN ON PLAN ASSETS

Beginning fair value of plan assets

+ contributions
+ Actual return on plan assets (squeeze)

- Benefit payment
Ending fair value of plan assets

IV. Amortization of Unrecognized Prior Service Cost

The cost of retroactive benefits (measured by the increase in the PBO) is
amortized by assigning an equal amount to each future period of service of
each employee who is active at the date of initiation of the plan (or
amendment).

V. (Gains) or Losses (Unrecognized)

a. Difference between expected and actual return on plan assets
b. Changes in actuarial assumptions (actuarial gains and losses)

Minimum Reportable Amount of (gains) or losses

Unrecognized gain or loss Beg of Yr
 (10% of PBO or market related value of plan assets (GREATER)) Beg of Yr
Excess
/ Average remaining service life
Minimum recognized amount to be reported

VI. Amortization of Existing Net Obligation or Net Asset at Implementation

This transition adjustment is the difference between the PBO and fair
value or plan assets when the sponsor company adopted FASB 87.

Amortization of Existing Net Obligation or Net Asset at

Implementation
Projected Benefit Obligation
(Fair market value plan assets)
Initial unfunded obligation
/ 15 years OR average employee job life (GREATER)
Minimum Amortization

Pensions are “GREAT”!

-When deciding which balance (assets or liabilities) for the gains/losses components, use
the “GREATER” of the two.

-When deciding which period to amortize the existing obligation over (15 years or
average service life), use the “GREATER” of the two.

5. The Minimum Pension Liability is the excess of the ABO over the fair value of
the plan assets. An additional liability will be recorded to the extent that the MPL
exceeds the accrued pension cost already recorded, limited to the extent of
unrecognized prior service costs. Any excess at that point will be reported as a
component of Other Comprehensive Income (the P in PUFE).
a. Fair Value (Asset) > ABO (Liability) – the plan is considered to be
sufficiently funded – no entry is necessary.
b. ABO (Liability) > Fair Value (Asset) – the plan is considered to be under
funded and the sponsor company must ensure that the BS reflects a
liability at least equal to the excess of the ABO at the end of the year. This
is the Minimum Pension Liability.
i. Accrued Pension Cost >= Minimum Liability –No entry is
necessary because the liability on the BS already equals or exceeds
the minimum.
 ii. Accrued Pension Cost< Minimum Liability - The liability
already on the BS is insufficient (below the minimum). An
additional liability must be recorded

Additional Liability = Minimum liability – accrued pension cost

iii. A prepaid pension asset exists – to record the minimum liability,
the additional liability must both: cancel the prepaid asset, and
create the minimum liability.
Additional liability =Prepaid pension asset + minimum liability

In this situation the additional liability will exceed the minimum

liability

6.
CURRENT LIABILITY (accrued pension cost liability)
"SIR-AGE"
(payments)
(prior year prepaid)
CURRENT LIABILITY
DR NET PENSION EXPENSE
CR ACCRUED PENSION COST/LIABILITY

NONCURRENT ADDITIONAL PENSION LIABILITY

(unfunded accumulated pension liability)
ABO
(FMV of plan assets - current overfunded/prepaid)
Minimum pension liability
(Accrued pension cost)
Additional pension liability
(Unrecognized prior service costs)
Additional pension liability in excess of unamortized prior service cost (PUFE)

DR INTANGIBLE ASSET - DEFERRED PENSION COST

DR EXCESS OF ADDITIONAL PENSION LIABILITY OVER UNRECOGNIZED PRIOR SERVICE
COST (contra – equity account)
CR ADDITIONAL PENSION LIABILITY

PROJECTED BENEFIT OBLIGATION (use expected salaries)

PBO
(FMV of plan assets - current overfunded/prepaid)
Total Unfunded
(Current unfunded)
Unfunded PBO Obligation
MUST BE DISCLOSED

6. Non-GAAP Methods – (both Pension and other postretirement benefits)

a. “Pay-as-you-go” – cash basis method of expensing pension plan

payments after someone has retired.
 b. Terminal Funding – cash basis method where a company pays an entire
pension plan liability upon retirement of an employee, generally by
purchasing an annuity-type insurance policy.

ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN

PENSIONS

1. The cost of retire health care and other benefits is accrued if the obligation is
attributable to services already rendered, these rights accumulate or “vest”,
payment is probable and the amount can be reasonably estimated.

2. Benefits are accrued over the attribution period, the period from the date of hire
to the date fully eligible for the benefit. The components of the cost and other
disclosures follow rules similar to defined benefit pension plans.

3. Accumulated Postretirement Benefit Obligation (APBO) – present value of

future benefits that have vested as of the measurement date.

4. Expected Postretirement Benefit Obligation (EPBO) –

a. The amount that has vested (APBO).

b. Plus, the present value of expected future benefits that have not yet vested.

5. Net postretirement benefit expense/cost is determined the same way as the

pension expense.
a. Except when amortizing the Transition Obligation
i. Immediate expense recognition by recording the entire obligation
in one year.
ii. Delaying recognition by using the straight-line amortization over
the average remaining service period to active plan participants. If
this period is less than 20 years. A 20-year amortization period
may be elected.
Amortization of Expense of the Transition Obligation
Accumulated postretirement benefit obligation
(Fair market value plan assets)
Initial unfunded obligation
/ 20 years OR average employee job life (GREATER)
Minimum Amortization
OR
Expense full amount (reported as an accounting change on the income
statement)

6. Three significant differences between accounting for post retirement benefits and
accounting for pensions. For postretirement benefits other than pensions:
a. Option to Expense total transition obligation
b. 20 year minimum for amortization of transition obligation
 c. A minimum liability/obligation need NOT be recorded, no journal entry is
required, however, report in notes.

ACCOUNTING FOR POSTEMPLOYMENT BENEFITS

1. These benefits (severance pay, salary continuation, etc.) are enjoyed after
employment and are not the same as after retirement benefits.

2. GAAP requires the accrual of a liability if the same four criteria as for
postretirement benefits are met.

3. Footnote Disclosure – when all four criteria are not met.

4. Treat this issue in a similar manner to contingencies.

CONTINGENCIES

1. Contingencies are existing conditions whose outcome depends on some future

event or occurrence. The three categories of contingencies are probable,
reasonably possible and remote.
a. Probable – likely to occur. (REPORT)
b. Reasonably possible – more than remote, but less than likely. (DISCLOSE)
c. Remote – slight chance of occurring. (IGNORE)

2. Loss contingencies that are probable and can be reasonably estimated must be
accrued. The best estimate of the loss should be accrued. However, if there is no
best estimate, a range of losses is given, the minimum amount is accrued and the
remaining amount is disclosed in a footnote. Gain contingencies that are probable
are not accrued but are disclosed.

3. The nature and amount of a loss or gain contingency that is reasonably possible
is disclosed in a footnote and is not accrued.

4. Remote contingencies are generally ignored. However, disclosure (nature,

amount of guarantee, and any expected recovery) should be made for “guarantee
type” remote loss contingencies such as:
IGNORE, UNLESS (DISCLOSE)
a. Debts of others guaranteed (officers/related parties)
b. Obligations of commercial banks under standby letters of credit, and
c. Guarantees to repurchase receivables (or related property) that have been
sold or assigned.

5. Unasserted claims follow similar rules for disclosure and/or accrual for any other
loss contingency.
 6. General or unspecified business risk (such as fire, floods, strikes, and war) do
not meet the conditions for accrual, and no loss accrual shall be made, nor a
disclosure.

7. Appropriation of retained earnings (such as for general loss contingencies)

must be shown within the stockholders’ equity section and clearly identified. Such
amounts should be restored once its purpose is no longer deemed necessary.

CONTINGENCY TREATMENTS
Accrue Disclose
Amounts Amt Nature Ignore
1 LOSS contingency that is probable and:
a. Amount or range can be reasonably estimated X (or minimum) X
b. Amount cannot be reasonably estimated Range X

2 LOSS contingency that is a reasonable possibility: Range X

3 LOSS contingency that is remote X

a. Loss contingency that is remote, but is guarantee for others X X

4 GAIN contingencies that are probable or reasonably possible X X

5 GAIN contingencies that are remote X*

*old rule of conservatism

INTRAPERIOD ACCOUNTING FOR INCOME TAXES

Intraperiod tax allocation involves apportioning the total tax provision for financial
accounting purposes in a period between the income or loss among the multistep income
statement. (IDEA, PUFE, & Components of stockholders’ equity).

INTERPERIOD ACCOUNTING FOR INCOME TAXES (see PG 48)

The objective of interperiod tax allocation is to recognize through the matching principle
the amount of current and future tax related events that have been recognized in financial
accounting income.

The asset and liability (sometimes referred to as the Balance Sheet Approach) method is
required by GAAP for comprehensive allocation.
 1. GAAP and tax (IRS) accounting rules differ considerably. Some of the
differences are permanent because they never reverse. Other differences are
temporary because they involve mere timing differences between the financial
and tax accounting implications.

2. Permanent Differences – no deferred taxes because they do not reverse

themselves

a. Tax-exempt interest (municipal, state)

b. Life insurance proceeds on officer’s key man policy
c. Life insurance premiums when corporation is beneficiary
d. Certain penalties, fines, bribes, kickbacks, etc
e. Nondeductible portion of meal and entertainment expense.
f. Dividends-received deduction for corporations
g. Excess percentage depletion over cost depletion

Investment interest expense is limited to net (taxable) investment income.

3. Only temporary differences cause deferred tax consequences.

4. Tax expense is subdivided into two components: current tax expense [CTE] and
deferred tax expense [DTE].
OWE NOW + OWE LATER = EXPENSE ON FINANCIAL STMT
5. Current tax expense [CTE] is merely the result of multiplying taxable income
from the tax return by the tax rate. The exam routinely ignores estimated tax
payments by firms.

TEMPORARY
TAX RETURN DIFFERENCE FINANCIAL STATEMENT

* CURRENT TAX * FUTURE (ENACTED)

RATE TAX RATE

+DEFERRED LIABILITY
CURRENT LIABILITY = TOTAL TAX EXPENSE
- DEFERRED ASSET

NEVER MULTIPLY THE F/S INCOME BY THE TAX RATE TO GET THE TAX EXPENSE

Total tax expense for financial statements is the combination of current tax plus/minus
deferred taxes.
The CPA examiners frequently provide an incorrect calculation of financial statement
income times the current tax rate. This is an incorrect method to determine the total
expense for the following reasons:

Use of financial statement income (which has permanent differences) is incorrect

 Use of the current tax rate, ignores future changes to the enacted rate.

6. The deferred tax account(s) is the balance sheet must be adjusted at the end of
each year to reflect the appropriate amount of deferred tax liability [DTL] or the
appropriate amount of a deferred tax asset [DTA].

FINANCIAL STATEMENT
A INCOME FIRST B TAX RETURN INCOME FIRST
FINANCIAL STATEMENT
TAX RETURN INCOME LATER INCOME LATER
GIFT CERTIFICATE
FUTURE PREPAID
TAX INC. LATER = TAX TAX INC. FIRST = TAX
LIABILITY BENEFIT
(ASSET)
1 Installment Sales 1 Prepaid rent
2 Contractors accounting (% vs completed) 2 Prepaid interest
3 Equity method (undistrubuted dividends) 3 Prepaid royalties

FINANCIAL STATEMENT
C EXPENSE FIRST D TAX RETURN EXPENSE FIRST
FINANCIAL STATEMENT
TAX RETURN EXPENSE LATER EXPENSE LATER
GIFT CERTIFICATE
FUTURE FUTURE
TAX DEDUCT LATER = TAX TAX DEDUCT FIRST = TAX
BENEFIT LIABILITY
(ASSET)
1 Bad debt expense (allowance vs. direct w/o) 1 Depreciation expense
2 Est. liability/warranty expense 2 Amortization of franchise
3 Start-up expenses 3 Prepaid expense (cash basis for tax)

7. Permanent differences, such as tax-exempt interest on municipal bonds, or live

insurance premiums when the corporation is beneficiary, are embedded in tax law
and will not reverse in the future; therefore they only affect current tax paid and
not the deferred tax accounts.
8. Temporary differences will “turn around” in the future and are part of the deferred
tax calculations. GAAP requires accrual accounting, while tax law treats some
items on a “cash basis”:e.g., estimated liabilities or bad debt expense. Since these
are recognized for book purposes before they are deductible for tax purposes a
deferred tax asset (DTA) will result. Using straight-line depreciation for the books
and MACRS for tax purposes will result in lower taxable income in the early
years of the asset life and a deferred tax liability (DTL). The corporate Taxation
Summary on page F6-48 gives an excellent breakdown of various differences
between book and tax income.

9. DTA’s and DTL’s must be re-calculated each year based on enacted tax rates in
the year(s) in which the taxable item is expected to be realized or paid.

a. Use the tax rate in effect when the temporary difference reverses itself. Do
not allow the CPA examiners to trick you into using the following:
i. Anticipated
ii. Proposes
iii. Unsigned

b. ADJUSTMENTS FOR CHANGING TAX RATES – (in future years) the

following changes should be included in the period of change and reported
in income from continuing operations (IDEA), as change in estimates, in
the period of the change.
i. Changes in Tax Laws or Rates
ii. Change in the Valuation Allowance
iii. Change in the Tax Status of the Enterprise

10. For Balance Sheet presentation, deferred tax items are classified as they relate to
current or noncurrent assets and liabilities. DTA’s and DTL’s classified as current
are netted together and only one account appears on the Balance Sheet.
Noncurrent DTA’s and DTL’s receive similar treatment.
a. RULE #1 – Deferred tax items should be classified based on the
classification of the related asset or liability for financial reporting
b. RULE #2 – Deferred tax items not related to an asset or liability should be
classified (current or noncurrent) based on the expected reversal date of
the temporary difference.
c. RULE #3 – Deferred tax liabilities and assets should be net across the
balance sheet NOT up & down. Current with current & noncurrent only
with noncurrent.

11. If it is more likely than not (a likelihood of more than 50 percent) that all or
part of a deferred tax asset will not be realized, a valuation allowance must be set
up to reduce the asset.

a. DR Income tax expense

CR Deferred tax asset valuation allowance
 12. Operating loss carrybacks are “assured” (no valuation allowance) and can be
recognized as a reduction in the book loss in the year of the loss. An operating
loss carryforward (valuation account may be required) is a DTA and is
recognized to the extent that it is “more likely than not to be realized.”

13. INVESTEE’S UNDISTRIBUTED EARNINGS (both temp and perm difference)

Undistributed earnings of an investee are presumed to be distributed in the future
and are a temporary difference.
Taxable income is the dividend received.
However, the excludable portion of investee income is considered to be a
permanent difference.

- Ownership 0-19%: 70% exclusion

- Ownership 20%-80%: 80% exclusion
- Ownership over 80%: 100% exclusion

Intraperiod tax allocation relates to apportioning the total tax provision among the
various Income Statement sections (IDEA) from F1.

The Required Reading reviews Other Liabilities that have some history on the CPA
exam. There are also three appendices adding more detail on defined benefit pension
plans.
 Financial Accounting & Reporting
CHAPTER 7

FINANCIAL INSTRUMENTS

A. Financial instruments fair value disclosures and disclosures about

concentrations of credit risk (default risk – failure of another party) are
required by all firms except ‘small’ private firms (assets < $100 million
and no derivatives).
i. Disclosure can be in the body of the F/S or the notes.
B. Market risk (change in market value – economic circumstances) disclosure
is encouraged but not required.
C. Derivatives (“legalized gambling”- under/over contracts) get their values
from some other instrument. Options, forward, futures and swap contracts
are examples. Derivatives have terms indicating ‘price’, quantity and a
settlement amount (or payment provision). Derivatives are reported at fair
value.
i. If there is no hedging designation any gain or loss must be
reported in the income statement.
ii. When hedging the fair value of an asset or liability currently in the
balance sheet, the gain/loss on the asset/liability and the loss/gain
on the hedge are both reported in the income statement for the
current year. The hedge must be expected to be highly effective in
reducing the risk (or you’re speculating).
iii. If hedging the variability in future cash flows, the effective portion
of the hedge goes into other comprehensive income and the
ineffective portion is reported in net income for the current period.
The effective portion is the ‘E’ in PUFE from F1.
iv. Hedging foreign currency risks generally parallels comments
above in C2.
v. Hedging future cash flow variability in connection wit foreign
currency parallels comments above in C3.

Derivatives have all of the following 3 characteristics:

 a. One or more underlyings and one or more notional amounts
i. Underlyings – specified price, rate, or other variable
ii. Notional amount – measurement unit, used to calculate gain or loss
b. No initial net investment
c. Multiple ways to settle the contract.
i. Settlement amount – underlyings * notional amount
ii. Payment provision – settlement that is to be made if the underlying
behaves in a specified way.

DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES ACCOUNTING APPLIES TO

ALL ENTITIES, INCLUDING NOT-FOR-PROFIT

TYPE OF HEDGE INSTRUMENT ACCOUNTING FOR CHANGES IN FAIR VALUE

No hedge designation Included in current earnings

Fair value hedge Included in current earnings

cash flow hedge

Effective portion Included in other comprehensive income (PUFE)
Ineffective portion Included in current earnings

Foreign exchange hedge

Fair value hedge Included in current earnings
Cash flow hedge Included in other comprehensive income (eff. Portion)
Included in other comprehensive income, as cumulative translation
Net investment hedge adjustment

STOCKHOLDERS’ EQUITY
 Capital Corp

Shareholder’s Equity - December 31, 20XX

CAPITAL STOCK (capital equal to par or stated)

Preferred stock, non-cumulative, $100 par value, authorized 1,000

shares, issued and outstanding 500 shares $ 50,000.00

Common stock, $10 par value, authorized 50,000 shares, issued 30,000
shares of which 5,000 are held in the treasury 300,000.00
350,000.00
ADDITIONAL PAID-IN CAPITAL (capital in excess of par or stated value)
Excess of issue price over par value of common/preferred stock sold $29,000.00
Excess of sales price over cost of treasury shares sold 15,000.00
Excess of FMV over par of stock issued as stock dividend 20,000.00
Defaulted stock subscriptions 10,000.00
FMV of common shares contributed by shareholders to corporation 75,000.00
FMV of fixed assets contributed by local government 60,000.00 209,000.00

RETAINED EARNINGS
Appropriated (reserved) for general contingencies 50,000.00
Appropriated (reserved) for possible future inventory decline 20,000.00
Appropriated (reserved) for plant expansion 40,000.00
Appropriated (reserved) for higher replacement cost of fixed assets 60,000.00
Unappropriated (unreserved) 200,000.00 370,000.00
929,000.00
ACCUMULATED OTHER COMPREHENSIVE INCOME 10,000.00

LESS: COST OF SHARES IN TREASURY (85,000.00)

TOTAL SHAREHOLDERS' EQUITY $854,000.00

A. The owners’ equity section is illustrated on page F7-7 and

should be reviewed for the details contained in it.

B. Common Stock includes these terms: authorized, issued

and outstanding. Treasury stock is issued but not outstanding.

C. Common shareholders’ equity equals total stockholders’

equity reduced for the claims for preferred stock.

COMMON STOCKHOLDERS' EQUITY FORMULA

Total Shareholders' equity (Assets - Liabilities)
- Preferred stock outstanding ( at greater of call price or par value)
- Cumulative preferred dividends in arrears
Common shareholders' equity
 Book Value per common share = Common shareholders' equity (A-L)
Common shares outstanding

D. Book value per share is the common shareholders’ equity

divided by the number of common shares outstanding at year-end.

E. Preferred shares are “first in line,” before common, for

dividends and payment in liquidation. P/S may also be cumulative, participating
or convertible.

a. Cumulative – all or part of the preferred dividend not paid in any year
accumulates and must be paid in the future before dividends can be
paid to common shareholders. (dividends in arrears)
b. Participating – “first share equally then pro-rata”
. Fully participating – means that preferred stockholders participate in excess dividends
without limitation.

. Partially participating means preferred shareholders participate in excess dividends, but

to a limited extent (ex. Percentage limit)

. Convertible – may be exchanged for common stock (at the option of the stockholder) at a
specified conversion rate.

F. Additional paid-in capital can come from several sources in

addition to any amount paid above the par value of shares issued.

G. Retained earnings can be increased or decreased by a large

number of events including: income, (losses), cash dividends, property
dividends, stock dividends, prior period adjustments, cumulative effects of
changes in accounting principles and quasi-reorganizations.
RETAINED EARNINGS FORMULA
Retained earnings beg. Balance
=/
- Net income/loss
- Dividends (cash, FMV Property, and stock) declared
=/
- Prior period adjustment (Correction of an error)
=/
- Accounting changes treated as prior period adjustment
+ Adjustment from quasi-reorganization
RETAINED EARNINGS ENDING BALANCE
Appropriation of R/E
The following entry should be recorded when an appropriation is to be
made (and should be reversed when the purpose of the appropriation has
occurred.
DR Retained earnings (unappropriated) - reduce
CR Retained earnings appropriated for (purpose) - increase

*There is no change in total S/E.

 H. Quasi-reorganizations eliminate deficit balances in retained
earnings by reducing the amount of C/S or APIC. It is not a legal
reorganization. It allows a corporation to have a “fresh start”. A quasi-
reorganization requires formal approval by the shareholders.
d. Procedures
i. Any necessary write-down to assets is charged directly to R/E.
ii. Bring R/E to 0 by charging it to APIC then to the capital stock
account.
iii. Date of reorganization must be disclosed until deemed
unreasonable to do so.

A. Accumulated other comprehensive income is an equity

account into which the components of other comprehensive income flow.
(PUFE)

B. Treasury stock (contra equity account – reduces SE) may

be accounted for by the cost method or the legal (par value) method.

- Transactions with owners (ie. Issue/repurchase own stock and paying

dividend) never record on income statement.

- The primary difference between the cost method and the legal method is
the timing of the recognition of “gain or loss” on treasury stock
transactions. Note that under both methods the “gains or losses” are
recorded as a direct adjustment to stockholders’ equity and are not
included inn the determination of net income.

- COST METHOD- the treasury shares are recorded and carried at their
reacquisition cost. A gain or loss will be determined when treasury stock
is reissued or retired, and the original issue price and book value of the
stock do not enter into the accounting.

- LEGAL (PAR) METHOD – the treasury shares are recirded by reducing

the amounts of par (or stated) value and additional paid-in capital received
at the time of the original sale.

ACCOUNTING FOR TREASURY STOCK TRANSACTIONS

COST METHOD JOURNAL ENTRIES LEGAL (OR PAR/STATED VALUE) METHOD JE'S
example displays stock originally sold at $10/share

TO RECORD PURCHASE OF TREASURY SHARES TO RECORD PURCHASE OF TREASURY SHARES AT A LOSS

DR Treasury stock (1,000 shares @ $15 per share cost) DR Treasury stock (1,000 @ $1 par)
CR Cash (paid for treasury stock) DR APIC (pro rata: 1,000 * $9)
 DR Retained Earnings (1,000 * 5) PLUG
CR Cash (paid for treas. Stock)

TO RECORD THE RESALE OF TREAS. STOCK AT A GAIN TO RECORD PURCHASE OF TREASURY SHARES AT A GAIN
DR Cash (amount of the sale) DR Treasury stock (1,000 @ $1 par)
D
CR Treasury stock (at cost) R APIC (pro rata: 1,000 * $9)
CR Additional paid-in capital (sales proceeds > cost) CR Cash (1,000*8)
CR APIC - Treas. Stock (2000) PLUG

TO RECORD THE RESALE OF TREAS. STOCK AT A LOSS TO RECORD THE RESALE OF TREAS. STOCK
DR Cash DR Cash (amount of the sale) (18,000)
DR APIC - Treasury Stock CR Treasury stock (1,000 shares @ $1 par) 1,000
DR R/E (excess of loss beyond the APIC balance) CR APIC $17,000
CR Treasury Stock (at cost)

TO RECORD THE RETIREMENT OF TREASURY STOCK

DR Common stock @ par (under both methods)
DR Additional paid in capital (under the cost method)
CR Treasury Stock (under both methods)
CR Additional paid In capital from treasury stock retirement
(if the cost is less than the original issue price under the cost method)

C. Donated shares result in a credit to contributed capital.

DONATED TREASURY STOCK

TO RECORD RECEIPT OF DONATED TREASURY STOCK

DR Donated treasury stock (@FMV)
CR Additional paid-in capital (@FMV)
NO CHANGE TO TOTAL STOCKHOLDER'S EQUITY

TO RECORD SALE OF DONATED STOCK

DR Cash (@ sales price)
DR APIC (If SP < Original FMV)
CR APIC (If SP > Original FMV)
CR Donated treasury stock (@ book value, or Original FMV)
D. Stock subscriptions are contracts to buy stock at a future
date.

STOCK SUBSCRIPTIONS

TO RECORD SALE OF SUBSCRIPTIONS

DR Subscriptions Receivable CONTRA-EQUITY (1,000 shares @ sales price of $100/share) 100,000
CR Common stock subscribed ($10 par * 1,000 shares) 10,000
CR Additional paid-in capital (1,000s * $90/share) 90,000
NO CHANGE TO TOTAL STOCKHOLDER'S EQUITY

TO RECORD THE COLLECTION OF SUBSCRIPTIONS

DR Cash (@ sales price) 85,000
CR Subscriptions receivable ELIMINATE CONTRA EQUITY 85,000

TO RECORD ISSUANCE OF STOCK PREVIOUSLY SUBSCRIBED

DR Common stock subscribed (800 shares @ $10) 8,000
CR Common stock (issued) 8,000
NO CHANGE TO TOTAL STOCKHOLDER'S EQUITY

E. Stock rights provide existing shareholders with the

opportunity to buy additional shares and do not affect equity until exercised.
- issuance of stock rights requires a memo entry only
- If the rights are redeemed by the issuing company, there is a decrease in
SE in the amount of the redemption price.
TO RECORD THE EXERCISE OF STOCK RIGHTS (SAME AS A NORMAL ISSUANCE OF STOCK)
DR CASH
CR COMMON STOCK
CR ADDITIONAL PAID IN CAPITAL

F. Dividends declared reduce R/E on declaration date.

G. Liquidating dividends are dividends in excess of R/E.

First charge to R/E, then APIC, and lastly Common or Preferred par/stated.

H. Property dividends are recorded at their fair value at the

declaration date. Gain or loss is recognized on that date.

TO RECORD DISTRIBUTION OF PROPERTY (IN-KIND) DIVIDENDS

DR RETAINED EARNINGS (FMV OF PROPERTY 100
DR ACCUMULATED DEPRECIATION 20
CR BUILDING COST 70
CR/DR GAIN/LOSS (GAIN) 50
ANY GAIN OR LOSS SHOULD BE RECOGNIZED IN INCOME
 I. Stock dividends occur in two sizes: small and large. The
“break point” is around 20% to 25% of outstanding C/S. Small stock dividends
tend to be on the exam more often.

ACCOUNTING FOR STOCK DIVIDENDS

SMALL STOCK DIVIDEND (<20-25%) LARGE STOCK DIVIDEND (>20-25%)
REDUCE R/E BY FMV OF STOCK REDUCE R/E BY PAR VALUE

TO RECORD THE DECLARATION OF THE STOCK DIVIDEND AT PAR

DR Retained earnings (5,000*$15 FMV) $75,000 DR Retained Earnings (use par)
CR Common stock (5,000*$10 par value) $50,000 CR Common stock distributible
CR Paid-in capital (difference=$75,000-50,000) $25,000
TO RECORD THE DISTRIBUTION OF THE STOCK DIVIDEND
DR Common stock distributible
CR Capital Stock, $10 par common

NO CHANGE IN TOTAL EQUITY UNDER BOTH PERCENTAGES

THERE IS NO DIVIDEND INCOME REPORTED BY THE INVESTOR

J. Stock splits do not require a journal entry and total book

value of C/S is unchanged
- Reduces the par (or stated)value per share proportionately
- Stock splits are usually not applied to treasury stock. The only exceptions
are when:
i. The company is maintaining a ration of treasury shares to shares
outstanding in order to meet stock option or other contractual
commitments
ii. State law requires that treasury stock be protected from dilution.

K. Compensatory stock option plans are now accounted via

the fair value method (per SFAS 123R)
- A stock option is the right to purchase shares of a corporation’s capital
stock under fixed conditions of time, place, and amount.
- Noncompensatory Stock Option/Purchase Plans – All full time employees
can participate in the plan, the stock is offered to eligible employees
equally, and any discount from the market price is no greater than would
be a reasonable offer of stock to shareholders or others.
- No Journal entry, there is only a JE when the option is exercised.
- The JE is the same as for a regular issuance of stock

Compensatory Plan- SFAS 123R, issued in December, 2004 now requires that
compensatory stock options be valued at the fair value of the option issued, not on
the market value of underlying stock.
 This compensation expense, calculated on the grant date of the options, is
allocated over the service period, in accordance with the matching principle. The
service period is the vesting period, which is the time between the grant dated and
the vesting date.
Any subsequent changes in the market price should be reflected in the fiscal
periods in which the changes take place as adjustments to the compensation
expense for that period. (CHANGE IN ESTIMATE – PROSPECTIVE)

DR COMPENSATION EXP
CR APIC- STOCK OPTIONS

When option is exercised:

DR CASH (@ OPTION EXERCISE PRICE)
DR APIC- STOCK OPTIONS
CR COMMON STOCK
CR APIC – COMMON STOCK (SQUEEZE)

EXPIRATION OF STOCK OPTIONS

TO RECORD THE EXPIRATION OF STOCK OPTIONS

DR APIC - STOCK OPTIONS
CR APIC - STOCK OPTIONS EXPIRED
NO CHANGE TO TOTAL STOCKHOLDER'S EQUITY

L. Stock appreciation rights entitle an employee to receive as

compensation an amount tied to an increase in stock price.
- Incentive where officers are given cash if stock goes above a hurdle price.
- This excess over hurdle times the number of rights outstanding is the
compensation expense of the corporation.
- Compensation expense for stock appreciation rights outstanding must be
adjusted annually to account for changes in the market price of the stock
- Unlike stock options, stock appreciation rights do not require the
employee to make cash payment.

M. Stock issued for outside service should be recorded at the

FV of the stock.

N. Scrip dividends – a special form of notes payable whereby

a corporation commits to paying a dividend at some later date. May be used
when there is a cash shortage. It may even bear interest until payment is made.

EARNINGS PER SHARE

A. Basic earnings per share assume no potentially dilutive securities. Basic EPS
divides ‘income available for common shareholders’ by the weighted average
number of common shares outstanding.
 Simple Capital Structure – No options, warrants, convertible PS, convertible bonds.
Present EPS for income from continuing operations and for net income on the face of
the income statement. Only report Basic EPS.

Basic EPS = Income available to common shareholders (NI - preferred dividends)

Weighted Average Number of Common Shares Outstanding

Weighted Average Number of Common Shares Outstanding

Shares outstanding at the beginning of the period

+ Shares sold during the period (on a time-weighted basis)
- Shares reacquired during the period ( on a time-weighted basis)
+ Stock dividends and stock splits (retroactively adjusted)
- Reverse stock splits (retroactively adjusted)

Weighted - Average Number of Common Shares Outstanding

for the entire period

Stock dividends and Stock Splits must be treated as though they occurred at the
beginning of the period. The shares outstanding before the stock dividend or
split must be restated for the portion of the period before the stock
dividend/split.

Complex Capital Structure – when it has securities that can potentially be converted
to common stock and would therefore dilute (reduce) EPS (of common stock). Both
basic and diluted EPS must be presented.

Potentially dilutive securities include:

- convertible securities (convertible PS and bonds)
- warrants and other options
- contracts that may be settled in cash or stock
- contingent shares

B. Diluted EPS employs the “if converted” and/or “treasury stock” method to re-
compute EPS as it would be if any dilutive securities such as convertible bonds or
preferred stock, rights, warrants and options. Antidilutive securities are not
considered.

Dilutive EPS = Income available to common shareholder + net interest on dilutive securities
Weighted Average Number of Common Shares, assuming all dilutive securities
are converted to common stock

TREASURY STOCK METHOD

 TO COMPUTE DILUTION FROM OPTIONS, WARRANTS, AND THEIR EQUIVALENTS
FORMULA TO COMPUTE ADDITIONAL SHARES

investor receives cash received

number of exercise
- * =
( )
shares price additional shares
outstanding (add to
Number of shares average market price WACSO)

# of shares issuer can

repurchase
C. Preferred stock, especially cumulative issues, cause calculation difficulties since
preferred claims are not available for common shareholders and preferred
dividends do not reduce net income.

D. The “if-converted” method should be used to determine the dilutive effects of the
convertible securities. The “if-converted” method assumes that the securities were
converted to common stock at the beginning of the period (or at time of issue, if
later).

E. Contingent shares, if dilutive, are part of the Basic EPS calculation if all
conditions for issuance are met. The numerator is simply NI, since it is assumed
all convertible PS are converted to CS at the beginning of the period or when
issued (which ever is later). Thus, PS dividends are not paid out.

F. Basic and Diluted EPS are disclosed by income statement component (IDEA) for
a proper presentation. Cash flow per share should not be reported. Basic and
diluted EPS for discontinued items and extraordinary items are reported on the
face of the income statement or in the notes.

EPS Summary
Weighted
Average Options & Warrants Convertible Bonds convertible P/S Contingent issues
Conditions have
BASIC yes N/A N/A N/A been fully satisified
FMV > Exercise
Price Any Dilutive Any Dilutive
If Converted
Treasury Stock If Converted Method
Method "pretend" Method "pretend" "pretend" Based upon
DILUTED yes Do NOT reduce conditions having
NIAT by the been met to date
Adjust net income preferred stock
Repruchase common for interest expense dividend
stock at the average (not incurred) (pretend they
price reduced by taxes were converted)
 STATEMENT OF CASH FLOWS

A. This statement is comprised of three sections: Cash Flows from:

a. Operating Activities – includes the Normal recurring commercial

activities and transactions involving trading securities.
i. Direct Method – major classes of cash receipts and disbursements
are presented in their gross amounts.

Effect on Cash Direct Method Categories

increase Cash received form customers
increase/decrease Interest received & paid
increase Dividends received
increase Other operating cash receipts such as insurance proceeds
increase/decrease Cash received/paid from the sales/purc. of trading securities
decrease Cash paid to suppliers and employees
decrease Income taxes paid (current and deferred)
decrease Other operating cash payments

ii. Indirect Method – Adjustments to Net Income. Reconciliation on

the face of the financial statement. More popular method used.
Indirect Method
Net Income per the Income Statement
- Depreciation and Amortization Expense (discounts)
+ Losses on sales of PPE/LTI (add to investing)
- Gains/amortization of premiums (add to investing)
- Undistributed earnings from affiliate (equity method)
- Increase to CA
+ Decrease to CA
+ Increase to CL
- Decrease to CL
CASH FLOW FROM OPERATIONS

b. Investing Activities – includes transactions in property, plant &

equipment, investments and lending activities

i. All other securities besides trading are investing activity

ii. Changes in non-current Assets have an inverse relation ship to the
effect on cash.

c. Financing Activities – includes all cash transactions with long-term debt-

holders and owners.

i. Dividends paid
 ii. Paying principal on note/bond/mortgage
iii. Common Stock/Equity transactions
iv. Owner-Oriented and Creditor-Oriented Activities

B. Cash equivalents (treated as cash) are debt securities with an original maturity
date of three months or less

C. The Operating Activities section adjusts Net Income to Cash Provided, or Used,
by Operating Activities. The mnemonic CLAD is useful to remember the various
adjustments.

a. Current assets and liabilities

b. Losses & Gains
c. Amortization and Depreciation
d. Deferred Items

D. The Indirect Method nets the cash flows from the three sections and reconciles it
to beginning and ending cash. Supplemental Disclosures of Cash Flow and
Noncash Investing and Financing Activities and Accounting Policy are also
included.

E. The Direct Method is preferred since it includes a Reconciliation of Net Income

to Cash Provided by Operating Activities in addition to all of the information
contained in the Indirect Method. This reconciliation involves calculations to
convert accrual basis accounts to a cash basis and these can be difficult.

F. Information about material non-cash financing and investing activities (those that
do not result in cash receipts or payments) should be provided separately in a
supplemental disclosure.

As you can see, there is a lot to cover in F7 and, once again, the simulations will bring
out most of the important concepts to know

There is a Required HW Reading on Ration Analysis detailing the key Liquidity,

Activity, Profitability, Investor and Long-Term Debt-Paying Ability Rations. The second
Required Reading contains detailed Treasury Stock examples using the Cost and Par
Value Methods. An Optional Reading demonstrates detailed Statements of Cash Flow
and an excellent summary on page 58.

FINANCIAL REPORTING AND CHANGING PRICES (SEE CHAPTER 2)

A. Financial statements may be restated to demonstrate the effects of changes in

purchasing power of the dollar or the current cost of specific items. GAAP financials
are “Historic Cost/Nominal Dollar” and can be restated to current costs and/or
constant dollar.
 -Historic cost – the actual exchange value in the dollars at that time.
-Current cost – the cost that would be incurred at the present time, the replacement
cost
-Nominal dollars – unadjusted for changes in purchasing power.
-Constant dollars – dollars restated based on calculations of CPI ratios

B. Monetary assets and liabilities are “fixed” in terms of dollars while non-monetary
assets and liabilities are not. Holding net monetary assets during inflation results in a
loss of purchasing power.

-Monetary – held during periods of inflation will result in a loss of purchasing power,
holding monetary liabilities will result in a gain of purchasing power.

-Non-Monetary – assets and liabilities will fluctuate with inflation and deflation.
Holders of non-monetary items may lose or gain with the rise or fall on the CPI if the
non-monetary item does not rise or fall in proportion to the change in the CPI. In
other words, a non-monetary asset or liability is affected by (1) the rise or fall of the
CPI and (2) the increase or decrease in the fair value of the non-monetary asset.

MONETARY ASSET vs MONETARY LIABILITIES

PURCHASING PURCHASING
POWER GAINS POWER LOSSES

HOLDING
MONETARY During a period of During a period of
ASSETS deflation inflation

HOLDING
MONETARY During a period of During a period of
LIABILITIES inflation deflation

FOREIGN CURRENCY ACCOUNTING (SFAS 52)

A. Foreign currency transactions are transactions denominated in a currency other

than that used for financial reporting.

B. Foreign currency transactions require adjusting the receivable of the payable at

any year-end for changes in the dollar equivalent of the foreign currency
denominated transaction since the transaction date. This adjustment puts the gain
or loss in to the year when that gain or loss occurred.
- Forward Exchange Contracts – are agreements to exchange tow
different currencies at a specific future date and at a specific rate. Use
contract rates when doing calculations
- Changes in Exchange Rate – A foreign exchange transaction gain or loss
will result if the exchange rate changes between the time a purchase or
 sale in foreign currency is contracted for and the time actual payment is
made.
- Transaction not settled at BS date – A foreign exchange transaction gain
or loss that is recognized in current net income must be computed at each
BS date on all recorded transactions denominated in foreign currencies
that have not been settled. The difference between the exchange rate used
in recording the transaction in dollars and the exchange rate at the balance
sheet date (current exchange rate) is an unrealized gain or loss on the
foreign currency transaction.

C. Foreign financial statement translation is a two-step process involving

remeasurement to the functional current and translation to the reporting currency.
- Reporting Currency – The reporting currency is the currency of the
entity ultimately reporting the financial results of the foreign entity, and is
always the U.S dollar for the CPA exam.
- Functional Currency – the functional currency is the currency of the
primary economic environment in which the entity operates, usually the
local currency of the U.S. dollar.

Remeasurement (Temporal Method) – (Local to Functional currency)

Translation (Current Method) – Functional to Reporting currency)
FOREIGN FINANCIAL STATEMENT TRANSLATION SEE PAGE 54
Method Translation Remeasurement
Income Statement @ weighted avg. BS - Monetary @ year end rate
1st Step
BS - Non-monetary @ historical

Balance Sheet @ Year-end rate Income Statement @ weighted avg.

2nd Step C/S & APIC @ historical Historical for BS related accounts
Roll forward R/E

Plug Equity - Accumulated other Gain/loss so I/S is at amount

comprehensive income necessary for R/E plug

Reported PUFE IDEA

Financial Accounting & Reporting

CHAPTER 8

GOVERNMENTAL ACCOUNTING OVERVIEW

A. Governmental financial reporting is designed to demonstrate operational

accountability for the entity as a whole and fiscal accountability for specific funds.
Standards for accounting are established by the Governmental Accounting Standards
Board (GASB). The Government Accountability Office (GAO) governs audits under the
Single Audit Act. The government uses GASB, the rest of the world uses FASB.
Funds (= legal restrictions) are separate, independent self-balancing sets of accounts,
similar to a “checkbook.” The three major categories of funds are Governmental
(GRASPP), Proprietary (SE), and Fiduciary (PAPI). Fund accounting enables service
and mission-driven organizations to easily monitor and report compliance with spending
purposes (fund restrictions), spending limits (budget), and other fiscal accountability
objectives.

Governments – se fund accounting for a portion of external reporting and for

internal reporting.
Not-for-profit Organizations – use fund accounting exclusively for internal
reporting.

INDUSTRIES THAT USE GOVERNMENTAL OR NOT-FOR-PROFIT ACCOUNTING AND

REPORTING PRINCIPLES

Governmental Units
Colleges and Universities
Health Care Organizations
Voluntary Health and Welfare Organizations
Foundations
Other not-for-profit Organizations

B. Government – wide financial statements are prepared using the accrual method of
accounting to permit an economic resources and measurement focus. This method is
essentially the same as used in ‘for profit’ accounting and is covered in more detail in F9.

Presentation of a reconciliation of fund financial statements to government-wide

financial statements to fully integrate reporting objectives is also required.

Major funds are presented using the basis of accounting and measurement focus unique
to each category of fund. Only major funds (as defined by the GASB) are presented. Non-
major funds are displayed in the aggregate.

Fiduciary funds are excluded form the government-wide presentation. Enterprise funds
are carried into the Business-type Activities section of the government-wide financial
statements. Internal Service funds are often merged with Governmental Activities
displayed in the government-wide financials.

The use of a measurement focus and basis of accounting in the governmental y funds
different from the measurement focus and basis of accounting used in the government-
wide financial statements provides the elements of the reconciliation between the
governmental fund financial statements and the government-wide financial statements.

Adding fixed assets excluded from governmental fund financial statements and
subtracting non-current liabilities also excluded from governmental fund financial
statements are two of the most significant reconciling items between governmental fund
financials and government-wide financials.
 C. Governmental funds use modified accrual basis of accounting and provide a current
financial resources measurement focus. Revenues are recognized when measurable
and available. Expenditures (not “expenses”) are generally recognized when resources
are spent. There are no non-current assets in governmental funds. The five
governmental (GRASPP) funds are the General, Special Revenue, Debt Service, Capital
Projects and Permanent funds.

D. Proprietary (SE) funds use full accrual accounting and the economic resources
measurement focus. The Internal Service and Enterprise Fund are the two proprietary
funds

E. Fiduciary (Trust) funds use full accrual accounting and the economic resources
measurement focus. The “PAPI” funds are Pension, Agency, Private Purpose and
Investment Trust funds.

GOVERNMENTAL FUNDS

Statement of Revenues, GOVERNMENTAL

Expenditures, and Changes in Fund FUNDS ARE "MAC-
Balance Sheet Balance COMMENTS GRASPP"
Current assets Revenues NO PROFIT MOTIVE
Modified
[Current liabilities] [Expenditures] REPORT CURRENT ONLY Accrual accounting
Current financial
Other financing sources [uses] resources
measurement focus
Fund balance Net change in fund balance GRASPP
 PROPRIETARY FUNDS
PROPRIETARY AND
Statement of Net Statement of Revenues, Expenses, FIDUCIARY FUNDS
Assets and Changes in Fund Net Assets COMMENTS HAVE "SPACE'
SE
All assets Operating revenue TREAT LIKE CUSTOMER PAPI
Accrual accounting
[All liabilities] [Operating expenses] NOT CITIZEN Carry fixed asset and
long-term debt
Non-operating revenue [expenses] CARRY EVERYTHING Economic resources
measurement focus
Net Assets Change in net assets (FIXED ASSETS & LTD) REQUIRED STMT CF

FIDUCIARY (TRUST) FUNDS

Statement of PROPRIETARY AND
Fiduciary Net Statement of Changes in Fiduciary FIDUCIARY FUNDS
Assets Net Assets COMMENTS HAVE "SPACE'

All assets Additions TRUST ACCOUNTS SE

PAPI
Accrual accounting
[All liabilities] [Deductions] CARRY EVERYTHING Carry fixed asset and
long-term debt
Economic resources
Net Assets Change in net assets (FIXED ASSETS & LTD) measurement focus

APPLICATIONS OF MODIFIED ACCRUAL ACCOUNTING

MODIFIED ACCRUAL ACCOUNTING

NO Profit Motive
NO Income Statement
NO Matching Principle
NO Accrual Method

Use Modified Accrual

 Budget
Activity
Encumbrances

A. The governmental (GRASPP) funds record budgets, activity and encumbrances

during the year and closes them out at the end of each year. [BAE BAE] The Budget,
Activity, and Encumbrances are booked and closed at the same amount.

B. Recording the budget at the start of the year requires creating a journal entry
involving Estimated Revenues, Appropriations and Estimated Other Sources/Uses. Any
excess, or projected surplus, is credited to Budgetary Fund Balance. A projected shortfall,
or deficit, would be debited to that account. This entry is closed at the end of the year.

JOURNAL ENTRY TO BOOK BUDGET

DR Estimated revenue control

DR Estimated transfers from other funds (transfer-in)
DR Budgetary fund balance (negative/deficit)
CR Appropriations control
CR Estimated transfers to other funds (transfer-out)
CR Budgetary fund balance (positive/surplus)

THE JOURNAL ENTRY THAT RECORDS THE BUDGETED AMOUNTS FOR

(1) ESTIMATED REVENUE AND APPROVED EXPENSES [APPROPRIATIONS] ARE
POSTED ON THE OPPOSITE SIDE OF THE "T" ACCOUNT COMPARED TO
ACTUAL AMOUNTS
THE JOURNAL ENTRY AT PERIOD END TO REVERSE THE BUDGET IS ALWAYS
(2) FOR THE SAME DOLLAR AMOUNTS AS THE ORIGINAL BUDGETARY JOURNAL
ENTRY +/- ANY SUPPLEMENTAL APPROPRIATIONS

MODIFIED ACCRUAL ACTIVITY

REVENUE BOOK WHEN MEASURABLE AND AVAILABLE (NOT TO EXCEED 60 DAYS FROM YEAR END
EXPENDITURES ALL SPENDING
ASSETS EXPENDITURED (CAPITALIZED ON GOVERNMENT WIDE F/S
DEBTS RECORDED AS OTHER FINANCING SOURCES (ON "I/S" STMT)

C. Revenue is recorded in the real accounts when it is measurable and available. Real
property taxes are considered revenue when billed to property owners. Sales taxes, if
measurable, due within sixty days after fiscal year-end are considered revenue.

MODIFIED ACCRUAL REVENUE RECOGNITION

THE FOLLOWING ITEMS ARE DEEMED MEASURABLE AND AVAILABLE AT THE TIME THE RELATED EVENT OCCURS:
(1) BILLED/RECORDED = REVENUE
(imposed) REAL ESTATE TAXES (DUE)
(imposed) FINES AND PENALTIES
(2) RECEIVED = REVENUE
 (derived) INCOME TAXES
(derived) SALES TAXES
(3) EARNED = REVENUE (deferred revenue when collected)
(imposed) REAL ESTATE TAXES PAID IN ADVANCE
(government mandated) RESTRICTED GRANTS (EARNED WHEN SPENT)

D. Expenditures are recorded as funds are spent. There is no difference between

operating and capital expenditures. Expenditures for supplies, (prepaid) insurance and
inventory can be accounted for by the Purchase Method or Consumption Method. There
is no accrual of any expenditures. The timing of the expenditure is when the voucher
payable is recorded. The modified accrual method does not delay the expenditure until
the cash payment is made.

MODIFIED ACCRUAL METHOD

ACCOUNTING FOR INVENTORY
EXPENSE THEN CAPITALIZE CAPITALIZE THEN EXPENSE
PURCHASE CONSUMPTION
BUYING ITEM DR EXPENDITURE DR SUPPLIES INVENTORY
CR VOUCHERS PAYABLE CR VOUCHERS PAYABLE
USE OF ITEM NO ENTRY DR EXPENDITURE
CR SUPPLIES INVENTORY
ON-HAND AT YEAR END DR SUPPLIES INVENTORY NO ENTRY
CR RESERVE FOR SUPPLIES

E. Transfers out to other funds, or Interfund Transfers, represent a use of financial

resources, not an expenditure.

F. Governmental expenditures are classified as Function (Program), Organizational Unit,

Activity, Character or Object Class.

(1) Function – groups expenditures into the major services of the

governmental entity. (eg. Public safety, highways, education, health &
welfare, & gen. govt services)
(2) Program – groups expenditures into activities, operations, or
organizational units that are directed to the attainment of a specific
purpose or objectives. (eg. Programs for the elderly, drug addiction and
education)
(3) Organizational Unit – corresponds to the organizational structure of the
governmental entity. May be responsible for carrying out several
programs. Roll up into functional presentations. (eg. Police and fire
department)
(4) Activity – Measure of expenditure as a unit amount
(5) Character – pertains to the fiscal period the expenditure is presumed to
benefit.
i. Current expenditures- period expense (current fiscal period)
 ii. Capital outlays – Fixed Assets (present & future benefit)
iii. Debt service – Pay off of LTD ( benefits past, current, & future)
iv. Inter-governmental – transfers

(6) Object Classes – type of item purchased (chart of accounts)

G. Fixed Assets purchased, constructed or leased are not capitalized; however, they are
reported on the Government-Wide F/S (F9). Likewise, long-term debt is not recorded as
debt in a governmental fund, it is an Other Financing Source. LTD also goes to the
Government-Wide F/S. Nor is there depreciation expense recorded on governmental fund
F/S.

H. Open purchase orders represent an encumbrance of a governmental fund. An

Encumbrance (debit) is set up with a credit to Reserve for Encumbrances when the order
goes out. When the order is filled, the Encumbrance J/E is reversed for the amount
originally recorded and the actual Expenditure is recorded in a separate J/E.

I. Governmental funds will prepare a Balance Sheet and a Statement of Revenues,

Expenditures, and Changes in Fund Balance (not I/S).

J. The outstanding encumbrances at year-end is treated as a reserve of the fund balance.

In the following year, when the item is received and paid, it is not reported as
expenditures in the budget and actual comparison schedules since they are not a charge
against current period appropriations.

GOVERNMENTAL FUNDS [MODIFIED ACCRUAL ACCOUNTING] GRASPP

A. There is only one general fund in a particularly governmental entity. The general
fund is created at beginning of the governmental unit, and it exists throughout the life of
that unit. The general fund accounts for the general activities of a government that are not
accounted for by any other fund.

General Fund Revenue

Sources Expenditure Types

General government
Taxes activities
Public safety and Regulation Public Safety
Intergovernmental Culture and Recreation
Charges for Services
Other Revenues
B. Special revenue funds contain funds ‘earmarked’ (legally restricted) for particular
purposes. Users of these funds services are expected to provide less than 50% of the
costs. Intent controls the accounting, regardless of future realization.

EXAMPLES OF SPECIAL REVENUE FUNDS

REVENUE
SOURCE RESTRICTED PURPOSE
sales tax fund to operate park and tourist facility
gasoline tax fund to operate and maintain streets
special fees to operate school programs
parking fees to operate traffic court
state grants state juvenile rehabilitation fund to operate a youth center

Expendable trust funds are special revenue funds. Expendable trust activities (scholarship
and endowment funds) represent funding whose principal and income may be expended
in the course of their designated operations so that they are depleted by the end of their
designated lives.

Grants – when a grant is received, the recipient government monitors and/or determines
eligibility. Recognize revenues and expenditures equally based on payments of the
grantor.

RECEIPT OF GRANT
RULE OF THUMB FOR USE OF THE CORRECT FUND IS:
MONITORING = SPECIAL REVENUE FUND
NONMONITORING = AGENCY TRUST FUND

C. Debt service funds (DSF) pay for the principal and interest related to general
obligation debt. This is debt incurred by governmental funds (GRASPP). Other (SE-
PAPI) funds service their own debt. There is no accrual of interest expenditures or
interest payable.

The balance and interest payable in the debt service fund represent currently due
installments only.

The general fund may pay interest and principal directly form the general fund to the
bondholders, instead of directly to the debt service fund if the use of a debt service fund
is not mandated.

ENCUMBRANCES ACCOUNTS ARE NOT USED FOR DEBT SERVICE FUNDS AND
PERMANENT FUNDS.

D. Capital projects funds are created for each project underway for better accountability
of resources budgeted for each project. Only projects for governmental funds are
accounted for within a capital projects fund. These funds will use BAE-BAE accounting.
Financing sources may be long-term debt issues, capital grants, government grants or
special assessments charged to property owners benefited by the project.

Capital Grants – received in advance are often recorded as a liability and displayed as
earned as they are expended. Government grants may be restricted and are reported as
“revenues” when earned or may be unrestricted, and recognized immediately.
Restricted = Deferred Revenue, Reverse deferral when amount was earned.

Special Assessments – Accounting for special assessment transactions depends on the

degree to which the governmental unit is responsible or potentially liable for debt often
associated with the assessment.

ACCOUNTING FOR SPECIAL ASSESSMENTS

Account for the capital project and debt
related transactions through the appropriate
Primarily or Potentially Liable
governmental ("contribution form property
owners" or proprietary fund
Transactions should be reported in an agency
Not Primarily or Potentially Liable fund (assets and liabilities excluded from
govt.-wide F/S

Bond Issue Proceeds – Other Financing Sources (no amortization of pre/dis)

E. Permanent funds are legally restricted. Only income can be spent with the principal
amounts ‘permanently’ restricted from spending. The funds are used for the benefit of the
public.
ENCUMBRANCES ACCOUNTS ARE NOT USED FOR DEBT SERVICE FUNDS AND
PERMANENT FUNDS.
THE EASY WAY TO DETERMINE WHERE RESTRICTED FUNDS ARE RECORDED
IS:
FUND USE SPENDING
Special Revenue Fund Public Principal and interest (expendable)
Permanent Fund Public Interest Only (nonexpendable)
Private purpose Fund Private Interest and/or principal (expendable)

JOURNAL ENTRY AMOUNT TO REPORT FIXED ASSETS IN GOVERNMENT-WIDE F/S

MANNER ACQUIRED AMOUNT RECORDED
Purchase Cost to buy
Construction Cost to construct
Capital lease PV lease payments
Donated FMV
Forfeiture lower of cost (to acquire) or market
 PROPRIETARY FUNDS [ACCRUAL ACCOUNTING] SE
Treat like customer/not citizen
Require cash flow stmt

JOURNAL ENTRY AMOUNT TO REPORT ESTABLISHING OF PROPRIETARY FUNDS

INTERNAL SERVICE FUND ENTERPRISE FUND
CONTRIBUTIONS FROM OTHER FUNDS CONTRIBUTIONS FROM OTHR FUNDS
DR CASH DR CASH
CR INTERFUND TRANSFER CR INTERFUND TRANSFER

SALE OF "GENERAL OBLIGATIONS BONDS" SALE OF "GENERAL OBLIGATIONS BONDS"

DR CASH DR CASH
CR LONG-TERM BOND PAYABLE * CR LONG-TERM BOND PAYABLE *

LONG-TERM ADVANCES
DR CASH
CR DUE TO OTHER FUND
* FULL ACCRUAL CARRY EVERYTHING * FULL ACCRUAL CARRY EVERYTHING

A. Internal service funds serve other governmental units. The financial statements of an
IS fund are the Statement of Net Assets a Statement of Revenues, Expenses and Changes
in Net Assets, and a Statement of Cash Flows. Net Assets are classified as Unrestricted,
Restricted and invested in capital assets, net of related debt.

Internal Service Funds – established to finance and account for services and supplies
provided exclusively to other departments within a government unit or to other
governmental units, typically on a cost reimbursement basis. (eg. Central janitorial
services, central printing)

Restricted grant revenue is recognized when spent

Operating revenue is recognized when earned

Self Insurance Funds – when a government elects to establish self-insurance funds, the
internal service is the appropriate fund. Other funds transfer “self-insurance premiums”

Reconciling item – combined with governmental funds for purposes of displaying

governmental activities in the government wide financial stmts since they are often set up
to primarily service the governmental funds.

B. Enterprise funds serve users that are expected to provide over 50% of the resources
to fund the operation. The financial statements of an Enterprise Fund are the same as
those for an Internal Service Fund.

Enterprise Fund – used to account for operations that are financed and operated in a
manner similar to private business enterprises.
Activities are required to be reported as enterprise funds if:
- The activity is financed w/debt that is secured solely by a pledge of net
revenue from fees and charges.
 - Laws and regulations require that the cost of providing services be
recovered through fees
- The pricing policies of the activity establish fees and charges designed to
recover its costs.

Eg. Public utilities, public hospitals, lotteries

Municipal Landfills (The Dump)- Reporting and Disclosure – the estimated total current
cost of MSWLF closure and postclosure care should be disclosed as “estimated total
current cost of MSWLF closure and postclosure care to be recognized”
Estimated total costs should include:
- cost of equipment expected to be installed and facilities expected to be
constructed near or after the date that the MSWLF stops accepting solid
waste and during the post closure period. Only equipment to be
exclusively used for the MSWLF.
- Cost of gas monitoring & collection system
- Cost of final cover (capping) expected to be applied near or after the date
that the MSWLF stops accepting solid waste.

This estimate should be adjusted annually. Under proprietary fund reporting, a portion of
this estimated cost is recognized as an expense and as a liability, based on usage, each
period the MSWLF is operating. All costs are recognized as of the date of closure.

FIDUCIARY FUNDS [ACCRUAL METHOD] PAPI

TRUST FUNDS
STATEMENT OF CASH FLOWS NOT REQUIRED

A. Pension trust funds account for government-sponsored pension (defined benefit and
defined contribution) and post-retirement plans such as health care benefits. (eg.
Employee retirement plan, deferred compensation plan) Additions and Deductions
replace Revenues and Expenses in the Statement of Changes in Fiduciary Net Assets.

Statement of Fiduciary net Assets does not include the required actuarial liability. It is
reported in the statement of funding progress.

Actuarial valuations in RSI are required biennially for plans with over 200 participants
and triennially for plans w/less than 20 participants.

B. Agency trust funds “MAILMAN” (no monitoring of recipient) are custodial funds.
Their assets equal their liabilities and there is no fund balance.
- Tax Collection Funds
Sales tax agency fund
- Clearance Funds
Food stamps, alimony
* If a governmental unit has monitoring and/or determines eligibility,
then the special revenue fund is used.
- Special Assessments
 * If a governmental unit has liability, accounting is made through the
capital projects and debt service funds.

AGENCY TRUST FUNDS

NO NET ASSETS

NO INCOME STATEMENT
NO CASH FLOWS
CA = CL

JOURNAL ENTRY TO RECORD THE COUNTY

COLLECTION AND RETAINING FEE OF (%)
DR CASH
CR DUE TO OTHER UNITS (TOWNS)
CR DUE TO COUNTY GENERAL FUND

C. Private purpose trust funds (not general public use), such as an Escheat Property
Fund, contain resources for the benefit of other parties or entities

The private purpose trust fund is the designated fund for reporting all other trust
arrangements under which principal and income are for the benefit of one of the
following:
-specific individual
-private organizations
-other governments

Income form the principal of a private purpose trust may be placed w/another fund.

Capital gains & losses are recorded as adjustments to fund principal and not to income,
unless the grantor specified otherwise.

D. Investment Trust funds – accounting and reporting for certain investments and for
external investment pools established that a government entity that sponsors one or more
external investment pools (sponsoring government) should report the external portion of
each pool as separate investment trust fund. Investment trust funds are generally reported
using fair value.
Accounting & Reporting
CHAPTER 9

GOVERNMENTAL ACCOUNTING (PART B)

A. Government-wide financial statements are prepared

on the accrual basis reflecting the economic resource measurement focus.

B. Governmental Accounting focuses on two types of

accountability.
 i. Fiscal Accountability – the focus of fund
F/S is to demonstrate that the government entity’s actions have
complied with public decisions concerning the raising and spending of
public funds in the short term (one budgetary cycle or one year).
ii. Operational Accountability – the focus of
govt.-wide F/S is to report the extent to which the government has met
its operating objectives efficiently & effectively, using all resources
available for that purpose, and the extent to which it can continue to
meet its objectives for the future.

C. The integrated approach requires reconciliation

between operational & fiscal accountability. That is between the fund F/S and the
government-wide F/S.

MANAGEMENT'S DISCUSSION AND ANALYSIS

GOVERNMENT- WIDE FUND FINANCIAL

FINANCIAL STATEMENTS STATEMENTS

NOTES TO FINANCIAL STATEMENTS

REQUIRED SUPPLEMENTARY INFORMATION (OTHER

THAN MD&A)

i. Government entity’s financial statements

start with management’s discussion and analysis (MD&A)
ii. Government-wide financial statements and
fund financial statements follow (including reconciliation between modified
accrual governmental funds and government-wide F/S on the accrual basis.)
Internal service funds are included with the governmental funds (GRASPP)
in the reconciliation as Governmental Activities. Enterprise funds are
included as business type activities. Fiduciary Funds are not included in
GWF/S since they are custodial in nature.
iii. Notes to the F/S
iv. Required supplementary information (other
than MD&A)
1. Schedule of Funding Progress (for
entities reporting Pension trust funds)
2. Schedule of employer contributions
(for entities reporting Pension Trust Funds)
3. Budgetary Comparison Schedules
(originally adopted budget and comparison of final amended
budget to actual)
4. Information about infrastructure
Assets (for entities reported using the modified approach)

v. The financial reporting entity consists of the primary government entity

(general purpose governmental units), organizations for which the primary
 government is financially accountable (special purpose governmental units),
and certain other specifically identified organizations (component units).

- The primary Govt. consists of all organizations that make up the legal
govt. entity. Neucleus of the financial reporting entity.

THE PRIMARY GOVT REPORTS "BY ITSELF"

S Separately -
E Elected governing body
L Legally separate
F Fiscally independent of other state & local govts
STATE GOVERNMENTS, LOCAL GOVERNMENTS, & SPECIAL PURPOSE
ENTITIES IF THEY MEET THE SELF REQUIREMENTS ABOVE.

- Special Purpose Governmental Units – that are not primary governments

are organizations that are financially accountable to a primary
government.

- Component Unit – legally separate organization for which the elected

officials of the primary govt are financial accountable. Its nature and the
significance of its relationship with the primary government are such that
exclusion of the unit’s financial information would cause the primary
governments financial statements to be misleading or incomplete.

Blended Presentation of financial info:

i. A board of the component unit is substantially the same as that of

the primary govt.
ii. Component unit serves the primary government exclusively or
almost exclusively.

Discrete Presentation (or separate presentation) MOST COMMON

(ex. Bd. of Ed & Rescue Squad)
- F/S of reporting entity should provide an overview of the entity based on
financial accountability

- Used when criteria for blended are not met.

- Most component units should be discrete presentation

- Displays component units in separate columns.

MD&A must be easily readable and analyze material variances

- Description of the F/S

- Identity of the Primary Govt & Descrete Component Units
- Economic Conditions and Outlook
 - Major Initiatives

E. Government-wide F/S are presented in net asset

format. Net assets consists of 3 components:

1. Invested in capital assets net of

accumulated depreciation & related debt. (includes infrastructure)
2. Restricted (external restrictions)
imposed by creditors, grantors, contributors, laws or regulations of other
governments, and restrictions imposed by law through constitutional
provisions or legislation.
3. Unrestricted Net Assets (no external
restrictions) – These reserves are controlled by mgmt and can be
modified or removed. When restrictions on restricted assets are satisfied
the amounts are reclassified as unrestricted.

F. Capitalized Assets will include infrastructure – type

assets. The cost of capital assets should include all ancillary charges
necessary to place the asset into its intended location and condition of
intended use. Capitalization of construction period interest is not required
for capital assets used in governmental activities.
- Depreciation – is required in the accrual method, however, a modified
approach may be used for infrastructure assets. In this approach, ordinary
expenditures are expensed and additions or improvements are capitalized.
There are 2 conditions regarding record-keeping that must be met for the
modified approach to apply.
1. The govt’s asset mgmt system meets certain conditions:
a. inventory of eligible infrastructure assets is up to date
b. A summarized condition assessment of the eligible
infrastructure assets is performed and the results use a
measurement scale.
c. Each year an estimate is made of the amount necessary to
maintain and preserve the eligible infrastructure assets at
the condition level established and disclosed by the
government.
2. The government documentation should include data on
asset preservation :
a. A complete condition assessment of eligible
infrastructure assets must be performed in a consistent
manner at least every three years.
b. Information that the results of the 3 most recently
completed condition assessments provide reasonable
assurance that the eligible infrastructure assets are being
presented approximately at (or above) the conditions
level established and disclosed by the government.

Change in Estimate for either the required method to the modified or the modified to the
required.
 G. Donated artwork and historical treasures should be capitalized at their fair values
unless they will be exhibited, preserved and the proceeds of any sale will be used
to acquire other assets for the collection. (same for not –for-profits)

H. The government-wide statement of activities will include program revenues

(SOC) resulting from exchange-type (charges for services) or non-exchange-type
transactions such as operating or capital grants.
- Charges for services -
-to customers or applicants who directly benefit from goods or services
(ex. Water and sewer fees, licenses, building permits. Etc)
-to other governments. (ex. Charges to housing prisoners)
-fines and forfeitures.
- *Operating Grants & Contributions
- *Capital Grants & Contributions

*Mandatory and voluntary non-exchange transactions with other governments,

organizations or individuals that are restricted for use in a particular program. (ex. Grant
revenues in support of specific program.

I. Fund F/S – Reporting by major fund provides more meaningful information.

There are two criteria (10% (like segment reporting) of GRASPPS or E (the
“separate columns) and 5% of GRASPP and E (the “total column”) must be met
for a fund to be considered major. When determining if a fund qualifies as a major
fund, remember that aggregate fund balance/equity is not used in either test.
Government officials may elect to report a fund as major if they believe that the
public interest is served by the reporting, regardless of the quantitative criteria.

J. Reconciliation bet. Modified accrual govt. funds and govt.-wide accrual basis F/S
is preformed for the Balance Sheet (GALSBARE) and the statement of Revenues,
Expenditures and changes in Fund Balance (GOES BARE). Review pg 22

BALANCE SHEET
G GRASPP - Fund Balance
+ A Assets (non-current)
 - L Liabilities (non-current)
+ S Service (internal) Fund Net Assets

B Basis of Accounting
A Accrued
R Revenue &
E Expenses
STATEMENT OF REVENUED, EXPENDITURES AND CHANGES IN FUND
BALANCE
G GRASPP - Net Change in Fund Balance
- O Other Financing Sources
+ E Expenditure - Capital Outlay (net of depreciation)
+ S Service (internal) Fund Net Income

B Basis of Accounting
A Additional Accrued
R Revenues &
E Expenses

K. Proprietary Funds
a. Statement of Cash Flows
i. Direct method is required
ii. Reconciliation of operating income (not net income) to net cash
provided by operations is required
iii. There are 4 categories (instead of three categories in commercial
accounting)
1. operating activity
2. investing activity
3. capital and related financing activities
4. non-capital financing activities

iv. interest income/cash receipts are reported as “investing activities”

(not as operating activities)
v. interest expense/cash payments are either:
1. capital and related financing or
2. non-capital financing

vi. Capital asset purchases are reported as “financing activities”(not as

investing)

L. Required supplementary info other than MD&A will include interfund loans (due
to/form), interfund services provided or used, and interfund transfers or
reimbursements. Include budgetary comparison schedules that show the original
budget, the final amended budget, and actual amounts (budgetary basis).

M. Within columns we will eliminate interfund activity and between columns we will
not eliminate interfund activity.
 NOT-FOR-PROFIT ORGANIZATIONS

A. Not-for-profit entities depend significantly on

donations or contributions. The accounting rules for these organizations come form
FASB.

The operating purpose does not include profit although there is nothing precluding the
generation of a profit.

THESE ENTITIES INCLUDE:

Health Care Organizations (Hospitals, Nursing Homes, Hospices)
Educational Institutions (Colleges & Universities, other schools)
Voluntary Health & Welfare Organizations (United way, Red Cross)
Other Not-for-profit entities (cemetery org, fraternal org, labor unions, AICPA)

(non-governmental)

B. Use Accrual Accounting

C. Required F/S
Statement of Financial Position (A-L =NA)
Statement of Activities
Statement of Cash Flows
Statement of Functional Expenses (required HW reading)

D. Net Assets are comprised of 2 elements:

-Unrestricted Net Assets (no external restrictions)
-Available to finance general operations of the particular government and
may be expended at the discretion of the governing board. Internally board
designated funds are considered unrestricted.
-Temporarily Restricted net assets (external restrictions as to time or purpose)
-Donor imposed stipulations either expire by passage of time or can be
fulfilled and removed by actions of the organization.
-Should not be displayed as a deficit.
-Any over expenditure should be classified as a reduction of unrestricted
net assets
-When a donor-imposed restriction is satisfied, the amount ceases being
temporarily restricted and is re-classified to unrestricted.
-Permanently restricted net Assets (principal cannot be used)
-Donor imposed stipulations do not expire by passage of time and cannot
be fulfilled and removed by actions of the organization

Assets and Liabilities are displayed according to relative liquidity. Classified as current
or noncurrent. Nearness to cash and nearness to maturity.
Contributions, pledges, and gifts are classified into one of the following three categories
according to the existence or absence of donor imposed stipulations

Timing of reclassification of restrictions:

- Contributions with donor-imposed restrictions are recorded as restricted
revenue in the period in which they are received. They increase
temporarily or permanently restricted net assets.
- When a donor restriction is satisfied, a reclassification is reported on the
statement of activities. Reclassifications are items that simultaneously
increase one net asset class and decrease another.
- Donor-imposed restrictions that are met in the same period they are
received maybe recorded as unrestricted support (contribution revenue),
provided that the organization discloses and consistently applies this
accounting policy.
- Support that results in permanently restricted net assets ordinarily are not
reclassified, as they were permanently restricted by the donor.
- Revenue, gains, and other support that result in unrestricted net assets
ordinarily do not become restricted.

E. Expenses – reported as decreases in unrestricted net assets. Detail functional

classification must be presented either on the face of the financials or the notes to
the F/S.
Expense Categories:
- Program Services – major or main activities of the organization.
- Support Services – represent administration- type functions within the
organization.
- Combined Costs – not-for-profit organizations that combine fund-raising
efforts with educational (or program) services, should allocate the
combined costs between functions using any reasonable means

F. STATEMENT OF CASH FLOWS

- required for all non-profit organizations
- commercial format is followed
- indirect or direct method can be used
- most donations are operating activities except for certain restricted
donations that are financing

Operating Activities
- include applicable agency transactions
- when using the direct method, operating activities should be reported by
major class of gross receipts (contributions, program income, etc)
- include receipts of unrestricted resources designated by the governing
body to be used for long lived assets

Financing Activities
 - include cash transactions related to borrowing that are typically found in
commercial statements of cash flows but also include cash transactions
related to certain restricted contributions
- SUBCLASSES OF FINANCING ACTIVITIES
i. Proceeds form Restricted contributions – cash received with donor
imposed restrictions limiting its use to long-term purposes such as
increases to an endowment, purchases of assets or annuity
agreements is displayed as a financing activity. Disbursements of
these restricted contributions for either temp. investments or the
purpose for which they were intended are classified as investing
activity.
ii. Other financing activity – receipts & disbursements associated
with borrowing, disbursements associated with split interest
agreements, and receipts of interest & dividends restricted to
reinvestment.
Investing Activities
- Proceeds form the sale of works of art or purchases
- Investment in equipment
- Proceeds from the sale of assets that were received in prior periods and
whose sale proceeds were restricted to investment in equipment.

G. STATEMENT OF FUNCTIONAL EXPENSES

- clearly disclosed in the statement of activities and/or the footnotes.

- 3 Major Categories
i. Program Support expenses
ii. Fund Raising Expenses
iii. Mgmt & General

H. REVENUE

- Contributions count as revenues or other support, Revenues usually reflect

“exchange-type” transactions. Other support usually includes donations.
- Unconditional promises (pledges) are recorded as revenue for the portion
considered collectible after treating the entity’s estimate of uncollectibility
as a contra-asset.
- Conditional Promises are not recognized until the condition has been
satisfied.
- Multi-year pledges-recorded at the net present value at the date the pledge
is made.
i. Future collections are considered temp. restricted revenues & net
assets(time).
ii. Difference between the previously recorded present value and the
current amount collected is considered contribution revenue, not
interest income.
Donated Services – do not cause any journal entry unless the donated service is essential
and SOME requirements are met.

S Specialized skills are required & possessed by donor

O Otherwise needed by the organization
M Measureable
E Easily (at fair value)

DR Expense or asset
CR contributions - non operating revenue

Donated Collection Items – (same as for govt.)

Not required to be recorded, if:
- item is part of a collection, which is held for public vieweing, exhibition,
education, or research (not for investment or financial gain)
- the collection is cared for, preserved, and protected by the organization
- policy that requires proceeds from the sale of donated items to be
reinvested in other collection items.

If the following (above) are not met, the donation must be recognized as an asset &
revenue.

Donated Materials –
- to be used will increase assets and support at the time of the
donation.
DR Asset
CR Contribution – support

- that merely pass through the organization to an ultimate beneficiary,

should not be recorded, unless the amounts are substancial
Record and Properly Disclose
DR Expense
CR Unrestricted contributions –supplies

When donated items are sold at greater than FMV, the amount received in excess is
contribution income.

Unrestricted Pledges (w/implied time restrictions)

DR Pledge Receivable
CR Allowance for doubtful accounts
CR Contributed revenue - temp. rest. Revenue

Restricted Contributions
DR Pledge Receivable
CR Allowance for uncollectible
CR Restricted Rev- (temp. res. Net assets)
RESTRICTED
DR Reclassification: satisfaction of restriction
 CR Cash/restricted net assets
UNRESTRICTED
DR Cash/unrestricted net assets
CR Reclass: satisfaction of restriction
DR Operating Expense
CR Cash/unrestricted

Distinguishing contributions from Other Transactions

1. Agency Transactions – result in an asset and a liability
- these amounts are really the property of another party
- little or no discretion or variance power
Variance Power – the ability to use assets in any
way the not-for-profit deems appropriate.

2. Gifts In-Kind – non-cash contributions to a not-for-profit

- measured at their FMV
- donated as part of a fund-raising appeal are valued at FMV when
received and revalued upon their sale as part of the fund raising appeal.
The difference between the fair vale at the time of donation and the
value at the time of sale is accounted for as an additional contribution.

3. Exchange Transactions – Reciprocal transfers in which each party receives and

sacrifices something of approximately equal value.
- cost of premiums (coffee mugs, tote bag) given to potential donors as part
of a fund raising appeal is classified as a fund-rising expense.
- cost of premiums given to acknowledge donations is also classified as a
fund raising expense.
- Generally the difference between the fair value of dues or other purchases
and the amount transferred is classified as a contribution.
- Exchange transactions are classified as unrestricted revenues and nto
assets, even in circumstances in which resource providers place limitations
on the use of the resources.

AMOUNT TRANSFERRED
(FAIR VALUE DUES/ PURCHASE)
CONTRIBUTION REVENUE

Transfers of assets to a NFP org. or charitable trust that holds contributions for others are
treated as “an extension of the equity method of accounting “If variance power is present,
treat inflows as revenue. If no variance power is present, treat inflows as liabilities.
Beneficiaries recognize their rights to assets held by others unless the recipient is
explicitly granted variance power.

DR Asset
AS LIABILITY
CR Refundable Advance
DR Asset
AS INCOME
CR Contribution Revenue
Investments in securities are reported at fair value. Gains and losses are reported in the
Statement of Activities as increases or decreases in unrestricted net assets unless use is
restricted (by donor).