GAAP: Inside and Out. Course #5270J/QAS5270J Course Material

Transcription

1 GAAP: Inside and Out Course #5270J/QAS5270J Course Material

2 GAAP: Inside and Out (Course #5270J/QAS5270J) Table of Contents Page SECTION I. GAAP Q&A I. Balance Sheet A. Comparative Statements/Individual Statements B. Property and Equipment Review Questions and Suggested Solutions #1 C. Cash and Investments Review Questions and Suggested Solutions #2 D. Receivables E. Inventories F. Cash Value of Life Insurance G. Intangible Assets Review Questions and Suggested Solutions #3 H. Current Liabilities I. Notes Payable J. Other Liabilities K. Stockholders Equity Review Questions and Suggested Solutions #4 II. Revenues and Expenses A. Income Statement Title B. Involuntary Conversions C. Percentage Revenue D. Accounting for Shipping and Handling Costs Billed E. Income Statement Characterization of Reimbursements Received F. Reporting Revenue Gross Versus Net G. Cash Received by a Reseller from a Vendor Review Questions and Suggested Solutions #5 H. Depreciation and Amortization I. Other Expense and Income Items Review Questions and Suggested Solutions #6 J. Cash Flows K. Concentrations L. Fiscal Years Review Questions and Suggested Solutions #7 M. Personal Financial Statements N. Related Party Disclosures and Transactions O. Miscellaneous Disclosures P. Income and Other Taxes Review Questions and Suggested Solutions #8 Q. Dealing with Acts of God (Natural Disasters), Terrorist Acts and Insurance Related Thereto R. Accounting for Entities in Bankruptcy GAAP: Inside and Out 1

3 S. Accounting for Web Site Development Costs T. Fair Value Disclosures U. Subsequent Events Under GAAP V. Peer Review Deficiencies Review Questions and Suggested Solutions # SECTION II. OCBOA: CASH AND INCOME TAX BASIS FINANCIAL STATEMENTS (Other Comprehensive Basis of Accounting) I. Overview A. Definition of OCBOA B. Definition of Income Tax Basis Statements C. When to Use and Not Use OCBOA Income Tax Basis Financial Statements D. Present Reporting and Disclosure Authority OCBOA E. Items Peculiar to Income Tax Basis Statements Include F. Disclosure and Financial Statement Requirements G. Making Income Tax Basis Financial Statements Simpler to Use and Understand H. Converting to OCBOA Statements I. Cash Flows Statement J. OCBOA Financial Statement Titles K. Authority for OCBOA Disclosures L. Other OCBOA Issues M. Using OCBOA Based on a Method That Differs from the Income Tax Return N. Combining Financial Statements Prepared in Accordance with the Income Tax Basis of Accounting O. Issuing OCBOA Financial Statements for a One-Member LLC P. Section 179 Depreciation OCBOA Q. Agreements Not to Compete OCBOA Review Questions and Suggested Solutions # Glossary 348 Index 349 GAAP: Inside and Out 2

4 SECTION I. GAAP Q&A Introduction In 2009, the FASB completed its Accounting Standards Codification (Codification) which was published in FASB No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (FASB ASC 105). The Codification was effective for interim and annual periods ending after September 15, With the Codification, the FASB had as its goal to consolidate U.S. GAAP into one system that can be more easily researched by topic, rather than by reference number. The Codification changes the citations for GAAP from the typical FASB or APB statement number to an Accounting Standards Codification (FASB ASC) reference. For example, FASB No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, has been codified into FASB ASC Topic 825, Financial Instruments. In this course, the author has included the original U.S. GAAP reference (e.g., FASB No. 115) parenthetically along with the FASB ASC topic number under the Codification (e.g., FASB ASC 320). For abbreviation purposes, the author uses the terms ASC, FASB ASC and FASB ASC Topic, interchangeably. I. Balance Sheet A. COMPARATIVE STATEMENTS/INDIVIDUAL STATEMENTS Question: Are both a balance sheet and an income statement (and also a statement of cash flows) required for all annual reports, and must all such statements be in comparative form for at least two years? Response: ASC 205, Presentation of Financial Statements (formerly ARB No. 43), recommends, but does not require comparative financial statements. However, the SEC requires comparative financial statements for publicly held companies. Question: Is either statement alone a fair presentation? Does a balance sheet alone fairly present the financial position if the client incurred a material operating loss during the current year? Response: With respect to presenting one financial statement, reference can be made to SAS No. 122, AU-C Section 805, Special Considerations Audits of Single Financial Statements and Specific Elements, or Items of a Financial Statement. AU-C 805 permits the auditor to report on a single financial statement, such as a balance sheet or income statement. The auditor may be asked to report on one basic financial statement and not on the others. For example, he or she may be asked to report on the balance sheet and not on the statements of income, retained earnings or cash flows. These engagements do not involve scope limitations if the auditor's access to information underlying the basic financial statements is not limited and if he applies all the procedures he considers necessary in the circumstances. GAAP: Inside and Out 3

5 Therefore, a separate balance sheet may fairly present financial position, and a separate statement of income may fairly present results of operations. Question: When financial statements are presented, should the notes to financial statements disclose details for both periods? Response: Generally, notes should relate to all periods presented, provided such information is relevant to both periods. In practice, many practitioners present certain disclosures comparatively (e.g., fixed assets, long-term debt), yet other disclosures for the current period only (e.g., short-term notes receivable and payable). B. PROPERTY AND EQUIPMENT 1. Idle Property and Equipment Question: What is the appropriate balance sheet classification and presentation of idle property and equipment? Should the property and equipment continue to be depreciated while idle? Response: ASC 360, Property, Plant and Equipment, states that when a long-lived asset ceases to be used, the carrying amount of the asset should equal its salvage value, which should not be less than zero. Accounting Research Study No. 7, Inventory of Generally Accepted Accounting Principles for Business Enterprises, provides further guidance by stating: Plant assets may include property held with reasonable expectation of it being used in the business. It is not customary to segregate or indicate the existence of temporarily idle plant, reserve, or standby equipment. Property abandoned but not physically retired or no longer adapted for use in the business, if material in amount, should be removed from plant accounts and recorded separately at an estimated (net) realizable amount, appropriately explained. When a material portion of plant and equipment has been idle for a protracted period with no apparent likelihood of resuming operations, the amount should be set forth separately with an appropriate caption. Depreciation should continue only if the equipment is temporarily idle and it is expected that operations will resume at some time. 2. Categorization of a Building Question: A corporation purchased a building and intends to sell it within six months. Should it be accounted for as an investment or fixed asset? Should it be depreciated? GAAP: Inside and Out 4

6 Response: ASC 360, Property, Plant and Equipment (formerly ARB 43), states that GAAP requires that the cost of a productive facility be spread over its expected useful life. Because the building is not a productive facility, and no services will be derived from it, it should not be depreciated. Instead, it should be carried at the lower of cost or net realizable value (estimated selling price less selling costs) and categorized as a current asset since it will be converted into cash within six months. 3. Deposit on Machinery Question: What is the balance sheet classification of a deposit on machinery to be purchased within one year? Response: ASC 340, Other Assets and Deferred Costs (formerly ARB No. 43), states that the concept of a current asset excludes any resources that are restricted as to withdrawal or use for other than current operations. Accordingly, the deposit should be presented as a long-term asset even though the equipment will be purchased within one year. 4. Non-Monetary Exchanges Question: What are the accounting rules for non-monetary exchanges? Response: The authority for non-monetary transactions is found in ASC 845, Non- Monetary Transactions (formerly FASB No. 153). The general rule is that exchanges of nonmonetary assets should be accounted for at the fair value of the asset surrendered or asset received, whichever is more determinable. ASC 845 provides three exceptions from the general rule under which the transaction is recorded at carrying value (book value) instead of fair value. These exceptions are: a. Fair value is not determinable: The fair value of the asset(s) received or the asset(s) relinquished is not determinable within reasonable limits. b. Exchange transaction to facilitate sales to customers: The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange. c. Exchange transaction that lacks commercial substance: A transaction lacks commercial substance if the configuration (risk, timing, and amount) of the future cash flows of the asset received do not differ significantly from the future cash flows of the asset transferred. Using the carrying value (book value) approach the transaction is recorded as follows: Book value of the + Cash = Cost of asset received asset given paid GAAP: Inside and Out 5

7 Although the first two exceptions may be relevant, the third one (the transaction lacks commercial substance) is the most common to consider in practice and is the focus of the discussion in this section. How do you determine whether a transaction lacks commercial substance? ASC 845 provides that the assessment of commercial substance may be made either quantitatively (e.g., cash flow analysis) or qualitatively by comparing the configuration (risk, timing, and amount) of the future cash flows of the assets exchanged. Further, ASC 845 states that a significant difference in any one of the three elements (risk, timing and amount) of cash flows means that the transaction has commercial substance and thus is recorded at fair value. A practical way in which to determine whether a transaction lacks commercial substance is to focus only on the timing element of future cash flows because it can be easily assessed qualitatively. This qualitative assessment of the timing of cash flows can be made simply by comparing the remaining useful lives of the exchanged assets with the theory being that the useful lives represent the remaining time over which the assets will generate cash flows for the entity. If the remaining useful life of the asset received differs significantly from the useful life of the asset surrendered, the transaction has commercial substance and is recorded at fair value. Conversely, if the useful lives do not differ significantly, a carrying value approach should be used. Following are several examples that illustrate the application of ASC 845. Example 1: Company X trades in a motor vehicle with a carrying value of $10,000 for a new motor vehicle. No cash is exchanged. The remaining useful life of the old motor vehicle at the time of the exchange is 3 years. The useful life of the new motor vehicle is 3 years. Conclusion: The transaction lacks commercial substance and is recorded at carrying value. The configuration (risk, timing and amount) of future cash flows of the motor vehicle received does not differ significantly from that of the motor vehicle transferred. More specifically, the timing of the cash flows to be generated from the asset received (3 years) is the same as the timing of the cash flows generated from the asset given (3 years). Entry: New motor vehicle 10,000 Book value of old motor vehicle 10,000 Example 2: Company X trades in a motor vehicle with a carrying value of $10,000 for a new motor vehicle plus $8,000 cash paid. The fair value of the new motor vehicle is $22,000. At the time of the exchange, the remaining useful life of the old motor vehicle is 2 years while the new motor vehicle s useful life is 5 years. Conclusion: The transaction does not lack commercial substance and is recorded at fair value. The configuration (risk, timing and amount) of future cash flows of the motor vehicle received differs significantly from that of the motor vehicle transferred. The GAAP: Inside and Out 6

8 reason is because the large amount of cash paid suggests the upgrade in assets is significant. Thus, the useful life of the new asset (5 years) is significantly longer than the old motor vehicle transferred (2 years), resulting in the timing of cash flows differing significantly between the two assets. Entry: New motor vehicle 22,000 Book value of old motor vehicle 10,000 Cash 8,000 Gain on exchange 4,000 Example 3: Company X exchanges a commercial rental property for 100 acres of land to be used for future development. The commercial property is currently rented to several tenants. The new land will be held for future development or speculation. At the earliest, the land would be sold or developed in five years. Details associated with the exchange follows: Commercial rental property given: Carrying value of rental property (cost less accumulated depreciation) $2,000,000 Fair value 4,000,000 Land received: Fair value of rental property given $4,000,000 Cash paid 1,000,000 Total fair value given for land $5,000,000 Conclusion: The transaction should be recorded at fair value, with the land recorded at the fair value of the property given ($5,000,000). The reason is because the exchange has commercial substance. In this example, using a qualitative analysis, it is evident that the future cash flows of the new land are expected to significantly change as a result of the exchange. First, the risk associated with the future cash flows will change as the land will be held for speculation or future development. Second, the timing of the cash flows will change with the current cash flows from net rental income related to the commercial property being replaced with long-term cash flows from the land development or sale not likely to occur for another five years. Finally, the amount of the cash flows is likely to be different between the two properties. Entry: Land 5,000,000 Book value-commercial property 2,000,000 Gain on exchange of property* 2,000,000 Cash 1,000,000 * Gain: Fair value of old property ($4,000,000) - carrying value of old property ($2,000,000) = Gain ($2,000,000) GAAP: Inside and Out 7

9 May the commercial substance test be performed quantitatively? Conclusion: Yes. ASC 845 allows the test to be done either quantitatively or qualitatively. In most instances, a qualitative analysis such as the one given in the above three examples is the easiest and most effective way to determine commercial substance. The following example illustrates how a quantitative analysis can be done. Example 4: Company X has a plant with a carrying value of $1,000,000 with no debt outstanding. X purchases a new plant for $12 million by exchanging the old plant (fair value of $3,000,000) plus cash and financing paid of $9,000,000. The transaction is summarized as follows: Carrying value of old plant (cost less accumulated depreciation) $1,000,000 New plant: Fair value of old plant exchanged $3,000,000 Cash paid 4,000,000 Financing obtained for new purchase 5,000,000 Total purchase price- new plant $12,000,000 Future cash flows expected to run the new plant, versus the old plant follows: New plant Old plant Net operating income- annual $2,000,000 $1,200,000 Add: depreciation 400, ,000 Debt service- principal payments (200,000) 0 Average annual cash flows 2,200,000 1,400,000 # years useful life of plant ,000,000 14,000,000 Residual value- assume sale at the end of the useful life 10,000,000 1,000,0000 Total cash flows over the useful life of each asset $76,000,000 $15,000,000 Conclusion: The transaction should be recorded at fair value as the transaction has commercial substance. The reason is because the future cash flows are expected to significantly change as a result of the exchange to the new plant. In this example, the configuration (risk, timing and amount) of future cash flows of the new plant differs significantly from the configuration of the future cash flows of the old plant transferred. Because the new plant is partially financed, there is risk associated with the new plant as compared with the old plant. The timing of the cash flows differs because the new plant will generate cash flows over a longer period of time. Finally, the amount of the future cash flows is greater with the new plant versus the old one ($76,000,000 versus $15,000,000). Note that future cash flows of each asset reflect the assumption that the asset is sold at the end of the useful life of the asset. GAAP: Inside and Out 8

10 Second, although not necessary to this analysis, the entity-specific value of the new plant differs from the entity-specific value of the old plant, and the difference is significant in relation to the fair values of the assets exchanged. Entry: New plant 12,000,000 Book value of old plant Gain on exchange of old plant 1,000,000 2,000,000 Cash 4,000,000 Note payable 5,000,000 (1) Gain: Fair value of old ($3,000,000)- carrying value of old plant ($1,000,000) = Gain ($2,000,000) Note further that the analysis could have been done on a qualitative (rather than a quantitative) basis, thereby eliminating the need to perform the cash flow computations. How is cash received accounted for in an exchange that lacks commercial substance? If cash is received in a transaction that lacks commercial substance, a partial gain is recognized on the transaction based on the following ratio: Cash received Total FMV received x Gain realized = Gain recognized Example: A motor vehicle with a book value of $5,000 is traded in for a new vehicle and the receipt of $1,500 cash. The useful lives of the assets are about the same so that the transaction lacks commercial substance and should be recorded at carrying value. The new motor vehicle has a FMV of $4,500. Step 1: Calculate the realized gain: Total FMV received: FMV of new motor vehicle $4,500 Cash received 1,500 Total FMV received 6,000 BV of motor vehicle given up 5,000 Gain realized $1,000 The gain recognized for GAAP purposes is based on the ratio of cash received to total fair value received computed as follows: Cash received 1,500 = 25% x 1,000 = 250 gain recognized Total FMV received 6,000 GAAP: Inside and Out 9

11 Entry: Cash New motor vehicle (plug) Gain BV of old motor vehicle 1,500 3, ,000 Note that when cash is received in an exchange that lacks commercial substance, the result is a hybrid transaction under which a partial gain is recognized with the remainder of the transaction being recorded at carrying value. The theory behind this approach is that a portion of the old asset was sold for cash resulting in a partial gain being recognized while the remainder of the old asset was exchanged at carrying value. What if there is an exchange that lacks commercial substance that results in an indicated loss? Should the loss be recorded for GAAP? Yes. ASC 845 has an indicated loss rule that should be followed in dealing with exchanges recorded at carrying value, including those that lack commercial substance. Example: A company has a fleet of motor vehicles for its sales staff. Once a vehicle reaches 50,000 miles, it is traded in for a new vehicle. This usually occurs after approximately months. The motor vehicle exchanges are accounted for at carrying value, as non-monetary exchanges that lack commercial substance. After several exchanges, the book value of several assets appears much higher than its fair value. How should this be accounted for? Response: ASC 845 states that an exchange that lacks commercial substance is accounted for at carrying (book) value. The new vehicle is recorded at the book value of the old vehicle plus any cash or boot paid. However, ASC 845 provides an indicated loss rule based on the concept of conservatism. The indicated loss rule states that the new asset should never be recorded at more than its fair value. If the new asset is recorded at more than its fair value, it should be written down to its fair value and an indicated loss should be recorded on the income statement. Example: A company has an old motor vehicle with a book value of $25,000. The old vehicle is traded in for a new vehicle and the company pays a cash difference of $5,000. The cash selling price (FMV) of the new vehicle is $26,000. Entries New motor vehicle 30,000 Book value- old vehicle 25,000 Cash 5,000 To record the trade in: book value of the old asset plus cash paid equals the cost of the new asset Loss 4,000 New motor vehicle 4,000 To write down the new vehicle to market value of $26,000 GAAP: Inside and Out 10

12 Note: If the fair value of the new motor vehicle were $38,000, the second entry would not be made, nor would an entry be made to record any unrealized gain. This is because the fair value of $38,000 is greater than the recorded value of $30,000. Note: For tax purposes, like-kind exchanges under section 1031 of the IRC are the same for book purposes as for tax purposes provided the transaction involves an exchange of asset for asset with no cash or where cash is given. However, the indicated loss is not allowed for tax purposes. Further, when cash is received, section 1031 requires gain recognition up to the amount of cash (boot) received (limited, of course to the total gain). How to deal with the GAAP Treatment of Delayed Exchanges: Section 1031 of the IRC Question: Section 1031 of the IRC permits a taxpayer to defer a gain on the exchange of certain property. How are delayed exchanges treated for GAAP? Response: Section 1031 allows a taxpayer to use the technique known as a delayed like-kind exchange. This technique is the most popular one used under Section 1031 because it does not require an actual direct exchange of one property for another between two parties. Here s how it works! An entity (the seller) sells rental Property A for $500,000 cash under a transaction treated as a delayed exchange under section The basis of this property for tax purposes is $200,000, resulting in a realized gain of $300,000 ($500,000 less $200,000). The cash is held in an escrow account by an independent party (referred to as a qualified intermediary) on behalf of the seller until the seller finds a new investment property (the replacement property) to acquire with the escrowed cash. Within 45 days of the sale of Property A, the seller must identify a replacement property (Property B) to acquire with the $500,000 cash. Further, the intermediary must purchase Property B on behalf of the seller within 180 days of the sale of Property A. All of the $500,000 cash must be spent on the acquisition of the new property and, there are special net boot rules relating to mortgages as well as qualifying replacement property, both of which are details beyond the scope of this discussion. If this transaction is structured properly, Property B s basis is the same as Property A s, $200,000 with no gain recognition. GAAP: Inside and Out 11

13 Seller Property A Property A- Sold to Buyer for $500,000 cash Selling price $500,000 Basis 200,000 Replacement Property B $500,000 cash to seller within 180 days to intermediary Qualified Intermediary Replacement Property B (Escrow Account for Seller) $500,000 cash $500,000 cash $500,000 cash Replacement propertyidentified within 45 days and purchased within 180 days of sale or original property Does a delayed exchange qualify for GAAP as an exchange that lacks commercial substance so that it is recorded at carrying value? In reviewing the GAAP codification, there is no authority dealing with the accounting treatment for delayed exchanges. However, the FASB has offered an unofficial position that a delayed exchange does not qualify as an exchange that lacks commercial substance for purposes of applying ASC 845. Instead, for GAAP purposes, the delayed exchange should be treated as two monetary transactions, each recorded at fair value as follows: Transaction 1: Sale of first property and recognition of a gain on the sale Transaction 2: Purchase of new property for cash In the above example, there is a gain recognized on the sale of Property A and a step up in the basis in the new property to the acquisition price of $500,000. Example: Same facts as above applied to GAAP: GAAP Entries: Transaction 1: Sale of Property A: Cash 500,000 Book value- Property A 200,000 Gain on sale of Property A 300,000 To record sale of Property A and recognition of gain. Transaction 2: Purchase of Property B: Property B 500,000 Cash 500,000 To record purchase of Property B. GAAP: Inside and Out 12

14 Tax Entries (if made for tax purposes): If entries are actually made for tax purposes, the entries to record the deferred gain under Section 1031 of the Internal Revenue Code would be as follows: Cash escrow account 500,000 Book value of Property A 200,000 Deferred gain 300,000 To record sale of Property A Property B 200,000 Deferred gain 300,000 Cash escrow account 500,000 To record purchase of Property B as replacement property for sale of Property A. As a result of the transaction, the basis of Property B is different for GAAP ($500,000) and tax ($200,000) purposes. The book-tax basis difference of $300,000 is a temporary difference and deferred taxes should be set up on this difference, if material. One way of avoiding the need to record the new property at fair market value would be to issue OCBOA-income tax basis financial statements under which the new property would be recorded using the IRC Section 1031 rules- at the book value of the property sold, rather than at its fair market value. Another option is to record the transaction at book value and note a GAAP exception in the report. Is the FASB s position on delayed exchanges documented or codified? The FASB has not published its position on delayed exchanges despite numerous requests for it to do so. Absent a published opinion, a company or its accountant could ignore the FASB s unofficial position based on the argument that there is no written authority on delayed exchanges. What about reverse exchanges? Section 1031 permits use of a so-called reverse exchange. Under this exchange, a seller actually purchases the replacement property before selling the initial property. In essence, the transaction is done in reverse of a typical exchange. The IRS has published safe-harbor guidance under which such an exchange qualifies as a 1031 exchange (e.g., no gain or loss recognized on the sale with the replacement property receiving substituted basis), if certain criteria are met. As for the GAAP treatment of a reverse exchange, there is no formal authority that has been issued by the FASB. Because the transactions are not simultaneous, the author believes the FASB s position would be to consider such a transaction as two separate and distinct transactions. That is, transaction one would be to purchase a property at fair value, followed by a second transaction which is the sale of an initial property and recognition of a gain. GAAP: Inside and Out 13

15 5. Dealing with the Impairment of Real Estate Held for Use Question: What are the rules for testing real estate for impairment? Response: ASC 360, Property Plant and Equipment (formerly FASB No. 144), requires a company to recognize an impairment loss on a long-lived asset when certain conditions are met and the carrying amount of a long-lived asset exceeds its fair value. The ASC applies to both personal and real property. Specifically, ASC 360 states that an impairment loss exists when the carrying amount of real estate exceeds its fair value. There are essentially three steps to applying the impairment test: Step 1: Perform a Review of Events and Changes in Circumstances Step 2: Test for Impairment Step 3: Measure the Impairment Loss Observation: During the past few years, impairment of real estate has become an ongoing phenomenon in light of the softening in real estate values. Consequently, certain real estate has to be tested for impairment even though such tests were not required in previous years. Following is the application of the three steps: Step 1: Perform a review of events and changes in circumstances: An impairment test of real estate is performed only if there is an indication that an impairment might exist. Thus, an annual test is typically not required in a strong real estate market, because there is unlikely to be events and changes in circumstances that would indicate an impairment. Real estate is tested whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. In Step 1, the entity reviews all of the events and changes in circumstances to determine if a potential impairment exists- that is, the carrying amount of the asset(s) may not be recoverable. Examples of events and changes in circumstances that might warrant a test include: Significant decline in the market price of the real estate or similar real estate Continued decline in rental rates and vacancies Failure to meet debt service on a regular basis Change in the use of the property Known environmental contamination, and Legal changes such as rent control or use restrictions. If any of the above factors are known to exist, a test for impairment (Step 2) should be performed. GAAP: Inside and Out 14

16 Step 2: Test for impairment: If the review of the events and changes in circumstances in Step 1 indicates that there might be an impairment (e.g., carrying value may not be recoverable), Step 2 should be performed. The formula for testing for impairment of the real estate in Step 2 is as follows: The carrying amount of the real estate is compared with the estimated future undiscounted cash flows to be generated from use of ultimate disposition of the real estate. Estimated future cash flows Estimated future cash flows Carrying amount of the real estate < Carrying amount of the real estate = No impairment exists (no further action required) = Impairment exists- Go to Step 3 and measure the impairment Step 3: Measure the impairment: If, based on Step 2, estimated future cash flows are less than the carrying amount of the real estate, the real estate carrying amount is not recoverable. Therefore, an asset impairment must be measured in Step 3. Formula for measuring an impairment: Carrying amount of the real estate Less: Fair value of the real estate Equals: Impairment loss If the carrying amount is less than the fair value of the real estate, an impairment loss is recorded as follows: Impairment loss Real estate xx xx After an impairment loss is recognized, the reduced carrying amount shall become the new cost and is depreciated over the real estate's remaining useful life. Restoration of previously recognized impairment losses is prohibited. Consider the following example: Example 1: Harry owns a commercial office building in downtown Boston. He purchased the property in the height of the real estate market. Presently, there is a glut of vacant commercial space and events and circumstances suggest that the building might be impaired. GAAP: Inside and Out 15

17 Assume: Carrying amount of the land and building $2,000,000 Estimated net cash flows per year $110,000 Remaining useful life of the building 30 years Fair value of the building $1,100,000 Step 1: Review of events and changes in circumstances: Presently, there is a glut of vacant commercial space and events and circumstances suggest that the building might be impaired. Thus, a test for impairment should be performed under Step 2. Step 2: Test for impairment: Estimated annual future cash flows $110,000 x 30 years = $3,300,000 Estimated future > cash flows $3,300,000 Carrying amount $2,000,000 = NO IMPAIRMENT Step 3: Measure the impairment loss: Not applicable. Step 2 did not result in an impairment so that Step 3 is not required. If Step 3 had been done, the impairment loss would have looked like this: Carrying amount of all assets and liabilities $2,000,000 Fair value (above) 1,100,000 Impairment loss $(900,000) Conclusion: The real estate has declined to the extent that the fair value of $1,100,000 is less than the carrying amount of $2,000,000. However, that decline in value is not recorded as an impairment loss. The reason is because Step 2 did not result in an impairment. The estimated future cash flows of $3,300,000 exceed the carrying amount of $2,000,000. Because the remaining useful life of the real estate is 30 years, cash flows for the impairment test are accumulated over a 30-year period, resulting in ample cash flow to exceed the carrying amount and, thus, avoid having to measure an impairment in Step 3. This example is in contrast to a test for impairment of machinery or equipment, where cash flows must be accumulated using a much shorter remaining life of perhaps five years. Let s consider the steps to testing and measuring an impairment of real estate. Step 1: Review of the events and change in circumstances: As previously noted, events and changes in circumstances that suggest that real estate might be impaired include: Significant decline in the market price of the real estate or similar real estate Continued decline in rental rates and vacancies GAAP: Inside and Out 16

18 Failure to meet debt service on a regular basis Change in the use of the property Known environmental contamination Legal changes such as rent control or use restrictions If any of the above factors are known, a test for impairment should be performed. Step 2: Test for impairment: In testing for impairment, there are a few issues that are indigenous to real estate: 1. Annual net cash flows should include: a. Net operating income (rental income less operating expenses) before interest, depreciation and amortization, but after principal payments. Note: The cash flows should reflect estimated increases or decreases in rental income and operating expenses over the remaining useful life of the property. b. Estimated capital expenditures needed to maintain the property over the remaining useful life. Examples: Roof replacement every 8 years Apartment renovation during turnovers Painting and porch replacement Note: Capital expenditures that would increase the future service potential of the asset (e.g., qualify the property for an alternative use), are not included in the future cash flows. c. Salvage (residual) value at the end of the life of the real estate assuming the real estate is sold. The residual value should be net of selling costs such as commissions, and should reflect the payoff of any remaining mortgages on the property at the expected time of sale. Salvage value formula: Estimated sell price at the end of the asset s useful life Less: Estimated costs to sell the property including, commissions, advertising, etc. Less: Mortgage payoff at estimated time of sale Salvage value (net) $XX (XX) (XX) $XX The cash flow formula is summarized like this: GAAP: Inside and Out 17

19 Annual net cash flow Net operating income before interest, depreciation and amortization* $XX - Principal payments on mortgages secured by real estate (XX) - Estimated reserves for capital expenditures and replacements needed to maintain the property (XX) + Salvage value at the end of the asset s life, assuming the real estate is sold (net of costs to sell) XX NET CASH FLOW $XX * Rental income less cash operating expenses, accrual basis. 2. The remaining useful life should be based on the remaining life in the hands of the entity. a. The remaining useful depreciable life is a strong indicator of the remaining life for purposes of computing cash flows. b. If an entity plans to sell the property within a certain period of time (e.g., next five years), the remaining useful life should not exceed the estimated remaining time that the entity plans to hold the property. c. The ability to obtain renewed or replacement financing should be a factor in determining the remaining useful life of the asset. Step 3: Measure the impairment: If there is an impairment determined in Step 2, the real estate impairment loss must be measured. If the real estate is rental property, the best way to determine fair value is to use a capitalization rate. Example: Net operating income / Capitalization rate = Fair value of real estate If the property is land, fair value should be determined based on the quoted market price or price for similar land. Example 2: The following example illustrates a more complex application of ASC 360 to real estate. Facts: Company X is a real estate company that has 100 commercial and residential rental properties. Property C is a residential rental property that was purchased 12 years ago at the height of the real estate market. Management believes that the real estate might be impaired. The neighborhood in which the property is located has deteriorated significantly since the date of purchase, resulting in declining rents and higher-than-usual vacancies. Management believes that in the future, the property may be located in a valuable location where a downtown redevelopment may occur. As a result, management has decided to hold onto the property indefinitely. GAAP: Inside and Out 18

20 When the property was purchased, X obtained a 20-year commercial mortgage. For GAAP purposes, management has selected 39 years as the useful life, which is consistent with management s intent to use the property and, coincidentally the same life as the tax life. Specific details follow: Carrying amount: Land $500,000 Building Fixtures and appliances 7,200, ,000 Total 7,800,000 Mortgage on property (1,000,000) Net carrying amount of asset group $6,800,000 Remaining useful life (based on depreciation schedule) 27 years* Fair value of asset group 2,500,000** * Original life: 39 years less 12 years depreciation = 27 years remaining. ** NOI $350,000/ 10% capitalization rate = $3,500,000 less mortgage balance $(1,000,000) = $2,500,000. Estimated future cash flows follow: ESTIMATED FUTURE CASH FLOWS Capital Salvage Total Operating expenditures** Principal value of undiscounted Year cash flows* NOI payments assets*** cash flows 1 $400,000 ($50,000) $350,000 $(50,000) $0 $300, ,000 (50,000) 200,000 (50,000) 0 150, ,000 (50,000) 200,000 (50,000) 0 150, ,000 (50,000) 200,000 (50,000) 0 150, ,000 (50,000) 200,000 (50,000) 0 150, ,000 (50,000) 200,000 (50,000) 0 150, ,000 (50,000) 200,000 (50,000) 0 150, ,000 (50,000) 200,000 (50,000) 0 150, ,000 (50,000) 200,000 (50,000) 0 150, ,000 (50,000) 200,000 (50,000) 0 150, ,250,000 (250,000) 1,000,000 (250,000) 0 750, ,250,000 (250,000) 1,000,000 (250,000) 0 750, ,000,000 (250,000) 750, , ,000 (50,000) 150, , ,000 (50,000) 150, ,500,000 1,650,000 $6,550,000 $(1,350,000) $5,200,000 $(1,000,000) $1,500,000 $5,700,000 Calculations: * Rental income less operating expenses (real estate taxes, insurance, maintenance, utilities, management). Excludes depreciation, amortization and interest. ** Estimated capital expenditures to maintain the existing property such as roof replacement, windows, apartment renovation. *** Estimated salvage at the end of the property s life: Year 27 NOI $150,000/10% capitalization rate = $1,500,000 estimated value in year 27. GAAP: Inside and Out 19

21 Step 1: Review of events and changes in circumstances: Management believes that Property C might be impaired. The neighborhood in which the property is located has deteriorated significantly since the date of purchase, resulting in declining rents and higher-than-usual vacancies. Thus, a test for impairment should be performed under Step 2. Step 2: Test for impairment: Estimated future < cash flows $5,700,000 Carrying amount $6,800,000 = IMPAIRMENT Because the estimated future cash flows is less than the carrying amount of the property, there is an impairment, and Step 3 must be performed to measure the impairment loss. Step 3: Measure the impairment loss: Carrying amount of the property $6,800,000 Fair value (above) (2,500,000) Impairment loss $(4,300,000) The loss should be allocated to the components of the long-lived assets (building, land and equipment) based on each asset s relative carrying amount as follows: Carrying amount: Carrying amount % of total CV Allocation of loss Revised carrying amount Land $500, $(275,200) $224,800 Building 7,200, (3,968,900) 3,231,100 Fixtures and appliances 100, (55,900) 44,100 Total $7,800, % $(4,300,000) $3,500,000 Entry for impairment loss Impairment loss 4,300,000 Land 275,200 Building 3,968,900 Fixtures and appliances 55,900 GAAP: Inside and Out 20

22 After the assets are written down, the revised carrying amount of the building and fixtures and appliances should be depreciated over the remaining useful life of the assets. Further, once written down, the assets may not be written back up. Observation: In computing net cash flows from real estate, the amount of principal payments is deducted in arriving at the net cash flow amount. At first glance, one might think that an accelerated mortgage amortization schedule could result in negative cash flows and, thus, an impairment of real estate. However, this is not the case. Although it is true that an accelerated amortization schedule reduces net cash flows per year, the offset occurs in the year in which the asset is assumed sold. The net salvage value of the real estate is computed after deducting the mortgage balance and costs to sell. Therefore, an accelerated principal schedule results in reductions in cash flows in earlier years, but a smaller or no reduction in the salvage value in later years when the mortgage balance is lower. Question: How should an entity deal with the impairment of land that does not generate cash flow? Response: An impairment loss is more likely to be incurred for land as compared with rental property. The reason is primarily due to the fact that land s only cash flow may be from the ultimate disposition of the property, resulting in the carrying amount not being recoverable. Example: Assume Company X holds land for investment. The only cash flows related to the property are carrying costs (real estate taxes and insurance) and proceeds from the ultimate sale of the property. The Company s plan is to hold the property for another five years and then sell it. Management is concerned that the asset might be impaired given the deterioration of the surrounding area coupled with the economic downturn. The property was originally purchased for $5,000,000 and presently has a fair value of $3,000,000 as indicated in the table below: Carrying amount $5,000,000 Fair value** 3,000,000 ** Based on quoted market value per acre for similar properties in the area. Management tentatively plans to hold the property for another five years. It believes that, at worst, the fair value of the property will not deteriorate any further and could be sold for $3,000,000 at the end of five years. Estimated future cash flows over the next five years are as follows: GAAP: Inside and Out 21

23 ESTIMATED FUTURE CASH FLOWS Year Operating cash flows* Capital expenditures NOI Salvage value of assets Total undiscounted cash flows 1 $(50,000) $ 0 $(50,000) $ 0 $(50,000) 2 (55,000) 0 (55,000) 0 (55,000) 3 (60,000) 0 (60,000) 0 (60,000) 4 (65,000) 0 (65,000) 0 (65,000) 5 (75,000) 0 (70,000) 3,000,000 2,930,000 $(300,000) $ 0 $(300,000) $ 0 $2,700,000 * Consists of costs to maintain the property including real estate taxes insurance and maintenance. There is no income other than salvage value. Step 1: Review of events and changes in circumstances: Management is concerned that the asset might be impaired given the deterioration of the surrounding area, coupled with the economic downturn. Step 2: Test for impairment: Estimated future cash flows $2,700,000 < Carrying amount $5,000,000 = IMPAIRMENT Step 3: Measure the Impairment Loss: Carrying amount $5,000,000 Fair value (above) (3,000,000) Impairment loss $(2,000,000) Entry for impairment loss Impairment loss 2,000,000 Land 2,000,000 Observation: The above example illustrates how easy it is to record an impairment loss on land versus rental property. Because rental property generates net cash flow over an extended useful life of usually twenty to thirty years, rarely will a rental property fail the impairment test. That is, future estimated cash flows will most likely exceed the carrying amount, notwithstanding unusual facts and circumstances. The result is that Step 2 does not result in an impairment and therefore, Step 3 is not performed to measure an impairment. With respect to non-leased land, the result may be different. It is more likely that land that has declined in value may be written down to recognize an impairment loss. Because non-leased land does not generate annual cash flows, exclusive of the net proceeds from the ultimate sale of the land, it is possible that the future cash flows from ultimate use of the land will be less than the carrying amount, resulting in an impairment in Step 2 of the test. Then, Step 3 is performed to measure the impairment in which the carrying amount is written down to the fair value of the land. GAAP: Inside and Out 22

24 REVIEW QUESTIONS #1 The following questions are designed to ensure that you have a complete understanding of the information presented in the assignment. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this assignment. 1. Which of the following statements is true with respect to non-sec companies: a) GAAP requires that a company present comparative balance sheets but not comparative income statements b) GAAP requires that a company present a comparative income statement but not a comparative balance sheet c) a company is required to present all comparative financial statements d) a company is not required to present comparative financial statements 2. What is the proper balance sheet classification and presentation of temporarily idled property and equipment: a) it should be removed from plant accounts b) it should be recorded separately at an estimated realizable amount c) it should not be segregated, and should continue to be depreciated d) it should be written off as obsolete 3. According to ASC 845 (formerly FASB No. 153), which of the following is not one of the three exceptions to the general rule regarding non-monetary exchanges: a) the fair market value is not determinable b) the carrying value is higher than the fair value c) the transaction is an exchange transaction to facilitate sales to customers d) the transaction lacks commercial substance 4. According to ASC 845 (formerly FASB No. 153), the assessment of commercial substance in a non-monetary exchange: a) must be made quantitatively b) must be made qualitatively c) can be made either quantitatively or qualitatively d) is determined by a very precise formula 5. According to GAAP codification, a delayed exchange should be treated as: a) a single monetary transaction b) two monetary transactions c) as an exchange that lacks commercial substance d) none of the above; there is no authority dealing with the accounting treatment of delayed exchanges GAAP: Inside and Out 23

25 6. Which of the following is correct as it relates to a test for the impairment of real estate: a) an impairment test of real estate must be performed annually b) an impairment test of real estate is performed only if there is an indication of an impairment c) an impairment test is never required because the real estate is depreciated d) an impairment test is optional if the entity elects not to depreciate the real estate GAAP: Inside and Out 24

26 SOLUTIONS AND SUGGESTED RESPONSES #1 1. A: Incorrect. ASC 205 recommends, but does not require, a comparative balance sheet. The SEC, on the other hand, does require that public companies present all financial statements on a comparative basis for the last two fiscal years. B: Incorrect. ASC 205 recommends, but does not require, a comparative income statement. The SEC, on the other hand, does require that public companies present all financial statements on a comparative basis for the last two fiscal years. C: Incorrect. ASC 205 recommends, but does not require, comparative financial statements. D: Correct. ASC 205 recommends, but does not require, any financial statements to be presented on a comparative financial statements. (See page 3 of the course material.) 2. A: Incorrect. It is not customary to segregate or indicate the existence of temporarily idle plant, reserve, or standby equipment. B: Incorrect. Recording the property and equipment at an estimated realizable amount may be appropriate for permanently idle property and equipment, but not appropriate for temporarily idled property and equipment. C: Correct. Temporarily idled property and equipment should continue to be depreciated if it is expected that operations will resume at some time. D: Incorrect. Temporarily idled property and equipment should not be written off as obsolete, making the answer incorrect. (See page 4 of the course material.) GAAP: Inside and Out 25