LIMITED EDITION. Conceptual Framework, Standards, Standard Setting, and Presentation of Financial Statements

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2 LIMITED EDITION Conceptual Framework, Standards, Standard Setting, and Presentation of Financial Statements

3 Contents Learning Outcomes U.S. Securities and Exchange Commission 2 SEC Rulemaking Process 2 Relevant SEC Standards Included in FASB Codification FASB Accounting Standards Codification 3 Financial Accounting Standards Board (FASB) 3 FASB Codification 3 How the Codification Content is Organized International Accounting Standards Board 6 IASB-FASB Convergence Project 6 Convergence versus Adoption 6 IFRS Standards and Interpretations FASB Conceptual Framework Objective of General-Purpose Financial Reporting 7 Objective 7 Primary Users 7 Financial Information Provided by General-purpose Financial Statements Qualitative Characteristics of Useful Financial Information (SFAC No. 8, Chapter 3) 8 Fundamental Qualitative Characteristics 9 Enhancing Qualitative Characteristics 9 Cost Constraints on Useful Financial Reporting (cost-benefit) Review of the Underlying Principles and Assumptions 10 Definitions Elements of Financial Statements (SFAC No. 6) 12 Elements of Financial Statements 12 Interrelationship of Elements Articulation 14 Valuation Accounts 14 Realization and Recognition 14

4 ii 1.9 Recognition and Measurement in Financial Statements (SFAC No. 5) 14 Full Set of Financial Statements 15 Measurement Attributes Used in Financial Statements 15 Guidance for Recognizing Revenues and Gains is Based on Their Being Realized or Realizable and Earned 16 The Guidance for Recognizing Expenses and Losses Using Cash Flow Information and Present Value in Accounting Measurements (SFAC No. 7) 17 Purpose of Using Cash Flow and Present Value in Accounting Measurements 17 Objectives of Using Cash Flow and Present Value in Accounting Measurements 17 Elements of Present Value Measurements 18 Traditional Approach and Expected Cash Flow Approach 18 Traditional vs. Expected Cash Flow Approach as a Measurement Tool 18 Consideration of Risk Adjustment 20 Issues Unique to the Measurement of Liabilities Balance Sheet 20 Statement of Financial Position 20 Calendar Year vs. Fiscal Year Income Statement 21 Revenues, Expenses, Gains, and Losses 21 Presentation Order in Income from Continuing Operations, Discontinued Operations and Income Tax Effect 22 Income Statement May be Presented in Either Multiple-step or Single-step Format Discontinued Operations 27 Definitions 28 Items Included in the Calculation of Discontinued Operations 30 Reporting and Presentation of Discontinued Operations 30 Disclosure Exit or Disposal Activities and Discontinued Operations 32 Exit or Disposal Costs 32 Recognition and Measurement 33 Contract Termination Costs 35 Reporting 37

5 iii 1.15 Overview of Accounting Changes and Error Correction 36 General 36 Definitions 36 Type of Accounting Change and Effect on Financial statements (accounting treatment) Changes in Accounting Principles 37 Definition of a Change in Accounting Principle 37 Acceptable Change in Accounting Principle 38 Effects of Change 38 Reporting Changes in Accounting Principle 40 Impracticable to Determine Cumulative Effect 40 Examples of a Change in Accounting Principle Changes in Accounting Estimates (Prospective Application) 41 Definition 41 Reporting 42 Examples of a Change in Accounting Estimates Changes in Reporting Entity 43 Definition 43 Reporting a Change in Reporting Entity 43 Examples of Changes in Reporting Entity Error Correction (Restatement) 44 General 44 Reporting 45 Examples of Types of Errors that Might Occur Statement Of Comprehensive Income 47 Definitions 47 Reporting and Display of Comprehensive Income 50 Reclassification Adjustments 53 Reporting the Tax Effect of Other Comprehensive Income Items 53 Reporting Accumulated Other Comprehensive Income 53 Disclosures Summary 55

6 iv 1.21 Notes to Financial Statements And Accounting Policy Disclosure 55 General 55 Accounting Policy Disclosure 56 Form and Content of Accounting Policy Disclosure 56 Examples of Accounting Policy Disclosure Related Parties and Related-party Transactions 57 General 57 Related-party Disclosures Interim Financial Reporting 62 General 62 Reporting of Interim Financial Information is not Required 62 Complete or Condensed Set of Financial Statements 62 Accounting Principles and Practices 63 Interim Period Revenues, Costs, Expenses, Losses and Gains 63 Income Taxes 65 Inventory in Interim Financial Statements 66 Seasonal Revenue 67 Minimum Components of an Interim Financial Report (IFRS only) Segment Reporting 68 General 68 Objective 69 Definitions 69 Quantitative Thresholds 70 The All Other Category 72 Reporting Comparative Operating Segments 73 Aggregations Criteria 73 Profit or Loss and Assets Allocation 73 Disclosure Requirements 74

7 1.25 SEC Reporting Requirements 79 Definitions 79 Periodic Reporting 79 SEC Regulations 82 Management s Discussion and Analysis Extensible Business Reporting Language: XBRL Overview Questions for Review 84 List of Terms 121 List of Abbreviations 131

8 Learning Outcomes After completing this unit you should be able to do the following: 1. Understand the differences between U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) as they relate to this chapter 2. Distinguish between the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB) 3. Know the objectives of general-purpose financial reporting, its primary users, and the purpose of financial reports 4. Understand the fundamental and enhancing qualitative characteristics of financial reports 5. Know the role of financial statements, each of their elements, and their importance to business entities 6. Calculate amounts for financial statement components 7. Know how to report income from continuing operations and discontinued operations 8. Distinguish between an accounting change and an error correction 9. Know the process used to make adjustments to a preliminary trial balance or preliminary financial reports 10. Know about making adjustments to financial reports to account for a change in accounting principle 11. Know how to report comprehensive income, other comprehensive income, and items within other comprehensive income 12. Understand the importance of and how to prepare notes to financial statements and accounting policy disclosure 13. Know about the preparation of financial reports for interim and annual reporting periods 14. Understand the aspects of financial reporting that pertain to business segments 15. Produce financial statement filings that meet regulatory or reporting requirements (e.g., Form 10-Q, 10-K, Annual Report) We also recommend that you study the examples included in the notes, most of which are taken from prior years AICPA-released exam questions and are summarized by topic. We also advise that you study the questions at the end of this chapter because they either include new information not found in our notes or they emphasize important points you should know.

9 2 1.1 U.S. Securities and Exchange Commission The Securities and Exchange Commission (SEC) is a governmental body established to protect the interests of investors. It does so by ensuring the full and adequate disclosure of all publicly traded companies (also called issuers or registrants). A company is considered public if its securities trade on public markets and it regularly discloses to the public certain business and financial information. Congress created the SEC with the Securities Exchange Act of Under this act, it empowers the SEC to regulate the securities markets in the United States. The SEC consists of five commissioners appointed by the president of the United States over staggered fiveyear terms. To ensure non-partisanship, by law, no more than three commissioners may belong to the same political party. Although the SEC has the authority to establish standards, it generally defers to the Financial Accounting Standards Board (FASB). The SEC has chosen to follow the pronouncements of the FASB. Nevertheless, in the event the SEC does not agree with a particular FASB pronouncement, it has the power to overrule it, which it has done on a few occasions. LAST MINUTE NOTE Congress gave the SEC both the power and the responsibility for setting the accounting and reporting standards of companies whose securities are publicly traded. However, the SEC has delegated the primary responsibility for setting these accounting standards to the private sector (e.g., FASB). It is important to understand that the SEC delegated only the responsibility, and not the authority, to set standards. This power still lies with the SEC. SEC Rulemaking Process Rule-making is the process by which federal agencies implement legislation that has been passed by Congress and signed into law by the president. Major pieces of legislation provide the framework for the SEC s oversight of the securities markets. They include the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Sarbanes-Oxley Act, among others. Rule-making involves several steps, such as concept release, rule proposal, and rule adoption. The SEC issues its own rules in the form of Financial Reporting Releases, which generally agree with the U.S. Generally Accepted Accounting Principles (U.S. GAAP).

10 3 Relevant SEC Standards Included in FASB Codification To increase the utility of the Codification for public companies, the relevant portions of the authoritative content issued by the SEC have been included for reference in the Codification. Related question FASB Accounting Standards Codification Financial Accounting Standards Board (FASB) The FASB is the body responsible for establishing, developing, and improving the accounting standards that govern the preparation of financial reports by non-governmental entities in the U.S. FASB Accounting Standards Codification As of July 1, 2009, the FASB Accounting Standards Codification (ASC) became the single source of authoritative non-governmental U.S. GAAP. SEC rules and Interpretive Releases, currently under federal securities laws, are also sources of authoritative GAAP for publicly traded companies. The Codification contains the authoritative standards that are applicable to both public and non-public, non-governmental entities. All guidance contained in the Codification carries equal authority. Accounting and financial reporting practices not included in the Codification are non-authoritative (non- U.S. GAAP). If an entity that is undertaking a transaction or an event cannot find the relevant, specified guidance within a source of authoritative U.S. GAAP, this entity must first consider accounting principles for similar transactions or events within a source of authoritative U.S. GAAP, before considering non-authoritative guidance from other sources. The Codification contains only accounting guidance, and not guidance on auditing or tax preparation. The Codification is applicable only to U.S. non-governmental entities. It does not contain GAAP for other countries or International Financial Reporting Standards (IFRS).

11 25 LAST MINUTE NOTE You must know how to calculate the following: 1. Net sales: Gross Sales - Sales discounts - Sales returns and allowances Net Sales 2. Cost of Goods Sold (under periodic inventory system): Beginning Inventory + Purchases (Cost of goods purchased) Cost of goods available-for-sale - Ending Inventory Cost of goods sold 3. Cost of goods purchased: Gross purchases - Purchase discounts - Purchase returns and allowances Net Purchases + Freight in Cost of goods purchased Cost of goods purchased is included in the calculation of the cost of goods sold. Therefore, purchase discounts reduce cost of goods sold. 4. General and Administrative expenses: General and administrative expenses relate to day-to-day business-operation expenses and not to expenses related to the production of goods or services. They include: a. Accounting and legal fees b. Officers salaries & office staff wages c. Rent for office space d. Insurance e. Depreciation expense on a machine used in the accounting department is part of general and administrative expenses. 5. Selling expenses: Selling expenses include all expenses incurred to increase sales, such as: a. Advertising b. Freight and transportationout (e.g. free shipping to customer at company s expense) c. Sales salaries and commissions d. Depreciation of sales equipment (e.g. showroom) e. Uncollectible accounts expense (bad debt expense) if associated with losses from normal credit sales f. Warranty expense g. Shipping supplies and expense h. Postage and stationery i. Depreciation on the sales staff s automobiles

12 37 LAST MINUTE NOTE The FASB chose to describe the method of accounting for and reporting corrections of errors as restatements, rather than as a retrospective application. The Board chose to use the term retrospective application to describe the manner of reporting a change in the accounting principle or a change in the reporting entity and to use the term restatement only to refer to the correction of an error. In fact, except for the different terms used, the computation and manner of presenting a retrospective application and a restatement are essentially the same. 3. Prior Period Adjustments: These are rare events that are recorded as direct adjustments to retained earnings rather than as income-statement elements. The correction of errors in previously issued financial statements is an example of a prior-period adjustment. 4. Prospective application: A change should be accounted for in the period of change if the change affects only that period. Alternatively, a change should be accounted for in both the period of change and in future periods if the change affects them both. Type of Accounting Change and Effect on Financial Statements (accounting treatment) Type of accounting change Change in accounting principle Change in accounting estimate Change in reporting entity Accounting treatment Retrospective application, except when it is impracticable to determine. (Prospective if impracticable to determine) Prospective Application Retrospective Application 1.16 Changes in Accounting Principles Retrospective Application Definition of a Change in Accounting Principle A change from one acceptable accounting principle to another is treated as a change in accounting principle. This does not include a change from an accounting principle that is not generally accepted to one that is generally accepted. The latter would be classified as an error correction.

13 38 Acceptable Change in Accounting Principle An entity may change the accounting principle used only if: a. The change is required by a newly issued codification update, or b. The entity can justify its use of the alternative accounting principle because it is preferable. A preferable change is one that will result in a more reliable and relevant presentation of the financial statements. Effects of Change A. Direct effects of a change in accounting principle The direct effects of a change are recognized in prior periods. Therefore, it is necessary to restate the prior periods financial statements. A retrospective application should only include the direct effects of a change in accounting principle. An example of a direct effect is an adjustment to an inventory balance due to a change in the inventory-valuation method. Related changes, such as an effect on deferred income tax assets or liabilities, are also examples of the direct effects of a change in accounting principle. B. Indirect effects of change The indirect effects of a change are any changes to current or future cash flows that result from making a change in accounting principle. An example of an indirect effect is a change in profit-sharing or royalty payment, based on revenue or net income. Any indirect effects of the change are reported in the period in which the accounting change is made. Indirect effects should not be included in the retrospective application LAST MINUTE NOTE Direct effects are reported retrospectively for the earliest period presented, if practicable. Indirect effects of a change in accounting principle should be reported in the period in which the accounting change occurs. MAJOR DIFFERENCES U.S. GAAP VERSUS IFRS IFRS does not address the reporting of the indirect effects of changes in accounting principles.

14 39 C. Cumulative effect 1. Comparative financial statements If comparative financial statements are being presented, then the cumulative effect of a change is reported as an adjustment to the beginning-of-year retained-earnings balance of the earliest year presented. This cumulative effect must be reported on a net-of-tax basis. Beta Co. began operations in 20x1. In the years from 20x1 to 20x3, it appropriately reported income under the completed-contract method. In 20x4, Beta justifiably changed to the percentage-of-completion method. If Beta Co. includes financial statements for 20x3 and 20x4, in its 20x4 financial report, Beta Co. should report this change in accounting principle as if it had taken place at which of the following dates: a. January 1, 20x1 b. January 1, 20x2 c. January 1, 20x3 d. January 1, 20x4 Example Correct answer: c. The change in method of accounting for long-term construction contracts had taken place in 20x4. The change in accounting principle is to be reported as if it had been made at the beginning of the earliest year presented in the current year s financial report. Thus, if Beta Co. includes financial statements for 20x3 and 20x4, in its 20x4 financial report, it should report this change in accounting principle as if it had taken place at January 1, 20x3, which is the earliest year presented in the 20x4 financial report. In some questions, examiners may refer to January 1, 20x3 as December 31, 20x2. Therefore, you need to read the question carefully. If Beta Co. had included the financial statements of 20x2, 20x3, and 20x4, in its 20x4 financial report, it should report this change in accounting principle as if it had taken place at January 1, 20x2, the earliest year presented in the current year s financial report. LAST MINUTE NOTE Regardless of how many prior years financial statements are presented in its 20x4 financial report, to bring the accounting records into alignment with this change, Beta Co. would record an adjusting journal entry for the cumulative effect of the change at January 1, 20x4, the beginning of the year in which the accounting change was made.

15 40 2. Non-Comparative financial statements If non-comparative financial statements are being presented, then the cumulative effect of the change is reported as an adjustment to the beginning-of-year retainedearnings balance. This cumulative effect must be reported on a net-of-tax basis. Example On September 30, year 1, Johnson Co. decided to change from the moving average perpetual inventory system to the first in, first out (FIFO)perpetual inventory system. Johnson Co. does not present comparative financial statements and its fiscal year ends on December 31, year 1. The cumulative effect of the change is determined as of January 1, year 1. Reporting Changes in Accounting Principle An entity should report a change in accounting principle through a retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Under a retrospective application, an entity must report the cumulative effect of the change as a net-of-tax adjustment to the beginning retained earnings of the earliest period presented in the current financial report. If the cumulative effect of applying the accounting change can be determined, but the period-specific effects on all prior periods cannot be determined, the cumulative effect is applied to the carrying amounts of the assets and liabilities at the beginning of the earliest period to which it can be applied or calculated. An offsetting adjustment is made to the opening balance of the retained earnings for that period. Impracticable to Determine Cumulative Effect If it is impracticable to determine and calculate the cumulative effect for any of the prior periods, the new accounting principle is applied as if the change was made prospectively at the earliest date practicable. An example of this occurs when management of an entity decides to change from an acceptable inventory costing method to last-in, first-out (LIFO) under U.S. GAAP, and the records of inventory purchases and sales are no longer available for all prior years. In this case, it is deemed impracticable to apply the retrospective approach. This is because management would be unable to estimate what the inventory and the cost of goods sold would have been in prior years if the entity had been using the LIFO method. Accordingly, the entity applies the new accounting principle (i.e., LIFO), prospectively, at the earliest date practicable.

16 41 LAST MINUTE NOTE A change in the method of inventory costing is a change in accounting principle and is accounted for retrospectively. If the change in the method of inventory costing is, for example, to LIFO under U.S. GAAP, and it is impracticable to determine and calculate the cumulative effect for any of the prior periods, then the change is accounted for prospectively at the earliest date practicable. When the cumulative effect on any prior period is not known, then the concept of consistency is sacrificed when accounting for a change in accounting principle. MAJOR DIFFERENCES U.S. GAAP VERSUS IFRS LIFO is an acceptable inventory costing method under U.S. GAAP. Nevertheless, LIFO is prohibited under IFRS. Examples of a Change in Accounting Principle a. A change in the method of inventory costing (e.g., from FIFO to weighted average) b. A change to or from completed contract to percentage of completion c. A change from the individual-item approach to the aggregate approach in applying to inventories the lower of FIFO cost or market d. A change to or from the cost method to the equity method Related questions Changes in Accounting Estimates (Prospective Application) Definition Changes in accounting estimates are changes to the amounts, in the financial statements, that are based on new information or experience. Changing an estimate is different from making a correction of errors. Changing an estimate does not mean that what the company has done in a prior year is wrong. Rather, it means that management has received more reliable data for an estimate. Accounting estimates change as new events occur, as more experience is acquired, or as additional information becomes available.

17 42 Reporting A. Reporting Changes in Accounting Estimates There is no cumulative-effect adjustment to retained earnings Changes in accounting estimates must be accounted for and reported, prospectively, in the period of change, if the change affects only that period, or in the period of change and future periods, if the change affects them both. The entity should not account for a change in accounting estimate by restating or retrospectively adjusting the amounts reported in the financial statements of prior periods or by reporting the pro forma amounts for prior periods. B. A Change in Accounting Estimate Effected by a Change in Accounting Principle If a change in the accounting estimate is effected by and inseparable from a change in accounting principle, then it is treated as a change in estimate. An example of a change in estimate that is affected by a change in accounting principle, and that must be reported as a change in accounting estimate, is a change in the method used for depreciation, amortization, or depletion for long-lived, non-financial assets. LAST MINUTE NOTE Whenever it is impossible to determine whether a change in accounting estimate or a change in accounting principle has occurred, the change should be considered a change in estimate and should be reported as a component of income from continuing operations. Changes in accounting estimates are handled on a prospective basis in the period of change and in future periods if the change affects both. Example On January 1, 20x1, Mitchell Co. purchased a machine for $75,000 and depreciated it by the straight-line method, using an estimated useful life of 10 years with no salvage value. During 20x4, Mitchell Co. determined that the machine had a useful life of 6 years, from the date of acquisition, with no salvage value. The analysis necessary to account for this change is as follows: Cost $75,000 Accumulated depreciation ($75,000 10) 3 (22,500) Book value at December 31, 20x3, after three years 52,500 depreciation Depreciation over remaining 3 years (including 20x4): $17,500 ($52,500 3)

18 43 Mitchell Co. records depreciation for the year 20x4 as follows: Dr. Depreciation expense Machines $17,500 Cr. Accumulated depreciation Machines $17,500 Depreciation for the year 20x4 after a change in estimate The depreciation charge per year after a change in estimate can be calculated as follows: Book value of asset = $52,500 = $17,500 Remaining service life 6 3 Examples of a Change in Accounting Estimates a. A change in depreciation, amortization, and depletion method (e.g., straight-line to double-declining balance) b. A change in the estimated warranty costs or obligations due to technological advances in production c. A change in the estimation of the service lives and salvage values of depreciable assets d. A change in the estimated quantity recoverable when using the units-of-production depletion method e. A change in the estimation of uncollectible accounts receivable or bad debts f. A change in the estimation of inventory obsolescence Related questions Changes in Reporting Entity Retrospective Application Definition Under U.S. GAAP, a change in reporting entity occurs when a change in the structure of the organization is made and this results in financial statements that represent either a different entity or a changed entity. Reporting a Change in Reporting Entity A change in reporting entity is reported by restating all prior years financial statements and presenting them as if the new reporting entity existed during all of those years (the change is

19 Interim Financial Reporting General Interim financial information is essential to provide investors and others with timely information on the progress of the entity. The usefulness of such information rests on the relationship it has to the annual results of operations. Accordingly, each interim period 10 should be viewed primarily as an integral part of an annual period. Reporting of Interim Financial Information is not Required Neither U.S. GAAP nor IFRS require the reporting of interim financial information nor do they mandate which entities should publish interim financial reports 11, the frequency of these reports, or how soon these reports must be released after the end of an interim period. However, both U.S. GAAP and IFRS provide guidance and prescribe principles for recognition, measurement, and disclosure in the interim financial statements. Complete or Condensed Set of Financial Statements Interim financial information may be issued on a monthly or quarterly basis or at other intervals and may take the form of either complete financial statements or summarized, condensed, financial data. LAST MINUTE NOTE Interim financial statements: a. Emphasize timeliness over reliability b. Are relevant because they are capable of making a difference in the decisions made by users c. Should be viewed as an integral part of the annual financial statements d. Contain either complete or condensed sets of financial statements for an interim period e. Are generally not audited, therefore each page of unaudited interim financial information should be clearly marked as unaudited 10 Interim Period: A financial reporting period shorter than a full financial year, typically a quarter or half-year. 11 Interim Financial Report: A financial report that contains either a complete or condensed set of financial statements for an interim period.

20 63 Accounting Principles and Practices In general, the results for each interim period should be based on the accounting principles and practices used by an entity in the preparation of its latest annual financial statements unless a change in an accounting practice or policy has been adopted in the current year. MAJOR DIFFERENCES U.S. GAAP VERSUS IFRS Under IFRS, an entity should apply the same accounting policies and practices in its interim financial report as are applied in its annual financial statements. However, under U.S. GAAP, certain accounting principles and practices followed for annual reporting purposes may require modification at interim reporting dates so that the reported results for the interim period may better relate to the results of operations for the annual period. Interim Period Revenues, Costs, Expenses, Losses and Gains 1. Revenues: Revenues must be recognized during an interim period on the same basis as is followed for the full year. 2. Costs and Expenses: Costs and expenses for interim reporting purposes may be classified as either of the following: (a) Costs associated with revenue: Those costs and expenses that are directly associated with or allocated to the products sold or to the services rendered, for annual reporting purposes, including, for example, material costs; wages, salaries and related fringe benefits; manufacturing overhead; and warranties, which should be similarly treated for interim reporting purposes. (b) All other costs and expenses: Costs and expenses other than product costs should be charged to income in interim periods as incurred, or be allocated among interim periods, based on an estimate of the time expired, the benefit received, or the activity associated with the periods. Smith Corp. has estimated that total depreciation expense for the yearending December 31 will amount to $30,000, and that year-end bonuses to employees will total $90,000. In Smith s interim income statement for the 6 months ended June 30, what total amount should be reported for expenses related to these two items? Example Costs and expenses other than product costs should be charged to income in interim periods as incurred or be allocated among interim periods, based on the benefit received. The depreciation expense and bonuses to employees provide benefits throughout the year and should be allocated evenly to all interim periods. In the interim income statement for the six months ended June 30, the amount of expense that should be recorded is $60,000. (30, ,000) 6 months = 60, months

21 64 Example On March 20, year 2, Smith Company paid property taxes of $120,000 on its factory building for the year-2 calendar year. On April 2, year 2, Smith made $300,000 in unanticipated repairs to its plant and equipment. The repairs will benefit operations for the remainder of the calendar year. What amount should be included for these expenses in Smith s quarterly income statement for the 3 months ended June 30, year 2? a. 105,000 b. 115,000 c. 130,000 d. 140,000 Correct answer: c. The payment of property taxes will benefit four quarters of year 2 and should be pro-rated at $30,000 ($120,000 4) per quarter. The unanticipated repairs to plant and equipment will benefit the second, third, and fourth quarters. They should be spread evenly over these quarters at $100,000 ($300,000 3) per quarter. The total amount of expenses that should be included in the quarterly income statement for the 3 months ended June 30, year 2 is therefore $130, Losses should be recognized in full during the interim period in which the existence of such losses becomes evident. Gains and losses that arise in any interim period similar to those that would not be deferred at year-end should not be deferred to later interim periods within the same fiscal year. Example During the third quarter of year 20x1, Smith Company sold a piece of equipment at a gain of $24,000. What portion of the gain should Smith report in its income statement for the third quarter? a. 24,000 b. 12,000 c. 6,000 d. 3,000 Correct answer: a. The $24,000 gain on the equipment disposal should be recognized in full in the third quarter, which is the interim period in which the transaction occurred. LAST MINUTE NOTE Gains or losses from the disposal of a component of an entity and from unusual or infrequently occurring items should not be pro-rated over the balance of the fiscal year. (The next example is linked to this note)

22 65 A company that issues quarterly financial statements incurs an unusual loss in one of the first three quarters. In which of the following ways would the company report this loss? a. Only in the annual report b. Entirely in the quarter wherein the loss occurs c. Pro-rated over the remaining quarters of the current year d. Disclosed only by a note in the quarter wherein the loss occurs Correct answer: b. Example Income Taxes A. Estimated annual effective tax rate The tax (or benefit) 12 related to ordinary income (or loss) 13 should be computed at an estimated annual effective tax rate. At the end of each interim period, the entity should make its best estimate of the effective tax rate that is expected to be applicable for the full fiscal year. If a reliable estimate cannot be made, then the actual effective tax rate for the year-to-date may be the best estimate of the annual effective tax rate. The estimated annual effective tax rate should be applied to the year-to-date ordinary income (or loss), at the end of each interim period, to compute the year-to-date tax (or benefit) applicable to ordinary income (or loss). The interim period tax (or benefit) related to ordinary income (or loss) should be the difference between the amount so computed and the amounts reported for the previous interim periods of the fiscal year. Smith Co. earns ordinary income in all interim periods. The quarterly tax computations are as follows: Example Reporting Period Ordinary Income Tax Reporting Period Estimated Annual Effective Tax Rate Year-todate Year-todate Less Previously Provided Reporting Period First quarter $20,000 $20,000 40% ($8,000 - $ ) =$8,000 + Second quarter 20,000 40,000 40% ( 16,000-8,000) = 8,000 + Third quarter 20,000 60,000 40% (24,000-16,000) = 8,000 + Fourth quarter 40, ,000 40% (40,000-24,000) = 16,000 Fiscal year $100,000 $40,000 Multiply the year-to-date ordinary income by the estimated annual effective tax rate and subtract the result from the provision previously provided in the previous quarter. 12 The tax (or benefit) is the total income tax expense (or benefit), including the provision (or benefit) for both currently payable and deferred income taxes. 13 Ordinary income (or loss) refers to the income (or loss) from continuing operations before income taxes (or benefits).

23 66 The estimated effective tax rate should reflect the anticipated investment tax credits, foreign tax rates, percentage depletion, capital gains rates, and other available tax-planning alternatives. B. Changes in estimates A change in the estimated effective annual tax rate is accounted for as a change in accounting estimate and should be accounted for in the period in which the change in estimate is made. No restatement of previously reported interim information should be made for changes in estimates. Example Smith Co. has ordinary income in all interim periods. The estimated annual effective tax rate changed from one quarter to another. The quarterly tax computations are as follows: Reporting Period Ordinary Income Tax Reporting Period Estimated Annual Effective Tax Rate Year-todate Year-todate Less Previously Provided Reporting Period First quarter $25,000 $25,000 45% = $11,250 $ - $11,250 + Second quarter 5,000 30, % = 13,125 11,250 1,875 + Third quarter 25,000 55, % = 20,625 13,125 7,500 + Fourth quarter 45, ,000 40% =40,000 20,625 19,375 Fiscal year $100,000 $40,000 Multiply the year-to-date ordinary income by the estimated annual effective tax rate and subtract the result from the provision previously provided in the previous quarter. Inventory in Interim Financial Statements Practices vary in terms of determining costs of inventory. While entities should generally use the same inventory pricing methods and make provisions for write-downs at interim dates on the same basis as those used for annual inventory dates, it is appropriate to use following exceptions for interim reporting dates: A. Different inventory methods at interim periods Some entities use estimated gross profit rates to determine the cost of goods sold during interim periods or they use other methods that differ from those used at annual inventory dates. These entities must disclose the method used at the interim date and any significant adjustments that result from reconciliations with the annual physical inventory. B. Entities that use the LIFO method (U.S. GAAP only) Entities that use the LIFO method may encounter a liquidation of base period inventories at an interim date that is expected to be replaced by the end of the annual period. In those

24 82 G. Form 6-K Form 6-K is filed by foreign private issuers to report the occurrence of any material events or corporate changes not previously reported to investors. Form 6-K may be filed, any time during the year, to report the occurrence of any material events. Reports on Form 6-K typically cover events, including a change in control, a significant acquisition or disposition of assets, a bankruptcy or receivership, or a change in accountants. Regarding interim reporting, the SEC requires only a semi-annual report of non-adjusted earnings, filed on Form 6-K, if and when firms are required to report interim earnings in their home country. Form 6-K contains unaudited financial statements, management s discussion and analysis of the entity s financial condition and results of operations, and selected financial data and statistical information. Reports on Form 6-K that are filed by foreign private issuers generally take the place of reports on Form 10-Q (which include unaudited financial reports) and current reports on Form 8-K (which include disclosure on material events) that U.S. domestic issuers are required to file. H. Forms 3, 4, 5 Corporate insiders meaning a company s officers and directors and any beneficial owners of more than 10 percent of a class of the company s equity securities must file with the SEC a statement of ownership regarding those securities. SEC Regulations A. Regulation S-X Regulation S-X describes the form and content of the financial statements filed with the SEC. It contains information regarding the financial statements, including the notes and schedules for both interim and annual statements that must be submitted to the SEC. LAST MINUTE NOTE Regulations for the financial-statement presentation-and-disclosure requirements of SEC filings can be found in Regulation S-X. B. Regulation S-K Regulation S-K describes the requirements for the information and forms required by Regulation S-X. It contains instructions for filing the non-financial statement forms required by the SEC. Management s Discussion and Analysis SEC regulations require management s discussion and analysis of the financial condition and results of operations (MD&A).

25 83 The MD&A requirements are intended to provide a narrative explanation of a company s financial statements, to enhance the overall financial disclosure, and to provide information about the quality and potential variability of a company s earnings and cash flow. These requirements ensure that investors can ascertain the likelihood that past performance is indicative of future performance. The MD&A presents the company s operations and financial results, including information about the company s liquidity, capital resources, and any known trends or uncertainties (critical accounting estimates) that could materially affect the company s results. It may also discuss management s views of key business risks and what it is doing to address them. Related question Extensible Business Reporting Language: XBRL Overview Extensible Business Reporting Language (XBRL) is a powerful and flexible version of XML that has been specifically defined to meet the requirements of business and financial information. It is an open specification that uses XML-based data tags to describe financial statements. These tags identify the contents of each data item. For example, a tag might indicate that a data item represents accounts receivable. XML means extensible markup language and is standard for the electronic exchange of data between businesses and on the Internet. Under XML, identifying tags are applied to items of data so they can be efficiently processed by computer software. The SEC adopted rules that require public companies to provide to the Commission financial statements in XBRL format. These rules apply to domestic and foreign companies using U.S. GAAP and to foreign private issuers using IFRS as issued by the IASB. XBRL exhibits enable investors to compare information between companies using analytic software. LAST MINUTE NOTE All SEC filers that use U.S. GAAP and foreign issuers that use IFRS are required to submit their reports to the SEC, using XBRL. XBRL is used in filings with the SEC that are made available on EDGAR.

26 Questions for Review 1.1 U.S. Securities and Exchange Commission 1. The SEC was created under which of the following acts? a. The Securities Act of 1933 b. The Securities Exchange Act of 1934 c. Both the Securities Act of 1933 and the Securities Exchange Act of 1934 d. The Tax Equity and Fiscal Responsibility Act Correct answer: b. Congress created the SEC with the Securities Exchange Act of Both the Securities Act of 1933 and the Securities Exchange Act of 1934 were designed to restore investor confidence subsequent to the 1929 stock market crash. The 1933 Act contains accounting and disclosure requirements for the initial offering of a stock or bond. The Securities Exchange Act of 1934 also identifies and prohibits certain types of conduct in the markets and provides the Commission with disciplinary powers over regulated entities and the persons associated with these entities. The Securities Exchange Act of 1934 empowers the SEC to require companies that issue publicly traded securities to report certain information on a periodic basis. 1.2 FASB Accounting Standards Codification 2. Which of the following accounting literature is not included in the FASB Accounting Standards Codification? a. The American Institute of Certified Public Accountants (AICPA) Audit and Accounting Guide b. FASB Interpretations c. FASB Concepts Statements d. Derivatives Implementation Group Issues Correct answer: c. A Statement of Financial Accounting Concepts does not establish U.S. Generally Accepted Accounting Principles (U.S. GAAP). The FASB Concepts Statement is listed as one of the non-authoritative literatures. All guidance contained in the Codification carries equal authority. Accounting literature that is not included in the Codification will be considered non-authoritative.

27 90 To be relevant to the investors, creditors, lenders, and other users, accounting information must be capable of making a difference in a decision. Financial information is capable of making a difference if it has predictive and/or confirmatory value and if it is material. With the issuance of SFAC No. 8, Chapter 3, U.S. GAAP and IFRS have the same Qualitative Characteristics of Useful Financial Information. 1.7 Review of the Underlying Principles and Assumptions 11. Ande Co. estimates its uncollectible accounts expense using the ratio of past actual losses from uncollectible accounts to past net credit sales, adjusted for anticipated conditions. This practice follows which of the following accounting concepts? a. Matching b. Going concern c. Consistency d. Substance over form Correct answer: a. For an accounting period, net income or loss is determined by the process of associating realized revenues with the expenses and expired costs that were necessary to generate them. This often requires estimates and allocations. The matching principle states that income or loss is determined by a process of associating realized revenues with the expenses necessary to generate them. 1.8 Elements of Financial Statements (SFAC No. 6) 12. According to the IASB Framework, an item that meets the definition of an element should be recognized in the financial statements if: I. It is probable that any future economic benefit associated with the item will flow to or from the entity; or II. The item has a cost or value that can be measured with reliability. Please choose one of the following: a. I b. II c. I and II d. None of the above Correct answer: c. According to the IASB Framework, an item that meets the definition of an element should be recognized in the financial statements if: 1) It is probable that any future economic benefit associated with the item will flow to or from the entity; and

28 91 2) The item has a cost or value that can be measured with reliability. If the item meets the definition of an element and can be reliably measured, then it will be incorporated into the income statement or the statement of financial position. Under U.S. GAAP, an item that meets the definition of an element should be recognized in the financial statements if the item: 1) Meets the recognition criteria (e.g., the revenue recognition criteria); and if it 2) Possesses a relevant attribute that can be reliably measured. If an item possesses the characteristics that define an element, then this is a necessary but not sufficient condition for formally recognizing the item in the financial statements. 13. FASB s conceptual framework explains concepts of both financial and physical capital maintenance. Which capital-maintenance concept is applied to currently reported net income and which is applied to comprehensive income? Currently reported net income Comprehensive income a. Financial capital Physical capital b. Physical capital Physical capital c. Financial capital Financial capital d. Physical capital Financial capital Correct answer: c. As per SFAC No. 6, the financial capital concept is the traditional basis of financial statements, including comprehensive income. Concepts of Capital Maintenance (As per SFAC No. 6) Two major concepts of capital maintenance exist, both of which can be measured in units of either money or constant purchasing power. The major difference between them involves the effects of price changes on assets held and liabilities owed during a period. These two concepts are: 1. Financial Capital Concept: Under the financial capital concept, if the effects of these price changes are recognized, then they are called holding gains and losses and are included in computing return on capital. 2. Physical Capital Concept: Under the physical capital concept, these changes would be recognized but called capital maintenance adjustments. These would be directly included in equity, but would not be included in return on capital. The physical capital maintenance concept supports current cost accounting. Under the physical capital concept, adjustments would be a separate element rather than gains and losses.

29 92 MAJOR DIFFERENCES U.S. GAAP VERSUS IFRS The IASB, in its statement Concepts of Capital and Capital Maintenance, allows the enterprise to select either financial or physical maintenance. Financial capital maintenance is the basis for U.S. GAAP in SFAC No According to SFAC No. 6, Elements of Financial Statements, assets are probable future economic benefits that are controlled by a particular entity and are the result of past transactions or events. Which of the following is not a characteristic of an asset? a. A probable future benefit in a contribution to future net cash inflows b. An entity can obtain and control access to this benefit c. A transaction or an event that has already occurred that leads to control by the entity d. Little or no discretion is needed to avoid future sacrifice Correct answer: d. According to SFAC No. 6, Elements of Financial Statements, the characteristics of assets are: 1) A probable future benefit in a contribution to future net cash inflows; 2) An entity can obtain and control access to this benefit; and 3) A transaction or an event that has already occurred that leads to control. Little or no discretion required to avoid future sacrifice is a characteristic of liabilities. An asset continues to be an asset until it is collected, transferred, used, or destroyed. Once acquired, an asset continues to be an asset of the entity until the entity collects it, transfers it to another entity, uses it up, or some other event or circumstance destroys the future benefit or removes the entity s ability to obtain it. 15. According to SFAC No. 6, Elements of Financial Statements, liabilities are the present obligations of a particular entity, that are the results of past transactions or events. Entities that incur liabilities face probable future sacrifices of economic benefits. Which of the following is not a characteristic of liabilities? a. Little or no discretion to avoid future sacrifice b. A legal, equitable, or constructive duty to transfer assets in the future c. A transaction or event that has already occurred for the obligated enterprise d. A probable future benefit in a contribution to future net cash inflows Correct answer: d. According to SFAC No. 6, Elements of Financial Statements, the characteristics of liabilities are the following: 1) A legal, equitable, or constructive duty to transfer assets in the future 2) They leave little or no discretion for the entity to avoid future sacrifice 3) A transaction or event that has already occurred for the obligated enterprise