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CPA Review: Financial Accounting & Reporting

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bullet Topic: CPA Review: Financial Accounting & Reporting
    Posted: 30/11/2007 at 07:48
 

Part IV - Financial Accounting & Reporting

Partnership Taxation

Partnership Formation and Admission
Retirement and Liquidation
Distributions of Income and Bonus

Shareholders Equity

Elements of Stockholders Equity
Treasury Stock
Preferred Stock
Computation of Book Value
Stock Dividends and Splits
Quasi Reorganizations
FASB Statement 115
Dividends
Stock Rights
Stock Splits

Inventories

Inventory Definition
Inventory Valuation Methods
Lower of Cost or Market
Other Inventory Issues
Depletion

Consolidated Financial Statements

Business Combinations
Purchase Method
Other Intercompany Eliminations
SFAS 141
SFAS 142
Parent Company vs. Entity
Goodwill And The Equity Method

Earnings Per Share

EPS Calculation
Diluted Earnings Per Share
Treasury Stock Method
Additional Points
SFAS 131


Price Level and Foreign Exchange

Financial Reporting and Changing Prices
Accounting For Foreign Currency (SFAS 52)
Foreign Currency And SFAS 133
Restatement Of Foreign Currency Financial Statements

Accounting Theory

FASB Conceptual Framework
Elements of Financial Statements
SFAC 5
GAAP

Statement of Cash Flows (FASB 95)

FASB 95 Purpose
Classifications Of Cash Flows
Direct Method of Reporting
Indirect Method
Steps For Preparation Of The Statement
Financial Statement Analysis

Bonds, Accounting For Debt

Bonds, Accounting for Debt
Investment In Bonds
Convertibles And Warrants
Disclosure of Long Term Obligations
Derivatives
Contingencies SFAS 5
Statement Of Position 94:6
Classification Of Short-Term Obligations (SFAS 6)

Revenue and Expense Recognition

Contract Accounting
Installment Sales
Correction Of Errors
Accounting For Stock Options As Compensation
Summary Of Accounting For Stock-Based Compensation
Miscellaneous Items

Other Assets, Liabilities and Disclosures

Accounts Receivable
Pledging, Assigning And Factoring Receivables
Summary Of SFAS 140
Fixed Assets
Depreciation Methods
SFAS 121
Research And Development Costs (SFAS 2)
Accounting For Nonmonetary Transactions-(APB 29)
Cap lization Of Interest Cost (SFAS 34)
Interest On Receivables And Payables (APB 21)
Other SFAS

Reporting the Results of Operations

Income Statement
APB No. 20
Prior Period Adjustments-SFAS No. 16
Discontinued Operations
Extraordinary Items-APB No. 30
Interim Financial Statements (APB No. 28)
Reporting Accounting Changes In Interim Financials
Reporting Comprehensive Income (SFAS No. 130)
Financial Forecasts And Projections
Accounting And Reporting By Development Stage Enterprise
Accounting By Debtors And Creditors For Troubled Debt

Income Taxes

Income Tax Allocation (SFAS 109)
Valuation Allowance
Loss Carrybacks And Loss Carryforwards
Illustrative Problem
Undistributed Earnings

Accounting for Leases, Pension and Postretirement Plans

Accounting for Leases
Initial Direct Costs SFAS No. 91, 98
Employer's Accounting For Pensions
Settlements And Curtailments Of Defined Benefit Pensions
List of Pension Terms
Accounting For Postretirement Benefits (SFAS No.106)
Statement Of Financial Accounting Standards NO. 132

Governmental Accounting

Governmental Accounting
Modified Accrual Basis
GENERAL FUND
SPECIAL REVENUE FUNDS
INTERNAL SERVICE FUND
FUND BASED FINANCIAL STATEMENTS
GOVERNMENT-WIDE FINANCIAL STATEMENTS
REQUIRED GOVERNMENT-WIDE FINANCIAL STATEMENTS
OVERVIEW OF MINIMUM DISCLOSURE REQUIREMENTS
SGAS 33, Reporting for Non-exchange Transactions
Governmental Accounting Standards Board

Not-for-Profit Accounting

PUBLIC (GOVERNMENTALLY OWNED) COLLEGES AND UNIVERSITIES
PRIVATE NFP ORGANIZATIONS SFAS NO. 116
STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 117
HEALTH CARE ORGANIZATIONS

Accounting And Reporting By Development Stage Enterprise
SFAS No. 7 Summary
Some development stage enterprises have developed 
specialized accounting and reporting practices. Such 
enterprises are now required to present financial statements 
in conformity with generally accepted accounting principles 
with revenue and expense recognition to be the same as 
applied to established enterprises.  Further, development 
stage companies are required to disclose additional 
information.
Development Stage Enterprise Defined
An enterprise is considered in the development stage if it 
is devoting substantially all of its efforts to establishing 
a new business and either planned principal operations have 
not begun, or if operations have begun, there has been no 
significant revenue therefrom.
Financial Accounting and Reporting
Financial statements should present financial position, 
changes in financial position and results of operations in 
conformity with generally accepted accounting principles 
that apply to established operating enterprises.  GAAP 
should be applied to expense and revenue recognition; 
deferral of costs and cap lization should be subject to 
the same assessment of recoverability that would be 
applicable in an established operating enterprise.  For 
a subsidiary or investee, the recoverability of costs 
should be assessed within the entity for which separate 
financial statements are being presented.
Disclosures
The basic financial statement(s) to be presented should 
include the following information:
(a)  A balance sheet showing any accumulated net losses 
     with a descriptive caption such as "deficit 
     accumulated during the development stage" in the 
     stockholders' equity section.
(b)  An income statement, showing amounts of revenue 
     and expenses for each period covered by the income 
     statement and cumulative amounts from the 
     enterprise's inception.
(c)  A statement of cash flows showing the investing 
     and financing activities for each period and 
     cumulative amounts from the enterprise's inception.
(d)  A statement of stockholders' equity showing from 
     the enterprise's inception:
     1.  For each issuance, the date and number of 
         shares of stock, warrants, rights, or other 
         equity securities issued for cash or other 
         consideration.
     2.  For each issuance, the dollar amounts 
         assigned to the consideration received for 
         shares of stock, warrants, rights, or other 
         equity securities.  Dollar amounts should be 
         assigned to any noncash consideration received.
3.  For each issuance involving noncash consideration, 
    the nature of the noncash consideration and the basis 
    for assigning amounts.
The financial statements should be identified as those of 
a development stage enterprise and include a description 
of the activities in which the enterprise is engaged.
Transition from Development Stage
The first fiscal year in which an enterprise is no longer 
considered in the development stage should disclose its 
prior status as a development stage enterprise.

Accounting By Debtors And Creditors For Troubled Debt RESTRUCTURINGS-SFAS No. 15, SFAS No. 114 and SFAS No. 145 A restructuring of a debt constitutes a "Troubled Debt Restructuring" when a creditor, for economic or legal reasons related to the debtor's financial difficulties, grants a concession (by agreement or imposition of law or a court) to the debtor that it would not otherwise consider. A creditor participates in a troubled debt restructuring because it no longer expects its investment to earn the original rate of return expected and may view loss of all or part of its investment as likely if the debt is not restructured. For the purposes of this statement, debt represents a contractual right to receive, or obligation to pay, money that is already included as an asset or liability in the creditor's or debtor's balance sheet at the time of the restructuring and consists of such items as accounts receivable or payable, notes, debentures, bonds (secured or unsecured, convertible or nonconvertible), and related accrued interest. "Debt" does not include lease agreements or employment-related agreements. Accounting by Debtors The accounting treatment for troubled debt restructuring depends on the type of restructuring as follows: * Transfer of Assets in Full Settlement: The excess of the carrying value of the debt settled over the fair value of the assets transferred to the creditor should be recognized as a gain on debt restructuring. A difference between the fair value and carrying value of the asset transferred to the creditor should be recognized as a gain or loss on the transfer of assets, included in the determination of net income for the period of transfer, and reported in accordance with APB No. 30. (Note that a gain on debt restructuring and a gain or loss on the transfer of assets may be reported.) * Grant of an Equity Interest in Full Settlement: The excess of the carrying value of the debt settled over the fair value of the equity interest granted to the creditors should be recognized as a gain on debt restructuring. The equity interest granted is to be recorded at its fair value. Modification of Terms a. Total future cash payments of interest and principal equal or exceed the carrying value of the debt. The carrying value of the debt should not change and the effects of changes in the amount or timing (or both) of future interest or principal (or both) payments are reflected in future periods. Interest expense is computed in a way that a constant effective interest rate is applied to the carrying amount of the debt at the beginning of each period between restructuring and maturity (refer to Chapter 9, Amortization of Bond Discount and Premium-Effective Interest Method). The new effective interest rate is the discount rate that equates the present value of the future cash payments specified by the new terms with the carrying value of the debt. b. Total future cash payments of interest and principal are less than the carrying value of the debt. The carrying value of the debt is reduced to an amount equal to the total future cash payments specified by the new terms and a gain is recognized on the reduction of the debt equal to the amount of the reduction. Thereafter, all future cash payments are accounted for as reductions of the carrying value of the debt and no interest expense is recognized for any period between restructuring and maturity. * Combination of Above Types: The fair value of assets transferred or equity interest granted in partial settlement shall first be applied to the reduction of the carrying value of the debt; then, the modification of terms is accounted for as prescribed above. No gain on debt restructuring is recognized unless the remaining carrying value of the debt (after application of fair value of assets transferred and equity interest granted) exceeds the total future cash payments. SFAS No. 145 requires that gains recognized on restructuring should be aggregated, included in income for the period of restructuring and normally reported as a part of income from continuing operations. Accounting by Creditors The accounting for troubled debt restructuring depends on the type of restructuring as follows: * Receipt of Assets in Full Settlement (including equity interest in debtor): The assets received are to be recorded at their fair market value when received, and the excess of the carrying value of the investment in the receivable (debt) satisfied over the fair value of the assets received should be recognized as a loss. Subsequently, the creditor should account for the assets received the same as if the assets had been acquired for cash. * Modification of Terms: SFAS No. 114 requires the creditor to recognize a new value for the loan receivable. This new value is the present value of the future cash flows from the restructured agreement discounted at the historical (original) interest rate (not the interest rate in the restructuring agreement). An ordinary loss is recognized as the difference between the carrying value of the loan and the present value of the future cash flows. Interest revenue after the restructuring should be based on the historical (original) interest rate times the new carrying value of the loan receivable. Losses recognized on debt restructuring, to the extent that they are not offset against allowance for uncollectible amounts or other valuation accounts, should be included in the determination of net income for the period of the restructuring and reported according to APB No. 30. Troubled Debt Restructuring Trouble Company which is experiencing financial difficulty has a note payable of $500,000 and the current year's interest of $50,000 outstanding at December 31 of the current year. The note is a 10% obligation due at the end of the following year. A. Lender accepts land from Trouble Company in full payment of the note. The land has a fair value of $400,000 and a book value of $220,000. The entry to be made upon execution of the agreement: Trouble Co.(000) Lender(000) Accrued interest payable $ 50 Note payable 500 Land $400 Land $220 Loan loss 150 Gain on disposal Note receivable $ 500 of fixed asset 180 Accrued interest Gain on restructuring of debt 150 receivable 50 B. Lender accepts Trouble Company stock with a par value of $100,000 and a fair market value of $400,000 in full payment of the note. Accrued interest payable $50 Note payable 500 Investment in Trouble Co. $400 Common stock $100 Loan loss 150 Cap l in excess of par 300 Note receivable $500 Gain on restructuring of debt 150 Accrued interest receivable 50 C. Lender agrees to extend the note for two years beyond the original due date, forgive the $50,000 accrued interest, reduce the principal of the note to $400,000, and revise the interest rate to 8%. DEBTOR - TROUBLE CO. Future cash payments = $400,000 + ($32,000 x 3) = $496,000 Carrying value (including interest) = 550,000 Ordinary gain $ 54,000 Journal entry when agreement is signed: Accrued interest payable $50,000 Note payable 4,000 Gain on restructuring of debt $54,000 CREDITOR - LENDER In accordance with SFAS No. 114 the creditor should record the note receivable at the present value of future cash flows at the historical interest rate of 10% based on the restructured receipts of $400,000 for the principal and $32,000 per year for the interest ($400,000 × 8% = $32,000). Present value of future cash flows at 10%: FUTURE PRESENT VALUE TOTAL RECEIPTS X OF 1 FACTOR = PRESENT VALUE Year 1 32,000 x .909091 = $ 29,091 Year 2 32,000 x .826446 = 26,446 Year 3 32,000 x .751315 = 24,042 Year 4 400,000 x .751315 = 300,526 Total Present Value $380,105 Carrying value on books (500,000 + 50,000) 550,000 Loss on loan restructuring $169,895 Journal entry when agreement is signed: Loss on loan restructuring 169,895 Interest receivable 50,000 Notes receivable 119,895 Journal entries to record interest revenue and receipt of the interest and principal are based on the amortization table listed below: Year 1 Year 2 Year 3 a. Cash 32,000 32,000 32,000 Notes receivable 6,010 6,612 7,273 Interest revenue 38,010 38,612 39,273 b. Cash 400,000 Notes receivable 400,000 Amortization of "Discount" on Notes Receivable 10% 8% Cash Addition Carrying Value Interest Interest to Carrying Value of Notes (Amtz. Discount) Receivable Balance 380,105 Year 1 38,010 32,000 6010 386,115 Year 2 38,612 32,000 6612 392,727 Year 3 39,273 32,000 7273 400,000 D. Lender agrees to extend the note for two years beyond the original due date, forgive the accrued interest, reduce the principal amount of the note to $450,000 and revise the interest rate to 9%. DEBTOR - TROUBLE CO. Future cash payments = $450,000 + ($40,500 x 3) = $571,500 Carrying value (including interest) = 550,000 Future interest to be recognized* $ 21,500 Journal entry when agreement is signed: Accrued interest payable $50,000 Note payable $50,000 Journal entry when first cash payment is made: * Interest expense $ 7,700 Note payable 32,800 Cash $40,500 * Represents an interest rate of 1.4% on the new carrying value of $550,000. CREDITOR - LENDER Journal entry when agreement is signed: Loss on loan restructuring 111,191 Interest receivable 50,000 Note receivable 61,191 The present value of future payments of $40,500 interest per year and $450,000 principal are as follows: Year 1 - $40,500 × .909091 = $36,818; Year 2 - $40,500 × .826446 = $33,471; Year 3 - $40,500 × .751315 = $30,428 and Year 3 - $450,000 x .751315 = $338,092 for a total of $438,809. The loss on loan restructuring is the carrying value less the present value of future cash flows ($550,000 - 438,809 = $111,191). Journal entry when first cash payment is made: Cash 40,500 Notes receivable 3,381 Interest revenue(a) 43,881 (a) Interest revenue is the historical interest rate × the total present value (10% × 438,809 = $43,881). Loan Impairments - Creditors A loan impairment should be differentiated from a debt restructuring. An impairment does not involve a formal restructuring but is a conclusion by the creditor, based on its normal review procedures, that there is a problem with the collectibility of the loan receivable. SFAS No. 114 states that a loan is impaired when it is probable that a creditor will be unable to collect all amounts due according to the contracted terms. The calculation of the loss on impairment is similar to the calculation of the loss on debt restructuring in which there is a modification of terms. The creditor calculates the present value of future cash flows using the historical (original) interest rate and the difference between the cash flows and the carrying value of the loan is the loss. The loss should be charged to Bad Debt Expense and credited to the Allowance for Doubtful Loans. SFAS No. 114 allows an alternative calculation in which the impaired loan may be measured at the loan's observable market price of the fair value of the collateral. Example of Loan Impairment: On January 1, 20X2, ABC Corporation received a $50,000, 3-year non-interest bearing note yielding 8% from XYZ Corporation. At December 31, 20X2, ABC determines through its normal credit review procedures that it is probable that XYZ will not be able to pay but $40,000 of the $50,000 loan. The loss on impairment would be calculated: Carrying Value - 12/31/X2 (a) $42,867 Less present value of future cash receipts ($40,000 × PV of 1 for 2 periods at 8% = 40,000 × .857339) (34,294) Loss on Impairment at 12/31/X2 8,573 The journal entry to record the impairment: Bad Debt Expense 8,573 Allowance for Doubtful Loans 8,573 Note: ABC's future interest revenue will be based on the new carrying value of $34,294. (a) The calculation of the carrying value of the loan at 12/31/X2: Balance 1/1/X2 = Present Value of $50,000 for 3 periods at 8% (50,000 × .793832) $39,692 Plus Amortization of Discount on the note for 20X2 = 8% × January 1 carrying value (8% × 39,692) 3,175 Total carrying value 12/31/X2 $42,867

Accounting For Foreign Currency (SFAS 52) In General This statement encompasses both expressing in dollars transactions denominated in a foreign currency, and expressing in dollars the foreign-currency-based financial statements of a subsidiary. To incorporate foreign currency transactions and foreign currency financial statements in its financial statements, include all assets, liabilities, revenue and expenses that are measured in foreign currency or denominated in foreign currency. Measure - To quantify an attribute of an item in a unit of measure other than the reporting currency. Denominate - When asset and liability amounts are fixed in terms of a foreign currency regardless of exchange rate changes. Illustration: Two foreign branches of a U.S. company, one Swiss and one German, purchase on credit identical assets from a Swiss vendor at identical prices stated in Swiss francs. The German branch measures the cost (an attribute) of that asset in German marks. Although the corresponding liability is also measured in marks, it remains denominated in Swiss francs since the liability must be settled in a specified number of Swiss francs. The Swiss branch measures the asset and liability in Swiss francs. Its liability is both measured and denominated in Swiss francs. Assets and liabilities can be measured in various currencies. However, currency and rights to receive or obligations to pay fixed amounts of a currency are denominated only in that currency. Foreign Currency Transactions These are transactions which are denominated in a foreign currency. A change in the exchange rate between the foreign currency and the dollar results in a gain or loss that is recognized in determining the dollar net income for the period in which the rate changes. (No gain or loss is recognized on hedges of net investments in foreign currency commitments.) Example - On December 20, a U.S. company purchases inventory from a foreign company for an invoice price of LCU 300,000 when the exchange rate is LCU 6 = $1. The invoice is due in 30 days. On December 31, the exchange rate is LCU 8 = $1 and on the payment date, the exchange rate is LCU 7.5 = $1. The company would make the following journal entries (in U.S. dollars) 12/20 Purchase $50,000 (LCU 300,000 * 6) Accounts Payable $50,000 12/31 Accounts Payable $12,500 (LCU 300,000 * 6) Exchange Gain $12,500 (LCU 300,000 * 8) 1/19 Accounts Payable $37,500 Exchange loss 2,500 Cash $40,000 (LCU 300,000 * 7.5)

Accounting for Leases ACCOUNTING FOR LEASES-SFAS No. 13 A lease is in form a rental of property, but may be in substance the acquisition of an asset and the related obligation. This has financial accounting and reporting implications for both the lessor and the lessee. The lessee should, if certain criteria are met, treat the lease as a cap l lease and record an asset and related obligation equal to the present value of the minimum lease payments. If the criteria are not met, the lease should be treated as an operating lease (lease payments are charged to expense when payable on a straight-line basis). The lessor should treat the lease as a sales-type lease if a profit or loss is involved and certain criteria are met. Sales-type leases are usually confined to manufacturers and dealer lessors, but not necessarily. If the lease is not a sales-type lease, but the incidence of ownership has been relinquished by the lessor due to the terms of the lease (in effect, a cap l lease for the lessee), the lease should be classified as a direct financing lease. Leases that meet the criteria of leveraged leases are not to be treated as direct financing leases. Operating leases are those which do not qualify for treatment in the other categories, and lease rentals received are credited to income. Classification of Leases Lessees can classify leases as: 1. Cap l leases, or 2. Operating leases Lessors can classify leases as either: 1. Sales-type leases 2. Direct financing leases 3. Leveraged leases 4. Operating leases Lessee Lease Categories Cap l Leases. The lessee will record an asset and an obligation equal to the present value of the minimum lease payments during the lease term, not to exceed fair value, if at least one of the following criteria are met: a. The lease transfers ownership of the property at the end of the lease term. b. The lease contains a bargain purchase option. c. The lease term is 75% or more of the economic life of the property. d. The present value of the minimum lease payments (excluding reimbursements for other costs) is 90% or more of the fair value of the leased property. In general, minimum lease payments are those required to be made in connection with the lease, except that executory costs such as insurance, maintenance and taxes should be excluded. Charge executory costs to lease expense. Minimum lease payments are increased by: any guarantee of the residual value at the expiration of the lease term; any payment required because of failure to renew or extend the lease. Minimum lease payments are increased by escalator provisions in the lease agreement or commitment, where property is being constructed or acquired for later use. If the lease meets criterion (a) or (b), the asset should be amortized consistent with the lessee's normal depreciation policy for owned assets. If not, and the lease falls under either criterion (c) or (d) as a cap l lease, normal depreciation policies should be followed except that the period of amortization should be the lease term. The lease should be amortized to its expected value, if any, at the end of the lease term. Operating Leases. Rent is charged to expense over the lease term on a straight-line basis. If prepayments are made under the lease terms, such prepayments will be classified as assets and amortized over the life of the lease. Assume a 10-year lease providing for a $10,000 advance payment on 1/1/97 and $4,000 annual payments: 1/1/97 Leasehold $10,000 Cash $10,000 12/31/97 Rent Expense 5,000 Leasehold 1,000 Cash 4,000 Lessor Lease Categories Sales-Type Leases. Leases which give rise to a profit or loss at the inception of the lease; i.e., the fair value of the leased property is greater or less than the lessor cost or carrying value, if different, and: a. The lease meets the cap l lease criteria for lessees, and b. Both of the following conditions are met: 1. Collectibility of the lease payments is reasonably predictable, and 2. There are no important uncertainties that exist as to unreimbursable costs yet to be incurred by the lessor. However, a lease of real estate which otherwise would be classified as a sales type lease shall be classified as an operating lease by the lessor unless at the beginning of the lease term such lease also complies with SFAS B relative to sales of real estate. This provision relates to the adequacy of the buyer's initial and continuing investment in the property acquired and the conditions relating to the seller's continued involvement with the property sold. Direct Financing Leases. Leases that meet all the above criteria of sales-type leases except that no manufacturer or dealer profit or loss is involved, and the lease is not a leveraged lease. Otherwise, the lease should be classified as an operating lease. In direct financing leases, the cost of the leased property and the fair value are the same at the inception of the lease. SFAS . defines "Inception of the Lease" as the date of the lease agreement or commitment, if earlier. A commitment shall be in writing and specifically set forth the principal provisions of the transaction. A preliminary agreement does not qualify. A renewal or extension of an existing sales-type or direct financing lease which otherwise qualifies as a sales-type lease shall be classified as a direct financing lease unless the renewal or extension occurs within the last few months of the existing lease in which case it shall be classified as a sales-type lease. Operating Leases. Rent is reported as income as it becomes receivable over the lease term on a straight-line basis. Initial direct costs should be deferred and allocated over the lease term in proportion to the recognition of rental income, but may be expensed as incurred if the effect is not material. The leased property should be included with or near property, plant and equipment in the balance sheet. Computing the Present Value of Minimum Lease Payments Lessee-The present value of the minimum lease payments should be computed using the lessee's incremental borrowing rate (the rate the lessee would pay if the asset were purchased with borrowed funds). Exception: See Lessor below. Lessor-The rate implicit in the lease must be used. If the lessee knows the lessor's implicit rate and it is less than the lessee borrowing rate, the lessee should also use the implicit rate. Computation of the Rate Implicit in the Lease The implicit rate is the interest rate necessary to make the present value of the minimum lease payments plus the unguaranteed residual value of the leased property equal to the fair value of the leased property less any investment tax credit retained by the lessor. Example: A crane is leased for $750 per month for 84 months. The lessee receives the investment credit of 10%. The leased property reverts to the lessor at the end of the lease. The cost of the property to the lessor is $40,000. Computation of implicit rate by the lessor: Fair Value of Lessor's Property (Normal Selling Price) $42,490 Minimum Lease Payments (84 * $750) 63,000 Present Value of an Annuity of $1 at 1% per period, 84 periods (months) (56.6484 * $750) 42,490 Note: The 1% per month rate is shown in this example without details as to its computation. The computation is complex, particularly when the present value of the residual value is involved, and CPA exam candidates would not have the means to compute the rate, but may be required to solve a problem with the rate given. Question: Referring to the previous example, assume the lessee's borrowing rate is 13% and the lessee knows the lessor's implicit rate. What rate will the lessee use in determining the amount to be cap lized? Answer: 12%, because the rate implicit in the lease is less than the lessee's incremental borrowing rate. Question: Cap lize the lease for the lessee assuming the lessee's incremental borrowing rate is 12%. Answer: Lease payments (84 * $750) = $63,000 Present value of $63,000 (84 periods at 1% per period, 750 * 56.6484) = 42,490 Interest expense over the lease term $20,510 Initial Direct Costs 1. Sales-type lease-charge to income in the period in which the sale is recorded. 2. Direct financing lease-part of the gross investment in the lease along with the minimum lease payments and the unguaranteed residual value.

Accounting For Nonmonetary Transactions-(APB 29) APB 29 Summary When nonmonetary transactions occur, the fair values of the items exchanged are compared and the resulting gain or loss is recognized. Exceptions to the general rule: 1. If fair value is not determinable, recorded value should be used. 2. Exchange of similar type assets, e.g., a machine for a machine of the same general type, does not culminate the earning process, and a gain is not recorded. 3. If monetary consideration is received in an exchange of similar assets, partial gain is recognized. The gain is the percentage of monetary consideration to total consideration X total gain. 4. When similar assets are exchanged, and monetary consideration is paid, gain should not be recognized on the transaction, but the "income tax method" should be used in recording the new asset. However, if a loss is indicated by the terms of a transaction, such loss should be recognized. Definitions Monetary assets and liabilities. Assets and liabilities whose amounts are fixed in terms of units of currency by contract or otherwise. Examples are cash, short- or long-term accounts and notes receivable in cash, and short- or long- term accounts and notes payable in cash. Nonmonetary assets and liabilities. Assets and liabilities other than monetary ones. Examples are inventories; investments in common stocks; property, plant and equipment; and liabilities for rent collected in advance. Exchange (or exchange transaction). A reciprocal transfer between an enterprise and another entity that results in the enterprise's acquiring assets or services or satisfying liabilities by surrendering other assets or services or incurring other obligations. Nonreciprocal transfer. A transfer of assets or services in one direction, either from an enterprise to its owners (whether or not in exchange for their ownership interests) or another entity, or from owners or another entity to the enterprise. An entity's reacquisition of its outstanding stock is an example of a nonreciprocal transfer. Similar productive assets. Productive assets that are of the same general type, that perform the same function, or that are employed in the same line of business. Examples include the trade of player contracts by professional sports organizations, exchange of leases on mineral properties, exchange of one form of interest in an oil-producing property for another form of interest, exchange of real estate for real estate. Monetary assets are as defined in price-level accounting; i.e., assets and liabilities whose amounts are fixed in terms of currency by contract or otherwise, such as cash, accounts and notes receivable, and accounts and notes payable. Nonmonetary assets are everything else, including investments in securities, inventories, fixed assets, etc. Exchange of Dissimilar Assets If dissimilar assets are exchanged, the cost of the nonmonetary asset received is the fair value of the asset surrendered to obtain it, and a gain or loss should be recognized; which is measured by the difference between the fair value and the book value of the asset given up. If the fair value of the asset given up is unknown, or the fair value of the asset received is more clearly evident, then the latter should be used to record the cost of the asset received. In such situations the gain or loss is computed as the difference between the fair value received and the book value of the asset given up. This is the case in the following example: Dissimilar assets are exchanged. The asset received has a fair value of $1,000. The asset given up has a book value of $500. Asset Received $1,000 Asset Given Up $500 Gain 500 (earnings process is considered culminated) If a monetary consideration was involved in the exchange of dissimilar assets, the gain or loss would be the same. Exchange of Similar Productive Assets 1. No monetary consideration-gain indicated. If the assets were similar, the treatment for dissimilar assets would be modified so as to result in no gain. Assume the same facts as above: Asset Received $500 Asset Given Up $500 2. No monetary consideration-loss indicated. Regardless of the circumstances, an indicated loss is recognized. Assume the asset received has a fair value of $2,000, whereas the asset exchanged cost $4,000 with accumulated depreciation of $1,600. The indicated loss of $400 would be recorded as follows: Loss $ 400 Accumulated Depreciation 1,600 New Asset 2,000 Old Asset $4,000 3. Monetary consideration received. Assume that similar assets are exchanged. The asset given up has a book value of $800. The asset received has a fair value of $900 and $600 in cash is received. Asset Received $480 Cash 600 Asset Given Up $800 Gain 280 (earnings process partially culminated) The cash received is considered to be a partial realization of the F.V. of the asset given up and gain is recognized pro-rata. The gain can be computed as: 600 (Cash) / 1,500 (Total Proceeds) x Gain (700) = $280 If a loss is indicated in such an exchange, the entire loss should be recognized. 4. Monetary consideration paid. If cash is paid in addition to a similar asset exchanged, no gain should be recognized; the cash paid merely increases the recorded cost. Treatment is the same as the "income tax method." Ex.: Asset Received $1,000 Asset Given Up (BV) $600 Cash 400 5. Monetary consideration paid-loss indicated. If a loss is indicated by a transaction, the entire loss should be recognized. For example, assume the following: An old machine that cost $6,000, with accumulated depreciation of $3,000, was traded in on a new machine, with a $5,500 cash payment. The new machine has a list price of $8,000, but normally sells for $7,500 without a trade-in. Computation of Indicated Loss: Book value of old machine ($6,000 - $3,000) $3,000 Cost of new machine $7,500 Less: Cash paid 5,500 Value received for old machine 2,000 Indicated loss $1,000 Journal Entry to Record the Loss: New machine $7,500 Accumulated depreciation 3,000 Loss 1,000 Old machine $6,000 Cash 5,500 Nonreciprocal Transfers to Owners Nonreciprocal transfers are payments to or from an entity, such as dividends, contributions to others or from others, and sales of stock. Gain or loss should be recognized on nonreciprocal transfers to owners and others. For example, nonmonetary assets worth $10,000, book value $6,000 are distributed to shareholders. Assets $ 4,000 Gain $ 4,000 Dividends Paid 10,000 Assets 10,000 Other Points 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 facil te sales to customers does not culminate the earnings process. No gain or loss should be recorded. A difference between the amount of gain or loss recognized for tax purposes and that recognized for accounting purposes may constitute a timing difference to be accounted for according to SFAS m, Accounting for Income Taxes. An enterprise that engages in one or more nonmonetary transactions during a period should disclose in financial statements for the period the nature of the transactions, the basis of accounting for the assets transferred, and gains or losses recognized on transfers. INTANGIBLE ASSETS SFAS 142 and Goodwill SFAS 142 provides two major changes in financial reporting related to business combinations. The first major change is that goodwill will no longer be amortized systematically over time. This non-amortization approach will be applied to both previously recognized and newly acquired goodwill. In the second major change, goodwill will be subject to an annual test for impairment. When the carrying amount of goodwill exceeds its implied fair value, an impairment loss is recognized equal to that excess. SFAS 142 and Other Intangible Assets SFAS 142 recommends that all identified intangible assets should be amortized over their economic useful life, unless such life is considered indefinite. The term indefinite life is defined as a life that extends beyond the foreseeable future. A recognized intangible asset with an indefinite life should not be amortized unless and until its life is determined to be finite. Importantly, indefinite does not mean infinite. Also, the useful life on an intangible asset should not be considered indefinite because a precise finite life is not known. For those intangible assets with finite lives, the method of amortization should reflect the pattern of decline in the economic usefulness of the asset. If no such pattern is apparent, the straight-line method of amortization should be used. The amount to be amortized should be the value assigned to the intangible asset less any residual value. In most cases the residual value is presumed to be zero. However, that presumption may be overcome if the acquiring enterprise has a commitment from a third party to purchase the intangible at the end of its useful life, or an observable market exists for the intangible asset that provides a basis for estimating a terminal value. The length of the amortization period for identifiable intangibles (i.e., those not included in goodwill), depends primarily on the assumed economic life of the asset. Factors that should be considered in determining the useful life of an intangible asset include * Legal, regulatory, or contractual provisions * The effects of obsolescence, demand, competition, industry stability, rate of technological change, and expected changes in distribution channels * The expected use of the intangible asset by the enterprise * The level of maintenance expenditure required to obtain the asset's expected future benefits Note: SFAS 142 eliminated the arbitrary limit of 40 years for amortization of intangibles. Any recognized intangible assets considered to possess indefinite lives are not amortized but instead are tested for impairment on an annual basis. To test for impairment, the carrying amount of the intangible asset is compared to its fair value. If the fair value is less than the carrying amount, then the intangible asset is considered impaired and an impairment loss is recognized and the asset's carrying value is reduced accordingly. Internally Generated Cost of Intangibles The cost of developing, maintaining, or restoring intangible assets which are not specifically identifiable, have indeterminate lives, or are inherent in a continuing business, should be expensed. ORGANIZATION COST AND COST OF START-UP ACTIVITIES - SOP 98-5 In 1998 the AICPA decided that organizational cost and start-up cost should be expensed as incurred. For entities that had cap lized organizational cost in the past, the adoption of the new method should be reported as the cumulative effect of a change in accounting principle, but entities are not required to report the pro forma effects of retroactive application.

Accounting For Postretirement Benefits (SFAS No.106) SFAS No 106 The Statement applies to all postretirement benefits expected to be provided by an employer to current and former employees, their beneficiaries, and dependents. Postretirement benefits include health care, life insurance, and other welfare benefits such as tuition assistance, day care, legal services, and housing subsidies provided after retirement. A plan is an arrangement to provide current and former employees with benefits after they retire in exchange for the employees' services over a specified period of time, upon attaining a specified age while in service, or both. Benefits may commence immediately upon termination of service or may be deferred until retired employees attain a specified age. The expected postretirement benefit obligation for an employee is the actuarial present value as of a particular date of the postretirement benefits expected to be paid by the employer's plan to or on behalf of the employee. Measurement of the expected postretirement benefit obligation is based on the expected amount and timing of future benefits, taking into consideration the expected future cost of providing the benefits and the extent to which those costs are shared by the employer, the employee, or others. The accumulated postretirement benefit obligation as of a particular date is the actuarial present value of all future benefits attributed to an employee's service rendered to that date. Prior to the date on which an employee attains full eligibility for the benefits that employee is expected to earn under the terms of the postretirement benefit plan (the full eligibility date), the accumulated postretirement benefit obligation for an employee is a portion of the expected postretirement benefit obligation. The service cost component of net periodic postretirement benefit cost is the actuarial present value of benefits attributed to services rendered by employees during the period. The other components of net periodic postretirement benefit cost are interest cost (interest on the accumulated postretirement benefit obligation, which is a discounted amount), actual return on plan assets, amortization of unrecognized prior service cost, amortization of the transition obligation or transition asset, and the gain or loss component. Measurement of Cost and Obligations An employer's cost-sharing policy, as evidenced by past practice or communication, shall constitute the cost-sharing provisions of the substantive plan, even if such practices are in contrast to the written plan. Otherwise, the written plan shall be considered to be the substantive plan. Contributions expected to be received from active employees toward the cost of their postretirement benefits and from retired plan participants are treated similarly for purposes of measuring an employer's expected postretirement benefit obligation. That obligation is measured as the actuarial present value of the benefits expected to be provided under the plan, reduced by the actuarial present value of contributions expected to be received from the plan participants during their remaining active service and postretirement periods. Automatic benefit changes specified by the plan that are expected to occur shall be included in measurements of the expected and accumulated postretirement benefit obligations and the service cost component of net periodic postretirement benefit cost. Also, plan amendments shall be included in the computation of the expected and accumulated postretirement benefit obligations once they have been contractually agreed to. The service cost component of postretirement benefit cost, any prior service cost, and the accumulated postretirement benefit obligation are measured using actuarial assumptions and present value techniques to calculate the actuarial present value of the expected future benefits attributed to periods of employee service. Each assumption used shall reflect the best estimate solely with respect to that individual assumption. All assumptions shall presume that the plan will continue in effect in the absence of evidence that it will not continue. Principal actuarial assumptions include the time value of money (discount rates); participation rates (for contributory plans); retirement age; and factors affecting the amount and timing of future benefit payments. Assumed discount rates shall reflect the time value of money as of the measurement date in determining the present value of future cash outflows currently expected to be required to satisfy the postretirement benefit obligation. In making that assumption, employers shall look to rates of return on high-quality fixed-income investments currently available whose cash flows match the timing and amount of expected benefit payments. The expected long-term rate of return on plan assets shall reflect the average rate of earnings expected on the existing assets that qualify as plan assets and contributions to the plan expected to be made during the period. Recognition of Net Periodic Postretirement Benefit Cost The following components shall be included in the net postretirement benefit cost recognized for a period by an employer sponsoring a defined benefit postretirement plan: a. Service cost. b. Interest cost. c. Actual return on plan assets, if any. d. Amortization of unrecognized prior service cost, if any. e. Gain or loss (including the effects of changes in assumptions) to the extent recognized. f. Amortization of the unrecognized obligation or asset existing at the date of initial application of the Statement, referred to as the unrecognized transition obligation or unrecognized transition asset. Service Cost The service cost component recognized in a period shall be determined as the portion of the expected postretirement benefit obligation attributed to employee service during that period. The measurement of the service cost component requires identification of the substantive plan and the use of assumptions and an attribution method. Interest Cost The interest cost component recognized in a period shall be determined as the increase in the accumulated postretirement benefit obligation to recognize the effects of the passage of time. Measuring the accumulated postretirement benefit obligation as a present value requires accrual of an interest cost at rates equal to the assumed discount rates. For a funded plan, the actual return on plan assets shall be determined based on the fair value of plan assets at the beginning and end of the period, adjusted for contributions and benefit payments. Prior Service Cost Plan amendments or the initiation of a plan may include provisions that attribute the increase or reduction in benefits to employee service rendered in prior periods or only to employee service to be rendered in future periods. For purposes of measuring the accumulated postretirement benefit obligation, the effect of a plan amendment on a plan participant's expected postretirement benefit obligation shall be attributed to each year of service in that plan participant's attribution period, including years of service already rendered by that plan participant, in accordance with the attribution of the expected postretirement benefit obligation to years of service. The cost of benefit improvements is the increase in the accumulated postretirement benefit obligation as a result of the plan amendment, measured at the date of the amendment. The prior service cost is amortized by assigning an equal amount to each remaining year of service to the full eligibility date of each plan participant active at the date of the amendment who was not yet fully eligible for benefits at that date. If all or almost all of a plan's participants are fully eligible for benefits, the prior service cost shall be amortized based on the remaining life expectancy of those plan participants rather than on the remaining years of service to the full eligibility dates of the active plan participants. To reduce the complexity and detail of the computations required, consistent use of an alternative amortization approach that more rapidly reduces unrecognized prior service cost is permitted. For example, a straight-line amortization of the cost over the average remaining years of service to full eligibility for benefits of the active plan participants is acceptable. Gains and Losses Gains and losses are changes in the amount of either the accumulated postretirement benefit obligation or plan assets resulting from experience different from that assumed or from changes in assumptions. The Statement generally does not distinguish between those sources of gains and losses. As a minimum, amortization of an unrecognized net gain or loss (excluding plan asset gains and losses not yet reflected in market-related value) shall be included as a component of net postretirement benefit cost for a year if, as of the beginning of the year, that unrecognized net gain or loss exceeds 10 percent of the greater of the accumulated postretirement benefit obligation or the market-related value of plan assets. If amortization is required, the minimum amortization shall be that excess divided by the average remaining service period of active plan participants. If all or almost all of a plan's participants are inactive, the average remaining life expectancy of the inactive participants shall be used instead of the average remaining service period. Case Example: XYZ Company maintains an unfunded postretirement healthcare plan which provides its employees with full benefits at age 60. Its four employees were hired at age 30 and the company uses a 10% discount rate. The company implements the provisions of SFAS No.106 for 1999. Expected retirement age is 65. Information at 1/1/99: Actuarially Actuarially Expected Accumulated Postretirement Postretirement Employee Age Benefit Obligation Benefit Obligation A 40 $ 25,000 $ 15,000 B 50 $ 35,000 $ 25,000 C 60 $ 55,000 $ 55,000 D 70 $ 30,000 $ 30,000 $ 145,000 $ 125,000 The EPBO and the APBO are the same for employees C and D since they have reached the time for full eligibility. Computation of Net Periodic Postretirement Benefit Cost (1) Service cost (actuarially determined) $ 2,000 (2) Interest cost----$125,000 x 10% $ 12,500 (3) Return on plan assets (unfunded plan) $0 (4) Amortization of prior service cost $0 (5) Gain or loss $0 (6) Amortization of transition obligation- $125,000 / 20 $ 6,250 Total $ 20,750 The company chooses to amortize the benefits over the 20-year optional period. The transition amount is the same as the APBO since this is an unfunded plan.

Accounting For Stock Options As Compensation Intrinsic vs Fair Value Stock options for compensation are accounted for using either of the following methods: Intrinsic Value Method (APB 25) Fair Value Method (SFAS 123) Intrinsic Value Method - Stock Options When stock options are granted to employees, compensation expenses is measured by the difference between the exercise price and the fair value of the stock at the measurement date. The measurement date is the first date on which both the exercise price and the number of shares to be granted are known. On the measurement date a journal entry is made for the total compensation cost. The entry is a debit to deferred compensation cost and a credit to paid-in cap l - stock options. Both of these accounts are reported in the stockholders' equity section of the statement of financial position. Deferred compensation expense is allocated equally over the periods in which the employee performs the service (service period). The service period is the time between the grant date and the first date the employee can exercise the option (the vesting date). When the intrinsic value method is used for the calculation of compensation cost, SFAS 123 requires pro-forma disclosure of net income and earnings-per-share as if the fair value method had been used. Fair Value Method - Stock Options The fair value method calculates compensation expense based on the fair value of the options expected to vest on the date the options are granted to the employees. The computation is done with an option - pricing model (such as the Black-Scholes option pricing method) that considers the following: a. the stock price at the grant date b. exercise price c. expected life of the option d. volatility of the stock e. expected dividend from the stock f. a risk-free interest rate for the expected term of the stock option Total compensation cost is determined at the grant date and allocated equally to the periods benefited by the employee's service. Stock Option Example To illustrate the two methods of accounting for a stock option plan, assume that on December 1, 1999 the stockholders of Gerlack Corp. approve a plan to grant the corporation's ten executives options to purchase 1,000 shares each of the company's $5 par value common stock. The options are granted on January 1, 2000 and may be exercised at any time between January 1, 2002 and January 1, 2005. The option price is $55, the market price is $65 and the service period is two years. Total Compensation Cost - Intrinsic Value Method Market value at grant date of 10,000 shares at $65 $650,000 Option price at grant date of 10,000 shares at $55 (550,000) Total compensation expense $100,000 Total Compensation Expense - Fair Value Method Assume that Gerlack Corp. applies the Black-Scholes pricing model and determines that the total compensation expense is $250,000. Basic Journal Entries Intrinsic Value Fair Value January 1, 2000 - grant date (To record total compensation) Deferred compensation cost $100,000 No Paid-in cap l stock options $100,000 entry December 31, 2000 (To record compensation expense) Compensation expense $50,000 $125,000 Deferred compensation cost $50,000 Paid-in cap l stock options $125,000 ($100,000 / 2) and ($250,000 / 2) December 31, 2001 (To record compensation expense) Compensation expense $50,000 $125,000 Deferred compensation cost $50,000 Paid-in cap l stock options $125,000 January 2, 2002 (Assume 90% of the stock options are exercised) Cash (9,000 shares x $55 per share) $495,000 $495,000 Paid-in cap l stock options 90,000* 225,000** Common Stock (9,000 shares x $5 par) $ 45,000 $ 45,000 Paid-in cap l in excess of par $540,000 $675,000 * 90% x total paid-in cap l stock options of $100,000 ** 90% x total paid-in cap l stock options of $250,000 January 2, 2005 (Assume the remaining 10% of stock options expire) Paid-in cap l stock options $10,000* $25,000** Paid-in cap l expired stock options $10,000 $25,000 * 10% x total paid-in cap l stock options of $100,000 ** 10% x total paid-in cap l stock options of $250,000 NOTE: If the stock option is forfeited because an employee leaves the company and fails to meet the service requirement, the compensation expense associated with the employee is adjusted as a change in accounting estimate in the current period. The journal entry would be a debit to paid-in cap l stock options and a credit to either deferred compensation expense or compensation expense (intrinsic value method) or a credit to compensation expense (fair value method).

Accounts Receivable DISCLOSURE Accounts receivable should be disclosed on the statement of financial position at net realizable value: Accounts Receivable (gross) XX Less Allowance for Uncollectible Accounts (XX) Net Realizable Value XX ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS There are two approaches to accounting for uncollectible accounts: Allowance method Direct write-off method A. Allowance Method The allowance method is preferred by GAAP because it matches uncollectible accounts expense with credit sales in the same accounting period and establishes a valuation account to report the accounts receivable at net realizable value. The normal journal entries are: 1. To establish uncollectible accounts: JE Bad debt expense XX Allowance from uncollectible accounts XX 2. To write off an uncollectible account: JE Allowance from uncollectible accounts XX Accounts receivable XX 3. To record the recovery of an account previously written off: JE Accounts receivable XX Allowance for uncollectible accounts XX JE Cash XX Accounts receivable XX NOTE: The effect of the two above journal entries is JE Cash XX Allowance for uncollectible accounts XX T-Account Summary of the above journal entries: Allowance for Doubtful Accounts | Beginning balance Write-offs | Estimated expense | Recoveries |------------------ | Ending balance Methods of estimating uncollectible accounts: The allowance method uses two approaches to estimate the charges to bad debt expense. Balance sheet approach Income statement approach Balance Sheet Approach: The balance sheet approach analyzes accounts receivable and uses either a percentage of accounts receivable or an aging of accounts receivable to determine the required balance in the allowance for uncollectible accounts. Income Statement Approach: The income statement approach analyzes credit sales and uses a percentage of credit sales to determine the required balance in the bad debt expense account. Example: X Company had credit sales of $100,000 in the current year. The allowance for doubtful accounts had a balance of $1,200 at the beginning of the year. Writeoffs of $1,600 were recorded during the year, recoveries were $300. The Company estimates bad debt expense at 1% of credit sales and an aging of the accounts receivable at year-end indicates that the required balance in the allowance account is $1,100. To record estimated uncollectible accounts: Income Statement Balance Sheet Approach Approach ------------------ ---------------------- JE Bad debt expense $1,000* $1,200** Allowance for uncollectible accounts $1,000 $1,200 * 1% X credit sales of $100,000 = $1,000 ** The beginning balance in the allowance account of $1,200 - the write-offs of $1,600 + the recoveries of $300 = a debt balance of $100. The aging of accounts receivable indicates a required balance in the allowance account at the end of the year of $1,100. Therefore, the journal entry should be for $1,200 (the debit balance of $100 + the ending balance of $1,100 in the allowance account). B. Direct Write-off Method The direct write-off method may be used if bad debts are immaterial. This method is also used for tax purposes. Using the direct write-off method recognizes bad debt expense only upon the actual write-off of the account receivable. No allowance account is used. Recoveries are normally credited to the current year's expense account. In the above example, if the direct write-off method had been used, the expense for the year would have been the $1,600 in writeoffs less the $300 in recoveries or $1,300. The net journal entry would be a debit to bad debt expense and a credit to accounts receivable for $1,300. Note that the direct write-off method does not use an allowance for uncollectible accounts.

Additional Points ADDITIONAL POINTS In situations in which an entity has different conversion rates for convertible securities or different stock option or warrant prices over a period of time, the Diluted EPS is based on the most advantageous conversion rate or exercise price from the point of view of the security holder. The most advantageous option price is the lowest one and the most advantageous conversion rate is the one that results in the most shares. CONTINGENT SHARES In a business combination the purchaser may promise to issue additional shares in the future if a contingency is met. If the contingency is passage of time, the contingent shares should be considered potential common shares and included in the denominator for the calculation of Diluted EPS. If the contingency is the attainment of a certain income or market price level and this level is met at the end of the year, the contingent shares are considered potential common shares and included in the calculation of the Diluted EPS. DISCLOSURE REQUIREMENTS For each period for which a company presents an income statement, it must disclose: * A reconciliation of the numerators and denominators of basic and diluted EPS from continuing operations, including the individual income and per share effects of all securities used in the computations. * The effect of preferred dividends in arriving at income available to common stockholders in basic EPS. * The securities not included in the Diluted EPS computation (because they were antidilutive in the current period) that could potentially dilute Basic EPS in the future. * A description of any transaction that occurs after the end of the period but before the financial statements are issued that would materially change the number of common shares or potential shares. Examples of these transactions include the issuance or acquisition of common shares, the issuance of warrants, options, convertible securities and the conversion or exercise of potential common shares outstanding at the end of the period into common shares. Note: See Appendix B for a Summary of EPS Formulas.

APB No. 20 ACCOUNTING CHANGES-APB No. 20 In General APB No. 20 defines various types of changes in accounting principles and the manner of reporting each type. The opinion also defines and establishes reporting requirements for special types of accounting changes, change in an accounting estimate, change in entities, and the correction of an error. Change in Accounting Principle Changes in accounting principles require a retroactive computation of the effect of the change on prior periods. The cumulative effect on net income of prior periods is included in the net income of the current period (except special changes) as a segregated item described as, for example, "cumulative effect on prior years of changing to a different depreciation method." The "accounting change" income caption is included in the income statement between "extraordinary items and net income." The after-tax effect of the change in accounting principle on "income before extraordinary items" and on net income is disclosed. Prior periods are not restated; however, "income before extraordinary items" and net income computed on a pro forma basis, along with the related per share amounts, should be shown for prior periods on the face of the income statements. It is presumed that once an accounting principle is adopted for events and transactions of a similar type, it should not be changed without justification. It is therefore required that the nature and justification of a change in accounting principle be disclosed in the financial statements of the year of change. Examples of a Change in Accounting Principle: 1. A change in inventory accounting methods 2. A change in depreciation accounting methods 3. A change in accounting for long-term construction-type contracts 4. A change in composition of the elements of cost included in inventory. The initial adoption of an accounting principle in recognition of events or transactions occurring for the first time or items that were previously immaterial is not a change in accounting principle; similarly with respect to adoption or modification of an accounting principle because of events or transactions clearly different in substance from those previously occurring. Changes in Methods of Accounting for Long-Lived Assets Retroactive recognition is not required for the adoption of a new depreciation or amortization method for newly acquired, identifiable, long-lived assets of the same class while continuing to depreciate (amortize) existing assets of the same class using the previous method. A description of the nature of the change in method and its effect on income before extraordinary items and net income should be disclosed, along with the related per share amounts. If the new method is applied to previously recorded assets of the same class, the cumulative effect of the change should be applied. Case Example: The Wing Company purchased a machine on January 1, 20X5, for $240,000. At the date of acquisition, the machine had an estimated useful life of ten years with an estimated salvage value of $20,000. The machine is being depreciated on a straight-line basis. On January 1, 20X8, Wing appropriately adopted the sum-of-the-years-digits method of depreciation for this machine. Required: 1. Prepare a schedule computing the cumulative effect on prior years of changing to a different depreciation method for the year ended December 31, 20X8. The income tax rate was 30% in all years. 2. Prepare a schedule computing the book value of this machine, net of accumulated depreciation, that would be included in Wing's balance sheet at December 31, 20X8. 1. Wing Company COMPUTATION OF CUMULATIVE EFFECT ON PRIOR YEARS OF CHANGING TO A DIFFERENT DEPRECIATION METHOD For the year ended December 31, 20X8 Sum-of- Straight- the-years line digits method method Increase Depreciationfor20X5 $22,000 $40,000 ($220,000(10/55)$18,000 20X6 22,000 36,000 ($220,000 (9/55) 14,000 20X7 22,000 32,000 ($220,000 (8/55) 10,000 $66,000 $108,000 42,000 Income tax effect at 30% 12,600 Cumulative effect of change $29,400 2. Wing Company COMPUTATION OF BOOK VALUE OF MACHINES, NET OF ACCUMULATED DEPRECIATION December 31, 20X8 Cost of machine at date of purchase $240,000 Depreciation for 20X5 (Schedule I) $22,000 20X6 (Schedule I) 22,000 20X7 (Schedule I) 22,000 66,000 Book value of machine at December 31, 20X7 174,000 Excess of sum-of-the-years digits depreciation method over straight-line depreciation method (Computation per Requirement 2) 42,000 Depreciation for 20X8, using sum-of-the-years digits method ($220,000 ( 7/55-Computation format per Requirement 2) 28,000 70,000 Book value of machine at December 31, 20X8 104,000 Schedule I-Computation of Depreciation for 20X5, 20X6, and 20X7 Cost of machine at date of purchase $240,000 Estimated salvage value 20,000 Amount subject to depreciation 220,000 Depreciation rate 10% Straight-line annual depreciation expense $ 22,000 Special Changes in Accounting Principle The Accounting Principles Board concluded that for some types of accounting changes, restatement of prior years' statements was advantageous because of the ordinarily large credits to income that may result. The special situations are primarily: 1. A change from the LIFO method of inventory pricing to another method. 2. A change in method of accounting for long-term construction-type contracts. For example, from completed contract to percentage of completion or vice versa. These type changes require the cumulative effect of the accounting change to be reported as an adjustment to retained earnings (net of tax) and require retroactive restatement of prior period financial statements when presented. This exemption is available only once for changes made at the time a company's financial statements are first used for these purposes and is not available to companies whose securities are widely held. Pro Forma Amounts Not Determinable In those rare situations where the pro forma amounts cannot be computed (e.g., breakdown of data for specific periods not available) or reasonably estimated for prior periods but the cumulative effect on retained earnings is determinable, the cumulative effect should be reported in the year of change with disclosure of the reason for not showing the pro forma amounts otherwise required. The cumulative effect on the beginning retained earnings of the current period may also not be determinable (e.g., a change from FIFO to LIFO in accounting for inventories). The required disclosure can then be limited to showing the effect of the change on the results of operations of the change period and the reason for omitting the required disclosures. Change In Accounting Estimates Changes in accounting estimates are an essential part of accounting and adjustments of these estimates are necessary as events occur and experience is acquired. Changes in estimates may involve: Uncollectible receivables * Inventory obsolescence * Service lives and salvage value of assets * Warranty costs * Periods benefited by a deferred cost * Recoverable mineral reserves Changes in accounting estimates should affect the period of change only or the period of change and future periods if the change affects both. No restatements of prior periods or pro forma computations are required. The effect of a change in estimate should be disclosed. Change In Estimate Effected By A Change In Accounting Principle For example, a company may change from deferring and amortizing a cost to recording it as an expense when incurred because future benefits are doubtful. Since the change in accounting principle is inseparable from the effect of the accounting estimate, this type of change should be treated as a change in accounting estimate. Therefore, only the year of change and future periods will be affected. Changes In The Reporting Entity This type of change requires the restatement of all prior periods to show financial information for the new reporting entity. Examples of such changes are: 1. Consolidated or combined statements instead of individual statements. 2. Changes among the specific subsidiaries for which consolidated statements are presented. 3. Changes the companies included in combined financial statements. Combined statements are different from consolidated statements. Examples: a. One individual owns a controlling interest in several corporations. b. The financial position and results of operations of a group of unconsolidated subsidiaries. c. Combined statements of companies under common management. Intercompany transactions, minority interests, etc., are treated in the same manner as in consolidated statements. Correction of an Error A correction of an error is not an accounting change and should be reported as a prior period adjustment. This requires adjustment of financial statements of the year(s) affected. Correction of errors would include: * Mathematical mistakes * Mistakes in the application of an accounting principle * Oversight or misuse of information available when the financial statements were prepared. In contrast, a change in accounting estimate results from new information, better insight or improved judgment. A change of an accounting principle not generally accepted to one that is generally accepted is a correction of an error (changing from the direct write-off method for bad debts to the allowance method when bad debts are material).

Bonds, Accounting for Debt BONDS ISSUED Long-term certificates of indebtedness usually issued in denominations of $1,000 with the market price being quoted in 100's. The terms of the debt issue are specified in the indenture (contract between issuer and investor) which is policed by a trustee (representative of investors). Interest is normally paid semi-annually based on a stated percentage of the face value of the bond issue, referred to as the coupon or nominal rate. This fixed dollar interest is adjusted to the prevailing market (yield) rate of interest for securities of equivalent risk by changes in the market price of the bond issue. The market value of the bonds will vary inversely with changes in the market rate of interest. Issuance Bonds are recorded as liabilities at their face value when issued. The issuance of bonds above or below their face value reflects the difference between the market rate of interest and the coupon rate on the date of issuance, as follows: IF Bonds Sell Market Rate < Coupon Rate Above F.V. @ Premium Market Rate = Coupon Rate At F.V. Market Rate > Coupon Rate Below F.V. @ Discount Note: Market price and market rate [yield] are inversely related. Any difference between the amount paid and the face value should be recorded separately as a Premium or Discount on bonds payable. Journal entries to record issuance at Premium and Discount: Cash $102,000 Bonds Payable $100,000 Premium Premium on Bonds Payable 2,000 (102) Cash $ 98,000 Discount on Bonds Payable 2,000 Discount Bonds Payable $100,000 (98) The carrying value of the liability will be its face value plus any premium or less any discount, and will be periodically adjusted by the amortization of the premium or discount to interest expense over the life of the issue so as to reflect the face value at maturity. The discount or premium should not be reported separately as a deferred charge or credit, as it does not represent an asset or liability separable from the debt which gave rise to it (APB No. 21). Issue Costs Issue costs are treated separately as deferred charges and amortized over the life of the bond issue. They should not be combined with a discount or used to reduce a premium. Issue costs include all costs of issuing the bond, such as underwriting, accounting, and legal fees, S.E.C. registration, printing, etc., and represent an asset which is carried on the balance sheet as a deferred charge (APB 21). In order to establish the proceeds of a bond issue, the present value of the interest payments and the maturity payment of face value are computed using the factors for the yield rate. Example: On January 2, 19XX, Firm A issued 7% bonds, face value $1,000,000 due at the end of 5 years with interest paid annually. Case A-Yield Rate 8% Case B-Yield Rate 6% Present value of 1 .68058 .74726 Present value of annuity 3.99271 4.21236 P.V. of int pmts 3.9927 x $70,000 = $279,490 4.21236 x $70,000 = $294,865 P.V. of prin pmts .68058 X $1,000,000 = 680,580 .74726 X $1,000,000 = 747,260 $960,070 $1,042,125 Amortization of Bond Discount and Premium The discount or premium on a bond issue should be amortized over the life of the issue to reflect the face value at maturity. There are two methods of bond premium or discount amortization: 1. The effective interest method (preferable per APB No. 21). 2. The straight-line method (allowed if not materially different than the interest method). SFAS No. 91 requires an enterprise which acquires or originates a loan (lender and purchaser) to defer loan origination fees and costs and recognize such amounts as adjustments of the yield using the interest method. The charges (revenues) may not be offset against the costs of the loan. These adjustments are to be made on a contract by contract basis (unless aggregation of the adjustments causes immaterial differences). The straight-line method may only be used for demand loans or revolving lines of credit under certain circumstances. Sale at Discount-Case Example A (above) (1) Effective Interest Method Amortization (1) (2) (3) (4) (5) Interest Discount Carrying Interest Expense Interest Amort. Value EOY Rate Year (4) x 8% Paid (1) - (2) (4) + (3) (1)/(4) Issue - - - $ 960,070 - 1 $ 76,806 $70,000 $ 6,806 966,876 8% 2 77,350 70,000 7,350 974,226 8% 3 77,938 70,000 7,938 982,164 8% 4 78,573 70,000 8,573 990,737 8% 5 79,263 70,000 9,263 1,000,000 8% $389,930 $39,930 (2) Straight-Line Method Amortization (1) (2) (3) (4) (5) Discount Interest Carrying Interest Interest Amort. Expense Value EOY Rate Year Paid 39,930/5 (1)+(2) (4)+(2) (3)/(4) Issue - - - 960,070 - 1 70,000 7,986 77,986 968,056 8.12% 2 70,000 7,986 77,986 976,042 8.06% 3 70,000 7,986 77,986 984,028 7.99% 4 70,000 7,986 77,986 992,014 7.93% 5 70,000 7,986 77,986 1,000,000 7.86% $39,930 $389,930 Note: (1) Total discount amortizations are the same. (2) Total interest expenses are the same. (3) The effective interest method results in: * constant rate of interest * increasing interest expense per period * increasing discount amortization per period (4) The straight-line method results in: * varying interest rate * constant interest expense and discount amortization Journal entry to record interest expense and amortization for Year 1: Effective Interest Straight-Line Interest Expense $76,806 $77,986 Cash $70,000 $70,000 Discount on Bonds Payable 6,806 7,986 Sale at Premium-Case Example B (previous) (1) Effective Interest Method (1) (2) (3) (4) (5) Interest Premium Carrying Interest Expense Interest Amort. Value Rate Year (4)x6% Paid (1)-(2) (4)-(3) (1)/(4) Issue - - - $1,042,125 6% 1 $ 62,527 $70,000 $ 7,473 1,034,652 6% 2 62,079 70,000 7,921 1,026,731 6% 3 61,604 70,000 8,396 1,018,335 6% 4 61,100 70,000 8,900 1,009,435 6% 5 60,565 70,000 9,435 1,000,000 6% $307,875 $42,125 (2) Straight-Line Method (1) (2) (3) (4) (5) Premium Interest Carrying Interest Interest Amort. Expense Value Rate Year Paid 42,125/5 (1)-(2) (4)-(2) (3)/(4) Issue - - - $1,042,125 - 1 $70,000 $ 8,425 $ 61,575 1,033,700 5.91% 2 70,000 8,425 61,575 1,025,275 5.96% 3 70,000 8,425 61,575 1,016,850 6.01% 4 70,000 8,425 61,575 1,008,425 6.06% 5 70,000 8,425 61,575 1,000,000 6.11% $42,125 307,875 Note: a. Total premium amortizations are the same. b. Total interest expenses are the same. c. The effective interest method results in: * constant rate of interest * decreasing interest expense per period * increasing premium amortization d. The straight-line method results in: * varying rate of interest per period * constant interest expense and premium amortization Journal entry to record interest expense and amortization for Year 1: Effective Interest Straight-Line Interest Expense $62,527 $61,575 Premium on Bonds Payable 7,473 8,425 Cash $70,000 $70,000 Issuance of Bonds Between Interest Dates Bonds issued between interest dates are sold for their market value (refer above) plus accrued interest since the last interest payment date. For example, if $1,000,000 F.V., 6% bonds, interest payment dates 1/1 and 7/1, are issued on 3/1 at 102, the price paid for the five-year bonds would be computed as follows: Market value on 3/1 (102% x $1,000,000) $1,020,000 Accrued interest 1/1 to 3/1 ($1,000,000 x 6% x 2/12) 10,000 Total to be paid on 3/1 $1,030,000 Journal entry to record issuance on 3/1: Cash $1,030,000 Bonds Payable $1,000,000 Premium on bonds payable 20,000 Bond interest payable* 10,000 * The credit could also be made to interest expense, in which case, on 7/1 there would be no charge to bond interest payable and the charge to interest expense would be for $28,621 (6 months interest of $30,000 less the premium amortization of $1,379). The journal entry to record the payment of interest on 7/1 would be (assuming straight-line amortization): Bond interest payable $10,000 Premium on bonds payable (20,000/58 x 4) 1,379 Interest expense 18,621 Cash 1,000,000 x 6% x 1/2 $30,000 If the bonds had been sold at a discount, it would not have affected the accrued interest as of 3/1; however, it would affect the interest expense recognized on 7/1, as the amortization of the discount for 4 months would increase interest expense. The debit to bond interest payable on 7/1 would also be unaffected. Gains or Losses From Debt Extinguishment APB No. 26,SFAS No. 4, 64, 125 Determining Gain or Loss on Redemption or Purchase: APB No. 26 states that: " . . . A difference between the reacquisition price and the net carrying amount of the extinguished debt should be recognized currently in income of the period of extinguishment as losses or gains and identified as a separate item . . . Gains and losses should not be amortized to future periods." When bonds are redeemed or purchased prior to maturity, the gain or loss is determined by the difference between the carrying value of the bonds and the amount given up to acquire the bonds. If the bonds are redeemed at a time other than a scheduled interest payment date, the accrued interest, including amortization of bond premium or discount, and the amortization of bond issue costs should be determined and recorded up to the date of redemption or purchase. SFAS No. 4 states that: "Gains and losses from extinguishment of debt that are included in the determination of net income shall be aggregated and if material, classified as an extraordinary item, net of related income tax effect . . . the following information . . . shall be disclosed (except when such extinguishments are made to satisfy sinking-fund requirements that a company must meet within one year of the date of the extinguishment-SFAS No.64) . . . (a) a description of the extinguishment transaction, including the source of any funds used to extinguish debt if it is practicable to identify the source, (b) the income tax effect in the period of extinguishment, (c) the per share amount of the aggregate gain or loss net of related income tax effect." Note that APB No. 30 re-extraordinary items does not apply to gains or losses from extinguishment of debt. According to SFAS 125, a liability is not extinguished by an insubstance defeasance. It is derecognized only if the debtor: * pays the creditor and is relieved of its obligation or * is legally released from being the primary obligor. Balance Sheet Presentation-Long-Term Debt Bond Discount: Current Previous Year Year Principal Amount $24,000,000 $24,000,000 Less unamortized discount 2,070,000 2,192,000 Long-term debt less unamortized discount $21,930,000 $21,808,000 Bond Premium: Principal Amount $24,000,000 $24,000,000 Add unamortized premium 600,000 650,000 Long-term debt plus unamortized premium $24,600,000 $24,650,000

Business Combinations BUSINESS COMBINATIONS AND SUBSTANCE OVER FORM "A business combination occurs when a corporation and one or more incorporated or unincorporated businesses are brought together into one accounting entity. The single (accounting/economic) entity carries on the activities of the previously separate, independent enterprises" (APB .). The accounting concept of a business combination emphasizes the single entity and the independence of the combining companies prior to the combination. In a business combination one or more of the combining companies may lose their separate legal identities; however, dissolution of the legal entities is not necessary within the accounting concept of a business combination. Although financial accounting is concerned with both the legal and economic effects of transactions and events, and many of its conventions are based upon legal rules, the economic substance of transactions and events is usually emphasized when the legal form differs from the economic substance and suggests different treatment. Therefore, financial accounting emphasizes the single entity in business combinations even if more than one legal entity continues to exist (substance over form). TYPES OF BUSINESS COMBINATIONS Merger: One corporation acquires the assets, liabilities, and operations of another business entity and that entity ceases to exist and is dissolved. All assets and liabilities are recorded on the books of the acquiring corporation. Consolidation: A new corporation is formed to acquire the assets, liabilities, and operations of two or more separate business entities, and those entities cease to exist and are dissolved. All assets and liabilities are recorded on the books of the new corporation. Note the distinction between Consolidation and Accounting Consolidation shown below. Acquisition: One corporation (the investor/parent) acquires controlling interest (greater than 50% of the outstanding common stock) in another corporation (the investee/subsidiary). Both corporations continue their separate legal existence. The assets and liabilities, although under the control of a single business entity (the parent), are recorded on two separate sets of books. ACCOUNTING CONSOLIDATIONS Preparation of financial statements for the single entity resulting from business combinations classified as mergers and consolidations is accomplished through the normal accounting process, as all assets, liabilities and operations are recorded on a single set of books. However, preparation of single entity financial statements for business combinations classified as acquisitions generally requires the bringing together (accounting consolidation) of assets, liabilities, and operations from two sets of books (the parent and subsidiary) as the combining companies continue their separate legal existence, and maintain their own accounting records. This accounting consolidation is based on the financial accounting concept of substance over form. FASB Statement 94 requires that all majority-owned subsidiaries (companies in which a parent has a controlling financial interest through direct or indirect ownership of a majority voting interest) be consolidated except those in which control is likely to be temporary or if control does not rest with the majority owner (subsidiary is in legal reorganization or in bankruptcy or operates under foreign exchange restrictions, controls, or other governmentally imposed uncertainties so severe that they cast significant doubt on the parent's ability to control the subsidiary). METHODS OF ACCOUNTING FOR BUSINESS COMBINATIONS Historically, there were two generally accepted methods of accounting for business combinations – the Pooling of Interest Method and the Purchase Method. With the release of SFAS 141 in 2001, the purchase method is now required for all business combinations, thus effectively prohibiting future use of the pooling of interests method. Importantly, though, previous combinations qualified for polling of interests treatment will continue to be accounted for as poolings in their future consolidated financial reports.

Cap lization Of Interest Cost (SFAS 34) Cap lization of Interest Material interest costs incurred by a firm for assets constructed or produced for its use or assets which are intended to be leased or sold should be cap lized as part of the cost of the asset. Interest is not to be cap lized for routinely manufactured inventories, inventories produced in large quantities (inventories requiring aging, for example), assets which are ready for use, or assets which are not yet ready for use but are not in the process of completion (a building which is one-half completed but construction is halted due to litigation). In this case, interest would continue to be cap lized when construction continues. Interest costs are initially cap lized during planning stages and cap lization continues even if such cap lization raises the asset cost above market value. (The reduction of the asset to market is a separate accounting transaction.) The amount of interest to be cap lized is based upon the Company's actual borrowings. The amount to be cap lized is that portion of interest incurred during the construction or acquisition period which could have been avoided had the assets not been acquired. If there is a specific borrowing related to the qualifying asset, the interest on such borrowing is the amount used. If the borrowing is less than the cost of the asset, then the interest cap lized for the excess is the amount paid for recent borrowings. If the Company has no specific or other recent borrowings, then the rate to be used is the average rate of old borrowings. When computing the amount of interest to be cap lized, such interest should be compounded; i.e., the amount is based on all costs previously incurred including interest. The amount of interest to be cap lized cannot exceed the total interest cost for the period, both of which must be disclosed. FORMULA FOR CAP LIZATION OF INTEREST [Average accumulated expenditures during X [Appropriate X [Construction construction] Interest Rate] Period] Example: X Company began construction of a new plant on January 1, 1999 and the expenditures incurred evenly throughout the year totaled $4,000,000 on December 31. X Company had the following debt structure at year-end. Mortgage on plant under construction at an 8% interest rate $1,500,000 Other borrowings at a weighted average interest rate of 10% 500,000 Calculation of Average Accumulated Expenditures for 1999: = (January 1 total expenditures + December 31 total expenditures)/2 = ( 0 + $4,000,000. ) / 2 = $2,000,000 Average accumulated expenditures Formula Amount of Cap lized Interest: [Average accumulated expenditures during X [Appropriate X [Construction construction] Interest Rate] Period] $1,500,000* X 8% Mtg rate X 1 year = $120,000 500,000 X 10% other interest rate X 1 year = 50,000 formula amount of interest cap lized = $170,000 *The steps used in selecting the interest rates for the $2,000,000 of average accumulated expenditures are to first use the 8% interest rate on the $1,500,000 mortgage and then use the 10% interest rate on the other borrowings for the remaining $500,000. Calculation of Actual Interest Cost: Mortgage Interest = $1,500,000 X 8% X 1 year = $120,000 Other borrowings = $ 800,000 X 10% X 1 year = $80,000 Actual interest cost = $200,000 The amount of interest cap lized is the lower of the formula amount of interest and the actual interest. In this case the formula amount of interest is lower and the amount cap lized would be $170,000. SFAS 142 Intangible Asset Disclosure For intangible assets acquired either individually or with a group of assets, the following information shall be disclosed in the notes to the financial statements in the period of acquisition: a. For intangible assets subject to amortization: 1. The total amount assigned and the amount assigned to any major intangible asset class 2. The amount of any significant residual value, in total and by major intangible asset class 3. The weighted-average amortization period, in total and by major intangible asset class b. For intangible assets not subject to amortization, the total amount assigned and the amount assigned to any major intangible asset class c. The amount of research and development assets acquired and written off in the period and the line item in the income statement in which the amounts written off are aggregated. The following information shall be disclosed in the financial statements or the notes to the financial statements for each period for which a statement of financial position is presented: a. For intangible assets subject to amortization: 1. The gross carrying amount and accumulated amortization, in total and by major intangible asset class 2. The aggregate amortization expense for the period 3. The estimated aggregate amortization expense for each of the five succeeding fiscal years b. For intangible assets not subject to amortization, the total carrying amount and the carrying amount for each major intangible asset class

Classification Of Short-Term Obligations (SFAS 6) SFAS 6 SUMMARY Short-term obligations such as trade accounts payable and normal accrued liabilities should always be classified as current. Other short-term obligations (maturing within one year) must also be classified as current unless the company intends to and has the ability to refinance such obligations within one year. Ability to refinance must be demonstrated by either accomplishing the refinancing or entering into an agreement to do so before the balance sheet is issued. Criteria For Current Liability Classification Short-term obligations arising from transactions in the normal course of business that are due in customary terms shall be classified as current liabilities. Examples are obligations for items which have entered into the operating cycle, such as payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale; collections received in advance of the delivery of goods or performance of services; and debts which arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other taxes. Criteria For Exclusion as a Current Liability 1. The enterprise intends to refinance the obligation on a long-term basis, and 2. The enterprise's intent to refinance on a long-term basis is supported by an ability to consummate the refinancing demonstrated in either of the following ways: a. Post-balance-sheet-date issuance of a long-term obligation or equity securities. After the date of an enterprise's balance sheet but before that balance sheet is issued, a long-term obligation or equity securities have been issued for the purpose of refinancing the short-term obligation on a long-term basis; or b. Financing agreement. Before the balance sheet is issued, the enterprise has entered into a financing agreement that clearly permits the enterprise to refinance the short-term obligation on a long-term basis on terms that are readily determinable, and all of the following conditions are met: (1) The agreement does not expire within one year or within the operating cycle, if greater, from the date of the enterprise's balance sheet. Further, during that period the agreement cannot be cancelable by the lender or the prospective lender or investor except for violation of a provision with which compliance is objectively determinable or measurable. Additionally, obligations incurred under the agreement cannot be callable during that period. (2) No violation of any provision in the financing agreement exists at the balance-sheet date and no available information indicates that a violation has occurred thereafter but prior to the issuance of the balance sheet, or, if one exists at the balance-sheet date or has occurred thereafter, a waiver has been obtained. (3) The lender or the prospective lender or investor with which the enterprise has entered into the financing agreement is expected to be financially capable of honoring the agreement. Disclosure The total of current liabilities shall be presented in classified balance sheets. If a short-term obligation is excluded from current liabilities pursuant to the provisions of this Statement, the notes to the financial statements shall include a general description of the financing agreement and the terms of any new obligation incurred or expected to be incurred or equity securities issued or expected to be issued as a result of a refinancing. CLASSIFICATION OF CALLABLE OBLIGATIONS-SFAS 78 In determining the classification of debt for balance-sheet and/or disclosure purposes, the following should be classified as current: 1. Demand obligations or those which will become demand within one year from the balance sheet date. 2. Long-term obligations which are callable by the lender because of a violation of the debt agreement. Exceptions include: a. When the creditor has waived or lost the right to demand repayment within one year. b. When the long-term obligation includes a grace period for curing the violation and it is probable that such violation will be cured prior to the end of the grace period.

Classifications Of Cash Flows Operating Activities OPERATING ACTIVITIES: Include all transactions and other events that are not defined as investing or financing activities. Operating activities generally involve producing and delivering goods and/or providing services to customers. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income. Cash inflows from operating activities include cash receipts from: 1. Sale of goods or services. 2. Collection or sale (discounting) of accounts and both short- and long-term notes receivable from customers arising from sales (trade). 3. Interest on loans and investments in debt securities of other enterprises (return on investment). 4. Dividends on investments in equity securities of other enterprises (return on investment). 5. Settlement of lawsuits. 6. Refunds from suppliers. 7. Insurance settlements except those that are directly related to investing or financing activities, such as from destruction of a building. Cash outflows from operating activities include cash payment for: 1. Acquisition of materials for manufacture or goods for resale. 2. Principal payments on accounts and both short- and long-term notes payable to suppliers for materials or goods. 3. Suppliers and employees for other goods or services. 4. Taxes (FASB Statement _ concluded that allocating income taxes to operating, investing and financing activities would be complex and arbitrary and that the benefits would not justify the cost). 5. Other government imposed duties, fines, fees and penalties. 6. Interest paid to creditors (net of amounts cap lized). 7. Settlement of lawsuits. 8. Contribution to charity. 9. Refunds to customers. Investing Activities INVESTING ACTIVITIES: Include transactions relating to making and collecting loans, acquiring and disposing of: debt or equity investments (other than cash equivalents); property, plant and equipment; and other productive assets. Generally, investing activities relate to the acquisition and disposal of assets other than those directly related to the enterprise's operations (such as trade accounts and notes receivable, inventory, prepaid expenses). Cash inflows from investing activities include cash receipts from: 1. Collection of non-trade loan/note principal (not interest on the loan which relates to operating activities). 2. Sale of non-trade loans/notes receivable (discounting). 3. Sale of debt or equity investments in other enterprises. 4. Returns of equity investments in other enterprises (liquidating dividends, but not regular dividends which are a return on investment). 5. Sale of productive assets (land, buildings, equipment, natural resources, intangibles). 6. Sale of a business unit (discontinued operations). Cash outflows from investing activities include cash payments for: 1. Loans made to other entities. 2. Purchase of loans from another entity. 3. To acquire debt or equity investments in other entities. 4. Acquisition of productive assets including interest cap lized as part of the cost of those assets. (Includes payments soon before, at, or soon after the time of purchase. Incurring directly related debt to the seller is a financing transaction and subsequent payments of principal are, therefore, financing cash flow.) 5. Acquisition of a business. Cash flows from securities, loans and other assets acquired specifically for resale (SFAS No. 102 and SFAS No. 115) 1. Banks, brokers and dealers in securities, and other enterprises may carry securities and other assets in a trading account. Cash receipts and cash payments resulting from purchases and sales of securities and other assets shall be classified as operating cash flows if those assets are acquired specifically for resale and are carried at market value in a trading account. 2. Some loans are similar to securities in a trading account in that they are originated or purchased specifically for resale and are held for short periods of time. Cash receipts and cash payments resulting from acquisitions and sales of loans also shall be classified as operating cash flows if those loans are acquired specifically for resale and are carried at market value or at the lower of cost or market value. Cash receipts resulting from sales of loans that were not specifically acquired for resale shall be classified as investing cash inflows. That is, if loans were acquired as investments, cash receipts from sales of those loans shall be classified as investing cash inflows regardless of a change in the purpose for holding those loans. Financing Activities FINANCING ACTIVITIES: Include transactions related to obtaining resources from owners and providing them with a return on, and return of their investment; borrowing money and repaying or otherwise settling the obligation; and obtaining and paying for other resources obtained from creditors on long-term credit. Cash inflows from financing activities include cash receipts from: 1. Issuing equity securities (stocks, detachable warrants). 2. Issuing bonds, notes and other short-term or long-term debt. Cash outflows from financing activities include cash payments for: 1. Dividends or other distributions to owners. 2. Repurchase of the enterprise's equity securities (treasury stock). 3. Repayment of amounts borrowed. 4. Other principal payments to creditors who have extended long-term credit (includes principal payments on seller-financed debt directly related to the acquisition of productive assets, and principal payments on cap lized leases). Noncash Investing NONCASH INVESTING AND FINANCING ACTIVITIES: Includes transactions which result in no cash inflow or outflow during the period; however, they affect the assets, liabilities and/or equity of the enterprise. Although these items do not affect the current cash flows of the enterprise, they frequently have a significant effect on the current financial position and on prospective cash flows of the enterprise. For example, a cap lized lease affects both the assets and liabilities of the current period and requires future lease payments in cash; conversion of debt to equity affects the cap l structure of the current period and generally eliminate future, nondiscretionary payments of interest. Noncash investing and financing activities (to be disclosed in a related schedule or narrative) include: 1. Conversion of debt to equity. 2. Acquisition of assets by issuance of debt or equity securities or the assumption of debt. 3. Acquisition of assets by entering into a cap l lease. 4. Exchanges of noncash assets or liabilities for other noncash assets or liabilities. Items With Possible Alternative Classification (Marginal Items) The FASB recognized that the most appropriate classification of items will not always be clear. Certain cash receipts and payments may have aspects of more than one class of cash flow as the three classifications are not clearly mutually exclusive. In those circumstances, the appropriate classification should depend on the nature of the activity that is likely to be the predominant source of cash flows. For example, the acquisition and sale of equipment to be used by the enterprise or rented to others generally are investing activities. However, equipment may be acquired or produced to be used by the enterprise or rented to others for a short period and then sold. In those circumstances, the acquisition or production and subsequent sale of the equipment should be considered operating activities.

Computation of Book Value COMPUTATION OF BOOK VALUE Stockholders' Equity must be allocated to the various classes of shareholders. If there is only one class of stock, book value is based on the number of shares issued and outstanding. Exclude treasury shares. If preferred shares have redemption premium, allocate to preferred shareholders. Common and Preferred Book Value Computation Problem: Preferred-5% cumulative, $100 par, 5,000 shares sold for $800,000 Common-$2 par, 500,000 shares sold for $1,000,000 Retained earnings $200,000 Preferred dividends, 4 years in arrears including current year. Compute book value. Preferred Common Balance $500,000 $1,000,000 4 years dividend @ 5% 100,000 C.C. in Excess--Preferred 300,000 Balance of Retained Earnings _______ 100,000 Book Value $600,000 $1,400,000 Book Value Per Share $120.00 $2.80 Same problem except that preferred stock is participating. R.E. Preferred Common Balance $200,000 $500,000 $1,000,000 4 years dividends (100,000) 100,000 Common at 5% ( 50,000) 50,000 Remainder of R.E. $500,000 Preferred --------- * 50,000 16,667 1,500,000 $1,000,000 Common ----------- * 50,000 33,333 1,500,000 C.C. in Excess-Preferred _______ 300,000 Book Value $616,667 $1,383,333 Book Value Per Share $123.33 $2.77 ILLUSTRATIVE PROBLEM: The balance sheet of Able Company on December 31st contains the following items: Provision for Warranty Obligations $103,732 Bonds Payable 500,000 Reserve for Contingencies 220,000 6% cumulative preferred stock, $50 par (entitled to $55 and accumulated dividends per share liquidation) Authorized 6,000 shares, 3,000 shares issued, of which 300 shares are in the treasury 135,000 Common stock, $50 par, authorized 20,000 shares- issued and outstanding, 8,000 shares 400,000 Premium on preferred stock 10,000 Premium on common stock 78,500 Retained earnings 265,000 NOTE: Preferred dividends have been paid or set up as payable through December 31st. Required: Book value per share-common. Book value per share-preferred. SOLUTION TO ILLUSTRATIVE PROBLEM: Preferred Common Par $135,000 $400,000 Premium 13,500 (13,500) R.E. and Reserve for Contingencies 485,000 Premium on Preferred 10,000 Premium on Common _______ 78,500 Book Value $148,500 $960,000 Book Value Per Share $55 $120

Contingencies SFAS 5 Summary of SFAS 5 If the contingency is probable or likely to occur, and both of the following conditions are present, the contingency loss should be recognized. 1. It is probable that an asset has been impaired or a liability incurred at the balance sheet date, and 2. The amount of loss can be reasonably estimated. In such cases, an adjustment should be made and the contingency loss recognized. If the chance of occurrence is only reasonably possible or less than likely, disclosure should be made. If the event is probable but the amount of loss cannot be reasonably estimated, disclosure should be made. Definitions Contingency. A situation involving uncertainty as to possible loss that will be resolved when one or more future events occur or fail to occur. Examples are: Litigation, threat of expropriation, collectibility of receivables, claims arising from product warranties or product defects, self-insured risks, and possible catastrophe losses of property and casualty insurance companies. Probable. The future event or events are likely to occur. Reasonably possible. The chance of occurrence is more than remote but less than likely. Remote. The chance of occurrence is slight. Conditions Required for Recognition of Contingency Loss 1. It must be probable that an asset has been impaired or a liability incurred at the date of the financial statements. It must be probable that a future event or events confirming the fact of loss will occur. 2. The amount of loss can be reasonably estimated. Examples of loss contingencies included: a. Collectibility of receivables. b. Obligations related to product warranties and product defects. c. Risk of loss or damage of enterprise property by fire, explosion, or other hazards. d. Threat of expropriation of assets. e. Pending or threatened litigation. f. Actual or possible claims and assessments. g. Risk of loss from catastrophies assumed by property and casualty insurance companies including reinsurance companies. h. Guarantees of indebtedness of others. i. Obligations of commercial banks under "standby letters of credit." j. Agreements to repurchase receivables (or to repurchase the related property) that have been sold. Estimation of the Amount of a Loss Where it is probable that an asset has been impaired or a liability incurred, the amount of loss estimable is within a range of amounts. If so, the provision for loss should be: a. The amount within the range that appears to be the best estimate of loss, or b. Where no amount is a better estimate than any other, the minimum amount in the range should be accrued. Example: Hokum, Inc., has been involved in litigation and it is probable that an unfavorable verdict will result in payment of damages between $3 million and $9 million. No amount in the range appears to be a better estimate than any other amount. A loss of $3 million should be accrued for the year, the minimum amount of the range of estimated loss. Disclosure of the nature of the contingency and the exposure to an additional amount of loss of up to $6 million should be made. Disclosure If no accrual is made for a loss contingency because one or both of the conditions for accrual are not met, disclosure should be made when there is at least a reasonable possibility that a loss may have been incurred. The disclosure should include the nature of the contingency, an estimate of the probable loss or range of loss, or state that such an estimate cannot be made. Examples of situations that normally meet the conditions for accrual are losses from uncollectible receivables and obligations related to product warranties and product defects. Conversely, accrual for loss or damage of property, loss from injury to others, damage to property of others and business interruption (sometimes called self-insured risks) should not be made until the loss has taken place. Self-Insured Risks The mere absence of insurance does not fulfill the requirements for accrual. Casualties are random in their occurrence and there is no diminution in the value of the property until the event has occurred. Earnings Variability Some have advocated the recognition of estimated losses from contingencies without regard to whether it is probable that an asset has been impaired or a liability incurred to avoid reporting net income that fluctuates widely from period to period. The FASB concluded that "financial statement users have indicated that information about earnings variability is important to them." If the nature of an enterprise's operations is such that irregularities in the incurrence of losses cause variations in periodic net income, that fact should not be obscured by accruing for anticipated losses that do not relate to the current period. Gain Contingencies These should not be recognized, since to do so might be to recognize revenue prior to its realization. Disclosure should be made, but care exercised to avoid misleading implications as to the likelihood of realization. General or Unspecified Business Risks So-called "reserves for general contingencies" or similar type reserves do not meet the criteria for accrual. These type reserves or other appropriations of retained earnings should not be shown outside the Stockholders' Equity section of the balance sheet and losses should not be charged to appropriations of retained earnings. The only proper disposition of an appropriation (reserve) of retained earnings, contingency or otherwise, is reversal. Remote Contingencies Even though the possibility of loss is remote, disclosure of certain types of loss contingencies which are now being disclosed should be continued. These are: guarantees of indebtedness of others, obligations of commercial banks under "standby letters of credit," and guarantees to purchase receivables that have been sold or otherwise assigned. Disclosure of these type contingencies and others that have the same characteristics should be continued.

Contract Accounting Methods of Income Measurement 1. Percentage of Completion: Income is recognized as work on a contract progresses based on a percentage of estimated total income, either as: a. a percentage of incurred costs to date to estimated total costs, or b. any other measure of progress toward completion that may be appropriate having due regard for work performed. 2. Completed Contract: Profit is measured when contract is complete. Results in deferral of profit until year contract is substantially finished. This method does not measure current performance and may result in erratic reporting of income. When the completed-contract method is used, general and administrative costs are usually treated as period costs; however, it may be appropriate to allocate such costs to contracts in progress. In any case, there should not be excessive deferral of overhead costs, which might occur if total overhead is assigned to abnormally few or small contracts in progress. Percentage-of-Completion Method The completed-contract method does not present a significant income measurement problem. Costs are accumulated and deferred until the contract is substantially complete at which time contract costs are matched with the income generated. The percentage-of-completion method, however, presents some accounting problems which can easily cause confusion. Ordinarily, the act of billing, a debit to accounts receivable, results in a credit to a revenue account. In percentage of completion, revenue does not coincide with the act of billing, since the contract may provide for billings to be made either ahead of or after various stages of completion. Further, revenue earned is determined periodically, not necessarily at the time billings are permitted under the provisions of the contract. Costs and Estimated Earnings in Excess of Billings "Billings in excess of costs and estimated earnings" is offset against "Costs and estimated earnings in excess of billings" when the same contract is involved in both accounts. Where different contracts are involved, their status with regard to this account should not be netted. ARB 43 states, "...current assets may include costs and recognized income not yet billed with respect to certain contracts; and liabilities (in most cases current liabilities) may include billings in excess of costs and recognized income with respect to other contracts." Other titles found in current accounting literature were: Construction in Progress Unbilled Construction in Progress-At Contract Price Billings on Construction in Process Partial Billings on Contract Contract Accounting problems in past CPA exams have followed ARB 43. Completed-Contract Method Contact Costs are recorded: Contract Costs Cash, A/P, etc. Progress Billings are made: Accounts Receivable-Contracts Progress Billings Contract is completed and the full contract price has been billed: Progress billings Contract Costs Income on Long-Term Contracts The balance sheet would show as a current asset the following, prior to completion of the contract, assuming costs of $125,000 and billings of $65,000. Contract Costs to date $125,000 Less: Progress billings 65,000 Costs on uncompleted contracts in excess of billings $ 60,000 If progress billings exceed costs, show the balance as a current liability, "Billings on uncompleted contracts in excess of costs." ARB 43 states, "When the completed-contract method is used, an excess of accumulated costs over related billings should be shown in the balance sheet as a current asset, and an excess of accumulated billings over related costs shown among the liabilities, in most cases as a current liability." "If costs exceed billings on some contracts, and billings exceed costs on others, the contracts should ordinarily be segregated so that the figures on the asset side include only those contracts on which costs exceed billings, those on the liability side include only those on which billings exceed costs." Treatment of Losses on Contracts in Progress Losses should be provided for in full when it is apparent that the contract will result in a loss. This applies to both methods. Journal Entry: Loss on Contract Allowance for Contract Loss ARB 43 states: "When the current estimate of total contract costs indicates a loss, in most circumstances provision should be made for the loss on the entire contract." Illustrative Problem 1 Facts: Total contract price $9,000,000 Estimated costs 8,000,000 3-year contract Actual Estimated Additional Costs Year Costs to Complete Billings Collections 1 $1,944,000 $6,156,000 $1,800,000 $1,620,000 2 5,232,000 2,024,000 4,950,000 4,455,000 3 1,844,000 - 2,250,000 2,925,000 Required: Prepare journal entries for the above contract assuming: 1. Percentage of completion 2. Completed contract The contract calls for the customer to retain 10% of contract billings until the last payment is submitted. Solution: (1) Percentage of Completion: Year 1 Year 2 Year 3 Cost of contract work $1,944,000 $5,232,000 $1,844,000 Materials, Cash, etc. $1,944,000 $5,232,000 $1,844,000 Accounts receivable 1,800,000 4,950,000 2,250,000 Billings in excess of cost and estimated earnings 1,800,000 4,950,000 2,250,000 Cash 1,620,000 4,455,000 2,925,000 Accounts receivable 1,620,000 4,455,000 2,925,000 Cost and estimated earnings in excess of billings 2,160,000 4,860,000 1,980,000 Revenue from contracts 2,160,000 4,860,000 1,980,000 Loss on contract 44,000 Allowance for contract loss 44,000 Closing Entries: Revenue from contracts 2,160,000 4,860,000 1,980,000 Allowance for contract loss 44,000 Cost of contract work 1,944,000 5,232,000 1,844,000 Loss on contract 44,000 Income summary 216,000 416,000 180,000 SCHEDULES Revenue to be recognized Year 1 Year 2 Year 3 Costs incurred to date $1,944,000 $1,944,000 + 5,232,000 = 7,176,000 Total costs (1,944,000 + (7,176,000 + 6,156,000 = 2,024,000 = --------- --------- 8,100,007) 9,200,000) % = 24% 78% 100% X 9,000,000 = 2,160,000 7,020,000 9,000,000 Less prior years' revenue 2,160,000 7,020,000 4,860,000 1,980,000 Accumulated Profit (Loss) on contract and allowance for contract loss Year 1 Year 2 Year 3 Revenue recognized $2,160,000 $4,860,000 $1,980,000 Current costs 1,944,000 5,232,000 1,844,000 Profit (loss) 216,000 (372,000) 136,000 Cumulative-Year 2 (156,000) Provision for additional loss (44,000) 44,000 See (1) (200,000) 180,000 Cumulative-Year 3 (20,000) See (2) (1) [9,000,000 - (1,944,000 + 5,232,000 + 2,024,000)] (2) [9,000,000 - (1,944,000 + 5,232,000 + 1,844,000)] (2) Completed Contract: Year 1 Year 2 Year 3 Construction in progress $1,944,000 $5,232,000 $1,844,000 Materials, cash, etc. $1,944,000 $5,232,000 $1,844,000 Accounts receivable 1,800,000 4,950,000 2,250,000 Progress billings 1,800,000 4,950,000 2,250,000 Cash 1,620,000 4,455,000 2,925,000 Accounts receivable 1,620,000 4,455,000 2,925,000 Provision for contract loss 200,000 Allowance for loss 200,000 Contract costs 9,020,000 Progress billings 9,000,000 Construction in progress 9,020,000 Contract revenues 9,000,000 Closing entries: Income summary 200,000 Provision for contract loss 200,000 Contract revenues 9,000,000 Allowance for loss 200,000 Contract costs 9,020,000 Income summary 180,000 Illustrative Problem 2 Following is data related to the DeWitt Construction Company and the completed-contract method and the percentage-of-completion method of accounting for long-term contracts for reporting in the Company's financial statements. DeWitt commenced doing business on January 1, 19XA. Construction activities for the year ended December 31, 19XA: Contract Cash Costs Estimated Billings Collections Incurred Additional Total Through Through Through Costs to Contract December December December Complete Project Price 31, 19XA 31, 19XA 31, 19XA Contracts A $ 520,000 $ 350,000 $ 310,000 $ 424,000 $ 106,000 B 670,000 210,000 210,000 126,000 504,000 C 475,000 475,000 395,000 315,000 - D 200,000 70,000 50,000 112,750 92,250 E 460,000 400,000 400,000 370,000 30,000 $2,325,000 $1,505,000 $1,365,000 $1,347,750 $732,250 All contracts are with different customers. Any work remaining to be done on the contracts is expected to be completed in 19XB. DeWitt Construction Company BALANCE SHEET December 31, 19XA Assets Completed- Percentage- Contract of Completion Method Method Cash xxxx xxxx Accounts receivable: Due on contracts $140,000 (1) $140,000 (5) Cost of uncompleted contracts in excess of billings 116,750 (2) - Costs and estimated earnings in excess of billings on uncompleted contracts - 127,250 (6) Property, plant, and equipment, net xxxx xxxx Other assets xxxx xxxx $ xxxx $ xxxx Liabilities and Stockholders' Equity Accounts payable and accrued liabilities xxxx xxxx Billings on uncompleted contracts in excess of costs $114,000 (3) - Billings in excess of costs and estimated earnings - $76,000 (7) Estimated losses on uncompleted contracts 15,000 (4) - Notes payable xxxx xxxx Common stock xxxx xxxx Retained earnings xxxx xxxx $ xxxx $ xxxx Explanations: (1)(5) Total billings of $1,505,000 less cash collections of $1,365,000. (2)(3) See Schedule 3 below. (4) See Schedule 1 below. (6)(7) See Schedule 4 below. Schedule 1 DeWitt Construction Company SCHEDULE OF REVENUE AND INCOME (LOSS) THAT WOULD BE REPORTED UNDER THE COMPLETED-CONTRACT METHOD AND THE PERCENTAGE-OF-COMPLETION METHOD For the Year Ended December 31, 19XA 1. Completed- Revenue Income (Loss) Contract to be Costs Provision to be Project Reported Incurred for Loss Reported A $10,000 $ (10,000) C $475,000 $315,000 160,000 D _______ _______ 5,000 (5,000) Totals $475,000 $315,000 $15,000 $145,000 Percentage- Revenue of- to be Income (Loss) Completion Reported Costs Provision to be Project (Schedule 2) Incurred for Loss Reported A $ 416,000 $ 424,000 $2,000 $(10,000) B 134,000 126,000 8,000 C 475,000 315,000 160,000 D 110,000 112,750 2,250 (5,000) E 425,500 370,000 55,500 $ 1,560,500 $1,347,750 $4,250 $208,500 Schedule 2 DeWitt Construction Company COMPUTATION OF REVENUE RECOGNIZED UNDER THE PERCENTAGE-OF-COMPLETION METHOD For the Year Ended December 31, 19XA Projects A 424,000/530,000 x 520,000 = $ 416,000 B 126,000/630,000 x 670,000 = 134,000 C 315,000/315,000 x 475,000 = 475,000 D 112,750/205,000 x 200,000 = 110,000 E 370,000/400,000 x 460,000 = 425,500 $1,560,500 Schedule 3 DeWitt Construction Company COMPUTATION OF COSTS IN EXCESS OF BILLINGS AND BILLINGS IN EXCESS OF COSTS INCURRED UNDER THE COMPLETED-CONTRACT METHOD For the Year Ended December 31, 19XA Costs in Billings Construction Related Excess of in Excess Project in Process Billings Billings of Costs A $ 424,000 $ 350,000 $ 74,000 B 126,000 210,000 $ 84,000 D 112,750 70,000 42,750 E 370,000 400,000 - 30,000 $1,032,750 $1,030,000 $116,750 $114,000 Schedule 4 DeWitt Construction Company COMPUTATION OF COSTS AND ESTIMATED EARNINGS IN EXCESS OF BILLINGS AND BILLINGS IN EXCESS OF COSTS AND ESTIMATED EARNINGS UNDER THE PERCENTAGE-OF-COMPLETION METHOD For the Year Ended December 31, 19XA Costs and Billings in Costs and Estimated Excess of Estimated Earnings Costs and Earnings Related in Excess Estimated Project or Losses Billings of Billings Earnings A $ 414,000 $ 350,000 $ 64,000 B 134,000 210,000 $76,000 D 107,750 70,000 37,750 E 425,500 400,000 25,500 $1,081,250 $1,030,000 $127,250 $76,000

Convertibles And Warrants Issuance of Convertible Debt and Debt With Stock Purchase Warrants (APB No. 14) Rule 1. Convertible debt and debt with nondetachable warrants: No portion of the proceeds from the issuance should be accounted for as attributable to the conversion privilege or the nondetachable stock purchase warrants. The debt securities should be recorded as shown previously, with appropriate recognition of any premium or discount. Rule 2. Debt with detachable warrants: The portion of the proceeds of the debt securities issued with detachable stock purchase warrants which is allocable to the warrants should be accounted for as paid-in cap l. The allocation should be based on the relative fair market values of the two securities at the time of issuance. Any resulting discount or premium on the debt securities should be accounted for as such. Example: The A Company issued $100,000, 8%, 20-year bonds payable with stock purchase warrants. Each $1,000 bond carried 20 warrants and each warrant was for one share of $10 par value common stock at an option price of $50. At the date of issuance, the debentures sold at 105 including the warrants. Journal entries to record the issuance: 1. If warrants are nondetachable (or if bonds were convertible to 20 shares-conversion price $50): Cash $105,000 Bonds Payable $100,000 Premium on Bonds Payable 5,000 (recorded as debt only) 2. If warrants are detachable and traded separately for $5 immediately after issue: Cash $105,000 Discount on Bonds Payable 5,000 Bonds Payable $100,000 Common Stock Warrants 10,000 Computation of Paid-In Cap l Attributable to Warrants Proceeds $100,000 x 1.05 $105,000 Less FMV Warrants (20 x 100 x $5) 10,000 Proceeds Attributable to Bonds $ 95,000 Resulting Discount 5,000 Face Value of Bonds $100,000 FMV of Warrants/ = 10,000/ x $105,000 = $10,000 FMV of Bonds & Warrants 105,000 Conversion of Debt At the date of conversion, the carrying value of the bonds must be removed from the accounts and the issuance of the new common stock recorded. There are two methods by which the issuance may be recorded: 1. Record the stock issuance at the fair market value of the stock or bonds, whichever is more clearly evident, recognizing a gain or loss on conversion as the difference between the carrying value of the bonds and the fair market value of the stock or bonds. 2. Record the stock issuance at the carrying value (book value) of the bonds. Upon conversion, if the par value of the stock issued is greater than the book value of the bonds, the excess is recorded as a debit to retained earnings. If the carrying value of the bonds is greater than the par value of the stock issued, the excess is credited to paid-in cap l in excess of par. The first method is generally viewed as theoretically preferable; however, the second method is generally used in practice. Example: The B Company has outstanding $100,000 of 8% convertible bonds with an unamortized bond premium of $5,000. The conversion privilege provides for a conversion ratio of 20 to 1 (20 shares for each bond) for B Company's $10 par value common stock. A bondholder tenders for conversion a $1,000 bond when the market price of the common stock is $60. Journal entries to record conversion: 1. Conversion Recorded at Fair Market Value: Bonds Payable $1,000 Premium on Bonds Payable 50 Loss on Bond Conversion 150 Common Stock (20 shares of $10 par) $ 200 Paid-in Cap l in Excess of Par 1,000 Computation of Loss: FMV Stock: 20 shares x $60 $1,200 BV Bonds: Face Value $ 1,000 Premium 5,000 x 100 50 1,050 Loss on Conversion $ 150 2. Conversion Recorded at Book Value of Bonds: Bonds Payable $1,000 Premiums on Bonds Payable 50 Common Stock $200 Paid-in Cap l in Excess of Par 850 Prior to recording the conversion of the debt securities, all account balances related to the bonds must be brought up to date-amortization bond discount or premium and accrued interest from the last interest payment date to the date of conversion must be recorded. Convertible bonds which are reacquired by the exercise of the call provision, by the issuer, should be accounted for in accordance with APB No. 26 and SFAS No. 4. (See "Determining Gain or Loss on a Redemption or Purchase.") Exercise of Warrants Warrants give the holder the option to buy a specified number of shares of stock, at a specified price, for a specified period of time. Upon exercise of the warrants, the holder must pay the price stated in the warrants and surrender the warrants to the issuing corporation. The issuance of the stock is recorded at the amount paid for the shares which includes any paid-in cap l attributed to the warrants at issuance (refer above to Rule No. 2). Example: Referring to the A Co. example, in which each bond carried 20 warrants each convertible into one share of common stock and assuming that 50 bondholders exercise their warrants: (a) Number of Warrants Exercised 50 bonds x 20 = 1,000 warrants (b) Amount Paid for Stock 1,000 shares x $50 = $50,000 Journal entries to record exercise of warrants: 1. If warrants were nondetachable:** Cash $50,000 Common Stock (1,000 shares x $10) $10,000 Paid-in Cap l in Excess of Par 40,000 2. If warrants were detachable: Cash $50,000 Common Stock Warrants* 5,000 Common Stock $10,000 Paid-in Cap l in Excess of Par 45,000 * 1,000 warrants exercised 1,000 at $5 of paid-in cap l attributable to warrants at issuance. ** This treatment presumes that the bonds remain outstanding after the warrants are exercised. Convertible Stock and Stock with Stock Purchase Warrants Although APB NO. 14 related specifically to the issuance of convertible debt and debt with stock purchase warrants, the reasoning is also applicable to the issuance of stock with stock purchase warrants and convertible stock. Therefore, the issuance of convertible stock and stock with stock purchase warrants is given the same accounting treatment as convertible debt and debt with stock purchase warrants. Furthermore, its conversion or the exercise of its warrants is accounted for in the same manner as convertible debt or debt with stock purchase warrants. Investments in Convertible Securities and Securities with Stock Purchase Warrants Valuation: The accounting for investments in convertible securities and securities with stock purchase warrants follows the accounting for their issuance. 1. Convertible securities and securities with nondetachable warrants: The investment is recorded at cost which includes the costs of acquisition. No portion of the cost is attributed to the conversion privilege or the nondetachable stock purchase warrants. 2. Securities with detachable warrants: The investment in securities with detachable stock purchase warrants constitutes the acquisition of two separate securities and requires that the cost of the investment be allocated to the different securities according to their relative market values. Example: Referring to the same A Co. example, the acquisition of one of the bonds as an investment would be recorded as follows: 1. If warrants are nondetachable (or if bonds were convertible to 20 shares): Investment in Bonds $1,050 Cash $1,050 2. If warrants are detachable: Investment in Bonds $950 Investment in Stock Warrants 100 Cash $1,050 Computation of Costs Attributable to Warrants MV of Warrants/ = 5/ x $1,050 = $5 per warrant MV of Bond & Warrants 1,050 20 warrants/bond x $5 = $100 Subsequent to acquisition, the valuation of the investment in bonds or stock account would be accounted for as explained in the earlier sections on investments in stocks and bonds. Conversion of Investment Securities At conversion, the carrying value of the investment being converted must be removed from the accounts and the receipt of the investment in stock recorded. There are two methods by which the investment in stock may be recorded: 1. Record the new investment at its fair market value, or the fair market value of the converted security, whichever is more clearly evident, recognizing a gain or loss on the conversion at the difference between the carrying value of the converted security and the fair market value used to record the new investment. 2. Record the new investment at the carrying value of the security converted, recognizing no gain or loss on the conversion. The first method is generally viewed as theoretically preferable; however, the second method is generally used in practice. Example: Referring to the A Co. example, assuming that the investor's books also reflect a carrying value of $1,050 for one of these bonds, the journal entries to record the conversion would be: 1. Conversion recorded at fair market value: Investment in Common Stock $1,200 Investment in Bonds $1,050 Gain on Conversion of Bond Investment 150 Computation of Gain FMV on Stock: 20 shares @ $60 = $1,200 BV of Bonds Surrendered 1,050 Gain on Conversion $ 150 2. Conversion recorded at book value of converted security: Investment in Common Stock $1,050 Investment in Bonds $1,050 Prior to conversion of the convertible security, all account balances related to the convertible security must be brought up to date so as to reflect the current carrying value at conversion. Exercise of Warrants Investments in stock are initially recorded at cost, including the cost of acquisition. When warrants are exercised to acquire stock investments, the cost includes the book value of the warrants surrendered and the amount paid in cash as specified in the warrants. Example: Referring again to the A Co. example, assuming an investor owns 50 bonds and exercises all of his warrants to purchase stock, the journal entries to record his purchase would be: 1. If warrants are nondetachable: Investment in Common Stock $102,500 Cash $50,000 Investment in Bonds $52,500 Computation 50 bonds x 20 warrants per bond = 1,000. 1000 shares x $50 = $50,000. 2. If warrants are detachable: Investment in Common Stock $55,000 Cash $50,000 Investment in Stock Warrants 5,000 Computation Amount Paid: 1,000 shares at $50 = $50,000 Plus: 1,000 warrants at $5 = 5,000 = $55,000 Total Cost

Correction Of Errors Types of Errors SFAS 16 defines accounting errors which qualify as prior period adjustments. Such errors should result in correction of the statements of prior years, if material. These errors usually result from mistake, oversight or misuse of facts. Errors which affect the net income of two or more periods and/or the balance sheet of one or more periods can be grouped as counterbalancing and noncounterbalancing errors. Counterbalancing Errors This type of error affects the net income of two or more periods, but has no effect on retained earnings for the years for which the statements are being corrected. Assume that the years 1997, 1998, and 1999, are under review and that net income for the three years is to be corrected and a balance sheet is to be prepared for the year ended December 31, 1999. The following are examples of counterbalancing errors. a. $3,000 of 1996 advertising was paid and recorded as an expense in 1997. b. The ending inventory for 1997 was understated by $2,500. c. 1997 real estate taxes of $6,000 payable in 1998 were not accrued as an expense in 1997. d. The 1999 beginning inventory was overstated by $12,000. e. A three-year insurance policy totaling $27,000 was paid on January 1, 1997, and charged to expense. If statements are to be presented only for these years, the specific accounts should be corrected as follows: Dr. (Cr.) Net Income for Years 1997 1998 1999 a. Advertising Expense 1($3,000) b. 1997 Ending Inventory ($2,500) $2,500 c. Real Estate Taxes $6,000 ($6,000) d. 1999 Beginning Inventory $12,000 ($12,000) e. Insurance Expense ($18,000) 9,000 9,000 1 Beginning retained earnings requires a counterbalancing debit of $3,000. Noncounterbalancing Errors Such errors require an adjustment to a balance sheet account at the end of the period for which corrections are being made. Examples of such errors are failure to properly record depreciation, amortization or to provide for uncollectible accounts receivable. For example: Equipment purchased in 1997 costing $11,000 was expensed. The equipment has a ten-year useful life and a $1,000 salvage value. The company uses straight-line depreciation but does not take depreciation in the year of purchase. Correct the years 1997, 1998, and 1999. Dr. (Cr.) Net Income for Years 1997 1998 1999 Equipment Adjustment ($11,000) $1,000 $1,000 Journal Entry: Equipment $11,000 Allowance for Depreciation $2,000 Retained Earnings (12/31/99) 9,000

Depletion DEPLETION Unit of Production Method (Accounting Method) (Cost or value assigned to asset)/(Number of recoverable units) Example: Assume that $150,000 is paid for mining property estimated to contain 500,000 tons of ore. The unit depletion charge would be $.30. Depletion, as well as amortization of drilling and development, applicable to units not sold should be included in inventory. Consequently, depletion expense will apply only to units sold. Depletion cost, however, applies to all units extracted. Percentage Depletion (Income Tax Method, not acceptable for accounting purposes) Gross income * depletion percentage Lim tion: Depletion expense cannot exceed 50% of the taxable income from the property without the allowance for depletion. Percentage depletion can be deducted without regard to cost of the property. Cost Depletion Accounting For accounting purposes (unit production method) depletion rates are adjusted as it becomes apparent that the recoverable deposit or growth is more or less than previously estimated. The periodic depletion charge is credited to the Allowance for Depletion account. Assume that depletion cost for ore mined is $50,000, beginning inventory is $10,000 and ending inventory is $15,000. Depletion Cost (cost of goods produced) 50,000 Allowance for Depletion 50,000 To record depletion based on ore mined. At year end when the ending inventory has been determined: Ending Inventory 15,000 Beginning Inventory 10,000 Depletion Cost 5,000 To compute cost of goods sold: $50,000 - $5,000 = $45,000 Illustrative Problem: Cost of land $ 200,000 Development cost 150,000 Estimated tonnage 1,750,000 In the first year of operation 100,000 tons were sold for $3.00 a ton. Mining costs were $150,000 and administrative expenses were $75,000, and 125,000 tons were extracted. Prepare an income statement and compute the value of the ending inventory. Solution: Sales 100,000 * $3.00 $300,000 Cost of Goods Sold: Depletion 100,000 * $ .20 $ 20,000 Extraction 100,000 * $1.20 120,000 140,000 Gross Profit $160,000 Expenses 75,000 Net Income $ 85,000 (350,000)/(1,750,000) = $ .20 depletion cost (150,000)/(125,000) = $1.20 extraction cost ----- $1.40 x 25,000 = $35,000

Depreciation Methods Depreciation Methods Accounting for depreciation is a system of accounting to distribute the cost (or other book value) of tangible cap l assets, less salvage, over their useful lives in a systematic and rational manner. Under generally accepted accounting principles as presently understood, depreciation accounting is a process of allocation, not of valuation, through which the productive effort (cost) to be matched with productive accomplishment (revenue) for the period is measured. Depreciation accounting, therefore, is concerned with the timing of the expiration of the cost of tangible fixed assets. Straight Line Asset cost is allocated based on time. (Cost - Salvage Value)/Useful Life = Depreciation Units-of-Production Method Cost less salvage value is spread over the service life of the asset such as production hours, miles, etc. For example, if a machine costing $10,000 has a productive life of 14,000 hours and 3,500 hours are used in year 1, depreciation in year 1 will be $2,500. Decreasing Charge Methods Called accelerated depreciation because the depreciation charge is greatest initially and decreases during the later years of useful life. Uneven expense is justified by proponents of this method on the basis that when the asset is new, repairs are lower, and in later years of useful life when depreciation is low, repairs would ordinarily be higher. This results in more even annual charges to operations during the asset life. Decreasing charge methods are also justified on the basis of greater expected output when the asset is new. Methods used are: a. Declining balance (at a percentage of the straight line rate) b. Sum-of-the-years' digits Assume that an asset cost $20,000, has a $2,000 salvage value and a 5-year estimated life. Depreciation computation: a. Declining balance at 200% of the straight-line rate. Year S/L Rate 200% Rate Depreciation 1 20% 40% $ 8,000 2 20% 40% 4,800 3 20% 40% 2,880 4 20% 40% 1,728 5 20% 40% 592 Total $18,000 Computations: Year (1) $20,000 x 40% = $8,000 Year (2) $20,000 - 8,000 = 12,000 x 40% = $4,800 Year (3) $12,000 - 4,800 = 7,200 x 40% = $2,880 Year (4) $ 7,200 - 2,880 = 4,320 x 40% = $1,728 Year (5) $ 4,320 - 1,728 = 2,592 x 40% = $1,037 (limited to $592) Salvage value is ignored in the declining-balance method computations. However, depreciation is only recorded until the book value of the asset equals salvage value. In the above example, at the end of the asset's useful life $18,000 has been assigned to depreciation with $2,000 as salvage value. The example shows a rate of 200% of the straight-line rate, whereas the rate can be any amount over 100%, usually 125%, 150%, 175% or 200%. b. Sum-of-the-years' digits. Year Digits Depreciation Fraction 1 5 5/15 2 4 4/15 3 3 3/15 4 2 2/15 5 1 1/15 Total 15 15/15 Depreciation amounts are computed as follows: Cost Year Less Salvage Fraction Depreciation 1 $18,000 5/15 $ 6,000 2 18,000 4/15 4,800 3 18,000 3/15 3,600 4 18,000 2/15 2,400 5 18,000 1/15 1,200 Total 15/15 $18,000 Illustrative Problem: Thompson Corporation, a manufacturer of steel products, began operations on October 1, 1995. The accounting department of Thompson has started the fixed- asset and depreciation schedule presented below. You have been asked to assist in completing this schedule. In addition to ascertaining that the data already on the schedule are correct, you have obtained the following information from the company's records and personnel: * Depreciation is computed from the first of the month of acquisition to the first of the month of disposition. * Land A and Building A were acquired from a predecessor corporation. Thompson paid $812,500 for the land and building together. At the time of acquisition, the land had an appraised value of $72,000 and the building had an appraised value of $828,000. * Land B was acquired on October 2, 1995, in exchange for 3,000 newly issued shares of Thompson's common stock. At the date of acquisition, the stock had a par value of $5 per share and a fair value of $25 per share. During October 1995, Thompson paid $10,400 to demolish an existing building on this land so it could construct a new building. * Construction of Building B on the newly acquired land began on October 1, 1996. By September 30, 1997, Thompson had paid $210,000 of the estimated total construction costs of $300,000. Estimated completion and occupancy are July 1998. * Certain equipment was donated to the corporation by a local university. An independent appraisal of the equipment when donated placed the fair value at $16,000 and the salvage value at $2,000. * Machinery A's total cost of $110,000 includes installation expense of $550 and normal repairs and maintenance of $11,000. Salvage value is estimated as $5,500. Machinery A was sold on February 1, 1997. * On October 1, 1996, Machinery B was acquired with a down payment of $4,000 and the remaining payments to be made in ten annual installments of $4,000 each beginning October 1, 1996. The prevailing interest rate was 8%. The following data were abstracted from present-value tables: PV of $1.00 at 8% PV of annuity of $1.00 in arrears at 8% 10 years .463 10 years 6.710 11 years .429 11 years 7.139 15 years .315 15 years 8.559 Thompson Corporation FIXED ASSET AND DEPRECIATION SCHEDULE For Fiscal Years Ended September 30, 1996, and September 30, 1997 Depreciation Expense Acquire Depn Est Year Ended 9/30 Assets Date Cost Salvage Method Life 1996 1997 Land A 10/1/95 (1) N/A N/A N/A N/A N/A Building A 10/1/95 (2) $47,500 SL (3) $14,000 (4) Land B 10/2/95 (5) N/A N/A N/A N/A N/A Building B Under 210,000 - SL 30 - (6) Construction to date Donated 10/2/95 (7) 2,000 150%DB 10 (8) (9) Equipment Machinery A 10/2/95 (10) 5,500 SYD 10 (11) (12) Machinery B 10/1/95 (13) - SL 15 - (14) Required: For each numbered item (1) to (14), supply the correct amount. Round each answer to the nearest dollar. Do not recopy schedule. Show supporting computations in good form. Illustrative Solution: Computations for Fixed Asset and Depreciation Schedule (1) $65,000. Allocated in proportion to appraised values (72/900 x $812,500). (2) $747,500. Allocated in proportion to appraised values (828/900 x 812,500). (3) Fifty years. Cost less salvage ($747,500 - $47,500) divided by annual depreciation ($14,000). (4) $14,000. Same as prior year since it is straight-line depreciation. (5) $85,400. (Number of shares [3,000] times fair value [$25]) plus demolition cost of existing building ($10,400). (6) None. No depreciation before use. (7) $16,000. Fair market value. (8) $2,400. Cost ($16,000) times percentage (15%). (9) $2,040. Cost ($16,000) less prior year's depreciation ($2,400) equals $13,600. Multiply $13,600 times 15%. (10) $99,000. Total cost ($110,000) less repairs and maintenance ($11,000). (11) $17,000. Cost less salvage ($99,000 - $5,500) times 10/55. (12) $5,100. Cost less salvage ($99,000 - $5,500) times 9/55 times one-third of a year. (13) $30,840. (Annual payment [$4,000] times present value of annuity at 8% for 10 years [6.71]) plus down payment ($4,000). This can be computed from an annuity due table since the payments are at the beginning of each year. To convert from an annuity in arrears to an annuity due factor, proceed as follows: For eleven payments use the present value in arrears for 10 years (6.710) plus 1.00. Multiply this factor (7.710) times $4,000 annual payment. (14) $2,056. Cost ($30,840) divided by estimated life (15 years). Group and Composite Depreciation Depreciation on homogenous (group) assets or on heterogeneous (composite) assets with similar characteristics may be computed by compiling the assets into a single asset account for depreciation purposes. A rate is established based upon the average life of the assets in the account and the rate is applied to the balance in the asset account each period to compute the depreciation expense. A retirement of an asset is recorded by crediting the asset account for the original cost of the asset and debiting the accumulated depreciation account for the difference between the original cost and the proceeds received. Gains and losses on retirements are not usually recognized. A gain or loss is normally recognized only after the last asset within the group is retired.

Derivatives Derivatives Background Derivatives are financial devices that "derive" their value from other financial instruments. Examples of derivatives are futures contracts, forward contracts, interest rate swaps and put options. Derivatives may be freestanding or embedded in a host contract that is itself not a derivative. The combination of a host contract and an embedded derivative is a hybrid instrument. A common example of an embedded derivative is the conversion feature of convertible debt. It represents a call option on the issuer's stock. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 133 ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES The pronouncement addresses the accounting for derivative instruments including certain derivative instruments embedded in other contracts, and hedging activities. Fundamental Decisions a. Derivative instruments that meet the definition of assets and liabilities should be reported in the financial statements. b. Fair value is the only relevant measure for derivative instruments. Types of Derivative Instruments a. Fair value hedges of assets, liabilities & commitments. b. Cash flow hedges. c. Foreign currency hedges. Gains or Losses on Derivative Instruments a. Fair Value Hedges: Gains or losses on fair value hedges are recognized in current earnings. b. Cash Flow Hedges: Gains or losses on cash flow hedges are reported as a component of comprehensive income because the gain or loss on the hedged item will not occur until a future period. The other comprehensive income will be reclassified to income when the gain or loss on the transaction is recognized in earnings. c. Foreign Currency Hedges: 1. Gains or losses on hedged firm commitments are recognized currently. 2. Gains or losses on hedged assets and liabilities are recognized currently. 3. Gains or losses on hedges of available-for-sale securities are recognized currently. 4. Gains or losses on hedges of forecasted foreign-currency- denominated transactions are reported as a component of comprehensive income and reclassified to earnings when the transaction is complete. These hedges are considered cash flow hedges. 5. Gains or losses on hedging of a net investment in a foreign operation are reported in comprehensive income as part of the translation adjustment. Embedded Derivatives a. Embedded derivatives must be accounted for separately from the related host contract if the following conditions are met: 1. The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics of the host. 2. The hybrid instrument is not remeasured at fair value under otherwise applicable GAAP, with changes in fair value reported in earnings as they occur. 3. A freestanding instrument with the same terms as the embedded derivative would be subject to the requirements of SFAS 133. b. If an embedded derivative is accounted for separately, the host contract is accounted for based on the accounting standards that are applicable to instruments of its type. The separated derivative should be accounted for under SFAS No. 133. If separating the two instruments is impossible, the entire contract must be measured at fair value, with gains and losses recognized in earnings. It may not be designated as a hedging instrument because nonderivatives usually do not qualify as hedging instruments. Disclosures a. Disclose the objectives for holding or issuing derivative instruments. b. Disclose the context needed to understand these objectives. c. Disclose the strategies for achieving these objectives. d. Risk management policies. e. Details about fair value hedges, cash flow hedges, and hedges of a net investment in a foreign operation. FASB Definition of Derivative Instruments A derivative instrument is a financial instrument or other contract with all three of the following characteristics: a. It has: (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required. b. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. c. Its terms require or permit net settlement. It can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. Definitions of Underlying, Notional Amount, and Payment Provisions: a. An underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable. An underlying may be a price or rate of an asset or liability but is not the asset or liability itself. b. A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in the contract. The settlement of a derivative instrument with a notional amount is determined by interaction of that notional amount with the underlying. The interaction may be simple multiplication, or it may involve a formula with leverage factors or other constants. c. A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner. Example: FAIR VALUE HEDGE ABC Company has an inventory of 1,000,000 pounds of a commodity called widgets which has a cost of $.48 per pound. The company hedges the fair value of its inventory by selling a futures contract on September 1, 1999 for 1,000,000 pounds at $.63 per pound for delivery on March 1, 2000. The following table lists the market rates and the company's estimates of the changes in the fair value of its inventory. FUTURE RATE CHANGE IN DATE SPOT MARCH 1 VALUE OF RATE DELIVERY INVENTORY 9/1/1999 .61 .63 12/31/1999 .59 .61 $22,000 loss 3/31/2000 .62 .62 $31,000 gain On March 1, 2000, ABC bought a futures contract for 1,000,000 pounds of widgets at $.62 per pound which offsets the company's sale of the futures contract on September, 1999 and closes its futures position. ABC sold its inventory on March 1, 2000 at the market rate of $.63 per pound. Journal Entries: 1999, September 1 No journal entry because the futures rate of $.63 per pound and the fair value are the same and the futures contract is an executory contract. 1999, December 31 JE Loss on Inventory 20,000 Inventory - widgets 20,000 To record the company's estimate of the inventory loss. 1999, December 31 Received from broker 20,000 Gain on futures contract 20,000 * ABC has a futures sale for a contract price of $.63 per pound but could theoretically buy a contract on December 31 to deliver the widgets for $.61 per pound for a net gain of $.02 per pound x 1,000 pounds or $20,000. 2000, March 1 JE Inventory - widgets 31,000 Gain on Inventory 31,000 JE Loss on futures contract 10,000 Receivable from broker 10,000 ABC has a futures sale for a contract price of $.63 per pound and buys a contract to settle the futures obligation for $.62 per pound for a net gain of $.01 per pound or a total gain of $10,000. Since the company anticipated a $20,000 gain on December 31, 1999, the company must recognize a $10,000 loss on March 1, 2000 in order to recognize a total gain of $10,000. 2000, March 1 JE Accounts receivable 620,000 Cost of goods sold 491,000 Sales 620,000 Inventory - widgets 491,000 To record sale and cost of goods sold. Sale = 1,000,000 pounds x $.62 = 620,000. Cost of goods sold = 1,000,000 pounds x the original cost of $.48 per pound for a total cost of $480,000. The cost of $480,000 is reduced by the loss on the inventory in 1999 of $20,000 but increased by the year 2000's gain of $31,000 for a net cost of $491,000 ($480,000 - $20,000 + $31,000). FAIR VALUE HEDGE - INTEREST RATE SWAP ABC Inc. borrows $500,000 for 3 years at a fixed interest rate of 7% annually. On the same date, ABC enters into an interest rate swap in which the company receives a 7% fixed rate but pays a variable rate on $500,000 based on an agreed upon standard index for interest rates. ABC designates the interest swap as a fair value hedge of the risks associated with a change in market interest rates. Assuming that the hedge meets the criteria for an effective hedge, changes in fair values of the interest rate swap will be used to measure the changes in the fair value of the debt. The following table lists the changes in fair value of the debt and the variable interest rates from the agreed-upon index. DATE FAIR VALUE FAIR VALUE OF INDEX OF DEBT INTEREST RATE VARIABLE SWAP INTEREST RATES Dec. 31, 2000 500,000 -0- 6.2% Dec. 31, 2001 480,000 $20,000 loss 6.8% Dec. 31, 2002 505,000 $5,000 gain 6.0% Journal entries: Dec. 31, 2000 Cash 500,000 Notes Payable 500,000 To record the borrowing Dec. 31, 2001 Interest Expense 35,000 Cash 35,000 To record the annual interest of $500,000 x 7% = $35,000. Dec. 31, 2001 Cash 4,000 Interest expense 4,000 On the interest rate swap, ABC receives 7% of $500,000 or $35,000 and pays the variable rate of 6.2% x $500,000 or $31,000, for a net decrease in interest expense of $4,000. Dec. 31, 2001 Notes payable 20,000 Gain from hedge 20,000 The year-end increase in interest rates reduced the debt's fair value. Dec. 31, 2001 Loss from hedge 20,000 Interest rate swap contract 20,000 To record the decrease in value of the interest rate swap. Dec. 31, 2002 Interest Expense 35,000 Cash 35,000 To record annual interest cost. Dec. 31, 2002 Cash 1,000 Interest Expense 1,000 ABC receives $35,000 from the fixed rate and pays 6.8% x $500,000 or $34,000 for the variable rate, for a net decrease in interest expense of $1,000. Dec. 31, 2002 Loss from hedge 25,000 Notes payable 25,000 The decrease in interest rates to 6% increased the debts fair value from $480,000 to $505,000, for a loss of $25,000. Dec. 31, 2002 Interest rate swap 25,000 Gain from hedge 25,000 To record increase in value of the hedge from a loss of $20,000 to a gain of $5,000, for a total of $25,000. CASH FLOW HEDGE - Forecasted Transaction On January 1, 1999, XYZ Company decides that it will purchase 200,000 pounds of commodity A on July 1, 2000 at the spot rate. The company further decides to purchase a futures contract for 200,000 pounds of commodity A at the June 30 futures price of $2.50 per pound to hedge the forecasted transaction. The effectiveness of the hedge will be measured by the changes in the cash flows of forecasted purchase vs. the changes in the fair value of the futures contract. On June 30, 1999, XYZ purchases 200,000 pounds of commodity A at $2.60 per pound. Journal Entries: June 1, 1999 No journal entry because the futures contract is at the spot rate which is the fair value. (For simplicity, margin deposits are ignored.) June 30, 1999 Inventory - Commodity A 520,000 Cash 520,000 To record the purchase of 200,000 pounds of commodity A at $2.60 per pound. June 30, 1999 Futures Contract (Asset) 20,000 Gain on hedge - other Comprehensive Income 20,000 The gain is the difference between the current rate of $2.60 per pound and the futures contract price of $2.50 per pound of $.10 x 200,000 pounds or $20,000. June 30, 1999 Cash 20,000 Futures contract (Asset) 20,000 To record the net cash settlement of the futures contract.

Diluted Earnings Per Share IN GENERAL Diluted EPS is required for companies with a complex cap l structure. A complex structure is one that includes potential common shares as convertible securities, stock options, stock warrants, and contingent shares. The purpose of Diluted EPS is to measure the performance of an entity over the reporting period while taking into account the effect of all dilutive potential common shares that were outstanding during the period. All antidilutive potential common shares, securities that if converted or exercised would individually increase EPS, are disregarded. LOSS FROM CONTINUING OPERATIONS For a company with a loss from continuing operations, the exercise of options or conversions of securities would normally increase the number of potential common shares outstanding and reduce the loss per share. Since this would be antidilutive, SFAS 128 states that if there is a loss from continuing operations, Diluted EPS would be the same as Basic EPS. EXAMPLE OF DILUTIVE EPS WITH CONVERTIBLE PREFERRED STOCK - IF CONVERTED METHOD In 1999 the Stevens Corp. had 90,000 shares of common stock and 10,000 shares of preferred stock outstanding for the full year. During 1999 Stevens paid preferred dividends of $2.50 per share and the preferred stock is convertible into 20,000 shares of common stock. The net income for the year is $485,000 and the tax rate is 30%. The cap l structure is complex because of the presence of the convertible preferred stock. The first step is to calculate the Basic EPS and then compare it to the Dilutive EPS to determine if the convertible stock is dilutive. Net Income - Preferred Dividends Basic EPS = ------------------------------------------------------ Weighted Average Number of Common Shares Outstanding = 485,000 - (2.50 per share x 10,000 shares) ------------------------------------------------- 90,000 common shares = $5.11 per share To determine the dilutive effect, assume the convertible preferred stock was converted (if converted method) into 20,000 shares of common stock at January 1, 1999 and the $2.50 per share preferred dividend was not distributed. Therefore, the Diluted EPS would be calculated as follows: Net Income Dilutive EPS = --------------------------------------------------- Weighted Average Number + Dilutive Potential Of Common Shares Outstanding Common Shares $485,000 = ------------------------------ 90,000 shares + 20,000 shares = $4.41 per share The convertible preferred stock is dilutive because it reduced the EPS from $5.11 to $4.41. Stevens Corp. would disclose on the face of the income statement a Basic EPS of $5.11 and a Diluted EPS of $4.41. NOTE: The if converted method assumes the conversion of the preferred stock at the earliest possible date. Since in our example the preferred stock was outstanding for the full year, the earliest date was January 1, 1999. However, if the preferred stock was issued on April 1, 1999, the earliest date for conversion would be April 1, 1999. The if converted method would then assume that the preferred stock was converted into 20,000 on April 1 and weight the shares as having been outstanding for 9 months (20,000 shares x 9/12 = 15,000 shares). The Diluted EPS would use the 15,000 shares as the potential common shares in the denominator of the formula. EXAMPLE OF DILUTED EPS WITH CONVERTIBLE BONDS - IF CONVERTED METHOD In 1999 Johnson Company had 100,000 shares of common stock and $1,000,000 of 9% convertible bonds outstanding for the full year. The bonds are convertible into 30,000 shares of common stock, the tax rate is 30% and the net income for the year is $485,000. Net Income Basic = ----------------------------------------------------- Weighted Average Number of Common Shares Outstanding $485,000 = --------------------- 100,000 common shares = $4.85 per share The Diluted EPS assumes that the bonds were converted into 30,000 shares of common stock on January 1, 1999 and that Johnson Co. did not have bond interest of $90,000 (9% x $1,000,000 of bonds) for the year. Since the bond interest has already been deducted from the $485,000 in net income, the diluted EPS calculation would add back the $90,000 of bond interest and increase the income before tax by $90,000. The tax effect of the increase at 30% would be $27,000 and the net effect of the increase after taxes would be $63,000 ($90,000 - $27,000). Net Income + Interest Expense (Net of Tax) Dilutive EPS = ------------------------------------------------ Weighted Average Number + Dilutive Potential of Common Shares Outstanding Common Shares $485,000 + ($90,000 - $27,000) = ------------------------------------ 100,000 shares + 30,000 shares = $4.22 per share Since the Diluted EPS of $4.22 is lower that the Basic EPS of $4.85, the convertible bonds are dilutive.

Direct Method of Reporting DIRECT METHOD OF REPORTING OPERATING CASH FLOW FASB Statement No. 95 encourages enterprises to use the direct method in reporting cash flows from operating activities; however, it does not require its use. The direct method reports major classes of gross cash receipts and gross cash payments and the resulting net cash flow from operating activities. Basically, the direct method results in the reporting of a cash basis income statement in the operating activities section of the statement of cash flows. If the direct method is used, the following classes of operating cash receipts and payments should, at a minimum, be separately reported: a. Cash collected from customers, including lessees, licensees, and the like b. Interest and dividends received c. Other operating cash receipts, if any d. Cash paid to employees and other suppliers of goods or services, including suppliers of insurance, advertising, and the like. e. Interest paid (exclusive of amounts cap lized) f. Income taxes paid g. Other operating cash payments, if any. Enterprises are encouraged to provide further breakdowns of operating cash receipts and payments that they consider meaningful and feasible. For example, a retailer or manufacturer might decide to further divide cash paid to employees and suppliers [category (d) above] into payments for costs of inventory and payments for selling, general, and administrative expenses. Advantages of Direct Method * The principal advantage of the direct method is that it shows gross operating cash receipts and payments. Knowledge of specific sources of operating cash flows is useful in estimating future cash flows. Commercial lenders generally maintain that amounts of operating cash receipts and payments are particularly important in assessing an enterprise's external borrowing needs and its ability to repay borrowings. * The direct method is more consistent with the objectives of a statement of cash flows—to provide information concerning gross cash receipts and payments during a period. Disadvantages of Direct Method * The direct method does not link the net income reported on the income statement to the cash flow from operating activities. * The direct method does not provide information about intervals of lead and lags between cash flows and income by showing how the changes in current assets and current liabilities, relating to operations, affect operating cash flows. Additional Required Disclosures To avoid the disadvantages associated with the direct method and gain the benefits associated with the indirect method (refer below), FASB Statement No. 95 requires that if the direct method is used, a reconciliation of net income to net cash flow from operating activities must be provided in a separate disclosure. The reconciliation must meet the same requirements as those for the indirect method (refer below). Example: The Hiram Supply Company had the following income statement for the year ended December 31, 19X1: Sales $70,000 Cost of goods sold 30,000 Gross profit $40,000 Operating expenses Salaries $10,000 Depreciation 5,000 Interest 3,000 18,000 Income before income taxes $22,000 Income taxes 3,300 Net income $18,700 Hiram Supply Company also reported the following changes in current assets and liabilities related to operations: Accounts receivable $8,000 increase Inventory 2,500 increase Accounts payable 1,300 decrease Salaries payable 1,000 increase Under the direct method, the cash flows from the operating activities section of the statement of cash flows would appear as follows: Cash flows from operating activities: Cash received from customers $62,000 Cash paid to suppliers *(33,800) Cash paid to employees *( 9,000) Interest paid ( 3,000) Income taxes paid ( 3,300) Net cash provided by operating activities $12,900 * Amount may be combined as cash paid to suppliers and employees. Supporting computations: Cash received from customers: Sales $70,000 Less increase in accounts receivable (8,000) Cash collected $62,000 Cash paid to suppliers: Cost of goods sold $30,000 Add increase in inventory 2,500 Purchases $32,500 Add decrease in accounts payable 1,300 Cash paid to suppliers $33,800 Cash paid to employees: Salaries expense $10,000 Less increase in salaries payable (1,000) Cash paid to employees $ 9,000

Disclosure of Long Term Obligations DISCLOSURE OF LONG-TERM OBLIGATIONS-SFAS No. 47, No. 129 Long-Term Borrowings and Stock Redemptions SFAS No. 47 requires the following information to be disclosed regarding long-term borrowings and cap l stock for each of the five years following the latest balance sheet: (a) The combined aggregate amount of maturities and sinking fund requirements for all long-term borrowings. (b) The amount of redemption requirements for all issues of cap l stock that are redeemable at fixed or determinable prices on fixed or determinable dates, separately by issue or combined. Example: D Company has outstanding two long-term borrowings and one issue of preferred stock with mandatory redemption requirements. The first borrowing is a $100 million sinking fund debenture with annual sinking fund payments of $10 million in 19X2, 19X3, and 19X4, $15 million in 19X5 and 19X6, and $20 million in 19X7 and 19X8. The second borrowing is a $50 million note due in 19X5. The $30 million issue of preferred stock requires a 5 percent annual cumulative sinking fund payment of $1.5 million until retired. D's disclosures might be as follows: Maturities and sinking fund requirements on long-term debt and sinking fund requirements on preferred stock subject to mandatory redemption are as follows (000's): Long-term debt Preferred stock 19X2 $10,000 $1,500 19X3 10,000 1,500 19X4 10,000 1,500 19X5 65,000 1,500 19X6 15,000 1,500 Unconditional Purchase Obligations An unconditional purchase obligation is the amount which a company is obligated to pay for a contract which calls for the purchase of a minimum quantity of goods at a fixed minimum price. For such obligations which are noncancelable and have a remaining term in excess of one year (and have not been pre-recorded on the balance sheet), the following shall be disclosed. (a) The nature and term of the obligation(s). (b) The amount of the fixed and determinable portion of the obligation(s) as of the date of the latest balance sheet presented in the aggregate and, if determinable, for each of the five succeeding fiscal years. (c) The nature of any variable components of the obligation(s). (d) The amounts purchased under the obligation(s) for each period for which an income statement is presented. For those unconditional purchase obligations which have been recorded on the balance sheet (asset and related liability), the aggregate amount of payments which have been recognized (on the balance sheet) shall be disclosed. Case Example of Unrecorded Purchase Obligation F Company has entered into a take-or-pay contract with an ammonia plant. F is obligated to purchase 50 percent of the planned capacity production of the plant each period while the debt used to finance the plant remains outstanding. The monthly payment equals the sum of 50 percent of raw material costs, operating expenses, depreciation, interest on the debt used to finance the plant, and a return on the owner's equity investment. F's disclosure might be as follows: To assure a long-term supply, the company has contracted to purchase half the output of an ammonia plant through the year 2005 and to make minimum annual payments as follows, whether or not it is able to take delivery (in thousands): 19X2 through 19X6 ($6,000 per annum) $ 30,000 Later years 120,000 Total 150,000 Less: Amount representing interest *(65,000) Total at present value *$ 85,000 *not required disclosure In addition F must reimburse the owner of the plant for a proportional share of raw material costs and operating expenses of the plant. F's total purchases under the agreement were (in thousands) $7,000, $7,100, and $7,200 in 19X9, 19X0, and 19X1, respectively. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS--SFAS No. 107 SFAS No. 107 requires all entities to disclose the fair value of many financial instruments. These disclosures are for both assets and liabilities and also include financial instruments not shown on the balance sheet ("off-balance-sheet"). Examples include accounts, notes, loans receivable and payable, investment securities, options, standby letters of credit and financial guarantees and bonds. If it is not practical to estimate these fair values, descriptive information about the financial instruments such as the terms of the instrument and why it is not possible to estimate the fair value should be provided. It is important to note that the disclosure of fair values are provided as supplemental information and do not normally replace the historical cost basis used on the balance sheet. (An exception to this traditional reliance on historical cost is the valuing of certain investments in debt and equity securities at fair market value. See SFAS No. 115 in chapter 2). FASB No. 107 requires disclosure of information about significant concentrations of risk for all financial instruments. Concentrations of credit exist when a company has a business activity, economic characteristic, or location that is common to most of its financial instruments. SFAS NO. 107 lists a number of items that are covered in other standards and are exempted from coverage by this standard: obligations for pension and other post-retirement benefits, employee stock option and deferred compensation plans, substantially extinguished debt and the related assets in trust, many insurance contracts, lease contracts, obligations and rights resulting from warranties, unconditional purchase obligations, equity method investments, minority interests in consolidated statements, and instruments classified as stockholders' equity on the balance sheet. SFAS NO. 126, Exemption from Certain Required Disclosures about Financial Instruments for Certain Nonpublic Entities, amends SFAS No. 107, Disclosures about Fair Value of Financial Instruments, to make such disclosures optional for entities that are nonpublic, have total assets of less than $100 million, and have not held or issued any derivative financial instruments, other than loan commitments, during the reporting period.

Discontinued Operations Discontinued Operations Reporting Discontinued operations are reported on one line in the special section under Continuing Operations and is shown net of tax SFAS 144 made some major changes in the reporting of discontinued operations: 1. The new definition of a discontinued operation is a component unit with a set of operating and cash flows that are clearly distinguishable from the rest of the entity for operational and financial reporting purposes. A component unit may be a reportable segment or an operating segment, a reporting unit, a subsidiary or an asset group. 2. The FASB also requires that the entity not have any significant continuing post-disposal involvement in the discontinued components operations. 3. If a company commits to a plan to dispose of the component and completes the disposal within one accounting period, the operating results plus or minus the gain or loss on disposal are shown under Discontinued Operations Net of Tax. 4. If the company's disposal plan extends over more than one accounting period, the accounting becomes more difficult. The component unit must qualify as "Held for Sale". SFAS 144, in paragraphs B70 to B79, list the criteria for held for sale as: a. Commit to a plan to sell b. Assets are available for sale c. Begun to actively seek a buyer d. Completion of sale within one year is probable e. Component is actively marketed at a reasonable price f. There is little chance of a significant change in or withdrawal of the plan 5. Once a component unit qualifies as held for sale, SFAS 144 requires that the assets be tested for an impairment loss. The impairment loss is then netted with the operational results to calculate the amount shown under Discontinued Operations. For example: On December 1, 20X5, the Johnson Co. committed to a plan to dispose of its Gilmore Company, a subsidiary. Gilmore's assets were tested for impairment and a loss of $200,000 was calculated. This loss, plus Gilmore's operational loss of $500,000, were reported as a $700,000 loss from discontinued operations before tax effects. 6. SFAS 144 also requires that the operating results, plus or minus the gain or loss on disposal, be reported in the period(s) in which they occur. Example: On January 2, 2002, Jo Corp. agreed to sell its Ellen Division and the sale was completed on March 31, 2003. The Ellen Division had operational losses of $400,000 in 2002 and $100,000 for the first quarter of 2003, but the transaction resulted in a gain on sale of $600,000. Assuming that the criteria for discontinued operations are met and taxes are ignored, how would Jo Corp. report the disposal of the segment? 2002-Loss from Discontinued Operations $400,000 2003-Gain from Discontinued Operations ($600,000 gain - $100,000 loss) = $500,000 Other Points Projections of operating income or loss should not ordinarily cover more than one year. Adjustments, costs, and expenses that should have been recognized on a going concern basis up to the measurement date should not be included in the gain or loss on disposal. Examples: Adjustments of accruals on long-term contracts; write-down or write-off of receivables, inventories, property, plant equipment, research and development costs or other intangible assets. Costs or adjustments directly associated with the decision to dispose include such items as severance pay, additional pension costs, employee relocation expenses, and future rentals on long-term leases. The notes to the financial statements encompassing the measurement date should include pertinent details of the disposal including what, when and how the disposal will be made, the remaining asset and liabilities of the segment at the balance sheet date, the income or loss from operations and the proceeds from disposal from the measurement date to the balance sheet date.

Distributions of Income and Bonus CASH DISTRIBUTION PLANS Another method of determining the amount(s) that can be distributed to a partner is by preparation of a cash distribution plan. An accountant may be asked by a partnership to devise such a plan, if the partnership should subsequently choose to liquidate, showing how any cash generated by the sale of assets should be distributed. This is similar to the ordinary procedures in liquidation where, as cash is accumulated, the accountant calculates the payments which can safely be made to partners in installments. Once the plan is prepared it may be used to determine all subsequent distributions unless the mix of partners' cap l is changed by investment or withdrawal. The use of MPL and the cash distribution plan is necessary because the partners' cap l account ratios differ from their P and L ratios. The plan will eventually equalize the partners' cap l accounts. The procedure for a plan for distribution of cash is as follows: 1. Add the loan accounts to the partners' cap l accounts. 2. Determine the amount of loss which will extinguish the weakest partner's cap l balance. 3. Distribute the loss in (2) to all partners. After one partner is eliminated, repeat the same process with the remaining partners. 4. After all but one of the partners' cap l accounts are eliminated, cash distributions are determined by starting with the remaining partner's final balance (which becomes the first cash distribution) and working backwards. ILLUSTRATION 1: The ABCD Partnership is being dissolved. All liabilities have been liquidated. The balance of assets on hand is being realized gradually. Following are details of partners' accounts: Cap l Account P and L (Original Investment) Ratio A $30,000 4 B 36,000 3 C 16,000 2 D 22,000 1 PREPARE a schedule showing how cash payments should be made to the partners as assets are realized. A (40%) B (30%) C (20%) D (10%) Cap l balance $30,000 $36,000 $16,000 $22,000 Loss (1) $75,000 30,000 22,500 15,000 7,500 --0-- 13,500 1,000 14,500 Loss to eliminate C $1,000 * 2/6 = $3,000 1,500 (3/6) 1,000 (2/6) 500 (1/6) 12,000 --0-- 14,000 Loss to eliminate B $12,000 *3/4 = $16,000 12,000 (3/4) 4,000 (1/4) First cash payment --0-- 10,000 Cash distribution plan-- 1st $10,000 to D (Liabilities must be Next $16,000 - 3/4 to B; 1/4 to D paid or cash reserved Next $3,000 - 3/6 to B; 2/6 to C; 1/6 to D before payments are All remaining cash in P and L ratio made to partners) (1) To determine the weakest partner, compare the cap l account balance with the P and L ratio. A is weaker than B because A would be charged with 40% of any loss. A is also weaker than C and D even though A has greater total cap l. Another method of determining the weakest partner is to divide the cap l account by the loss ratio. A = 30,000/.4 = 75,000 loss will eliminate A B = 36,000/.3 = 120,000 loss will eliminate B C = 16,000/.2 = 80,000 loss will eliminate C D = 22,000/.1 = 220,000 loss will eliminate D We can see from this that D will receive the first cash distribution made to the partners, followed by B, C, and then A. (2) After each partner is eliminated, the loss which eliminates the next weakest partner is determined by using the loss ratio of the remaining partners, or after A is eliminated 3:2:1. Assume that $20,000 in cash is available for distribution but $5,000 is reserved for payment of liabilities. Following the plan the cash would be distributed as follows: A B C D To D $10,000 $10,000 To B and D 5,000 $3,750 (3/4) 1,250 (1/4) $15,000 $3,750 $11,250 Assume that next month $20,000 is to be distributed. The plan would continue at the point reached last month. A B C D $16,000 - $5,000 = $11,000 $ 8,250 (3/4) $2,750 (1/4) Next 3,000 1,500 (3/6) $1,000 (2/6) 500 (1/6) Next 6,000 $2,400 1,800 1,200 600 $20,000 $2,400 $11,550 $2,200 $3,850 Observe that when all partners have received some cash, the cap l accounts are in the same percentage as the P and L ratio and that future distributions can be made in the P and L ratio. INCORPORATION OF A PARTNERSHIP Procedures A. Adjust asset values to bring balances into conformity with values agreed upon for the purpose of transfer to the corporation. The net effect of these adjustments will be carried to the partners' cap l accounts in their respective P and L ratios. B. Change from a partnership to corporation is made by debiting the partners' cap l accounts and crediting cap l stock account for the shares issued to the partners. BONUS COMPUTATIONS Frequently accountants are asked to compute the amount of bonus to be paid a corporate executive, a partner or employee under a profit sharing plan. The factors which may affect the bonus are: * Net income before tax and/or bonus * Tax rate - The bonus itself affects the tax since the bonus is deductible. The bonus may be computed before or after the tax depending on the profit sharing arrangement. Partnerships as entities do not pay taxes; however, an imputed tax rate may be used to compute the bonus. * Bonus percentage - May be before or after bonus and may be applicable to income above a certain amount. In solving such problems, a good approach is to write the particular problem in equation form with no attempt to quantify the elements of the equation. Then substitute known quantities in the equation and solve for B (Bonus). Example: A company's bonus plan provides that the company will pay a bonus of one-third of its net income after taxes each year. Income before taxes and before deducting the bonus for the year is $600,000. The tax rate is 40%. What amount is the bonus? Start with a simple expression of the situation 1. Bonus = Bonus Percent * Net Income Now begin to substitute quantities 2. B = 33 1/3% (NI - Tax - Bonus) 3. B = 33 1/3% (600,000 - .40 [600,000 - B] - B) Multiply the factors using the rules of algebra 4. B = 33 1/3% (600,000 - 240,000 + .4B - B) 5. B = 200,000 - 80,000 + 13 1/3% B - 33 1/3% B Combine like terms when possible 6. B = $120,000 - 20% B Add .2B to both sides of the equation 7. 1.2B = 120,000 Divide both sides by 1.2 8. B = 100,000 Example: The West Company provides an incentive compensation plan under which its president is to receive a bonus equal to 20% of the company's income in excess of $200,000 before deducting income tax but after deducting the bonus. If income before income tax and bonus is $320,000 and the effective tax rate is 40%, the amount of bonus should be: Bonus = 20% (NI - Exclusion - Bonus) B = 20% (320,000 - 200,000 - B) B = 20% (120,000 - B) B = 24,000 - .2B 1.2 B = 24,000 B = 24,000/1.2 B = 20,000

Dividends DIVIDENDS Represent income only to the extent paid from earnings subsequent to the date the investment was acquired. Dividends usually are not accrued as the mere passage of time gives no legal right to the receipt of dividends. Dividends may be recorded on the date of (a) declaration, (b) record, or (c) payment (most common-taxed on receipt), and are classified as nonoperating income on the income statement. Types of Dividends: Assume that an investor owns 100 shares of K Corporation, $100 par value, common stock, which cost $88 per share. 1. Cash Dividends: K Corporation paid a cash dividend of $4 per share. Cash (100 shares * $4 ) $400 Dividend Income $400 (If recorded before date of payment, debit would be to Dividends Receivable.) 2. Property Dividends: K Corporation distributes a property dividend of one share of N Corporation stock for every 10 shares of K Corporation stock held when N Corporation stock is selling at $40 per share. Investments: N Corp. Stock $400 Dividend Income $400 100 shares ---------- = 10 * 1 share * $40 FMV = $400 10 3. Stock Dividends: Usually not income. a. Like Kind: K Corp. distributes a stock dividend of one common share for every ten shares held. Memorandum entry and recomputation of basic per share Total Cost $8,800 ------------- = ------ = $80 per share Total Shares 110 There are now more shares representing the same ownership interests. Individual shareholders' relative positions of ownership interests are unchanged. b. Unlike Kind: K Corp. then declares a stock dividend of one preferred share for every ten common shares held when the preferred sold at $150 per share and the common sold at $85 per share. An allocation of cost is necessary based on the relative fair market values of the different classes of stock. Computation and resulting entry: 110 shares ------------ = 11 preferred shares 10 1,650 P/S 1 shs. * $150 = $1,650 ------- * $8,800 = $1,320 11,000 C/S 110 shs. * $85 = 9,350 9,350 $7,480 ------- ------ * 8,800 = ------ Total Value $11,000 11,000 $8,800 Investments: K Corp. P/S $1,320 Investments: K Corp. C/S $1,320 4. Liquidating Dividends: K Corp. paid a cash dividend of $5 per share when retained earnings accumulated subsequent to the investment acquisition would only support a $3 dividend per share. Cash (110 shs. * $5) $550 Dividend Income (110 shs. * $3) $330 Investment: K Corp. C/S (110 shs. * $2) 220 (The $2 per share is a liquidating dividend representing a return of investment.)

Elements of Financial Statements SFAC 6 Statement of Financial Accounting Concepts No. 6 deals with the elements of financial statements, which are the building blocks with which financial statements are constructed. SFAC 6 defines ten elements that are directly related to measuring the performance and status of an enterprise. The Balance-sheet elements include assets, liabilities, and equity, which describe amounts of resources or claims to resources at a moment in time. The Income Statement elements include income, revenue, expenses, gains. and losses and describe the effects of transactions and other events and circumstances that affect an enterprise during intervals of time. These two classes of elements are related because assets, liabilities, and equity are changed by elements of the other class and at any time. All elements are defined in relation to a particular entity such as a business enterprise, an educational or char ble organization, or a governmental unit. Assets are probable future economic benefits obtained or controlled by a particular enterprise as a result of past transactions or events. An asset has the capacity to contribute to future net cash inflows. A particular enterprise can obtain the benefit and control others' access to it. The transaction or other event giving rise to the enterprise's right to the benefit has already occurred. The common characteristic possessed by all assets and economic resources is "service potential" or "future economic benefit," the capacity to provide services or benefits to the entities that use them. In a business enterprise, that service potential or future economic benefit eventually results in net cash inflows to the enterprise. That characteristic is the primary basis of the definition of assets in this statement. A separate item that reduces or increases the carrying amount of an asset is sometimes found in financial statements. For example, an estimate of uncollectible amounts reduces receivables to the amount expected to be collected, or a premium on a bond receivable increases the receivable to its cost or present value. Those "valuation accounts" are part of the related assets and are neither assets in their own right nor liabilities. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular enterprise to transfer assets or provide services to other enterprises in the future as a result of past transactions or events A liability is a present duty to other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand. The duty obligates a particular enterprise, leaving it little or no discretion to avoid the future sacrifice. The transaction or other event obligating the enterprise has already happened. Uncertainty about economic and business activities and results is pervasive, and it often clouds whether a particular item qualifies as an asset or a liability of a particular enterprise at the time the definitions are applied. The presence or absence of future economic benefit that can be obtained and controlled by the enterprise or of the enterprise's legal, equ ble, or constructive obligation to sacrifice assets in the future can often be discerned reliably only with hindsight. As a result, some items that with hindsight actually qualified as assets or liabilities of the enterprise under the definitions may, as a practical matter, have been recognized as expenses, losses, revenues, or gains or remained unrecognized in its financial statements because of uncertainty about whether they qualified as assets or liabilities of the enterprise or because of recognition and measurement considerations stemming from uncertainty at the time of assessment. Conversely, some items that with hindsight did not qualify under the definitions may have been included as assets or liabilities because of judgments made in the face of uncertainty at the time of assessment. A highly significant practical consequence of the features described above is that the existence or amount (or both) of most assets and many liabilities can be probable but not certain. Estimates and approximations will often be required unless financial statements are to be restricted to reporting only cash transactions. Equity is the residual interest in the assets of an enterprise that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. It involves a relationship between an enterprise and its owners in their ownership capacity rather than as employees, suppliers, customers, lenders, or some other non owner role. Since it ranks after liabilities as a claim to, or interest in, the assets of the enterprise, it is a residual interest. Equity is the same as net assets, the difference between the enterprise's assets and its liabilities. Equity is enhanced or impeded by changes in net assets. Events that affect a business enterprise can be placed into three classes: 1. changes in assets and liabilities not associated with changes in equity 2. changes in assets and liabilities that are accompanied by changes in equity 3. changes in equity that do not affect assets or liabilities. For example, exchanges of assets for other assets. An enterprise may have several classes of equity (for example, one or more classes each of common stock or preferred stock) with different degrees of risk stemming from different rights to participate in distributions of enterprise assets or different priorities of claims on enterprise assets in the event of liquidation. In contrast, a not-for-profit organization has no ownership interest or profit purpose in the same sense as a business enterprise and thus receives no investments of assets by owners and distributes no assets to owners. Rather, its net assets often are increased by receipts of assets from resource providers (contributors, donors, grantors, and the like) who do not expect to receive either repayment or economic benefits proportionate to the assets provided, but who are nonetheless interested in how the organization makes use of those assets and often impose temporary or permanent restrictions on their use. Although the line between equity and liabilities is clear in concept, it may be obscured in practice. Applying the definitions to particular situations may involve practical problems because several kinds of securities issued by business enterprises seem to have characteristics of both liabilities and equity in varying degrees or because the names given some securities may not accurately describe their essential characteristics. For example, convertible debt instruments have both liability and residual interest characteristics, which may create problems in accounting for them. Similarly, the line between net assets and liabilities of not-for- profit organizations may be obscured in practice because donors' restrictions that specify the use of contributed assets may seem to result in liabilities, although most do not. The essence of a not-for- profit organization is that it obtains and uses resources to provide specific types of goods or services, and the nature of those goods or services is often critical in donors' decisions to contribute cash or other assets to a particular organization. Most donors contribute assets (restricted as well as unrestricted) to an organization to increase its capacity to provide those goods or services and receipt of donated assets not only increases the assets of the organization but also imposes a fiduciary responsibility on its management to use those assets effectively and efficiently in pursuit of those service objectives. That responsibility pertains to all of the organization's assets and does not constitute an equ ble or constructive obligation. In other words, a not-for-profit organization's fiduciary responsibility to use assets to provide services to beneficiaries does not itself create a duty of the organization to pay cash, transfer other assets, or provide services to one or more creditors. Rather, an obligation to a creditor results when the organization buys supplies for a project, its employees work on it, and the like, and the organization therefore owes suppliers, employees, and others for goods and services they have provided to it. A donor's restriction focuses that fiduciary responsibility on a stipulated use for specified contributed assets but does not change the basic nature of the organization's fiduciary responsibility to use its assets to provide services to beneficiaries. A donor's gift of cash to be spent for a stipulated purpose or of another asset to be used for a stipulated purpose - for example, a mansion to be used as a museum, a house to be used as a dormitory, or a sculpture to be displayed in a cemetery - imposes a responsibility to spend the cash or use the asset in accordance with the donor's instructions. In its effect on the liabilities of the organization, a donor's restriction is essentially the same as management's designating a specified use for certain assets. That is, the responsibility imposed by earmarking assets for specified uses is fundamentally different, both economically and legally, from the responsibility imposed by incurring a liability, which involves a creditor's claim. Consequently, most donor-imposed restrictions on an organization's use of contributed assets do not create obligations that qualify as liabilities of the organization. Investments by owners are increases in net assets of a particular enterprise resulting from transfers to it from other enterprises of something of value to obtain or increase ownership interests (or equity) in it. Assets are most commonly received as investments by owners, but that which is received may also include services or satisfaction or conversion of liabilities of the enterprise. Distributions to owners are decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease ownership interests or equity in the enterprise. Comprehensive income is the change in equity (net assets) of an enterprise, during a period, from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Over the life of a business enterprise, its comprehensive income equals the net of its cash receipts and cash outlays, excluding cash investments by owners and cash distributions to owners. That characteristic holds whether the amounts of cash and comprehensive income are measured in nominal dollars or constant dollars. Timing of recognition of revenues, expenses, gains, and losses is also a major difference between accounting based on cash receipts and outlays and accrual accounting. Accrual accounting may encompass various timing possibilities - for example, when goods or services are provided or when cash is received. Revenues are inflows or other enhancements of assets of an enterprise or settlements of its liabilities or a combination of both, during a period, from delivering or producing goods, rendering services, or other activities that constitute the enterprise's ongoing major or central operations. Revenues represent cash inflows that have occurred or will eventuate as a result of the enterprise's major operations during the period. Expenses are outflows or other uses of assets or incurrences of liabilities (or a combination of both), during a period, from delivering or producing goods, rendering services, or carrying out other activities that constitute the enterprise's ongoing major or central operations. Expenses represent cash outflows that have occurred or will occur because of the enterprise's major operations during the period. Gains are increases in equity, or net assets, from peripheral or incidental transactions of an enterprise and from all other transactions and other events and circumstances affecting the enterprise, during a period, except those that result from revenues or investments by owners. Losses are decreases in equity (net assets) from peripheral or incidental transactions of an enterprises and from all other transactions and other events and circumstances affecting the enterprise, during a period, except those that result from expenses or distributions to owners. Articulation is a term used to describe the interrelationship of the elements of the financial statements. Some elements reflect aspects of the enterprise at a point in time, at December 31, 19xx, such as assets, liabilities, and equity. The remaining elements of the financial statements describe effects of transactions and other events and circumstances that occur over periods of time. These two types of elements are related in such a way that assets, liabilities and equity are changed by elements of the other type and at any time are their cumulative result, and an increase or decrease in an asset cannot occur without a corresponding increase or decrease in another asset, liability, or equity. The resulting financial statements are, therefore interrelated, even though they include different elements which reflect different characteristics of the enterprise and its activities.

Elements of Stockholders Equity ELEMENTS OF STOCKHOLDERS' EQUITY Contributed Cap l: Cap l Stock (Legal Cap l) Cap l Contributed in Excess of Par or Stated Value Retained Earnings Treasury Stock Accumulated Other Comprehensive Income Cap l Stock Cap l stock can be common or preferred. Preferred stock has one or more preferences over common stock, usual preference is in dividend payment and/or in liquidation. Cap l stock is recorded at: 1. Par Value: Par value is established in the articles of incorporation and constitutes legal cap l. Legal cap l is that portion of corporate cap l required by state statute to be retained in the business to afford creditors a minimum degree of protection. 2. No-Par Value (Stated Value): Stated value can be set by the board of directors when no-par value is established in the articles of incorporation and functions the same as the par value. 3. No-Par Value (No Stated Value): Entire proceeds from the issuance of cap l stock is credited to the cap l stock account and becomes legal cap l. Cap l Contributed Cap l Contributed in Excess of Par Value of Stock (C.C. in Excess) In published statements this element of stockholders' equity is normally shown under one title; however, separate accounts must be maintained in the accounting records by source. Frequently this account is titled "Additional Paid-In Cap l." This title is used to describe numerous accounts kept for record and statement purposes, such as: 1. Contributions paid in by stockholders and subscribers: a. Premiums on par value or stated value stock. b. Conversion of convertible bonds or preferred stock. c. Forfeited part payments on stock subscriptions. d. Assessments on stockholders. e. Donations by stockholders, including gifts of assets and forgiveness of indebtedness. f. Increments arising from cap l stock transactions and changes. (1) Donations of stock. (2) Purchase and resale of treasury stock at a profit. (3) Retirement of stock at a cost less than the amount set up as stated cap l. (4) Conversion of stock of one class into a smaller amount of stock of another class. (5) Reduction of stated or legal cap l. (6) Issuance of stock dividend recognized at market value which exceeds par. 2. Contributed cap l by others, including forgiveness of indebtedness and gifts of assets, such as a plant site given to induce a company to locate in the donor city. Examples of journal entries for issuance of common stock follow: Stock Issued at More Than Par or Stated Value 1. 100 shares of $50 par value common issued at $55. Cash $5,500 Common Stock 5,000 (Legal Cap l) C.C. in Excess 500 2. 100 shares of no-par common, stated value $10, issued at $12. Cash $1,200 Common Stock 1,000 (Legal Cap l) C.C. in Excess 200 3. 200 shares no-par common (no stated value) issued at $12. Cash $2,400 Common Stock 2,400 (Legal Cap l) Stock Issued for Less Than Par Value Illegal in some states. Subscribers face contingent liability if corporation becomes insolvent. Contingent liability generally does not pass to subsequent holder unless he had notice or should have known of it. Discount should never be written off against income or retained earnings. It remains open on books. Show on balance sheet as reduction of cap l contributed in excess or can be netted against premium received on other shares to arrive at total cap l contributed. Because of these factors, stock is rarely issued at a discount. Subscription of Cap l Stock A subscription of cap l stock occurs when an investor contracts to purchase stock, making payment(s) in the future. Usually, a partial payment is made at the time of the contract and the stock is not issued until final payment has been made. When a subscription contract is made: 1. Subscriptions Receivable is debited for the amount of the future payments. Subscriptions receivable is reported as a current asset or as the SEC requires, a contra stockholders' equity account. 2. Common or Preferred Stock Subscribed is credited for the portion of the proceeds representing legal cap l. Common or Preferred Stock Subscribed represents a claim against the unissued stock and is reported in stockholders' equity after the issued common or preferred stock. 3. Additional Paid-in Cap l (in excess of par) is credited for the proceeds in excess of legal cap l. Note that the A.P.I.C. is not identified as subscribed. Example: A company accepts subscriptions for 100 shares of common stock ($10 par value) at $25 per share. The agreement calls for an initial payment of 20% with the remainder to be paid in 60 days. Entry to record subscription: Cash (20% * $2,500) $ 500 Subscriptions receivable: Common stock 2,000 Common stock subscribed (100 * $10 par) $1,000 A.P.I.C. in excess of par 1,500 When final payment is received, the following entries would be made: Cash $2,000 Subscriptions receivable: Common stock $2,000 Common stock subscribed $1,000 Common stock $1,000 Default on Subscription If a subscriber defaults on the subscription contract the accounting treatment depends upon the state law and/or the agreement. The default could result in: 1. Forfeiture of all amounts paid. 2. Refund of amount paid. 3. Partial refund. 4. Issuance of shares in proportion to amount paid for. Regardless of which alternative is applied, the subscription receivable, common stock subscribed and A.P.I.C. applicable to the shares which will not be issued must be removed from the accounts. The remaining credit will depend upon the alternative applied. Using the prior example and assuming the subscriber forfeits any amounts paid, the default would be recorded as follows: Common stock subscribed $1,000 A.P.I.C. in excess of par 1,500 Subscription receivable: Common stock $2,000 A.P.I.C. defaulted subscriptions 500 If the subscriber defaulted and was to receive the proportion of shares paid for, the entry would be as follows: Common stock subscribed $1,000 A.P.I.C. in excess of par ($1,500 * 80%) 1,200 Common stock ($1,000 * 20%) $ 200 Subscription receivable: Common stock 2,000 Shares issued = $500 paid * $25 subscription price = 20 shares. Note that A.P.I.C. in excess of par is charged for the subscribed shares which were not issued (80 shares or 80% of the 100 shares subscribed). Retained Earnings Retained earnings balance is cumulative net income of a corporation from date of incorporation or reorganization, after deducting losses, distributions to stockholders, transfers to cap l accounts, and after accounting for prior period adjustments. Retained earnings include operating profits and other items of net income as included therein by GAAP. Examples of items which are part of net income under GAAP but shown separately on the income statement from operating net income are: 1. Income or loss from discontinued operations 2. Gain or loss on a disposal of a segment of a business 3. Extraordinary items 4. Cumulative effect of a change in method of accounting Sometimes, portions of the retained earnings of a corporation may have been appropriated for special purposes. This would restrict the payment of dividends from such earnings. Generally, to earmark such appropriations, details would be shown as follows: Retained Earnings 1. Free (or unappropriated) 2. Appropriated a. Reserve for contingencies b. Reserve for plant extensions, retirement of preferred stock, etc. The use of the term reserve in this manner is the only proper use of term per AICPA Terminology Bulletin No. 1, Par. 59(3). Reserves for self-insurance may be set up by appropriating retained earnings. As with other appropriations of retained earnings, losses may not be charged thereto. Losses arising from the self-insurance position of the company would be charged to expense with no effect on the reserve for self-insurance. To set up appropriated retained earnings: Retained Earnings $100,000 Reserve for Self-Insurance $100,000 When the reserve is no longer needed, the entry should be reversed. Losses should never be charged against reserve accounts.

Employer's Accounting For Pensions Employer's Accounting For Pensions In reviewing for Pensions, the candidate should focus on the following key points: 1. Terminology (see glossary) 2. Differences between a defined contribution plan and a defined benefit plan. 3. Calculation of pension expense (5 elements-ignore element No.6). 4. Journal entry to record a pension expense and employer funding. 5. Calculation, journal entry and reporting of minimum pension liability. 6. Calculation of actual return on plan assets and the balance in the projected benefit obligation (see worksheet). 7. Pension plan disclosures. (SFAS No.132) Types of Pension Plans * Defined benefit pension plan A pension plan that defines an amount of pension benefit to be provided, usually as a function of one or more factors such as age, years of service, or compensation. Any pension plan that is not a defined contribution pension plan is, for purposes of this Statement, a defined benefit pension plan. * Defined contribution pension plan A plan that provides pension benefits in return for services rendered, provides an individual account for each participant, and specifies how contributions to the individual's account are to be determined instead of specifying the amount of benefits the individual is to receive. Under a defined contribution pension plan, the benefits a participant will receive depend solely on the amount contributed to the participant's account, the returns earned on investments of those contributions, and forfeitures of other participants' benefits that may be allocated to such participant's account. SFAS No. 87 EMPLOYER'S ACCOUNTING FOR PENSIONS In General Statement No.87 applies measurement, recognition and disclosure requirements primarily for a single employer defined benefit pension plan. NET PERIODIC PENSION COST (PENSION EXPENSE) The employer's net periodic pension cost includes: 1. Service cost-The present value of benefits earned by employees during the period according to the pension benefit formula contained within the pension plan. 2. Interest cost-The increase in the projected benefit obligation due to the passage of time. Such interest costs are to be measured based upon rates at which the pension benefits could be effectively settled (PBGC annuity rates and high quality fixed income rates). 3. Actual return on plan assets-Based upon the fair value of plan assets at the beginning and end of the period, adjusted for contributions and benefit payments. Although the actual return is disclosed as a component of pension cost, pension expense will include an amount equal to the expected return in plan assets. The difference between expected return and the actual return is included in the gain or loss component ( No.5) below. 4. Amortization of unrecognized prior service cost - The cost of retroactive benefits is amortized by assigning an equal amount to each future period of service of each employee who is active at the date of the initiation of the plan (or amendment). If essentially all of the employees are inactive, such cost shall be amortized based upon the remaining life expectancy of those participants. The amortization can, alternatively, be computed using a straight-line approach based upon the average remaining service life of the employees or any other rational approach which results in a faster write-off than the service-life approach first discussed above (disclosure of method is required). 5. Amortization of cumulative unrecognized gains or losses using the "corridor" approach. * Gains & Losses consist of the following two items: a. Changes in the amount of the projected benefit obligation or plan assets resulting from experience which is different from what was assumed, or from changes In assumptions. b. The difference between the actual return on plan assets and the expected return on plan assets. * Amortization using the corridor approach: a. The corridor was arbitrarily established by the FASB as 10% of the greater of the beginning period balance in the projected benefit obligation or the market related value of the plan assets. This corridor establishes a threshold for amortization. b. The excess of the beginning of the period cumulative unrecognized gains or losses over the corridor amount is amortized in the same manner as the prior period costs. 6. Amortization of net obligation or net assets at date of implementation-An employer must determine, as of the beginning of the year in which SFAS No.87 is initially applied, both the amount of the projected benefit obligation as well as the fair value of plan assets (plus previously recognized unfunded accrued pension cost or minus previously recognized prepaid pension cost). The differential is amortized over the average remaining service period of employees expected to receive benefits under the plan (or the employer may use 15 years if greater). RECOGNITION OF ASSET AND LIABILITY ON THE BALANCE SHEET Pension Cost If the net pension cost (expense) recognized pursuant to SFAS No.87 exceeds the employer's contribution to the pension plan, the excess is recognized as an accrued pension liability. If the employer contributes more than the net pension cost; an asset, prepaid pension cost, is recognized. Accounting Entries XYZ Corporation adopts a defined benefit pension plan on January 1, 1999, with no retroactive benefits to employees. The company uses a 10% rate as appropriate for settling any projected benefit obligation and the expected return on assets is also projected at 10%. Using the benefits/years of service approach, the actuary has determined a service cost of $300,000 for 1999 and $330,000 for 2000. Accounting entries assuming these amounts are funded: 1999 2000 Pension Expense $300,000 $330,000 Cash $300,000 $330,000 Accounting entries assuming the company funds $275,000 in 1999 and $300,000 in 2000: 1999 Pension expense $300,000 Cash $275,000 Accrued pension liability 25,000 2000 Pension expense computation: Service cost $330,000 Interest on projected benefit obligation 10% x $300,000 30,000 Return on assets-$275,000 * 10% (27,500) $332,500 Pension expense $332,500 Cash $300,000 Accrued pension liability 32,500 Accounting entries assuming the company funds $320,000 in 1999 and $340,000 in 2000: 1999: Pension expense $300,000 Prepaid pension cost 20,000 Cash $320,000 2000: Pension expense computation: Service cost $330,000 Interest on PBO 10% x $300,000 30,000 Return on assets 10% x $320,000 (32,000) $328,000 Pension expense $328,000 Prepaid pension cost 12,000 Cash $340,000 Minimum Pension Liability In addition to the journal entry to record pension cost, the FASB was concerned that a company may need to record an additional pension liability to report a minimum liability on the balance sheet. After much discussion the FASB decided that the minimum liability should be the excess of the accumulated benefit obligation over the fair value of the plan assets at the end of the accounting period. The offset to the recording of the additional pension liability is a debit to deferred pension cost-intangible asset. This deferred pension cost account is limited to the amount of the unrecognized prior service cost. If the additional pension liability which must be recorded is greater than the unrecognized service cost, the excess is recognized net of tax as an other comprehensive income account called excess of additional pension liability over unrecognized prior service cost. The change in the account is shown in the calculation of comprehensive income and the accumulated balance in the account is reported net of tax as a part of accumulated other comprehensive income in the equity section of the balance sheet. EXAMPLE OF MINIMUM PENSION LIABILITY ABC Company provides the following information relative to its defined benefit plan for the years 1999 and 2000. December 31 1999 2000 Accrued Pension Liability $20,000 -0- Prepaid Pension Cost -0- $ 10,000 Unrecognized Prior Service Cost $75,000 $ 60,000 Minimum Pension Liability Accumulated Benefit Obligation $80,000 $160,000 Fair Value of Plan Assets 90,000 120,000 Minimum Pension Liability -0- $ 40,000 Instruction: Prepare the journal entry required by the minimum pension liability calculation. Solution: 1999 A journal entry is not required because the fair value of the plan assets exceed the accumulated benefit obligation. The FASB does not permit the recognition of a net investment in the pension plan when the plan assets exceed the pension obligation. ABC's balance sheet would report an accrued pension liability of $20,000. 2000 JE Intangible Asset-Deferred Pension Cost $50,000 Additional Pension Liability $50,000 * * Minimum Liability required $40,000 Plus balance in prepaid pension cost 10,000 Additional Pension Liability $50,000 ABC's balance sheet would report the following balances: Intangible Asset- Deferred Pension Cost $50,000 Pension Liability $40,000 Note: The additional pension liability account is netted against the prepaid pension cost account for a balance of $40,000. PENSION DISCLOSURES The pension plan and post-retirement benefit plan disclosures were combined in SFAS No.132. These disclosures are listed after the section on post-retirement benefits on page 14-25. Comprehensive Illustration XYZ Corp. implements a noncontributory defined benefit pension plan on January 1, 1999, and the company anticipates relatively constant employment levels in the future with a turnover rate approximating 5% each year. The independent trustee administering the plan indicates a prior service cost of $1,000,000 at 1/1/99. The settlement rate as well as the rate of return on assets is 8%. The average remaining service life of the employees is 20 years and the company uses a straight-line approach to amortization. Additional information for the years ended December 31: 1999 2000 Annual service cost $450,000 $500,000 Accumulated benefit obligation, 12/31 $1,400,000 $2,000,000 Fair value of plan assets $500,000 *$1,100,000 Company cash contribution (made 12/31) $500,000 $550,000 * reflects gain of $10,000, immaterial, therefore not amortized Determination of pension expense: 1999 2000 1. Service cost $450,000 $500,000 2. Interest on projected benefit obligation 8% x 1,000,000 + 8% x $1,530,000 80,000 122,400 3. Earnings on assets 8% x 500,000 (40,000) 4. Amortization of prior service cost 5% x 1,000,000 50,000 50,000 5. Gains and losses (not greater than 10% of P.B.O.) 0 0 Expense $580,000 $632,400 Asset-Liability to be Recognized 1999 2000 Accrued pension at January 1 $ - 0 - $( 80,000) Pension expense (580,000) (632,400) Cash contribution 500,000 550,000 Accrued pension liability at December 31, 1999 $( 80,000) Accrued pension liability at December 31, 2000 $(162,400) 1999 2000 Computation of additional liability: Plan assets December 31 $ 500,000 $1,100,000 Accumulated benefit obligation 1,400,000 2,000,000 Minimum pension liability (900,000) (900,000) Accrued pension liability (above) 80,000 162,400 Additional liability required $ 820,000 $737,600 Intangible asset to be recognized (adjustment) 820,000 $(82,400) Journal entries: DR CR Dec. 31, 1999 Pension expense $580,000 Cash $500,000 Accrued pension liability 80,000 Deferred pension cost-intangible asset$820,000 Additional pension liability $820,000 To establish additional liability required Dec. 31, 2000 Pension expense $632,400 Accrued pension liability $ 82,400 Cash 550,000 Additional pension liability $82,400 Deferred pension cost-intangible asset $82,400 To adjust additional pension liability required ILLUSTRATION FOR SFAS No.130-COMPREHENSIVE INCOME Using the same illustration assume that at December 31, 1999, the unrecognized prior service cost is $750,000 instead of $950,000 and that the tax rate is 30%. In this case the journal entry to establish the additional pension liability becomes more complicated. The original entry was a debit to deferred pension cost for $820,000 and a credit to additional pension liability for $820,000. Under the new assumption, the debit to deferred pension cost - intangible asset cannot exceed the unrecognized prior service cost of $750,000. The additional debit of $70,000 is to an account called excess of additional pension liability over unrecognized prior service cost. The journal entry is as follows: December 31, 1992 JE Deferred pension cost - Intangible asset $750,000 Excess of additional pension liability over unrecognized prior service cost 70,000 Additional pension liability $820,000 The change in the excess of additional pension liability over unrecognized prior service cost account is reported as other comprehensive income net of the 30% tax effect in the calculation of comprehensive income (No.130). The accumulated balance in the account is included net of taxes as a part of the accumulated other comprehensive income shown in the equity section of the statement of financial position. AMORTIZATION OF CUMULATIVE UNRECOGNIZED GAINS AND LOSSES (CORRIDOR METHOD) In our comprehensive example the amortization gains or losses (step 5) was zero because the cumulative unrecognized gains or losses did not exceed the "corridor" (threshold) account. Please use the following example to prepare for the amortization calculation. Example: Magic Corporation obtained the following information from its actuary. All amounts given are as of 1/1/99 (beginning of the year). 1/1/99 Projected benefit obligation $1,500,000 Market-related asset value $1,600,000 Cumulative unrecognized loss $200.00 Average remaining service period 5 years Required: What amount of the cumulative unrecognized net loss should be amortized (step 5) as part of pension expense in 1999? Solution: Step 1- Calculate the corridor amount. 10% of the greater of the January 1 projected benefit obligation or market related asset value. 10% X $1,600.000 = $160,000 corridor Step 2- Calculate the amount to be amortized by comparing the cumulative unrecognized loss to the corridor. $200,000 - $160,000 = $40,000 amount to be amortized. Step 3- Calculate the amortization amount to be included in the 1999 pension expense by dividing the amortization by the average remaining service period. $40,000 / 5 years = $8,000 (the 1999 amortization).

EPS Calculation EPS IN GENERAL In 1997 the FASB issued SFAS 128 on computing earnings per share. Its purpose is to simplify the calculation of EPS and make it more comparable with international accounting standards. The objective of FASB 128 is to measure the performance of an entity over the reporting period. The statement requires the reporting of a Basic EPS for companies with a simple cap l structure and a Basic EPS plus a Diluted EPS for companies with a complex cap l structure. BASIC EARNINGS PER SHARE SFAS 128 requires all public companies to disclose Basic EPS if they have a simple cap l structure with no potential common shares from convertible securities, stock options, warrants, or contingent shares. Basic EPS must be reported on the face of the income statement for income from continuing operations and net income. The Basic EPS amounts for discontinuing operations, extraordinary items and the cumulative effect of the changes in accounting principles must be disclosed in the face of the income statement or in the notes to the financial statements. Computation of Basic Earnings Per Share Net Income Available to Common Shareholders Basic EPS = ------------------------------------------------------ Weighted Average Number of Common Shares Outstanding Net Income Available to Common Shareholders Income available to common shareholders is net income less preferred dividends for declared non cumulative preferred stock. For cumulative preferred stock the current year preferred dividend is deducted whether it is declared or not. If the company has preferred stock whose dividend is cumulative only if earned, it must deduct the dividend earned in calculating Basic EPS. Net Income - Preferred Dividends Basic EPS = ----------------------------------------------------- Weighted Average Number of Common Shares Outstanding Weighted Average Number of Common Shares Outstanding Takes into account the number of shares outstanding during the period, weighted to reflect the portion of the period outstanding. Example: T Corporation has 100,000 common shares outstanding on January 1 of the current year and issued 6,000 shares on March 1. Weighted average shares outstanding for the quarter ended March 31: 100,000 + 1/3 (6,000) = 102,000 (3/1 to 3/31 = 1/3 of period 1/1 to 3/31) For the 6 months ended June 30: 100,000 + 4/6 (6,000) = 104,000 (3/1 to 6/30 = 4/6 of period 1/1 to 6/30) For the year ended December 31: 100,000 + 10/12 (6,000) = 105,000 (3/1 to 12/31 = 10/12 of period 1/1 to 6/30) If T Corporation had reacquired 6,000 shares on March 1 of the current year, the weighted average shares outstanding for the same periods would be: Quarter ended March 31 - 94,000 + 2/3 (6,000) = 98,000 (1/1 to 3/1 = 2/3 of period) 6 months ended June 30 - 94,000 + 2/6 (6,000) = 96,000 (1/1 to 3/1 = 2/6 of period) Year ended December 31 - 94,000 + 2/12 (6,000) = 95,000 (1/1 to 3/1 = 2/12 of period) * Stock dividends and stock splits require retroactive adjustment to current equivalent shares as of the beginning of the period(s) being presented for the determination of weighted average shares outstanding. If such changes occur after the close of the period, but before the financial statements are completed, the computation of earnings per share should be based on the new number of shares because the reader's primary interest is presumed to be related to the current cap lization. Example: The X Corporation completed the following common stock transactions during the period January 1, 1995, through July 1, 1999: Date Transaction No. of Shares 1/1/95 Issued (original issue) 1,000 1/1/96 Stock dividend to preferred stockholders 50 5/1/97 Shares exchanged for stock of another corporation 600 4/1/98 3 for 2 stock split 2/1/99 100% stock dividend to common stockholders 7/1/99 Shares issued to preferred stockholders in exchange for preferred on a 2 for 1 basis 442 Compute the number of shares outstanding, weighted average shares outstanding, and current equivalent shares outstanding for each year. Solution: * Shares outstanding: 1995 1996 1997 1998 1999 Outstanding beginning of year -0- 1,000 1,050 1,650 2,475 1/1/95 issued 1,000 1/1/96 dividend to P/S 50 5/1/97 exchanged 600 4/1/98 3:2 split (1/2) 825 2/1/99 dividend to C/S 2,475 7/1/99 exchanged 442 1,000 1,050 1,650 2,475 5,392 * Weighted average shares outstanding: 1995 1996 1997 1998 1999 O/S beginning of year (100%) -0- 1,000 1,050 1,650 2,475 '95 1,000 from 1/1 = 100% 1,000 '96 50 from 1/1 = 100% 50 '97 600 from 5/1 = 8/12 400 '98 825 split retroactive to 1/1 825 '99 2,475 dividend retroactive to 1/1 2,475 442 from 7/1 = 6/12 221 Weighted Average outstanding 1,000 1,050 1,450 2,475 5,171 Current equivalent shares outstanding: 1995 1996 1997 1998 1999 Weighted average shares o/s *1,000 *1,050 *1,450 2,475 5,171 Adjustment for 3:2 split in 1998 (1/2) 500 525 725 - - Current equivalent shares for 1998 1,500 1,575 2,175 2,475 - Adjustment for 100% stock dividend in 1999 1,500 1,575 2,175 2,475 - Current equivalent shares for 1999 3,000 3,150 4,350 4,950 5,171

Extraordinary Items-APB No. 30 Extraordinary Items Criteria Extraordinary items should be both a. Unusual and b. Infrequent Unusual Nature The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. The environment in which the entity operates is a primary consideration in determining whether an underlying event or transaction is abnormal and significantly different from the ordinary and typical activities of the entity. This includes the characteristics of the industry, the geographical location of operations, and nature and extent of governmental regulation. Unusual nature is not established by the fact that an event or transaction is beyond the control of management. Infrequency The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. Determining the probability of recurrence of a particular event or transaction in the foreseeable future should take into account the entity environment. A transaction of an entity not reasonably expected to recur in the foreseeable future is considered to occur infrequently. By definition, extraordinary items occur infrequently. Case Examples of Extraordinary Items Events or transactions which would meet both criteria in the circumstances described are: (1) A large portion of a tobacco manufacturer's crops are destroyed by a hailstorm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare. (2) A steel fabricating company sells the only land it owns. The land was acquired ten years ago for future expansion, but shortly thereafter the company abandoned all plans for expansion and held the land for appreciation. (3) A company sells a block of common stock of a publicly traded company. The block of shares, which represents less than 10% of the publicly held company, is the only security investment the company has ever owned. (4) An earthquake destroys one of the oil refineries owned by a large multinational oil company. The following are illustrative of events or transactions which do not meet both criteria in the circumstances described and thus should not be reported as extraordinary items: (5) A citrus grower's Florida crop is damaged by frost. Frost damage is normally experienced every three or four years. The criterion of infrequency of occurrence taking into account the environment in which the company operates would not be met since the history of losses caused by frost damage provides evidence that such damage may reasonably be expected to recur in the foreseeable future. (6) A company which operates a chain of warehouses sells the excess land surrounding one of its warehouses. When the company buys property to establish a new warehouse, it usually buys more land than it expects to use for the warehouse with the expectation that the land will appreciate in value. In the past five years, there have been two instances in which the company sold such excess land. The criterion of infrequency of occurrence has not been met since past experience indicates that such sales may reasonably be expected to recur in the foreseeable future. (7) A large diversified company sells a block of shares from its portfolio of securities which it has acquired for investment purposes. This is the first sale from its portfolio of securities. Since the company owns several securities for investment purposes, it should be concluded that sales of such securities are related to its ordinary and typical activities in the environment in which it operates and thus the criterion of unusual nature would not be met. (8) A textile manufacturer with only one plant moves to another location. It has not relocated a plant in twenty years and has no plans to do so in the foreseeable future. Notwithstanding the infrequency of occurrence of the event as it relates to this particular company, moving from one location to another is an occurrence which is a consequence of customary and continuing business activities, some of which are finding more favorable labor markets, more modern facilities, and proximity to customers or suppliers. Therefore, the criterion of unusual nature has not been met and the moving expenses (and related gains and losses) should not be reported as an extraordinary item. Another example of an event which is a consequence of customary typical business activities (namely financing) is an unsuccessful public registration, the cost of which should not be reported as an extraordinary item. Items Not Extraordinary Not extraordinary because they are usual and can be expected to recur a. Write-down or write-off of receivables, inventories, equipment leased to others, and other intangible assets. b. Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations. c. Gains or losses on disposal of segment of a business. d. Other gains or losses from sale or abandonment of property, plant, or equipment used in the business. e. Effects of a strike, including those against competitors and major suppliers. f. Adjustment of accruals on long-term contracts. Rarely, an event such as the above may also meet the extraordinary criteria of unusualness and infrequency of occurrence. If so, gains and losses such as (a) and (d) above should be included in the extraordinary items if they are the direct result of a major casualty, an expropriation or a prohibition under a newly enacted law or regulation. Any portion of such losses that would have resulted from a valuation of assets on a going concern basis should not be included in extraordinary items. FASB No. 145 Historically, gains or losses on retirement of debt and gains or losses by the debtor on restructuring of debt have been mandated by the FASB as extraordinary items. This changed with the issuance of FASB No. 145. FASB No. 145 considers these gains or losses to be ordinary unless the transaction meets the criteria established by APB No. 30 of being both unusual and infrequent. Disclosure of Unusual or Infrequently Occurring Items A material event or transaction meeting one but not both of the extraordinary item criteria (unusualness and infrequency) should be reported as a separate component of income from continuing operations. The nature and financial effects of each event or transaction should be disclosed on the face of the income statement or in the notes to the financial statements.

FASB 95 Purpose Statement of Cash Flows (FASB Statement No. 95) A Statement of Cash Flows is a financial statement which shows the cash receipts, cash payments and net change in cash from the operating, investing, and financing activities of an enterprise during a period, in a manner that reconciles beginning and ending cash balances. FASB Statement No. 95 requires that all business enterprises include a statement of cash flows in a complete set of financial statements. When both the balance sheet (financial position) and income statement (results of operations) are provided, a statement of cash flows must be provided for each period for which an income statement is provided. A statement of cash flows is generally not required for defined benefit pension plans and other employee benefit plans; investment companies subject to the Investment Company Act of 1940; and trusts or similar funds (SFAS No. 95 and No. 102). The theoretical foundation for the statement of cash flows and its classifications of cash flows is established in FASB Concepts No. 1 and No. 5. Concept No. 1 states that, "financial reporting should provide information to help ... (external users) ... in assessing the amount, timing, and uncertainty of prospective cash receipts..." and that, "expected cash flows to investors and creditors are related to expected cash flows to the enterprise." Concept No. 5 of the FASB states, "Classification in financial statements facil tes analysis by grouping items with essentially similar characteristics and separating items with essentially different characteristics. Analysis aimed at objectives such as predicting amounts, timing, and uncertainty of future cash flows requires financial information segregated into reasonably homogeneous groups." Previous accounting practice has been to segregate cash (or funds) flow by sources and uses. The major disadvantages of this grouping are that it does not focus on categories of related cash flows, and has resulted in a lack of comparability among enterprises due to differing definitions of funds, reporting formats and/or classification of transaction. It is also contended that this classification of cash flows frequently explains little concerning an enterprise's ability to meet obligations, pay dividends, or needs for external financing. To implement the guidelines established in the FASB concepts and to promote consistent, comparable reporting by enterprises, the FASB decided that cash flows must be grouped according to operating, investing and financing activities, thereby enabling significant relationships within and among the three types of enterprise activities to be evaluated. PURPOSE OF STATEMENT The primary purpose of the Statement of Cash Flows is to provide external users with relevant information concerning an enterprise's gross cash receipts and payments during a period. This information, if used with related disclosures and information in the other financial statements, should help external users to assess: 1. The enterprise's ability to generate positive net cash flows in the future 2. The enterprise's ability to meet its obligations and pay dividends 3. The enterprise's need for external financing 4. The reasons for differences between net income and associated cash receipts and payments 5. The effects on financial position of both cash and non-cash investing and financing transactions during the period. Focus on Cash and Cash Equivalents The primary focus of the statement is on gross cash receipts and payments. However, enterprises commonly invest temporarily idle cash as part of their cash management activities, purchasing and selling shortterm, highly liquid investments such as treasury bills, commercial paper and money market funds. These investments are referred to as cash equivalents and are usually reported with cash on the balance sheet. Whether cash is on hand, on deposit or invested in short-term financial instruments that are readily convertible to known amounts of cash is largely irrelevant to users' assessment of liquidity and future cash flows. Because these transactions relate to cash management activities rather than the operating, investing and financing activities of the enterprise and because the distinction between cash and cash equivalents is largely irrelevant to external users, the details of these transactions are not reported in a statement of cash flows and the focus of the statement is changed to explain the change in cash and cash equivalents. Requirements for cash equivalents: Cash equivalents are short-term, highly liquid investments that are both: a. Readily converted to known amounts of cash b. So near maturity that they present insignificant risk of change in value because of changes in interest rates. Generally, only investments with original maturities (to the enterprise holding the investment) of three (3) months or less qualify under this definition. Furthermore, the investment should relate to the cash management activities of the enterprise (investment of temporarily idle cash balances) rather than its investing activities (such as bank's or investment company's trading as part of their investment portfolio). Enterprises must develop a clear and consistent policy for determining which short-term highly liquid investments, that satisfy the above criteria for cash equivalents are, and are not treated as cash equivalents for statement purposes. This policy must be disclosed in the footnotes to the financial statements. Any change in the policy should be treated as a change in accounting principle that will require a company to restate financial statements presented for comparative purposes. REQUIREMENTS: STRUCTURE AND DISCLOSURES 1. The statement shall use descriptive terms such as cash or cash and cash equivalents rather than ambiguous terms such as funds. 2. The statement shall group and classify cash receipts and cash payments as resulting from operating, investing or financing activities of the enterprise. 3. Generally, cash receipts and payments must be presented as gross amounts rather than as net changes in related balance sheet amounts. Exception: Net amounts of related cash receipts and payments may be used for: a. When the enterprise is substantively holding or disbursing cash on behalf of its customers (demand deposits of banks, customer accounts payable of a broker-dealer). b. Investments (other than cash equivalents), loans receivable (including credit card receivables), and debt, providing that the original maturity of the asset or liability is three months or less. (Because the turnover is quick, the amounts are large, and the maturities are short, information on gross receipts and payments is deemed no more relevant than information about only the net changes.) 4. The statement shall report net cash provided or used by operating, investing and financing activities and the net effect of those flows on cash and cash equivalents during the period in a manner that reconciles beginning and ending cash and cash equivalents. 5. The total amounts of cash and cash equivalents at the beginning and end of the period shown in the statement of cash flows shall be the same amounts as similarly titled line items or subtotals shown on the balance sheet as of those dates. 6. A reconciliation of net income to net cash flow from operating activities shall be provided regardless of whether the direct or indirect method of reporting net cash flow from operating activities is used. The reconciliation shall separately report all major classes of reconciling items. * If the direct method is used, the reconciliation shall be provided in a separate schedule. * If the indirect method is used, the reconciliation may be either reported within the statement of cash flows or provided in a separate schedule, with the statement of cash flows reporting only the net cash flow from operating activities. In addition, if the indirect method is used, cash payments for interest (net of amounts cap lized) and income taxes during the period shall be provided in related disclosures. 7. Noncash investing and financing activities that affect recognized assets or liabilities shall be reported in related disclosures (either narrative or summarized in a schedule). For transactions that are part cash and part noncash, only the cash portion shall be reported in the statement of cash flows. The related disclosures shall clearly describe the cash and noncash aspects of such transaction. 8. Cash flow per share shall not be reported in financial statements. Neither cash flow per share, nor any component thereof, is an acceptable alternative to net income or earnings per share as a measure of performance. 9. An enterprise shall disclose its policy for determining which investments are treated as cash equivalents.

FASB Conceptual Framework FASB CONCEPTUAL FRAMEWORK The Financial Accounting Standard Board's conceptual framework consists of five statements identified as Statements of Financial Accounting Concepts "SFAC" 1, 2, 4, 5, and 6. SFAC 3 was superseded by SFAC 6. SFAC 4 deals with non-business organizations. The ideas contained in the conceptual framework for the most part are normative in nature, that is they suggest what financial reporting should be rather than what it currently is, and as a result there is some discrepancy with current accounting practice. Statements of Financial Accounting Concepts are issued by the FASB as guidance in setting accounting principles but are not equivalent to Statements of Financial Accounting Standards. A conceptual statement does not set generally accepted accounting principles but rather address certain issues. Among the major ones : Objectives of Financial Reporting by Business Enterprises Qual tive Characteristics of Accounting Information Elements of Financial Statements of Business Enterprises Recognition and Measurement in Financial Statements of Business Enterprises OBJECTIVES OF FINANCIAL REPORTING Statement of Financial Accounting Concepts No. 1 establishes and identifies three major objectives of general purpose external financial reporting. The objectives are stated in terms of financial reporting: Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. Investors and creditors include those users who deal directly with an enterprise as well as those who deal through intermediaries. The information should help in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. The prospects for those cash receipts are affected by an enterprise's ability to generate enough cash to meet its obligations when due and its other cash operating needs, to reinvest in operations, and to pay cash dividends and may also be affected by perceptions of investors and creditors generally about that ability, which affect market prices of the enterprise's securities. Thus, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise. Financial reporting should provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners' equity), and the effects of transactions, events, and circumstances that change resources and claims to those resources. In other words, investors, creditors, and others should be able to identify the enterprise's financial strengths and weaknesses and assess its liquidity and solvency. They should be able to measure the enterprise's performance whose primary focus is information about earnings and its components. Information is based on accrual accounting. Information is provided about management's stewardship function. Information is not designed to measure the value of a business. Users make their own decisions, the information is to aid them. Management should identify events and circumstances not directly reported in the financial statements and should explain the financial effects of these on the enterprise. QUAL TIVE CHARACTERISTICS OF ACCOUNTING INFORMATION Statement of Financial Accounting Concepts No. 2, defines the characteristics which make accounting information useful. These characteristics guide the selection of accounting policies from available alternatives. The qual tive characteristics of accounting information are those that make the information useful to users in the decision-making process. These characteristics are the basis for evaluating the information against the cost of providing and using it and help distinguish more useful information from that which is less useful. The qual tive characteristics of accounting information should be used when faced with different alternatives. There is a hierarchy of desirable qual tive characteristics of accounting information. HIERARCHY OF ACCOUNTING QUALITY Users of Accounting Information DECISION MAKERS Pervasive Constraint BENEFIT > COSTS User Specific Qualities UNDERSTANDABILITY Primary Decision Specific Qualities DECISION USEFULNESS | |-----------------------| RELEVANCE | REALIBILITY Ingredients of Primary Qualities / \ | / | \ / TIMELINESS | VERIFIABILITY | | --------| | ------------ | PREDICTIVE FEEDBACK / | REPRESENTATIONAL VALUE VALUE | | FAITHFULNESS | NEUTRALITY | Secondary Qualities COMPARABILILTY CONSISTENCY Threshold for Recognition MATERIALITY Primary Characteristics The primary qual tive characteristics are relevance and reliability. Relevance: To be relevant to investors, creditors, and other users, accounting information must be capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations reducing uncertainty about future events. Unless information is useful in making decisions, there is no reason to report it. While accuracy of information is important, totally accurate information would not be useful if it did not pertain to the decision being made. Reliability: To be reliable, investors, creditors and other users must be able to depend on accounting information to accurately represent the economic conditions or events that it purports to describe. Relevance has three ingredients: Predictive value: information can make a difference in decisions by improving the decision makers' capacity to predict. Feedback value: confirming or correcting previous expectations. Timeliness: To be useful, information must be timely otherwise the information is irrelevant for the decision process. Reliability has three ingredients Verifiability: Accounting information must be verifiable, that is, several people, making independent evaluations, are likely to obtain the same measures. In other words, there would be a high degree of consensus among independent measurers. Representational faithfulness: What it is described faithfully discloses the information it represents. Neutrality: This means rule makers should be concerned with the relevance and reliability of the resulting information, not the effect a new rule may have on a particular interest. Since there are many users of financial accounting information, a general purpose approach is more relevant. The financial statements and footnotes present a complete picture of the current financial position and changes over time, under the assumption that each user will select the elements most relevant to that users purposes. Information must be trusted to be useful. Trust results from belief that the information is representationally faithful, that is, it is what it claims to be. Financial accounting data is usually based on source documents which can be examined again. This verifiability enhances the reliability of the information. To be relevant, information must have either predictive value or feedback value. To be reliable, information must be neutral. However, sometime the most relevant information may not be the most reliable. For example, future values of assets might be the most relevant information for certain decisions if they could be determined objectively, but they cannot be. Therefore, more objective information based on actual historical transactions is presented under generally accepted accounting principles. Several of the concepts which are included in the hierarchy are closely related to the primary concepts of relevance and reliability. Secondary Characterstics The secondary qual tive characteristics are comparability and consistency. Comparability: Users evaluate accounting information by comparison. Similar companies should account for similar transactions in similar ways. Operating trends should not be disguised by changing accounting methods. Comparability indicates that the information can be compared to other data in order to identify similarities and differences and allow users to make meaningful comparisons between enterprises Consistency: A goal of this concept is comparison of one company's information from one period to the next. The application of methods over time increases the informational value of comparisons and it indicates that accounting policies and procedures remain unchanged from period to period. There are two constraints related to the usefulness of accounting information. Cost/Benefit: The usefulness and benefit to be derived from having certain information must exceed the cost of providing it. The cost/benefit pervasive constraint states that unless the benefits to be derived exceed the costs of providing that information, it should not be provided. Materiality: Is a consideration if it is probable that a person relying on certain information will be influenced in making investment or credit decisions by an error or omission. The materiality of an item must be considered. A small amount, considered immaterial in normal transactions, might influence users of the information when it pertains to an unusual item. In order to be useful to a particular individual, the information must be understandable. Understandability indicates that a user is able to comprehend the information. If a user does not comprehend the information, it creates a necessity for the user to find help in interpreting the information. Financial information is a tool and is useful only if understood by users of it. The FASB has attempted to develop standards that relate to general purpose of decision makers and their abilities to understand financial information. In other words, the most relevant, reliable, and timely information would be useless if it were presented in a manner that isn't understandable. There must be agreement on accounting methods followed and sufficient explanations to allow a user to comprehend the message.

FASB Statement 115 FASB STATEMENT 115 Defined ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES This statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and all investments in debt securities. The fair value of an equity security is readily determinable if sales prices are currently available on a registered securities exchange, publicly reported over-the-counter market, or comparable foreign market. SFAS 115 does not apply to 1) investments accounted for under the equity method nor investments in consolidated subsidiaries; 2) enterprises whose specialized accounting practices include accounting for substantially all investments at market or fair value, such as brokers and dealers in securities, defined benefit pension plans and investment companies; 3) not-for-profit organizations. FASB 115 Requirements: At acquisition, investments in equity securities with readily determined fair values, and all investments debt securities must be classified into one of the following three categories and accounted for as follows: 1. Held to Maturity: Debt securities that the entity has the positive intent and ability to hold to maturity are classified as held-to- maturity securities and are reported at amortized cost. On a classified balance sheet, individual held-to-maturity securities should be classified as current assets or noncurrent assets (investments), as appropriate for the individual security. 2. Trading: Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and are reported at fair value, with unrealized holding gains and losses included in earnings. All trading securities should be classified as current asssets on a classified balance sheet. 3. Available for Sale: Debt and equity securities not classified either as held-to-maturity securities or trading securities are classified as available for sale securities and are reported at fair value. On a classified balance sheet, individual available-for-sale securities should be classified as current assets or noncurrent assets (investments), as appropriate for the individual security. SFAS 130 SFAS 130 "Reporting Comprehensive Income," amends SFAS s to require that unrealized holding gains and losses on securities classified as available-for-sale (previously reported as a separate component of stockholders' equity) be reported in comprehensive income as a component of other comprehensive income. Reporting changes re: Securities classified as Available-for-Sale: 1. The change in the unrealized holding gain/loss for the period is reported as a component of other comprehensive income in reporting comprehensive income. This includes: a. The unrealized holding gain/loss for the period; b. Reversal of previously recorded unrealized holding gain/loss for securities sold, (referred to as a reclassification adjustment in the computation of other comprehensive income). 2. The total other comprehensive income for the period is transferred to accumulated other comprehensive income which is reported as a separate element of equity. The balance of the unrealized holding gain/loss must be disclosed. Refer to Chapter 12 for alternative formats for reporting comprehensive income and disclosure of accumulated other comprehensive income. Transfers Between Categories Transfers Between Categories The transfer of a security between categories must be accounted for at fair value. At the date of transfer, a security's unrealized holding gain or loss is accounted for as follows: Transfer Required accounting From Trading Unrealized holding gain or loss at the date of transfer has already been recognized in earnings and shall not be reversed. To Trading Unrealized holding gain or loss at the date of transfer must be recognized in earnings immediately. To Available for Unrealized holding gain or loss at the date of transfer Sale From Held to must be recognized as a separate component of other Maturity comprehensive income. To Held to Maturity Unrealized holding gain or loss at the date of transfer From Available for will continue to be reported as a separate component in Sale stockholders' equity, but will be amortized over the remaining life of the security as an adjustment of yield (in a manner consistent with the amortization of any premium or discount). The use of fair value to record the transfer of debt securities (to HTM) may create a premium or discount on the investment (fair value vs. face value) that would be amortized as an adjustment of yield (interest income) over the life of the investment. The amortization of the unrealized holding gain or loss will offset or mitigate the effect on interest income of the amortization of any such premium or discount. Impairment of Securities (other than Temporary Declines): For individual securities classified as Available-for-Sale and Held-to- Maturity, a determination must be made as to whether a decline in fair value below amortized cost basis is other than temporary. If the decline is judged to be other than temporary (permanent), the cost basis of the individual security shall be written down to fair value as a new cost basis and the amount of the write-down will be accounted for as a realized loss (included in earnings for the period). The new cost basis will not be changed for subsequent recoveries in fair value. For securities classified as available-for-sale, subsequent increases and decreases (other than permanent decreases) in fair value will be included in unrealized holding gains and losses reported in the separate component of equity. Income Recognition Unrealized holding gains and losses: * Trading securities-included in earnings. * Available-for-sale securities (including those classified as current assets) - excluded from earnings and the current change reported as other comprehensive income and the cumulative changes reported as accumulated other comprehensive income in the stockholders' equity. Dividend and Interest Income: SFAS 115 does not affect the methods used for recognizing and measuring dividend and interest income. Dividends and interest income, including amortization of any premium or discount arising at acquisition, for all three classifications of investments continue to be included in earnings. Gains and Losses: Realized gains and losses for securities classified as available-for-sale and held-to-maturity continue to be reported in earnings. FASB 115 Disclosures a) As of the date of each balance sheet presented, the following segregated for securities classified as available-for-sale and held- to-maturity: 1. Aggregate fair value. 2. Gross unrealized holding gains and losses; and 3. Amortized cost basis by major security type. b) As of the date of the most recent balance sheet presented, information about the contractual maturities of debt securities, segregated for securities classified as available-for-sale and held- to-maturity. c) For each period for which an income statement is presented: 1. Proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales. 2. Basis on which cost was determined for gain or loss computation (specific identification, average, or other). 3. Gross gains and losses included in earnings from transfers from available-for-sale trading securities. 4. Change in net unrealized holding gain or loss on available- for-sale securities included as a separate component in other comprehensive income. 5. Change in net unrealized holding gain or loss on trading securities that has been included in earnings during the period. 6. For sale or transfer of held-to-maturity securities, the amortized cost, realized or unrealized gain or loss and the circumstances leading to the decision to sell or transfer the securities. The individual amounts for the three categories of securities do not have to be presented in the balance sheet, if the information is included in the notes to the financial statements. Overview FASB 115 Marketable Equity and Debt Securities Includes: All Investments in Debt Securities Investments in Equity Securities that have a readily determinable fair value (listed on a publicly reported stock exchange) CLASSIFICATIONS TRADING AVAILABLE FOR SALE HELD TO MATURITY SECURITIES SECURITIES SECURITIES | | | | | | A. Current Assets A. Current or Noncurrent A. Positive intent and Assets and ability to hold hold to Maturity | | | | | | B. Report at Fair B. Report at Fair Value B. Current or Value Noncurrent Asset | | | | | | C. Unrealized Gains/ C. Unrealized Gains/Losses C. Report at Carrying Losses Are Reported Are Reported as Other Value On Income Statement Comprehensive Income and Transferred to Accumulated Other Comprehensive Income, a Stockholders' Equity Account | | D. Amortize Premium or Discount | | E. Do Not Record Unrealized Gains or Losses

Financial Forecasts And Projections PROSPECTIVE FINANCIAL INFORMATION)-SSAE No. 10, Section 301 The AICPA in its 1998 content specification outline added Prospective Financial Information to its coverage of FARE. Definitions Prospective Financial Statements * Include: a. Financial forecast b. Financial projections c. Summaries of significant assumptions d. Accounting policies * Exclude: a. Pro forma financial statements b. Partial presentations c. Financial statements for periods that have expired d. Statements used solely in support service litigation Financial Forecast * Prospective financial statements that present, to the best of the responsible party's knowledge and belief, an entity's expected financial position; results of operations; and changes in financial position. * A financial forecast is based on assumptions reflecting conditions that are expected to exist and the course of action that is expected to be taken. * A financial forecast may be expressed in specific monetary amounts or as a range. Financial Projections * Prospective financial statements that present, to the best of the responsible party's knowledge and belief, (given one or more hypothetical assumptions) an entity's expected financial position, results of operations, and cash flows. * A financial projection is sometimes prepared to present one or more hypothetical courses of actions for valuation, as in response to a question such as "what would happen if...?" * A financial projection is based on assumptions that are expected to exist and the course of action that is expected to be taken, given one or more hypothetical assumptions. * A financial projection my contain a range. Responsible Party The responsible party usually is management, but it can be persons outside the entity, such as a party considering acquiring the entity. SSAE No. 10, Section 301 This standard provides guidance to the accountants concerning performance and reporting for engagements to examine, compile, or apply agreed-upon procedures to prospective financial statements if these statements are (or reasonably might be) expected to be used by another (third) party and * if the accountant submits to his client or others prospective financial statements that he assembled or assisted in assembling. * Or if the accountant reports on prospective financial statements. Assumptions Although the accountant may assist in identifying assumptions, gathering information and assembling the statement, the responsible party is responsible for the preparation and presentation of the prospective financial statements. Users of Prospective Financial Statements Prospective financial statements are for either "general use" or "limited use." * General Use General use refers to use of statements by persons with whom the responsible party is not negotiating directly; for example, in an offering statement of an entity's debt or equity interest. Since the users are unable to ask the responsible party directly about the presentation, the presentation more useful to them is one that portrays the expected results. Only financial forecasts are appropriate for general use. * Limited Use "Limited use" of prospective financial statements refers to use of prospective financial statements by the responsible party alone or by the responsible party and third parties with whom the responsible party is negotiating directly. Examples include use in negotiations for a bank loan, submission to a regulatory agency, and use solely within the entity. Third-party recipients of prospective financial statements intended for limited use can ask questions of the responsible party and negotiate terms directly with it. Either financial forecasts or financial projections are appropriate for limited use. Financial forecast and projections should reflect a reasonably objective basis as a result of preparing them in good faith, which due care by qualified personnel, in accordance with GAAP, with the highest qualify of information that is reasonably available, using information that is in accordance with plans of the entity. Identifying key factors as the basis for assumptions, and using appropriate assumptions.

Financial Reporting and Changing Prices FINANCIAL REPORTING AND CHANGING PRICES In General Attributes of assets that accountants might measure are * Historical cost or * Current cost The measuring units that can be used to measure either attribute are * Nominal dollars or * Constant dollars As a result, there are four possibilities: Historical Cost Current Cost Nominal Constant Nominal Constant dollars dollars dollars dollars -1- -2- -3- -4- This four-column characterization presents the framework of "Financial Reporting and Changing Prices," and it will be referred to in the discussion that follows. Working definitions of these four terms follow: * Historical cost - the historical exchange price experienced in an actual transaction. * Current cost - the cost that would be incurred at the present time (its specific measurement is discussed later). * Nominal dollars - dollars that are not adjusted to reflect changes in purchasing power. * Constant dollars - dollars that are restated to reflect changes in purchasing power. Historical Cost/Constant Dollars To use the constant dollar measuring unit, price index numbers are the means with which to measure the effects of inflation. The Consumer Price Index-Urban (CPI-U) is the index that is used, and its amount is published monthly. Two index numbers are needed to restate nominal dollars into constant dollars. The period whose nominal dollars are being restated is called the base period, the period into whose dollars' purchasing power the nominal dollars are being restated is the current period. Current period CPI-U --------------------- = conversion factor Base period CPI-U Example: To restate land purchased in January 19X2 for $10,000 into December 19X8 constant dollars, use the appropriate CPI-U numbers. (December 19X8 =) 180 = 1.5 --------------------- (January 19X2 =) 120 The result is that $10,000 is restated into ($10,000 * 1.5 =) $15,000 in the December 31, 19X8, constant dollar balance sheet. FASB Statement No. 33 allows as an acceptable alternative to have the numerator contain the weighted average CPI-U for the current year, thus (19X8 average =) 168 = 1.4 --------------------- (January 19X2 =) 120 In average 19X8 constant dollars, the restated cost basis of the land would be ($10,000 * 1.4 =) $14,000. In the CPA Exam, you will be told whether the constant dollar is based on the year-end CPI-U or the year-average CPI-U. Monetary Items Monetary items are sums of money whose amount is fixed or determinable without reference to future prices of specific goods or services. They include cash, and those receivables and payables which will be discharged in cash. Such receivables and payables qualify irrespective of their being current or noncurrent. All other financial statement amounts are nonmonetary, e.g., investments (except an investment in debt securities which will be held until maturity - which would be a monetary asset), inventory, plant assets, intangibles, owners' equity balances, revenues and expenses. The monetary-nonmonetary distinction applies when accounting measurements use constant dollars as the measuring unit: * Only nonmonetary items are restated from nominal dollars into constant dollars. * Gains or losses are not recognized as a result of restating nonmonetary items. * Monetary items are not restated - because their sums are fixed. * Gains or losses are recorded to reflect the increase or decrease in purchasing power that results from holding monetary items during inflation. Example: Assuming that the year-end dollar is the constant dollar, if a company holds $3,000 cash and $7,000 land bought in January 19X7 and during 19X7 the CPI-U moves from 100 to 120, the constant dollar balance sheet as of December 31, 19X7, would disclose $3,000 cash and [$7,000 * (120/100 =) 1.2 =] $8,400 land. The constant dollar income statement would contain a ($3,000 * .2 =) $600 purchasing power loss. Restatement of a Depreciable Asset Restatement of a depreciable asset entails restating the related accumulated depreciation and depreciation expense amounts with the same conversion factor used to restate the asset proper. Thus, if the $7,000 land in the last example had instead been a machine being depreciated at a rate of $1,400 per year for 5 years, the constant dollar financial statements would contain the following amounts: 19X7 19X8 Current index 120 156 Machinery: (7,000 * 1.2) $8,400 (7,000 * 1.56) $10,920 Depreciation expense: (1,400 * 1.2) $1,680 (1,400 * 1.56) $2,184 Accumulated depreciation: (1,400 * 1.2) $1,680 (2,800 * 1.56) $4,368 If the $7,000 machinery account had consisted of 3 machines that had been bought at different dates, the cost of each machine is restated individually and the 3 restated amounts are then added together. Machine A Machine B Machine C Total Date acquired March 19X5 August 19X6 January 19X7 Base index number 80 90 100 Cost $4,000 $2,000 $1,000 $7,000 Conversion factor: Dec. 31, 19X7 (120/80)=1.50 (120/90)=1.33 (120/100)=1.20 Dec. 31, 19X8 (156/80)=1.95 (156/90)=1.73 (156/100)=1.56 Constant dollars: Dec. 31, 19X7 $6,000 $2,666 $1,200 $ 9,866 Dec. 31, 19X8 7,800 $3,460 $1,560 $12,820 If the nonmonetary asset had been Inventory (instead of Land or Machinery), it would be necessary to restate both the asset and the cost of goods sold by using the appropriate conversion factor. Purchasing Power gain/loss The purchasing power gain/loss is the gain/loss from holding monetary items. The calculation of the gain or loss is now illustrated in an example for which the following index numbers apply: December 19X1 110 December 19X2 132 Average for 19X2 120 Reference to the beginning and ending balance sheets yields the following information. Assuming the average-for-the-year dollar is the constant dollar (i.e., the year-average CPI-U), the purchasing power gain is $454, as follows: January 1 December 31 Monetary assets $10,000 $ 12,000 Monetary liabilities $ 7,000 $ 20,000 Net monetary assets (liabilities) $ 3,000 $ (8,000) Nominal Conversion Constant dollars factor dollars Net monetary assets (liabilities): January 1: $10,000 - $7,000: $ 3,000 120/110 $ 3,273 Monetary flows: In 19X2: ($8,000) - $3,000: (11,000) (11,000) (7,727) Net monetary assets (liabilities): December 31: $12,000 - ($20,000): $(8,000) 120/132 $(7,273) Purchasing power gain $ 454 The discussion to this point has dealt with the historical cost/constant dollar approach. Certain amounts that would appear in historical cost/constant dollar financial statements may be presented by corporations in schedular form as a supplement to their basic historical cost/nominal dollar financial statements, to be discussed later. Current Cost Accounting A second aspect of the expanded financial reporting disclosures set forth in FASB Statement No. 89 entails disclosing certain amounts which would appear in current cost/constant dollar financial statements. These are the data that result in the approach depicted in Column 4 of the framework (which appeared in the first paragraph of the discussion). To understand the nature of that approach, we will deal initially with current cost data using the nominal dollar measuring unit, Column 3 in the framework. The current cost of an asset is the current replacement cost of the asset owned, adjusted for the value of any operating advantages or disadvantages of the asset owned. However, it may not exceed the recoverable amount, which is the higher of the net realizable value or the net present value of the future cash flows. Use of current cost as the attribute of assets to be measured is implemented either by indexation or by direct pricing. The "indexation" approach should not be confused with general price index numbers (CPI-U) that are used to restate nominal dollars into constant dollars. Instead, it refers to specific indices that are generated either internally or externally for particular classes of goods and services. Direct pricing can be effected by reference to current invoice prices, vendors' price lists or standard manufacturing costs that reflect current costs. When revaluing an asset to reflect its current cost, the resulting increase (or decrease) from its previous valuation is a holding gain (or a holding loss) and in theory would be recognized as such in a current- cost income statement. For example, if the value of land that had been purchased for $10,000 were to increase subsequently to $16,000, the land asset account would be increased to $16,000, and a $6,000 holding gain would appear in the current-cost income statement. An SFAS Y current- cost income statement differs from a historical cost income statement in another important respect as well; namely, it reflects depreciation expense and cost of goods sold at their current cost. The holding gain (or loss) would not be a component of Income from Continuing Operations, however. Proceeding now to the current cost/constant dollar approach (Column 4 in the framework), we observe its dominant characteristics: * Monetary assets and monetary liabilities are not restated in the balance sheet. * The effect of inflation on monetary assets and monetary liabilities is calculated and disclosed in the income statement as the purchasing power gain or loss in the manner described earlier. * Nonmonetary assets (plant assets and inventory) appear in the balance sheet at their current cost, and related expenses appear in the income statement at their current cost (depreciation expense and cost of goods sold). * The change in the current cost of nonmonetary assets (the holding gain or loss) reflects the change only to the extent not caused by general inflation; an example follows. Assume that land had been purchased in March for $12,000 when the CPI-U was 130. On December 31, the current cost of the land is $15,000 and the CPI-U is 156. The asset would be valued as $15,000, and assuming the constant dollar is based on the year-end CPI-U, the holding gain that appears in the income statement would be $600. The $600 is based on the following calculation: $15,000 - [$12,000 * (156/130 =) 1.2 =] $14,400 = $600 FASB Statement No. 89 The primary disclosure rules set forth by FASB Statement No. 89 are as follows: 1. Disclosures are optional for all companies. 2. The disclosures, if applied, are a supplement to, not a substitute for, financial statements prepared in the traditional (historical cost/nominal dollar) manner. 3. The specific items suggested for disclosure are: * Purchasing power gain or loss from holding monetary assets and owing monetary liabilities. * Income from continuing operations - with cost of goods sold and depreciation expense on a current cost/constant dollar basis. * Inventory and plant assets on a current-cost basis. * Changes in the current cost/constant dollar amounts of inventory and plant assets (the holding gain or loss). * Five-year comparison of selected historical cost and current cost data - expressed in constant dollars (e.g., sales, dividends per share, market price per share, and some of the already computed amounts). 4. Constant dollars can reflect either end-of-year or average-for-the- year purchasing power. In the five-year summary, however, constant dollars could also reflect the purchasing power of the base year used by the Bureau of Labor Statistics (which is currently 1967).

Financial Statement Analysis FINANCIAL STATEMENT ANALYSIS Financial analysis is the process of interpreting the financial statements of an enterprise to identify and evaluate its strengths and weaknesses as reflected in those statements. Accountants rely upon techniques of financial analysis in the performance of the audit function to assist in designing the audit program with respect to scope and specific items to be evaluated. Because of their familiarity with the development of financial statements, accountants are also frequently called upon to analyze and interpret the results of operations as reflected in the statements for management. Basic techniques of financial statement analysis include: 1. Comparative financial statements and horizontal analysis, 2. Common size statements (vertical analysis), 3. Ratio analysis. Comparative Financial Statements and Horizontal Analysis Financial statements for two or more years and statements of percentages indicating the relative change in items on the statements over time facil te the identification, comparison and evaluation of trends. They also provide perspective in evaluating the reasonableness of current performance. Common Size Statements Statements which express each item on a particular financial statement as a percentage of a base amount emphasize the relationship among the items included, the relative importance of amounts included, and the significance of changes in items from one period to the next. Ratio Analysis Ratio analysis develops comparisons and measures relationships between two amounts from a single statement or from two different statements. A ratio may be expressed as a percentage (25%), a fraction (1/4) or a comparison of numbers (4 to 1). The essence of ratio analysis is to point out areas where further investigation is warranted. a. Basic ratio computations: RATIO COMPUTATION SIGNIFICANCE 1. Current ratio Current Assets/ Primary measure liquidity-- Current Liabilities able to meet current obligations 2. Quick ratio (acid test) C+M/S+Rec/ or CA – Inv/ Degree of immediat liquidity CL CL 3. Receivables turnover Net Credit Sales/ Av. Rec. (net) Liquidity of receivables– efficiency and collection period 4. No. of days sales (a) Av Rec (net)/ No. of days to collect in receivables or Daily Cr Sales receivables- Av. collection period efficiency of collections Or (b) 365/Rec.Turnover 5. Inventory turnover Cost of Goods Sold/ Liquidity of inventory Av. Inv. and inventory efficiency 6. Days supply in inventory 365/ Efficiency inv. mgmt. Inv. Turnover over- under-stocking 7. Asset turnover Net Sales/ Efficiency of resource Total Assets utilization 8. Profit margin Net Income/ Protit margin per (return on sales) Net Sales dollar of sales 9. Return on investment (ROI) Net Income/ Earning power of Total Assets business-prof bility—measure of management performance 10. Return on stockholders' equity Net Income/ Earning power per Stockholders' Equity dollar of owner's investment 11. Debt-equity Debt/ Relative debt funds-- Equity financial structure 12. Equity to total assets (equity ratio) Owner's Equity/ %equity financing-- Total Assets protection of creditors 13. Book value per share Common stock equity/ CSE=TSE Liquidating value No. shares C/S P/S–cumulative dividends P/S 14. Times interest earned Net Income Before Interest and Taxes/ Protection of creditors Interest Expense 15. Times fixed charges earned Net Income Before Interest and Taxes/ Operating risk Interest + Preferred Dividends 16. E.P.S. Net Income Available for C/S/ Earnings per unit of Av. No. Shares C/S ownership—dividend potential 17. Dividend Payout Dividends per share/ % profit paid out to owners— ESP % retained for internal finance of growth 18. Price-earning ratio Market value per sh. C/S/ Indication of relative EPS value of stock risk 19. Dividend yield Dividend per share/ Market value per share Investment prof bility b. The DuPont System The rate of return on investment is generally considered the most important ratio for providing information concerning the general prof bility of the firm and the overall effectiveness of management. The DuPont system of analysis highlights and examines in detail the elements comprising the rate of return on investment, emphasizing the effect that various elements of the financial statements have on this ratio. The two major elements which interact to determine R.O.I. are asset turnover and profit margin. The relationship is as follows: R.O.I. = Asset Turnover x Profit Margin or Net Income/ = Sales/ x Net Income/ Total Assets Total Assets Sales

Fixed Assets Fixed Assets In General Fixed assets should be carried at cost of acquisition or construction in the historical accounts, unless such cost is no longer meaningful. Cost of land should ordinarily be shown separately. Cost of construction includes direct costs and overhead costs incurred, such as engineering, supervision and administration, interest, and taxes. Items treated as fixed assets should have at least one year of expected useful life to the enterprise, and normally the life is considerably longer. Items no longer in service should be written off in order that fixed assets will represent the cost of properties in service. Classification Those tangible assets used in operations and not intended for sale in the ordinary course of business are classified on the balance sheet as fixed assets provided they have an expected service life of more than one year. No one designation of this category has been accepted, and captions such as "fixed assets," "property, plant, and equipment," "general property," "properties," and numerous others are found in published financial statements. Depreciable and nondepreciable property ordinarily should be shown separately, and a further classification is often given. Property Stated on Cost Basis Cost means cost in cash or its equivalent. Preferably, the words "at cost" are appended to the principal plant caption to avoid any possibility of misunderstanding. Although cost is the accepted basis of reporting property, plant, and equipment, there are situations in which cost is no longer meaningful. By carrying plant at cost, less accumulated depreciation, there is a representation that the remaining balance of the investment is properly chargeable to future operations and has a fair chance to be recovered. If this assumption appears no longer valid with respect to material items, it may be prudent to recognize the loss by reducing the book value to the estimated remaining useful cost to the enterprise. Components of Cost The cost of properties acquired by purchase is the net price paid on a cash basis, plus all incidental payments necessary to put the asset in condition and location for use, such as freight and installation costs. When several assets are acquired at a group price, the price paid is allocated between the assets based on their relative value, as determined by such evidence as independent appraisal by professional appraisers or real estate brokers, or assessed valuations for property tax purposes. If property other than cash is the consideration in a transaction, a fair measure of the actual cash cost is the amount of money which would have been realized if such property had first been directly converted into cash. If the property has no determinable fair market value, the market value of the properties received in the exchange may be used. A gain or loss will occur when fair market value differs from the book value of the property given up. In practice, exchanges of fixed assets often are recorded at the book values of the properties given up. If the consideration employed in acquiring properties is in the form of the cap l stock of the buying enterprise, a fair measure of actual cost is the amount of money which could have been raised through the issue of the securities for cash. If the securities are of uncertain value, however, an alternative measurement would be the estimated fair market price of the property acquired. The principle of costing of self-constructed property, plant, and equipment is similar to the principle of costing of purchased assets of this type-they are recorded at the price paid to get them in condition and location for use. The practical problems involved in determining their cost are the same problems that are encountered in determining the cost of goods manufactured for resale. The direct costs of materials and labor are readily identified and charged to construction work in process. Indirect or overhead costs may be specifically identifiable items, as well as those allocated to construction in process on supportable cost-incurrence principles. Overhead costs include supervision, engineering and interest during construction. Enterprises which do not normally carry out their own construction usually follow the incremental cost method by limiting the overhead charged to construction to the increase which can be directly attributed to the work done on the plant and equipment. (See "Cap lization of Interest" later in this chapter.) Land and land rights. These asset accounts should include the purchase cost of land owned in fee and of rights, interest, and privileges held in land owned by others. The following incidental costs are also properly included, among others: commissions to agents, attorneys' fees, demolition, clearing and grading, streets, sewer lines, and relocating or reconstructing property of others elsewhere in order to acquire possession. Buildings. A building is a relatively permanent structure designed to house or safeguard property or persons, and its total cost should include not only the cost of the shell, but also expenditures for service equipment and fixtures made a permanent part of the structure. In addition to direct costs of construction, it is proper to cap lize such items as permits, architects' and engineers' fees, legal fees, and overhead directly applicable to construction. Machinery and equipment. It is important to include all costs of purchase or manufacture together with all costs of installation. The latter would include such costs as transportation, labor, and testing during an experimental period. If machines are purchased under an agreement providing for royalties to be paid on units of production, these royalty payments are not costs of acquisitions and should be charged to operating expenses. Accounting for Retirements The asset accounts for property, plant, and equipment should include the costs of only those units which are used and useful to the enterprise; the allowance for depreciation accounts should relate to those units, and to no others. Although these objectives are theoretically simple, they are in practice difficult to achieve. Idle plant, reserve, and stand-by equipment. Plant assets on the balance sheet may include property in use and property held with reasonable expectation of its 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 and facilities still owned but no longer adapted for use in the business, if material in amount, should be removed from plant accounts and recorded separately at an estimated realizable amount, appropriately explained. Classification of Cap l Expenditures Additions. Additions represent entirely new units or extensions and enlargements of old units. Expenditures for additions are cap lized by charging either old or new asset accounts depending on the nature of the addition. Betterments. A betterment does not add to existing plant. Expenditures for betterments represent increases in the quality of existing plant by rearrangements in plant layout or the substitution of improved components for old components so that the facilities are better in some way than they were when acquired. Such increases in the quality of improved facilities are measured by their increased productivity, greater capacity, or longer life. The cost of betterments is accounted for by charges to the appropriate property accounts and the elimination of the cost and accumulated depreciation associated with the replaced components, if any. Extraordinary repairs. Expenditures to replace parts or otherwise to restore assets to their previously efficient operating condition are regarded as repairs. To be classified as an extraordinary repair, an expenditure must benefit future periods by increasing the useful life of an existing asset. Expenditures for extraordinary repairs are cap lized by charges to the appropriate accumulated depreciation account or by eliminating from the accounts the cost and accumulated depreciation on the replaced parts and charging the asset account for the cost of the repairs. The latter treatment is preferred because it maintains the integrity of the accounts in that the actual cost of the asset in use is recorded. Deferred maintenance. Deferred maintenance is an amount equal to the expenditure necessary to restore a plant or item of equipment to normal operating efficiency. Accounting for deferred maintenance involves the establishment of an allowance account by a charge to operations in the period during which it occurs. Actual repairs and other deferred maintenance expenditures are then charged to the allowance account when they occur. Replacements. Replacements involve an "in kind" substitution of a new asset for an old asset or part. Accounting for major replacements requires entries to retire the old asset or part and to record the cost of the new asset or part. Minor replacements are treated as period costs.

Foreign Currency And SFAS 133 ACCOUNTING FOR DERIVATIVES AND HEDGING ACTIVITIES SFAS 133 looks at foreign currency in the following areas: Fundamental Decisions a. Derivative instruments that meet the definition of assets and liabilities should be reported in the financial statements. b. Fair value is the only relevant measure for derivative instruments. Foreign Currency Hedges * Fair Value Hedge of an exposed asset or liability. Gains and losses are recognized currently. * Fair Value Hedge of a firm commitment. Gains and losses are recognized currently. * Cash Flow Hedge of a forecasted transaction denominated in foreign currency. Gains and losses are recognized in comprehensive income * Hedge of a Net Investment in a foreign entity. Gains or losses are reported in comprehensive income as part of the translation adjustment. Speculation of Foreign Currency Gain and losses are recognized currently based on foreign exchange rates. A FAIR VALUE HEDGE OF AN ASSET WITH A FORWARD CONTRACT The Beal Company sells goods to a German Company for 1,000,000 marks on December 15, 1999 and allows the customer 30 days to pay the invoice. The spot rate at that time is $.58 and the company appropriately records a sale of $580,000. Beal Company is concerned about the fluctuation in the German mark and on December 31, 1999 enters into a 30-day forward contract hedge to sell 1,000,000 marks for $570,000 to AMEX at the forward rate of $.57. At this point, Beal has "locked-in" the amount of cash it will receive from the 1,000,000 marks and eliminated any further risk from foreign currency changes. Listed below is a table of the changes in exchange rates: DATE SPOT RATE 30 DAY FORWARD RATE December 15, 1999 .58 $.57 December 31, 1999 .59 .585 January 15, 2000 .56 .56 Journal Entries: December 15, 1999 Accounts Receivable (DM) 580,000 Sales 580,000 To record the sale at the current spot rate. Note: No entry is made to record the forward contract because its value is zero. December 31, 1999 Accounts Receivable (DM) 10,000 Foreign Currency Transaction Gain 10,000 To adjust the accounts receivable to the Dec. 31 spot rate of $.59 which is $.01 above the December 15 rate (1,000,000 marks x .01 = 10,000). December 31, 1999 Loss on Forward Contract 15,000 Forward Contract (Liability) 15,000 SFAS 133 requires Beal Company to record the forward contract at fair value and to recognize the loss in current earnings. The calculation is the change in the forward rate from $.57 to $.585 or $.015 x 1,000,000 marks = $15,000. Since the current rate is $.585, a forward contract for marks at $.57 is less valuable and a loss should be recognized. January 15, 2000 Foreign Currency transaction loss 30,000 Accounts Receivable (DM) 30,000 To adjust the accounts receivable for the decrease in the spot rate since December 31, 1999 ($.59 - $.56 = $.03 x 1,000,000 marks = $30,000). January 15, 2000 Forward Contract (Asset) 25,000 Gain on Forward Contract 25,000 The change in the value of the forward rate from December 31, 1999 to January 15, 2000 is $.025 ($.585 - $.56) x 1,000,000 marks = $25,000. January 15, 2000 Foreign Currency (DM) 560,000 Accounts Receivable (DM) 560,000 To record the receipt of 1,000,000 marks at the current spot rate of $.56 for a total of $560,000. January 15, 2000 Cash 570,000 Foreign Currency (DM) 560,000 Forward Contracts 10,000 To record the sale of 1,000,000 marks to AMEX on the forward contract for $570,000 and to remove the forward contract from the books. FAIR VALUE HEDGE OF AN ASSET USING A FOREIGN CURRENCY PUT OPTION As an alternative to the forward contract, Beal Company could hedge its accounts receivable exposure to fluctuations in the value of the mark by purchasing a foreign currency put option. A put option gives Beal the right to sell 1,000,000 marks on January 15, 2000 at a pre-determined price. If the spot rate on January 15 is less than the option price, Beal will exercise the option and sell the 1,000,000 marks. If the spot rate is greater than the option price, Beal will allow the option to expire and sell the 1,000,000 marks at the spot rate. The advantage to Beal is that it does not have to exercise the option. Using the same basic information as the first example, assume that Beal buys a put option on December 15, 1999 for $9,000 to sell 1,000,000 marks at $.57 on January 15, 2000. FOREIGN CURRENCY OPTION DATE SPOT RATE FAIR VALUE CHANGE IN FAIR VALUE December 15, 1999 $.58 $9,000 -0- December 31, 1999 $.59 $6,000 - $3,000 January 15, 2000 $.56 $10,000 + $4,000 The journal entries for the transactions will be the same as the first example, so concentrate on the entries affecting the put option. December 15, 1999 Accounts Receivable (DM) 580,000 Sales 580,000 Foreign Currency Option (asset) 9,000 Cash 9,000 To record the purchase of the put option. December 31, 1999 Accounts Receivable (DM) 10,000 Foreign Currency Transaction Gain 10,000 Loss on Foreign Currency Option 3,000 Foreign Currency Option 3,000 To record the loss on the foreign currency option. January 15, 2000 Foreign Currency transaction loss 30,000 Accounts Receivable (DM) 30,000 Foreign Currency Option 4,000 Gain on Foreign Currency Option 4,000 January 15, 2000 Foreign Currency (DM) 560,000 Accounts Receivable (DM) 560,000 January 15, 2000 Cash 570,000 Foreign Currency (DM) 560,000 Foreign Currency Option 10,000 To record the exercise of the put option at the option price of $.57 and remove the foreign currency option from the books. Note: The option was exercised because the option price of $.57 was greater than the spot rate of $.56. Fair Value Hedge of Future Firm Committment FAIR VALUE HEDGE OF FUTURE FIRM COMMITMENT USING A FORWARD CONTRACT AS A HEDGE In our previous examples, Beal did not hedge its transactions until the sale was made and the concern was for the exposure of its accounts receivable. Another approach would be for Beal to hedge its transaction when an order is received (a firm commitment). Assume that Beal received an order on November 15, 1999 in the amount of 1,000,000 German marks for delivery within 60 days. Assume further that payment will be due on the delivery date of January 14, 1999 (60 days). On November 15, 1999, Beal enters into a 60-day forward contract to sell 1,000,000 German marks at the forward rate of $.54. FORWARD RATE to 1/14/2000 11/15/99 .54 12/31/99 .55 1/14/00 .535 Journal Entries: November 15, 1999 No Entry The fair value of the forward contract is zero. December 31, 1999 Loss on Forward Contract 10,000 Forward Contract (liability) 10,000 The loss on the forward contract is the change in the forward rate of $.01 x 1,000,000 marks = $10,000 (.54 - .55 = -.01) December 31, 1999 Firm Commitment (asset) 10,000 Gain on Firm Commitment 10,000 To record an offsetting gain on the firm commitment. January 15, 2000 Forward Contract (asset) 15,000 Gain on Forward Contract 15,000 To record gain in the change of the rates from December 31. (.55 - .535) = .015 x 1,000,000 = $15,000 January 15, 2000 Loss on Firm Commitment 15,000 Firm Commitment 15,000 To record offsetting loss on firm commitment. January 15, 2000 Foreign Currency (DM) 535,000 Sales 535,000 To record the sale and receipt of 1,000,000 DM at the current spot rate of $.535. January 15, 2000 Cash 540,000 Foreign Currency (DM) 535,000 Forward Contract 5,000 To record the sale of the 1,000,000 marks at the forward contract rate of $.54 and to remove the forward contract from the books. January 15, 2000 Firm commitment 5,000 Sales 5,000 The firm commitment and the foreign currency offset and the sales are exactly equal to the cash received (535,000 + 5,000) = $540,000. HEDGE OF A NET INVESTMENT IN A FOREIGN OPERATION SFAS 52 requires U.S. companies with foreign subsidiaries whose functional currency is the local currency to translate the subsidiary's financial statements into U.S. dollars using the current-rate method. This method produces a translation adjustment for the period that is reported as other comprehensive income. Companies wanting to hedge its fluctuation from the translated adjustment may use a forward contract or may borrow funds in the local currency. To hedge the foreign currency exposure, the translation adjustment from the hedging activity must move in the opposite direction from the translation adjustments of the net assets of the subsidiary. Since our previous examples have all used forward contract, this illustration will use a loss as a hedge. Assume that the Beal Corp. has an investment in a foreign German subsidiary equal to 10,000,000 marks which at the current spot rate of $.54 would translate into $5,400,000. To hedge its equity investments, Beal borrows 10,000,000 marks for a year on January 1, 2000. Assume that the spot rate for marks on December 31, 2000 is $.51. Journal Entries: January 1, 2000 Cash 5,400,000 Loan Payable 5,400,000 December 31, 2000 Loan Payable 300,000 Gain on Loan - Other Comprehensive Income 300,000 The gain on the loan would be the change in the spot rate from $.54 to $.51 at the end of the year for a net change of $.03 x 10,000,000 = $300,000. Note: SFAS 133 allows the gain on the loan - other comprehensive income to offset the translated adjustment associated with translating the foreign financial statement into U.S. dollars. SPECULATION IN FOREIGN CURRENCY A foreign contract does not have to be used as a hedge; it may be used for speculation. As with any derivative financial instrument, SFAS 133 requires the forward contract to be recorded at fair value and any gains or losses reported in current earnings. For example, Beal Company expects the value of the German mark to increase in the next 90 days. Accordingly, on December 1, 1999, Beal enters into a 90-day forward contract to buy 1,000,000 marks at the forward rate of $.52. On December 31, 1999 the forward rate was $.53 and by March 1, 2000 the spot rate had moved to $.55. Journal Entries: December 1, 1999 No Entry - the forward contract is at fair value. December 31, 1999 Forward Contract 10,000 Gain on Forward Contract 10,000 Increase in forward rate from $.52 to $.53 = $.01 x 1,000,000 marks = $10,000. March 1, 2000 Forward contract 20,000 Gain on Forward contract 20,000 Increase in forward rates from December 31 to March 1 ($.53 to $.55) = $.02 x 1,000,000 marks. March 1, 2000 Investment in German Marks 520,000 Cash 520,000 To record the purchase at the forward contract rate of $.52 x 1,000,000 marks = $520,000. March 1, 2000 Cash 550,000 Investment in German Marks 520,000 Forward Contract 30,000 To record the sale of 1,000,000 marks at the current spot rate of $.55.

FUND BASED FINANCIAL STATEMENTS Focus and Criteria of Fund Based Financial Statements The focus of governmental and proprietary fund financial statements is on major funds (but major fund reporting is not required for internal service funds). Each major fund is presented in a separate column, and Non-major funds are aggregated in one column. Combining statements are not required for non-major funds. The main operating fund such as the general fund or its equivalent is always a major fund. For other funds to be considered a major fund they must meet the following criteria established by GASB statement " in paragraph 76: 1. Total assets, liabilities, revenues, or expenditures/expenses of that individual governmental or enterprise fund are at least 10 percent of the corresponding total (assets, liabilities, and so forth) for all funds of that category or type (that is, total governmental or total enterprise funds), and 2. Total assets, liabilities, revenues or expenditures/expenses of the individual governmental fund or enterprise fund are at least 5 percent of the corresponding total for all governmental and enterprise funds combined. In addition to funds that meet the major fund criteria, any other governmental or enterprise fund that the government's officials believe is particularly important to financial statement users (for example, because of public interest or consistency) may be reported as a major fund. Types of Fund Financial Statements SFAS 34 requires the following fund-based financial statements: Governmental Funds Balance Sheet Statement of Revenues, Expenditures, and Changes in Fund Balances Proprietary Funds Statement of Net Assets (or Balance Sheet) Statement of Revenues, Expenses, and Changes in Fund Net Assets (or Fund Equity) Statement of Cash Flows (must use the direct method) Fiduciary Funds Statement of Fiduciary Net Assets Statement of Changes in Fiduciary Net Assets Reconciliation A reconciliation of the fund financial statements to the government-wide statements is also required. This reconciliation must be presented at the bottom of the fund statements or in an accompanying schedule. Note: Candidates should know the various types of financial statements, but concentrate on the details of the Governmental Funds Balance Sheet and Statement of Revenues, Expenditures, and Changes in Fund Balances. GOVERNMENTAL FUNDS BALANCE SHEET Please review the Sample City governmental balance sheet * Note that a separate column is presented for the general fund plus three other funds that meet the criteria for separate column disclosure. All other funds not considered major are grouped together in the "other" column. * No cap l assets or long-term debt are reported because governmental funds focus on measuring current financial resources. * The "Total Governmental Funds" column includes internal amounts for due from other funds and due to other funds. These inter-fund accounts are not eliminated. * The final total fund balances figure for the governmental funds of approximately $34.9 million is significantly different from the $123.6 million in total net assets reported for governmental activities as a whole in the statement of net assets. (See Exhibit A) To help understand that large discrepancy a reconciliation is included at the bottom of the balance sheet. This reconciliation shows that four amounts were left off the balance sheet: cap l assets, other long-term assets, internal service fund accounts, and long-term debt. Those items made up the difference in the two totals. Note: The Governmental-wide Financial Statements are presented a little later in the chapter as Exhibit A and B. STATEMENT OF REVENUES, EXPENDITURES, AND CHANGES IN FUND BALANCES * The revenues are listed by source and the expenditures by function. For example, expenditures are listed for the function called "Public Safety." Therefore, no net revenue or expense can be determined for Public Safety. * Since the current financial resource management focus is being applied, the term "expenditure" instead of expense is being used. * Other financing sources (uses) reflect proceeds of bonds and inter-company transfers. Again these inter-fund accounts were not eliminated. * GASB Statement 34 in paragraph 56 explains the "special item" section at the bottom of the report as "significant transactions or other events within the control of management that are either unusual in nature or infrequent in occurrence are special items. Special items should also be reported separately in the statement of activities, before extraordinary items, if any." Note: Once we have covered Governmental-wide Financial Statements, please come back and review the reconciliation in Exhibit II.

GAAP GENERALLY ACCEPTED ACCOUNTING PRINCIPLES An accounting principle is "generally accepted" if it is an official pronouncement or has other substantial author tive support. GAAP is a technical term in financial accounting, encompassing the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. The standard of "generally accepted accounting principles" includes not only broad guidelines of general application, but also detailed practices and procedures. GAAP is conventional - that is, principles become generally accepted by tacit agreement. The principles have developed on the basis of experience, reason, custom, usage, and practical necessity. In recent years, Opinions of the Accounting Principles Board and standards of the Financial Accounting Standards Board have received considerable emphasis as a major determinant of the composition of generally accepted accounting principles. GAAP is the result of an evolutionary process and can be expected to change over time. Principles change in response to changes in economic and social conditions, to new knowledge and technology, and to demands by users for more useful information. GAAP as defined by rule 203 of the Code of Professional Conduct of the American Institute of Certified Public Accountants, includes: Accounting Research Bulletins Accounting Principles Board Opinions Financial Accounting Standards Board Statements Financial Accounting Standards Board Interpretations The AICPA issued ARBs at the beginning and created the APB later. Some of these bulletins and opinions have been superseded by the Financial Accounting Standards Board, issuing the Statements Financial Accounting Standards. In addition to statements, the FASB issues interpretations that cover various clarifications of previous official pronouncements. Statements of Financial Accounting Concepts are also issued by the FASB. A conceptual statement does not have the same authority under Code of Conduct rule 203 as statements and interpretations. Instead, they are viewed as general frameworks on which specific rules will be built. If an area is not covered by an official pronouncement, then GAAP consists of other support, such as pronouncements of the SEC or other regulatory bodies, textbooks, or industry practice. Generally accepted accounting principles are divided into three sections: pervasive principles, which relate to financial accounting as a whole and provide a basis for the other principles; broad operating principles, which guide the recording, measuring, and communicating processes of financial accounting; and detailed principles, which indicate the practical application of the pervasive and broad operating principles. Depicted below is the GAAP Hierarchy. GAAP HIERARCHY SUMMARY(SAS 69) Note: If a specified accounting procedure cannot be found in category 10a, the auditor/accountant would proceed to the next lowest category. Established Accounting Principles: 10a. FASB Statements and Interpretations, APB Opinions, and AICPA Accounting Research Bulletins. 10b. FASB Technical Bulletins, AICPA Industry Audit and Accounting Guides, and AICPA Statements of Position. 10c. Consensus positions of the FASB Emerging Issues Task Force and AICPA Practice Bulletins. 10d. AICPA accounting interpretations, "Qs and As" published by the FASB staff, as well as industry practices widely recognized and prevalent. Other Accounting Literature:** 11. Other accounting literature, including FASB Concepts Statements; APB Statements; AICPA Issues Papers; International Accounting Standards Committee Statements; GASB Statements, Interpretations, and Technical Bulletins; pronouncements of other professional associations or regulatory agencies; AICPA Technical Practice Aids; and accounting textbooks, handbooks, and articles. * Paragraph references correspond to the paragraphs of this Statement that describe the categories of the GAAP hierarchy. ** In the absence of established accounting principles, the auditor may consider other accounting literature, depending on its relevance in the circumstances. The pervasive principles are few in number and fundamental in nature. The broad operating principles derived from the pervasive principles are more numerous and more specific, and guide the application of a series of detailed principles. The detailed principles are numerous and specific. When more than one pronouncement relates to a given issue or type of transaction, an individual can determine which pronouncement is the most author tive based upon this hierarchy. Financial statements can be prepared using principles other than those defined in official pronouncements if, due to very unusual conditions, following the official pronouncement would seriously mislead the statement's reader. The independent CPA is required to follow GAAP via Rule 203 of the AICPA Code of Professional Conduct. This rule indicates that an opinion shall not be issued if statements contain a departure from accounting principles unless the CPA can demonstrate that due to unusual circumstances the financial statements would otherwise be misleading. If such a departure exists, the report should describe the departure, the approximate effect on the financial statements, and the reasons why compliance with the principle would result in a misleading statement. Justification for departure from the official pronouncements would not include reasons such as materiality of the amount or industry practice that is contrary to the pronouncements. Circumstances that permit departure from an official pronouncement are extremely rare, and, in fact, very few audit opinions have indicated a departure from the official pronouncement concept of GAAP. UNDERLYING PRINCIPLES Revenue Recognition Revenue is recognized when it is earned, measurable and collectible, that is when the income earning process is complete and an exchange has taken place. Matching Dictates that efforts and expenses be matched with the revenue of the period. Some costs are recognized as expenses on the basis of a presumed direct association with specific revenue. Examples of expenses that are recognized by associating cause and effect are sales commissions and costs of products sold or services provided. In the absence of a direct match, some costs are associated with specific accounting periods as expenses in a systematic and rational manner among the periods in which benefits are provided. Examples of items that are recognized in a systematic and rational manner are depreciation of fixed assets, amortization of intangible assets, and allocation of rent and insurance. Some costs associated with the current accounting period are expensed immediately because costs incurred during the period provide no future benefits, costs recorded as assets in prior periods no longer provide discernible benefits, or allocating costs serve no useful purpose. Examples include officers' salaries, selling costs, amounts paid to settle lawsuits. Unit of Measure While adequate disclosure requires information about nonmonetary events, comparability and understandability of financial information are enhanced if it is presented in terms of a common denominator. Measurement in terms of money is not completely accurate since the value of money changes over time, but it is the most understandable basis available. The US. dollar is the unit of measure in financial accounting in the United States. Changes in its general purchasing power are not recognized in the basic financial statements. Historical Cost As a measurement basis, historical cost is the most objectively determinable and it is the proper basis for recording assets, equity, costs, and expenses. However, five measurement attributes are used in current practice. Historical cost - historical proceeds Current replacement cost Current market value Net realizable value Present - discounted value of future cash flows Separate Entity Accounting information is reported as if the business were separate from its owners, customers, employees, and creditors. When consolidated statements are prepared for a group of related businesses, the group is the assumed entity; separate statements for each business assume a different definition of the entity to enhance the usefulness of information. Disclosure For information to be relevant, there must be adequate disclosure. This implies knowledge of the use to which the information will be put to differentiate between relevant and irrelevant disclosures. Going Concern Unless there is other evidence, accounting information assumes the company will continue in operation long enough to realize its objectives and fulfill its legal obligations. Objectivity/Verifiability Information should be free from bias on the part of the individual who prepared the information. If several independent individuals examined the same transactions and used the same reporting principles, the accounting information prepared by each should be the same. Periodicity Because of the need for timely information, accounting information is reported for set time intervals. While different time periods might be appropriate for different types of companies, it is generally accepted that information related to annual periods is reported annually. Consistency To achieve comparability of accounting information over time, the same accounting methods must be followed. If accounting methods are changed from period to period the effects of the change are disclosed. MODIFYING CONVENTIONS Conservatism Historically, managers, investors, and accountants have generally preferred that possible errors in measurement be in the direction of understatement rather than overstatement of net income and net assets. This has led to the convention of conservatism, which is expressed in rules adopted by the profession as a whole, such as the rule that inventory should be measured at the lower of cost or market. These rules may result in stated net income and net assets at amounts lower than would otherwise result from applying the pervasive measurement principles. Therefore, when confronted with alternative accounting procedures, the accountant follows that which has the least favorable impact on current income. If there are no reasons that make one accounting treatment preferable to another, the least favorable effect on current operations is selected. Losses may be anticipated while gains are normally not recognized in the accounts until they are realized. There is a relationship between the relevance and reliability of accounting information with the convention of conservatism. Conservatism ensures that the uncertainty and risks inherent in business situations are adequately considered. Conservatism should not imply the deliberate understatement of assets and profits and should lead toward fairness of presentation. An attempt to understate results on a consistent basis will lead accounting information to be unreliable. Emphasis on Income Over the years, financial statement users, and accountants have increasingly tended to emphasize the importance of net income and that trend has affected the emphasis in financial accounting. Accounting principles that are deemed to increase the usefulness of the income statement are, therefore, sometimes adopted by the profession as a whole regardless of their effect on the balance sheet or other financial statements. For example, the last-in, first- out method of inventory pricing may result in balance sheet amounts for inventories that become further removed from current prices with the passage of time. LIFO, however, is often supported on the grounds that it usually produces an amount for cost of goods sold in determining net income that more closely reflects current prices. Application of Judgment Sometimes, strict adherence to the pervasive measurement principles produces results that are considered by the accounting profession to be unreasonable in the circumstances or misleading. The exception to the usual revenue realization rule for long-term, construction-type contracts, for example, is justified in part because adherence to realization at the time of sale would produce results that are considered to be unreasonable. The judgment of the profession is that revenue should be recognized in this situation as construction progresses. Materiality If information is insignificant, it has no effect on the decisions of an accounting information user, therefore, there is no need to report that information. Materiality cannot be precisely defined, but is related to absolute values and relationships of an amount to other accounting information. Industry Practices Departure from strict compliance with GAAP may exist in some cases due to the peculiar nature of the industry in which an enterprise operates. Substance over Form The economic substance of a transaction determines the accounting treatment, even though the legal form of the transaction may indicate a different treatment. In some cases, strict adherence to GAAP produces results that are unreasonable. because the legal form of a transaction does not fully represent the underlying intentions of that transaction. For example, some leases are actually purchases of assets, although the legal form of the transaction is a lease, the true intent of a transaction differs from its legal form, the profession supports reporting substance rather than legal form. Summary of Conceptual Framework Objectives Provide Information 1. Useful in rational investment and credit decisions 2. Useful in assessing future cash flows 3. About enterprise resources, claims to resources and changes in them Qual tive Elements Characteristics 1. Pervasive Constraint 1. Assets Benefits exceed costs 2. Liabilities 2. User Specific Qualities 3. Equity A. Understandability 4. Investment by owners B. Decision usefulness 5. Distribution to owners 3. Primary Qualities 6. Comprehensive income A. Relevance 7. Revenues 1. Predictive Value 8. Expenses 2. Feedback Value 9. Gains 3. Timeliness 10. Losses B. Reliability 1. Verifiability 2. Representational faithfulness 3. Neutrality 4. Secondary Qualities A. Comparability B. Consistency Recognition and Measurement Concepts MODIFYING ASSUMPTIONS UNDERLYING CONVENTIONS 1. Economic entity 1. Historical cost 1. Cost-benefit 2. Going concern 2. Revenue recog 2. Materiality 3. Monetary unit 3. Matching 3. Industry practice 4. Periodicity 4. Full disclosure 4. Converatism 5. Consistency 5. Substance over form 6. Judgment

GENERAL FUND FUND BASED REPORTING The General Fund accounts for all revenues and expenditures of a governmental unit which are not accounted for in other funds. It is usually the primary and most important fund for state and local governments, and it is used to account for most routine operations. Revenue received should be classified by source. The primary sources are taxes, fines, and licenses. All other resources that are not accounted for in other governmental funds are included in the general fund. 1. To record the budget for the year (Budgets are recorded by the general, special revenue, and cap l projects ). Budgetary accounts are a part of the double entry accounting system in fund accounting where appropriations and estimated revenues are subject to approval by a legislative body. This is necessary because of the need to control expenditures and to levy taxes sufficient to cover estimated expenditures. At the beginning of the year Estimated Revenue Control $400,000 Appropriations Control $398,000 Budgetary Fund Balance 2,000 2. To record the property tax levy Property Tax Receivable - Current $280,000 Allowance for uncollectible Taxes - Current $ 20,000 Revenues Control 260,000 Notice that the revenues control is credited for the expected collections. Governmental funds do not use a bad debt expenditure account because it does not have any budgetary implications. 3. Revenues from fines, licenses, and permits Aamount to $30,000. Cash $ 30,000 Revenues Control $ 30,000 Note that miscellaneous revenues are recognized on a cash basis. 4. City's share of sales taxes 4. Received a letter from the state indicating the city's share of sales taxes amounted to $25,000. State Sales Tax Receivable $ 25,000 Revenue Control $ 25,000 Based on the letter from the state, the sales tax revenue is susceptible to accrual. 5. Encumbrances Encumbrances are recorded obligations for unperformed contracts for goods or services. Because authorizations to spend are limited to appropriations, it is necessary to demonstrate compliance with legal requirements. This is done to prevent overspending of appropriations. For example, equipment is ordered with delivery expected in 60 days, at an estimated cost of $6,000 on July 1, 19X9. July 1, 19X9 To Record the Encumbrance Encumbrances Control $6,000 Budgetary Fund Balance Reserve for Encumbrances $6,000 August 30, 19X9 Equipment is received costing $6,200. The encumbrances entry is reversed. Budgetary Fund Balance Reserve for Encumbrances $6,000 Encumbrances Control $6,000 August 30, 19X9 The actual expenditure is recorded. Expenditures Control $6,200 Vouchers Payable $6,200 6. Expenditures for various consumables Expenditures for Supplies Inventory and Prepaid Insurance Accounting for supplies inventory or prepaid insurance may be done using either the consumption method (accrual) or the purchase method (cash basis). THE KEY POINT IS THAT UNDER THE CONSUMPTION METHOD THE AMOUNT CHARGED TO EXPENDITURES IS THE AMOUNT CONSUMED AND THE AMOUNT CHARGED TO EXPENDITURES UNDER THE PURCHASE METHOD IS THE AMOUNT PURCHASED. 7. Interfund Transactions 7. Interfund transactions are used within most government units as a means of directing sufficient resources to all activities and functions; monetary transfers made from the General Fund are quite prevalent since many government revenues are originally accumulated in this fund. A. Operating transfers are often made to provide financing for the broad range of government activities. * The asset outflow is recorded as an other financing use by the fund making the transfer while the receipt is labeled as an other financing source. * The other financing sources and the other financing uses accounts are reported as a part of the Statement of Revenues and Expenditures. For example: The general fund transfers $20,000 of operating funds to subsidize the swimming pool enterprise fund. Other Financing Uses - operating transfers out $20,000 Cash $20,000 B. Equity transfers are nonrecurring or nonroutine transfers of equity between funds. * They are made to create permanent financing for an Enterprise Fund or an Internal Service Fund. * The transfer-out is recorded as Other Financing Uses - operating transfers out while the transfer-in is shown as contributed cap l. For example: The general fund transfers $80,000 to an internal service fund to establish a centralized motor pool. Other Financing Uses - operating transfers out $80,000 Cash 80,000 NOTE: The Internal Service Fund would debit cash and credit contributed cap l. C. Quasi-external transactions are payments for work done within the government and are recorded as normal revenues and expenditures. For example: The city-owned water utility bills the general fund for water used in the city hall. Expenditures Control $5,000 Cash 5,000 Illustrative Problem Illustrative Problem and Year-end reclassification and closing entries. General Fund Transactions for the fiscal year ending June 30, 19X1: 1. A budget was approved for FY 19X1 showing estimated revenue of $1,896,000 and appropriations of $1,875,000 including estimated other financing uses of $20,000. The revenue estimate includes a real estate tax levy of $1,805,000 after allowing for estimated uncollectible taxes of 5%. 2. Supplies totaling $8,000 and two fire trucks costing $22,000 each were ordered. 3. An advance of $30,000 was made to establish an internal service fund (ISF) to acquire and maintain city owned vehicles. The $30,000 is expected to be repaid. 4. An annual payment of $20,000 was made to provide for redemption of serial bonds which begin to mature in ten years. 5. Wages of city departments totaled $678,000 during the year of which $11,200 was unpaid at June 30, 19X1. Included in wages was $62,000 in payments to the city pension fund which have not been paid. 6. The supplies inventory is $2,000 at year-end. It is the city's policy to show the supplies inventory in the balance sheet, but a city ordinance requires all supplies purchased to be charged to expenditures. 7. A total of $1,121,000 was transferred to the general fund of the town's school district which fund is operated independently of the city's general fund. 8. The supplies and one fire truck arrived costing $7,800 and $21,650 respectively. The other fire truck will be received in July. 9. Vouchers for the supplies and fire equipment were approved and paid. 10. Taxes previously written off in the amount of $850 were collected. 11. Miscellaneous tax receipts totaled $94,500. Real estate taxes of $1,802,000 were collected. REQUIRED: a. Journal entries for FY 19X1 transactions. b. Year-end reclassification and closing entries. Solution to Illustrative Problem: 1. Estimated Revenues Control $1,896,000 Appropriations Control $1,855,000 Estimated Other Financing Uses Control - Operating Transfers Out 20,000 Budgetary Fund Balance 21,000 Taxes Receivable-Current $1,900,000 Estimated Uncollectible Taxes $ 95,000 Revenue Control 1,805,000 X = $1,805,000 + .05 X X = $1,900,000 2. Encumbrances Control $52,000 Budgetary Fund Balance Reserve for Encumbrances $52,000 3. Due from Internal Service Fund $30,000 Cash $30,000 4. Other Financing - Operating Transfers Out $20,000 Cash $20,000 This transaction will result in entries in the Debt Service Fund. 5. Expenditures Control-Wages $678,000 Wages Payable $ 11,200 Due Trust Fund-Pensions 62,000 Cash 604,800 The Trust Fund for city pensions is affected by this entry. 6. Inventory of Supplies $2,000 Fund Balance Reserved for inventory of supplies $2,000 7. Expenditures Control-Schools $1,121,000 Cash $1,121,000 8. Budgetary Fund Balance Reserve for Encumbrances $30,000 Encumbrances Control $30,000 Encumbrances for $8,000 in supplies and $22,000 for one fire truck are reversed. A $22,000 encumbrance remains open. Expenditures Control $29,450 Vouchers Payable $29,450 ($7,800 supplies; $21,650 fire truck) 9. Vouchers Payable $29,450 Cash $29,450 10. Cash $850 Revenue Control $850 11. Cash $94,500 Revenue Control $94,500 Cash $1,802,000 Taxes Receivable-Current $1,802,000 Closing Entries 12. Step One: Close the budgetary accounts. Budgetary Fund Balance $21,000 Estimated Other Financing Uses - Operating Transfers Out 20,000 Appropriations Control 1,855,000 Estimated Revenues Control 1,896,000 13. Step Two: Close Revenue, Expenditures, and Other Financing accounts to Unreserved Fund Balance. Revenue Control $1,900,350 Expenditure Control $1,828,450 Other Financing Uses Control 20,000 Unreserved Fund Balance 51,900 14. Step Three: Close Encumbrance Accounts Budgetary Fund Balance Reserve for Encumbrances $22,000 Encumbrances Control $22,000 Reclassification Journal Entries 15. Restrict Balance Sheet Fund Balance for outstanding Encumbrances Unreserved Fund Balance $22,000 Fund Balance Reserved for Encumbrances $22,000 16. At the end of the accounting period, any uncollected taxes should be reclassified from current to delinquent along with the related estimated uncollectible taxes. Taxes Receivable - Delinquent $98,000 Estimated Uncollectible Taxes - Current 95,000 Taxes Receivable - Current 98,000 Estimated Uncollectible Taxes - Delinquent 95,000

Goodwill And The Equity Method Goodwill and the Equity Method The calculation of goodwill is the difference between the cost of the investment and the underlying value in the net assets which is the same calculation used in the purchase of a subsidiary. For example, assume a 40% investment and the net income of the investee is $65,000. Cost of Investment $150,000 FV of Net Assets $350,000 x 40% (140,000) Excess of Cost Over FV (Goodwill) 10,000 Historically, goodwill implicit in equity method investments wa amortized over periods less than or equal to 40 years. However, with the release of SFAS 142, the FASB stated that in applying the equity method, goodwill amotization would not be allowed in future periods. The change will be accounted for prospectively and retroactive adjustments would not be allowed. Instead, the goodwill amount reported for each equity method investment will be tested for permanent declines in value as any other asset on the balance sheet is tested for declines in value. Book value different than fair value: Assume further that the book value of the net assets (S.E.) was $300,000 and that the difference between the FV of the net assets and the carrying value (BV) was attributable to a fixed asset with a remaining useful life of 5 years. We can then make the following computation: Cost $150,000 Less: Goodwill 10,000 FV of Identifiable Assets 140,000 BV 40% * $300,000 120,000 Attributable to Fixed Assets 20,000 Annual Additional Depreciation 20,000 * 5 $ 4,000 This will result in additional depreciation ($4,000) per year for 5 years. To show the investment account in three parts: Cost of Assets at BV $120,000 * Cost of Fixed Asset in Excess of BV 20,000 Goodwill (ECOFV) 10,000 $150,000 * Will be written off over the useful life of the asset If in year 1 the investee had net income of $65,000, the entries to reflect investor's share of investee income ($26,000) and the adjustment to investment income would be: Investment $26,000 Investment Income $26,000 Investment Income 4,250 Investment 4,250 A simpler entry would probably be made as follows: Investment $21,750 Investment Income $21,750 OTHER POINTS * Sales of stock by an investor should be accounted for as gains or losses for the difference between selling price and carrying amount of stock sold. * The investor should record its share of the earnings or losses of an investee from the most recent financial statements. A lag in reporting should be consistent from year to year. * A loss in value that is other than temporary should be recognized. * In the event that an investor's share of losses exceeds the carrying amount of an investment accounted for by the equity method plus advances, the equity method should be discontinued when the investment is reduced to zero. If the investee subsequently reports net income, the investor should resume applying the equity method only after its share of net income equals the net losses not previously recognized. CHANGES IN STOCK OWNERSHIP—RETROACTIVE ADJUSTMENTS When a company buys less than a 20% interest in another company, the investment will ordinarily be recorded at cost unless significant influence can be shown. An increase in the investment by the investor to 20% or above (significant influence is presumed) requires retroactive application of the equity method to the period during which the cost method was used. Assume the following: Percentage Investee's Investee's Undistributed Year Stock Owned Net Income Dividends Income X1 5% $150,000 $ 50,000 $100,000 X2 10% 200,000 75,000 125,000 X3 15% 300,000 100,000 200,000 X4 25% 360,000 160,000 200,000 In 19X4 the investor is presumed to have significant influence and should use the equity method with retroactive application. The change from the cost method of accounting to the equity method is required by A.P.B. 18 and necess tes the retroactive adjustment of the investment, results of operations and retained earnings. Prior year statements are therefore restated to reflect the investor's share of net income. Since the investor already included the dividends in net income, only the difference between net income and dividends (the increase in investee's retained earnings) will be included in the adjustment. Journal Entry to show retroactive application: Investment $47,500 19X1 Investment Income $ 5,000 19X2 Investment Income 12,500 19X3 Investment Income 30,000 To include in income 5% * $100,000 for X1; 10% * $125,000 for X2; 15% * $200,000 for X3 The actual credits would be to Retained Earnings; however, if comparative statements are prepared, the investment income would be adjusted as shown. Journal Entries for 19X4: Investment $90,000 Investment Income $90,000 25% * $360,000 earnings for the year Cash $40,000 Investment $40,000 25% * 160,000 dividends paid by investee A comprehensive example of the retroactive adjustment of Investment Income follows: 10,000 shares of S outstanding at $100,000 Cap l contributed in excess 48,000 Shares Purchased by Parent at Undistributed Retained Included in Year Beginning of Year Cost Income Earnings—S P's R.E. X1 None —0— 1,000 1,000 None X2 1,000 $ 20,000 10,000 11,000 None * X3 1,000 22,000 14,000 25,000 3,800 ** X4 2,000 50,000 50,000 75,000 23,800 *** X5 4,000 106,000 75,000 150,000 83,800 **** * X1, X2—Equity method cannot be used unless significant influence can be shown. Investment should be carried at cost. ** X3 10% * 10,000 = 1,000 20% * 14,000 = 2,800 3,800 Equity Method Intercompany profit eliminated—20% *** X4 40% * 50,000 = 20,000 Plus X3 amt. = 3,800 23,800 Equity Method Intercompany profit eliminated—40% **** X5 80% * $75,000 60,000 Plus X4 amount 23,800 83,800 Consolidated statements should be prepared. If so, investment may be carried at cost. If consolidated statements cannot be prepared, the cost method must be used. Intercompany profit eliminated—100%. We can also show how S's stockholder's equity will be handled in making elimination entries in year X5. [Stockholder's equity = $148,000 paid-in cap l + $150,000 R.E.] Minority interest 20% or 298,000 = $59,600 Elimination vs Investment Account (A) $154,600 Included in consolidated R.E. $83,800 (A) 80% * 100,000 = $ 80,000 80% * 48,000 = 38,400 Total C/S and C.C. $118,400 Add: Purchased R.E. 10% * 1,000 (X2) 100 10% * 11,000 (X3) 1,100 20% * 25,000 (X4) 5,000 30% * 75,000 (X5) 30,000 $154,600 Remember to apply the rules for purchase accounting to each acquisition to determine if there is an excess of cost over fair value or an excess of fair value over cost. Also a difference in fair value may result in a change in depreciation or amortization of an asset thereby affecting investment income. Of course, if the acquisition results in an excess of cost over fair value (goodwill), the excess should be amortized over 40 years or the period benefited, if less. Combined Financial Statements To justify the preparation of consolidated statements, the controlling financial interest should rest directly or indirectly in one of the companies included in the consolidation. There are circumstances, however, where combined financial statements (as distinguished from consolidated statements) of commonly controlled companies are likely to be more meaningful than their separate statements. For example, combined financial statements would be useful where one individual owns a controlling interest in several corporations which are related in their operations. Combined statements would also be used to present the financial position and the results of operations of a group of unconsolidated subsidiaries. They might also be used to combine the financial statements of companies under common management. Where combined statements are prepared for a group of related companies, such as a group of unconsolidated subsidiaries or a group of commonly controlled companies, intercompany transactions and profits or losses should be eliminated, and if there are problems in connection with such matters as minority interests, foreign operations, different fiscal periods, or income taxes, they should be treated in the same manner as in consolidated statements. To the extent there is any intercompany investment, it is offset against the related equity. If there is no intercompany investment, the individual companies' equities are combined.

GOVERNMENT-WIDE FINANCIAL STATEMENTS Government Wide Financials Government wide-financial statements provide an overall entity perspective and include information about the long-term stewardship of governmental resources. In other words, the financial statements report a government's activities and financial position as a whole. On page 2 of the preface to SGAS 34, the GASB stated that government-wide financial statements will help users: * Assess the finances of the government in its entirety, including the year's operating results * Determine whether the government's overall financial position improved or deteriorated * Evaluate whether the government's current-year revenues were sufficient to pay for current-year services. * See the cost of providing services to its citizenry * See how the government finances its programs-through user fees and other program revenues versus general tax revenues * Understand the extent to which the government has invested in cap l assets, including roads, bridges, and other infrastructure assets * Make better comparisons between governments. To achieve these goals, the government-wide financial statements use an economic resources focus and accrual accounting. All assets and liabilities are reported and all revenues and expenses are recognized in a way comparable to business-type accounting. PRIMARY GOVERNMENTS AND COMPONENT UNITS Government-wide financial statements differentiate between the primary government and component units. * The primary government unit is usually a city, town, county, parish, state or a general-purpose local government. For example, a local school system may be deemed a primary government unit if it is legally independent, fiscally independent and has a separately elected governing body. * Component units are any functions that are legally separate from the primary government but where financial accountability exists. Examples are a Transit Authority, ABC Board, Redevelopment Commission or Housing Authority. GOVERNMENT AND BUSINESS-TYPE ACTIVITIES The primary government is divided into governmental activities and business-type activities. * Governmental activities summarize all the activities in the governmental funds into one column (See Exhibit A). The governmental funds must be adjusted from modified accrual to accrual and from a current resources focus to an economic measurement focus. These adjustments may be made on a worksheet or through specialized software. The major adjustments would be to eliminate the budgetary and encumbrance accounts, to record the fixed assets, the depreciation, long-term debt and accrue the bond interest. For example, the other financing sources - bond proceeds account used in fund-based accounting would be reclassified to bonds payable or the expenditures - cap l assets account used in fund-based accounting would be reclassified to cap l assets. The governmental activities column usually includes the Internal Service Funds. Even though the Internal Service Funds are considered proprietary funds for fund reporting, they are normally included in governmental activities for government-wide reporting. The logic is that their services are rendered primarily to benefit activities with governmental funds. However, if a particular Internal Service Fund predominantly services an enterprise fund, the internal service fund should be included as a business-type activity. * The business-type activities column (Exhibit A) summarizes the activities of all the Enterprise Funds and any Internal Service Fund that predominantly services enterprise funds. * The Fiduciary Funds are not included in government-wide financial statements because their resources are not available to finance governmental programs. (Remember the statement of fiduciary net assets and the changes in fiduciary assets are reported in fund-based financial statements).

Governmental Accounting Governmental Accounting Overview Governmental Accounting is the accounting for state and local governments. Its generally accepted accounting principles are established by the Governmental Accounting Standards Board (GASB) which is the public sector equivalent of the FASB. The Accounting procedures are established based on the perceived needs of the financial statement users as well as the underlying nature of the reporting units. Primary Users of Governmental Financial Statements GASB Concepts Statement No. 1 lists the following three groups as primary users of financial statements: 1. Citizenry - Want to evaluate the likelihood of tax or service fee increases, to forecast revenues in order to influence spending decisions, to ensure that resources were used in accordance with appropriations, to assess financial condition, and to compare budgeted to actual results. 2. Legislative and oversite bodies - Want to assess the overall financial condition when developing budgets and program recommendations, to monitor operating results to assure compliance with mandates, to determine the reasonableness of fees and the need for tax changes, and to ascertain the ability to finance new programs and financial needs. 3. Investors and creditors - Want to know the amount of available and likely future financial resources, to measure the debt position and the ability to service that debt, and to review operating results and cash flow data. Goals of Governmental Reporting * The goal of making the government accountable to the public is the one goal that has been constant over the years. This goal should assist users in making economic, social and political decisions. * Interperiod equity is an important component of accountability that is fundamental to public administration (Balance Budget Concept). Financial resources received by a government during a period should suffice to pay for the services provided during that period. Moreover, debt should be repaid during the probable period of usefulness of the assets acquired. Thus, financial reporting should help taxpayers assess whether future taxpayers will have to assume burdens for services already provided. FOCUS SGAS 34 introduced two new phrases describing the focus of governmental reporting: * Current Resources Management Focus This concept is a focus on short-term results and is used in areas where the focus is on measuring current financial resources such as cash, investments and receivables and the current claims against them. These areas do not report buildings, equipment or long-term debt because they do not have a direct impact on current financial resources. * Economic Resources Management Focus This concept provides an overall entity perspective and provides information about the long-term stewardship of governmental resources. This concept is used in areas that do not focus solely on current financial resources but report all the assets at the disposal of the government as well as the liabilities that must be paid. FINANCIAL STATEMENTS In its desire to provide information to satisfy the broad needs of its users, the GASB created two distinct sets of financial statements which it defined as follows: * Fund-based Financial Statements have been designed "to show restrictions on the planned use of resources or to measure, in the short term, the revenues and expenditures arising from certain activities." * Government-wide Financial Statements will have a longer-term focus because they will report "all revenues and all costs of providing services each year, not just those received or paid in the current year or soon after year-end." Since the fund-based financial statements follow the traditional governmental funds, journal entries and accounts, the emphasis in the first part of this chapter will be on fund-based accounting and the adjustments and reporting for government-wide financial statements will be covered at the end of the chapter. PRIMARY ACCOUNTING EMPHASIS OF FUND-BASED REPORTS The primary accounting emphasis has traditionally been on reporting short-term results that was directed toward answering the following three basic questions: * Where did the financial resources come from? * Where did the financial resources go? * What amount of financial resources is presently held? FUND ACCOUNTING One of the most unique aspects of governmental accounting is the use of fund accounting. Each fund is a separate accounting entity and all the funds taken together make up the government's financial reporting system. The GASB defines a fund as an independent fiscal and accounting entity with a self-balancing set of accounts recording cash and other financial resources together with all related liabilities and residual equities or balances and changes therein which are segregated for the purpose of carrying on specific activities or attaining certain objectives in accordance with special regulations, restrictions, or lim tions. Because the accounting for the police department, the school systems, the motor pool, trust funds, and the water system have such diverse objectives, the funds are divided into three categories: * Governmental Funds which account for activities primarily designed to serve the public. * Proprietary Funds which are business-type activities which are supported by user charge. * Fiduciary Funds are activities in which the government accounts for monies it holds in a trustee capacity to benefit others. These funds cannot be used for government purposes. TYPES OF FUNDS * Governmental Funds account for activities primarily designed to serve the public and are generally financed through taxes. For example, governmental funds would account for activities of the fire and police departments. Governmental funds and fund-based reporting focus on short-term results (current resources management focus) and use modified accrual approach for the recognition of revenues and expenditures. These funds are often called "expendable" funds because of the focus on current resources such as cash, investments, and receivables and the current claims against them. The difference between the current assets and current liabilities is called fund balance. Because of its short-term focus, governmental funds do not account for non-current fixed assets or non-current debt. There are five governmental funds: 1. General Fund - to account for all financial activities and resources not required to be accounted for in another fund. All accounts are "current". 2. Special Revenue Funds - to account for the proceeds of specific revenue sources that are legally restricted to expenditures for specified purposes (roads, bridges). For example: A federal grant restricted for road repairs. 3. Cap l Projects Funds - to account for financial resources to be used for the acquisition or construction of major cap l facilities other than those financed by proprietary funds and trust funds. 4. Debt Service Funds - to account for the accumulation of resources for, and the payment of, general long-term debt principal and interest. 5. The Permanent Funds category is a new fund type within the governmental funds. It accounts for assets contributed to the government by an external donor with the stipulation that the principal cannot be spent but any income can be used within the government, often for a designated purpose. (These contributions were formerly reported in the non-expendable trust fund.) Permanent Funds are unusual in that the funds include long-term assets from the non-expendable portion of the external donations. Most governmental funds include only current assets and current liabilities. The first three funds, the General Fund, Special Revenue Funds and the Cap l Projects Funds are unique in that budgets are recorded in the fund and encumbrances are used for accruals. Budgets and encumbrances are not needed in the Debt Service Funds and Permanent Funds because their transactions are prescribed by contract or agreement. * Proprietary Funds are business-type activities run by the government and supported by user charge. These funds have a long-term focus (economic resources focus) and use accrual accounting. Their accounting is similar to the accounting for a business and the equity section of these funds use terms such as contributed cap l and retained earnings. There are two types of proprietary funds: 1. Enterprise Funds are governmental operations that benefit the general public and are financed by user charges. Examples are the water and sewer systems, public golf courses, public swimming pools and an airport. 2. Internal Service Funds - to account for the financing of goods or services provided by one department or agency to other departments or agencies of the government unit, or to other governmental units, on a cost-reimbursement basis. Examples are a centralized motor pool, engineering pool, and centralized data processing facility. * Fiduciary Funds are assets that are held in a trustee capacity for external parties and the funds cannot be used to support the government's own programs. Fiduciary Funds use the economic resources measurement focus and accrual accounting for the reporting of revenues and expenses. The fiduciary funds consist of three trust funds and the agency fund. 1. Investment Trust Funds - This fund type accounts for the outside portion of investment pools where the reporting government has accepted funds from other governments to have more money to invest and, hopefully, earn a higher return. 2. Private-Purpose Trust Funds - This fund type accounts for any monies held in a trustee capacity where principal and interest are for the benefit of external parties outside of the governmoent such as individuals, private organizations, or other governments. 3. Pension Trust Fund Accounts - This fund type accounts for employee retirement funds. 4. Agency Funds - This fund type accounts for assets held on a purely custodial basis (assets equal liabilities) and thus do not involve measurement of results of operations. For example, the money withheld from employees' paychecks for health insurance premiums would be recorded in an agency fund. Review the overview of the types of funds on page 15-4 and the format of the financial statements of the general fund on page 15-5. Notice that the balance sheet includes only current assets and current liabilities. The other financing sources and uses shown on the statement of revenues, expenditures, and changes in fund balances will be discussed later. Categories of Funds Three major categories of funds used in accounting for governmental financial operations: Governmental Funds Proprietary Funds Fiduciary Funds (Expendable) (Non-expendable) 1. General Fund 1. Enterprise Fund 1. Trust Funds 2. Special Revenues (Activities which benefit A. Investment trust funds the population and are 3. Cap l Projects Fund supported by user fees) B. Private-purpose trust funds 4. Debt Service Fund 2. Internal Service 5. Permanent Funds (Provides services of C. Pensions & other facilities to other employee benefit departments within trust funds the government) 2. Agency Fund Only assets and liabilities; no equity, revenue, or expenditure accounts Characteristics of Fund for Fund-Based Report Accounting Accounting A. FOCUS: current resources A. FOCUS: economic A. FOCUS: economic management focus resources management resources focus management focus B. All use Modified Accrual B. Accrual accounting B. Accrual accounting since they are expendable. C. Records Budget EXCEPT Debt C. Like a corporation Service & Permanent Funds D. Encumbrance System - Funds D. Equity includes RE are committed (earmarked) and contributed cap l EXCEPT Debt Service & Permanent Funds E. No fixed assets exist. F. No long-term debt exists. Example: Financial Statements of the General Fund GUIL COUNTY General Fund Statement of Revenues, Expenditures, and Changes in Fund Balance (Condensed) Year Ended June 30, 19X9 Revenues $600,000 Expenditures (533,000) Excess of revenues over expenditures $ 67,000 Other financing sources (uses): Bond proceeds - Cap l debt $200,000 Operating transfers in 100,000 Operating transfers out (200,000) Total other financing sources (uses) 100,000 Excess of revenues and other financing sources over expenditures and other financing uses $167,000 Unreserved fund balance, July 1, 19X8 90,000 Less: Increase in reserve for encumbrances (20,000) Unreserved fund balance, June 30, 19X9 $237,000 GUIL COUNTY General Fund Balance Sheet (Condensed) June 30, 19X9 Assets Cash $ 61,900 Investments 105,000 Receivables (net of allowances): Taxes 184,000 Accounts 48,850 Due from other funds 26,000 Total assets $425,750 Liabilities Vouchers payable $125,930 Contracts payable 16,720 Due to other funds 26,100 Total liabilities $168,750 Equity Fund balances: Reserved for encumbrances $ 20,000 Unreserved, undesignated 237,000 Total fund balances 257,000 Total liabilities and equity $425,750

Governmental Accounting Standards Board Statement No. 39 Determining Whether Certain Organizations are Component Units. (An amendment of GASB Statement No. 14) Background: In GASB statement ., component units were defined as legally separate organizations for which the elected officials of the primary government are financially accountable. In addition, a component unit can be another organization for which the nature and significance of its relationship with a primary government are such that exclusion would cause the reporting entity's financial statements to be misleading or incomplete. Specifically left out of the statement for further study were the reporting of foundations and other similarly affiliated organizations. Statement ' clarifies existing accounting guidance and provides greater consistency in accounting for such organizations that are closely related to primary governments. Examples of such organizations are not-for-profit foundations of public universities, schools and qualifying fund raising foundations of state and local governments. STATEMENT NO. 39 Statement No. 39 amends Statement No. 14 to provide additional guidance to determine whether certain organizations for which the primary government is not financially accountable should be reported as component units based on the nature and significance of their relationship with primary government. The Statement sets forth criteria on which a government is required to provide a discrete presentation that published financial information about its own activities as well as those of the affiliated organization. Generally, it requires reporting, as a component unit, an organization that raises and holds economic resources for the direct benefit of a governmental unit. Organizations that are legally separate, tax-exempt entities and that meet all of the following criteria should be discretely presented as component units. These criteria are: 1. The economic resources received or held by the separate organization are entirely or almost entirely for the direct benefit of the primary government, its component units, or its constituents. 2. The primary government, or its component units, is entitled to, or has the ability to otherwise access, a majority of the economic resources received or held by the separate organization. 3. The economic resources received or held by an individual organization that the specific primary government, or its component units, is entitled to, or has the ability to otherwise access, are significant to that primary government. This Statement continues the requirement in Statement 14 to apply professional judgment in determining whether the relationship between a primary government and other organizations for which the primary government is not financially accountable and that do not meet these criteria is such that exclusion of the organization would render the financial statements of the reporting entity misleading or incomplete.

HEALTH CARE ORGANIZATIONS Health Care Organizations Examples of Health Care Organizations are clinics, medical group practices, individual practice associations, individual practitioners, emergency care facilities, laboratories, surgery centers, other ambulatory care organizations, continuing care retirement communities, health maintenance organizations, home health agencies, hosp ls, nursing homes, and rehabil tion centers. Most questions and problems from this area focus on hosp ls. Hosp ls were discussed in Chapter 15 as enterprise funds of state and local governments and would follow SGAS 34. At the beginning of this chapter, hosp ls were discussed as being component units of universities and would follow SGAS 35. In the previous section of this chapter hosp ls were discussed as private not-for-profits and would follow the reporting requirements of SFAS 116 and 117. Given the diversity in requirements, the AICPA issued its AICPA Audit and Accounting Guide: Health Care Organizations in order to promote some consistency in reporting requirements. The CPA Exam seems to focus on this audit guide. Major points associated with the audit guide * Health care organizations may be investor owned Health Care Enterprises (SFAS 116, 117), private not-for-profit entities (SFAS 116, 117), and governmental health care organizations (SGAS 34, 35). * Financial statements include four basic financial statements: 1. Balance Sheet (statement of financial position). 2. Statement of Operations. 3. Statement of Changes in Equity or Net Assets or Fund Balance 4. Statement of Cash Flows. * Health care organizations, except for continuing care retirement communities, are to present a classified balance sheet, with current assets and current liabilities shown separately. Continuing care retirement communities may sequence assets in terms of nearness to cash and liabilities in accordance with the maturity date. * Accrual accounting is used for the recognition of revenues and expenses. * The statement of operations should provide a performance indicator such as operating income, revenue over expenses, etc. The institution should disclose the policy used by the health care entity for determining its performance indicator. * Expenses may be reported by function or by natural classification (object). However, if the institution reports expenses by the natural classification, a supplemental schedule must be provided to list expenses. * Depreciation, interest and bad debt expenses are reported along with disclosures by function. * Patient service revenue is reported as net patient revenue. Net patient service revenue is calculated by deducting contractual adjustments and other adjustments such as hosp l employee discounts from gross patient service revenue. The amounts of contractual amounts adjustments and descriptions of the types of adjustments must be disclosed in the footnotes. * Patient service revenue does not include charity care. Management's policy for providing charity care and the level of charity care provided should be disclosed in the notes. * Cap tion agreements, which are revenues from third parties based on the number of employees covered instead of services performed, should be shown separately on the statement of operations. The audit guide example (Exhibit E) lists them as premium revenue on the line below net patient revenue. Net Patient Service Revenue Example: The hosp l rendered $1,000,000 in services to patients of which $800,000 is charged to third party payors. The collections department estimates that $850,000 will be collected Of the $150,000 difference, $60,000 is the estimated contractual adjustments with insurance and Medicare providers, $50,000 is charity care, and $40,000 is the uncollected accounts. The journal entries are: 1. Accounts receivable - patients 200,000 Accounts receivable - third party payors 800,000 Patient service revenue 1,000,000 To accrue patient service revenue. 2. Contractual adjustments 60,000 Allowance for contractual adjustments 60,000 To recognize amounts not expected to be collected from third party payors. Note: A contractual adjustment is a difference between what the hosp l considers a fair price for a service vs. an agreed upon amount for the service with the insurance companies or Medicare. For example, the hosp l may consider $3,000 a fair price for a service, but agree with Medicare to accept $2,800. The difference of $200 must be written off as contractual adjustment which becomes a reduction in patient service revenue. 3. Patient service revenue 50,000 Accounts receivable - patients 50,000 To reduce patient service revenue for charity care. Charity care is defined as patient service revenue in which there is no intention to collect for the services. Remember that charity care is not shown on the statement of operations but is disclosed in the footnotes. 4. Bad debt expense 40,000 Allowance on uncollected accts. 40,000 To accrue estimated uncollectible accounts. The calculation of the net patient service revenue would be: Gross patient service revenue $1,000,000 Less contractual adjustments ( 60,000) Less charity care ( 50,000) Net patient service revenue $ 890,000 Cap tion Agreements Cap tion agreements are agreements with third parties based on the number of employees instead of services rendered. For example, ABC hosp l signed an agreement with the XYZ Corporation to provide hosp l services for $200 per month for each of XYZ's 100 employees. JE: Accounts receivable - XYZ Corporation 20,000 Premium Revenue 20,000 To accrue billings for the first month under the cap tion agreement. Other Revenues Other revenues consist of revenues earned by the hosp l that are not patient service revenues or premium revenues. Examples are the revenues from the hosp l's pharmacy, parking deck, flower and gift shop, educational programs, donated materials and services. For example: A computer consultant donated her services to upgrade several hosp l computers. The hosp l would have paid $4,000 for these services if they had not been donated. JE Expenses for professional services 4,000 Other revenue - donated services 4,000 Another example: Cafeteria sales to non-patients and gift shop receipts total $80,000. JE Cash 80,000 Other revenue - cafeteria and gift shop 80,000

Illustrative Problem Illustrative Carryback(forward) In January 2000, you began the examination of the financial statements for the year ended Dec. 31, 1999, of Sesame Corporation, a new audit client. During your examination the following information was disclosed: 1. The 1999 federal tax return reported taxable income of $175,000 and taxes due of $52,500. Taxable incomes were reported for 1996, 1997 and 1998. The company had a deferred tax asset balance of $20,025 at 12/31/98. Sesame Corp. implements the provisions of SFAS No 109 for the year ended 12/31/99 for the first time. 2. On Jan. 2, 1997, equipment was purchased at a cost of $225,000. The equipment had an estimated useful life of five years and no salvage value. The MACRS (5-year) method of recovery was used for income tax reporting and the straight-line method was used on the financial statements. 3. On Jan. 8, 1998, $60,000 was collected in advance rental of a building for a three-year period. The $60,000 was reported as taxable income in 1998, but $40,000 was reported as deferred revenue in 1998 in the financial statements. The building will continue to be rented for the foreseeable future. 4. On Jan. 5, 1999, office equipment was purchased for $10,000. The office equipment has an estimated life of 10 years and no salvage value. Straight-line depreciation was used for both financial and income tax reporting purposes. Management, however, elected to write off $5,000 of the cost of the equipment for income tax purposes in 1999 and use straight-line over 5 years for the remaining $5,000 cost. As a result, the total depreciation for this equipment on the tax return was $5,500. (Half-year convention is used). 5. On Feb. 12, 1999, the Corporation sold land with a book and tax basis of $150,000 for $200,000. The gain, reported in full in 1999 on the financial statements, was reported by the installment method on the income tax return equally over a period of 5 years. 6. On Mar. 15, 1999, a patent developed at a cost of $34,000 was granted. The Corporation is amortizing the patent over a period of 4 years on the financial statements and over 17 years on its income tax return. The Corporation elected to record a full year's amortization in 1999 on both its financial statements and income tax return. 7. The income tax rates for 1997, 1998 and 1999 are assumed to be 30% for each year. Required: a. For each item causing a temporary difference, prepare a schedule showing the taxable or deductible amount for each year. b. Prepare a schedule showing the taxable and deductible amounts for 1999 for each item. c. Compute the deferred tax asset and liability at 12/31/99. d. Compute the 1999 income tax expense. Solution: a. Net taxable or deductible amounts: (2) Equipment Schedule 1997 1998 1999 2000 2001 2002 Tax (MACRS) $45,000 $72,000 $43,200 $25,920 25,920 $12,960 Book (S.L.) 45,000 45,000 45,000 45,000 45,000 - 0 Difference $ - 0 - $27,000 $(1,800) (19,080)(19,080) $12,960 Taxable amounts $ 1,800 $19,080 $19,080 Deductible amounts $27,000 $12,960 (3) Rental receipts 1998 1999 2000 Book income $20,000 $20,000 $20,000 Tax income 60,000 ______ ______ Difference $(40,000) $20,000 $20,000 Deductible amount $20,000 $20,000 Taxable amount $40,000 (4) Office equipment 2005- 1999 2000 2001 2002 2003 2004 2008 Tax depn $5,500 $1,000 $1,000 $1,000 $1,000 $ 500 $ 0 Book depn 1,000 1,000 1,000 1,000 1,000 1,000 4,000 (1M ea.) Difference 4,500 - 0 - - 0 - - 0 - - 0 - $(500) $(4,000) Taxable amounts $500 $4,000 Ded amt $4,500 (5) Installment gain: 1999 2000 2001 2002 2003 Book income $50,000 Tax income 10,000 10,000 10,000 10,000 10,000 Difference $40,000 $(10,000) $(10,000) $(10,000) $(10,000) Deductible $40,000 Taxable amounts $10,000 $10,000 $10,000 $10,000 (6) Patent 1999 2000 2001 2002 2003 2004 2005 2006 After Tax amort 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 18,000 Book amort 8,500 8,500 8,500 8,500 _____ _____ _____ _____ _____ Diff $6,500 6,500 6,500 6,500 (2,000) (2,000) (2000) (2,000) (18,000) Taxable $6,500 $6,500 6,500 6,500 Deductible amounts 2,000 2,000 2,000 2,000 18,000 b. Taxable and deductible amounts for 1999: Taxable Deductible (2) Equipment $27,000 - $1,800 $25,200 (3) Rental income $40,000 - $20,000 $20,000 (4) Office equipment 4,500 (5) Installment gain 40,000 (6) Patent 6,500 ______ c. Deferred tax balances: Totals $26,500 $69,700 Tax rate 30% 30% Asset $7,950 Liability $20,910 Current portion: $20,000 x .3 = $6,000 d. Income tax expense for 1999: Income tax payable $52,500 Change in deferred tax accounts: Liability at 12/31/99 $20,910 Asset - 7,950 12,960 Income tax expense $65,460 Note: The $20,025 deferred tax asset balance at 12/31/98 would be shown on the income statement at 12/31/99 as an accounting change due to the implementation of a new accounting standard in accordance with APB 20.

Income Statement Reporting the Results of Operations INCOME STATEMENT- MULTI-STEP FORMAT This approach is called multi-step because of the number of "steps" or sub-totals between the beginning net sales number and the calculation of income from continuing operations. Examples of the "steps" are the calculation of gross profit, operating profit, and income from continuing operations before income taxes. Complex Corporation Statement of Earnings For the Years Ended December 31, (in thousands) 20X5 20X4 Net sales $5,000 $4,000 Cost of sales 2,800 1,900 GROSS PROFIT 2,200 2,100 Operating expenses 1,000 850 Selling expenses 100 100 Administrative expenses 500 450 1,600 1,400 OPERATING PROFIT 600 700 Other income, principally interest (80) (60) Other expenses, principally interest 20 30 Income from continuing operations before income taxes 660 730 Provision for income taxes 300 350 INCOME FROM CONTINUING OPERATIONS $ 360 $ 380 Discontinued operations: Loss from operations of discontinued widget component including a loss on disposal of $350 and net of taxes of $170 (250) Adjustment to actual loss net of income taxes of $10 $(15) $(250) NET INCOME BEFORE EXTRAORDINARY GAIN AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 345 130 Extraordinary gain from settlement with State for condemnation of property net of income taxes of $30 70 Cumulative effect of change from the declining balance to straight-line method of depreciation on previously owned assets net of income taxes of $60 75 ____ NET INCOME $420 $200 Earnings per common share (100,000 shares): Income from continuing operations $3.60 $3.80 Loss from discontinued widget division (.15) (2.50) Income before extraordinary gain and cumulative effect of accounting change 3.45 1.30 Extraordinary gain net of income taxes .70 Cumulative effect of changing to a different depreciation method net of taxes .75 ____ Net income $4.20 $2.00 Pro forma amounts assuming the new depreciation method is applied retroactively: Income from continuing operations $360 $390 Income per share 3.60 3.90 Net income before extraordinary gain and cumulative effect of accounting change 345 140 Income per share 3.45 1.40 Net income 345 210 Net income per share 3.45 2.10 EXAM HINT: The abbreviation for December (DEC) is a useful acronym for remembering the order of the lower sections of the income statement: D = Discontinued Operations, E = Extraordinary items; and C = Change in Accounting Principle. INCOME STATEMENT- SINGLE STEP FORMAT A single-step approach lists all revenues together and then lists all expenses together regardless of the source. The approach is called single-step because a single calculation of total revenues less total expenses equals income from continuing operations. A single-step income statement would differ from a multi-step income statement only in the calculation of income from continuing operations as shown below. The calculation of discontinued operations, extraordinary items, changes in accounting principles, earnings per share, etc., would be the same under both the single-step and the multi-step method. Complex Corporation Partial Income Statement For the Years Ended December 31, (in thousands) Single-Step Format REVENUES 20X5 20X4 Net sales $5,000 $4,000 Other Income - Principally Interest 80 60 Total Revenues $5,080 $4,060 EXPENSES Cost of Sales 2,800 1,900 Operating Expenses 1,000 850 Selling Expenses 100 100 Administrative Expenses 500 450 Other Expenses - Principally Interest 20 30 Provision for Income Taxes 300 350 Total Expenses 4,720 3,680 Income from Continuing Operations $360 $380 DISCLOSURE OF ACCOUNTING POLICIES-APB N0. 22 Issuance of financial statements, purporting to present fairly such statements in accordance with GAAP should include a description of all significant accounting policies. This applies to profit or not-for-profit entities and situations where one or more of the basic statements are appropriately issued purporting to present financial position, results of operations or changes in financial position. Disclosure is not required for interim unaudited statements issued between annual reporting dates where the entity has not changed accounting policies since the end of the preceding year. Disclosure should include accounting principles and methods of applying them that involve the following criteria: a. A selection from existing acceptable alternatives. (Where there is only one acceptable application of GAAP, no disclosure is required.) b. Principles and methods peculiar to the industry in which the reporting entity operates, even if such principles and methods are predominantly followed in that industry. c. Unusual or innovative applications of generally accepted accounting principles (and, as applicable, of principles and methods peculiar to the industry in which the reporting entity operates). Examples of disclosures by a business entity commonly required with respect to accounting policies would include, among others, those relating to depreciation methods, amortization of intangibles, inventory pricing, recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. This is not all-inclusive. Disclosure need not duplicate details furnished elsewhere in the financial statements. In some cases, disclosure may be cross-referenced to other required disclosure; for example, the disclosure of a change in accounting principle as required by Opinion No. 20. Format for disclosure is flexible, but it is suggested that disclosure be included separately under the heading: Summary of Significant Accounting Policies.

Income Tax Allocation (SFAS 109) Accounting for Income Taxes Income tax allocation in accounting is necessary because of the accrual concept that costs incurred in an accounting period should be matched with the income that resulted in such costs, regardless of when such costs are ultimately paid. Income taxes-federal, state, local, and foreign-are significant costs which must be matched with the income that gave rise to the taxes to fulfill the major objective of corporate financial reporting. Principal Problem Areas 1. Transactions affect book income in one period and taxable income in another, and result in temporary differences. 2. Recognition of the tax effects of a net operating loss. Will the effect be recognized in the period of the loss or in the period the taxable income is reduced by means of carrybacks and carryforwards? 3. The treatment of tax effects of extraordinary items, disposal of a segment of a business, and discontinued operations referred to as intraperiod income tax allocation. The FASB's conclusions regarding these problem areas are as follows: 1. There should be interperiod income tax allocation and the "asset and liability" method should be used. 2. The deferred tax account will be calculated using future enacted tax rates. 3. Carrybacks should affect the loss periods; carryforwards will usually be recognized subject to a valuation allowance. 4. The statements will disclose the income taxes currently payable and the expense related to the period. 5. Deferred taxes should be classified net current and net noncurrent. 6. Tax allocation within a period (intraperiod) is appropriate in that the tax effects of all items which are segregated from income from continuing operations should be shown along with the related tax effect of such items. 7. Tax allocation within a period (intraperiod) is also appropriate for other comprehensive income items included in comprehensive income. (SFAS No 130) Basic Principles and Objectives One objective of accounting for income taxes is to recognize the amount of taxes payable or refundable for the current year. A second objective is to recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an enterprise's financial statements or tax returns. Ideally, the second objective might be stated more specifically to recognize the expected future tax consequences of events that have been recognized in the financial statements or tax returns. However, that objective is realistically constrained because (a) the tax payment or refund that results from a particular tax return is a joint result of all the items included in that return, (b) taxes that will be paid or refunded in future years are the joint result of events of the current or prior years and events of future years, and (c) information available about the future is limited. As a result, attribution of taxes to individual items and events is arbitrary and, except in the simplest situations, requires estimates and approximations. To implement the objectives in light of those constraints, the following basic principles are applied in accounting for income taxes at the date of the financial statements: a. A current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year. b. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards. c. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. d. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized. TEMPORARY DIFFERENCES The tax consequences of most events recognized in the current year's financial statements are included in determining income taxes currently payable. However, because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenues, expenses, gains, and losses, differences arise between the following: a. The amount of taxable income and pretax financial income for a year b. The tax bases of assets or liabilities and their reported amounts in financial statements. An assumption inherent in an enterprise's statement of financial position prepared in accordance with generally accepted accounting principles is that the reported amounts of assets and liabilities will be recovered and settled, respectively. Because of that assumption, a difference between the tax basis of an asset or a liability and its reported amount in the statement of financial position will result in taxable or deductible amounts in some future year without regard to other future events. Examples follow: a. Revenues or gains that are taxable after they are recognized in financial income (installment sale). b. Expenses or losses that are deductible after they are recognized in financial income (a product warranty liability). c. Revenues or gains that are taxable before they are recognized in financial income (subscriptions received in advance). d. Expenses or losses that are deductible before they are recognized in financial income (depreciable property). These examples pertain to revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than the year in which they are recognized in financial income. Those differences between taxable income and pretax financial income also create differences between the tax basis of an asset or liability and its reported amount in the financial statements. The differences result in taxable or deductible amounts when the reported amount of an asset or liability in the financial statements is recovered or settled, respectively. SFAS No 109 refers collectively to these differences as temporary differences. Temporary Differences Example In 1999 Noll Corp. reported income before depreciation of $900,000. Noll deducted depreciation for financial reporting of $400,000 and $600,000 on its 1999 tax return. The $200,000 temporary depreciation difference is expected to reverse equally over the next three years. Noll's enacted tax rates are 30% for 1999 and 25% for the following three years. Required: Prepare the tax journal entry for 1999. Solution: Book Tax Income before depreciation $900,000 $900,000 Depreciation Expense (400,000) (600,000) Income before tax 500,000 300,000 Income taxes (see JE) Currently payable ( 90,000) ( 90,000) Deferred taxes ( 50,000) ( 0) Net Income $360,000 $210,000 Journal Entry: Income tax expense - current 90,000 Income tax expense - deferred 50,000* Income tax payable 90,000** Deferred tax payable 50,000 * The deferred tax of $50,000 is the temporary difference of $200,000 times the future enacted tax rate of 25%. ** The income tax payable is the taxable income of $300,000 times the current tax rate of 30%. PERMANENT DIFFERENCES A permanent difference arises when revenues are exempt from taxation or expenses are not allowable as deductions for tax purposes. Permanent differences cause differences in book net income and tax net income. Permanent differences do not cause differences in taxes (only temporary differences can create differences in taxes). Some examples of common permanent differences are listed below: a. State and municipal bond interest income: included in book income but not included in taxable income. b. Dividends received exclusion: deducted for taxable income but not for book income. c. Life insurance premiums on executives when the corporation is the beneficiary: deducted as an expense for book purposes but not deducted for tax purposes. Conversely, proceeds received from life insurance policies are included in book income but excluded from taxable income. d. Payment of fines and penalties: included in book income but not included in taxable income. The following problem illustrates the effect of permanent differences: Example: Seaboard Corp. has income of $200,000 for books and taxes before considering the permanent differences listed below: a. Interest income on municipal bonds is $30,000. b. Life insurance premiums of $20,000 have been paid on Seaboard executives and the Corporation is the beneficiary. Assuming a 30% tax rate, what would be the journal entry to record the taxes? Solution: Book Tax Income before permanent differences $200,000 $200,000 Interest income on municipal bonds 30,000 0 Life insurance premiums on executives ( 20,000) 0 Income before taxes $210,000 $200,000 Taxes at 30% (see below*) (60,000) (60,000) Net income $150,000 $140,000 * Entry to record taxes: Income tax expense - current 60,000 Tax payable 60,000 Note from the above problem that the permanent differences cause a difference in net income but do not cause a difference in taxes. Deferred Tax Assets and Liabilities An enterprise shall recognize a deferred tax liability or asset for all temporary differences and operating loss and tax credit carryforwards in accordance with the provisions below. Deferred tax expense or benefit is the change during the year in an enterprise's deferred tax liabilities and assets. The statement requires comprehensive allocation using the liability method. This method is balance-sheet oriented. The total tax that will be assessed on temporary differences when they reverse is accrued and reported. The deferred tax amount that is reported as an asset or liability on the balance sheet represents the effect of all temporary differences, which will reverse in the future using current tax rates and laws and those in existence in the year(s) in which the temporary differences reverse. Therefore, income tax expense is equal to income taxes currently payable plus or minus the change in the deferred tax account. An Enacted Change in Tax Laws or Rates A deferred tax liability or asset shall be adjusted for the effect of a change in tax law or rates. The effect shall be included in income from continuing operations for the period that includes the enactment date. Annual Computation of a Deferred Tax Liability or Asset Deferred taxes shall be determined separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction. That determination includes the following procedures: a. Identify (1) the types and amounts of existing temporary differences and (2) the nature and amount of each type of operating loss and tax credit carryforward and the remaining length of the carryforward period. b. Measure the total deferred tax liability for taxable temporary differences using the tax rate in effect when temporary difference reverses. c. Measure the total deferred tax asset for deductible temporary differences and operating loss carryforwards using the applicable tax rate. d. Measure deferred tax assets for each type of tax credit carryforward. e. Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. The objective is to measure a deferred tax liability or asset using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized. Under current U.S. federal tax law, if taxable income exceeds a specified amount, all taxable income is taxed, in substance, at a single flat tax rate. That tax rate shall be used for measurement of a deferred tax liability or asset by enterprises for which graduated tax rates are not a significant factor. Enterprises for which graduated tax rates are a significant factor shall measure a deferred tax liability or asset using the average graduated tax rate applicable to the amount of estimated annual taxable income in the periods in which the deferred tax liability or asset is estimated to be settled or realized.

Indirect Method INDIRECT METHOD OF REPORTING OPERATING CASH FLOWS The indirect method reports the same amount for net cash flow from operating activities; however, it does not report major classes of gross cash receipts and payments from operating activities. Rather, the indirect method starts with net income and adjusts it for revenue and expense items that were not the result of operating cash transactions in the current period, to reconcile it to net cash flow from operating activities. The reconciliation must separately report all major classes of reconciling items, including at a minimum, separately reporting changes during the period in receivables, inventory, and payables, pertaining to operating activities and clearly identify all adjustments to net income as reconciling items. The reconciliation may be either within the statement of cash flows or in a separate schedule with the statement reporting only the net cash flow from operating activities. Common reconciling items to adjust net income to net cash flow from operating activities are: Additions to net income decreases in receivables and inventory related to operations decrease in prepaid expenses increase in payables related to operations increases in accrued expenses and deferred income taxes depreciation, depletion and amortization expenses amortization of discount on notes or bonds payable amortization of premium on investments in notes or bonds loss on the sale or disposal of productive assets loss recognized under the equity method loss on discontinued operations loss on retirement of debt Deductions from net income increases in receivables and inventory related to operations increase in prepaid expenses decrease in payables related to operations decreases in accrued expenses and deferred income taxes amortization of premium on notes or bonds payable amortization of discount on investments in notes or bonds gain on sale or disposal of productive assets undistributed income recognized under the equity method gain on discontinued operations gain on retirement of debt Advantages of Indirect Method * The principal advantage of the indirect method is that it focuses on the differences between net income and net cash flow from operating activities, linking the income statement to the statement of cash flows. Identifying differences between income items and related cash flows can assist external users to identify differences between enterprises in the measurement and recognition of noncash items that affect income. * The indirect method provides information about intervals of leads and lags between cash flows and income by showing how the changes in current assets and current liabilities, relating to operations, affect operating cash flows. External users frequently assess future cash flows by first estimating future income (based in part on reports of past income) and then converting those estimates to estimates of future cash flows by allowing for leads and lags between income and cash flows. Disadvantages of Indirect Method * The indirect method does not show gross operating cash receipts and payments. * The indirect method is inconsistent with the statement objective of providing information concerning gross cash receipts and payments during a period. Additional Required Disclosures If the indirect method is used, related disclosures must include the amounts paid for interest (exclusive of amounts cap lized) and income taxes. This information, together with the information included in the reconciliation of net income to net cash flow from operating activities, should enable external users to indirectly approximate the cash receipts and payments related to operations, and thereby partially avoid the inherent disadvantages of this method. Example: Using the facts of the example for the direct method (Hiram Supply Company), the cash flows from the operating activities section of the statement of cash flows, under the indirect method, would appear as follows: Cash flows from operating activities: Net income $18,700 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense 5,000 Increase in accounts receivable (8,000) Increase in inventory (2,500) Decrease in accounts payable (1,300) Increase in salaries payable 1,000 Net cash provided by operating activities $12,900

Initial Direct Costs SFAS No. 91, 98 Costs To Be Included As Initial Direct Costs, SFAS No. 91, 98 Costs incurred by lessor to originate a lease and costs directly associated with lessor activities related to the lease. Such activities include evaluating lessee's financial condition or collateral, negotiations and processing activities. Employment costs are included insofar as they relate directly to the initiation of the lease. Recording Cap l Leases by Lessee Journal entries, assuming the date of lease is 1/1/97 and the property has a 7-year useful life and no salvage value. Facts are as previously given. 1/1/97 Leased property under cap l lease1 $42,490 Obligations under cap l leases2 $42,490 To record cap l lease 1/31/97 Interest expense 1% * 42,490 425 Obligations under cap l leases 325 Cash 750 To record first payment under cap l lease Depreciation expense 506 A/D leased property under cap l leases 506 To record 1 month's depreciation (1) Classified on B/S separately under Property, Plant and Equipment. May not exceed FV. (2) Classified separately under Long-Term Liabilities, except that current portion should be classified as such. Recording Sales-Type Leases by Lessor Assume the same facts as above, and the lessee classified the lease as a cap l lease, collection of the lease payments is reasonably predictable, and there are no important uncertainties as to reimbursable costs. The lease is properly classified as a sales-type lease. The leased property reverts to the lessor at the termination of the lease. 1. Gross investment in the lease: Minimum lease payments 84 * 750 $63,000 (1) (1) The gross investment in the lease would be increased by the unguaranteed residual value reverting to the lessor. 2. Normal selling price (fair value) $42,490 3. Rate implicit in the lease It is the rate at which the present value of the gross investment is equal to the fair value (less any investment credit if retained by the lessor) or the rate at which $42,490 is the present value of $63,000. That rate is 1% per month. Note: The computation of the rate would probably be done by computer. CPA candidates in the past have not been required to make such computations. Application of the rate to the gross investment is: P.V. of 84 monthly $750 payments: $750 * 56.6484 (P.V. of annuity of $1 at 1% compounded monthly) $42,490 4. Computation of unearned income "Unearned income" is the difference between the gross investment and the present value of the components of the gross investment. Gross investment $ 63,000 P.V. of minimum lease rentals (42,490) Unearned income $ 20,510 Journal entries recording the lease, assuming that in addition to the above, initial direct costs are $500. Note that this transaction results in a gross profit in the year of sale of $2,490. Minimum lease receivables $63,000 Cost of sales 40,000 Sales $42,490 Property or Inventory 40,000 Unearned income 20,510 Journal entries recording initial direct cost: Selling expense (initial direct cost) 500 Cash 500 When the first monthly payment is received: Cash 750 Unearned income (1) 425 Minimum lease receivables 750 Lease income (1) 425 (1) 1% * $42,490 = 425 Note: This lease would be recorded by the lessee as a cap l lease. Recording Direct Financing Leases by Lessor Assume the same facts as shown for a sales-type lease above, except that the cost of the leased property is the same as the lessor's fair value ($42,490) at the inception of the lease and that no investment credit is available. Note: Frequently the lessee may acquire the property and be reimbursed by the lessor. Journal entries recording the lease: Minimum lease payments receivable (gross investment) $63,000 Property $42,490 Unearned income 20,510 Initial direct cost (gross investment) * 500 Cash 500 When the first annual payment is received: Cash 750 Unearned income (1) 425 Minimum lease payments receivable 750 Lease income (1) 425 (1) 1% * $42,490 = 425 * adjustment of interest rate due to the initial direct cost omitted Note: This lease would be recorded by the lessee as a cap l lease. Recording Leveraged Leases The lessor's investment is recorded net of nonrecourse debt. DR Rentals Receivable (total rent receivable less principal and interest on nonrecourse debt) DR Investment Tax Credit Receivable DR Estimated Residual Value CR Unearned Deferred Income (investment credit plus pretax income) CR Cash (investment outlay) Note to students: We have not included examples of leverage lease computations because of their specialized nature and complexity. We do not expect the computations to be CPA exam material. Comprehensive Example Dumont Corporation, a lessor of office machines, purchased a new machine for $500,000 on December 31, 1999, which was delivered the same day (by prior arrangement) to Finley Company, the lessee. The following information relating to the lease transaction is available: * The leased asset has an estimated useful life of seven years which coincides with the lease term. * At the end of the lease term, the machine will revert to Dumont, at which time it is expected to have a residual value of $60,000 (none of which is guaranteed by Finley). * Dumont's implicit interest rate (on its net investment) is 12%, which is known by Finley. * Finley's incremental borrowing rate is 14% at December 31, 1999. * Lease rentals consist of seven equal annual payments, the first of which was paid on December 31, 1999. * The lease is appropriately accounted for as a direct financing lease by Dumont and as a cap l lease by Finley. Both lessor and lessee are calendar-year corporations and depreciate all fixed assets on the straight-line basis. Information on present value factors is as follows: Present value of $1 for seven periods at 12% 0.452 Present value of $1 for seven periods at 14% 0.400 Present value of an annuity of $1 in advance for seven periods at 12% 5.111 Present value of an annuity of $1 in advance for seven periods at 14% 4.889 Required: 1. Compute the annual rental. 2. Compute the amount to be recorded by the lessee for the leased asset and lease obligation as well as Finley's expenses for the year ended December 31, 2000. 3. Compute the gross lease rentals receivable by Dumont and the unearned interest at December 31, 1999. Solution: 1. Dumont Corporation COMPUTATION OF ANNUAL RENTAL UNDER DIRECT FINANCING LEASE Dated December 31, 1999 Cost of leased machine $500,000 Deduct present value of estimated residual value $60,000 * 0.452 (present value of $1 at 12% for 7 periods) 27,120 Net investment to be recovered 472,880 Present value of an annuity of $1 in advance for 7 periods at 12% / 5.111 Annual rental $ 92,522 2. Finley Company LEASED ASSET AND OBLIGATION, 12/31/99 Expenses Year Ended December 31, 2000 Asset and initial liability under cap l lease-$92,522 * 5.111 (present value of an annuity of $1 in advance for 7 periods at 12%*) $472,880 Deduct lease payment on December 31, 1999 92,522 Balance December 31, 1999 (after initial payment) 380,358 Interest rate * x 12% Interest expense year ended December 31, 2000 $ 45,643 Depreciation ($472,880 / 7) 67,554 Total expense on lease $113,197 * Finley Company must use Dumont Corporation's (Lessor's) implicit rate of 12% (which is known to it), since it is lower than Finley's incremental borrowing rate of 14%. 3. Dumont Corporation COMPUTATION OF GROSS LEASE RENTALS RECEIVABLE AND UNEARNED INTEREST REVENUE AT INCEPTION OF DIRECT FINANCING LEASE Dated December 31, 1999 Gross lease rentals receivable ($92,522 x 7) $647,654 Deduct recovery of net investment in machine on cap l lease Cost of machine $500,000 Residual value of machine (60,000) 440,000 Unearned interest revenue $207,654 Disclosures-Lessor When leasing is a significant part of the lessor's business activities, the following information should be disclosed in the financial statements or footnotes along with a general description of the lessor's leasing activities. For Sales-Type and Direct Financing Leases 1. The components of the net investment as of the date of each balance sheet presented: a. Future minimum lease payments to be received, less executory costs and the accumulated allowance for uncollectible minimum lease payments receivable. b. The unguaranteed residual values estimated to be recovered. c. Unearned income. d. For direct financing leases, initial direct costs. 2. Future minimum lease payments to be received for each of the five succeeding fiscal years. 3. Total contingent rentals included in income for each period presented. For Operating Leases 1. The cost and carrying amount by major classes of property and the amount of accumulated depreciation in total. 2. Minimum future rentals in total and for each of the next five years. 3. Total contingent rentals in income for each period presented. Disclosures-Lessee For cap l leases: 1. The gross amount of assets recorded under cap l leases as of the date of each balance sheet presented by major classes according to nature or function. This information may be combined with the comparable information for owned assets. 2. Future minimum lease payments as of the date of the latest balance sheet presented, in the aggregate and for each of the five succeeding fiscal years, with separate deductions from the total for the amount representing executory costs, including any profit thereon, included in the minimum lease payments and for the amount of the imputed interest necessary to reduce the net minimum lease payments to present value. 3. The total of minimum sublease rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented. 4. Total contingent rentals actually incurred for each period for which an income statement is presented. For operating leases having initial or remaining noncancelable lease terms in excess of one year: 1. Future minimum rental payments required as of the date of the latest balance sheet presented, in the aggregate and for each of the five succeeding fiscal years. 2. The total of minimum rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented. For all operating leases, rental expense for each period for which an income statement is presented, with separate amounts for minimum rentals, contingent rentals, and sublease rentals. Rental payments under leases with terms of a month or less that were not renewed need not be included. A general description of the lessee's leasing arrangements including, but not limited to, the following: 1. The basis on which contingent rental payments are determined. 2. The existence and terms of renewal or purchase options and escalation clauses. 3. Restrictions imposed by lease agreements, such as those concerning dividends, additional debt, and further leasing. Real Estate Leases Special provisions apply to the following categories of real estate leases: 1. Land only 2. Land and buildings 3. Equipment and real estate, and 4. Part of a building If the lease is in category 3, the minimum lease payments should be estimated by whatever means are appropriate and the equipment should be considered separately according to its classification by both lessors and lessees. Related Party Leases Classification is the same as other leases except where the terms of the lease have been significantly affected by the relationship. In such cases, the economic substance of the transaction should be recognized in classifying the lease instead of its legal form. The nature and extent of leasing transactions with related parties should be disclosed. In consolidated statements or statements accounted for on the equity basis, profit or loss on lease transactions should be treated according to generally accepted accounting principles for such statements. Subsidiaries whose principal business activity is leasing property or facilities to the parent or other affiliates should be consolidated. The equity method is not adequate for fair presentation. Sale-Leaseback Transactions A sale-leaseback transaction is essentially a financing arrangement whereby the property is sold and leased back to the seller. The sale and the leaseback cannot be accounted for as independent transactions. Any gain or loss on the sale should be deferred and amortized as follows: a. If the transactions meet the criteria for treatment as a cap l lease, over the useful life of the asset, or b. Over the period of time the asset is expected to be used if classified as an operating lease. If the fair value of the property at the time of the transaction is less than its undepreciated cost, a loss should be recognized for the difference immediately. If the seller retains use of a minor part (if the present value of the rentals is 10% or less of the fair value of the asset sold) of the property, SFAS No.28 requires the sale and lease to be accounted for based on their separate terms (unless the rentals called for are unreasonable relative to current market conditions in which case an appropriate amount would be deferred or accrued by adjusting the profit or loss on the sale). If the seller retains more than a minor part but less than substantially all of the use of the property and the profit on the sale exceeds the present value of the minimum lease payments, the excess would be recognized as profit at the date of the sale. Criteria for Sale-Leaseback Accounting (SFAS No.98) Sale-leaseback accounting shall be used by a seller-lessee only if a sale-leaseback transaction includes all of the following: a. A normal leaseback as described below. b. Payment terms and provisions that adequately demonstrate the buyer-lessor's initial and continuing investment in the property. c. Payment terms and provisions that transfer all of the other risks and rewards of ownership as demonstrated by the absence of any other continuing involvement by the seller-lessee. A normal leaseback is a lessee-lessor relationship that involves the active use of the property by the seller-lessee in consideration of payment of rent, and excludes other continuing involvement provisions or conditions. A sale-leaseback transaction that does not qualify for sale-leaseback accounting because of any form of continuing involvement by the seller-lessee other than a normal leaseback shall be accounted for by the deposit method or as a financing. Continuing involvement includes provisions where: a. The seller-lessee has an obligation or an option to repurchase the property or the buyer-lessor can compel the seller-lessee to repurchase the property. b. The seller-lessee guarantees the buyer-lessor's investment or a return on that investment for a limited or extended period of time. The financial statements of a seller-lessee shall include a description of the terms of the sale-leaseback transaction, including future commitments, obligations, provisions, or circumstances that require or result in the seller-lessee's continuing involvement. The financial statements of a seller-lessee that has accounted for a sale-leaseback transaction by the deposit method or as a financing according to the provisions of this Statement also shall disclose: a. The obligation for future minimum lease payments as of the date of the latest balance sheet presented in the aggregate and for each of the five succeeding fiscal years. b. The total of minimum sublease rentals, if any, to be received in the future under noncancelable subleases in the aggregate and for each of the five succeeding fiscal years. Example: On January 1, 2000, Marsh Company sold an airplane with an estimated useful life of ten years. At the same time, Marsh leased back the airplane as follows in the three separate situations: A B C Sales price (fair value) $500,000 $500,000 $500,000 Book value 100,000 100,000 100,000 Lease period 1 year 3 years 9 years Annual rental $50,000 $60,000 $74,000 Present value of lease rentals in advance at 10% $50,000 $164,000 $469,000 Criterion met-Use of minor part more than substantially minor part, all less than substantially all Journal entries (ignoring income taxes): a) 1/1/00 Cash 500,000 Aircraft (net) 100,000 Gain 400,000 Since a minor part of the use of the asset is being leased back, the entire gain is recognized. Rent expense 50,000 Cash 50,000 Rent expense is recorded for an operating lease. b) 1/1/00 Cash 500,000 Aircraft (net) 100,000 Gain 236,000 Deferred gain 164,000 Since more than a minor part but less than substantially all of the asset's use is being leased back, gain is recognized to the extent of the excess of the gain over the present value of the lease payments. Rent expense 5,333 Deferred gain 54,667 Cash 60,000 Rent expense and amortization of the deferred gain under an operating lease is recorded. The amortization is for the 2000 year. c) 1/1/00 Cash 500,000 Aircraft (net) 100,000 Gain - 0 - Deferred gain 400,000 Leased aircraft 469,000 Lease liability 469,000 Lease liability 74,000 Cash 74,000 The entire gain is deferred and a cap lized lease is recorded. 12/31/00 Interest expense 39,500 Liability 39,500 Depreciation expense 7,667 Deferred gain 44,444 Accumulated depreciation 52,111 469,000 / 9 = 52,111 400,000 / 9 = 44,444 Difference 7,667 Interest and depreciation is recorded on a cap lized lease.

Installment Sales Key Points Sales are made with payment to be received in the current and future accounting periods. Payments received are partly a return of cost and profit. 1. Each year's accounts receivable are maintained separately. 2. Each year has separate gross profit and cost of sales percentage. 3. Unrealized gross profit is the gross profit percentage times the accounts receivable balance for that year. 4. Realized gross profit is the gross profit percentage times the collections of the A/R for a given year. Accounting Problems: a. Defaults on installment contracts-loss on defaults would be the balance on the contract times the cost of sales percentage for that year. For example: In 19X2, $15,000 in 19X1 contracts was defaulted. The cost of sales percentage in 19X1 was 58%. Entry would be: Loss on defaulted contracts $8,700 Deferred gross profit 19X1 6,300 Installment Accounts Receivable $15,000 To record loss and clear deferred gross profit account. b. Merchandise may be repossessed- Assume the same facts as in (a) except that merchandise with a wholesale market value of $3,200 was repossessed. Entry: Loss on defaulted contracts $5,500 Deferred gross profit in 19X1 6,300 Used merchandise inventory 3,200 Installment Accounts Receivable $15,000 c. Trade-Ins- Trade-ins should be placed on the books at estimated inventory market value. Gross profit is computed based on estimated value of trade-in. Example: Merchandise costing $1,000 was sold for $1,500. A trade-in of $175 was taken having an inventory value of $125. Entry: Installment A/R $1,325 Trade-in inventory 125 Installment Sales $1,450 Note: Gross profit on sale is $450 and percentage of gross profit is $450/1,450 or 31%. Illustrative Problem: FACTS: Sale Oct. 15 $8,000 Cost 6,000 Gross profit 2,000 Ratio gross profit to selling price 25% Down Payment 2,000 Monthly Payments 500 Solution: 10/15 Cash $2,000 Installment A/R 6,000 Installment Sales $8,000 Cost of Installment Sales 6,000 Inventory 6,000 11/15 Cash $500 & 12/15 Installment A/R $500 12/31 Closing Entries: Installment Sales $8,000 Cost of Installment Sales $6,000 Deferred G.P. on Inst. Sales 1,250 Realized G.P. on Inst. Sales 750 Realized G.P. on Inst. Sales 750 Revenue and Exp. 750 Matching Costs and Revenue Even though procedure of deferring income and not deferring expenses does not result in matching of costs and revenues, it is permissible because of the difficulty of matching costs with revenue. When Installment Accounting Is Acceptable AICPA position on Installment Accounting: "Profit is deemed to be realized when a sale in the ordinary course of business is effected, unless the circumstances are such that the collection of the sale price is not reasonably assured." (Emphasis supplied) The Board believes that in the absence of the above circumstances, the installment method of accounting is not acceptable. The Board believes that revenues should be ordinarily accounted for at the time a transaction is completed with appropriate provision for uncollectible accounts. Therefore, the installment method would appear to be acceptable, only where receivables are collectible over extended periods, and, because of the terms of the transactions or other conditions, there is no reasonable basis for estimating the degree of collectibility. Cost-Recovery Method The Board has also indicated that the cost-recovery method may be used where the installment method is also acceptable. Under the cost-recovery method, equal amounts of revenue and expense are recognized as collections are made until all costs have been recovered, postponing any recognition of profit until that time. Interest If installment sales contracts call for interest on uncollected balances, the interest should be taken into income during the period in which it accrues. Balance Sheet Presentation Installment receivables may be classified as a current asset if they conform to normal trade practices. Balances should be shown by years (parenthetically). Deferred gross profit should be shown as a contra account from installment accounts receivable.

Interest On Receivables And Payables (APB 21) Interest on Receivables How should a note receivable or note payable be recorded when the face amount does not represent the present value of the consideration given or received in the exchange? Example: A Co. gives B Co. a note for $5,000 as payment for equipment which has a fair or cash value of $3,500. The note is to be paid $1,000 per year with no interest stipulated. In such case the note should be recorded at the fair value of the equipment or the market value of the note. This requires recognition of the interest element which exists in the transaction. Entry for A. Co.: Equipment $3,500 Discount on N/P $1,500 Notes Payable $5,000 Entry for B Co.: N/R $5,000 Discount on N/R $1,500 Sales $3,500 As the periodic payments are made by A to B, A will recognize interest expense and B will recognize interest income. (Note: This example presumes that both parties recognize the interest element involved and record the transaction correctly. There is no requirement that parties to a transaction coordinate the entries.) Scope of APB . The opinion does not apply to the following situations: a. Receivables and payables arising from transactions with customers or suppliers in the normal course of business which are due in customary trade terms not exceeding approximately one year; b. amounts which do not require repayment in the future, but rather will be applied to the purchase price of the property, goods, or service involved (e.g., deposits or progress payments on construction contracts, advance payments for acquisition of resources and raw materials, advances to encourage exploration in the extractive industries); c. amounts intended to provide security for one party to an agreement (e.g., security deposits, retainages on contracts); d. the customary cash lending activities and demand or savings deposit activities of financial institutions whose primary business is lending money; e. transactions where interest rates are affected by the tax attributes or legal restrictions prescribed by a governmental agency (e.g., industrial revenue bonds, tax exempt obligations, government guaranteed obligations, income tax settlements); and f. transactions between parent and subsidiaries and between subsidiaries of a common parent. The opinion applies to situations which otherwise qualify where the debt instrument contains no provision for interest or an unrealistic interest rate. Note Exchanged for Cash A note issued or received for cash with no other right or privilege exchanged has a value equal to the cash proceeds. Example: A loans B $10,000 at 4% interest. The rate for similar loans at the time of the transaction is 9%. No other rights or privileges are included in the exchange. The note would be recorded at the $10,000 amount and the interest at 4%. Other Rights or Privileges Included When unstated rights or privileges are exchanged along with a note, such items should be given accounting recognition. Example: On January 1, Sell Co. received a 5-year $100,000 interest-free loan from Buy, Inc., in exchange for a contract to supply spare parts at a certain price for five years. Sell Co. normally would pay 10% for the use of the funds. The present value of 1 at 10% for five periods is .62092. Sell should record the loan in the following manner: Cash $100,000 Discount on Note Payable 37,908 Note Payable $100,000 Unearned Income 37,908 Calculations: Present Value of Note - $100,000 × .62092 = $62,092 Discount on Note - $100,000 - 62,092 = $37,908 Unearned Income - Amortized over the life of the contract During the year, Sell Co. sold an estimated 10% of the amount to be involved in the 5-year contract and amortized 10% of the unearned income. Unearned Income 3,791 Sales 3,791 At year end, Sell Co. recorded interest as follows: Interest Expense $6,209 (10% x 62,092) Discount on Note Payable $6,209 Sell Co. would show the following for Notes Payable: Notes Payable $100,000 Less Discount 31,699 ($37,908 - 6,209) $ 68,301 Note Exchanged for Property, Goods, or Service There is a general presumption that the stated interest rate represents fair and adequate compensation for the goods or services. This does not apply, however, if (1) interest is not stated, (2) is unreasonable, or (3) the stated face amount of the note is materially different from the current cash sales price for the same or similar items or from the market value of the note at the date of the transaction. In such cases, the property exchanged for the note should be recorded at the fair value of the property or note, whichever is more clearly determinable. Any resulting discount or premium should, of course, be accounted for as interest using an imputed rate. 1. Asset acquired for note-periodic payments An asset was acquired in exchange for a $100,000 note, payable $10,000 a year for 10 years. The interest for similar risks is 6%. The present value of an ordinary annuity of 1 at 6% for 10 periods is 7.36. Face amount $100,000 P.V. of ten $10,000 payments over a 10-year period at 6% 73,600 Discount-to be amortized as interest expense $ 26,400 1st year: Amount of note $73,600 Payment $10,000 Interest @ 6% 4,416 5,584 $68,016 5th year: Amount of note $42,123 Payment $10,000 Interest @ 6% 2,528 7,472 $34,651 Last Payment: Amount of note $ 9,433 Interest @ 6% 567 Payment $10,000 Recording the Asset Asset $ 73,600 Note discount 26,400 Notes Payable $100,000 Stacking machine purchased for $100,000 to be paid over 10 years @ $10,000 per year. Balance Sheet Presentation Year 0 Year 1 Notes Payable $100,000 $90,000 Less: Discount on Note Payable 26,400 21,984 $ 73,600 $68,016 Entry to record first payment Interest Expense $ 4,416 Notes Payable 10,000 Cash $10,000 Note discount 4,416 First payment of $10,000 on Note Payable Interest at 6% x $73,600 2. Asset acquired for note-lump sum payment The same asset was acquired for a $100,000 note to be paid in a lump sum at the end of 10 years. The present value of 1 at 6% for 10 periods is .5584. Face amount $100,000 P.V. of one $100,000 payment to be paid in 10 years 55,840 Discount-to be amortized as interest expense $ 44,160 1st year: Amount of note $55,840 Interest payable at 6% 3,350 Total payable $59,190 2nd year: Interest payable at 6% 3,551 Total payable $62,741 Note: The amount payable at the end of any year can be obtained from "present value of 1" interest tables. 10th year: Amount of note $ 55,840 Nine years' interest 38,500 94,340 Interest at 6% 5,660 Total amount payable $100,000 Recording the Asset Asset $55,840 Note discount 44,160 Notes Payable $100,000 Stacking machine purchased for $100,000 to be paid at the end of 10 years.Balance Sheet Presentation Year 0 Year 1 Notes Payable $100,000 $100,000 Less: Discount on Notes Payable 44,160 40,810 $ 55,840 $59,190 Interest Expense $3,350 Note discount $3,350 Amortization of note discount for year 1-6% x 55,840 Statement Presentation of Discount and Premium The discount or premium resulting from the determination of present value in cash or noncash transactions is not an asset or liability separable from the note which gives rise to it. Therefore, the discount or premium should be reported in the balance sheet as a direct deduction from or addition to the face amount of the note. It should not be classified as a deferred charge or deferred credit. The description of the note should include the effective interest rate; the face amount should also be disclosed in the financial statements or in the notes to the statements. Amortization of discount or premium should be reported as interest in the statement of income. Issue costs should be reported in the balance sheet as deferred charges. Discounting a Note Receivable When a company discounts a note which it is holding, the proceeds are determined by taking the (bank's) discount rate and applying it against the maturity value of the note for the period the bank will be holding the note. This amount is the bank's discount and is subtracted from the maturity value to arrive at the proceeds. Example: Terms of note: $10,000, 12% 90-day note Discounted after 30 days Maturity value: $10,300 ($10,000 x 12% x 90/360) Bank's discount rate = 15% $10,300 x 15% x 60/360 = $257.50 Proceeds = $10,300 - 257.50 = $10,042.50

Interim Financial Statements (APB No. 28) Interim Financial Statements In General The results for each interim period should be based on the accounting principles and practices used by an enterprise 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. 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. Some modifications are necessary at interim dates in accounting principles or practices followed for annual periods. Interim financial information is essential to provide investors and others with timely information of the progress of the enterprise. Accordingly, each interim period should be viewed primarily as an integral part of an annual period. Seasonal fluctuations in revenue and irregular incurrence of costs and expenses limit the comparability of operating results for interim periods. Guidelines for Preparing Interim Statements 1. Revenue should be recognized as earned based on criteria used for the full year. 2. Costs and expenses associated directly with or allocated to products sold require the same treatment in interim statements as in fiscal-year financial statements. Exceptions for Cost of Goods Sold * If the gross profit method is used for preparing interim statements, such fact should be disclosed including any year-end adjustments resulting therefrom. * If LIFO is used and the LIFO base is temporarily depleted during an interim period, the inventory reported at the interim date should not reflect the LIFO liquidation and the cost of goods sold should include the estimated cost of replacing the depleted LIFO base. Example: Assume that at the end of the 2nd quarter, the ending inventory was $25,000 below the LIFO base and the condition is temporary. Perpetual system is used. Journal Entries: (1) At the end of the 2nd quarter Cost of Good Sold $25,000 Allowance for temporary LIFO liquidation $25,000 (2) When the inventory is replaced by purchase of $40,000 in merchandise Inventory $15,000 Allowance for temporary LIFO liquidation 25,000 Accounts Payable $40,000 * LCM writedowns of inventories should be used in interim periods unless such writedowns are considered temporary. * Standard cost variances should be reported for interim periods similar to fiscal year reporting; however, planned price or volume variances which are expected to be absorbed should be deferred until year end. 3. Costs other than product costs should be associated with interim periods based on benefits derived, time expired or activity associated with the period. 4. Seasonal variations in revenues, costs, etc., should be disclosed. For example, fixed costs can be allocated to interim periods based on expected sales activity where revenues follow a seasonal pattern. 5. Income tax expense should be based on an estimated effective rate for the year as a whole. 6. Extraordinary items and disposals of a segment of a business should be reflected in the period in which they occurred. Contingencies should be disclosed in interim reports in the same manner required for annual reports. 7. The tax effects of losses that arise in the early portion of a fiscal year (in the event carryback of such losses is not possible) should be recognized only when realization is assured beyond any reasonable doubt. An established seasonal pattern of loss in early interim periods offset by income in later interim periods should constitute evidence that realization is assured beyond reasonable doubt. The tax benefit of interim losses carried forward to a later interim period would reduce each later interim period's tax provision. 8. Each report of interim financial information should indicate any change in accounting principles or practices from those applied in (a) the comparable interim period of the prior annual period, (b) the preceding interim periods in the current annual period, and (c) the prior annual report. 9. When publicly traded companies report summarized financial information to their security holders at interim dates (including reports on 4th quarters), the following data should be reported, as a minimum: (a) Sales, provision for income taxes, extraordinary items, cumulative effect of a change in accounting principles or practices, and net income; (b) primary and fully diluted earnings per share data; (c) seasonal revenue, costs or expenses; (d) significant changes in estimates or provisions for income taxes; (e) disposal of a segment of a business and extraordinary, unusual or infrequent occurring items; (f) contingent items; (g) changes in accounting principles or estimates; (h) significant changes in financial position. Treatment of Nonrecurring Adjustments Under SFAS No. 16 SFAS No. 16 requires that prior interim periods be restated for nonrecurring adjustments due to adjustment or settlement of litigation, income taxes, renegotiation proceedings or rate-making for utilities provided that each such adjustment meets each of the following criteria: 1. The adjustment is material. 2. The adjustment is specifically related to business activities of a specific prior interim period of the current year. 3. The amount of the adjustment or settlement could not have been reasonably estimated prior to the current interim period but becomes "reasonably estimable" during the current interim period. An example of such an adjustment would be a change in the statutory rate of income tax which was enacted in September and applicable to the entire calendar year. The adjustment should be reported as a restatement of the applicable prior interim periods with any amount applicable to prior fiscal years being reflected in the determination of net income of the first interim period of the current fiscal year.

INTERNAL SERVICE FUND Internal Service Fund Overview Internal Service Funds are established to finance and account for services and commodities furnished by a designated agency of a governmental unit to other departments of the same governmental unit. Typical examples of Internal Service Funds are those established for central garages and motor pools, central printing and duplicating services, and central purchasing and stores departments. Resources for the establishment of Internal Service Funds are derived from one or more of the following three sources: (1) contributions from another operating fund, such as the General Fund or an Enterprise Fund; (2) the sale of general obligations bonds, and (3) by long-term advances from other funds which are to be repaid over a specified period of time from the earnings of this fund. Once the fund's cap l has been acquired from one or more of these sources, cash is expended for materials, parts and supplies which are used in the same form as purchased or are manufactured into other products and issued to the various using departments. These departments are charged with the cost of such materials, parts, and supplies plus labor and overhead. The Service Fund is then reimbursed by interdepartmental cash transfers from the budgeted appropriations of the departments served. Throughout the entire cycle of these operations, the financial objective of the fund is to recover the complete costs of operations, including overhead, without producing any significant amount of profit in the long run. Since each department served by an Internal Service Fund will include among its estimated expenditures an amount sufficient to cover the estimated cost of services and commodities to be secured from the Service Fund, the latter fund does not have the same status or budgetary requirements in the annual budget as other operating funds. The accounting for all Service Funds should be on the accrual basis, with all charges to departments being billed at the time services are rendered and expenditures being recorded when incurred. With the exception of buildings financed from Cap l Projects Funds, depreciation must be recorded on fixed assets to secure an accurate computation of costs and to prevent depletion of the fund's cap l. When a Service Fund is created, the entry to be made will depend upon the source of fund cap l. If the fund's cap l is acquired as a contribution from the General Fund, the entry would be a debit to Cash and a credit to Contribution from General Fund. If the fund is created by the proceeds of a general obligation bond issue-a less frequent procedure-the entry to be made in the Service Fund upon receipt of cash from the Cap l Projects Fund is a debit to Cash and a credit to Contribution from General Obligation Bonds. Where fund cap l is in the form of a long-term loan from another fund of the same governmental unit, the credit in this opening entry would be to Advance from General (or other) Fund. It is important that the latter account title be used to differentiate the resulting liability from the Due to Other Funds account which refers only to short-term liabilities. Bonds, notes, and other long-term liabilities (e.g., for cap l leases, pensions, judgments, and similar commitments) directly related to and expected to be paid from entity funds should be included in the accounts. These are specific fund liabilities, even though the full faith and credit of the governmental unit may be pledged as further assurance that the liabilities will be paid. Too, such liabilities may constitute a mortgage or lien on specific fund properties or receivables. At the time charges are billed, the exact amounts of overhead expenses are usually not known. Moreover, even if they were known, it is desirable to charge overhead expenses at a uniform rate throughout the year to prevent jobs worked on during a month when large indirect expenses were incurred from being charged more than identical jobs performed during another month when overhead expenses happened to be low. Therefore, departments are billed with direct costs plus a uniform rate per mile, per hour, or other applicable unit of measurement for their portion of the estimated total overhead charges for the fiscal year. The entry to record such billings is a debit to Due from (name of) Fund and a credit to Operating Revenues Control. Accounting for the Internal Service Fund is the same as industrial accounting, and the balance sheet and the income statement follow GAAP. No budget is necessary. The excess of assets over liabilities consists of the source of funds to start the activity such as "Contribution from General Fund" and "Retained Earnings," which would ordinarily be small. ISF Financial Statement City of Passville Internal Service Type Fund Balance Sheet December 31, 19XX Current Assets: Cash Due from general fund Inventory of materials and supplies Total current assets Fixed assets: Machinery and equipment Less - Allowance for depreciation Total fixed assets Total assets Liabilities, Contribution and Retained Earnings Vouchers payable Long-term liabilities: Advance from general fund Contributions from general fund Retained earnings Total liabilities, contributions and Retained Earnings Illustrative Journal Entries for Central Garage Fund 1. Inventory of Material and Supplies Vouchers Payable To record purchases of material and supplies. 2. Operating Expenses Control Inventory of Material and Supplies To record usage of material and supplies. 3. Operating Expenses Control Vouchers Payable To record liability of expenses incurred for salaries, wages, shop supplies and utilities. 4. Building Equipment Vouchers Payable To record cost of addition to building and cost of equipment installed. 5. Operating Expenses Control Accumulated Depreciation-Building Accumulated Depreciation-Equipment To record depreciation charges. 6. Due from Special Revenue Fund-Schools Due from General Fund Operating Revenues Control To record billings for services rendered. 7. Operating Revenues Control Operating Expenses Control Unreserved Retained Earnings To close out revenue and expense accounts and arrive at the excess of net charges over costs (net income) for the year.

Inventory Definition Inventory definition The term inventory designates tangible personal property which is: 1. Held for sale in the ordinary course of business 2. In process of production for such sale, or 3. To be currently consumed in production of goods and services to be available for sale. MAJOR CATEGORIES 1. Merchandise items purchased for resale 2. Raw Materials materials on hand not yet placed into production 3. Supplies manufacturing supplies only, others are prepaid expenses 4. Work in process direct material, labor and overhead cost of unfinished units 5. Finished goods The major objective of inventory accounting is proper income measurement through the process of matching costs against revenues. The inventory method used should be consistently applied. The primary basis of accounting for inventories is cost which is the price paid plus the direct or indirect cost of bringing the article to its existing condition or location. METHODS OF INVENTORY MEASUREMENT 1. Periodic Method. The asset costs are accumulated in inventory and in related purchases accounts. The cost expiration is determined through use of a cost of goods sold account and is affected by the period change in the asset inventories. A physical inventory is necessary to prepare statements. 2. Perpetual or Book Inventories. The cost of goods sold can be determined with each sale or issuance of raw material to production. The physical inventory can be taken on a cycle basis with the objective of verifying the inventory records. A perpetual inventory system is costly to install and maintain. 3. Gross Profit Method. The gross profit method is used to estimate the inventory in situations in which it is not desirable or possible to take a physical inventory. It is used mostly for interim financial statements or in determining inventory in the event of a fire or other casualty. The gross profit method is not appropriate for year end financial reporting purposes as it does not provide for a "proper determination of the realized income"; an estimate of cost of goods sold and ending inventory is not adequate. The gross profit method does not provide for the taking or pricing (costing) of physical inventory on hand under any cost flow assumption. Example: Beginning inventory $ 12,000 Sales 100,000 Gross profit percentage 25% Purchases 80,000 Compute the ending inventory. Sales $100,000 Gross profit 25% 25,000 Cost of goods sold $ 75,000 Beginning inventory $ 12,000 Purchases 80,000 Cost of goods available for sale $ 92,000 Less: Cost of goods sold 75,000 Ending inventory $ 17,000 Problem: The Washington Company estimates the cost of its physical inventory at 3/31/X6 for use in an interim financial statement. The rate of markup on cost is 25%. The following account balances are available: Inventory 3/1/X6 $160,000 Purchases during March 86,000 Purchase returns 4,000 Sales during March 140,000 The estimate of the cost of inventory at March 31 would be: a. $137,000 b. $130,000 c. $112,000 d. $102,000 Answer: (b) Cost of sales = $140,000 * 1.25 = $112,000 Inventory at 3/31/X6 = $160,000 + $82,000 – $112,000 = $130,000 ADJUSTMENTS TO INVENTORY COST 1. Cash Discounts. Should be treated as a reduction of the cost of purchases. Because of the difficulty of associating a discount with a particular purchase, discounts are frequently treated as other income or as a reduction of purchases in the income statement. Theoretically, discounts are cost reductions since income cannot be generated by purchasing goods. Discounts are usually handled in one of two ways in the accounts: Use of "Discounts Lost" Account. (Net Price Method) In the use of a "discounts lost" account, it is assumed the discount will be taken and the amount originally recorded in purchases and accounts payable is net of the discount. Example: Merchandise is purchased for $100 with terms of 2/10 net 30. Journal Entry: Purchases 98 A/P 98 Inventory recorded at cost less discount. A/P 98 Cash 98 Payment for inventory within the discount period. Assume in the above example that the payment is not made within the discount period and $100 must be remitted. A/P 98 Discounts lost 2 Cash 100 Inventory A/P paid—no discount taken. The use of a discounts lost account has two advantages: a. The inventory can be priced at cost less the discount. In most situations it is impossible to associate the discount with the inventory at a later date. b. Management can evaluate the effectiveness of the company's handling of discounts. The "discounts lost" account discloses what has been lost in discounts not taken. The other method only shows the amount taken (not providing any indication or control of the discounts not taken). Use of "Discounts" Account. (Gross Price Method) Same example as above. Journal Entry: Purchases 100 A/P 100 Inventory recorded at cost. A/P 100 Discount 2 Cash 98 Payment made taking 2% discount. If this method is used, discounts are deducted from purchases. Problem: The use of a Discounts Lost account implies that the recorded cost of a purchased inventory item is its: a. Invoice price b. Invoice price plus the purchase discount lost. c. Invoice price less the purchase discount taken. d. Invoice price less the purchase discount allowable whether or not taken. Answer: (d). 2. Transportation Costs. Should be added to inventory cost. 3. Purchasing, Handling and Storage Costs. These costs should also be added to inventory cost, but because of the difficulty of association, are usually expensed as period costs. 4. Trade Discounts. Trade discounts (also referred to as volume or quantity discounts) are discounts from a catalog or list price, used to establish a pricing policy and, therefore, do not enter into the accounting system. These discounts are usually stated as a percentage of the list price and are deducted from the list or catalog price to determine the recorded invoice price. Each discount applies to the net price computed after deducting the previous discount. Example: Merchandise is purchased with a list price of $10,000 subject to trade discounts of 20%, 10% and 5%. The invoice price is calculated as follows: List price $10,000 Less 20% discount (20% * $10,000) (2,000) $ 8,000 Less 10% discount (10% * $8,000) (800) $ 7,200 Less 5% discount (5% * $7,200) (360) Invoice price before cash discount $ 6,840

Inventory Valuation Methods Specific Identification 1. Specific Identification. Individual inventory lots purchased or manufactured are separately identified. When items are sold or otherwise disposed of, the actual cost of the specific item is assigned to the transaction and the ending inventory consists of the actual costs of the specific items on hand. Usually used for high cost items which are individually identifiable (autos, appliances, jewelry, etc.). Average Cost 2. Average Cost. The average cost flow assumption assumes that all costs and units are merged (commingled) so that no specific item or cost can be separately identified. Both the cost of goods sold and ending inventory are valued at the average unit cost. The average cost method may be used with either the periodic or perpetual inventory system. a) Weighted Average Periodic: The cost of units is calculated at the end of the period based upon the average price paid (including freight, etc.), weighted by the number of units purchased at each price (the cost of goods available for sale divided by the number of units available for sale). Illustration of Weighted Average Units Unit Cost Total Cost 1/1 Balance 200 $1.50 $ 300 1/5 Purchase 300 $1.60 480 1/15 Sold 400 units 1/18 Purchase 200 $1.65 330 1/27 Purchase 300 $1.78 534 1,000 $1,644 Weighted Average Unit Cost = $1,644 * 1,000 units = $1.644 per unit Ending inventory (600 units @ $1.644) $986.40 b) Moving Average -- Perpetual: The cost of units is calculated in the same manner as was used for weighted average except a new weighted average cost is calculated after each purchase. This average cost is used to determine the cost of each unit sold prior to the next purchase. Illustration of Moving Average Total Cost Total Units Average Cost 1/1 Balance $ 300 200 $1.50 1/5 Purchase (300 units @ $1.60 = $480) $ 780 500 1.56 1/15 Sale (400 units @ $1.56 Av. = $624) $ 156 100 1.56 1/18 Purchase (200 units @ $1.65 = $330) $ 486 300 1.62 1/27 Purchase (300 units @ $1.78 = $534 ) $1,020 600 1.70 Ending Inventory (600 units @ $1.70) $1,020. FIFO 3. FIFO (First In, First Out): An assumption that goods are sold in the chronological order purchased. The ending inventory will consist of the last purchases made during the accounting period. LIFO 4. LIFO (Last In, First Out): The last goods purchased are assumed to be sold. The ending inventory consists of the goods first purchased. The use of LIFO and the techniques for its application stem from federal tax law and regulations. If it is used for either tax or financial statement purposes, it must be used for the other. Historically, LIFO was considered a "cost" method and, therefore, could not be used in conjunction with the lower of cost or market method of inventory valuation. In the early 1980's, federal tax rules re. conformity were relaxed allowing the application of LCM with LIFO for financial statement purposes (however, not for tax purposes). The use of LIFO for one type of inventory does not preclude the use of other methods for other inventory categories for either tax or financial statement purposes. You must obtain permission from the Internal Revenue Service to use the LIFO method and/or to change inventory methods. (1) Unit Based LIFO. In the year of changeover to LIFO, the beginning inventory in the year of change must be restated. If permission is granted to change to LIFO in 19X2, the January 1, 19X2, inventory must be converted to weighted average and will become the BASE. Conversion to weighted average will mean that all units in the BASE will have the same cost. For example: Ending 19X1 inventory on a FIFO basis consisted of: 9/2 1,000 units @ $6.00 $ 6,000 10/15 2,000 units @ $7.00 14,000 11/20 1,000 units @ $8.00 8,000 12/15 1,000 units @ $7.00 7,000 5,000 units $35,000 Weighted average $7.00 per unit. Normally, a LIFO inventory will consist of a base and layers, which we call LIFO layers, brought about by subsequent increases in inventory. We must concern ourselves with the valuation of these increases or, as they are sometimes called, increments. In our example, we revalued the beginning inventory of 19X2, the base, to weighted average. Assume that at the end of 19X2 the inventory has increased from 5,000 to 7,000 units with purchases during the year as follows: Units Unit Cost Total 1/17 2,400 $7.25 $ 17,400 2/22 4,600 $7.00 32,200 6/30 2,000 $8.00 16,000 7/27 2,500 $9.00 22,500 10/28 1,500 $8.00 12,000 13,000 $100,000 Average $7.70 At this point, an election must be made to value increases in inventory by one of three methods: FIFO 2. LIFO 3. Weighted Average Purchases Purchases 10/28 1,500 @ 8 = 12,000 1/17 2,000 @ $7.25 = $14,500 2,000 @ $7.70 = $15,400 7/27 500 @ $9 = 4,500 ______ ______ LIFO LAYER 16,500 14,500 15,400 BASE 35,000 35,000 35,000 INV. VALUE $51,500 $49,500 $50,400 Subsequent layers must be valued the same way once an election is made to value LIFO layers by any of the three methods. The question may reasonably be asked that--if this is a LIFO inventory method, why is it that increases can be valued by FIFO or weighted average? It is the layers that are valued on a LIFO basis rather than the value of the content of a particular layer or inventory increment. When there is a decrease in inventory, the last layer to be formed is the first to be costed out. Assume an inventory as follows: 1/1/X2 BASE 5,000 units @ $7.00 $35,000 12/31/X2 LAYER 2,000 units @ $7.70 15,400 12/31/X3 LAYER 3,000 units @ $8.00 24,000 12/31/X4 LAYER 1,000 units @ $9.00 9,000 11,000 $83,400 On 12/31/X5, the inventory dropped to 8,500 units. The ending inventory would be valued at: 1/1/X2 BASE 5,000 units @ $7.00 $35,000 12/31/X2 LAYER 2,000 units @ $7.70 15,400 12/31/X3 LAYER 1,500 units @ $8.00 12,000 8,500 $62,400 Once the base or a layer has been costed, i.e., charged to cost of goods sold, it is permanently removed from the inventory; however, see Chapter 12, Interim Financial Statements, for the treatment of the liquidation of base period inventories during an interim period. Further, there are some who advocate maintaining the basic LIFO inventory intact even though a temporary liquidation has occurred at year-end. This is done by charging cost of goods sold with current costs and crediting the account, "Excess of Replacement Cost Over LIFO Cost of Basic Inventory Temporarily Liquidated," for that part of replacement cost in excess of LIFO cost. When the inventory is replenished, the "Excess ... " account is removed and the goods acquired replaced in inventory at their LIFO cost. The "Excess ... " account is a current liability. (2) Dollar Value LIFO. As is characteristic of all LIFO methods, the dollar value LIFO inventory consists of a base, and layers when the inventory has increased during the period. In dollar value, however, the inventory is expressed in terms of dollars instead of units. This is necessary if LIFO is to be used in businesses in which units change from year to year and cannot be reduced to a common unit of measurement such as tons, bushels, barrels or cubic yards. The first year inventory is the base and a price index is constructed from a sampling of inventory items to determine the price change in subsequent years in relation to the base. The price index is used to convert the subsequent year inventory to base year prices so that it can be determined if the inventory has increased. For example: Assume that the Royster Appliance Company converted to dollar value LIFO on January 1, 19X2, and the inventory in subsequent years was as follows: Cost Index 12/31/X1 $15,000 100 12/31/X2 16,800 105 12/31/X3 21,280 112 12/31/X4 22,680 126 12/31/X5 23,970 141 12/31/X6 30,000 150 To determine whether an increment has occurred, express the inventory in all years in terms of base year prices. Increase (Decrease) 19X1 $15,000 19X2 $16,800 / 1.05 = 16,000 $ 1,000 19X3 21,280 / 1.12 = 19,000 3,000 19X4 22,680 / 1.26 = 18,000 (1,000) 19X5 23,970 / 1.41 = 17,000 (1,000) 19X6 30,000 / 1.50 = 20,000 3,000 The inventory by year would be computed as: 19X2 Base year $15,000 19X2 Increment $1,000 * 1.05 1,050 $16,050 19X3 Base year $15,000 19X2 Increment 1,050 19X3 Increment $3,000 * 1.12 3,360 $19,410 19X4 Base year $15,000 19X2 Increment 1,050 19X3 Increment after $1,000 of 19X3 layer is costed out $2,000 * 1.12 2,240 $18,290 19X5 Base year $15,000 19X2 Increment 1,050 19X3 Remaining $1,000 of 19X3 layer $1,000 * 1.12 1,120 $17,170 19X6 Base year $15,000 19X2 Increment 1,050 19X3 Increment 1,120 19X6 Increment $3,000 * 1.50 4,500 $21,670 What if you were given the inventory for 19X3, for example $21,280 and the 19X3 inventory in base year prices, but not the price index. You can construct your own index by dividing the base year inventory into the current year inventory. 19X3 Inventory at X3 Prices $21,280 ------------------------------------- = 1.12 19X3 Inventory at Base Prices $19,000 Retail Method 5. Retail Method - An inventory method in which records are maintained at cost and retail. The method is used to maintain accountability and control of inventory assigned to retail units. Retail units are responsible for the retail price of goods on hand and goods shipped during the period, adjusted for price increases and decreases (markups and markdowns). The relationship of cost to retail is assumed to be the applicable ratio to apply to the ending inventory at retail to determine its cost. This is a valid assumption only if the relationship between cost and retail is relatively constant and that the mix of goods in the ending inventory is similar to that of goods included in the computation of the ratio. We can analyze the retail unit's responsibility in this way. Cost Retail Beginning inventory X X + Period shipments X X + Markups (price increases) X - Markdowns (price decreases) __ (X) Total responsibility for period X X - Sales (deposited to the credit of company) (X) - Employee discounts, sales discounts (X) Book inventory at retail X Physical inventory at retail X Shrink X The retail units' book inventory under ideal conditions with no shrinkage, theft, spoilage or recording errors would be exactly the same as the physical at retail. The difference between the book inventory and the physical is called shrink or spoilage. The retail inventory method may be applied on the basis of the Average, FIFO, and LIFO cost flow assumptions. The lower of cost or market method may also be used in conjunction with the retail method under these flow assumptions by excluding markdowns from the cost to retail ratio (refer to LIFO Method section regarding LIFO and L.C.M.) Terminology: Original Retail - Price at which goods first offered for sale. Additional Markups - Additions that raise selling price above original retail. Markdowns - Deductions that lower price below original retail. Markup Cancellations - Deductions that do not decrease price below original retail. Markdown Cancellations - Additions that do not increase price above original retail. Net Markups - Additional markups minus markup cancellations. Net Markdowns - Markdowns minus markdown cancellations. Net markdowns are not used to determine the cost ratio if the retail method is used to approximate cost or market, whichever is lower. The following information will be used to illustrate the various retail methods. The Grand Department Store, Inc., uses the retail-inventory method to estimate ending inventory for its monthly financial statements. The following data pertain to a single department for the month of October: Inventory, October 1: At cost $17,000 At retail 30,000 Purchases (exclusive of freight and returns): At cost 100,151 At retail 146,495 Freight-in 5,100 Purchase returns: At cost 2,100 At retail 2,800 Additional markups 2,500 Markup cancellations 265 Markdowns (net) 5,000 Normal spoilage and breakage 3,000 Sales 132,930 * Conventional Retail Method (Lower of Average Cost or Market) In conventional retail, markups are included as part of the cost ratio computation, but markdowns are excluded. This does not affect the computation of the ending inventory at retail, but does affect the cost ratio by reducing the percentage of cost to retail. The exclusion of markdowns in computing the ratio is a feature of conventional retail, its purpose being to approximate lower of cost or market. A more conservative inventory results. Example: Grand Department Stores, Inc. - Conventional Retail (Lower of Average Cost or Market) At Cost At Retail Inventory, October 1 $ 17,000 $ 30,000 Purchases 100,151 146,495 Freight-In 5,100 - Purchase Returns (2,100) (2,800) Additional Markups - 2,500 Markup Cancellations ______ (265) Available for sale 120,151 175,930 Cost Ratio: $120,151 * $175,930 = 68% Markdowns (Net) (5,000) Normal spoilage and breakage (3,000) Sales (Net) (132,930) Inventory, October 31, at retail $ 35,000 Inventory, October 31, at lower of average cost or market (estimated) $35,000 * 68% $ 23,800 * Average Cost Retail Method: For a retail cost method both net markups and net markdowns are included in the cost to retail ratio. This has the effect of reducing the retail value (denominator) and increasing the cost percentage. Example: Grand Department Stores, Inc. - Average Cost Retail At Cost At Retail Inventory, October 1 $17,000 $ 30,000 Purchases 100,151 146,495 Freight-In 5,100 - Purchase Returns (2,100) (2,800) Additional Markups 2,500 Mark-up Cancellations (265) Net Markdowns _______ (5,000) $120,151 $170,930 Cost Ratio: $120,151 * $170,930 = 70% Normal Spoilage and Breakage (3,000) Sales (Net) (132,930) Inventory, October 31 at Retail $ 35,000 Inventory, October 31 at Average Cost $35,000 * 70% $ 24,500 Note that ending inventory at retail ($35,000) is the same as under conventional retail. The retail method selected does not affect the retail value of the ending inventory. * FIFO Cost Retail Method: To compute FIFO Cost Retail, the beginning inventory is excluded from the cost to retail ratio calculation. The cost ratio is then applied to the ending inventory at retail to obtain the cost of the ending inventory. Example: Grand Department Stores, Inc. - FIFO Cost Retail At Cost At Retail Inventory, October 1 $ 17,000 $ 30,000 Purchases $100,151 $146,495 Freight-In 5,100 - Purchase Returns (2,100) (2,800) Additional Markups - 2,500 Markup Cancellations (265) Net Markdowns _______ 5,000) Current Period Inventory $103,151 $140,930 Cost Ratio: $103,151 * $140,930 = 73% Total Available 170,930 Normal Spoilage and Breakage (3,000) Sales (Net) (132,930) Inventory, October 31 at retail $ 35,000 Inventory, October 31, at FIFO Cost $35,000 * 73% $ 25,550 Note the following: 1. Net Markdowns and Markups are assumed to apply only to the current period's inventory. 2. The Ending Inventory at retail is the same as it was for the Average Cost Methods ($35,000). 3. The Ending Inventory at cost has been valued at the current period's cost ratio (FIFO flow). 4. Although beginning inventory is excluded from the ratio, it must be used to compute the ending inventory at retail. * Lower of FIFO Cost or Market Retail Method. The lower of FIFO cost or market is computed the same way as FIFO cost except net markdowns would be excluded from the cost rates. Example: Grand Department Stores, Inc. - Lower of FIFO Cost or Market Retail Referring to the Retail FIFO Cost Computation, the cost ratio would be computed as follows: Current period cost 103,151 Cost ratio = ------------------------------------------- = --------------- = 71% Current period retail before net markdowns 140,930 + 5,000 Inventory at October 31, Lower of FIFO Cost or Market $35,000 * 71% $24,850 * LIFO Cost Retail Method: As in other LIFO methods, retail LIFO consists of a base and layers. To compute LIFO cost retail, the beginning inventory is excluded from the cost to retail ratio calculation (as it was for FIFO). Remember, however, that the beginning inventory must be used to compute the ending inventory at retail. In LIFO retail the ending inventory at retail is compared with the beginning inventory at retail to determine if a layer has been added. If there is an increase, a LIFO layer is established and the current period cost ratio is applied only to that layer to determine its cost. The cost of the layer is then added to the cost of the beginning inventory to determine the cost of the ending inventory. If there is a decrease in ending inventory, the current period ratio is not applicable since there is no LIFO layer. The decrease is included in cost of goods sold on a LIFO basis, in that the latest layer formed is eliminated first. Example: Grand Department Stores, Inc. - LIFO Cost Retail At Cost At Retail Inventory, October 1 $ 17,000 $ 30,000 Purchases $100,151 $146,495 Freight-In 5,100 - Purchase Returns (2,100) (2,800) Additional markups - 2,500 Markup cancellations (265) Net Markdowns _______ (5,000) Current period inventories $103,151 $140,930 Cost ratio: $103,151 * $140,930 = 73% Total available 170,930 Normal spoilage and breakage (3,000) Sales (net) (132,930) Inventory October 31 at retail $35,000 Inventory October 31 at LIFO Cost Beginning inventory $17,000 Layer $5,000 * 73% 3,650 $20,650 Note the following: 1) The ending inventory at retail is the same as it was under the other retail methods. 2) The current year cost to retail ratio is applied only to the increase in inventory at retail. 3) Similarity of set up with FIFO Cost Retail * Lower of LIFO Cost or Market Retail: The lower of LIFO cost or market retail is computed the same as LIFO cost except net markdowns would be excluded from the cost ratio computation. (Refer to the section on LIFO method regarding application of L.C.M. with LIFO Cost). Example: Grand Department Stores, Inc. - Lower of LIFO Cost or Market Retail Referring to the Retail LIFO cost computation, the cost ratio would be computed as follows: (Current Period Cost) Cost ratio = ---------------------------------------------- (Current period retail before net markdowns) Cost ratio = 103,151/(140,930 + 5,000) = 71% Inventory @ October 31, Lower of LIFO Cost or Market Base $17,000 Layer $5,000 * 71% 3,550 $20,550 Dollar Value LIFO Retail. Dollar Value is similar to LIFO retail except that the inventory layers contain an additional dimension; that is, the effect of changes in price levels. Inventory increase at retail can only be determined by converting current year inventory to base year prices. Inventory layers are then computed similar to LIFO retail except that price of the current year is used, such as: (Inventory at retail) * (cost/retail) * (price index). Determination of Price Level Index in Dollar Value LIFO Retail - The price level index specifically relates to the inventory and is not a measure of general price levels as in price level accounting (sometimes called "replacement cost" accounting). The price index may be one internally generated or if a government index is available for the particular inventory, it may be used. The index must be su ble to convert the ending inventory to base year or at least previous year prices to determine if inventory quantities have increased. Illustration of Dollar Value LIFO Retail Procedure to be followed: 1. Compute the ending inventory at retail. 2. Restate the current year inventory in terms of base year prices. Divide the inventory into the base and layers to determine whether there is an increase in quantities. 3. Convert the base and layers into inventory price levels by use of the index and the cost to retail ratio. Facts: The James Company switched to dollar value LIFO retail on December 31, 19X1, at which time the inventory, using the dollar value LIFO retail inventory method, at retail was $166,000 and the cost/retail ratio was 76%. Inventory data for subsequent years are as follows: Inventory at Respective Price Index Cost/Retail Year Year-end Retail Prices (Base Year 19X1) Ratio 19X2 $186,560 106 72% 19X3 198,000 110 75% 19X4 218,500 115 78% 19X5 231,250 125 74% 19X6 264,000 132 73% Computation of Inventories by Years Retail Ratio Index Total Base $166,000 76% 100 $126,160 19X2 Layer (1) 10,000 72% 106 7,632 19X3 Layer (2) 4,000 75% 110 3,300 19X4 Layer (3) 10,000 78% 115 8,970 19X5 Layer (4) (5,000) 78% 115 (4,485) 19X6 Layer (5) 15,000 73% 132 14,454 Inventory at 12/31/X6 at cost $156,031 (1) $186,560 * 1.06 = $176,000 - $166,000 = $10,000 (2) $198,000 * 1.10 = $180,000 - $176,000 = $ 4,000 (3) $218,500 * 1.15 = $190,000 - $180,000 = $10,000 (4) $231,250 * 1.25 = $185,000 - $190,000 = (5,000) decrease Results in reduction of 19X4 layer - 19X5 cost/retail ratio not applicable (5) $264,000 * 1.32 = $200,000 - $185,000 = $15,000 Illustrative Problem: Under your guidance as of January 1, 19X5, the Penny Wise Discount Store installed the retail method of accounting for its merchandise inventory. When you undertook the preparation of the store's financial statements at June 30, 19X5, the following data were available: Selling Cost Price Inventory, January 1 $26,900 $ 40,000 Markdowns 10,500 Markups 19,500 Markdown cancellations 6,500 Markup cancellations 4,500 Purchases 86,200 111,800 Sales 122,000 Purchase returns and allowances 1,500 1,800 Sales returns and allowances 6,000 Required: a. Prepare a schedule to compute the Penny Wise Discount Store's June 30, 19X5, inventory under the retail method of accounting for inventories. The inventory is to be valued at cost under the LIFO method. b. Without prejudice to your solution to part (a), assume that you computed the June 30, 19X5, inventory to be $44,100 at retail and the ratio of cost to retail to be 80%. The general price level has increased from 100 at January 1, 19X5, to 105 at June 30, 19X5. Prepare a schedule to compute the June 30, 19X5, inventory at the June 30 price level under the dollar-value LIFO method. Solution - Penny Wise Discount Store a. COMPUTATION OF INVENTORY AT LIFO COST UNDER THE RETAIL INVENTORY METHOD June 30, 19X5 Selling Cost Price Inventory, January 1 $ 26,900 $ 40,000 Add: Purchases 86,200 111,800 Less purchase returns and allowances (1,500) (1,800) Markups 19,500 Less markup cancellations _______ (4,500) Goods available for sale $111,600 $165,000 Less: Sales at retail $122,000 Sales returns and allowances 6,000 Net sales 116,000 Markdowns $10,500 Less markdown cancellations 6,500 4,000 120,000 Ending inventory at retail $ 45,000 Inventory, January 1 $ 26,900 Add LIFO Layer: [70% of ($45,000 - $40,000)] 3,500 Inventory, June 30, at LIFO $ 30,400 Cost to Retail Ratio Net purchases at cost ------------------------------------------------ = Cost to Retail Ratio Net purchases at retail + net markups - net markdowns ($86,200 - $1,500) ----------------------------------------------- = 70% $111,800 - $1,800 + $19,500 - $4,500 - $10,500 + $6,500 b. COMPUTATION OF INVENTORY UNDER THE DOLLAR-VALUE LIFO COST METHOD June 30, 19X5 Ending inventory at retail at January 1 price level (44,100 * 1.05) $42,000 Less beginning inventory at retail 40,000 Inventory increment at retail, January 1 price level $ 2,000 Inventory increment at retail, June 30 price level ($2,000 * 1.05) $ 2,100 Beginning inventory at cost 26,900 Inventory increment at cost at June 30 price level ($2,100 * .80) 1,680 Ending inventory at dollar-value LIFO cost $28,580

Investment In Bonds Valuation The acquisition of bonds as an investment is initially recorded at cost which includes the costs of acquisition. Any difference between the cost and face value of the bonds should be amortized over the remaining life of the bond issue, except for short-term investments. After acquisition, the carrying value of the investment in bonds is not usually adjusted for subsequent changes in the market rate of interest or resultant changes in the market value of the bonds; however, when a substantial decline in market value occurs, and it is evident that it is not a mere temporary decline, the loss in value should be recognized currently in income (refer LCM). Investment in bonds is usually reported on the balance sheet at cost with the market value being disclosed parenthetically or in the notes to the financial statements. Amortization of Bond Discount and Premium The discount or premium on a bond investment should be amortized over the life of the bond so as to reflect the face value as the book value at maturity, and to adjust the interest earned over the life of the investment to the effective yield. There are two methods of bond premium or discount amortization: 1. The effective interest method (preferable per APB No. 21). 2. The straight-line method (allowable if result is not materially different). Example: Referring to Case Examples A and B, entries to record the investment in the bonds and the first year's interest income on the investor's books by the effective interest and straight-line methods would be: (a) Purchase at Discount-investment of $960,070 1. Acquisition: Investment in Bonds $960,070 Cash $960,070 2. First year's interest income: Effective Interest Straight-Line Cash $70,000 $70,000 Investment in Bonds 6,806 7,986 Interest Income $76,806 $77,986 (b) Purchase at Premium-investment of $1,042,125 1. Acquisition: Investment in Bonds $1,042,125 Cash $1,042,125 2. First year's interest income: Effective Interest Straight-Line Cash $70,000 $70,000 Investment in Bonds $ 7,473 $ 8,425 Interest Income 62,527 61,575 Note that separate accounts for Bond Discount or Premium were not used; the investments were recorded at net cost, and the amortization of the discount or premium was directly to the investment account. Alternatively, separate accounts for premium or discount could be used; however, this method is usually not used. Purchase of Bond Investments Between Interest Dates Bonds purchased between interest dates are purchased at cost (refer above) plus accrued interest since the last interest payment date. The entry to record the purchase of the bonds will include a receivable for the interest "purchased" which will be received when the first interest payment is received. Example: $100,000 FV, 6% bonds are purchased on April 1 at 96, cost of acquisition $500. Interest payment dates are 1/1 and 7/1, and the bonds mature in 8 3/4 years-35 quarters. Amount Paid for Bonds Market value on 4/1 ($100,000 x 96%) $96,000 Acquisition Costs 500 Cost of Bond Investment $96,500 Accrued Interest 1/1 to 4/1 ($100,000 x 6% x 3/12) 1,500 Total Paid on 4/1 $98,000 Journal entry to record purchase on 4/1: Investment in Bonds $96,500 Bond interest receivable 1,500 Cash $98,000 Journal entry to record first interest payment on 7/1: Cash ($100,000 x 6% x 1/2) $3,000 Investment in bonds (3,500/35 quarters) 100 Interest receivable $1,500 Interest income 1,600 Journal entry to record accrual of interest at 12/31: Bond interest receivable $3,000 Investment in bonds (2 quarters) 200 Interest income $3,200

List of Pension Terms PENSION TERMS Accumulated benefit obligation The actuarial present value of benefits (whether vested or nonvested) attributed by the pension benefit formula to employee service rendered before a specified date and based on employee service and compensation (if applicable) prior to that date. The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation levels. For plans with flat-benefit or non-pay-related pension benefit formulas, the accumulated benefit obligation and the projected benefit obligation are the same. Actual return on plan assets component (of net periodic pension cost) The difference between fair value of plan assets at the end of the period and the fair value at the beginning of the period, adjusted for contributions and payments of benefits during the period. Benefit/years-of-service approach One of three benefit approaches. Under this approach, an equal portion of the total estimated benefit is attributed to each year of service. The actuarial present value of the benefits is derived after the benefits are attributed to the periods. Expected return on plan assets An amount calculated as a basis for determining the extent of delayed recognition of the effects of changes in the fair value of assets. The expected return on plan assets is determined based on the expected long-term rate of return on plan assets and the market-related value of plan assets. Flat-benefit formula (Flat-benefit plan) A benefit formula that bases benefits on a fixed amount per year of service, such as $20 of monthly retirement income for each year of credited service. A flat-benefit plan is a plan with such a formula. Fund Used as a verb, to pay over to a funding agency (as to fund future pension benefits or to fund pension cost). Used as a noun, asset accumulated in the hands of a funding agency for the purpose of meeting pension benefits when they become due. Market-related value of plan assets A balance used to calculate the expected return on plan assets. Market-related value can be either fair market value or a calculated value that recognizes changes in fair value in a systematic and rational manner over not more than five years. Different ways of calculating market-related value may be used for different classes of assets, but the manner of determining market-related value shall be applied consistently from year to year for each asset class. Measurement date The date as of which plan assets and obligations are measured. Net periodic pension cost The amount recognized in an employer's financial statements as the cost of a pension plan for a period. Components of net periodic pension cost are service cost, interest cost, actual return on plan assets, gain or loss, amortization of unrecognized prior service cost, and amortization of the unrecognized net obligation or asset existing at the date of initial application of this Statement. This Statement uses the term net periodic pension cost instead of net pension expense because part of the cost recognized in a period may be cap lized along with other costs as part of an asset such as inventory. Participant Any employee or former employee, or any member or former member of a trade or other employee association, or the beneficiaries of those individuals, for whom there are pension plan benefits. PBGC The Pension Benefit Guaranty Corporation. Prepaid pension cost Cumulative employer contributions in excess of accrued net pension cost. Prior service cost The cost of retroactive benefits granted in a plan amendment. See also Unrecognized prior service cost. Projected benefit obligation The actuarial present value as of a date of all benefits attributed by the pension benefit formula to employee service rendered prior to that date. The projected benefit obligation is measured using assumptions as to future compensation levels if the pension benefit formula is based on those future compensation levels (pay-related, final-pay, final-average-pay, or career-average-pay plans). Retroactive benefits Benefits granted in a plan amendment (or initiation) that are attributed by the pension benefit formula to employee services rendered in periods prior to the amendment. The cost of the retroactive benefits is referred to as prior service cost. Service cost component (of net periodic pension cost) The actuarial present value of benefits attributed by the pension benefit formula to services rendered by employees during that period. The service cost component is a portion of the projected benefit obligation and is unaffected by the funded status of the plan. Single-employer plan A pension plan that is maintained by one employer. The term also may be used to describe a plan that is maintained by related parties such as a parent and its subsidiaries. Unfunded accrued pension cost Cumulative net pension cost accrued in excess of the employer's contributions. Unfunded accumulated benefit obligation The excess of the accumulated benefit obligation over plan assets. Unfunded projected benefit obligation The excess of the projected benefit obligation over plan assets. Unrecognized net gain or loss The cumulative net gain or loss that has not been recognized as part of the net periodic pension cost. See Gain or loss. Unrecognized prior service cost That portion of prior service cost that has not been recognized as a part of net periodic pension cost. Vested benefits Benefits for which the employee's right to receive a present or future pension benefit is no longer contingent on remaining in the service of the employer. (Other conditions, such as inadequacy of the pension fund, may prevent the employee from receiving the vested benefit.). Under graded vesting, the initial vested right may be to receive in the future a stated percentage of a pension based on the number of years of accumulated credited service; thereafter, the percentage may increase with the number of years of service or of age until the right to receive the entire benefit has vested.

Loss Carrybacks And Loss Carryforwards Computing loss carrybacks The 1997 tax law allows a pretax operating loss to be carried back to the two preceding periods resulting in a tax credit. The tax rate in existence at each of prior balance sheet dates is used to calculate the amount of the tax credit. Losses remaining after the carrybacks may be carried forward for 20 years to offset income if income exists in any of the future 20 years. FASB No 109 requires that the tax benefit of a loss carryforward be recognized as a deferred tax asset in the year of the loss. The deferred tax asset may be reduced by a valuation allowance if necessary. Companies at the time of the loss may forgo the loss carryback and elect to use only the carryforward provision. Carryback(forward) Example Example of loss carryback and loss carryforward: BG Corp. has reported combined income before taxes of $150,000 for the years 1998 and 1999. In 2000 the Corporation has a pretax loss (NOL) of $250,000. The tax rate is 30% for 1998 and 1999 and 25% for the year 2000. Solution: In 2000 BG Corp. would take $150,000 of the NOL and carry it back for two years. At a 30% tax rate, the Corporation would receive a $45,000 tax refund (30% × $150,000). The journal entry would be: Tax refund receivable $45,000 Tax benefit of operating loss carryback $45,000 The remaining $100,000 of the NOL should be recognized as a carryforward in 2000. The tax benefit of the carryforward is $25,000 (25% × $100,000). However, the company feels that based on the weight of evidence available, it is more likely than not that $10,000 of the tax benefit will not be realized. The Company's entries to record the tax benefit and the valuation allowance are as follows: Deferred tax asset $ 25,000 Tax benefit of operating loss carryforward $25,000 Tax benefit of loss carryforward $ 10,000 Allowance to reduce deferred tax assets to expected realizable value $10,000 Income Statement Presentation The income statement for the year 2000 would appear as follows: Loss before income taxes ($250,000) Less: Benefit from operating loss carryback $45,000 Benefit from operating loss carryforward 15,000 60,000 Net Loss ($190,000) Balance Sheet Disclosure Deferred tax asset $ 25,000 Less: Allowance to reduce deferred tax assets to expected realizable value ( 10,000) Expected realizable value $ 15,000 Temporary Differences Illustration Example No 1-Deferred Tax Liability (one difference) Asset acquired in 1999 for $10,000. For financial reporting, the asset is depreciated over five years using straight-line. For tax purposes, the asset is recovered using MACRS three-year class. Assume a current (and future) tax rate of 30%. The company's taxable income for 1999 is $100,000. a) Depreciation 1999 2000 2001 2002 2003 Tax (rounded) $3,300 $4,400 $1,500 $ 800 - 0 - Book 2,000 2,000 2,000 2,000 2,000 b) Net taxable or deductible amounts in each year: 1999 2000 2001 2002 2003 Taxable $500 $1,200 $2,000 Deductible $1,300 $2,400 c) Flow of deferred tax liability account: Deductible (Taxable) Change in Balance in Year amount account (30%) account 1999 $1,300 + $390 $ (390) 2000 2,400 + 720 (1,110) 2001 (500) - 150 (960) 2002 (1,200) - 360 (600) 2003 (2,000) - 600 -0- The journal entry for income tax expense at 12/31/99 would be: 12/31/99 Income tax expense $30,390 Deferred income tax liability 390 Income tax payable (.30 x $100,000) 30,000 The journal entry for income tax expense for 12/31/00 assuming a taxable income of $100,000 would be: 12/31/00 Income tax expense $30,720 Deferred income tax liability 720 Income tax payable 30,000 Example of Multiple Temporary Differences Using the same facts as in Example No 1, assume that, in addition, the company recognized a warranty expense of $3,000 for financial reporting in 2000 which (the company estimates) will be recognized for tax purposes as follows: 2000-$300; 2001-$400; 2002-$1,000; 2003-$1,300 The deferred tax asset is determined independently from the deferred tax liability. Flow of deferred tax asset account: Taxable (Deductible) Change in Balance in Year amount account (30%) account 2000 $2,7001 +$810 $810 2001 (400) - 120 690 2002 (1,000) - 300 390 2003 (1,300) - 390 -0- Since the deferred tax asset is greater than the liability, the need for a valuation allowance must be evaluated. It is assumed that no such allowance is required in this example. $3,000 -$300 12/31/00 Income tax expense $29,910 Deferred tax asset 810 Income tax payable $30,000 Deferred tax liability 720

Lower of Cost or Market LOWER OF COST OR MARKET ARB 43 states that, "A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost . . . the difference should be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market." As used in the phrase "lower of cost or market", the term market means current replacement cost except that: 1. Market should not exceed the net realizable value (NRV) which is the selling price in the ordinary course of business less reasonably predictable costs of completion and disposal, and 2. Market should not be less than NRV reduced by an allowance for an approximately normal profit margin. For example, assume a selling price of $1. Selling price $1.00 Cost of completion and disposal .15 NRV - Upper limit .85 Normal profit margin 20% .20 Lower limit $ .65 This means that market cannot be greater than $.85, the upper limit, nor lower than $.65, the lower limit. Therefore, in determining LC/M compare replacement cost with the upper and lower limit, and a. If the replacement cost falls between the upper and lower limit, use replacement cost as market. b. If the replacement cost exceeds the upper limit, use upper limit as market. c. If lower than the lower limit, use the lower limit. Then compare market as determined above with cost to determine the inventory value. The lower of cost or market rules resulted from balance sheet conservatism and were modified by the upper and lower limit rules to assure that inventory losses will be taken in the current period and that excessive inventory writedowns cannot be taken which could result in increasing income in the next period. Consider as follows: a. The upper limit will not allow the inventory item or group to be carried at more than selling price less the cost of completion and disposal. This forces losses into the current period. b. The lower limit provides a floor that prevents the inventory item from generating a greater than normal profit margin in the next period. The LC/M rules can be applied to inventory a. item by item, or b. components of each major category, or c. the total inventory. The basis of stating inventories should be consistently applied and since there are acceptable alternative methods, should be disclosed. An example of the application of the LC/M rules is as follows: Cost Selling Cost to Normal Profit Item Original Replacement Price Complete and Sell Margin 1 $1.18 $1.27 $1.40 .13 .20 2 .69 .72 .98 .14 .30 3 1.90 1.62 2.40 .30 .40 4 .27 .25 .40 .06 .12 5 .90 .96 1.10 .22 .25 Determine the LC/M for the above items. Upper Lower Solution: Item Limit Limit Market Cost LC/M 1 $1.27 $1.07 $1.27 $1.18 $1.18 2 .84 .54 .72 .69 .69 3 2.10 1.70 1.70 1.90 1.70 4 .36 .24 .25 .27 .25 5 .88 .63 .88 .90 .88

Miscellaneous Items Cash to Accrual At times, incomplete or cash basis statements are presented, and candidates are asked to convert such statements to the accrual basis (or vice versa) based on supplemental information furnished. To convert to the accrual basis: 1. Cash sales must be adjusted to sales recognized under GAAP. 2. Purchases must be converted to the accrual basis. 3. Cost of goods sold must be computed taking into account purchases in (2) above and beginning and ending inventories. 4. Expenses must be converted to the accrual basis recognizing accrued expenses at the beginning and end of the period. 5. Other items of revenue and cost expirations under GAAP must be recognized such as: Income tax allocation Amortization of intangibles Receivables and payables requiring imputed interest computations TIMING OF REVENUE AND EXPENSES-ACCRUAL BASIS The timing of revenue and expense recognition has been the subject of exam questions in recent years. These questions generally relate to insurance expense, warranty expense, royalty expense or revenue, service contract revenue, and similar areas. In most cases, the question will describe the company's recognition policy. Income and expense in these areas are recognized on a strict accrual basis and the cash exchanges generally should not impact the recognition of income or expense. It is helpful to understand the function of the related balance sheet account. Example 1: Under Hart Company's accounting system, all insurance premiums paid are debited to prepaid insurance. For interim financial reports, Hart makes monthly estimated charges to insurance expense with credits to prepaid insurance. Additional information for the year ended December 31, 1999, is as follows: Prepaid insurance at December 31, 1998 $210,000 Charges to insurance expense during 1999 (including a year-end adjustment of $35,000) 875,000 Unexpired insurance premiums at December 31, 1999 245,000 What was the total amount of insurance premiums paid by Hart during 1999? a. $910,000 b. $875,000 c. $840,000 d. $665,000 Solution: Prepaid Insurance ----------------------------- Balance 12/31/98 210,000 | | 875,000 1999 expenses Premiums paid ??? | Balance 12/31/99 245,000 | In order to generate a balance of $245,000 in the "prepaid insurance" account, the premiums paid in 1999 must have been $910,000. $210,000 - 875,000 + X = $245,000 X = $910,000 Answer (a) Example 2: Lane Company acquires copyrights from authors, paying advance royalties in some cases, and in others, paying royalties within 30 days of year end. Lane reported royalty expense of $375,000 for the year ended December 31, 1999. The following data are included in Lane's December 31 balance sheets: 1998 1999 Prepaid royalties $60,000 $50,000 Royalties payable 75,000 90,000 During 1999 Lane made royalty payments totaling a. $350,000 b. $370,000 c. $380,000 d. $400,000 Solution: The net effect of the balance sheet accounts is a net credit of $25,000 (asset decreased by $10,000 and liability increased by $15,000). Therefore, if the expense was $375,000 for the year and the impact on the prepaid and accrual accounts was a credit of $25,000, then the cash payment must have been $350,000-answer (a). PERSONAL FINANCIAL STATEMENTS A statement of financial position is required. A statement of changes in net worth is optional. Income statements and statements of cash flows are not usually disclosed. In presenting Personal Financial Statement, assets and liabilities are reported at estimated current values. Features of Personal Financial Statements Title of Statement: Statement of Financial Position Categories: Assets - listed in order of liquidity (not a current/non- current basis) Liabilities - listed in order of maturity (not a current/ non-current basis) Estimated income taxes on the excess of the estimated current values of assets over their tax basis. Net Worth Data Presentation: Use estimated fair market value Cost may be shown in comparison if desired Use accrual basis of accounting Other Points: 1. Income taxes should be accrued on unrealized asset appreciation. 2. Deferred income taxes should be included where appropriate to reflect timing differences between financial statement and income tax reporting. BANK RECONCILIATIONS Because of the differences in the timing of recording transactions, the cash balance per books and the balance per the bank statement will not agree. Further, it is probable that neither the bank statement nor the balance per books represents the correct balance of cash at the date of reconciliation. The basic form of the standard bank reconciliation is therefore an adjustment of both balances to the balances of cash on hand, as follows: Balance per bank 12/31/X1 $65,000 Less: Outstanding checks 14,000 $51,000 Add: Deposits in transit $7,000 Check erroneously charged 500 7,500 Correct bank balance 12/31/X1 $58,500 Balance per books 12/31/X1 $53,112 Less: Bank Service Charge 12 NSF check of Vulcan Co. 600 612 $52,500 Add: Bank loan of 12/16 unrecorded 6,000 Correct bank balance 12/31/X1 $58,500 Adjusting entries should be made for any items reconciling the book balance: (1) Bank Service Charge, Expense 12 Account Receivable, Vulcan Co. 600 Cash 612 To record bank service charge and reinstate A/R (2) Cash 6,000 Notes Payable 6,000 To record note payable RECOGNIZING REVENUE WHEN RIGHT OF RETURN EXISTS-SFAS 48 If an enterprise sells its product but gives the buyer rights to return the product, revenue from the sales transaction shall be recognized at time of sale only if all of the following conditions are met: (a) The seller's price to the buyer is substantially fixed or determinable at the date of sale. (b) The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product. (c) The buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. (d) The buyer acquiring the product for resale has economic substance apart from that provided by the seller. (e) The seller does not have significant obligations for the future performance to directly bring about resale of the product by the buyer. (f) The amount of future returns can be reasonably estimated. Sales revenue and cost of sales that are not recognized at time of sale because the foregoing conditions are not met shall be recognized either when the return privilege has substantially expired or if those conditions subsequently are met, whichever occurs first. If sales revenue is recognized because the above conditions are met, any costs or losses that may be expected in connection with any returns shall be accrued in accordance with FASB Statement No. 5, Accounting for Contingencies. Sales revenue and cost of sales reported in the income statement shall be reduced to reflect estimated returns. ACCOUNTING FOR FRANCHISE FEE REVENUE-SFAS 45 Franchise fee revenue from an individual franchise sale is ordinarily recognized when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor. Installment or cost recovery accounting methods should be used to account for franchise fee revenue only in those exceptional cases when the franchise revenue is collectible over an extended period and no reasonable basis exists for estimating collectibility. If an initial franchise fee is substantial in comparison to the continuing franchise fee and the services to be performed in the future, a portion of the initial fee should be deferred and amortized over the life of the franchise. The portion deferred should be an amount sufficient to cover the costs of (and reasonable profit on) the continuing services to be provided. If the franchise agreement contains other options for which there is reasonable expectation for exercise, then that portion of the initial franchise fee attributable to such option should be deferred and, upon exercise, allocated to the asset acquired as a result of such exercise. Franchisor Disclosures (a) The nature of all significant franchising commitments and agreements. (b) Revenue and related costs deferred (and the period due to be collected) for any fees accounted for using the installment or cost recovery method. (c) Segregation of initial franchise fees from other franchise fee revenue. (d) Revenue and costs related to franchisor-owned outlets shall be distinguished from revenue and costs related to franchised outlets when practicable. That may be done by segregating revenue and costs related to franchised outlets. If there are significant changes in franchisor-owned outlets or franchised outlets during the period, the number of (a) franchises sold, (b) franchises purchased during the period, (c) franchised outlets in operation and (d) franchisor-owned outlets in operation shall be disclosed. Franchise Illustrative Problem Southern Fried Shrimp sells franchises to independent operators throughout the Southeastern part of the United States. The contract with the franchisee includes the following provisions: * The franchisee is charged an initial fee of $25,000. Of this amount $5,000 is payable when the agreement is signed and a $4,000 noninterest bearing note is payable at the end of each of the five subsequent years. All of the initial franchise fee collected by Southern Fried Shrimp is to be refunded and the remaining obligation canceled if, for any reason, the franchisee fails to open his franchise. In return for the initial franchise fee Southern Fried Shrimp agrees to (1) assist the franchisee in selecting the location for his business, (2) negotiate the lease for the land, (3) obtain financing and assist with building design, (4) supervise construction, (5) establish accounting and tax records and (6) provide expert advice over a five-year period relating to such matters as employee and management training, quality control and promotion. In addition to the initial franchise fee the franchisee is required to pay to Southern Fried Shrimp a monthly fee of 2% of sales for menu planning, recipe innovations and the privilege of purchasing ingredients from Southern Fried Shrimp at or below prevailing market prices. Management of Southern Fried Shrimp estimates that the value of the services rendered to the franchisee at the time the contract is signed amounts to at least $5,000. All franchisees to date have opened their locations at the scheduled time and none has defaulted on any of the notes receivable. The credit ratings of all franchisees would entitle them to borrow at the current interest rate of 10%. The present value of an ordinary annuity of five annual receipts of $4,000 each discounted at 10% is $15,163. Required: Given the nature of Southern Fried Shrimp's agreement with its franchisees, when should revenue be recognized? Discuss the question of revenue recognition for both the initial franchise fee and the additional monthly fee of 2% of sales and give illustrative entries for both types of revenue. Illustrative Solution Because the initial cash collection of $5,000 must be refunded if the franchisee fails to open, it is not fully earned until the franchisee begins operations so that Southern Fried Shrimp should record the initial franchise fee as follows: Cash $ 5,000 Notes Receivable 20,000 Discount on Notes Receivable $ 4,837 Unearned Initial Franchise Fee 20,163 When the franchisee begins operations, the $5,000 would be earned and the following entry should be made: Unearned Initial Franchise Fee $ 5,000 Earned Initial Franchise Fee $ 5,000 After Southern Fried Shrimp has experienced the opening of a large number of franchises, it should be possible to develop probability measures so that the expected value of the retained initial franchise fee can be determined and recorded as earned at the time of receipt. Interest at 10% should be accrued each year by a debit to Discount on Notes Receivable and a credit to Interest Revenue. Each year as the services are rendered an appropriate amount would be transferred from Unearned Initial Franchise Fee to Earned Initial Franchise Fee. Since these annual payments are not refundable, the Earned Initial Franchise Fee revenue might be recognized at the time the $4,000 is collected, but this may result in the mismatching of cost and revenue. At the time that a franchise opens, only two steps remain before Southern Fried Shrimp will have fully earned the entire franchise fee. First, it must provide expert advice over the five-year period. Second, it must wait until the end of each of the next five years so that it may collect each of the $4,000 notes. Since collection has not been a problem, it could be maintained that a substantial portion of the $15,163, the present value of the notes, should be recognized as revenue when a franchisee begins operations. At some time in the future, after Southern Fried Shrimp has experienced a large number of franchises that have opened and operated for five years or more, it should be possible to develop probability measures so that the earned portion of the present value of the notes may be recognized as revenue at the time the franchisee begins operations. The monthly fee of 2% of sales should be recorded as revenue at the end of each month. This fee is for current services rendered and should be recognized as the services are performed. REAL ESTATE SALES-SFAS 66 Sales of Real Estate (other than retail land sales) Profit is recognized in full when real estate is sold, provided (a) the profit is determinable, (collectibility of the sales price is reasonably assured or the amount that will not be collectible can be estimated), and (b) the seller is not obliged to perform significant activities after the sale to earn the profit. Unless both conditions exist, recognition of all or part of the profit shall be postponed. Full profit on real estate sales transactions shall not be recognized until all of the following criteria are met: (a) A sale is consummated (usually at closing). (b) The buyer's initial and continuing investments are adequate to demonstrate a commitment to pay for the property. (c) The seller's receivable is not subject to future subordination. (d) The seller has transferred to the buyer the usual risks and rewards of ownership in a transaction that is in substance a sale and the seller does not have a substantial continuing involvement with the property. ACCOUNTING FOR FUTURES CONTRACTS-SFAS 80 A gain or loss resulting from a change in the market value of a futures contract should be recognized in income except when such a contract is a hedge of specified assets, liabilities or firm commitments. Such an exception must result from a hedge against price or interest rate risk; terms of the transaction must be identified, and it should be probable that such a transaction will occur. COMPREHENSIVE BASES OF ACCOUNTING OTHER THAN GAAP The following accounting bases may be used to prepare financial statements in conformity with a comprehensive basis of accounting other than GAAP: a. Basis of accounting used by an entity to file its income tax return. b. Cash receipts and disbursements basis of accounting. c. Cash basis. d. Modifications of cash basis such as accruing income taxes and recording depreciation. e. A definite set of criteria having substantial support that is applied to all material items. For example: constant dollar or current cost statements.

Modified Accrual Basis MODIFIED ACCRUAL BASIS (Part Cash and Part Accrual) Modified accrual is used by the five governmental funds. Revenues Revenues are recognized by the expendable funds when they are both "measurable and available." Examples: 1. Property tax revenues are recognized on the accrual basis when the taxes are levied, assuming that all taxes are collected during the year or within 60 days from the end of the year. Any taxes expected to be collected after the 60-day period would be considered deferred revenue in the current period and revenue in the following period. 2. Income taxes and sales taxes are recognized when they become susceptible to accrual. 3. Miscellaneous revenues such as parking fees, traffic court fines, building permits and business licenses are recognized on a cash basis. Expenditures Expenditures are generally recognized on the accrual basis. The exceptions are interest and long-term debt. Interest and long-term debt payments are not accrued but are recognized when due. Inventory of supplies and prepaid insurance may be recognized on either the cash basis (purchase method) or the accrual basis (consumption met SUMMARY OF MODIFIED ACCRUAL CONCEPTS Revenues/Expenditures Accounting Treatment Revenues (Concept) Recognize when available and measurable Property Tax Revenues Usually accrual Income Taxes and Sales Recognize when susceptible to accrual Taxes Revenue Miscellaneous Revenues (parking fees,traffic court fines, building permits, and business license) Recognize when cash is received Expenditures in General Accrual basis Interest and payments on long-term debt Recognize when due Expenditures for Supplies Inventory or Prepaid Insurance Accrual (Consumption Method) Cash (Purchase Method) Note: Most problems on the CPA Exam contain a standard group of questions that appear in every problem. Study carefully the next seven groups of journal entries on governmental funds to become familiar with these typical areas.

Other Intercompany Eliminations OTHER INTERCOMPANY ELIMINATIONS AND ADJUSTMENTS In general, elimination of intercompany receivables and debt; income and expense; sales and purchases; profits and loss on sales of assets is related to the single entity concept of business combinations. While the effect of intercompany transactions is ignored as to the separate entities involved, elimination is necessary when the separate entities purport to show their financial results as one. An entity cannot owe itself, cannot make a profit or suffer a loss from itself nor sell to itself. The adjustments and eliminations necessary to reflect transactions as though a single entity were involved are not book entries, but rather worksheet entries. A review of these areas and the special considerations relevant to each follow: Receivables and Payables 1. Receivables and payables This is the simplest of elimination entries; however, be careful to screen the statements to pick up all such items whether referred to in the problem or not. These take different form such as: (a) Accounts receivable and accounts payable (b) Dividends receivable and payable (c) Advances to subsidiary (d) Interest receivable and payable (e) Notes receivable and payable If the receivable and payable are related to an income, expense or dividend item, eliminate. DR LIABILITY CR ASSET Expense and Income 2. Expense and income Eliminate: (a) Dividend income and dividend paid. (b) Interest income and interest expense on notes, advances, bonds, etc. This entry is not necessary if the closing entries have been made and a consolidated balance sheet only is being prepared. DR INCOME CR EXPENSE OR DIVIDEND Sales and Purchases 3. Sales and purchases Eliminate by a debit to sales and a credit to purchases. If a consolidated balance sheet only is being prepared no entry is necessary. If the inventory and purchase accounts have been closed to Cost of Sales, the entry will be DR SALES CR COST OF SALES Profit in Ending Inventory 4. Profit in Ending Inventory Eliminate 100% of gross profit where more than 50% ownership exists. Allocate to the minority interest if the profit resulted from sale by the subsidiary to the parent and that profit is in subsidiary's retained earnings. Illustration: P S Intercompany Sales $70,000 $125,000 Markup on cost 20% 25% Year-end inventory of intercompany purchases at cost 30,000 24,000 Percentage ownership in S 80% Elimination computations: Sales by S to P of $30,000 remains in ending inventory of P. Cost 100% + Markup 25% = Selling Price 125% 25/125 * 30,000 = 1/5 * 30,000 = $6,000 profit in S's R/E Minority interest allocation 20% * $6,000 = $1,200 Sales by P to S—$24,000 remains in ending inventory of S. Cost 100% + Markup 20% = Selling Price 120% 20/120 * 24,000 = 1/6 * 24,000 = $4,000 profit in P's R/E Eliminating entry when income accounts have been closed (balance sheet only): (1) R/E — P $8,800 Minority Interest 1,200 Inventory $10,000 (1) Eliminate against parent's retained earnings even though some profit was earned by the subsidiary, since the parents' R/E will be consolidated R/E. Alternatively, it is not necessary according to GAAP to allocate to the minority interest; however, exam solutions usually show the allocation method and in some cases allocation is stated as the company's policy. Journal entry where income and expense have not been closed: To eliminate intercompany sales: Sales $195,000 Cost of Sales $195,000 To eliminate intercompany profit in ending inventory: Cost of Sales 8,800 Minority Interest 1,200 Inventory 10,000 Profit in Beginning Inventory 5. Profit in beginning inventory Whereas profit in the ending inventory decreases net income, profit in the beginning inventory has the opposite effect; however, the entry made is as follows: For profit in beginning inventory Retained earnings $2,000 Cost of Sales $2,000 To eliminate profit in the beginning inventory. The credit to cost of sales will have the effect of increasing the current year's net income. The debit to retained earnings has the effect of adjusting the beginning retained earnings for the effect of the profit in the prior years' ending inventory. This entry coincides with the elimination entry of the prior year which would have been: R/E or Cost of Sales Inventory If the consolidation policy is to allocate to the minority interest, the entry would be changed accordingly. Intercompany Transactions Involving Other Assets 6. Intercompany transactions involving other assets From a consolidation standpoint the effects of all intercompany transactions must be eliminated. In the sale of non-depreciable or non- amortizable assets the adjusting entry is relatively simple. For example, land costing P $7,000 was sold to S for $10,000. The adjusting entry would be: Gain on sale of land or retained earnings $3,000 Land $3,000 To restore land account to cost If the asset is depreciable, an adjustment is required involving the present and prior depreciation expense and the allowance for depreciation, in that depreciation taken on a gain or depreciation not taken on a loss must be adjusted. Assume that P acquired S on January 1 and sold two assets to S on April 1. Asset Book Value Price Paid Depreciation No. Parent Sub. Method Life 1 $16,000 $22,000 SYD 5 2 10,000 8,000 SL 10 The adjusting entry need only involve the depreciation on the profit or loss portion of the assets since the depreciation on the cost portion would have occurred no matter which company owned the assets. The adjustment for Asset 1 would be: Allowance for depreciation $1,500 Depreciation expense or retained earnings $1,500 $22,000 – $16,000 = 6,000 * 5/15 = 2,000 * 3/4 = $1,500 Adjustment for Asset 2 would be: Depreciation expense $150 Allowance for depreciation $150 $10,000 – 8,000 = 2,000 * 10 = $200 * 3/4 = $150 The preceding section is a good illustration of the point made earlier that elimination entries are not book entries and therefore not recorded on the books of the related entities. Consequently, the same or similar entries must be made year after year because the consolidation starting point is, of course, a trial balance taken from the books of the related entities, which have not been adjusted. For example, use the previous illustration where land costing $7,000 was sold to S for $10,000. The same elimination entry must be made each period (DR R/E $3,000, CR Land $3,000). For depreciable assets, the entire accumulated depreciation related to the gain must be eliminated with the prior year depreciation affecting retained earnings and the current year affecting depreciation expense (except when the closing entries have already been made). Effect of Purchase of Asset on Minority Interest 7. Effect of Purchase of Asset on Minority Interest What is the difference between a purchase by a subsidiary from the parent or vice versa? The distinction is very important and frequently misunderstood. The importance of the question centers around allocation of intercompany profit or loss to the minority interest. Obviously, if the subsidiary is 100% owned, there is no difference in the treatment of the sale for consolidation purposes because there is no minority interest. If the sale is downstream, from the parent to the subsidiary, the profit or loss is in the retained earnings of the parent. Since the profit rests in a retained earnings account which does not have a minority interest, no allocation is necessary. If the sale is upstream, from the subsidiary to the parent, however, the minority interest is affected by the profit or loss when the sale takes place. Therefore, the minority interest should be affected by the elimination entry, the purpose of which is to restate the sold asset to cost. Intercompany Notes Receivable Discounted 8. Intercompany Notes Receivable Discounted If intercompany notes receivable are discounted with outsiders (for example, a bank), eliminate the note receivable discounted against notes receivable. Assume the following book entries by P and S: P Intercompany N/R $10,000 Cash $10,000 S Cash $10,000 Intercompany N/P $10,000 To record 60 day 9% intercompany note Thirty days later P discounted S's note at 12% and recorded the following: Cash $10,048.50 Interest Expense 101.50 * Intercompany Interest Income $ 150 ** Intercompany N/R discounted 10,000 Note: If this entry did not involve affiliated companies, the interest expense and interest income amounts would be netted. * $10,150 * 12% * 1/12 = $101.50 ** $10,000 * 9% * 2/12 = $150 In consolidation the following elimination entry will be made: Intercompany N/R discounted 10,000 Intercompany N/R 10,000 Intercompany Interest Income 150 Intercompany Interest Expense 150 *** *** Assuming that S recorded interest expense for the note. Note that the result of the above entries, relating to the notes only, is that a $10,000 N/P remains. Intercompany Bondholdings 9. Intercompany Bondholdings From a consolidation standpoint, intercompany bondholdings are just like any other debt which along with the related receivable must be eliminated. A complication may arise, however, if bonds are issued at a discount or premium or when purchased as an investment are purchased above or below par. For elimination purposes, the intercompany bonds should be regarded as repurchased by the issuing company and retired, with the resulting gain or loss affecting consolidated retained earnings or net income. Further, the interest expense and interest income for the period must be eliminated. For example: L acquired 100% of the stock of C on January 1, 20X2. At year end L acquired $500,000 of C's outstanding bonds for $500,000 which includes $10,000 of accrued interest. These bonds were part of $1,000,000 of 8% 20-year bonds which were issued on April 1, 1991, for $960,000. Account balances are as follows: L C Investment in Bonds of C $490,000 Bonds Payable ($1,000,000) Bond Discount 16,500 Interest Receivable 10,000 Interest Payable (Bonds) (20,000) Interest Expense (Bonds) * 82,000 * 80,000 cash plus 2,000 bond discount amortization Objective: Adjust the accounts to eliminate all balances which relate to intercompany transactions. The remaining balances will relate to outsiders only. Elimination entry: Bonds Payable $500,000 Interest Payable 10,000 Interest Receivable $ 10,000 Investment in Bonds of C 490,000 Bond Discount 8,250 Gain on purchase of bonds (extraordinary item) 1,750 Supporting Computations Gain on purchase of bonds: Par value of intercompany bonds $500,000 Less: Unamortized discount 16,500 * 2 8,250 Carrying value 12/31/02 491,750 Cost to L 490,000 Gain $ 1,750 Preferred and Common Stock Investment 10. Preferred and Common Stock Investment To make proper intercompany elimination where an investment is held in both preferred and common stock, the retained earnings account must be divided between the preferred and common, and intercompany elimination made based on the respective increases in R.E. (common) and R.E. (preferred) since date of acquisition. To break up the R.E. account, remember that preferred are entitled to par, redemption premium (if applicable), and dividends including any that may be in arrears if the stock is cumulative. (Refer to Chapter 2.) Example: P owns 25% of the $100,000 par value, 8% cumulative preferred shares of S purchased on June 30, 2000, for $30,000. At date of purchase, the preferred dividends were 2 years in arrears. P also owns 90% of the common, and at June 30, 2000, the retained earnings of S was $80,000 and has increased to $190,000 at December 31, 2004, at which date the preferred dividends were 5 years in arrears. Allocate the retained earnings at date of acquisition of the preferred and determine the change up to 12/31/2004. R.E. Total Preferred Common 6/30/00 $ 80,000 $ 16,000 $ 64,000 12/31/04 190,000 40,000 150,000 Change—Increase $110,000 $24,000 $ 86,000 Preferred elimination entry—Cost method Preferred Stock $100,000 R.E.—S 40,000 Excess of Cost over FV 1,000 R.E.—P $ 6,000 ($24,000 * 25%) Investment 30,000 MI—Preferred Stock 75,000 ($100,000 * 75%) MI—Preferred R.E. 30,000 ($40,000 * 75%) Supporting Computations Cost of Preferred Stock $30,000 Elimination: Preferred 25% * 100,000 = 25,000 R/E date of acquisition 25% * 16,000 4,000 29,000 Excess of cost over FV $ 1,000 Minority Interest: 75% * 100,000 (C/S) $75,000 75% * 40,000 (R/E) 30,000 Addition to R/E — P P's share of increase from date of acquisition to 12/31/04 — 25% * 24,000 = $6,000. Elimination entries as to common would be made in the normal manner, using the retained earnings applicable to common instead of total retained earnings.

Other Inventory Issues STATEMENT OF INVENTORIES ABOVE COST Only in exceptional cases may inventories be stated above cost. Items, such as precious metals, agricultural, mineral and other products, which are interchangeable and have an immediate marketability may justifiably be stated above cost. Where inventories are stated at sales prices, they should be reduced by expenses to be incurred in disposal. TREATMENT OF INVENTORY LOSSES Accrued net losses on firm purchase commitments for goods for inventory are measured in the same way as are inventory losses, and should, if material, be recognized in the accounts and the amounts thereof separately disclosed in the income statement (Statement 10, Inventory Pricing). 1. Illustration of Statement 10 - Accrued net losses on firm purchase commitments for goods. On September 1, a purchase commitment is entered into for $40,000. On December 31 of the same year the current market price of such commitment is $25,000. The shipment arrives during January of the following year: Entry 12/31 Loss on purchase commitments 15,000 (current liability) Est. liability on purchase commitments 15,000 Entry 1/21 Purchases 25,000 Est. liability on purchase commitments 15,000 Accounts payable 40,000 2. Assume that title to goods passed on September 1, 19X7, and delivery will not be made until February 1, 19X8. 9/1/X7 Purchases 40,000 (CGS) Accounts payable 40,000 12/31/X7 Loss on purchase commitment 15,000 Inventory 15,000 or no entry is necessary if the item is valued at lower of cost or market in the ending inventory. General Rule: Statement 10 (consistent with FASB 5 re. contingencies) permits taking inventory losses on firm purchase commitments in the period of loss. However, inventory losses should not be anticipated, whereby one accounting period is charged with inventory losses anticipated in a subsequent accounting period. If a reserve for inventory losses is set up, it represents only an appropriation of retained earnings, and in no way should be used to absorb actual losses. CONSIGNMENTS As part of their marketing activities, some companies consign goods to others. In such cases, the consignor ships goods to the consignee who acts as an agent of the consignor and receives a commission when the goods are sold. It is, of course, the consignee's responsibility to remit payment for the goods sold on a periodic basis. The consigned goods, therefore, are a part of the consignor's inventory until sold. Conversely, goods on consignment are not included in the consignee's inventory even though in the consignee's possession. Goods should be included in inventory at purchase price or cost of production plus cost of shipping to the consignee. Usually, the shipping costs must be allocated to goods sold and unsold.

Other SFAS RELATED PARTY DISCLOSURES-(SFAS 57) SFAS 9 established formal requirements for disclosures which are to be made of material related party transactions (not compensation). Related party transactions include those between the company and its parent, subsidiary, (also between subsidiaries of a common parent), principal owners or management (including their families), affiliates, or a pension trust managed by the company. Required disclosures do not include transactions which are eliminated in consolidation but include: a. The nature of the relationship. b. A description of the transaction (includes transactions to which no or small amounts are ascribed). c. Other information necessary to understand the effects of the transactions or the financial statements. d. Amounts of the transactions for each period and the effects of any change in the method of establishing the terms from that used in the preceding period. e. Balance due from or to related parties at balance sheet date for each balance sheet presented. f. Nature of control relationships when reporting company and one or more other companies are under common control; (applies even if no transactions between companies) if such common control could result in financial results significantly different than those that would have been obtained if the companies were autonomous. In addition, companies may not imply that related party transactions were on terms equivalent to those as if they were at arm's length (unless such representations can be substantiated). ACCOUNTING FOR COMPENSATED ABSENCES-SFAS 43 An employer shall accrue a liability for employees' compensation for future absences if all of the following conditions are met: (a) The employer's obligation relating to employees' rights to receive compensation for future absences is attributable to employees' services already rendered. (b) The obligation relates to rights that vest or accumulate. (c) Payment of the compensation is probable, and (d) The amount can be reasonably estimated. If an employer meets conditions (a), (b), and (c) and does not accrue a liability because condition (d) is not met, that fact shall be disclosed. Notwithstanding the conditions specified above, an employer is not required to accrue a liability for nonvesting accumulating rights to receive sick pay benefits (that is, compensation for an employee's absence due to illness) since the lower degree of reliability of estimates of future sick pay does not justify such an accrual. Statement of Financial Accounting Standards No. 143 Accounting for Asset Retirement Obligations In FASB's words, Statement No. 143's stated objective is to "establish accounting standards for recognition and measurement of a liability for an asset retirement obligation and an associated asset retirement cost." Statement No. 143 applies to tangible long-lived assets, including individual assets, functional groups of related assets and significant parts of assets. It covers a company's legal obligations resulting from the acquisition, construction, development or normal operation of a cap l asset. Basic Approach * A business must recognize an asset retirement obligation for a long-lived asset at the point an obligating event takes place - provided it can reasonably estimate its fair value (or at the earliest date it can make a reasonable estimate). * The entity must record the obligation at its fair value, either the amount at which the liability could be settled in a current transaction between willing parties in an active market, or - more likely-at a substitute for market value, such as the present value of the estimated future cash flows required to satisfy the obligation. * To offset the credit portion of the asset retirement liability entry, businesses must cap lize the asset retirement costs as an increase in the carrying amount of the related long-term asset. ? Businesses must include certain costs in the income statement during the asset's life-namely depreciation on the asset, including additional cap lized retirement costs, and interest for the accretion of the asset retirement liability due to the passage of time. This statement is particularly applicable to industries such as oil refineries, electric power plants and mines which all have unusually long lives. Therefore, the calculation of the fair value of the retirement obligation will probably be based on projections of the present value of future cash flows using educated guesses about inflation, labor cost, technological advances and profit margins. This discount rate used is what the FASB calls a credit-adjusted risk-free rate. Therefore, the effect of the entity's credit standing is reflected in the discount rate rather than in the estimated cash flows. Example: * XYZ purchases an asset for $1,000,000 * Company incurs an obligation upon installation to retire the asset * Straight-line depreciation over a 10-year life * 10% credit-adjusted risk-free discount rate * Because of the difficulty in projecting cash flows the company used three different estimates and weights them based on probability. Estimated Cash Outflow Estimates Year 10 Probability Weighting 1 300,000 20% $ 60,000 2 500,000 60% 300,000 3 550,000 20% 110,000 Expected cash outflow $470,000 Present value at 10% = 470,000 x pv of $1 (.38554) = $181,204 XYZ would make the following journal entries to record the purchase of the asset and record the asset retirement liability: JE Tangible Asset (cost) 1,000,000 Cash 1,000,000 JE Tangible Asset 181,204 Asset Retirement Liability 181,204 At the end of the first year the following entries would be made: JE Depreciation Expense 118,120 Accumulated Depreciation 118,120 ($1,181,204 / 10 years = $118,120) JE Interest Expense (accretion) 18,120 Asset Retirement Liability 18,120 (10% x $181,204 = $18,120) Note: The increase in the asset retirement liability will total $470,000 at the end of 10 years. This is similar to our recording of a non-interest bearing note payable earlier in the chapter. Disclosures An entity shall disclose the following information about its asset retirement obligations: * A general description of the asset retirement obligations and the associated long-lived assets * The fair value of assets that are legally restricted for purposes of settling asset retirement obligations * A reconciliation of the beginning and ending aggregate carrying amount of asset retirement obligations showing separately the changes attributable to 1. liabilities incurred in the current period 2. liabilities settled in the current period 3. accretion expense 4. revisions in estimated cash flows, whenever there is a significant change in one or more of those four components during the reporting period. If the fair value of an asset retirement obligation cannot be reasonably estimated, that fact and the reasons therefor shall be disclosed.

OVERVIEW OF MINIMUM DISCLOSURE REQUIREMENTS Minimum Disclosure Requirements SGAS 34 on page 5, paragraph 7, presents the following diagram that illustrates the minimum requirements for general purpose financial statements. MANAGEMENT'S DISCUSSION AND ANALYSIS (MD&A) One new requirement is that every government that reports GAAP financial statements present Management's Discussion and Analysis as supplemental information preceding the financial statements. This analysis provides an overview of financial activities based on current known facts, decisions or conditions. It includes comparisons of current and prior years, with an emphasis on the current year, based on government-wide information. GASB Statement Number 34 provides minimum requirements for the types of disclosures that must be included in the MD&A although a government is not prohibited from providing additional information and explanations. The MD&A presented by a government must have all of the following according to paragraph 11: 1. A brief discussion of the basic financial statements. This discussion should describe the relationship of the statements to each other and the significant differences in information provided. Analysis should also be included to help explain why measurements and results reported in the fund-based statements reinforce or provide additional information to the government-wide financial statements. 2. Condensed financial information derived from the government-wide financial statements comparing the current year to the prior year. At a minimum, governments should include: * Total assets, distinguishing between cap l and other assets. * Total liabilities, divided between long-term and other liabilities. * Total net assets, distinguishing among amounts invested in cap l assets, net of related debt; restricted amounts; and unrestricted amounts. * Program revenues, by major source. * General revenues, by major source. * Total revenues. * Program expenses, at a minimum by function. * Total expenses. * Excess or deficiency before contributions to term and permanent endowments or permanent fund principal, special and extraordinary items, and transfers. * Contributions. * Special and extraordinary items. * Transfers. * Change in net assets. * Ending net assets. 3. An analysis of overall financial position and results of operations to aid assessment of whether financial position has improved or deteriorated as a result of the year's operations. 4. An analysis of balances and transactions of individual funds explaining the reasons for significant changes in fund balances or net assets as well as any significant restrictions. 5. An analysis of significant variations between original and final budget amounts along with variations between final budget amounts and actual results for the General Fund. 6. A description of significant cap l asset and long-term debt activity during the year. 7. If the modified approach is used for some or all infrastructure assets, information should be provided about its application. 8. A description of currently known facts, decisions, or conditions that are expected to have a significant effect on financial position or results of operations. As can be seen, the MD&A is intended to provide a broad range of information to help decision-makers evaluate the operations and financial position of the government unit. NOTES TO THE FINANCIAL STATEMENT Notes to the financial statements are an integral part of the basic financial statements. Some examples of items disclosed in the footnote are as follows: A description of the government-wide financial statements. A disclosure of the measurement focus and the basis of accounting for government-wide financial statements. Policy for eliminating internal activity in the statement of activities. Policy and details about cap lization of assets including, if applicable, the modified approach to reporting infrastructure assets. Normal details about long-term liabilities such as dates due and amounts. Segment information for activities that are reported using enterprise fund accounting. REQUIRED SUPPLEMENTAL INFORMATION (other than management's discussion and analysis) Budgetary Comparison Schedules are required for the general fund and the special revenue fund. This schedule includes the original budget, the final budget and the actual revenues and expenditures. A variance column may or may not be used. Information about infrastructure assets reported using the modified approach. The disclosure includes schedules for the assessed condition of the assets (done every 3 years), the amounts needed to maintain the assets at the established condition level and the amounts actually expensed for each of the last five periods. Schedules of funding progress for entities reporting pension trust funds. Schedule of employer contributions for entities reporting pension trust funds. SUMMARY OF REPORTING REQUIREMENTS Since our text has covered each of these items in detail, it is helpful in summary to look at an outline of the minimum reporting requirements required by SGAS 34 for local governments and states. * Management's Discussion and Analysis (MD&A) * Government-wide Financial Statements Statement of Net Assets Statement of Activities * Fund-Based Financial Statements Governmental Funds Balance Sheet Statement of Revenues, Expenditures, and Changes in Fund Balances Proprietary Funds Statement of Net Assets (or Balance Sheet) Statement of Revenues, Expenses, and Changes in Fund Net Assets (or Fund Equity) Statement of Cash Flows Fiduciary Funds Statement of Fiduciary Net Assets Statement of Changes in Fiduciary Net Assets * Notes to Financial Statement * Required Supplementary Information (RSI) Other Than Management's Discussion and Analysis DIFFERENCES BETWEEN GOVERNMENT-WIDE AND FUND-BASED REPORTING As mentioned early in the chapter, the obvious differences would include the elimination of the budgetary and encumbrance accounts, the adjusting from modified accrual to accrual, recording cap l assets, long-term debts, depreciation, and accruing bond interest cost. A few of the differences should be noted: * Cap lized Leases - The government-wide reporting is the same as for-profit enterprise. As a reminder, the normal journal entries are listed below: JE Leased Assets XXX Lease Obligation XXX To record the signing of the lease agreement. JE Depreciation Expense XXX Accumulated Depreciation XXX To record the depreciation on the leased asset. JE Interest Expense XXX Lease Obligation XXX Cash XXX To record lease payment, interest expense, and the reduction in the lease obligation. * Cap lized Leases - Fund-based reporting If the lease is recorded in the Enterprise Fund, the accounting would be the same as for government-wide reporting. However, in our example, assume the lease is recorded in the General Fund. JE Expenditures - Leased Asset XXX Other Financing Sources - Cap l Lease XXX To record the signing of the lease agreement (the amount would be the same as in government-wide reporting.) JE No journal entry for depreciation JE Expenditures - Interest XXX Expenditures - Lease Principal XXX Cash XXX To record lease payment, interest expense, and the reduction in the lease obligation. * Solid Waste Landfill Since candidates are normally not familiar with the accounting for landfills, a detailed example is probably needed. Assume that ABC City opens a landfill in year one that is expected to take 10 years to fill. The city estimates $l,000,000 in closure cost and $1,000,000 in post closure cost. At the end of the first year the city estimates that the landfill is 12% filled and makes an initial payment of $100,000 on the closure cost. For Government-wide reporting the city would use an economic resources measurement focus and accrual accounting. Since the landfill is 12% filled at the first year, 12% of the cost or $240,000 (12% x $2,000,000) should be recorded. JE Expense - Landfill $240,000 Landfill Closure Liability $240,000 JE Landfill Closure Liability $100,000 Cash $100,000 To record year one's payment for the closure cost. For Fund-Based reporting, the city would use the same journal entries if the landfill was an Enterprise Fund. However, if the landfill is recorded in the General Fund, the current resources focus is used and only the current year's payment is recorded. JE Expenditures - Landfill Closure Cost $100,000 Cash $100,000

Parent Company vs. Entity PARENT COMPANY THEORY vs. ENTITY THEORY A COMPARISON The Parent Company theory emphasizes the presentation of the financial statements of the parent company and its share of the subsidiary's assets, liabilities and operating results. The minority interest is shown on the equity side of the consolidated balance sheet between the liabilities and stockholder's equity sections, the minority therefore being regarded as neither a liability nor a part of stockholder's equity under the parent company theory. On the consolidated income statement minority interest is shown as a deduction in arriving at consolidated net income. The Entity theory of minority interest regards the ownership of the entity to be comprised of two groups of owners—the majority and minority groups. The minority interest is, therefore, classified in the stockholder's equity section of the consolidated balance sheet and the minority portion of the subsidiary's net income is considered to be a segment of the consolidated net income. A further difference is that in the Entity theory, the excess of cost over fair value (goodwill) is attributed to the enterprise as a whole and recognizes the implied value of the goodwill. This is sometimes referred to as the "grossing up" of goodwill. For example, if goodwill was $20,000 based on 80% ownership, it would follow that goodwill for the enterprise as a whole could be stated as $25,000. While the question of which of these two concepts is acceptable has not been answered by APB's or FASB's, it would appear that the parent company theory is currently in favor. Equity Method (20% to 50% Ownership) Investments in common stock of all unconsolidated domestic and foreign subsidiaries should be accounted for by the cost method in consolidated statements. Further, parent-company financial statements prepared for issuance to stockholders as the financial statements of the primary reporting entity are not a valid substitute for consolidated financial statements and not in accordance with GAAP (FASB Statement 94). The equity method should be followed where an investor's interest in voting stock enables it to exercise significant influence over operating and financial policies of an investee even though the investor holds 50% or less of the voting stock. Significant influence may be indicated in several ways such as representation on the board of directors, participation in policy making processes, material intercompany transactions, interchange of managerial personnel or technical dependency. An investment of 20% or more (direct or indirect) in the voting stock, in the absence of evidence to the contrary, is a presumption that an investor has the ability to exercise significant influence over an investee. Conversely, an investment of less than 20% should lead to a presumption that an investor does not exercise significant influence (unless such ability can be demonstrated) and the cost method should be used. ADJUSTMENTS TO NET INCOME UNDER THE EQUITY METHOD Elimination of unrealized intercompany profits and losses: RULE— Eliminate based on the investor's percentage of ownership. Problem: At the investee's balance sheet date, the investee holds inventory for which the investor recorded a $100,000 gross profit. The investor owns 30% of the common stock of the investee, the investment is accounted for under the equity method. Ignoring income taxes, what adjustments are required? Solution: The net income of the investee to be included in the investor's income statement should be adjusted for only 30% of the gross profit resulting from intercompany sales and included in the investee's inventory—not 100% where control is exercised in consolidation (over 50% control). Assume further that investee had net income of $450,000 for the period: Investee's net income $450,000 Investor's % share x .30 Investor's share of net income $135,000 Less: Intercompany profit 30% * 100,000 (30,000) Equity method investment income $105,000 Journal Entry Investment $105,000 Investment Income $105,000

Partnership Formation and Admission Partnership Definitions Definition Association of two or more persons to carry on, as co-owners, a business for profit. Partnership Agreements Can be expressed (oral or written contract) or implied (actions). Should be in writing for protection of partners. The agreement governs the formation, operation, distribution of income or loss, and dissolution of the partnership. DIVISION OF PROFITS * Profits can be shared in any way agreeable to the partners. * If the agreement is silent, the law assumes that profits and losses will be shared equally. * Amount of cap l contributed has no effect on profit division unless specified in the agreement. ADMISSION OF PARTNER * Admission or withdrawal of a partner generally dissolves the partnership and brings into being a new partnership. * New articles of partnership should be drawn up. * A new partner can purchase an interest or invest in the partnership. Care should be taken to distinguish between a purchase of an interest and the investment in a partnership. The difference is critical to the proper procedure to follow in partnership problems. 1. Purchase of interest. Example: A purchases interest of X in XYZ partnership or part of interest of XYZ in XYZ partnership. The amount A paid for his interest is outside the partnership and not recorded in the books. 2. Investment. Example: A invests $10,000 in XYZ partnership, thereby increasing the cap l of the partnership. PURCHASE OF AN INTEREST 1. Payment to an existing partner No cash transaction is to be entered on the books in the purchase of an interest. X, Y, and Z have cap ls of $10,000, $15,000 and $20,000 respectively. Z sells half of his cap l interest to P for the sum of $12,000. Entry: Z, Cap l $10,000 P, Cap l $10,000 Transaction is between Z and P as to amount and Z has merely transferred one-half of his interest to P. 2. Payment to more than one partner Purchase at book value: P purchases a one-fourth interest for $11,250. Entry: X, Cap l $2,500 (25% * $10,000) Y, Cap l $3,750 (25% * $15,000) Z, Cap l $5,000 (25% * $20,000) P, Cap l $11,250 Purchase At More Than Book Value Purchase at more than book value: Where purchase is at more than book value, goodwill may or may not be recognized. Example: P pays $15,000 for a one-fourth interest and XYZ share profits on a 4:3:3 basis. a. Goodwill not recognized. Transfer of cap l same as above. The existing partners will divide the $15,000 cash on some agreed basis or as follows: X(40) Y(30) Z(30) Total For Cap l $2,500 $3,750 $5,000 $11,250 Amount in Excess of Cap l in P&L Ratio 1,500 1,125 1,125 3,750 $4,000 $4,875 $6,125 $15,000 b. Goodwill recognized. If P is willing to pay $15,000 for a one- fourth interest, the implied value of the partnership is $60,000 ($15,000 * 4). Goodwill must be placed on the books prior to the admission of P to bring total cap l to $60,000. Goodwill $15,000 ($60,000 - $45,000 XYZ total cap l) X, Cap l $6,000 ($15,000 * 40%) Y, Cap l 4,500 ($15,000 * 30%) Z, Cap l 4,500 ($15,000 * 30%) To recognize goodwill and increase total cap l to $60,000. (1) X, Cap l $4,000 (2) Y, Cap l 4,875 (3) Z, Cap l 6,125 P, Cap l $15,000 (1) $16,000 * 1/4 (2) $19,500 * 1/4 (3) $24,500 * 1/4 To record transfer of cap l to P. Purchase At Less Than Book Value Purchase at less than book value: P pays $10,000 for a one-fourth interest. a. No adjustment of the old partner's cap l account. The same journal entry as above will be recorded since P will receive $11,250 in cap l for $10,000. The existing partners will divide the $10,000 cash on some agreed basis or as follows: X(40) Y(30) Z(30) Total Cap l $2,500 $3,750 $5,000 $11,250 Loss: * (500) (375) (375) (1,250) Division of Cash $2,000 $3,375 $4,625 $10,000 * Loss is computer (11,250 - 10,000 in P&L ratio) b. Adjustment of old partner's cap l account: In this situation the partners are giving recognition to the loss in value of their interest. Total cap l is reduced to $40,000 implied value ($10,000 * 4), with the resulting asset write-down of $5,000. X(40) Y(30) Z(30) P Total Original Cap ls $10,000 $15,000 $20,000 $45,000 Asset write-down $45,000 - $40,000 in P&L ratio (2,000) (1,500) (1,500) (5,000) 8,000 13,500 18,500 40,000 Cap l transfers (2,000) (3,375) (4,625) 10,000 $ 6,000 $10,125 $13,875 $10,000 INVESTMENT IN A PARTNERSHIP BY CONTRIBUTION TO THE FIRM'S CAP L Asset values may be adjusted before admission of any new partner(s). An investment may result in the following: * Recognition of either goodwill or bonus to the old partners. Goodwill is placed on the books before admission of a new partner. Bonus--part of the cap l contributed is credited to the account of the old partners. * Recognition to the incoming partner in the form of either goodwill or bonus. 1. No goodwill or bonus. A and B have cap ls of $10,000 and $20,000 respectively, share profits and losses equally, and C is to be admitted to the firm by making a contribution to the firm's cap l. C is to invest $10,000. Entry: Cash $10,000 C, Cap l $10,000 Note that C's profit sharing ratio is not determined by the amount of cap l contributed, but must result from agreement with the original partners. 2. Goodwill recognized to old partners C is to invest $12,000 for a one-fourth interest. Analysis: Implied value is $48,000 (4 * $12,000). C's contribution plus A and B's cap l equals $42,000; therefore, $6,000 in goodwill must be added to total cap l. Entries: Goodwill $6,000 A, Cap l $3,000 B, Cap l 3,000 Cash 12,000 C, Cap l $12,000 3. Bonus allowed to old partners C is to invest $18,000; cap l of A and B plus C's contribution equals $48,000. Since C is contributing $18,000 but is to receive only a one- fourth interest of $12,000 (1/4 * $48,000), a bonus of $6,000 is given to A and B. Entry: Cash $18,000 A, Cap l $ 3,000 B, Cap l 3,000 C, Cap l 12,000 Note that in bonus situations total cap l equals the old cap l plus the partner's contribution. 4. Goodwill allowed to new partner C is to invest $9,000 of miscellaneous business assets and agreed total cap l is to be $40,000. Entry: Goodwill $1,000 ($40,000 - $30,000 - $9,000) Misc. Assets 9,000 C, Cap l $10,000 (1/4 * 40,000) 5. Bonus allowed to new partner C is to invest $9,000; a bonus is allowed to C. Entry: Cash $9,000 A, Cap l 375 B, Cap l 375 C, Cap l $9,750 (1/4 * 39,000) DIVISION OF PROFITS Division of profits is governed by the partnership agreement. Profits may be divided: 1. Equally 2. On some other fractional basis 3. In cap l ratio 4. On average cap l ratio 5. By allowing interest on cap ls and dividing remainder, and 6. By allowing salaries to the partners and dividing remaining profit. If the agreement makes no provision for the division of profit and losses, the law assumes they will be shared equally. 1. Interest on Cap l * Partner cannot claim interest on cap l unless provided for in the partnership agreement. * Interest on cap l should not be included in income statement as an expense. * Interest paid on partners' loans may be treated as a financial expense. 2. Partners' Salaries: Treated as a division of profits. Allocation of partners' "salaries" may exceed partnership income and create a loss to be allocated to all partners according to the partnership agreement. Method of Distribution * Allocate salaries, interest first * Distribute remaining profit (loss) per agreement Example: A, B, and C agreed to the following distribution of profit: A B C Annual salary $10,000 $ 8,000 0 Interest on average cap l 0 4% 10% Remainder 40% 40% 20% Average cap l $50,000 $50,000 $200,000 Profit distribution under three different assumptions: A B C Total Interest allocation --0-- $ 2,000 $20,000 $22,000 Salary allowance $10,000 8,000 -0-- 18,000 $10,000 $10,000 $20,000 $40,000 1. Assume $50,000 profit Remainder ($50,000 - $40,000) 4,000 4,000 2,000 10,000 2. Assume $20,000 profit Remainder ($20,000 - $40,000) (8,000) (8,000) (4,000) (20,000) 3. Assume $10,000 loss Remainder ($10,000 - $40,000) (20,000) (20,000) (10,000) (50,000)

Pledging, Assigning And Factoring Receivables PLEDGING (SECURED BORROWING) Pledging is an agreement in which receivables are used as collateral for loans. The customers are usually unaware that the receivables have been pledged and continue to remit their payments to the company. The only accounting issue associated with pledging is proper disclosure. The accounts receivable continue to be shown as a current asset but must be labeled as having been pledged. This identification can be done by a footnote or parenthetical disclosure. The related liability should also be identified as secured by the accounts receivable. ASSIGNMENT OF RECEIVABLES (SECURED BORROWING) The assignment of receivables is a more formalized type of collateral for a loan. The lender will identify specific receivables that will be used for the loan and approve the receivables to be used for collateral. The receivables usually remain on the books of the company seeking the loan and the customers are normally unaware that their accounts have been assigned. The accounting problem is adequate disclosure. The financial statements must disclose either by footnote or parenthetically that the receivables have been assigned and the related liability should disclose that receivables are being used as collateral for the loan. FACTORING (SALE OF RECEIVABLES) In order to accelerate the receipt of cash, some companies will sell (factor their receivables). Factoring is common in the furniture, textile and apparel industries. Factoring may be done on a with recourse or without recourse basis. Factoring (Sale) Without Recourse If receivables are factored without recourse, the buyer of the receivables assume the risk of collection and absorbs the loss for any uncollectible accounts. The receivables are removed from the books of the seller and the title and control of the receivables are transferred to the buyer. SFAS 140 pointed out that a common form of factoring is the credit card sale, which is a means of transferring receivables without recourse, or with all of the risks and benefits of ownership. Example: Burns Furniture Co. factors $250,000 of accounts receivable to commercial factors on a without recourse basis. Commercial factors charges 2% of accounts receivable as a finance charge and retains 4% of the accounts receivable as a contingency to cover possible sales discounts and sales returns and allowance. The journal entry for Burns is as follows: JE Cash $235,000 Due from factor (4% x $250,000) 10,000 Loss on sale of receivables (2% x $250,000) 5,000 Accounts receivable $250,000 Factoring (Sale) With Recourse If accounts receivable are sold with recourse, the seller guarantees payment to the buyer if any of the accounts receivable become uncollectible. In recording this type of transaction, SFAS 125 requires a financial components approach because the seller retains a continuing involvement with the receivables. The financial components approach assigns a value to the recourse provision. Example: Use the same facts as in the previous example but assume that the recourse obligation is valued at $4,000. Burns Furniture Co. recorded the following journal entry: JE Cash $235,000 Due from factor 10,000 Loss on sale of receivables* 9,000 Accounts receivable $250,000 Recourse liability 4,000 *The loss on the receivables is the finance charge of $5,000 plus the $4,000 estimated costs of the recourse obligation.

Preferred Stock PREFERRED STOCK Characteristics Characteristics a. Fixed dividend rate b. Preference in liquidation of assets c. Participating or non-participating. Participation must be stated in problem. d. Cumulative or non-cumulative. e. Absence of voting rights Redemption What are preferred shares entitled to receive? Par value + Dividends (in arrears if cumulative and any participating dividends) + Redemption premium Conditions of redemption are important. Most preferred shares are entitled to a premium if called (call price, e.g. 105), but may provide no premium in event of liquidation. Participation in Dividends Rule 1: When the common stock has a par or stated value, participation is allocated on the aggregate dollar amount of preferred and common stock outstanding. Current dividends should be the same percentage of total par value of each class of stock outstanding. Problem: Common-$10 par, 20,000 shares $200,000 Preferred-6% cumulative and participating $100 par, 1,000 shares, 2 years' dividends in arrears plus the current year 100,000 A $51,000 dividend is to be paid Preferred Common Total Preferred in arrears 2 * $ 6,000 12,000 12,000 Current dividend 6,000 6,000 Common, 1 year at preferred rate 6% * 200,000 12,000 12,000 Remainder divided based on Rule 1 Preferred 1/3 * 21,000 7,000 7,000 Common 2/3 * 21,000 ______ 14,000 14,000 Total Dividend $25,000 $26,000 $51,000 Rule 2: When the common stock is no-par with no stated value, retained earnings available for participation is based on the number of shares of preferred and common stock outstanding. Problem: Preferred-6% cumulative and participating, 4,000 shares, $25 par-$100,000 Common-8,000 shares no-par, sold for $250,000 One year's dividends in arrears on the preferred (plus current year) Common stock gets $1.50 per share dividend (fixed by the Board of Directors) Retained earnings $51,000 Retained earnings $51,000 2 years' dividends at $6,000 12,000 39,000 Amount to common 8,000 * $1.50 12,000 Remainder for distribution $27,000 Must be based on number of shares: Preferred Common 4,000 shares 8,000 shares $9,000 $18,000

Prior Period Adjustments-SFAS No. 16 Reporting Criteria A prior period adjustment is required for the correction of an error in the financial statements of a prior period. Items such as income tax settlements or assessments, litigation claims or settlements, proceeds from renegotiation proceedings, initiated in a prior year should be included in the determination of net income for the applicable current period as stipulated in APB No. 30. Most such items will not qualify for extraordinary item treatment, but may fulfill the criteria for being either unusual or infrequent, thus requiring disclosure as a separate component of income from continuing operations. Adjustments of prior year income tax provisions which result from income tax settlements should be reported as part of the income tax provision in the year of settlement. If such treatment causes a material distortion in the income tax provision as compared to the earnings before income taxes, an explanation as to the adjustment should be given in the footnote for income taxes. Disclosure and Presentation Items qualifying for prior period adjustment treatment will result in adjustment of the financial statements of the affected period(s) along with the related income tax effect (if appropriate) when such statements are included in the annual report. The adjustment of net income in the affected year will result in a change in retained earnings for such year and subsequent years, including the beginning retained earnings for the current year. When single period statements only are being presented, disclosure should be made of the effects of such restatement on the beginning retained earnings. Example: A material error was made in the preparation of the income statement for the year ended 12/31/X7 is discovered when preparing the income statement for the year ended 12/31/X9: Year Ended 12/31 20X9 20X8 Net Income $420,000 $380,000 Retained earnings at beginning of year: As previously reported 1,200,000 950,000 Adjustments (Note 1) (60,000) (30,000) As Restated 1,140,000 920,000 1,560,000 1,300,000 Dividends 180,000 160,000 Retained earnings at end of period: $1,380,000 $1,140,000 NOTE 1: The balance of retained earnings at January 1, 20X9, has been restated to reflect a retroactive charge of $60,000 for amortization of patent not previously recognized. Of this amount, $30,000 ($.02 per share) is applicable to 20X8 and has been reflected as an expense for that year; the remaining $30,000 (applicable to 20X7) is being charged to retained earnings at January 1, 20X8.

PRIVATE NFP ORGANIZATIONS SFAS NO. 116 Contributions of Cash or Other Assets SFAS 116 establishes standards of accounting and reporting for contributions. It applies to all organizations that receive or make contributions; therefore, it affects hosp ls, universities, businesses, individuals, and any other entities which make or receive contributions. SFAS 116 defines a contribution as "an unconditional transfer of cash or other assets to an entity or settlement or cancellation of its liabilities in a voluntary non-reciprocal transfer by another entity acting other than as an owner." This is consistent with earlier definitions; however, SFAS 116 continues, "Other assets include [...] unconditional promises to give those items in the future." Thus SFAS 116 introduces the requirement that contributions be recognized as revenue (support) at fair market value on the date the unconditional promise to give occurs. The definition of a promise to give is, "a written or oral agreement to contribute cash or other assets to another entity; however, to be recognized in financial statements there must be sufficient evidence in the form of verifiable documentation that a promise was made and received." Therefore, if an unconditional promise to give is received in public with witnesses or in writing, the organization is required to record the support and an amount receivable for the promise. Prior to SFAS 116, these promises were not recorded in the financial statements because they are not legally enforceable. An allowance for uncollectible support is appropriate and advisable. With the advent of SFAS 116, not-for-profits will now report on a full accrual basis. Contributed Services Under SFAS 116, contributed services are "recognized if the services received * create or enhance nonfinancial assets or * require specialized skills, are provided by individuals possessing those skills, and would typically need to be purchased if not provided by donation." No other contributed services can be recognized. Contributed Works of Art, etc. Contributed collections of works of art, historical treasures, or similar assets need not be cap lized and recognized as revenue if they meet all of the following conditions: * Are held for public exhibition, education, or research in furtherance of public service rather than financial gain. * Are protected, kept unencumbered, cared for, and preserved. * Are subject to an organizational policy that requires the proceeds from sales of collection items to be used to acquire other items for collections. Contributions SFAS 116 makes a distinction between three types of contributions based solely upon the donor's instructions. Promises to give fall into three categories: * unrestricted * temporarily restricted * permanently restricted Unrestricted support is available for the organization to use immediately and for any purpose. Temporarily restricted support is restricted by the donor in such a way that availability of the support is dependent upon the happening of some event, the performance of a task, or the passage of time. Such support is available to the organization when the event occurs, the task is performed, or the time restraint passes. At that time, the support is reclassified from temporarily restricted to unrestricted and the support is available for use. Permanently restricted funds are those which the donor restricts in such a way that the organization will never be able to use the support itself. The organization may be able to use the income from the gift, but never the gift itself. Conditional Promises to Give * These are recognized when the conditions are substantially met. * A conditional promise is considered unconditional if the likelihood is remote that the condition will not be met. * A transfer of assets subject to a conditional promise is treated as a refundable advance

PUBLIC (GOVERNMENTALLY OWNED) COLLEGES AND UNIVERSITIES SGAS 35 Overview SGAS 35 requires that all public colleges and universities adopt the financial reporting model for government-wide statements used by state and local governments as described in SGAS 34 in the previous chapter. This means that most of the colleges will no longer be required to report fund-based statements. There is an exception but we believe that the CPA Exam will concentrate on the majority rule. An overview of the required disclosures follows along with exhibits for financial statements from SGAS 35. * Management's discussion and analysis. * Institution-wide statement of net assets. * Institution-wide statement of revenues, expenses and changes in net assets. * Statement of cash flows (direct method is required). * Statements will use an economic resources management focus and accrual accounting. * Infrastructure assets must be reported. * Cap l assets must be depreciated. * Notes to the financial statements include: 1. Cap l assets by type and amount of cost and accumulated depreciation such as land, buildings, infrastructures, etc. 2. Long-term liabilities listing liabilities by type and beginning balance, additions, reductions, ending balance and current portion. 3. Disclosures about collections held by the public institution such as a rare book collection, art collection, coin collection or historical artifacts and whether these collections are cap lized and depreciated. 4. Endowments such as endowments which do not provide specific instructions as to expenditure of the cap l appreciation on the assets. The public institution should disclose its policy for handling this cap l appreciation and the amount spent, if any, in the current year. 5. Segment information such as revenue-backed bonds used to support residential life or the book store. VOLUNTARY HEALTH AND WELFARE ORGANIZATIONS Voluntary Health and Welfare Organizations, and Other Nonprofit Organizations, are entities which provide services to the public made possible by the generosity of the public contributions. These organizations are accountable to the community for their administration and policies. Included in this category are United Way, YMCA, religious, research and scientific organizations, public broadcasting stations, private and community foundations, museums and other cultural institutions, performing arts, libraries, zoological and botanical societies, political parties, cemetery, civic, fraternal, labor unions, professional and trade associations, private elementary schools, and social and country clubs. SOP 78-10, Accounting Principles and Reporting Practices for Certain Nonprofit Organizations, recommends financial principles and reporting practices for nonprofit organizations for which there are no audit guides. This SOP does not apply to organizations that are primarily commercial businesses operated to benefit their members or stockholders, such as farm cooperatives, employee benefit and pension plans, trusts, mutual banks, and mutual insurance companies. Public voluntary health and welfare organizations follow GASB pronouncements and private voluntary health and welfare organizations follow FASB principals. Two unique aspects of voluntary health and welfare reporting are the use of the word "support" rather than revenue for contributions received, and the division of its functional expenses between program services and supporting services. Program services are the unique services associated with the organization and supporting services are costs that support the programs such as management and general expenses, cost of fundraising and membership development.

Purchase Method Purchase Method The purchase method accounts for a business combination as the acquisition of one enterprise by another, and accordingly follows principles normally applicable under historical-cost accounting. The acquiring corporation records the net assets (assets less liabilities assumed) at its cost, not to exceed their fair market value as of the date of acquisition. The total cost is allocated to the individual, identifiable assets and liabilities acquired based upon their fair market values as of the date of acquisition. Any excess of cost over the fair market value of the net assets acquired is attributed to "goodwill" (an unidentifiable, intangible asset). The reported income of the acquiring corporation includes the operations of the acquired enterprise only after the date of acquisition, and is based upon the cost to the acquiring corporation. Goodwill SFAS 142 provides that goodwill will be subject to an annual test for impairment. When the carrying amount of goodwill exceeds its implied fair value, an impairment loss is recognized equal to that excess. This nonamortization approach will be applied to both previously recognized goodwill and newly acquired goodwill. Negative Goodwill SFAS 141 states that in some cases, the sum of the amounts assigned to assets acquired and liabilities assumed will exceed the cost of the acquired entity. (exces over cost or excess). That excess shall be allocated as a pro rata reduction of the amounts that otherwise would have been assigned to all of the acquired assets except (a) financial assets other than investments accounted for by the equity method, (b) assets to be disposed of by sale, (c) deferred tax assets, (d) prepaid assets relating to pension or other postretirement benefit plans, and (e) any other current assets. If any excess remains after reducing to zero the amounts that otherwise would have been assigned to those assets, that remaining shall be recognized as an extraordinary item. METHODS OF ACCOUNTING FOR INVESTMENTS IN COMMON STOCK Percent of Level of Balance Common Stock Influence Valuation of sheet Owned (assumed) Investment Presentation Income ------------ ---------- ------------ ------------ ------ <20 Normal Cost/Fair Value* Investment Dividends 20 - 50 Significant Equity Investment % share >50 Control * Consolidate Consolidate * If consolidated statements are prepared, the cost and equity methods will produce the same results. If consolidated statements are not prepared because of the restrictions on consolidation (refer above to "Accounting Consolidations"), the cost method of accounting for investment must be used. (Refer below to "Restrictions on use of the equity method".) ** Refer to Chapter 2 on use of fair value for equity securities with readily determinable fair values, and use of the Cost/LCM method. Note: The level of the investor's influence over the operating and financial policies of an investee controls the method of accounting used for valuation of the investment, balance sheet presentation and the reporting of income. The percentage of ownership is merely an indication of the degree of influence. Cost A. Cost: Initial investment is recorded at cost. Income is recognized as dividends are distributed from the net accumulated earnings of the investee since the date of acquisition by the investor. Dividends received in excess of earnings subsequent to the date of investment are considered a return of investment (cap l) and are recorded as reductions of the cost of the investment. A series of operating losses of an investee or other factors may indicate that a decrease in the value of the investment has occurred which is other than temporary and should accordingly be recognized. Refer to Chapter Two (Corporations— Stockholders' Equity and Investments in Stock) concerning valuation of investments in common stock and examples of the cost method. Since only dividends paid are reflected on the books of an investor, the investor's statements may not reflect substantial changes in the affairs of an investee. For example, dividends may not be paid for several periods when earnings are high, or dividends could be paid substantially in excess of earnings for a period. Dividends from earnings of prior periods could be paid even though the investee suffered a loss in the current period. Because of these characteristics, the cost method may prevent an investor from reflecting adequately the earnings related to an investment in common stock. Equity B. Equity: Initial investment is recorded at cost. (At date of acquisition the cost and equity methods are the same.) The investor adjusts the carrying value of the investment to recognize its share of earnings or losses after date of acquisition, reflecting such adjustment in income as follows: DR Investment CR Net Income Losses would receive similar treatment such as: DR Net Income CR Investment The investor also adjusts the carrying value of the investment for changes in the investee's cap l. Dividends received reduce the carrying amount of the investment as follows: DR Cash CR Investment A series of operating losses or other factors may indicate a decrease in the value of the investment which is other than temporary. If so, such decrease in value should be recognized even though in excess of that recognized by use of the equity method (LCM). Restrictions on use of the equity method: The equity method may not be used to account for a majority-owned subsidiary if control is likely to be temporary or if it does not rest with the majority owner (if the subsidiary is in legal reorganization or in bankruptcy or operates under foreign exchange restrictions, controls, or other governmentally- imposed uncertainties so severe that they cast significant doubt on the parent's ability to control the subsidiary) per FASB Statement ^ Note that the above restrictions on the use of the equity method are the same as the restrictions on consolidation of subsidiaries. Therefore, an unconsolidated subsidiary must be accounted for using the cost method, and the equity method may not be used to account for an unconsolidated subsidiary. The equity method is not a valid substitute for consolidation. Consolidation C. Consolidation: The combining of the assets, liabilities, revenues and expenses of subsidiaries (a corporation controlled, directly or indirectly, by another corporation) with the corresponding items of the parent after all intercompany items are eliminated to prevent double accounting. The usual condition for consolidation is ownership of more than 50% of the outstanding voting stock. The purpose of preparing consolidated statements is to present the statements of two or more entities as the statements of a single entity (substance over form). There is a presumption that consolidated statements are more meaningful than separate statements. However, a subsidiary should not be consolidated where control is likely to be temporary or the majority owners do not have control (legal reorganization, bankruptcy, or operates under foreign exchange restrictions, controls, or other governmentally-imposed uncertainties so severe that they cast significant doubt on the parent's ability to control the subsidiary). The single most important elimination entry is that of the parent's investment account vs. the net assets or stockholders' equity of the subsidiary. At the date of acquisition, the investment represents the cost of the net assets purchased and these two accounts are reciprocal and must be eliminated in the preparation of consolidated statements. EXAMPLE: On January 1, 20X2 , A Company purchased 80% of the outstanding common stock of B Company for $650,000. At the date of purchase, the book and fair values of Company B's assets and liabilities were the same. The balance sheets of A and B on this date were as follows: Co. A Co. B Current assets $ 400,000 $ 300,000 Equipment (net) 1,000,000 700,000 Investment in B 650,000 — Total $2,050,000 $1,000,000 Liabilities $ 750,000 $ 200,000 Common stock 500,000 300,000 APIC 200,000 100,000 R/E 600,000 400,000 Total $2,050,000 $1,000,000 Under the purchase method the cost of the investment is allocated to the individual, identifiable assets and liabilities acquired based upon their fair market values as of the date of acquisition. Any excess of cost over the fair market value of the net assets acquired is attributed to "goodwill" (an unidentifiable, intangible asset). Computation of Goodwill: Investment cost $650,000 Fair value of net assets acquired: Common stock $300,000 APIC 100,000 R/E 400,000 Net assets $800,000 % acquired x .80 640,000 Goodwill $ 10,000 Because Company A did not acquire 100% of the outstanding common stock of Company B, there is a minority interest in the subsidiary equity of $160,000 (20% * $800,000). Eliminating entry: Common stock (B) $300,000 APIC (B) 100,000 R/E (B) 400,000 Goodwill 10,000 Investment in B $650,000 Minority interest 160,000 Alternatively, two entries can be made: 1 To establish minority interest in Company B. Common stock (20% * $300,000) $60,000 APIC (20% * $100,000) 20,000 R/E (20% * $400,000) 80,000 Minority interest $160,000 2 To eliminate the 80% investment in Company B. Common stock (80% * $300,000) $240,000 APIC (80% * $100,000) 80,000 R/E (80% * $400,000) 320,000 Goodwill 10,000 Investment in B $650,000 The consolidation worksheet would appear as follows: Eliminations Co.A Co.B Dr.(Cr.) Consolidated Current assets $ 400,000 $ 300,000 $ 700,000 Equipment (net) 1,000,000 700,000 1,700,000 Goodwill 10,000 10,000 Investment in B 650,000 — (650,000) - Total $2,050,000 $1,000,000 $2,410,000 Liabilities $ 750,000 $ 200,000 $ 950,000 Minority Int. (160,000) 160,000 Common stock 500,000 300,000 300,000 500,000 APIC 200,000 100,000 100,000 200,000 R/E 600,000 400,000 400,000 600,000 Total $2,050,000 $1,000,000 $2,410,000 Note the following: 1. The assets of Company B have been combined with the assets of Company A at their fair market value as of the date of acquisition. 2. The equity accounts are those of the single economic entity, Company A. 3. The investment in B and the equity accounts of Company B have been eliminated—they are reciprocal. 4. There is a minority interest established to represent their claim against the assets of the subsidiary. 5. An intangible asset, goodwill, has been established representing the excess of the cost of the investment over the fair market value of the net assets acquired. This new asset would have to be amortized over a maximum period of 40 years, starting January 1, 1989. Negative Goodwill Negative goodwill: If Company A acquired its investment in B for $620,000 this would result in negative goodwill of $20,000, which would be applied as a reduction in the fair market value of the non-current assets (equipment). The computations and elimination would be as follows: Computation of negative goodwill Investment cost $620,000 Fair value of net assets acquired ($800,000 * 80%) 640,000 Negative goodwill $ 20,000 Elimination entry Common stock $300,000 APIC 100,000 R/E 400,000 Equipment $ 20,000 Minority interest 160,000 Investment 620,000 The consolidation worksheet would appear as follows: Eliminations Co.A Co.B Dr.(Cr.) Consolidated Current assets $ 400,000 $ 300,000 $ 700,000 Equipment (net) 1,000,000 700,000 (20,000) 1,680,000 Goodwill Investment in B 620,000 — (620,000) — Total $2,020,000 $1,000,000 $2,380,000 Liabilities $ 720,000 $ 200,000 $ 920,000 Minority Int. (160,000) 160,000 Common stock 500,000 300,000 300,000 500,000 APIC 200,000 100,000 100,000 200,000 R/E 600,000 400,000 400,000 600,000 Total $2,020,000 $1,000,000 $2,380,000 Using the facts of the original investment of $650,000 for 80% of the outstanding common stock of B, assume B reported net income of $100,000 for 20X2 and paid dividends of $40,000 during the year. Equity Method Equity method: If Company A used the equity method to account for consolidated subsidiaries, it would make the following entries for 1989: 1. To record its share of B's income: Investment in B (80% * $100,000) $80,000 Investment income $80,000 2. To record dividends received Cash (80% * $40,000) $32,000 Investment in B $32,000 Computation of goodwill Investment in B ($650,000 + $80,000 – $32,000) $698,000 Fair value of net assets acquired @ 12/31/89 Original amount $800,000 Add net income 100,000 Less dividends (40,000) $860,000 % share x .80 688,000 Goodwill $ 10,000 Note that the goodwill is the same as that calculated at the date of acquisition. Under the equity method the investment is adjusted for the investor share of the change in net assets subsequent to acquisition (net income and dividends), and the stockholders equity of the subsidiary is also adjusted for this change. Therefore, the difference between the investment and the investors share of the net assets will remain the same. Computation of minority interest: 20% * $860,00 net assets = $172,000 Eliminating entry: Common stock $300,000 APIC 100,000 R/E (400,000 + 100,000 – 40,000) 460,000 Goodwill 10,000 Minority interest $172,000 Investment in B 698,000 Cost Method Cost method: If Company A used the cost method to account for consolidated subsidiaries, it would make the following entry for 20X2: To record dividends received: Cash (80% * 40,000) $32,000 Dividend income $32,000 Computation of goodwill: The computation of goodwill at 12/31/02 would be the same as the original computation. Because the investment is carried at cost as of 1/1/02, it would be compared to the fair value of the net assets acquired on 1/1/02, and the resulting goodwill would be $10,000, the original amount. Computation of minority interest: 20% * $860,000 net assets at 12/31/89 = $172,000 Note that the computation of the minority interest is the same as under the equity method above. The minority interest has a claim to 20% of the subsidiary equity as of 12/31/02. Eliminating entry: When the cost method is used to account for the investment in a consolidated subsidiary, the parent's share of the subsidiary's undistributed income, subsequent to acquisition, is not eliminated. It is carried forward and combined with the parent's retained earnings. If a single eliminating entry is used it would be as follows: Common stock $300,000 APIC 100,000 R/E* 412,000 Goodwill 10,000 Minority interest $172,000 Investment in B 650,000 *Retained earnings eliminated Original retained earnings $400,000 Undistributed income subsequent to acquisition ($100,000 NI – $40,000 dividend) 60,000 R/E at 12/31/89 $460,000 Less parent's share of undistributed income subsequent to acquisition (80% * $60,000) (48,000) R/E to be eliminated $412,000 If two eliminating entries are used, they are: 1 To establish minority interest in Company B Common stock (20% * $300,000) $60,000 APIC (20% * $100,000) 20,000 R/E (20% * $460,000) 92,000 Minority interest $172,000 2 To eliminate the 80% investment in Company B Common stock (80% * $300,000) $240,000 APIC (80% * $100,000) 80,000 R/E (80% * $400,000 original amount) 320,000 Goodwill 10,000 Investment in B $650,000 Note that when two eliminating entries are used, the entry to eliminate (only) the 80% investment in B at 12/31/02 is the same as the entry to eliminate (only) the investment in B as of 1/1/02. The parent's share of the undistributed subsidiary income, subsequent to acquisition, is not eliminated. It is carried forward and combined with the parent's retained earnings. The final consolidated balances are the same under the equity and cost methods of accounting for investments in consolidated subsidiaries. Referring to the examples above, under both methods the minority interest was $172,000 and the common stock and APIC of the subsidiary were eliminated. Under the equity method, the parent picked up, in its retained earnings, $80,000 of subsidiary income when it recorded its investment income (equity method, entry .) and eliminated the subsidiary retained earnings on the consolidation worksheet (equity method, eliminating entry). Under the cost method, the parent picked up, in its retained earnings, $32,000 of subsidiary income when it recorded dividend income and did not eliminate $48,000 of subsidiary retained earnings on the consolidation worksheet. The $48,000 of subsidiary income not eliminated was combined with the parent's retained earnings resulting in $80,000 of subsidiary income ($32,000 + $48,000) being included in the parent's consolidated retained earnings. Using the facts of the original investment of $650,000 for 80% of the outstanding common stock B, however, assuming the equipment was worth $705,000 with a book value of $700,000, the computation and worksheet would be as follows: Computation of goodwill: Investment $650,000 Fair value of net assets acquired: Book value $800,000 Add increase in value of equipment 5,000 805,000 % acquired x .80 644,000 Goodwill $ 6,000 Computation of minority interest: 20% * $805,000 F.V. net assets = $161,000 Eliminating entry: Common stock (B) $300,000 APIC (B) 100,000 R/E (B) 400,000 Equipment 5,000 * Goodwill 6,000 Minority interest $161,000 * Investment 650,000 * Alternative is to write up equipment only $4,000 (80% * $5,000), the amount attributable to the parent, and compute minority interest based upon the book value of the subsidiary equity ($800,000). All increased depreciation would then be attributed to the parent. Consolidation worksheet: Eliminations Co. A Co. B Dr.(Cr.) Consolidated Current assets $ 400,000 $ 300,000 $ 700,000 Equipment (net) 1,000,000 700,000 5,000 $ 1,705,000 Goodwill 6,000 6,000 Investment 650,000 ________ (650,000) — Total $2,050,000 $1,000,000 $2,411,000 Liabilities 750,000 200,000 950,000 Minority interest (161,000) 161,000 Common stock 500,000 300,000 300,000 500,000 APIC 200,000 100,000 100,000 200,000 R/E 600,000 400,000 400,000 600,000 Total $2,050,000 $1,000,000 $2,411,000 Note the following: 1. The assets of B have been combined with the assets of A at their fair market value as of the date of acquisition. 2. The equity accounts are those of the single economic entity, Company A. 3. The minority interest reflects their share of the increase in the value of the equipment. 4. As the recorded value of the equipment has been changed, an adjustment to depreciation expense will be required at the end of the period to reflect the depreciation of this amount over its remaining useful economic life. 5. Goodwill should be tested for impairment. OTHER POINTS—PURCHASE METHOD 1. An acquiring corporation should not record the previously recorded goodwill of an acquired company. 2. Deferred income taxes recorded previously by an acquired company should not be recorded. 3. Deferred income taxes should not be recorded at date of acquisition. 4. No part of the excess of acquired net assets over cost should be added directly to stockholder's equity at the date of acquisition. 5. Expenses incident to consummating a purchase (finders fees, commissions) are considered part of the cost of the acquired company. However, indirect and general expenses related to acquisitions should be charged to expenses when incurred. 6. Registration fees incurred in connection with the issuance of securities reduce the fair value of the securities issued and should be charged to APIC. 7. Parent and subsidiaries may have different fiscal periods, but this condition does not preclude consolidation. The subsidiary may prepare statements that closely correspond to the parent's fiscal period, or if the difference is not more than about three months (A.R.B. 3), it is acceptable to use the subsidiary's statements for its fiscal period. Recognition should be given to material intervening events by disclosure.

Quasi Reorganizations QUASI-REORGANIZATION OR CORPORATE READJUSTMENT Quasi-reorganization: A fresh start in an accounting sense. 1. The corporate entity remains intact. 2. Recorded asset values should be readjusted to the fair value. 3. A deficit is eliminated (usually). 4. Facts must be disclosed. Why Quasi-Reorganization? Assets may be overvalued and/or the corporation may have a deficit in its retained earnings account. These factors may hinder the corporation's ability to attract investors because dividends are unlikely. Procedure: Asset write-downs are charged against retained earnings and cap l stock adjustments (reductions in legal cap l) are transferred to Additional Paid in Cap l in Excess of Par Value, then to Retained Earnings, to eliminate any deficit. The new retained earnings account is dated to show that it runs from the date of the readjustment and should be disclosed in the financial statements until the date no longer has any special significance. Dating would rarely be needed after 10 years and in only exceptional cases should be discontinued in less than 10 years. Reorganization ILLUSTRATIVE PROBLEM: Current conditions warrant that the Austin Company have a quasi- reorganization (corporate readjustment) at December 31, 20X3. Selected balance sheet items prior to the quasi-reorganization (corporate readjustment) are as follows: * Inventory was recorded in the accounting records at December 31, 20X3, at its market value of $3,000,000. * Property, plant, and equipment was recorded in the accounting records at December 31, 20X3, at $6,000,000 net of accumulated depreciation. * Stockholders' equity consisted of: Common stock, par value $10 per share; authorized, issued, and outstanding 350,000 shares $3,500,000 Additional paid-in cap l 800,000 Retained earnings (deficit) (450,000) Total stockholders' equity $3,850,000 Additional information is as follows: * Inventory cost at December 31, 20X3, was $3,250,000. * Property, plant, and equipment had a fair value of $4,000,000. * The par value of the common stock is to be reduced from $10 per share to $5 per share. Required: Prepare the stockholders' equity section of the Austin Company's balance sheet at December 31, 20X3, as it should appear after the quasi-reorganization (corporate readjustment) has been accomplished. Show supporting computations in good form. Ignore income tax and deferred tax considerations. SOLUTION: Austin Company STOCKHOLDERS' EQUITY SECTION OF BALANCE SHEET AFTER QUASI-REORGANIZATION (CORPORATE READJUSTMENT) December 31, 20X3 Common stock; par value $5 per share; authorized issued, and outstanding 350,000 shares $1,750,000 Additional paid-in cap l from reduction in par value of common stock (Schedule 1) 100,000 Retained earnings from December 31, 20X3 (Schedule 2) -0- Total stockholders' equity $1,850,000 Schedule 1 -- Computation of Additional Paid-In Cap l Balance at December 31, 20X3 $800,000 Reduction in par value of common stock (350,000 shares x $5 per share) $1,750,000 Elimination of deficit in retained earnings ($450,000 + $2,000,000) (2,450,000) Balance at December 31, 20X3, after quasi-reorganization (corporate readjustment) $100,000 Schedule 2 -- Computation of Retained Earnings Balance (deficit) at December 31, 20X3 $(450,000) Writedown of property, plant, and equipment (2,000,000) Elimination of deficit in retained earnings 2,450,000 Balance at December 31, 20X3, after quasi-reorganization (corporate readjustment) $ --0--

Reporting Accounting Changes In Interim Financials STATEMENTS (SFAS No. 3) Summary: If an accounting change (APB 20) is made in other than the first interim period of a fiscal year, the cumulative effect of the change on retained earnings at the beginning of that year will be included in the determination of net income of the first interim period of the year of change. This is accomplished by restatement of that period's financial information. In those rare situations where cumulative effect of the change on retained earnings cannot be computed (principally a change to the LIFO method) specific disclosures are required. Cumulative Effect Changes Other Than Changes to LIFO 1. If a cumulative effect type accounting change is made during the first interim period of an enterprise's fiscal year, the cumulative effect of the change on retained earnings at the beginning of that fiscal year shall be included in net income of the first interim period. 2. If a cumulative effect type accounting change is made in other than the first interim period of an enterprise's fiscal year, no cumulative effect of the change shall be included in net income of the period of change. Instead, financial information for the pre-change interim periods of the fiscal year in which the change is made shall be restated by applying the newly adopted accounting principle to those pre-change interim periods. The cumulative effect of the change on retained earnings at the beginning of that fiscal year shall be included in restated net income of the first interim period of the fiscal year in which the change is made. Changes to the LIFO Method of Inventory Pricing 1. If a change of that type is made in the first interim period of an enterprise's fiscal year, the disclosures specified below shall be made. 2. If the change is made in other than the first interim period of an enterprise's fiscal year, the disclosure specified below shall be made and in addition, interim periods of that fiscal year shall be re-stated by applying the newly adopted accounting principle to those pre-change interim periods. Whenever financial information that includes those pre-change interim periods is presented, it shall be presented on the restated basis. Changes to Interim Financial Statement Disclosures The following disclosures will be made in interim financial reports: a. Nature of and justification of the change. b. Effect of the change on income from continuing operations, net income, and related per share amounts for the interim period in which the change is made. In addition, in other than the first interim period of a fiscal year, financial reports for the period of change shall also disclose (i) the effect of the change on income from continuing operations, net income, and related per share amounts for each pre-change interim period of that fiscal year, and (ii) income from continuing operations, net income, and related per share amounts for each pre-change interim period as restated. c. In financial reports for the interim period in which the new accounting principle is adopted, disclosure shall be made of income from continuing operations, net income, and related per share amounts computed on a pro forma basis for (i) the interim period in which the change is made, and (ii) any interim periods of prior fiscal years for which financial information is being presented.

Reporting Comprehensive Income (SFAS No. 130) Definition of Comprehensive Income Comprehensive income is net income plus other comprehensive income. Other Comprehensive Income Other comprehensive income includes the following items and changes in each item: a. Foreign currency translation adjustments b. Minimum pension liability adjustments c. Unrealized gains and losses on certain investments in debt and equity securities (example: available-for-sale marketable securities) Disclosure of Comprehensive Income The FASB permits four alternative disclosures of the components of the comprehensive income and a disclosure of accumulated other comprehensive income in the equity section of The Statement of Financial Position. a. Format A includes other comprehensive income as an integral part of the Statement of Income and Comprehensive Income. b. Format B shows other comprehensive income as a separate Statement of Comprehensive Income following the Income Statement. c. Formats C and D include other comprehensive income as a part of the Statement of Changes in equity. Although the SFAS-130 does not require a single display presentation for elements of comprehensive income and the total of comprehensive income, it does require that these items be presented in a financial statement that is displayed with the same prominence as other financial statements, which together constitute a full set of financial statements. The total of other comprehensive income for a period is transferred to a stockholder's equity account called accumulated other comprehensive income. The accumulated balance in this account for each classification must be disclosed in the balance sheet, a statement of changes in equity or the footnotes. A total for comprehensive income is reported in interim financial statements. Tax Effect Other comprehensive items may be shown net of tax effects or before tax effects with one amount shown for the total tax. Reclassification Adjustments a. Reclassification of adjustments are made to avoid double accounting of items that are part of net income that may be included in the other comprehensive income of the current or earlier periods. (Example: Realized gains on available-for-sale marketable equity securities recognized as a part of current net income were included in other comprehensive income as unrealized holding gains in a previous period. These unrealized holding gains must be deducted in the current period from other comprehensive income to avoid double accounting of the gains.) b. Reclassification adjustments must be shown separately for foreign currency items and unrealized gains and losses on certain investment in debt and equity securities. c. Reclassification adjustments are not used with minimum pension liability adjustments. Earnings Per Share Not Required Earnings per share numbers are not calculated for other comprehensive income or comprehensive income. Other Terms Although SFAS No. 130 uses the term "comprehensive income," other equivalent terms such as total nonowner changes in equity may be used. Three Additional Examples of Other Comprehensive Income SFAS No. 133 - Accounting for derivatives and hedging activities added the following additional items to be included in comprehensive income: * Gains or losses on cash flow hedges. * Gains or losses on hedges of forecasted foreign-currency-denominated transactions. * Gains or losses on hedging of a net investment in a foreign operation are reported in comprehensive income as part of the translation adjustment. Examples of Disclosures The following pages include examples of disclosures taken from SFAS No. 130. Format A: One-Statement Approach Enterprise Statement of Income and Comprehensive Income Year Ended December 31, 20X9 Revenues $140,000 Expenses (25,000) Other gains and losses 8,000 Gain on sale of securities 2,000 Income from operations before tax 125,000 Income tax expense (31,250) Income before extraordinary item and cumulative effect of accounting change 93,750 Extraordinary item, net of tax(28,000) Income before cumulative effect of accounting change 65,750 Cumulative effect of accounting change, net of tax (2,500) [Net income 63,250] Other comprehensive income, net of tax: Foreign currency translation adjustmentsa 8,000 Unrealized gains on securities:(b) Unrealized holding gains arising during period $13,000 Less: reclassification adjustment for gains included in net income (1,500) 11,500 Minimum pension liability adjustment (c) (2,500) Other comprehensive income 17,000 [Comprehensive income $80,250] Alternatively, components of other comprehensive income could be displayed before tax with one amount shown for the aggregate income tax expense or benefit: Other comprehensive income, before tax: Foreign currency translation adjustments (a) $10,666 Unrealized gains on securities:(b) Unrealized holding gains arising during period $17,333 Less: reclassification adjustment for gains included in net income (2,000) 15,333 Minimum pension liability adjustment (c) (3,333) Other comprehensive income, before tax22,666 [Income tax expense related to items of other comprehensive income (5,666)] Other comprehensive income, net of tax $17,000 (a) It is assumed that there was no sale or liquidation of an investment in a foreign entity. Therefore, there is no reclassification adjustment for this period. (b) This illustrates the gross display. Alternatively, a net display can be used, with disclosure of the gross amounts (current-period gain and reclassification adjustment) in the notes to the financial statements. (c) This illustrates the required net display for this classification. Format B: Two-Statement Approach Enterprise Statement of Income Year Ended December 31, 20X9 Revenues $140,000 Expenses (25,000) Other gains and losses 8,000 Gain on sale of securities 2,000 Income from operations before tax 125,000 Income tax expense(31,250) Income before extraordinary item and cumulative effect of accounting change 93,750 Extraordinary item, net of tax (28,000) Income before cumulative effect of accounting change 65,750 Cumulative effect of accounting change, net of tax (2,500) [Net income $63,250] Enterprise Statement of Comprehensive Income Year Ended December 31, 20X9 [Net income $63,250] Other comprehensive income, net of tax: Foreign currency translation adjustments (a) 8,000 Unrealized gains on securities: (b) Unrealized holding gains arising during period $13,000 Less: reclassification adjustment for gains included in net income (1,500) 11,500 Minimum pension liability adjustment (c) (2,500) Other comprehensive income 17,000 [Comprehensive income $80,250] Alternatively, components of other comprehensive income could be displayed before tax with one amount shown for the aggregate income tax expense or benefit as illustrated in Format A. (a) It is assumed that there was no sale or liquidation of an investment in a foreign entity. Therefore, there is no reclassification adjustment for this period. (b) This illustrates the gross display. Alternatively, a net display can be used, with disclosure of the gross amounts (current-period gain and reclassification adjustment) in the notes to the financial statements. (c) This illustrates the required net display for this classification. Format D: Statement-of-Changes-in-Equity Approach (Alternative 2) Enterprise Statement of Changes in Equity Year Ended December 31, 20X9 Retained earnings Balance at January 1 $88,500 Net income 63,250 [$63,250] Dividends declared on common stock (10,000) Balance at December 31 141,750 Accumulated other comprehensive income (a) Balance at January 1 25,000 Unrealized gains on securities, net of reclassification Adjustment (see disclosure) 11,500 Foreign currency translation adjustments 8,000 Minimum pension liability adjustment (2,500) Other comprehensive income 17,000 17,000 Comprehensive income [$80,250] Balance at December 31 42,000 Common stock Balance at January 1 150,000 Shares issued 50,000 Balance at December 31 200,000 Paid-in cap l Balance at January 1 300,000 Common stock issued 100,000 Balance at December 31 400,000 Total equity $783,750 Disclosure of reclassification amount: (b) Unrealized holding gains arising during period $13,000 Less: reclassification adjustment for gains included in net income (1,500) Net unrealized gains on securities $11,500 (a) All items of other comprehensive income are displayed net of tax. (b) It is assumed that there was no sale or liquidation of an investment in a foreign entity. Therefore, there is no reclassification adjustment for this period. All Formats: Accompanying Statement of Financial Position Enterprise Statement of Financial Position December 31, 20X9 Assets: Cash $ 150,000 Accounts receivable 175,000 Available-for-sale securities 112,000 Plant and equipment 985,000 Total assets $1,422,000 Liabilities: Accounts payable $112,500 Accrued liabilities 79,250 Pension liability 128,000 Notes payable 318,500 Total liabilities $638,250 Equity: Common stock $200,000 Paid-in cap l 400,000 Retained earnings 141,750 [Accumulated other comprehensive income 42,000] Total equity $783,750 Total liabilities and equity $1,422,000 All Formats: Required Disclosure of Related Tax Effects Allocated to Each Component of Other Comprehensive Income Enterprise Notes to Financial Statements Year Ended December 31, 20X9 Tax Before-Tax (Expense) Net-of-Tax Amount or Benefit Amount Foreign currency translation adjustment $10,666 $(2,666) $8,000 Unrealized gains on securities: Unrealized holding gains arising during period 17,333 (4,333) 13,000 Less: reclassification adjustment for gains realized In net income (2,000) 500 (1,500) Net unrealized gains 15,333 (3,833) 11,500 Minimum pension liability adjustment (3,333) 833 (2,500) Other comprehensive income $22,666 $(5,666) $17,000 Alternatively, the tax amounts for each component can be displayed parenthetically on the face of the financial statement in which comprehensive income is reported. All Formats: Disclosure of Accumulated Other Comprehensive Income Balances Enterprise Notes to Financial Statements Year Ended December 31, 20X9 Minimum Accumulated Foreign Unrealized Pension Other Currency Gains on Liability Comprehensive Items Securities Adjustment Income Beginning balance $(500) $25,500 $0 $25,000 Current-period change 8,000 11,500 (2,500) 17,000 Ending balance 7,500 $37,000 $(2,500) $42,000 Alternatively, the balances of each classification within accumulated other comprehensive income can be displayed in a statement of changes in equity or in a statement of financial position.

REQUIRED GOVERNMENT-WIDE FINANCIAL STATEMENTS SGAS 34 SGAS 34 requires two government-wide financial statements: * A Statement of Net Assets * A Statement of Activities Statement of Net Assets * Note primary government vs. component units. * Note columns for governmental activities and business-type activities. * The statement of net assets is a form of balance sheet except the equity section is replaced by three types of net assets. * GASB encourages assets and liabilities to be presented in order of liquidity for assets and due dates for liabilities or as a classified statement indicating current and non-current sections. * Internal asset balances ($175,000) result from inter-activities transactions between the governmental activities and business-type activities. The internal balances reported on the statement offset each other so that there is not an impact on the total primary government. Intra-activities solely within the governmental funds or the business-type funds should not be reported because the assets and liabilities cancel out. For example, a due to the cap l projects fund account would be offset by a due from the general fund account. (Remember these accounts would be reported in fund-based statements). * Cap l Assets (Fixed Assets) are reported as historical cost less accumulated depreciation. Infrastructure assets such as roads, bridges, water & sewer systems, etc. are included as a part of cap l assets and reported as net of accumulated depreciation. Exception: SGAS 34 permits a modified approach in which depreciation need not be recorded if the infrastructure assets are a part of a network or a subsystem of a network ("eligible infrastructure assets"). The government must document that the assets are being preserved at approximately (or above) an established level disclosed by the government. As a part of this documentation, the government must have in place an asset management system to monitor the particular eligible infrastructure assets. In addition, the government must be able to make an annual estimate of the cost of maintaining and preserving the infrastructure assets to meet the condition level requirements that have been established. For example, the Golden Gate Bridge was built a number of years ago and if properly maintained will last indefinitely. So, what useful life should be used to depreciate the initial construction cost? Under the modified approach, the GASB stated that the life was indefinite and that depreciation should not be recorded. The cost of the bridge would be reflected by expensing all the maintenance cost necessary to preserve the bridge at an established condition level. However, cost of future additions or improvements must be cap lized and depreciation recorded. * Donated assets are generally recorded at fair value the date of donation. * Collections of works of art or historical treasures or similar items are normally cap lized and depreciated based on the theory that the useful lives are reduced by display or educational and research uses. Exception: Cap lization is not required if the collection is used for public service and not for gain, protected, preserved, cared for, kept uncumbered, and subject to a policy that sale proceeds are used to obtain other items for the collection. (Note: This is the same theory used by the FASB in SFAS t that is covered in Chapter 16). * Note that non-current liabilities are presented on the government-wide statements and not on the fund-based statements. * Net assets are divided into three areas: 1. Invested in cap l assets net of related debt 2. Restricted net assets - restricted in this case means restricted by external parties or imposed by law through constitutional provisions or enabling legislation. If permanent endowments or permanent fund principal amounts are included in restricted net assets, two additional components - expendable and non-expendable amounts should be displayed. 3. Unrestricted net assets is a residual category. For example, net assets that are internally restricted should be listed in this category. * Note that component units are shown to the far right side of the statement so that the reported amounts do not affect the primary government figures. * Go back and review the reconciliation at the bottom of Exhibit I. Statement of Activities * Note that the right side of the statement is divided between primary government and component units. * Expenses (not expenditures) are shown by function such as public safety rather than by object such as salaries, rent, depreciation, etc. * SGAS 34 in paragraph 41 states that "as a minimum, governments should report direct expenses for each function. Direct expenses are those that are specifically associated with a service, program, or department and, thus, are clearly identifiable to a particular function." Many indirect expenses are simply assigned to a relatively generic function such as general government; (first line under government activities on Exhibit B); however, as an alternative, indirect expenses can be allocated in some appropriate manner to the various operating functions. * Interest expense on long-term debt is an exception to the disclosure by function rule and is shown by object. This is done because of its size and informational value. * Remember that the internal service funds have been combined with the governmental activities. This means that the cost of the internal service funds must be allocated to the function to which it provides services. All intra-activities must be eliminated and the internal service funds' net income reduced to zero. * Revenues are divided into three areas: Charges for services Operating grants and contributions Cap l grants and contributions * General revenues include Taxes: (property taxes, levied for general purposes; property taxes, levied for debt service; franchise taxes; and public service taxes), payment from Sample City, grants and contributions not restricted to specific programs, investment earnings, miscellaneous. * The special item-gain on a sale of park land is interesting. On the government-wide statements, only the gain is recognized but on the fund-based statements, (Exhibit II) total proceeds from the sale are recognized. * Format - the statement of activities is a type of income statement but in a very unique format. (See Exhibit B.) It is designed to be read horizontally to indicate whether an area operated at a net revenue or expense. The report is read vertically to indicate the total change in net assets. For example, reading horizontally, the Health and San tion area's expenses exceeded its revenues by $551,405, but reading vertically the total governmental activities show a decrease in net assets of $3,144,286. Again reading horizontally along the change in net asset line, the report indicates that this decrease in net assets under the governmental activities is offset by the increase of $3,219,885 for business activities for a total increase in net assets of $105,599. Two Types of Financial Statements Overview The following overview may be helpful in looking at the two types of financial statements: Fund-based Financial Government-wide Financial Statements Statements Governmental Use the current financial Use the economic resources resources measurement measurement focus and focus and modified accrual accounting for the accrual accounting for timing of revenue and the timing of revenue and expense recognition. expenditure recognition. Proprietary Use the economic resources Use the economic resources measurement focus and measurement focus and accrual accounting for the accrual accounting for the timing of revenue and timing of revenue and expense recognition. expense recognition. Fiduciary Use the economic resources Not included because measurement focus and fiduciary fund's resources accrual accounting for the are not available for use by timing of revenue and the governmental unit. expense recognition.

Research And Development Costs (SFAS 2) Under this statement all items defined as research and development (R&D) costs are to be expensed when incurred. The statement defines the inclusions and exclusions as to research and development costs as well as elements of cost to be identified as research and development activities. Definition of R&D Costs a. Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service (hereinafter "product") or a new process or technique (hereinafter "process") or in bringing about a significant improvement to an existing product or process. b. Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants. It does not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other ongoing operations, even though those alterations may represent improvements, and it does not include market research or market testing activities. Activities Included in R&D Costs a. Laboratory research aimed at discovery of new knowledge. b. Searching for applications of new research findings or other knowledge. c. Conceptual formulation and design of possible product or process alternatives. d. Testing in search for or evaluation of product or process alternatives. e. Modification of the formulation or design of a product or process. f. Design, construction, and testing of pre-production prototypes and models. g. Design of tools, jigs, molds, and dies involving new technology. h. Design, construction, and operation of a pilot plant that is not of a scale economically feasible to the enterprise for commercial production. i. Engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready for manufacture. Exclusions from R&D Costs a. Engineering follow-through in an early phase of commercial production. b. Quality control during commercial production, including routine testing of products. c. Trouble-shooting in connection with breakdowns during commercial production. d. Routine, ongoing efforts to refine, enrich, or otherwise improve upon the qualities of an existing product. e. Adaptation of an existing capability to a particular requirement or customer's need as part of a continuing commercial activity. f. Seasonal or other periodic design changes to existing products. g. Routine design of tools, jigs, molds, and dies. h. Activity, including design and construction engineering, related to the construction, relocation, rearrangements, or start-up of facilities or equipment other than (1) pilot plants (see paragraph h. above), and (2) facilities or equipment whose sole use is for a particular research and development project (see below). i. Legal work in connection with patent applications or litigation, and the sale or licensing of patents. Elements of Costs Identified with R&D Activities a. Materials, equipment, and facilities. The costs of materials (whether from the enterprise's normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for R&D activities and that have alternative future uses (in R&D projects or otherwise) shall be cap lized as tangible assets when acquired or constructed. The cost of such materials consumed in R&D activities and the depreciation of such equipment or facilities used in those activities are R&D costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular R&D project that have no alternative future uses (in other R&D projects or otherwise), and, therefore, no separate economic values, are R&D costs at the time the costs are incurred. b. Personnel. Salaries, wages and other related costs of personnel engaged in R&D activities shall be included in R&D costs. c. Intangibles purchased from others. The costs of intangibles that are purchased from others for use in R&D activities and that have alternative future uses (in R&D projects or otherwise) shall be cap lized and amortized as intangible assets in accordance with APB Opinion No. 17 (section 5141). The amortization of those intangible assets used in R&D activities is an R&D cost. However, the costs of intangibles that are purchased from others for a particular R&D project and that have no alternative future uses (in other R&D projects or otherwise), and, therefore, no separate economic values, are R&D costs at the time the costs are incurred. d. Contract services. The costs of services performed by others in connection with the R&D activities of an enterprise, including R&D conducted by others in behalf of the enterprise, shall be included in R&D costs. e. Indirect costs. R&D costs shall include a reasonable allocation of indirect costs. However, general and administrative costs that are not clearly related to R&D activities shall not be included as R&D costs. Outside Funding-SFAS 68 When a research and development arrangement is funded by others and the enterprise is obligated to repay any of the funds provided by the other parties regardless of the outcome of the research and development, the enterprise shall estimate and recognize that liability. To conclude that a liability does not exist, the transfer of the financial risk involved with research and development from the enterprise to the other parties must be substantive and genuine. To the extent that the enterprise is committed to repay any of the funds provided by the other parties regardless of the outcome of the research and development, all or part of the risk has not been transferred. If conditions suggest that it is probable (see SFAS .) that the enterprise will repay any of the funds regardless of the outcome of the research and development, there is a presumption that the enterprise has an obligation to repay the other parties. That presumption can be overcome only by substantial evidence to the contrary. An enterprise that incurs a liability to repay the other parties shall charge the research and development costs to expense as incurred. The amount of funds provided by the other parties might exceed the enterprise's liability. If so, the enterprise shall charge its portion of the research and development costs to expense in the same manner as the liability is incurred. For example, the liability might arise as the initial funds are expended, or the liability might arise on a pro rata basis.

Restatement Of Foreign Currency Financial Statements Functional Currency The rules for expressing foreign currency in dollars depend upon the functional currency involved. An entity's functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash. Once the functional currency of an entity is determined, such determination remains in effect unless significant changes in the economic facts and circumstances warrant a change in the functional currency. Functional Currency is the Local Currency If an entity's operations are relatively self-contained within a particular foreign country, then that country's currency (local currency) would be the functional currency. An example would be an entity whose operations are not integrated with those of the parent, whose buying and selling activities are primarily local, and whose cash flows are primarily in the foreign currency. Since the local currency is the functional currency, the company's financial statements would be translated to U.S. dollars using the current-rate method. Current-rate method procedures: * The assets and liabilities of an entity are translated using the current rate which means the exchange rate at the balance sheet date. * Equity accounts are translated using historical exchange rates. * Revenues, expenses, gains, and losses use the weighted average exchange rate for the period. * The resulting translation adjustment for the current period is reported as other comprehensive income net of tax. * The cumulative translation adjustment is reported as a part of the accumulated other comprehensive income in the equity section of the statement of financial position. * Reclassification of Translation Adjustments: 1. SFAS interpretation 37 states that if an enterprise sales part of its ownership interest in a foreign entity, a pro rata portion of the accumulated translation adjustment attributable to that investment shall be recognized in measuring the gain or loss on the sale in the current period. 2. Since this portion of the translation adjustment would have been recognized in previous periods as other comprehensive income, the translation adjustment would have to be reclassified ("reversed out") in other comprehensive income of the current period to avoid a double counting of the translation adjustment gain or loss. Functional Currency is the Reporting Currency If the foreign entity is a branch or extension of its U.S. parent, its functional currency would likely be the U.S. dollar (reporting currency). An example would be an entity whose operations are integrated with those of the parent, whose buying and selling activities are primarily in the parent's country and/or the parent's currency, and whose cash flows are available for remittance to the parent. Since the reporting currency is the functional currency, the financial statements would be expressed in dollars using the remeasurement method. Remeasurement method procedures: Balance sheet accounts are placed in two categories -- monetary and nonmonetary. Monetary items include cash, and those receivables and payables which represent a fixed amount of cash, as opposed, for instance, to an unearned revenue liability which will be satisfied with goods or services. The fact that a receivable or payable is classified as current or noncurrent has no effect on its being monetary in nature. All other balance sheet items are nonmonetary (except an investment in debt securities which will be held until maturity -- which would be a monetary asset). * Monetary assets and liabilities are remeasured at the current exchange rate. * Non-monetary accounts are remeasured using the historical exchange rates. * Revenues, expenses, gains and losses use the weighted average exchange rate for the period except for cost allocations such as depreciation expense which uses the historical rate. * Foreign exchange gains and losses are reported on the consolidated income statement. Functional Currency and Local Currency Functional Currency is Neither Local Currency nor Reporting Currency If the functional currency is a foreign currency other than the local currency, then the foreign currency statements are first remeasured in the functional currency before they are translated to U.S. dollars using the current rate method. Example: Park Company, a U.S. parent, has a wholly-owned subsidiary, Schnell Corp., which maintains its accounting records in German marks. Because all of Schnell's branch offices are in Switzerland, its functional currency is the Swiss franc. Since the functional currency is the Swiss franc, the financial statements of the subsidiary must first be remeasured from German marks into Swiss francs and a foreign exchange remeasurement gain or loss must be recognized. The remeasured financial statements are then translated into U.S. Dollars and a foreign exchange translation gain or loss is calculated. The consolidated financial statements would then report a foreign exchange remeasurement gain or loss on the Income Statement and a translation gain or loss would be reported as other comprehensive income. Functional Currency in a Highly Inflationary Economy If a foreign entity is located in a country that is experiencing high inflation (if the cumulative inflation rate is > than 100% over a 3-year period), the foreign currency is considered unstable. In this case, the foreign currency statements are remeasured into the reporting currency (the U.S. dollar). Disclosure An analysis of the changes during the period in the separate component of other comprehensive income and for the "cumulative translation adjustment" portion of accumulated other comprehensive income is provided in a separate financial statement, in notes to the financial statements, or as part of a statement of changes in equity. At a minimum, the analysis discloses: a. Beginning and ending amount of cumulative translation adjustments. b. The aggregate adjustment for the period resulting from translation adjustments and gains and losses from certain hedges and intercompany balances. c. The amount of income taxes for the period allocated to translation adjustments. d. The amounts transferred from cumulative translation adjustments and included in determining net income for the period as a result of the sale or complete or substantially complete liquidation of an investment in a foreign entity. An enterprise's financial statements are not adjusted for a rate change that occurs after the date of the enterprise's financial statements or after the date of the foreign currency statements of a foreign entity if they are consolidated, combined, or accounted for by the equity method in the financial statements of the enterprise. However, disclosure of the rate change and its effects on unsettled balances pertaining to foreign currency transactions, if significant, may be necessary. Example: Financial statements of the Peso Corporation, a foreign subsidiary of the Dollar Corporation (a U.S. company) are shown below at and for the year ended December 31, 199X. The statements are first translated using the LCU (local currency unit) as the functional currency (translation method), then the dollar as the functional currency (remeasurement). Assumptions: 1. The parent company organized the subsidiary on December 31, 199W. 2. Exchange rates for the LCU were as follows: December 31, 199W to March 31, 199X $.18 April 1, 199X to June 30, 199X .13 July 1, 199X to December 31, 199X .10 3. Inventory was acquired evenly throughout the year and sales were made evenly throughout the year. 4. Fixed assets were acquired by the subsidiary on December 31, 199W. Peso Corporation Foreign Currency Financial Statements, Expressed in Dollars at and for the year ended December 31, 199X Current Rate Method Remeasurement Method Exchange Exchange Rate Dollars Rate Dollars Income Statement Sales LCU 525,000 $.1275* $66,938 $.1275 $66,938 Costs and expenses: Cost of goods sold LCU 400,000 .1275 $51,000 .1275 $51,000 Depreciation expense 22,000 .1275 2,805 .18 3,960 Selling expenses 31,000 .1275 3,953 .1275 3,953 Other operating expenses 11,000 .1275 1,403 .1275 1,403 Income taxes expense 19,000 .1275 2,423 .1275 2,423 Total costs & expenses LCU 483,000 $61,584 $62,739 Currency exchange (gain) (6,854) Net income LCU 42,000 $ 5,354 $11,053 Other Comprehensive Income Foreign Currency Translation Adjustments (17,154) Comprehensive Los ($11,800) Statement of Retained Earnings R.E. beg. of year LCU -0- -0- -0- Net income 42,000 5,354 11,053 R.E., end of year LCU 42,000 $ 5,354 $11,053 Balance Sheet - Assets Cash LCU 10,000 .10 $ 1,000 .10 $ 1,000 Accounts receivable (net) 50,000 .10 5,000 .10 5,000 Inventories (at cost) 95,000 .10 9,500 .1275 12,113 Fixed assets 275,000 .10 27,500 .18 49,500 Accumulated depreciation (22,000) .10 (2,200) ***(3,960) Total assets LCU 408,000 $40,800 $63,653 Liabilities & Stockholders' Equity Accounts payable LCU 34,000 .10 $3,400 .10 $3,400 Long-term debt 132,000 .10 13,200 .10 13,200 Common stock 10,000 shares 200,000 .18 36,000 .18 36,000 Retained earnings 42,000 5,354 11,053 Accumulated other comprehensive income ______ **(17,154) ______ Total liabilities & stockholders' equity LCU 408,000 $40,800 $63,653 * ( ($.18 * 3) + ($.13 * 3) + ($.10 * 6) )/12 = .1275 ** Residual amount (to balance). *** 22,000/275,000 = x/49,500 ; x = $3,960 (or $.18 in this case)

Retirement and Liquidation RETIREMENT OF A PARTNER Adjustment of asset values may be required to determine the fair equity of a retiring partner. This may be necessary to: a. Correct improper operating charges of prior periods (bad debts, accruals, depreciation and recognition of inventories). b. Give recognition to the existence of goodwill. c. Give recognition to changes in market values. Problem: C is to retire from A, B, C partnership. A goodwill value of $6,000 has been agreed upon. 1. Goodwill recorded on the books for (1) all partners or (2) only the retiring partner. (1) Goodwill $6,000 A, Cap l $2,000 B, Cap l 2,000 C, Cap l 2,000 (2) Goodwill $2,000 C, Cap l $2,000 2. Implied bonus or goodwill Assume that A, B and C have cap ls of $10,000 each and share profits equally. C is to retire and is to be paid $12,000 from partnership assets. The $2,000 excess of the payment to C over his cap l may be recorded as a bonus or as goodwill. Bonus A, Cap l $ 1,000 B, Cap l 1,000 C, Cap l 10,000 Cash $12,000 Goodwill: Goodwill $ 2,000 C, Cap l $ 2,000 C, Cap l 12,000 Cash 12,000 DISSOLUTION AND LIQUIDATION 1. Causes of Dissolution Dissolution occurs when the existing partnership arrangement is altered for some reason. Liquidation may follow dissolution but often outsiders would be unaware of the end of one partnership and the start of another. 2. Liquidation - Terminating the Affairs of a Business A. Procedure: (1) Realization of assets - convert assets into cash (2) Division of loss or gain on realization, by charges or credits to partner's cap l (3) Payment of the liabilities (4) Payment of the partner's interest B. Order of distribution in liquidation (1) Outside creditors (a) Priority claims such as artisans, government, liquidation expenses. (b) Secured creditors to the extent covered by proceeds from sale of pledged assets. Excess claim treated as unsecured credit. (c) Unsecured credit to the extent covered by proceeds from sale of unpledged (or free) assets. (2) Partners for loan accounts (right of "offset" reserved, however) (3) Partners' cap l As a practical matter partners' loans and cap l are considered as one. Any known gain or loss should be distributed before any payments are made to partners. Problem: A and B have non-cash assets of $40,000, liabilities of $5,000 and cap l of $20,000 and $15,000 respectively. Assets are sold for $32,000. Determine amount distributable to A and B in liquidation. A and B Statement of Partnership Liquidation Assets Partners' Cap ls Cash Non-Cash Liabilities A 50% B 50% $40,000 $(5,000) $(20,000) $(15,000) Realization and Loss $32,000 (40,000) ______ 4,000 4,000 $32,000 --0-- $(5,000) $(16,000) $(11,000) Payment Liabilities (5,000) 5,000 Payment to Partners (27,000) 16,000 11,000 Problem: Debit balance in partner's cap l account. Assets were sold for $50,000. Assets Partners' Loans Partners' Cap ls Cash Non-Cash Liabilities X Y X 80% Y 20% --0-- $80,000 $(15,000) $(10,000) $(17,000) $(20,000) $(18,000) (1)* $50,000 (80,000) ______ ______ ______ 24,000 6,000 50,000 --0-- (15,000) (10,000) (17,000) 4,000 (12,000) (2)* ______ ______ ______ 10,000 17,000 (10,000) (17,000) 50,000 (15,000) --0-- --0-- ( 6,000) (29,000) (3)* (15,000) 15,000 (4)* (35,000) 6,000 29,000 (1) Realization and Loss (2) Combine Loan and Cap l Acct (3) Pay Liabilities (4) Pay Partners NOTE: Right of offset exercised. Neither partner would be paid any cash until there is no danger that possible loss could exceed his cap l account and loan account combined. LIQUIDATION IN INSTALLMENTS -- MAXIMUM POSSIBLE LOSS (MPL) Where a partnership is liquidated and the full amount to be paid to a partner is determined before any distributions are made, losses have already been distributed to the partners. In these situations it is assured that no partner will receive more than he will be entitled to receive. However, where a liquidation occurs in stages and disbursements are made periodically, there must be assurance that no partner will receive more than he could possibly be entitled to receive. This can be done by distributing the maximum possible loss to the partners and the remaining cap l balance(s) can safely be paid. The maximum possible loss is the total of the non-cash assets. The procedure to determine the safe distribution is: A. Determine the maximum possible loss that the partnership could suffer. MPL = Total Assets - Cash (or Non-Cash assets) B. Distribute the MPL to the partners in P and L ratio. C. The remaining balance is the amount that can be distributed to each partner. D. Distribute the amount determined in C. E. The same calculation must be made each time a distribution is made. NOTE: Remember, MPL's are not actual losses, only theoretical losses; therefore, the determination of MPL should be done on a separate schedule. ABC Partnership has the following balance sheet as of December 31st: Assets Liabilities and Cap l Cash $ 35,000 Liabilities $ 21,000 Receivables 14,000 Partners' Loans Other Assets 85,000 A 5,000 C 8,000 Partners' Cap l A 50,000 B 35,000 ______ C 15,000 $134,000 $134,000 A, B and C share profits and losses on a 5:3:2 basis. Determine the amount the partner(s) will receive by distributing the maximum possible loss. Solution: The maximum possible loss is $99,000 ($14,000 receivables + $85,000 other assets). A (50%) B (30%) C (20%) Cap l balance $50,000 $35,000 $15,000 Additional loans 5,000 -- 8,000 55,000 35,000 23,000 MPL - $99,000 49,500 29,700 19,800 Amount distributed $ 5,500 $ 5,300 $ 3,200 NOTE: The cash to be distributed - $14,000 - is equal to the cash available -$35,000- less the liabilities of $21,000.

Settlements And Curtailments Of Defined Benefit Pensions SFAS No.88 A settlement of a pension obligation is an irrevocable elimination of an employer's pension liability usually through an annuity contract or a lump sum cash payment. A curtailment is an event which significantly reduces the expected future service of employees or eliminates the accrual of benefits for some or all employees. Curtailments generally include plan suspension or termination, plant closings or discontinuation of a business segment. FASB Statement No. 88 requires that the net gain or loss from a settlement or curtailment be included in the net income of the period. When a plan is settled, the net gain or loss is the unrecognized net gain or loss that has not been recognized as part of pension expense plus any remaining unrecognized net asset existing when FASB Statement No. 87 was initially applied. When a plan is curtailed, the portion of the unrecognized prior service cost associated with the estimated reduced future benefits is a loss. This amount is combined with any gain or loss from a change in the projected benefit obligation due to the curtailment in order to determine the net gain or loss. Termination Benefits Paid to Employees Such benefits may include lump-sum cash payments, payments over future periods, or similar inducements. SFAS No. 88 requires that a company record a loss and a liability for these termination benefits when the following two conditions are met: 1. The employee accepts the offer. 2. The amount can be reasonably estimated. The amount of the loss includes the amount of any lump-sum payments and the present value of any expected future benefits.

SFAC 5 RECOGNITION AND MEASUREMENT IN FINANCIAL STATEMENTS OF BUSINESS ENTERPRISES Statement of Financial Accounting Concepts No. 5 sets forth recognition criteria and guidance on what information should be incorporated into financial statements and when. The statement makes the following major conclusions: Financial statements are a central feature of financial reporting as a principal means of communicating financial information to those outside an entity. Some useful information is better provided by financial statements and some is better provided, or can only be provided, by notes to financial statements, supplementary information, or other means of financial reporting. For items that meet criteria for recognition, disclosure by other means is not a substitute for recognition in financial statements. Recognition is the process of formally incorporating an item into the financial statements of an entity as an asset, liability, revenue, expense, or the like. A recognized item is depicted in both words and numbers, with the amount included in the statement totals. A full set of financial statements for a period should show: * Financial position at the end of the period * Earnings for the period * Comprehensive income for the period* * Cash flows during the period * Investments by and distributions to owners during the period. * In June 1997 the FASB adopted SFAS 130 - which requires the disclosure of comprehensive income. (See Chapter 12 for complete disclosure requirements.) SFAC 5 Characteristics Following are some characteristics of financial statements identified in SFAC 5 General purpose financial statements are directed toward the common interests of various users and are feasible only because groups of users of financial information have similar needs. Financial statements, individually and collectively, contribute to meeting the objectives of financial reporting. No one financial statement is likely to provide all the financial statement information that is useful for a particular kind of decision. The parts of a financial statement also contribute to meeting the objectives of financial reporting and may be more useful to those who make investment, credit, and similar decisions than the whole. Financial statements result from simplifying, condensing, and aggregating masses of data. As a result, they convey information that would be obscured if great detail were provided. Although those simplifications, condensations, and aggregations are both necessary and useful, the Board believes that it is important to avoid focusing attention almost exclusively on "the bottom line," earnings per share, or other highly simplified condensations. A statement of financial position provides information about an entity's assets, liabilities, and equity and their relationships to each other at a moment in time. The statement delineates the entity's resource structure - major classes and amounts of assets - and its financing structure - major classes and amounts of liabilities and equity. A statement of financial position does not purport to show the value of a business enterprise but, together with other financial statements and other information, should provide information that is useful to those who desire to make their own estimates of the enterprise's value. Those estimates are part of financial analysis, not of financial reporting, but financial accounting aids financial analysis. Statements of earnings and of comprehensive income together reflect the extent to which and the ways in which the equity of an entity increased or decreased from all sources other than transactions with owners during a period. The concept of earnings set forth in this Statement is similar to net income for a period in present practice; however, it excludes certain accounting adjustments of earlier periods that are recognized in the current period - cumulative effect of a change in accounting principle is the principal example from present practice. The Board expects the concept of earnings to be subject to the process of gradual change or evolution that has characterized the development of net income. Earnings is a measure of entity performance during a period. It measures the extent to which asset inflows revenues and gains associated with cash-to-cash cycles substantially completed during the period exceed asset outflows expenses and losses associated, directly or indirectly, with the same cycles. Further guidance in applying the criteria for recognizing components of earnings is necessary because of the widely acknowledged importance of earnings as a primary measure of entity performance. Guidance for recognizing components of earnings is concerned with identifying which cycles are substantially complete and with associating particular revenues, gains, expenses, and losses with those cycles. The monetary unit or measurement scale in current practice in financial statements is nominal units of money, that is, unadjusted for changes in purchasing power of money over time. The Board expects that nominal units of money will continue to be used to measure items recognized in financial statements. Earnings and comprehensive income are not the same because certain gains and losses are included in comprehensive income but are excluded from earnings. Those items fall into three classes that are illustrated by certain present practices: * Foreign currency translation adjustments * Minimum pension liability adjustments * Unrealized gains and losses on certain investments in debt and equity securities (example: available-for-sale marketable securities) THREE OTHER EXAMPLES OF OTHER COMPREHENSIVE INCOME SFAS 133 - Accounting for derivatives and hedging activities added the following additional items to be included in comprehensive income: * Gains or losses on cash flow hedges. * Gains or losses on hedges of forecasted foreign-currency-denominated transactions. * Gains or losses on hedging of a net investment in a foreign operation are reported in comprehensive income as part of the translation adjustment. A variety of terms are used for net income in present practice. The Board anticipates that a variety of terms will be used in future financial statements as names for earnings for example, net income, profit, or net loss and for comprehensive income for example, total nonowner changes in equity or comprehensive loss. Comprehensive income is a broad measure of the effects of transactions and other events on an entity, comprising all recognized changes in equity net assets of the entity during a period from transactions and other events and circumstances except those resulting from investments by owners and distributions to owners. Comprehensive income is closely related to the concept of cap l maintenance. The full set of financial statements discussed in this Statement is based on the concept of financial cap l maintenance. The concept of cap l maintenance applied to a particular enterprise will have a direct effect on what is included in comprehensive income. Under the financial cap l approach, the effects of changing prices will be included in comprehensive income. Under the physical cap l approach, the effects of changing prices will not be included. In other words, physical and financial can be used to separate return on cap l (earnings) from return of cap l (cap l recovery). Assume the company has $ 1,000 in inventory and at the end of the year the company sells it for $1,500. Also consider that at the end of the year the company needs to spend $1,200 to replace the inventory. Under the financial cap l approach, $1,000 is considered return of investment and $500 is considered return on cap l or income. In other words, the effects of changing prices on assets and liabilities are holding gains and losses and part of the return on cap l being earned by the enterprise. The objective is to maintain purchasing power. Under the physical cap l approach, $1,200 is considered the sum that must be reinvested to replenish the inventory, and $300 is considered return on cap l or income. In other words, the operating capability of the enterprise must be maintained. As a result, changing prices would be part of cap l maintenance rather than return on cap l. The effects of those changes, referred to as cap l maintenance adjustments, are included directly in equity. The objective is to maintain operating capacity. Future standards may change what is recognized as components of earnings. Future standards may also recognize certain changes in net assets as components of comprehensive income but not of earnings. A statement of cash flows directly or indirectly reflects an entity's cash receipts classified by major sources and its cash payments classified by major uses during a period, including cash flow information about its operating, financing, and investing activities. A statement of investments by and distributions to owners reflects an entity's cap l transactions during a period - the extent to which and in what ways the equity increased or decreased from transactions with owners as owners. An item and information about it should meet four fundamental recognition criteria to be recognized and should be recognized when the criteria are met, subject to a cost-benefit constraint and a materiality threshold. Those criteria are: * Definitions. The item meets the definition of an element of financial statements. * Measurability. It has a relevant attribute measurable with sufficient reliability. * Relevance. The information about it is capable of making a difference in user decisions. * Reliability. The information is representationally faithful, verifiable, and neutral. Items currently reported in the financial statements are measured by different attributes (for example, historical cost, current [replacement] cost, current market value, net realizable value, and present value of future cash flows), depending on the nature of the item and the relevance and reliability of the attribute measured. The Board expects use of different attributes to continue. Guidance for recognizing revenues and gains is based on their being: * Realized or realizable. Revenues and gains are generally not recognized as components of earnings until realized or realizable and * Earned. Revenues are not recognized until earned. Revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. For gains, being earned is generally less significant than being realized or realizable. Guidance for expenses and losses is intended to recognize: * Consumption of benefit. Expenses are generally recognized when an entity's economic benefits are consumed in revenue- earning activities or otherwise or * Loss or lack of benefit. Expenses or losses are recognized if it becomes evident that previously recognized future economic benefits of assets have been reduced or eliminated, or that liabilities have been incurred or increased, without associated economic benefits. In a limited number of situations, the Board may determine that the most useful information results from recognizing the effects of certain events in comprehensive income but not in earnings, and set standards accordingly. Certain changes in net assets that meet the fundamental recognition criteria may qualify for recognition in comprehensive income even though they do not qualify for recognition as components of earnings. Information based on current prices should be recognized if it is sufficiently relevant and reliable to justify the costs involved and more relevant than alternative information. Most aspects of current practice are consistent with the recognition criteria and guidance in this Statement, but the criteria and guidance do not foreclose the possibility of future changes in practice. When evidence indicates that information that is more useful (relevant and reliable) than information currently reported is available at a justifiable cost, it should be included in financial statements.

SFAS 121 Impairment of Long-Lived Assets A. Review for Impairment When events and circumstances indicate that the carrying amount of the asset is not recoverable, it is assumed to be impaired. Examples of possible events and circumstances are listed below: 1. Drop-off in demand; coupled with the company's inability to keep pace with advancing technology. 2. A current period operating loss. 3. A significant decrease in the fair value of the asset. 4. A negative cash flow. B. Impairment Test If the future net cash flows (not present value) expected to be generated by the asset are less than the carrying value, an impairment loss should be recognized. C. Measurement of the Impairment Loss The loss is the amount by which the carrying amount exceeds the fair value. If the fair value is not available, the present value of future cash flows may be used. Note: After the impairment loss is recognized, the adjusted carrying amount is considered the new "cost" and the restoration of the impairment loss is prohibited. II. Assets to be Disposed of A. Assets to be disposed of should be reported at the lower of the carrying amount or fair value less the cost to sell. B. Unlike the impaired long-lived assets, future changes in the estimated fair value including recoveries may be reflected as adjustments to the carrying value of the assets to be disposed of as long as the adjusted carrying value does not exceed the initial carrying value. III. NOTE: SFAS y does not apply to disposal of a segment of a business. Example of Asset Impairment: AMC Corporation experienced its first loss in 1997. The loss along with a decrease in demand for its products and an inability to keep pace with advancing technology has management concerned about possible impairment of its assets. The three-year old factory is being depreciated over 20 years and the machinery over 10 years, but because of the decrease in demand AMC believes that a more realistic estimate would be five years. The carrying value of the factory and machinery is $2,500,000. The company projects total (not discounted) net cash flows for the next five years to be $2,000,000. Since it is difficult to estimate the fair value of the factory and the machinery, AMC calculates the present value of the net cash flows for the next five years as a substitute for the fair market value ($1,400,000). (The discount rate used is the rate of return used for evaluating cap l budgeting projects.) The calculation of the potential impairment is done in two steps: A. The Impairment Test B. Calculation of the Loss A. Impairment Test Compare the carrying value of the factory and machinery $2,500,000 vs. Nondiscounted expected net cash flows $2,000,000 Since the net cash flows are less than the carrying value, an impairment loss must be recognized. B. Calculation of the Loss Carrying value of the factory and machinery $2,500,000 vs. Fair Market Value (Present Value of Future Cash Flows $1,400,000 IMPAIRMENT LOSS TO BE RECOGNIZED $1,100,000

SFAS 131 SFAS 131 Overview DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION SFAS 131 determines the reporting standards for segment reporting, the disclosure of information about different components of an enterprise operation as well as information related to the enterprise's products and services, its geographic areas and its major customers. OBJECTIVES The objectives of SFAS 131 are to help users of financial statements: * Better understand enterprise performance. * Better assess its prospects for future net cash flows. * Make more informed judgments about the enterprise as a whole. IDENTIFYING REPORTABLE OPERATING SEGMENTS A. MANAGEMENT APPROACH SFAS 131 adopts a management approach to identifying segments in which segments are based on the way that management organizes segments internally for making operating decisions and assessing performance. Segments can be organized by product or services by geography, by legal entity, or by the type of customer. These are referred to as operating segments. Operating segments are components of an enterprise which meet three criteria: 1. Engage in business activities and earn revenues and incur expenses. 2. Operating results are regularly reviewed by the chief operating decision-maker to assess performance and make resource allocation decisions. 3. Discrete financial information is available from the internal reporting system. B. AGGREGATION OF OPERATING SEGMENTS IF APPROPRIATE After identifying the segments based on internal reporting, management must decide which of the segments should be reported separately. If two or more of the segments have essentially the same business activities in essentially the same economic environment, information for these individual segments may be combined (aggregated). For example, a retail chain may have 20 stores that individually meet the definition of an operating segment but each store is essentially the same. In this case management may desire to combine the 20 stores into one operating segment. To aggregate similar operating segments the following criteria must be considered: 1. The nature of the products and services provided by each operating segment. 2. The nature of the production process. 3. The type of class of customer. 4. The distribution methods. 5. If applicable, the nature of the regulatory environment. Segments must be similar in each and every one of these areas to be combined. However, aggregation of similar segments is not required. C. 10 PERCENT QUANT TIVE THRESHOLD TESTS Once operating segments have been identified, three quant tive threshold tests are then applied to identify segments of sufficient size to warrant separate disclosure. Any segment meeting even one of these tests is separately reportable. 1. Revenue test - segment revenues, both external and intersegment, are 10 percent or more of the combined revenue, external and intersegment, of all reported operating segments. 2. Profit or loss test - segment profit or loss is 10 percent or more of the greater (in absolute terms) of the combined reported profit of all prof ble segments or the combined reported loss of all segments incurring a loss. 3. Asset test - segment assets are 10 percent or more of the combined assets of all operating segments. D. MANAGEMENT'S JUDGMENT Operating segments that were reported in previous periods that do not meet the 10 percent test in the current period may continue to be reported if judged to be of continuing significance to management. E. SUFFICIENCY TEST If the total external revenue of the operating segments is less than 75% of consolidated revenue, additional operating segments are identified as reportable until the 75% level is reached. F. ALL OTHERS All other segments that are not reportable should be combined with other business activities such as corporate headquarters and disclosed in an all other category. INFORMATION TO BE DISCLOSED BY OPERATING SEGMENT A. GENERAL INFORMATION about the operating segment including factors used to identify operating segments and the types of products and services from which each segment derives its revenues. B. SEGMENT PROFIT OR LOSS AND THE FOLLOWING COMPONENTS OF PROFIT OR LOSS 1. Revenues from external customers. 2. Revenues from transactions with other operating segments. 3. Interest revenue. 4. Interest expense. 5. Depreciation, depletion, and amortization expense. 6. Other significant noncash items included in segment profit or loss. 7. Unusual items (discontinued operations and extraordinary items). 8. Income tax expense or benefit. 9. Equity in net income of investee accounted for on the equity method. C. TOTAL SEGMENT ASSETS AND THE FOLLOWING RELATED ITEMS 1. Investment in equity method affiliates. 2. Expenditures for additions to long-lived assets. D. ADDITIONAL DISCLOSURES 1. Basis of accounting. 2. Differences in measurement practices between a segment and the complete entity. 3. Reconciliations - the enterprise will need to reconcile the segment amounts disclosed to the corresponding enterprise amounts. E. INTERIM PERIOD DISCLOSURES Four items of information must also be disclosed by operating segment in interim financial statements: 1. Revenues from external customers. 2. Intersegment revenues. 3. Segment profit or loss. 4. Total assets for which there has been a material change from the amount disclosed in the last annual report. ENTERPRISE-WIDE DISCLOSURES A. INFORMATION ABOUT PRODUCTS AND SERVICES 1. Additional information must be provided if operating segments have not been determined based on differences in products and services, or if the enterprise has only one operating segment. 2. In those situations, revenues derived from transactions with external customers must be disclosed by product or service. B. INFORMATION ABOUT GEOGRAPHIC AREAS 1. Revenues from external customers and long-lived assets must be reported for: ? the domestic country. ? all foreign countries in which the enterprise has assets or derives revenues. ? each individual foreign country in which the enterprise has material revenues or material long-lived assets. 2. The FASB does not provide any specific guidance with regard to determining materiality of revenues or long-lived assets; this is left to management's judgment. C. INFORMATION ABOUT MAJOR CUSTOMERS If revenues from a single customer are 10 percent or more of consolidated revenues, the following disclosures should be made: 1. Amount of revenue to each customer that has 10 percent or more of consolidated revenues. 2. Amount of revenue to domestic government agencies or foreign governments if 10 percent or more of consolidated revenues. 3. Identify the industry segment making the sale. 4. Disclosures of the customer's name is not required. Case Example Case Example: Assume that an enterprise has seven industry segments some of which incurred operating losses, as follows: Operating Profit or Industry Segment (Operating Loss) A $100 ---\ B 500 --- $1,000 C 400 ---/ D (295) ---\ E (600) ---\ F (100) --- (1,100) G (105) ---/ $(100) The combined operating profit of all industry segments that did not incur a loss (A, B, and C) is $1,000. The absolute amount of the combined operating loss of those segments that did incur a loss (D, E, F, and G) is $1,100. Therefore, Industry Segments B, C, D, and E are significant because the absolute amount of their individual operating profit or operating loss equals or exceeds $110 (10 percent of $1,100). Additional industry segments might also be significant under the revenue and identifiable asset tests. ILLUSTRATIVE PROBLEM FOR SEGMENT REPORTING X Corporation operates in various diversified industries within the U.S. as well as in several foreign locations. The company has designated certain operating units as segments in an attempt to comply with the tests in SFAS 131 Listed below are the designated reporting units along with the revenues, operating profit and assets of each (000's). Appli- Furni- Elimina- Consol- Toys ances ture Toys Bottles Total tions idated Gross revenues $1,000 $18,000 $4,000 $600 $400 $24,000 $(500) $23,500 Operating profit 100 2,000 (800) (50) 10 1,260 (20) 1,240 Assets 800 6,000 1,000 300 100 8,200 - 8,200 The company combines its foreign and U.S. toy operations as one segment for testing purposes. Application of tests: 1. Revenues - 10% x gross revenues = $24,000 x .10 = $2,400 Therefore, appliances and furniture are reportable segments. 2. Operating profit (loss)/profits = 10% x $2,060* = $206 or losses = 10% x 800 = $80 Use 206. Therefore, appliances and furniture are reportable segments. *U.S. toys $100 Foreign toys (50) Toys net $ 50 Appliances 2,000 Bottles 10 $2,060 Operating profits for test purposes 3. Assets - 10% x $8,200 = $820. Therefore, appliances, furniture and toys are reportable segments. 4. Segments sufficiency test (75% test): .75 x $23,500 (revenues to unaffiliated customers) = $17,625 required. Revenues included in reportable segments exceed the requirement. Therefore, the three segments determined to be reportable are sufficient. Appendix A -- FLOWCHART FOR IDENTIFYING REPORTABLE OPERATING SEGMENTS* APPENDIX B Summary of EPS Formulas Net Income - Preferred Dividends* Basic EPS = ------------------------------------------------------ Weighted Average Number of Common Shares Outstanding Net Income Dilutive EPS = --------------------------------------------------- with Weighted Average Number + Weighted average Convertible Of Common Shares Outstanding Potential Shares Preferred Stock Net Income + (Bond Interest - Tax Effect) Dilutive EPS = --------------------------------------------------- with Weighted Average Number + Weighted average Convertible Of Common Shares Outstanding Potential Shares Bonds Net Income Dilutive EPS = --------------------------------------------------- with Weighted Average Number + Weighted average Stock Of Common Shares Outstanding Potential Shares Options or (Treasury stock method) Warrants * Current cumulative preferred dividends are always deducted. Non-cumulative current dividends are deducted if declared.

SFAS 141 SFAS 141 Business Combinations SFAS 141 provides three major changes in financial reporting: * Eliminates the use of pooling of interest and requires that all business combinations use the purchase method. * Provides greater guidance in recognizing intangible assets. * Requires disclosures of the primary reasons for business combinations and expanded purchase price allocation information. Intangible Assets Intangible assets include both current assets and non-current assets that lack physical substance. SFAS 141 describes two attributes for recognition of an intangible asset. * Does the intangible asset arise from contractual or other legal rights? * Is the intangible asset capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged. Appendix A of SFAS 141 includes a list of intangible assets that meet the recognition criteria. Illustrative Examples Illustrative Examples of Intangible Assets That Meet the Criteria for Recognition Separately from Goodwill (SFAS 141) The following are illustrative examples of intangible assets that, if acquired in a business combination, generally would meet the criteria for recognition as an asset separately from goodwill. Assets designated by the symbol © are those that would generally be recognized separately from goodwill because they meet the contractual-legal criterion. Assets designated by the symbol (s) do not arise from contractual or other legal rights, but should nonetheless be recognized separately from goodwill because they meet the separability criterion. The determination of whether a specific identifiable intangible asset acquired meets the criteria in this Statement for recognition separately from goodwill should be based on the facts and circumstances of each individual business combination.* Marketing-related intangible assets 1. Trademarks, tradenames c 2. Service marks, collective marks, certification marks c 3. Trade dress (unique color, shape or package design) c 4. Newspaper mastheads c 5. Internet domain names c 6. Noncompetition agreements c Customer-related intangible assets 1. Customer lists s 2. Order or production backlog c 3. Customer contracts and the related customer relationships c Artistic-related intangible assets 1. Plays, operas and ballets c 2. Books, magazines, newspapers and other literary works c 3. Musical works such as compositions, song lyrics, advertising jingles c 4. Pictures and photographs c 5. Video and audiovisual material, including motion pictures, music videos, and television programs c Contract-based intangible assets 1. Licensing, royalty, standstill agreements c 2. Advertising, construction, management, service or supply contracts c 3. Lease agreements c 4. Construction permits c 5. Franchise agreements c 6. Operating and broadcast rights c 7. Use rights such as landing, drilling, water, air, mineral, timber cutting, and so forth c 8. Servicing contracts such as mortgage servicing contracts c 9. Employment contracts c Technology-based intangible assets 1. Patented technology c 2. Mask works c 3. Internet domain names c 4. Unpatented technology s 5. Databases, including title plants s 6. Trade secrets including secret formulas, processes, recipes c *The intangible assets designated by the symbol © also might meet the separability criterion. However, separability is not a necessary condition for an asset to meet the contractual-legal criterion. Note: The FASB specifically states that an assembly workforce shall not be recognized as an intangible asset a part from goodwill. Purchased In Process Research and Development SFAS 141 does not change the accounting for purchased in process research and development. The criterion usually used is technological feasibility. If the R & D has not reached technological feasibility, it should be expensed. Furthermore, any tangible assets or intangible assets associated with the R & D project that have no alternative use should be expensed at the acquisition date. Disclosures in Financial Statements I. The notes to the financial statements of a combined entity shall disclose the following information in the period in which a material business combination is completed: a. The name and a brief description of the acquired entity and the percentage of voting equity interests acquired. b. The primary reason for the acquisition, including a description of the factors that contributed to a purchase price that results in recognition of goodwill. c. The period for which the results of operations of the acquired entity are included in the income statement of the combined entity d. The cost of the acquired entity and, if applicable, the number of shares of equity interests (such as common shares, preferred shares, or partnership interests) issued or issuable, the value assigned to those interests, and the basis for determining that value e. A condensed balance sheet disclosing the amount assigned to each major asset and liability caption of the acquired entity at the acquisition date f. Contingent payments, options, or commitments specified in the acquisition agreement and the accounting treatment that will be followed should any such contingency occur g. The amount of purchased research and development assets acquired and written off in the period and the line item in the income statement in which the amounts written off are aggregated h. For any purchase price allocation that has not been finalized, that fact and the reasons therefore. In subsequent periods, the nature and amount of any material adjustments made to the initial allocation of the purchase price shall be disclosed. II. The notes to the financial statements also shall disclose the following information in the period in which a material business combination is completed if the amounts assigned to goodwill or to other intangible assets acquired are significant in relation to the total cost of the acquired entity: a. For intangible assets subject to amortization: 1. The total amount assigned and the amount assigned to any major intangible asset class 2. The amount of any significant residual value, in total and by major intangible asset class 3. The weighted-average amortization period, in total and by major intangible asset class b. For intangible assets not subject to amortization, the total amount assigned and the amount assigned to any major intangible class c. For goodwill: 1. The total amount of goodwill and the amount that is expected to be deductible for tax purposes 2. The amount of goodwill by reportable segment (if the combined entity is required to disclose segment information in accordance with FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information), unless not practicable.

SFAS 142 SFAS 142 Goodwill and Other Intangible Assets SFAS 142 provides two major changes in financial reporting related to business combinations. The first major change goodwill will no longer be amortized systematically over time. This nonamortization approach will be applied to both previously recognized and newly acquired goodwill. In the second major change, goodwill will be subject to an annual test for impairment. When the carrying amount of goodwill exceeds its implied fair value, an impairment loss is recognized equal to that excess. Testing Goodwill for Impairment SFAS 142 describes the following two-step approach for testing goodwill for impairment: * The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, thus the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any. * The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill shall be its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is completed. Calculation of Implied Fair Value of Goodwill The implied fair value of goodwill shall be determined in the same manner as the amount of goodwill recognized in a business combination is determined. That is, an entity shall allocate the fair value of a reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unity. The excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. That allocation process shall be performed only for purposes of testing goodwill for impairment; an entity shall not write up or write down a recognized asset or liability, nor should it recognize a previously unrecognized intangible asset as a result of that allocation process. Simple Example On January 2, 20x2, ABC Company purchased all the outstanding stock of XYZ Corporation for $2,000. The fair value of identifiable assets is $1600 and $400 of goodwill is recorded. XYZ recorded a loss for 20x2 and forecast continuing losses. An analysis of the company (reporting unit) indicates that the reporting units fair value is now only $150 above the fair value of the identifiable net assets. Therefore, the implied value of goodwill has fallen to $150. As a result the consolidated unit will report a $250 ($400 - $150) goodwill impairment loss on a separate line on the income statement and report goodwill on a separate line on the balance sheet at $150. What are Reporting Units? The FASB noted that goodwill is primarily associated with individual reporting units within the consolidated entity. Such goodwill is often considered "synergistic" because it arises from the interaction of the assets of the acquired company with those of the acquirer in specific ways. To better assess potential declines in value for goodwill (in place of amortization), the most specific business level at which goodwill is evident was chosen as the appropriate level for impairment testing. This specific business level is referred to as the reporting unit. The FASB also noted that, in practice, goodwill is often assigned to reporting units either at the level of a reporting segment – as described in SFAS 131 Disclosures about Segments of an Enterprise and Related Information – or at a lower level within a segment of a combined enterprise. Consequently, the reporting unit became the designated enterprise component for tests of goodwill impairment. Reporting units may thus include the following: * A component of an operating segment at a level below the operating segment. Segment management should review and assess performance at this level. Also, the component should be a business in which discrete financial information is available and differ economically from other components of the operating segment. * The segments of an enterprise * The entire enterprise For example, ABC consolidated company includes four operating segments resulting from the parent company and three acquisitions of companies X, Y, and Z. ABC tested each separate reporting unit for goodwill impairment. ABC compared the fair market of each of its reporting units to its carrying value. The comparison revealed that the fair value of each of the reporting units exceeded its carrying value except segment Z. According to SFAS 142, Segment Z must apply the second step of impairment testing, a comparison of the implied value of its goodwill to its carrying value. The carrying value of its goodwill was $150,000. The following data was used for the test: Segment Z: December 31, 20x2 fair market value $3,000,000 Fair values of Segment Z net assets at Dec. 31, 20x2 Current Assets $1,000,000 Property 1,500,000 Equipment 500,000 Subscriber list 300,000 Patented technology 400,000 Current liabilities (250,000) Long-term debt (550,000) Value assigned to identifiable net assets (2,900,000) Value assigned to goodwill $ 100,000 Carrying value before impairment (150,000) Impairment loss $ 50,000 The necessary comparisons to determine if goodwill is impaired depend first on the fair value computation of the reporting unit and then, if necessary, the fair value computation for goodwill. But how are such values computed? How can fair values be known if the subsidiary is wholly-owned and thus not traded publicly? Several alternative methods exist for determining the fair values of the reporting units that comprise a consolidated entity. * First, any quoted market prices that exist can provide a basis for assessing fair value – particularly for subsidiaries with actively traded non-controlling interests. * Second, a comparable businesses may exist that can help indicate market values. * Third, there are a variety of present value techniques for assessing the fair value of an identifiable set of future cash flow streams, or profit projections discounted for the riskiness of the future flows. SFAS 142 Disclosures: The changes in the carrying amount of goodwill during the period including: 1. The aggregate amount of goodwill acquired 2. The aggregate amount of impairment losses recognized 3. The amount of goodwill included in the gain or loss on disposal of all or a portion of a reporting unit. For each impairment loss recognized related to an intangible asset, the following information shall be disclosed in the notes to the financial statements that include the period in which the impairment loss is recognized: a. A description of the impaired intangible asset and the facts and circumstances leading to the impairment b. The amount of the impairment loss and the method for determining fair value c. The caption in the income statement or the statement of activities in which the impairment loss is aggregated d. If applicable, the segment in which the impaired intangible asset is reported under Statement 131. For each goodwill impairment loss recognized, the following information shall be disclosed in the notes to the financial statements that include the period in which the impairment loss is recognized: a. A description of the facts and circumstances leading to the impairment b. The amount of the impairment loss and the method of determining the fair value of the associated reporting unit (whether based on quoted market prices, prices of comparable businesses, a present value or other valuation technique, or a combination thereof) c. If a recognized impairment loss is an estimate that has not yet been finalized that fact and the reasons therefore and, in subsequent periods, the nature and amount of any significant adjustments made to the initial estimate of the impairment loss.

SGAS 33, Reporting for Non-exchange Transactions SGAS 33 Overview Although most of the recent discussion has revolved around the GASB's massive 402 page SGAS 34, the GASB's release of SGAS 33 is also important. The candidate should be familiar with the types of transactions and examples of each. In December 1998, the GASB released its Statement Number 33, Accounting and Financial Reporting for Non-exchange Transactions" to provide a comprehensive system for recognizing the wide array of revenues applicable to state and local government units. This statement did not apply to true revenues such as interest or rents where an earning process exists. Instead, the GASB concentrated on "non-exchange transactions," a classification that would encompass most taxes, fines, grants, and the like because the government does not have to provide a direct and equal benefit for the amount received. For organizational purposes, the GASB classified all such non-exchange transactions into four distinct classifications, each with its own rules as to proper recognition: * Derived tax revenues. Income taxes and sales taxes are the best example of this type of revenue. In a derived tax revenue transaction, a tax assessment is imposed because an underlying exchange takes place. A sale occurs and a tax is imposed, or income is earned and an income tax is assessed. * Imposed non-exchange revenues. Property taxes and fines and penalties are viewed as imposed non-exchange revenues because the government imposes an assessment but no underlying transaction exists. Real estate or other property is owned and a property tax is levied each period. Ownership is being taxed by the government and not a specific transaction. * Government-mandated non-exchange transactions. This category is used for monies such as grants that are conveyed from one government to another to help pay for the costs of required programs. For example, if a state specifies that a city must create a homeless shelter and then provides a grant of $400,000 to help defray the cost, that money should be recorded using these prescribed rules because the final goal for the money has been mandated by the state. City officials have no choice; the state government has required the shelter to be constructed and provided part or all of the funding. * Voluntary non-exchange transactions. In this final classification, money has been conveyed willingly to the state or local government by an individual, another government, or an organization usually for a particular purpose. For example, assume that a state grants a city $300,000 to help improve reading programs in its schools. Unless the state has mandated an improvement in these reading programs, this grant would be accounted for as a voluntary non-exchange transaction. The decision has been made that use of the money will provide an important benefit but no government requirement exists that led to the conveyance. EXPENDITURE CLASSIFICATION In addition to the types of non-exchange transactions, the CPA Exam occasionally asks for definitions of various types of expenditures. Please concentrate on the definitions of "function," "object," and "character." The GASB Codification includes guidelines for the classification of governmental fund expenditure as set forth in NCGA Statement 1, paragraphs 111-116. Classification Description Examples Function (or provides information on Highways and streets Program) the overall purposes Health and welfare Or objectives of expenditures Education Represents a major service or General administration area of responsibility Public safety Organization Grouped according to the Police department unit government's organizational Fire department (department) structure Parks and recreational The responsibility for a department department is fixed Personnel department City clerk Activity Specific and distinguishable Police protection line of work performed by function an organizational unit as Sub activities part of one of its Police administration functions or Crime control and Programs Investigation More meaningful if the Traffic control performance of each Police training actability is fixed Support services Character Classifies expenditures Current expenditures by the fiscal period Cap l outlays benefited Debt service Intergovernmental Object Classified according Personal services to the types of items Supplies purchased or Rent service obtained Utilities Buildings SGAS 33 Comprehensive Illustration The following transactions represent practical situations frequently encountered in accounting for municipal governments. Each transaction is independent of the others. 1. The city council of Bernardville adopted a budget for the general operations of the government during the new fiscal year. Revenues were estimated at $695,000. Legal authorizations for budgeted expenditures were $650,000. 2. Taxes of $160,000 were levied for the special revenue fund for Millstown. One percent was estimated to be uncollectible. 3. a. On July 25, 1981, office supplies estimated to cost $2,390 were ordered for the city manager's office of Bullersville. Bullersville, which operates on the calendar year, does not maintain an inventory of such supplies. b. The supplies ordered July 25 were received on August 9, 1981, accompanied by an invoice for $2,500. 4. On October 10, 1981, the general fund of Washingtonville repaid to the utility fund a loan of $1,000 plus $40 interest. The loan had been made earlier in the fiscal year. 5. a. Conrad Thamm, a citizen of Basking Knoll, donated common stock valued at $22,000 to the city under a trust agreement. Under the terms of the agreement, the principal amount is to be kept intact; use of revenue from the stock is restricted to financing academic college scholarships for needy students. b. On December 14, 1981, dividends of $1,100 were received on the stock donated by Mr. Thamm. 6. a. On February 23, 1981, the town of Lincoln, which operates on the calendar year, issued 4% general obligation bonds with a face value of $300,000 payable February 23, 1991, to finance the construction of an addition to the city hall. Total proceeds were $308,000. b. On December 31, 1981, the addition to the city hall was officially approved, the full cost of $297,000 was paid to the contractor. Assume the governments have formally adopted GASB Statement Number 34. First prepare journal entries for the governments based on the production of fund-based financial statements. Then prepare journal entries in anticipation of preparing government-wide financial statements. Solution to Comprehensive Illustration Fund-based Reporting 1. General Fund Estimated revenues control 695,000 Appropriations control 650,000 Budgetary fund balance 45,000 To record adoption of the budget. Government-Wide Reporting No journal entry recorded for budget 2. Special Revenue Fund Taxes receivable-current 160,000 Estimated uncollectible Current taxes 1,600 Revenues control 158,400 To record levy of taxes in special revenue fund. Government-Wide Reporting Same journal entry 3. General Fund Encumbrances control 2,390 Fund balance reserved for Encumbrances 2,390 To record encumbrances for purchase orders. Government-wide Reporting No journal entry for encumbrances Fund balance reserved for Encumbrances 2,390 Encumbrances control 2,390 To record cancellation of encumbrances upon receipt of supplies. Government-wide Reporting No journal entry for encumbrances Expenditures control 2,500 Vouchers payable 2,500 Government-wide Reporting Office supplies 2,500 Vouchers Payable 2,5000 To record actual expenditures on supplies encumbered for $2,390. 4. General Fund Due to utility fund 1,000 Expenditures control 40 Cash 1,040 To record disbursement to liquidate a loan from the utility fund. Government-wide Reporting Same journal entry except debit expenses instead of expenditurs Enterprise Fund - Utilities Cash 1,040 Interest income 40 Due from general fund 1,000 To record receipt to liquidate a loan to the general fund. Government-Wide Reporting Same journal entry 5. Private-Purpose Trust Fund Investment in stock 22,000 Revenues - contributions 22,000 To record contributions of stock Cash 1,100 Dividend Revenue 1,100 To record receipt of dividends. Government-Wide Reporting Same journal entry 6. Cap l Projects Fund Cash 308,000 Other financing sources- bond proceeds 300,000 Due to debt service fund 8,000 Government-wide Reporting Cash 308,000 Bonds Payable 300,000 Bond Premium 8,000 Due to debt service fund 8,000 Government-wide Reporting No journal entry Intra-funds transfers are not recorded on government-wide statements. To record receipt of bond proceeds and transfer of bond premium to debt service fund Debt Service Fund Cash 8,000 Other financing sources - transfers in 8,000 Government-wide Reporting No journal entry Intra-funds transfers are not recorded on government-wide statements. To record receipt of bond premium from cap l projects fund. Cap l Projects Fund Expenditures control 297,000 Cash 297,000 Government-wide Reporting Buildings 297,000 Cash 297,000 To record expenditures on building. Other financing uses - transfers out 3,000 Cash 3,000 Government-wide Reporting No journal entry Intra-funds transfers are not recorded on government-wide statements. To record transfer of cash balance in cap l projects fund to the debt service fund. Debt Service Fund Cash 3,000 Other financing sources- transfers in 3,000 Government-wide Reporting No journal entry Intra-funds transfers are not recorded on government-wide statements. To record the receipt of cash from the cap l projects fund. Note: Although the problem does not require adjusting journal entries, candidates should note that for government-wide reporting, adjusting journal entries would be made to accrue the interest to the bonds, to amortize the bond premium and to adjust office supplies for the supplies used.

SPECIAL REVENUE FUNDS SPECIAL REVENUE FUNDS - FUND BASED ACCOUNTING Special Revenue Funds are used to account for revenues derived from specific taxes or other earmarked revenue sources. They are usually required by statute, charter provision, or local ordinance to finance particular functions or activities of government. Examples of such funds are those established for the benefit of facilities such as parks, schools, and museums and for particular functions or activities such as highway construction, street maintenance, law enforcement, and the licensing and regulation of professions and businesses. A Special Revenue Fund may be required for financing either current operating expenditures or cap l outlays, or both. The accounting principles applicable to the General Fund apply generally to all Special Revenue Funds, and in the absence of legal requirements to the contrary, the same basis of accounting should be used for the Special Revenue Funds of a governmental unit as is used for its General Fund. CAP L PROJECTS FUND - FUND BASED ACCOUNTING Accounts for the purchase or construction of major cap l facilities. The Cap l Projects Fund has a limited life. It continues to operate until all of the proceeds derived from the sale of the bonds are expended. When the fund finances the construction of improvements, proceeds are expended gradually as construction proceeds. Expenditures are closed at the end of each fiscal period. * Review the following Illustrative Problem: * Notice the expanded budget journal entry in Number 1. * Note that the sale of bonds in Number 2 is credited to other financing sources, not to bonds payable. Special Revenue Funds Illustrative Problem: 1. Hilltop City proposed the construction of a new $490,000 municipal building and authorized the issuance of $300,000 of bonds on April 1 with $200,000 to be financed equally by State and Federal matching funds. 2. The bonds are sold for $308,000, including a premium of $8,000. 3. A $300,000 contract is entered into with Paul Construction Co. for the main building to be completed in 4 months. The city is to purchase some material and furnish some labor for the project. 4. Wages up to the end of the fiscal year were $18,000 and were paid. 5. Purchase orders for $17,000 of materials were placed on May 15. 6. A bill for $150,000 was received from Paul Construction Co. on June 20 for construction to date. 7. On June 15 a bill for $15,000 for all of the materials ordered on May 15 was received. 8. On June 30 the city paid the bill due Paul Construction Co. but retained 10%. 9. On June 30 $6,000 of materials was ordered. Prepare: Journal entries to record all transactions. Illustrative Solution: 1. Estimated Revenue Control $200,000 Estimated Other Financing Source Control 300,000 Appropriations Control $490,000 Budgetary Fund Balance 10,000 1a. Due from State $100,000 Due from Federal Government 100,000 Revenues Control $200,000 2. Cash $308,000 Other Financing Sources Control $308,000 (Proceeds of Gen'l Obligation Bonds) Other Financing Sources Control $8,000 (Operating Transfer Out) Cash $8,000 (to record transfer of premium to Debt Service Fund) 3. Encumbrances Control $300,000 Budgetary Fund Balance Reserve for Encumbrances $300,000 4. Expenditures Control $18,000 Cash $18,000 5. Encumbrances Control $17,000 Budgetary Fund Balance Reserve for Encumbrances $17,000 6. Expenditures Control $150,000 Contracts Payable $150,000 Budgetary Fund Balance Reserve for Encumbrances $150,000 Encumbrances Control $150,000 7. Budgetary Fund Balance Reserve for Encumbrances $17,000 Encumbrances Control $17,000 Expenditures Control $15,000 Vouchers Payable $15,000 8. Contracts Payable $150,000 Cash $135,000 Contracts Payable-Retained Percentage 15,000 9. Encumbrances Control $6,000 Budgetary Fund Balance Reserve for Encumbrances $6,000 Closing Entries 10. Step One: Close the budgetary accounts. Appropriations Control $490,000 Budgetary Fund Balance 10,000 Estimated Revenues Control $200,000 Estimated Other Financing Sources Control 300,000 11. Step Two: Close Revenue, Expenditures, and Other Financing accounts to Unreserved Fund Balance. Revenues Control $200,000 Other Financing Sources Control 308,000 Expenditures Control $183,000 Unreserved Fund Balance 317,000 Other Financing Sources Control 8,000 12. Step Three: Close Encumbrance Accounts Budgetary Fund Balance Reserve for Encumbrances $156,000 Encumbrances Control $156,000 13. Reclassification: Restrict Balance Sheet Fund Balance for outstanding Encumbrances Unreserved Fund Balance $156,000 Fund Balance Reserved for Encumbrances $156,000 DEBT SERVICE FUNDS - FUND BASED ACCOUNTING The function of this fund is to accumulate resources for the payment of principal and interest on general obligation long-term debt. The debt service fund does not account for the debt itself and does not use encumbrances. The "when due" non-accrual approach is normally used. However, Typical journal entries are as follows: 1. Debt service fund receives a $500,000 transfer from the general fund for the payment of interest and long-term debt. Cash $500,000 Other Financing Sources - transfers in $500,000 2. To record the payment of debt and interest: Expenditures control $500,000 Cash $500,000 Special Assessments Special Assessment Funds were used to account for compulsory levies made against certain properties to defray part of all costs of specific cap l improvements or services deemed to benefit primarily those properties. GASB No. 6 eliminates the Special Assessment Fund for financial reporting purposes and requires that these special assessments are accounted for in the Cap l Projects Fund. Summary of "Governmental Accounting Standards Board Statement No. 6" 1. The "Special Assessment Fund" is eliminated for financial reporting purposes. 2. Transactions of a "service type" special assessment should be reported in the fund type that best reflects the nature of the transactions; usually the general fund, a special revenue fund, or an enterprise fund. a. "Service-type" special assessment revenues should be treated like "user fees." b. Assessment revenues and expenditures for which the assessments were levied should be recognized on the same basis of accounting as that normally used for that fund type. 3. If the government is obligated in some manner to assume payments on special assessment debt on "cap l type" special assessments, in the event of default by the property owners, all transactions related to cap l improvements financed by special assessments should be reported in the same fund types and on the same basis as any other cap l improvement and financing transactions. a. The fixed assets constructed or acquired should be reported in the general fixed assets account group or in an enterprise fund, as appropriate. Proprietary Funds There are two proprietary funds that focus on "economic resources management" and use the accrual basis of accounting. These funds are like profit-seeking business organizations where the intent is to have all costs and expenses of providing the services to be financed by the users of such services. They are: The Enterprise Fund and The Internal Service Fund. There are two proprietary funds that focus on "economic resources management" and use the accrual basis of accounting. These funds are like profit seeking business organizations where the intent is to have all costs and expenses of providing the services to be financed by the users of such services. They are: The Enterprise Fund and The Internal Service Fund. ENTERPRISE FUND The Enterprise Fund is used to account for financing of self-supporting enterprises which render public service. Examples of enterprise funds are water, electricity, gas, steam, etc. Accounting for the enterprise fund is the same as that for privately owned utilities and no budgetary entries are necessary. Fixed assets and bonds are, therefore, included in the accounts of an enterprise fund. Enterprise activities are frequently administered by departments of general-purpose governments, such as a municipal water department or a state parks department. In other cases these activities are the exclusive function of a local special district-water district, power authority, port authority, etc. Regardless of the pattern of governmental organization, however, the significant attribute of such enterprise activities is that they are financed primarily by charges to consumers and that the accounting for them must make it possible to show whether they are operated at a profit or loss similar to private enterprises. City Of Passville Enterprise Fund Type Balance Sheet December 31, 19XX Current Assets: Cash Accounts receivable - Customers Less: estimated uncollectible AR Due from General Fund Inventory of Materials and supplies Total current assets Restricted Assets: Revenue Bond reserves Cash Investments Customer Deposits: Investments Interest Receivable on investments Total restricted Assets Utility plant in service: Land Building Less: Allowance for depreciation Construction in progress Total plant in service Total assets Liabilities, Reserves, Contributions, and Retained Earnings Current liabilities (payable from current assets) Vouchers payable Accrued wages payable Advance from municipal general obligation Bonds Current liabilities (Payable from restricted assets) Construction contracts payable Customer deposits Other liabilities: Advance from municipal general obligation bonds Total liabilities Reserves - for revenue bonds Contributions from municipality Contributions from customers Total contributions Retained earnings Total

STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 117 Applies to all Nongovernmental Nonprofits SFAS 117 establishes standards for not-for-profit organizations general-purpose external statements and designates the statement of financial position, the statement of activities, the statement of cash flows and the accompanying notes as a complete set of financial statements. The Statement of Financial Position is required to show total assets, total liabilities, and net assets. Following the lead of SFAS 116, SFAS 117 requires reporting of unrestricted net assets, temporarily restricted net assets, and permanently restricted net assets. The standard also requires that the statement of activities report the changes in net assets for each of the thre Flows can be reported under the direct or indirect method, with the change in net assets being the equivalent of net income. Aggregation and order of presentation should, generally, be similar to those of a business enterprise. Not-for-profit organizations must present in the financial statements all information required by GAAP (unless specifically exempted) and all information required by specialized principles. This information includes display and disclosure provisions of: * Accounting changes * Financial instruments * Extraordinary, unusual and infrequent events * Loss contingencies For the Statement of Cash Flows, the Statement of Activities takes the place of the Income Statement in a business enterprise and change in net assets takes the place of net income. Restricted resources that are used for long-term purposes because of donor stipulation are classified as financing activities. Revenue, Support and Cap l The primary sources and amounts of revenue, support, and cap l funds should be disclosed in the statement of activity. Cap l additions restricted for plant assets should be shown as deferred cap l support in the balance sheet until they are used. Current restricted funds should be reported as revenue and support to the extent that expenses conforming to the grantor's restrictions have been incurred. Any remaining funds should be reported as deferred revenue or support in the balance sheet until the restrictions are met and the expenses incurred. Unrestricted funds are reported in the unrestricted fund. Legally enforceable pledges should be reported as assets at the estimated realizable value and should be recognized as support when so designated by the donor. If that designation occurs after the balance sheet date, these pledges would be shown as deferred support in the balance sheet. If no designation is made, pledges should be reported when they are expected to be received. Revenue from the sale of goods or services is recognized when goods are sold or services are performed. Revenue from membership dues should be allocated over the dues period. Donated Material and Services The method used to value, record, and report donated services should be disclosed in the financial statements. Furthermore, recorded services should be distinguished from unrecorded services. Expenses Expenses should be identified by function unless another basis would be useful to the users of the financial statement. Expenses for specific program services and for supporting services such as management and general costs and fund-raising costs should be presented separately for each significant program or activity such as fund-raising, membership development, and unallocated management and general expenses. Classification of expenditure by type may be presented also. Costs which are attributable to more than one function should be allocated on a reasonable basis. An expense and a liability should be reported when grant recipients are entitled to receive the grant. Grants to be made over several years should be reported in the year the grant is first made, unless the grantor retains the right to revoke the grant or unless grants are subject to periodic renewal. Depreciation Depreciation should be recognized. SFAS 93 also requires the disclosure of depreciation expense, balances of the major classes of depreciable assets, accumulated depreciation at the balance sheet date, and a description of the depreciation method used. Tax Allocation Interperiod tax allocations should be made when temporary differences occur with respect to federal or state income taxes or federal excise taxes. Fund Accounting Although fund accounting has not been required by the AICPA guides on not-for-profit organizations, it is used by many such organizations in preparing their annual financial statements. Often accounts are grouped into funds through calculations outside of the accounting system. While SFAS No. 117 does not prohibit using fund accounting, it does require providing information about the three classes of net assets mentioned above: * unrestricted * temporarily unrestricted * permanently restricted (Internal restrictions of net assets, such as board designations, may be disclosed; however, they are considered to be unrestricted.) Fund accounting may not accomplish the goal of informing the reader about donor restrictions. As an example, some of the net assets of a fund established to account for property and equipment may be unrestricted, either because they were acquired with unrestricted support or because the donor restriction was satisfied when specified equipment was purchased. Therefore, merely accounting for property and equipment in a separate fund would not satisfy the disclosure requirements about donor restrictions. Financially Interrelated Organizations A combined financial statement should be used when one organization controls another and any of the following exist: * An organization solicits funds for the reporting organization and the donor intends or requires the funds to be transferred or used by the reporting organization. * An organization receives resources from the reporting organization to be used for the reporting organization. * An organization, funded by nonpublic contributions, is assigned responsibilities by the reporting organization. Disclosure of the basis for the combination is required. The combined financial statement should include all resources of the related organization. Organizations which are affiliated, but do not meet the requirements for combination, should be disclosed. Statement of Financial Position According to paragraph 11 of SFAS No. 117, a statement of financial position should provide information about liquidity, financial flexibility, and the interrelationship of assets and liabilities. Liquidity is the nearness to cash of an asset or liability, and financial flexibility is the ability to take effective actions to alter amounts and timing of cash flows to respond to unexpected needs and opportunities. SFAS No. 117 requires using one or more of the following methods of presenting information about liquidity. They also might be used to provide information about financial flexibility: * Sequencing assets according to their nearness to conversion to cash and sequencing liabilities according to the nearness of their maturity and resulting use of cash. * Classifying assets and liabilities as current and noncurrent following the requirements of ARB No. 43. * Disclosing in the notes to the financial statements relevant information about liquidity, including restrictions on the use of particular assets. Sequencing assets and liabilities may require separating some items. The listing of assets may start with unrestricted cash, but cash that is restricted to current operating needs and cash that is restricted to the payment of long-term notes may be farther down the list. Promises to give may appear two or more times depending on whether the proceeds from some of them are restricted by the donors. Presenting a classified statement of financial position for a not-for-profit organization requires some considerations that normally are not required for nonpublic commercial entities. Cash and promises to give that the donor has restricted to the payment of a long-term note are excluded from current assets. Similarly, all of the principal outstanding under a long-term note is classified as noncurrent if noncurrent assets will be used to liquidate it. Information about restricted assets may be provided through financial statement captions, such as cash restricted to operations and cash restricted to payment of long-term notes, or through discussions in the notes to the financial statement. Lambers Social Club Statements of Financial Position June 30, 2001 and 2000 (in thousands) 2001 2000 Assets: Cash and cash equivalents $ 75 $ 460 Accounts and interest receivable 2,130 1,670 Inventories and prepaid expenses 610 1,000 Contributions receivable 3,025 2,700 Short-term investments 1,400 1,000 Assets restricted to investment in land, buildings, and equipment 5,210 4,560 Land, buildings, and equipment 61,700 63,590 Long-term investments 218,070 203,500 Total Assets $ 292,220 $ 278,480 Liabilities and net assets: Accounts payable $2,570 $ 1,050 Refundable advance 650 Grants payable 875 1,300 Notes payable 1,140 Annuity obligations 1,685 1,700 Long-term debt 5,500 6,500 Total Liabilities 10,630 12,340 Net assets: Unrestricted 115,228 103,670 Temporarily restricted (Note B) 24,342 25,470 Permanently restricted (Note C) 142,020 137,000 Total net assets 281,590 266,140 Total liabilities and net assets $ 292,220 $278,480 Statement of Activity The statement of activity is designed to provide information about changes in the organization's net assets. Paragraph 18 of SFAS No. 117 requires using a caption such as change in net assets or change in equity to designate the change. While the total net assets at the beginning and end of the period must be shown, there is no requirement for the statement to present a net change amount for each category of assets. Information about the changes in the three categories of net assets--unrestricted, temporarily restricted, and permanently restricted--may be provided using a multi-column format or a layered format. Comparative presentations are more easily accommodated by a layered approach. The order in which items are presented in the statement of activity is flexible. The most common format will be one that presents two groupings, increases in net assets and decreases in them, which is similar to the single-step approach to the income statement used by commercial enterprises. Multiple-step approaches also are acceptable and may be more appropriate when revenue-producing activities are significant to the organization's results of operations. Netting Expenses and Support. Many not-for-profit organizations hold special events as a fund-raising technique. Practice currently nets expenses of those events against the proceeds, with the net amount reported as support. Under SFAS No. 117, that practice no longer will be acceptable; instead, gross amounts must be reported. Netting is permitted only for incidental transactions, such as a gain on the sale of equipment. Expenses are reported on the statement of activities by function. For example, on Format 1 & Format 2 that follow, the expenses are classified by program, management and general, and fund raising. These areas are considered functions. Statement of Functional Expenses. Voluntary health and welfare organizations are required to continue providing a statement of functional expenses which shows how the natural expense classifications are allocated to the significant program and supporting services. For example, the program expenses shown by function would be divided into expenses by object. The statement would have a column labeled program expenses and under the column the expenses would be listed by their natural (object) classification such as salaries, benefits, depreciation, etc. While other not-for-profit organizations are encouraged to present information about natural expense classifications, they only are required to present information about expenses by their functional classifications. SFAS No. 117 suggests providing information about support by functional classifications as well. This information would be useful because readers of the financial statements can assess the financial effect of adding or deleting program services. While a variety of ways can be used to present the information, a useful technique is to disclose support restricted for individual programs, either on the face of the statement of activity or in a related note. An internal allocation of unrestricted support to the programs normally is not necessary unless the organization believes the program affects it. SFAS 117 offers multiple formats for the Statement of Activities. We present here two of them. Format 1 is a layered presentation which would be necessary to report multiple periods and allow comparative statements. Format 2 is a columnar format which is easy to read and would be easily understood by most readers. Either format is acceptable, as are others. Note in both presentations that expenses are reported by program with managerial and fund raising expenses disclosed separately. Format 1 Lambers Social Club Statement of Activities Year Ended June 30, 2001 (in thousands) Changes in unrestricted net assets: Revenues and gains: Contributions $8,640 Fees 5,400 Income on long-term investments (Note E) 5,600 Other investment income (Note E) 850 Net unrealized and realized gains on long-term investments (Note E) 8,228 Other 150 Total unrestricted revenues and gains 28,868 Net assets released from restrictions (Note D): Satisfaction of program restrictions 11,990 Satisfaction of equipment acquisition rest 1,500 Expiration of time restrictions 1,250 Total net assets released from restrictions 14,740 Total unrestricted revenues, gains, and other support 43,608 Expenses and losses: Program A 13,100 Program B 8,540 Program C 5,760 Management and general 2,420 Fund raising 2,150 Total expenses (Note F) 31,970 Fire loss 8O Total expenses and losses 32,050 Increase in unrestricted net assets 11,558 Changes in temporarily restricted net assets: Contributions 8,110 Income on long-term investments (Note E) 2,580 Net unrealized and realized gains on long-term investments (Note E) 2,952 Actuarial loss on annuity obligations (30) Net assets released from restrictions (Note D) (14,740) Decrease in temporarily restricted net assets (1,128) Changes in permanently restricted net assets: Contributions 280 Income on long-term investments (Note E) 120 Net unrealized and realized gains on long-term investments (Note E) 4,620 Increase in permanently restricted net assets 5,020 Increase in net assets 15,450 Net assets at beginning of year 266,140 Net assets at end of year $ 281,590 Format 2 Lambers Social Club Statement of Activities Year Ended June 30, 2001 (in thousands) Temporarily Permanently Unrestricted Restricted Restricted Total Revenues, gains, and other support: Contributions $8,640 $8,110 $280 $17,030 Fees 5,400 5,400 Income on long-term investments (Note E) 5,600 2,580 120 8,300 Other investment income (Note E) 850 850 Net unrealized and realized gains on long-term investments (Note E) 8,228 2,952 4,620 15,800 Other 150 150 Net assets released from restrictions (Note D): Satisfaction of program restrictions 11,990 (11,990) Satisfaction of equipment acquisition restrictions 1,500 (1,500) Expiration of time rest 1,250 (1,250) Total revenues, gains, and other support 43,608 (1,098) 5,020 47,530 Expenses and losses: Program A 13,100 13,100 Program B 8,540 8,540 Program C 5,760 5,760 Management and general 2,420 2,420 Fund raising 2,150 2,150 Total expenses (Note F) 31,970 31,970 Fire loss 80 80 Actuarial loss on annuity obligations 30 30 Total expenses and losses 32,050 30 32,080 Change in net assets 11,558 (1,128) 5,020 15,450 Net assets at beginning of year 103,670 25,470 137,000 266,140 Net assets at end of year $115,228 $24,342 $142,020 $281,590 Statement of Cash Flows A statement of cash flows, prepared following the requirements of SFAS No. 95, is a part of the basic financial statements once SFAS No. 117 is adopted. In general, SFAS No. 117 modifies SFAS No. 95 only to extend its requirements to financial statements of not-for-profit organizations and to address whether some transactions are operating, investing, or financing activities. Although the statement of financial position is required to disclose the three categories of net assets and the statement of activity is required to disclose the changes in them, no distinction is required to be made in the statement of cash flows. When the indirect method is used to present cash flows from operating activities, the statement begins with the change in total net assets for the reporting period. Adjustments of that to derive the cash effect remove noncash items, such as changes in unconditional promises to give; items that are to be presented as investing or financing activities. Such as receipts from contributions for constructing a building; and items that are to be disclosed as noncash investing and financing activities, such as in-kind contributions. Accounting for Certain Investments Held by NPOs (SFAS 124) This statement requires fair value accounting for most equity and debt investments held by not-for-profit organizations and requires the reporting of realized and unrealized gains and losses on the Statement of Activities. An exception is when a not-for-profit organization exercises significant influence over the operating and financing policies of the investee company. In this case, the institution would use the equity method as required by APB .

Statement Of Financial Accounting Standards NO. 132 Applies to all Nongovernmental Nonprofits SFAS 117 establishes standards for not-for-profit organizations general-purpose external statements and designates the statement of financial position, the statement of activities, the statement of cash flows and the accompanying notes as a complete set of financial statements. The Statement of Financial Position is required to show total assets, total liabilities, and net assets. Following the lead of SFAS 116, SFAS 117 requires reporting of unrestricted net assets, temporarily restricted net assets, and permanently restricted net assets. The standard also requires that the statement of activities report the changes in net assets for each of the thre Flows can be reported under the direct or indirect method, with the change in net assets being the equivalent of net income. Aggregation and order of presentation should, generally, be similar to those of a business enterprise. Not-for-profit organizations must present in the financial statements all information required by GAAP (unless specifically exempted) and all information required by specialized principles. This information includes display and disclosure provisions of: * Accounting changes * Financial instruments * Extraordinary, unusual and infrequent events * Loss contingencies For the Statement of Cash Flows, the Statement of Activities takes the place of the Income Statement in a business enterprise and change in net assets takes the place of net income. Restricted resources that are used for long-term purposes because of donor stipulation are classified as financing activities. Revenue, Support and Cap l The primary sources and amounts of revenue, support, and cap l funds should be disclosed in the statement of activity. Cap l additions restricted for plant assets should be shown as deferred cap l support in the balance sheet until they are used. Current restricted funds should be reported as revenue and support to the extent that expenses conforming to the grantor's restrictions have been incurred. Any remaining funds should be reported as deferred revenue or support in the balance sheet until the restrictions are met and the expenses incurred. Unrestricted funds are reported in the unrestricted fund. Legally enforceable pledges should be reported as assets at the estimated realizable value and should be recognized as support when so designated by the donor. If that designation occurs after the balance sheet date, these pledges would be shown as deferred support in the balance sheet. If no designation is made, pledges should be reported when they are expected to be received. Revenue from the sale of goods or services is recognized when goods are sold or services are performed. Revenue from membership dues should be allocated over the dues period. Donated Material and Services The method used to value, record, and report donated services should be disclosed in the financial statements. Furthermore, recorded services should be distinguished from unrecorded services. Expenses Expenses should be identified by function unless another basis would be useful to the users of the financial statement. Expenses for specific program services and for supporting services such as management and general costs and fund-raising costs should be presented separately for each significant program or activity such as fund-raising, membership development, and unallocated management and general expenses. Classification of expenditure by type may be presented also. Costs which are attributable to more than one function should be allocated on a reasonable basis. An expense and a liability should be reported when grant recipients are entitled to receive the grant. Grants to be made over several years should be reported in the year the grant is first made, unless the grantor retains the right to revoke the grant or unless grants are subject to periodic renewal. Depreciation Depreciation should be recognized. SFAS 93 also requires the disclosure of depreciation expense, balances of the major classes of depreciable assets, accumulated depreciation at the balance sheet date, and a description of the depreciation method used. Tax Allocation Interperiod tax allocations should be made when temporary differences occur with respect to federal or state income taxes or federal excise taxes. Fund Accounting Although fund accounting has not been required by the AICPA guides on not-for-profit organizations, it is used by many such organizations in preparing their annual financial statements. Often accounts are grouped into funds through calculations outside of the accounting system. While SFAS No. 117 does not prohibit using fund accounting, it does require providing information about the three classes of net assets mentioned above: * unrestricted * temporarily unrestricted * permanently restricted (Internal restrictions of net assets, such as board designations, may be disclosed; however, they are considered to be unrestricted.) Fund accounting may not accomplish the goal of informing the reader about donor restrictions. As an example, some of the net assets of a fund established to account for property and equipment may be unrestricted, either because they were acquired with unrestricted support or because the donor restriction was satisfied when specified equipment was purchased. Therefore, merely accounting for property and equipment in a separate fund would not satisfy the disclosure requirements about donor restrictions. Financially Interrelated Organizations A combined financial statement should be used when one organization controls another and any of the following exist: * An organization solicits funds for the reporting organization and the donor intends or requires the funds to be transferred or used by the reporting organization. * An organization receives resources from the reporting organization to be used for the reporting organization. * An organization, funded by nonpublic contributions, is assigned responsibilities by the reporting organization. Disclosure of the basis for the combination is required. The combined financial statement should include all resources of the related organization. Organizations which are affiliated, but do not meet the requirements for combination, should be disclosed. Statement of Financial Position According to paragraph 11 of SFAS No. 117, a statement of financial position should provide information about liquidity, financial flexibility, and the interrelationship of assets and liabilities. Liquidity is the nearness to cash of an asset or liability, and financial flexibility is the ability to take effective actions to alter amounts and timing of cash flows to respond to unexpected needs and opportunities. SFAS No. 117 requires using one or more of the following methods of presenting information about liquidity. They also might be used to provide information about financial flexibility: * Sequencing assets according to their nearness to conversion to cash and sequencing liabilities according to the nearness of their maturity and resulting use of cash. * Classifying assets and liabilities as current and noncurrent following the requirements of ARB No. 43. * Disclosing in the notes to the financial statements relevant information about liquidity, including restrictions on the use of particular assets. Sequencing assets and liabilities may require separating some items. The listing of assets may start with unrestricted cash, but cash that is restricted to current operating needs and cash that is restricted to the payment of long-term notes may be farther down the list. Promises to give may appear two or more times depending on whether the proceeds from some of them are restricted by the donors. Presenting a classified statement of financial position for a not-for-profit organization requires some considerations that normally are not required for nonpublic commercial entities. Cash and promises to give that the donor has restricted to the payment of a long-term note are excluded from current assets. Similarly, all of the principal outstanding under a long-term note is classified as noncurrent if noncurrent assets will be used to liquidate it. Information about restricted assets may be provided through financial statement captions, such as cash restricted to operations and cash restricted to payment of long-term notes, or through discussions in the notes to the financial statement. Lambers Social Club Statements of Financial Position June 30, 2001 and 2000 (in thousands) 2001 2000 Assets: Cash and cash equivalents $ 75 $ 460 Accounts and interest receivable 2,130 1,670 Inventories and prepaid expenses 610 1,000 Contributions receivable 3,025 2,700 Short-term investments 1,400 1,000 Assets restricted to investment in land, buildings, and equipment 5,210 4,560 Land, buildings, and equipment 61,700 63,590 Long-term investments 218,070 203,500 Total Assets $ 292,220 $ 278,480 Liabilities and net assets: Accounts payable $2,570 $ 1,050 Refundable advance 650 Grants payable 875 1,300 Notes payable 1,140 Annuity obligations 1,685 1,700 Long-term debt 5,500 6,500 Total Liabilities 10,630 12,340 Net assets: Unrestricted 115,228 103,670 Temporarily restricted (Note B) 24,342 25,470 Permanently restricted (Note C) 142,020 137,000 Total net assets 281,590 266,140 Total liabilities and net assets $ 292,220 $278,480 Statement of Activity The statement of activity is designed to provide information about changes in the organization's net assets. Paragraph 18 of SFAS No. 117 requires using a caption such as change in net assets or change in equity to designate the change. While the total net assets at the beginning and end of the period must be shown, there is no requirement for the statement to present a net change amount for each category of assets. Information about the changes in the three categories of net assets--unrestricted, temporarily restricted, and permanently restricted--may be provided using a multi-column format or a layered format. Comparative presentations are more easily accommodated by a layered approach. The order in which items are presented in the statement of activity is flexible. The most common format will be one that presents two groupings, increases in net assets and decreases in them, which is similar to the single-step approach to the income statement used by commercial enterprises. Multiple-step approaches also are acceptable and may be more appropriate when revenue-producing activities are significant to the organization's results of operations. Netting Expenses and Support. Many not-for-profit organizations hold special events as a fund-raising technique. Practice currently nets expenses of those events against the proceeds, with the net amount reported as support. Under SFAS No. 117, that practice no longer will be acceptable; instead, gross amounts must be reported. Netting is permitted only for incidental transactions, such as a gain on the sale of equipment. Expenses are reported on the statement of activities by function. For example, on Format 1 & Format 2 that follow, the expenses are classified by program, management and general, and fund raising. These areas are considered functions. Statement of Functional Expenses. Voluntary health and welfare organizations are required to continue providing a statement of functional expenses which shows how the natural expense classifications are allocated to the significant program and supporting services. For example, the program expenses shown by function would be divided into expenses by object. The statement would have a column labeled program expenses and under the column the expenses would be listed by their natural (object) classification such as salaries, benefits, depreciation, etc. While other not-for-profit organizations are encouraged to present information about natural expense classifications, they only are required to present information about expenses by their functional classifications. SFAS No. 117 suggests providing information about support by functional classifications as well. This information would be useful because readers of the financial statements can assess the financial effect of adding or deleting program services. While a variety of ways can be used to present the information, a useful technique is to disclose support restricted for individual programs, either on the face of the statement of activity or in a related note. An internal allocation of unrestricted support to the programs normally is not necessary unless the organization believes the program affects it. SFAS 117 offers multiple formats for the Statement of Activities. We present here two of them. Format 1 is a layered presentation which would be necessary to report multiple periods and allow comparative statements. Format 2 is a columnar format which is easy to read and would be easily understood by most readers. Either format is acceptable, as are others. Note in both presentations that expenses are reported by program with managerial and fund raising expenses disclosed separately. Format 1 Lambers Social Club Statement of Activities Year Ended June 30, 2001 (in thousands) Changes in unrestricted net assets: Revenues and gains: Contributions $8,640 Fees 5,400 Income on long-term investments (Note E) 5,600 Other investment income (Note E) 850 Net unrealized and realized gains on long-term investments (Note E) 8,228 Other 150 Total unrestricted revenues and gains 28,868 Net assets released from restrictions (Note D): Satisfaction of program restrictions 11,990 Satisfaction of equipment acquisition rest 1,500 Expiration of time restrictions 1,250 Total net assets released from restrictions 14,740 Total unrestricted revenues, gains, and other support 43,608 Expenses and losses: Program A 13,100 Program B 8,540 Program C 5,760 Management and general 2,420 Fund raising 2,150 Total expenses (Note F) 31,970 Fire loss 8O Total expenses and losses 32,050 Increase in unrestricted net assets 11,558 Changes in temporarily restricted net assets: Contributions 8,110 Income on long-term investments (Note E) 2,580 Net unrealized and realized gains on long-term investments (Note E) 2,952 Actuarial loss on annuity obligations (30) Net assets released from restrictions (Note D) (14,740) Decrease in temporarily restricted net assets (1,128) Changes in permanently restricted net assets: Contributions 280 Income on long-term investments (Note E) 120 Net unrealized and realized gains on long-term investments (Note E) 4,620 Increase in permanently restricted net assets 5,020 Increase in net assets 15,450 Net assets at beginning of year 266,140 Net assets at end of year $ 281,590 Format 2 Lambers Social Club Statement of Activities Year Ended June 30, 2001 (in thousands) Temporarily Permanently Unrestricted Restricted Restricted Total Revenues, gains, and other support: Contributions $8,640 $8,110 $280 $17,030 Fees 5,400 5,400 Income on long-term investments (Note E) 5,600 2,580 120 8,300 Other investment income (Note E) 850 850 Net unrealized and realized gains on long-term investments (Note E) 8,228 2,952 4,620 15,800 Other 150 150 Net assets released from restrictions (Note D): Satisfaction of program restrictions 11,990 (11,990) Satisfaction of equipment acquisition restrictions 1,500 (1,500) Expiration of time rest 1,250 (1,250) Total revenues, gains, and other support 43,608 (1,098) 5,020 47,530 Expenses and losses: Program A 13,100 13,100 Program B 8,540 8,540 Program C 5,760 5,760 Management and general 2,420 2,420 Fund raising 2,150 2,150 Total expenses (Note F) 31,970 31,970 Fire loss 80 80 Actuarial loss on annuity obligations 30 30 Total expenses and losses 32,050 30 32,080 Change in net assets 11,558 (1,128) 5,020 15,450 Net assets at beginning of year 103,670 25,470 137,000 266,140 Net assets at end of year $115,228 $24,342 $142,020 $281,590 Statement of Cash Flows A statement of cash flows, prepared following the requirements of SFAS No. 95, is a part of the basic financial statements once SFAS No. 117 is adopted. In general, SFAS No. 117 modifies SFAS No. 95 only to extend its requirements to financial statements of not-for-profit organizations and to address whether some transactions are operating, investing, or financing activities. Although the statement of financial position is required to disclose the three categories of net assets and the statement of activity is required to disclose the changes in them, no distinction is required to be made in the statement of cash flows. When the indirect method is used to present cash flows from operating activities, the statement begins with the change in total net assets for the reporting period. Adjustments of that to derive the cash effect remove noncash items, such as changes in unconditional promises to give; items that are to be presented as investing or financing activities. Such as receipts from contributions for constructing a building; and items that are to be disclosed as noncash investing and financing activities, such as in-kind contributions. Accounting for Certain Investments Held by NPOs (SFAS 124) This statement requires fair value accounting for most equity and debt investments held by not-for-profit organizations and requires the reporting of realized and unrealized gains and losses on the Statement of Activities. An exception is when a not-for-profit organization exercises significant influence over the operating and financing policies of the investee company. In this case, the institution would use the equity method as required by APB .

Statement Of Position 94:6 DISCLOSURE OF CERTAIN SIGNIFICANT RISKS AND UNCERTAINTIES The AICPA in the form statement of position (SOP) 94-6 added to the required disclosures of financial instruments and contingencies (SFAS No. 5) The SOP uses two terms that should be defined: * Near term - a period of time not to exceed one year from the date of the financial statements. * Severe impact - the threshold is higher than that of materiality, yet lower than that of catastrophic in nature. The additional disclosures are in four areas: * Nature of operations * Use of estimates in the preparation of financial statements * Certain significant estimates * Current vulnerability due to certain concentrations Nature of Operations The SOP requires that users of financial statements be informed about the following specific areas of operations (these disclosures do not have to be quantified): * Description of the major products and/or services provided by the Company. * Principle markets and locations of the markets. * Relative importance of the operations of each (line of) business and the basis for such a determination (sales, asset commitment, income, etc.) Use of Estimates in the Preparation of Financial Statements This is a general disclosure that puts users on notice that preparation of financial statements requires the use of estimates on the part of management. Certain Significant Estimates In this area the SOP requires a significant increase in disclosure responsibilities in financial statements. Disclosure may have to be made regarding estimates that are not required under current first-level GAAP. Two Tests Estimates used in the preparation of financial statements are subject to the following two tests: 1. Could it be at least reasonably possible that the estimate of the effect on the financial statements of the estimate (at the financial statement date) in question will change in the near-term due to one or more future confirming events? 2. Would that potential change have a material effect on the financial statements? Disclosures Such disclosure surrounding estimates meeting the criteria should, at a minimum, include (where applicable): * The nature of the uncertainty. * An indication that it is at least reasonably possible that one or more of the confirming events may occur. * If this is a potential loss contingency (SFAS No. 5), there should be an estimate of the potential loss or a statement that such an estimate is not possible. (It is encouraged, but not required, to include the factors that make the estimation especially subject to change.) * Disclosure of risk reduction techniques employed by the Company is encouraged, not required. Examples The SOP offers numerous examples of assets and/or liabilities that involve estimation, and may need to be disclosed under this requirement. Some of those examples include: * Inventories * Specialized equipment * Certain valuation allowances * Litigation related obligations Conditions The SOP also offers examples of conditions that might indicate those areas that are particularly sensitive: * A significant decrease in the market value of an asset. * A change (perhaps brought on by technology) in the usage of a particular asset. * Changing legal environment. * Significant cost over-runs. * A continuing loss trend. Current Vulnerability Due to Certain Concentrations The idea of disclosing areas of potential exposure from concentrations was introduced in SFAS No. 107 and is expanded in SOP 94-6. The SOP addresses those concentrations (defined below) that meet each of the following three criteria: 1. The concentration exists at the balance sheet date. 2. The concentration subjects the Company to potential near-term risk (potentially severe-impact). 3. It is at least reasonably possible that the adverse events could occur that would cause the severe-impact condition. Concentration There are four defined concentrations for purposes of this disclosure: a. Volume of business transacted with any customer, supplier, lender, grantor, or creditor. b. Product or service revenue generation. c. Available sources of supply, labor, services, material, licenses and/or other rights used in operations. d. Market and/or geographic areas in which the Company conducts business. Concentrations - Labor Supply Concentrations related to labor supply subject to collective bargaining must disclose the following: Percentage of labor force * Covered by collective bargaining. * Under agreements that will expire within a one-year period. Concentration - Outside of Entity's Home Country Concentrations related to operations outside of the entity's home country must disclose the carrying amounts of net assets and geographic areas in which the assets are located. Concentrations related to financial instruments, and concentrations other than described above are not subject to the SOP provisions. ESTIMATED LIABILITIES The CPA exam often includes questions regarding liabilities which must be accrued due to obligations incurred in the company's operations. Such liabilities include obligations for gift certificates, coupon and premium offers, deposits, trading stamps, warranties, and similar items. The expense recognition and resulting liability balance is usually based upon estimates of occurrences which are matched with the recognition of revenues. Example 1: In packages of its products, Curran Co. includes coupons that may be presented at retail stores to obtain discounts on other Curran products. Retailers are reimbursed for the face amount of coupons redeemed plus 10% of that amount for handling costs. Curran honors requests for coupon redemption by retailers up to three months after the consumer expiration date. Curran estimates that 70% of all coupons issued will ultimately be redeemed. Information relating to coupons issued by Curran during the current year is as follows: Consumer expiration date 12/31/XX Total face amount of coupons issued $600,000 Total payments to retailers as of the end of the current year 220,000 The company must recognize $462,000 as the expense of the coupon offer which is matched against the revenues which were recognized from the sale of the product which contain the coupons. Since $220,000 has already been paid, the remaining $242,000 is the remaining liability at year end. Expense = $600,000 x 70% = $420,000 + (10% x $420,000) = $462,000 Example 2: Marr Co. sells its products in reusable containers. The customer is charged a deposit for each container delivered and receives a refund for each container returned within two years after the year of delivery. Marr accounts for the containers not returned within the time limit as being retired by sale at the deposit amount. Information for 1999 is as follows: Container deposits at December 31, 1998, from deliveries in: 1997 $150,000 1998 430,000 $580,000 Deposits for containers delivered in 1999 780,000 Deposits for containers returned in 1999 from deliveries in: 1997 $ 90,000 1998 250,000 1999 286,000 $626,000 At December 31, 1999, the liability for deposits on returnable containers would appear as follows: Deposit Liability Account --------------------------------------- | $580,000 Balance 12/31/98 | 780,000 1992 deposits 1999 returns $626,00 | 1997 deposits | not returned | ($150,000 - 90,000) 60,000 | | $674,000 Balance 12/31/99

Steps For Preparation Of The Statement STEPS FOR PREPARATION OF THE STATEMENT AND REQUIRED DISCLOSURES 1. Prepare the heading and format for the statement of cash flows and for supplemental schedules (such as noncash investing and financing activities), if required. Amounts can be filled in as determined. 2. Determine the balance of cash and cash equivalents as of the beginning and end of the period, and the net change in cash and cash equivalents during the period. 3. Determine the changes in all other balance sheet amounts if this information is not provided. 4. Determine the cash flow from operating activities. Analysis and use of amounts related to operations will depend on whether the direct or indirect method of reporting cash flow from operating activities is used. Direct method Convert income statement amounts to major classes of operating cash receipts and payments by adjusting for: a. noncash revenue and expenses (such as gains and depreciation) b. changes in balance sheet amounts related to operations (primarily changes in current assets, other than cash, and current liabilities which relate to an enterprise's operating cycle, such as receivables, inventory and payables). Indirect method Convert net income to cash flow from operations by adjusting for: a. noncash revenue and expenses b. changes in balance sheet amounts related to operations including, at a minimum, separately reported changes in receivables, inventory and payables related to operating activities c. items which are not operating activities. 5. Analyze all other changes in balance sheet amounts to determine and classify: a. gross cash receipts and payments relating to investing and financing activities b. noncash investing and financing activities for required supplemental disclosure. 6. Proof of totals: The total of the net cash flows from operating (step 4), investing, and financing (step 5) activities should equal the net change in cash and cash equivalents (step 2). The net increase (decrease) in cash and cash equivalents, per the statement, plus the beginning balance of cash and cash equivalents (step 2) should equal the ending balance of cash and cash equivalents (step 2). Illustrative Problem Following are the balance sheets of the Trowel Company as of December 31, 19X2, and 19X1, and its income statement for the year ended December 31, 19X2. Trowel Company BALANCE SHEET December 31, 19X2 and 19X1 Increase 19X2 19X1 (Decrease) Assets: Cash and cash equivalents $ 2,530 $ 600 $1,930 Accounts receivable (net of allowance for doubtful accounts of $450 and $600) 1,785 1,770 15 Notes receivable 150 400 (250) Inventory 1,025 1,230 (205) Prepaid expenses 135 110 25 Property, plant and equipment 7,560 6,460 1,100 Accumulated depreciation (2,300) (2,100) (200) Investments 275 250 25 Intangibles (net) 25 40 (15) Total assets $11,185 $8,760 $2,425 Liabilities: Accounts payable and accrued expenses$ 835 $1,085 $(250) Interest payable 45 30 15 Income taxes payable 25 50 (25) Short-term debt 750 450 300 Cap l lease obligation 725 — 725 Long-term debt 2,050 2,150 (100) Deferred taxes 525 375 150 Other liabilities 275 225 50 Total liabilities 5,230 4,365 Stockholders' equity: Common stock 3,000 2,000 1,000 Retained earnings 2,955 2,395 560 Total stockholders' equity 5,955 4,395 _____ Total liabilities and stockholders' equity $11,185 $8,760 $2,425 Trowel Company INCOME STATEMENT For the Year Ended December 31, 19X2 Sales $13,965 Operating expenses: Cost of goods sold $10,290 Selling, general and administrative expenses 1,890 Depreciation and amortization 445 12,625 Operating income $ 1,340 Other revenues and expenses: Equity in income of affiliate $ 45 Gain on sale of equipment 80 Interest income 55 Insurance proceeds 15 Interest expense (235) Loss from patent infringement lawsuit (30) ( 70) Income before taxes $ 1,270 Provision for income taxes 510 Net income $ 760 Additional information: a. During 19X2, Trowel Company wrote off $350 of accounts receivable as uncollectible and included in its selling, general and administrative expenses a provision for bad debts expense of $200 for the year. b. During 19X2, Trowel collected $100 on a note receivable from the sale of inventory and $150 on a note resulting from the sale of property. Interest on these notes amounted to $55 during 19X2 and was collected during the year. c. Selling, general and administrative expenses include an accrual of $50 for deferred compensation. The obligation for the deferred compensation was included in other liabilities. d. Trowel Company received dividends of $20 from an affiliate accounted for using the equity method. e. Trowel Company collected insurance proceeds of $15 from a business interruption claim. f. Trowel Company paid $30 to settle a lawsuit relating to patent infringement. g. For 19X2, Trowel Company's depreciation totaled $430, and amortization of intangible assets totaled $15. h. Trowel Company constructed and placed in services a new plant facility at a cost of $1,000, including cap lized interest of $10. i. During 19X2, Trowel Company sold equipment with a book value of $520 and an original cost of $750 for $600 cash. It also entered into a cap l lease for new equipment with a fair value of $850. Principal payments under the lease obligation totaled $125 during 19X2. j. Trowel Company borrowed and repaid various amounts during the year under a line-of-credit agreement, which provides for repayments within 60 days of the date borrowed. The result of these activities was a net increase of $300 in short-term debt. k. Trowel Company issued $400 of long-term debt securities during 19X2. l. Trowel Company issued $1,000 of additional common stock of which $500 was issued for cash, and $500 was issued upon conversion of long-term debt. m. Trowel Company paid dividends of $200 during 19X2. STATEMENT OF CASH FLOWS For the Year Ended December 31, 19X2 (Direct Method) Cash flows from operating activities: Cash received from customers $13,850 Cash paid to suppliers and employees (12,000) Dividends received from affiliate 20 Interest received 55 Insurance proceeds received 15 Interest paid (net of amount cap lized) (220) Cash paid to settle lawsuit for patent infringement (30) Income taxes paid (385) Net cash provided by operating activities $1,305 Cash flows from investing activities: Collection on note from sale of property $ 150 Payments to construct new plant facility (1,000) Proceeds from sale of equipment 600 Net cash used in investing activities (250) Cash flows from financing activities: Net borrowings under line of credit $ 300 Principal payment on cap l lease obligations (125) Proceeds from issuance of long-term debt 400 Proceeds from issuance of common stock 500 Dividends paid (200) Net cash provided by financing activities 875 Net increase in cash and cash equivalents $1,930 Cash and cash equivalents, January 1, 19X2 600 Cash and cash equivalents, December 31, 19X2 $2,530 Note: For explanation of statement amounts refer below to Analysis and Supporting Computations (Direct Method), which follows the same sequence as the amounts in the statement. Schedule of Noncash Investing and Financing Activities * A cap l lease obligation of $850 was incurred when the company entered into a lease for new equipment. * Additional common stock was issued upon the conversion of $500 of long-term debt. If the direct method is used, a separate schedule, "Reconciliation of Net Income to Net Cash Provided by Operating Activities" is required. The schedule would be the same as the "Cash flow from operating activities" section of the statement of cash flows, using the indirect method, except that the title of the schedule would be as shown above. Refer below to the statement of cash flows using the indirect method. Analysis and Supporting Computations (Direct Method): * Sequence of analysis and computations follows the sequence of amounts in the statement of cash flows. * Letters in parentheses refer to additional information provided in the illustrative problem. Computation of Cash Flows from Operating Activities 1. Cash received from customers: Sales $13,965 Less increase in accounts receivable: Increase in A/R—net $ 15 Increase in allowance from bad debts expense 200(a) Increase in A/R from uncollected sales (215)* Add: Collection on trade notes receivable 100(b) Cash received from customers $13,850 * Alternative computation: Beginning balance ($1,770 A/R net + $600 allowance) $2,370 Less accounts written off as uncollectible (350)(a) Adjusted beginning balance $2,020 Ending balance ($1,785 A/R net + $450 allowance) 2,235 Increase in A/R from uncollected sales $ 215 2. Cash paid to suppliers and employees* Cost of goods sold $10,290 Selling, general and administrative expenses $1,890 Less bad debts expense (200)(a) S.G. & A. expenses requiring cash payments 1,690 Adjustments for changes in related balance sheet amounts: Less decrease in inventory 1 (205) Add increase in prepaid expenses 2 25 Add decrease in accounts payable and accrued expenses 3 250 Less increase in other liabilities 4 (50)(c) Total cash paid to suppliers and employees $12,000 * Cash paid to suppliers and employees cannot be broken down to amounts paid suppliers and amounts paid employees as prepaid expenses, and accounts payable and accrued expenses are not broken down in that manner. 1 The decrease in inventory has been charged to cost of goods sold; however, it does not require the payment of cash in the current period, therefore it is deducted from expenses to determine cash flow. 2 The increase in prepaid expenses resulted from a payment of cash that was not charged to expenses, therefore it is added to expenses to determine cash flow. 3 The decrease in accounts payable and accrued expenses required cash payment, however, did not affect expenses; therefore, it is added to expenses to determine cash flow. 4 The increase in other liabilities resulted from the accrual of an expense that did not require cash payment; therefore, it is deducted from expenses to determine cash flow. 3. Depreciation and amortization are not cash flow items and, therefore, are excluded from the computation of cash flow from operating activities. 4. Dividends received from affiliate: Equity in income of affiliate $ 45 Less dividends received (20)(d) Increase in investment account $ 25 Under the equity method of accounting for investments, the investor debits investment and credits equity in income of affiliate for its share of the investee's income. When dividends are received, the investor debits cash and credits the investment account. (Refer to Chapter 4, Equity Method.) Equity in income of affiliate is not a cash flow item and is excluded from cash flow from operating activities. 5. Gain on sale of equipment is excluded from the computation of cash flows from operating activities because: 1. it is not the gross cash flow from the sale of the equipment, and 2. sale of equipment is an investing activity, not an operating activity. 6. Interest received is the same amount as interest income reported on the income statement ($55). Additional information (b) states that interest of $55 was collected on the notes receivable. This amount agrees to the interest income; therefore, there are no accruals to adjust for. 7. Insurance proceeds received is the same amount as reported on the income statement ($15). Refer to additional information (e). 8. Interest paid: Interest expense $235 Less increase in interest payable (15) $220 Interest paid is qualified as "net of amount cap lized" as interest was cap lized as part of the cost of constructed assets. Refer to additional information (h). 9. Payment for settlement of patent infringement lawsuit is the same amount as the related loss in the income statement. Refer to additional information (f). 10. Income taxes paid: Provision for income taxes $510 Add decrease in income taxes payable 25 $535 Less increase in deferred taxes payable (150) $385 Computation and classification of cash flows from investing and financing activities and identification of noncash investing and financing activities. 11. Change in notes receivable (b): Collection of trade note receivable $100 (operating) Collection of note receivable from sale of property 150 (investing) Decrease in notes receivable $250 12. Changes in P.P. & E. and Accumulated Depreciation: Accumulated P.P.&E. depreciation Depreciation expense (g) $430 (operating) Construction of new facility (h) $1,000 (investing) Sale of equipment for $600 (i) (750) (investing) ($750 cost – $520 book value) (230) Asset under cap l lease (i) 850 ____ (noncash)* Net change $1,100 $200 * The cap l lease for new equipment is a noncash investing (asset acquisition) and financing (cap l lease obligation) activity. 13. Change in investments: Equity in income of affiliate $45 (operating/noncash) Less dividends received (d) (20) (operating) Increase in investments from undistributed affiliate income $25 Refer to No. 4 above regarding the equity method. 14. Change in intangibles: The $15 decrease in intangibles results from amortization expense of $15. Refer to additional information (g). 15. Change in short-term debt: The $300 increase resulted from net borrowings under a line-of-credit agreement. These activities may be shown net as the original maturity of the debt(s) was three (3) months or less. Refer to additional information (j) and requirements section No. 3. 16. Change in cap l lease obligation: Original amount of cap l lease (i) $850 (noncash)* Less: Principal payments (i) (125) (financing) Increase in cap l lease obligation $725 * The cap l lease obligation for the acquisition of new equipment is a noncash investing (asset acquisition) and financing (cap l lease obligation) activity. 17. Change in long-term debt: Issuance of debt securities for cash (k) $ 400 (financing) Retirement of debt securities by conversion to common stock (l) (500) (noncash)* Decrease in long-term debt $(100) * The conversion of bonds to common stock is a noncash financing activity. 18. Change in common stock: Issuance of stock for cash $ 500 (financing) Issuance of stock on conversion of long-term debt 500 (noncash)* Increase in common stock $1,000 * The issuance of common stock upon the conversion of long-term debt is a noncash financing activity. 19. Increase in retained earnings: Net income $ 760 (operating) Less dividends paid (200) (financing) Increase in retained earnings $ 560 Trowel Company STATEMENT OF CASH FLOWS For the Year Ended December 31, 19X2 (Indirect Method) Cash flow from operating activities: Net income $760 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization expense 445 Bad debts expense 200 Undistributed income of affiliate (25) Gain on sale of equipment (80) Increase in accounts receivable (215) Collection of trade notes receivable 100 Decrease in inventory 205 Increase in prepaid expenses (25) Decrease in accounts payable and accrued expenses (250) Increase in interest payable 15 Decrease in income taxes payable (25) Increase in deferred taxes 150 Increase in other liabilities 50 Net cash flow from operating activities $1,305 Cash flows from investing activities: Collection on note from sale of property $ 150 Payments to construct new plant facility (1,000) Proceeds from sale of equipment 600 Net cash used in investing activities (250) Cash flows from financing activities: Net borrowings under line of credit $ 300 Principal payment on cap l lease obligations (125) Proceeds from issuance of long-term debt 400 Proceeds from issuance of common stock 500 Dividends paid (200) Net cash provided by financing activities 875 Net increase in cash and cash equivalents $1,930 Cash and cash equivalents, January 1, 19X2 600 Cash and cash equivalents, December 31, 19X2 $2,530 Note: For explanation of statement amounts, refer below to Analysis and Supporting Computations (Indirect Method) which follows the same sequence as the amounts in the statement. If the indirect method is used, supplemental disclosures must be made for: 1. Interest paid (net of amounts cap lized) 2. Income taxes paid 3. Noncash investing and financing activities These amounts would be the same as in the prior example of the statement of cash flows using the direct method. Analysis and Supporting Computations (Indirect Method) * Only analysis and computations relating to cash flow from operating activities are shown in this section. Amounts relating to investing and financing activities are the same as when the direct method is used. Refer to "Analysis and Supporting Computation (Direct Method)" for explanation of amounts related to investing and financing activities. * Sequence of analysis and computations follow the sequence of amounts shown in the statement. * Letters in parentheses refer to additional information provided in the illustrative problem. Computation of cash flow from operating activities: 1. Depreciation and amortization expense are not cash flow items; therefore, the expense for these items would be added back to net income to determine cash flow from operating activities. 2. Bad debts is a noncash expense and would be added to net income to determine cash flow (a). 3. Equity in income of affiliate $45 Less dividends received (d) (20) Undistributed affiliate income and increase in investments $25 4. Gain on sale of equipment relates to investing activities rather than operating activities. Therefore, the gain is deducted from net income to remove its effect. 5. Increase in accounts receivable—net $ 15 Increase in allowance from bad debts expense (a) 200 Increase in accounts receivable $215 Alternative computation of increase in accounts receivable: Beginning balance ($1,770 A/R net + $600 allowance) $2,370 Less accounts written off (a) (350) Adjusted beginning balance 2,020 Ending balance ($1,785 A/R net + $450 allowance) 2,235 Increase in A/R from uncollected sales $ 215 6. Collection of trade note receivable (b) in the amount of $100 resulted in cash flow from operation; however, it would not have been included in revenues (and net income) of the current period. 7. The decrease in inventory would have increased cost of goods sold and decreased net income in the current period. Because the decrease is not a cash flow item, it is added to net income to determine cash from operating activities. 8. An increase in prepaid expenses results from cash payments which are not charged to expenses in the current period. The increase is therefore deducted from net income to determine cash flows from operating activities. 9. The decrease in accounts payable and accrued expenses resulted from cash payments which were not charged to expense. The decrease is deducted from net income to determine cash flow related to operating activities. 10. The increase in interest payable results from accrual of unpaid interest expense. The increase is added to net income to remove the effect of unpaid interest expense. 11. A decrease in income taxes payable results from cash payments which are not charged to income taxes in the current period. Therefore, the decrease is deducted from net income to determine cash flow from operating activities. 12. The increase in deferred taxes results from accrual of current period taxes for income determination which are not paid in the current period. The increase is therefore added to net income to determine cash flow from operating activities. 13. The increase in other liabilities results from accrual of deferred compensation (c). Because compensation relates to operating activities, the increase is added to net income to determine cash flow from operating activities.

Stock Dividends and Splits STOCK DIVIDENDS AND STOCK SPLITS Neither a stock dividend nor a stock split changes stockholders' equity. Distinction centers mainly on the representations of management as to whether the additional stock being distributed to shareholders is a distribution of earnings (stock dividend) or is an effort to improve the marketability of the stock (stock split). In ARB 43, a guideline was established that where additional shares were issued, less than 20% or 25% of the total shares outstanding indicated a stock dividend; whereas a distribution in excess of that indicated a stock split. The rationale behind the 20-25% guideline was a study of market action when stock distributions were made, in that "where the number of additional shares issued as a stock dividend is so great that it has . . . the effect of materially reducing the share market value . . . the transaction clearly partakes of the nature of a stock split-up." Under such circumstances, there is no need to cap lize retained earnings, other than to satisfy legal requirements. Stock Dividend If the transaction is a stock dividend, cap lize retained earnings based on fair value of additional shares issued. Example: Common, no- par, $10 stated value; $15 market value, 10,000 shares outstanding. A 2% stock dividend is declared. Retained Earnings 3,000 (FV $15) Cap l Stock 2,000 ($10 par) C.C. in Excess 1,000 Stock Split A stock split, that is, a distribution of additional shares effected to reduce the market price per share, may be recorded in several ways: 1. Stock split with no change in total cap l. Requires only a memorandum entry. Example: 100,000 shares of Blue Corp. stock $20 par or stated value split two for one. Old Cap l 100,000 shares @ $20 $2,000,000 New Cap l 200,000 shares @ $10 $2,000,000 2. A stock split in which retained earnings are cap lized to the extent of the par or stated value of the shares. Example: Same as above except that the par value remains the same. FV is $40 per share. Old Cap l 100,000 shares @ $20 $2,000,000 New Cap l 200,000 shares @ $20 $4,000,000 Retained Earnings $2,000,000 C/S $2,000,000 The Committee on Accounting Procedure of the AICPA recommends that distributions such as the above should not be called a stock dividend, but could be stated as "a split-up effected in the form of a dividend," the main difference being that retained earnings are not cap lized based on fair value. 3. Cap l stock must be increased to satisfy legal requirements. Example: Same facts except a 12 for 1 stock split and state law requires a minimum $2 par or stated value. Retained Earnings $400,000 Cap l Stock $400,000 To increase the Cap l Stock account to $2,400,000. Shares outstanding increased to 1,200,000 at $2 stated value. General Rule General Rule: If the distribution is 25% or more, retained earnings will not generally be cap lized based on FV. Cap lize retained earnings based on par or stated value. Closely held corporations may cap lize retained earnings in stock dividend situations based on par value instead of fair value. Exercise: On December 31, 1985, the stockholders' equity section of the balance sheet of Mason Co. was as follows: Common stock (par value $1, 1000 shares authorized, 300 shares issued and outstanding) $ 300 Additional paid-in cap l (C.C. in Excess) 1,800 Retained earnings 2,000 $4,100 On January 2, 1986, the board of directors declared a stock dividend of one share for each three shares owned. Accordingly, 100 additional shares of stock were issued. On January 2, the fair market value of Mason's stock was $10 per share. The most appropriate presentation of Mason's stockholders' equity on January 2, 1986, following the issuance of the 100 additional shares is: a. Common stock (par value $1, 1000 shares authorized, 400 shares issued and outstanding) $ 400 Additional paid-in cap l 1,700 Retained earnings 2,000 $4,100 b. Common stock (par value $1, 1000 shares authorized, 400 shares issued and outstanding) $ 400 Additional paid-in cap l 1,800 Retained earnings 1,900 $4,100 c. Common stock (par value $1, 1000 shares authorized, 400 shares issued and outstanding) $ 400 Additional paid-in cap l 2,700 Retained earnings 1,000 $4,100 d. Common stock (par value $1, 1000 shares authorized, 400 shares issued and outstanding) $ 400 Additional paid-in cap l 2,400 Retained earnings 1,300 $4,100 Solution: (b), since the distribution exceeds 25%. Answer (c) would be correct if the distribution is considered a stock dividend. EXAMPLE: STOCKHOLDERS' EQUITY GRUBBS CORPORATION STOCKHOLDERS' EQUITY DECEMBER 31, 20XX Preferred Stock -- par $100, authorized 1,000 shares 20,000 Issued and outstanding 200 shares Common Stock -- par $10, authorized 5,000 shares issued 3,000 shares outstanding 2,600 shares 30,000 Total Cap l Stock $ 50,000 Paid-in Cap l in excess of par -- Common Stock 40,000 Paid-in Cap l - Treasury Stock Transactions 5,000 Paid-in Cap l - Donations 15,000 Total Additional Paid-in Cap l $ 60,000 Total Contributed Cap l $110,000 RETAINED EARNINGS Restricted for Treasury Stock $ 10,000 Not Restricted 150,000 Total Retained Earnings $160,000 Total $270,000 Less: Treasury Stock - Cost of $25 per share (400 shares) (10,000) Total $260,000 Accumulated Other Comprehensive Income 75,000 Total Stockholders' Equity $335,000

Stock Rights STOCK RIGHTS When an investor purchases stock, he acquires certain legal rights granted by the corporate charter and the laws of the state in which the corporation is organized. A legal right usually granted to stockholders is the pre-emptive right which allows the individual stockholders to subscribe to any additional issues of the same class of stock on a pro rata basis. This privilege allows the existing stockholders to maintain their relative interests in the corporation's earnings, assets, and management. One right is offered for each share held; however, usually more than one right is required to subscribe to a new share. A warrant is issued with which the shareholder may: 1. exercise the rights and acquire stock, 2. sell the rights, or 3. do nothing allowing the rights to lapse. After the announcement of the rights offering but before the rights are issued, the stock will sell Rights-On-the "right" is a part of the share. When the rights or warrants are issued (usually three days before), the stock will sell Ex-Rights-without the "right" as the right is traded separately. No matter what a stockholder does with the rights, a cost should be assigned to the rights based on the relative fair market values of the stock and the rights at the date of issue. Example: An investor purchased 100 shares of Co. A common stock for $120 per share, and later received 100 rights to subscribe to 50 additional shares at $100 per share. The market value, after the issuance of the stock rights, of a share of common stock (ex-rights) is $200 and of a right is $40. Investments: Co. A C/S Rights $2,000 Investments: Co. A C/S $2,000 Stock 100 shs. * $200 = $20,000 Rights 100 shs. * $ 40 = 4,000 Total Value $24,000 Value of Stock 20,000/24,000 * $12,000 (TC) = $10,000 Value of Rights 4,000/24,000 * $12,000 = 2,000 Total Cost (100 shares @ $120) $12,000 Cost of shares if rights are exercised: Lot 1: Original Stock 100 Shares @ 100 per Share $10,000 Lot 2: New Stock Amount Paid (50 shs. * $100) $5,000 Value of Rights (100 * $20) 2,000 50 Shares @ $140 per Share 7,000 $17,000 (Note: $140 per share = $100 paid + 2 rights @ $20 each.)

Stock Splits STOCK SPLIT OVERVIEW From the investors' viewpoint, there is little or no difference between a stock split and a stock dividend of the same class of stock (refer above). The investors' relative position of ownership interests is unchanged; there are merely more shares representing the ownership rights. As the investor has received nothing which he did not own before the stock split, no accounting entry is required-memorandum entry may be made. However, the basis of a share of stock must be recomputed. Example: An investor owns 200 shares of Z Corporation, $50 par value, common stock, which cost $60 per share. Z Corporation announces a 2-for-1 stock split, reducing the par value to $25 per share. Recomputation of cost per share: Total Cost $60 * 200 shs. $12,000 ----------- = ------------- = -------- = $30 per share Total Shares 200 shs. * 2 400 shs. Later, Z Corporation announces a 3-for-2 stock split. The cost per share would now be $20. Total Cost $30 * 400 shs. $12,000 ----------- = ------------- = --------- = $20 per share Total Shares 400 shs. * 1 1/2 600 (Note that the total value of the investment, $12,000, does not change.)

Summary Of Accounting For Stock-Based Compensation SFAS 123 This pronouncement applies to stock purchase plans, stock options, and stock appreciation rights. It also applies to the issue of equity instruments for goods or services from nonemployees. I. The measurement of the cost of stock compensation plans under APB 25 is still permissible. SFAS 123 encourages but does not require the use of the fair value based method. A. When APB 25 is used for the calculation of compensation cost, SFAS 123 requires pro-forma disclosure of net income and earnings per share as if the fair value based method had been used. B. In justifying a change in accounting principle, the fair value method is preferred. II. The recognition of compensation cost using the fair value based method is based on the value of the award at the grant date and is amortized over the service period which is usually equal to the vesting period. A. Stock Options The fair value of stock options is calculated using an option- pricing model. This model considers the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the stock, expected dividends from the stock, and a risk-free interest rate for the expected term of the stock option. B. Restricted Stock The fair value based method measures the value of nonvested stock (restricted stock) at the market price on the grant date unless a restriction applies after the vesting date. In that case the restriction would have to be considered. C. Stock Purchase Plans Entities that offer stock purchase plans do not incur any compensation cost if the plan allows a small discount of 5% or less, offers the plan to substantially all of its full-time employees and the plan does not have any other option feature except the discount. D. Stock Appreciation Rights Stock appreciation rights allow employees to receive as compensation an amount equal to the excess of the market price of the entities stock over a stated amount. The compensation is allocated over the periods benefited. If the rights are for past services, the cost is charged to the current period. III. Issuance of equity instruments to nonemployees for goods or services. The cost of the goods or services is based on the fair value of the equity instruments or the fair value of the goods or services whichever is more objective. IV. DISCLOSURES A. Vesting requirements, maximum term of options granted, and number of shares authorized of grants or options or other equity instruments. B. The number and weighted-average exercise prices of each group of options. C. The weighted-average grant-date fair value of options granted during the year, classified according to whether the exercise price equals, exceeds, or is less than the fair value of the stock at the date of the grant. D. A description of methods used and assumptions made in determining fair values of the options. E. Total compensation cost recognized for the year. F. The range of exercise prices and weighted-average remaining contractual life for all options still outstanding. Reminder: If APB 25 is used for the calculation of compensation cost, SFAS 123 requires pro-forma disclosure of net income and earnings per share as if the fair value based method had been used. ESOPS Companies with Employee Stock Ownership Plans (ESOPs) recognize expense when cash and/or stocks are contributed to the plan (stocks measured at FMV). When the ESOP borrows funds to purchase company stock, the company reports an equal reduction in shareholders' equity and an increase in debt for the endorsed note payable of the ESOP when the loan is so guaranteed. Deferred Compensation Contracts Deferred compensation contracts should be accounted for individually on an accrual basis. If the contract is equivalent to a pension plan, apply SFAS 87, "Accounting for the Cost of Pension Plans." Deferred compensation contracts customarily include requirements such as continued employment for a specified period and availability for consulting services and agreements not to compete after retirement, which, if not complied with, remove the employer's obligations for future payments. The estimated amounts to be paid under each contract should be accrued over the period of active employment from the time the contract is entered into, unless it is evident that future services are commensurate with the payments to be made. If both current and future services are involved, only the portion applicable to the current services should be accrued. Where contracts provide for periodic payments to employees or their surviving spouses for life, the estimated amount of future payments should be accrued over the period of active employment. Estimates should be based on the life expectancy of each individual concerned or on the estimated cost of an annuity contract.

Summary Of SFAS 140 ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS SFAS 140 adopted a financial components approach to the transfer of financial assets based on control. The financial components approach replaces the old approach of viewing transferred financial assets as an inseparable unit that had been entirely sold or entirely retained. Values are now assigned to financial components such as recourse provisions, servicing rights and agreements to reacquire. BASIC ACCOUNTING ISSUE The basic accounting issue is whether the transferred assets result in a sale or secured borrowing. A sale results when a transferor gives up control. After a transfer, an entity recognizes the assets and liabilities it controls and derecognizes the assets it no longer controls and derecognizes liabilities that have been extinguished. CONTROL IS SURRENDERED: SALE IS RECORDED Control is considered to have been surrendered if the three following conditions have been met: * The transferred assets are isolated from or beyond the reach of the transferor and its creditors (even a bankruptcy trustee). * The transferee has a right to freely exchange or pledge the assets transferred without unreasonable constraints or conditions imposed on its contractual right. or The holders of beneficial interest in a qualifying special-purpose entity can pledge or exchange those interests freely without unreasonable constraints or conditions imposed on their right. * The transferor does not maintain control through an agreement to repurchase or redeem the transferred assets prior to maturity or an agreement, not obtainable elsewhere, to repurchase or redeem the transferred assets. If these three conditions are met, the transaction is considered a sale and if the three conditions are not met, the transaction is considered a secured borrowing. Example: An application of SFAS 140 can be seen in our previous discussion of transfer of receivables either by factoring, pledging, or assignment. TRANSFER OF RECEIVABLES Transfer of Receivables | Does transfer meet conditions for surrender of control? a. Transferred assets beyond the reach of the transferor b. Transferee has unconstrained right to pledge or sale the assets c. Transferee does not maintain control through a repurchase agreement | | YES NO | | Record as a sale Record as secured borrowing | | Is there continuing involvement? Examples: | | Pledging or Yes No Assignment of | | receivables Example: Factor Example: Factor with recourse without recourse | Record using financial components approach SFAS 140 added the following three new terms * SECURITIZATION is the transfer of a portfolio of financial assets (e.g., trade receivables, mortgage loans, automobile loans, and credit card receivables) to a special-purpose entity, often a trust, and the sale of beneficial interests in the special-purpose entity to investors. The proceeds of the sale of these interests are paid to the transferor. Amounts of interest and principal collected on the securitized assets are paid to the investors in accordance with the legal agreement that established the special-purpose entity. * A SERVICING ASSET is a contract under which future revenues from servicing fees, late charges, etc., are expected to more than adequately compensate the servicer. A servicing liability arises when such compensation is inadequate. * An UNDIVIDED INTEREST is partial ownership as a tenant in common, for example, the right to the interest but not the principal of a security. This interest also may be pro rata, for example, a right to a proportion of the interest payments on a security

Treasury Stock Treasury Stock Defined Definition Treasury stock is a corporation's own stock, once issued and fully paid, and later reacquired but not canceled in accordance with a formal procedure specified by law. Treasury stock may be either common or preferred stock, reacquired by donation, purchase or in settlement of a debt. Stock held in treasury has no cash dividend, liquidation, preemptive or voting rights; however, it does participate in stock splits. Treasury Stock Purchased 1. The cost of treasury stock, regardless of par, should be carried as the value of treasury stock as a reduction of stockholders' equity. 2. The total cost of treasury stock carried should also be shown as a restriction of retained earnings in the balance sheet. STOCKHOLDERS' EQUITY ILLUSTRATION WITH TREASURY STOCK: Cap l Stock: Authorized and issued, 10,000 shares of $100 par value of which 500 shares are in the treasury $1,000,000 Contributed Cap l in Excess of Par Value 150,000 Retained Earnings: (of which $62,000, representing the cost of treasury stock, is restricted) 784,000 Total $1,934,000 Less: Cost of Treasury Stock 62,000 Total Stockholders' Equity $1,872,000 If cost of treasury stock exceeds the Retained Earnings Account, restrict excess against Contributed Cap l in Excess of Par Value. Acquisition for Purposes Other Than Retirement * "Gains" on sales of treasury stock not previously accounted for as constructively retired should be credited to cap l in excess. * "Losses" should be charged to cap l in excess to the extent that previous net "gains" from sales or retirements of the same class of stock are included therein, otherwise to retained earnings. Note that the terms "gains" and "losses" are used in connection with describing the transaction; however, treasury stock transactions do not result in net income for financial reporting purposes. Also, treasury stock transactions are not taxable. * When state law is at variance with GAAP treatment of treasury stock, the accounting should conform to the applicable law. When state laws relating to acquisition of stock restrict retained earnings for payment of dividends or have other effects of a significant nature, these facts should be disclosed. Accounting Methods 1. Cost (preferable) 2. Par-value or retirement method Where the "cost" method is used, acquisitions are recorded at cost and the total cost is shown in the balance sheet as a reduction of stockholders' equity. The par-value method, which has theoretical support, results in the shares being recorded at par with the treasury shares shown in the balance sheet as a reduction of cap l stock outstanding. ILLUSTRATIONS: Assume 10,000 shares were originally issued at $15 (par value $10). Cash $150,000 C/S 100,000 C.C. in Excess 50,000 Application of Cost Method Where 200 Shares Were Reacquired at $18: Treasury Stock $3,600 Cash 3,600 If resold at the same price, the entry would be reversed. If 100 shares were resold at $20, the entry would be: Cash $2,000 Treasury Stock 1,800 C.C. in excess from treasury stock transaction 200 If the remaining 100 shares were resold at $13: Cash $1,300 *C.C. in Excess 200 Retained Earnings 300 Treasury Stock 1,800 *Can be used to the extent that "previous net 'gains' from sales or retirements of the same class are included therein, otherwise to retained earnings." Application of Par Value Method Using the Same Facts Under the Par Method the excess of cost of treasury stock over par or stated value: (1) May be allocated between A.P.I.C. and retained earnings. The portion allocated to A.P.I.C. is limited to the sum of: a) the pro rata portion of A.P.I.C. on the same issue; and b) all A.P.I.C. from retirements and net "gains" on the sale of treasury stock of the same issue. (2) May be charged entirely to retained earnings. An excess of par or stated value over cost shall be credited to additional paid in cap l (C.C. in excess). 200 shares reacquired at $18: Treasury Stock (par) $2,000 *C.C. in Excess 1,000 Retained Earnings 600 Cash $3,600 *Based on original issue premium of $5 per share. 200 shares reacquired at $15: Treasury Stock $2,000 C.C. in Excess 1,000 Cash $3,000 200 shares reacquired at $12: Treasury Stock $2,000 Treasury Stock $2,000 C.C. in Excess 1,000 C.C. in Excess 400 OR C.C. in excess from Cash $2,400 Treasury Stock Transaction 600 Cash $2,400 (preferable entry) 100 shares are reissued at $11: Cash $1,100 C.C. in Excess $ 100 Treasury Stock 1,000 Reissuance of treasury shares is given the same treatment as any original issue of stock. PROBLEM: Hillside Corporation has 80,000 shares of $50 par value common stock authorized, issued, and outstanding. All 80,000 shares were issued at $55 each. Retained earnings of the company are $160,000. If 1,000 shares of Hillside common were reacquired at $62 and the retirement (par value) method of accounting for treasury stock were used, cap l stock would decrease by: a. $62,000 b. $55,000 c. $50,000 d. $0. Answer: (d) The retirement or par value method does not decrease the number of shares. Retirement of Treasury Stock When a corporation's stock is retired, or purchased for constructive retirement (with or without an intention to retire the stock formally in accordance with applicable laws): 1. An excess of purchase price over par or stated value may be allocated between C.C in excess and retained earnings. The portion of the excess allocated to C.C. in excess should be limited to the sum of: a. All C.C. in excess arising from previous retirements and net "gains" on sales of treasury stock of the same issue, and b. The pro rata portion of C.C. in excess paid in, voluntary transfers of retained earnings, cap lization of stock dividends, etc., on the same issue. For this purpose, any remaining C.C. in excess applicable to issues fully retired (formal or constructive) is deemed to be applicable pro rata to shares of common stock. Alternatively, the excess may be charged entirely to retained earnings in recognition of the fact that a corporation can always cap lize or allocate retained earnings for such purposes. 2. An excess of par or stated value over purchase price should be credited to C.C. in Excess. ILLUSTRATIONS Facts: 10,000 shares, no-par, $10 stated value issued $100,000 Cap l Contributed in Excess, Common 20,000 Cap l Contributed in Excess, Common from T/S transactions 1,000 Retained Earnings 40,000 Treasury Stock, 100 shares at cost 2,500 Treasury Stock is retired Retirement of Treasury Stock Method 1: Cap l Stock, stated value $10 1,000 C.C. in Excess-T.S. transactions 1,000 C.C. in Excess-Common 200 Retained Earnings 300 Treasury Stock 2,500 Shares Retired 100 $20,000 -------- * ---------------------- = $200 Total Shares 10,000 C.C. in Excess, Common Method 2: (Simplest Method) Cap l Stock, stated value $10 1,000 Retained Earnings 1,500 Treasury Stock 2,500 Same facts except that Treasury Stock was acquired at $8 per share or $800. Cap l Stock 1,000 C.C. in Excess 200 Treasury Stock 800 Donated Stock General Purpose: Donations may be made to provide stock that may be resold to furnish working cap l, to eliminate the water from the stock, to wipe out a deficit, to provide common stock to be given as a bonus to purchasers of a preferred stock, or for other reasons. It may be purchased to buy out a stockholder, or to create a market demand for the stock and thus retard a downward trend in the market value. If the donated stock is not to be resold, the company should effect a formal reduction of its stated cap l. If the donated stock is to be resold, since the company will part with nothing of value, there is no cost to record in the Treasury Stock account. There would be only a memo entry. If stock is donated to provide stock that can be sold to raise working cap l, no entry other than a memorandum in the Treasury Stock account should be made for the donation. The proceeds of the sale should be credited to C.C. in Excess, Donated Cap l. Retained earnings should never be increased as a result of treasury stock transactions. Cash dividends would not be paid on treasury shares. Stock dividends and stock splits apply to all issued shares, however.

Treasury Stock Method TREASURY STOCK METHOD Earnings per share is computed as if the funds obtained from the exercising of options and warrants at the beginning of the period (or at time of issuance, if later) were used to purchase common stock (treasury stock), at the average market price during the period. The excess of shares assumed issued, from the exercise of options and warrants, over the shares assumed purchased as treasury stock is considered dilutive and included in the denominator of the Diluted EPS as potential common shares. If the shares assumed purchased exceeds the shares assumed issued, the options and warrants are antidilutive and the options and warrants are excluded from the earnings per share computation. This antidilutive situation occurs when the exercise price exceeds the average market price of the options or warrants. Example: A corporation has 10,000 warrants outstanding, exercisable at $54 with the average market price per common share during the reporting period being $60. The potential common shares included in the Diluted earnings per share computation is determined as follows: Number of shares issued from exercise of warrants 10,000 Less: Number of shares purchased with proceeds 10,000 x $540,000 / $60 9,000 Potential Common Shares 1,000 The $540,000 realized from exercise of the warrants and issuance of 10,000 shares would be sufficient to acquire 9,000 shares of treasury stock. Therefore, 1,000 shares would be added to the weighted average common shares outstanding in computing Diluted earnings per share for the period. The potential common shares also be determined with the following formula: Market price - Option price Potential Common Shares = ----------------------------- x Option Shares Market price For the example: ($60 - $54) ----------------- x 10,000 = 1,000 C.S.E. shares 60

Undistributed Earnings Investee and Subsidiary An additional deferred tax problem relates to the temporary difference between the earnings of an investee or subsidiary accounted for by the equity method and a dividend distributed by them. The tax effect of this temporary difference depends upon whether the temporary difference will ultimately be distributed as future dividends or future cap l gains. If the assumption is made that the temporary difference (undistributed earnings) is to be distributed as future dividends and the corporation is a domestic corporation, the tax effect of the temporary difference would normally be adjusted for the dividends received deduction. Example of domestic investee ABC Corp. owns 30% of the outstanding stock of Investee Corp., a domestic corporation. ABC's net income for the current year is $60,000 and its dividends are $20,000. The Company accounts for its investment on the equity basis and assumes that future distributions of undistributed earnings will be as dividends. The tax rate for all years is assumed to be 40%. Solution: ABC's income before taxes would include $18,000 of income from earnings of investee ($60,000 × 30%). The company would also receive $6,000 in dividends from Investee ($20,000 × 30%). This creates a temporary difference between the earnings and dividends of $12,000. Since the Company assumes that the difference will be distributed as future dividends, it is eligible for the 80% dividends received deduction. This means that 80% of the $12,000 temporary difference ($9,600) will never be taxed and is considered a permanent difference. Therefore, only 20% of the $12,000 temporary difference ($2,400) will be taxable. The deferred tax liability on ABC's books from the temporary difference will be $960 ($2,400 × 40%). Note: The rule for the 80% dividends received deduction is that the investment must be in a domestic corporation and that the ownership percentage must be equal to or greater than 20% but less than 80%. For investments in a domestic corporation in which the ownership is less than 20%, a 70% dividends received deduction is allowed. This investment would normally be accounted for by using the cost method and the company would recognize dividend income for both financial and tax purposes. In this case, a temporary tax difference would not exist. Example of a domestic subsidiary ABC also owns 60% interest in Subsidiary Corp., a domestic corporation. Subsidiary's net income and dividends for the current year are $100,000 and $40,000 respectively. ABC accounts for its investment on the equity basis and assumes that all undistributed earnings will be distributed as dividends. The tax rate for all years is 40%. Solution: ABC's income before taxes would include earnings from Subsidiary Corp. of $60,000 ($100,000 × 60%), and dividends of $24,000 ($40,000 × 60%). This creates a temporary difference between earnings and dividends of $36,000. Since ABC is a domestic corporation and the ownership interest is between 20% or more and less than 80%, it is eligible for the 80% dividend received deduction. Therefore, 80% of the temporary difference (undistributed earnings) will never be taxed and is considered a permanent difference. Only 20% of the temporary difference is considered taxable. The deferred tax liability on ABC's books would be $2,880: the temporary difference ($36,000) times 20% times the future enacted tax rate of 40%. Note: The dividends received deduction is 100% for investments in domestic corporations in which the ownership percentage is 80% or above. This means that 100% of the dividends would never be taxed and would be considered a permanent difference. In this case, the company would not have a temporary tax difference. DIFFERING VIEWPOINTS (1) Asset and liability method (method to be used) (2) "Deferred" method (3) Net of tax method The asset and liability approach to deferred taxes is most consistent with the definitions established in the Concepts Statements for assets and liabilities. This method recognizes a deferred tax liability (or asset) which represents the amount of taxes payable or recoverable in future years as a result of temporary differences at the end of the current year. This method emphasizes those rates in effect when the tax difference reverses (future rates). In the deferred method, the tax effects of income tax allocation are deferred currently and current tax rates are used. If the current taxes are reduced below the income tax expense per books, a deferred credit arises. Similarly, where income tax payable exceeds the income tax expense, a deferred charge arises. In this method, the emphasis is on the income statement and matches tax expense with related revenues and expenses for the year in which they are recognized in pretax financial income. The label "deferred" or "liability" is really the principal difference between the first two methods. One other difference relates to tax rates. In the deferred method, current tax rates are used; whereas, in the liability method, rates expected to prevail when the differences reverse are used. In the "net of tax" method, the tax effects under either the deferred or liability method are recognized in the valuation of assets and liabilities and the related revenues and expenses. The tax effects are applied to reduce specific assets or liabilities on the basis that tax deductibility or taxability are factors in their valuation. Another viewpoint, partial allocation, is not acceptable. Partial allocation advocates maintain that the tax expense should be the tax payable with the possible exception of non recurring differences that lead to material distortions of tax expense and net income. Holders of this view state that comprehensive tax allocation advocates rely on the "revolving" account approach which suggests a similarity between deferred tax accruals and other balance sheet items, like accounts payable, where the individual items within an account balance remain constant or grow. They argue that deferred tax accruals are not owed to anyone, there is no payable date, and represent at best vague estimates of future amounts due depending on future tax rates and other factors. INTRAPERIOD TAX ALLOCATION Income Statement Income tax expense or benefit for the year shall be allocated among continuing operations, discontinued operations, extraordinary items, and changes in accounting principles. The amount allocated to continuing operations is the tax effect of the pretax income or loss from continuing operations that occurred during the year, plus or minus income tax effects of changes in circumstances that cause a change in judgment about the realization of deferred tax assets in future years, changes in tax laws or rates, and changes in tax status. If there is only one item other than continuing operations, the portion of income tax expense or benefit for the year that remains after the allocation to continuing operations is allocated to that item. If there are two or more items other than continuing operations, the amount that remains after the allocation to continuing operations shall be allocated among those other items in proportion to their individual effects on income tax expense or benefit for the year. Comprehensive Income a. Other comprehensive items are shown net of tax effects or before tax effects with one amount shown for the total tax. b. Accumulated other comprehensive income shown in the equity section of the statement of financial position is shown net of tax. Stockholder's Equity Accounting errors are shown net of tax as adjustments to beginning retained earnings. EXAMPLES OF TEMPORARY DIFFERENCES Item FINANCIAL IRS - TAX FINANCIAL IBT* DEFERRED REPORTING REPORTING IS > < TAX TAXABLE IBT Sales Accrual Installment Greater Liability LT Cont Percentage Completed Greater Liability Completion Contract Investments Equity Cost Greater Liability Depreciation Straight SYD Greater Liability Line Prepaid Accrual Cash Greater Liability Expenses Rent Received Accrual Cash Less Asset In Advance Subscriptions Accrual Cash Less Asset Receoved in Advance Warranty Accrual Cash Less Asset Cost Estimated Accrual Cash Less Asset Litigation Losses Unrealized Accrual Cash Less Asset Loss on Marketable Securities *Income Before Taxes

Valuation Allowance Determining the Allowance All available evidence, both positive and negative, should be considered to determine whether, based on the weight of that evidence, a valuation allowance is needed. Information about an enterprise's current financial position and its results of operations for the current and preceding years ordinarily is readily available. That historical information is supplemented by all currently available information about future years. Sometimes, however, historical information may not be available (for example, start-up operations) or it may not be as relevant (for example, if there has been a significant, recent change in circumstances) and special attention is required. Future realization of the tax benefit of an existing deductible temporary difference or carryforward ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or cap l gain) within the carryback, carryforward period available under the tax law. The following four possible sources of taxable income may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards: a. Future reversals of existing taxable temporary differences. b. Future taxable income exclusive of reversing temporary differences and carryforwards. c. Taxable income in prior carryback year(s) if carryback is permitted under the tax law. d. Tax-planning strategies that would, if necessary, be implemented to, for example: (1) Accelerate taxable amounts to utilize expiring carryforwards (2) Change the character of taxable or deductible amounts from ordinary income or loss to cap l gain or loss. (3) Switch from tax-exempt to taxable investments. Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years. Other examples of negative evidence include (but are not limited to) the following: a. A history of operating loss or tax credit carryforwards expiring unused b. Losses expected in early future years (by a presently prof ble entity) c. Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years d. A carryback, carryforward period that is so brief that it would limit realization of tax benefits if (1) a significant deductible temporary difference is expected to reverse in a single year or (2) the enterprise operates in a traditionally cyclical business. Examples (not prerequisites) of positive evidence that might support a conclusion that a valuation allowance is not needed when there is negative evidence include (but are not limited to) the following: a. Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures b. An excess of appreciated asset value of the tax basis of the entity's net assets in an amount sufficient to realize the deferred tax asset c. A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for example, an unusual, infrequent, or extraordinary item) is an aberration rather than a continuing condition. An enterprise must use judgment in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists (a) the more positive evidence is necessary and (b) the more difficult it is to support a conclusion that a valuation allowance is not needed for some portion or all of the deferred tax asset. A Change in the Valuation Allowance The effect of a change in the beginning-of-the-year balance of a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years ordinarily shall be included in income from continuing operations. Exceptions include certain temporary differences of an acquired corporation and adjustments to beginning retained earnings for certain accounting changes or prior period adjustments. FINANCIAL STATEMENT PRESENTATION In a classified statement of financial position, an enterprise shall separate deferred tax liabilities and assets into a current amount and a noncurrent amount. Deferred tax liabilities and assets shall be classified as current or noncurrent based on the classification of the related asset or liability for financial reporting. A deferred tax liability or asset that is not related to an asset or liability for financial reporting, including deferred tax assets related to carryforwards, shall be classified according to the expected reversal date of the temporary difference. The valuation allowance for a particular tax jurisdiction shall be allocated between current and noncurrent deferred tax assets for that tax jurisdiction on a pro rata basis. For a particular tax-paying component of an enterprise and within a particular tax jurisdiction, (a) all current deferred tax liabilities and assets shall be offset and presented as a single amount and (b) all noncurrent deferred tax liabilities and assets shall be offset and presented as a single amount. Financial Statement Disclosure The components of the net deferred tax liability or asset recognized in an enterprise's statement of financial position shall be disclosed as follows: a. The total of all deferred tax liabilities. b. The total of all deferred tax assets. c. The total valuation allowance recognized for deferred tax assets. The net change during the year in the total valuation allowance also shall be disclosed. A public enterprise shall disclose the approximate tax effect of each type of temporary difference and carryforward that gives rise to a significant portion of deferred tax liabilities and deferred tax assets (before allocation of valuation allowances). A nonpublic enterprise shall disclose the types of significant temporary differences and carryforwards but may omit disclosure of the tax effects of each type. A public enterprise that is not subject to income taxes because its income is taxed directly to its owners shall disclose that fact and the net difference between the tax bases and the reported amounts of the enterprise's assets and liabilities. The significant components of income tax expense attributable to continuing operations for each year presented shall be disclosed in the financial statements or notes thereto. Those components would include, for example: a. Current tax expense or benefit b. Deferred tax expense or benefit (exclusive of the effects of other components listed below) c. Investment tax credits d. Government grants (to the extent recognized as a reduction of income tax expense) e. The benefits of operating loss carryforwards f. Tax expense that results from allocating certain tax benefits either directly to contributed cap l or to reduce goodwill or other noncurrent intangible assets of an acquired entity g. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of the enterprise h. Adjustments of the beginning-of-the-year balance of a valuation allowance because of a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset in future years. The amount of income tax expense or benefit allocated to continuing operations and the amounts separately allocated to other items shall be disclosed for each year for which those items are presented. A public enterprise shall disclose a reconciliation using percentages or dollar amounts of (a) the reported amount of income tax expense attributable to continuing operations for the year to (b) the amount of income tax expense that would result from applying domestic federal statutory tax rates to pretax income from continuing operations. The "statutory" tax rates shall be the regular tax rates if there are alternative tax systems. The estimated amount and the nature of each significant reconciling item shall be disclosed. A nonpublic enterprise shall disclose the nature of significant reconciling items but may omit a numerical reconciliation. An enterprise shall disclose the amounts and expiration dates of operating loss and tax credit carryforwards for tax purposes.

       
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