Intermediate Accounting 2 (Quickstudy Reference Guide) 1423239857, 9781423239857

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WORLD’S WORLD’S #1 QUICK #1 ACADEMIC REFERENCE OUTLINE GUIDE

INTERMEDIATE ACCOUNTING COVERAGE Intermediate accounting is typically covered in two separate courses: Intermediate Accounting I and Intermediate Accounting II. This QuickStudy guide covers Intermediate II content. Intermediate I content (also covered in a QuickStudy guide) covers the following accounting concepts, some of which are prerequisite to the understanding of Intermediate Accounting II concepts:

Conceptual framework Balance sheet Research and development Income statement Cash and equivalents Depreciation, depletion, and amortization

Revenue recognition Receivables Intangible assets Comprehensive income Inventory Time value of money

Statement of changes in equity Inventory valuation methods Financial disclosures Statement of retained earnings Property, plant, and equipment Auditor’s report

INVESTMENTS Classification of investments: Debt securities (bonds and notes) and equity securities (common and preferred stocks): • Debt securities: Debt instrument that can be bought or sold between two parties and has basic terms defined, such as the amount borrowed (principal), interest rate, and maturity date. • Equity securities: An ownership interest in an entity or a right to acquire such an interest. -These are recorded at cost and measured at fair values when quoted market prices are available. -If - quoted market prices do not exist, equity securities are reported at cost until sold. • When the investing company lacks significant influence over the operating and financial policies of the investee, the investments are recorded using three categories: Category

Criteria

Reporting Method Used

Held to maturity

Debt securities that the company has the intent to hold until maturity

Investment is reported Not recognized at amortized cost with disclosure of fair value in the financial statement notes.

Trading

Debt or equity securities that the company intends to sell in the near future

Investment is reported Recognized in net at fair value. income

Available for sale

Debt or equity securities not classified as held to maturity or trading

Investment is reported Recognized in other at fair value. comprehensive income

Trading Securities Debt or equity securities that are acquired principally for the intent of selling them in the near future • These are typically reported as a current asset. • Cash flows from buying and selling trading securities are typically classified as operating activities if traded by financial institutions. -If - the company that is buying and selling trading securities is not a financial institution, then the cash flows from buying and selling the securities is classified as investing activity cash flows if the investment is not held for sale in the near term. • It is recorded at cost but reported at fair value when the balance sheet is prepared. -Investment is written up or down to its fair value; this process is called “marking to market.” -A - valuation allowance account (fair value adjustment) is used to record the fair value adjustment, and an account called “net unrealized holding gains or losses” is used to record the rise or fall in fair value. ›Fair › value adjustment account is used to increase or decrease the carrying value of the trading securities asset value. ›Net › unrealized holding gains or losses are reported on the income statement. ◦◦Unrealized means that the gain or loss has not been realized because the investment has not yet been sold. EX: Investment A is a trading security that was acquired for $100,000. Upon preparing a balance sheet, it is determined that investment A has lost $10,000 of value. The entry would be as follows to record the unrealized loss and to re-value the investment account: Debit Credit Net unrealized holding gains and losses $10,000

Treatment of Unrealized Gains and Losses

Fair value adjustment

Held-to-Maturity Securities • These securities have a specified date that they mature and on that date the principal (face value) is paid to investors. • Usually, interest is paid to the investor periodically during the life of the security. • Premium: If the interest rate (stated rate) paid by the debt security is higher than the prevailing market rate on similar risk debt securities, the debt instrument will be sold for a value greater than its face value. EX: A company buys a bond with a face value of $1,000,000 for $1,100,000. The premium is $100,000. The bond would be recorded upon purchase as follows: Debit Credit Investment in bonds $1,000,000 Premium on bonds

EX: Investment B is a trading security that was acquired for $100,000. Upon preparing a balance sheet, it is determined that investment B has gained $20,000 of value. The entry would be as follows to record the unrealized gain and to re-value the investment account: Debit Fair value adjustment $20,000 Net unrealized holding gains and losses

Credit $20,000

Available-for-Sale Securities Investments that are not intended to be traded actively but are available for sale if certain conditions are met or need arises • These are neither held-to-maturity nor trading securities. • Cash flow from buying and selling available-for-sale securities are classified as investing activities on the statement of cash flows. • Like trading securities, they are recorded at cost when acquired and reported at fair value on the balance sheet. • Unlike trading securities, unrealized gains or losses on available-for-sale securities are not included in net income, but rather are reported on the statement of comprehensive income as other comprehensive income. -Comprehensive income includes not only net income, but other changes in equity that do not arise from transactions with owners. EX: Investment A is an available-for-sale security that was acquired for $100,000. Upon preparing a balance sheet, it is determined that investment A has lost $10,000 of value. The entry would be as follows to record the unrealized loss and to re-value the investment account: Debit Credit

$100,000

Cash $1,100,000 • Discount: If the interest rate (stated rate) paid by the debt security is lower than the prevailing market rate on similar risk debt securities, the debt instrument will be sold for a value less than its face value. EX: A company buys a bond with a face value of $1,000,000 for $750,000. The discount is $250,000. The bond would be recorded upon purchase as follows: Debit Credit Investment in bonds $1,000,000 Discount on bonds $250,000 Cash

$10,000

$750,000

Recognizing Interest Revenue on Held-to-Maturity Investments

• The effective interest method is used to calculate the interest revenue. -Effective interest rate: The prevailing market rate of interest on debt securities with risk similar to the investment’s risk. EX: A company buys a bond with a face value of $1,000,000 for $1,100,000. The stated rate of interest is 6%, but the market rate on debt securities with similar risk is 8%. The 8% rate will be used to calculate the interest income.

Net unrealized holding gains and losses (OCI) $10,000 Fair value adjustment 1

$10,000

Investments (continued )

EX: Investment B is an available-for-sale security that was acquired for $100,000. Upon preparing a balance sheet, it is determined that investment B has gained $20,000 of value. The entry would be as follows to record the unrealized gain and to re-value the investment account:

Debit

Fair value adjustment $20,000 Net unrealized holding gains and losses (OCI)

Credit $20,000

• When available-for-sale securities are sold, unrealized gains or losses that were previously recorded are removed from the fair value adjustment and OCI (other comprehensive income).

TRANSFERS BETWEEN CATEGORIES Transfer To: from:

Unrealized Gain or Loss from Transfer at Fair Value

Held-tomaturity securities

Trading securities

Include in net income the unrealized gain or loss as if it all occurred in the current period.

Availablefor-sale securities

Trading securities

Include in net income the unrealized gain or loss as if it all occurred in the current period.

Trading securities

Held-tomaturity securities

Include in current net income any unrealized gain or loss that occurred in the current period prior to the transfer.

Trading securities

Availablefor-sale securities

Include in current net income any unrealized gain or loss that occurred in the current period prior to the transfer.

Held-tomaturity securities

Availablefor-sale securities

No impact on net income. Report total unrealized gain or loss as other comprehensive income.

Availablefor-sale securities

Held-tomaturity securities

No impact on net income. Amounts in other comprehensive income are amortized to net income over the remaining life of the security. Fair value amount becomes the security’s amortized cost basis.

Fair Value Option • Companies have the option to value most types of financial assets at fair value. • A company can choose the fair value option for some assets without choosing it for all assets. The fair value option must be chosen at the time the asset is acquired. • If the fair value option is used, the asset is reported on the balance sheet at fair value and all unrealized gains and losses are reported in net income. • For investments measured at fair value, companies disclose three levels to allow users to assess the fair value estimates and reasonableness of assumptions made in determining fair values: Level 1: Fair values are determined based on quoted prices in active markets for identical assets. Level 2: Fair values are determined using other significant observable inputs. Other observable inputs could include securities, dealer quotes, or prices based on similar assets in other markets. Level 3: Fair values are determined using significant unobservable inputs. EX: Fair values in the level 3 group could be estimated based on pricing models such as discounted cash flows.

Investor Has Significance Influence over the Investment When the investing company has significant influence over the operating and financial policies of the investee, either the equity method or consolidation method of reporting should be used.

Equity Method

If the investee owns between 20% and 50% of the voting stock of the investee, the equity method should be used. • The investment’s cost is initially recorded and is then adjusted for subsequent earnings and dividends of the investee. • If the fair value option is elected, this type of investment can be accounted for with the investment reported at fair value and unrealized holding gains and losses included in net income.

CURRENT PAYABLES -Sales taxes imposed on certain types of merchandise Obligations that will be either paid using current and services are normally paid by the buyer upon assets or replaced by another current liability purchase, but the seller is responsible to remit such • Current liabilities: Liabilities expected to be paid taxes periodically (usually quarterly or monthly) to within the company’s operating cycle or one year, the state government. whichever is longer. -Property taxes owed to local municipalities • Accounts payable: Obligations owed to sellers are usually expensed monthly or quarterly incurred when a business purchases goods or services with a current liability recorded (property taxes on credit. EX: Money owed for supplies, inventory, utilities, payable) for unpaid property taxes. and consulting fees Unearned Revenue/Advances -Usually no interest is charged if paid within credit A deposit or any other type of advance made prior terms granted. to the provision of a product or service is a current Gross Method liability if the earnings processed for the transaction • Ignores cash discounts and accounts for the accounts will be substantially complete during the next year or payable at face value operating cycle. EX: A company owes a supplier $1,000 with terms EX: A company receives an advance of $120,000 2/10, net 30. The payable would be credited by for services to be provided over the next year. The $1,000. advance would be recorded as: • Purchase discounts taken are credited to a contra Debit Credit purchases account and closed to cost of goods sold Cash $1 20,000 at the end of the period. Unearned revenue $120,000 Net Method • Records payables net of the discount for early payment EX: A company owes a supplier $1,000 with terms 2/10, net 30. The payable would be credited by $980 ($1,000 – Anticipated discount of $20 for early payment). • When the discount is taken, no additional adjustment is needed. • Adjustment entry is needed if discount is not taken (payment not made within the discount period). EX: Net method is used. A company owes a supplier $1,000 with terms 2/10, net 30. The payable was credited by $980, but the payment was made within 15 days for $1,000. Debit: accounts payable $1,000, credit: cash $980, credit: purchase discount lost $20

If the services are provided in a uniform manner each month and the reporting period ends after five months of services provided, the adjusting entry would be:

Debit

Credit

Unearned revenue $50,000 Fees earned

$50,000

Warranties

A written guarantee that the seller agrees to repair or replace a product, refund part or all of the price, or provide additional services related to the product • Warranties are offered for a limited time. • They create a loss contingency. -If - the incurrence of a warranty expense is probable Net Settlement Value and can be reasonably estimated, it results in both an expense and an obligation (liability) • Current liabilities should be recorded at net on the date that the related revenue is recorded settlement value. (i.e., the sale). -Net settlement value is the undiscounted amount of cash expected to be paid upon meeting the EX: A $1,000 product is sold. It is estimated obligation. that its warranty will cost $40. The sale would Accrued Expenses be recorded. Then the warranty would be recorded as: Expenses that were already incurred but have not yet Debit Credit been paid EX: Salaries and wages payable, income taxes payWarranty expense $40 able, and interest payable Estimated warranty liability $40 • Accrued interest payable results from outstanding notes payable. ›When › actual warranty expenditures are paid, • Usually recorded as an adjusting entry at the end of the estimated warranty liability is reduced. a period EX: If a product under warranty were repaired EX: $800,000 note payable is outstanding for a cost of $30, the transaction would be at year-end. It carries a 12% interest rate. On recorded as: 12/31, there are two months of accrued interest Debit Credit on the note: $800,000 × .12 × 2/12 = $16,000. An adjusting entry would be to debit: interest Estimated warranty liability $30 expense $16,000 and credit: interest payable Cash $30 $16,000. • Compensation owed to employees as a result of their Current Maturities of Long-Term Debt work efforts, including salaries, wages, commissions, • Long-term obligations such as bonds, notes, and leases bonuses, and stock compensation plans, must be are reclassified and reported as current liabilities when recognized as an expense and a liability as an they become payable in the upcoming twelve months adjusting entry at the end of a reporting period. (or operating cycle, if greater than a year). EX: A company’s employees are owed $120,000 EX: A 10-year bond will be reported as a longof salaries when the reporting period ends. term liability for the first 9 years of its life, but The employees won’t be paid until the following after the 9th year, it will be reported as a current period. The adjusting entry for year-end finanliability on the balance sheet. cial statements would be debit: salaries expense • Long-term debt that is callable in a particular year, $120,000, credit: salaries payable $120,000. even if it is not expected to be called, is classified as Taxes Payable a current liability. -Callable debt is due upon demand of the • Taxes owed but not yet paid are usually current creditor. liabilities. EX: Federal unemployment taxes, state sales taxes, EX: A lender grants a 5-year $50,000 and local property taxes callable loan. Although the loan matures in 5 years, the lender can ask for payment at any -Federal unemployment taxes and FICA taxes time. The loan should be reported as a current should be recognized as an expense and a liability liability on the balance sheet. when payroll is made. 2

INCOME TAX ACCOUNTING

LONG-TERM LIABILITIES

• Income tax expense is based on book (accounting) income. EX: GAAP determines what is included in revenues and expenses. The income tax expense for GAAP is calculated based on net income before taxes:

Bonds A type of long-term debt of large corporations • Bonds are evidence of a bond certificate issued by a corporation and purchased by an investor. • The corporation issuing the bond is borrowing money from an investor who becomes a lender and bondholder. • A bond is a formal contract that requires the issuing corporation to typically pay the bondholder’s interest every six months based on the bond’s stated interest rate and the principal or face amount on the bond’s maturity date. • Initial measurement -Debt issue costs are recorded as a debit to an asset account called debt issue costs and are amortized to expense over the term of the debt, usually on a straight-line basis. EX: A $5,000,000 30-year bond is issued with $200,000 of debt issue costs. The bond is issued at its par value; upon issue, the entries would be as follows:

Revenues – Expenses = Net income before taxes

• Income tax payable is based on taxable income. -What is actually owed the U.S. government is based on tax law. EX: IRS code determines what is included in taxable income, and IRS tax rates derive tax owed. • Current income tax payable or tax refunds must be recognized on financial statements. -A - current income tax liability is recognized for estimated income taxes payable on current-year tax returns. -A - current tax asset is recognized for taxes refundable on current-year tax returns. • Measurement of tax liabilities and assets is based upon enacted tax law at the time of the financial statements. The effects of future changes in income tax law are not anticipated in the accounting records. • A permanent difference arises when book income and taxable income differ because either: -An - item is included in the computation of taxable income but never in book income. -An - item is included in the computation of book income but never in taxable income. • Temporary differences result because tax laws and accounting principles differ on the calculation of revenues and expenses, and gains and losses. Revenues or Gains

Cash

Expenses or Losses

$4,800,000

Bond issue expense

$6,667

Debt issue costs

$6,667

• Bonds are issued at: -Par - value when the stated interest rate on the bond equals the market rate ›Bonds › payable issued at par are recorded at their face value. -A - discount when the stated interest rate is lower than the market rate -A - premium when the stated rate is greater than the market rate • The bond issue price is the present value of future cash flows. For bonds that make interest payments, the future cash flows are: -The periodic interest payments

.. Estimated bad debt losses reported using the allowance method .. Unrealized losses from investments .. Unrealized loss on inventory under the lower-of-cost or market-value method

Presently reported on the tax return but on the income statement at a later date .. Revenues collected in advance

Credit

Debt issue costs $200,000 Bonds payable $5,000,000 At the end of year 1, the debt issue costs would be amortized as one year of the bond’s life has expired: Debit Credit

Presently reported on the income statement but on the tax return in a later period .. Installment sales where the installment method is used for income tax reporting .. Unrealized gain from investments

Debit

.. Accelerated depreciation allowed by tax code in excess of the straight-line method used on an income statement .. Prepaid expenses that are tax deductible when paid

Face value × Stated interest rate

-The principal payment at maturity • Bonds are carried at the present value after issuance. -Any bond discount or premium is amortized over the life of the bond. • Under the effective interest rate method (GAAP), interest expense is calculated as:

-Income tax reported in a period should reflect the amount of taxable income caused by that period’s activities, regardless of when the tax law requires that such amounts be paid. ›If › tax law allows the delay of making a tax payment until the taxable event is required to be included in taxable income, then a deferred tax liability arises and must be recorded. ◦◦If income under GAAP is greater than taxable income, then there will be future taxable amounts and a deferred tax liability arises. EX: Year 1 GAAP income is greater than taxable income by $500,000. The company’s tax rate is 20%. $500,000 × .2 = $100,000 deferred tax liability. ›If › tax law requires the delay of a deduction to a future period, then a deferred tax asset arises and must be recorded. A deferred tax asset recognizes the benefit of a future deductible amount (tax savings).

Interest expense = Carrying value of the bond at the beginning of the period × Market interest rate

• The discount or premium amortization under the effective interest rate method is:

Discount/Premium amortization = Effective interest expense – Cash interest paid Noncurrent Notes Payable

• Various noncurrent notes payables are possibilities, such as mortgage payable or unsecured bank loans with a term greater than a year. -Notes payable are initially recognized at their fair value. -They are essentially accounted for the same as bonds. ›Any › significant discount, premium, loan origination fee, etc. is re-amortized using the effective-interest method. ›Discount › or premium is not an asset or liability separable from the note and is a direct subtraction or addition to the face amount of the note as reported on the balance sheet.

Deferred tax asset = Future deductible amount × Enacted tax rate EX: The excess of taxable income over GAAP income is $50,000 with a tax rate of 20%. $50,000 × .2 = $10,000 deferred tax asset. -Firms assess deferred tax assets for realizability and report them on the balance sheet at the amount they expect them to realize. ›U.S. › GAAP uses a two-step process with regards to recording deferred tax assets: Step 1: Record the full amount of the deferred tax asset. Step 2: Assess the deferred tax asset for realizability and set up a valuation allowance account if needed.

Interest expense = Carrying value of the note payable × Effective interest rate

-An - installment note requires a fixed payment each period that includes both principal and interest.

Interest = Note balance at the beginning of the period × Interest rate Principal = Total payment − Interest

-When a loan has no interest rate stated (a non-interest-bearing note) or the stated interest rate is less than the market interest rate, the present value is measured as the value of the note discounted at the market rate of interest.

ASSET RETIREMENT OBLIGATIONS • Some long-term assets incur significant legal obligation costs at the end of their productive/useful lives called asset retirement obligations (AROs). -These are costs associated with the disposition of property, plant, equipment, and natural resources. EX: A company may be required by law to return a parcel of land to its original state after a certain period of time/usage or when it is abandoned.

EX: A company acquires a factory for $1,200,000 cash that has an expected ARO (present value) of $300,000: Debit Credit

• AROs are obligations (liabilities), as they arise from the acquisition, construction, development, or operation of a tangible asset. • Companies must recognize the fair value of the liability associated with an ARO (if it can be reasonably estimated) while capitalizing the present value of the cost of the ARO, also called asset retirement cost (ARC). -The fair value is estimated using an expected present value technique using the creditadjusted risk-free rate.

Asset retirement obligation $300,000 • During the life of the related asset, the ARC is depreciated and the liability must be adjusted for the passage of time (accretion expense) and for revisions of the original estimate. • If the actual asset retirement obligation is more than the liability on the books, then a loss is recognized upon retirement of the asset. • If the actual asset retirement obligation is less than the liability on the books, then a gain is recognized upon retirement of the asset.

Factory

$1,500,000

Cash

3

$1,200,000

LEASES Classified in one of two ways: • Operating lease: Substantially all of the benefits and risks of ownership remain with the lessor. -An - operating lease is a simple rental agreement. -Rent is an expense by the lessee. EX: The lease agreement requires a $500 payment per month: Debit Credit Rent expense $500 Cash (or rent payable) $500 • Capital lease: Substantially all of the benefits and risks of ownership have been transferred to the lessee. -It - is a purchase-and-financing arrangement. -The existence of any of the following indicates that substantially all of the benefits and risks of ownership have been transferred to the lessee: ››The lease involves the transfer of ownership. ››The lease has a bargain purchase option (BPO). ◦◦Gives the lessee the option of purchasing the leased property at a bargain price ◦◦A bargain price is one that is substantially below the property’s expected fair value that the exercise of the purchase option is reasonably assured and is expected to happen when the purchase option becomes exercisable. -The lease term is 75% or more of the estimated economic life of the leased property. -The present value of the minimum lease payments is at least 90% of the fair value of the leased property at the start of the lease.



Debit

Credit

Leased property $500,000 Capital lease obligation $500,000 • The discount rate used to determine the present value of the minimum lease payments should be the lower of: -The lessor’s implicit rate, if known to the lessor -The lessee’s incremental borrowing rate

Lessee Accounting for Capital Leases: Subsequent Measurement • Lease liability should be allocated between current liabilities and noncurrent portions on a classified balance sheet. • Capital leases are amortized as lease payments are made. -Each periodic lease payment made by the lessee is made up of two parts: interest and a reduction (amortization) of the lease obligation (liability). -The effective interest method is required.

Interest expense = Lease obligation carrying value × Effective interest rate

››The portion of the lease payment in excess of the interest expense equals the reduction in the lease liability. EX: The lease carrying value is $600,000, the effective rate is 10%, and the lease payment is $100,000. The interest expense would be $60,000 and the reduction in the lease obligation would be $40,000 ($100,000 – $60,000). Debit Credit Capital lease obligation $60,000 Interest expense $40,000 Cash $100,000 • The capital asset (leased property) is depreciated just as if the company (lessee) owned the asset. -If - the lease either transfers ownership to the lessee at the end of the lease term or contains a bargain purchase option, the “asset” is depreciated over the entire estimated economic life; otherwise, the “asset” is depreciated over the lease term.

Capital Lease Liability

• The lessee records a capital lease as both an asset and an obligation at the present value of the minimum lease payments. Minimum lease payments include: ››Minimum rental payments: Periodic amounts owed by the lessee and paid to the lessor. ››Bargain purchase option amount: See definition above. ››Guaranteed residual value: Estimated fair value of the leased property at the expiration of the lease, as guaranteed by the lessee as part of the lease agreement. ◦◦Any amount of guaranteed residual value to be paid by the lessee is considered Lease Disclosures a final payment to the lessor. ››Any nonrenewal penalty that is a required payment by the lessee upon failure to • For all leases, the following should be disclosed as a note to the financial statements. renew or extend the lease at the end of the lease term -General description of the leasing arrangement EX: The present value of the minimum lease payments is equal to $500,000. -The minimum future payments, in the aggregate and for each of the five The lessee would record the following: succeeding fiscal years

PENSIONS A separate accounting entity into which an employer is required to make contributions, usually into a pool of funds set aside for a worker’s future benefit • There are two basic forms: defined contribution plan and a defined benefit plan.

Defined Contribution Plan • Individual account for each participating employee EX: 401(k) plans • A certain contribution must be made periodically on behalf of the employee. -Sometimes the amount of the employer contribution is tied to the amount contributed by the employee. • Benefits to be paid during retirement depend on: -The amounts contributed to the plan (by both the employer and the employee) -The returns generated on the investment of the amounts contributed • There is no guaranteed post-retirement benefit by the employer. ››Employees bear 100% of the investment risk. • The company’s annual pension expense is the amount of the company’s contribution to the defined contribution pension plan. -The employer reports a pension liability only if the contribution is less than the required amount (per the plan formula). -The employer reports a pension asset only if the contribution is more than the required amount (per the plan formula). EX: The plan formula calls for a contribution of $200,000 to the pension plan. The employer makes the contribution. Debit Credit Pension expense $200,000 Cash

$200,000

EX: The plan formula calls for a contribution of $200,000 to the pension plan. The employer makes a contribution of $170,000.



Debit

Credit

Pension expense $200,000 Payable Cash

$30,000 $170,000

Defined Benefit Plan • A defined benefit plan promises an amount of pension benefit to retirees. • The employer is responsible for providing the promised benefit and bears the investment risk. • The retirement benefits that the employer is required to pay depend upon: -How long the employee or covered survivor lives -How many years of service the employee gives to the company -The employee’s compensation before retirement EX: A benefit formula could be as follows: 1 ½ × Years of service × Average of the last 3 years of salary Employee works for 30 years with an average of the last 3 years of salary of $100,000. 1 ½ × 30 × $100,000 = Annual pension benefit of $45,000 • Uncertainties make it a complex exercise to determine how much the company should set aside (deposit into pension plan assets) each year to ensure that sufficient funds are available to pay the promised benefits. • At any point in time, the exact payout of all benefits to all covered employees is unknown and can only be estimated actuarial assumptions. -A - pension actuary assesses the financial consequences of risks and uses mathematics, statistics, and financial theory to analyze and determine the financial impact of uncertain future events. -A - pension actuary calculates the required amount of an employer’s annual contribution to a defined benefit plan to ensure that current and future plan benefits are available to the participants. • Each year, a company with a defined benefit plan must recognize pension expense, the funding provided, and the funded status of the plan. 4

-The funded status of a pension plan refers to the relationship between the assets of the plan versus the liabilities of the plan. ››If the assets are greater than the liabilities, the plan is fully funded. ››If the assets are less than the liabilities of the plan, then a portion of the plan is unfunded. • Key concepts of a defined benefit plan: -Employer’s obligation: The liability that the company has as a result of offering a pension plan to employees. -Plan assets: The assets invested in the pension plan. -Periodic pension expense: The expense incurred each accounting period for the pension plan.

Pension Expense • The pension expense reflects both the changes in the pension obligation and the pension plan assets. Pension expense components: + Service costs + Interest cost − Expected return on plan assets + or – Amortization of net gain or loss + or – Amortization of prior service cost or credit = Net periodic pension expense • Service cost: The actuarial present value of benefits related to services rendered by employees during the current period. -Service cost is calculated by the pension plan actuary. • Interest cost: The increase of the pension benefit obligation (PBO) resulting from the passage of time. EX: The beginning PBO is $200,000 and the discount rate is 4%. The interest component of the current-year pension expense is $8,000 ($200,000 × .04). • Expected return on plan assets: The fair value of the plan at the beginning of the period multiplied by the expected long-term rate of return. EX: At the beginning of the year, the fair value of the plan is $500,000 and the expected long-term annual rate of return is 6%. The expected return on plan assets would be $30,000 ($500,000 × .06).

Pensions (continued )

-The expected return on plan assets decreases the pension expense. • Amortization of net gain or loss -Gains or losses result from changes in the value of: ››The pension benefit obligation (PBO) (liability gains or losses) ››The plan assets (asset gains or losses) -A - liability gain or loss can be determined by “plugging” a liability gain or loss into the pension benefit equation: Beginning pension benefit obligation: + Service cost + Interest costs + Prior service cost – Prior service credit – Benefits paid + or – Liability gain or loss = Ending pension benefit obligation EX: A company’s beginning PBO is $250,000 and the net of service cost, interest cost, prior service cost, and credit and benefits paid is + $90,000. The ending PBO, as determined by an actuary, is $400,000. The liability loss would be $60,000 ($250,000 + $90,000 + Liability loss of $60,000 = $400,000). • Actual return on plan assets for the period is the difference between the beginning and ending fair value of the plan assets adjusted for contributions to the plan and benefits paid out of the plan during the period. Beginning fair value of plan assets: + Contributions to the plan during the period – Benefits paid out of the plan during the period

CONTINGENCIES An existing condition, situation, or set of situations involving uncertainty as to possible gain or loss to a company that will ultimately be resolved when one or more future events occur or fail to occur

Probable Loss Contingencies • A contingency is probable if the future events are likely to occur. • If the contingency is probable that at the balance sheet date an asset has been impaired or a liability has been incurred and it can be reasonably estimated, it must be recognized in the financial statements. • The amount that seems to be the best estimate within a range of loss must be accrued. -If - no amount within a range can be identified as the best estimate, then the minimum of the range should be accrued.

Reasonably Possible Loss Contingencies • If one or both of the criteria—probable or reasonably estimated—cannot be met, the contingency must be described, if possible, as estimated. -If - it is not possible to estimate it, that conclusion should be disclosed (indicating that an estimate cannot be reasonably made).

+ or – Actual return on plan assets during the period = Ending fair value of plan benefits -An - asset gain or loss for a period is the difference between the actual return on plan assets and the expected return. EX: The expected return on plan assets was $20,000 while the actual return was $25,000. The plan had an asset gain of $5,000 ($25,000 – $20,000). ››If the actual return is greater than the expected return, there is an asset gain. ››If the actual return is less than the expected return, there is an asset loss.

Calculation of Pension Benefit Obligation (PBO) at End of Period • The PBO is the actuarial present value of all benefits attributed by the pension benefit formula to employee services rendered prior to the date of the balance sheet. -Actuarial present value is found by considering the time value of money and the probability of future events, including death, changes in future compensation, disability, and election of retirement. PBO formula: + Beginning PBO + Service cost + Interest cost + Prior service cost – Prior service credit – Benefits paid + or – Changes in PBO resulting from experience different from that assumed and changes in assumptions = Ending PBO

A residual concept—an amount that remains after creditors’ claims have been subtracted from assets

Assets – Liabilities = Equity

• Equity of a corporation is called shareholders’ equity or stockholders’ equity. • Equity arises from two sources: -Investment by shareholders (paid-in capital) -Earnings retained in the business (retained earnings) ››These are a type of earned capital. • The major components of corporate equity include contributed capital, retained earnings, and accumulated other comprehensive income.

Common Stock • Ownership interest represented by units called shares • Owners of common stock are known as stockholders, shareholders, or common stockholders/shareholders. • It is the general ledger account that is credited when a corporation issues new shares of common stock. • If common stock has a par value (also called stated value), the par value of the issued stock is credited to the common stock account while the remainder is credited to an account called additional paid-in capital. EX: A corporation issues 1,000 shares of $10 par value common stock for $30 per share. Debit Credit Cash

$30,000

Common stock

$10,000

• If the chances of the occurrence of an event is slight (remote probability), the loss contingency is usually not disclosed. Note: The guarantee of the indebtedness of another or to repurchase accounts receivable must be disclosed even if the probability of loss is remote.

Additional paid-in capital common stock

$20,000

• Possible gain contingencies are only recognized when realized. EX: A company is appealing the award of significant damages to a customer from a lawsuit and management believes the company will win the appeal suit. That possible gain is not recognized in the financial statements unless the company actually wins the appeal. -Gain contingencies must be adequately disclosed in the financial statement notes.

• Pension plan assets are invested by an independent third party called a trustee. • The funds are put into a trust for the benefit of the covered employees. • The fair value of the assets change based on investment experience (investment dividends, interest, gains or losses), benefit payments (decrease plan assets), and contributions (increase plan assets). • The fair value of plan assets at the end of a period is calculated as follows: Fair value of pension plan formula: + Beginning fair value + Contributions – Benefits paid + or – Actual return on plan assets = Ending fair value

Pension Liability or Asset • If a pension is underfunded, it is because the PBO exceeds the fair value of the plan assets. -Unfunded amounts must be reported as a liability on the balance sheet.

Pension liability = PBO – Fair value of plan assets

• If a pension is overfunded, it is because the fair value of the plan assets exceeds the PBO. -Overfunded amounts must be reported on the balance sheet as an asset.

Pension asset = Fair value of plan assets – PBO

• The net of the pension plan obligation and plan assets is reported on the balance sheet.

EQUITY

Remote Loss Contingencies

Gain Contingencies

Fair Value of Pension Plan Assets

Preferred Stock • Preferred stock shareholders have preferential treatment over common stockholders. They receive dividends before the common stockholders. • If the corporation does not declare and pay the dividends to preferred stock, it cannot declare and pay a dividend on the common stock. • Preferred stockholders usually give up the right to share in the corporation’s earnings.

Issuance of Preferred Stock

• Like par value common stock, the par value of preferred stock is recorded in its own paid-in capital account called preferred stock. • If the corporation receives more than the par value amount, the amount greater than par is recorded in another section called paid-in capital in excess of par— preferred stock. 5

Conversion of Convertible Preferred Stock

• A type of preferred stock is convertible preferred—a preferred stock that can be exchanged for a stated number of shares of the corporation’s common stock. EX: A corporation issues convertible preferred stock that can be converted at any time into four shares of common stock. • When conversion happens, all related amounts are removed from the accounts and replaced with amounts related to the common stock. • Gains or losses cannot be recognized as a result of conversion of a corporation’s own stock. EX: A company has on its books preferred stock with a par value of $300,000 and with additional paidin capital of $200,000. That stock is converted into 32,000 shares of $10 par value common stock: Debit Credit Convertible preferred stock $300,000 Additional paid-in capital preferred stock $200,000 Common stock $320,000 Additional paid-in capital common stock $180,000

Treasury Stock • The purchase by a company of its own stock. It is a temporary reduction in equity. • It is considered issued but not outstanding stock. • The cost of acquiring the stock is debited to a contraequity account called treasury stock. EX: Under the cost method, a company buys back $500,000 of its own stock: Debit Credit Treasury stock $500,000 Cash

$500,000

• When treasury shares are sold, any excess value above the cost of the treasury stock is credited to additional paid-in capital. EX: The stock that was acquired for $500,000 is sold for $600,000. Debit Credit Cash $600,000 Treasury stock Additional paid-in capital

$500,000 $100,000

Equity (continued )

Retained Earnings • Retained earnings represents the earned capital of a corporation and results from the corporation’s accumulated, undistributed net income (or net loss). • Net income increases retained earnings; net loss and dividends declared decrease retained earnings. • The amount available for dividends is called the retained earnings. -Amounts paid in excess of retained earnings would be a return of capital and not a return on capital. • Restricted retained earnings would be an amount of earnings not available to be paid to stockholders. EX: A corporation has $10,000,000 of retained earnings. Management decides to restrict $2,000,000 so that it cannot be paid in the form of dividends. The entry to record and allocate that amount to a restricted status would be as follows: Debit Credit Retained earnings $2,000,000 Retained earnings restricted

$2,000,000

Cash Dividends • Corporations may provide their stockholders with a return on invested capital by paying them a dividend, typically in cash (check). • Dividends are voted on and “declared” by the board of directors.

• Upon the declaration of dividends, the retained earnings amount is reduced by the amount of the dividends. EX: On July 1, the board of directors of a corporation declared a $1,000,000 cash dividend to be paid next month. Debit Credit Retained earnings $1,000,000 Cash dividends payable Upon paying the dividend:

Debit

$1,000,000 Credit

Cash dividends payable $1,000,000 Cash $1,000,000

• On the declaration date, the retained earnings amount is reduced by the fair value of the shares of stock that make up the dividend. -The common stock account increases by the par value of the stock dividend. -Any excess of the fair value above the par value is credited to additional paid-in capital. EX: A company’s board of directors declares a 10% stock dividend on 500,000 shares of $5 par value common stock. The fair value of the stock on the declaration date was $20 per share. Below are the entries made upon declaration of the stock dividend: Debit Credit Retained earnings $1,000,000 Common stock dividend distributable Additional paid-in capital (common)

Stock Dividends • A board of directors might decide to distribute additional shares of stock as a dividend. • A stock dividend does not involve the distribution of cash, property, or the incurrence of liability. • Because each shareholder must receive the same percentage increase in shares as the result of the stock dividend, the shareholders’ proportional share in the ownership of the corporation does not change. • A stock dividend is less than 25% of the previously outstanding shares. -More than 25% of the previously outstanding shares would be classified as a stock split.

$250,000 $750,000

• Upon the distribution of the stock dividend, the following entries would be made: Debit Credit Common stock dividend distributable $250,000 Common stock $250,000

Stock Splits Stock splits do not require a journal entry. Usually only a memorandum entry in the accounting records is necessary.

STATEMENT OF CASH FLOWS -Cash advances and loans made to other parties

Shows the summary cash receipts and disbursements of a business during an accounting period • Statement of cash flows is required (GAAP) as part of a full set of financial statements. • Cash inflows and outflows are classified into three categories: operating, investing, and financing activities.

Financing Activities • Financing activities involve transactions that are related to the issuance, settlement, or reacquisition of the company’s debt and equity securities, such as: -Cash inflows from issuing shares of common or preferred stock and other equity instruments -Cash inflows from issuing loans, notes, bonds, and other short-term borrowings -Cash payments of principal on amounts borrowed -Cash payments of dividends -Cash payments to acquire (e.g., treasury stock) or redeem the company’s own shares -Cash payments by the company (as lessee) for a reduction in the outstanding liability of a capital lease

Basic Statement of Cash Flows Formula Net cash provided by or used by operating activities: + or – Net cash provided by or used by investing activities + or – Net cash provided by or used by financing activities = Net increase or decrease in cash during the period + Cash at the beginning of the period = Cash at the end of the period

Noncash Investing & Financing Activities

Two Statements of Cash Flow Formats • Direct method: Major classes of gross operating receipts and payments are revealed. • Indirect method: Net cash flow from operations is determined by adjusting net income for noncash revenues and expenses, items included in net income attributed to cash effects of investing and financing, deferrals of past operating cash flows, and accruals of future cash flow.

• Information regarding all investing and financing activities that impact assets or liabilities but not cash flows must be disclosed. -If - there are only a few transactions, the disclosure can be made on the same page as the statement of cash flows; otherwise, these transactions can be disclosed elsewhere with a reference to the statement of cash flows. EX: Conversion of debt into equity

Operating Activities

Direct Method Format & Equations

• Operating activities are all transactions that are not related to financing or investing. • Cash flow from operating activities is primarily from the principal revenue-producing activities of the business. • Generally, operating cash flows are part of the determination of net income. • Examples of operating activities: -Cash receipts from the sale of goods or the provision of services, such as cash sales and the collection of accounts receivable -Cash receipts from other forms of revenue, such as rent, service fees, and royalties -Cash received from interest and dividends -Cash payments to suppliers for goods and services -Cash payments for wages and salaries -Cash paid for rent and utilities -Cash payments for taxes and interest

• Under the direct method, at a minimum, the following operating cash flows must be presented: -Cash collected from customers -Interest and dividends received -Other operating receipts -Cash paid to employees and other suppliers of goods and services -Interest and income taxes paid -Other operating cash payments

Equations

• Formulas can help convert accrual-basis accounting to cash basis. EX: Cash collected from customers Beginning accounts receivable: + Sales during the period – Ending accounts receivable = Cash collected from customers

Investing Activities • Investing activities are transactions related to the acquisition and sale of resources intended to generate future income and cash flows, such as: -Cash payments to acquire or cash receipts from the sale of property, plant, and equipment; intangible assets; and other long-lived assets -Cash payments to acquire or cash receipts from the sale or maturity of equity and debt investments, including cash flows from the purchase, sale, and maturity of availablefor-sale and held-to-maturity securities

EX: Cash paid to suppliers Beginning accounts payable: + Purchases during the period – Ending accounts payable = Cash paid to suppliers

U.S. $6.95 Author: Michael Griffin, CPA, CMA

NOTE TO STUDENT: This guide is intended for informational purposes only. Due to its condensed format, this guide cannot cover every aspect of the subject; rather, it is intended for use in conjunction with course work and assigned texts. BarCharts Publishing, Inc., its writers, editors, and design staff are not responsible or liable for the use or misuse of the information contained in this guide.

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