Becker - Module 10

Question 1

Define fair value

Answer 1

Fair value is the price to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date.

Question 2

Describe the valuation techniques that can be used to measure the fair value of an asset or liability.

Answer 2

1) Market Approach - Uses prices and other relevant information from market transactions involving identical or comparable assets or liabilities to measure fair value.
2) Income Approach - Converts future amounts, including cash flows or earnings, to a single discounted amount to measure the fair value of assets or liabilities
3) Coast Approach - Uses current replacement cost to measure the fair value of assets

Question 3

Describe the valuation techniques that can be used to measure the fair value of an asset or liability.

Answer 3

1) Market Approach - Uses prices and other relevant information from market transactions involving identical or comparable assets or liabilities to measure fair value.
2) Income Approach - Converts future amounts, including cash flows or earnings, to a single discounted amount to measure the fair value of assets or liabilities
3) Coast Approach - Uses current replacement cost to measure the fair value of assets

Question 4

Describe the valuation techniques that can be used to measure the fair value of an asset or liability.

Answer 4

1) Market Approach - Uses prices and other relevant information from market transactions involving identical or comparable assets or liabilities to measure fair value.
2) Income Approach - Converts future amounts, including cash flows or earnings, to a single discounted amount to measure the fair value of assets or liabilities
3) Coast Approach - Uses current replacement cost to measure the fair value of assets

Question 5

Describe the hierarchy of fair value inputs. Which inputs have the highest priority?

Answer 5

Level 1 Inputs - Quoted prices in active markets for identical assets or liabilities

Level 2 Inputs - Inputs other than quoted market prices that are directly or indirectly observable for an asset or liability.

Level 3 Inputs - Unobservable inputs for the asset or liability that reflect the entities assumptions and are based on the best available information.

Note: Level 1 inputs have the highest priority

Question 6

In creating a new partnership interest with an investment of additional capital, what three methods can be used?

Answer 6

• Exact method
• Bonus method
• Goodwill method

Question 7

Describe the exact method of creating a new partnership interest with an investment of additional capital.

Answer 7

The purchase price equals the book value of the capital account purchased.

• No adjustment to the existing partners’ capital accounts
• No goodwill or bonus

Question 8

Describe the bonus method of creating a new partnership interest with an investment of additional capital

Answer 8

Bonus Method:
New partner’s capital account = (A + B + C) x C’s percentage ownership. Excess of new partner’s contribution over capital interest received is a bonus to the old partners. Excess of capital interest received over new partner’s contribution is a bonus to the new partner.

Question 9

Describe the goodwill method of creating a new partnership interest with an investment of additional capital.

Answer 9

• Goodwill is recognized based on the total value of partnership implied by the new partner’s contribution.
• Good will is shared by the existing partner using the agreed profit/loss ratio.

Question 10

Describe the bonus method of withdrawal of a partner.

Answer 10

• The difference between the balance of the withdrawing partner’s capital account and the amount that person is paid is the amount of the bonus.
• The bonus is allocated among the remaining partners’ capital accounts in accordance with their remaining profit and loss ratios.

Question 11

Describe thegoodwill method of withdrawal of a partner.

Answer 11

The partners may elect to record the implied goodwill in the partnership based on the payment to the withdrawing partner. The amount of the implied goodwill is allocated to all of the partners in accordance with their profit and loss ratios.

After allocating goodwill, the balance in the withdrawing partner’s capital account should equal the final distribution to the withdrawing partner.

Question 12

In liquidating a partnership, what is the order of preference?

Answer 12

• Creditors
• Loans and advances to partners
• Capital accounts of partners

Remember that all losses must be provided for before disposal; that is, maximum potential losses before distribution of cash.

Question 13

What is a variable interest entity (VIE)?

Answer 13

A corporation, partnership, trust, LLC, or other legal structure used for business purposes that either does not have equity investors with voting rights or lacks sufficient financial resources to support its activities.

Question 14

Who is the primary beneficiary of a VIE and how does the primary beneficiary account for its VIE investment?

Answer 14

The entity with the power to direct the activities of the VIE that most significantly impact the entity’s economic performance and:
1) Absorbs the expected VIE losses; or
2) Receives the expected VIE residual returns.
The primary beneficiary must consolidate the VIE.

Question 15

Who consolidates when one entity receives the expected returns from a VIE and another entity absorbs the expected loss?

Answer 15

The entity that absorbs the expected losses consolidates.

Question 16

Define an asset retirement obligation (ARO).

Answer 16

A legal obligation associated with the retirement of a tangible long-lived asset that results from the acquisition, construction, development, and/or normal operation of a long-lived asset.

Question 17

How is an ARO initially measured?

Answer 17

At fair value (present value of the future obligation) as an asset (asset retirement cost) and a liability (asset retirement obligations).

Question 18

How is an ARO accounted for in periods after initial measurement?

Answer 18

The ARO liability is adjusted for accretion expense and the ARO asset is depreciated.

Question 19

Name four types of restructurings involving debt.

Answer 19

1) transfer of assets
2) transfer of equity interest
3) modification of terms
4) a combination of above three

Question 20

How is the gain (loss) measured in a troubled debt restructuring involving the modification of terms?

Answer 20

It is the difference between the carrying amount of the obligation prior to restructuring and undiscounted total future cash flows required after restructuring, if undiscounted future cash flows are less than the carrying amount.

Question 21

How is the gain (loss) measured in a troubled debt restructuring involving a transfer of assets?

Answer 21

Restate the assets transferred to fair value and recognize a gain or loss in ordinary income.

Recognize a gain for the difference between the fair value of the assets transferred and the carrying amount of the debt forgiven. The gain is possibly reported as extraordinary under US GAAP if it meets the US GAAP requirements (material, infrequent, and unusual).

Question 22

When is a gain (loss) not recognized on troubled debt restructuring?

Answer 22

For debtor, when there is a modification of terms and payment of the entire debt is not affected.

For creditor, when the total cash to be received is greater than the amount receivable. The difference is amortized as interest.

Question 23

When is a loan considered impaired?

Answer 23

Probable that all amounts due (principal and interest) will not be received.

Question 24

How is an impaired loan reported by the creditor?

Answer 24

Present value of the loan’s expected future cash flows discounted at the loan’s effective interest rate.

Dr. Bad debt expense
Cr. Allowance for credit losses

Question 25

What are the general disclosures for the debtor in a troubled debt restructuring?

Answer 25

1. a description of the main changes in terms and/or features of settlements.
2. gain on restructuring of payables (in the aggregate)
3. net gain or loss on transfers of assets is recognized in the period (in the aggregate)
4. per share amount of the aggregate gain on the restructuring of payables.
5. the amount of contingently payable amounts included in the carrying amount of restructured payables (and any conditions that would cause those amounts to become payable or to be forgiven)

Question 26

What are the general disclosures for creditors in a troubled debt restucturing?

Answer 26

1. the creditor’s policy for recognizing interest income.
2. any commitment the creditor has to lend additional fund to the debtor.
3. the activity in the allowance account for the reporting period.
4. the average recorded investment in impaired loans for the period (including the amount of related interest income and the interest income recognized on a cash basis).

Question 27

Identify the three ranges of likelihood that a future event will confirm a contingent liability.

Answer 27

• Probable
• Reasonably possible
• Remote

Question 28

When are contingent liabilities accrued?

Answer 28

• When the loss is both probable and can be reasonably estimated, then record and disclose.
• Financial statement disclosure only for reasonably possible contingent losses.
• Remote contingent losses are not disclosed, unless they are “guarantee-type” contingent losses, which must be disclosed.

Question 29

What is the accounting treatment of gain contingencies?

Answer 29

Gain contingencies are not reflected on the balance sheet but are disclosed as to their nature and amount if likelihood is probable and to do so would not be misleading.

Question 30

What is a subsequent event and what are the two categories of subsequent events?

Answer 30

An event or transaction that occurs after the balance sheet date but before the financial statements are issued or are available to be issued.

1. Recognized subsequent events - provide additional information about conditions that existed at the balance sheet date.
2. Nonrecognized subseqent events - provide information about conditions that occurred after the balance sheet date and did not exist on the balance sheet date.

Question 31

What disclosures are required for subsequent events?

Answer 31

1. If an entity is not an SEC filer, the entity must disclose the date through which subsequent events have been evaluated.
2. Nonrecognized subsequent events should be disclosed if disclosure is necessary to keep the financial statements from being misleading.

Question 32

List the disclosure requirements for financial instruments under US GAAP

Answer 32

• Fair value and related carrying amounts
• Concentrations of credit risk
• Market risk (optional)

Question 33

Describe the financial instrument fair value option under US GAAP.

Answer 33

On specified election dates, an entity may choose to measure eligible financial instruments at fair value with unrealized gains and losses reported in earnings. The fair value option is irrevocable.

Question 34

Define derivative instrument

Answer 34

A “derivative instrument” is a financial instrument (or other contract) that “derives” its value from the value of some other instrument and has all three of the following characteristics:

1. one or more underlying and one or more notional amounts or payment provisions (or both);
2. requires no initial net investment; and
3. its terms require or permit a net settlement.

Question 35

Define underlying and notional amount as they relate to a derivative financial instrument.

Answer 35

Underlying: a specified price, rate, or other variable (e.g. interest rate, security price, foreign exchange rate, index of prices or rate, etc.)

Notional amount: a specified unit of measurement (e.g. currency units, shares, bushels, pounds, etc.)

Question 36

Name four common derivative instruments.

Answer 36

• Option contracts
• Futures contracts
• Forward contracts
• Swap contracts

Question 37

Identify the three types of hedge designations

Answer 37

• Fair value hedge
• Cash flow hedge
• Foreign currency hedge

Question 38

Describe the accounting for changes in fair value associated with each type of hedge designation.

Answer 38

Fair value hedge: included in current earnings with gain or loss from change in value of offsetting asset/liability

Cash flow hedge:
Effective portion - included in other comprehensive income until cash flows from hedged item are realized
Ineffective portion - included in current earnings

Foreign currency hedge:
Fair value hedge - included in current earnings with gain or loss from change in value of offsetting asset/liability
Cash flow hedge - included in other comprehensive income (effective portion)
Net investment hedge - included in other comprehensive income, as cumulative translation adjustment.