F10 Flashcards
Fair Value
is the price that would be received to sell an asset or paid to transfer a liability at the measurement date under current market conditions
- exit price*
- market based measure, not entity based
- does not include transactions costs, EXCEPT used to calculated most advantageous market (but not included in FV measurement)
- includes transportation costs, but not transaction costs
~
- FV of liab should include nonperformance risk
Orderly Transaction
asset or liab exposed to market for period before measurement date long enough to allow for marketing activities that are usual and customary
- cannot be a forced transaction
Principal Market
market w greatest volume or level of activity for the asset or liab
- 1st option even if more advantageous market available
Most Advantageous Market
market w best price for asset or liab, after considering transaction costs
- use transaction costs to determine most advantageous market, but not included in FV measurement
- 2nd option if no principal market
Highest and Best Use
applies to Nonfinancial Assets
- doesnt apply to Liabilities and Financial Assets
Valuation Techniques
FV Measurement Framework
should be appropriate and should maximize use of observable inputs and minimize use of unobservable inputs
- change in valuation technique is change in accounting estimate
- Market Approach
- uses prices and other relevant info from comparable market transactions to measure FV
- can be used for assets or liabs - Income Approach
- PV discounted cash flows - Cost Approach
- current replacement cost to measure FV of assets
Hierarchy of Inputs
FV Measurement Framework
if multiple levels (1, 2, 3) are used, FV is classified as “lowest level” used- the weakest link
- Level 1
- quoted prices in active market for identical assets or liabs as of measurement date
- identical items - Level 2
- other that quoted market prices that are directly or indirectly observable for the asset or liab
- similar items
- identical items not in active markets - Level 3
- unobservable inputs for asset or liab
- assumptions based on best available info
- used only when no observable inputs or when undue cost and effort is required to obtain observable
- discounted cash flows
Admission of a Partner
Partnerships
- By Purchase or Sale of Existing Partnership Interest
- consent of all partners
- no JE, just change of name on capital acct - Formation of a Partnership
- assets are valued at FV (tax uses NBV), net of any related liabilities
- liabilities recorded at PV - Creation of a New Partnership Interest w Investment of Add. Capital
- total capital of partnership changes and purchase price can be equal to, more than, or less than book value
a) Exact Method
- when purchase price = book value of capital acct, no goodwill or bonuses are recorded
- old partners’ capital acct “dollars” stay the same, just % ownership changes
- *finger math? (get 1/4 = 4 - 1 = divide by 3)
b) Bonus Method
- when purchase price is more or less than book value of capital acct purchased
- bonuses are adj. b/w old and new parters’ capital accts and do not affect partnership assets
- recognize intercapital transfers
1. determine total capital and interest to new partner
2. if interest is less than amt contributed, bonus to old partners
3. if interest is more than amt contributed, bonus to new partner
c) Goodwill Method
- goodwill recognized based on total value of partnership implied by new partner’s contribution
1. compute new “net assets before GW” before goodwill after admitting new partner
2. memo: compute new “capitalized” net assets and compare w net assets before GW
3. difference is “Goodwill” to be allocated to old partners according to partners profit ratios
Profit and Loss Distribution
Partnerships
interest on capital, salaries, and bonuses are deducted from total profit before profit and loss distributions
- provided for in full, even in loss situation
Withdrawal of a Partner
Partnerships
- Bonus Method
- bonus = diff b/w balance of capital acct and amt the person paid
- bonus allocated among remaining partners’ capital accts in accordance w remaining profit and loss ratios
- partnership’s identifiable assets may be revalued to FV at date of withdrawal, but any goodwill implied by excess payment to retiring partner is NOT recorded - Goodwill Method
- may elect to record implied goodwill in partnership based on payment to withdrawing partner
- amt of implied goodwill is allocated to ALL partners in accordance w profit and loss ratios
- get him to exact amt of buyout
Liquidation of a Partnership
Partnerships
Order of Preference for Distribution of Assets
- Creditors, including partners who are creditors
- Partner’s Capital
Losses Consideration
- all possible losses must be provided for in a liquidation before any distribution is made to partners
- losses in accordance w partnership agreement, if none then equally
Convert Noncash Assets
- all liabs are paid, and if any remainder distribute to partners
Gain or Loss on Realization
- liquidation may result in: gain on realization, loss, or loss resulting in capital deficiency
Capital Deficiency
- a debit balance in partner’s capital acct indicating partnership has claim against partner for amt of deficiency
1. Right of Offset - if partner w capital deficiency has a loan account (partnership has payable to partner), can offset to satisfy capital deficiency
2. Remaining Partners Charged - if deficiency still exists, remaining partners must absorb according to respective remaining profit and loss ratios
Variable Interest Entities
consolidation required (even if comp owns no stock) if 3 conditions met
- variable interest
- we have financial stake in another company
- most liabilities, excluding ST payables (accts payable), represent variable interests* - Variable Interest Entities (VIEs)
- either does not have equity investors w voting rights or lacks sufficient financial resources to support activities
- equity/characteristics are strange - Primary Beneficiary
- has power to direct activities and get profits and losses (not all but some)
- the entity required to conslidate the VIE
- first identify whether to consolidate under VIE, then if meets 50%+ sub
- Identifying a Variable Interest in a Business Entity
Variable Interest Entities
company has variable interest when all are met:
- Company and Business Entity Have an Arrangement
- financial stake in another company
- F10-16 - Business Entity is a Legal Entity
- Business Entity Fails to Qualify for Exclusion
- nonprofit, employee benefit plans, registered investment comp, separate accts of life insurance companies, gov. orgs - Interest is more than Insignificant
- Comp has Explicit or Implicit Variable Interest in Entity
- absorb portion of business entity’s losses or
- receive portion of residual returns
- Business Entity is a Variable Interest Entity
Variable Interest Entities
VIE if following characteristics
- company’s equity characteristics are strange: didn’t put in money, get the gains and losses
- Insufficient Level of Equity Investment at Risk
- needs outside financial support for activities - Inability to Make Decisions or Direct Activities
- equity holders dont have power to direct activities that most significantly impact economic performance - No Obligation to absorb’s entity’s Expected Losses
- No Right to Receive Expected Residual Returns/Profits
- Disproportional Voting Rights
- entity is automatically deemed to be VIE when all 3 conditions are present:
1) substantially all activities of the entity are conducted on behalf of an equity investor or involving an equity investor
2) voting rights of that equity investor are small in comparison w focus of the equity on that investor and
3) voting rights of 1 or more equity investors, including that equity investor, are out of line w investor’s obligation to absorb expected losses, the investor’s right to receive expected residual returns, or both
- Primary Beneficiary Consolidates
Variable Interest Entities
company is primary beneficiary if it has power to direct activities of a VIE that most sig. impact the entity’s economic performance and:
- absorbs expected VIE losses or
- receives expected VIE residual returns/profits
- if one part receives profits and another absorbs losses, party that absorbs losses consolidates
- it’s possible for an entity to be a VIE, but no primary beneficiary so no consolidation
IFRS SPE*
Variable Interest Entities
IFRS focuses on accting for special purpose entities, a specific type of VIE created by a sponsoring comp to hold assets and liabs, often for structure financing purposes
- under IFRS, sponsoring comp controls and must consolidate an SPE when:
1. benefited by SPE’s activities
2. has decision-making powers
3. absorbs risks and rewards
4. has residual interest
Private Company Accounting Alternative
Variable Interest Entities
under GAAP, a private comp may elect to aply accounting alternative for consolidation of a VIE for common control lease arrangements if all 4 are met:
- lessee and lessor are under common control
- lessee has leasing arrangement w lessor
- substantially all activities b/w lessee and lessor are related to leasing activities
- lessee explicitly guarantees or collateralizes any obligation of the lessor, then the principal amt of the obligation at inception of such guarantee or collateral agreement doesn’t exceed value of asset leased by private comp from lessor
- elected by lessee and applies to all current and future leasing arrangements
- applied using full retrospective approach to all periods presented
- disclosures required
Asset Retirement Obligations (AROs)
ARO Recognition when meet def. of a liability:
- duty or responsibility
- little or no discretion to avoid
- obligating event
Initial Measurement
- Asset Retirement Obligations (ARO)
- fair value: PV
- liability
- if reasonable estimate of FV cannot be made, liab and asset are recognized when it can be
- *IFRS, ARO is called decommissioning liability- initially measured at best est. of expenditure required to settle the obligation - Asset Retirement Cost
- amt capitalized (asset) that increases carrying amt of the asset when liab. ARO is recognized
- dr: asset retirement cost, cr: asset retirement obligation
Subsequent Measurement
- Accretion and Depreciation
- Accretion Expense: “interest expense” every year on ARO
- dr: accretion expense (IS), cr: ARO (liab. inrease)
- Depreciation Expense: every year decreases ARC asset
- dr: depreciation expense (IS), cr: accum. depr (ARC)
- cumulative accretion expense + cumulative depr expense = ARO
- * use credit-adjusted risk free interest rate - Revision to Cash Flow Estimates
- changes in value of the liab after the property has been fully depreciated will be recognized in profit or loss*
- upward revisions are new liabilities- use current discount rate
- downward revisions are removal of old liabilities- use historical (or weighted avg) discount rate
- *IFRS, decommissioning obligation is remeasured each period for changes in amt, timing of cash flows, and changes in disc. rate
- GAAP, obligation is only adjusted for changes in amt or timing of cash flows
ARO Accounting and Leases
- Lessees
- if ARO is included in min. lease payments, no separate ARO accting req.
- ARO is imposed otherwise, ARO accting applies - Lessors
- ARO accting applies
Troubled Debt Restructurings
creditor allows debtor certain concessions to improve likelihood of collection that would not be considered normally
- reduced interest rates, extension of maturity dates, reduction of face amt, etc
- often result of legal proceedings or negotiation
Accounting and Reporting by Debtor
Troubled Debt Restructurings
Transfer of Assets
- ordinary gain/loss on: FV asset transfer - NBV asset transferred
- recognized ordinary gain on: carrying amt of payable - FV asset transferred = gain
- gain on amt of debt discharged
Transfer of Equity Interest
- recognize gain: carrying amt of payable - FV asset transferred
- gain on amt of debt discharged
Modification of Terms
- debtor usually accounts for effects of restructuring prospectively
- when total future cash payments < carrying amt, debtor should reduce carrying amt and recognize difference as a gain
Accounting and Reporting by Creditor
Troubled Debt Restructurings
Measurement of Impairment
- Receipt of Assets or Equity
- accounted for at FV at time of restructuring
- excess of recorded receivable over the FV of asset received is recognized as an ordinary loss - Modification of Terms
- use PV of expected future cash flows discounted at historical effective interest rate (or market rate if more readily available)
- any costs to sell should be estimated and reduce cash flows
- impairment recorded by creating a valuation allowance w corresponding charge to bad debt expense
(dr: bad debt expense, cr: allowance for credit losses)
*^ those are for if foreclosure is not probable, but if it is probable then impairment must be measured using FV of collateral (1) hw
Exceptions
- troubled debt restructuring accting by creditors does not apply to
- groups of loans collectively evaluated for impairment
- loans measured at market value
- leases
- held to maturity debt securities
Debt Covenants
creditors use debt covenants in lending agreements to protect their interest by limiting or prohibiting actions of debtors
common debt covenants
- limitations on issuing add. debt
- restrictions on payment of dividends
- limitations on disposal of certain assets
- min. working capital requirements
- collateral requirements
- limitations on how borrowed money can be used
- maintenance of specific financial ratios
Violation
- when violated, debtor is in technical default and creditor can demand repayment
- most of the time concessions are negotiated and real default is avoided
- concessions can result in violated covenants being waived and change in interest rate or other terms of debt
Debt Covenants
creditors use debt covenants in lending agreements to protect their interest by limiting or prohibiting actions of debtors
common debt covenants
- limitations on issuing add. debt
- restrictions on payment of dividends
- limitations on disposal of certain assets
- min. working capital requirements
- collateral requirements
- limitations on how borrowed money can be used
- maintenance of specific financial ratios
Violation
- when violated, debtor is in technical default and creditor can demand repayment
- most of the time concessions are negotiated and real default is avoided
- concessions can result in violated covenants being waived and change in interest rate or other terms of debt
Premiums
Estimated Liabilities
offered in return for coupons, box tops, labels, etc
- cost of premium is charged to sales in periods that benefit from premium offer
- gr all premiums will not be redeemed in the same period
- *the # of o/s premium offers must be estimated to reflect current liability at end of each period
total # of coupons issued * estimated redemption rate = total estimated coupon redemptions
Warranties
Estimated Liabilities
must create liability account if cost of warranty can be reasonably estimated*
- entire liab. for warranty should be accrued in year of sale to “match” cost w corresponding revenue
- even if warranty expenditure incurred later
- sales * total est. expense = total liability
- total liability - actual expenditures = balance in liab account
Service Contracts
Estimated Liabilities
cash received prior to earning
- deferred revenue
- earn it or return it
- when services performed, unearned revenue is debited and revenue is credited
Accrued Liabilities
an expense recognized or incurred but not yet paid
Bonuses
Accrued Liabilities
complicated- select middle answer and plug and work your way backwards
Classification of Contingencies
Contingencies
- probable: likely to occur
- reasonably possible: more than remote, less than likely
- remote: slight chance of occurring
GAAP vs IFRS*
- under IFRS
- probable: more likely than not to occur
- possible: may but probably will not occur
Loss Contingencies
Contingencies
Loss is Probable and Can Be Reasonably Estimated
- provision for loss should be accrued by charge to income, if both exist
- record JE
1. probable: as of date of FS an asset has been impaired or liab incurred, based on info available prior to issuance of FSs
2. amt of loss reasonably estimated - if range of probable losses is given, GAAP requires best estimate if no amt is better than any other, use MIN. amt in range and a note disclosing the range
- IFRS* uses mid point in range
Loss is Reasonably Possible
- disclose, no JE no accrual
- disclose nature of contingency and nature of possible loss or range
Loss is Remote
- ignore EXCEPT disclose “DOG”
- Debts of others guaranteed
- Obligations of commercial banks under standby letters of credit and
- Guarantees to repurchase receivables (or related property) that have been sold or assigned
Gain Contingencies
Contingencies
do not record JEs
Financial Statements
- not reflected in accounts bc may cause recognition of revenue prior to realization (conservatism)
Disclosures
- adequate disclosures shall be made but be careful to avoid misleading implications as to likelihood of realization
good summary chart F10-38
Subsequent Events
event or transaction that occurs after BS date but before FSs are issued or available to be issued
- Recognized Subsequent Events
- provide add. info about conditions that existed at BS date
- record JE and disclose - Nonrecognized Sub. Events
- did not exist at BS date
- just disclose
Sub. Event Evaluation Period
- public companies and others that intend to widely distribute FSs must evaluate sub. events through date the FSs are issued
- all others must evaluate through date FSs are available to be issued
Reissuance of FSs
- if entity reissues it’s FSs, should not recognize events that occurred b/w date of original FSs are reissued FSs
- unless adj. is required by GAAP or other regulatory requirements
Sub. Event Disclosures
- if entity is not an SEC filer, must disclose date through which sub. events have been evaluated and indicate if that is date FSs issud or available to be issued
- not required for SEC filers
- nonrecognized sub. event should be disclosed, nature and estimate, plus possibly pro forma FS showing effects
GAAP vs IFRS
Subsequent Events
under IFRS, sub. events are “events after the reporting period”
- evaluation period: from reporting period through date FSs are authorized for issuance
- recognized sub. events: “adjusting events after the reporting period”
- nonrecognized sub. events: “nonadjusting events after the reporting period”
IFRS specifically addresses going concern issues in guidance on events after the reporting period, stating that an entity cannot prepare its financial statements on a going concern basis if mgmt determines after YE that it intends to liquidate the company or cease trading
Types of Financial Instruments
Financial Instruments
- cash, foreign currency, and demand deposits
- evidence of an ownership interest in an entity
- Contracts which result in an exchange of cash or ownership interest in an entity
- bonds - Derivatives: financial instruments whose value or settlement amt is derived from the value of another unit of measure
- “OFFS”: options, futures, forwards, swaps
Fair Value Option
Financial Instruments
on specified election dates, entities may choose to measure financial instruments at FV
- unrealized gains and losses reported in earnings
- FV option is irrevocable and applied to individual financial instruments
Eligible Financial Instruments
- F10-41
- excluded: investments in subsidiaries, pension benefit assets/liabilities, and assets/liabs recognized under leases
Election Dates
- FV option may only be applied on certain dates
- the date an entity first recognizes an eligible financial instrument, date an investment becomes subject to equity method accting, or date entity ceases to consolidate an investment in a subsidiary or VIE
GAAP vs IFRS
- IFRS, can only elect if doing so eliminates or significantly reduces a measurement or recognition inconsistency
FV Disclosures Required for Financial Instruments
- FVs must be disclosed for all financial instruments for which it is practicable to estimate the value, together w the related carrying amts showing clearly if asset or liability
- disclosure should state methods and assumptions used to estimate FV and description of changes in methods and ass
- if not practicable to estimate FV, disclose info why
Disclosures about “Concentration of Credit Risk” of all Financial Instruments
Financial Instruments
credit risk is possibility of loss from failure of another party to perform according to contract
- concentration of credit risk occurs when entity has contracts of material value w one or more parties in same industry or region having similar economic characteristics
- tech, mortgage, greece
- required disclosure in notes to FSS*
Disclosure about “Market Risk” of all Financial Instruments
Financial Instruments
market risk is possibility of loss from changes in market value
- under GAAP, all entities are encouraged, but not required, to disclose quantitative info about market risk
GAAP vs IFRS - IFRS requires disclosure of nature and extent of risks arising from financial instruments, including credit risk for each class of FI, liquidity risk, and market risk (vs GAAP it's optional)
Derivative Instrument
Derivative Instruments and Hedging Activities
Financial Instruments
financial instrument that “derives” its value from the value of some other instrument and has all 3 characteristics:
- one or more underlyings and one or more notional amounts or payment provisions (or both)
- require no initial net investment or one that is smaller than other types of similar contracts
- terms require or permit a net settlement, or it can be readily settled net outside the contract or by delivery of an asset that gives substantially the same results
- under/over contract
Underlying
Derivative Instruments and Hedging Activities
Financial Instruments
specified price, rate, or other variable including a scheduled event that may or may not occur
- what are we gambling on, “strike”
Notional Amount
Derivative Instruments and Hedging Activities
Financial Instruments
specified unit of measure (currency units, shares, bushels, etc)
- used to calculate gain/loss
Value or Settlement Amt
Derivative Instruments and Hedging Activities
Financial Instruments
amt determined by the multiplication of notional amt and the underlying
(e.g. shares of stock times the price per share)
Payment Provision
Derivative Instruments and Hedging Activities
Financial Instruments
specified (fixed) or determinable settlement that is to be made if the underlying behaves in a specified way
Hedging
Derivative Instruments and Hedging Activities
Financial Instruments
use of a derivative to offset anticipated losses or reduce earnings volatility
- when hedge is effective, change in value of the derivative offsets the change in value of a hedged item or the cash flows of the hedged items
Option Contract
Common Derivatives “OFFS”
Derivative Instruments and Hedging Activities
Financial Instruments
Option Contract
- contract that gives one party right, but not obligation, to buy/sell something at a specified price (strike price) during a specified period of time
- option buyer/holder must pay premium to option seller to enter into option contract
- call option: gives holder right to buy from the option writer at a specified price during a specified period of time (hope price goes up)
- put option: gives holder right to sell option to writer at specified price during specified period of time (hope price goes down)
Futures Contract
Common Derivatives “OFFS”
Derivative Instruments and Hedging Activities
Financial Instruments
- agreement to exchange a commodity or currency at specified price on specified future date
- one party takes long position and agrees to buy (profit if price goes up)
- one party takes short position and agrees to sell (profit if price goes down)
- made through a clearinghouse and have standardized notional amts and settlement dates
Forward Contract
Common Derivatives “OFFS”
Derivative Instruments and Hedging Activities
Financial Instruments
similar to future contracts, except privately negotiated w the assistance of an intermediary, rather than through a clearinghouse
- do not have standardized notional amts or settlement dates
- terms established by contract
Swap Contract
Common Derivatives “OFFS”
Derivative Instruments and Hedging Activities
Financial Instruments
private agreement, generally assisted by intermediary, to exchange future cash payments
- common swaps: interest rate, currency, equity, and commodity
- swap agreement is equivalent to a series of forward contracts
Derivative Risks
Derivative Instruments and Hedging Activities
Financial Instruments
Market Risk
- risk entity will incur a loss
Credit Risk
- risk the other party will not perform according to terms of contract
Balance Sheet
Accounting for Derivative Instruments Including Hedges
Financial Instruments
all derivative instruments are recognized as assets or liabilities, depending on the rights or obligations under the contracts
- winner = asset, receivable protect you
- loser = liability, pay hurt you
- all DIs measured at FV
Reporting Gains and Losses
Accounting for Derivative Instruments Including Hedges
Financial Instruments
No Hedging Designation
- recognized currently in earnings (like trading sec.)
- reported in investing activities
- if held for trading: operating activities
- if derivative contains other-than-insignificant financing element at inception, all cash flows associated reported as financing activities
Fair Value Hedge
- instrument designated as a hedge of exposure to changes in FV
- recognized in earnings in same accting period
- derivative must be expected to be highly effective in offsetting the FV change
Cash Flow Hedge
- hedges exposure to variability in expected future cash flows
- ineffective portion: report in current income
- effective portion: deferred and reported in OCI
- effective is w/i 1/5*
Foreign Currency Hedge
a) FC FV Hedge
- gains/losses recog. in earnings IS
b) FC Cash Flow Hedge
- ineffective: current income
- effective: OCI
c) FC Net Investment Hedge
- ineffective: current income
- effective: reported in OCI as part of cumulative translation adjustment
Derivative Disclosure
Financial Instruments
more disclosures the better, some are:
- description of entity’s objectives for holding or issuing derivatives and strategies to achieve those objectives
- info on volume of company’s derivative activity
- location and amt of gains and losses reported on IS and OCI
- for FV hedges, net gain/loss recognized in earnings during the current period, effective portion of the hedge, and portion of gain/loss excluded from the assessment of effectiveness
- for cash flow hedges, description of events that will result in reclassification of gains/losses from OCI to earnings
Distinguishing Liabilities from Equity
Financial Instruments
certain FIs have characteristics of both liabilities and equity, classify them as liabilities
- FIs in the form of shares that are mandatorily redeemable
- FIs that represent an obligation to repurchase the issuer’s equity shares
- FIs that represent an obligation to issue a variable number of shares
IFRS 9
Financial Instruments
FASB has not yet issued a pronouncement that converges w IFRS 9. 3 phases:
- Classification and Measurement of Financial Assets
- financial assets are initially recognized at FV then subsequently measured at either amortized cost or FV
a) Single Model for Classification and Measurement:
- single model that applies to all types of financial assets
- consists of two parts: business model and contractual cash flows
- business model for managing financial assets: entity’s purpose for holding the assets
- contractual cash flow model: how cash is received, principal and interest or collection of proceeds upon sale
b) Debt Instruments
- Amortized Cost Measurement
…
Normally interest is imputed when no (or unreasonably low) rate is stated
- an exception exists for receivables and payables arising from transactions w customers or suppliers in normal course of business when trade terms do not exceed 1 year
F10-30
HW
Loan origination fees shall be recognized over the life of the loan as an adjustment of interest income (similar to bond discount amortization)
HW
if something is discounted w recourse
HW
disclose contingent liability at maturity value
A derivative may be designated and qualify as a Fair Value Hedge if
- formal documentation of hedging relationship b/w the derivative and the hedged item
- hedge must be expected to be highly effective and effectiveness assessed every 3 months
- hedged item is specifically identified
- hedged item presents exposure to changes in fair value that could affect income
HW
a qualified derivative may be used (designated) to hedge exposure to variability in Cash Flow w an asset, a liab, or a forecasted transaction
- but not a firm commitment, which would be a fair value hedge
Perfect Hedge
HW
no possibility of future gain or loss
