FAR SEC 3 Flashcards
1
Q
What is the Securities and Exchange Commission (SEC)?
A
The Securities and Exchange Commission (SEC) was created by the Securities Exchange Act of 1934 to regulate the trading of securities and otherwise to enforce securities legislation.
2
Q
What is the Securities Exchange Act of 1934?
A
The Securities and Exchange Commission (SEC) was created by the Securities Exchange Act of 1934 to regulate the trading of securities and otherwise to enforce securities legislation.
3
Q
What are the two basic purposes of the securities laws?
A
1) to prevent fraud and misrepresentation.
2) to require full and fair disclosure so investors can evaluate investments.
4
Q
What are the two main requirements of the Securities Exchange Act of 1934?
A
1) PUBLIC COMPANIES REGISTER WITH SEC. Under the Securities Exchange Act of 1934, all regulated, publicly held companies must register with the SEC. Registration is required of all securities listed on a national exchange.
2) SEC FILERS FILE PERIODIC REPORTS TO SEC. Under the 1934 act, disclosures about subsequent trading of securities are made by filing periodic reports using the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system that are available to the public for review.
5
Q
What is Regulation S-X?
A
Regulation S-X describes the form and content of, and requirements for, financial statements filed with the SEC. It applies to the reporting of interim and annual financial statements, including notes and schedules.
6
Q
Which 4 items are included in Management’s Discussion and Analysis (MD&A)?
A
This information includes the entity’s outlook and significant effects of known trends, events, and uncertainties. It addresses such matters as (1) liquidity, (2) capital resources, (3) results of operations, and (4) the effect of changing prices.
7
Q
What is MD&A?
A
Management’s discussion and analysis (MD&A) of financial condition and results of operations includes the entity’s outlook and significant effects of known trends, events, and uncertainties.
8
Q
What are the main examples of items other than the complete set of financial statements that must be submitted to the SEC as per Regulation S-X? (6 elements)
A
1) Management’s discussion and analysis (MD&A) of financial condition and results of operations
2) Management and general data for each director and officer
3) Compensation of the five highest-paid directors and officers
4) Security holdings of directors, officers, and those owning 5% or more of the security
5) Matters submitted to shareholders for approval
6) Pending litigation, e.g., principal parties, allegations, and relief sought
9
Q
What is the Securities Act of 1933?
A
-The Securities Act of 1933 was created and passed into law to protect investors after the stock market crash of 1929.
-The Securities Act of 1933 was designed to create transparency in the financial statements of corporations.
-The Securities Act also established laws against misrepresentation and fraudulent activities in the securities markets.
-The Securities Act is enforced by the Securities and Exchange Commission, created by the Exchange Act of 1934.
10
Q
What is the difference between the Securities Act of 1933 and the Securities Exchange Act of 1934?
A
The Securities Act of 1933 created the foundational laws regulating the issuance of securities on exchanges, whereas the Securities Exchange Act of 1934 mainly served to create the SEC for the purpose of enforcing the Securities Act of 1933.
11
Q
What is the form 10-k?
A
Form 10-K is the annual report to the SEC. It must be audited by an independent public accountant.
12
Q
What are the annual financial statements included in the form 10-k? (2 elements)
A
1) Balance sheets for the 2 most recent fiscal year ends
2) Statements of income, cash flows, and changes in equity for the 3 most recent fiscal years
13
Q
What is the 10-k filing deadline for large accelerated filers?
A
60 days of the last day of the fiscal year by large accelerated filers [companies with a public float (the market value of shares held by the public) of $700 million or more]
13
Q
What is the 10-k filing deadline for accelerated filers?
A
75 days by accelerated filers (public float of $75 million to $700 million and annual revenues of $100 million or more)
14
Q
What is the 10-K filing deadline for nonaccelerated filers?
A
90 days by nonaccelerated filers [(1) public float of less than $75 million or (2) public float of $75 million to $700 million and annual revenues of less than $100 million]
15
Q
What are large accelerated filers?
A
Companies with a public float (the market value of shares held by the public) of $700 million or more.
16
Q
What are nonaccelerated filers?
A
Nonaccelerated filers have either: (1) public float of less than $75 million or (2) public float of $75 million to $700 million and annual revenues of less than $100 million
17
Q
What are accelerated filers?
A
Accelerated filers have a public float of $75 million to $700 million and annual revenues of $100 million or more.
18
Q
What is the form 10-Q?
A
Form 10-Q is the quarterly report of operations and financial condition filed with the SEC. It must be reviewed by an independent public accountant. A review offers a lower level of assurance than an audit regarding financial condition and the results of operations.
19
Q
What is the difference in rigor between the form 10-K and the form 10-Q?
A
The form 10-K requires a complete audit by an independent CPA, whereas the form 10-Q requires a review by an independent CPA. A review offers a lower level of assurance than an audit regarding financial condition and the results of operations.
20
Q
Is form 10-Q required for the fourth quarter of the year?
A
No filing for the fourth quarter is required; Form 10-K is filed instead.
21
Q
Do entities filing the form 10-K also have to file the form 10-Q?
A
Yes. An entity required to file Form 10-K also must file Form 10-Q for each of the first three quarters.
22
Q
What is the 10-Q filing deadline for both large accelerated filers and accelerated filers?
A
It must be filed within 40 days of the last day of the fiscal quarter by large accelerated filers and accelerated filers.
23
Q
What is the 10-Q filing deadline for nonaccelerated filers?
A
It must be filed within 45 days of the last day of the fiscal quarter by nonaccelerated filers.
24
What is the form 8-K?
Form 8-K is a current report to disclose material events. It must be filed within 4 business days after the material event occurs.
25
What are the main examples of material events that would warrant the filing of a form 8-K? (5 examples)
1) A change in control of the registrant
2) Acquisition or disposition of a significant amount of assets not in the ordinary course of business
3) Bankruptcy or receivership
4) Resignation of a director
5) A change in the registrant’s certifying accountant
26
What is the deadline for filing the form 8-K?
It must be filed within 4 business days after the material event occurs.
27
What is form 20-F?
Form 20-F is the annual report to the SEC filed by foreign private issuers. It is similar to Form 10-K. The financial statements in Form 20-F may be prepared in accordance with U.S. GAAP or IFRS (International Financial Reporting Standards).
28
Who certifies the forms 10-K and 10-Q?
They are certified by the CEO and CFO, and the certifiers bear responsibility for any false reporting.
29
Doe GAAP require reporting of interim financial information?
No. GAAP do not require reporting of interim financial information.
30
Must GAAP be applied if entities report interim financial information?
Yes. GAAP must be applied when entities report such information, including when publicly traded companies issue summarized interim information.
31
What is interim financial information?
Interim financial information is information reported midway through an annual reporting period, e.g., the quarterly 10-Q reports.
32
What is an issuer?
-An issuer is a legal entity that develops, registers and sells securities to finance its operations.
-Issuers may be corporations, investment trusts, or domestic or foreign governments.
-Issuers make available securities such as equity shares, bonds, and warrants.
33
What is the best qualitative characteristic of interim financial information?
For many reasons, the usefulness of interim financial information is limited. Thus, its best qualitative characteristic is timeliness.
34
What accounting principles should be used to prepare interim financial statements?
Each interim period is treated primarily as an integral part of an annual period. Ordinarily, the results for an interim period should be based on the same accounting principles the entity uses in preparing annual statements, but certain principles may require modification at interim dates.
35
How is revenue recognized for interim financial reporting?
Revenue should be recognized as earned during an interim period on the same basis as followed for the full year.
36
Can interim period revenue be recognized under different rules than those that apply for end of period financial reporting?
No. Revenue should be recognized as earned during an interim period on the same basis as followed for the full year.
37
What are the three differences in interim financial reporting of inventory as compared to normal reporting of inventory?
1) VALUE INVENTORY WITH GROSS PROFIT METHOD. The gross profit method may be used for estimating cost of goods sold and inventory because a physical count at the interim date may not be feasible (described in Study Unit 6, Subunit 7).
2) TEMPORARY INVENTORY LOSS WRITE-DOWNS ARE DEFERRABLE AT THE INTERIM STATEMENT. An inventory loss from a write-down below cost may be deferred if no loss is reasonably anticipated for the year.
3) NON-TEMPORARY INVENTORY LOSS WRITE-DOWN'S AREN'T DEFERRABLE. But inventory losses from nontemporary declines below cost must be recognized at the interim date. If the loss is recovered during the year (in another quarter), it is treated as a change in estimate. The amount recovered is limited to the losses previously recognized. (Study Unit 6, Subunit 6, contains the relevant outlines.)
38
Can inventory be reported differently for interim financial reporting as compared to end of period financial reporting?
Yes. Costs associated with revenue are treated similarly for annual and interim reporting. However, some exceptions are appropriate for inventory accounting at interim dates.
39
What special method can be used to estimate COGS and Inventory at interim dates? Why is this reasonable?
The gross profit method may be used for estimating cost of goods sold and inventory for interim reporting. This is reasonable because a physical count at the interim date may not be feasible (described in Study Unit 6, Subunit 7).
40
For interim financial reporting, how are inventory losses treated? (2 elements)
1) An inventory loss from a write-down below cost may be deferred if no loss is reasonably anticipated for the year.
2) But inventory losses from nontemporary declines below cost must be recognized at the interim date. If the loss is recovered during the year (in another quarter), it is treated as a change in estimate. The amount recovered is limited to the losses previously recognized. (Study Unit 6, Subunit 6, contains the relevant outlines.)
41
For interim financial reporting, how are costs and expenses treated?
Costs and expenses other than product costs are either charged to income in interim periods as incurred or allocated among interim periods.
42
For interim financial reporting of costs and expenses other than product costs, what is the basis for the allocation among interim periods? (3 elements)
The allocation is based on the (1) benefits received, (2) estimates of time expired, or (3) activities associated with the period. If an item expensed for annual reporting benefits more than one interim period, it should be allocated.
43
Under what circumstances would gains or losses pertaining to costs and expenses other than product costs definitely not be deferred for interim financial reporting?
Gains and losses that are similar to gains and losses that would not be deferred at year end are not deferred to later interim periods. For example, an unusual or infrequently occurring item and a gain or loss on the disposal of an asset are recognized in full in the quarter in which they occur. They must not be prorated over the fiscal year.
44
What are the two major categories of costs and expenses addressed by interim financial reporting?
1) Product costs (costs associated with revenues).
2) All costs and expenses other than product costs.
45
For interim financial reporting of costs and expenses other than product costs, how are unusual or infrequently occurring items accounted for?
An unusual or infrequently occurring item and a gain or loss on the disposal of an asset are recognized in full in the quarter in which they occur. They must not be prorated over the fiscal year.
46
For interim financial reporting of costs and expenses other than product costs, can unusual or infrequently occurring items be prorated over the fiscal year?
No. They must not be prorated over the fiscal year. They are recognized in full in the quarter in which they occur.
47
Is it possible that some items expensed in annual statements should be allocated to interim periods? If so, how is this done?
Some items expensed in annual statements should be allocated to the interim periods that are clearly benefited.
48
For interim financial reporting of costs and expenses other than product costs, what is the basis for charging quantity discounts to interim periods?
Quantity discounts based on annual sales volume should be charged to interim periods based on periodic sales.
49
For interim financial reporting of costs and expenses other than product costs, how are interest, rent, and property taxes treated?
Interest, rent, and property taxes may be accrued or deferred at interim dates to assign an appropriate cost to each period.
50
For interim financial reporting of costs and expenses other than product costs, how are advertising costs treated?
Advertising costs may be deferred within a fiscal year if the benefits clearly extend beyond the interim period of the expenditure.
51
In interim financial reporting of costs and expenses other than product costs, what is year-end adjustment?
Certain costs and expenses, such as (1) inventory shrinkage, (2) allowance for credit losses, and (3) discretionary bonuses, are subject to year-end adjustment. To the extent possible, these adjustments should be estimated and assigned to interim periods.
52
For interim financial reporting of costs and expenses other than product costs, which three items are subject to year-end adjustment?
Certain costs and expenses, such as
(1) inventory shrinkage,
(2) allowance for credit losses, and
(3) discretionary bonuses, are subject to year-end adjustment.
53
How is seasonality addressed in interim financial reporting?
If interim information is issued, certain disclosures are mandatory for businesses that have material seasonal fluctuations. These fluctuations cannot be smoothed in interim information. Accordingly, reporting entities must disclose the seasonal nature of their activities. They also should consider supplementing interim reports with information for the 12-month period that ended at the interim date for the current and preceding years.
54
Can the reporting of seasonal fluctuations be smoothed in the interim financial reports?
No. These fluctuations cannot be smoothed in interim information.
55
When should the entity estimate the annual effective tax rate?
At the end of each interim period, the entity should estimate the annual effective tax rate.
56
What is the equation for calculating the interim period tax expense (benefit)?
Interim Period Tax Expense (Benefit) = [Estimated Annual Effective Tax Rate]*[Year-to-date Ordinary Income (Loss) Before Income Taxes] – Interim Tax Expense (Benefit) Recognized in Previous Interim Periods
57
For interim financial reporting, are unusual and infrequently occurring events or results of discontinued operations included in the "ordinary" year-to-date income (loss) used to calculate the interim period tax expense (benefit)?
No, they are not. "Ordinary" in this context means excluding unusual or infrequently occurring items and results of discontinued operations.
58
How is the estimated annual effective tax rate determined? (3 elements)
1) The estimated annual effective tax rate is based on the statutory rate adjusted for the current year’s expected conditions. These include (1) anticipated tax credits, (2) foreign tax rates, (3) capital gains rates, and (4) other tax planning alternatives.
2) The rate also includes the effect of any expected valuation allowance at year end for deferred tax assets related to deductible temporary differences and carryforwards arising during the year.
3) The rate is determined without regard to (1) significant unusual or infrequently occurring items to be reported separately or (2) items reported net of tax effect. However, such items are recognized in the interim period when they occur. The method of intraperiod tax allocation described in Study Unit 9, Subunit 5, is used.
59
In determining the estimated annual effective tax rate, which two items are excluded from the rate estimate?
The rate is determined without regard to (1) significant unusual or infrequently occurring items to be reported separately or (2) items reported net of tax effect. However, such items are recognized in the interim period when they occur.
60
When is a tax benefit recognized for interim periods?
A tax benefit is recognized for a loss early in the year if the benefits are expected to be realized during the year or recognizable as a deferred tax asset at year end.
61
What is a valuation allowance?
A valuation allowance is a reserve that is used to offset the amount of a deferred tax asset. The amount of the allowance is based on that portion of the tax asset for which it is more likely than not that a tax benefit will not be realized by the reporting entity.
62
When is a valuation allowance recognized?
A valuation allowance must be recognized if it is more likely than not that a deferred tax asset will not be fully realized. Accordingly, the tax benefit of an ordinary loss early in the year is not recognized to the extent that this criterion is met. However, no income tax expense is recognized for subsequent ordinary income until the earlier unrecognized tax benefit is used.
63
How do the principles for tax benefits in interim reporting, including the rules for valuation allowances, relate to determining the estimated tax benefit of an ordinary loss for the fiscal year?
The foregoing principles are applied in determining the estimated tax benefit of an ordinary loss for the fiscal year used to calculate (1) the annual effective tax rate and (2) the year-to-date tax benefit of a loss.
64
When is a change in accounting principle retrospectively applied?
In interim as well as annual periods, a change in accounting principle is retrospectively applied unless it is impracticable to determine the cumulative or period-specific effects of the change.
65
Under what circumstance would a change in accounting principle not be retrospectively applied?
It would not be retrospectively applied if it is impracticable to determine the cumulative or period-specific effects of the change in principle.
66
How is the cumulative effect of a change in accounting principle on prior periods reported in the interim financial reports?
The cumulative effect of the change on periods prior to those presented is reflected in the carrying amounts of assets, liabilities, and retained earnings at the beginning of the first period presented. All periods presented must be adjusted for period-specific effects.
67
For interim financial reporting, how is a change in accounting estimate accounted for?
A change in an accounting estimate, including a change in the estimated effective annual tax rate, is accounted for prospectively in the interim period in which the change is made and in future periods. Prior-period information is not retrospectively adjusted.
68
What rules apply for prior interim period adjustments to litigation, income taxes (except for the effects of retroactive tax legislation), or renegotiation proceedings? (2 elements)
1) All or part of the adjustment or settlement must relate specifically to a prior interim period of the current year. Moreover, its effect must be material, and the amount must have become reasonably estimable only in the current interim period.
2) If an item of profit or loss occurs in other than the first interim period and meets the criteria for an adjustment, the portion of the item allocable to the current interim period is included in net income for that period.
i) The financial statements for the prior interim periods are restated to include their allocable portions of the adjustment.
ii) The portion of the adjustment directly related to prior fiscal years is included in net income of the first interim period of the current fiscal year.
69
70
What is the valid justification for an entity to voluntarily change their accounting principles?
If financial information is to be comparable and consistent, entities must not make voluntary changes in accounting principles unless they can be justified as preferable.
71
How are accounting principles applied in preparing accounting statements? Hint: which enhancing qualitative characteristic should be maximized?
An adopted accounting principle must be applied consistently in preparing financial statements.
72
What are the three types of accounting changes?
1) A change in accounting principle,
2) A change in accounting estimate, and
3) A change in the reporting entity.
73
What are the two temporal modalities for applying accounting changes?
1) Retrospective
2) Prospective
74
What are three situations by which a change in accounting principle can occur?
A change in accounting principle occurs when an entity
(1) adopts a generally accepted principle different from the one previously used,
(2) changes the method of applying a generally accepted principle, or
(3) changes to a generally accepted principle when the principle previously used is no longer generally accepted.
75
How does initial adoption of a principle differ from a change in principle?
A change in principle does not include the initial adoption of a principle because of an event or transaction occurring for the first time.
76
What are direct effects from a change in accounting principle?
A direct effect of a change in accounting principle is a recognized change in an asset or liability that is required in order to effect the change in principle. An example of a direct effect is an adjustment of an inventory balance to implement a change in the method of measurement.
77
What are indirect effects of a change in accounting principle?
These are changes in current or future cash flows from a change in principle applied retrospectively. An example of an indirect effect is a required profit-sharing payment based on a reported amount that was directly affected (e.g., revenue).
-Indirect effects are recognized and reported in the period of change.
78
What is the difference between direct and indirect effects of a change in accounting principle.
The direct effects are the first order effects of the change in accounting principle - the accounting changes required to immediately implement the change in principle. Indirect effects are second order effects during the current or future periods as a result of an accounting change being applied retrospectively.
79
When are indirect effects recognized and reported?
Indirect effects are recognized and reported in the period of change.
80
Can a change in accounting principle (retrospective application) include indirect effects?
No. Retrospective application must not include indirect effects.
81
How a change in accounting principle implemented via retrospective application? (2 elements)
1) Retrospective application requires the carrying amounts of (1) assets, (2) liabilities, and (3) retained earnings at the beginning of the first period reported to be adjusted for the cumulative effect (CE) of the new principle on the prior periods.
2) All periods presented must be individually adjusted for the period-specific effects (PSE) of the new principle.
82
Which 3 accounting elements are adjusted for the cumulative effect of the new accounting principle on prior periods when there is retrospective application of a change in accounting principle?
Retrospective application requires the carrying amounts of
(1) assets,
(2) liabilities, and
(3) retained earnings at the beginning of the first period reported to be adjusted for the cumulative effect (CE) of the new principle on the prior periods.
83
Which periods presented are adjusted for the period-specific effects (PSE) of the new accounting principle resulting from a change in accounting principle?
All periods presented must be individually adjusted for the period-specific effects (PSE) of the new principle.
84
What happens if it is impracticable to determine the cumulative effect of a new accounting principle on any prior period for a change in accounting principle?
It may be impracticable to determine the CE of a new principle on any prior period. The new principle then must be applied as if the change had been made prospectively at the earliest date practicable.
85
What happens if it is practicable to determine the cumulative effect of applying the new principle to all prior periods but it is impracticable to determine the period-specific effects?
It may be practicable to determine the CE of applying the new principle to all prior periods but not the PSE. In these circumstances, CE adjustments must be made to the beginning balances for the first period to which the new principle can be applied.
86
What is shown on the Impracticability Exceptions flow chart?
87
CE practicable for all prior periods (YES/NO) => ?
CE practicable for all prior periods => ?
Yes => ASK: PSE practicable for all periods presented?
NO => Apply new principle as if the change had been made prospectively at the earliest practicable date.
88
PSE practicable for all periods presented (YES/NO) => ?
PSE practicable for all periods presented (YES/NO) => ?
YES => (1) apply cumulative effect of change in principle to beginning balances of the first period reported and (2) apply period-specific effects to all periods reported.
NO => apply cumulative effect of change in accounting principle to the earliest period to which the principle can be applied.
89
What is a change in accounting estimate?
A change in accounting estimate results from new information. It is a reassessment of the future status, benefits, and obligations of assets and liabilities. Its effects must be accounted for only in (1) the period of change and (2) any future periods affected (prospectively).
90
By what temporal modality is a change in accounting estimate applied?
Prospectively
91
How are the effects of a change in accounting estimate applied? (2 elements)
Its effects must be accounted for only in (1) the period of change and (2) any future periods affected (prospectively).
92
In what period does prospective application of a change in accounting estimate begin?
The prospective application must be applied from the beginning of the accounting period in which the accounting estimate was changed.
93
For a change in accounting estimate, what 2 restrictions exist?
For a change in estimate, the entity must not
1) Restate or retrospectively adjust prior-period statements or
2) Report pro forma amounts for prior periods.
94
What is the accounting treatment for a change in estimate inseparable from a change in principle?
A change in estimate inseparable from a change in principle is accounted for as a change in estimate, i.e., prospective application. An example is a change in a method of depreciation, amortization, or depletion of long-lived, nonfinancial assets.
95
What is a change in the reporting entity?
A change in the reporting entity results in statements that are effectively those of a different entity.
96
What are the main situations that cause a change in the reporting entity? (3 elements)
1) Consolidated or combined statements replace those of individual entities,
2) Consolidated statements include different subsidiaries, or
3) Combined statements include different entities.
97
Is a business combination or consolidation of a variable interest entity a change in the reporting entity?
No. A business combination or consolidation of a variable interest entity is not a change in the reporting entity.
98
What is the temporal modality for applying a change in the reporting entity?
A change in the reporting entity is retrospectively applied to interim and annual statements.
99
What are the three main causes of an error in a prior statement?
1) A mathematical mistake,
2) A mistake in the application of GAAP, or
3) An oversight or misuse of facts existing when the statements were prepared.
100
Is changing from a non-GAAP principle to a GAAP principle a change in principle or an error correction?
A change to a generally accepted accounting principle from one that is not generally accepted is an error correction, not an accounting change.
101
What is the temporal modality for applying an error correction?
Retrospective. Any error related to a prior period discovered after the statements are, or are available to be, used must be reported as an error correction by restating the prior-period statements. In addition to the revision of the previously issued financial statements, restatement requires the same adjustments as retrospective application of a new principle.
102
What is the procedure for applying an error correction? (4 elements)
1) Any error related to a prior period discovered after the statements are, or are available to be, used must be reported as an error correction by restating the prior-period statements.
2) In addition to the revision of the previously issued financial statements, restatement requires the same adjustments as retrospective application of a new principle.
3) The carrying amounts of (1) assets, (2) liabilities, and (3) retained earnings at the beginning of the first period reported are adjusted for the cumulative effect of the error on the prior periods.
4) Corrections of prior-period errors must not be included in current period net income.
103
Are corrections of prior period errors included in current period net income?
No. Corrections of prior-period errors must not be included in current period net income.
104
How does error correction compare to a change in accounting principle in terms of the temporal modality of application?
In addition to the revision of the previously issued financial statements, restatement requires the same adjustments as retrospective application of a new principle.
105
How are error corrections reported on single-period statements? How are they reported on comparative statements (statements with multiple periods)?
-Error corrections must be reported in single-period statements as adjustments of the opening balance of retained earnings.
-If comparative statements are presented, corresponding adjustments must be made to net income (and its components) and retained earnings (and other affected balances) for all periods reported.
106
What work is done by a correcting journal entry?
A correcting journal entry combines the reversal of the error with the correct entry.
107
What three objectives are achieved by a correcting journal entry?
Thus, it requires a determination of the
1) Journal entry originally recorded,
2) Event or transaction that occurred, and
3) Correct journal entry.
108
What four topics are addressed by error analysis?
1) Whether an error affects prior-period statements,
2) The timing of error detection,
3) Whether comparative statements are presented, and
4) Whether the error is counterbalancing.
109
How do errors affecting prior-period statements impact prior-period net income?
An error affecting prior-period statements may or may not affect prior-period net income. For example, misclassifying an item as a gain rather than a revenue does not affect income and is readily correctable. No prior-period adjustment to retained earnings is required.
110
What are counterbalancing errors?
An error that affects prior-period net income is counterbalancing if it self-corrects over two periods. Figures 6-2 and 6-3 in Study Unit 6, Subunit 7, illustrate self-correction of inventory errors. However, despite the self-correction, the financial statements remain misstated. They should be restated if presented comparatively in later periods.
111
What are noncounterbalancing errors?
An example of a noncounterbalancing error is a misstatement of depreciation. Such an error does not self-correct over two periods. Thus, a prior-period adjustment will be necessary.
112
What are three examples of changes in the reporting entity?
The following are changes in the reporting entity: (1) presenting consolidated or combined statements in place of statements of individual entities, (2) changing the specific subsidiaries included in the group for which consolidated statements are presented, and (3) changing the entities included in combined statements.
113
What are subsequent events?
Subsequent events are events or transactions that occur after the balance sheet date and prior to the issuance or availability for issuance of the financial statements.
114
What are the two types of entities and their respective dates through which they must evaluate subsequent events?
1) An SEC filer evaluates subsequent events through the date the statements are issued (become widely available for general use).
2) Other entities evaluate subsequent events through the date statements are available for issuance (are complete in accordance with GAAP and approved).
115
Must the entity disclose the date through which subsequent events have been evaluated?
Yes. The entity must disclose the date through which subsequent events have been evaluated.
116
What are the two types of subsequent events?
1) Recognized subsequent events
2) Unrecognized subsequent events
117
What are recognized subsequent events?
Recognized subsequent events provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in statement preparation.
118
Must recognized subsequent events be recognized (reported) in the financial statements?
Yes. This type of event must be recognized in the financial statements.
119
Which two situations ORDINARILY result in a recognized subsequent event?
Subsequent events
1) affecting the realization of assets (such as receivables and inventories) or
2) the settlement of estimated liabilities
ordinarily require recognition.
120
What is the typical timeframe for the preconditions for a recognized subsequent event?
They usually reflect the resolution of conditions that existed over a relatively long period.
121
Give three examples of recognized subsequent events.
1) The settlement of litigation for an amount differing from the liability recorded in the statements,
2) A loss on a receivable resulting from a customer’s bankruptcy, and
3) Changes in the data used in inventory valuation at the lower of cost or NRV.
122
Is EPS adjusted for subsequent recognition of stock dividends and stock splits that occurred after the balance sheet date but prior to the issuance of the financial statements?
Yes. Adjustments to earnings per share (EPS) are made as a result of stock dividends and stock splits that occurred after the balance sheet date but prior to the issuance of the financial statements (discussed in Study Unit 2, Subunit 2).
123
What are unrecognized subsequent events?
Unrecognized subsequent events provide evidence about conditions that did not exist at the date of the balance sheet. These events do not require recognition, but some of them do require disclosure.
124
What differs in treatment between recognized and unrecognized subsequent events?
Recognized subsequent events are always recognized in the financial statements, whereas unrecognized subsequent events are always unrecognized (but may or may not be disclosed in some manner).
125
What are seven examples of unrecognized subsequent events requiring disclosure only?
Examples of nonrecognized subsequent events requiring disclosure only include
1) Sale of a bond or capital stock issue
2) A business combination
3) Settlement of litigation when the event resulting in the claim occurred after the balance sheet date
4) Loss of plant or inventories as a result of a fire or natural disaster
5) Losses on receivables resulting from conditions (e.g., a customer’s major casualty) occurring after the balance sheet date
6) Classification of long-lived assets as held for sale
7) Extinguishment of debt after the balance sheet date
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What is done for the disclosure of certain highly significant unrecognized subsequent events?
Some events of the second type may be so significant that the most appropriate disclosure is to supplement the historical statements with pro forma financial data.
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What criteria are used to distinguish recognized from unrecognized subsequent events?
Certain subsequent events may provide additional evidence about conditions at the date of the balance sheet, including estimates inherent in the preparation of statements. These events require recognition in the statements at year end. Other subsequent events provide evidence about conditions not existing at the date of the balance sheet but arising subsequent to that date and before the issuance of the statements or their availability for issuance. These events may require disclosure but not recognition in the statements. Thus, the loss must not be recognized in Zero’s statements, but disclosure must be made.
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What are accounting policies?
Accounting policies are the specific principles and the methods of applying them used by the reporting entity. Management selects these policies as the most appropriate for fair presentation of financial statements.
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Who selects accounting policies? Why?
Management selects these policies as the most appropriate for fair presentation of financial statements.
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What are the accounting policy disclosure requirements for businesses and not-for-profit entities?
Business and not-for-profit entities must disclose all significant accounting policies as an integral part of the financial statements.
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Is disclosure of accounting policy required in interim financial statements?
Not unless there has been an accounting policy change in the interim period. Disclosure of accounting policies in unaudited interim financial statements is not required when the reporting entity has not changed its policies since the end of the preceding fiscal year.
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What is the title of the accounting policies disclosure section of the financial statements? Where is this disclosure located in the financial reporting?
The preferred presentation is a summary of accounting policies in a separate section preceding the notes or in the initial note.
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What kinds of details are about the accounting policies are provided in the summary of accounting principles?
The disclosure should include accounting principles adopted and the methods of applying them that materially affect the financial statements.
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Which three types of accounting policies relating to the unique accounting principles adopted by a particular entity have required disclosures?
Disclosure extends to accounting policies that involve
1) A selection from existing acceptable alternatives,
2) Policies unique to the industry in which the entity operates, even if they are predominantly followed in that industry, and
3) GAAP applied in an unusual or innovative way.
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Which disclosures about the accounting policies of business entities are commonly required? (6 elements)
1) Basis of consolidation
2) Depreciation methods
3) Amortization of intangibles
4) Inventory pricing
5) Recognition of revenue from contracts with customers
6) Recognition of revenue from leasing operations
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Should information unrelated to accounting policies that was presented elsewhere in the financial statements be included in the summary of accounting polices?
No. Disclosure of accounting policies should not duplicate details presented elsewhere. For example, the summary of significant policies should not contain the composition of plant assets or inventories or the maturity dates of noncurrent debt.
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What is credit risk?
Credit risk is the risk of accounting loss from a financial instrument because of the possible failure of another party to perform.
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Should an entity disclose its concentrations of credit risk?
With certain exceptions, for example, (1) instruments of pension plans, (2) certain insurance contracts, (3) warranty obligations and rights, and (4) unconditional purchase obligations, an entity must disclose significant concentrations of credit risk arising from financial instruments, whether from one counterparty or groups.
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What are concentrations of credit risk?
Credit risk is concentrated when an inordinate share of the entity's credit instruments are with one counterparty or a group of interconnected counterparties whose failure to perform their obligations would be mutually correlated.
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What are group concentrations of credit risk?
Group concentrations arise when multiple counterparties have similar activities and economic characteristics that cause their ability to meet obligations to be similarly affected by changes in conditions.
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What are the four exceptions to the general requirement of the entity to disclose its concentrations of credit risk?
(1) instruments of pension plans,
(2) certain insurance contracts,
(3) warranty obligations and rights, and
(4) unconditional purchase obligations
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What should be included in disclosures for concentrations of credit risk? (3 elements)
Disclosures (in the body of the statements or the notes) should include
1) Information about the shared activity, region, or economic characteristic that identifies the concentration.
2) The maximum loss due to credit risk if parties failed completely to perform and the security, if any, proved to be of no value.
3) The policy of requiring collateral or other security, information about access to that security, and the nature and a brief description of the security.
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Where should the disclosures for concentrations of credit risk be placed in the financial statements?
They should appear in the body of the financial statements or in the notes.
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What is market risk?
Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets.
-Market risk, or systematic risk, affects the performance of the entire market simultaneously.
-Market risk cannot be eliminated through diversification.
-Specific risk, or unsystematic risk, involves the performance of a particular security and can be mitigated through diversification.
-Market risk may arise due to changes to interest rates, exchange rates, geopolitical events, or recessions.
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Is the entity required to make disclosures about market risk?
No, but entities are encouraged to disclose quantitate information about their market risk management approach.
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What kind of disclosures about market risk are encouraged (not required)?
An entity is encouraged, but not required, to disclose quantitative information about the market risks of instruments that is consistent with the way the entity manages those risks.
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Who established the framework for fair value measurements (FVMs)?
GAAP establish a framework for fair value measurements (FVMs) required by other pronouncements.
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Does GAAP determine when fair value measurements are required?
No. They do not determine when FVMs are required
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What is fair value?
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
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What four objectives are achieved in GAAP's fair value measurement framework?
1) Define fair value,
2) Discuss valuation techniques,
3) Establish a fair value hierarchy of inputs to valuation techniques, and
4) Require expanded disclosures about FVMs.
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What is the scope of applicability for the FVM definition?
The FVM is for a particular asset or liability that may stand alone (e.g., a financial instrument) or constitute a group (e.g., a business). The definition also applies to instruments measured at fair value that are classified as equity.
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In the GAAP FVM, what is the exit price?
The price is an exit price paid or received in a hypothetical transaction considered from the perspective of a market participant.
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In the GAAP FVM framework, who are market participants? What 5 attributes do they have.
1) Market participants are not related parties.
2) They are independent of the reporting entity.
3) They are knowledgeable (i.e., they have a reasonable understanding based on all available information).
4) They are willing and able (but not compelled) to engage in transactions involving the asset or liability.
5) The FVM is market-based, not entity-specific.
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In the GAAP FVM, what are the 4 attributes of an orderly transaction?
1) An orderly transaction is not forced, and 2) time is assumed to be sufficient to allow for customary marketing activities.
3) The transaction is assumed to occur in the reporting entity’s principal market for the asset or liability.
4) In the absence of such a market, it is assumed to occur in the most advantageous market. This market is the one in which the specific reporting entity can
-Maximize the amount received for selling the asset or
-Minimize the amount paid for transferring the liability, after considering transaction costs.
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Does the FVM adjust for transaction costs?
No. Given a principal (or most advantageous) market, the FVM is the price in that market without adjustment for transaction costs.
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How does "principal market" status affect which price should be used under FVM?
Suppose there are two markets, a principal market and a lesser market that is not the principal market. If one of the two stock exchanges is a principal market, the quoted stock price on this stock exchange is the fair value.
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What is the advantageous market? When should its valuations be used under FVM?
Suppose the asset being valued trades in two markets. If neither of the two markets is a principal market, the most advantageous market is the market in which the entity using FVM can receive the maximum proceeds from selling the shares
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How does highest and best use relate to FVM? (3 elements)
1) The FVM is based on the highest and best use (HBU) by market participants.
2) The HBU is in-use if the value-maximizing use is in combination with other assets in a group. An example is machinery in a factory.
3) The HBU is in-exchange if the value-maximizing use is as a stand-alone asset. An example is a financial asset.
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How does the GAAP FVM treat liabilities?
The FVM assumes transfer, not settlement.
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What are the three valuation techniques used under the GAAP FVM?
The following valuation techniques (approaches) are used to measure fair value:
1) The market approach is based on information, such as multiples of prices, from market transactions involving identical or comparable items.
2) The income approach uses valuation methods based on current market expectations about future amounts, e.g., earnings or cash flows.
-It converts future amounts to one present discounted amount.
-Examples are present value methods and option-pricing models.
3) The cost approach is based on current replacement cost. It is the cost to buy or build a comparable asset.
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What are inputs to valuation techniques?
Inputs to valuation techniques are the pricing assumptions of market participants.
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What are the two types of inputs to valuation techniques for the GAAP FVM?
1) Observable inputs are based on market data obtained from independent sources.
2) Unobservable inputs are based on the entity’s own assumptions about the assumptions of market participants that reflect the best available information.
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What are observable inputs?
Observable inputs are based on market data obtained from independent sources.
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What are unobservable inputs?
Unobservable inputs are based on the entity’s own assumptions about the assumptions of market participants that reflect the best available information.
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What is the market approach?
The market approach is based on information, such as multiples of prices, from market transactions involving identical or comparable items.
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What is the income approach?
The income approach uses valuation methods based on current market expectations about future amounts, e.g., earnings or cash flows.
-It converts future amounts to one present discounted amount.
-Examples are present value methods and option-pricing models.
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What is the cost approach?
The cost approach is based on current replacement cost. It is the cost to buy or build a comparable asset.
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How should an entity prioritize its use of observable and unobservable inputs?
An entity should maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
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What are the three levels of the Fair Value Hierarchy for GAAP FVM?
1) Level 1 inputs are the most reliable. They are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.
EXAMPLE: If the entity has an investment in securities that are traded in an active market, the investment is measured within 2) Level 1. The FVM equals the quantity of securities held times the securities’ quoted price.
Level 2 inputs are observable. But they exclude quoted prices included within Level 1. The following are examples:
Quoted prices for similar items in active markets,
Quoted prices in markets that are not active, and
Observable inputs that are not quoted prices.
3) Level 3 inputs are the least reliable. They are unobservable inputs that are used given no observable inputs. They should be based on the best available information in the circumstances. An example of a Level 3 input is the reporting entity’s own data (e.g., present value of future cash flows).
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What are Level 1 inputs to the Fair Value Hierarchy?
1) Level 1 inputs are the most reliable. They are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.
EXAMPLE: If the entity has an investment in securities that are traded in an active market, the investment is measured within Level 1. The FVM equals the quantity of securities held times the securities’ quoted price.
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What are Level 1 inputs to the fair value hierarchy?
Level 1 inputs are the most reliable. They are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.
EXAMPLE: If the entity has an investment in securities that are traded in an active market, the investment is measured within Level 1. The FVM equals the quantity of securities held times the securities’ quoted price.
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What are level 2 inputs to the fair value hierarchy?
Level 2 inputs are observable. But they exclude quoted prices included within Level 1. The following are examples:
Quoted prices for similar items in active markets,
Quoted prices in markets that are not active, and
Observable inputs that are not quoted prices.
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What are level 3 inputs to the fair value hierarchy?
Level 3 inputs are the least reliable. They are unobservable inputs that are used given no observable inputs. They should be based on the best available information in the circumstances. An example of a Level 3 input is the reporting entity’s own data (e.g., present value of future cash flows).
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What disclosures are made for fair value? How are they made?
Quantitative disclosures in a tabular format are made for each class of assets and liabilities measured at fair value in the balance sheet after initial recognition.
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What are the four main examples of quantitative fair value disclosures made in tabular format?
1) Fair value measurement at the end of the reporting period
2) The level of the fair value hierarchy within which the fair value measurements are categorized (Level 1, 2, or 3)
3) A description of the valuation technique(s) and the inputs used in the fair value measurements categorized within Level 2 and Level 3
4) Quantitative information about the significant unobservable inputs used in the fair value measurements categorized within Level 3
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What is the gross profit method for estimating inventory value?
The gross profit (or gross margin) method uses the previous year's average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory. Keep in mind the gross profit method assumes that gross profit ratio remains stable during the period.
How to Use the Gross Profit Method
Follow these steps to estimate ending inventory using the gross profit method:
Add together the cost of beginning inventory and the cost of purchases during the period to arrive at the cost of goods available for sale.
Multiply (1 - expected gross profit %) by sales during the period to arrive at the estimated cost of goods sold.
Subtract the estimated cost of goods sold (step #2) from the cost of goods available for sale (step #1) to arrive at the ending inventory.
In addition, it is useful to compare the resulting cost of goods sold as a percentage of sales to the recent trend line for the same percentage, to see if the outcome is reasonable.
Example of the Gross Profit Method
Amalgamated Scientific Corporation (ASC) is calculating its month-end inventory for March. Its beginning inventory was $175,000 and its purchases during the month were $225,000. Thus, its cost of goods available for sale are:
$175,000 beginning inventory + $225,000 purchases = $400,000 cost of goods available for sale
ASC's gross margin percentage for all of the past 12 months was 35%, which is considered a reliable long-term margin. Its sales during March were $500,000. Thus, its estimated cost of goods sold is:
(1 - 35%) x $500,000 = $325,000 cost of goods sold
By subtracting the estimated cost of goods sold from the cost of goods available for sale, ASC arrives at an estimated ending inventory balance of $75,000.
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