FAR SEC 4 Flashcards
What is the threshold for reporting sales to a single external customer?
Reporting of sales to a single external company is required if the amount of sales is 10% or more of total revenue.
What is the threshold for reporting sales to foreign countries?
No percentage threshold is established for practicable disclosures of geographic information.
1) An entity must disclose revenues attributable to all foreign countries in total.
2) Separate disclosure of revenues from external customers attributed to a single foreign country is also required if those revenues are material. These disclosures are intended to provide information about reliance on particular markets or customers.
Does GAAP require a particular format and location in the financial statements fort the disclosure of a summary of accounting policies?
No. GAAP express a preference for, but do not require, including a summary of accounting policies in a separate section preceding the notes or in the initial note.
How should accounting policies be reported in the financial statements.
A summary of accounting policies preferably SHOULD be included in a separate section preceding the notes or in the initial note.
HOWEVER, GAPP does not require any disclosure of significant accounting policies!
What is the difference between disclosure and recognition?
A disclosure is additional information attached to an entity’s financial statements, usually as explanation for activities which have significantly influenced the entity’s financial results.
Recognition is the recordation of a business transaction in an entity’s accounting records. For example, a loss can be recognized on a lower of cost or market analysis, thereby recording the loss in the accounting records. Or, a sale transaction is recognized by recording revenue in the accounting records.
Disclosure of an event can be accomplished by mentioning an event in the notes without giving quantitative details, whereas recognition requires adjustment to the relevant financial statement line items.
When does an entity recognize adjusting events?
An entity recognizes in the financial statements adjusting events after the reporting period.
What are adjusting events?
Adjusting events are events occurring after the reporting date that provide evidence of conditions that existed at the end of the reporting period. Non-adjusting events are events occurring after the reporting date that do NOT provide evidence of conditions that existed at the end of the reporting period.
Where in its financial statements should a company disclose information about its concentration of credit risks?
The notes to the financial statements.
How is fair market valuation of an asset using prices in the most advantageous market done?
If there is a principle market for the asset, the price in the principle market is used without adjustment for transaction costs. If the asset trades in multiple markets, the most advantageous market is used, i.e., the market with the maximum price without adjusting for transaction costs.
What is credit risk from an accounting standpoint?
Credit risk is the risk of accounting loss from a financial instrument because of the possible failure of another party to perform. An entity must disclose most significant concentrations of credit risk arising from instruments. Group concentrations arise when multiple counterparties have similar characteristics that cause their ability to meet obligations to be similarly affected by change in conditions. An example of such a group is an industry.
For reporting purposes, 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. Certain subsequent events or transactions provide evidence about conditions at the date of the balance sheet, including the estimates inherent in statement preparation. Other subsequent events or transactions provide evidence about conditions that did not exist at the date of the balance sheet.
What is segment reporting?
Segment reporting includes interim financial reports and annual financial statements of public business entities. The objective is to provide information about the different business activities of the entity and the economic environments in which it operates.
When should information be reported for segment reporting?
Ordinarily, information is to be reported on the basis that is used internally for evaluating performance and making resource allocation decisions. This approach aligns external and internal reporting.
Disclosure of information is not required if it is not prepared for internal use, and reporting it would not be feasible.
What are three characteristics of an operating segment?
An operating segment has three characteristics:
1) It is a business component of the entity that may recognize revenues and incur expenses.
2) Its operating results are regularly reviewed by the entity’s chief operating decision maker (CODM) for the purpose of resource allocation and performance assessment.
3) Its discrete financial information is available.
What are the necessary and sufficient conditions for aggregating operating segments?
Operating segments may be aggregated if
1) Doing so is consistent with the objective;
2) They have similar economic characteristics; and
3) They have similar products and services, production processes, classes of customers, distribution methods, and regulatory environments.
Full Disclosure Principle
According to the full disclosure principle, understandable information capable of affecting user decisions should be reported. The financial statements are the primary means of disclosure. However, almost all accounting pronouncements require additional disclosures in the notes. Because memorizing them is virtually impossible, candidates should anticipate the disclosure requirements before reading the summary, outline, or actual pronouncement. The appropriate perspective is that of an informed creditor or investor.
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.
Must businesses and not-for-profit entities disclose all significant accounting policies?
Yes. Business and not-for-profit entities must disclose all significant accounting policies as an integral part of the financial statements.
Is disclosure of accounting policies required in the unaudited interim financial statements?
It depends. 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. [NOTE: textbook is unclear on this point, but it seems obvious from what is said that reporting a change in significant accounting principle that has occurred after the end of the preceding fiscal year would be required.]
What is the preferred presentation (disclosure method) for significant accounting policies?
The preferred presentation is a summary of accounting policies in a separate section preceding the notes or in the initial note.
What are the two main elements that must be disclosed about the significant accounting policies?
The disclosure should include accounting (1) principles adopted and (2) the methods of applying them that materially affect the financial statements.
Disclosure of accounting policies extends to which three broad types of accounting policies?
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.
What are 6 specific types of accounting policies are commonly required to have disclosure?
Certain disclosures about policies of business entities are commonly required. These items include the following:
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
Should disclosure of accounting polices avoid duplicating details presented elsewhere?
Yes. 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.
What is segment reporting?
Segment reporting includes interim financial reports and annual financial statements of public business entities.
What is the objective of segment reporting?
The objective of segment reporting is to provide information about the different business activities of the entity and the economic environments in which it operates.
What is the basis for determining what kind of information is included in segment reporting disclosures?
Ordinarily, information is to be reported on the basis that is used internally for evaluating performance and making resource allocation decisions. This approach aligns external and internal reporting.
For segment reporting, when is disclosure of information not required?
Disclosure of information is not required if it is not prepared for internal use, and reporting it would not be feasible.
What are the 3 characteristics of an operating segment?
1) It is a business component of the entity that may recognize revenues and incur expenses.
2) Its operating results are regularly reviewed by the entity’s chief operating decision maker (CODM) for the purpose of resource allocation and performance assessment.
3) Its discrete financial information is available.
What are the 3 necessary and sufficient conditions for aggregating operating segments?
Operating segments may be aggregated if
1) Doing so is consistent with the objective;
2) They have similar economic characteristics; and
3) They have similar products and services, production processes, classes of customers, distribution methods, and regulatory environments.
What are the three individually sufficient conditions (one only need apply) for reportable segments?
Reportable segments are operating segments that must be separately disclosed if one of the following quantitative thresholds is met:
1) Revenue test. Reported revenue, including sales to external customers and intersegment sales or transfers, is at least 10% of the combined revenue (external and internal) of all operating segments.
2) Asset test. Assets are at least 10% of the combined assets of all operating segments.
3) Profit (loss) test. The absolute amount of reported profit or loss is at least 10% of the greater, in absolute amount, of either the combined reported profit of all operating segments that did not report a loss or the combined reported loss of all operating segments that did report a loss.
What is the revenue test for reportable segments?
Revenue test. Reported revenue, including sales to external customers and intersegment sales or transfers, is at least 10% of the combined revenue (external and internal) of all operating segments.
This is 1 of 3 necessary & sufficient conditions for segment reportability.
What is the asset test for reportable segments?
Asset test. Assets are at least 10% of the combined assets of all operating segments.
This is 1 of 3 necessary & sufficient conditions for segment reportability.
What is the profit (loss) test for reportable segments.
Profit (loss) test. The absolute amount of reported profit or loss is at least 10% of the greater, in absolute amount, of either the combined reported profit of all operating segments that did not report a loss or the combined reported loss of all operating segments that did report a loss.
This is 1 of 3 necessary & sufficient conditions for segment reportability.
What is the value of the percentage threshold used for each of the 3 tests for segment reportability?
(greater than or equal to) 10% of revenue, assets, or absolute profit(loss)
What are the 3 exceptions to the 3 segment reportability tests?
1) If an operating segment does not meet any threshold, management still may report it if such information would be useful.
2) If the total external revenue of the operating segments meeting the quantitative thresholds is less than 75% of consolidated revenue, additional operating segments are identified as reportable until the 75% level is reached.
3) As the number of reportable segments increases above 10, the entity may decide that it has reached a practical limit.
What can happen if an operating segment doesn’t meet any threshold?
If an operating segment does not meet any threshold, management still may report it if such information would be useful.
What procedure is followed if the total external revenue of the operating segments meeting the quantitative thresholds is less than 75% of consolidated revenue?
If the total external revenue of the operating segments meeting the quantitative thresholds is less than 75% of consolidated revenue, additional operating segments are identified as reportable until the 75% level is reached.
What is the “all other” segment category?
Information about nonreportable activities and segments is combined and disclosed in an all other category as a reconciling item.
What option does the entity have when the number of reportable segments exceeds 10?
As the number of reportable segments increases above 10, the entity may decide that it has reached a practical limit.
Operating segments may be aggregated if ______________ (3 elements).
1) Doing so is consistent with the objective;
2) They have similar economic characteristics; and
3) They have similar products and services, production processes, classes of customers, distribution methods, and regulatory environments.
What general information is disclosed for each reportable segment (2 elements)?
General information disclosed includes
1) The factors used to identify reportable segments, such as the basis of organization, and
2) Revenue-generating products and services.
What measure of profit or loss and total assets is reported for each reportable segment (8 elements)?
A measure of profit or loss and total assets should be reported. Moreover, the following amounts should be disclosed if they are included in the measure of profit or loss reviewed by the CODM:
1) Revenues from external customers and other operating segments,
2) Interest revenue and expense,
3) Depreciation,
4) Depletion and amortization,
5) Unusual items,
6) Equity in the net income of equity-based investees,
7) Income tax expense or benefit, and
8) Other significant noncash items.
What are the two major categories of disclosures for each reportable segment?
1) General information
2) A measure of profit or loss and total assets
What is the CODM?
Chief operating decision maker (CODM)
How is external information reported measured for reportable segments?
The external information reported is measured in the same way as the internal information used for resource allocation and performance evaluation. The amount of a reported segment item, such as assets, is the measure reported to the CODM.
What reconciliations are reported for reportable segments?
Reconciliations to the consolidated amounts must be provided for the total reportable segments’ amounts for significant items of information disclosed. These significant items include (1) revenues, (2) profit or loss, (3) total assets, etc.
What restatements may occur for reportable segments (2 elements)?
1) Restatement of previously reported information is required if changes in internal organization cause the composition of reportable segments to change.
2) The entity may choose not to restate segment information for earlier periods, including interim periods. Segment information for the year of the change then must be disclosed under the old basis and the new basis of segmentation if feasible.
For reportable segments, when is restatement of previously reported information required?
Restatement of previously reported information is required if changes in internal organization cause the composition of reportable segments to change.
If a reportable segment must restate previously reported information, what is the alternative to restating segment information for earlier periods?
The entity may choose not to restate segment information for earlier periods, including interim periods. Segment information for the year of the change then must be disclosed under the old basis and the new basis of segmentation if feasible.
When must entity-wide disclosures be provided?
Such disclosures must be provided only if they are not given in the reportable operating segment information.
What are the 4 entity-wide disclosures?
1) Such disclosures must be provided only if they are not given in the reportable operating segment information.
2) Revenues from external customers for each product and service (or each group of similar products and services) are reported if feasible based on the financial information used to produce the general-purpose financial statements.
3) The following information about geographic areas is also reported if feasible:
-External revenues attributed to the home country and to all foreign countries,
-Material external revenues attributed to an individual foreign country,
-The basis for attributing revenues from external customers, and
-Certain information about assets.
4) If 10% or more of revenue is derived from sales to any single customer, (1) that fact, (2) the amount from each such customer, and (3) the segment(s) reporting the revenues must be disclosed. Single customers include entities under common control and each federal, state, local, or foreign government.
In entity-wide disclosures, The following information about geographic areas is also reported if feasible (4 elements).
1) External revenues attributed to the home country and to all foreign countries,
2) Material external revenues attributed to an individual foreign country,
3) The basis for attributing revenues from external customers, and
4) Certain information about assets.
In entity-wide disclosures, how are revenues from external customers reported?
Revenues from external customers for each product and service (or each group of similar products and services) are reported if feasible based on the financial information used to produce the general-purpose financial statements.
What are the single customer thresholds and reporting requirements for entity-wide disclosures (3 elements)?
If 10% or more of revenue is derived from sales to any single customer, (1) that fact, (2) the amount from each such customer, and (3) the segment(s) reporting the revenues must be disclosed. Single customers include entities under common control and each federal, state, local, or foreign government.
What is the best qualitative characteristic of interim financial reports (or other interim information)?
For many reasons, the usefulness of interim financial information is limited. Thus, their best qualitative characteristic is timeliness.
Does GAAP require reporting of interim financial information?
No. But GAAP must be applied when entities report such information, including when publicly traded companies issue summarized interim information. Moreover, federal securities law requires certain entities that meet the definition of an issuer to report interim quarterly information on Form 10-Q.
Is GAAP required for the interim financial reports?
Yes, always. Although interim financial reporting is optional for some entities, entities electing to file interim reports must follow GAAP in the report preparation.
Each interim period is treated primarily as an integral part of _____________.
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___________.
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.
For preparing interim financial statements, can the entity use different principles from those ordinarily used?
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.
How should revenue be recognized during an interim period?
Revenue should be recognized as earned during an interim period on the same basis as followed for the full year.
How are those costs associated with revenue treated for interim reports?
Costs associated with revenue are treated similarly for annual and interim reporting. But there are two significant exceptions for inventory accounting at inventory dates.
What are the two special cases of costs associated with revenue for interim dates?
Both cases pertain to inventory.
1) 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 7, Subunit 7).
2) An inventory loss from a write-down below cost may be deferred if no loss is reasonably anticipated for the year.
-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 7, Subunit 6, contains the relevant outlines.)
Why is the gross profit method allowable for estimating COGS and inventory at interim dates?
Because a physical count at the interim date may not be feasible.
At interim dates, is it allowable to recognize an inventory loss write-down below cost?
An inventory loss from a write-down below cost may be deferred if no loss is reasonably anticipated for the year. That is, if the loss at the interim date is expected to be temporary, recognition can be deferred until year-end, giving the loss a chance to reverse.
What is the treatment of nontemporary losses at interim dates?
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 7, Subunit 6, contains the relevant outlines.)
How are costs and expenses other than product costs treated at interim periods?
Costs and expenses other than product costs are either charged to income in interim periods as incurred or allocated among interim periods.
What are the 3 elements of the basis for interim period cost allocation?
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.
What are the 6 rules for interim cost allocation?
1) GAINS & LOSSES. 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.
2) ANNUAL V. INTERIM PERIOD. Some items expensed in annual statements should be allocated to the interim periods that are clearly benefited.
3) QUANTITY DISCOUNTS. Quantity discounts based on annual sales volume should be charged to interim periods based on periodic sales.
4) INTEREST, RENT, & PROPERTY TAXES. Interest, rent, and property taxes may be accrued or deferred at interim dates to assign an appropriate cost to each period.
5) ADVERTISING COSTS. Advertising costs may be deferred within a fiscal year if the benefits clearly extend beyond the interim period of the expenditure.
6) YEAR-END ADJUSTMENT. Certain costs and expenses, such as (a) inventory shrinkage, (b) allowance for credit losses, and (c) discretionary bonuses, are subject to year-end adjustment. To the extent possible, these adjustments should be estimated and assigned to interim periods.
How are gains and losses treated by interim period cost allocation?
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.
How do items expensed in the annual statements potentially relate to interim period cost allocation?
Some items expensed in annual statements should be allocated to the interim periods that are clearly benefited.
How are quantity discounts treated by interim period cost allocation?
Quantity discounts based on annual sales volume should be charged to interim periods based on periodic sales.
How are interest, rent, and property taxes treated by interim period cost allocation?
Interest, rent, and property taxes may be accrued or deferred at interim dates to assign an appropriate cost to each period.
What is the basis for quantity discounts under interim period cost allocation?
The basis is periodic sales (or sales occurring during the period).
How are advertising costs treated by interim period cost allocation?
Advertising costs may be deferred within a fiscal year if the benefits clearly extend beyond the interim period of the expenditure.
What is year-end adjustment with respect to interim period cost allocation?
Certain costs and expenses, such as (a) inventory shrinkage, (b) allowance for credit losses, and (c) discretionary bonuses, are subject to year-end adjustment. To the extent possible, these adjustments should be estimated and assigned to interim periods.
Which 3 cost categories are subject to year-end adjustment under interim period cost allocation?
(1) inventory shrinkage, (2) allowance for credit losses, and (3) discretionary bonuses
How is seasonality addressed in interim period reporting requirements?
1) If interim information is issued, certain disclosures are mandatory for businesses that have material seasonal fluctuations. These fluctuations cannot be smoothed in interim information.
2) 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.
How does the estimated annual effective tax rate relate to interim period tax expense (benefit)?
At the end of each interim period, the entity should estimate the annual effective tax rate.
Formula for Interim period tax expense (benefit)
Interim period tax expense (benefit) equals the estimated annual effective tax rate, times year-to-date ordinary income (loss) before income taxes, minus the tax expense (benefit) recognized in previous interim periods.
NOTE: Ordinary in this context means excluding unusual or infrequently occurring items and results of discontinued operations.
What are the 6 elements of determining the estimated annual effective tax rate for interim period tax reporting?
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.
5) 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.
6) The rate is determined without regard to (a) significant unusual or infrequently occurring items to be reported separately or (b) 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 10, Subunit 6, is used.
Under what conditions is a tax benefit recognized for interim period tax reporting?
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.
What are the 2 rules for recognizing a tax benefit for interim period tax reporting?
BACKGROUND. 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.
1) 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.
2) The foregoing principles are applied in determining the estimated tax benefit of an ordinary loss for the fiscal year used to calculate (a) the annual effective tax rate and (b) the year-to-date tax benefit of a loss.
For interim period tax expense (benefit) reporting, how are taxes on items other than continuing operations reported?
Taxes on all items other than continuing operations are determined at incremental rates. Thus, their marginal effect on taxes is calculated.
What are the 3 elements of interim period accounting changes reporting (2 elements)?
1) 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.
2) The cumulative effect of the change on periods prior to those presented is reflected in the carrying amounts of assets, liabilities, and retained earnings (or other appropriate components of equity or net assets) at the beginning of the first period presented.
All periods presented must be adjusted for period-specific effects.
3) 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.
How are interim period changes in accounting principle treated?
1) RETROSPECTIVE. 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.
2) CE & PSE. The cumulative effect of the change on periods prior to those presented is reflected in the carrying amounts of assets, liabilities, and retained earnings (or other appropriate components of equity or net assets) at the beginning of the first period presented.
-All periods presented must be adjusted for period-specific effects.
How are interim period changes in accounting estimate treated?
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.
What are the 2 rules for prior interim period adjustments?
BACKGROUND. The following items apply to adjustment or settlement of (1) litigation, (2) income taxes (except for the effects of retroactive tax legislation), or (3) renegotiation proceedings.
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.
-The financial statements for the prior interim periods are restated to include their allocable portions of the adjustment.
-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.
What are 2 requirements for an adjustment of prior period interim settlement as per interim period reporting?
1) All or part of the adjustment or settlement must relate specifically to a prior interim period of the current year.
2) Moreover, its effect must be material, and the amount must have become reasonably estimable only in the current interim period.
If an item of profit or loss occurs in other than the first interim period and meets the criteria for an adjustment, how is the adjustment allocated across the current and previous interim periods? (3 Elements)
1) The portion of the item allocable to the current interim period is included in net income for that period.
2) The financial statements for the prior interim periods are restated to include their allocable portions of the adjustment.
3)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.
When should disclosures be made about certain items that could significantly affect reported amounts?
These disclosures should be made at the balance sheet date if the items could significantly affect amounts within a period of 1 year.
When should disclosures be made in the notes of the annual and interim financial statements? (2 elements)
Disclosures should be made in the notes of annual and interim financial statements when substantial doubt…
1) Substantial doubt exists about an entity’s ability to continue as a going concern or
2) Substantial doubt was alleviated as a result of management’s plans.
What 2 sets of disclosures for risks and uncertainties are required? (3 elements per set for 6 total elements)
Set 1. One set of disclosures applies to risks and uncertainties relating to the nature of operations. Thus, entities must disclose their
1) Major products or services,
2) Principal markets, and
3) The locations of those markets.
Set 2. They also should disclose (1) all industries in which they operate; (2) the relative importance of each; and (3) the basis for determining the relative importance, e.g., assets, revenue, or earnings. However, this set of disclosures need not be quantified.
Which two elements are required in the disclosure required for the use of estimates? (2 elements)
1) A second type of disclosures concerns the use of estimates in the preparation of financial statements. Financial statements should explain that conformity with GAAP requires management to use numerous estimates.
2) Disclosure about certain significant estimates used to value assets, liabilities, or contingencies is required when the estimated effects of a condition, situation, or set of circumstances at the balance sheet date are subject to a reasonable possibility of change in the near term and the effects will be material.
When is a set of disclosures required due to concentrations?
A third set of disclosures relates to current vulnerability due to concentrations, for example, when entities fail to diversify.
What are the 3 criteria for concentration disclosures to be required?
Disclosure is necessary if management knows prior to issuance of the statements that
1) The concentration exists at the balance sheet date,
2) It makes the entity vulnerable to a near-term severe impact, and
3) Such impact is at least reasonably possible in the near term.
What are the 4 disclosable concentrations?
Disclosable concentrations include those in
1) The volume of business with a given customer, supplier, lender, grantor, or contributor;
2) Revenue from given products, services, or fund-raising events;
3) The available suppliers of materials, labor, services, or rights (e.g., licenses) used in operations; and
4) The market or geographic area where the entity operates.
-For concentrations of operations in another country, disclosure should include the carrying amounts of net assets and the areas where they are located.
What are the 3 sets of disclosures for uncertainties and risks?
1) One set of disclosures applies to risks and uncertainties relating to the nature of operations.
2) A second type of disclosures concerns the use of estimates in the preparation of financial statements. Financial statements should explain that conformity with GAAP requires management to use numerous estimates.
3) A third set of disclosures relates to current vulnerability due to concentrations, for example, when entities fail to diversify.
What are subsequent events? (give time period)
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.
When does an SEC filer evaluate subsequent events?
An SEC filer evaluates subsequent events through the date the statements are issued (become widely available for general use).
When do entities other than SEC filers evaluate subsequent events?
Other entities evaluate subsequent events through the date statements are available for issuance (are complete in accordance with GAAP and approved).
-The entity must disclose the date through which subsequent events have been evaluated.
What are the two types of subsequent events?
1) Recognized Subsequent Events. This type of subsequent event provides additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in statement preparation.
2) Unrecognized Subsequent Events. This second type of subsequent event provides 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.
What are recognized subsequent events?
This type of subsequent event provides additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in statement preparation.
What are unrecognized subsequent events?
This type of subsequent event provides 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.
Must recognized subsequent events be recognized in the financial statements?
Yes.
Which two types of subsequent events ordinarily require recognition and are therefore recognized subsequent events?
Subsequent events affecting the realization of assets (such as receivables and inventories) or the settlement of estimated liabilities ordinarily require recognition.
-They usually reflect the resolution of conditions that existed over a relatively long period. Examples are
-The settlement of litigation for an amount differing from the liability recorded in the statements and
A loss on a receivable resulting from a customer’s bankruptcy.
What are two common examples of recognized subsequent events involving assets or estimated liabilities?
1) The settlement of litigation for an amount differing from the liability recorded in the statements and
2) A loss on a receivable resulting from a customer’s bankruptcy.
Are adjustments to EPS recognized subsequent events? If so, when do they occur?
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 (or availability for issuance) of the financial statements (discussed in Study Unit 3, Subunit 2).
What are 5 examples of unrecognized subsequent events requiring disclosure?
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
How does pro forma financial data relate to 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.
What is the difference between recognition and disclosure?
In accounting recognition is the act of including a transaction of a financial statement. Recognition is the recordation of a business transaction in an entity’s accounting records. For example, a loss can be recognized on a lower of cost or market analysis, thereby recording the loss in the accounting records. Or, a sale transaction is recognized by recording revenue in the accounting records.
A disclosure is additional information attached to an entity’s financial statements, usually as explanation for activities which have significantly influenced the entity’s financial results.
Disclosure, in financial terms, basically refers to the action of making all relevant information about a business available to the public in a timely manner.
Disclosure, in financial terms, basically refers to the action of making all relevant information about a business available to the public in a timely fashion.
Relevant information about a business refers to any and every piece of information, including facts, figures, dates, procedures, innovations, and so on, that can potentially influence an investor’s decision.
The disclosure requirements are strictly regulated by the Securities and Exchange regulation bodies of each country for all businesses listed on the respective national stock exchanges.
Should historical cost be used as the basis for valuation of financial instruments?
No. Historical cost is an appropriate measurement attribute for property, plant, and equipment. An entity often holds these assets for years. Historical cost is not appropriate for financial instruments, which often are current assets. The FASB therefore requires all entities either to report on the face of the balance sheet or disclose in the notes the fair values of all financial instruments. Current GAAP are found in FASB ASC 825.
Is fair value the correct basis for valuation of financial instruments?
Historical cost is not appropriate for financial instruments, which often are current assets. The FASB therefore requires all entities either to report on the face of the balance sheet or disclose in the notes the fair values of all financial instruments. Current GAAP are found in FASB ASC 825.
What are the two elements of the definition of a financial instrument?
A financial instrument is cash, evidence of an ownership interest in an entity, or a contract that both
1) Imposes on one entity a contractual obligation to
-Deliver cash or another financial instrument to a second entity or
-Exchange other financial instruments on potentially unfavorable terms with the second entity and
2) Conveys to that second entity a contractual right to
-Receive cash or another financial instrument from the first entity or
-Exchange other financial instruments on potentially favorable terms with the first entity.
What are three necessary conditions for the substance of a financial instrument? (3 elements)
A financial instrument is (1) cash, (2) evidence of an ownership interest in an entity, or (3) a contract
What contractual obligations are imposed by a financial instrument? (2 elements)
Imposes on one entity a contractual obligation to
1) Deliver cash or another financial instrument to a second entity or
2) Exchange other financial instruments on potentially unfavorable terms with the second entity
What contractual rights are conveyed by a financial instrument? (2 elements)
Conveys to that second entity a contractual right to
1) Receive cash or another financial instrument from the first entity or
2) Exchange other financial instruments on potentially favorable terms with the first entity.
What are the two modes of financial statements presentation for financial instruments?
On the balance sheet or in the notes to the financial statements, financial assets and financial liabilities are separately presented by
1) Measurement category (i.e., amortized cost, fair value through net income, and fair value through OCI) and
2) Form of financial asset (i.e., loans, securities, and receivables).
Which two disclosures are required for financial instruments?
Public business entities must disclose, either in the body of the financial statements or in the notes, the
1) Fair value of financial instruments, regardless of whether they are recognized (e.g., financial instruments measured at amortized cost) or not recognized in the balance sheet (e.g., unrecognized firm commitments), and
2) Level of the fair value hierarchy (Level 1, 2, or 3) in which the fair value measurements of the financial instruments are categorized.
What is the fair value hierarchy?
Level of the fair value hierarchy (Level 1, 2, or 3) in which the fair value measurements of the financial instruments are categorized.
Is fair value disclosure required for all financial instruments?
No. Fair value disclosure is not required for certain financial instruments, such as trade receivables and payables due in 1 year or less and investments accounted for under the equity method.
Should disclosures net the fair values of financial instruments?
No. Ordinarily, disclosures should not net the fair values of instruments even if they are of the same class or are related, e.g., by a risk management strategy.
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.
Must an entity report significant concentrations of credit risk? (4 elements)
It depends. 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.
What are the group concentrations of 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. Unless an exception applies, group concentrations of credit risk must be disclosed.
Which disclosures apply if a significant concentration of credit risk must be disclosed? (4 elements)
Disclosures (in the body of the statements or the notes) should include:
I1) 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.
4) The policy of entering into master netting arrangements to mitigate the credit risk; information about them; and a description of the terms, including the extent to which they reduce the maximum amount of loss.
Is disclosure of market risk required?
No. 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.
Does GAAP determine when fair value measurements are required?
No. “Other pronouncements” than GAAP tell when fair value measurement is required. GAAP does define a framework for fair value measurements.
What are the four elements of the GAAP fair value measurement framework?
1) Defines fair value,
2) Discusses valuation techniques,
3) Establishes a fair value hierarchy of inputs to valuation techniques, and
4) Requires expanded disclosures about FVMs.
What is the GAAP definition of 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.
What is Fair Value Measurement (FVM) according to GAAP?
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.
What is the definition of fair value price?
The price is an exit price paid or received in a hypothetical transaction considered from the perspective of a market participant.
For FVM, what are market participants?
Market participants are not related parties. They are independent of the reporting entity.
What are three attributes of market participants under FVM?
1) They are knowledgeable (i.e., they have a reasonable understanding based on all available information).
2) They are willing and able (but not compelled) to engage in transactions involving the asset or liability.
3) The FVM is market-based, not entity-specific.
For FVM, what is an orderly transaction?
An orderly transaction is not forced, and time is assumed to be sufficient to allow for customary marketing activities.
What are four elements of an orderly transaction?
1) An orderly transaction is not forced, and time is assumed to be sufficient to allow for customary marketing activities.
2) The transaction is assumed to occur in the reporting entity’s principal market for the asset or liability.
3) 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.
4) Given a principal (or most advantageous) market, the FVM is the price in that market without adjustment for transaction costs.
For FVM, what are assets?
Assets. The FVM is based on the highest and best use (HBU) by market participants.
-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.
-The HBU is in-exchange if the value-maximizing use is as a stand-alone asset. An example is a financial asset.
What are two attributes of the Highest and Best Use (HBU)?
1) 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.
2) The HBU is in-exchange if the value-maximizing use is as a stand-alone asset. An example is a financial asset.
For FVM, what are the 3 valuation techniques?
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.
What are inputs to the valuation techniques of FVM? (2 elements)
Inputs to valuation techniques are the pricing assumptions of market participants.
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.
-An entity should maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
What are observable inputs? (valuation under FVM)
Observable inputs are based on market data obtained from independent sources.
What are unobservable inputs? (valuation under FVM)
Unobservable inputs are based on the entity’s own assumptions about the assumptions of market participants that reflect the best available information.
-An entity should maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
What is the fair value hierarchy? (more complete definition)
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.
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.
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.
What are level 1 inputs in 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.
What are level 2 inputs in the fair value hierarchy? (3 elements)
Level 2 inputs are observable. But they exclude quoted prices included within Level 1. The following are examples:
1) Quoted prices for similar items in active markets,
2) Quoted prices in markets that are not active, and
3) Observable inputs that are not quoted prices.
What are level 3 inputs in 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.
For fair value measurement, what are quantitative disclosures?
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.
For fair value measurement, what are the five main examples of quantitative disclosures?
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
5) A reconciliation from the opening balances to the closing balances for fair value measurements categorized within Level 3
What is the basis for determining the appropriate classes of assets and liabilities in the quantitative disclosures for FVM? (2 elements)
The appropriate classes of assets and liabilities are determined on the basis of the following:
1) The nature, characteristics, and risks of the asset or liability
2) The level of the fair value hierarchy within which the fair value measurement is categorized
