Financial Accounting & Reporting Review Course: F1 Angel Chau , AICPA (inactive) angelchau@yahoo.com

1. Financial Accounting & Reporting Review Course: F1 Angel Chau, AICPA (inactive) angelchau@yahoo.com

2. Financial Accounting and Reporting (FAR) Intro - 3 • This section contains 3 testlets ( 30 MC each , total of 60 points) + 1testlet(7 Task based simulations, 40 points) and lasts for 4 hours. • The weights attached to five basic tasks are as follows: • Concepts and principles for financial statements (17%–23%) • Typical items of financial statements (27%–33%) • Specific types of transactions and events in financial statements (27%–33%) • Accounting and reporting for governmental units (8%–12%) • Accounting and reporting for nongovernmental and not-for-profit organizations(8%–12%)

3. F1 Outline • GAAP history and SFA concepts • Financial Statements Presentation: • Income Statement • Statement of Retained Earnings • Statement of Comprehensive Income • Balance Sheet • Notes to Financial Statements • Interim Financial Reporting • Segment Reporting • Development Stage Enterprises (DES) • Fair Value Measurement & Disclosure • First Time Adoption of IFRS • SEC Filing Requirements

4. GAAP Setting Bodies & History • 1934: Securities and Exchange Commission (SEC) (the ultimate legal authority to establish US GAAP) • 1939 – 1959: Accounting Research Bulletins (ARB) • 1959 – 1973: Accounting Principles Board (APB) • 1973 : Financial Accounting Standards of Board (FASB) • Effective 2009/7/1: the FASB Accounting Standards Codification became the single source of authoritative nongovernmental US GAAP. Accounting and financial reporting practices not included in the Codification are not GAAP.

5. Authoritative Literature Included in the Codification (FEDPRIA) • Financial Accounting Standards Board (FASB) • Statements of Financial Accounting Standards • Interpretations • Technical Bulletins • Staff Positions • Staff Implementation Guides • Statement No. 138 Examples • Emerging Issues Task Force (EITF) Abstracts and Topics D • Derivative Implementation Group Issues • Accounting Principles Board Opinions • Accounting Research Bulletins • Accounting Interpretations • American Institute of Certified Public Accountants (AICPA) • Statements of Position • Auditing and Accounting Guides (Incremental accounting guidance only) • Practice Bulletins • Technical Inquiry Service (for software revenue recognition)

6. SEC Standards Included in the Codification Relevant portions of the following pronouncements issued by SEC are included for reference: • Regulations S-X • Financial Reporting Release (FRR) • Accounting Series Releases (ASR) • Interpretative Releases (IR) • Staff Accounting Bulletins (SAB) • EITF Topic D and SEC Staff Observer Comments • The SEC section of the Codification do not contain the entire population of SEC rules and regulations

7. Ongoing Standard – setting Process • The FASB updates the codification for new GAAP issued by FASB & for amendments to SEC content with Accounting Standards Updates. • An Exposure draft is issued for public comments. Staff analyzes and studies all comment letter and position papers for the board to redeliberate on the issue. When Board is satisfied that all reasonable alternative have been considered, an Accounting Standards Update is issued. • A majority vote of 3 of 5 FASB members is required to approve an Exposure Draft for issuance and to amend the ASC. • All new GAAP and SEC amendments are fully integrated into the existing structure of the Codification

8. International Accounting Standards Board (IASB) • Established in 2001 as part of International Accounting Standards Committee (IASC) Foundation • Purpose of IASB is to develop a single set of high quality, global accounting standards • Adopts International Accounts Standards (IAS) issued by IASC • Issues International Financial Reporting Standards (IFRSs) • IASC Foundation also sponsors International Financial Reporting Interpretations Committee (IFRIC) which • provides guidance on newly identified financial reporting issues not addressed in the IFRSs and assists the IASB in achieving international convergence of accounting standards

9. International Convergence of Accounting Standards • The IASB and the FASB have been working together towards the international convergence of accounting standards since 2002 by eliminating differences between US GAAP and IFRS, target to complete by 2011. • The goal of convergence project is a single set of high quality, international accounting standards that companies can use for both domestic and cross border financial reporting. • SEC supports the IASB/FASB convergence project and will make a decision regarding the incorporation of IFRSs (in 2011?). First time US issuer report in that system will follow within 4-5 years after decision made.

10. Conceptual Frameworks underlying Financial Accounting • The FASB creates a conceptual framework (set forth in 6 Statements of Financial Accounting Concepts or SFAC) that are not GAAP, but provides basic reasoning behind US standards. • The IASB developed a conceptual framework for IFRS(set forth in the Framework for the Preparation and Presentation of Financial Statements)

11. SFAC No. 1 "Objectives of Financial Reporting by Business Enterprises“ F1 - 7 • Defines the users of accounting information as 1. Present and potential investors and creditors (external users) 2. users with a reasonable understanding of economic and business situations. • Defines the objectives of financial reporting. (focus on informational needs of external users) 1. To provide information that is useful in making rational investment and credit decisions 2. To help users assess the timing and uncertainty of cash flows. (to value the company how do they generate cash flow) 3. To provide information on economic resources, claims and changes in them. (to assess risk / required rate of return from FS)

13. F1 -8 external

14. F1 -8 SFAC No.2 - Constraints • US GAAP • Benefits > Costs • Materiality • IFRS • Timeliness • Balance between benefit and cost • Balance between qualitative characteristics Under IASB framework, materiality is a component of relevance

15. F1 - 9 SFAC No.2: B.U.D • Benefit > Cost • Understandability • Primary Qualities of Decision Usefulness • Relevance Make a difference to decision making process • Predictive Value (information has ability to assist users in evaluating past, present, or future events) • Feedback Value (enables decision makers to confirm prior expectations or to adjust or correct he assessment made) • Timeliness (having the information available while it is able to influence decisions) R & R Passing Feels Terrific Under IASB framework, the subcategories of relevance are predictive value, feedback value and materiality.

16. F1 - 9 SFAC No.2: B.U.D R & R • Primary Qualities of Decision Usefulness • Reliability • Neutrality (information is free from bias and free from outside influences) • Representational Faithfulness (agreement between financial reporting and the recourses or events represented. Information must be valid. ) Substance over legal form. • Verifiability (same results could be duplicated with the same measurement techniques) Nobody Relies on Financials unless Verified Under IASB framework, the subcategories of reliability are neutrality, representational faithfulness, substance over form, prudence, and completeness.

17. SFAC No.2: Secondary Characteristics • Comparability. (Apple vs. Microsoft) • Accounting information that has been measured and reported in a similar manner for different enterprises is considered comparable. • Consistency. (Current Yr vs. Prior Yr) • Accounting information is consistent when an entity applies the same accounting treatment to similar events from period to period. When applies new accounting policies, cumulative effect must be disclosed.

18. SFAC 7: Using Cash Flow Information & Present Value in Accounting Measurements F1 - 15 • Provides a framework for accountants when using future cash flow as a measurement basis for assets or liabilities. • e.g. for bonds, the forecasted future cash flow includes factors such as future coupon payments, timing of payments, principle payment at maturity date etc. Accountants need to consider the risk of achieving the cash flow, take the discount rate as the required rate of return and discount the future value into present value as basis of measuring the bond

19. SFAC 7: Using Cash Flow Information & Present Value in Accounting Measurements Five elements of Present Value Measurement (Asset or Liability) • Estimate of future cash flow (e.g. Estimate future dividend, future selling price etc.) • Expectations about timing variations of future cash flows (e.g. term of lease or bond interest payments) • Time value of money (inflation, losing of purchasing power) • The price for bearing uncertainty • Other factors (e.g. liquidity risk and exchange rate risk)

20. SFAC 7: Using Cash Flow Information & PV in Accounting Measurements • Traditional Approach • Used when assets and liabilities have contractual (i.e. fixed) cash flows that are not expected to vary. • Present value bonds – scheduled known payments • Expected Cash Flow Approach • Used in more complex cases, uses only the risk free rate of return as the discount rate and then turns its attention to the expected future cash flows, considering uncertainties (e.g. default risk) as adjustment to the future cash flows. • PV of warranties – uncertain future payments (Toyota sells a 5 yrs long car warranty

23. CPA-0010 According to the FASB SFAC No.2, neutrality is an ingredient of: Reliability   Relevance   A Yes   Yes   B Yes   No   C No   Yes   D No   No  

24. CPA-0010 Answer is B • Relevance : Passing Feels Terrific • Predictive Value • Feedback Value • Timeliness • Reliability: Nobody Relies on Financials unless Verified • Neutrality • Representational Faithfulness • Verifiability

25. CPA - 00005 What is the underlying concept governing the recording of gain contingencies? • Conservatism • Relevance • Consistency • Reliability

26. CPA – 00005 Explanation • A is correct (detailed explanation after page F1-78 on the book) • Gain contingency – defer it until it actually happens so we don’t overstate asset or revenue • Loss contingency – accrue it now so we don’t understate liability or loss

27. Uses of the Income Statement performance for “a period of time” • The income statement is useful in determining profitability, value for investment purposes, and credit worthiness. • Also useful in predicting information about future cash flows based on past performance

28. Presentation order (IDEA) Reported on Income Statement IIncome (or Loss) from Continuing Operations • Includes operating activities, non-operating activities, and income taxes • individual line items show gross of tax, then total reported net of tax DIncome (or Loss) from Discontinued Operations (reported net of tax) E Extraordinary Items (reported Net of Tax) A Cumulative Effect of Change in Accounting Principle • reported net of tax • is the cumulative effect of a change from one GAAP to another GAAP because the new method presents the financial information more fairly than the old method (Must Remember IDEA) Reported on Statementof Retained Earnings

29. Get Familiar w/ Multiple Step Income Stmt Presentation Review example on F1-19 Get familiar with it

30. CPA-00031 Scott Corporation sold a fixed asset used for operations for greater than its carrying amount. Scott should report the transaction in the income statement using the: a. Gross concept, showing the proceeds as part of revenues and the carrying amount as part of expenses in the continuing operations section. b. Net concept, showing the total amount as an extraordinary item, net of income taxes. c. Net concept, showing the total gain as part of discontinued operations, net of income taxes. d. Net concept, showing the total gain as part of continuing operations, not net of income taxes.

31. CPA-0031 Explanation • Choice "d" is correct. The transaction resulted in a gain, which should be reported using the net concept (i.e., proceeds less carrying amount). This gain resulted in the recognition of an asset not in the ordinary course of business, but it did not qualify as an extraordinary item or as part of discontinued operations. • Choices "a", "b", and "c" are incorrect, per the above explanation.

32. CPA-00052 Which of the following should be included in general and administrative expenses? Interest Advertising a. Yes Yes b. Yes No c. No Yes d. No No

33. CPA-00052 Explanation • Choice "d" is correct. Interest expense is classified as a separate line item on the income statement. Advertising is classified as a selling expense. • G&A expenses: Officers, Accountants, Legal, Insurance, Property Tax.

34. Introduction to Discontinued Operations • Discontinued operations are reported separately from continuing operations in the income statement according to the IDEA mnemonic, net of tax. • The (normal) loss from discontinued operations can consist of an impairment loss (net realizable value –carrying value), a gain/loss from actual operations, and a gain/loss on disposal.

35. Definitions of A Component of an Entity • Component of an Entity – a part of entity for which operations and cash flows can be clearly distinguished, both operationally and for financial reporting purposes, from the rest of entity • U.S. GAAP • An operating segment • A reportable segment • A reporting unit • A subsidiary • An asset group • IFRS • A separate major line of business or geographical area of operations • A subsidiary acquired exclusively with a view to resale

36. Definitions of Discontinued Operations • Held for Sale - in the period in which ALL of the following criteria are met: • Management commits to a plan to sell the component • The component is available for immediate sale in its present condition • An active program to locate a buyer has been initiated • The sale of the component is probable and the sale is expected to be complete within one year • The sale is being actively marketed • Actions required to complete the sale make it unlikely that significant changes to the plan will be made or that the plan will be withdrawn

37. U.S. GAAP vs. IFRS • IFRS: before a component can be classified as held for sale, the individual assets and liabilities of the component must be measured in accordance with applicable standards and any resulting gains and losses must be recognized. After classification as held for sale, the component is reported at the lower of carrying value and fair value less cost to sell. • U.S. GAAP: does not require the measurement of individual assets & liabilities before classification as held for sale, but the classification of a component as held for sale does trigger an impairment analysis of the component.

38. Discontinued Operations: Accounting Rules • Types of Entities to be considered discontinued operations: • Has been disposed of, or • Is classified as held for sale • Conditions that both must be present • Eliminated from ongoing operations – the operations and cash flows of the component have been or will be eliminated from the on going operation of the entity as a result of the disposal • No Significant continuing involvement – the entity will not have any significant continuing involvement in the operations of the component after the disposal

39. Discontinued Operations: Accounting Rules Discontinued Operations Calculation • Types of items included in results of discontinued operations • Results of operations of the component • Gain or loss on disposal of the component • Impairment loss (and subsequent increases in fair value) of the component • Initial and subsequent impairment losses are recognized • Subsequent increases in fair value results in a gain on I/S (subsequent increase in FV minus cost to sell) and is recognized no more than previously recognized cumulative loss; excess goes to OCI • Report in the Period disposed or held for sale • Stop Depreciation and Amortization

40. Calculation Example • F1 – 23 • Understand this example, you are good with discontinued operations

41. Accrue liability related to Exit or Disposal Activities • New – U.S. GAAP. requires recognition of a liability for the costs in association with exit or disposal activities • Exit and disposal costs include: • Involuntary employee termination benefits • Costs to terminate a contract • Other costs associated with exit or disposal activities, including costs to consolidate facilities or relocate employees • Criteria for liability recognition - commitment to exit by itself is not enough, all followed must be met: • An obligating event has occurred • The event results in a present obligation to transfer assets (payment) or to provide services in the future, and • The entity has little or no discretion to avoid the future transfer of assets or proving of services Future operating losses expected to be incurred as part of an exit or disposal activity are recognized in the periods incurred.

42. Exit or Disposal Activities • Liability Measurement - should be at fair value which should be determined using the US GAAP fair value measurement techniques discussed later. The liability may be adjusted in future periods as a result of revisions to the timing of or estimated cash flows from the exit or disposal activity. Revisions are accounted for prospectively (change in estimate) • Income Statement Presentation – costs associated with exit or disposal activity related to Discontinued Operation in D; costs not related to Discontinued Operation in I. • Disclosure – in the notes to the FS in the period the exit or disposal activity is initiated and all subsequent periods until the activity is completed

43. TBS-00010 (7 Task based simulation) The board of directors of Super Conglomerate, Inc. voted to dispose of its Tiny Co. subsidiary on Oct 31, Yr 8. On that date, the net book value of the subsidiary was $15M, but Super believes it could not sell for more than $12.5M. No buyer had been found as of Dec 31 Yr 8, but the company was committed to the plan to sell and was actively looking for a buyer. On May 1 Yr 9, the sale was completed for $13M. The subsidiary’s operating results for Yr 8 & Yr 9 were: 1/1/Yr8 – 10/31/Yr8 $5M 11/1/Yr8 – 12/31/Yr8 $1.5M 1/1/Yr9 – 4/30/Yr9 $2.25M Super’s tax rate is 30% How Should the disposal of Tiny Co. be reported on Super’s Yr 8 FS?

44. TBS – 00010 Answer Loss from Discontinued operations – Yr 8

45. Extraordinary Item Under U.S. GAAP: • Material • Unusual (significantly different from the typical business) • And Infrequent (not expected to recur in the foreseeable future) • Not normally considered in evaluating the ordinary operating results of an entity Examples of extraordinary item: • The abandonment of or damage to a plant due to an unusual and infrequent natural disaster • An expropriation of a plant by the government • A prohibition of a product line by a newly enacted law or regulation • Certain gains or losses from early retirement of long term debt only if which meet the criteria of unusual and infrequent and if so will be stated in CPA exam question

46. Non-extraordinary items • Examples: • Gain or loss from disposal of PPE used in the business • Large write down or write off of : receivable, inventory, intangible, long term security • Gain or loss from foreign currency transactions or translation • Loss from major labor strike • Long term debt early retirement that is NOT both unusual & infrequent • Material unusual OR infrequent items are presented as a separate line item (non-operating) in Income from Continued Operations. The nature and financial effects should be disclosed on the face of Income Statement or in the footnotes. IFRS prohibits the reporting of extraordinary item on the Income Statement or in notes to the FS.

47. CPA-00050

48. CPA-00050 Explanation Choice "a" is correct. Raim - component of income from continuing operations. Because Raim sustains flood losses every two to three years, the flood losses are not "infrequent." Thus, the flood loss is not an "extraordinary item." (U or I) Cane - as an extraordinary item. Here, the flood losses are infrequent because Cane never before (in the last 20 years) had flood losses. Furthermore, the flood losses are unusual in nature in that they are unrelated to the ordinary and typical activities of the company. (U & I, Net of Tax) Choices "b", "c", and "d" are incorrect, per rules above.

49. CPA-00098 Midway Co. had the following transactions during 1992: • $1,200,000 pretax loss on foreign currency exchange due to a major unexpected devaluation by the foreign government. • $500,000 pretax loss from discontinued operations of a division. • $800,000 pretax loss on equipment damaged by a hurricane. This was the first hurricane ever to strike in Midway's area. Midway also received $1,000,000 from its insurance company to replace a building, with a carrying value of $300,000 that had been destroyed by the hurricane. What amount should Midway report in its 1992 income statement as extraordinary loss before income taxes? a. $100,000 b. $1,300,000 c. $1,800,000 d. $2,500,000

50. CPA-00098 Explanation • Choice "a" is correct. Foreign currency devaluations and losses from discontinued operations are not extraordinary items. The hurricane is an extraordinary item and the loss, net of insurance, is $100,000. • Choice "b" is incorrect. The loss from devaluation is not considered to be extraordinary. • Choice "c" is incorrect. The hurricane loss is as follows: Equipment loss $ 800,000 Building loss 300,000 Insurance proceeds (1,000,000) Hurricane loss $ 100,000 • Choice "d" is incorrect. Foreign currency devaluations and losses from discontinued operations are not extraordinary items.