FAR 2 TEST ONE CONCEPTS

Differentiate between the accumulated benefit obligation and the projected benefit obligation

The accumulated benefit obligation is the discounted present value of retirement benefits calculated by applying the pension formula with no attempt to forecast what salaries will be when the formula actually is applied. The projected benefit obligation is the present value of those benefits when the actuary includes projected salaries in the pension formula.

What is the vested benefit obligation?

The vested benefit obligation is the pension benefit obligation that is not contingent upon an employee's continuing service.

Define the service cost component of the periodic pension expense

The service cost in connection with a pension plan is the present value of benefits attributed by the pension formula to employee service during the period, projecting future salary levels (i.e., the projected benefits approach).

There are three basic accounting approaches to reporting accounting changes. What are they?

Accounting changes can be accounted for: 1. Retrospectively (prior years revised), 2. Modified retrospectively, (adoption period only revised), or 3. Prospectively (only current and future years affected).

Southeast Steel, Inc., changed from the FIFO inventory costing method to the LIFO method during 2017. How would this change likely be reported in the 2018 comparative financial statements?

Accounting records of prior years usually are inadequate to determine the cumulative income effect of the change for prior years when a company changes to the LIFO inventory method from another inventory method. For example, it would be necessary to make assumptions as to when specific LIFO inventory layers were created in years prior to the change. Accordingly, a company changing to LIFO generally does not revise the balance in retained earnings. Rather, the beginning inventory in the year the LIFO method is adopted becomes the base year inventory for all future LIFO calculations. A disclosure note would be included in the financial statements describing the nature of and justification for the change as well as an explanation as to why retrospective application was impracticable.

How do we report components of comprehensive income created during the reporting period?

Components of comprehensive income created during the reporting period can be reported in either (a) an expanded version of the income statement or (b) a separate statement immediately following the income statement. Regardless of the placement a company chooses, the presentation is similar. It will report net income, other components of comprehensive income, and total comprehensive income.

What is comprehensive income? How does comprehensive income differ from net income? Where do companies report it in a balance sheet?

Comprehensive income is a broader view of the change in shareholders' equity than traditional net income. It is the total nonowner change in equity for a reporting period. It encompasses all changes in equity except those caused by transactions with owners. Transactions between the corporation and its owners (shareholders) primarily include dividends and the sale or purchase of shares of the company's stock. Most nonowner changes (e. g., revenues and expenses) are reported in the income statement. So, the changes other than the ones that are part of net income are those reported as "other comprehensive income." Two attributes of other comprehensive income are reported: (1) components of comprehensive income created during the reporting period and (2) the comprehensive income accumulated over the current and prior periods. The components of comprehensive income created during the reporting period can be reported in either (a) an expanded version of the income statement or (b) a separate statement immediately following the income statement. Regardless of the choice a company makes, the presentation will report net income, other components of comprehensive income, and total comprehensive income. The second attribute—the comprehensive income accumulated over the current and prior periods— is reported as a separate component of shareholders' equity. This amount represents the cumulative sum of the changes in each component created during each reporting period throughout all prior years.

What action is required when it is discovered that a five-year insurance premium payment of $50,000 two years ago was debited to insurance expense? (Ignore taxes)

During the two-year period, insurance expense would have been overstated by $30,000, so net income during the period was understated by $30,000. This means beginning retained earnings is currently understated by that amount. During the two- year period, prepaid insurance would have been understated, and continues to be understated by $30,000. So, a correcting entry would debit prepaid insurance and credit retained earnings. Also, the financial statements that were incorrect as a result of the error would be retrospectively restated to report the prepaid insurance acquired and reflect the correct amount of insurance expense when those statements are reported again for comparative purposes in the current annual report. A "prior period adjustment" to retained earnings would be reported because retained earnings is one of the accounts incorrect as a result of the error. And, a disclosure note should describe the nature of the error and the impact of its correction on each year's net income, income from continuing operations, and earnings per share.

The prescribed accounting treatment for stock dividends implicitly assumes that shareholders are fooled by small stock dividends and benefit by the market value of their additional shares. Explain this statement. Is it logical?

For a stock dividend of less than 25%, a "small" stock dividend, the fair value of the additional shares distributed is transferred from retained earnings to paid-in capital. The reduction in retained earnings is the same amount as if cash dividends were paid equal to the market value of the shares issued. The treatment is consistent with the belief that per share prices remain unchanged by stock dividends. This is not logical. If the value of each share were to remain the same when additional shares are distributed without compensation, the total value of the company would grow simply because additional stock certificates are distributed. Instead, the market price per share will decline in proportion to the increase in the number of shares distributed in a stock dividend.

Most preferred shares are cumulative> Explain what this means.

If preferred shares are noncumulative, dividends not declared in any given year need never be paid. However, if cumulative, when the specified dividend is not paid in a given year, the unpaid dividends accumulate and must be made up in a later dividend year before any dividends are paid on common shares. These unpaid dividends are called "dividends in arrears."

Sugarbaker Designs Inc. changed from the FIFO inventory costing method to the average cost method during 2018. Which items in the 2017 financial statements should be restated on the basis of the average cost method when reported in the 2018 comparative financial statements?

In general, we report voluntary changes in accounting principles retrospectively. This means Sugarbaker will revise all previous period's financial statements presented in comparative statements, including 2017, as if the average cost method always had been used. Sugarbaker will revise cost of goods sold for 2017 as well as any other income statement amounts affected by that revision, including income taxes and net income. Since the change affects income, retained earnings also changes. Sugarbaker reflects the cumulative prior year difference in cost of goods sold (after tax) as a difference in prior years' income and therefore in the balance in retained earnings. It also revises inventory in the balance sheet. The company also will revise deferred taxes. Income tax effect is reflected in the deferred income tax asset because retrospectively decreasing accounting income, but not taxable income, creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will become lower than accounting income—a future deductible amount, creating a deferred tax asset. Recall from Chapter 16 that in the meantime, the temporary difference is reflected in the deferred tax asset.

We report most changes in accounting principle retrospectively. Describe the general way of recording and reporting changes in accounting principle.

In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous periods' financial statements presented in comparative statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. Specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we revise the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders' equity (or statements of retained earnings if they're presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change. In the first set of financial statements after the change, a disclosure note would describe the change and justify the new method as preferable. It also would describe the effects of the change on all items affected, including the fact that the retained earnings balance was revised in the statement of shareholders' equity.

Corporations offer the advantage of limited liability. Explain what is meant by that statement

In the eyes of the law, a corporation is a separate legal entity—separate and distinct from its owners. The owners are not personally liable for debts of the corporation. So, shareholders generally may not lose more than the amounts they invest when they purchase shares. This is perhaps the single most important advantage of corporate organization over a proprietorship or a partnership.

Lynch Corporation changes from the sum-of-the-years'-digits method of depreciation for existing assets to the straight-line method. How should the change be reported? Explain.

Lynch should report its change in depreciation method as a change in estimate, rather than as a change in accounting principle. This is because a change in depreciation method is considered a change in accounting estimate reflected by a change in accounting principle. In other words, a change in the depreciation method is adopted to reflect a change in (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company's knowledge about those benefits. The effect of the change in depreciation method is inseparable from the effect of the change in accounting estimate. Such changes frequently are related to the ongoing process of obtaining new information and revising estimates and, accordingly, are actually changes in estimates not unlike changing the estimated useful life of a depreciable asset. Logically, the two events should be reported the same way. Accordingly, Lynch reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight line over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported.

The par value of shares historically indicated the real value of shares and all shares were issued at that price. The concept has changed with time. Describe the meaning of par value as it has evolved to today.

Par value was defined by early corporation laws as the amount of net assets not available for distribution to shareholders (as dividends or otherwise). However, now the concepts of "par value" and "legal capital" have been eliminated entirely from the Model Business Corporation Act. Most shares continue to bear arbitrarily designated par values, typically nominal amounts. Although many states already have adopted these provisions, most established corporations issued shares prior to changes in the state statutes. So, most companies still have par value shares outstanding and continue to issue previously authorized par value shares.

What i s a pension plan? What motivates a corporation to offer a pension plan for its employees?

Pension plans are arrangements designed to provide income to individuals during their retirement years. Funds are set aside during an employee's working years so that the accumulated funds plus earnings from investing those funds are available to replace wages at retirement. An individual has a pension fund when she or he periodically invests in stocks, bonds, CDs, or other securities for the purpose of saving for retirement. When an employer establishes a pension plan, the employer provides some or all of the periodic contributions to the retirement fund. The motivation for corporations to establish pension plans comes from several sources. Pension plans provide employees with a degree of retirement security. They may fulfill a moral obligation many employers feel toward employees. Pension plans often enhance productivity, reduce turnover, satisfy union demands, and allow employers to compete in the labor market.

Define prior service cost. How is it reported in the financial statements? How is it included in pension expense?

Prior service cost is the obligation (present value of benefits) due to giving credit to employees for years of service provided before either the date of an amendment to (or initiation of) a pension plan. Prior service cost is recognized as other comprehensive income as incurred and then as a component of accumulated other comprehensive income in the company's balance sheet. The account is allocated (amortized) to pension expense over the service period of affected employees. The straight-line method allocates an equal amount of the prior service cost to each year. The service method recognizes the cost each year in proportion to the fraction of the total remaining "service years" worked in each of these years.

Explain why presentation formats are different for retired stock as opposed to treasury stock/ why some account balances are different for the two methods

Reacquired shares that are retired have their status restored to that of authorized but unissued shares. Although theoretically identical to retired shares, treasury shares are treated as issued, but not outstanding shares—at the same time both (a) issued and (b) not outstanding. This artificial status has provided companies an effective device to evade the superficial constraints imposed on par value shares. Treasury stock is reported as a reduction in total shareholders' equity, not associated with any specific shareholders' equity account. By either method, total shareholders' equity is the same. Retiring shares clearly is conceptually superior because it effectively restores the shares to the status of being authorized, but unissued, shares. Treated as treasury stock, the cost of acquiring the shares is debited to the treasury stock account. Recording the effects on specific shareholders' equity accounts is delayed until later when the shares are reissued. In the meantime, the shares assume the artificial status of being neither unissued nor outstanding.

Which are the components of pension expense that involve delayed recognition?

The components of pension expense that involve delayed recognition are the prior service cost and gains and losses.

Brandon Components declares a 2-for-1 stock split. What will be the effects of the split, and how should it be recorded?

The effect and maybe the motivation for the 2-for-1 stock split is to reduce the per share market price (by half). This will likely increase the stock's marketability by making it attractive to a larger number of potential investors. The appropriate accounting treatment of a stock split is to make no journal entry, which avoids the reclassification of "earned" capital as "invested" capital. However, if the stock distribution is referred to as a "stock split effected in the form of a stock dividend," and the per share par value of the shares is not changed, a journal entry is recorded that increases the common stock account by the par value of the additional shares. To avoid reducing retained earnings Brandon can reduce (debit) paid-in capital—excess of par to offset the credit to common stock, although it's permissible to debit retained earnings.

Define the interest cost component of the periodic pension expense

The interest cost is the projected benefit obligation outstanding at the beginning of the period multiplied by the actuary's interest (discount) rate. This is the "interest expense" that accrues on the PBO and is included as a component of pension expense rather than being separately reported.

What are the components that might be included in the calculation of net pension cost recognized for a period by an employer sponsoring a defined benefit pension plan?

The pension expense reported on the income statement is a composite of periodic changes that occur in both the pension obligation and the plan assets. These include service cost, interest cost, return on the plan assets, and the amortization of prior service cost and of net gains or losses. The service cost component of pension expense is reported in the income statement as part of the total compensation costs arising from services rendered by the employees during the period, separate from the other components of pension expense. This presentation reflects the nature of service cost being different from that of the other elements of pension cost. The other components of pension expense are presented in the income statement also, but separate from the service cost component and outside the subtotal of income from operations.

Identify the three common forms of business organization and the primary difference between the way they are accounted for

The three primary ways a company can be organized are (1) a sole proprietorship, (2) a partnership, or (3) a corporation. Transactions are accounted for the same regardless of the form of business organization with the exception of the method of accounting for capital—the ownership interest in the company. Several capital accounts (as discussed in this chapter) are used to record changes in ownership interests for a corporation, rather than recording all changes in ownership interests in a single capital account for each owner, as we do for sole proprietorships and partnerships.

What are two components of pension expense may be negative (I.e., reduce pension expense)?

The two components of pension expense that may reduce pension expense are the return on plan assets (always) and the amortization of a net gain-AOCI (amortizing a net loss-AOCI increases the expense).

Identify and briefly describe the two primary sources of shareholders' equity

The two primary sources of shareholders' equity are amounts invested by shareholders in the corporation and amounts earned by the corporation on behalf of its shareholders. Invested capital is reported as paid-in capital and earned capital is reported as retained earnings.

Terminology varies in the way companies differentiate among share types. But many corporations designate shares as common or preferred. What are the two special rights usually given to preferred shareholders?

The typical rights of preferred shares usually include one or both of the following: a. A preference to a predesignated amount of dividends, that is, a stated dollar amount per share or percent of par value per share. This means that when the board of directors of a corporation declares dividends, preferred shareholders will receive the specified dividend prior to any dividends being paid to common shareholders. b. A preference over common shareholders in the distribution of assets in the event the corporation is dissolved.

Most changes in accounting principles are recorded and reported retrospectively. In a few situations, though, the changes should be reported prospectively. When is prospective application appropriate? Provide Examples.

Voluntary changes in accounting principles usually are reported retrospectively. We don't report changes in depreciation method that way, though, because such changes are considered to be changes in estimate and thus reported prospectively. Also, it's not practicable to report some changes in principle retrospectively because insufficient information is available. Revising balances in prior years means knowing what those balances should be. For instance, suppose we're switching from the FIFO method of inventory costing to the LIFO method. Recall that LIFO inventory consists of "layers" added in prior years at costs existing in those years. So, if FIFO has been used, the company probably hasn't kept track of those costs. Accounting records of prior years typically are inadequate to report the change retrospectively, so a company changing to LIFO usually reports the change prospectively. The beginning inventory in the year the LIFO method is adopted becomes the base year inventory for all future LIFO calculations. Another exception is when authoritative accounting literature requires prospective application for specific changes in accounting methods. For example, when there's a change from the equity method to another method of accounting for long-term investments, GAAP requires the prospective application of the new method. From Chapter 12, recall that if an investor's level of influence over an investee changes, it may be necessary to change from the equity method to another method. This might happen if a sale of shares causes the investor's ownership interest to fall from, say, 20% to 10%, resulting in the equity method no longer being appropriate. In such a case, we make no adjustment to the book value of the investment, but instead, simply discontinue the equity method and apply the new method from then on. The existing balance in the investment account when the equity method is discontinued serves as the new "cost" basis from then on.

What is a reverse stock split? What would the effect of a reverse stock split on one million $1 par shares? On the accounting records?

When a company decreases, rather than increases, its outstanding shares, a reverse stock split occurs. A 1-for-2 reverse stock split would cause one million $1 par shares to become one-half million $2 par shares. No journal entry would be recorded, so no account balances will change. But the market price per share would double, and the par amount per share would double.

Describe the process of correcting an error when it's discovered in a subsequent reporting period.

When an error is discovered, previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that currently are incorrect as a result of the error should be corrected by a journal entry. Also, if retained earnings is one of the accounts whose balance is incorrect, the correction is reported net of tax as a "prior period adjustment" to the beginning balance in a Statement of Shareholders' Equity (or Statement of Retained Earnings if that's presented instead). A disclosure note is needed also to describe the nature of the error and the impact of its correction on operations.

It's not easy sometimes to distinguish between a change in principle and a change in estimate. In these cases, how should the change be accounted for?

When it's not possible to distinguish between a change in principle and a change in estimate, the change should be treated as a change in estimate.

Suppose you own 80 shares of Facebook common stock when the company declares a 4% stock dividend. What will you receive as a result?

You would be entitled to 3.2 shares (4% x 80 shares). Since cash in lieu of payments usually are made when shareholders are entitled to fractions of whole shares, you probably would receive 3 shares and cash equal to the market value of 1/5 of one share. Sometimes fractional share rights are issued for the partial shares, which would entitle you to a fractional share right for 1/5 of a share.