FAR CPA Exam

Industry Practice (FASB Conceptual Framework)

The unique nature of some industries and business concerns sometimes requires departure from basic accounting theory

Perpetual Versus Periodic FIFO and LIFO

When FIFO is used, inventory and cost of goods sold will be the same value at the end of the month whether a perpetual or periodic system is used When LIFO is used, inventory and cost of goods sold may not be the same value at the end of the month under the perpetual and periodic methods

Verifiability

Occurs when independent measurers, using the same methods, obtain similar results

Conceptual Release

The process usually begins with a rule proposal, or a request by the SEC for public input on which regulatory approach is appropriate a. A concept release is issued describing the area of interest and the SEC's concerns b. It identifies different approaches to addressing the problem d. In a concepts release, the SEC: (1) Issues a series of questions to the public (2) Seeks public feedback (3) Then decides which approach, if any, is appropriate The SEC publishes a detailed formal rule proposal for public comment outlining specific objectives and methods for achieving them SEC provides between 30 and 60 days for review and comment

Cost of Goods Sold Formula

Beginning Inventory + Net Purchases (including Freight-In) Cost of Goods Available for Sale - Ending Inventory Cost of Goods Sold (COGS)

Held-to-Maturity Securities

Carried on balance sheet at amortized cost Classify as current/noncurrent based on maturity date

Act of 1933

Contains accounting and disclosure requirements for the initial public offering of stocks or bonds (IPO) Lots of requirements: Registration Statement

FASB Conceptual Framework Constraints

Cost Constraint Industry Practice

Cost Constraint (FASB Conceptual Framework)

Cost of providing information must be weighed against the benefits that can be derived from using it

The 1934 Securities Exchange Act

Created the Securities and Exchange Commission (SEC) and contains requirements for operating in the open or secondary markets. The Acts of 1933 and 1934 were designed to restore investor confidence in the U.S. capital markets The Acts provided investors and the markets: -With more reliable information -Clear rules of honest dealing

Neutrality

A company cannot select information to favor one set of interested parties over another

Full Disclosure

All material information should be disclosed in the financial statements − Financial statements should provide the necessary information so that users can make informed business decisions about the company

Completeness

All the information that is necessary for faithful representation is provided

Continuity/Going Concern

An entity is assumed to have an indefinite life, or at least a life sufficiently long enough for it to accomplish its objectives and fulfill its legal obligations

Consistency

An entity should apply the same accounting procedures from period to period, to enhance financial statement comparability

FASB Conceptual Framework Elements

Assets Liabilities Equity Investments by Owners Distributions to Owners Comprehensive Income Revenues Expenses Gains and Losses

Weighted Average Unit Cost

(Cost of Goods Available)/(Units Available for Sale)

Converting markup on cost percentage to gross profit %

(Markup on Cost % )/(100+Markup)

Artistic-Related Intangible Assets

- Artistic-related intangible assets involve ownership rights to copyrights - Examples: plays; literary works; musical works; pictures; photographs; video - A copyright is granted for the life of the creator plus 70 years, and is not renewable - Costs of defending a copyright are capitalized - The costs of the copyright should be allocated to the years in which the benefits are expected to be received

Cost of Intangible Assets

- Cost is the appropriate basis for recording purchased intangible assets - Cost includes acquisition price and all other expenditures necessary in making the asset ready for its intended use - Costs incurred to create internally created intangibles are generally expensed as incurred

Perpetual System

- Costly to Maintain - Inventory transactions run through the Inventory account - No Purchase account - Time consuming - More accurate (know value of inventory at any point in time)

Amortization of Intangibles

- Intangibles have either a limited (finite) useful life or an indefinite useful life - An intangible asset with a limited life is amortized over its expected useful life - An intangible asset with an indefinite life is not amortized (tested for impairment)

Periodic System

- Inventory transactions run through the Purchases account - Inventory account adjusted at end of period - Easier to use - Inventory amounts estimated (not as accurate) -Don't know COGS until inventory count at the end of the period and apply estimation method (LIFO, FIFO, Weighted Average Cost) -> back out COGS

Trademarks

- Registration of a trademark with the U.S. Patent and Trademark Office provides legal protection for an indefinite number of renewals for a period of 10 years each - The life of a trademark or trade name is indefinite, and therefore its cost is not amortized

Contract-Related Intangible Assets

- The cost of a contract-related intangible with a limited life should be amortized as operating expense over the life of the franchise - Those with an indefinite life should be carried at cost and not amortized

Permanent Declines

If permanent decline in AFS or HTM: December 31, Year 3 Debit Credit Realized Loss (I/S) Investment $$$ $$$ (Note: Permanent Declines are not an issue for Temporary Securities)

Determining Cost of Inventory

Includes all costs incurred to bring the inventory to purchaser and get it ready for sale Purchase price (net) Shipping (freight-in, FOB shipping point) Handling Insurance Warehousing

Industry Practices

It may be necessary for an entity to depart from strict compliance with GAAP due to the unique nature of the industry in which an entity operates

Materiality

Items are material if they could influence the economic decisions of users, taken on the basis of financial statements

Intangible Assets

Lack physical existence The most common types reported are: Patents Copyrights Franchises Licenses Trademarks Trade names Goodwill

Expense Recognition

Let the expense follow the revenues

Monetary Unit

Money is the common denominator

Effect of Inflation

During periods of rising prices (i.e., inflation) Under LIFO − Last unit purchased -> First unit sold higher COGS -> Lower Net Income Under FIFO − First unit purchased -> First unit sold lower COGS -> Higher Net Income

Specific Identification

Each item of inventory is identified for cost − Time consuming − Expensive

FASB Conceptual Framework Assumptions

Economic Entity Going Concern Monetary Unit Periodicity

Separate Entity

Economic activities of the business are kept separate from those of its owners and other business entities

Which inventory valuations methods are acceptable under IFRS?

FIFO and Average Cost are the only cost flow assumptions permitted under IFRS IFRS prohibits the use of LIFO

Objectivity

Financial and accounting information needs to be independent and free from bias

Unit of Measure

Financial data should be measured using a common, stable, monetary unit

Revenue Recognition

Generally occurs when realized or realizable and when earned

Measurement Principle

The most commonly used measurements are based on historical cost and fair value

Understandability

The quality of information that lets reasonably informed users see its significance

Technology-Related Intangible Assets

These intangible assets relate to innovations or technological advances Examples: Patented technology Trade secrets

The SEC's mission is to:

Protect investors Maintain fair, orderly, and efficient markets Facilitate capital formation

Full Disclosure

Providing information that is of sufficient importance to influence the judgment and decisions of an informed user Financial Statements Notes to the Financial Statements Supplementary information

Conversion Price Index

A conversion price index must be computed for dollar-value LIFO. If the index is not provided on the exam: Calculate the extended cost of ending inventory at the most recent prices Calculate the extended cost of ending inventory at base year prices (base year = year adopted method) Price Index = (Ending Inventory at Current Prices)/(Ending Inventory at Base Year Prices)

Rule Adoption

A final measure is adopted by vote of the full Commission; if approved, the rule becomes part of the official rules that govern the securities industry

Periodic Inventory Journal Entries-Sales

Purchases XX Accounts Payable XX To record purchase of inventory Accounts Receivable XX Accounts Payable XX To record sale -No entry for COGS until end of period

FASB Conceptual Framework Level 2

Qualitative Characteristics Fundamental Qualities Enhancing Qualities

Cost Method JE

On January 1, year 1, Parent purchased 1000 shares of Sub Stock for $10 per share Investment in Sub 10K Cash 10K Carried on balance sheet as available-for-sale security Parent does not recognize profits or losses. Only recognize dividend income. Sub sends Parent $500 Dividend Cash 500 Dividend Income 500

Evidence of "Significant Influence"

Parent on Sub's board Parent makes policy for Sub Parent largest single shareholder of Sub No Evidence: Use Guideline If parent owns 20% or more of Sub's common stock, assume "significant influence"

Example: Equity Method

Parent purchased 20% of Sub shares for $280,000 Investment in Sub Cash 280,000 280,000 Carried separately on balance sheet: Not trading Not AFS Not HTM Sub reports $60,000 Net Income ($60,000 × 20% = $12,000) Investment in Sub Equity in Sub Earnings or Investment Income 12,000 12,000 Sub pays a $12,000 Dividend ($12,000 × 20% = $2,400) Cash Investment in Sub 2,400 2,400 Investment in Sub 280,000 12,000 2,400 $289,600

Underlying Principles

The basic general rules upon which more detailed accounting standards are built Historical Cost Revenue Recognition Matching Principle Consistency Full Disclosure Objectivity Verifiability Separate Entity Continuity/Going Concern Unit of Measure Periodicity

Verifiability

The information is objectively obtained

Periodicity

The life of business is divided into artificial time periods

FASB Conceptual Framework Level 1: Objective

To provide information that is useful to present and potential equity investors, lenders, creditors in their capacity as capital providers

Investments in Common Stock

Use Cost Method if < 20% of stock purchased Use Equity Method for investment purchases between 20% and 50%

Dollar-Value LIFO Calculations

Year E/I at Current Prices Price Index E/I Base Year Prices Layer 20X1 $300,000 ÷ 1.00 $300,000 = $300,000 20X2 $363,000 ÷ 1.10 $330,000 = $30,000 20X3 $420,000 ÷ 1.20 $350,000 = $14,000 20X4 $430,000 ÷ 1.25 $344,000 = For year 4 we have to dip into the last layer, sub 20K - 6K -We want to sell inventory, not build layers Multiply by price index: Base $300,000 20X2 Layer (30,000 x 1.1) 33,000 20X3 Layer (14,000 x 1.20) 24,000 Dollar Value LIFO E/I $349,000 COGS Income Ending Inventory Overstated Ending Inventory Understated Purchases Overstated Purchases Understated Beginning Inventory Overstated Beginning Inventory Understated

Which inventory valuations methods are acceptable under U.S. GAAP?

− Specific Identification − FIFO − LIFO − Average Cost IFRS

Periodic Inventory Journal Entries-End of Period

Ending Inventory (put on the books) XX COGS (Plug to balance the entry) XX Beginning Inventory (take off the books) XX Accounts Payable XX To record ending inventory

FASB Conceptual Framework Qualitative Characteristics: Fundamental Qualities

Relevance Faithful Representation

FASB Conceptual Framework Level 3

Assumptions Principles Constraints

Available-for-Sale Securities

Classify as current/noncurrent based on maturity date (debt) or management intent (equity) Carried on balance sheet at aggregate fair market value (FMV) Unrealized holding gains/losses reported in stockholder's equity as item of Other Comprehensive Income

Periodicity

Company can divide its economic activities into time periods

Historical Cost

Business transactions should be recorded at original cost − Historical cost is the most objective measure of value used in accounting

Economic Entity

Company keeps its activity separate from its owners and other businesses

Going Concern

Company to last long enough to fulfill objectives and commitments

Modifying Conventions

Conservatism Industry Practices

Substance Over Form

Report the economic substance of an event over its legal form

When transfer from one portfolio to another:

Day of transfer: must write the security to its FMV -Security must enter portfolio at FMV Unrealized Loss $ Investment $ If related to -HTM to AFS -AFS to HTM Record decline to OCI OCI $ Investment $

Realized gain/loss when sell Trading Securities

Debit Credit Cash Realized Loss (I/S) Investment in Ritz $12,000 $ 5,000 $17,000 Note that the basis used to compute the realized loss is the new, revised cost basis of $17,000, not the original basis of $18,000. Realized gains and losses always go to the Income Statement.

Trading Securities Example

December 31 Cost Market Pillsbury Security (debit) Quaker Security (debit) Ritz Security (equity) $ 4,000 $ 7,000 $18,000 $10,000 $ 6,000 $17,000 Net transactions (adjust basis) together to determine the holding gain December 31, Year 2 Debit Credit Investment in Pillsbury Investment in Quaker Investment in Ritz Unrealized Gain (I/S) $ 6,000 $1,000 $1,000 $4,000

Example: Available-for-Sale Securities

December 31, Year 1 Cost Market G Security (equity) H Security (equity) I Security (debt) Total $ 5,000 $ 3,000 $10,000 $18,000 $ 3,000 $12,000 $15,000 $30,000 Not adjusted by individual security, must be computed at the aggregate level December 31, Year 1 Debit Credit Security FV Market Adjustment Other Comprehensive Income Cost = $18,000 Market = $30,000 12,000 12,000 Balance Sheet: Dec. 31, Year 1 A-F-S (at cost) $18,000 Market Adjustment 12,000 A-F-S $30,000

FIFO

First In First Out Balance Sheet method (favors the Balance Sheet) Recent prices are on the balance sheet − Ending inventory contains most recent prices Old prices are on the income statement as COGS − Causes distortion in matching current revenue with current expenses

Materiality

Information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information

Comparability

Information that is measured and reported in a similar manner for different companies is considered comparable

Perpetual Journal Entries

Inventory XX Accounts Payable XX To record purchase Accounts Receivable XX Accounts Payable XX COGS XX Inventory XX To record sale

Marketing-Related Intangible Assets

Marketing-related intangible assets are those assets used in the marketing or promotion of products or services Examples: Trademarks or trade names (most commonly tested) Newspaper masthead Internet domain names Noncompetition agreements

Matching Principle

Match revenues with expenses in same period to properly report profitability − Match realized revenues with those expenses and expired costs necessary to generate them

FASB Conceptual Framework Principles

Measurement Principle Revenue Recognition Expense Recognition Full Disclosure

Faithful Representation

The numbers and descriptions match what actually existed or happened Completeness Neutrality Free from error

FASB Conceptual Framework Enhancing Qualities

Comparability Verifiability Timeliness Understandability Relevance^ Information is helpful in making decisions Predictive value Confirmatory value Materiality

SEC Rule Making Process

Conceptual (Concept) Release Rule Proposal Rule Adoption

Free from error

More accurate (faithful) representation of a financial item

Timeliness

Having information available to decision-makers before it loses its capacity to influence decisions

Equity Method

If Parent has "Significant Influence" over Subsidiary (Sub), Equity Method required If Parent does not have "Significant Influence" over Sub, Cost Method required ALWAYS BE CAREFUL OF DATES! (Entitled to full year of earnings? Only for the portion of year owned investment) Preferred stock always uses the cost method

LIFO

Last In First Out LIFO is an Income Statement method (favors the income statement) Recent prices are in the income statement − No distortion in matching current revenue with current expenses Old prices are on the balance sheet -LIFO but First In Still Here -Inventory base is made up of old prices; does not reflect true value of inventory

Conservatism

The practice of prudence when there is uncertainty Examples: Expenses and liabilities should be recognized as soon as possible when there is uncertainty about the outcome Revenues and assets should be recognized when they are assured of being received Lower of cost or market theory should be applied to inventory and certain securities

Trading Securities

Classify as current asset Carried on balance sheet at fair market value (FMV) Unrealized holding gains/losses on income statement Gains = debit investment account Losses = credit investment account -plug unrealized gain/loss

Example: Available-for-Sale Securities, Next Year:

Market is $4,000 below cost December 31, Year 2 Cost Market G Security (equity) H Security (equity) I Security (debt) Total $ 5,000 $ 3,000 $12,000 $20,000 $ 3,000 $ 2,000 $11,000 $16,000 Use a T-Account for figure adjustment (to get from a $12,000 debit to a $4,000 credit balance, we need a credit adjustment of $16,000) Market Adjust 12,000 16,000 4,000 Remember: Always adjust at the aggregate level December 31, Year 1 Debit Credit Other Comprehensive Income Security FV Market Adjustment Cost = $20,000 Market = $16,000 16,000 16,000 Balance Sheet Dec. 31, Year 2 A-F-S Cost $20,000 Market Adjustment 4,000 A-F-S $16,000 Year 3: Assume Investment in "I" is sold for $8,000 December 31, Year 2 Cost Market G Security (equity) H Security (equity) I Security (debt) Total $ 5,000 $ 3,000 $12,000 $20,000 $ 3,000 $ 2,000 $11,000 $16,000 Remember: The security basis was never adjusted; it's still at the original $12,000 December 31, Year 3 Debit Credit Cash Realized Loss (I/S) Investment in I 8,000 4,000 12,000

Gross Profit Method

Method used to estimate ending inventory without taking a count Use for interim reporting Use to estimate inventory when there is damage Need Gross Profit % and COGS %

Dollar-Value LIFO

Pools cost information for large amounts of inventory so that individual cost layers do not need to be computed for each inventory item When prices rise, dollar-value LIFO shows an increased COGS and a lower net income Can reduce a company's taxes But shows a lower net income on shareholder reports

Inventory Ownership—In Transit

Record inventory when significant risks of ownership have passed from seller to buyer

Confirmatory Value

Relevant information also helps users confirm or correct prior expectations

Predictive Value

Relevant information is used by investors to form their own expectations about the future

Revenue Recognition

Revenue is recognized when earned, realizable, collectible...when the earnings process is virtually complete

Financial Reporting Releases

SEC issued rules

FOB Shipping Point

Seller retains ownership until goods leave the shipping point; buyer owns once the goods depart the seller's warehouse

FOB Destination

Seller retains ownership until goods reach their destination (delivered to buyer)