ACC 640 Final

Impairment of LT assets: affect on earnings quality

1. Some long-lived assets must be tested for impairment annually or sooner if circumstances warrant. This applies to .............. Goodwill and other intangibles not subject for amortization 2. Other LT assets are tested for impairment if a "triggering event" occurs. This applies to .............. Property, plant and equipment and other intangible assets that are subject to amortization 3. Examples of triggering events from the Codification include: • A significant decrease in the market price of the long-lived asset (asset group) • A significant adverse change in the extent of manner in which a long-lived asset (asset group) is being used or in its physical condition • Others are in paragraph 360-10-35-21

Characteristics of market participants: they are "the buyers or sellers of an asset or a liability in the exit market"

1. They are independent of each other, they are not related parties 2. Have knowledge of the asset or liability necessary to appropriately benefit from the asset or cure (i.e., permanently resolve) the liability. 3. Have the willingness and ability to transact at fair value

Post-retirement benefits: affect on earnings quality

1. Two examples of post-retirement benefits are: • Deferred benefit pension plan • Postretirement health care plan 2. The amount of expense to recognize for a period (in the income statement) for these examples of post-retirement benefits as well as the amount of the obligation that exists at the end of the period (in the balance sheet) entail the use of many significant estimates and assumptions 3. Some of the estimates and assumptions that affect the amount of the period expense and the balance in the liability include: • Discount rate • Mortality rates • When are they going to retire • Employee turnover • Salary increases • Future health care costs

How might an analyst or financial advisor evaluate the quality of earnings if it is affected by a "one time"/nonrecurring item or a non-operating item?

1. With "one time"/nonrecurring items, the item is often .............. Completely factored out, or ignored, in the assessment of earnings quality 2. Consider the nature of the item • A restructuring charge that includes an amount related to reducing its workforce; how might the charge affect the sustainability of net income? • The analyst must know why the situation is occurring • Gains or losses on investments in high-risk securities; how might the gains and losses affect the substance and sustainability of net income? • Is management putting the company in jeopardy with these investments

Earnings quality issues can really have two perspectives

Analyst: advising investors: to find which companies are smoothing earnings Statement preparer: might have motivation to smooth earnings

Business combinations: Professional Judgment

Assets and liabilities of acquired entity are restated to fair value

One of the few bright line rules promulgated by CAP

Bulletin 51 Consolidated Financial Statements

Statement 87: Pensions

Did more to allow smoothing earnings than any other stanards

What represents the single most important item in corporate financial reports

Earnings

Only instance where GAAP specifies how to calculate a ratio

Earnings Per Share

Arthur Anderson was auditor and gave unqualified opinions to

Enron, Global Crossing & WorldCom

How is it determined whether a transaction or other event is considered a "business combination" in US GAAP and IFRS? If it is determined that the transaction is a "business combination" what method must be used to account for it under US GAAP and IFRS? What steps must be applied in the method identified in the previous questions under US GAAP and IFRS?

Exactly the same in US GAAP and IFRS Paragraph 805-10-25-1 requires that a business combination be accounted for by applying what is referred to as the acquisition method. The acquisition method requires all of the following steps: a. Identifying the acquirer b. Determining the acquisition date c. Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree d. Recognizing and measuring goodwill or a gain from a bargain purchase.

Fair Value Definition

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.

Fair Value Perspective

Fair value measurement is always from the perspective of market participants; not from the entities perspective. It is based on the assumptions that market participants would use in pricing the asset or liability acting in their economic best interests.

For segment reporting purposes, in US GAAP, an operating segment is a component of a public entity that must have three characteristics. What are these characteristics? What characteristics do operating segments of an entity have in IFRS?

Fair value/Business Combinations/Operating Segments are the same

If an entity recognizes an impairment on a long-lived asset other than goodwill under IFRS or US GAAP, under what circumstances, if any, should that impairment be reversed under IFRS and US GAAP?

IFRS - Impairments are measured in difference between book value of the asset and recoverable amount, idea here is that once an impairment has been recorded, if the recoverable amount recovers it is ok to reverse an impairment US GAAP - Restoration of a previously recognized impairment loss is prohibited

Identify the condition that are necessary for contingent loss to be accrued under US GAAP. Under IFRS, what are a) a contingent liability and b) a provision? What conditions are necessary for a provision to be recognized? What conditions are necessary for a contingent liability to be recognized?

In US GAAP the focus is on the recognition of the loss, remember probability and reasonability to measure the loss Focus in IFRS is on the provision US GAAP is focused on the loss while IFRS is focused on the provision

Level 2 inputs

Inputs other than quoted prices within Level 1 that are observable for the asset or liability, either directly or indirectly. 1. All observable inputs other than level one inputs. 2. Includes • quoted prices in non-active markets or in active markets for similar assets or liabilities • Inputs other than quoted prices that are observable and • Inputs that are not directly observable but are corroborated by observable market data. 3. Adjustments to Level 2 inputs can be made

How could a penny a share matter?

Investors believed well run companies could always find a penny or two per share. Small misses offered evidence of hidden problems. This cockroach theory held that revealing one small problem suggested the presence of hundreds more behind the wall. Missing a number implied management had little control over the firm.

Bad debts: Professional Judgment

Management chooses a method: multiple methods to determine bad debts Management has to estimate percentage of accounts receivable or sales that will not be collected Income statement effect - Bad debt expense Balance Sheet effect - Allowance for doubtful accounts

Inventory: Professional Judgment

Management must choose a method Income statement effect - cost of goods sold Balance sheet effect - inventory

Depreciation: Professional Judgment

Management must choose a method Estimate salvage value and useful life Income statement effect - Depreciation expense Balance sheet effect - Accumulated depreciation

Most significant speech in the history of US accounting

On Monday, September 28, 1998, SEC Chairman Arthur Levitt gave a presentation against the "numbers game", a too little challenged custom where management suppressed commonsense business practices, satisfied consensus earnings estimates, and projected a smooth earnings path in an attempt to grow a company's stock price and the value of underlying options.

Baptist Foundation of Arizona

Ponzi Scheme, took millions of retirement benefits from senior citizens

Level 1 inputs

Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. 1. Level 1inputs are observable and should always be used if available. 2. Adjustments (see above) to Level 1 inputs are not made.

What discount rate is used to find the present value of minimum lease payments for a) the lessor and b) the lessee when a lease is correctly identified as a finance/capital lease under IFRS or US GAAP, respectively?

Rate A = Rate implicit in the lease, rate lessor used to structure the lease Rate B = Leases incremental borrowing rate US GAAP rate A has to be less than Rate B, which is not true in IRFS Don't answer question with rate A and rate B, be more specific US GAAP Rate B unless (a) lease knows Rate A and (b) Rate A is less than Rate B Then use Rate A IFRS Rate B unless lease knows Rate A, then use Rate A

Decomposition of Income to Assess Earnings Power

Recurring Primary - Operating profit from sale of core products Peripheral - Interest income on excess cash holdings Nonrecurring Primary - Profit from discontinued product lines Peripheral - Insurance proceeds from a building damaged by fire

What is the tax rate that should be used to measure deferred tax assets and liabilities under IFRS and US GAAP?

Same rule applies to both, be able to summarize both. Paragraph 740-10-10-3 establishes that the objective is to measure a deferred tax liability or asset using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized. Deferred taxes shall not be accounted for on a discounted basis.

Enron used

Statement 115 and Special purpose entities

Ultimate rules based accounting standard

Statement 13 - Accounting for leases

Quality of income

Substance - operations has highest substance Sustainability into the future

How do the conditions for recognizing revenue on the sale of goods differ under IFRS and US GAAP?

The US GAAP and IFRS have similar conditions but IFRS specifies goods while US GAAP does not specific between goods and services

Earnings Management (Earnings smoothing)

The manipulation of revenues and expenses to achieve a specific outcome. Note that at times "manipulation" may occur within the confines of generally accepted accounting principles (GAAP); sometimes it may not. As earnings management increase, the quality of earnings is reduced.

Quality of Earnings

The quality of a company's earnings refers to the substance of earnings and their sustainability into future accounting periods

Transactions may not be orderly if:

There is not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions. ► There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant. ► The seller is in or near bankruptcy or receivership (i.e., distressed sale) or the seller was required to sell to meet regulatory or legal requirements (i.e., forced sale). ► The transaction price is an outlier when compared with other recent transactions for the same or similar asset or liability.

most advantageous market

This is the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer a liability after adjusting for transaction costs (excluded from the estimation of FV) and transportation costs (included in the determination of FV).

Costs that are not considered in determining FV include

Transaction costs are not considered

The Big Land Acquisition Company (BLAC) has a piece of agricultural machinery that is 10 years old. The machinery is located in Illinois and BLAC intends to sell the machinery in its principal market, which includes the state of Ohio. The machinery has not been utilized for several years and, therefore, BLAC needs to get it reconditioned, which will cost $100,000. The equipment will also need to be transported across the three states at a cost of $10,000. Lastly, BLAC will incur sales commissions of $30,000 in order to sell the asset. BLAC has determined that the exit price for this asset is $400,000 (after reconditioning) based on comparable sales of identical machines in principal markets.

Transformation cost + Transportation cost = 100,000 + 10,000 = $110,000 Exit Price - Costs = $400,000 - $110,000 = $290,000

Costs that are considered in determining FV include

Transformation costs and Transportation costs

Impairments: of plant assets (tangible assets): Professional Judgment

Triggering event (literature says if triggering event occurs you need to check for impairment) Recoverability test: If the company cannot recover the book value of the asset, then the asset must be impaired Compare book value to future cash flows from use and ultimate disposal of asset If recoverable amount is less than book value, impairment has occurred Impairment loss (impairment charge) is equal to the book value of the asset less the fair value of the asset (fair value is typically the present value of the future cash flows) Income statement effect - Impairment Loss (Impairment charge) [No such thing as impairment gain] Balance sheet effect - Accumulated depreciation

Under IFRS and US GAAP, for which subtotals must an entity present basic and diluted earnings per share? What is the appropriate place for these presentations?

US GAAP Income from continuing operations - Income Statement Net Income - Income Statement Discontinued Operations - Income Statement or Notes Extraordinary - Income Statement or Notes IFRS Profit Loss from operation - comprenhsive income

Are there circumstances under which a contingent gain can be recognized under US GAAP? Is it allowable to disclose information related to contingent gains in US GAAP? In IFRS are there circumstances under which it is allowable to recognize a contingent asset? In IFRS is it allowable to disclose information related to a contingent asset?

US GAAP - Can't recognize contingent gains - Can disclose them but have to be careful IFRS - an entity shall not recognize a contingent asset, can disclose it but has to be probable US GAAP is more conservative

Valuation techniques: Market approach

a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets and liabilities, or a group of assets and liabilities such as a business

Managers believe investors consider...

bumping earnings, up and down, a blemish, reporting smooth predictable earnings increases stock price

Financial assets and liabilities

convert directly into cash

Non-financial assets and liabilities

do not convert directly into cash

Global Crossing

engaged in concurrent transactions, otherwise known as capacity swaps

The determination of the principle market is made from the perspective of the

entity

Colonel Carter accomplished two things

he kept the federal government out of corporate auditing and distinguished CPAs from controllers, academics, cost accountants, and internal auditors. In the Federal Governments mind, CPAs carried the profession's colors

Waste Management

lengthened truck depreciation lives to boost earnings

Adelphia Communications and Tyco International

looting scandals

WorldCom

made accounting adjustments to capitalize line costs, classifying them as property, plant, and equipment

Arthur Andersons two traits that distinguished themselves

power of its culture and business success of the Administrative Services Division (consulting services)

Cost systems aim to

seek to detect or prevent problems

The principle market is

the market in which the reporting entity would normally enter into a transaction to 'sell an asset or transfer a liability' with the greatest volume and level of activity

Valuation techniques: Income approach

valuation techniques that convert future amounts (e.g., cash flows or income and expenses) to a single current (i.e., discounted) amount. The fair value measurement is determined on the basis of the value indicated by current market expectations of those future amounts.

Largest misstatement in accounting history

WorldCom equity dropped from positive 58 billion to a negative 13 billion

orderly transaction

a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities. It is not a forced transaction (e.g., a forced liquidation or distress sale).

Where should one focus when assessing earnings quality?

1. Reporting areas that are impacted by professional judgment in terms of making significant estimates and assumptions (80% of class time on) 2. "One-time" or nonrecurring items and non-operating items 3. Discretionary revenues and expenses

Valuation techniques: Cost approach

a valuation technique that reflects the amount that would be required to currently replace the service capacity of an asset (often referred to as current replacement cost)

Non-financial assets and liabilities are priced based upon the concept of

"highest and best use": a FV that would maximize the benefit or value of the asset or asset group and liabilities to market participants (these are known as valuation premises).

The fair value of the land used in the manufacturing operation, which presumes that the land would continue to be used as currently developed for industrial use, is determined to be $8 million. The fair value of the land as a vacant site for residential use, considering the demolition and other costs necessary to convert the land to a vacant site, is determined to be $11 million.

$11 million, highest and best use, it is a non-financial asset

Two common examples of discretionary fixed expenses are

(1) Advertising expenses (2) Research and Development

What are the requirements under IFRS and US GAAP regarding the presentation of comparative prior year financial statements?

- IFRS: current year + prior year minimum - US GAAP: no requirement

Costs that are not considered in determining fair value:

- Transaction costs: incremental direct costs to sell the asset or transfer the liability (e.g., commissions, certain due diligence costs).

Costs that are considered in determining fair value include:

- Transformation costs: costs to recondition the asset - Transportation costs: costs to move the asset

Determining the appropriate "market" (the principal or the most advantageous) in which to measure fair values

1. Always use the principal market if it exists 2. Use the most advantageous only if no principal market exists.

Entry price vs. exit price: fair value measurement relies of the notion of an exit price rather that an entry price notion to measure fair value.

1. An "entry" price is the price paid to acquire an asset or the amount received to assume a liability in an exchange transaction. 2. The "exit" price is described in the definition of fair value above and is "conceptually different from its transaction price" (an entry price)

Plant assets and depreciation: affect on earnings quality

1. As above, management must first use professional judgment to select a depreciation method. The objective should be to determine which method best reflects the economic reality of how the company's depreciable assets are being consumed to generate revenue. Depreciation methods include: o Straight-line o Double declining o Backers o Sum of years digits o Accelerated method

Fair Market Disclosures: Are designed to enhance the transparency of financial statements regarding:

1. Extent to which FV is used to measure assets and liabilities 2. Valuation techniques, inputs and assumptions used in measuring FV 3. Effect on earnings

Examples of "one time" or nonrecurring items

1. Extraordinary gains and losses 2. Impairment charges 3. Litigation settlements

Accounts receivable and bad debts: affect on earnings quality

1. From the discussion above, initially management exercises professional judgment in determining the method used to estimate bad debts. Ordinarily, one of two variations (usually not disclosed) of the "allowance method" is used: • The income statement approach or An approach that estimates a percentage of credit sales, focus is on an income statement • The balance sheet approach An estimate of accounts receivable

Examples of non-operating items

1. Litigation settlements 2. Restructuring charges 3. Discontinued operations 4. Gains and losses on investment securities (realized and unrealized) 5. Interest revenue and interest expense

In US GAAP, for interim reporting purposes, what are the two classifications of "costs and expenses"? How is each classification accounted for? What does IFRS say about the recognition of expenses for interim reporting purposes?

US GAAP - Costs and expenses for interim reporting purposes may be classified as either of the following a. Costs associated with revenue - those costs that are associated directly with or allocated to the products sold or to the services rendered and that are charged against income in those interim periods in which the related revenue is recognized b. All other costs and expenses - those costs and expenses that are not allocated to the products sold or to the services rendered and that are charged against income in interim fiscal periods as incurred, or are allocated among interim periods based on an estimate of time expired, benefit received, or other activity associated with the periods. IFRS - The Framework says that expenses are recognized in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably

When preparing and issuing financial statements it is necessary to include in the footnotes information related to accounting policies. What exactly should be disclosed in US GAAP and IFRS, respectively, related to accounting policies?

US GAAP - Disclosure of accounting policies shall identify and describe the accounting principles followed by the entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. IFRS - An entity shall disclose in the summary of significant accounting policies Both are similar US GAAP is more concise

If an entity borrows funds to construct a long-term asset, it may earn interest on those funds prior to their use. If that is the case, how is that interest income treated when determining the interest (or borrowing) costs that are eligible for capitalization under IFRS and US GAAP?

US GAAP - Interest earned shall not be offset against interest cost in determining either capitalization rates or limitations on the amount of interest cost to be capitalized IFRS - excess invested would offset interest for borrowing

How is the amount of interest paid reflected on the statement of cash flows under IFRS and US GAAP?

US GAAP - Operating IFRS - Operating or Financing

May an entity elect the last-in first-out (LIFO) method of accounting for its inventory costs under IFRS and (or) US GAAP?

US GAAP - YES CHOICE IFRS - NOT ALLOWED

In US GAAP, corporate joint ventures must be accounted for using one of three methods. What are these methods? What method must a joint venrturer use to account for its interest (investment) in a joint venture under IFRS?

US GAAP - allows for three methods, equity method, cost method, and fair value method don't need to know how they operate just need to know what they are IFRS - determines the type of join arrangement in which is involved, use equity method US GAAP has three choices while IFRS has 1 method

Are property, plant, and equipment (PP&E) initially recorded at historical cost under both IFRS and US GAAP? How might the subsequent accounting for PP&E differ significantly under IFRS and US GAAP?

US GAAP - depreciation is going to be recorded over the life of the asset IFRS - chose either cost model or the revaluation model

Are research and development costs incurred by an entity capitalized or expensed under IFRS and US GAAP?

US GAAP - expense as incurred for both research and development IFRS - Research expense as incurred, but development capitalize if 6 criteria are met, if not expense as incurred

What does US GAAP say about the use of the direct and indirect method of determining the cash flow provided by operating activities in the statement of cash flows? What does IFRS say?

US GAAP - tells what to do if use direct or indirect method, the direct method is encouraged IFRS - IAS 7 - choice to use indirect or direct method and encourage direct method

Under what circumstances, if any, should inventory write-downs be reversed under IFRS and US GAAP?

US GAAP - write downs cannot be reversed IFRS - Reversal is possible if there is an increase in net realizable value

What does US GAAP say about the use of valuation techniques in measuring fair value? What does IFRS say? What are the three valuation techniques that can be used to measure fair value in US GAAP? How about IFRS? How many "levels" of inputs to the valuation techniques are there in US GAAP? Describe each. How many "levels" of inputs to the valuation techniques are there in IFRS? Describe each.

US GAAP and IFRS are identical

What criteria are in place in US GAAP and IFRS to determine whether a lease should be accounted for as a finance/capital lease or as an operating lease?

US GAAP have to meet four criteria to be classified • Is there a bargain purchase option • Does title to the lease property transfer to the lessee after the lease term • Is the present value of minimum future lease payments greater than or equal to 90% of the fair value of the leased property • Is the lease term greater to or equal to 75% of the remaining useful life of the lease property IFRS - Does it transfer risks and rewards

What method of accounting is used under IFRS and US GAAP to recognize revenue on a construction contract when an entity cannot determine the percentage of completion for the construction activities associated with the construction contract?

US GAAP the approach is called completed contract method, do not need to know about IFRS

How are deferred tax assets and liabilities classified or presented on the balance sheet under IFRS and US GAAP?

Under IFRS, deferred tax asset and liabilities are always classified as long-term whereas under US GAAP deferred income taxes may be classified as current or long-term depending on the classification of the underlying asset or liability

What is the recognition threshold for deferred tax assets under IFRS and US GAAP? In other words, how are deferred tax assets not expected to be realized treated under IFRS and US GAAP?

Under IFRS, deferred tax asset is recognized only when probable, whereas under U.S. GAAP the criteria is more likely than not. Judgment is used in both cases but probable is considered to require a higher probability.

Level 3 inputs

Unobservable inputs for the asset or liability. Level 3 inputs should only be used when no observable inputs are available. The use of Level 3 inputs may require an entity to make assumptions about the assumptions that a market participant would use in estimating fair value.

Determining whether a lessee (i.e., renter) should account for a lease as an operating lease or a capital lease is very rules-oriented. If any of four "rules-based" criteria are met, a capital lease exists; if none is met, an operating lease exists.

• Is there a bargain purchase option • Does title to the lease property transfer to the lessee after the lease term • Is the present value of minimum future lease payments greater than or equal to 90% of the fair value of the leased property • Is the lease term greater to or equal to 75% of the remaining useful life of the lease property