FINANCIAL REPORTING UPDATE FOR
Financial Accounting: An Introduction to Concepts, Methods, and Uses
12th Edition
Clyde P. Stickney and Roman L. Weil
Rapid change has occurred in the financial reporting environment since the publication of the 12th edition. Consider the following:
- The continuing convergence of U.S. GAAP and international financial reporting standards (IFRS).
- The willingness of the Securities and Exchange Commission (SEC) in the U.S. and corresponding regulatory bodies in other countries to permit, or to consider permitting or requiring,firms to report using IFRS instead of standards developed within individual countries.
- The movement to measure certain assets and liabilities at fair value instead of acquisition cost.
- The movement to include more changes in fair value in net income instead of other comprehensive income or another shareholders’ equity account.
- The codification of U.S. GAAP into a single source. The FASB has said that it will issue, early in 2009, a compilation of U.S. GAAP, including Statements of Financial Accounting Standards, Accounting Principles Board Opinions, Accounting Research Bulletins, Staff Accounting Bulletins, EITF Consensuses, FASB Interpretations, and several other sorts of pronouncements. This compilation, which organizes the material by topic, brings together into one place the various accounting methods and procedures that treat that topic. Students will need to think in terms of topic numbers, not pronouncement names and numbers, in order to participate in accounting conversations during their professional careers. In this note, we provide both conventional citations and Codification Topic numbers in all citations to U.S. GAAP (except for Statements of Financial Accounting Concepts, which are not part of the Codification).
We summarize the current status of these developments in this note, except that we merely illustrate the last point, the Codification, in footnote references.
CONVERGENCE OF U.S. GAAP AND IFRS
The rapid development and growth of worldwide capital markets during the last decade has led to the need for comparable accounting information across countries. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working toward convergence of U.S. GAAP and IFRS to achieve this objective. The pace of convergence has accelerated during the last several years to the point where the SEC decided in 2007 to permit foreign corporations selling securities in the United States to report using IFRS without having to show a reconciliation to earnings and shareholders’ equity using U.S. GAAP, beginning with fiscal years ending after November 15, 2007. Furthermore, the SEC has set a timetable for deciding whether to require U.S. firms to report using IFRS. The targeted decision date is 2011, with a positive decision leading to implementation beginning in 2014.The SEC proposal would permit early adoption of IFRS for U.S companies (1) that are among the 20 largest companies in their industry, measured by market capitalization, and (2) that are in an industry where a majority of the 20 largest companies now report using IFRS. Those firms could adopt IFRS for fiscal years ending on or after December 31, 2009.
Most of U.S. GAAP discussed in the textbook describes IFRS as well. Exhibit 1 summarizes the major differences between U.S. GAAP and IFRS. Exhibit 1 indicates the chapter in the textbook that discusses each reporting topic. The 13thedition will continue to monitor the convergence of U.S. GAAP and IFRS.
Exhibit 1
Differences Between U.S. GAAP and IFRS
Chapter / Reporting Topic / U.S. GAAP / IFRS6 / Revenue recognition / Must have delivered a product or service in return for net assets capable of reasonably precise measurement. Over 200 specific documents provide guidance to a variety of industries. / No specific industry guidance. For long-term contracts, use percentage of completion method if amounts are estimable. Otherwise, use cost-recovery first method. Cannot use completed contract method.
7 / Inventories and cost of goods sold: lower of cost or market / Measurement of market value uses a combination of replacement cost and net realizable values. / Measurement of market value uses net realizable value.
7 / Inventories: cost flow / Specific identification. FIFO, weighted average, and LIFO cost flow assumptions / Specific identification. FIFO and weighted average cost flow assumptions. No LIFO.
8 / Property, plant and equipment: revaluations above acquisition cost / Not permitted. / Permitted.
8 / Research and development cost / Recognize as an expense in the period incurred. / Recognize research cost as an expense in the period incurred but capitalize development costs and subsequently amortize them over the expected period of benefit.
8 / Property, plant and equipment: impairment loss / If carrying value exceeds undiscounted cash flows, then recognize an impairment loss equal to the excess of carrying value over fair value. / Recognize an impairment loss forthe excess of carrying value over recoverable amount. Recoverable amount is larger of the fair value less cost to sell and the value in use.
8 / Intangible assets with finite lives: impairment loss / If carrying value exceedsundiscounted cash flows, then recognize an impairment loss equal to the excess of carrying value over fair value. / Recognize an impairment loss for the excess of carrying value over recoverable amount. Recoverable amount is larger of the fair value less cost to sell and the value in use.
8 / Intangible assets, other than goodwill, with indefinite lives: impairment loss / Recognize an impairment loss for the excess of carrying value over fair value. / Recognize an impairment loss for the excess of carrying value over recoverable amount. Recoverable amount is the larger of the fair value less cost to sell and the value in use. Test these assets annually for impairment losses and recoveries of impairment losses.
8 / Goodwill: impairment loss / Step 1: Compare the carrying value to the fair value of a reporting unit.
If carrying value exceeds fair value, proceed to Step 2.
Step 2: Allocate the fair value of the reporting unit to assets and liabilities based on their fair values and any excess to goodwill. Recognize an impairment loss on the goodwill if the carrying value exceeds the allocated fair value.
Step 3: Test goodwill annually for impairment loss or whenever a goodwill impairment loss is probable. / Step 1: Compare the carrying value to the recoverable amount for a cash generating unit.
Step 2: Recognize an impairment loss for any excess of carrying value over recoverable amount of the cash generating unit. First write down goodwill to its recoverable amount and then allocate any remaining loss to other assets based on their relative recoverable amounts.
Step 3: Test goodwill annually for impairment losses and recoveries of impairment losses.
9 / Contingent obligations / Recognize as liabilities if payment is probable (probability usually exceeds 80%). Measure at low end of range if no one estimate is better than any other. / Recognize as liabilities if payment is more likely than not (probability exceeds 50%). Measure at fair value.
9, 11 / Fair Value / Provides a hierarchy of measurement methods using measurements from market prices of asset being valued, to market prices of similar assets, to estimated prices derived from models with assumptions. / Uses exit values based on market observations and, at press time, provides no other guidance.
10 / Leases / A lease is a capital lease if it satisfies one of four conditions. Otherwise it is an operating lease. / Judgment required based on several indicators to identify the entity that enjoys the rewards and bears the risk of leasing.
11 / Consolidation of joint ventures / Not permitted. Firms must use the equity method. / Firms have option to use proportionate consolidation or the equity method.
11 / Variable interest entities (VIE) or special purpose entities (SPE): consolidation policy / Primary beneficiary consolidates a VIE. Need not consolidate a Qualified Special Purpose Entity. / Firm controlling a SPE consolidates it.
12 / Preferred stock redeemable at the option of the preferred shareholders / Classified between liabilities and shareholders’ equity. / Classified as a liability.
12 / Convertible bonds or preferred stock / Allocate issue price to bonds or preferred stock and none to conversion option. / Allocate issue price between the bonds or preferred stock and the conversion option.
FAIR VALUE OPTION (Chapters 9 and 11)
U.S. GAAP and IFRS allow firms to account for certain financial assets and certain financial liabilities, including notes and bonds, using either (1) amortized cost, with measurements based on the historical market interest rate, as illustrated in Chapter 9, or (2) fair value, with measurements based on current market conditions, including the current market interest rate.[1] Firms include any unrealized gain or unrealized loss from changes in fair value in net income each period when they select the fair value option. GAAP currently requires firms to include the unrealized gain or loss on certain financial assets (for example, marketable securities classified as available for sale, cash flow hedges) in other comprehensive income when they do not elect the fair value option. We discuss fair value measurements in this section. The discussion of the fair value option also applies to investments in equity securities and derivatives discussed in Chapter 11.
U.S. GAAP and IFRS have taken the position that fair value measurements of financial assets and financial liabilities provide more relevant information than cost-based measurements. Accounting for notes and bonds using the historical market interest rate under the amortized cost approach is a cost-based approach. The FASB and the IASB already require firms to report certain financial instruments related to hedging activities at fair value.[2] Standard-setting bodies are not yet prepared, however, to require fair value measurement for all financial assets and financial liabilities. Thus, they view the option to account for selected financial assets and financial liabilities at fair value as an interim step toward reporting all financial instruments at fair value.
Firms can choose between fair value measurement and the amortized cost approach based on historical market interest rates on a case-by-case (instrument-by-instrument) basis. Firms make this choice when they first adopt the FASB Statement No. 159 (Codification Topic 825)or IAS 39 or when they subsequently acquire a financial asset or incur a financial liability. The choice to use the fair value option is generally irrevocable.
Statement No. 157 (Codification Topic 811)[3]sets forth the requirements for measuring fair value. Perhaps because it views the fair value option as an interim step, the FASB did not provide detailed requirements for applying fair value measurements to the calculation of net income for specific assets and liabilities (for example, notes and bonds). A later section illustrates one possible way to calculate the income effects of notes and bonds under the fair value option.
Underlying concepts for fair value option
Fair value is the amount a firm would receive if it sold an asset or would pay if it settled a liability in an orderly transaction at the measurement date. Measuring fair value rests on the assumption that the transaction would occur in the principal market for the asset or liability or, in the absence of a principal market, in the most advantageous market from the viewpoint of the reporting entity. Thus, a firm that normally obtains and repays long-term debt in public capital markets would determine fair value based on the amount it would pay to repay bonds in those markets. However, a firm that obtained long-term financing from both public capital markets and private placements with insurance companies could choose the market that would provide the most advantageous terms to settle the debt.
Measuring fair value also rests on the assumption that the market participants in the principal (or most advantageous) market are independent of the reporting entity, knowledgeable about the asset or liability, and willing and able to engage in a transaction with the reporting entity. Fair value must reflect assumptions that market participants, as opposed to the reporting entity, would make about the best use of a financial asset or the best terms for settling a financial liability. The best use for a financial asset for a manufacturer might be in combination with other assets, as when an automobile manufacturer uses customer receivables to enhance sales of its automobiles. The best use for a financial asset for a financial institution might be as a standalone asset, as when an investment bank purchases and sells automotive receivables for profit.
Inputs to measuring fair value fall into three categories:
- Level 1: Observable quoted market prices in active markets for identical assets or liabilities that the reporting entity is able to access at the measurement date.
- Level 2: Observable inputs other than quoted market prices within Level 1. This category might include quoted prices for similar assets or liabilities in active market or quoted market prices for identical assets or liability in markets that are not active. This category also includes observable factors that would be of particular relevance in using present values of cash flows to measure fair value, including interest rates, yield curves, foreign exchange rates, credit risks, and default rates.
- Level 3: Unobservable inputs reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing an asset or settling a liability.
Firms should use Level 1 inputs if available to measure fair value, then Level 2 inputs, and lastly Level 3 inputs.
Illustration of Fair Value Option
Assume that Ford issues $250 million face value of 20-year, 8% semiannual coupon bonds, on January 1, 2008. Assume that the market requires a yield of 8% compounded semiannually. Thus, Ford issues the bonds on January 1, 2008, for the $250 million face value. Interest expense for the first period is $10 million (= .08 × ½ × $250 million). The entry to record interest expense is as follows:
June 30, 2008
Interest Expense...... 10,000,000
Cash...... 10,000,000
Assets / = / Liabilities / + / Shareholders’ Equity / (Class.)−10,000,000 / −10,000,000 / IncSt RE
To record interest expense of $10,000,000 (= .04 × $250,000,000) and the required cash payment of $10,000,000. The carrying value of the bonds at the end of the first period is $250 (= $250 initial valuation + $10 interest expense − $10 cash payment) million.
Assume now that the market interest rate on these bonds at the end of the first period increases to 9%. The market price of the bonds decreases to $227,212,930 as the following computations show:
Present Value of an Annuity of $10 million for 39 Periods at 4.5% per Period: $10 million ×18.22966 / $182,296,557Present Value of $250 million for 39 Periods at 4.5% per Period: $250 million × .17967 / 44,916,373
Present Value (Market Value) at End of Period 1...... / $227,212,930
For purposes of this illustration, assume that the market price of $227,212,930 is fair value. If Ford had elected the fair value option for this bond at the time of issue, Ford would now recognize an unrealized gain at the end of the first period of $22,787,070 (= $250,000,000 − $227,212,930), equal to the change in fair value during the period. Ford’s entry to record the unrealized gain is as follows:
June 30, 2008
Bonds Payable...... 22,787,070
Unrealized Gain from Remeasurement of Bonds...... 22,787,070
Assets / = / Liabilities / + / Shareholders’ Equity / (Class.)−22,787,070 / +22,787,070 / IncSt RE
To remeasure bonds from a carrying value of $250,000,000 to a fair value of $227,212,930 and recognize an unrealized gain of $22,787,070.
Ford would include the unrealized gain in net income for this first period.
Continuing this illustration, let’s consider the second period. Interest expense for the second period based on the current market yield at the beginning of the period of 9% compounded semiannually is $10,224,582 (= .09 × 1/2 × $227,212,930). The entry to record interest expense and the cash payment is:
December 31, 2008
Interest Expense...... 10,224,582
Cash...... 10,000,000
Bonds Payable...... 224,582
Assets / = / Liabilities / + / Shareholders’ Equity / (Class.)−10,000,000 / +224,582 / −10,224,582 / IncSt RE
To record interest expense of $10,224,582 (= .045 × $227,212,930), the required cash payment of $10,000,000, and an increase in Bonds Payable for the difference. The carrying value of the bond at the end of the second period before revaluation to fair value is $227,437,512 (= $227,212,930 + $10,224,582− $10,000,000).
Assume now that the yield required by the market on this bond decreases to 7% at the end of the second six months. The fair value of this bond increases to $276,051,359 as the following computations show:
Present Value of an Annuity of $10 million for 38 Periods at 3.5% per Period: $10 million × 20.84109 / $208,410,874Present Value of $250 million for 38 Periods at 3.5% per Period: $250 million × .27056 / 67,640,485
Fair Value at End of Period 2...... / $276,051,359
Ford must now recognize an unrealized loss of $48,613,847 because the fair value of these bonds of $276,051,359 exceeds their carrying value of $227,437,512. The entry is:
December 31, 2008
Unrealized Loss from Remeasurement of Bonds...... 48,613,847
Bonds Payable...... 48,613,847
Assets / = / Liabilities / + / Shareholders’ Equity / (Class.)+48,613,847 / −48,613,847 / IncSt RE
To remeasure bonds from a carrying value of $227,437,512 to a fair value of $276,051,359 and recognize an unrealized loss of $48,613,847.
The total of interest expense and unrealized gains and losses for 2008 is as follows:
Period / Interest Expense / Unrealized Gain (Loss) / Total1 / ($10,000,000) / $22,787,070 / $12,787,070
2 / (10,224,582) / (48,613,847) / (58,838,429)
Total / ($20,224,582) / ($25,826,777) / ($46,051,359)
The effect on net income before taxes of −$46,051,359 equals the cash payments for interest of $20,000,000 (= $10,000,000 × 2) plus the −$26,051,359 increase in fair value of the debt from $250,000,000 at the beginning of the year to $276,051,359 at the end of the year. An increase (decrease) in the fair value of a liability implies an unrealized loss (gain).
The FASB stated that it would not specify how firms applying the fair value option should measure interest expense. An alternative to using the effective interest method illustrated above might be to set interest expense equal to the cash payments of $20,000,000. This approach would result in $224,582 (= $20,224,582 − $20,000,000) less interest expense, a $224,582 smaller carrying value of the bonds at the end of the second period before remeasurementand a $224,582 larger unrealized loss. Thus, the effect on net income before taxes is the same regardless of the allocation between interest expense and net unrealized loss.