Balance Sheet: Reporting Liabilities

Publication Date: June 2021

Balance Sheet: Reporting Liabilities

Copyright © 2021 by

DELTACPE LLC

All rights reserved. No part of this course may be reproduced in any form or by any means, without permission in

writing from the publisher.

The author is not engaged by this text or any accompanying lecture or electronic media in the rendering of legal,

tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this

material have been reviewed with sources believed to be reliable, concepts discussed can be affected by changes

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All numerical values in this course are examples subject to change. The current values may vary and may not be

valid in the present economic environment.

Course Description

A liability is a legal debt or obligation that arises during business operations. A current liability, such as accounts

payable, is payable within one year. A noncurrent liability, such as bonds payable, long-term loan, and finance

lease, is an obligation that is due in over a year. This course discusses generally accepted accounting principles

(GAAP) for reporting both current and noncurrent liabilities on the balance sheet.

Learning Objectives

After completing this course, you should be able to:

1. Recognize basic principles of reporting liabilities on the balance sheet

2. Identify classification and characteristics of liabilities

3. Recognize the appropriate rules to account for contingencies

4. Identify accounting procedures for accounts payable and deferred revenues

5. Recognize rules for the troubled debt, environmental liabilities, and lessee accounting

6. Recognize the accounting procedures for bonds payable and notes with no stated rate of interest

Field of Study Accounting

Level of Knowledge Intermediate

Prerequisite Basic Accounting

Advanced Preparation None

Table of Contents Chapter 1: Financial Reporting Standards ...................................................................................... 1

Objectives of Financial Reporting ................................................................................................................1

Characteristics of Liabilities ........................................................................................................................4

Present Obligation .............................................................................................................................................................. 4

Obligation to Provide Economic Benefits ........................................................................................................................... 6

Recognition and Measurement ...................................................................................................................8

Current Liabilities ................................................................................................................................................................ 9

Noncurrent Liabilities ........................................................................................................................................................ 11

Loss Contingencies ............................................................................................................................................................ 12

Review Questions − Section 1 ................................................................................................................... 17

Fair Value Accounting ............................................................................................................................... 19

General Rules .................................................................................................................................................................... 20

Scope ................................................................................................................................................................................. 21

The Fair Value Hierarchy ................................................................................................................................................... 22

Disclosure Requirements .................................................................................................................................................. 24

Fair Value Option ..................................................................................................................................... 28

Scope ................................................................................................................................................................................. 28

Election Dates ................................................................................................................................................................... 29

Presentation and Disclosures ............................................................................................................................................ 30

Other Matters .......................................................................................................................................... 31

Risks and Uncertainties ..................................................................................................................................................... 31

Exit or Disposal Activities .................................................................................................................................................. 33

IFRS Connection ................................................................................................................................................................ 35

Review Questions − Section 2 .................................................................................................................. 36

Chapter 2: Current Liabilities .......................................................................................................... 38

Accounts Payable ..................................................................................................................................... 38

Deferred Revenues ................................................................................................................................... 39

Step 1: Identify the Contract with a Customer ................................................................................................................. 39

Step 2: Identify the Performance Obligations................................................................................................................... 40

Compensated Absences .................................................................................................................................................... 42

Other Matters .......................................................................................................................................... 44

Callable Obligations .......................................................................................................................................................... 44

Troubled Debt Restructuring ............................................................................................................................................ 45

Termination Benefits (Early Retirement) .......................................................................................................................... 47

Environmental Liabilities ................................................................................................................................................... 48

Review Questions − Section 3 .................................................................................................................. 49

Chapter 3: Noncurrent Liabilities ................................................................................................... 52

Bond Accounting ...................................................................................................................................... 52

General Rules .................................................................................................................................................................... 52

Convertible Debt ...................................................................................................................................... 58

General Rules .................................................................................................................................................................... 58

Inducement Offer to Convert Debt to Equity ................................................................................................................... 61

Early Extinguishment of Debt .................................................................................................................... 64

Short-Term Obligations Refinanced........................................................................................................... 67

Review Questions − Section 4 .................................................................................................................. 69

Deferred Tax Liability ............................................................................................................................... 71

Lease Obligations ..................................................................................................................................... 73

General Rules .................................................................................................................................................................... 73

Disclosure Requirements .................................................................................................................................................. 76

Other Matters .......................................................................................................................................... 78

Interest on Noninterest Notes Payable ............................................................................................................................ 78

Presentation and Disclosure of Long-Term Debt .............................................................................................................. 82

Review Questions − Section 5 .................................................................................................................. 85

Glossary ..................................................................................................................................................... 87

Index .......................................................................................................................................................... 89

Appendix ................................................................................................................................................... 90

Review Question Answers ........................................................................................................................ 94

Review Questions − Section 1 .................................................................................................................. 94

Review Questions − Section 2 .................................................................................................................. 96

Review Questions − Section 3 .................................................................................................................. 98

Review Questions − Section 4 ................................................................................................................ 101

Review Questions − Section 5 ................................................................................................................ 103

1

Chapter 1: Financial Reporting Standards

“A statement of financial position provides information about an entity’s assets, liabilities, and equity and their

relationships to each other at a moment in time. The statement delineates the entity’s resource structure—major

classes and amounts of assets—and its financing structure—major classes and amounts of liabilities and equity.”

Statement of Financial Accounting Concepts No. 5

Objectives of Financial Reporting

Financial statements are a central feature of financial reporting; a principal means of communicating financial

information to those outside an entity. There are two different types of elements of financial statements:

1. Assets, liabilities, and equity describe resources or claims to or interests in resources at a specified date

2. The effects of transactions and other events and circumstances affect an entity during specified time

intervals (reporting periods). In a business entity, this consist of comprehensive income and its

components—revenues, expenses, gains, and losses—and investments by owners and distributions to

owners

The three main financial statements are the balance sheet or the statement of financial position, income

statement, and statement of cash flows. The balance sheet portrays the financial position of an entity at a

particular point in time (as of a specific date), including an entity’s:

1. Assets (economic resources): What it owns, such as cash, land, and equipment;

2. Liabilities (economic obligations): How much it owes to vendors and lenders, such as loans payable and

mortgage payable; and

3. Owners' equity: Residual interest remaining after assets have been reduced by liabilities.

A balance sheet, a snapshot of the entity's financial position, delineates its resource structure. It provides

information about an entity’s assets, liabilities, and equity and their relationships to each other at a moment in

time. Balance sheets are usually presented in comparative form. Comparative statements include the current

year’s statement and statements of one or more of preceding accounting periods. Comparative statements help

evaluate and analyze trends and relationships.

Entities routinely incur liabilities in exchange transactions to acquire the funds, goods, and services they need to

operate. For example:

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✓ Borrowing cash (acquiring funds) obligates an entity to repay the amount borrowed;

✓ Acquiring assets on credit obligates an entity to pay for the assets; and

✓ Selling products with a warranty or guarantee obligates an entity to stand ready to either pay cash or repair

or replace any products that prove defective.

Exhibit A shows a comparative balance sheet for the Beta Company.

According to Concepts Statement No. 8, Conceptual Framework for Financial Reporting:

“The objective of general purpose financial reporting is to provide financial information about the reporting entity

that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing

resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and

providing or settling loans and other forms of credit.”

If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent.

The usefulness of financial information is enhanced if it is comparable, verifiable, timely, and understandable.

The fundamental qualities under relevance are predictive value and confirmatory value, which is information that

is capable of making a difference in one of those decisions only if it will help users to make new predictions,

confirm or correct prior predictions, or both. Concepts Statement No. 8 specifies that financial information has:

• Predictive value if it can be used as an input to processes employed by users to predict future outcomes

• Confirmatory value if it provides feedback (confirms or changes) about previous evaluations

Materiality is mentioned as an aspect of relevance. Materiality is entity-specific. The omission or misstatement of

an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such

that it is probable that the judgment of a reasonable person relying upon the report would have been changed or

influenced by the inclusion or correction of the item.

Faithful representation means that financial information represents the substance of an economic phenomenon

rather than merely representing its legal form. It has three characteristics:

1. Completeness

2. Neutrality

3. Free from error

A complete depiction includes all information necessary for a user to understand the phenomenon being shown,

together with all necessary descriptions and explanations. A neutral depiction is without bias in the selection or

presentation of financial information. Concepts Statement No. 8 explains that it is not slanted, weighted,

emphasized, deemphasized, or otherwise manipulated to increase the probability that financial information will

be received favorably or unfavorably by users. Free from error means:

• There are no errors or omissions in the description of the phenomenon; and

• The process/procedures used to generate the reported information have been selected and applied with

no errors in the process.

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Exhibit A: Consolidated Balance Sheet for Beta Company

Beta Company

Consolidated Balance Sheet

December 31, 20X9 and 20X8

(Millions of dollars)

20X9 20X8

Assets

Current assets

Cash and cash equivalents $40.0 $30.0

Short-term marketable securities 80.0 64.0

Accounts receivable, net of allowances of $88

in 20X9 and $69 in 20X8 312.0 290.0

Inventories 360.0 370.0

Prepaid expenses and other current Assets 8.0 6.0

Total current assets 800.0 760.0

Property, plant, and equipment 770.0 693.2

Less accumulated depreciation (250.0) (195.0)

Property, plant, and equipment, net 520.0 498.2

Intangibles (patents,) 4.0 5.0

Total Assets $1,324.0 $1,263.2

Liabilities and stockholders' equity

Current liabilities

Accounts payable $144.0 $138.0

Current portion of long-term debt and short-term borrowings 102.0 122.0

Accrued payroll-related liabilities 94.0 102.0

Total current liabilities 340.0 362.0

Noncurrent liabilities

Long-term debt 272.0 272.0

Deferred income taxes 20.0 18.0

Total liabilities $632.0 $652.0

Stockholders' equity

Preferred stock $5.83 cumulative, $100 par value, authorized

150,000, outstanding 120,000 $12.0 $12.0

Common stock $5 par value, outstanding 20X9 30,000,000 shares,

20X8 29,000,000 150.0 145.0

Additional paid-in capital on common stock 32.0 15.0

Retained earnings 498.0 439.2

Stockholders' equity 692.0 611.2

Total Liabilities and Stockholder's Equity $1,324.0 $1,263.2

4

Characteristics of Liabilities

“A liability is a present obligation of an entity to transfer an economic benefit.”

Concepts Statement No. 8: Chapter 4, Elements of Financial Statements

In July 2020, the Financial Accounting Standards Board (FASB) issued a proposed chapter (Chapter 4: Elements of

Financial Statements) of Concepts Statement No.8 for defining 10 elements of financial statements (e.g. assets,

liabilities, equity). This proposed chapter would replace Concepts Statement No. 6 and clarify the definition of the

elements in Concepts Statement No. 6 by:

✓ Clearly identifying the right or obligation that gives rise to an asset or a liability;

✓ Eliminating terminology that makes the definitions of assets and liabilities difficult to understand and

apply;

✓ Clarifying the distinction between liabilities and equity and between revenues and gains and expenses

and losses; and

✓ Modifying the distinctions in equity for not-for-profit entities

While not considered authoritative, Concepts Statements serve as the framework that the FASB uses to create

requirements in future standards.

According to Concepts Statement No. 8, a liability has the following two essential characteristics:

1. Present obligation: An entity must have an obligation that exists at the financial statement date.

2. Obligation to provide economic benefits: The obligation requires an entity to transfer or otherwise provide

economic benefits to others

Typically, obligations incurred in exchange transactions are contractual based on written or oral agreements to

pay cash or to provide goods or services to specified or determinable entities on demand at specified or

determinable dates or on the occurrence of specified events.

Each characteristic is addressed in the following sections.

Present Obligation

A liability requires that an entity be obligated to perform or act in a certain manner. Most liabilities are legally

enforceable through binding contracts, agreements, rules, statutes, or other requirements upheld by a judicial

system or government. In a financial reporting context:

✓ An obligation is any condition that binds an entity to some performance or action.

✓ Something is binding on an entity if it requires performance.

✓ Performance is what the entity is required to do to satisfy the obligation.

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Although most liabilities are based on a foundation of legal rights and duties, the existence of a legally enforceable

claim is not a prerequisite for an obligation to qualify as a liability.

An obligation of an entity to itself cannot be a liability. That is, liabilities must involve other parties, society, or

law. For example, in the absence of external requirements a company is not obligated to maintain its plant and

equipment. Some obligations require nonreciprocal transfers from an entity to one or more other entities.

Example of such obligations include:

✓ Taxes imposed by governments;

✓ Donations pledged to charitable entities; and

✓ Cash dividends declared but not yet paid.

To have a liability, an entity must have an obligation that exists at the financial statement date. Although the

settlement date of the liability may occur in the future, the entity must present the obligation at the financial

statement date.

Transactions or other events expected to occur in the future do not in and of themselves give rise to obligations

today. For instance, an intention to purchase equipment; equipment does not in and of itself create a liability.

However, a contractual obligation that requires an entity to pay more than the fair value of the equipment at the

transaction date may create a liability before it is received, reflecting what the entity might have to pay to undo

the unfavorable contract.

Various circumstances give rise to business risks. The sources of risk can arise from an entity’s objectives, the

nature of its operations/industry, the regulatory environment in which it operates, and its size and complexity.

Business risk is not a present obligation, though at some point in the future an event may occur that creates a

present obligation.

Concepts Statement No. 8 explains that the essence of distinguishing business risks from liabilities is determining

the point in time when an entity has a present obligation. For example, the operation of a passenger airline is

considered a business risk. Airlines have the business risk that a plane might crash, creating liabilities for the

airlines. However, those business risks do not produce a present obligation for the consequences of a plane crash

that has yet to occur. Other examples of business risks include:

• Selling goods in overseas markets might expose an entity to the risk of future cash flow fluctuations

because of changes in foreign exchange rates

• Technological developments may make a particular product obsolete

• Operating in a highly specialized industry might expose an entity to the risk that it will be unable to attract

sufficient skilled staff to sustain its operating activities

Companies usually discuss business risks in the forward-looking statements of their Annual Report Form 10-K as

demonstrated in Exhibit B.

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To be presently obligated, an entity must be bound, either legally or in some other way, to perform or act in a

certain way such as constructive obligations. A constructive obligation is created, inferred, or construed from the

facts in a particular situation rather than contracted by agreement with another entity or imposed by the

government. Examples of constructive obligations include:

✓ Policies and practices for sales returns and those for warranties in the absence of a contract may create a

present obligation.

✓ Companies pay their employees for vacation or year-end bonuses every year.

Determining whether an entity is bound by an obligation to a third party in the absence of legal enforceability is

often extremely difficult. Thus, the concepts of constructive obligations must be applied with great care.

Obligation to Provide Economic Benefits

The obligation establishes the responsibility of the entity to fulfill the requirements of the obligation or otherwise

satisfy or settle the obligation in different ways such as:

• Transferring cash or other assets

• Providing services

• Granting a right to use an asset

• Replacing that obligation with another obligation

• Converting the obligation to equity

• Transferring shares of the entity

Such obligations are often documented including:

1. How the entity is required to fulfill the obligation; and

2. When—by a specified date or when specified events occur

For example, a company receives a payment from its customer resulting in an obligation if the company receiving

it is expected to provide a product on a certain day or refund the payment if the product is not provided.

If arrangements allow or require settlement of obligations by the issuance of a variable number of the entity’s

own shares, those shares are essentially being used in lieu of assets to settle an obligation and therefore meet the

definition of a liability.

In some cases, the amount and timing of settlement or performance associated with a present obligation are

uncertain; commonly referred to as stand-ready obligations. With a stand-ready obligation, an entity’s timing of

settlement or performance, the amount of economic benefits that the entity will transfer, or both are not known

at the financial reporting date. Examples of stand-ready obligations include:

✓ Warranties: The warranty issuer recognizes its liability arising from its obligation to provide warranty

coverage. The amount of the warranty depends on an uncertain future event; the product developing a fault

during the warranty period. However, that uncertainty does not affect the existence of a present obligation

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to provide warranty coverage. Instead, the uncertainty about whether the product will require repair or

replacement is reflected in the measurement of the liability.

In non-contractual situations, an entity may implicitly warrant a product and, as a result, that entity would

stand ready to provide services.

✓ Guarantees: Writing a guarantee creates a present obligation even if an outflow resulting from the guarantee

is remote. The uncertainty of the payment affects the measurement of the guarantee, not the existence of an

obligation to honor the guarantee if called upon to do so.

✓ Options: An entity formally documents that it will act in a certain way in the future if called upon by the holder

of the option. Even though the external party (option holder) may never exercise the option, the entity that

wrote the option is obligated to act as required by the option contract.

Present obligations with uncertain amounts and timing are referred to as contingent liabilities.

Although both stand-ready obligations and business risks can result in an outflow of economic benefits, stand-

ready obligations are liabilities because they involve present obligations. As mentioned, a business risk does not

give rise to a present obligation. Thus, the existence of a present obligation distinguishes stand-ready obligations

(and more generally liabilities) from business risks.

Exhibit B: Forward-Looking Statements

Netflix, Inc.

Annual report for the fiscal year ended December 31, 2020

Risks Related to Our Business

Changes in competitive offerings for entertainment video, including the potential rapid adoption of piracy-based video

offerings, could adversely impact our business.

The market for entertainment video is intensely competitive and subject to rapid change. Through new and existing

distribution channels, consumers have increasing options to access entertainment videos. The various economic models

underlying these channels include subscription, transactional, ad-supported, and piracy-based models. All of these have

the potential to capture meaningful segments of the entertainment video market. Piracy, in particular, threatens to

damage our business, as its fundamental proposition to consumers is so compelling and difficult to compete against:

virtually all content for free. Furthermore, in light of the compelling consumer proposition, piracy services are subject to

rapid global growth. Traditional providers of entertainment video, including broadcasters and cable network operators, as

well as internet-based e-commerce or entertainment video providers are increasing their streaming video offerings.

Several of these competitors have long operating histories, large customer bases, strong brand recognition, exclusive rights

to certain content, and significant financial, marketing, and other resources. They may secure better terms from suppliers,

adopt more aggressive pricing and devote more resources to product development, technology, infrastructure, content

acquisitions and marketing. New entrants may enter the market or existing providers may adjust their services with unique

offerings or approaches to providing entertainment video. Companies also may enter into business combinations or

alliances that strengthen their competitive positions. If we are unable to successfully or profitably compete with current

8

and new competitors, our business will be adversely affected, and we may not be able to increase or maintain market

share, revenues or profitability.

If government regulations relating to the internet or other areas of our business change, we may need to alter the

manner in which we conduct our business or incur greater operating expenses.

The adoption or modification of laws or regulations relating to the internet or other areas of our business could limit or

otherwise adversely affect the manner in which we currently conduct our business. As our service and others like us gain

traction in international markets, governments are increasingly looking to introduce new or extend legacy regulations to

these services, in particular those related to broadcast media and tax. For example, recent changes to European law enable

individual member states to impose levies and other financial obligations on media operators located outside their

jurisdiction. We anticipate that several jurisdictions may, over time, impose greater financial and regulatory obligations on

us. In addition, the continued growth and development of the market for online commerce may lead to more stringent

consumer protection laws, which may impose additional burdens on us. If we are required to comply with new regulations

or legislation or new interpretations of existing regulations or legislation, this compliance could cause us to incur additional

expenses or alter our business model.

Changes in laws or regulations that adversely affect the growth, popularity or use of the internet, including laws impacting

net neutrality, could decrease the demand for our service and increase our cost of doing business. Certain laws intended

to prevent network operators from discriminating against the legal traffic that traverses their networks have been

implemented in many countries, including across the European Union. In others, the laws may be nascent or non-existent.

Furthermore, favorable laws may change, including for example, in the United States where net neutrality regulations

were repealed. Given uncertainty around these rules, including changing interpretations, amendments or repeal, coupled

with potentially significant political and economic power of local network operators, we could experience discriminatory

or anti-competitive practices that could impede our growth, cause us to incur additional expense or otherwise negatively

affect our business.

Recognition and Measurement

“For items that meet criteria for recognition, disclosure by other means is not a substitute for recognition in

financial statements.”

Statement of Financial Accounting Concepts No. 5

Recognition is the process of formally recording or incorporating an item into the financial statements as an asset,

liability, revenue, expense, or the like. Recognition includes the depiction of an item in both words and numbers,

with the amount included in the totals of the financial statements. For a liability, recognition involves recording

not only acquisition or incurrence of the item but also later changes in it, including changes that result in removal

from the financial statements.

According to Statement of Financial Accounting Concepts No. 5, liabilities are recognized in the balance sheet

when the following four criteria are met, subject to a cost-benefit constraint and a materiality threshold:

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1. Definitions: The item meets the definition of a liability;

2. Measurability: It has a relevant attribute measurable with sufficient reliability;

3. Relevance: The information about it is capable of making a difference in user decisions; and

4. Reliability: The information is representationally faithful, verifiable, and neutral.

Cost-benefit constraint means that the expected benefits from recognizing a particular item should justify the

perceived costs of providing and using the information. Materiality indicates that an item and information about

it need not be recognized in a set of financial statements if the item is not large enough to be material and the

aggregate of individually immaterial items is not large enough to be material to those financial statements.

A classified balance sheet generally breaks down liabilities into two categories; current liabilities and noncurrent

liabilities. Liabilities are typically listed on the balance sheet in order of shortest term to longest term to help users

understand what is due and when at a glance.

Current Liabilities

Current liabilities are those to be paid or liquidated from current assets or created from other current liabilities.

They are due on demand or within one year or the normal operating cycle of the business, whichever is greater.

Current liabilities may arise in which:

• The payee and amount are known.

• The payee is not known but the amount may be reasonably estimated.

• The payable is known but the amount must be estimated.

• The liability arises from a loss contingency.

In general, current liabilities include:

✓ Obligations that by their terms are or will be due on demand within one year (or the operating cycle, if

longer); and

✓ Obligations that are or will be callable by the creditor within one year because of a violation of a debt

covenant. An exception exists, however, if the creditor has waived or subsequently lost the right to

demand repayment for more than one year (or the operating cycle, if longer) from the balance sheet date.

Thus, the following transactions may result in current liabilities:

1. Payables incurred in the acquisition of materials and supplies are used in the production of goods or in

providing services offered for sale

2. Collections are received in advance of the delivery of goods or performance of services

3. Debts arise from operations directly related to the operating cycle, such as accruals for wages, salaries,

commissions, rentals, royalties and income, and other taxes

4. Liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period,

usually 12 months, such as:

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• Short-term debts arising from the acquisition of capital assets

• Serial maturities of long-term obligations

• Amounts required to be extended within one year under sinking fund provisions

5. Agency liabilities are amounts withheld by the company from employees or customers for taxes owed to

federal, state, or local taxing agencies.

6. The liability for an underfunded defined benefit plan may be classified as a current liability, noncurrent

liability, or a combination of both.

7. Obligations are due on demand or within one year even if liquidation is not anticipated within that period.

8. Long-term obligations that are or will be callable by the creditor either because the debtor's violation of

a provision of the debt agreement at the balance sheet date makes the obligation callable or because of

the violation.

Common current liabilities include:

• Accounts payable

• Bank account overdrafts

• Short-term notes payable

• Current maturities of noncurrent liabilities (e.g. the current portion of long-term debt to be paid within

the next year, the amount due on demand)

• Deferred revenues (or unearned revenues)

• Short-term lease obligations

• Accrued expenses (e.g. payrolls, interest, taxes, product warranties)

ASC 606, Revenue from Contracts with Customers, refers to “contract liabilities” rather than “deferred revenues”.

The concept of contract liabilities remains the same as deferred revenues. However, circumstances and amounts

could differ. Details are addressed in the “Deferred Revenues” section.

These accounts also fall into one of three groups:

Groups of Current Liabilities Definition Examples

Clearly determinable

liabilities

Liabilities are certain and can be

measured

− Accounts payable

− Notes payable

− Interest payable

− Wages payable

− Sales tax payable

− Federal excise tax payable

− Current portions of long-term debt

− Payroll liabilities

Estimated liabilities Liabilities are certain but its amount

only can be estimated

− Warranty payable

− Obligations for pension benefits

− Deferred taxes

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Contingent liabilities Liabilities arise from an existing

situation or set of circumstances

involving uncertainty as to possible

loss to an entity that will ultimately be

resolved when one or more future

events occur or fail to occur

− Potential lawsuits

− Product warranties

− Pending investigation

Details of contingent liabilities are addressed in the “Loss Contingencies” section.

Noncurrent Liabilities

In general, debt is classified as noncurrent if it is due in over a year’s time. It is not to be paid from current assets

or the incurrence of current liabilities. However, current maturities of noncurrent liabilities (e.g. the current

portion of long-term debt to be paid within the next year, the amount due on demand) are considered current

liabilities.

If a borrowing arrangement permits the debtor to redeem the debt instrument within one year, it is presented

under current liabilities. However, the debt is classified as noncurrent if the letter of credit agreement satisfies

the following criteria:

✓ The financing agreement does not terminate within one year.

✓ The refinancing is on a long-term basis.

✓ The lender cannot cancel the agreement unless there is a clearly ascertainable violation.

Common noncurrent liabilities include:

• Bonds payable

• Long-term loans (e.g. mortgage payable)

• Refinancing of short-term obligations

• Deferred tax liabilities

• Long-term lease obligations

Long-term debt should be recorded at the present value discounted of future payments using the market rate of

interest. Derivatives and liabilities arising from the transfer of financial assets are recorded at fair market value as

discussed in the “Fair Value Accounting” section.

ASC 470-10-35, Debt: Overall, stipulates that notes maturing in three months having a continual extension option

for up to five years may be classified after taking into account the intentions of the parties and the issuer's ability

to pay the debt. If the source of repayment is current, the debt should be classified as current. However, if the

source of repayment is noncurrent, the debt is noncurrent in nature. Interest should be computed based on the

interest method. Debt interest costs should be deferred and amortized over the outstanding period of the debt.

If excess accrued interest arises from paying the debt before maturity, it should be used to adjust interest expense.

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Example 1

Shapiro Company presented the following, liabilities at year-end 20X2:

Accounts payable $100,000

Notes payable, 10%, due 7/1/20X3 600,000

Contingent liability 150,000

Accrued expenses 20,000

Deferred income tax credit 25,000

Bonds payable, 9%, due 5/1/20X3 500,000

The contingent liability represents a reasonably possible loss arising from a $400,000 lawsuit against Shapiro. In

the opinion of legal counsel, the lawsuit is expected to be resolved in 20X4. The range of loss is $200,000 to

$600,000. The deferred income tax credit is expected to reverse in 20X4.

At year-end 20X2, current liabilities equal $1,220,000, computed as follows:

Accounts payable $ 100,000

Notes payable, due 7/1/20X3 600,000

Accrued expenses 20,000

Bonds payable, due 5/1/20X3 500,000

Total $1,220,000

Loss Contingencies

Contingency is an existing condition, situation, or set of circumstances involving uncertainty as to loss (loss

contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur.

The following table lists examples of loss contingencies and the general accounting treatment accorded them.

Accounting Treatment Loss Related to:

Usually Accrued

• Collectibility of receivables

• Obligations related to product warranties and product defects

• Premiums offered to customers

Not Accrued

• Risk of loss or damage of enterprise property by fire, explosion, or other hazards

• General or unspecified business risks

• Risk of loss from catastrophes assumed by property and casualty insurance

companies, including reinsurance companies

May Be Accrued*

• Threat of expropriation of assets

• Pending or threatened litigation

13

• Actual or possible claims and assessments**

• Guarantees of indebtedness of others

• Obligations of commercial banks under "standby letters of credit"

• Agreements to repurchase receivables (or the related property) that have been sold

*Should be accrued when both criteria—probable and reasonably estimable—are met.

**Estimated amounts of losses incurred prior to the balance sheet date but settled subsequently should be accrued as of the

balance sheet date.

An estimated loss from a loss contingency must be accrued in the accounts and reported in financial statements

as a charge against income and as a liability if both of the following conditions are met:

✓ It is probable that a liability has been incurred at the date of the financial statements; and

✓ The amount of the loss can be reasonably estimated.

The likelihood that a liability has been incurred ranges from “remote” to “reasonably possible” to “probable.

Probable is considered “likely to occur,” which is generally considered a 75%-80% threshold.

The accrual is required because of the conservatism principle. The journal entry to record a probable loss

contingency is:

Expense (loss) xxx

Estimated Liability xxx

The conservatism principle means being cautious or prudent and making sure that assets and net income are not

overstated to avoid misleading potential investors and creditors. The principle is sometimes expressed as

“Recognize all losses and anticipate no gains.” Thus, a gain contingency is not recorded in the financial statements.

Details of accrual accounting are addressed in the “Accrued Expenses” section.

If there exists a reasonably possible loss, no accrual should be made. However, footnote disclosure is required.

The disclosure includes the nature of the contingency and the estimated probable loss or range of loss. In the

event an estimate of loss cannot be made, that fact should be stated. A remote contingency (slight chance of

occurring) is typically ignored, with no disclosure required. However, entities are required to disclose remote

contingency for agreements to repurchase receivables, indebtedness guarantees (direct or indirect), and standby

letters of credit.

Reasonably possible indicates that the chance of the future event or events occurring is more than remote but

less than likely. Remote means that the chance of the future event or events occurring is slight.

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Example 2

A company cosigned a loan guaranteeing the indebtedness if the borrower defaults on it. The likelihood of default

is remote. This is an exception to the rule that remote contingencies need not be disclosed because it represents

a guarantee of indebtedness and thus requires disclosure.

No accrual is made for general (unspecified) contingencies, such as for self-insurance and hurricane losses.

However, footnote disclosure and appropriation of retained earnings can be made for such contingencies. To be

accrued, the future loss must be specific and measurable, such as freight or parcel post losses.

If the loss amount is within a range, the accrual should be based on the best estimate within that range. If no

amount within the range is better than any other amount, the minimum amount of the range should be accrued.

There should be the disclosure of the maximum loss. If later events indicate that the minimum loss initially accrued

is insufficient, an additional loss must be accrued in the year this becomes evident. This accrual is treated as a

change in estimate. If a probable loss cannot be estimated, it should be footnoted.

Example 3

XYZ Company is involved in a tax dispute with the Internal Revenue Service (IRS). As of December 31, 20X3, XYZ

Company believed that an unfavorable outcome is probable and the amount of loss may be in the range of $2.5

million to $3.5 million. After year-end, when the 20X3 financial statements had been issued, XYZ Company settled

with the IRS and accepted an offer of $3 million. Because a range of loss is involved, it is appropriate to accrue the

minimum amount or $2.5 million for 20X3 year-end.

A company may offer potential customers premiums (something free or for a minimal charge, such as samples) to

stimulate product sales. The customer may be required to return evidence of the purchase of certain products

(e.g. box top) to get the premium. A nominal cash payment may be necessary. A current liability arises for the

amount of anticipated redemptions in the next year. If the premium and redemption period is for more than one

year, an estimated liability must be allocated to the current and noncurrent portions.

If there is a loss contingency at year-end but no asset impairment or liability incurrence exists (e.g., uninsured

equipment), footnote disclosure should be made. If there is a loss contingency occurring after year-end but before

the audit report date, subsequent event disclosure should be made. An explanatory paragraph should be provided

regarding the contingency.

Unasserted claims exist when the claimant has elected not to assert the claim or because the claimant lacks

knowledge of the existence of the claim. If it is probable that the claimant will assert the unasserted claim, and it

is either probable or reasonably possible that the outcome will be unfavorable, the unasserted claim should be

disclosed in the financial statements. Contingent consideration in a business combination relates to an additional

amount paid by the acquirer to the shareholders of the acquiree when certain conditions (such as meeting futures

earnings targets) are met. Under ASC 805-30-25-5 through 25-7, the acquisition method requires that the

contingency be measured at fair value and a liability be recorded at the closing date. Subsequent changes in the

fair value of contingent consideration are recorded in earnings.

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Exhibit C shows how a company discloses its loss contingency.

Exhibit C: Loss Contingencies

General Electric Company

Annual report for the fiscal year ended December 31, 2020

Alstom legacy legal matters. On November 2, 2015, we acquired the Thermal, Renewables and Grid businesses from

Alstom. Prior to the acquisition, the seller was the subject of two significant cases involving anti-competitive activities and

improper payments: (1) in January 2007, Alstom was fined €65 million by the European Commission for participating in a

gas-insulated switchgear cartel that operated from 1988 to 2004 (that fine was later reduced to €59 million), and (2) in

December 2014, Alstom pled guilty in the United States to multiple violations of the Foreign Corrupt Practices Act and paid

a criminal penalty of $772 million. As part of GE’s accounting for the acquisition, we established a reserve amounting to

$858 million for legal and compliance matters related to the legacy business practices that were the subject of these and

related cases in various jurisdictions, including the previously reported legal proceedings in Slovenia that are described

below. The reserve balance was $858 million and $875 million at December 31, 2020, and December 31, 2019, respectively.

Regardless of jurisdiction, the allegations relate to claimed anti-competitive conduct or improper payments in the pre-

acquisition period as the source of legal violations and/or damages. Given the significant litigation and compliance activity

related to these matters and our ongoing efforts to resolve them, it is difficult to assess whether the disbursements will

ultimately be consistent with the reserve established. The estimation of this reserve involved significant judgment and

may not reflect the full range of uncertainties and unpredictable outcomes inherent in litigation and investigations of this

nature, and at this time we are unable to develop a meaningful estimate of the range of reasonably possible additional

losses beyond the amount of this reserve. Damages sought may include disgorgement of profits on the underlying business

transactions, fines and/or penalties, interest, or other forms of resolution. Factors that can affect the ultimate amount of

losses associated with these and related matters include the way cooperation is assessed and valued, prosecutorial

discretion in the determination of damages, formulas for determining fines and penalties, the duration and amount of

legal and investigative resources applied, political and social influences within each jurisdiction, and tax consequences of

any settlements or previous deductions, among other considerations. Actual losses arising from claims in these and related

matters could exceed the amount provided.

In connection with alleged improper payments by Alstom relating to contracts won in 2006 and 2008 for work on a state-

owned power plant in Šoštanj, Slovenia, the power plant owner in January 2017 filed an arbitration claim for damages of

approximately $430 million before the International Chamber of Commerce Court of Arbitration in Vienna, Austria. In

February 2017, a government investigation in Slovenia of the same underlying conduct proceeded to an investigative phase

overseen by a judge of the Celje District Court. In September 2020, the relevant Alstom legacy entity was served with an

indictment, which we had anticipated as we are working with the parties to resolve these matters.

16

Comprehensive Illustration

XYZ Company offers its customers a camera in exchange for 20 boxtops and $3. The camera costs the company

$18. It is expected that 60% of the boxtops will be redeemed. The following journal entries are required:

1. To record the purchase of 10,000 cameras at $18 each:

Inventory of premium cameras 180,000

Cash 180,000

2. To record the sale of 400,000 boxes of the company's major product at $3 each:

Cash 1,200,000

Sales 1,200,000

3. To record the actual redemption of 120,000 boxtops, the receipt of $3 per 20 boxtops, and the delivery of the

cameras:

Cash [(120,000/20 × $3)] 18,000

Premium expense 90,000

Inventory of premium cameras [(120,000/20) × $18] 108,000

4. To record end-of-year adjusting entry for estimated liability for outstanding offers (boxtops):

Premium expense 90,000

Estimated liability 90,000

Computation:

Total boxtops sold 400,000

Total estimated redemptions (60%) 240,000

Boxtops redeemed 120,000

Estimated future redemptions 120,000

Cost of estimated claims outstanding (120,000/20) ×

($18 - 3) = $90,000

Note: The premium expense account is presented as a selling expense. The inventory of premium cameras account

balance is presented as a current asset, and the estimated liability account is reported as a current liability.

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Review Questions − Section 1

1. All of the following are the basic recognition criteria established by the Concepts Statement No. 5 EXCEPT:

A. Definitions

B. Measurability

C. Relevance

D. Understandable

2. Buc Co. receives deposits from its customers to protect itself against nonpayments for future services. How

should these deposits be classified by Buc?

A. As a liability

B. As revenue

C. As a deferred credit deducted from accounts receivable

D. As a contra account

3. Which of the following would be classified as a current liability?

A. Unearned revenue

B. Net working capital

C. Capital stock

D. Prepaid expenses

4. A company receives an advance payment for special order goods that are to be manufactured and delivered

within 6 months. How should the advance payment be reported in the company's balance sheet?

A. Deferred charge

B. Contra asset account

C. Current liability

D. Noncurrent liability

5. J&E Inc. has these liabilities at year end: 1) Accounts payable of $100,000 2) Mortgage note payable $10,000

due within 12 months 3) $80,000 short-term debt that the company is refinancing with long-term debt. What

amount should J&E include in the current liability section of the balance sheet?

A. $80,000

B. $110,000

C. $180,000

D. $190,000

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6. The accrual of a loss contingency is based on which of the following concepts?

A. Conservatism

B. Matching

C. Comparability

D. Going concern

7. On April 20, 20X6, an employee filed a $3,000,000 lawsuit against Johnson Co. for damages suffered when

one of Johnson’s plants exploded. Johnson’s legal counsel expects the company will lose the lawsuit and

estimates the loss to be between $1,500,000 and $2,000,000. The employee has offered to settle the lawsuit

out of court for $1,800,000, but Johnson will not agree to the settlement. In its December 31, 20 X6 balance

sheet, what amount should Johnson report as liability from the lawsuit?

A. $0

B. $1,500,000

C. $1,800,000

D. $2,000,000

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Fair Value Accounting

Fair values are commonly used in financial reports and have increased in business importance in recent years.

Elaborate financial instruments and risk management practices have created financial statement elements for

which historical cost is less meaningful, increasing the relevance for fair value and fluctuations in fair value. Fair

value information may be more useful than the historical cost for certain types of assets and liabilities and in

certain industries.

ASC 820, Fair Value Measurements, provides a framework for determining fair value for GAAP purposes containing

the following key concepts:

1. Fair value is a market-based measurement, not an entity-specific measurement.

2. Fair value is the price to sell an asset or transfer a liability (an exit price), not the price that is paid to acquire

the asset or received to assume the liability (an entry price).

3. The definition of fair value and the measurement framework applies to assets, liabilities, and instruments

measured at fair value classified in stockholders’ equity.

4. A fair value measurement should be determined based on the assumptions that market participants would

use in pricing the asset or liability.

5. The concepts of highest and best use and valuation in a fair value measurement are only relevant in measuring

the fair value of nonfinancial assets, not financial assets or liabilities.

6. The fair value hierarchy provides a basis for considering market-participant assumptions and distinguishes

between:

✓ Market-participant assumptions developed based on market data that are independent of the entity

(observable inputs); and

✓ An entity’s own assumptions about market-participant assumptions developed based on the best

information available in the particular circumstances, including assumptions about the risk inherent

in inputs or valuation techniques (unobservable inputs)

Observable inputs should be maximized and unobservable inputs should be minimized.

Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect

an entity’s market assumptions.

7. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three

broad levels. The levels range from the highest priority, which is assigned to quoted prices (unadjusted) in

active markets for identical assets or liabilities (Level 1), to the lowest priority, which is assigned to

unobservable inputs (Level 3).

As shown in Exhibit D, the fair value hierarchy is divided into three broad levels.

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8. Market participant assumptions include assumptions about risk. For instance, the risk inherent in a particular

valuation technique used to measure fair value (e.g. pricing model) and/or the risk inherent in the inputs to

the valuation technique.

9. ASC 820 recognizes three valuation approaches to measure fair value including the market approach, cost

approach, and income approach.

10. A fair value measurement should include an adjustment for risk if market participants would include one in

pricing the related asset or liability, even if the adjustment is difficult to determine.

11. A “mark-to-model” measurement that does not include an adjustment for risk does not represent a fair value

measurement if market participants would include such an adjustment in pricing the related asset or liability.

Exhibit D: Fair Value Hierarchy

Level 1: Quoted (unadjusted) prices in active markets for

identical assets or liabilities.

Level 2: Inputs other than quoted prices included in Level 1

that are observable for the asset or liability either directly

or indirectly.

Level 3: Unobservable inputs (for example, the reporting

entity’s assumptions).

Most Reliable

Least Reliable

Details of the fair value hierarchy are addressed in the “The Fair Value Hierarchy” section.

General Rules

Fair value is based on the price that would be received to sell an asset or paid to transfer a liability (an exit price)

in a hypothetical transaction on the date of the measurement. This hypothetical transaction is assumed to be an

orderly one meaning that it is not a forced or hasty sale. In addition, this hypothetical transaction is assumed to

occur between two unrelated, informed market participants. Thus, as an entity seeks to determine the fair value

of an asset it holds, it does not focus on the price it could receive in selling the asset. Instead, the entity must

determine what price would be acceptable to a seller without that particular company's special skills or unique

handicaps.

Market participants do not include parties who engage in forced or liquidation sales or are otherwise compelled

to act. Market participants need not be specifically identified. Instead, the entity must identify its general

characteristics, with consideration of factors specific to (1) the asset or liability, (2) the market, and (3) parties

with whom the entity would deal. Thus, it is based on the pricing assumptions of the hypothetical market

participants.

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A fair value measurement for liability should take into account the risk that the obligation will not be fulfilled

(nonperformance risk). In evaluating this risk, the reporting entity's credit risk should be considered. In addition,

in measuring the fair value of a liability, the quoted price of the asset should not be adjusted for any limitation on

its sale.

A fair value measurement assumes the transaction takes place in the principal market for the asset or liability. The

principal market is one in which the reporting entity would sell the asset or transfer the liability with the greatest

volume and activity level. If there is no principal market, then the most advantageous market should be used. The

most advantageous market is one in which the reporting entity would sell the asset or transfer the liability with

the price that maximizes the amount that would be received for the asset or minimizes the amount that would be

paid to transfer the liability after considering the transaction costs.

In measuring fair value, valuation techniques in conformity with the market, income, and cost approaches should

be used:

1. Under the “market approach,” the prices for market transactions for identical or comparable assets or

liabilities are used. One example of a market approach is matrix pricing. This is a mathematical method used

primarily to value debt securities that are not actively traded. The securities do have readily available quoted

prices. The price of the security is estimated by comparing it to other securities with an active market, and

that have similar maturities, coupon rates, credit rating, etc.

2. Under the “income approach,” valuation techniques are used to convert future amounts (e.g., profits, cash

flows) to a present value amount. For example, future cash flows are discounted to their present value amount

using the present value tables (Tables 1 and 2 in the Appendix). The measurement is based on market

expectations of the future amounts. Examples of these valuation techniques are present value determination,

option pricing models, and the multiyear excess earnings method (to value goodwill).

3. The “cost approach” is based on the amount that would be required to replace an asset's service capability

(current replacement cost). An example is the cost to purchase or build a substitute asset of comparable utility

after adjusting for obsolescence.

Depending on the circumstances, a single or multiple valuation technique may be needed. Input availability and

reliability associated with the asset or liability may influence the selection of the best-suited valuation method.

Scope

ASC 820 applies when accounting pronouncements require or permit fair value measurements, measurements

based on fair value (e.g. fair value less the costs to sell), and disclosures about fair value measurements, except

for:

1. Share-based payment transactions addressed under ASC 505-50 Equity and ASC 718 Compensation −

Stock Compensation (excluding ASC 718-40, which is within the scope of ASC 820); and

2. Accounting pronouncements require or permit measurements that are similar to fair value but that are

NOT intended to measure fair value, including both of the following:

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The measurement of the standalone selling price

ASC 330 Inventory

3. Recognition and measurement of revenue from contracts with customers under ASC 606 Revenue from

Contracts with Customers

4. Recognition and measurement of gains and losses upon the derecognition of nonfinancial assets under

ASC 610-20 Other Income

Standalone selling price is the price at which an entity would sell a promised good or service separately to a

customer.

ASC 820 does not eliminate certain practicability exceptions presented in other accounting standards. ASC 820-

10-15-3 indicates those practicability exceptions, which include:

1. The use of a transaction price (an entry price) to measure fair value (an exit price) at initial recognition.

For instance, ASC 820 does not impact the ability under ASC 460 to initially measure the fair value (an exit

price) of a guarantee using a transaction price (an entry price).

2. Instruments for which fair value is not reasonably determinable such as:

• Nonmonetary assets under ASC 845 and ASC 605-20-25 and 605-20-50

• Asset retirement obligations under ASC 410-20 and ASC 440-10-50 and 440-10-55

• Restructuring obligations under ASC 420

• Participation rights under ASC 715-30 and 715-60

3. The use of particular measurement methods referred to in ASC 805-20-30-10 allows measurements other

than fair value for specified assets acquired and liabilities assumed in a business combination.

4. Financial assets or financial liabilities of a consolidated variable interest entity that is a collateralized

financing entity when the financial assets or financial liabilities are measured using the measurement

alternative in ASC 810-10-30-10 through 30-15 and ASC 810-10-35-6 through 35-8.

5. Instruments for which fair value cannot be reasonably estimated, such as noncash consideration promised

in a contract under ASC 606-10-32-21 through 32-24.

A collateralized financing entity is a variable interest entity that holds financial assets, issues beneficial interests

in those financial assets, and has no more than nominal equity.

The Fair Value Hierarchy

Inputs to Fair Value Measurement

Under ASC 820, Level 1 inputs are the most reliable and are quoted prices in active markets for identical assets or

liabilities. Level 2 inputs are of intermediate reliability and are prices for similar (but not identical) assets or

liabilities or observable market inputs used in a valuation model. Level 3 inputs are unobservable inputs such as

internal cash flow forecasts, discount rate estimations, and so forth.

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Level 1 inputs are based on quoted prices (unadjusted) in active markets for identical assets or liabilities that the

reporting entity can access at the measurement date. Thus, Level 1 is the most reliable as it is based on or prices

or quotes from exchanges or listed markets (e.g. Chicago Board of Trade, London Stock Exchange, Tokyo Stock

Exchange, or New York Stock Exchange and Euronext).

Level 2 inputs are those (except quoted prices included within Level 1) that are observable for the asset or liability,

either directly or indirectly. If the asset or liability has a specified (contractual) term, a Level 2 input must be

observable for substantially the full term of the asset or liability. Included as Level 2 inputs are:

1. Quoted prices for similar assets or liabilities in active markets.

2. Quoted prices for similar or identical assets or liabilities in markets that are not active namely in markets

having few transactions, noncurrent prices, price quotations that vary significantly, or very limited public

information.

3. Inputs excluding quoted prices that are observable for the asset or liability. Examples are:

✓ Interest rates observable at often quoted intervals

✓ Credit spreads

✓ Implied volatilities

4. Market-corroborated inputs; inputs derived in most part from observable market data by correlation or

other means.

Adjustments to Level 2 inputs vary depending on factors specific to the asset or liability. Those factors include:

• The location or condition of the asset or liability;

• Market volume and activity level; and

• The extent to which the inputs relate to comparable items to the asset or liability.

A major adjustment to the fair value measurement may result in a Level 3 measurement.

Examples of Level 2 inputs for particular assets and liabilities are discussed in the “Comprehensive Illustrations: 1.

Level 2 Inputs” section.

Level 3 inputs are unobservable for the asset or liability. Unobservable inputs are used to measure fair value to

the extent that observable inputs are unavailable. This allows for cases in which there is little or no market activity

for the asset or liability at the measurement date. Unobservable inputs reflect the reporting entity's own

assumptions about the assumptions (e.g., risk) that market participants would use in pricing the asset or liability.

If an input used to measure fair value is based on bid and ask prices, the price within the bid-ask spread that is

most representative of fair value shall be used to measure fair value regardless of where in the fair value hierarchy

the input falls.

Examples of Level 3 inputs for particular assets and liabilities are discussed in the “Comprehensive Illustrations: 2.

Level 3 Inputs” section.

24

Inactive Market

ASC 820 also addresses valuations in markets that were previously active, but are inactive in the current reporting

period. It provides guidance for estimating fair value when the volume and activity level for the asset or liability

have significantly decreased.

If the reporting entity decides there has been a major decrease in the volume and level of activity for the asset or

liability relative to normal market activity for the asset or liability, transactions or quoted prices may not be

determinative of fair value. Further analysis is needed, and a significant adjustment to the transaction or quoted

prices may be necessary to estimate fair value. Significant adjustments also may be needed in other situations (for

instance, when a price for a similar asset requires significant adjustment to make it more comparable to the asset

being measured or when the price is old).

Even in cases where there has been a significant decrease in the volume and level of activity for the asset or

liability regardless of the valuation technique used, the objective of a fair value measurement remains the same.

Determining the price at which willing market participants would transact at the measurement date under current

market conditions if there has been a significant decrease in the volume and level of activity for the asset or

liability depends on the facts and circumstances and requires the use of judgment. However, a reporting entity's

intention to hold the asset or liability is not relevant in estimating fair value. As mentioned, fair value is a market-

based measurement, not an entity-specific measurement.

Even if there has been a significant decrease in the volume and level of activity for the asset or liability, it is not

appropriate to conclude that all transactions are not orderly (that is, distressed or forced).

Disclosure Requirements

Disclosures are mandated for fair value measurements to improve financial statement user understanding.

Specifically, ASC 820 requires disclosures designed to provide users of financial statements with additional

transparency regarding:

1. The valuation techniques and inputs that a reporting entity uses to arrive at its measures of fair value,

including judgments and assumptions that the entity makes

2. The uncertainty in the fair value measurements as of the reporting date

3. How changes in fair value measurements affect an entity’s performance and cash flows

ASC 820-10-50-1D indicates that when complying with the disclosure requirements, a reporting entity should

consider all of the following:

✓ The level of detail necessary to satisfy the disclosure requirements

✓ How much emphasis to place on each of the various requirements

✓ How much aggregation or disaggregation to undertake

✓ Whether users of financial statements need additional information to evaluate the quantitative

information disclosed

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The fair value disclosures fall into two categories. The first category is for assets (and liabilities) that are measured

at fair value on a recurring basis. Examples are trading securities, available-for-sale securities, and derivatives.

These items are reported at their fair values on every reporting date. For items measured at fair value on a

recurring basis, the first required valuation input disclosure is a simple table with the assets as the rows and the

three input levels as the columns.

Most balance sheet items are not reported at fair value on a recurring basis but are occasionally reported at fair

value. A common example is impaired assets. The required disclosure for assets reported at fair value on a

nonrecurring basis. With items reported at fair value on a nonrecurring basis, it is unlikely that Level 1 inputs will

be available in the disclosure. A reconciliation of the beginning and ending balances is required for any assets or

liabilities measured at fair value on a recurring basis that use Level 3 (that is, significant unobservable inputs)

during the period.

26

Comprehensive Illustrations

Illustration 1: Level 2 Inputs

ASC 820 provides the following examples of Level 2 inputs for particular assets and liabilities.

820-10-55-21

Examples of Level 2 inputs for particular assets and liabilities include the following:

a. Receive-fixed, pay-variable interest rate swap based on the London Interbank Offered Rate (LIBOR) swap rate.

A Level 2 input would be the LIBOR swap rate if that rate is observable at commonly quoted intervals for

substantially the full term of the swap.

b. Receive-fixed, pay-variable interest rate swap based on a yield curve denominated in a foreign currency. A

Level 2 input would be the swap rate based on a yield curve denominated in a foreign currency that is

observable at commonly quoted intervals for substantially the full term of the swap. That would be the case

if the term of the swap is 10 years and that rate is observable at commonly quoted intervals for 9 years,

provided that any reasonable extrapolation of the yield curve for Year 10 would not be significant to the fair

value measurement of the swap in its entirety.

c. Receive-fixed, pay-variable interest rate swap based on a specific bank’s prime rate. A Level 2 input would be

the bank’s prime rate derived through extrapolation if the extrapolated values are corroborated by observable

market data, for example, by correlation with an interest rate that is observable over substantially the full

term of the swap.

d. Three-year option on exchange-traded shares. A Level 2 input would be the implied volatility for the shares

derived through extrapolation to Year 3 if both of the following conditions exist:

1. Prices for one-year and two-year options on the shares are observable.

2. The extrapolated implied volatility of a three-year option is corroborated by observable market data

for substantially the full term of the option.

In that case, the implied volatility could be derived by extrapolating from the implied volatility of the one-year

and two-year options on the shares and corroborated by the implied volatility for three-year options on

comparable entities’ shares, provided that correlation with the one-year and two-year implied volatilities is

established.

e. Licensing arrangement. For a licensing arrangement that is acquired in a business combination and was

recently negotiated with an unrelated party by the acquired entity (the party to the licensing arrangement), a

Level 2 input would be the royalty rate in the contract with the unrelated party at the inception of the

arrangement.

f. Finished goods inventory at a retail outlet. For finished goods inventory that is acquired in a business

combination, a Level 2 input would be either a price to customers in a retail market or a price to retailers in a

wholesale market, adjusted for differences between the condition and location of the inventory item and the

comparable (that is, similar) inventory items so that the fair value measurement reflects the price that would

27

be received in a transaction to sell the inventory to another retailer that would complete the requisite selling

efforts. Conceptually, the fair value measurement will be the same, whether adjustments are made to a retail

price (downward) or to a wholesale price (upward). Generally, the price that requires the least amount of

subjective adjustments should be used for the fair value measurement.

g. Building held and used. A Level 2 input would be the price per square foot for the building (a valuation

multiple) derived from observable market data, for example, multiples derived from prices in observed

transactions involving comparable (that is, similar) buildings in similar locations.

h. Reporting unit. A Level 2 input would be a valuation multiple (for example, a multiple of earnings or revenue

or a similar performance measure) derived from observable market data, for example, multiples derived from

prices in observed transactions involving comparable (that is, similar) businesses, taking into account

operational, market, financial, and nonfinancial factors.

Illustration 2: Level 3 Inputs

ASC 820 provides the following examples of Level 3 inputs for particular assets and liabilities.

ASC 820-10-55-22

Examples of Level 3 inputs for particular assets and liabilities include the following:

a. Long-dated currency swap. A Level 3 input would be an interest rate in a specified currency that is not

observable and cannot be corroborated by observable market data at commonly quoted intervals or

otherwise for substantially the full term of the currency swap. The interest rates in a currency swap are the

swap rates calculated from the respective countries’ yield curves.

b. Three-year option on exchange-traded shares. A Level 3 input would be historical volatility, that is, the

volatility for the shares derived from the shares’ historical prices. Historical volatility typically does not

represent current market participants’ expectations about future volatility, even if it is the only information

available to price an option.

c. Interest rate swap. A Level 3 input would be an adjustment to a mid-market consensus (nonbinding) price for

the swap developed using data that are not directly observable and cannot otherwise be corroborated by

observable market data.

d. Asset retirement obligation at initial recognition. A Level 3 input would be a current estimate using the

reporting entity’s own data about the future cash outflows to be paid to fulfill the obligation (including market

participants’ expectations about the costs of fulfilling the obligation and the compensation that a market

participant would require for taking on the asset retirement obligation) if there is no reasonably available

information that indicates that market participants would use different assumptions. That Level 3 input would

be used in a present value technique together with other inputs, for example, a current risk-free interest rate

or a credit-adjusted risk-free rate if the effect of the reporting entity’s credit standing on the fair value of the

liability is reflected in the discount rate rather than in the estimate of future cash outflows.

28

e. Reporting unit. A Level 3 input would be a financial forecast (for example, of cash flows or earnings) developed

using the reporting entity’s own data if there is no reasonably available information that indicates that market

participants would use different assumptions.

Fair Value Option

Scope

ASC 825-10, Financial Instrument—Fair Value Option, allows entities to measure many financial instruments and

some other items at fair value. ASC 825-10-20 defines a financial instrument as cash (including currencies of other

countries), evidence of an ownership interest in another entity (e.g. common or preferred stock), or a contract

that both:

1. Imposes on one entity the obligation to:

✓ Deliver cash or another financial instrument to another entity or

✓ Exchange financial instruments with another entity on potentially unfavorable terms

2. Conveys to the other entity the right to:

✓ Receive cash or another financial instrument from the first entity, or

✓ Exchange other financial instruments on potentially favorable terms with the first entity

Conventional assets and liabilities (e.g. accounts and notes receivable, accounts and notes payable, investment in

equity and debt securities, and bonds payable) are deemed to be financial instruments. The definition also

encompasses many derivative contracts, such as options, swaps, caps, and futures. The eligible items for the fair

value measurement option are:

1. Most recognized financial assets and financial liabilities excluding:

Investments in a subsidiary that the entity is required to consolidate.

An interest in a variable interest entity that the entity is required to consolidate.

Employers' and plans' obligations (or assets from net overfunded positions) for pension benefits,

other postretirement benefits, post-employment benefits, employee stock option and stock purchase

plans, and other forms of deferred compensation arrangements.

Most financial assets and liabilities under lease contracts.

Deposit liabilities, withdrawable on demand, of banks, savings and loan associations, credit unions,

and other similar depository institutions.

Financial instruments that are, in whole or in part, classified by the issuer as a component of

shareholders’ equity (including temporary equity).

2. The rights and obligations under an insurance contract that has both of the following characteristics:

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✓ The insurance contract is not a financial instrument (because it requires or permits the insurer to

provide goods or services rather than a cash settlement).

✓ The insurance contract’s terms permit the insurer to settle by paying a third party to provide those

goods or services.

3. The rights and obligations under a warranty that has both of the following characteristics:

✓ The warranty is not a financial instrument (because it requires or permits the warrantor to provide

goods or services rather than a cash settlement).

✓ The warranty’s terms permit the warrantor to settle by paying a third party to provide those goods or

services.

4. Firm commitments applying to financial instruments such as a forward purchase contract for a loan not

readily convertible to cash.

5. Written loan commitment (e.g. a note payable such as a mortgage or credit line note). The option may be

used whether the notes are discounted or not.

6. Host financial instruments arising from separating an embedded nonfinancial derivative instrument from

a nonfinancial hybrid instrument.

Election Dates

According to ASC 825-10-25-4, an entity may choose to elect the fair value option for an eligible item only on the

election date, which is the date on which one of the following occurs:

1. The company first recognizes the eligible item.

2. The company engages in an eligible firm commitment.

3. The accounting treatment for an investment in another entity changes because the investment becomes

subject to the equity method of accounting.

4. Specialized accounting treatment no longer applies to the financial assets that have been reported at fair

value such as under an AICPA Audit and Accounting Guide.

5. An event mandates an eligible item to be measured at fair value on the event date but does not require

fair value measurement at each subsequent reporting date.

Some events that require remeasurement of eligible items at fair value, initial recognition of eligible items, or

both, and thus create an election date for the fair value option are:

✓ Business combination

✓ Sale of a portion of a consolidated subsidiary; any previously recorded noncontrolling interest must be

measured at fair value

✓ Major debt modification

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An entity may elect the fair value option for eligible items at the effective date. The difference between the book

(carrying) value and the fair value of eligible items chosen for the fair value option at the effective date must be

removed from the balance sheet and included in the cumulative-effect adjustment. These differences include:

1. Valuation allowances (e.g., loan loss reserves);

2. Unamortized deferred costs, fees, discounts and premiums; and

3. Accrued interest associated with the fair value of the eligible item.

Presentation and Disclosures

U.S. GAAP does not allow for netting on the balance sheet. Entities must report assets and liabilities measured at

the fair value option in a way that separates those reported fair values from the book (carrying) values of similar

assets and liabilities measured with a different measurement attribute. To achieve this, ASC 825-10-45-2 requires

an entity either reports:

• Two separate line items to display the fair value and non-fair value carrying amounts; or

• The aggregate fair value and nonfinancial fair value amounts in the same line items in the balance sheet and, in parenthesis, disclose the amount measured at fair value included in the aggregate amount.

Example 4

Option 1:

Long-term debt:

At fair value 80

At carrying value 30

Option 2:

Long-term debt ($80 at fair value) 110

The fair value option does not limit the presentation of an asset or liability to the long-term section of the balance

sheet. Most entities will have both long- and short-term items that are measured at fair value.

A company that selects the fair value option for items at the effective date must provide, in the financial

statements that include the effective date, the following:

1. The impact on deferred tax assets and liabilities of selecting the fair value option.

2. The reasons for choosing the fair value option for each existing eligible item or group of similar items.

3. The amount of valuation allowances removed from the balance sheet because they applied to items for which

the fair value option was selected.

4. The schedule presenting the following by line items in the balance sheet: (a) before tax portion of the

cumulative-effect adjustment to retained earnings for the items on that line and (b) fair value at the effective

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date of eligible items for which the fair value option is selected and the book (carrying) amounts of those same

items immediately before opting for the fair value option.

5. In the event the fair value option is selected for some but not all eligible items within a group of similar eligible

items, a description of similar items and the reasons for the partial election. In addition, information should

be provided so financial statement users can comprehend how the group of similar items applies to individual

items on the balance sheet.

Finally, disclosures of fair value are required in annual and interim financial statements. When a balance sheet is

presented, the following must be disclosed:

1. The reasons why the company selected the fair value option for each allowable item or group of similar items.

2. In the event the fair value option is chosen for some but not all eligible items within a group of similar items,

management must describe those similar items and the reasons for partial election. In addition, information

must be provided so that financial statement users can comprehend how the group of similar items applies

to individual line items on the balance sheet.

3. For every line item on the balance sheet that includes an item or items for which the fair value option has

been selected, management must provide information on how each line item relates to major asset and

liability categories. In addition, management must provide the aggregate carrying amount of items included

in each line item that are not eligible for the fair value option.

4. To be disclosed is the difference between the aggregate fair value and the aggregate unpaid principal balance

of loans, long-term receivables, and long-term debt instruments with contractual principal amounts for which

the fair value option has been chosen.

5. In the case of loans held as assets for which the fair value option has been selected, management should

disclose the aggregate fair value of loans past due by 90 days or more. If the company recognizes interest

revenue separately from other changes in fair value, disclosure should be made of the aggregate fair value of

loans in the nonaccrual status. Disclosure should also be made of the difference between the aggregate fair

value and aggregate unpaid principal balance for loans that are 90 days or more past due or in nonaccrual

status.

6. Disclosure should be made of investments that would have been reported under the equity method if the

company did not elect the fair value option.

Other Matters

Risks and Uncertainties

To help users assess risks and uncertainties, ASC 275, Risks and Uncertainties, requires disclosure about risks and

uncertainties existing as of the date of the financial statements that could significantly affect the amounts

reported in the near term. ASC 275 requires disclosure of risks and uncertainties involving:

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• The nature of operations: Disclosure should be made of the company's major products and services,

including by geographic locations. The relative importance of operations in multiple markets should also

be discussed.

• Use of estimates: Disclosure should be made of estimated accounts on which estimates are sensitive to

near-term changes, such as technological obsolescence.

• Business vulnerability: Disclosure of corporate vulnerability to concentrations includes lack of

diversification (e.g., customer base, suppliers, lenders, geographic areas, government contracts).

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Disclosure is required when a change in estimate would have a material effect on the financial statements.

Examples of items requiring disclosure according to ASC 275-10-50-15 include:

✓ Rapid technological obsolescence of assets.

✓ Inventory subject to perishability, changing fashions, and styles.

✓ Capitalization of certain costs, such as for computer software or motion picture production.

✓ Insurance companies' deferred policy acquisition costs.

✓ Litigation-related liabilities and contingencies due to obligations of other enterprises.

✓ Valuation allowances for commercial and real estate loans, and allowances for deferred tax assets.

✓ Amounts of long-term obligations, such as for pension obligations and other benefits.

✓ Amounts of long-term contracts.

✓ Proceeds or expected loss on disposition of assets.

✓ Nature and amount of guarantees.

When an entity is vulnerable to concentration-related risks, disclosure is required if the concentration existed at

the date of financial statements, the entity may suffer significantly because of the concentration risk, and it is

reasonably possible that concentration-risk-related events will occur in the near future.

Uncertainties with labor unions should be noted. For organizations with significant concentrations of labor subject

to collective bargaining agreements, the disclosure should include:

1. The percentage of the labor force covered by a collective bargaining agreement.

2. The percentage of the labor force covered by a collective bargaining agreement where the agreement will

expire within one year.

Exit or Disposal Activities

ASC 420, Exit or Disposal Cost Obligations, addresses financial accounting and reporting for costs associated with

exit or disposal activities such as:

✓ One-time termination benefits to current employees

✓ Costs to terminate a contract that is not a lease

✓ Costs to consolidate facilities or relocate workers

An exit activity includes but is not limited to restricting. Restructurings include altering the management structure,

relocating business operations, closing a location, and ceasing a business line.

These costs are recognized as incurred (not at the commitment date to an exit plan) based on fair value along with

the related liability. Therefore, the company must actually incur the liabilities before recognition may be made. If

fair value cannot reasonably be estimated, recognizing the liability must be postponed to such time.

The initiation date of an exit or disposal activity is when management obligates itself to a plan to exit or otherwise

dispose of a long-lived asset if the activity includes worker termination. In years following initial measurement,

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changes to the liability should be measured based on the credit-adjusted risk-free rate that was used to initially

measure the liability.

The cumulative effect of a change due to revising either the timing or the amount of estimated cash flows should

be recognized as an adjustment to the liability in the year of change and reported in the same line items in the

income statements used when the related costs were recognized initially. Changes due to the passage of time are

recognized as an increase in the carrying value of the liability and as an expense (e.g. accretion expense).

Examples of costs attributable to exit or disposal activities are included in income from continuing operations

unless they apply to discontinued operations.

If an event arises that discharges a company's obligation to settle a liability for a cost associated with an exit or

disposal activity recognized in a prior year, the liability and the related costs are reversed.

Consideration is given to when and how much a liability for one-time termination benefits is, based on whether

employees are obligated to work until they are let go in order to be eligible for termination benefits and, if such

is the case, whether workers will be kept to work beyond a minimum retention period. The minimum retention

period cannot be more than the legal notification period or, in the event none exists, 60 days.

For situations in which workers do not have to work until they are let go to obtain termination benefits or will not

be retained to work beyond a minimum retention period, the obligation for termination benefits is recorded at

fair value at the date of communication. If workers must work until they are terminated so as to obtain benefits

and will be kept to work beyond the minimum retention period, the liability is initially measured at the

communication date, based on the fair value as of the termination date but recorded ratably over future service

years.

The following should be footnoted:

• A description of the exit or disposal activity and the expected completion date.

• The place in the income statement or statement of activities where exit or disposal costs are presented.

• If a liability for a cost is not recorded because fair value is not reasonably estimated, that should be noted

along with the reasons.

• For each major kind of cost attributable to the exit activity, the total cost expected, the amount incurred

in the current year, and the cumulative amount to date.

• Reconciliation of the beginning and ending liability balances presenting the changes during the year

associated with costs incurred and charged to expense, costs paid or otherwise settled, and any

adjustments of the liability along with the reasons for doing so.

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IFRS Connection

IFRS and U.S. GAAP have similar definitions for liabilities. IFRS related to reporting and recognition of liabilities is

found in IAS I (Presentation of Financial Statements) and IAS 37 (Provisions, Contingent Liabilities, and Contingent

Assets).

• Similar to U.S. practice, IFRS requires that companies present current and noncurrent liabilities on the face of

the balance sheet, with current liabilities generally presented in order of liquidity.

• Under IFRS, the measurement of a provision related to a contingency is based on the best estimate of the

expenditure required to settle the obligation. If a range of estimates is predicted and no amount in the range

is more likely than any other amount in the range, the "mid-point" of the range is used to measure the liability.

In U.S GAAP, the minimum amount in a range is used.

• Both GAAPs prohibit the recognition of liabilities for future losses. However, IFRS permits recognition of a

restructuring liability, once a company has committed to a restructuring plan. U.S. GAAP has additional criteria

(i.e., related to communicating the plan to employees) before a restructuring liability can be established.

• IFRS and U.S. GAAP are similar in the treatment of asset retirement obligations (AROs). However, the

recognition criteria for an ARO are more stringent under U.S. GAAP: The ARO is not recognized unless there is

a present legal obligation and the fair value of the obligation can be reasonably estimated.

• IFRS and U.S. GAAP are similar in their treatment of contingencies. However, the criteria for recognizing

contingent assets are less stringent in the U.S. Under U.S. GAAP, contingent assets for insurance recoveries

are recognized if probable; IFRS requires the recovery be “virtually certain” before recognition of an asset is

permitted.

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Review Questions − Section 2

1. What is fair value?

A. It is an entry price

B. It is based on an actual transaction

C. It is an exit price

D. It is an entity-specific measurement

2. For the purpose of a fair value measurement of an asset or liability, what is the preferred market for a

transaction to occur?

A. An advantageous market

B. A principal market if one exists

C. A market in which the result is optimized

D. The market chosen by the reporting entity

3. When measuring fair value, which level reflects the reporting entity's own assumptions about the

assumptions?

A. Level 1

B. Level 2

C. Level 3

D. Level 4

4. In which of the following instances may the reporting entity elect the fair value option?

A. An investment consisting of more than 50% of the outstanding voting interests of another entity

B. An interest in a variable interest entity if the reporting entity is the primary beneficiary

C. Most financial assets and liabilities

D. Its obligation for pension and other postretirement employee benefits

5. An entity may choose to elect the fair value option for an eligible item only on the date that any one of the

following occurs EXCEPT:

A. The entity first recognizes the eligible item

B. The entity enters into an eligible firm commitment

C. It is the anniversary date of the FASB statement's effective date

D. The accounting treatment for an investment in another entity changes

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6. Which of the following is the correct way to report assets and liabilities on the balance sheet under the fair

value option?

A. Use two separate line items for fair value and non-fair value carrying amounts.

B. Combine assets and liabilities on a net basis.

C. Create a separate fair value mezzanine section between current and long-term debt

D. Place assets and liabilities in the long-term assets and liabilities sections.

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Chapter 2: Current Liabilities

“Current liabilities is used principally to designate obligations whose liquidation is reasonably expected to

require the use of existing resources properly classifiable as current assets, or the creation of other current

liabilities.”

ASC 210-10-20

Accounts Payable

Accounts payable, commonly termed trade accounts payable, are liabilities reflecting the obligations to sellers

that are incurred when an entity purchases inventory, supplies, or services on credit. Accounts payable should be

recorded at their settlement value. Short-term liabilities, such as accounts payable, do not usually provide for a

periodic payment of interest unless the accounts are not settled when due or payable. They also are not secured

by collateral.

As a liability account, Accounts Payable is expected to have a credit balance. Thus, the balance in Accounts Payable

is increased by a credit entry and the balance is decreased by a debit entry.

Example 5-1

Sunny Corp. gets an $800 invoice for office supplies.

When the Accounts Payable department receives the invoice, it records:

Office supplies $800

Accounts payable $800

When the Accounts Payable department pays the bill, it records:

Accounts payable $800

Cash $800

Example 5-2

As of December 31, 20X2 before adjustment for the following items, accounts payable had a balance of $700,000:

• A check to a supplier amounting to $40,000 was recorded on December 30, 20X2. The check

was mailed on January 3, 20X3.

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• On December 31, 20X2, the company has a $30,000 debit balance in its accounts payable to a

supplier due to an advance payment for a product to be produced.

The accounts payable to be presented on the December 31, 20X2 balance sheet is computed as follows:

Unadjusted balance $700,000

Unmailed check 40,000

Supplier with debit balance 30,000

Adjusted balance $770,000

Bank overdrafts, short-term loans provided by a bank, are presented under current liabilities, typically accounts

payable. Bank overdrafts are usually not offset against the cash account. However, offsetting is allowed for two

or more accounts at the same bank.

Deferred Revenues

Although ASC 606 refers to “contract liabilities” rather than “deferred revenue”, it does not prohibit an entity

from using alternative descriptions in the balance sheet for those items. Many companies continue to use deferred

revenue on their financial statements as demonstrated in Exhibit E. ASC 606 establishes a five-step process for

recognizing deferred revenue:

Key requirements of each step are discussed in the following sections.

Step 1: Identify the Contract with a Customer

Generally, any agreement that creates legally enforceable rights and obligations meets the definition of a contract.

An agreement does not have to be in writing to constitute a contract - a contract may exist if parties orally agree

to an arrangement’s terms. Alternatively, a contract could be implied through customary business practices if

those practices create enforceable rights and obligations. A contract with a customer is in the scope of ASC 606

when it is legally enforceable and meets all of the following five criteria.

1. Approval and Commitment: All parties to the contract have approved the document and substantially

committed to its contents.

Identify the Contract

Identify the Performance Obligations

Determine Transaction

Price

Allocate Transaction

Price

Recognize Revenue

Step 1 Step 2 Step 3 Step 4 Step 5

The Revenue Recognition Model

How much revenue can be recognized? When can revenue be recognized?

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2. Rights: All parties’ rights are clearly identified in the document.

3. Payment Terms: The payment terms for goods or services must be known before a contract can exist.

4. Commercial Substance: A contract has commercial substance if the risk, timing, or amounts of the entity’s

future cash flows change as a result of the contract.

5. Collectibility of the Consideration: It is probable that the entity will collect the amount stated in the

contract in exchange for the goods or services transferred to the customer.

A contract with a customer creates legal rights and obligations, which may give rise to contract assets and contract

liabilities. A contract liability is an entity’s obligation to transfer goods or services to a customer when:

✓ The customer prepays consideration; or

✓ The customer’s consideration is due for goods and services that the entity will yet provide

Example 6

Beta Inc. places an order for a product from Smith Corp. Smith Corp delivers the product before the end of the

month.

Smith Corp enters into a written sales agreement with Beta Inc. that requires the signatures of the authorized

representatives of both parties. Smith Corp signs the agreement before the end of the month. However, Beta Inc.

does not sign the agreement. Its Purchasing department has verbally agreed to the purchase and stated that it is

highly likely that the contract will be signed in the first week of the following month.

Smith Corp determines that based on the local laws in Beta Inc.’s jurisdiction that Beta Inc. is legally obliged to

pay for the product shipped to it under the agreement, even though Beta Inc. has not yet signed the agreement.

Step 2: Identify the Performance Obligations

Identification of all promises in a contract is very important. Promises are what comprise performance obligations

and entities recognize revenue based on the satisfaction of performance obligations. Those promises create a

reasonable expectation of the customer that the entity will transfer a good or service to the customer.

ASC 606 specifies that promised goods or services do not include activities that an entity must undertake to fulfill

a contract unless those activities transfer a good or service to a customer. For example, a service provider may

need to perform various administrative tasks to set up a contract. Those tasks do not transfer a service to the

customer as the tasks are performed. Therefore, those setup activities are not promised goods or services in the

contract with the customer.

An entity is required to assess the goods or services promised in a contract and identify as a performance

obligation each promise to transfer to the customer either:

• A good or service (or a bundle of goods or services) that is distinct, or

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• A series of distinct goods or services that are substantially the same and that have the same pattern of

transfer to the customer.

An entity needs to determine whether goods or services are distinct, and therefore separate performance

obligations, when there are multiple promises in a contract. A good or service is distinct if both of the following

criteria are met:

1. The customer can benefit from the good or service either on its own or together with other resources that

are readily available to the customer. That is, the good or service is capable of being distinct, and

2. The entity’s promise to transfer the good or service to the customer is separately identifiable from other

promises in the contract. That is, the promise to transfer the good or service is distinct within the context

of the contract.

The following table discusses the features of each criterion.

Criteria Description

Capable of

being distinct

1. A customer can benefit from a good or service if it can be used, consumed, sold (for

an amount that is greater than scrap value) to generate economic benefits.

2. A good or service that cannot be used on its own, but can be used with readily

available resources, also meets this criteria. A readily available resource is a:

✓ Good or service that is sold separately (by the entity or another entity), or

✓ Resource that the customer has already obtained from the entity (e.g. good or

service delivered up-front) or from others in the market

• A good or service is regularly sold separately by an entity indicating that a customer

can benefit from the good or service on its own or with other readily available

resources.

Distinct

within the

context of the

contract

In determining whether an entity’s promises to transfer goods or services are separately

identifiable, the objective is to assess whether the nature of the promise within the

context of the contract, is to transfer each of those goods or services individually or a

combined item or items to which the promised goods or services are inputs.

The following example demonstrates how to determine whether goods or services are distinct.

Example 7

Diamond Corporation enters into a contract with a customer to sell equipment. The contract also provides the

customer with the right to receive up to 20 hours of training services on how to operate the equipment at no

additional cost.

The equipment and training services are each distinct and therefore give rise to two separate performance

obligations because:

• The equipment is distinct because it meets both criteria:

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1. Capable of being distinct: The customer can benefit from the product on its own without the training

services.

2. Distinct within the context of the contract: Diamond Corporation promises to transfer the product that is

separately identifiable from other promises in the contract.

• The training services are distinct because it meets both criteria:

1. Capable of being distinct: The customer can benefit from the training services together with the product

that has already been provided by Diamond Corporation.

2. Distinct within the context of the contract:

− Diamond Corporation promises to transfer the product that is separately identifiable from other promises

in the contract.

− Diamond Corporation does not provide a significant service of integrating the training services with the

product.

− The training services are not significantly modified or customized by the product.

The training services are not highly dependent on, or highly interrelated with, the product.

Compensated Absences

ASC 710-10, Compensation—General, states that compensated absences include sick leave, vacation time, and

holidays. The pronouncement also applies to sabbatical leaves related to past services rendered. ASC 710-10-25-

1 indicates that an estimated liability based on current salary rates should be accrued for compensated absences

when all of the following criteria are satisfied:

a. Employee services have been rendered;

b. Employee rights have vested, meaning the employer is obligated to pay the employee even though he or

she leaves the employment voluntarily or involuntarily;

c. Probable payment exists; and

d. The amount of estimated liability can be reasonably determined.

If the conditions are met but the amount cannot be determined, no accrual can be made. However, there should

be footnote disclosure.

Exhibit F shows an example of accrual for compensated absences.

ASC 710-10 does not apply to deferred compensation, postretirement benefits, severance (termination) pay, stock

option plans, and other long-term fringe benefits (e.g., disability, insurance).

Accrual for sick leave is required only when the employer allows employees to take accumulated sick leave days

off regardless of actual illness. No accrual is made if workers may take accumulated days off only for actual illness

because losses for these are usually insignificant in amount. An employer should not accrue a liability for

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nonvesting rights for compensated absences expiring at the end of the year they are earned, because no

accumulation is involved. However, if unused rights do accumulate, a liability should be accrued.

Finally, compensation costs applicable to an employee's right to a sabbatical or other similar arrangement should

be accrued over the mandatory service years.

Example 11-1

The estimated compensation for future absences is $40,000. The journal entry is:

Expense 40,000

Estimated liability 40,000

If, at a later date, a payment of $35,000 is required, the journal entry is:

Estimated liability 35,000

Cash 35,000

Example 11-2

Blumenfrucht Corporation has a plan for compensated absences providing workers with 8 and 12 paid vacation

and sick days, respectively, that may be carried over to future years. Instead of taking their vacation pay, the

workers may select payment. However, no payment is allowed for sick days not taken. At year-end X13, the

unadjusted balance of the liability for compensated absences was $34,000. At year-end 20X3, it is estimated that

there are 110 vacation days and 80 sick leave days available. The average per-day pay is $125. On December 31,

20X3, the liability for compensated absences is $13,750 ($125 per day × 10 days). There is no accrual for unpaid

sick days because payment of the compensation is not probable.

Exhibit F: Balance Sheet Presentation of Accrual for Compensated Absences

Current liabilities

Accounts payable $ 6,308

Accrued salaries, wages, and commissions 2,278

Compensated absences 2,271

Accrued pension liabilities 1,023

Other accrued liabilities 4,572

$16,452

If an employer meets conditions ASC 710-10-25-1 (a), (b), and (c) but does not accrue a liability because of a

failure to meet condition (d), it should disclose that fact. Exhibit G shows an example of such a disclosure, in a

note from the financial statements of Gotham Utility Company.

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Exhibit G: Disclosure of Policy for Compensated Absences

Gotham Utility Company

Employees of the Company are entitled to paid vacation, personal, and sick days off, depending on job status,

length of service, and other factors. Due to numerous differing union contracts and other agreements with

nonunion employees, it is impractical to estimate the amount of compensation for future absences, and,

accordingly, no liability has been reported in the accompanying financial statements. The Company's policy is to

recognize the cost of compensated absences when actually paid to employees; compensated absence payments

to employees totaled $2,786,000.

Other Matters

Callable Obligations

ASC 470-10-45-11 deals with long-term debt callable or payable on demand by the creditor. If the debtor violates

the debt agreement, and the long-term obligation, therefore, becomes callable, the debt must be included as a

current liability unless either of the following conditions is met:

• The creditor waives or loses his or her right to require repayment for a period exceeding one year from

the balance sheet date

• There exists a grace period under which it is probable that the debtor will cure the violation.

ASC 470-10-50-3 defines a subjective acceleration clause as one allowing the lender unilaterally to accelerate all

or part of a noncurrent debt. For example, the lender in its sole discretion may accelerate repayment of the debt

if it is believed that the borrower is experiencing significant profitability or cash difficulties. If it is probable that

the acceleration provision will be enforced by the lender, the amount of the noncurrent debt likely to be

accelerated should be classified as a current liability by the debtor. However, if acceleration by the lender is only

reasonably possible, footnote disclosure is sufficient. If a remote possibility exists as to acceleration, no disclosure

is needed.

An objective acceleration clause in a long-term debt agreement includes objective criteria to assess calling all or

part of the debt. Examples are setting forth a minimum cash position or a minimum current ratio. If there is a

violation of an objective acceleration provision, most noncurrent debts become callable immediately by the lender

or are callable after some predetermined grace period. In such cases, the creditor may demand repayment of all

or part of the debt due as per the contract.

Footnote disclosure is required for the reasons and circumstances surrounding callable obligations and their

balance sheet classification. Subsequent event disclosure is required when the violation occurs after year-end but

before the audit report date.

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Troubled Debt Restructuring

Frequently, during depressed economic times, debtors may be unable to pay their creditors. Because of the

debtor's financial difficulties, it may be necessary for a creditor to grant a concession that otherwise would not

have been considered. The accounting of debtors and creditors for troubled debt is based on the guidance of two

FASB statements:

1. ASC 310-40 Receivables: Troubled Debt Restructurings by Creditors

2. ASC 470-60 Debt: Troubled Debt Restructurings by Debtors

ASC 470-60 states that in a troubled debt situation the debtor is having significant financial problems and receives

partial or full relief of the debt by the creditor. The relief may be in the form of any of the following:

✓ Creditor/debtor agreement

✓ Repossession or foreclosure

✓ Relief dictated by law

The types of troubled debt restructuring include:

1. Debtor transfers to creditor receivables from third parties or other assets in part or in full satisfaction of

the obligation.

2. Debtor transfers to creditor stock to satisfy the debt.

3. Modification of debt terms, such as through extending the maturity date, reducing the balance due, or

reducing the interest rate.

In restructuring, a gain is recognized by the debtor, but a loss is recognized by the creditor. In most cases, it is an

ordinary loss. The gain of the debtor equals the difference between the fair market value of the assets exchanged

and the book value of the debt, including accrued interest. In addition, there may arise a gain on the disposal of

the assets exchanged equal to the difference between the fair market value and the book value of the transferred

assets. This gain or loss is not from the restructuring but instead an ordinary gain or loss arising from asset disposal.

If a debtor transfers an equity interest to the creditor, the debtor records the stock issued at its fair market value,

not the recorded value of the debt relieved. The difference between these values is recorded as a gain.

Example 12-1

A debtor transferred assets having a fair market value of $7,000 and a book value of $5,000 to satisfy a debt with

a carrying value of $8,000. The gain on restructuring is $1,000 ($8,000 - $7,000), and the ordinary gain is $2,000

($7,000 - $5,000).

Example 12-2

The debtor owes the creditor $70,000. The creditor relieves the debtor of $10,000, with the balance payable at a

future date. The journal entries follow:

46

Debtor

Accounts payable 10,000

Gain on debt restructuring 10,000

Creditor

Ordinary loss 10,000

Accounts receivable 10,000

Example 12-3

The debtor owes the creditor $90,000. The creditor commits to accept a 30% payment in full satisfaction of the

obligation. The journal entries are:

Debtor

Accounts payable 63,000

Gain on debt restructuring 63,000

Creditor

Ordinary loss 63,000

Accounts receivable 63,000

Example 12-4

The following information applies to the transfer of property arising from a troubled debt restructuring:

Book value of liability liquidated $300,000

Fair market value of property transferred 170,000

Book value of property transferred 210,000

The gain on restructuring equals:

Book value of liability liquidated $300,000

Less: fair market value of property transferred 170,000

Gain $130,000

The ordinary gain (loss) on the transfer of the property equals:

Book value of property transferred $210,000

Less: fair market value of property transferred 170,000

Ordinary loss $ 40,000

Any adjustment in the terms of the initial obligation is accounted for prospectively. A new interest rate is

computed based on the new terms. The interest rate is then used to allocate future payments as a reduction in

principal and interest. When the new terms of the agreement result in the total future payments being less than

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the book value of the debt, the debt is reduced, with a restructuring gain being recorded for the difference. ASC

470-60 requires that the gain on restructuring be based on the undiscounted restructured cash flows. Future

payments are considered a reduction of principal only. Interest expense is not recognized.

There may be a mix of concessions offered to the debtor. This may arise when assets or equity are transferred for

partial satisfaction of the debt, with the balance subject to the modification of the terms. The two steps are:

1. Reduce the debt by the fair market value of the asset or equity transferred.

2. The balance of the debt is treated as an adjustment of the terms for accounting purposes.

Any direct costs (e.g., attorney fees) incurred by the debtor in the equity transfer reduce the fair market value of

the equity interest. Any other costs reduce the gain on restructuring. If no gain is involved, direct costs are

expensed.

Footnote disclosure by the debtor should be made of the terms surrounding the restructuring, gain on

restructuring in aggregate and per-share amounts, and contingently payable amounts and terms.

The following should be footnoted:

• Description of restructuring provisions (e.g., time period, interest rate).

• Outstanding commitments.

• Receivables by major category.

Example 13

The debtor owes the creditor $80,000 and, owing to financial difficulties, may be unable to make future payments.

Footnote disclosure is required.

Termination Benefits (Early Retirement) An accrual of a liability for employee termination benefits in the period that management approves the

termination benefit package is required if the following circumstances are met:

✓ The benefits that terminated employees will receive have been agreed on and have been accepted by

management prior to the financial statement date.

✓ Employees are made aware of the termination agreement prior to the issuance of the financial

statements.

✓ The termination benefit plan provides the following data: (a) the number of employees to be terminated,

(b) their job categories, and (c) the location of their jobs.

✓ Significant changes to the plan are not likely, so that completion of the plan may be expected in a short

time.

The termination plan may include both individuals who have been involuntarily terminated and those who have

voluntarily decided to leave their current employ. The latter may have been coaxed into leaving with the promise

of higher termination benefits. The accrued liability should be based on the number of employees who will be

48

terminated and the benefits that will be paid to both involuntarily and voluntarily terminated employees. The

amount of the accrual equals the down payment plus the present value discounted of future payments.

When it can be objectively measured, the impact of changes on the employer's previously accrued expenses

related to other employee benefits directly associated with employee termination should be included in

measuring termination expense.

Example 14

On January 1, 20X3, an incentive is offered for early retirement. Employees are to receive a payment of $100,000

today, plus payments of $20,000 for each of the next 10 years. Assume a discount rate of 10%. The journal entry

is:

Expense 222,900

Estimated liability 222,900

Down payment $100,000

Present value of future payments ($20,000 × 6.145)* 122,900

Total $222,900 *Present value factor for n = 10, i = 10% is 6.145. (Table 2 in the Appendix)

Environmental Liabilities

In determining a loss contingency to accrue for environmental liabilities, the following should be taken into

account:

• Type and degree of hazardous waste at a site.

• Remediation approaches available and remedial action plan.

• Level of acceptable remediation.

• Other responsible parties and their extent of liability.

Securities and Exchange Commission Staff Accounting Bulletin No. 92 requires full disclosure of environmental

problems, how environmental liabilities are determined, “key” factors associated with the environment as it

affects the business, and future contingencies. Depending on the circumstances, a liability and/or footnote

disclosure would be required. Examples of environmental importance requiring accounting or disclosure

recognition based on the facts follow:

✓ Information on site remediation projects, such as current and future costs, and remediation trends. (Site

remediation may include hazardous waste sites.)

✓ Contamination due to environmental health and safety problems.

✓ Legal and regulatory compliance issues, such as with regard to cleanup responsibility.

✓ Water or air pollution.

49

ASC 410-30-45, Asset Retirement and Environmental Obligations: Environmental Obligations, stipulates that if a

liability for environmental losses is required, it should be reduced only when there is probable realization of

recovery from a third party. However, both the liability and probable recovery must be shown separately. The

present value of payments associated with a liability may be recognized only when the future cash flows are

reliably determinable in amount and timing. If the liability is discounted, so must be the anticipated recovery.

Disclosure is required of the gross cash flows and the discount rate used to determine present value.

According to ASC 410-30-55-18, environmental contamination treatment costs should be expensed. However, in

the following cases only, the company may elect to either expense or capitalize the following costs:

1. The expenditures made are to get the property ready for sale.

2. The expenditures prevent or lessen environmental contamination that may result from future activities of

property owned.

3. The expenditures extend the life or capacity of the asset or enhance the safety of the property.

Other authoritative guidance for the accrual and disclosure of environmental liabilities include ASC 450-20-25, 4-

5, Contingencies: Loss Contingencies, ASC 210-20-45, Balance Sheet: Offsetting, and ASC 410-30-45-6.

Environmental costs should be allocated across departments, products, and services.

Review Questions − Section 3

1. Delhi Co. is preparing its financial statements for the year ended December 31, 20X2. Accounts payable

amounted to $360,000 before any necessary year-end adjustment related to the following: 1) At December

31, 20X2, Delhi has a $50,000 debit balance in its accounts payable to Madras, a supplier, resulting from a

$50,000 advance payment for goods to be manufactured to Delhi's specifications. 2) Checks in the amount of

$100,000 were written to vendors and recorded on December 29, 20X2. The checks were mailed on January

5, 20X3. What amount should Delhi report as accounts payable in its December 31, 20X2 balance sheet?

A. $510,000

B. $410,000

C. $310,000

D. $210,000

2. To create legally enforceable rights and obligations, an agreement must meet all of the following criteria of a

contract EXCEPT:

A. In writing

B. Approval and commitment to the contract

C. Identification of each party’s rights and payment terms

D. Commercial substance and collectibility of the consideration

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3. Depending on the contract, promised goods or services include all of the following activities EXCEPT:

A. Granting licenses

B. Granting options to purchase additional good or services

C. Resale of goods purchased by an entity

D. Administrative tasks to set up a contract

4. A retail store received cash and issued a gift certificate that is redeemable in merchandise. What should

happen when the gift certificate was issued?

A. Deferred revenue account should be decreased

B. Deferred revenue account should be increased

C. Revenue account should be decreased

D. Revenue account should be increased

5. Vadis Co. sells appliances that include a 3-year warranty. Service calls under the warranty are performed by

an independent mechanic under a contract with Vadis. Based on experience, warranty costs are estimated at

$30 for each machine sold. When should Vadis recognize these warranty costs?

A. Evenly over the life of the warranty

B. When the service calls are performed

C. When payments are made to the mechanic

D. When the machines are sold

6. How should a company classify long-term obligations that are or will become callable by the creditor because

of the debtor's violation of a provision of the debt agreement at the balance sheet date?

A. Noncurrent liabilities

B. Current liabilities unless the creditor has waived the right to demand repayment for more than 1 year

from the balance sheet date

C. Contingent liabilities until the violation is corrected

D. Current liabilities unless it is reasonably possible that the violation will be corrected within the grace

period

7. On January 3, Year 1, North Company issued long-term bonds due January 3, Year 6. The bond covenant

includes a call provision that is effective if the firm's current ratio falls below 2:1. On June 30, Year 1, the fiscal

year-end for the company, its current ratio was 1.5:1. How should the bonds be reported on the financial

statements?

A. Long-term debt because their maturity date is January 3, Year 6.

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B. Long-term debt if it is reasonably possible that North can cure the covenant violation before the end of

any allowed grace period.

C. Current liability if the covenant violation is not cured.

D. Current liability, regardless of any action by the bondholder, because the company was in violation of the

covenant on the balance sheet date.

52

Chapter 3: Noncurrent Liabilities

Bond Accounting

General Rules

A bond, a long-term debt, is owed by its issuer. The portion of a bond liability that will not be paid within the

upcoming year is recorded as a noncurrent liability. Bonds usually come in $1,000 denominations. Many bonds

have maturities of 10 to 30 years. Bonds derive their value primarily from two promises made by the borrower

to the bondholder. That is, the borrower promises to pay:

1. The face value or principal amount of the bond on a specific maturity date in the future; and

2. Periodic interest

A bond indenture, the contract, is prepared between the issuer and bondholders. It specifies the terms such as

the interest rate, maturity date and maturity amount, possible restrictions on dividends, repayment plans, and

other provisions relating to the debt.

The interest payment to the bondholder is called nominal interest (coupon interest, stated interest), which is the

interest on the face value (maturity value, par) of the bond. Although the interest rate is stated on an annual

basis, interest on a bond is typically paid semiannually. Interest expense is usually tax-deductible. The yield on a

bond may be calculated based on either the simple yield or yield to maturity (effective interest) methods:

Simple yield = (Nominal interest) ÷ (Present value of bond)

Yield to maturity = Nominal interest + Discount/Years (or - Premium/Years)

(Present value + Maturity value)/2

Simple yield is less accurate than yield to maturity.

Example 15

A $300,000, 8%, 10-year bond is issued at 98%.

Simple Yield = Nominal interest = $24,000 = 8.16%

Present value of bond $294,000

Yield to maturity = Nominal interest + Discount/Years = $24,000 + $6,000/10 = 8.2%

(Present value + Maturity value/2) ($294,000 + $300,000)/2

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Bond issue costs are the expenditures incurred in issuing bonds, such as legal, accounting, underwriting,

commissions, registration, engraving, and printing fees. Bond issue costs should preferably be deferred and

amortized over the life of the bond. They are presented as a deferred charge. However, two alternative acceptable

methods exist to account for bond issue costs: to expense such costs immediately or to treat them as a reduction

of bonds payable.

The selling price of a bond is set by the supply and demand of buyers and sellers, based on market risks and

conditions. The value of a bond sold is the present value of its principal and all future cash flows, with the present

value calculated by using an interest rate that provides an acceptable return on investment commensurate with

the risk of the bond. If a bond is sold at a discount, the yield will exceed the nominal interest rate. However, if a

bond is sold at a premium, the yield will be less than the nominal interest rate. A bond discount or premium may

be amortized using either:

1. Straight-line method: The amortization per period results in a fixed dollar amount but at a varying effective

rate.

2. Effective-interest method: The amortization per period results in a constant rate of interest but a varying

dollar amount. This method is preferred because it results in a better matching of periodic expense with

revenue.

The amortization entry under the effective-interest method is:

Interest expense (Yield × Carrying value of bond at the beginning of the year)

Discount (for balance)

Cash (nominal interest rate × face value of bond)

In the early years, using the effective-interest method results in a lower amortization amount relative to the

straight-line method (either for discount or premium), and a higher interest expense. The periodic amortization

will increase if the bonds were issued at either a discount or a premium.

Exhibit H presents the comparison of straight-line and effective-interest amortization methods.

Example 16-1

On January 1, 20X2, a $200,000 bond is issued at $194,554. The yield rate is 5% and the nominal interest rate is

4%. The effective-interest method is used. A schedule for the first two years follows:

Date

Debit Interest

Expense Credit Cash Credit Discount Book Value

1/1/20X2 $194,554

12/31/20X3 $9,727 $8,000 $1,727 $196,281

12/31/20X4 $9,814 $8,000 $1,814 $198,095

12/31/20X5 $9,905 $8,000 $1,905 $200,000

Note: Interest expense is increasing because the carrying value of the bond is increasing.

54

55

On December 31, 20X3, the journal entry is:

Interest expense 9,727

Cash 8,000

Discount 1,727

Example 16-2

Cohen Company has outstanding an 8%, 10-year, $200,000 bond. The bond was initially issued to yield 7%.

Amortization is based on the effective interest method. On July 1, 20X2, the carrying value of the bond was

$211,943. The unamortized premium on the bond on July 1, 20X3, was $10,779 computed as follows:

Unamortized premium—7/1/20X2

($211,943 - $200,000) $11,943

Less: amortized premium for the year-ended 7/1/20X3:

Nominal interest ($200,000 × 8%) $16,000

Effective interest ($211,943 × 7%) 14,836 1,164

Unamortized premium—7/1/20X3 $10,779

Serial bonds (bonds maturing in installments) may be issued as if each series were a separate bond issue or as one

issue having varying maturity dates. In most cases, each series has the same interest rate and yield but different

issue prices, depending upon their maturity period. One discount or premium account exists for all the bonds in

the series. The effective-interest method is used in determining amortization of the discount or premium.

The price of a bond is calculated as follows:

1. The face value is discounted using the present value of $1 table (Table 1 in the Appendix).

2. Interest payments are discounted using the present value of an ordinary annuity of $1 table. (Table 2 in

the Appendix)

3. Yield is used as the discount rate.

Example 17

A $100,000 10-year bond is issued at an 8% nominal interest rate. Interest is payable semiannually. The yield rate

is 10%. The present value of $1 table factor for n = 20, i = 5% is 12.46221. The price of the bond is

Present value of principal $100,000P × .37689 $37,689

Present value of interest payments $4,000 × 12.46221 49,849

Present value $87,538

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Bonds Payable is presented in the balance sheet at its book value in the following manner:

Bonds payable

Add: premium on bonds payable

Less: discount on bonds payable

Carrying value

Bonds payable may be issued between interest dates at a premium or discount. If a bond is issued between

interest dates, the journal entry is:

Cash

Discount (or credit premium)

Bonds payable

Interest expense

Exhibit H: Comparison of Straight-line and Effective-Interest Amortization Methods

57

Comprehensive Illustrations

Illustration 1

On April 1, 20X2, a $500,000, 8% bond with a five-year life dated 1/1/20X2, is issued at 106%. Interest is payable

on 1/1 and 7/1. The company uses the straight-line amortization method. The journal entries are:

4/1/20X2

Cash ($530,000 + $10,000) 540,000

Bonds payable 500,000

Premium on bonds payable ($500,000 × 6%) 30,000

Interest expense ($500,000 × 8% × 3/12) 10,000

7/1/20X2

Interest expense 20,000

Cash 20,000

Premium on bonds payable 1,578

Interest expense 1,578

4/1/20X2 - 1/1/20X7 = 4 years, 9 months = 57 months $30,000/57 = $526 per month (rounded)

4/1/20X2 - 7/1/20X2 = 3 months

3 months × $526 = $1,578

12/31/20X2

Interest expense 20,000

Interest payable 20,000

Premium on bonds payable 3,156

Interest expense 3,156

(6 months × $526 = $3,156)

1/1/20X3

Interest payable 20,000

Cash 20,000

58

Illustration 2

On January 1, 20X3, a company issued 10% bonds with a face value of $600,000 for $560,000 to yield 11%. Interest

is payable semi-annually on January 1 and July 1. The effective interest method of amortization is used. The journal

entries for 20X3 are:

1/1/20X3

Cash 560,000

Discount on bonds payable 40,000

Bonds payable 600,000

7/1/20X3

Interest expense

(11% × $560,000 × 6/12) 30,800

Cash (10% × $600,000 × 6/12) 30,000

Discount on bonds payable 800

The book value of the bonds on July 1, 20X3, after the preceding entry, is as follows:

Bonds payable $600,000

Less: discount on bonds payable ($40,000 - $800) 39,200

Book value $560,800

12/31/20X3

Interest expense (11% × $560,800 × 6/12) 30,844

Cash (10% × $600,000 × 6/12) 30,000

Discount on bonds payable 844

Convertible Debt

General Rules

The issuance of convertible bonds usually allows the company to issue the securities at a lower interest rate with

fewer restrictions compared to a conventional bond. When issued, the face value of the convertible bond usually

will be more than the market value of the stock into which it is convertible. Further, at issuance, no value is

assigned to the conversion feature. The sale is only recorded as the issuance of debt. The conversion price is

typically set at about 15% more than the market price of the stock when the convertible bond is issued. Unless

attributable to anti-dilution, the conversion price remains the same. There may be a call feature allowing the

issuer to call the bonds back before maturity.

As the value of the stock increases, so does the value of the convertible bond. When the market value of the

shares associated with the convertible bond exceeds the face value of the debt, the holder will benefit by

converting the debt into shares. Alternatively, in such a situation the issuer may force conversion. If the market

59

price of the stock remains the same or goes down, the holder of the convertible bond will not convert it into the

stock. This is referred to as an overhanging bond. In other words, a holder will not convert if the market value of

the common stock is less than the face value of the convertible bond. When this occurs, the issuer has a number

of options, such as:

• Exercising the call feature and paying the bondholders the face amount of the bond;

• Providing an inducement in the form of additional consideration to convert; or

• Waiting until maturity to pay the principal of the debt.

In bankruptcy, the convertible bond is subordinate to nonconvertible debt.

The strongly preferred and widely used method to account for the conversion of a bond into stock is the book

value of bond method. A drawback to the book-value method is that it fails to recognize in the accounting for the

conversion the total value of the equity security issued. Under the book-value method, there is no gain or loss

reported on bond conversion, because the book value of the bond is the basis to credit equity. The entry to record

the conversion using this method follows:

Bonds payable: At face value

Premium on bonds payable: Unamortized amount

Discount on bonds payable: Unamortized amount

Common stock: At par value of shares issued

Additional paid-in-capital: The difference between the book value of the bonds and the par

value of common stock

Under the market value methods, gain or loss arises because the book value of the bond differs from the market

value of the bond or the market value of the stock, which is the basis to credit the equity account. The market-

value method is rarely used in practice and may be precluded under ASC 470-50-05. Although much less desirable,

in a few exceptional cases when justified, the market value of bond or market value of stock method might be

used.

Example 18-1

On July 1, 20X3, Klemer Company converted $1,000,000 of its 10% convertible bonds into 25,000 shares of $3 par

value common stock. On the date of the conversion, the book value of the bonds was $1,200,000; the market

value of the bonds was $1,250,000 and the market price of the stock was $54 per share. Using the preferred book

value of bond method, the journal entry would be:

Bonds payable 1,000,000

Premium on bonds payable 200,000

Common Stock (25,000 × $3) 75,000

Paid-in-capital 1,125,000

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Example 18-2

A convertible bond having a face value of $80,000 with an unamortized discount of $5,000 is converted into 10,000

shares of $6 par value stock. Under the book value method, the journal entry for the conversion is:

Bonds payable 80,000

Discount on bonds payable 5,000

Common stock (10,000 × $6) 60,000

Paid-in-capital 15,000

ASC 470-20-35-11, Debt: Debt with Conversion and Other Options, states that if the debt agreement specifies that

accrued interest at the conversion date is forfeited by the bondholder, such accrued interest (net of tax) since the

last interest date to the date of conversion should be treated as interest expense, with a corresponding credit to

capital, because it is considered an element of the cost of the securities issued.

ASC 470-20-55-68 explains that equity securities issued on the conversion of a debt instrument that has a

substantive conversion feature at the issue (commitment) date should be treated for accounting purposes as a

conversion if the debt security becomes convertible because the issuer has exercised a call option. In this case,

gain or loss is not recorded. However, if there is no substantive conversion feature at the issue date, the

conversion should be treated as a debt extinguishment if the debt security becomes convertible because of the

issuer's exercise of a call option based on the debt instrument's original conversion terms. In this situation, the

fair value of the equity security should be treated as a part of the price of reacquiring the debt. In determining if

a conversion feature is substantive, consideration should be given to assumptions and available market data.

Other authoritative sources of GAAP concerning convertible debt may be found in ASC 815-15-55, Derivatives and

Hedging: Embedded Derivatives.

Comprehensive Illustration

A $200,000 bond with an unamortized premium of $17,000 is converted to common stock. There are 200 bonds

($200,000/$1,000). Each bond is convertible into 100 shares of stock. Therefore, there are 20,000 shares of

common stock to be issued. The par value per share is $8. The market value of the stock is $12 per share. The

market value of the bond is 115%.

Using the book value of bond method, the journal entry for the conversion is:

Bonds payable 200,000

Premium on bonds payable 17,000

Common stock (20,000 × $8) 160,000

Premium on common stock 57,000

Using the market value of stock method, the journal entry is:

Bonds payable 200,000

61

Premium on bonds payable 17,000

Loss on bond conversion 23,000

Common stock (20,000 × $8) 160,000

Premium on common stock (20,000 × $4) 80,000

20,000 shares × $12 = $240,000

Using the market value of bond method, the journal entry is:

Bonds payable 200,000

Premium on bonds payable 17,000

Loss on bond conversion 13,000

Common stock (20,000 × $8) 160,000

Premium on common stock 70,000

$200,000 × 115% = $230,000

Inducement Offer to Convert Debt to Equity

The holder of the convertible debt has an option to receive (1) the face or redemption amount of the security or

(2) common shares. The debt and equity elements of convertible debt are inseparable. The entire proceeds should

be accounted for as debt until conversion.

ASC 470-20-05-10 states if convertible debt is converted into stock because of an inducement offer in which the

debtor changes the conversion privileges (e.g., conversion ratio, issuance of warrants, or cash compensation), the

debtor must record the inducement as an expense of the current period. The conversion expense equals the fair

market value of the securities and other consideration transferred in excess of the fair market value of the

securities issuable based on the original conversion term. It is measured at the date the inducement offer is

accepted by the convertible bondholders (usually the conversion or agreement date).

The FASB views the inducement given as a compensatory payment to convertible bondholders for converting their

securities to stock. If the additional inducement comprises stock, the market value of the stock is credited to

common stock at par value, with the excess over par credited to paid-in-capital and with the offsetting-debit-to-

debt conversion expense. If the additional inducement is assets, the market value of the assets is credited with an

offsetting-charge-to-debt conversion expense. For example, the inducement may be in the form of cash or

property. ASC 470-20-05-10 applies only to induced conversions that may be exercised for a limited time period.

Example 19-1

On April 1, 20X0, a company issued $500,000 8% bonds at face value. Each $1,000 bond is convertible into 15

shares of common stock having a par value of $30. On July 1, 20X3, the company offers to increase the conversion

rate to 18 shares per $1,000 bond to induce conversion through this “sweetener.” The debtholders accept this

offer. At this date, the market value of the stock is $50 per share. Therefore, the additional consideration given as

an inducement to the holders of the $500,000 bonds will be $75,000, computed as follows:

($500,000/$1,000) = 500 bonds

62

500 bonds × 3 shares per $1,000 band = 1500 shares

Fair market value of additional consideration equals 1500 shares × $ 50 = 75,000

The journal entry for the conversion is:

Bonds payable 500,000

Debt conversion expense 75,000

Common stock (9,000 shares* × $30) 270,000

Paid-in-capital 305,000 * 500 bonds × 18 shares per bond = 9,000 shares

Example 19-2

A company has $400,000 outstanding of convertible bonds issued at par value. Each $1,000 bond is convertible

into 12 shares of $20 par value common stock. To induce bondholders to convert, the company increased the

conversion rate from 12 shares per $1,000 bond to 16 shares per $1,000 bond. When the market price of the stock

was $25, one bondholder converted his $1,000 bond. The amount of incremental consideration is $100 (4

additional shares × $25). The journal entry is:

Bonds payable 1,000

Debt conversion expense 100

Common stock (16 shares × $20) 320

Paid-in-capital 780

Example 19-3

A bondholder is holding a $10,000 face value convertible bond that was issued at par. Each $1,000 bond is

convertible into 50 shares of stock having a par value of $12. To induce conversion, the company offers the

bondholder land having a fair market value of $1,500 at the date of conversion. The cost of the land is $1,200. The

journal entries associated with the induced conversion are:

Land 300

Gain 300

To increase land to fair value to use as inducement:

Bonds payable 10,000

Debt conversion expense 1,500

Land 1,500

Common stock (500* shares × $12) 6,000

Paid-in-capital 4,000 *$10,000/$1,000 = 10 bonds.

10 bonds × 50 shares = 500 shares.

63

If the debtor places cash or other assets in an irrevocable trust to be used only to pay interest and principal on the

obligation, disclosure is required of the particulars concerning the transaction and the amount of debt considered

extinguished.

ASC 470-20-30-27 and 30-28, states that interest costs associated with convertible debt instruments recognized

in periods subsequent to their initial recognition should constitute the borrowing rate a company would have

incurred had it issued a comparable debt instrument without the embedded conversion option. That objective is

achieved by requiring issuers to separately account for the liability and equity components of convertible debt

instruments.

The following steps should be used to initially measure the convertible debt:

1. Determine the carrying value of an instrument's liability component using a fair value measurement of a

similar liability (including embedded features, if any, other than the conversion option) that has no related

equity component.

2. Determine the carrying value of the instrument's equity component corresponding to the embedded

conversion option by subtracting the liability component's fair value from the initial proceeds applicable

to the total convertible debt instrument.

The principal amount of the liability component over its initial fair value must be amortized to interest cost using

the interest method.

A temporary tax basis difference associated with the liability component may occur. Additional paid-in-capital

should be adjusted when deferred taxes are initially recognized for the tax impact of the temporary difference.

If a conversion option has to be reclassified from stockholders' equity to a liability measured at fair value, the

difference between the amount that has been recognized in equity and the fair value of the conversion option at

the date of reclassification should be accounted for as an adjustment to stockholders' equity. On the other hand,

when a conversion option accounted for in stockholders' equity is reclassified as a liability, gains or losses

recognized to account for that conversion option at fair value while classified as a liability should not be reversed

if later the conversion option is reclassified back to stockholders' equity. The reclassification of a conversion option

does not impact the accounting for the liability component.

The following should be disclosed:

1. Conversion price and the number of shares used to calculate the total consideration to be delivered on

conversion.

2. Effective interest rate on the liability component.

3. Amount of interest cost applicable to both the contractual interest coupon and discount amortization on

the liability component.

4. Carrying value of the equity component.

5. Principal amount of the liability component, its amortized discount, and its carrying value.

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6. Remaining years for which the discount on the liability will be amortized.

7. Amount by which the instrument's if-converted value is more than the principal amount, irrespective of

whether the instrument is currently convertible.

8. Term of derivative transactions, reasons to enter into derivative transactions, and number of shares

underlying derivative transactions.

ASC 470-20 provides information on the following:

1. Provides accounting and reporting advice for bonds and other types of preferred stock with conversion

attributes. These include convertible bonds, bonds with detachable warrants, forfeiture of interest, and

conversions that are induced. (ASC 470-20-05-1)

2. Is applicable in the following instance:

• A firm that has a high cost of borrowed shares may contract for share lending separately transacted but along

with a convertible bond issuance.

• The share lending contract allows investors to hedge the conversion option. (ASC 470-20-05-12A)

3. Provides guidance when, in a share-lending contract, the firm issues loaned shares to an investment bank for

a small charge. This fee typically equals the par value of the common stock, which is usually below the market

value of the loaned securities. At maturity, the loaned shares are returned to the company. (ASC 470-20-05-

12B)

4. Offers guidance for properly recording a share-lending contract. When issued, a share-lending contract is

recorded at market value and recorded at issuance cost with an adjustment to paid-in-capital. (ASC 470-20-

25-20A)

Early Extinguishment of Debt

ASC 860-50, Transfers and Servicing: Servicing Assets and Liabilities and ASC 470-50, Debt: Modifications and

Extinguishments, cover the accounting, reporting, and disclosures associated with retiring debt. Long-term debt

may be called before its maturity date and new debt issued instead at a lower interest rate. On the other hand,

the company may just retire the long-term debt early because it has excess funds and wants to avoid paying

interest charges and having debt on its balance sheet. (A call provision allows the issuer the right to retire all or

part of the debt prior to the maturity date, typically at a premium price.)

If a defeasance clause exists instead of a call provision, the issuer may satisfy the obligation and receive a lien

release without retiring the debt. In a defeasance arrangement, the old debt is satisfied under law with a gain or

loss being recognized.

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When financial assets are transferred, any resulting debt or derivatives must be measured initially at fair value.

The amortization of a servicing liability is proportionate based on the time period associated with the net servicing

loss or gain. A change in fair value must be also considered. Disclosure is required of the nature of any limitations

placed on assets set aside to pay debt payments.

ASC 860-50 also addresses the issue of a debtor becoming secondarily liable, such as because of a third-party

assumption and a creditor's release. In this case, the original party is considered a guarantor. It is necessary to

recognize a guarantee obligation based on the likelihood that the third party will pay. The guarantee obligation

must initially be recognized at fair value. The guarantee obligation serves either to reduce the gain or increase the

loss on debt extinguishment.

In an advance refunding arrangement, new debt is issued to replace the old debt issue that cannot be called. The

amount received from issuing the new debt is used to buy high-quality investments, which are retained in an

escrow account. The income earned on the investments in the escrow account is used to pay the interest and/or

principal on the existing debt for a period ending on the date the existing debt is callable. When the call of the

existing date occurs, the balance in the escrow account is used to pay the call premium. Any residual remaining is

used to pay any interest due on the existing debt as well as the principal balance.

The reacquisition price for debt includes the call premium and any other associated costs (e.g. prepayment

penalties, reacquisition costs) to buy back the debt. If the extinguishment is based on the issuance of securities,

the reacquisition price is the fair value of the securities issued. The net carrying amount of the debt extinguished

is its book value (including any associated unamortized discount or premium) and any other issuance costs (e.g.,

accounting, underwriter's commissions, legal). Any unamortized bond issue costs reduce the carrying value.

ASC 470-50 stipulates that the gain or loss on extinguishment is based on either the fair value of the stock issued

in exchange for the debt or the value of the debt extinguished, whichever is more clearly evident. The gain or loss

on the retirement of debt equals the difference between the retirement price and the carrying value of the bonds.

The gain or loss on an extinguishment of debt is an ordinary item.

Debt is considered extinguished when the debtor is relieved of the principal liability and will most likely not need

to make future payments. This occurs when either the debtor pays the debt or reacquires the debt in the securities

market, or the debtor is legally discharged and it is probable that the debtor will not need to make future payments

as guarantor of the obligation. The latter occurs when the debtor is legally discharged as the primary obligor but

is secondarily liable for the debt.

No gain or loss arises from an early extinguishment of a fully owned subsidiary's mandatory preferred stock by

the parent company. It should be accounted for as a capital transaction. On the other hand, if a subsidiary has an

outstanding third-party debt instrument that is purchased by the parent, a gain or loss is reported in consolidation

equal to the difference between the carrying value of the debt on the subsidiary books and the purchase price

paid by the parent. This accounting is also applicable if it is the parent that issued the debt and it is the subsidiary

that purchases it.

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Example 20-1

A $300,000 bond payable with an unamortized bond discount of $7,000 is called at 90%. The journal entry is:

Bonds payable 300,000

Discount on bonds payable 7,000

Cash (90% × $300,000) 270,000

Gain 23,000

Example 20-2

On January 1, 20X3, a company called 500 outstanding, 8%, $1,000 face value bonds at 108%. The unamortized

bond premium on this date was $25,000. The journal entry is:

Bonds payable 500,000

Premium on bonds payable 25,000

Loss 15,000

Cash ($500,000 × 108%) 540,000

Example 20-3

A bond having a face value of $300,000 and an unamortized discount of $8,000 is called at 102%. Unamortized

deferred issue costs representing legal and accounting fees are $12,000. The journal entry for the extinguishment

is:

Bonds payable 300,000

Loss 26,000

Cash ($300,000 × 102%) 306,000

Discount on bonds payable 8,000

Deferred issue costs 12,000

There should be footnote disclosure in one footnote or cross-referenced footnotes concerning the extinguishment

as follows:

✓ Description of the extinguishment transaction including the funding used for it.

✓ Direct and indirect guarantees of indebtedness of others (this includes a situation in which the debtor is

released as the primary obligor but is contingently liable).

When a debtor contracts with a holder of its debt to redeem the obligation within one year for a predetermined

amount, it is classified as a current liability. The debtor recognizes a loss when the contract becomes legally binding

on the parties. However, a gain is not recognized until the redemption actually occurs.

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Short-Term Obligations Refinanced

Some short-term obligations are expected to be refinanced on a long-term basis and, therefore, are not expected

to require the use of enterprise working capital during the ensuing fiscal year. Examples include commercial paper,

construction loans, and the currently maturing portion of long-term debt.

Refinancing a short-term obligation on a long-term basis means either replacing it with a long-term obligation or

with equity securities or renewing, extending, or replacing it with short-term obligations for an uninterrupted

period extending beyond one year (or the operating cycle, if applicable) from the date of an enterprise’s balance

sheet.

The refinancing of one short-term obligation with another is not sufficient to demonstrate the ability to refinance

on a long-term basis.

ASC 470-10-45-13 and 45-14, Debt: Overall, specifies that a short-term obligation should be excluded from current

liabilities and included with noncurrent liabilities if both of the following conditions are met:

1. Intent to refinance: The entity intends to refinance a short-term obligation on a long-term basis by either

replacing it with a long-term obligation or with equity securities or renewing, extending, or replacing it

with short-term obligations for an uninterrupted period extending beyond one year (or the operating

cycle, if applicable) from the date of an entity's balance sheet.

2. Ability to consummate the refinancing demonstrated in either of the following ways:

• After year-end but before the audit report date, the short-term debt is rolled over into a long-term

debt, or an equity security is issued in substitution; or

• Before the audit report date, the company contracts to refinance the current debt on a long-term

basis and all of the following conditions are satisfied:

✓ The agreement is for a period of one year or more.

✓ No provision of the agreement has been violated.

✓ The parties are financially sound and therefore able to satisfy all of the requirements of the

agreement.

When debt is reclassified from short term to long term because of conditions described in item 1, it should be

classified under noncurrent liabilities, not stockholders' equity, even if equity securities were subsequently issued

in substitution of the debt.

If short-term debt is excluded from current liabilities, the amount of short-term debt excluded from current

liabilities should be the minimum amount expected to be refinanced based on conservatism. The exclusion from

current liabilities cannot exceed the net proceeds of debt or security issuances, or amounts available under the

refinancing agreement. The latter amount must be adjusted for any restrictions in the contract that limit the

amount available to pay off the short-term debt. If a reasonable estimate is not ascertainable from the agreement,

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the full amount must be classified as current debt. Further, a refinancing intent may be absent if the contractual

provisions permit the lender or investor to establish unrealistic interest rates, security, or other related terms.

ASC 470-10-55-1 stipulates that if cash is paid for the short-term debt, even if long-term debt of a similar amount

is issued the next day, the short-term debt should be presented under current liabilities because cash was paid.

The details of the refinancing must be disclosed in the notes (e.g. the amount excluded from current liabilities).

Disclosure is also mandated for the contractual terms and any noncurrent debt or equity securities issued or

expected to be issued in substitution of the short-term debt.

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Review Questions − Section 4

1. A bond issued on June 1, 20X3 has interest payment dates of April 1 and October 1. How long will be the

period of bond interest expense for the year ended December 31, 20X3?

A. Three months

B. Four months

C. Six months

D. Seven months

2. On March 1, 20X3, Clark Co. issued bonds at a discount. Clark incorrectly used the straight-line method instead

of the effective interest method to amortize the discount. How were the following amounts, as of December

31, 20X3, affected by the error?

A. Bond Carrying Amount is Overstated, and Retained Earnings is Overstated

B. Bond Carrying Amount is Understated, and Retained Earnings is Understated

C. Bond Carrying Amount is Overstated, and Retained Earnings is Understated

D. Bond Carrying Amount is Understated, and Retained Earnings is Overstated

3. Which of the following statements characterizes convertible debt?

A. The holder of the debt must be repaid with shares of the issuer's stock

B. No value is assigned to the conversion feature when convertible debt is issued

C. The transaction should be recorded as the issuance of stock

D. The issuer's stock price is less than market value when the debt is converted

4. On March 31, 20X3, Ashley, Inc.'s bondholders exchanged their convertible bonds for common stock. The

carrying amount of these bonds on Ashley's books was less than the market value but greater than the par

value of the common stock issued. If Ashley used the book-value method of accounting for the conversion,

which of the following statements correctly states an effect of this conversion?

A. Equity is increased.

B. Additional paid-in capital is decreased.

C. Retained earnings is increased.

D. A loss is recognized.

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5. On March 1, 20X3, Somar Co. issued 20-year bonds at a discount. By September 1, 20X8, the bonds were

quoted at 106 when Somar exercised its right to retire the bonds at 105. How should Somar report the bond

retirement on its 20X8 income statement?

A. A gain in continuing operations

B. A loss in continuing operations

C. Somar should not report the bond retirement

D. Somar should report the retirement in the footnotes only

6. A company has the following liabilities at year-end: 1) Interest payable is $8,000 due within 12 months, 2)

Short-term debt refinanced to long-term debt is $6,000, 3) Deferred tax liability arising from depreciation

$3,000. What amount should be reported as the noncurrent liability?

A. $3,000

B. $6,000

C. $8,000

D. $9,000

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Deferred Tax Liability

ASC 740, Income Taxes, requires deferred tax liabilities be classified as noncurrent on the balance sheet. A

deferred tax liability is recognized for temporary differences that will result in taxable amounts in future years.

That is, if book income exceeds taxable income, then tax expense exceeds tax payable, resulting in a deferred tax

liability. For example, an installment sale is recognized for the books in the year of sale but is recognized for tax

purposes when cash collections are received. The result is a taxable temporary difference and an increase in a

deferred tax liability. On the other hand, deferred tax assets are recognized for deductible temporary differences

(i.e., future deductible amounts).

Temporary differences ordinarily become taxable or deductible when the related asset is recovered or the related

liability is settled. Because permanent differences affect only the period in which they occur, they do not have

tax consequences and do not give rise to deferred tax assets or liabilities. Thus, an income tax liability should not

be classified as a deferred tax liability unless it results from a taxable temporary difference.

A permanent difference, such as nontaxable income and nondeductible expenses, is caused by a transaction that

is reported differently for financial and tax reporting purposes. Such a difference does not reverse over time.

Examples of nontaxable income include interest received on tax-exempt securities or a gain on foreign exchange

on capital transaction. Examples of nondeductible expenses include penalties/fines from a violation of laws,

expenses incurred in obtaining tax-exempt income, political contributions.

The following table identifies four types of temporary differences.

Transaction

Book

Income

Taxable

Income Example

Deferred

Tax Effect

Revenue or Gain Today Later An installment sale Liability

Revenue or Gain Later Today Advance rent receipts Asset

Expense or Loss Today Later Warranty expense Asset

Expense or Loss Later Today

Depreciation of fixed asset (MACRS

depreciation method vs. straight-line

depreciation method) Liability

Deferred tax liability, a tax obligation, results in a taxable amount in the future

Deferred tax asset, overpayment or advance payment of taxes, results in a deductible amount in the future

Because amounts received upon recovery of that receivable will be taxable, a deferred tax liability is recognized

in the current year for the related taxes payable in future years. It equals the temporary difference multiplied by

the tax rate scheduled to be in effect when the difference reverses.

Book Income > Taxable Income

Future Taxable Amounts Deferred Tax Liability

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It is important to know that even though a deferred tax liability for the LIFO inventory of a subsidiary will not be

settled if that subsidiary is sold before the LIFO inventory temporary difference reverses, recognition of a deferred

tax liability is required regardless of whether the LIFO inventory happens to belong to the parent entity or one of

its subsidiaries.

ASC 740-10-55-63 specifies that deferred tax liabilities may not be eliminated or reduced because an entity may

be able to delay the settlement of those liabilities by delaying the events that would cause taxable temporary

differences to reverse. Accordingly, the deferred tax liability is recognized. If the events that trigger the payment

of the tax are not expected in the foreseeable future, the reversal pattern of the related temporary difference is

indefinite. In other words, an entity delay a tax effect indefinitely; however, the ability to do so is not a factor in

determining whether a taxable temporary difference exists.

The liability for unrecognized tax benefits (or reduction in amounts refundable) should not be combined with

deferred tax liabilities or assets.

Example 21-1

An increase in prepaid insurance signifies the recognition of a deduction on the tax return of a cash-basis taxpayer

but not in the accrual-basis financial statements. The result is a temporary difference giving rise to taxable

amounts in future years when the reported amount of the asset is recovered. An increase in rent receivable

involves recognition of revenue in the accrual-basis financial statements but not in the tax return of a cash-basis

taxpayer. This temporary difference also will result in future taxable amounts when the asset is recovered. A

deferred tax liability records the tax consequences of taxable temporary differences. Hence, these transactions

increase deferred tax liabilities.

The deferred tax liability may also be calculated by multiplying the temporary difference by the applicable tax

rate.

Example 21-2

Book income and taxable income are both $200,000. Depreciation expense for book purposes is $20,000

using the straight-line method, but depreciation for tax purposes is $30,000 using an accelerated

depreciation method. Assuming a 21% tax rate, the entry is:

Income tax expense ($180,000 × 21%) 37,800

Income tax payable ($170,000 × 21%) 35,700

Deferred tax liability ($10,000 × 21%) 2,100

At the end of the life of the asset, the deferred tax liability of $2,100 will be completely reversed.

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Lease Obligations

General Rules

Prior to ASC 842, Leases, lessees only recognized assets and obligations related to capital leases. The expenses

associated with capital leases were accounted for by amortizing the leased asset and recognizing interest expenses

on the lease obligation. Lessees were not required to recognize assets and liabilities arising from operating leases

on the balance sheet but rather would only recognize lease payments as an expense on a straight-line basis over

the lease term.

According to ASC 842, a capital lease is now referred to as a finance lease.

Under ASC 842, leases of all types convey the right to direct the use and obtain substantially all the economic

benefit of an identified asset, creating an asset and liability for lessees. That is, both financing leases and operating

leases create an asset (right-of-use) and a liability, initially measured at the present value of the lease payments.

A lessee should classify a lease as a finance lease when the lease meets any of the following criteria at lease

commencement:

1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain

to exercise. The FASB determined that “reasonably certain” is a high threshold, such as probability

exceeding 75-80%.

3. The lease term is for the major part of the remaining economic life of the underlying asset (usually 75%).

However, if the commencement date falls at or near the end of the economic life of the underlying asset,

this criterion should not be used for purposes of classifying the lease.

4. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that

is not already reflected in the lease payments. An entity may use a threshold of 90 percent or more when

determining what constitutes substantially all of the fair value of the underlying asset.

5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the

lessor at the end of the lease term

When none of the criteria listed above are met, a lessee should classify the lease as an operating lease.

Example 22

IMX Corp. (Lessee) leases a truck from ACM Inc. (Lessor) with the following information:

• Lease term: 3 years, no renewal option

• Transfer of ownership: Title remains with ACM Inc. upon lease expiration

• Economic life of the truck: 5 years

• Purchase option: None

• Monthly lease payment: $500

• IMX Corp.’s incremental borrowing rate: 6%

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• The fair value of the truck: $32,000; IMX Corp. does not guarantee the residual value of the truck at the

end of the lease term

• Initial direct costs: None

• Incentives from ACM Inc.: None

IMX Corp. should assess the lease classification using the five criteria outlined above.

1. Transfer of ownership: Ownership of the truck does not transfer to IMX Corp. by the end of the lease term

2. Purchase option: N/A

3. Lease term: IMX Corp. is utilizing the asset for 60% of the economic life of the asset (3-year lease ÷ 5-year

economic life), which is not considered to be a major part.

4. Present value test: The present value of the lease payments (discounted at IMX Corp.’s incremental

borrowing rate of 6% because the rate charged in the lease is not readily determinable) is $16,518.

Therefore, the present value of the lease payments amounts to approximately 52% of the fair value of the

leased asset ($16,518 ÷ $32,000), which is not considered to be substantially all of the fair value of the

leased asset.

5. Alternative use: The truck is non-specialized and can be used by another party without major

modifications.

As a result, IMX Corp. should classify the lease as an operating lease because none of the criteria in ASC 842 have

been met.

For finance leases, a lessee is required to:

1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease

payments, in the balance sheet

2. Recognize interest on the lease liability separately from amortization of the right-of-use asset in the

income statement

3. Classify repayments of the principal portion of the lease liability within financing activities and payments

of interest on the lease liability and variable lease payments within operating activities in the statement

of cash flows.

For operating leases, a lessee is required to:

1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease

payments, in the balance sheet

2. Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term on a

generally straight-line basis

3. Classify all cash payments within operating activities in the statement of cash flows

For leases whose term is 12 months or less, however, lessees may make an accounting policy election by class of

underlying asset not to recognize lease assets and lease liabilities. If a lessee makes this election, it should

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recognize lease expense for such leases generally on a straight-line basis over the lease term. The following table

summarizes the accounting by lessees for the different types of leases.

Financial Statement Impact Snapshot for Lessee

Lessee Balance Sheet Income Statement Cash Flow Statement

Finance Right-of-Use Asset

Lease Liability

Front Loaded:

• Amortization Expense

(right-of-use asset)

• Interest Expense (lease

liability)

Interest expense: Operating

activities

Principal payment: Financing

activities

Operating Right-of-Use Asset

Lease Liability

Lease Expense Lease expense: Operating

activities

Exhibit I shows how an operating lease affects the balance sheet.

Exhibit I: The Impact of Operating Leases

Current Assets Cash 200,000

Accounts Receivable 260,000

460,000

Noncurrent Assets Property and Equipment, Net 800,000

Right to Use Asset – Operating 400,000

1,200,000

Total Assets 1,660,000

Current Liabilities Accounts Payable 100,000

Current Maturities of Long-Term Debt 20,000

Current Portion of Operating Lease Liability 120,000

240,000

Noncurrent Liabilities Long-Term Debt 140,000

Operating Lease Liability, Less Current Portion 280,000

420,000

Total Liabilities 660,000

Equity

1,000,000

Total Liabilities and Equity 1,660,000

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Disclosure Requirements

Balance Sheet

A lessee should either present in the balance sheet or disclose in the notes both of the following:

✓ Finance lease right-of-use assets and operating lease right-of-use assets separately from each other and

from other assets; and

✓ Finance lease liabilities and operating lease liabilities separately from each other and from other liabilities.

Right-of-use assets and lease liabilities are subject to the same considerations as other nonfinancial assets and

financial liabilities in classifying them as current and noncurrent in classified statements of financial position.

If a lessee does not present finance lease and operating lease right-of-use assets and lease liabilities separately in

the balance sheet, the lessee should disclose which line items in the balance sheet include those right-of-use

assets and lease liabilities.

In the balance sheet, a lessee is prohibited from presenting both of the following:

1. Finance lease right-of-use assets in the same line item as operating lease right-of-use assets; and

2. Finance lease liabilities in the same line item as operating lease liabilities

Qualitative and Quantitative Disclosure

ASC 842 requires lessees to disclose qualitative information including:

• Information about the nature of its leases, including:

1. A general description of those leases

2. The basis and terms and conditions on which variable lease payments are determined

3. The existence and terms and conditions of options to extend or terminate the lease. A lessee should

provide narrative disclosure about the options that are recognized as part of its right-of-use assets

and lease liabilities and those that are not.

4. The existence and terms and conditions of residual value guarantees provided by the lessee

5. The restrictions or covenants imposed by leases, for example, those relating to dividends or incurring

additional financial obligations

A lessee should identify the information relating to subleases included in the disclosures provided in (1)

through (5), as applicable.

• Information about leases that have not yet commenced but that create significant rights and obligations

for the lessee, including the nature of any involvement with the construction or design of the underlying

asset.

• Information about significant assumptions and judgments made in applying the ASC 842 requirements,

which may include the following:

1. The determination of whether a contract contains a lease

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2. The allocation of the consideration in a contract between lease and nonlease

3. The determination of the discount rate for the lease

Related party lessees should apply the disclosure requirements for related party transactions in ASC 850.

For each period presented in the financial statements, a lessee should disclose the following amounts relating to

a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any

amounts capitalized as part of the cost of another asset following other requirements, and the cash flows arising

from lease transactions:

1. Finance lease cost, segregated between the amortization of the right-of-use assets and interest on the

lease liabilities.

2. Operating lease cost

3. Short-term lease cost, excluding expenses relating to leases with a lease term of one month or less

4. Variable lease cost

5. Sublease income, disclosed on a gross basis, separate from the finance or operating lease expense

6. Net gain or loss recognized from sale and leaseback transactions

7. Amounts segregated between those for finance and operating leases for the following items:

• Cash paid for amounts included in the measurement of lease liabilities, segregated between operating

and financing cash flows

• Supplemental noncash information on lease liabilities arising from obtaining right-of-use assets

• Weighted-average remaining lease term

• Weighted-average discount rate

A lessee should also disclose a maturity analysis of its finance lease and operating lease liabilities, separately

showing:

✓ The undiscounted cash flows on an annual basis for a minimum of each of the next five years

✓ The sum of the undiscounted cash flows for all years thereafter

✓ A reconciliation of the undiscounted cash flows to the discounted finance lease liabilities and

operating lease liabilities recognized in the balance sheet

Exhibit J illustrates how a lessee may meet the quantitative disclosure requirements in ASC 842.

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Exhibit J: Quantitative Disclosure Requirements

Year Ending December 31

(000s) 20X9 20X8

Lease cost

Finance lease cost:

Amortization of right-of-use assets $ 1,820 $ 1,625

Interest on lease liabilities 220 180

Operating lease cost 350 320

Short-term lease cost 80 75

Variable lease cost 8 6

Sublease income 30 25

Total lease cost $ 2,508 $ 2,231

Other information

(Gains) and losses on sale and leaseback $ 100 $ 200

transactions, net

Cash paid for amounts included in the measurement of lease liabilities

Operating cash flows from finance leases 680 450

Operating cash flows from operating leases 240 216

Financing cash flows from finance leases 360 320

Right-of-use assets obtained in exchange for new finance lease liabilities 128 120

Right-of-use assets obtained in exchange for new operating lease liabilities 140 136

Weighted-average remaining lease term—finance leases 5.6 years 5.2 years

Weighted-average remaining lease term—operating leases 4.0 years 3.8 years

Weighted-average discount rate—finance leases 7.4% 7.2%

Weighted-average discount rate—operating 6.5% 6.0%

Other Matters

Interest on Noninterest Notes Payable

ASC 835-30-05, Interest: Imputation of Interest, covers notes with no stated rate of interest. If the face value of a

note differs from the consideration given or received, an interest calculation is required to avoid profit

misstatement. Interest is imputed on noninterest-bearing notes, on notes with unreasonably low interest rates

relative to market rates, and notes with face values substantially different from the prevailing selling prices of

such notes.

ASC 835-30 applies to long-term payables and receivables. Short-term payables and receivables are usually

recorded at face value because the additional work of amortizing a discount or premium on a short-term note

does not justify the information benefit derived. In addition, it is not applicable to receivables or payables in the

ordinary course of business, amounts not requiring repayment, security deposits, parent/subsidiary transactions,

and customary lending of banks and other similar financial institutions.

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If a note is issued just for cash, the note is recorded at the cash exchanged regardless of whether the interest rate

is realistic or of the amount of the face value of the note. The present value of the note at the issue date is

presumed to be the cash transacted.

If a note is exchanged for property, goods, or services, and the transaction is entered into at arm’s length, it is

assumed that the interest rate is fair and appropriate unless:

No interest rate is stated;

The interest rate is unreasonable;

The face value of the note received is materially different from the fair value of the property, goods, or

service received; or

The face value of the notes receivable is materially different from the current market value of the note at

the date of the transaction.

If the rate on the note is not reasonable and appropriate for the reasons noted above, the note should be recorded

at a value that reasonably approximates:

1. The market value of the note; or

2. The fair market value of the goods or services sold, whichever is more determinable.

If fair value is not ascertainable for the product or service, the discounted present value of the note using an

imputed market interest rate must be used. The imputed interest rate is the one in which an independent

borrower or lender would have engaged in a similar transaction. In determining the imputed interest rate,

consideration should be given to such factors as credit rating, tax effect, collateral requirements, and restrictions.

It is the “going” interest rate the borrower would have paid for financing in an arms-length transaction. There are

several considerations involved in determining an appropriate interest rate, such as prevailing market interest

rates, the prime interest rate, security pledged, loan restrictions, issuer's financial position, tax rate, and tax

planning issues.

Example 23

ABC Company sells equipment to XYZ Company on January 1, 20X3, in exchange for a $50,000 noninterest-bearing

note due December 31, 20X4. There is no established price for this equipment, and the prevailing interest rate for

this type of note is 10%. The present value of $1 at 10% for 2 years is 0.826446. Interest income will be recognized

by ABC Company each year and the discount amortized.

Date

Interest

Income

Discount

Amortized

Carrying

Amount

1/1/20X3 $41,322

12/31/20X3 $4,132 4,132 45,454

12/31/20X4 4,546* 4,546 50,000

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* $1 adjustment for rounding

The difference between the face value of a note and its present value constitutes a discount or premium, which

is to be an increment or decrement to interest over the life of the note. The present value of the payments of the

note depends on the imputed interest rate.

Discount or premium is amortized using the effective interest rate method, which results in a constant interest

rate. Amortization equals the interest rate multiplied by the present value of the note payable at the beginning of

the period. GAAP states that discount or premium is not an asset or liability separable from the related note. A

discount or premium should therefore be reported in the balance sheet as a direct deduction from or addition to

the face amount of the note. The borrower recognizes interest expense while the lender recognizes interest

revenue.

The presentation of the note payable or note receivable in the balance sheet follows:

Notes payable (face amount)

Less: discount

Equals present value (principal)

Notes receivable (face amount)

Add: premium

Equals present value (principal)

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Comprehensive Illustration

On January 1, 20X2, a fixed asset is purchased for $40,000 cash and the incurrence of a $60,000, five-year,

noninterest-bearing note payable. An imputed interest rate equals 10%. The present value factor for n = 5, i = 10%

is .62 (Table 1 in the Appendix). The journal entries follow:

1/1/20X2

Fixed asset ($40,000 + $37,200) 77,200

Discount 22,800

Notes payable 60,000

Cash 40,000

Present value of note = $60,000 × .62 = $37,200

On 1/1/20X2, the balance sheet presents:

Notes payable $60,000

Less: discount 22,800

Present value $37,200

12/31/20X2

Interest expense 3,720

Discount 3,720

10% × $37,200 = $3,720

On 1/1/20X3, the balance sheet presents:

Notes payable $60,000

Less: discount ($22,800 - $3,720) 19,080

Present value $40,920

12/31/20X3

Interest expense 4,092

Discount 4,092

10% × $40,920 = $4,092

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Presentation and Disclosure of Long-Term Debt

Companies that have large amounts and numerous issues of long-term debt frequently report only one amount

in the balance sheet, supported with comments and schedules in the accompanying notes. Long-term debt that

matures within one year should be reported as a current liability, unless using noncurrent assets to accomplish

retirement. If the company plans to refinance debt, convert it into stock, or retire it from a bond retirement fund,

it should continue to report the debt as noncurrent. However, the company should disclose the method it will use

in its liquidation.

Note disclosures generally indicate the nature of the liabilities, maturity dates, interest rates, call provisions, and

conversion privileges. Restrictions imposed by the use of the long-term debt should also be disclosed if it is

practical to estimate fair value. Companies must disclose future payments for sinking fund requirements and

maturity amounts of long-term debt during each of the next five years. These disclosures aid financial statement

users in evaluating the amounts and timing of future cash flows.

Finally, according to ASC 440-10-50-2, Commitments, the following must be disclosed with respect to long-term

obligations for each of the five years following the balance sheet date:

✓ The total payments for unconditional purchase obligations that have been recognized on the purchaser's

balance sheet. An unconditional purchase obligation is a duty to transfer a fixed or minimum amount of

funds at a later date or to transfer products or services at constant or minimum prices.

✓ The combined aggregate amount of maturities and sinking fund requirements for all long-term

borrowings.

✓ The amount of redemption requirements for all issues of capital stock that are redeemable at fixed or

determinable prices on fixed or determinable dates.

Exhibit K shows how a company discloses its debt.

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Exhibit K Long-Term Debt Disclosure

Netflix, Inc.

Annual report for the fiscal year ended December 31, 2020

6. Debt

As of December 31, 2020, the Company had aggregate outstanding notes of $16,309 million, net of $107 million

of issuance costs, with varying maturities (the "Notes"). Of the outstanding balance, $500 million, net of issuance

costs, is classified as short-term debt on the Consolidated Balance Sheets. As of December 31, 2019, the Company

had aggregate outstanding long-term notes of $14,759 million, net of $114 million of issuance costs. Each of the

Notes were issued at par and are senior unsecured obligations of the Company. Interest is payable semi-annually

at fixed rates. A portion of the outstanding Notes is denominated in foreign currency (comprised of €5,170 million)

and is remeasured into U.S. dollars at each balance sheet date (with remeasurement loss totaling $533 million for

the year ended December 31, 2020).

The following table provides a summary of the Company's outstanding debt and the fair values based on quoted

market prices in less active markets as of December 31, 2020 and December 31, 2019:

Principal Amount at Par Level 2 Fair Value as of

12/31/20 12/31/19 Issuance Date Maturity 12/31/20 12/31/19

(in millions) (in millions)

5.375% Senior Notes $ 500 $ 500 February-13 February-21 $ 502 $ 518

5.500% Senior Notes 700 700 February-15 February-22 735 744

5.750% Senior Notes 400 400 February-14 March-24 449 444

5.875% Senior Notes 800 800 February-15 February-25 921 896

3.000% Senior Notes (1) 574 - April-20 June-25 616 -

3.625% Senior Notes 500 - April-20 June-25 535 -

4.375% Senior Notes 1,000 1,000 October-16 November-26 1,110 1,026

3.625% Senior Notes (1) 1,588 1,459 May-17 May-27 1,776 1,565

4.875% Senior Notes 1,600 1,600 October-17 April-28 1,807 1,670

5.875% Senior Notes 1,900 1,900 April-18 November-28 2,280 2,111

4.625% Senior Notes (1) 1,344 1,234 October-18 May-29 1,630 1,378

6.375% Senior Notes 800 800 October-18 May-29 995 916

3.875% Senior Notes (1) 1,466 1,346 April-19 November-29 1,700 1,429

5.375% Senior Notes 900 900 April-19 November-29 1,061 960

3.625% Senior Notes (1) 1,344 1,234 October-19 June-30 1,533 1,273

4.875% Senior Notes 1,000 1,000 October-19 June-30 1,155 1,019

$ 16,416 $ 14,873 $ 18,805 $ 15,949

(1) The following Senior Notes have a principal amount denominated in euro: 3.000% Senior Notes for €470 million, 3.625% Senior Notes

for €1,300 million, 4.625% Senior Notes for €1,100 million, 3.875% Senior Notes for €1,200 million, and 3.625% Senior Notes for €1,100

million.

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The expected timing of principal and interest payments for these Notes are as follows:

As of

12/31/20 12/31/19

(in thousands)

Less than one year $ 1,264,020 $ 736,969

Due after one year and through three years 2,136,997 2,581,471

Due after three years and through five years 3,614,906 1,705,201

Due after five years 14,841,164 15,699,800

Total debt obligations $ 21,857,087 $ 20,723,441

Each of the Notes are repayable in whole or in part upon the occurrence of a change of control, at the option of

the holders, at a purchase price in cash equal to 101% of the principal plus accrued interest. The Company may

redeem the Notes prior to maturity in whole or in part at an amount equal to the principal amount thereof plus

accrued and unpaid interest and an applicable premium. The Notes include, among other terms and conditions,

limitations on the Company's ability to create, incur or allow certain liens; enter into sale and lease-back

transactions; create, assume, incur or guarantee additional indebtedness of certain of the Company's subsidiaries;

and consolidate or merge with, or convey, transfer or lease all or substantially all of the Company's and its

subsidiaries assets, to another person. As of December 31, 2020 and December 31, 2019, the Company was in

compliance with all related covenants.

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Review Questions − Section 5

1. Kent Co. identified: 1) Income from exempt municipal bonds $8,000 2) Fines from a violation of state law

$2,000. 3) Political contributions $10,000. What amount should Kent classify as deferred income tax liability?

A. $20,000

B. $8,000

C. $2,000

D. $0

2. Which of the following events will result in taxable temporary differences?

A. An advance payment

B. An installment sale

C. Warranty expense

D. Fines from a violation of laws

3. Which types of leases apply to lessees in accordance with ASC 842?

A. Leveraged lease

B. Operating lease

C. Capital lease

D. Sales-type lease

4. Johnson Inc. (Lessee) obtains control of leased equipment with a lease term that is 75% of the remaining

economic life of 3 years. How does Johnson Inc. account for this agreement?

A. Finance lease

B. Operating lease

C. Short-term lease

D. Sublease

5. How should a 3-year operating lease be accounted for?

A. The portion of the lease liability not be paid within the upcoming year is recorded as noncurrent liability

B. The operating lease liabilities are presented in the same line with finance lease liabilities

C. Lease payments are recorded within the financing activities section of the cash flow statement

D. The company may make an accounting policy election not to recognize lease assets and lease liabilities

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6. How should the discount resulting from the determination of a note payable's present value be reported on

the balance sheet?

A. As an addition to the face amount of the note

B. As a deferred charge separate from the note

C. As a deferred credit separate from the note

D. As a direct deduction from the face amount of the note

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Glossary

Balance sheet. It is a snapshot at a given point in time of the net worth of the business by detailing the assets,

liabilities, and owner’s equity.

Contingency. An existing condition, situation, or set of circumstances involving uncertainty as to possible gain

(gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more

future events occur or fail to occur.

Contingent liabilities. Obligations that are dependent upon the occurrence or nonoccurrence of one or more

future events to confirm either the amount payable, the payee, the date payable, or its existence.

Contract asset. An entity’s right to consideration in exchange for goods or services that the entity has transferred

to a customer when that right is conditioned on something other than the passage of time (for example, the

entity’s future performance).

Contract liability. An entity’s obligation to transfer goods or services to a customer for which the entity has

received consideration (or the amount is due) from the customer.

Convertible Bonds. If bonds are convertible into other securities of the corporation for a specified time after

issuance, they are convertible bonds.

Deductible temporary difference. Temporary differences that result in deductible amounts in future years when

the related asset or liability is recovered or settled respectively.

Deferred tax asset. The deferred tax consequence attributable to deductible temporary differences and

carryforwards.

Deferred tax liability. The deferred tax consequence attributable to taxable temporary differences.

Economic life. Either the period over which an asset is expected to be economically usable by one or more users

or the number of production or similar units expected to be obtained from an asset by one or more users.

Entry price. The price paid to acquire an asset or received to assume a liability in an exchange transaction.

Exit price. The price that would be received to sell an asset or paid to transfer a liability.

Fair value hierarchy. The priority of valuation techniques to be used to determine fair value into three broad

levels.

Fair value: 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.

Financial asset. Cash, evidence of an ownership interest in an entity, or a contract.

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Financial liability. A contract that imposes on one entity a contractual obligation to deliver cash or another

financial instrument to a second entity or to exchange other financial instruments on potentially unfavorable

terms with the second entity.

Lease. A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or

equipment (an identified asset) for a period of time in exchange for consideration.

Market approach. A valuation tool that uses prices for market transactions for identical or comparable assets or

liabilities.

Most advantageous market. The market in which the reporting entity would sell an asset or transfer a liability

with the price that maximizes the amount that would be received for the asset or minimizes the amount that

would be paid to transfer the liability, considering transaction costs in the respective market(s). The most

advantageous market (and thus, market participants) should be considered from the perspective of the reporting

entity, thereby allowing for differences between and among entities with different activities.

Operating cycle. The average time intervening between the acquisition of materials or services and the final cash

realization constitutes an operating cycle.

Permanent differences. Differences between taxable income and pretax financial income are caused by items

that (1) enter into pretax financial income but never into taxable income or (2) enter into taxable income but

never into pretax financial income.

Right-of-use asset. An asset that represents a lessee’s right to use an underlying asset for the lease term.

Short-term lease. A lease that, at the commencement date, has a lease term of 12 months or less and does not

include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

Temporary difference. A difference between the tax basis of an asset or liability and its reported amount in the

financial statements that will result in taxable or deductible amounts in future years when the reported amount

of the asset or liability is recovered or settled, respectively.

Troubled Debt Restructuring. When a creditor for economic or legal reasons related to the debtor’s financial

difficulties grants a concession to the debtor that it would not otherwise consider.

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Index

Accounts payable, 37 Callable obligations, 43 Compensated absences, 41 Convertible bonds, 55 Current liabilities, 9 Deferred revenue, 38 Deferred tax liability, 67 Disclosures of fair value, 30 Effective interest method, 51 Employee termination benefits, 46 Environmental liabilities, 47

Fair Value Hierarchy, 20 Fair value option, 28 Finance lease, 70 Imputed interest rate, 75 Noncurrent liabilities, 11 Obligation to provide economic benefits, 6 Operating lease, 70 Present obligations, 4 Risks and uncertainties, 31 Troubled debt restructuring, 44

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Appendix

TABLE 1

PRESENT VALUE OF $1

91

92

TABLE 2

PRESENT VALUE OF AN ANNUITY OF $1

93

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Review Question Answers

Review Questions − Section 1

1. All of the following are the basic recognition criteria established by the Concepts Statement No. 5 EXCEPT?

A. Incorrect. To be recognized in financial statements, the item must meet the definition of an element.

For example, a resource must meet the definition of an asset, and an obligation must meet the definition

of a liability.

B. Incorrect. To be recognized in financial statements, the item must be measurable. That is, the asset,

liability, or change in equity must have a relevant attribute that can be quantified in monetary units with

sufficient reliability.

C. Incorrect. To be recognized, the information conveyed by including an asset, liability, or change therein

in the financial statements must be relevant. Information is relevant if it has the capacity to make a

difference in investors’, creditors’, or other users’ decisions.

D. Correct. According to the FASB conceptual framework, understandable is an enhancing quality of

financial reporting which relates to both relevance and faithful representation.

2. Buc Co. receives deposits from its customers to protect itself against nonpayments for future services. How

should these deposits be classified by Buc?

A. Correct. A customer deposit is a liability because it involves 1) present obligation and 2) obligation to

provide economic benefits. That is, Buc has an obligation that exists at the financial statement date. The

obligation requires Buc to transfer or otherwise provide economic benefits to its customers.

B. Incorrect. A revenue is not recognized until it is earned.

C. Incorrect. GAAP ordinarily prohibits offsetting assets and liabilities. Most deferred credits are liabilities.

D. Incorrect. A contra account is a valuation account.

3. Which of the following would be classified as a current liability?

A. Correct. Unearned revenue (or deferred revenue) is a current liability account. It represents advance

payments from customers for products or services that are to be delivered or performed in the future.

B. Incorrect. Net working capital refers to the difference between current assets and current liabilities.

C. Incorrect. Capital stock is an equity account; it is stock owned by the corporation.

D. Incorrect. Prepaid expenses result from prepaying cash or incurring a liability. Prepaid expenses are

presented under current assets.

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4. A company receives an advance payment for special order goods that are to be manufactured and delivered

within 6 months. How should the advance payment be reported in the company's balance sheet?

A. Incorrect. An advance payment is a liability, recorded as an asset.

B. Incorrect. It is recorded on the asset side of the balance sheet. An advance payment is a liability.

C. Correct. A current liability is defined as an obligation that will be either liquidated using current assets

or replaced by another current liability. The advance is for special order goods that are to be

manufactured and delivered within 6 months. Hence, the obligation will be liquidated using current

assets, and the advance payment should be reported as a current liability.

D. Incorrect. The liability should be classified as current.

5. J&E Inc. has these liabilities at year end: 1) Accounts payable of $100,000 2) Mortgage note payable $10,000

due within 12 months 3) $80,000 short-term debt that the company is refinancing with long-term debt. What

amount should J&E include in the current liability section of the balance sheet?

A. Incorrect. The short-term debt has been refinanced and reclassified as noncurrent.

B. Correct. Both the accounts payable ($100,000) and the principal portion of the mortgage note ($10,000)

are current.

C. Incorrect. Since the short-term debt is refinanced to long-term debt, it should be reported as noncurrent

liability. The mortgage note payable of $10,000 due within 12 months should be reported as current

liability.

D. Incorrect. The short-term debt refinanced to long-term debt should be reported as noncurrent liability.

6. The accrual of a loss contingency is based on which of the following concepts?

A. Correct. A loss contingency is accrued if it is probable that a liability has been incurred at the balance

sheet date and the amount of the loss is reasonably estimable. The accrual of a loss contingency is

required because of the conservatism principle. The conservatism principle means being cautious or

prudent and making sure that assets and net income are not overstated to avoid misleading potential

investors and creditors.

B. Incorrect. For income to be stated fairly, all expenses incurred in generating the income must be recorded

in that same period as revenues. For example, the sale of merchandise must be offset by the actual cost

of the goods sold.

C. Incorrect. The comparability principle requires that financial information be measured and reported in a

comparable manner from company to company and from period to period. If there is an absence of

comparability, it should be disclosed.

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D. Incorrect. It is assumed that an entity is a going concern and will continue indefinitely unless there is

evidence to the contrary. Under this assumption, accountants must record assets at their original cost and

not at what they would be sold for if the company were to go out of business.

7. On April 20, 20X6, an employee filed a $3,000,000 lawsuit against Johnson Co. for damages suffered when

one of Johnson’s plants exploded. Johnson’s legal counsel expects the company will lose the lawsuit and

estimates the loss to be between $1,500,000 and $2,000,000. The employee has offered to settle the lawsuit

out of court for $1,800,000, but Johnson will not agree to the settlement. In its December 31, 20 X6 balance

sheet, what amount should Johnson report as liability from the lawsuit?

A. Incorrect. The lawsuit damages must be accrued as a loss contingency because an unfavorable outcome

is probable and the amount of the loss is reasonably estimable.

B. Correct. When a range of possible loss exists, the best estimate within the range is accrued. When no

amount within the range is a better estimate than any other amount, the dollar amount at the low end

of the range is accrued (in this case, $1,500,000).

C. Incorrect. When a range of possible loss exists, the best estimate within the range is accrued not what

the employee’s offer for settlement.

D. Incorrect. $2,000,000 is the maximum of the range. When no single amount within the range is a better

estimate than any other amount, the loss accrual should be the minimum of the range.

Review Questions − Section 2

1. What is fair value?

A. Incorrect. An entry price is what is paid or received in an orderly exchange to acquire an asset or assume

a liability, respectively.

B. Incorrect. Fair value is an exit price paid or received in a hypothetical transaction considered from the

perspective of a market participant.

C. Correct. 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. Thus, fair value is an exit

price.

D. Incorrect. Fair value is market-based, not entity-specific. It is based on the pricing assumptions of

market participants.

2. For the purpose of a fair value measurement of an asset or liability, what is the preferred market for a

transaction to occur?

A. Incorrect. If no principal market exists, the transaction is assumed to occur in the most advantageous

market.

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B. Correct. For fair value measurement purposes, a transaction is assumed to occur in the principal market

for an asset or liability if one exists. The principal market has the greatest volume or level of activity. If

no such market exists, the transaction is assumed to occur in the most advantageous market.

C. Incorrect. The principal market is not necessarily the most advantageous market.

D. Incorrect. Selection by the reporting entity is not allowed. The principal market must be used if one is

available.

3. When measuring fair value, which level reflects the reporting entity's own assumptions about the

assumptions?

A. Incorrect. Level 1 inputs are quoted prices. A quoted price in an active market provides the most reliable

evidence of fair value and should be used without adjustment to measure fair value whenever available.

B. Incorrect. Level 2 inputs are those (except quoted prices included within Level 1) that are observable

for the asset or liability, either directly or indirectly.

C. Correct. Level 3 inputs are unobservable for the asset or liability. Unobservable inputs are used to

measure fair value to the extent that observable inputs are unavailable. This allows for cases in which

there is little or no market activity for the asset or liability at the measurement date. Unobservable

inputs reflect the reporting entity's own assumptions about the assumptions (e.g., risk) that market

participants would use in pricing the asset or liability.

D. Incorrect. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair

value into three broad levels.

4. In which of the following instances may the reporting entity elect the fair value option?

A. Incorrect. An investment in a subsidiary required to be consolidated is not an eligible item.

B. Incorrect. The primary beneficiary must consolidate the variable interest entity. Thus, the interest in the

variable interest entity is not an eligible item.

C. Correct. An entity may elect the fair value option for (1) most recognized financial assets and liabilities,

(2) otherwise unrecordable firm commitments that involve only financial instruments, (3) a written loan

commitment, (4) insurance contracts and warranties that are not financial instruments (because they

require or permit settlement in goods or services instead of cash settlement) but permit payment to a

third party to provide goods or services, and (5) a host instrument that is part of a nonfinancial

instrument and is accounted for separately from an embedded nonfinancial derivative.

D. Incorrect. Items eligible for the fair value option election do not include employers' and plans'

obligations for (1) employee pension benefits, (2) other postretirement employee benefits, (3) post-

employment benefits, (4) employee stock option and stock purchase plans, and (5) other deferred

compensation.

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5. An entity may choose to elect the fair value option for an eligible item only on the date that any one of the

following occurs EXCEPT?

A. Incorrect. One of the events identified by ASC 825-10-25-4 is that the entity first recognizes the eligible

item. This is actually the preferable time to make the option so that the asset or liability is consistently

reported from its inception.

B. Incorrect. ASC 825-10-25-4 provides that an election may be made when the entity enters into an

eligible firm commitment. At this point, the entity is considered to have rights to and therefore control

of the asset or liability and may record the transaction for reporting purposes.

C. Correct. There is no provision that allows an election at each anniversary date of the effective date. If

that were the case, a company could annually decide whether it was more advantageous to value at

cost or fair value depending on how it would affect its reported profit.

D. Incorrect. One of the allowed election dates is when the accounting treatment for an investment in

another entity changes because the investment becomes subject to the equity method of accounting.

6. Which of the following is the correct way to report assets and liabilities on the balance sheet under the fair

value option?

A. Correct. One presentation approach is to show the balance sheet item as two separate line items for fair

value and non-fair value carrying amounts. The other approach is to report them as one line item, but

clearly note what dollar amount of that reported is measured at fair value.

B. Incorrect. ASC 825-10-45-2 does not allow for the netting on the balance sheet. Rather, it states that an

entity shall report its assets and liabilities that are subsequently measured at fair value in a manner that

separates those reported fair values from the carrying amounts measured differently.

C. Incorrect. ASC 825-10-45-2 does not allow for presenting a separate fair value mezzanine section. The

assets and liabilities which are reported at fair value must still be reported in the appropriate balance

sheet section.

D. Incorrect. The fair value option does not limit the presentation of an asset or liability to the long-term

section of the balance sheet. Most entities will have both long- and short-term items that are measured

at fair value.

Review Questions − Section 3

1. Delhi Co. is preparing its financial statements for the year ended December 31, 20X2. Accounts payable

amounted to $360,000 before any necessary year-end adjustment related to the following: 1) At December

31, 20X2, Delhi has a $50,000 debit balance in its accounts payable to Madras, a supplier, resulting from a

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$50,000 advance payment for goods to be manufactured to Delhi's specifications. 2) Checks in the amount of

$100,000 were written to vendors and recorded on December 29, 20X2. The checks were mailed on January

5, 20X3. What amount should Delhi report as accounts payable in its December 31, 20X2 balance sheet?

A. Correct. The ending accounts payable balance should include amounts owed as of 12/31/X2 on trade

payables. Although Delhi wrote checks for $100,000 to various vendors, that amount should still be

included in the accounts payable balance because the company had not surrendered control of the checks

at year-end. The advance to the supplier was erroneously recorded as a reduction of (debit to) accounts

payable. This amount should be recorded as a prepaid asset, and accounts payable should be credited

(increased) by $50,000. Thus, accounts payable should be reported as $510,000 ($360,000 + $50,000 +

$100,000).

B. Incorrect. $410,000 does not include the $100,000 in checks not yet mailed at year-end.

C. Incorrect. $310,000 does not include the $100,000 in checks, and it reflects the subtraction, not the

addition, of the $50,000 advance.

D. Incorrect. $210,000 results from subtracting the advance payment and the checks.

2. To create legally enforceable rights and obligations, an agreement must meet all of the following criteria of a

contract EXCEPT:

A. Correct. An agreement does not have to be in writing to constitute a contract - a contract may exist if

parties orally agree to an arrangement’s terms.

B. Incorrect. All parties to the contract have approved the document and substantially committed to its

contents.

C. Incorrect. All parties’ rights are clearly identified in the document. Also, the payment terms for goods or

services must be known before a contract can exist.

D. Incorrect. A contract has commercial substance if the risk, timing, or amounts of the entity’s future cash

flows change as a result of the contract. Additionally, it is probable that the entity will collect the amount

stated in the contract in exchange for the goods or services transferred to the customer.

3. Depending on the contract, promised goods or services include all of the following activities EXCEPT:

A. Incorrect. An entity may grant licenses to a customer whether a right-to-use or right-to-access license is

considered as a performance obligation that is within the scope of promised goods or services.

B. Incorrect. Granting options to purchase additional goods or services represents a material right to the

customer identified as a performance obligation. Therefore, it is considered as a promised good in a

contract.

C. Incorrect. Promised goods or services in the contract may include a provision to allow a customer to resell

goods purchased by an entity.

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D. Correct. Performance obligations do not include activities that an entity must undertake to fulfill a

contract unless those activities transfer a good or service to a customer. Therefore, administrative tasks

to set up a contract are not a performance obligation.

4. A retail store received cash and issued a gift certificate that is redeemable in merchandise. What should

happen when the gift certificate was issued?

A. Incorrect. The deferred revenue account should be decreased when the certificate expires or is

redeemed, not when it is issued.

B. Correct. An entity can only recognize revenue when (or as) it satisfies a performance obligation by

transferring a promised good or service to a customer. Consequently, when a gift certificate is issued,

the company receiving the cash should record the issuance as a deferred revenue.

C. Incorrect. A revenue account is not affected when gift certificates are issued.

D. Incorrect. It is not earned until the certificate expires or is redeemed. Consequently, when a gift

certificate is issued, the company receiving the cash should record the issuance as a deferred revenue.

A revenue account is therefore not affected when it is issued.

5. Vadis Co. sells appliances that include a 3-year warranty. Service calls under the warranty are performed by

an independent mechanic under a contract with Vadis. Based on experience, warranty costs are estimated at

$30 for each machine sold. When should Vadis recognize these warranty costs?

A. Incorrect. The accrual method matches the costs and the related revenues.

B. Incorrect. When the warranty costs can be reasonably estimated, the accrual method should be used.

Recognizing the costs when the service calls are performed is the cash basis.

C. Incorrect. Recognizing costs when paid is the cash basis.

D. Correct. Under the accrual method, a provision for warranty costs is made when the related revenue is

recognized.

6. How should a company classify long-term obligations that are or will become callable by the creditor because

of the debtor's violation of a provision of the debt agreement at the balance sheet date?

A. Incorrect. This kind of obligation should be classified as a current liability.

B. Correct. A current liability is defined as an obligation that will be either liquidated using a current asset

or replaced by another current liability. Current liabilities include (1) obligations that by their terms are or

will be due on demand within one year (or the operating cycle, if longer) and (2) obligations that are or

will be callable by the creditor within one year because of a violation of a debt covenant. An exception

exists, however, if the creditor has waived or subsequently lost the right to demand repayment for more

than one year (or the operating cycle, if longer) from the balance sheet date.

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C. Incorrect. The liability is not contingent.

D. Incorrect. The obligation may be classified as noncurrent if it is probable that the violation will be

corrected within the grace period.

7. On January 3, Year 1, North Company issued long-term bonds due January 3, Year 6. The bond covenant

includes a call provision that is effective if the firm's current ratio falls below 2:1. On June 30, Year 1, the fiscal

year-end for the company, its current ratio was 1.5:1. How should the bonds be reported on the financial

statements?

A. Incorrect. The violation of the debt agreement would allow the creditor to accelerate the maturity date.

B. Incorrect. The debt should be classified as current unless it is probable that the violation will be cured

within any grace period.

C. Correct. GAAP states that long-term obligations that are callable by the creditor because of the debtor's

violation of the debt agreement at the balance sheet date should be classified as current liabilities.

D. Incorrect. A creditor's waiver of the right to demand repayment of the debt would allow North to classify

the bonds as long-term.

Review Questions − Section 4

1. A bond issued on June 1, 20X3 has interest payment dates of April 1 and October 1. How long will be the

period of bond interest expense for the year ended December 31, 20X3?

A. Incorrect. 3 months is the period for which interest is accrued at year-end.

B. Incorrect. 4 months is the period for which interest expense is recorded on October 1.

C. Incorrect. 6 months is the period between payment dates.

D. Correct. The price of a bond issued between payment dates includes the amount of accrued interest.

Thus, this bond will include 2 months of accrued interest, which will be recorded as either a payable or a

decrease in interest expense. As a result, interest expense for the year will be reported only for the period

the bond is outstanding or 7 months (June-December).

2. On March 1, 20X3, Clark Co. issued bonds at a discount. Clark incorrectly used the straight-line method instead

of the effective interest method to amortize the discount. How were the following amounts, as of December

31, 20X3, affected by the error?

A. Incorrect. The error understates retained earnings.

B. Incorrect. The error overstates the carrying amount.

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C. Correct. The straight-line method records the same amount of expense (cash interest paid +

proportionate share of discount amortization) for each period. The effective-interest method applies a

constant rate to an increasing bond carrying amount (face value - discount + accumulated discount

amortization), resulting in an increasing amortization of discount and increasing interest expense.

Accordingly, in the first 10 months of the life of the bond, straight-line amortization of discount and

interest expense is greater than under the effective-interest method. The effects are an understatement

of unamortized discount, an overstatement of the carrying amount of the bonds, an understatement of

net income, and an understatement of retained earnings.

D. Incorrect. The error overstates the carrying amount and understates retained earnings.

3. Which of the following statements characterizes convertible debt?

A. Incorrect. The holder of the debt has an option to receive (1) the face or redemption amount of the

security or (2) common shares.

B. Correct. The debt and equity elements of convertible debt are inseparable. The entire proceeds should

be accounted for as debt until conversion.

C. Incorrect. The entire proceeds should be accounted for as debt until conversion.

D. Incorrect. Conversion is favorable to the holder when the market value of the issuer's common stock is

greater than the conversion price. (The conversion price exceeds market value upon initial issuance.)

4. On March 31, 20X3, Ashley, Inc.'s bondholders exchanged their convertible bonds for common stock. The

carrying amount of these bonds on Ashley's books was less than the market value but greater than the par

value of the common stock issued. If Ashley used the book-value method of accounting for the conversion,

which of the following statements correctly states an effect of this conversion?

A. Correct. Under the book-value method for recognizing the conversion of outstanding bonds payable to

common stock, the stock issued is recorded at the carrying amount of the bonds with no recognition of

gain or loss. Because the carrying amount of the bonds is greater than the par value of the common stock,

the conversion will record common stock at par value and additional paid-in capital for the remainder of

the carrying amount of the bonds. Ashley will decrease its liabilities (debit bonds payable) and increase

its equity (credit common stock and additional paid-in capital).

B. Incorrect. Additional paid-in capital will increase.

C. Incorrect. Retained earnings is not directly affected.

D. Incorrect. No loss is associated with the conversion.

5. On March 1, 20X3, Somar Co. issued 20-year bonds at a discount. By September 1, 20X8, the bonds were

quoted at 106 when Somar exercised its right to retire the bonds at 105. How should Somar report the bond

retirement on its 20X8 income statement?

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A. Incorrect. The amount paid exceeded the carrying amount. Thus, an ordinary loss is recognized.

B. Correct. All extinguishment of debt before scheduled maturities are fundamentally alike and should be

accounted for similarly. Gains or losses from early extinguishment should be recognized in the income of

the period of extinguishment. Because the bonds were issued at a discount and were retired early for

more than the carrying amount, a loss was incurred. Under GAAP, an event or transaction is perceived to

be ordinary and usual absent clear evidence to the contrary. No such evidence is presented, and Somar

should recognize an ordinary loss.

C. Incorrect. The amount paid exceeded the carrying amount. Therefore, it must be included in the income

statement.

D. Incorrect. Disclosures in the footnotes do not report any gain or loss correctly. It must be included in the

income statement itself.

6. A company has the following liabilities at year end: 1) Interest payable is $8,000 due within 12 months, 2)

Short-term debt refinanced to long-term debt is $6,000, 3) Deferred tax liability arising from depreciation

$3,000. What amount should be reported as the long-term ability?

A. Incorrect. Since the short-term debt has been refinanced and reclassified as noncurrent, it should also

be reported as noncurrent liability.

B. Incorrect. The deferred tax liability relating to depreciation is noncurrent and should be reported as a

noncurrent liability.

C. Incorrect. The interest payable and due within 12 months is classified as current liability.

D. Correct. Both the short-term debt ($6,000 refinanced/reclassified as noncurrent) and the deferred tax

liability ($3,000) are considered long-term ability.

Review Questions − Section 5

1. Kent Co. identified: 1) Income from exempt municipal bonds $8,000 2) Fines from a violation of state law

$2,000. 3) Political contributions $10,000. What amount should Kent classify as deferred income tax liability?

A. Incorrect. Income from exempt municipal bonds, fines from a violation of state and political contributions

are all considered permanent differences. A permanent difference does not result in a change in a

deferred tax asset or liability, that is, in a deferred tax expense or benefit.

B. Incorrect. Interest received on tax-exempt securities, such as municipal bonds creates permanent

differences. A deferred tax liability is recognized for temporary differences that will result in taxable

amounts in future years.

C. Incorrect. Fines from a violation of state law affect only the period in which they occur, they do not have

tax consequences and do not give rise to deferred tax assets or liabilities.

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D. Correct. An income tax liability should not be classified as a deferred tax liability unless it results from a

taxable temporary difference. Since there are no such differences, there is no deferred tax liability.

2. Which of the following events will result in taxable temporary differences?

A. Incorrect. Advance payment is recognized for tax purposes when it is received but is not recognized for

book purposes until the services are performed. Thus, it will result in deductible amounts in future years.

B. Correct. An installment sale is recognized for the books in the year of sale but is recognized for tax

purposes when cash collections are received. Thus, it will result in taxable amounts in future years.

C. Incorrect. Warranty expense is deducted on the books in the year of sale but is deducted on the tax return

when paid. Thus, it will generate deducible temporary differences.

D. Incorrect. Nontaxable or nondeductible differences between financial statements and tax returns refer to

as permanent differences. Fines from a violation of laws are considered nondeductible expenses.

3. Which types of leases apply to lessees in accordance with ASC 842?

A. Incorrect. Leveraged lease occurs when a lessor (equity participant) finances a minimal amount of the

purchase but has total equity ownership. Leveraged lease classification applies only to lessors. In addition,

ASC 842 eliminates leveraged lease accounting for new leases and existing leases modified on or after the

standard’s effective date.

B. Correct. Operating lease refers to a lease that a lessor transfers the use of an asset to a lessee for a period

of time but does not effectively transfer control of the underlying asset.

C. Incorrect. Upon adoption of ASC 842, leases defined as “Capital” will be replaced with “Finance”

D. Incorrect. A sales-type lease refers to a lease in which a lessor effectively transfers control of an

underlying asset to a lessee.

4. Johnson Inc. (Lessee) obtains control of leased equipment with a lease term that is 75% of the remaining

economic life of 3 years. How does Johnson Inc. account for this agreement?

A. Correct. For lessees, a lease is a finance lease if the lessee effectively obtains control of the underlying

asset, by meeting any of the five criteria required by ASC 842. For example, the lease term is for a major

part (generally 75%) of the remaining economic life of the underlying asset.

B. Incorrect. Operating lease occurs when a lessor transfers the use of an asset to a lessee for a period of

time but does not effectively transfer control of the underlying asset.

C. Incorrect. ASC 842 defines a short-term lease as a lease that, at the commencement date, has a lease term

of 12 months or less and does not include an option to purchase the underlying asset that the lessee is

reasonably certain to exercise.

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D. Incorrect. Sublease refers to an underlying asset that is re-leased by the original lessee (or intermediate

lessor) to a third party, and the lease (or head lease) between the original lessor and lessee remains in

effect.

5. How should a 3-year operating lease be accounted for?

A. Correct. The current portion of operating lease liability is considered a current liability. The portion of the

lease liability not being paid within the upcoming year is recorded as noncurrent liability.

B. Incorrect. In the balance sheet, a lessee is prohibited from presenting 1) finance lease right-of-use assets

in the same line item as operating lease right-of-use assets 2) finance lease liabilities in the same line item

as operating lease liabilities.

C. Incorrect. Operating lease payments are recorded within the operating activities section of the cash flow

statement as they are related to the operations of the business.

D. Incorrect. Lessees may make an accounting policy election by the class of underlying asset not to recognize

lease assets and lease liabilities for leases whose term is 12 months or less.

6. How should the discount resulting from the determination of a note payable's present value be reported on

the balance sheet?

A. Incorrect. A premium would be reported as a direct addition to the face amount of the note.

B. Incorrect. The discount should not be classified as a deferred charge; instead, it should be reported as

a direct deduction from or addition to the face value of the note.

C. Incorrect. The discount should not be classified as a deferred credit on the balance sheet.

D. Correct. GAAP states that discount or premium is not an asset or liability separable from the related

note. A discount or premium should therefore be reported in the balance sheet as a direct deduction

from or addition to the face amount of the note.