UPDATE MATERIALS – INTERMEDIATE ACCOUNTING, 10TH EDITION This document contains several discussions of the effects of new accounting standards as they relate to

the materials in Intermediate Accounting, 10th Edition by Kieso, Weygandt, and Warfield.

Topics addressed are:

SECTION 1: Business Combinations (SFAS No. 141)

SECTION 2: Intangible Assets (SFAS No. 142)

SECTION 3: Asset Retirement Obligations (SFAS No. 143)

SECTION 4: Cash Flows and Present Value in Accounting Measurements (Concepts Statement

No. 7)

SECTION 5: Goodwill Associated with Investments Accounted for Under the Equity Method

(application of SFAS No. 142)

SECTION 6: Impairments of Long-Lived Assets (SFAS No. 144)

SECTION 1: BUSINESS COMBINATIONS

Statement of Financial Accounting Standard No. 141, “Business Combinations”

(Business combinations are not covered in Intermediate Accounting. However, under this new standard, many more intangible assets will be recognized on companies’ balance sheets. Intangible assets are covered in Chapter 12, pages 599-621 with Update material presented in Section 2 below.)

Overview

Prior to this standard, business combinations were accounted for under one of two approaches, the

pooling of interests method (often referred to as the pooling method) or the purchase method. The

pooling method was required if a complex set of criteria were met. If one of these criteria was not met,

the purchase method was to be used.

The user community found the use of two different approaches to account for business

combinations confusing. It was very difficult, for example, to compare the financial results of

companies that used different methods to account for business combinations. In addition, users wanted

more information related to the intangibles purchased in a business combination. Unfortunately, the

pooling of interests method recorded only intangible assets that the company presently reported. In

other words, under poolings, only the book value of the existing net assets of the acquired company

was recorded in the merger. Under purchase accounting, all net assets of the acquired company

(including intangibles) were recognized and recorded at fair value.

Finally, many users indicated that the diversity in practice for mergers often left companies at a

competitive disadvantage. For example, companies that used poolings often were able to report higher

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earnings numbers because the assets acquired were recorded at book value, not fair value. As a result,

companies that used poolings did not have to depreciate or amortize the higher fair value amounts

against revenues.

Because of these user concerns, the FASB issued Statement of Financial Accounting Standard

No. 141, “Business Combinations,” which requires that all business combinations be accounted for

using the purchase method. In other words, pooling of interests accounting is now prohibited.

Recognition of Intangible Assets

Standard No. 141 also provides guidelines for how to recognize intangible assets in a business

combination. Prior to SFAS No. 141, the criterion to recognize intangible assets other than goodwill

was whether they could be identified and named. As a result, many intangible assets were simply

recorded as part of goodwill and not reported separately. Many users were not concerned with this

approach because all intangible assets (goodwill or otherwise) were amortized in a similar fashion

(over a period not to exceed their useful life or 40 years, whichever was shorter.)

The new rules will result in more intangible assets being separated from goodwill than

presently occurs in practice today. To help identify these intangible assets, the statement provides a

list of 29 different types of intangibles that might be recognized separately from goodwill in a business

combination. Some of the intangible assets that must be separately recognized under the new rules are:

• Trademarks and trade names

• Non-compete agreements

• Customer lists

• Order or production backlogs

• Copyrights and patents

• Secret formulas and processes

• Licensing agreements

• Supply contracts

It should be noted that amortization rules for intangible assets have also changed (see Section 2 in this

update document). As a result, certain types of intangibles have indefinite lives and are no longer

amortized. It therefore has become more important to make sure that all intangibles acquired in a

business combination are separately identified. Under the new standard, an acquired intangible asset

should be separately recognized if the benefit of the intangible asset is obtained through contractual or

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other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged,

regardless of the acquirer’s intent to do so.

Recognition of Negative Goodwill

In rare cases, negative goodwill may result. Negative goodwill arises when the fair value of the assets

acquired is higher than the purchase price of the assets. In the past, if negative goodwill arose, it was

classified as a deferred credit and was amortized systematically to revenue over the periods estimated

to be benefited, but not in excess of 40 years. Under the new rules, if negative goodwill arises, it

should be recognized immediately as an extraordinary gain.

Initial Measurement

It should be noted that SFAS No. 141 carries forward the provisions in the previous accounting

standards for applying the purchase method of accounting. Specifically, the new statement does not

change in any fundamental way the guidance for determining the cost of the acquired entity and

allocating that cost to assets acquired and liabilities incurred. Finally, SFAS No. 141 does not change

the requirement to write off certain research and development assets in a business combination--also

known as in-process research and development (IPR&D).

Financial Statement Disclosures under SFAS No. 141

SFAS No. 141 carries forward and expands on the financial statement disclosure requirements for

business combinations. Some of the more significant new disclosures related to material business

combinations are summarized below.

• The primary reasons for the acquisition, including a description of the factors that contributed

to a purchase price that results in recognition of goodwill

• A condensed balance sheet disclosing the amounts assigned to each major asset and liability

caption at the acquisition date.

• The amount of IPR&D assets acquired and written off and the line item in the income statement

in which that amount is included.

• If the purchase price allocation has not been finalized, that fact and the reasons for it should be

explained. In subsequent periods, the nature and amount of any material adjustments that were

made to the purchase price allocation must be disclosed.

• If the amounts assigned to goodwill or other intangible assets acquired are significant in

relation to the total cost of the acquired entity: (1) disclosures, in total and by major intangible

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asset class, of (a) the amounts assigned to amortizable and indefinite-lived intangibles and (b)

the estimated residual value and weighted-average amortization period for limited-life

intangibles; and (2) the total amount of goodwill and the amount expected to be deductible for

tax purposes (these disclosures are also applicable to aggregated disclosures of individually

immaterial business combinations).

• Detailed disclosures about material business combinations completed after the balance sheet

date, but before the financial statements are issued (unless not practicable).

Concluding Remarks

SFAS No. 141 significantly affects the accounting for business combinations. By requiring all

companies to follow purchase accounting, comparability among companies will be significantly

enhanced. In addition, more realistic balance sheet amounts, reflecting the acquisition cost of the net

assets acquired in a business combination, will be reported.

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SECTION 2: INTANGIBLE ASSETS

Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangibles”

(Updates material in Chapter12, pages 599-621)

Overview

Recently the FASB issued Statement of Financial Accounting Standards No. 142. This standard

changes the accounting for intangibles in a number of areas. The key provisions of this standard are

discussed below.

Definition of Intangible Assets

According to the FASB, intangibles have two main characteristics.

1. They lack physical existence Unlike tangible assets such as property, plant, and equipment,

intangible assets derive their value from the rights and privileges granted to the company using

them.

2. They are not financial instruments Assets such as bank deposits, accounts receivable, and long-

term investments in bonds and stocks lack physical substance but are not classified as intangible

assets. These assets are financial instruments and derive their value from the right (claim) to

receive cash or cash equivalents in the future.

Amortization of Intangibles

Intangibles have either a limited (finite) useful life or an indefinite useful life. An intangible asset with

a limited life is amortized; an intangible asset with an indefinite life is not amortized.

Limited-Life Intangibles

Limited-life intangibles should be amortized by systematic charges to expense over their useful lives.

The useful life should reflect the periods over which these assets will contribute to cash flows. The

amount of amortization expense for a limited-life intangible asset should reflect the pattern in which

the asset is consumed or used up if that pattern can be reliably determined.

Indefinite-Life Intangibles

If no legal, regulatory, contractual, competitive, or other factors limit the useful life of an intangible

asset, the useful life is considered indefinite. Indefinite means that there is no foreseeable limit on the

period of time over which the intangible asset is expected to provide cash flows.

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Indefinite-life intangibles should be tested for impairment at least annually. The impairment

test compares the fair value of an intangible asset with its carrying amount. This impairment test is

different from the one used for a limited-life intangible. That is, there is no recoverability test related

to indefinite-life intangibles. Only a fair value test is used to test for impairment. The reason:

Indefinite-life intangible assets might never fail the undiscounted cash flows recoverability test

because cash flows could extend indefinitely into the future.

In summary, the accounting treatment for intangible assets is shown below.

Illustration 12-1 Accounting Treatment for Intangibles

Type of Intangible Purchased Internally Created Amortization Impairment Test

Limited-life intangibles

Capitalize Expense* Amortize over useful life

Recoverability test and then fair value test

Indefinite-life intangibles

Capitalize Expense* Do not amortize Fair value test

*Except for direct costs, such as legal costs.

Goodwill Amortization

Goodwill acquired in a business combination is considered to have an indefinite life and therefore

should not be amortized. The Board’s position is that investors find the amortization charge of limited

usefulness in evaluating financial performance. In addition, although goodwill may decrease over

time, predicting the actual life of goodwill and an appropriate pattern of amortization is extremely

difficult.

Negative Goodwill

Negative goodwill arises when the fair value of the assets acquired is higher than the purchase price.

This situation is extremely rare. The FASB requires that this remaining excess be recognized as an

extraordinary gain. The Board noted that extraordinary treatment is appropriate to highlight the fact

that the excess exists and to reflect the unusual nature and infrequent occurrence of the item.

Impairment of Intangible Assets

The rules that apply to impairments of long-lived assets also apply to limited-life intangibles.

Indefinite-life intangibles other than goodwill should be tested for impairment at least annually. The

impairment test for an indefinite life asset other than goodwill is a fair value test. The test compares

the fair value of the intangible asset with the asset’s carrying amount. If the fair value of the intangible 6

asset is less than the carrying amount, impairment is recognized. This one-step test is used because it

would be relatively easy for many indefinite-life assets to meet the recoverability test because cash

flows may extend many years into the future. As a result, the recoverability test is not used.

Goodwill

The impairment test for goodwill is a two-step process. First, the fair value of the reporting unit should

be compared to its carrying amount including goodwill. If the fair value of the reporting unit is greater

than the carrying amount, goodwill is considered not to be impaired and the company does not have to

do anything else.

To illustrate, assume that Kohlbuy Corporation has three divisions in its company. One

division, Pritt Products, was purchased four years ago for $2 million. Unfortunately it has experienced

operating losses over the last three quarters, and management is reviewing the division for purposes of

recognizing impairment. The Pritt Division’s net assets including the associated goodwill of $900,000

from the purchase are listed below.

Cash $ 200,000 Receivables 300,000 Inventory 700,000 Property, plant, and equipment (net) 800,000 Goodwill 900,000 Less: Accounts and notes payable (500,000) Net assets $2,400,000

========

It is determined that the fair value of Pritt Division is $2,800,000. As a result, no impairment is

recognized because the fair value of the division is greater than the carrying amount of the net assets.

However, if the fair value of the Pritt Division is less than the carrying amount of the net assets,

then a second step must be performed. In the second step, the fair value of the goodwill (often called

the implied value of goodwill) must be determined and compared to its carrying amount.

To illustrate, assume that the fair value of the Pritt Division was $1,900,000 instead of

$2,800,000. In this case the implied fair value of the goodwill is computed as follows.

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Fair value of Pritt Division $1,900,000 Net identifiable assets (excluding goodwill) ($2,400,000 – $900,000)

(1,500,000)

Implied value of goodwill

$ 400,000

========

The implied value of the goodwill is then compared to the recorded goodwill to determine whether

impairment has occurred, as shown below.

Carrying amount of goodwill $900,000 Implied value of goodwill

(400,000)

Loss on impairment

$500,000

========

The following table summarizes the impairment tests for various intangible assets.

Type of Intangible Asset Impairment Test

Limited life Recoverability test, then fair value test

Indefinite life Fair value

Goodwill Fair value test on reporting unit, then fair value test on implied goodwill.

Concluding Remarks

These new guidelines have important implications for financial reporting. No longer will all intangible

assets be amortized against income. Impairment tests to determine the appropriate decline in value will

become more pervasive. As a result, there may be more volatility in reported income numbers than

under previous standards. It is likely under the new guidelines that more intangible assets other than

goodwill will be recognized in the financial statements. Finally, this new standard requires much more

extensive disclosures related to both goodwill and other intangible assets.

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SECTION 3: ASSET RETIREMENT OBLIGATIONS

Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations”

(Add this material as a separate section under “Dispositions of Plant Assets,” Chapter 10, pages 522-

523)

Overview

In many industries, the construction and operation of long-lived assets involve obligations associated

with the retirement of those assets. For example, when a mining company opens up a strip mine, it

may also make a commitment to restore the land on which the mine is located once the mining activity

is completed. Similarly, when an oil company erects an offshore drilling platform, it may be legally

obligated to dismantle and remove the platform at the end of its useful life.

There has been diversity in practice in the accounting for such asset retirement obligations. For

example, some companies created contra-asset accounts for their obligations; others, relying on the

accounting guidance for contingencies, recorded no obligation. The FASB was concerned that it was

difficult for users of financial statements to compare the financial positions and results of operations of

companies that have asset retirement obligations but account for them differently. To address this

diversity in practice, the FASB recently issued Statement of Financial Accounting Standards No. 143,

“Accounting for Asset Retirement Obligations.”

Accounting Recognition of Asset Retirement Obligations

Under SFAS No. 143, a company must recognize an asset retirement obligation (ARO) when the

company has an existing legal obligation associated with the retirement of a long-lived asset and when

the amount of the liability can be reasonably estimated. The ARO should be recorded at fair value.

Obligating Events

Examples of existing legal obligations, which would require recognition of a liability include, but are

not limited to, the following.

• Decommissioning nuclear facilities.

• Dismantling, restoring, and reclamation of oil and gas properties.

• Certain closure, reclamation, and removal costs of mining facilities.

• Closure and post-closure costs of landfills.

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In order to capture the benefits of these long-lived assets, the company is generally legally obligated

for the costs associated with retirement of the asset, whether the company hires another party to

perform the retirement activities or whether the company performs the activities with its own

workforce and equipment. AROs give rise to various recognition patterns, in which the obligation may

arise at the outset of the assets use (e.g., erection of an oil-rig) or may build over time (e.g., a landfill

that expands over time).

Measurement of AROs

An ARO is initially measured at fair value, which is defined as the amount that the company would be

required to pay in an active market to settle the ARO. Although active markets do not exist for many

AROs, an estimate of fair value should be based on the best information available. Such information

could include market prices of similar liabilities, if available. Alternatively, fair value can be estimated

based on present value techniques, using expected cash flows. This represents an example of applying

the concepts discussed in FASB Concepts Statement 7, “Using Cash Flow Information and Present

Value in Accounting Measurements,” (see Section 4 of this Update).

Recognition and Allocation

To record an ARO in the financial statements, the ARO’s cost is included in the carrying amount of the

related long-lived asset, and a liability is recorded for the same amount. An asset retirement cost is

recorded as part of the related asset because these costs are considered a cost of operating the asset and

are necessary to prepare the asset for its intended use. Therefore, the carrying value of the specific

asset (e.g., mine, drilling platform, nuclear power plant) should be increased because the future

economic benefit comes from the use of this productive asset. The capitalized asset retirement costs

should not be recorded in a separate account because there is no future economic benefit that can be

associated with these costs alone.

In subsequent periods, the cost of the ARO is allocated to expense over the period of the related

asset’s useful life. The straight-line method is acceptable for this allocation, and other systematic and

rational allocations also are permitted.

Illustration of ARO Accounting Provisions

To illustrate the accounting for AROs, assume that on January 1, 2003, Wildcat Oil Company erected

an oil platform in the Gulf of Mexico. Wildcat is legally required to dismantle and remove the

platform at the end of its useful life, which is estimated to be 5 years. Because there is significant

drilling activity in this area, there is an active market for dismantling and removal services. Based on 10

data from this market, Wildcat has determined that the initial fair value of the liability is $195,000.

Wildcat would make the following journal entry to record this ARO.

January 1, 2003

Drilling Platform (asset retirement cost) 195,000

Asset Retirement Obligation 195,000

During the life of the asset, the asset retirement cost would be allocated to expense. Using the

straight-line method, Wildcat would make the following entry to record this expense.

December 31, 2003, 2004, 2005, 2006, 2007

Depreciation Expense (asset retirement cost) 39,000

Accumulated Depreciation 39,000

On January 10, 2008, Wildcat contracts with Rig Reclaimers, Inc. to dismantle the platform at a

contract price of $193,000. Wildcat would make the following journal entry to record settlement of the

ARO.

January 10, 2008

Asset Retirement Obligation 195,000

Gain on Settlement of ARO 2,000

Cash 193,000

Change in Estimates

Following initial recognition, there can be changes in estimates of the fair value of the ARO. These

changes may arise from changing market conditions or from changes in assumptions used to estimate

cash flows required to settle the ARO. Increases (decreases) in the ARO should be recorded as an

adjustment to the liability with an offsetting entry to the asset retirement costs. Depreciation on the

new asset cost will be adjusted on a prospective basis.

For example, assume that on January 1, 2005, Wildcat receives new market information

indicating that the fair value of the dismantling contract for its platform has increased $15,000, to

$210,000. In this case, Wildcat makes the following entry.

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January 1, 2005

Drilling Platform (asset retirement cost) 15,000

Asset Retirement Obligation 15,000

The new basis of the drilling platform is now $132,000, computed as follows.

($195,000 – $39,000 – $39,000 + $15,000) = $132,000

Assuming no other changes in the fair value of the ARO over the following three years, the following

table shows the amounts recorded for the ARO liability and the related asset retirement cost at 2005,

2006, 2007.

Year Expense Carrying value of drilling platform

(asset retirement cost)

ARO

Balance 12/31/04 $ 39,000 $ 117,000 $ 195,000Increase in ARO -- 15,000 15,000Balance 1/1/2005 -- 132,000 210,00012/31/05 44,000 88,000 210,00012/31/06 44,000 44,000 210,00012/31/07 44,000 0 210,000

The entry to record depreciation expense for the asset retirement cost in each of the final three years

would be:

December 31, 2005, 2006, 2007

Depreciation Expense (asset retirement cost) 44,000

Accumulated Depreciation 44,000

($132,000 ÷ 3)

The entry to settle the ARO on January 10, 2008 would be as follows.

January 10, 2008

Asset Retirement Obligation 210,000

Cash 210,000

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In summary, recognition and measurement of the asset retirement obligation is based on the

measurement of the liability at fair value. The amount of the obligation increases the capitalized cost

of the related asset, which is allocated to expense over the related asset’s useful life.

Disclosures

Required disclosures for AROs include:

1. Description of the ARO and the related long-lived asset.

2. The fair value of any assets dedicated to satisfy the liability.

3. A reconciliation of the beginning and ending aggregate amounts of the liability arising from

liabilities incurred during the period, liabilities settled during the period, interest expense, and

significant revisions in expected cash flows.

Concluding Remarks

The provisions of SFAS No. 143 take effect for financial statements issued for fiscal years beginning

after June 15, 2002, although earlier application is encouraged. The initial application should be as of

the beginning of a company’s fiscal year, with any adjustments recorded as a cumulative-effect

accounting change. The provisions of the new standard improve financial reporting by recognizing

retirement obligations when incurred and by capitalizing the cost as part of the related asset’s carrying

amount, with expense allocated to periods of future use. This accounting combined with expanded

disclosure requirements will provide enhanced information about long-lived assets.

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SECTION 4: CASH FLOWS AND PRESENT VALUE IN ACCOUNTING MEASUREMENTS

Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements” (Updates material in Chapter 6, pages 270-273)

Overview

As indicated in Chapter 6, financial reporting uses different measurements in different situations.

Present value is one of those measurements, and its usage has been increasing. Recognizing that fact,

the FASB issued Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Information

and Present Value in Accounting Measurements” to provide a framework for using expected future

cash flows and present values as a basis for measurement. It should be noted that the FASB has

already incorporated the concepts developed in this new statement into its latest pronouncements on

business combinations, goodwill and other intangibles, asset retirement obligations, and impairments.

Expected Cash Flows

In the past, most accounting calculations of present value were based on the most likely cash flow

amount. Concepts Statement No.7 introduces an expected cash flow approach that uses a range of cash

flows and incorporates the probabilities of those cash flows to provide a more relevant measurement of

present value.

To illustrate the expected cash flow model, assume that there is a 30% probability that future

cash flows will be $100, a 50% probability that they will be $200, and a 20% probability that they will

be $300. In this case, the expected cash flow would be $190 [($100 X 0.3) + ($200 X 0.5) + ($300 X

0.2)]. Under traditional present value approaches, the most likely estimate ($200) would be used, but

that estimate does not consider the different probabilities of the possible cash flows.

After determining expected cash flows, the proper interest rate must then be used to discount

the cash flows. The interest rate used for this purpose has three components.

THREE COMPONENTS OF INTEREST 1. Pure Rate of Interest (2%-4%). This would be the amount a lender would charge if there

were no possibilities of default and no expectation of inflation. 2. Expected Inflation Rate of Interest (0% -?). Lenders recognize that in an inflationary

economy, they are being paid back with less valuable dollars. As a result, they increase their interest rate to compensate for this loss in purchasing power. When inflationary expectations are high, interest rates are high.

3. Credit Risk Rate of Interest (0% - 5%). The government has little or no credit risk (i.e. risk of nonpayment) when it issues bonds; a business enterprise, however, depending upon its financial stability, profitability, etc., can have a low or a high credit risk.

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The FASB takes the position that after the expected cash flows are computed, they should be

discounted by the risk-free rate of return, which is defined as the pure rate of return plus the expected

inflation rate. The Board notes that the expected cash flow framework adjusts for credit risk because it

incorporates the probability of receipt or payment into the computation of expected cash flows.

Therefore the rate used to discount the expected cash flows should consider only the pure rate of

interest and the inflation rate.

Fair Value

As part of the discussion in Concepts Statement No. 7, the Board explained the concept of fair value.

Fair value is defined as the amount at which an asset (or liability) could be bought (or incurred) or sold

(settled) in a current transaction between willing parties, that is, other than in a forced or liquidation

sale. Put more simply, fair value is the price at which two parties would agree to in an exchange

transaction.

In determining fair value, a number of assumptions are made.1 These are:

• The buyer of an asset (or the entity that is assuming a liability) has a use for the item in its

current state and the ability to put it to use. If the item is a backhoe, for example, we assume

that the buyer is in the construction trade or used-equipment business. Buyers who don’t

understand the item are not part of the market.

• The buyer of an asset will put the item to its highest and best use. This assumption is

especially important for fixed assets like real estate. For example, an entity may own land now

being used in agriculture. However, buyers of land in this area are interested in its potential for

residential or commercial development and set prices accordingly. Fair value of this piece of

land should incorporate assumptions about development, rather than continued operation in

agriculture.

• The buyer of an asset can obtain reasonable information about the item’s condition and

uncertainties surrounding the potential cash flows. If the item is a backhoe, for example, we

assume that the buyer can learn that it has an oil leak and several thousand hours of past use.

• The buyer of an asset is interested in the specific item in question. If the item is a backhoe, the

buyer is interested in this particular make, model, age, and physical condition, rather than a

“market average” asset.

151 Adapted from: Understanding the Issues, “ Measuring Fair Value,” (FASB, 2001), p. 2.

• The buyer and seller of an asset (or the entity seeking to extinguish or assume a liability) will

transact in the market that is most advantageous, provided it has the ability to enter that market.

This assumption is especially important when considering the fair value of groups of assets or

liabilities. If the entity can obtain a better price (or incur lower costs) by transacting for the

group of assets, and the entity has the ability to enter that market, we assume that the

transaction will take place in that market.

In the absence of a ready market, these are the assumptions that underlie the fair value

computation.

Fair Value of A Liability

How should the fair value of a liability be determined? In its simplest terms, the fair value is the

present value of the expected cash flows to be paid, discounted at the risk-free rate of interest. Some

believe that the calculation of the fair value of a liability is complicated because it is not clear how to

account for:

1. the profit element in a liability.

2. the credit standing of the borrower.

Here we look at each of these issues.

Profit Element

To illustrate the profit element, assume that Carson Repair Inc. is in the repair business and sells

service contracts to Niger Inc. The service contract stipulates that for $1,000,000, Carson will repair

all of Niger’s electrical appliances if they become defective any time within the next three years. In

this case, Carson would make the following entry at the time the contract is sold:

Cash 1,000,000

Warranty Liability 1,000,000

In this situation, the fair value of the liability is easily measurable because a transaction related

to the service contract has just occurred. It follows that the profit that Carson will receive on the

service contracts is incorporated into the liability measurement. This profit will be recognized when

the services are performed or when Carson is released from its obligation. The profit element in this

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case involves a future cash flow and should be reflected in the computation of the amount of the

liability.

Some disagree with this approach. They note that if Carson is going to settle a transaction using

only its own internal resources, the liability is for the costs incurred (cost accumulation approach) to

repair these appliances absent any profit. The problem, however, with the cost accumulation approach

is that the fair value of the liability is then not reported. Concepts Statement No.7 notes that any third

party that would settle the obligation would demand a profit and therefore the profit should be included

in the fair value of the liability.

Credit Standing

Another contentious issue involving the valuation of a liability relates to the credit standing of the

borrower. To understand this point, assume that Horton Corporation issues a zero-coupon, 5-year,

$100,000 note to First City Bank. Horton has an AAA-rated credit standing and therefore the note’s

interest rate is 8%. The entry to record the note payable is as follows.

Cash 68,058

Note Payable 68,058

($100,000 X .68058)

Assume that the same day, Cendar Corporation also issues a zero-coupon, 5-year, $1,000 note to First

City Bank. Cendar has a double-B rated credit standing and the note interest rate is 11%. The entry to

record the note payable is as follows.

Cash 59,345

Note Payable 59,345

($100,000 X .59345)

The reason Horton receives more cash, given the same terms as Cendar, is that it has a better

credit rating. In short, this example demonstrates that liability measurement on initial recognition must

include the company’s credit standing. Some have argued otherwise, but that argument does not

appear to have economic merit.

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Comprehensive Illustration

To illustrate application of the concepts introduced in Concepts Statement No. 7, assume Al’s

Appliance Outlet offers a two-year warranty on all products sold. In 2001, Al sold $250,000 of a

particular type of clothes dryer. Al’s Appliance has entered into an agreement with Ralph’s Repair to

provide all warranty service on the dryers sold in 2001. Al’s Appliance wishes to measure the fair

value of the agreement to determine the warranty expense to record in 2001 and the amount of

warranty liability to record on the 12/31/2001 balance sheet. Since there is not a ready market for

these warranty contracts, Al’s Appliance uses expected cash flow techniques to value the warranty

obligation.

Based on prior warranty experience, Al’s Appliance estimates the following expected cash

outflows associated with the dryers sold in 2001.

Expected Cash Outflows – Warranties

Cash Flow Estimate X

Probability Assessment =

Expected Cash Flow

2002 $3,800 20% $ 760 6,300 50% 3,150 7,500 30% 2,250 Total $6,160 =====2003 $5,400 30% $1,620 7,200 50% 3,600 8,400 20% 1,680 Total $6,900 =====

Applying expected cash flow concepts to this data, Al’s Appliance estimates warranty cash outflows of

$6,160 in 2002 (the first year of the warranty) and $6,900 in 2003 (the second year of the warranty).

The present value of these cash flows, assuming a risk-free rate of 5%, is shown in the

following schedule.

Present Value of Cash Flows (Risk-Free Rate = 5%)

Year Expected Cash Flow X

PV Factor, i = 5% = Present Value

2002 $6,160 0.95238 $ 5,870 2003 6,900 0.90703 6,260

Total $ 12,130 =======

Al’s Appliance would make the following entry to record warranty expense and the related

warranty liability in 2001.

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December 31, 2001

Warranty Expense 12,130

Warranty Liability 12,130

By applying the expected cash flow concepts, Al’s Appliance records a fair value estimate of the

warranty expense and liability that incorporates probabilities of the future cash outflows, discounted at

the appropriate risk-free rate.

Concluding Remarks

A present value measurement that fully captures all the relevant information should include the

following items:2

(a) To the extent possible, estimated cash flows and interest rates should reflect assumptions about

future events and uncertainties that would be considered in deciding whether to acquire an asset or

group of assets in an arm’s length transaction for cash.

(b) Interest rates used to discount cash flows should reflect assumptions that are consistent with those

inherent in the estimated cash flows. Otherwise, the effect of some assumptions will be double

counted or ignored. For example, an interest rate of 12 percent might be applied to contractual cash

flows of a loan. That rate reflects expectations about future defaults from loans with particular

characteristics. That same 12 percent rate should not be used to discount expected cash flows

because those cash flows already reflect assumptions about future defaults.

(c) Estimated cash flows and interest rates should be free from both bias and factors unrelated to the

asset, liability, or group of assets or liabilities in question. For example, deliberately understating

estimated net cash flows to enhance the apparent future profitability of an asset introduces a bias in

the measurement.

(d) Estimated cash flows or interest rates should reflect the range of possible outcomes rather that a

single most likely, minimum, or maximum possible amount.

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2 Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements” (FASB 2001), para. 41.

SECTION 5: GOODWILL ASSOCIATED WITH INVESTMENTS ACCOUNTED FOR UNDER THE EQUITY METHOD Application of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangibles” (Updates material in Chapter 18, pages 930-935)

The new standard for goodwill and other intangibles (SFAS No. 142) also addresses the accounting for

investments in common stock, which are accounted for using the equity method. As discussed in

Chapter 18 (pp. 930-935) of Intermediate Accounting, the equity method is used for equity investments

when the investor company has significant influence, but not control, over the investee company. Such

a level of control is generally presumed when the investor holds between 20% and 50% of the

investee’s common shares.

According to SFAS No. 142, goodwill arising from these investments should not be amortized.

However, goodwill recorded on equity-method investments will continue to be tested for impairment

in accordance with the provisions of APB Opinion No. 18, “The Equity Method of Accounting for

Investments of Common Stock.”

SECTION 6: IMPAIRMENTS OF LONG-LIVED ASSETS

Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

(Updates material in Chapter 4, pages 154-160 and Chapter 11, pages 561-566)

Prior standards addressing impairment of long-lived assets (SFAS No. 121) did not address the

impairment and disposal of a segment of a business. As a result, two accounting models existed for the

impairments of long-lived assets to be disposed of by sale. Under SFAS No. 121, impairments of assets

held for sale were measured based on the lower of book value or the fair value less costs to sale. In

contrast, impairments of assets in a discontinued operation (according to APB Opinion No. 30) were

measured at the lower of book value or net realizable value, adjusted for expected future operating

losses.3

SFAS No. 144 supersedes SFAS No. 121. The new standard carries forward the measurement

model in SFAS No 121, applying a single model to long-lived assets to be disposed of by sale, whether

previously held and used, or newly acquired. Consequently, discontinued operations are no longer

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3 APB Opinion No. 30, “ Reporting the Results of Operations – Reporting the Effects of Disposal of a Segment of a Business, Extraordinary, Unusual, and Infrequently Occurring Events,” (APB, 1973).

measured on a net realizable value basis, and future operating losses are no longer recognized before

they occur. By using a single measurement model, the accounting for similar events and

circumstances will be the same. The discussion in Chapter 11 of Intermediate Accounting (pp. 561-

565) illustrates the application of the impairment measurement model introduced in SFAS No. 121 and

continued in the new standard.

In addition, SFAS No. 144 retains the reporting provisions of APB Opinion 30 and broadens the

presentation of discontinued operations to include more disposal transactions. For example, disposal

of “groups” of assets may now receive discontinued operations presentation in financial statements.

Under prior standards, such special presentation was allowed only for disposal of a segment of the

business. Again, the Board felt that reporting is improved when disposal transactions with similar

characteristics are reported in a similar fashion.

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