ACCT612 - CHAPTER 5 End-of-Chapter Solutions Case 5-1 a. Earnings management is the attempt by corporate officers to influence short-term

reported income. It is believed that managers may attempt to manage earnings because they believe investors are influenced by reported earnings. The methods of earnings management include the use of production and investment decisions, and the strategic choice of accounting techniques (including the early adoption of new accounting standards). In most cases, earnings management techniques are designed to improve reported income effects; however, such is not always the case. An alternate explanation is the "Big Bath" theory which suggests that management may take the opportunity to report more bad news in periods when performance is low to increase future profits. An argument has also been made that management may choose to take large write-offs in periods when their performance is otherwise extremely positive.

Note to instructors: Although not specifically addressed in the case, it might be noted that efforts to manage earnings may be irrelevant in light of efficient market research. The general findings of this research indicate that the market is not deceived by the manipulation of accounting numbers. Alternately, if compensation is tied to earnings, there may be utility maximization reasons why managers attempt to manage earnings. Such explanations are tied to agency theory.

b. Some methods that may be used by management to smooth earnings are: postponing

end-of-the-year inventory replacement expenditures for merchandising companies, postponing the production of products for manufacturing companies, and the early adoption of new FASB accounting standards such as SFAS No. 109 when it has a positive effect on reported net income due to the recording of deferred tax benefits.

Arthur Levitt, the former chair of the SEC, has outlined five earnings management

techniques that he believes threaten the integrity of financial reporting

Taking a bath

The one-time overstatement of restructuring charges to reduce assets, which reduces future expenses. The expectation is that the one-time loss is discounted in the marketplace by analysts and investors who will focus on future earnings.

2. Creative acquisition accounting

Avoiding future expenses by one-time charges for in-process research and development.

3. Cookie jar reserves

Overstating sales returns or warranty costs in good times and using these overstatements in bad times to reduce similar charges.

4. Abusing the materiality concept

Deliberately recording errors or ignoring mistakes in the financial statements under the assumption that their impact is not significant.

5. Improper revenue recognition

Recording revenue before it is earned. It was noted that over half of the SECs enforcement cases filed in 1999 and 2000 involved improper revenue recognition issues.

Case 5-2 a. A major purpose of income reporting is to allow investors to predict future cash flows.

Despite the evidence that accounting earnings are good indicators of stock returns, the use of the transactions approach to income determination along with the principle of conservatism, and the materiality constraint; have led security analysts to the conclusion that economic income, rather than accounting income is a better predictor of future cash flows. Consequently, these individuals have suggested assessing the quality of earnings to predict future cash flows. Earnings quality is defined as the degree of correlation between a company's accounting income and its economic income. Several techniques have been developed to use in assessing earnings quality including:

1. Compare the accounting principles employed by the company with those

generally used in the industry and by competitions. Do the principles used by the company inflate earnings?

2. Review recent changes in accounting principles and changes in estimates to

determine if they inflate earnings. 3. Determine if discretionary expenditures, such as advertising, have been postponed

by comparing them to previous periods.

4. Attempt to assess whether some expenses, such as warranty expense, are not reflected on the income statement.

5. Determine the replacement cost of inventories and other assets. Is the company

generating sufficient cash flow to replace their assets?

6. Review the notes to financial statements to determine if loss contingencies exist that might reduce future earnings and cash flows.

7. Review the relationship between sales and receivables to determine if receivables

are increasing more rapidly than sales.

8. Review the management discussion and analysis section of the annual report and the auditor's opinion to determine management's opinion of the company's future and to identify any major accounting issues.

b. The answer to this part of the case is dependent upon the company selected. The students

should be able to address all, or, at least, most of the above issues and reference the section of the annual report that contained the relevant information.

Case 5-3 a. Income results from economic activity in which one entity furnishes goods or services to

another. To warrant revenue recognition, the earning process must be substantially complete and there must be realization--a change in assets that is capable of being objectively measured. Normally this involves an arm's length exchange transaction with a party external to the entity. The existence and terms of the transaction may be defined by operation of law, by established trade practice or may be stipulated in a contract.

Events that give rise to revenue recognition are: the completion of a sale; the performance of a service; the progress of a long-term construction project, as in shipbuilding; and the production of a standard interchangeable good (such as a precious metal or an agricultural product) which has an immediate market, a determinable market value, and only minor costs of marketing. The passing of time may also be the event that establishes the recognition of revenues, as in the case of interest or rental revenue As a practical consideration, there must be a reasonable degree of certainty in measuring the amount of revenue. Problems of measurement may arise in estimating the degree of completion of a contract, the net realizable value of a receivable, or the value of a nonmonetary asset received in an exchange transaction. In some cases, while the revenue may be readily measured, it may be impossible to reasonably estimate the related expenses. In such instances revenue recognition must be deferred until the matching process can be completed.

b. Bonanza, in effect, is a merchandising firm which collects cash (for stamps) far in

advance of furnishing the goods. In addition, since the data indicates that about five percent of the stamps sold will never be redeemed, it also has revenue from this source unless the stamps escheat. Bonanza's revenues from these two sources could be recognized on one of three major bases. First, all revenue could be recognized when the stamps are sold--the sales basis or cash-collection basis if all sales are for cash. Secondly, amounts collected at the time stamps are sold could be treated as an advance (sometimes referred to as deferred or unearned revenue) until stamps are exchanged for the merchandise premiums at which time all of the revenue including that relating to the never-to-redeemed stamps could be recognized. Thirdly, some revenue could be recognized at the time of redemption--this treatment would be especially appropriate for approximately five percent of the total, the stamps that will never be redeemed. A modification of this basis would be to recognize the revenue from the never-to-be-redeemed stamps on a passage-of-time basis.

The principal expense, merchandise premium costs, should be matched with the revenue. If all revenue is recognized when stamps are sold, and accrual of the cost of future premium redemptions would be necessary. In such a case, when stamp redemptions and related premium issuances occurred, the costs of the premiums would be charged to the

accrued liability account. On the other hand, if stamp sales were treated as an advance, the deferred revenue would be recognized and the matching cost of the premiums issued would be recognized with the revenue at the time of redemption.

Under the third alternative, some predetermined portion, at least, of the revenue from the never-to-be-redeemed stamps would be recognized when the stamps are sold, but the recognition of the merchandise premium expense would be deferred until time of redemption.

Reasonable estimation is crucial to income determination. Under the first alternative it is necessary to estimate future costs of premium issuances well in advance of the actual occurrence. In the second case it is necessary to estimate the proportion of revenue which has already been earned on the basis of premium costs already incurred. It is a vital certainty that not all stamps sold will ultimately be presented for redemption. Such factors as the number of stamps required to fill a book, the types of customers who receive stamps, and the ease of exchanging stamp books for premiums will all affect the proportion of stamps actually redeemed in relation to the potential redemptions. The difference between the five percent initial estimate and the actual proportion of unredeemed stamps affects the accrual of a liability for redemption of stamps issued under the first method and the rate of transfer of revenue from the advances account under the second and third methods.

There will be other expenses aside from the costs of premiums issued but they should be relatively small after the initial promotion period and they should be accounted for under the usual principles which apply to accrual-basis accounting. Thus, premium catalogs printed but undistributed would ordinarily be treated as prepaid expenses; wages and salaries would be treated as expenses when incurred; depreciation, taxes, and similar expenses would be recognized in the usual manner.

c. Under all of the alternatives Bonanza's major asset (in terms of data given in the

question) would be its inventory of premiums. Another inventory item, perhaps minor in amount, would be the cost of printing the stamps that were on hand awaiting sale to dealers. The major account with a credit balance would be either an estimated liability for cost of redeeming the outstanding stamps under the first alternative or an advance (deferred revenue) account under the second and third alternatives. In view of the nature of the operation, the inventory account(s) would be included in the current asset classification and the liability would be classified as current. The advances could be reported preferably as a current liability or possibly as deferred credit.

Case 5-4 A .1.. Cost is the amount measured by the current monetary value of economic resources given

up or to be given up in obtaining goods and services. Economic resources may be given up by transferring cash or other property, issuing capital stock, performing services, or incurring liabilities.

Costs are classified as unexpired or expired. Unexpired costs are assets and apply to the production of future revenues. Examples of unexpired costs are inventories, prepaid expenses, plant and equipment, and investments. Expired costs, which most costs become eventually, are those that are not applicable to the production of future revenues and are deducted from current revenues or charged against retained earnings.

2. Expense in its broadest sense includes all expired costs, i.e., costs which do not have any

potential future economic benefit. A more precise definition limits the use of the term expense to the expired costs arising from using or consuming goods and services in the process of obtaining revenues, e.g., cost of goods sold and selling and administrative expenses.

3. A loss is an unplanned cost expiration and for this reason is often included in the broad

definition of expenses. A more precise definition restricts the use of the term loss to cost expirations which do not benefit the revenue-producing activities of the firm. Examples include the unrecovered book value on the sale of fixed assets and the write-off of goodwill due to unusual events within an accounting period. The term loss is also used to refer to the amount by which expenses and extraordinary items exceed revenues during an accounting period.

i. Cost of goods sold is an expired cost and may be referred to as an expense in the broad

sense of the term. On the income statement it is most often identified as a cost. Inventory held for sale which is destroyed by an abnormal casualty should be classified as a loss.

ii. Bad debts expense is usually classified as an expense. However, some authorities believe

that it is more desirable to classify bad debts as a direct reduction of sales revenue (an offset to revenue). A material bad debt which was not provided for in the annual adjustment, such as bankruptcy of a major debtor, may be classified as a loss.

iii. Depreciation expense for plant machinery is a component of factory overhead and

represents the reclassification of a portion of the machinery cost to product cost (inventory). When the product is sold, the depreciation becomes a part of the cost of goods sold which is an expense. Depreciation of plant machinery during an unplanned and unproductive period of idleness, such as during a strike, should be classified as a loss. The term expense should preferably be avoided when making reference to production costs.

iv. Organization costs are those costs that benefit the firm for its entire period of existence

and are most appropriately classified as a non-current asset. When there is initial evidence that a firm's life is limited the organizational costs should be allocated over the firm's life as an expense, or amortized as a loss when going concern foresees termination. In practice, however, organization costs are often written off in early years of a firm's existence.

v. Spoiled goods resulting from normal manufacturing processing should be treated as a

cost of the product manufactured. When the product is sold the cost becomes an expense. Spoiled goods resulting from an abnormal occurrence should be classified as a loss.

c. Period costs and product costs are usually differentiated under one of two major concepts.

One concept identifies a cost as a period or product cost according to whether the cost expires primarily with the passage of time or directly for the production of revenue. The other concept identifies a cost as a product or a period cost according to whether or not the cost is included in inventory.

Under the first concept period costs are all costs which expire within the accounting period and are only indirectly related to the production of revenue within the period and

product costs are those costs associated with the manufacture of a firm's product and that generate revenue in the period of its sale. Some costs are easily associated with the production of revenue, such as the manufacturing or purchase cost of a product sold, and are designated as product costs. Other costs may be incurred as costs of doing business and are more difficult to relate to the production of revenue, such as general and administrative costs, and are classified as period costs. Costs which cannot be readily identified with the production of revenue in any particular period, such as the company president's salary which may produce revenue in many distant future accounting periods, are also classified as period costs because they cannot be specifically identified with any future accounting period. Under the second concept product costs include only the costs which are carried forward to future accounting periods in inventory and all expired costs are period costs.

Case 5-5 a. The point of sale is the most widely used basis for the timing of revenue recognition

because in most cases it provides the degree of objective evidence accountants consider necessary to reliably measure periodic business income. In other words, sales transactions with outsiders represent the point in the revenue generating process when most of the uncertainty about the final outcome of business activity has been alleviated.

It is also at the point of sale in most cases that substantially all of the costs of generating revenues are known, and they can at this point be matched with the revenues generated to produce a reliable statement of a firm's effort and accomplishment for the period. Any attempt to measure business income prior to the point of sale would, in the vast majority of cases, introduce considerably more subjectivity in financial reporting than most accountants are willing to accept.

b.i. Though it is recognized that revenue is earned throughout the entire production process,

generally it is not feasible to measure revenue on the basis of operating activity. It is not feasible because of the absence of suitable criteria for consistently and objectively arriving at a periodic determination of the amount of revenue to take up. Also, in most situations the sale represents the most important single step in the earnings process. Prior to the sale the amount of revenue anticipated from the processes of production is merely prospective revenue; its realization remains to be validated by actual sales. The accumulation of costs during production does not alone generate revenue; rather, revenues are earned by the entire process, including making sales.

Thus, as a general rule the sale cannot be regarded as being an unduly conservative basis for the timing of revenue recognition. Except in unusual circumstances, revenue recognition prior to sale would be anticipatory in nature and unverifiable in amount.

ii. To criticize the sales basis as not being sufficiently conservative because accounts

receivable do not represent disposable funds, it is necessary to assume that the collection of receivables is the decisive step in the earning process and that periodic review measurement, and therefore net income, should depend on the amount of cash generated during the period. This assumption disregards the fact that the sale usually represents the decisive factor in the earning process and substitutes for it the administrative function of managing and collecting receivables. In other words, the investment of funds in

receivables should be regarded as a policy designed to increase total revenues, properly recognized at the point of sale; and the cost of managing receivables (e.g., bad debts and collection costs) should be matched with the sales in the proper period.

The fact that some revenue adjustments (e.g., sales returns) and some expenses (e.g., bad debts and collection costs) may occur in a period subsequent to the sale does not detract from the overall usefulness of the sales basis for the timing of revenue recognition. Both can be estimated with sufficient accuracy so as not to detract from the reliability of reported net income. Thus, in the vast majority of cases for which the sale basis is used, estimating errors, though unavoidable, will be too immaterial in amount to warrant deferring revenue recognition to a later point in time.

c.i. During production. This basis of recognizing revenue is frequently used by firms whose

major source of revenue is long-term construction projects. For these firms the point of sale is far less significant to the earning process than is production activity because the sale is assured under the contract, except of course where performance is not substantially in accordance with the contract terms.

To defer revenue recognition until the completion of long-term construction projects could significantly impair the usefulness of the intervening annual financial statements because the volume of completed contracts during a period is likely to bear no relationship to production volume. During each year that a project is in process a portion of the contract price is therefore appropriately recognized as that year's revenue. The amount of the contract price to be recognized should be proportionate to the year's production progress on the project.

It should be noted that the use of the production basis in lieu of the sales basis for the timing of revenue recognition is justifiable only when total profit or loss on the contracts can be estimated with reasonable accuracy and its ultimate realization is reasonably assured.

ii. When cash is received. The most common application of this basis for the timing of

revenue recognition is in connection with installment sales contracts. Its use is justified on the grounds that, due to the length of the collection period, increased warrant revenue recognition until cash is received.

The mere fact that sales are made on an installment contract basis does not justify using the cash receipts basis of revenue recognition. The justification for this departure from the sales depends essentially upon an absence of a reasonably objective basis for estimation the amount of collection costs and bad debts that will be incurred in late periods. If these expenses can be estimated with reasonable accuracy, the sales basis should be used.

Case 5-6 Statement of Financial Accounting Concepts No.5, "Recognition and Measurement in Financial Statements of Business Enterprises." does not suggest major changes in the current structure and context of financial statements. However, it did suggest that a statement of cash flows should

replace the then required statement of changes in financial position (this change was subsequently adopted). In general, SFAC No. 5 attempts to set forth recognition criteria and guidance on what information should be incorporated into financial statements, and when this information should be reported. According to this Statement, a full set of financial statements for a period shows: 1. Financial position at the end of the period. 2. Earnings for the period. 3. Comprehensive income for the period. 4. Cash flows during the period. 5. Investments by and distributions to owners during the period. The statement of financial position should provide information about an entity's assets, liabilities, and equity and their relationship to each other at a moment in time. It should also delineate the entity's resource structure-major classes and amounts of assets-and its financing structure-major classes and amounts of liabilities and equity. The statement of financial position is not intended to show the value of a business, but it should provide information to users wishing to make their own estimates of the enterprise's value. Earnings is a measure of entity performance during a period. It measures the extent to which asset inflows (revenues and gains) exceed asset outflows. The concept of earning provided in SFAC No. 5 is similar to net income for a period in current practice. However, it excludes certain adjustments from earlier periods now recognized in the current period. It is expected that the concept of earnings will continue to be subject to the process of gradual change that has characterized its development. Comprehensive income is defined as a broad measure of the effects of transactions and other events on an entity. It comprises all recognized changes in equity of the entity during a period from transactions except those resulting from investments by owners and distributions to owners. The relationship between earnings and comprehensive income is illustrated as follows.

Revenues Earnings Less: Expenses Plus or minus cumulative accounting adjustments Plus: Gains Plus or minus other nonowner changes in equity Less: Losses = Earnings = Comprehensive income

The statement of cash flows should directly or indirectly reflect an entity's cash receipts classified by major source and its cash payments classified by major uses during a period. The statement should include cash flow information about its operating, investing and financing activities. A statement of investments by and distributions to owners reflects an entity's capital transactions during a period, that is, the extent to which and in what ways the equity of the entity increased or decreased from transactions with owners. Case 5-7 a. The matching concept associates efforts (costs) with accomplishments (revenues).

Expenses are generally recognized when economic benefits are used up in delivering

goods or producing services - i.e., revenues are earned. Expenses are defined in SFAC No. 6 as outflows or other using up as assets or incurrences of liabilities from producing goods or providing services, or rendering other activities that constitute the entitys ongoing or central operations. This definition is consistent with the matching concept.

The matching concept is important to income reporting because of the going concern assumption. Since business entities are presumed to be going concerns, enterprise performance must be assessed at intervals. That is, accountants must report periodically to investors, creditors and other users. Periodic reporting requires that accountants report on the performance of the entity during an accounting period so that users can assess enterprise how well the enterprise is utilizing resources to generate future cash flows for operations, reinvestment in operations, and dividends for investors.

b. Expenses, such as cost of goods sold, are directly linked to the production of revenue.

These costs are matched directly to the revenue generated during the accounting period. Many expenses are associated with the period in which the revenue was generated. These costs include such items as administrative salaries or electricity for the sales office. Other expenses are systematically allocated to the periods benefited by their use. For example, the cost of fixed assets is typically allocated to periods based on useful life.

c. According to SFAC No. 5, earnings and comprehensive income combined reflect the

extent to which and the ways in which the equity (net assets) of an entity increased or decreased from all sources other than transactions with owners during the accounting period. Users need information about the causes of changes in net assets and how these changes affected ongoing operations. Direct measures of asset and liability balances at the end of the accounting period are linked to expense and revenue measurement because financial statements are articulated.

The measurement of earnings using a balance sheet approach is consistent with the financial capital maintenance concept of income determination. This concept is critical to determining the return on invested capital. A return on capital occurs only if there has been an increase in net assets during the period exclusive of investments by and distributions to owners. Hence, financial capital maintenance and thus a balance sheet approach to income measurement is relevant to investor decision making.

d. The measurement of deferred income taxes uses the asset/liability approach. Under this

approach the deferred tax asset and liability balances are determined. Income tax expense is equal to the current provision for income tax plus the change in the deferred tax asset and or liability balance.

Aging of accounts receivable provides balance sheet measure of net realizable value. The resulting balance in the allowance account is used to measure the amount of bad debt expense in the income statement.

Measures of cost of goods sold utilize a balance sheet approach. Typically, the cost of inventory is determined, then cost of goods sold is computed as a residual amount.

Case 5-8

a. According to SFAC No. 2, if two estimates of an amount that is to be received or paid in the future are about equally likely, conservatism dictates using the less optimistic estimate.

a. Conservatism has affected financial reporting because there is a tendency for accountants

to recognize losses, but not gains. For example, loss contingencies are accrued when they are probable and the amount of the potential loss is reasonably estimable. Similar gain contingencies are not accrued. In accounting for sale-leasebacks where more than a minor portion is leased back, losses on sales are recognized; whereas, gains are deferred. Lower-of-cost-or-market is used for inventory whereby the carrying value of inventory is written down to market if it is lower, but not up to market if market is higher.

b. No. If an economic loss has occurred it should be reported. There is no reason that a

similar occurrence for a gain should not also be reported. Accountants should report what has happened during the accounting period in an unbiased objective way. Gains happen as well as losses. If they are not also reported, the reporting of gains and losses in the income statement will not be what it purports to be.

c. No. Physical capital maintenance implies that earnings occur when the physical capacity

exclusive of owner transactions increases during the accounting period. Physical capital is the replacement cost of a companys net assets. Replacement cost can increase or decrease. Such a concept of earnings would recognize increases and decreases in current value (gains and losses) during the accounting. However, these changes would be considered capital maintenance adjustments, rather than earnings adjustments. Physical capital maintenance matches current cost with current period revenues. Holding gains and losses would be excluded from the income statement.

d. Yes and no. Financial capital maintenance basically accommodates any measure of asset value, whether or not conservative. Whatever measurements are used, changes in assets and liabilities would flow through the income statement. Nevertheless, an argument could be made that financial capital is maintained only if the measurements reflect the purchasing power of dollars invested in the company. If so, measures based on price level changes, specific or general could arguably be preferred to historical cost. If so, gains and losses should both be recognized.

FASB ASC 5-1 Revenue Recognition A search for revenue recognition resulted in 96 different places in the FASB ASC where revenue recognition is discussed. FASB ASC 5-2 Recognition of Franchise Fee Revenue Accounting for franchise fee revenue is found at FASB ASC 952-605-25. It is found by searching franchise fee revenue. The students answers should incorporate the following:

> Initial Franchise Fees

> > Individual Franchise Sales

952-605-25-1 Franchise fee revenue from an individual franchise sale shall be recognized, with an appropriate provision for estimated uncollectible amounts, when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor.

952-605-25-2 Substantial performance for the franchisor means that all of the following conditions have been met:

a. The franchisor has no remaining obligation or intentby agreement, trade practice, or lawto refund any cash received or forgive any unpaid notes or receivables.

b. Substantially all of the initial services of the franchisor required by the franchise agreement have been performed.

c. No other material conditions or obligations related to the determination of substantial performance exist.

952-605-25-3 If the franchise agreement does not require the franchisor to perform initial services but a practice of voluntarily rendering initial services exists or is likely to exist because of business or regulatory circumstances, substantial performance shall not be assumed until either the initial services have been substantially performed or reasonable assurance exists that the services will not be performed. The commencement of operations by the franchisee shall be presumed to be the earliest point at which substantial performance has occurred, unless it can be demonstrated that substantial performance of all obligations, including services rendered voluntarily, has occurred before that time.

952-605-25-4 Sometimes, large initial franchise fees are required but continuing franchise fees are small in relation to future services. If it is probable that the continuing fee will not cover the cost of the continuing services to be provided by the franchisor and a reasonable profit on those continuing services, then a portion of the initial franchise fee shall be deferred and amortized over the life of the franchise. The portion deferred shall be an amount sufficient to cover the estimated cost in excess of continuing franchise fees and provide a reasonable profit on the continuing services.

> > Area Franchise Sales

952-605-25-5 Initial franchise fees relating to area franchise sales shall be accounted for following the same principles described in paragraphs 952-605-25-1 through 25-4 for individual franchise sales, that is, revenue ordinarily shall be recognized when all material services or conditions relating to the sale(s) have been substantially performed or satisfied by the franchisor. If the franchisor's substantial obligations under the franchise agreement relate to the area franchise and do not depend significantly on the number of individual franchises to be established, substantial performance shall be determined using the same criteria applicable to individual franchises (see paragraph 952-605-25-1). However, if the franchisor's substantial obligations depend on the number of individual franchises established within the area, area franchise fees shall be recognized in proportion to the initial mandatory services provided. Revenue that may have to be refunded because future services are not performed shall not be recognized by the franchisor until the franchisee has no right to receive a refund.

952-605-25-6 The substance of an area franchise agreement shall determine when material services or conditions relating to a sale have been substantially performed or satisfied.

Sometimes, the efforts and total cost relating to initial services are not affected significantly by the number of outlets opened in an area and, therefore, the area franchise sale is similar to an individual franchise sale. Conversely, when the efforts and total cost relating to initial services are affected significantly by the number of outlets opened in an area, it may be necessary to regard the franchise agreement as a divisible contract and to estimate the number of outlets involved so that revenue may be recognized in proportion to the outlets for which the required services have been substantially performed. Estimates shall consider the anticipated number of outlets based on the terms of the franchise agreement (for example, time limitations and any specified minimum or maximum number of outlets). Any change in estimate resulting from a change in circumstance shall result in recognizing remaining fees as revenue in proportion to remaining services to be performed.

> > Collectibility of Franchise Fees

952-605-25-7 Installment or cost recovery accounting methods (see paragraphs 605-10-25-3 through 25-5) shall be used to account for franchise fee revenue only in those exceptional cases when revenue is collectible over an extended period and no reasonable basis exists for estimating collectibility.

> Relationship Between Franchisor and Franchisee

> > Franchisor Guarantees Borrowing of a Franchisee

952-605-25-8 A franchisor may guarantee borrowings of a franchisee, have a creditor interest in the franchisee, or control a franchisee's operations by sales or other agreements to such an extent that the franchisee is, for all practical purposes, an affiliate of the franchisor. Sometimes, two franchisors may agree to pool their risks by selling their respective franchises to each other. In all those circumstances, revenue shall not be recognized if all material services, conditions, or obligations relating to the sale have not been substantially performed or satisfied (see paragraph 952-605-25-1).

> > Franchisor Option to Purchase Franchisee's Business

952-605-25-9 A franchise agreement may give the franchisor an option to purchase the franchisee's business. For example, a franchisor may purchase a profitable franchised outlet as a matter of management policy, or purchase a franchised outlet that is in financial difficulty or unable to continue in business to preserve the reputation and goodwill of the franchise system. If such an option exists, the likelihood of the franchisor's acquiring the franchised outlet shall be considered in accounting for the initial franchise fee. If at the time the option is given, an understanding exists that the option will be exercised or it is probable that the franchisor ultimately will acquire the franchised outlet, the initial franchise fee shall not be recognized as revenue but shall be deferred. When the option is exercised, the deferred amount shall reduce the franchisor's investment in the outlet.

> Commingled Revenue

> > Tangible Property Provided to the Franchisee

952-605-25-10 The franchise agreement ordinarily establishes a single initial franchise fee as consideration for the franchise rights and the initial services to be performed by the franchisor.

Sometimes, however, the fee also may cover tangible property, such as signs, equipment, inventory, and land and building. In those circumstances, the portion of the fee applicable to the tangible assets shall be based on the fair value of the assets and may be recognized before or after recognizing the portion applicable to the initial services. For example, when the portion of the fee relating to the sale of specific tangible assets is objectively determinable, it would be appropriate to recognize that portion when their titles pass, even though the balance of the fee relating to services is recognized when the remaining services or conditions in the franchise agreement have been substantially performed or satisfied.

> > Services Provided to the Franchisee

952-605-25-11 Although a franchise agreement may specify portions of the total fee that relate to specific services to be provided by the franchisor, the services usually are interrelated to such an extent that the amount applicable to each service cannot be segregated objectively. The fee shall not be allocated among the different services as a means of recognizing any part of the fee for services as revenue before all the services have been substantially performed unless actual transaction prices are available for individual services; for example, through recent sales of the separate specific services.

> Continuing Franchise Fees

952-605-25-12 Continuing franchise fees shall be reported as revenue as the fees are earned and become receivable from the franchisee. For guidance on related franchise costs, see Subtopic 952-720.

952-605-25-13 Although a portion of the continuing fee may be designated for a particular purpose, such as an advertising program, it shall not be recognized as revenue until the fee is earned and becomes receivable from the franchisee. An exception to the foregoing exists if the franchise constitutes an agency relationship under which a designated portion of the continuing fee is required to be segregated and used for a specified purpose. In that case, the designated amount shall be recorded as a liability against which the specified costs would be charged.

> Continuing Product Sales

952-605-25-14 The franchisee may purchase some or all of the equipment or supplies necessary for its operations from the franchisor. Sometimes, the franchisee is given the right to make bargain purchases of equipment or supplies for a specified period or up to a specified amount, when the initial franchise fee is paid. If the bargain price is lower than the selling price of the same product to other customers or if the price does not provide the franchisor a reasonable profit on the equipment or supply sales, then a portion of the initial franchise fee shall be deferred and accounted for as an adjustment of the selling price when the franchisee purchases the equipment or supplies.

952-605-25-15 The portion deferred shall be either of the following:

a. The difference between the selling price to other customers and the bargain purchase price

b. An amount sufficient to cover any cost in excess of the bargain purchase price and provide a reasonable profit on the sale, as appropriate.

> Agency Sales

952-605-25-16 Some franchisors engage in transactions in which they are, in substance, an agent for franchisees by placing orders for inventory and equipment and selling to franchisees at no profit. The franchisor shall account for such transactions as receivables and payables in its balance sheet and not as revenue and costs or expenses. See Section 605-45-55 for a discussion relating to reporting revenue gross as a principal versus net as an agent.

> Repossession of Franchise Rights

952-605-25-17 If franchise rights are repossessed but no refund is made, any consideration retained for which revenue was not previously recognized shall be reported as revenue.

FASB ASC 5-3 Real Estate Sales The answer is found at FASB ASC 360-20-40-3 and FASB ASC 360-20-40-27 and can be found by searching for real estate sales. The students answers should incorporate the following: > Criteria for Recognizing Profit on Sales of Real Estate Under Full Accrual Method 40-3 Profit shall be recognized in full when real estate is sold, provided that both of the following conditions are met:

a. The profit is determinable, that is, the collectibility of the sales price is reasonably assured or the amount that will not be collectible can be estimated.

b. The earnings process is virtually complete, that is, the seller is not obliged to perform significant activities after the sale to earn the profit.

Unless both conditions exist, recognition of all or part of the profit shall be postponed. Recognition of all of the profit at the time of sale or at some later date when both conditions exist is referred to as the full accrual method in this Subtopic. 40-4 In accounting for sales of real estate, collectibility of the sales price is demonstrated by the buyer's commitment to pay, which in turn is supported by substantial initial and continuing investments that give the buyer a stake in the property sufficient that the risk of loss through default motivates the buyer to honor its obligation to the seller. Collectibility shall also be assessed by considering factors such as the credit standing of the buyer, age and location of the property, and adequacy of cash flow from the property. 40-5Profit on real estate sales transactions shall not be recognized by the full accrual method until all of the following criteria are met:

a. A sale is consummated (see the following paragraph).

b. The buyer's initial and continuing investments are adequate to demonstrate a commitment to pay for the property (see paragraphs 360-20-40-9 through 40-24).

c. The seller's receivable is not subject to future subordination (see paragraph 360-20-40-25).

d. The seller has transferred to the buyer the usual risks and rewards of ownership in a transaction that is in substance a sale and does not have a substantial continuing involvement with the property (see paragraph 360-20-40-26).

Profit on a sale of a partial interest in real estate shall be subject to the same criteria for profit recognition as a sale of a whole interest. Recognition of Profit when the Full Accrual Method Is Not Appropriate 40-27 If a real estate sales transaction does not satisfy the criteria in paragraphs 360-20-40-3 through 40-26 for recognition of profit by the full accrual method, the transaction shall be accounted for as specified in paragraphs 360-20-40-28 through 40-64. > > Sale Not Consummated 40-28 The deposit method of accounting described in paragraphs 360-20-55-17 through 55-20 shall be used until a sale has been consummated (see paragraph 360-20-40-7). Consummation usually requires that all conditions precedent to closing have been performed, including that the building be certified for occupancy. However, because of the length of the construction period of office buildings, apartments, condominiums, shopping centers, and similar structures, such sales and the related income may be recognized during the process of construction, subject to the criteria in paragraphs 360-20-40-61 through 40-63, even though a certificate of occupancy, which is a condition precedent to closing, has not been obtained. 40-29If the net carrying amount of the property exceeds the sum of the deposit received, the fair value of the unrecorded note receivable, and the debt assumed by the buyer, the seller shall recognize the loss at the date the agreement to sell is signed. If a buyer defaults, or if circumstances after the transaction indicate that it is probable the buyer will default and the property will revert to the seller, the seller shall evaluate whether the circumstances indicate a decline in the value of the property for which an allowance for loss should be provided. 40-30Paragraph 970-360-35-3 specifies the accounting for property that is substantially completed and that is to be sold. > > Buyer's Initial or Continuing Investments Do Not Qualify 40-31 If the buyer's initial investment does not meet the criteria specified in paragraphs 360-20-40-9 through 40-18 for recognition of profit by the full accrual method and if recovery of the cost of the property is reasonably assured if the buyer defaults, the installment method described in paragraphs 360-20-55-7 through 55-12 shall be used. If recovery of the cost of the property is not reasonably assured if the buyer defaults or if cost has already been recovered and collection of additional amounts is uncertain, the cost recovery method (described in paragraphs 360-20-55-13 through 55-15) or the deposit method (described in paragraphs 360-20-55-17 through 55-20) shall be used. The cost recovery method may be used to account for sales of real estate for which the installment method would be appropriate. 40-32 Under the installment, cost recovery, and reduced-profit recognition methods, debt incurred by the buyer that is secured by the property, whether incurred directly from the seller or other parties or indirectly through assumption, and payments to the seller from the proceeds of such indebtedness shall not be considered buyer's cash payments. However, if the profit deferred under the applicable method exceeds the outstanding amount of seller financing and the outstanding amount of buyer's debt secured by the property for which the seller is contingently liable, the seller shall recognize the excess in income. FASB ASC 5-4 Current Value Search current value

274 Personal Financial Statements 10 Overall 05 Background

05-1 This Subtopic addresses personal financial statements. Personal financial statements are prepared for individuals either to formally organize and plan their financial affairs in general or for specific purposes, such as obtaining of credit, income tax planning, retirement planning, gift and estate planning, or public disclosure of their financial affairs. Users of personal financial statements rely on them in determining whether to grant credit, in assessing the financial activities of individuals, in assessing the financial affairs of public officials and candidates for public office, and for similar purposes. > Basis of Presentation of Personal Financial Statements 05-2 The primary focus of personal financial statements is a person's assets and liabilities, and the primary users of personal financial statements normally consider estimated current value information to be more relevant for their decisions than historical cost information. Lenders require estimated current value information to assess collateral, and most personal loan applications require estimated current value information. Estimated current values are required for estate, gift, and income tax planning, and estimated current value information about assets is often required in federal and state filings of candidates for public office. FASB ASC 5-5 Accounting for Inflation Search inflation 255 Changing Prices10 Overall

255-10-05 Overview and Background

General

05-1 The Changing Prices Topic provides guidance on reporting the effects of changing prices, or inflation, on financial statements of business entities. The reporting addresses both general inflation and price changes of certain assets.

255-10-15 Scope and Scope Exceptions General

> Overall Guidance 15-1 The Scope Section of the Overall Subtopic establishes the pervasive scope for the Changing Prices Topic. > Entities 15-2 The guidance in the Changing Prices Topic applies to the following entities:

a. Business entities that prepare their financial statements in U.S. dollars and in accordance with U.S. generally accepted accounting principles (GAAP)

b. Foreign entities that prepare financial statements in the currency of the country in which the operations reported on are conducted and that operate in countries with hyperinflationary economies.

255-10-30 Initial Measurement

General

30-1 This Subtopic provides guidance on encouraged disclosures on the effects of changing prices. For that reason, the guidance that describes how to measure items provided in the disclosures is included in paragraphs 255-10-50-19 through 50-55 rather than this Section.

255-10-35 Subsequent Measurement

General

35-1 This Subtopic provides guidance on encouraged disclosures on the effects of changing prices. For that reason, the guidance that describes how to measure items provided in the disclosures is included in paragraphs 255-10-50-19 through 50-55 rather than this Section.

255-10-45 Other Presentation Matters

General

45-1 This Subtopic provides guidance on encouraged disclosures on the effects of changing prices. For that reason, the guidance that describes how to present the disclosures is included in Section 255-10-50 rather than this Section. > Price-Level Adjusted Financial Statements for Certain Entities in Highly Inflationary Economies 45-2 The degree of inflation or deflation in an economy may become so great that conventional statements lose much of their significance and general price-level statements clearly become more meaningful. Although this is obvious with respect to some countries, the degree of inflation or deflation at which general price level statements clearly become more meaningful depends on the circumstances. 45-3 This Subtopic permits a comprehensive application of price-level adjusted financial statements (to the extent such presentation is not inconsistent with guidance in this Subtopic regarding historical cost-constant purchasing power accounting, such as the classification of assets and liabilities as monetary or nonmonetary) in presenting the basic foreign currency financial statements of entities operating in countries with highly inflationary economies if the statements are intended for readers in the United States. 45-4 This guidance applies only to statements prepared in the currency of the country in which the operations reported on are conducted. Only conventional statements of foreign subsidiaries should be used to prepare historical-dollar consolidated statements.

255-10-50 Disclosure General > Introduction 50-1 A business entity that prepares its financial statements in U.S. dollars and in accordance with U.S. generally accepted accounting principles (GAAP) is encouraged, but not required, to disclose supplementary information on the effects of changing prices. Entities are not discouraged from experimenting with other forms of disclosure.

> Presentation 50-2 This Subtopic provides guidance on those encouraged disclosures. For that reason, the guidance that describes how to present the disclosures is included in this Section rather than Section 2501045. > > Five-Year Summary of Selected Financial Data 50-3 An entity shall disclose all of the following information for each of the five most recent years:

a. Net sales and other operating revenues b. Income from continuing operations on a current cost basis c. Purchasing power gain or loss on net monetary items d. Increase or decrease in the current cost or lower recoverable amount of inventory and property, plant, and equipment, net of inflation e. The aggregate foreign currency translation adjustment on a current cost basis, if applicable f. Net assets at year-end on a current cost basis g. Income per common share from continuing operations on a current cost basis h. Cash dividends declared per common share i. Market price per common share at year-end.

50-4 For the purposes of this Subtopic, except where otherwise provided, inventory and property, plant, and equipment shall include land and other natural resources and capitalized leasehold interests but not goodwill or other intangible assets. 50-5 An entity that presents consolidated financial statements shall present the information required by this Subtopic on the same consolidated basis. The information required by this Subtopic need not be presented for a parent company, an investee company, or other entity in a financial report that includes the results for that entity in consolidated financial statements. 50-6 The information required by this Subtopic shall be presented as supplementary information in any published annual report that contains the primary financial statements of the entity except that the information need not be presented in an interim financial report. The information required by this Subtopic need not be presented for segments of a business entity although such presentations are encouraged. 50-7 The information presented in the five-year summary shall be stated as either of the following:

a. In average-for-the-year or end-of-year units of constant purchasing power

b. In dollars having a purchasing power equal to that of dollars of the base period used by the Bureau of Labor Statistics in calculating the Consumer Price Index for All Urban Consumers. As a practical matter, this option is not available to entities that measure a significant part of their operations in one or more functional currencies other than the U.S. dollar and that elect to use the restate-translate method for measuring inflation-adjusted current cost information.

50-8 An entity shall disclose the level of the Consumer Price Index for All Urban Consumers used for each of the five most recent years. If the level of the Consumer Price Index at the end of the year and the data required to compute the average level of the index over the year have not been published in time for preparation of the annual report, they may be estimated by referring to published forecasts based on economic statistics or by extrapolation based on recently reported changes in the index. 50-9 If the entity has a significant foreign operation measured in a functional currency other than the U.S. dollar, it shall disclose whether adjustments to the current cost information to reflect

the effects of general inflation are based on the Consumer Price Index for All Urban Consumers (the translate-restate method) or on a functional currency general price level index (the restate-translate method). 50-10 The entity shall provide an explanation of the disclosures required by this Subtopic and a discussion of their significance in the circumstances of the entity. Disclosure and discussion of additional information to help users of the financial report understand the effects of changing prices on the activities of the entity are encouraged. > > Additional Disclosures for the Current Year 50-11 In addition to the information required by paragraphs 255-10-50-3 through 50-10, an entity shall provide the information specified in paragraphs 255-10-50-12 through 50-16 if income from continuing operations on a current cost-constant purchasing power basis would differ significantly from income from continuing operations in the primary financial statements. 50-12 An entity shall disclose certain components of income from continuing operations for the current year on a current cost basis (see paragraphs 255-10-50-39 through 50-41), applying the same constant purchasing power option used for presentation of the five-year summary. The information may be presented in any of the following formats:

a. In a statement format (disclosing revenues, expenses, gains, and losses)

b. In a reconciliation format (disclosing adjustments to the income from continuing operations that is shown in the primary income statement)

c. In notes to the five-year summary required by paragraph 255-10-50-3.

50-13 Formats for presenting the supplementary information are illustrated in Example 1 (see paragraphs 255-10-55-14 through 55-21). Whichever format is used, the presentation shall disclose (for example, in a reconciliation format) or allow the reader to determine (for example, in a statement format) the difference between the amount in the primary statements and the current cost amount of all of the following items:

a. Cost of goods sold and depreciation

b. Depletion

c. Amortization expense.

50-14 If depreciation has been allocated among various expense categories in the supplementary computations of income from continuing operations (for example, among cost of goods sold and other functional expenses), the aggregate amount of depreciation on a current cost basis shall be included in the notes to the supplementary information. In addition to information about income from continuing operations, the entity may include the following items in a schedule of current year information:

a. The purchasing power gain or loss on net monetary items

b. The increase or decrease in the current cost or lower recoverable amount of inventory and property, plant, and equipment, net of inflation

c. The translation adjustment.

50-15 As illustrated in Example 1 (see paragraphs 255-10-55-14 through 55-21, income from continuing operations does not include the information that is described in paragraph 255-10-50-14(a) through 50-14(c). 50-16 An entity shall also disclose all of the following:

a. Separate amounts for the current cost or lower recoverable amount at the end of the current year of inventory and property, plant, and equipment (see paragraphs 255-10-50-20 through 50-33 and 255-10-50-36 through 50-38)

b. The increase or decrease in current cost or lower recoverable amount before and after adjusting for the effects of inflation of inventory and property, plant, and equipment for the current year (see paragraphs 255-10-50-42 through 50-43})

c. The principal types of information used to calculate the current cost of inventory; property, plant, and equipment; cost of goods sold; and depreciation, depletion, and amortization expense (see paragraphs 255-10-50-24 through 50-33)

d. Any differences between:

1. The depreciation methods, estimates of useful lives, and salvage values of assets used for calculations of current cost-constant purchasing power depreciation

2. The methods and estimates used for calculations of depreciation in the primary financial statements (see paragraph 255-10-50-29 ).

FASB ASC 5-6 Revenue and Gains Use revenue link 605-10-25 Recognition Revenue and Gains 25-1 The recognition of revenue and gains of an entity during a period involves consideration of the following two factors, with sometimes one and sometimes the other being the more important consideration:

a. Being realized or realizable. Revenue and gains generally are not recognized until realized or realizable. Paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. That paragraph states that revenue and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash.

b. Being earned. Paragraph 83(b) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue is not recognized until earned. That paragraph states that an entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. That paragraph states that gains commonly

result from transactions and other events that involve no earning process, and for recognizing gains, being earned is generally less significant than being realized or realizable.

25-2 See paragraphs 605-10-25-3 through 25-4 for the limited circumstances in which revenue and gains may be recognized using the installment or cost-recovery methods. FASB ASC 5-7 Accounting for Long-term Construction Contracts

Search percentage of completion

605 Revenue Recognition 35 Construction-Type and Production-Type Contracts\

605-35-05 Overview and Background General

05-1 This Subtopic provides guidance on the accounting for the performance of contracts for which specifications are provided by the customer for the construction of facilities or the production of goods or for the provision of related services. 05-2 Contracts consist of legally enforceable agreements in any form and include amendments, revisions, and extensions of such agreements. Performance will often extend over long periods, and the seller's right to receive payment depends on the seller's performance in accordance with the agreement. The service may consist of designing, engineering, fabricating, constructing, or manufacturing related to the construction or the production of tangible assets. 05-3 The problems in accounting for construction-type contracts arise particularly in connection with long-term contracts as compared with those requiring relatively short periods for completion. 05-4 The determination of the point or points at which revenue shall be recognized as earned and costs shall be recognized as expenses is a major accounting issue common to all business entities engaged in the performance of contracts of the types covered by this Subtopic. Accounting for such contracts is essentially a process of measuring the results of relatively long-term events and allocating those results to relatively short-term accounting periods. This involves considerable use of estimates in determining revenues, costs, and profits and in assigning the amounts to accounting periods. The process is complicated by the need to evaluate continually the uncertainties inherent in the performance of contracts and by the need to rely on estimates of revenues, costs, and the extent of progress toward completion. 05-5 Two accounting methods commonly followed by contractors are the percentage-of-completion method and the completed-contract method. The two methods should be used in specified circumstances and should not be used as acceptable alternatives for the same circumstances. Accordingly, identifying the circumstances in which either of the methods is preferable and the accounting that should be followed in the application of those methods are among the primary objectives of this Subtopic. 05-6 The use of either of the two generally accepted methods involves, to a greater or lesser extent, the following three key areas of estimates and uncertainties:

a. The extent of progress toward completion b. Contract revenues c. Contract costs.

> Percentage-of-Completion Method

05-7 The principal advantages of the percentage-of-completion method are periodic recognition of income currently rather than irregularly as contracts are completed, and the reflection of the status of the uncompleted contracts provided through the current estimates of costs to complete or of progress toward completion. The principal disadvantage of the percentage-of-completion method is that it is necessarily dependent on estimates of ultimate costs and consequently of currently accruing income, which are subject to the uncertainties frequently inherent in long-term contracts. 05-8 Under most contracts for construction of facilities, production of goods, or provision of related services to a buyer's specifications, both the buyer and the seller (contractor) obtain enforceable rights. The legal right of the buyer to require specific performance of the contract means that the contractor has, in effect, agreed to sell his rights to work-in-progress as the work progresses. Furthermore, the contractor has the right to require the buyer, under most financing arrangements, to make progress payments to support the buyer's ownership investment and to approve the facilities constructed (or goods produced or services performed) to date if they meet the contract requirements. 05-9 Also, under most contracts for the production of goods and the provision of related services that are accounted for on the basis of units delivered, both the contractor and the customer obtain enforceable rights as the goods are produced or the services are performed. As units are delivered, title to and the risk of loss on those units normally transfer to the customer, whose acceptance of the items indicates that they meet the contractual specifications. For such contracts, delivery and acceptance are objective measurements of the extent to which the contracts have been performed. The percentage-of-completion method recognizes the legal and economic results of contract performance on a timely basis. 05-10 Financial statements based on the percentage-of-completion method present the economic substance of an entity's transactions and events more clearly and more timely than financial statements based on the completed-contract method, and they present more accurately the relationships between gross profit from contracts and related period costs. The percentage-of-completion method informs the users of the general purpose financial statements of the volume of economic activity of an entity. 05-11 Paragraph 605-35-25-56 explains that the use of the percentage-of-completion method depends on the ability to make reasonably dependable estimates, which, for purposes of this Subtopic, relates to estimates of the extent of progress toward completion, contract revenues, and contract costs. > Completed-Contract Method 05-12 The principal advantage of the completed-contract method is that it is based on results as finally determined, rather than on estimates for unperformed work that may involve unforeseen costs and possible losses. The principal disadvantage of the completed-contract method is that it does not reflect current performance when the period of any contract extends into more than one accounting period and under such circumstances it may result in irregular recognition of income. FASB ASC 5-8 Use of the Installment and Cost Recovery Methods

Search installment method.

605-10-25-3 > Installment and Cost Recovery Methods of Revenue Recognition

25-3 Revenue should ordinarily be accounted for at the time a transaction is completed, with appropriate provision for uncollectible accounts. Paragraph 605-10-25-1(a) states that revenue and gains generally are not recognized until being realized or realizable and until earned. Accordingly, unless the circumstances are such that the collection of the sale price is not reasonably assured, the installment method of recognizing revenue is not acceptable. 25-4 There may be exceptional cases where receivables are collectible over an extended period of time and, because of the terms of the transactions or other conditions, there is no reasonable basis for estimating the degree of collectibility. When such circumstances exist, and as long as they exist, either the installment method or the cost recovery method of accounting may be used. As defined in paragraph 360-20-55-7 through 55-9, the installment method apportions collections received between cost recovered and profit. The apportionment is in the same ratio as total cost and total profit bear to the sales value. Under the cost recovery method, equal amounts of revenue and expense are recognized as collections are made until all costs have been recovered, postponing any recognition of profit until that time.) 25-5 In the absence of the circumstances referred to in this Subtopic or other guidance, such as that in Sections 360-20-40 and 360-20-55, the installment method is not acceptable. FASB ASC 5-9 Matching Search matching - 31 hits FASB ASC 5-10 Conservatism Search conservatism 852 Reorganizations > 20 Quasi-Reorganizations > 30 Initial Measurement 30-1 This Section provides guidance on the adjustment of accounts required by paragraph 852-20-25-3 as of the readjustment date in connection with the readjustments addressed by this Subtopic. 30-2 A write-down of assets below amounts that are likely to be subsequently realized, though it may result in conservatism in the balance sheet at the readjustment date, may also result in overstatement of earnings or of retained earnings when the assets are subsequently realized. Therefore, in general, assets shall be carried forward as of the date of readjustment at fair and not unduly conservative amounts, determined with due regard for the accounting to be subsequently employed by the entity. 30-3 If the fair value of any asset is not readily determinable a conservative estimate may be made, but in that case the amount shall be described as an estimate. Paragraph 852-20-35-2 describes the subsequent accounting for any material difference arising through realization or otherwise and not attributable to events occurring or circumstances arising after that date. 30-4 Similarly, if potential losses or charges are known to have arisen before the date of readjustment but such amounts are then indeterminate, provision may properly be made to cover the maximum probable losses or charges. FASB ASC 5-11 Materiality Search materiality - 19 hits Room for Debate Debate 5-1

Team 1 Arguments in favor of the physical capital maintenance concept 1. The concept of physical capital maintenance is concerned with maintaining productive

capacity. Productive capacity is provided by the companys assets, and capital is defined as the operating assets of the entity. Assets must eventually be replaced in order to maintain the current level of productive capacity. Hence, measurement of assets at their replacement cost is consistent with this theory.

2. Under the physical capital maintenance concept current period revenues are matched with

the current cost of the assets used to generate the revenue. The resulting periodic income is referred to as distributable or sustainable income because as a result of calculating depreciation and cost of goods sold based on their replacement cost, net income reflects the amount that can be distributed to stockholders without impairing the productive capacity of the entity. Thus, income is not recognized until provision has been made to replace these assets.

Most going concerns expect to operate in the future at a rate of physical activity equal to the current level.. Hence, periodic income should not be recognized until provision has been made to maintain the physical plant at the current level.

3. The major strength of the physical capital maintenance concept is based on the notion

that an increase in enterprise wealth as a result of price changes is excluded from income. According to SFAC No. 5, holding gains and losses are treated as adjustments to equity rather than income. Thus, the concept recognizes that long-run survival of the entity is dependent upon its ability to generate enough income to replace the productive capacity of its existing assets.

4. Another strength of the physical capital maintenance concept is that it provides insight

regarding the amount of dividends that may be paid to investors without impairing the entitys ability to replace existing assets.

5. The concept recognizes that fact that enterprises attempt to maintain share prices by

maintaining operating flows. Presumably by maintaining a given level of operating capacity, the ability to maintain operating flows is greatly enhanced.

Team 2 Arguments in favor of the financial capital maintenance concept. 1. Capital, under the financial capital maintenance concept is defined as the monetary

values of assets contributed by owners at the time they were contributed. This is the traditional, dominant view of capital maintenance in accounting. The primary emphasis of the financial capital maintenance concept is on the exchange transaction and events that affect the operations and status of the business entity. Hence, most of the information that would be provided under this concept is derived from actual experiences and is thus historical in nature.

2. Under the financial capital maintenance concept, income results from matching revenues

with the cost of generating revenues. Revenues are recognized by applying the realization principle. Accordingly, they are recognized when the earnings process is complete or virtually complete and when an exchange (transactions with customers) has taken place. Costs are matched directly with revenues (e.g., cost of goods sold), directly

with the period in which revenues occurred (e.g., utility bills), and allocated to periods in which revenue is generated (e.g., depreciation).

3. The financial capital maintenance concept presumes that historical cost is the significant

and relevant measurement approach. The major strength of this concept is that it is generally understood by users. According to SFAC No. 2, understandability is a desirable of useful accounting information.

4. Historical cost is objective and provides neutral, unbiased measures of the results of

financial transactions and events. Because it is transactions based, the measurements are verifiable and the approach is relatively easy to apply in practice. Moreover, since revenues are not recognized until realized, the financial capital maintenance concept is conservative.

5. Because adjustments are not made to historical cost for changes in the price level,

financial transactions are reported in terms of dollars invested by stockholders. Hence, the concept of financial capital maintenance enables accountants to fulfill their stewardship role to owners.

Debate 5-2 Team 1 Argue in favor of the economists view of income Economists generally agree that the objective of measuring income is to determine how much better off a company has become during the accounting period. This view of income is consistent with the notion of real income, or increases in economic wealth. Under this view, a company has income if it is better off at the end of the accounting period than at the beginning of the period and the increase is wealth is not due to investments by owners or distributions to owners. The amount of income during the period is equal to the maximum amount that could be distributed to owners and still leave the company as well off as it was in the beginning of the period. This notion is consistent with accounting for assets at current value. Economic income would take preservation of the physical plant into consideration, but would also adjust for changes in price levels. The difference between economic income and that derived from the physical capital maintenance concept is that economic income would include holding gains and losses, while physical capital maintenance income would not. According to SFAC No. 1, relevant information about an entity should provide predictive ability. Because current values represent the markets assessment of the value of assets and hence take into consideration the future cash flows that they would generate, income measurement utilizing current values should provide information relevant to predict future cash flows. The economic view of income is consistent with recognition of income during production. It is not based on the sale of the asset to customers. Instead it is presumed that the enterprise is in business to realize cash from the production of goods and the provision of services, but that the production process itself is earning the eventual cash inflow. Hence, revenue recognition is based on expectations regarding future events rather than on the transactions as they occur. By the same token, costs would be recognized as they are incurred, rather than be matched against revenue that is recognized in accordance with the realization principle. Team 2 Argue in favor of the accountants concept of income

Accountants feel that the elements of financial statements should be reported when there is evidence of an exchange. Revenue should be recognized only when it is earned. Accountants should not record revenue that is anticipated. Instead, the existence of revenue should be verified with evidence that an exchange has taken place. Income measurement should be based on matching efforts (costs) with accomplishments (revenues) that have actually occurred. The accountants concept of income is anchored on the historical cost model and is consistent with the concept of financial capital maintenance. See, Team 2 under Issue 1 for arguments favoring these concepts. Debate 5-3 Current value measures Team 1 The definition of an asset implies that assets are held to provide future benefits. A companys future benefits are derived from its use of assets held by it. Future benefit to a company would logically be related to expected future profits and the resultant future cash inflows. Thus, it is reasonable to assume that the measurement of assets should reflect those expectations. We argue that this goal is best met by reporting assets at current value, measured using exit prices. Current value embodies expectations regarding future earning power of net assets. Since assets are held because they provide future benefit, their measurement should be based on their current value in use that is, by entry values. An entry value is the current estimated fair market price of the asset. It is the cost that a company would incur to replace an existing asset (its replacement cost). According to Edwards and Bell, current entry prices allow the assessment of managerial decisions to hold assets by segregating current value income (holding gains and losses) from current operating income. Under the assumption that operations will continue, this dichotomy allows the long-run profitability of the enterprise to be assessed. The recurring and relatively controllable profits can be evaluated vis--vis those factors that affect operations over time but are beyond the control of management. Replacement cost provides a measure of the cost to replace the current operating capacity and, hence, a means of evaluating how much the firm can distribute to stockholders and still maintain its productive capacity. We do not believe that exit values provide appropriate asset measures because they measure what a company could receive if they sell the asset, not what the asset is worth to company while they keep it. Team 2 Since the company already owns the assets, it will not have to replace them. Hence, replacement cost is not relevant. We agree that the value of the asset should be tied to its expected benefit to the company. However, we believe that companies benefit by future cash flows that will result from the asset, not on cash flows to purchase assets already owned. According to Sterling, entry value is irrelevant to what could be realized upon sale of those assets and to their current purchase since they are already owned. Moreover, replacement cost does not measure the capacity to make decisions to buy, hold, or sell in the marketplace.

Chambers and Sterling contend that exit prices have decision relevance. Accordingly, during each accounting period, management decides whether to hold, sell, or replace the assets. It is argued that exit prices provide users with better information to evaluate liquidity and thus the ability of the enterprise to adapt to changing economic stimuli. Because management has the option of selling the asset, exit price provides a means of assessing downside risk. It measures the current sacrifice of holding the asset and thereby provides a guide for evaluating managements stewardship function. A recent FASB pronouncement agrees with Chambers and Sterling. SFAS No. 157 defines fair value as exit price. According to the pronouncement, 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. This definition emphasizes that fair value is market based rather than entity specific. To summarize, we believe that exit value captures the reasons why management buys, holds, and sells assets. It thus discloses the value of those assets to the entity, and thus is decision-relevant to financial statement users.