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CONTENTS
Chapter Title
Page
No.
Codification Taxonomy ..................................................................... xi
1 Researching GAAP Matters .............................................................. 1
2 Balance Sheet .................................................................................... 43
3 Statements of Income and Comprehensive Income .......................... 70
4 Statement of Cash Flows ................................................................... 107
5 Accounting Policies, Changes, and Restatements ............................. 124
6 Fair Value .......................................................................................... 157
7 Cash, Receivables, and Prepaid Expenses ......................................... 193
8 Short-Term Investments and Financial Instruments .......................... 246
9 Inventory ........................................................................................... 311
10 Revenue Recognition—Evolving Principles and Specialized
Applications ..................................................................................... 349
Revenue Recognition—General Principles ................................................. 350
Long-Term Construction Contracts ............................................................. 357
Service Revenues ......................................................................................... 371
Sales When Collection Is Uncertain ............................................................ 378
Revenue Recognition When Right of Return Exists ................................... 385
Profit Recognition on Real Estate Sales ..................................................... 388
Real Estate Operations ................................................................................. 409
Franchising: Accounting by Franchisors .................................................... 413
Other Special Accounting and Reporting Issues ......................................... 417
11 Long-Lived Assets ............................................................................ 427
12 Long-Term Investments .................................................................... 499
13 Business Combinations and Consolidated Financial Statements ...... 581
Appendix: Standards Applicable to Pre-2009 Business Combinations ...... 630
14 Current Liabilities and Contingencies ............................................... 718
15 Long-Term Liabilities ....................................................................... 739
16 Leases ................................................................................................ 786
17 Income Taxes .................................................................................... 862
18 Pensions and Other Postretirement Benefits ………………………... 935
19 Stockholders’ Equity ......................................................................... 984
Appendix A: Financial Statement Presentation .......................................... 1050
Chapter Title
Page
No.
20 Earnings Per Share ............................................................................ 1052
Appendix: Comprehensive Example .......................................................... 1078
21 Interim Reporting .............................................................................. 1081
22 Segment Reporting ............................................................................ 1094
23 Foreign Currency .............................................................................. 1105
Appendix: Accounts to Be Remeasured Using Historical Exchange
Rates ............................................................................................................ 1131
24 Personal Financial Statements ........................................................... 1132
Appendix: Hypothetical Set of Personal Financial Statements .................. 1137
25 Specialized Industry GAAP .............................................................. 1140
Banking and Thrift ....................................................................................... 1142
Broadcasting ................................................................................................. 1156
Cable Television ........................................................................................... 1161
Computer Software Developers ................................................................... 1163
Employee Benefit Plans, Including Pension Funds ..................................... 1172
Finance Companies ...................................................................................... 1180
Government Contractors .............................................................................. 1183
Insurance ...................................................................................................... 1185
Investment Companies ................................................................................. 1195
Mortgage Banking ........................................................................................ 1201
Motion Pictures ............................................................................................ 1207
Not-for-Profit Organizations ........................................................................ 1217
Oil and Gas Producers .................................................................................. 1231
Recording and Music ................................................................................... 1233
Regulated Operations ................................................................................... 1235
Title Plant ..................................................................................................... 1239
Appendix A: Disclosure Checklist ......................................................................... 1242
Appendix B: International vs. US Accounting Standards ....................................... 1297
Index ........................................................................................................................ 1317
PREFACE
GAAP 09: Codification Edition provides analytical explanations and copious illustrations
of all current generally accepted accounting principles. The book integrates principles
promulgated by all the relevant standard-setting bodies—the FASB, including its
Emerging Issues Task Force’s consensus summaries and discussion issues and staff
positions, and the AICPA’s Accounting Standards Executive Committee (AcSEC),
With the completion and public release of the FASB’s codification project, virtually all
extant U.S. GAAP has been superseded by a unified, codified set of standards. All such
guidance is now presented in a single, integrated set of materials, and former individual
standards, interpretations, and other requirements are to be withdrawn. This book represents
a complete integration of the new Accounting Standards Codification (ASC) references into
the Wiley GAAP reference work that is now in its 25th annual edition.
The principal intended audience for the book is the practitioner, with the primary
objective being to assist in resolving the myriad practical problems faced in applying GAAP.
Accordingly, meaningful, realistic examples abound, guiding users in the application of
GAAP to complex fact situations that must be dealt with in the real world practice of
accounting In addition to this emphasis, a major strength of the book is that it does explain
the theory of GAAP in sufficient detail to serve as a valuable adjunct to accounting
textbooks. Much more than merely a reiteration of currently promulgated GAAP, it provides
the user with the underlying conceptual bases for the rules, in order to facilitate the process
of reasoning by analogy that is so necessary in dealing with the complicated, fast-changing
world of commercial arrangements and transaction structures. It is based on the authors’
belief that proper application of GAAP demands an understanding of the logical
underpinnings of all its technical requirements.
Each chapter of this book, or major section thereof, provides an overview discussion of
the perspective and key issues associated with the topics covered; a listing of the professional
pronouncements which guide practice; and a detailed discussion of the concepts and the accompanying
examples. A comprehensive disclosure checklist, following the main text,
offers practical guidance to preparing financial statements in accordance with GAAP, with
supplemental insights into SEC-mandated disclosures as needed. Also included is a
comprehensive comparison of GAAP to International (IFRS) standards, increasingly the
norm for entities reporting outside the US, and soon, for U.S.-based entities as well.
The authors’ wish is that this book will serve preparers, practitioners, faculty, and
students, as a reliable reference tool to facilitate their understanding of, and ability to apply,
the complexities of the authoritative literature. Comments from readers, both as to errors and
omissions and as to proposed improvements for future editions, should be addressed to Barry
J. Epstein, c/o John Wiley & Sons, Inc., 155 N. 3rd Street, Suite 502, DeKalb, Illinois 60115.
Barry J. Epstein
Ralph Nach
Steven M. Bragg
March 1, 2009
ABOUT THE AUTHORS
Barry J. Epstein, PhD, CPA, is a partner with Chicago-based Russell Novak & Company,
LLP, where he specializes in technical consultation on accounting and auditing matters
and corporate governance, and maintains a national practice as a consulting and testifying
expert for commercial and other litigation matters, including accountants’ malpractice,
contractual dispute resolution, damages modeling, and white-collar criminal defense. He has
previously served in senior technical and litigation consulting positions with several regional
and national CPA firms, and as a corporate finance executive and college professor. Dr.
Epstein has authored or coauthored six books (including Wiley IFRS Interpretation and
Application), hundreds of professional education courses, several articles in business or
professional journals, and a weekly business column for an international newspaper. He has
served on several state and national technical committees, including the AICPA’s Board of
Examiners, served as chair of the Illinois CPA Society’s senior accounting technical
committee, and held teaching positions at several universities. Dr. Epstein received his
doctorate from the University of Pittsburgh, and also holds degrees from DePaul University
and the University of Chicago. He is a member of the Illinois CPA Society, the AICPA, and
the American Accounting Association.
Ralph Nach, CPA, is a Senior Consultant with AuditWatch, part of Thompson Reuters,
for which he writes, teaches, and consults on a wide range of accounting, auditing, and financial
reporting matters. He has been a practitioner for over thirty years, during which he
has served in capacities including accountant, auditor, quality control director, peer reviewer,
educator, chief learning officer, and consultant for several public accounting firms, including
Arthur Anderson LLP. Most recently Mr. Nach served as a partner in the National Office of
Audit and Accounting of McGladrey & Pullen, LLP. He is a former adjunct lecture in
graduate accounting and finance at Northwestern University in Evanston, Illinois. Mr. Nach
holds a BSBA with honors from the Walter E. Heller School of Business Administration of
Roosevelt University in Chicago, and is a licensed CPA in Illinois. Mr. Nach has coauthored
several other books and speaks nationally on accounting, auditing, and financial reporting
topics. He is a member of the American Institute of Certified Public Accountants, the Information
Systems Audit and Control Association (ISACA), the Illinois CPA Society, where he
has served as a chairman and/or member of numerous committees, and an associate member
of the Association of Certified Fraud Examiners.
Steven Bragg, CPA, CMA, CIA, CPIM, has been the chief financial officer or
controller of four companies, as well as a consulting manager at Ernst & Young and auditor
at Deloitte & Touche. He received a master’s degree in finance from Bentley College, an
MBA from Babson College, and a Bachelor’s degree in Economics from the University of
Maine. He is the author of 28 books, including Accounting Best Practices, The Ultimate
Accountants’ Reference, and Controllership. He has been the two-time president of the
Colorado Mountain Club. He resides with his wife and two daughters in Centennial,
Colorado. Sign up for his free accounting best practices newsletter at www.stevebragg.com.
CODIFICATION TAXONOMY
Topic # and title Subtopic # and title
I. General Principles and Objectives
105 Generally Accepted Accounting Principles
110 Conceptual Framework
II. Overall Financial Reporting, Presentation, and Display Matters
A. Overall Presentation of Financial Statements
205 Presentation of Financial Statements
205-20 Discontinued Operations
210 Balance Sheet
210-20 Offsetting
215 Statement of Shareholders’ Equity
220 Comprehensive Income
225 Income Statement
225-20 Extraordinary and Unusual Items
225-30 Business Interruption Insurance
(EITF 01-13)
230 Statement of Cash Flows
235 Notes to Financial Statements
B. Various Financial Reporting, Presentation, and Display Matters
250 Accounting Changes and Error Corrections
255 Changing Prices
260 Earnings Per Share
270 Interim Reporting
275 Risks and Uncertainties
280 Segment Reporting
III. Transaction-Related Topics
A. Financial Statement Accounts
305 Cash and Cash Equivalents
310 Receivables
310-20 Nonrefundable Fees and Other Costs
310-30 Loans and Debt Securities Acquired
with Deteriorated Credit Quality
310-40 Troubled Debt Restructurings by
Creditors
320 Investments—Debt and Equity Securities
323 Investments—Equity Method and Joint
Ventures
323-30 Partnerships and Unincorporated Joint
Ventures
325 Investments—Other
325-20 Cost Method Investments
325-30 Investments in Insurance Contracts
xii Wiley GAAP 2009 Codification Edition
Topic # and title Subtopic # and title
325-40 Beneficial Interests in Securitized
Financial Assets
330 Inventory
340 Deferred Costs and Other Assets
340-20 Capitalized Advertising Costs
340-30 Insurance Contracts That Do Not
Transfer Insurance Risk
350 Intangibles—Goodwill and Other
350-20 Goodwill
350-30 General Intangibles other than
Goodwill
350-40 Internal-Use Software
350-50 Web Site Development Costs
360 Property, Plant, and Equipment
360-20 Real Estate Sales
405 Liabilities
405-20 Extinguishment of Liabilities
405-30 Insurance-Related Assessments
410 Asset Retirement and Environmental
Obligations
410-20 Asset Retirement Obligations
410-30 Environmental Obligations
420 Exit or Disposal Cost Obligations
430 Deferred Revenue
440 Commitments
450 Contingencies
450-20 Loss Contingencies
450-30 Gain Contingencies
460 Guarantees
470 Debt
480 Distinguishing Liabilities from Equity
505 Equity
505-20 Stock Dividends and Stock Splits
505-30 Treasury Stock
505-40 Quasi Reorganizations
505-50 Equity-Based Payments to
Nonemployees
505-60 Spin-offs and Reverse Spin-offs
605 Revenue Recognition
605-15 Products
605-20 Services
605-25 Multiple-Element Arrangements
605-30 Rights to Use
605-35 Construction-Type and Production-
Type Contracts
605-40 Gains and Losses
605-45 Principal–Agent Considerations
605-50 Customer Payments and Incentives
705 Cost of Sales and Services
Codification Taxonomy xiii
Topic # and title Subtopic # and title
710 Compensation—General
712 Compensation—Nonretirement
Postemployment Benefits
715 Compensation—Retirement Benefits
715-20 Defined Benefit Plans-General
715-30 Defined Benefit Plans-Pensions
715-40 Defined Contribution Plans
715-50 Multiemployer Plans
715-60 Other Postretirement Benefit Plans
718 Compensation—Stock Compensation
718-20 Awards Classified as Equity
718-30 Awards Classified as Liabilities
718-40 Employee Stock Ownership Plans
718-50 Employee Stock Purchase Plans
720 Other Expenses
720-15 Start-Up Costs
720-20 Insurance Costs
720-25 Contributions Made
720-30 Real and Personal Property Taxes
720-35 Advertising Costs
720-40 Electronic Equipment Waste
Obligations
720-45 Business and Technology
Reengineering
730 Research and Development
730-20 Research and Development
Arrangements
740 Income Taxes
740-20 Intraperiod Tax Allocation
740-30 Other Considerations or Special Areas
B. Broad Transactional Categories
805 Business Combinations and Reorganizations
805-20 Reorganizations
805.xx Superseded by Bus. Comb. 2 Project
810 Consolidation
810-20 Control of Partnerships and Similar
Entities
815 Derivatives and Hedging
815-15 Embedded Derivatives
815-20 Hedging—General
815-25 Fair Value Hedges
815-30 Cash Flow Hedges
815-35 Net Investment Hedges
815-40 Contracts in Entity’s Own Equity
815-45 Weather Derivatives
820 Fair Value Measurements and Disclosures
825 Financial Instruments
825-20 Registration Payment Arrangements
830 Foreign Currency Matters
830-20 Translation of Transactions
xiv Wiley GAAP 2009 Codification Edition
Topic # and title Subtopic # and title
830-30 Translation of Financial Statements
835 Interest
835-20 Capitalization of Interest
835-30 Imputation of Interest
840 Leases
840-20 Operating Leases
840-30 Capital Leases
840-40 Sale-Leaseback Transactions
845 Nonmonetary Transactions
850 Related-Party Disclosures
855 Subsequent Events
860 Transfers and Servicing
860-20 Sales of Financial Assets
860-30 Secured Borrowings and Collateral
860-40 Transfers to Qualifying Special-
Purpose Entities
860-50 Servicing Assets and Liabilities
IV. Industry/Unique Topics
905 Agriculture
908 Airlines
910 Contractors—Construction
912 Contractors—Federal Government
915 Development Stage Entities
920 Entertainment—Broadcasters
922 Entertainment—Cable Television
924 Entertainment—Casinos
926 Entertainment—Films
928 Entertainment—Music
930 Extractive Activities—Mining
932 Extractive Activities—Oil and Gas
940 Financial Services—Brokers and Dealers
942 Financial Services—Depository and Lending
944 Financial Services—Insurance
946 Financial Services—Investment Companies
948 Financial Services—Mortgage Banking
950 Financial Services—Title Plant
952 Franchisors
954 Health Care Entities
956 Limited Liability Entities
958 Not-for-Profit Entities
960 Plan Accounting—Defined Benefit Pension
Plans
962 Plan Accounting—Defined Contribution
Pension Plans
965 Plan Accounting—Health and Welfare Benefit
Plans
970 Real Estate—General
972 Real Estate—Common Interest Realty
Associations
Codification Taxonomy xv
Topic # and title Subtopic # and title
974 Real Estate—Real Estate Investment Trusts
976 Real Estate—Retail Land
978 Real Estate—Time-Sharing Activities
980 Regulated Operations
985 Software
995 US Steamship Entities
V. Glossary
1 RESEARCHING GAAP MATTERS
Development of GAAP 1
What Is GAAP? 1
Who Created GAAP? 2
Committee on Accounting Procedure 2
Accounting Principles Board 2
Financial Accounting Standards Board 3
American Institute of Certified Public
Accountants (AICPA) 4
Emerging Issues Task Force (EITF) 5
Other sources 5
How Is GAAP Created? 6
The Hierarchy of GAAP 7
Materiality 10
The Crisis of Confidence Regarding
GAAP 12
The Sarbanes-Oxley Act of 2002 12
Principles-based standards 13
Standards overload 14
FASB initiatives 16
IASB initiatives 17
The AICPA and its diminished influence 17
Alleged harmful effects of standards 18
The Business Reporting Research
Project 19
Researching GAAP Problems 20
Research Procedures 20
Search Authoritative Literature
(Step 6)–Further Explanation 22
Researching authoritative sources of
GAAP 22
Research using Wiley GAAP Codification
Edition 23
Researching nonpromulgated GAAP 24
Internet-based research sources 25
Example of how to solve a GAAP
problem 26
The Conceptual Framework 28
Components of the conceptual framework
29
CON 1: Objectives of Financial Reporting
by Business Enterprises 30
CON 2: Qualitative Characteristics of
Accounting Information 31
Usefulness for decision making 31
Relevance 31
Reliability 32
Trade-offs 33
Constraints 33
Role of conservatism 33
CON 3: Elements of Financial Statements
of Business Enterprises 33
CON 5: Recognition and Measurement
in Financial Statements of Business
Enterprises 33
CON 6: Elements of Financial Statements
34
CON 7: Using Cash Flow Information
and Present Value in Accounting
Measurements 37
How CON 7 measures differ from currently
utilized present value techniques 37
Measuring liabilities 38
Interest method of allocation 38
Accounting for changes in expected cash
flows 38
Application of present value tables and
formulas 39
Example of the relevance of present values 40
Practical matters 40
Conducting Research through the
FASB Codification Web Site 41
DEVELOPMENT OF GAAP
What Is GAAP?
The phrase “generally accepted accounting principles” is a technical accounting term that
encompasses the conventions, rules, and procedures necessary to define accepted accounting
practice at a particular time. It includes not only broad guidelines of general application,
but also detailed practices and procedures. Those conventions, rules, and procedures
provide a standard by which to measure financial presentations. Auditing Standards Board
(ASB), AU Section 411
Generally accepted accounting principles (GAAP) are concerned with the measurement
of economic activity, the time when such measurements are to be made and recorded, the
disclosures surrounding this activity, and the preparation and presentation of summarized
2 Wiley GAAP 2009 Codification Edition
economic information in the form of financial statements. GAAP develops when questions
arise about how to best accomplish those objectives—measurement, timing of recognition,
disclosure, or presentation. In response to those questions, GAAP is either prescribed in official
pronouncements of authoritative bodies empowered to create it, or it originates over
time through the development of customary practices that evolve when authoritative bodies
fail to respond. Thus, GAAP is a reaction to and a product of the economic environment in
which it develops. As such, the development of accounting and financial reporting standards
has lagged the development and creation of increasingly intricate economic structures and
transactions.
There are two broad categories of accounting principles—recognition and disclosure.
Recognition principles determine the timing and measurement of items that enter the accounting
cycle and impact the financial statements. These are quantitative standards that
require economic information to be reflected numerically.
Disclosure principles deal with factors that are not always numeric. Disclosures involve
qualitative information that is an essential ingredient of a full set of financial statements.
Their absence would make the financial statements misleading by omitting information relevant
to the decision-making needs of the reader. Disclosure principles complement recognition
principles by explaining assumptions underlying the numerical information and providing
additional information on accounting policies, contingencies, uncertainties, etc., which
are essential to fully understand the performance and financial condition of the reporting
enterprise.
Who Created GAAP?
From time to time, the bodies given responsibility for the promulgation of GAAP have
changed, and indeed more than a single such body has often shared this responsibility.
GAAP established by all earlier standard-setting bodies, to the extent not withdrawn or superseded,
remains in effect at the present time. These bodies are described in the following
paragraphs.
Committee on Accounting Procedure. The first serious attempt to create formalized
generally accepted accounting principles began in 1930, primarily as a consequence of the
stock market crash of 1929 and the widespread perception that an absence of uniform and
stringent financial reporting requirements had contributed to the rampant stock market
speculation of the preceding decade that culminated with that crash. (Previously, GAAP had
largely been defined by academic writings and general industry practices.) The American
Institute of Accountants, (which in 1957 was renamed the American Institute of Certified
Public Accountants [AICPA]), created a special committee to work with the New York Stock
Exchange toward the goal of establishing standards for accounting procedures. The special
committee recommended five rules to the Exchange that were published in 1938 as Accounting
Research Bulletin (ARB) 1 of the Committee on Accounting Procedure. The
Committee subsequently published 51 such bulletins, including Accounting Research Bulletin
43, which consolidated and superseded Bulletins 142. The Committee also attempted to
achieve uniformity in accounting terminology. However, the Committee’s limited resources
and lack of serious research efforts in support of its pronouncements were questioned in the
late 1950s, particularly as a number of very complex controversial topics loomed on the
horizon.
Accounting Principles Board. The profession’s response was to substitute, under its
auspices, the Accounting Principles Board (APB) for the Committee on Accounting Procedure.
This was done to facilitate the development of principles, which were to be based primarily
on the research of a separate division of the AICPA, the Accounting Research Division.
Under this strategy, the Division was to undertake extensive research, publish its findChapter
1 / Researching GAAP Matters 3
ings, and then permit the Accounting Principles Board to take the lead in the discussions that
would ensue concerning accounting principles and practices. The Board’s authority was
enforced primarily through prestige and Rule 203 of the AICPA Code of Professional Conduct.
Furthermore, formal approval of Board issuances by the Securities and Exchange
Commission (SEC) gave additional support to its activities.
During the Board’s fourteen years of existence, it issued 31 authoritative opinions and 4
nonauthoritative statements. They dealt with amendments of Accounting Research Bulletins,
opinions on the form and content of financial statements, and issuances requiring changes in
both the recognition and disclosure principles of the profession. However, the Board did not
make use of the efforts of the Accounting Research Division, which published fifteen research
studies during its lifetime. Both the Board and the Division acted independently in
selecting topics for their respective agendas. The Board issued pronouncements in areas
where little research had been done, and the Division performed research studies without
seeking to be all-inclusive or exhaustive in analysis. The Accounting Principles Board did
not, ultimately, operate differently or more effectively than had the Committee on Accounting
Procedure.
Financial Accounting Standards Board. As a result of these operational problems, in
1971 the AICPA appointed the “Wheat Study Group” chaired by Francis M. Wheat, a former
SEC commissioner. The Wheat Study Group was charged with examining the standardsetting
process and making recommendations regarding the form and structure of the
standard-setting process as well as whether standard setting should reside in the government
or in the private sector. Based on the recommendations of this group, the Financial Accounting
Standards Board (FASB) was formed in 1972. The Board consists of seven fulltime
members; they have diverse backgrounds with three coming from public accounting,
two from private industry, and one each from academia and from an oversight body. The
Board is assisted by a staff of professionals who conduct research and work directly with the
Board.
FASB is recognized as authoritative through Financial Reporting Release 1 of the Securities
and Exchange Commission and through Rule 203 of the AICPA Code of Professional
Conduct.
FASB is an independent body relying on the Financial Accounting Foundation for selection
of its members and approval of its budgets. FASB is supported by the sale of its
publications and by fees assessed on all public companies based on their market capitalizations.
(The imposition of this fee was established by the Sarbanes-Oxley Act and replaces
the voluntary private-sector contributions that previously supported the Foundation. The
change was made to allay any public concerns about the FASB’s perceived independence
from contributors.) The Board of Trustees of the Foundation is composed of members of
American Accounting Association
American Institute of Certified Public Accountants
CFA Institute
Financial Executives International
Government Finance Officers Association
Institute of Management Accountants
National Association of State Auditors, Comptrollers, and Treasurers
Securities Industry Association
4 Wiley GAAP 2009 Codification Edition
The Board issues several types of pronouncements.1 The most important of these are
Statements of Financial Accounting Standards and Interpretations, which are used to clarify
or elaborate on existing Statements or pronouncements of predecessor bodies. Standards and
Interpretations constitute category A GAAP, which also includes FASB staff positions—a
relatively new form of guidance—and the Board’s FAS 133 implementation issues. Technical
Bulletins, which are category B GAAP, usually address issues not covered directly by
existing standards and are primarily used to provide guidance where it is not expected to be
costly or create a major change. Bulletins are discussed at Board meetings and subject to
Board veto. Both Bulletins and Interpretations are designed to be responsive to implementation
and practice problems on relatively narrow subjects (the last Bulletin was issued in
2001; that role will now apparently be filled by FASB staff positions, a substantial number of
which have already been produced).
The FASB staff can issue implementation guides and staff positions, which are category
D GAAP. In a question-and-answer format, implementation guides address specific
questions that arise when a standard is initially issued. Staff positions are responses to questions
on appropriate application of FASB literature that are expected to have widespread
relevance. The questions addressed in implementation guides and staff positions are submitted
by phone, letter, or through the FASB Web site’s technical inquiry service. Implementation
guides and staff positions are drafted by the staff and issued provided that a majority
of the FASB Board members do not object. In addition, staff positions must be
exposed on the FASB Web site for a 30-day comment period before issuance.
American Institute of Certified Public Accountants (AICPA). The Accounting Standards
Executive Committee (AcSEC) is the senior technical committee at the AICPA. It is
composed of fifteen volunteer members, representative of industry, academia, analysts, and
both national and regional public accounting firms. All AcSEC members are CPAs and
members of the AICPA.
AcSEC is authorized to set accounting standards and to speak for the AICPA on accounting
matters. The accounting standards that AcSEC issues are prepared largely through
the work of AICPA committees and task forces. AcSEC issues Statements of Position
(SOPs) and industry audit and accounting guides, which are reviewed and cleared by the
FASB and thus constitute category B GAAP. SOPs provide guidance on financial accounting
and reporting issues. Industry audit and accounting guides provide guidance to auditors
in examining and reporting on financial statements of entities in specific industries and provide
standards on accounting problems unique to a particular industry. AcSEC Practice
Bulletins (category C GAAP) usually provide guidance on very narrowly defined accounting
issues. Until recently, the standards issued by AcSEC addressed topics broadly applicable to
all industries in addition to industry-specific topics. Effective November 2002, FASB reclaimed
the sole authority to promulgate general-purpose GAAP, relegating AcSEC to the
issuance of industry-specific accounting and auditing standards.
1 To date, the FASB has issued 161 Statements on Financial Accounting Standards, 48 Interpretations,
51 Technical Bulletins, as well as over 60 Staff Positions and over 30 implementation compilations.
In addition, FASB has devoted substantial time and resources toward developing a Conceptual
Framework for Financial Accounting, which has resulted in the issuance of 7 Concepts Statements, 6
of which are still in effect and discussed later in this chapter. (FASB is currently pursuing a
complete review of the Concepts Statements as part of its convergence efforts with IASB.) (Since a
number of standards have been superseded or withdrawn, the number of standards, interpretations,
etc., which remain in force are somewhat fewer than the total issued. The preponderance of
currently effective GAAP is the product of the FASB, and not of its predecessors, although a number
of such older standards remain in effect.)
Chapter 1 / Researching GAAP Matters 5
Emerging Issues Task Force (EITF). The Emerging Issues Task Force (EITF) was
formed in 1984 by the FASB in order to assist the Board in identifying current or emerging
issues and implementation problems before divergent practices become entrenched. The
guidance provided is often on narrow issues that are of immediate interest and importance.
Task Force members are drawn primarily from public accounting firms but also include individuals
who would be aware of issues and practices that should be considered by the group.
The Task Force meets every other month with nonvoting representatives of the SEC and the
FASB attending for discussion purposes.
For each agenda item, an issues paper is developed by members, their firms, or the
FASB staff. After discussion by the Task Force, a consensus may be reached on the issue, in
which case the consensus is referred to the FASB for ratification at its next scheduled meeting.
If no consensus is reached, the problem may end up on the Board agenda or be resolved
by the SEC, or the issue will remain unresolved with no standard-setting organization currently
considering it. These issues may be in especially narrow areas having little broadbased
interest. Occasionally, FASB may include a narrow issue in the scope of a broader
project and reaffirm or supersede the work of the Task Force.
FASB publishes a volume of EITF Abstracts, which are summaries of each issue paper
and the results of Task Force discussion.
Although EITF pronouncements are technically category C GAAP, they are so specialized
that generally there is no category A or B GAAP covering the respective topics. The
SEC believes that a Task Force consensus is GAAP for public companies, and they will
question any accounting that differs from it. In addition, the SEC believes that the EITF
supplies a public forum to discuss accounting concerns and assist in providing advice. Thus,
they are supportive of the Task Force’s work.
The EITF also previously published Discussion Issues, which are FASB staff announcements
and SEC staff announcements regarding technical matters that are deemed important
by the FASB or SEC staff, but that do not relate specifically to a numbered EITF
issue. These announcements were designed to help provide guidance on the application of
relevant accounting pronouncements. It is anticipated that no further discussion issues will
be issued by EITF, however.
Other sources. Not all GAAP has resulted from a deliberative process and the issuance
of pronouncements by authoritative bodies. Certain principles and practices evolved into
current acceptability without adopted standards. For example, depreciation methods such as
straight-line and declining balance are both acceptable, as are inventory costing methods
such as LIFO and FIFO. There are, however, no definitive pronouncements that can be
found to state this. Furthermore, there are many disclosure principles that evolved into general
accounting practice because they were originally required by the SEC in documents
submitted to them. Among these are reconciling the actual rate with the statutory rate used
in determining income tax expense, when not otherwise obvious from the financial statements
themselves. Even much of the content of balance sheets and income statements has
evolved over the years without adopted standards.
Following about five years’ effort, FASB has completed its project to codify GAAP,
which will eliminate the multilevel hierarchy in favor of a bifurcation between authoritative
and nonauthoritative guidance. In early 2008, FASB initiated a one-year verification phase
of this Codification, during which time its constituents were encouraged to provide feedback
on whether its content accurately reflects existing US GAAP for nongovernmental entities.
Following completion of this trial period, pending any final revisions, FASB intends to
release this by mid-2009, at which time all existing authoritative literature will be withdrawn.
This book is based on the structure of the Codification as it exists in late 2008, which is not
anticipated to change much, if at all.
6 Wiley GAAP 2009 Codification Edition
In the interim, the GAAP hierarchy, which had been defined for decades in the auditing
literature, has been moved from SAS 69 to a new FASB standard, FAS 162. This was issued
in May 2008, to become effective when the PCAOB, responsible for public company
auditing rules, takes action to amend its version of SAS 69 (as of year-end 2008, this has not
been done). The only changes from the present hierarchy made were to include within
category A GAAP virtually all accounting principles that are issued after being subject to
FASB’s due process; EITF consensuses were not moved to category A, however.
According to the FASB, the new hierarchy was considered because of the complexity of
the long-standing hierarchy set forth by SAS 69, because that hierarchy was directed to
auditors rather than reporting entities, and because of the anomaly of ranking FASB concepts
statements lower than industry practices, although the former are subject to due process
while the latter are not. The new standard still relegates concepts statements to the lowest
level in the five-level hierarchy, but gives these primacy over all others in that level.
A further provision of FAS 162 holds that financial statements that depart materially
from principles set forth in the GAAP hierarchy could not be represented as being in
conformity with GAAP. While this does not (and, as an accounting standard, could not) alter
the auditing rule known as the “Rule 203 exception” which allows for rare situations where
departure from GAAP actually is believed warranted in the interest of fair presentation of the
reporting entity’s financial position or results of operations, it probably makes it a nearcertainty
that the Rule 203 exception will never be invoked, as indeed it has almost never
been used historically. (A similar “true and fair view” exception exists under IFRS.)
How Is GAAP Created?
The FASB and AICPA adhere to rigorous “due process” when creating new guidance in
category A and category B GAAP. The goal is to involve constituents who would be affected
by the newly issued guidance so that the standards created will result in information
that reports economic activity as objectively as possible without attempting to influence behavior
in any particular direction. Ultimately, however, the guidance is the judgment of the
FASB or the AICPA, based on research, public input, and deliberation. The FASB’s due
process procedures are described below. The AICPA follows similar procedures in its projects.
The FASB receives requests for new standards from all parts of its diverse constituency,
including auditors, industry groups, the EITF, and the SEC. Requests for action include both
suggestions for new topics and suggestions for reconsideration of existing pronouncements.
For each major project it adds to its technical agenda, the FASB begins by appointing an
advisory task force of approximately fifteen outside experts. Care is taken to ensure that
various points of view are represented on the task force. The task force meets with and advises
the Board and staff on the definition and scope of the project and the nature and extent
of any additional research that may be needed. The FASB and its staff then debate the significant
issues in the project and arrive at tentative conclusions. As it does so, the FASB and
its staff study existing literature on the subject and conduct or commission any additional
research as needed. The task force meetings and the Board meetings are open to public observation
and a public record is maintained. Many of these proceedings are also available by
live or archived audio Webcast as well as via telephone.
If the accounting problem being considered by the Board is especially complex, the
FASB will begin by publishing a Discussion Memorandum or another discussion document.
The discussion document generally sets forth the definition of the problem, the scope of the
project, and the financial accounting and reporting issues; discusses research findings and
relevant literature; and presents alternative solutions to the issues under consideration and the
arguments and implications relative to each. It is distributed to interested parties by request
Chapter 1 / Researching GAAP Matters 7
and is available on the FASB Web site. The document is prepared by the FASB staff with
the advice and assistance of the task force. It specifies a deadline for written comments and
often contains an invitation to present viewpoints at a public hearing.
Any individual or organization may request to speak at the public hearing, which is conducted
by the FASB and the staff assigned to the project. Public observers are welcome.
After each individual speaks, the FASB and staff ask questions. Questions are based on
written material submitted by the speakers prior to the hearing as well as on the speaker’s
oral comments. In addition to the hearing, the staff analyzes all the written comments submitted.
The FASB members study this analysis and read the comment letters to help them
reach conclusions. The hearing transcript and written comments become part of the public
record.
After the comment letters and oral presentations responding to the discussion document
are considered, formal deliberations begin. (If the accounting problem is not as complex and
no discussion document was issued, the due process begins at this point.) The FASB deliberates
at meetings that are open to public observation, although observers do not participate
in the discussions. The agenda for each meeting is announced in advance. Prior to each
Board meeting, the staff presents a written analysis and recommendations of the issues to be
discussed. During the meeting, the staff presents orally a summary of the written materials
and the Board discusses each issue presented. The Board meets as many times as is necessary
to resolve the issues.
When the Board has reached tentative conclusions on all the issues in the project, the
staff prepares an Exposure Draft. The Exposure Draft sets forth the Board’s conclusions
about the proposed standards of financial accounting and reporting, the proposed effective
date and method of transition, background information, and an explanation of the basis for
the Board’s conclusions. The Board reviews, and if necessary, revises, the Exposure Draft.
Then, a vote is taken about whether the Exposure Draft can be published for public comment.
A majority of the Board members must vote to approve an Exposure Draft for issuance
for comment. If four votes are not obtained, the FASB holds additional meetings and
redrafts the Exposure Draft.
Any individual or organization can provide comments about the conclusions in the Exposure
Draft during the exposure period, which is generally sixty days or more. The Board
may also decide to have a public hearing to hear constituents’ views. At the conclusion of
the comment period, all comment letters and oral presentations are analyzed by the staff, and
the Board members read the letters and the staff analysis. Then, the Board is ready to redeliberate
the issues, with the goal of issuing final accounting standards.
As in the earlier process, all Board meetings are open to the public. During these meetings,
the Board considers the comments received and may revise their earlier conclusions. If
substantial modifications are made, the Board will issue a revised Exposure Draft for additional
public comment. If so, the Board also may decide that another public hearing is necessary.
When the Board is satisfied that all reasonable alternatives have been adequately considered,
the staff drafts a final pronouncement for the Board’s vote. Four votes are required
for adoption of a pronouncement. Once issued, the standards become GAAP after the effective
date stated in the pronouncement.
The Hierarchy of GAAP
Under GAAP as it has been constituted over a number of decades, a number of standardsetting
and standard-interpreting bodies (including, as of early-2009, FASB, AICPA’s
AcSEC, and EITF) issue pronouncements which have, to varying degrees, the force of requirements
that financial statement preparers must follow. The multiplicity of standardsetting
entities made it necessary to set forth a hierarchy, so that preparers and auditors
8 Wiley GAAP 2009 Codification Edition
would have a set of behavioral rules to follow in selecting from overlapping or seemingly
contradictory rules. This hierarchy was first set forth by the auditing literature, but has been
replaced by an interim accounting standard (FAS 162) and, shortly thereafter, will be made
moot by the promulgation of the codification of GAAP. Under the forthcoming codification,
all extant standards will be incorporated into a single document, and former distinctions
among levels of the GAAP hierarchy will be eliminated. Future GAAP pronouncements will
be styled as modifications to or replacements of existing portions of this codification, and
will not exist as freestanding standards, interpretations, amendments, or staff positions. This
will represent a very fundamental change to the structure of the body of GAAP, and will require
substantial changes to how preparers and others undertake to stay abreast of evolving
GAAP.
Under precodification GAAP, the determination of which accounting principle is applicable
under a particular set of conditions requires an appreciation of the hierarchy of GAAP.
The hierarchy was developed to assist the researcher in identifying the different sources of
GAAP and to provide a means of resolving potential conflicts between standards by providing
differing levels of authority. In FAS 162, FASB has identified the following as the
sources of established generally accepted accounting principles:
A. Accounting principles promulgated by a body designated by the AICPA Council to
establish such principles, pursuant to rule 203 [ET section 203.01] of the AICPA
Code of Professional Conduct.
B. Pronouncements of bodies, composed of expert accountants, that deliberate
accounting issues in public forums for the purpose of establishing accounting principles
or describing existing accounting practices that are generally accepted, provided
those pronouncements have been exposed for public comment and have been
cleared by a body referred to in category A.
C. Pronouncements of bodies, organized by a body referred to in category A and composed
of expert accountants, that deliberate accounting issues in public forums for
the purpose of interpreting or establishing accounting principles or describing existing
accounting practices that are generally accepted, or pronouncements referred
to in category B that have been cleared by a body referred to in category A but have
not been exposed for public comment.
D. Practices or pronouncements that are widely recognized as being generally accepted
because they represent prevalent practice in a particular industry, or the knowledgeable
application to specific circumstances of pronouncements that are generally accepted.
Compliance with accounting pronouncements included in category A is mandatory. Auditors
are not to express an unqualified opinion on financial statements if the financial statements
contain a material departure from category A pronouncements unless, due to unusual circumstances,
adherence to the pronouncements would make the statements misleading. Rule 203
implies that application of officially established accounting principles almost always results
in fair presentation in conformity with generally accepted accounting principles, but this is
not an absolute prohibition of departures from promulgated GAAP.
If an accounting treatment is not specified by a pronouncement covered by Rule 203, accountants
and auditors are required to progress through the hierarchy to categories B, C, or
D, in that sequence, and use the treatment specified by the source in the highest category. If
an accounting pronouncement in category B, C, or D is relevant to the circumstances, accountants
or auditors must follow that pronouncement or be able to justify the conclusion
that another treatment is generally accepted.
Chapter 1 / Researching GAAP Matters 9
Departures from promulgated GAAP justified as being necessary in order for the financial
statements to not be misleading (the so-called “Rule 203 exception”) have been very
rarely observed in practice, but are clearly permitted under current standards. As of mid-
2008, survival of this exception is in doubt, since the proposed FASB statement on the
GAAP hierarchy would eliminate this exception. That is, departures from promulgated
GAAP would cause financial statements to be deemed not in conformity with GAAP and, if
the effect of the departure is material, not worthy of an unqualified auditors’ opinion. Note
that there are two reasons for the likely removal of this option. First, it pertains to the
auditors’ expression of an opinion, and not, as currently constituted, to the preparers’
selection among accounting principles or methods. Second, in order for US GAAP to
converge with IFRS (which does not have an exact equivalent to this exception), it was
deemed necessary to eliminate it.
For financial statements of entities other than governmental entities2
a. Category A, officially established accounting principles, consists of Financial
Accounting Standards Board (FASB) Statements of Financial Accounting
Standards (denoted as FAS in this book) and Interpretations (denoted as FIN),
Accounting Principles Board (APB) Opinions, and AICPA Accounting Research
Bulletins (ARB). As discussed later in this chapter, FASB has proposed
that its FASB Staff Positions (FSP) and Derivatives Implementation Group Issues
(DIG) also be classified in Category A.
b. Category B consists of FASB Technical Bulletins (FTB) and, if cleared by the
FASB, AICPA Industry Audit and Accounting Guides and AICPA Statements
of Position (SOP).
c. Category C consists of AICPA Accounting Standards Executive Committee
(AcSEC) Practice Bulletins (PB) that have been cleared by the FASB and consensus
positions of the FASB Emerging Issues Task Force (EITF).
d. Category D includes AICPA accounting interpretations (AIN), implementation
guides (Qs and As) published by the FASB staff, and practices that are widely
recognized and prevalent either generally or in the industry.
If financial statement preparers are unable to locate relevant guidance using one of the
above sources of established accounting principles, other accounting literature may be con-
2 The description of a governmental entity, which was agreed to in a joint meeting of the FASB and
GASB Boards in 1996, states
Public corporations and bodies corporate and politic are governmental organizations.
Other organizations are governmental organizations if they have one or more of the
following characteristics:
a. Popular election of officers or appointment (or approval) of a controlling majority of
the members of the organization’s governing body by officials of one or more state or
local governments;
b. The potential for unilateral dissolution by a government with the net assets reverting
to a government; or
c. The power to enact and enforce a tax levy.
Furthermore, organizations are presumed to be governmental if they have the ability to
issue directly (rather than through a state or municipal authority) debt that pays interest
exempt from federal taxation. However, organizations possessing only that ability (to
issue tax-exempt debt) and none of the other governmental characteristics may rebut the
presumption that they are governmental if their determination is supported by compelling
relevant evidence.
This publication does not describe GAAP for governmental entities. Readers interested in learning
more should consult the publication Wiley GAAP for Governments.
10 Wiley GAAP 2009 Codification Edition
sidered. These sources include FASB Statements of Financial Accounting Concepts, AICPA
Issues Papers, International Financial Reporting Standards of the International Accounting
Standards Board and of its predecessor, the International Accounting Standards Committee,
Governmental Accounting Standards Board (GASB) Statements, Interpretations and Technical
Bulletins, Federal Accounting Standards Advisory Board (FASAB) Statements, Interpretations,
and Technical Bulletins, pronouncements of other professional associations or
regulatory agencies, Technical Information Service Inquiries and Replies included in AICPA
Technical Practice Aids, and accounting textbooks, handbooks and articles. The use of those
other sources depends upon their relevance to the particular circumstances, the specificity of
the guidance, and the general recognition of the author or issuing organization as an authority.
This would mean that FASB publications in this category are to be considered more
influential in establishing an acceptable accounting practice than an accounting textbook.
Relying on guidance in this category requires the exercise of professional judgment and a
broader search of literature sources than would be true in the other four categories.
Note, in particular, that the FASB Concepts Statements are not included in the levels AD
of the GAAP hierarchy, at present. Thus, the guidance in those statements do not take
precedence over the various promulgated GAAP. Nonetheless, SAS 69 (current source of
the hierarchy) identifies the Concepts Statements as the first of the group of other literature
that should be consulted to guide practice in the absence of definitive guidance from a source
explicitly cited in the hierarchy. The proposed adoption of a GAAP hierarchy by FASB,
superseding that found in the current auditing literature, would effectively elevate the Concepts
Statements to level A GAAP. (Note further that FASB is currently reviewing the six
extant Concepts Statements with the announced intention of producing a new conceptual
framework document.)
Readers should pay close attention to both the relocation of the GAAP hierarchy from
the auditing to the accounting literature, and to the replacement of the GAAP hierarchy by
the codification. If (as expected) the codification is approved by FASB, all GAAP references
will change, not merely for new pronouncements, but for the entire extant body of GAAP.
Future editions of this book will reflect such changes when they become official.
Materiality
Materiality as a concept has great significance in understanding, researching, and implementing
GAAP. Each Statement of Financial Accounting Standards (FAS) issued by the
FASB concludes by stating that the provisions of the statement are not applicable to immaterial
items.
Materiality is defined by the FASB as the magnitude of an omission or misstatement in
the financial statements that makes it probable that a reasonable person relying on those financial
statements would have been influenced by the omitted information or made a different
judgment if the correct information had been known. However, due to its inherent subjectivity,
the definition does not provide definitive guidance in distinguishing material information
from immaterial information. The individual accountant must exercise professional
judgment in evaluating information and concluding on its materiality. Materiality as a
criterion has both quantitative and qualitative aspects, and items should not be deemed immaterial
unless all potentially applicable quantitative and qualitative aspects are given full
consideration and found not relevant.
Quantitatively, materiality has been defined in relatively few pronouncements, which is
a testament to the great difficulty of setting precise measures for materiality. For example, in
FAS 131, Disclosures about Segments of an Enterprise and Related Information, a material
segment or customer is defined as representing 10% or more of the reporting entity’s revenues
(although, even given this rule, qualitative considerations may cause smaller segments
Chapter 1 / Researching GAAP Matters 11
to be deemed reportable). The Securities and Exchange Commission has in various of its
pronouncements defined materiality as 1% of total assets for receivables from officers and
stockholders, 5% of total assets for separate balance sheet disclosure of items, and 10% of
total revenue for disclosure of oil and gas producing activities.
Although materiality judgments have traditionally been primarily based on quantitative
assessments, the nature of a transaction or event can affect a determination of whether that
transaction or event is material. For example, a transaction that, if recorded, changes a profit
to a loss or changes compliance with ratios in a debt covenant to noncompliance would be
material even if it involved an otherwise immaterial amount. Also, a transaction that might
be judged immaterial if it occurred as part of routine operations may be material if its occurrence
helps meet certain objectives. For example, a transaction that allows management to
achieve a target or obtain a bonus that otherwise would not become due would be considered
material, regardless of the actual amount involved.
Another factor in judging materiality is the degree of precision that may be attained
when making an estimate. For example, accounts payable can usually be estimated more
accurately than a possible loss from the incurrence of an asset retirement obligation. An error
that would be material in estimating accounts payable might be acceptable in estimating
the retirement obligation.
Certain events or transactions may be deemed material because of their nature, regardless
of the dollar amounts involved, and thus require disclosure under any circumstances.
Offers to buy or sell assets for more or less than book value, litigation proceedings against
the company pursuant to price-fixing or antitrust allegations, and active negotiations regarding
their settlement can have a material impact on the enterprise’s future profitability and,
thus, are all examples of items that would not be capable of being evaluated for materiality
based solely upon numerical calculations.
It is clear that materiality, as traditionally defined by the accounting and auditing establishment,
may no longer align with the definition implicitly applied by financial statement
users, including the SEC and other regulatory authorities. Given the epidemic of financial
reporting frauds in the late 1990s and early 2000s, it became clear that a more nuanced and
complex definition of materiality was probably required. In general, a decision regarding the
application of GAAP (e.g., the choice of a nonstandard costing or revenue recognition
method for a particular transaction) should be viewed as being immaterial only if all
conceivable effects, such as the impact on common financial statement ratios or trends, are
expected to be truly immaterial. A strict application of a quantitative threshold—say, 5% of
net income—should be avoided, and once a materiality level is established, it should be
strictly maintained in the face of identified errors or warranted adjustments in amounts
greater than what had been defined.
The SEC, in its Staff Accounting Bulletin 99 (SAB 99), provides a useful discussion of
this issue. Although not strictly applicable to nonpublic preparers of financial statements,
this guidance is worthy of consideration by all accountants and auditors. Among other
things, SAB 99 notes that deliberate application of nonacceptable accounting methods cannot
be justified merely because the impact on the financial statements is deemed to be
immaterial. SAB 99 also usefully reminds preparers and others that materiality has both
quantitative and qualitative dimensions, which must both be given full consideration. More
recently, Staff Accounting Bulletin 108 (SAB 108) has added to the literature of materiality
with its discussion of considerations applicable to prior period restatements. (See discussion
in Chapter 5.)
12 Wiley GAAP 2009 Codification Edition
The Crisis of Confidence Regarding GAAP
Over approximately the past decade, GAAP as a body of standards, and the standardsetting
process itself, have increasingly come under attack. A notable string of accounting
scandals unfolded in the late 1990s and early 2000s, and as one consequence the entire US
financial reporting system was put under the microscope by the nation’s leaders, the international
financial community, the media, and the general public. What resulted was not only
landmark legislation in the form of the Sarbanes-Oxley Act, but also a thorough and ongoing
self-examination undertaken by all accountants—from CEOs to auditors to regulators to
standard setters.
In 2001, Enron Corp., one of the world’s biggest companies at the time, publicly acknowledged
that it had failed to comply with existing accounting requirements in at least two
areas—sales of stock to special-purpose entities (SPE) and nonconsolidation of certain SPE.
This noncompliance caused material overstatements of assets, shareholders’ equity, and net
income, and the concealment of substantial debt obligations for several years. As a result,
Enron’s stock price fell to under twenty-five cents per share. As the ensuing events unfolded,
public policy discussions and media criticisms of GAAP, of standard setting in the
private sector, and of the accounting profession reached unprecedented levels. The criticisms
centered primarily on the failure of financial statements to warn investors of the impending
collapse of Enron, and on the lack of independence and objectivity of a self-regulating profession
that offers both consulting and auditing services to its clients.
Numerous other high-profile business failures and accounting scandals also occurred or
came to light during this period. Many involved aggressive accounting by large, formerly
well-regarded entities. A watershed event was the revelation of massive $11 billion fraud by
WorldCom, which led directly to the enactment of the far-reaching Sarbanes-Oxley Act.
The Sarbanes-Oxley Act of 2002. The result of these business failures and accounting
scandals was the Sarbanes-Oxley Act, which included among its provisions the following
sweeping changes:
1. Established the Public Company Accounting Oversight Board (PCAOB), to oversee
the audits of public companies that are subject to the securities laws of the United
States (referred to as “issuers”) and to establish auditing, quality control, ethics, independence,
and other standards relating to the auditing of the financial statements
of issuers. Three of the five PCAOB members cannot be and must not have been
certified public accountants.
2. Placed severe limits on an audit firm’s ability to provide nonaudit services to its issuer
audit clients.
3. Established a requirement that the CEO and the CFO of each issuer certify in each
periodic report to the SEC
a. The appropriateness of the financial statements and disclosures and
b. That those financial statements and disclosures fairly present, in all material respects,
the operational and financial condition of the issuer.
4. Required the SEC to conduct a study of off-balance-sheet transactions and the use
of special-purpose entities, and to report its recommendations to Congress.
5. Required the GAO to conduct a study regarding the consolidation of public accounting
firms since 1989, including the present and future impact of the consolidation,
and the solutions to any problems it discovers.
Another important provision of the Sarbanes-Oxley Act, set forth in Section 404, increases
corporate management’s responsibility for assessing the effectiveness of internal
control over financial reporting. Operational management, as well as financial management,
must be more cognizant of their joint responsibility for quality financial reporting. ManageChapter
1 / Researching GAAP Matters 13
ment’s methods for assessing internal control will, and should, vary from company to company.
Corporate management must assess the risk of material financial statement misstatement
along two dimensions: (1) Inherent risk—the susceptibility of one or more financial
statement assertions to a material misstatement, and (2) Fraud risk—the risk of material misstatement
due to fraudulent financial reporting or theft of assets.
The principal regulatory focus of the Sarbanes-Oxley Act is on auditors and corporate
management, which is appropriate because the Enron, WorldCom, and other scandals were
primarily the result of management fraud and audit failures, rather than faulty accounting
standards. However, there are several requirements of the Act that have the possibility of
affecting GAAP and its standards setters.
First, the Act defines the required characteristics of an accounting standards-setting
body. For the time being, standards will continue to be set by FASB, as the SEC reaffirmed
in 2003 that it will continue to acknowledge FASB’s pronouncements as being generally
accepted. However, FASB is expected to announce some changes to demonstrate that it “has
adopted procedures to ensure prompt consideration, by majority vote of its members, of
changes to accounting principles necessary to reflect emerging accounting issues and
changing business practices” and “considers, in adopting accounting principles. . . the extent
to which international convergence on high quality accounting standards is necessary or appropriate.”
Second, the Act requires that the SEC conduct a study on the adoption by the United
States financial reporting system of a principles-based accounting system. The study
shall include an examination of—(i) the extent to which principles-based accounting and financial
reporting exists in the United States; (ii) the length of time required for change from
a rules-based to a principles-based financial reporting system; (iii) the feasibility of and proposed
methods by which a principles-based system may be implemented; and (iv) a thorough
economic analysis of the implementation of a principles-based system.
That study was released in 2003 and can be found on the Special Studies section of the
SEC’s Web site (www.sec.gov). Briefly, it found that the oft-cited distinction between rulesbased
and principles-based standards was largely illusory, inasmuch as high-quality financial
reporting standards must be (and have generally been) based on sound principles, but that a
pure, principles-only set of standards, without practical guidance, would not serve the public
interest.
Principles-based standards. Some have suggested that rules-based accounting standards
contributed to the Enron, WorldCom and other collapses. It is true that certain detailed
rules found under US GAAP (e.g., capital lease requirements such as the 90% test) have
encouraged carefully constructed evasions (e.g., 89% leases), which often provoke even
more detailed rules, followed by yet more “engineered” transactions and reporting
stratagems. Some observers suggested that the answer to the problems of “gaming the rules”
and the ever-increasing complexity of resulting standards might have been found in
embracing a principles-based, as opposed to a rules-based, approach to standards setting. To
some (limited) extent, the standards published by the International Accounting Standards
Board exhibited that characteristic, and some therefore argued that a movement toward
principles-based standards might be facilitated by the convergence of US GAAP and international
standards.
The idea of a principles-based approach to US standard setting is not new. FASB’s conceptual
framework, summarized later in this chapter, contains the body of principles that
underlies US accounting and reporting. The FASB has used the conceptual framework in
developing its accounting standards for more than twenty years. However, FASB has sometimes
bowed to pressure to provide exceptions to its principles in order to achieve “desired”
accounting results (e.g., to limit the volatility of reported earnings, as with current pension
14 Wiley GAAP 2009 Codification Edition
accounting requirements under FAS 87). Indeed, it is probably the existence of multiple
exceptions to the promulgated standards, more than any failure to ground these in general
principles, that has opened the door to various reporting practices that, in certain circumstances,
permitted the conduct of financial reporting frauds.
If a principles-based approach were implemented by FASB, accounting standards would
continue to be developed from the conceptual framework (which is currently under revision),
but the principles would apply more broadly than under existing standards. That is, there
would be fewer exceptions to the principles in the standards. In addition, FASB, EITF, and
AICPA would provide less interpretive and implementation guidance for applying the standards
because the overall principle would ostensibly provide the necessary foundation for the
answer with such guidance being considered superfluous. Exceptions would be extremely
limited under a principles-based approach. In addition, a principles-based approach requires
accountants to exercise good professional judgment and to resist the urge to seek specific
answers and rulings on every implementation issue. It also would require that the SEC and
users of financial information accept the consequences of applying professional judgment,
which means there would undoubtedly be some divergence in practice, resulting in some loss
of comparability of the financial statements of reporting enterprises.
FASB issued for public comment a proposal for a principles-based approach to US standard
setting in 2002, followed by a public roundtable meeting with respondents to the proposal.
Many respondents agreed on the need for standards that emphasize principles over
detailed rules and report the economic substance of transactions or events. However, many
concluded that complex rules are primarily driven by increasingly complex economic transactions
(e.g., the explosive growth in the use of hedging and financial derivatives), and that
there is no way to return to a simpler time or to simpler GAAP. Also, many respondents
expressed concern about using principles-based standards in the current legal and regulatory
environment. The well-known penchant for litigation means that, as former Federal Reserve
Board Chairman Paul Volcker observed, “(T)he American tradition is to have clear and definite
rules, so firms can defend themselves from the hoards of lawyers who stand ready to sue
auditors for making a bad judgment.”
As of early-2009, it appears that the debate over rules- or principles-based standards
may be implicitly resolved by either the full convergence of US GAAP with IFRS or, in what
was formerly thought to be unlikely but which is now deemed to be a very real possibility,
having IFRS supersede US GAAP. The fact that well over 100 other nations have opted to
endorse IFRS (at least for publicly held companies’ financial reporting), with as many as
another 50 taking steps to have IFRS supersede their respective national GAAP regimes,
coupled with the possible granting of permission for IFRS-based reporting by US companies
registered with the SEC, makes this further development increasingly probable, in the authors’
view.
Standards overload. The recent criticisms of rules-based standards join earlier criticisms
about the complexity of accounting standards. Some accountants complain about
“standards overload,” saying that there are too many accounting standards, which are individually
too complex to be understood and implemented, and that too many organizations
(SEC, FASB, EITF, AICPA, etc.) are empowered to issue these pronouncements. Complaints
regarding standards overload are not new, and with about 163 FASB Statements and
myriad other standards (including hundreds of EITF Issues), these complaints must be given
credence. However, the solution, if there is one, is not obvious. Nor is it clear that financial
reporting frauds, audit failures, or other such phenomena have been the result of this overload.
Overwhelmingly, frauds result from the deliberate misapplication of GAAP, and not
from an inability on the part of preparers and auditors to comprehend the requirements of the
standards.
Chapter 1 / Researching GAAP Matters 15
Some say that a solution would be to reduce and simplify GAAP, especially for entities
having characteristics suggesting that the risk of misleading the users of the financial statements
might be low. For example, some recommend a size test, with smaller entities following
a subset of the standards that are mandated for larger entities (a system now used in
the UK, and being proposed by IASB as well). Even this simple suggestion has complications,
however; size could arguably be determined by assets, revenues, net worth, or number
of owners. Others recommend that public entities, regardless of size, follow a more comprehensive
set of standards than privately owned businesses.
Those who disagree say that differing standards would reduce the quality of financial reporting.
For example, if decisions about which entities should follow which standards were
made using a single criterion for all standards (such as size or ownership), some entities that
engage heavily in a certain type of transaction (e.g., derivative financial instruments) might
not be subject to the standards for that transaction—even though the recognition, measurement,
and disclosure of those transactions was critical to understanding the financial condition
and results of operations of the entity. To solve that problem, criteria would need to be
based in some way on the underlying subject matter of the standard, which would result in an
accountant having to examine each standard to determine if it would apply to a particular
entity. That could compound the standards overload problem rather than solve it.
This so-called “big GAAP vs. little GAAP” debate has raged off and on for many decades.
When advocates of differential standards are challenged, however, they typically have
been unable to identify alternative recognition or measurement principles for large (or public)
entities vs. those for smaller (or privately held) entities. Generally, at best, certain disclosures
are cited as candidates for slimming down in financial statements of the smaller or
private companies. The proposed IASB standard for nonpublicly accountable reporting entities
(inaccurately being referred to as smaller and medium-sized entities) would eliminate
some alternative but acceptable practices, but would nonetheless allow those entities access
to the full range of acceptable practices if so desired. In short, there may be less than meets
the eye to this entire controversy.
In fact, the FASB has endeavored in recent years to offer somewhat differentiated standards
for disclosures. FAS 126 exempts nonpublic companies from certain financial instrument
disclosures if the entity’s total assets are less than $100 million and the entity has not
held or issued any derivative financial instruments. Nonpublic companies also are not required
to disclose earnings per share (FAS 128), segment information (FAS 131), or certain
pension and postretirement information (FAS 132R). These exemptions have not, however,
been widely hailed as representing significant progress against the perceived problem of
standards overload.
To obtain better insight into these issues, in early 2004, the AICPA formed a Private
Company Financial Reporting Task Force and charged it with conducting empirical research
on the needs of preparers and users of private company financial statements and how well
GAAP was meeting those needs, and developing recommendations based upon the results of
the study.
The results of its research were mixed. As should have been expected, there were significant
perceptual differences between the owner/managers of reporting entities, independent
CPA practitioners, and external users. For example, when asked if they would consider
it useful for GAAP reporting to be different in certain respects for small companies, the
owner/managers’ “yes” responses averaged between 57% and 62% (depending on size of
their companies), the practitioners’ responses between 73% and 77%, the sureties 44%, investors/
venture capital firms 46%, and lender/creditors 69%. These results show the tension
that exists in the marketplace between financial statement users’ voracious needs for information
provided for their decision-making purposes on the one hand, and the expense borne
16 Wiley GAAP 2009 Codification Edition
by the reporting entities responsible for preparing those financial statements and for obtaining
independent assurance on them on the other hand.
The results of the Task Force’s research indicated a moderately high to high rating regarding
the overall value of GAAP financial statements to users (primarily lenders, sureties,
and equity investors). However, many GAAP accounting or disclosure requirements were
rated low by all of the constituents with respect to relevance or usefulness in decision making.
These included such topics as pension and postretirement plans; variable interest entities,
and share-based payments (FAS123[R] had not yet become effective when the survey
was conducted). Based on this and other data revealed by their study, the Task Force concluded
that these particular requirements were not meeting the needs of the various constituents
of private company reporting and that this would support the need for development of
differential GAAP.
In the authors’ opinion, this conclusion is based on incomplete information, and we believe
that if a similar research study were conducted by polling preparers, auditors, and users
of large and public company financial statements, most or all of these same GAAP requirements
would be identified as being of limited relevance and usefulness. That is, the authors
believe the fundamental problem to be more universal than just “big GAAP/little GAAP.” A
more holistic reexamination of the GAAP reporting model is necessary in the light of an environment
that includes such rampant abuses as earnings manipulation and many other visible
failures of GAAP financial statements to fully and truthfully inform stakeholders about
the precariousness of their investments.
In addition to the recommendation regarding differential GAAP, the Task Force also
recommended changes to the standard-setting model to address the needs of private companies
and offered alternatives such as
• Changing the composition of FASB and the Financial Accounting Foundation (FAF)
to increase participation from the private company financial statement community
• FAF establishment of a private company standards setter under its jurisdiction
• Creation of a private company standards setter outside the jurisdiction of the FAF
In early 2008, certain of these changes came to fruition, when FAF announced that, as of
mid-2008, membership of FASB was to be reduced to five from seven, with simple majority
voting being retained. The issue of greater involvement by the financial statement community
has been dealt with, in a fashion, by requiring that board members possess investment
experience broadly defined. The membership of the oversight body, FAF, is to be optionally
increased, and the number and breadth of organizations invited to nominate their trustees will
be expanded.
FASB initiatives. In 2002, FASB embarked on a multiple-year, phased initiative to
simplify and codify GAAP and make it more easily searchable and retrievable. As noted
above, this effort has resulted in a draft codification being made available for user testing in
2008, with implementation now promised for mid-2009.
In another part of the project, FASB has attempted to reduce the complexity of accounting
standards by reducing the number of standard-setting bodies that issue authoritative accounting
pronouncements. FASB changed the process of the EITF to give FASB more direct
involvement with its agenda, deliberations, and conclusions. Two FASB board members
were added to the EITF Agenda Committee and FASB is now required to ratify each EITF
consensus at a public board meeting before the consensus officially becomes GAAP. Also,
FASB and the AICPA agreed that AcSEC would cease issuing Statements of Position that
create broadly applicable GAAP, instead limiting its work to specialized industry accounting
standards. FASB intends to collaborate with representatives from the EITF, AICPA, and
SEC to develop a model for deciding if additional authoritative standards are necessary on a
Chapter 1 / Researching GAAP Matters 17
given topic and then how to most effectively segregate duties among those bodies with respect
to issuing those standards.
FASB also wants to more thoroughly assess the cost-benefit relationships of proposed
standards; presumably, complex standards are more costly to implement, and thus the costs
are more likely to outweigh the expected benefits to users. If so, enactment would be less
probable. To understand the costs of a proposed standard, FASB intends to actively engage
its constituents in a discussion of the costs as a formal step in the Board’s due process. To
understand more fully the benefits of a proposed standard, FASB has created a User Advisory
Council, a group of forty professionals representing a variety of investment and analytical
disciplines, which will be consulted on specific projects as well as helping the Board
formulate its overall agenda. During 2004, FASB also established a Small Business Advisory
Committee (SBAC) in order to obtain additional needed input from its small business
constituents.
In 2005, the FASB and AICPA separately issued Exposure Drafts proposing to move the
nongovernmental GAAP Hierarchy, discussed earlier in this chapter, from the auditing literature
to the accounting literature. In connection with this change, the Exposure Drafts also
designated FASB Staff Positions (FSP) and Derivatives Implementation Group Issues (DIG)
as “Level A” GAAP. This resulted in FAS 162, issued in May 2008.
FASB acknowledged that this standard is only transitional in nature. Its long-range plan
is to reduce the number of levels in the hierarchy to just two, authoritative and nonauthoritative,
and this will be achieved when the codification is finally promulgated. In addition, at
the conclusion of its current projects on codification and retrieval and on its conceptual
framework, FASB expects to address any inconsistencies in guidance that make the current
four-tier structure necessary and to address the role of its Statements of Financial Accounting
Concepts in the hierarchy.
Although these FASB initiatives are viewed by many as a step in the right direction, it
remains to be seen whether they successfully answer criticisms of standards overload. The
financial environment is increasingly complex and litigious, which makes a lessening of the
burden of GAAP unlikely in the near term.
IASB initiatives. While the debate in the US continues over the need for simplified
“small GAAP,” the international standard setter, IASB, has proposed a comprehensive standard
that would (much like an earlier, and apparently successful, UK GAAP initiative) capture
the key guidance for entities having no public reporting responsibilities (of whatever
size), streamlining some existing standards and culling alternatives that are deemed, for
whatever reason, nonapplicable to these nonpublic reporting entities. A controversial proposal,
the Exposure Draft (available at www.iasb.org/Current+Projects/IASB+Projects/Small
+Mediumsized+Entities/Exposure+Drafts+forSmall+Mediumsized+Entities.htm) was open
for comments until October 1, 2007, and is still being debated as of early-2009. It is highly
likely that the SME proposal, or a close approximation thereof, will be enacted before yearend
2009. The strongest argument against this (or any similar) proposal is that it is the
natures of the business transactions (e.g., those involving derivatives, guarantees, compound
instruments having attributes of debt and equity) that should dictate the required accounting,
and that even smaller or nonpublic entities engaging in such transactions should be bound by
proper financial reporting standards. On the other side of the argument are those who claim
that modern GAAP has become too complex for preparers, auditors, and users, particularly
when addressing financial statements of smaller, less-sophisticated companies, thus
justifying the use of streamlined standards.
The AICPA and its diminished influence. In the aftermath of the various financial reporting
scandals previously discussed, many in the business and accounting communities
criticized the AICPA for not proactively and forthrightly acknowledging systematic short18
Wiley GAAP 2009 Codification Edition
comings in both the financial reporting and auditing realms and for not taking a visible leadership
role in developing proposed solutions regarding their remediation. This perception
that the AICPA was “sitting on the sidelines” as these scandals unfolded undoubtedly contributed
to the creation, by the Sarbanes-Oxley Act, of the Public Company Accounting
Oversight Board and its charge to oversee the auditing profession with respect to the audits
of issuers. The PCAOB assumed the AICPA’s previous responsibilities for ethics, independence,
quality control, continuing professional education, peer review, and auditing standards
as they relate to auditors of public company issuers.
Under these circumstances, the AICPA was (and still is) in danger of being rendered irrelevant
as a standard setter and, no less, as a standard bearer for the profession. Its auditing
standards board (ASB) has continued to issue pronouncements that are binding on auditors of
nonissuers while the PCAOB has diverged from the AICPA’s auditing standards by issuing
its own standards. This provides fodder for debate regarding the advisability of “big GAAS,
little GAAS.” To the detriment of the auditing profession, the ultimate resolution of this
conflict might be left to the judiciary if, as is quite conceivable, a nonissuer audit failure is
alleged to have occurred that the plaintiff alleges might have been prevented had the auditor
followed the PCAOB standards instead of the Auditing Standards Board standards.
Alleged harmful effects of standards. In general, reporting entities have not welcomed
proposals for new standards, since these inevitably involve change, costs of implementation,
and, perhaps, a period of confusion while the marketplace assimilates the new information.
In addition, the business community often claims that FASB does not understand the economic
impact of new standards on their businesses. It complains that the implementation of
certain accounting standards will harm business’ ability to compete in the global marketplace
and will impede its ability to raise debt or equity capital on favorable terms.
Two early examples of such resistance were the issuance of FAS 43 (compensated absences)
and FAS 106 (postretirement benefits). In both cases, the business community said
that the new standard would force it to reduce benefits to employees—and in some cases it
did just that. The counterargument was perhaps more impressive, however: as a consequence
of formerly failing to fully account for the actual economics of promises made or
benefits granted, companies were misled regarding their true financial condition, which, once
exposed, resulted in changes in behavior that were arguably long overdue. Managers were
harmed by their former ignorance and by the delay; they were not hurt by the truth. (Proposed
changes to accounting for pensions and other postemployment benefits, discussed in
Chapter 16, will inevitably also trigger much anguish and again, quite possibly, reductions in
promised benefits).
In two recent cases, dissatisfaction with proposed standards escalated to the point where
the business community asked the federal government to intervene. When, in the mid-1990s,
FASB proposed that the value of stock options granted to employees be reflected as an expense
in the financial statements, the business community, and particularly technology firms,
loudly claimed that the proposed recognition would have a dramatic and negative economic
effect. First, the argument went, it would force them to discontinue issuing stock options,
which would prevent the companies from compensating valuable employees. Second, to the
extent options were granted and reflected in expense, it would cause the firms’ costs of capital
to increase significantly because of lower levels of reported profitability. Finally, it
would put US firms at a competitive disadvantage to foreign companies that did not have to
expense the value of stock options (or were not offering this benefit to employees).
Before that battle ended, “sense of the House” and “sense of the Senate” resolutions had
been introduced, objecting to FASB’s tentative conclusions, and a bill had been introduced
that would have, if enacted, precluded the recognition of the value of stock options as an
Chapter 1 / Researching GAAP Matters 19
expense as a matter of law. This debate threatened not only the stock-based compensation
standard, but also the future of accounting standard setting in the private sector itself. That
concern contributed to FASB’s decision to issue FAS 123 with only a requirement for disclosure
of the value of stock options, with recognition and measurement optionally continuing
under prior (APB 25) rules. Not surprisingly, virtually all publicly held companies continued
to utilize the “implicit value” approach of APB 25, even though FAS 123 clearly
stated that the “fair value” approach was preferable GAAP. (Interestingly, after the Enron
and WorldCom scandals, and the resulting Sarbanes-Oxley legislation, some companies began
to voluntarily expense options, and FASB responded by issuing an Exposure Draft in
March 2004, later finalized as FAS123(R), that requires companies to expense share-based
compensation.
Later, when FASB was pursuing its derivative financial instruments project, the business
community again approached the Congress with a request for it to intercede in the debate.
Although the federal government was not as quick to intervene in this instance, FASB was
again criticized by several members of Congress and by their staff. To have been thus criticized
and, in part, thwarted by influential government officials twice in a span of five years
might have proved to be detrimental as the Congress considered legislation in response to the
collapse of Enron Corp. However, standard setting in the private sector, and the supremacy
of FASB in the standard-setting role, appear to have survived those challenges, at least for
the immediate future. It remains to be seen how, if at all, convergence with—or possible
supersession by—IFRS might be responded to by those who wish to see a more prominent
role by government in the financial reporting standard-setting sphere.
The Business Reporting Research Project
Beginning in 1998, FASB undertook research on business reporting (which has been defined
to include both financial and nonfinancial information), with the goal of identifying the
types of information businesses were already voluntarily providing, and the means used to
deliver it.
FASB produced four reports setting forth results of this project as follows:
1. Update of Electronic Distribution of Business Reporting Information—Survey of
Business Reporting Research Information on Companies’ Internet Sites (May 2002),
an update of the report issued in 2000, which describes the reporting of business information
over the Internet and identifies notable practices.
2. Improving Business Reporting: Insights into Voluntary Disclosures (January 2001),
which identifies the kinds of business information that corporations in eight selected
industries are reporting outside of their financial statements.
3. GAAPSEC Disclosure Requirements (March 2001), which identifies redundancies
between GAAP and SEC disclosure requirements and ways to eliminate them.
4. Business and Financial Reporting: Challenges from the New Economy (April
2001), which examines the perceived “disconnect” between information provided in
financial statements (“old economy” financial reporting) and the information needs
of investors and creditors (“new economy” financial reporting).
The FASB business reporting research project appears, as of early-2009, to no longer be
an active undertaking.
Other projects and proposals have followed, produced by accounting standards-related
bodies and others, including a number of private-sector and academic proposals worthy of
attention. Most recently, a far-reaching set of changes to financial reporting has been proposed
by the CFA Institute (A Comprehensive Business Reporting Model: Financial Reporting
for Investors [draft, October 2005], which, among other things, strongly endorses
20 Wiley GAAP 2009 Codification Edition
universal use of fair value information). However, to this date, there have been no fundamental
changes in financial reporting requirements or expectations. Perhaps the most promising
currently ongoing effort is FASB’s Financial Statement Presentation (originally, Financial
Performance Reporting) project, preliminary views on which are expected to be unveiled
in late 2008. A joint undertaking with the International Accounting Standards Board
(IASB), this is intended to establish standards for the presentation of information in financial
statements that would improve the usefulness of that information in assessing the financial
performance of an entity.
This project is to focus on form and content, classification and aggregation, and display
of specified items and summarized amounts on the face of the financial statements. That
includes determining whether to require the display of certain items determined to be key
measures or necessary for the calculation of key measures. The project will not address
management discussion and analysis (MD&A found in SEC filings) or the reporting of pro
forma earnings in press releases or other communications outside financial statements. Also,
it will not address segment information or matters of recognition or measurement of items in
financial statements. As of mid-2008, a number of tentative decisions have been made by
FASB and IASB, but much work remains to be done on this project.
This project is discussed in somewhat more detail in Chapter 3.
RESEARCHING GAAP PROBLEMS
The research procedures presented here are intended to serve as a general model for approaching
research on accounting issues or questions you may have. These procedures are
only intended as an illustration of the process, not as a “cookbook” approach. These procedures
should be refined and adapted to each individual fact situation.
Research Procedures
Step 1: Identify the Problem
It has been observed that the act of defining a problem provides a large fraction of the
solution to the problem. This certainly applies to the domain of researching financial reporting
issues, as well. Most often it is found that incorrect answers (e.g., regarding the
proper way to report revenue-producing activities) flow from improper definition of the
actual question to be resolved. Provisional definitions of problems should be vigorously
challenged before attempting to search for solutions. The process to be employed is to
• Gain an understanding of the problem or question.
• Challenge the tentative definition of the problem and revise, as necessary.
• Problems and research questions can arise from new authoritative pronouncements,
changes in a firm’s economic operating environment, or new transactions, as well as
from the realization that the problem had not been properly defined in the past.
• It is important to remember that research can be performed before or after the critical
event has occurred. However, if proposed transactions and potential economic circumstances
are anticipated, more deliberate attention can be directed at finding the
correct solution, and certain proposed transactions having deleterious reporting consequences
might be avoided altogether or structured more favorably.
• If little is known about the subject area, it may be useful to consult general reference
sources (e.g., Journal of Accountancy, CPA Journal, Business Week) to become more
familiar with the topic and build up some “economic horse sense” in the area (i.e., the
basic what, why, how, when, who, where). Web-based research vastly expands the
ability to gather useful information.
Chapter 1 / Researching GAAP Matters 21
• If you are a preparer/auditor, ensure that you have sufficiently determined whether the
issue you are researching is a GAAP issue or an auditing issue so that your search is
directed to the appropriate literature.
• With the ongoing process of convergence with IFRS (and possible IFRS adoption) a
reality, it will be wise to consider not merely short-term implications under US
GAAP, but longer-term potential ramifications if changes are made to existing GAAP.
Step 2: Analyze the Problem
• Identify critical factors, issues, and questions that relate to the research problem.
• What are the options? Brainstorm possible alternative accounting treatments. Note
that alternatives continue to narrow both under US GAAP and also due to ongoing efforts
to converge to IFRS.
• What are the goals of the transaction? Are these goals compatible with full and
transparent disclosure and recognition? Evolving GAAP and IFRS will both place
greater emphasis on “transparency” in financial reporting.
• What is the economic substance of the transaction, irrespective of the manner in which
it appears to be structured?
• What limitations or factors can impact the accounting treatment?
Step 3: Refine the Problem Statement
• Clearly articulate the critical issues in a way that will facilitate research and analysis.
Step 4: Identify Plausible Alternatives
• Plausible alternative solutions are based upon prior knowledge or theory.
• Additional alternatives may be identified as steps 5-7 are completed.
• The purpose of identifying and discussing different alternatives is to be able to respond
to key accounting issues that arise out of a specific situation.
• The alternatives are the potential methods of accounting for the situation from which
only one will ultimately be chosen.
• Exploring alternatives is important because many times there is no single cut-anddried
financial reporting solution to the situation.
• Ambiguity often surrounds many transactions and related accounting issues and, accordingly,
the accountant and business advisor must explore the alternatives and use
professional judgment in deciding on the proper course of action.
• Remember that other accountants may reasonably disagree with the judgment used or
conclusions made, but this does not necessarily mean they are right.
Step 5: Develop a Research Strategy
• Determine which authorities or literature need to be searched. Often it will be necessary
to search all authoritative literature (FASB, EITF, SEC, AICPA, etc.) as well as
current reporting practices (e.g., annual reports).
• Generate keywords or phrases that will form the basis of an electronic search.
• Consider trying a broad search to
• Assist in developing an understanding of the area,
• Identify appropriate search terms, and
• Identify related issues and terminology.
• Consider trying very precise searches to identify if there is authoritative literature directly
on point.
22 Wiley GAAP 2009 Codification Edition
Step 6: Search Authoritative Literature (described in additional detail below)
• This step involves implementation of the research strategy through searching,
identifying, and locating applicable information.
• Research published GAAP.
• Research using Wiley GAAP.
• Research other literature.
• Research practice.
• Use theory.
• Find analogous events and/or concepts that are reasonably similar.
Step 7: Evaluation
• Analyze and evaluate all of the information obtained.
• This evaluation should lead to the development of a solution or recommendation.
Again it is important to remember that steps 3-7 describe activities that will interact
with each other and lead to a more refined process in total, and a more complete solution.
These steps may involve several iterations.
Search Authoritative Literature (Step 6) —Further Explanation
The following sections discuss in more detail how to search authoritative literature as
outlined in Step 6.
Researching authoritative sources of GAAP. Begin with the publications that set
forth the accounting standards in the GAAP hierarchy—the FASB, the AICPA, and the EITF
(and for public companies, the SEC).
FASB publishes both loose leaf and bound sets of books, as well as CDROMs, of the
Current Text and the Original Pronouncements. The former integrates all of the currently
recognized category A GAAP alphabetically in topic order (e.g., Accounting Changes, Business
Combinations, etc.). The AICPA Research Bulletins, APB Opinions, and FASB Statements
and Interpretations have been combined in this integrated document. Supplemental
guidance from the AICPA Accounting Interpretations and FASB Technical Bulletins is also
incorporated. All these materials have been edited down from the original pronouncements
and thus may lack the precision that can be obtained only from the unedited version. Each
paragraph in the Current Text is referenced to the pronouncement from which it is drawn,
which is useful for research or follow-up. The first volume of the Current Text deals with
general standards, while the second contains standards for specialized industries. Descriptive
materials, including reasons for conclusions, are absent from the Current Text.
The Original Pronouncements contains all of the AICPA Accounting Research Bulletins,
APB Opinions, the FASB Standards, Interpretations, Concepts Statements, and Technical
Bulletins. Paragraphs containing accounting principles that have been superseded or
dropped are shaded to alert the user. All changes are identified in detail on a status page
placed at the beginning of each pronouncement, which can also assist the user in finding
other relevant materials.
Generally, if a quick answer to a specific question is needed, the Current Text can be accessed
readily. If a fuller understanding of the answer and the reasons underlying it are required,
the Original Pronouncements may be preferable. In many cases, both sources should
be consulted.
FASB also publishes the EITF Abstracts (category C GAAP). Each EITF issue discussed
by the Task Force is included in the book, regardless of whether a consensus was
reached, in the order in which they were added to the EITF agenda. A status section at the
end of each issue indicates whether the consensus has been superseded or remains relevant
and whether any additional EITF discussion is planned. Many issues are discussed a number
Chapter 1 / Researching GAAP Matters 23
of times, and in some cases consensuses are withdrawn or modified in subsequent considerations
of a given issue. Accordingly, care must be exercised because, unlike FASB Statements,
for example, issues addressed in EITF consensuses can evolve without adequate notice
that they have been affected by subsequently issued standards.
EITF Abstracts also includes EITF Discussion Issues, which are FASB or SEC staff announcements
of positions taken on issues that have yet to be resolved, or even addressed, by
the EITF or other standard-setting bodies. While not within the GAAP hierarchy, these do
represent current thinking on the particular topic and should be given due consideration in
resolving practice problems. The more important of these are covered in this book.
FASB staff issues application guidance (like that found in FASB Staff Implementation
Guides and EITF Discussion Issues) through FASB Staff Positions (which it intends to belong
to category A GAAP). The staff positions are initially communicated through the
FASB Web site (www.fasb.org) and remain there until incorporated into printed FASB literature.
FASB staff positions are answers to questions about appropriate application of
FASB literature expected to be of widespread relevance to constituents and for which the
FASB staff believes that there is only one acceptable answer. The more important of these
are covered in this book.
The AICPA publishes all its outstanding Statements of Position and Practice Bulletins in
AICPA Technical Practice Aids. That book is organized in a manner similar to FASB’s
Original Pronouncements, with the SOP and Practice Bulletins included in the order in
which they were issued. There are 26 audit and accounting guides, which are listed at the
front of this publication following the AICPA Statements of Position. These publications are
available in soft-cover, loose-leaf binder, and electronically on the Internet or CD-ROM.
There are also several commercial services that provide electronic Web-based access to
all promulgated GAAP. The great advantage of electronic access is that information can be
randomly accessed, so a search by topic will yield a plethora of potentially useful leads. The
“fuzzy search” option is quite forgiving of poorly articulated search terms, most often leading
the researcher to relevant materials even when the seeker is not clear about what is actually
being sought.
Researching using Wiley GAAP Codification Edition. This publication can assist in
researching generally accepted accounting principles for the purpose of identifying technical
answers to specific inquiries. You can begin your search in one of two ways: by using the
contents page at the front of this book to determine the chapter in which the answer to your
question is likely to be discussed, or by using the index at the back of this publication to
identify specific pages of the publication that discuss the subject matter relating to your
question. The path chosen depends in part on how specific the question is; an initial reading
of the chapter or relevant section thereof will provide a broader perspective on the subject.
For example, if one wanted to know how to account for receivables pledged as collateral, it
would be best to start with Chapter 5. However, if one’s interest was limited to
securitizations of credit card portfolios, it might be better to search the index, because
securitizations are a very specialized type of transaction involving receivables, addressed in
only a few pages of the text.
Each chapter in this publication is organized in the following manner:
• A chapter table of contents on the first page of the chapter
• Perspective and Issues, providing an overview of the chapter contents and noting any
current controversy or proposed GAAP changes affecting the chapter’s topics
• Definition of Terms, defining any specialized terms unique to the chapter’s subject
matter
• Concepts, Rules, and Examples, setting forth the detailed guidance and examples
24 Wiley GAAP 2009 Codification Edition
After reading the relevant portions of this publication, the Sources of GAAP box can be
used to find the authoritative pronouncements related to the topic so that these can be appropriately
understood and cited in documenting your research findings and conclusions. Upon
identifying these pronouncements, refer to the Authoritative Accounting Pronouncements
section preceding this chapter, which lists all authoritative pronouncements currently in effect
in numerical order. The listed pronouncements are referenced both to the Current Text
published by FASB and to pages in this publication. Using this list, one can crossreference
to or from this publication to both the original pronouncements and/or the Current Text.
Likewise, the reader familiar with the professional literature can use the listing of authoritative
accounting pronouncements to quickly locate the pages in this publication relevant to
each specific pronouncement. The reader can therefore locate more detail on each topic covered
in this publication, and also be aware of those few, highly specialized topics and pronouncements
not covered within this publication.
The current status of each EITF Issue is indicated—that is, whether superseded, resolved,
or consensus reached by the EITF, or whether further discussion is pending. Explanations
of EITF Issues are integrated in the chapter text to facilitate a logical flow, enhance
readability, and increase the likelihood that the researcher will find the information relevant
to his or her issue logically grouped together in the most easily retrievable manner.
Researching nonpromulgated GAAP. Researching nonpromulgated GAAP consists
of reviewing pronouncements in areas similar to those being researched, reading accounting
literature mentioned in the GAAP hierarchy as “other sources” to be used when sources at
levels A through D do not exist, and careful reading of the relevant portions of the FASB
Conceptual Framework summarized later in this chapter. Understanding concepts and intentions
espoused by accounting experts can give the essential clues to a logical formulation of
alternatives and conclusions regarding problems that have not yet been addressed by the
standard-setting bodies.
Both the AICPA and FASB publish a myriad of nonauthoritative literature. FASB publishes
the documents it uses in its due process: Discussion Memorandums, Invitations to
Comment, Exposure Drafts, and Preliminary Views as well as minutes from its meetings. It
also publishes research reports, newsletters, and implementation guidance. The AICPA publishes
its Exposure Drafts, as well as Technical Practice Aids, Issues Papers, comment letters
on proposals of other standard-setting bodies, and the monthly periodical, Journal of Accountancy.
Technical Practice Aids are answers published by the AICPA Technical Information
Service to questions about accounting and auditing standards. AICPA Issues Papers
are research documents about accounting and reporting problems that the AICPA believes
should be resolved by FASB. They provide information about alternative accounting treatments
used in practice. These two AICPA publications, which are not approved by FASB,
have no authoritative status, but those who depart from their guidance should be prepared to
justify that departure based upon the facts and circumstances of the particular situation.
Listings of FASB and AICPA publications are available at their Web sites. (A list of Web
site addresses is located at the end of this chapter.)
The Securities and Exchange Commission issues Staff Accounting Bulletins and makes
rulings on individual cases that come before it, which create and impose accounting standards
on those whose financial statements are to be submitted to the Commission. The SEC,
through acts passed by Congress, has been given broad powers to prescribe accounting practices
and methods for all statements filed with it.
The International Accounting Standards Board (IASB) publishes its standards, interpretations,
the Framework for the Preparation and Presentation of Financial Statements, and
project archives. Summaries of the standards and interpretations and the project archives are
Chapter 1 / Researching GAAP Matters 25
available at the Board’s Web site, along with instructions for purchasing the complete standards,
interpretations, and other materials.
The American Accounting Association (AAA) is an organization consisting primarily of
accounting educators. It is devoted to encouraging research into accounting theory and practice.
The issuances of the AAA tend to be normative, that is, prescribing what GAAP ought
to be like, rather than explaining current standards. However, the monographs, committee
reports, and The Accounting Review published by the AAA may be useful sources for research
into applicable accounting standards.
Governmental agencies such as the Government Accountability Office, the Federal Accounting
Standards Advisory Board, and the Cost Accounting Standards Board have certain
publications that may assist in researching written standards. Also, industry organizations
and associations may be other helpful sources.
Certain publications are helpful in identifying practices used by entities that may not be
promulgated as standards. The AICPA publishes an annual survey of the accounting and
disclosure policies of many public companies in Accounting Trends and Techniques and
maintains a library of financial statements that can be accessed through a computerized
search process (NAARS). EDGAR (Electronic Data Gathering, Analysis, and Retrieval)
publishes the SEC filings of public companies, which includes the companies’ financial
statements. Through selection of keywords and/or topics, these services can provide information
on how other entities resolved similar problems.
Internet-based research sources. There has been and continues to be an information
revolution affecting the exponential growth in the volume of materials, authoritative and
nonauthoritative, that are available on the Internet. A listing of just a small cross-section of
these sources follows:
AccountingWeb sites
AICPA
Online
http://www.aicpa.org Includes accounting news section; CPE information;
section on professional ethics; information
on relevant Congressional/Executive
actions; online publications, such as the Journal
of Accountancy; Accounting Standards Executive
Committee; also has links to other organizations;
includes links to authoritative
standards for nonissuers including auditing
standards, attestation standards, and quality
control standards
American
Accounting
Association
http://www.aaahq.org Accounting news; publications; faculty information;
searchable; links to other sites
FASB http://www.fasb.org Information on FASB; includes list of new Pronouncements/
Statements; summaries of selected
projects; summaries/status of all FASB
Statements. Due to funding provided by
PCAOB, FASB now posts its statements, interpretations,
staff positions, and newly issued
EITF issues on its Web site.
FASB
Codification
http://asc.fasb.org/home Searchable database using the new accounting
codification; includes cross-referencing and
tutorials
26 Wiley GAAP 2009 Codification Edition
GASB http://www.gasb.org Information on GASB; new GASB documents;
summaries/status of all GASB statements; proposed
Statements; Technical Bulletins; Interpretations
International
Accounting
Standards
Board (IASB)
http://www.iasb.org.uk Information on the IASB; lists of Pronouncements,
Exposure Drafts, project summaries, and
conceptual framework
NASBA http://www.nasba.org National State Boards of Accountancy; includes
listings of registered CPE sponsors and links to
state boards of accountancy as well as standards
governing continuing professional education
that it jointly issues with the AICPA
PCAOB http://www.pcaobus.org Sections on rulemaking, standards (including the
interim auditing, attestation, quality control,
ethics, and independence standards), enforcement,
inspections and oversight activities
Rutgers
Accounting
Web
http://www.accounting.rutgers.edu Includes links to journals and publications, software,
publishers, educational institutions, government
agencies, and information regarding
continuous auditing initiatives
SEC http://www.sec.gov SEC digest and statements; EDGAR searchable
database; information on current SEC rulemaking;
links to other sites
WebCPA http://www.webcpa.com Breaking news regarding the profession, links to
regulators, taxing agencies, associations, and
agencies
Example of how to solve a GAAP problem. As an example of how to solve a GAAP
problem, let us examine how the FASB and its staff approached a question raised by the
Edison Electric Institute (EEI) in the project that eventually led to FAS 143, Asset Retirement
Obligations.
The EEI requested that the FASB add a project to its agenda to determine the appropriate
accounting for removal costs, such as the costs of nuclear decommissioning and similar
costs affecting other industries. At the time this was raised, the existing accounting practices
for removal costs were inconsistent as to the criteria used for recognition, measurement, and
the presentation of the obligation in the financial statements. Some entities did not recognize
any obligations for removal costs until actually incurred. Other entities estimated the cost of
retiring the asset and accrued a portion of that amount each period as an expense, with an
offsetting liability, so that when the asset was retired a liability for the full amount of the
removal costs would already be on the ledger. Still others recognized the expense but displayed
the credit side of the entry as a contra asset rather than a liability.
FASB looked for an analogous situation and found one in FAS 19, Financial Accounting
and Reporting by Oil and Gas Producing Companies. Paragraph 37 of that standard states
that “estimated dismantlement, restoration, and abandonment cost shall be taken into account
in determining amortization and depreciation rates.” The effect of that paragraph was that
the credit side of the entry was to accumulated depreciation, which could result in an accumulated
depreciation amount that exceeded the cost of the asset. There was no recognition
of an obligation to dismantle and restore the property (a liability). Instead the focus was on
achieving a particular pattern of expense recognition. Because the amount of the obligation
that the entity had incurred was not a central concern under FAS 19, the FASB (which emChapter
1 / Researching GAAP Matters 27
braced a balance sheet orientation in its conceptual framework, which was issued after FAS
19 was promulgated) rejected it and sought another solution.
FASB considered the definition of a liability in paragraphs 36-40 of CON 6 to determine
whether nuclear decommissioning and similar asset retirements could be considered liabilities
of the entities owning the assets. Since the first characteristic of a liability—that an entity
has “a present duty or responsibility to one or more other entities that entails settlement
by probable future transfer or use of assets at a specified or determinable date, on occurrence
of a specified event, or on demand”—would be met when an entity is required by current
laws, regulations, or contracts to settle an asset retirement obligation upon retirement of the
asset, FASB concluded that accounting for this liability would be the central goal of the new
standard.
In some situations, the duty or responsibility to remove the asset is created by an entity’s
own promise. In other situations, the duty or responsibility is created by circumstances in
which an entity finds itself bound to perform, and others are justified in relying on the entity
to perform. Thus, in its initial deliberations, the FASB decided that entities should report
both legal and constructive obligations in their financial statements. Paragraph 36 of CON 6,
which defines the essential characteristics of a liability, recognizes both types of obligations.
It states
...although most liabilities rest generally on a foundation of legal rights and duties, existence
of a legally enforceable claim is not a prerequisite for an obligation to qualify as a liability if
for other reasons the entity has the duty or responsibility to pay cash, to transfer other assets,
or to provide services to another entity.
Paragraph 40 of CON 6 provides further insight. It states
Liabilities stemming from equitable or constructive obligations are commonly paid in the
same way as legally binding contracts, but they lack the legal sanction that characterizes
most liabilities and may be binding primarily because of social or moral sanctions or custom.
An equitable obligation stems from ethical or moral constraints rather than from rules of
common or statute law....
During its due process, FASB heard from constituents that without improved guidance
for determining whether a constructive obligation exists, inconsistent application of the final
standard would result. After further consideration of the qualitative characteristics of reliability
and comparability found in CON 2, and the recognition characteristic of reliability in
CON 5, the FASB decided to confine recognition only to legal obligations, including legal
obligations created under the doctrine of promissory estoppel.
FASB also considered the second characteristic of a liability, that “the duty or responsibility
obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice.”
It concluded that an asset retirement obligation had that characteristic.
FASB considered the third and final characteristic of a liability, that “the transaction or
other event obligating the entity has already happened.” It concluded that an entity must
look to the nature of the duty or responsibility to assess whether the obligating event has occurred.
FASB provides the example of a nuclear power facility: although the operator assumes
responsibility for decontamination upon receipt of a license, it is not until the facility
is operated and contamination occurs that there is an obligating event.
When contemplating the manner in which the asset retirement obligation could be
measured, FASB was guided by CON 7. In that concepts statement, FASB concluded that
“the only objective of present value, when used in accounting measurements at initial recognition
and fresh-start measurements, is to estimate fair value.” Based on this, FASB determined
that an asset retirement obligation should be measured at fair value, but in the (typical)
absence of quoted market prices or prices for similar liabilities, entities should use present
value techniques to measure the liability.
28 Wiley GAAP 2009 Codification Edition
In deciding upon the appropriate designation of the debit offsetting the entry recording
the obligation, FASB first made reference to the definition of an asset under CON 6. FASB
concluded that capitalized asset retirement costs would not qualify for presentation as a separate
asset because no separate future economic benefit flows from these costs. Thus, asset
retirement costs do not meet the definition of an asset in paragraph 25 of CON 6. However,
FASB observed that current accounting practice includes in the historical-cost basis of an
asset all the costs that are necessary to prepare the asset for its intended use. FASB concluded
that the requirement for capitalization of the asset retirement cost as part of the historical
cost of the asset and then depreciating that asset both (1) obtains a measure of cost
that more closely reflects the entity’s total investment in the asset, and (2) permits the allocation
of that cost to expense in the periods over which the related asset would be expected
to provide benefits.
Thus, in this actual situation, by reasoning from analogous situations and applying established
accounting concepts, FASB was able to develop an important new standard. In a
like manner, solutions to GAAP practice problems can be reached. Those solutions will
serve the reporting entity in achieving GAAP-compliant financial reporting until a standardssetting
body resolves the problem by issuing authoritative guidance.
The Conceptual Framework
FASB has issued seven pronouncements (six of which remain extant) called Statements
of Financial Accounting Concepts (CON) in a series designed to constitute a foundation of
financial accounting standards. This conceptual framework is designed to prescribe the nature,
function, and limits of financial accounting and to be used as a guideline that will lead
to consistent standards. These conceptual statements do not establish accounting standards
or disclosure practices for particular items. They are not enforceable under the AICPA Code
of Professional Conduct.
FASB’s conceptual framework is intended to serve as the foundation upon which the
Board can construct standards that are both sound and internally consistent. The fact that the
framework was intended to guide FASB in establishing standards is embodied in the preface
to each of the Concepts Statements. The preface to CON 6 states
The Board itself is likely to be the most direct beneficiary of the guidance provided by the
Statements in this series. They will guide the Board in developing accounting and reporting
standards by providing the Board with a common foundation and basic reasoning on which
to consider merits of alternatives.
The conceptual framework is also intended for use by the business community to help
understand and apply standards and to assist in their development. This goal is also mentioned
in the preface to each of the Concepts Statements, as this excerpt from CON 6 shows.
However, knowledge of the objectives and concepts the Board will use in developing standards
also should enable those who are affected by or interested in financial accounting
standards to understand better the purposes, content, and characteristics of information provided
by financial accounting and reporting. That knowledge is expected to enhance the
usefulness of, and confidence in, financial accounting and reporting. The concepts also may
provide some guidance in analyzing new or emerging problems of financial accounting and
reporting in the absence of applicable authoritative pronouncements.
The FASB Special Report, The Framework of Financial Accounting Concepts and Standards
(1998), states that the conceptual framework should help solve complex financial accounting
or reporting problems by
• Providing a set of common premises as a basis for discussion;
• Providing precise terminology;
• Helping to ask the right questions;
Chapter 1 / Researching GAAP Matters 29
• Limiting areas of judgment and discretion and excluding from consideration potential
solutions that are in conflict with it; and
• Imposing intellectual discipline on what traditionally has been a subjective and ad hoc
reasoning process.
Of the seven CON, the fourth, Objectives of Financial Reporting by Nonbusiness Organizations,
is not covered here due to its specialized nature.
Components of the conceptual framework. The components of the conceptual framework
for financial accounting and reporting include objectives, qualitative characteristics,
elements, recognition, measurement, financial statements, earnings, funds flow, and liquidity.
The relationship between these components is illustrated in the following diagram reproduced
from a FASB Invitation to Comment, Financial Statements and Other Means of
Financial Reporting.
In the diagram, components to the left are more basic and those to the right depend on
components to their left. Components are closely related to those above or below them.
The most basic component of the conceptual framework is the objectives. The objectives
underlie the other phases and are derived from the needs of those for whom financial
information is intended. The qualitative characteristics are the criteria to be used in choosing
and evaluating accounting and reporting policies.
Elements of financial statements are the components from which financial statements are
created. They include assets, liabilities, equity, investments by owners, distributions to owners,
comprehensive income, revenues, expenses, gains, and losses. In order to be included in
financial statements, an element must meet criteria for recognition and possess a characteristic
that can be reliably measured.
Conceptual Framework
for Financial Accounting and Reporting
ACCOUNTING REPORTING
ELEMENTS FINANCIAL STATEMENTS/
FINANCIAL REPORTING
RECOGNITION EARNINGS
MEASUREMENT CASH FLOWS
AND LIQUIDITY
QUALITATIVE CHARACTERISTICS
OBJECTIVES
Reporting or display considerations is concerned with what information should be provided,
who should provide it, and where it should be displayed. How the financial statements
(financial position, earnings, and cash flow) are presented is the focal point of this part
of the conceptual framework project.
A Statement of Financial Accounting Concepts (CON) does not establish GAAP. Since
GAAP may be inconsistent with the principles set forth in the conceptual framework, the
FASB expects to reexamine existing accounting standards. Until that time, a CON does not
require a change in existing GAAP. CON do not amend, modify, or interpret existing
GAAP, nor do they justify departing from GAAP based upon interpretations derived from
them.
30 Wiley GAAP 2009 Codification Edition
FASB is currently pursuing several projects affecting the conceptual framework and the
GAAP hierarchy. As to the latter, FASB expects to revise the existing hierarchy, now consisting
of four levels or categories (plus a catchall fifth level of nonpromulgated guidance,
such as from textbooks or scholarly writings, but also including the concepts statements) to a
dichotomy between authoritative and nonauthoritative guidance. In the near term, FASB
intends to elevate concepts statements to “level A” GAAP. This is indicative of a greater
awareness of the relevance of the concepts statements as guidance for making accounting
decisions. As numerous older accounting standards have evolved and been superseded by
new requirements, such as mandates for the wider use of fair value information within the
financial statements, the principles espoused in CON no longer seem as divergent from actual
practice, and may more usefully serve as actual, authoritative guides to practice.
CON 1: Objectives of Financial Reporting by Business Enterprises
CON 1 identifies the objectives (purposes) of financial reporting and indicates that these
objectives apply to all financial reporting; they are not limited to financial statements. Financial
reporting includes the financial statements and other forms of communication that
provide accounting information (corporate annual reports, prospectuses, annual reports filed
with the Securities and Exchange Commission, news releases, and management forecasts).
CON 1 identifies three objectives of financial reporting. The first objective is to provide
information that is useful in making business and economic decisions. Users of financial
information are divided into internal and external groups. Internal users include management
and directors of the business enterprise. Internal reports tend to provide information that is
more detailed than the information available to or used by external users. External users include
both individuals who have or intend to have a direct economic interest in a business
and those who have an indirect interest because they advise or represent those individuals
with a direct interest. These users include owners, lenders, suppliers, potential investors and
creditors, employees, customers, financial analysts and advisors, brokers, underwriters, stock
exchanges, lawyers, economists, taxing authorities, regulatory authorities, legislators, financial
press and reporting agencies, labor unions, trade associations, business researchers,
teachers, students, and the public. CON 1 is directed at general-purpose external financial
reporting by a business enterprise as it relates to the ability of that enterprise to generate favorable
cash flows. External users’ needs are emphasized because these users lack the authority
to obtain the financial information they want and need from an enterprise. Thus, external
users must rely on the information provided to them by management.
The second objective of financial reporting is to provide understandable information that
will aid investors and creditors in predicting the future cash flows of a firm. Investors and
creditors want information about cash flows because the expectation of cash flows affects a
firm’s ability to pay interest and dividends, which in turn affects the market price of that
firm’s stocks and bonds.
The third objective of financial reporting is to provide information relative to an enterprise’s
economic resources, the claims to those resources (obligations), and the effects of
transactions, events, and circumstances that change resources and claims to resources. A
description of these informational needs follows:
• Economic resources, obligations, and owners’ equity. This information provides
the users of financial reporting with a measure of future cash flows and an indication
of the firm’s strengths, weaknesses, liquidity, and solvency.
• Economic performance and earnings. Past performance provides an indication of a
firm’s future performance. Furthermore, earnings based upon accrual accounting provide
a better indicator of economic performance and future cash flows than do current
Chapter 1 / Researching GAAP Matters 31
cash receipts and disbursements. Accrual basis earnings are a better indicator because
a charge for recovery of capital (depreciation/amortization) is made in determining
these earnings. The relationship between earnings and economic performance results
from matching the costs and benefits (revenues) of economic activity during a given
period by means of accrual accounting. Over the life of an enterprise, economic performance
can be determined by net cash flows or by total earnings since the two
measures would be equal.
• Liquidity, solvency, and funds flows. Information about cash and other funds flows
from borrowings, repayments of borrowings, expenditures, capital transactions, economic
resources, obligations, owners’ equity, and earnings may aid the user of financial
reporting information in assessing a firm’s liquidity or solvency.
• Management stewardship and performance. The assessment of a firm’s management
with respect to the efficient and profitable use of the firm’s resources is usually
made on the basis of economic performance as reported by periodic earnings. Because
earnings are affected by factors other than current management performance,
earnings may not be a reliable indicator of management performance.
• Management explanations and interpretations. Management is responsible for the
efficient use of a firm’s resources. Thus, it acquires knowledge about the enterprise
and its performance that is unknown to the external user. Explanations by management
concerning the financial impact of transactions, events, circumstances, uncertainties,
estimates, judgments, and any effects of the separation of the results of operations
into periodic measures of performance enhance the usefulness of financial information.
CON 2: Qualitative Characteristics of Accounting Information
The purpose of financial reporting is to provide decision makers with useful information.
When accounting choices are to be made by individuals or by standard-setting bodies, those
choices should be based upon the usefulness of that information to the decision-making process.
This CON identifies the qualities or characteristics that make information useful in the
decision making process. It also establishes a terminology and set of definitions to provide a
greater understanding of the characteristics. The diagram below from CON 2 summarizes
the qualitative characteristics of accounting information.
Usefulness for decision making. This is the most important characteristic of information.
Information must be useful to be beneficial to the user. To be useful, accounting information
must be both relevant and reliable. Both of these characteristics are affected by
the completeness of the information provided.
Relevance. Information is relevant to a decision if it makes a difference to the decision
maker in his/her ability to predict events or to confirm or correct expectations. Relevant information
will reduce the decision maker’s assessment of the uncertainty of the outcome of a
decision even though it may not change the decision itself. Information is relevant if it provides
knowledge concerning past events (feedback value) or future events (predictive value)
and if it is timely. Disclosure requirement information is relevant because it provides information
about past events and it improves the predictability of future events. The predictive
value of accounting information does not imply that such information is a prediction. The
predictive value refers to the utility that a piece of information has as an input into a predictive
model. Although timeliness alone will not make information relevant, information must
be timely to be relevant. It must be available before it loses its ability to influence the decision
maker.
32 Wiley GAAP 2009 Codification Edition
A Hierarchy of Accounting Qualities
COMPARABILITY
(INCLUDING CONSISTENCY)
DECISION MAKERS
AND THEIR CHARACTERISTICS
(FOR EXAMPLE,
UNDERSTANDING
OR PRIOR KNOWLEDGE)
UNDERSTANDABILITY
DECISION USEFULNESS
RELEVANCE RELIABILITY
TIMELINESS
PREDICTIVE
VALUE
FEEDBACK
VALUE
NEUTRALITY
VERIFIABILITY REPRESENTATIONAL
FAITHFULNESS
BENEFITS > COSTS
USERS OF
ACCOUNTING INFORMATION
INGREDIENTS OF
PRIMARY QUALITIES
THRESHOLD FOR
RECOGNITION
PERVASIVE
CONSTRAINT
USER-SPECIFIC
QUALITIES
PRIMARY DECISIONSPECIFIC
QUALITIES
SECONDARY AND
INTERACTIVE
QUALITIES
MATERIALITY
Reliability. Financial statements are an abstraction of the activities of a business enterprise.
They simplify the activities of the actual firm. To be reliable, financial statements
must portray the important financial relationships of the firm itself. Information is reliable if
it is verifiable and neutral and if users can depend on it to represent that which it is intended
to represent (representational faithfulness).
Information may not be representationally faithful if it is biased. Bias is the tendency
for an accounting measure to be consistently too high or too low. Bias may arise because the
measurer does not use the measurement method properly or because the measurement
method does not represent what it purports to represent.
Verifiability means that several independent measures will obtain the same accounting
measure. An accounting measure that can be repeated with the same result (consensus) is
desirable because it serves to detect and reduce measurer bias. Cash is highly verifiable.
Inventories and depreciable assets tend to be less verifiable because alternative valuation
methods exist. The direct verification of an accounting measure would serve to minimize
measurer bias and measurement bias. The verification of the procedures used to obtain the
measure would minimize measurer bias only. Finally, verifiability does not guarantee representational
faithfulness or relevance.
The characteristic of neutrality means that accounting information should serve to communicate
without attempting to influence behavior in a particular direction. This does not
mean that accounting should not influence behavior or that it should affect everyone in the
same way. It means that information should not favor certain interest groups.
To be useful, accounting information should be comparable. The characteristic of comparability
allows the users of accounting information to assess the similarities and differences
either among different entities for the same time period or for the same entity over different
time periods. Comparisons are usually made on the basis of quantifiable measurements of a
common characteristic. Therefore, to be comparable, the measurements used must be reliable
with respect to the common characteristic. Noncomparability can result from the use of
different inputs, procedures, or systems of classification. Noncomparability can also arise
when the data measurements lack representational faithfulness.
Chapter 1 / Researching GAAP Matters 33
The characteristic of consistency also contributes to information usefulness. Consistency
is an interperiod comparison that requires the use of the same accounting principles
from one period to another. Although a change of an accounting principle to a more preferred
method results in inconsistency, the change is acceptable if the effect of the change is
disclosed. Consistency does not insure comparability. If the measurements used are not representationally
faithful, comparability will not be achieved.
Trade-offs. Although it is desirable that accounting information contain the characteristics
that have been identified above, not all of these characteristics are compatible. Often,
one characteristic may be obtained only by sacrificing another. The trade-offs that must be
made are determined on the basis of the relative importance of the characteristics. This relative
importance, in turn, is dependent upon the nature of the users and their particular needs.
Constraints. The qualitative characteristics of useful accounting information are subject
to two constraints: the materiality and the relative cost benefit of that information. An
item of information is material and should be reported if it is significant enough to have an
effect on the decision maker. Materiality requires judgment. It is dependent upon the relative
size of an item, the precision with which the item can be estimated, and the nature of the
item. No general standards of materiality are provided (although an appendix to CON 2 lists
several guidelines that have been applied).
Accounting information provides the user with certain benefits. Associated with this
benefit, however, is the cost of using that information and of providing it to the user. Information
should be provided only if its benefits exceed its cost. Unfortunately, it is difficult to
value the benefit of accounting information. It is also difficult to determine whether the burden
of the cost of disclosure and the benefits of such disclosure are distributed fairly.
Role of conservatism. Conservatism is a reaction to uncertainty. For many years, accountants
have been influenced by conservatism. Conservatism in accounting may mislead
users if it results in a deliberate understatement of net assets and net income. Such understatement
is undertaken to minimize the risk of uncertainty to outside lenders. Unfortunately,
such understatements often lead to overstatements in subsequent years, produce biased
financial statements, and conflict with the characteristics of representational faithfulness,
neutrality, and comparability.
CON 3: Elements of Financial Statements of Business Enterprises
CON 3 was replaced by CON 6. CON 6 carried forward essentially all of the concepts
in CON 3, then added the elements unique to the financial statements of not-for-profit organizations.
CON 5: Recognition and Measurement in Financial Statements of Business Enterprises
CON 5 indicates that financial statements are the principal means of communicating
useful financial information. A full set of such statements contains
• Financial position at end of the period
• Earnings for the period
• Comprehensive income for the period
• Cash flows during the period
• Investments by and distributions to owners during the period
Financial statements result from simplifying, condensing, and aggregating transactions.
Therefore, no one financial statement provides sufficient information by itself and no one
item or part of each statement can summarize the information.
34 Wiley GAAP 2009 Codification Edition
A statement of financial position provides information about an entity’s assets, liabilities,
and equity. Earnings is a measure of entity performance during a period. It is similar to
net income but excludes accounting adjustments from earlier periods such as cumulative
effect changes in accounting principles. Comprehensive income comprises all recognized
changes in equity other than those arising from investments by and distributions to owners.
A statement of cash flows reflects receipts and payments of cash by major sources and uses
including operating, financing, and investing activities. The investments by and distributions
to owners reflect the capital transactions of an entity during a period.
Income is determined by the concept of financial capital maintenance which means that
only if the money amount of net assets increases during a period (excluding capital transactions)
is there a profit. For recognition in financial statements, subject to both cost benefit
and materiality constraints, an item must meet the following criteria:
1. Definition—Meet the definition of an element in financial statements
2. Measurability—Have a relevant attribute measurable with sufficient reliability
3. Relevance
4. Reliability
Items reported in the financial statements are based on historical cost, replacement cost, market
value, net realizable value, and present value of cash flows. Price level changes are not
recognized in these statements and conservatism guides the application of recognition criteria.
CON 6: Elements of Financial Statements
CON 6 defines ten interrelated elements that are used in the financial statements of business
enterprises.
1. Assets—Probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events
2. Liabilities—Probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities
in the future as a result of past transactions or events
3. Equity (net assets) —The residual interest in the assets that remains after deducting
its liabilities. In a business enterprise, equity is the ownership interest.
4. Revenues—Inflows or other enhancements of assets of an entity or settlement of its
liabilities (or a combination of both) from delivering or producing goods, rendering
services, or other activities that constitute the entity’s ongoing major and central operations
5. Expenses—Outflows or other using up of assets or incurrences of liabilities (or a
combination of both) from delivering or producing goods, rendering services, or
carrying out other activities that constitute the entity’s ongoing major and central
operations
6. Gains—Increases in equity (net assets) from peripheral or incidental transactions of
an entity and from all other transactions and other events and circumstances affecting
the entity except those that result from revenues or investments by owners
7. Losses—Decreases in equity (net assets) from peripheral or incidental transactions
of an entity and from all other transactions and other events and circumstances affecting
the entity except those that result from expenses or distributions to owners
8. Comprehensive income—The change in equity of a business enterprise during a period
from transactions and other events and circumstances from sources other than
investments by owners or distributions to owners
Chapter 1 / Researching GAAP Matters 35
9. Investments by owners—Increases in equity of a particular business enterprise
resulting from transfers to it for the purpose of increasing ownership interests
10. Distributions to owners—Decreases in the equity of a particular business enterprise
resulting from transferring assets, rendering services, or incurring liabilities to owners
The various elements articulate; that is, a change in one element causes an offsetting
change in another item of the same type or causes another element to change by the same
amount. For example, a purchase of a building for cash and a mortgage note increases an
asset (building), decreases another asset (cash), and increases a liability (mortgage note). A
diagram from CON 6 that illustrates the articulation of the elements is included below.
In this publication, assets, liabilities, and equity are described more fully in Chapter 2.
Revenues, expenses, gains, losses, and comprehensive income are described in Chapter 3.
Investments by owners and distributions to owners are described in Chapter 17.
CON 6 also defines several significant financial accounting and reporting terms that are
used in the Concepts Statements (and FASB pronouncements issued after the Concepts
Statements). An event is a happening of consequence to an entity. It can be an internal event
(the use of raw materials) or an external event with another entity (the purchase of labor) or
with the environment in which the business operates (a technological advance by a competitor).
A transaction is a particular kind of event. It is an external event that involves transferring
something of value to another entity. Circumstances are a condition, or set of conditions,
that create situations that might otherwise have not occurred and might not have been
anticipated. Accrual accounting attempts to record the financial effects on a entity of transactions
and of other events and circumstances that have consequences for the entity in the
periods in which those transactions, events, and circumstances occur rather than in the periods
in which cash is received or paid by the entity. Thus, accrual accounting is based not
only on cash transactions but also on credit transactions, bartering, changes in prices,
changes in the form of assets or liabilities, and other transactions, events and circumstances
that involve no current cash transfers but will have cash consequences in the future. Accrual
is the accounting process of recognizing the effects of future cash receipts and payments in
the current period. Deferral is the accounting process of recognizing a liability resulting
from a current cash receipt or an asset resulting from a current cash payment. Realization is
the process of converting noncash assets into cash. Recognition is the process of formally
incorporating a transaction or other event into the financial statements. Matching is the simultaneous
recognition of the revenues and expenses that result directly and jointly from the
same transaction or other event. Allocation is the process of assigning expenses to periods
when the transactions or events that cause the using up of the benefits cannot be identified or
when the cause can be identified but the actual amount of benefit used up cannot be reliably
measured.
CON 6 also discusses the elements used in the financial statements of not-for-profit organizations.
Of the ten elements, seven are used by not-for-profit organizations. The three
elements omitted are investments by owners, distributions to owners, and comprehensive
income. They are omitted because not-for-profit organizations do not have owners. The
seven remaining elements are defined for not-for-profit organizations the same as they are
for business enterprises. The net assets (equity) of not-for-profit organizations is divided into
three classes—unrestricted, temporarily restricted, and permanently restricted—based on the
existence or absence of donor-imposed restrictions. A portion of Chapter 24 describes the
accounting and reporting of not-for-profit organizations.
1. 2. 3. 4.
All changes in assets and liabilities not
accompanied by changes in equity A. All changes in assets or liabilities accompanied by
changes in equity B.
Changes within
equity that do
not affect assets
or liabilities
C.
Exchanges
of assets
for
assets
Exchanges
of
liabilities
for
liabilities
Acquisitions
of
assets by
incurring
liabilities
Settlements
of
liabilities
by transferring
assets
1. Comprehensive income
All changes in
equity from
transfers between a
business enterprise
and its owners
2.
All transactions and other events and circumstances that affect a business enterprise during a period
a. Revenues b. Gains c. Expenses d. Losses
Investments
by
owners
a.
Distributions
to
owners
b.
Chapter 1 / Researching GAAP Matters 37
CON 7: Using Cash Flow Information and Present Value in Accounting Measurements
CON 7 provides a framework for using estimates of future cash flows as the basis for
accounting measurements either at initial recognition or when assets are subsequently remeasured
at fair value (fresh-start measurements). It also provides a framework for using the
interest method of amortization. It provides the principles that govern measurement using
present value, especially when the amount of future cash flows, their timing, or both are uncertain.
However, it does not address recognition questions, such as which transactions and
events should be valued using present value measures or when fresh-start measurements are
appropriate.
Fair value is the objective for most measurements at initial recognition and for freshstart
measurements in subsequent periods. At initial recognition, the cash paid or received
(historical cost or proceeds) is usually assumed to be fair value, absent evidence to the
contrary. For fresh-start measurements, a price that is observed in the marketplace for an
essentially similar asset or liability is fair value. If purchase prices and market prices are
available, there is no need to use alternative measurement techniques to approximate fair
value. However, if alternative measurement techniques must be used for initial recognition
and for fresh-start measurements, those techniques should attempt to capture the elements
that when taken together would comprise a market price if one existed. The objective is to
estimate the price likely to exist in the marketplace if there were a marketplace—fair value.
CON 7 states that the only objective of using present value in accounting measurements
is fair value. It is necessary to capture, to the extent possible, the economic differences in the
marketplace between sets of estimated future cash flows. A present value measurement that
fully captures those differences must include the following elements:
1. An estimate of the future cash flow, or in more complex cases, series of future cash
flows at different times
2. Expectations about possible variations in the amount or timing of those cash flows
3. The time value of money, represented by the risk-free rate of interest
4. The risk premium—the price for bearing the uncertainty inherent in the asset or
liability
5. Other factors, including illiquidity and market imperfections
How CON 7 measures differ from previously utilized present value techniques.
Previously employed present value techniques typically used a single set of estimated cash
flows and a single discount (interest) rate. In applying those techniques, adjustments for
factors 2. through 5. described in the previous paragraph are incorporated in the selection of
the discount rate. In the CON 7 approach, only the third factor listed (the time value of
money) is included in the discount rate; the other factors cause adjustments in arriving at
risk-adjusted expected cash flows. CON 7 introduces the probability-weighted, expected
cash flow approach, which focuses on the range of possible estimated cash flows and estimates
of their respective probabilities of occurrence.
Previous techniques used to compute present value used estimates of the cash flows
most likely to occur. CON 7 refines and enhances the precision of this model by weighting
different cash flow scenarios (regarding the amounts and timing of cash flows) by their estimated
probabilities of occurrence and factoring these scenarios into the ultimate determination
of fair value. The difference is that values are assigned to the cash flows other than the
most likely one. To illustrate, a cash flow might be $100, $200, or $300 with probabilities of
10%, 50%, and 40%, respectively. The most likely cash flow is the one with 50% probability,
or $200. The expected cash flow is $230 [=($100 × .1) + ($200 × .5) + ($300 × .4)].
38 Wiley GAAP 2009 Codification Edition
The CON 7 method, unlike previous present value techniques, can also accommodate
uncertainty in the timing of cash flows. For example, a cash flow of $10,000 may be received
in one year, two years, or three years with probabilities of 15%, 60%, and 25%, respectively.
Traditional present value techniques would compute the present value using the
most likely timing of the payment—two years. The example below shows the computation
of present value using the CON 7 method. Again, the expected present value of $9,030 differs
from the traditional notion of a best estimate of $9,070 (the 60% probability) in this example.
Present value of $10,000 in 1 year discounted at 5% $9,523
Multiplied by 15% probability $1,428
Present value of $10,000 in 2 years discounted at 5% $9,070
Multiplied by 60% probability 5,442
Present value of $10,000 in 3 years discounted at 5% $8,638
Multiplied by 25% probability 2,160
Probability weighted expected present value $9,030
Measuring liabilities. The measurement of liabilities involves different problems from
the measurement of assets; however, the underlying objective is the same. When using present
value techniques to estimate the fair value of a liability, the objective is to estimate the
value of the assets required currently to (1) settle the liability with the holder or (2) transfer
the liability to an entity of comparable credit standing. To estimate the fair value of an entity’s
notes or bonds payable, accountants look to the price at which other entities are willing
to hold the entity’s liabilities as assets. For example, the proceeds of a loan are the price that
a lender paid to hold the borrower’s promise of future cash flows as an asset.
The most relevant measurement of an entity’s liabilities should always reflect the credit
standing of the entity. An entity with a good credit standing will receive more cash for its
promise to pay than an entity with a poor credit standing. For example, if two entities both
promise to pay $750 in three years with no stated interest payable in the interim, Entity A,
with a good credit standing, might receive about $630 (a 6% interest rate). Entity B, with a
poor credit standing, might receive about $533 (a 12% interest rate). Each entity initially
records its respective liability at fair value, which is the amount of proceeds received—an
amount that incorporates that entity’s credit standing.
Present value techniques can also be used to value a guarantee of a liability. Assume
that Entity B in the above example owes Entity C. If Entity A were to assume the debt, it
would want to be compensated $630—the amount that it could get in the marketplace for its
promise to pay $750 in three years. The difference between what Entity A would want to
take the place of Entity B ($630) and the amount that Entity B receives ($533) is the value of
the guarantee ($97).
Interest method of allocation. CON 7 describes the factors that suggest that an interest
method of allocation should be used. It states that the interest method of allocation is more
relevant than other methods of cost allocation when it is applied to assets and liabilities that
exhibit one or more of the following characteristics:
a. The transaction is, in substance, a borrowing and lending transaction.
b. Period-to-period allocation of similar assets or liabilities employs an interest
method.
c. A particular set of estimated future cash flows is closely associated with the asset or
liability.
d. The measurement at initial recognition was based on present value.
Accounting for changes in expected cash flows. If the timing or amount of estimated
cash flows changes and the asset or liability is not remeasured at a fresh-start measure, the
Chapter 1 / Researching GAAP Matters 39
interest method of allocation should be altered by a catch-up approach. That approach
adjusts the carrying amount to the present value of the revised estimated future cash flows,
discounted at the original effective interest rate.
Application of present value tables and formulas.
Present value of a single future amount. To take the present value of a single amount
that will be paid in the future, apply the following formula; where PV is the present value of
$1 paid in the future, r is the interest rate per period, and n is the number of periods between
the current date and the future date when the amount will be realized.
PV =
1
(1 + r)n
In many cases the results of this formula are summarized in a present value factor table.
(n)
Periods 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8265
3 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513
4 0.9239 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830
5 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209
Example
Suppose one wishes to determine how much would need to be invested today to have
$10,000 in 5 years if the sum invested would earn 8%. Looking across the row with n = 5 and
finding the present value factor for the r = 8% column, the factor of 0.6806 would be identified.
Multiplying $10,000 by 0.6806 results in $6,806, the amount that would need to be invested today
to have $10,000 at the end of 5 years. Alternatively, using a calculator and applying the present
value of a single sum formula, one could multiply $10,000 by 1/(1+.08)5, which would also give
the same answer—$6,806.
Present value of a series of equal payments (an annuity). Many times in business situations
a series of equal payments paid at equal time intervals is required. Examples of these
include payments of semiannual bond interest and principal or lease payments. The present
value of each of these payments could be added up to find the present value of this annuity, or
alternatively a much simpler approach is available. The formula for calculating the present
value of an annuity of $1 payments over n periodic payments, at a periodic interest rate of r
is
PV Annuity =
( 1 + r)n 1 _ 1
r
The results of this formula are summarized in an annuity present value factor table.
(n)
Periods 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091
2 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355
3 2.8839 2.8286 2.7751 2.7233 2.6730 2.6243 2.5771 2.5313 2.4869
4 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699
5 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908
40 Wiley GAAP 2009 Codification Edition
Example
Suppose four annual payments of $1,000 will be needed to satisfy an agreement with a supplier.
What would be the amount of the liability today if the interest rate the supplier is charging
is 6% per year? Using the table to get the present value factor, the n = 4 periods row, and the 6%
column, gives you a factor of 3.4651. Multiply this by $1,000 and you get a liability of $3,465.10
that should be recorded. Using the formula would also give you the same answer with r = 6% and
n = 4.
Caution must be exercised when payments are not to be made on an annual basis. If
payments are on a semiannual basis n = 8, but r is now 3%. This is because r is the periodic
interest rate, and the semiannual rate would not be 6%, but half of the 6% annual rate. Note
that this is somewhat simplified, since due to the effect of compound interest 3% semiannually
is slightly more than a 6% annual rate.
Example of the relevance of present values. A measurement based on the present
value of estimated future cash flows provides more relevant information than a measurement
based on the undiscounted sum of those cash flows. For example, consider the following
four future cash flows, all of which have an undiscounted value of $100,000:
1. Asset A has a fixed contractual cash flow of $100,000 due tomorrow. The cash
flow is certain of receipt.
2. Asset B has a fixed contractual cash flow of $100,000 due in twenty years. The
cash flow is certain of receipt.
3. Asset C has a fixed contractual cash flow of $100,000 due in twenty years. The
amount that ultimately will be received is uncertain. There is an 80% probability
that the entire $100,000 will be received. There is a 20% probability that $80,000
will be received.
4. Asset D has an expected cash flow of $100,000 due in twenty years. The amount
that ultimately will be received is uncertain. There is a 25% probability that
$120,000 will be received. There is a 50% probability that $100,000 will be received.
There is a 25% probability that $80,000 will be received.
Assuming a 5% risk-free rate of return, the present values of the assets are
1. Asset A has a present value of $99,986. The time value of money assigned to the
one-day period is $14 [$100,000 × .05/365 days]
2. Asset B has a present value of $37,689 [$100,000/(1 + .05)20]
3. Asset C has a present value of $36,181 [(100,000 × .8 + 80,000 × .2)/(1 + .05)20]
4. Asset D has a present value of $37,689 [($120,000 × .25 + 100,000 × .5 + 80,000 ×
.25)/(1 + .05)20]
Although each of these assets has the same undiscounted cash flows, few would argue
that they are economically the same or that a rational investor would pay the same price for
each. Investors require compensation for the time value of money. They also require a risk
premium. That is, given a choice between Asset B with expected cash flows that are certain
and Asset D with cash flows of the same expected amount that are uncertain, investors will
place a higher value on Asset B, even though they have the same expected present value.
CON 7 says that the risk premium should be subtracted from the expected cash flows before
applying the discount rate. Thus, if the risk premium for Asset D was $500, the risk-adjusted
present values would be $37,500 {[($120,000 × .25 + 100,000 × .5 + 80,000 × .25) – 500]/
(1 + .05)20}.
Practical matters. Like any accounting measurement, the application of an expected
cash flow approach is subject to a cost-benefit constraint. The cost of obtaining additional
information must be weighed against the additional reliability that information will bring to
the measurement. As a practical matter, an entity that uses present value measurements often
Chapter 1 / Researching GAAP Matters 41
has little or no information about some or all of the assumptions that investors would use in
assessing the fair value of an asset or a liability. Instead, the entity must use the information
that is available to it without undue cost and effort when it develops cash flow estimates.
The entity’s own assumptions about future cash flows can be used to estimate fair value using
present value techniques, as long as there are no contrary data indicating that investors
would use different assumptions. However, if contrary data exist, the entity must adjust its
assumptions to incorporate that market information.
Conducting Research through the FASB Codification Web site
As noted previously in this chapter, the FASB has completed its project to codify
GAAP, thereby eliminating the multilevel hierarchy in favor of a single, centralized database
of authorized documentation. The FASB has compiled this Codification into a Web site,
which is located at http://asc.fasb.org/home. The site is intended to be easily searchable for
research purposes. This section provides an overview of the site’s contents and search functionality.
On all pages of the site, all categories of the Codification are listed down the vertical
menu bar on the left side of the page, revealing the following primary topics, and the numbering
series for each one:
• Presentation (200). Covers the reporting aspects of GAAP, such as the balance sheet,
income statement, and segment reporting.
• Assets (300). Contains GAAP for all types of assets, such as receivables, investments,
and intangibles.
• Liabilities (400). Contains GAAP for all types of liabilities, such as commitments,
contingencies, and guarantees.
• Equity (500). Covers GAAP for such topics as stock, stock dividends, and treasury
stock.
• Revenue (600). Includes all revenue topics, including product revenue, services revenue,
and a great deal of industry-specific topics.
• Expenses (700). Clusters all types of expense-related GAAP into five broad categories,
which are cost of goods sold, research and development, compensation, income
taxes, and other expenses.
• Broad Transactions (800). Contains the major transactional topics, such as business
combinations, derivatives, and foreign currency matters.
• Industry (900). Itemizes GAAP for specific industries, such as entertainment, real estate,
and software.
• Master Glossary. Includes a compilation of terminology assembled from the multitude
of original GAAP source documents.
The numbering series indicated next to each bullet point above shows the three-digit
number assigned to each topic. For example, the Presentation topic contains a number of
subtopics, all indexed with numbers in the 200 range; the Balance Sheet subtopic is numbered
210, while the Interim Reporting subtopic is numbered 270. These index numbers
become more apparent while perusing the submenus attached to each primary topic. For
example, the submenu for the Presentation topic reveals 14 subcategories, numbered from
205 (for Presentation of Financial Statements) to 280 (for Segment Reporting). The entire
numbering system is noted in Appendix C.
At the most granular level of detail, the Codification has a two-digit numerical code for
a standard set of categories, which follow:
• Overview and background (05). Provides overview and background material.
• Scope and scope exceptions (15). Outlines the transactions, events, and other occurrences
to which the subtopic guidance does or does not apply.
42 Wiley GAAP 2009 Codification Edition
• Glossary (20). Contains definitions for terms found within the subtopic guidance.
• Recognition (25). Defines the criteria and timing for recording an item in the financial
statements.
• Initial measurement (30). Provides guidance on the criteria and amounts used to
measure a transaction at the initial date of recognition.
• Subsequent measurement (35). Provides guidance on the subsequent measurement
and recognition of an item.
• Other presentation matters (45). A catchall category providing guidance not included
in the preceding sections.
• Disclosure (50). Provides guidance regarding disclosure in the notes to or on the face
of the financial statements.
• Implementation guidance and illustrations (55). Contains illustrations of the guidance
provided in the preceding sections.
• Relationships (60). Contains links to guidance that may be helpful to the reader of the
subtopic.
• SEC Materials (S99). Contains selected SEC content for use by public companies.
By drilling down through the various topics and subtopics in the sidebar, a researcher
can eventually locate the relevant GAAP information. However, there are three other ways
to access GAAP information through the Codification site that may prove to be easier.
• Cross-referencing. If the researcher knows the reference number of an original GAAP
source document, such as an EITF consensus or a FASB Staff Position, then she can
enter this information through the Cross-Reference tab, which is located at the top
center of the Codification home page. A By Standard search box will appear, where
the researcher can select from a drop-down menu containing three-digit abbreviations
for all of the various GAAP source documents. For example, FTP represents the
FASB Staff Positions, while APB represents the Accounting Principles Board Opinions.
After making a selection from this menu, the available list of all corresponding
documents will appear next to it, in the Standard Number drop-down menu. Selecting
a document from this list will bring up the corresponding topic, subtopic, section, and
paragraph number in the Codification, as well as a hyperlink to the underlying text.
• Codification search. If the researcher is searching for specific words or phrases, then
the best search tool is the Codification search bar, which is located in the upper right
corner of any page on the site. To use it for a precision search, enter quotes around
the search text; for a less precise search that returns individual words within the search
text, do not use quotes. If the resulting set of links are too voluminous, then use the
Narrow by Topic option on the right side of the page. This option allows the researcher
to reduce the number of selections to only certain topic areas. For example,
to determine the appropriate presentation of cash on the balance sheet, search on the
word Cash, and then narrow the selection to just the Presentation topic, and then narrow
further to just the Balance Sheet subtopic.
• Advanced search. The most detailed researching method is the Advanced Search option,
which is located below the search bar in the upper right corner of any site page.
The resulting search page reveals a combination of options; the researcher can use
text, Codification numbers, document titles, and topics to prepare a more refined
search.
The simplified structure of the Codification makes it a much simpler database than the
old GAAP hierarchy for researching purposes, which is also enhanced by the Codification
Web site’s excellent search tools.
2 BALANCE SHEET
Perspective and Issues 43
Definitions of Terms 45
Concepts, Rules, and Examples 47
Limitations of a Balance Sheet 47
Form of Balance Sheet 48
Assets 49
Current assets 49
Noncurrent assets 51
Liabilities 52
Current liabilities 52
Noncurrent liabilities 53
Offsetting Assets and Liabilities 55
Stockholders’ Equity 56
Contributed capital 56
Capital stock 56
Additional paid-in capital 56
Retained earnings 56
Accumulated other comprehensive income
56
Treasury stock 57
Partners’ Capital 57
Members’ equity 57
Alternative Balance Sheet Segmentation
57
Definitions 58
Disclosures 60
Parenthetical explanations 60
Notes to financial statements 60
Cross-references 60
Valuation allowances 60
Supporting schedules 60
Accounting policies 61
Related parties 61
Comparative statements 61
Subsequent events 62
Contingencies 62
Commitments 63
Risks and Uncertainties 63
Nature of operations 63
Use of estimates in the preparation of financial
statements 64
Certain significant estimates 64
Current vulnerability due to concentrations
64
Forthcoming Changes to Financial
Statement Presentation Standards 65
Example of Balance Sheet Classification
and Presentation 68
PERSPECTIVE AND ISSUES
Balance sheets (also known as statements of financial position) present information
about assets, liabilities, and owners’ equity (depending on the type of reporting enterprise,
this is referred to as shareholders’ equity, net assets, members’ equity, or partners’ capital)
and their relationships to each other. They reflect an enterprise’s resources (assets) and its
financing structure (liabilities and equity) in conformity with generally accepted accounting
principles. The balance sheet reports the aggregate effect of transactions at a point in time,
whereas the statements of income, retained earnings, comprehensive income, and cash flows
all report the effect of transactions occurring during a specified period of time such as a
month, quarter, or year.
For years, users of financial statements put more emphasis on the income statement than
on the balance sheet. Investors’ main concern was the short-run maximization of earnings
per share. During the late 1960s and early 1970s, the future prospects of business enterprises
were largely judged based on measures of earnings growth. But the combination of inflation
and recession during the 1970s and the emphasis in FASB’s Conceptual Framework Project
on the asset-liability approach to accounting theory brought about a rediscovery of the balance
sheet. This shift toward emphasis on the balance sheet has marked a departure from the
traditional transaction-based concept of income toward a capital maintenance concept espoused
by economists. Under this approach to income measurement, the amount of beginning
net assets would be compared to the amount of ending net assets, and the difference
44 Wiley GAAP 2009 Codification Edition
would be adjusted for dividends and capital transactions. Only to the extent that an enterprise
maintained its net assets (after adjusting for capital transactions) would income be
earned. By using a capital maintenance concept, it was asserted that investors would theoretically
be better able to predict the overall profit potential of the reporting enterprise.
The balance sheet is studied in order to assess the enterprise’s liquidity, financial flexibility,
ability to pay its debts when due, and to distribute cash to its investors to provide an
acceptable rate of return. An enterprise’s liquidity refers to the extent to which it holds cash
or cash equivalents in the normal course of operating its business. The concept of financial
flexibility is broader than the concept of liquidity. Financial flexibility is a company’s ability
to take effective actions to alter the amounts and timing of its cash flows so it can respond to
unexpected needs and opportunities. Financial flexibility includes the ability to raise new
equity capital or to borrow additional amounts by, for example, utilizing unused lines of
credit.
The rights of the shareholders and other suppliers of capital (bondholders and other
creditors) of an enterprise are many and varied. The disclosure of these rights is an
important objective in the presentation of financial statements. The rights of shareholders
and creditors are mutually exclusive claims against the assets of the enterprise, and the rights
of creditors (liabilities) take precedence over the rights of shareholders (equity). Both
sources of capital are concerned with two basic rights: the right to share in the cash or property
disbursements (interest and dividends) and the right to share in the assets in the event of
liquidation.
Although a balance sheet presents an enterprise’s financial position, it does not purport
to report its value. It cannot for reasons that include
• The values of certain assets, such as human resources, secret processes, and competitive
advantages are not included in a balance sheet despite the fact that they have
value and will generate future cash flows.
• The values of other assets are measured at historical cost, rather than market value, replacement
cost, or specific value to the enterprise. For example, property and equipment
are measured at original cost reduced by depreciation, but the underlying assets’
value can significantly exceed that adjusted cost and the assets may continue to be
productive even though fully depreciated in the accounting records.
• The values of most liabilities are measured at the present value of cash flows at the
date the liability was incurred rather than at the current market rate. When market
rates increase, the increase in value of a liability payable at a fixed interest rate that is
below market is not recognized in the balance sheet. Conversely, when interest rates
decrease, the loss in value of a liability payable at a fixed rate in excess of the market
rate is not recognized.
In recent years, FASB standards have increasingly employed fair value as the relevant
measure for items presented in the balance sheet. For example, ASC 320, Investments—Debt
and Equity Securities, changed the relevant measure for most investments in securities to fair
value from the lower of cost or market. ASC 815, Derivatives and Hedging, requires derivative
financial instruments, whether asset or liabilities, to be reported at fair value which, prior
to that pronouncement, were not reported on the balance sheet at all. ASC 820, Fair Value
Measurements and Disclosures, improves the consistency and comparability of the fair value
measurements appearing in the balance sheet. Measuring more assets and liabilities at fair
value enhances the ability of a balance sheet to report a measure that more closely approximates
the enterprise’s value.
In many industries, it is common for the balance sheet to be divided into classifications
based on the length of the enterprise’s operating cycle. Assets are classified as “current” if
Chapter 2 / Balance Sheet 45
they are reasonably expected to be converted into cash, sold, or consumed either within one
year or within one operating cycle, whichever is longer. Liabilities are classified as “current”
if they are expected to be liquidated through the use of current assets or incurring other current
liabilities. The excess or deficiency of current assets over or under current liabilities,
which is referred to as net working capital, identifies, if positive, the relatively liquid portion
of the enterprise’s capital that is potentially available to serve as a buffer for meeting unexpected
obligations arising within the ordinary operating cycle of the business.
In some industries, the concept of working capital has little importance and the balance
sheet is not classified. Such industries include broker-dealers, investment companies, real
estate companies, and utilities. Personal financial statements are unclassified for the same
reason.
Major Topics and Subtopics in the FASB Accounting Standards Codification
Presentation
205-10-45 Presentation of Financial Statements—Other Presentation Matters
210-10-45 Balance Sheet—Other Presentation Matters
210-20-45 Balance Sheet Offsetting—Other Presentation Matters
272 Limited Liability Entities
275-10-50 Risks and Uncertainties—Disclosure
280 Segment Reporting
Assets
320 Investments—Debt and Equity Securities
350 Intangibles—Goodwill and Other
360-10-50 Property, Plant, and Equipment—Disclosure
Liabilities
450 Contingencies
460 Guarantees
480 Distinguishing Liabilities from Equity
Expenses
715-30 Compensation-Retirement Benefits—Defined Benefit Plans—Pension
Broad Transactions
815 Derivatives and Hedging
830 Foreign Currency Matters
835 Interest
850 Related-Party Disclosures
860 Transfers and Servicing
DEFINITIONS OF TERMS
Assets. Probable future economic benefits obtained or controlled by a particular enterprise
as a result of past transactions or events (CON 6).
The following three characteristics must be present for an item to qualify as an asset:
1. The asset must provide probable future economic benefit that enables it to provide
future net cash inflows.
2. The enterprise must be able to receive the benefit and restrict others’ access to it.
3. The event that provides the enterprise with the right to receive the benefit has occurred.
All three characteristics must be present for an item to meet the definition of an asset.
Assets have other characteristics, but those characteristics are not essential to the definition.
For example, most assets are exchangeable, legally enforceable, or tangible. But an item can
still be an asset even if it cannot be exchanged, provided that the enterprise that owns it can
use it in a manner that generates future cash flows or other benefits. Similarly, rights to an
item need not be legally enforceable if the rights can be enforced in other ways, such as by
46 Wiley GAAP 2009 Codification Edition
using social or moral persuasion. Finally, assets need not be tangible. Securities, patents,
and similar ownership rights are assets despite the fact that they cannot be touched or seen.
The characteristic possessed by all assets is service potential (also called future economic
benefit); the ability to directly or indirectly provide services or benefits to the owner
of the asset, usually in the form of future cash inflows. Once recognized, an asset remains on
the balance sheet until it is exchanged for another asset, used to settle a liability, its future
economic benefits are used up, or it no longer is expected to provide future benefits (e.g.,
obsolescence of inventory or impairment of long-lived assets).
Liabilities. Probable future sacrifices of economic benefits arising from present obligations
of an enterprise to transfer assets or provide services to others in the future as a result
of past transactions or events (CON 6).
The following three characteristics must be present for an item to qualify as a liability:
1. A liability requires that the enterprise settle a present obligation by the probable
future transfer of an asset on demand, when a specified event occurs, or at a
particular date.
2. The obligation cannot be avoided.
3. The event that obligates the enterprise has occurred.
Liabilities usually result from transactions in which enterprises obtain economic resources.
For example, trade accounts payable result from purchasing raw materials; salaries
and wages payable result from employees providing services, and notes payable result from
borrowing cash from a lender. Other liabilities may arise from nonreciprocal transfers such
as the declaration of dividends payable to the owners of the enterprise or the pledging of assets
as a contribution to a charitable organization. An enterprise may incur a liability involuntarily.
A liability may be imposed on the enterprise by government or by the court system
in the form of taxes, fines, or levies. A liability may arise from changes in prices or interest
rates.
Liabilities are imposed by agreement, by law, by court, by equitable or constructive obligation,
and by business ethics and custom. Liabilities may be legally enforceable or they
may be equitable obligations that arise from social, ethical, or moral requirements.
Liabilities are reflected on the balance sheet until the enterprise is no longer responsible
for discharging them. Most liabilities are discharged either by transferring an asset or incurring
another liability. However, some liabilities simply expire. For example, warranty liabilities
are estimates of goods that will be returned for repair or replacement or cash that
will have to be paid to a dissatisfied customer. At the end of the warranty period, any remaining
liability simply is removed from the balance sheet.
Some financial instruments that have historically been reported as equity are now
reported as liabilities. These include mandatorily redeemable financial instruments issued in
the form of shares, a financial instrument that includes an obligation to repurchase the
issuer’s equity shares, and obligations requiring issuance of equity shares based on various
limiting criteria. This change has been quite controversial, and indeed certain provisions of
the standard (ASC 480) have been indefinitely postponed as to effective date (see Chapter 19
for discussion).
Equity. Equity is the residual interest in the assets of the enterprise that remains after
deducting its liabilities. In a business enterprise, as distinguished from a not-for-profit organization
or governmental unit, the equity represents the interest of its owners (CON 6).
Equity is increased by owners’ investments and by comprehensive income, and it is reduced
by distributions to the owners. Equity of a business enterprise is the source of its distributions
to the owners; all such distributions of enterprise assets to owners are voluntary.
Because equity is a residual (the net amount of assets less liabilities), equity is affected by all
Chapter 2 / Balance Sheet 47
transactions and events that increase or decrease assets without increasing or decreasing liabilities
by the same amount.
A diagram reproduced from CON 6 that appears in the “Researching GAAP Problems”
section of Chapter 1 illustrates this relationship. For example, issuing a bond does not
change equity because the increase in the asset (cash) is the same as the increase in the liability
(bonds payable). Paying interest on the bond does change equity. The decrease in the
asset (cash) is not offset by a corresponding decrease in the liability (bonds payable).
In practice, the distinction between equity and liabilities may be difficult to ascertain.
Securities such as convertible debt and preferred stock may have characteristics of both
equity (residual ownership interest) and liabilities (nondiscretionary future sacrifices). For
such items, the objective of accounting standards is to ensure that transactions that are
similar in substance are reported in a similar manner by different enterprises, irrespective of
their form.
Valuation allowance. The valuation allowance is a separate item on a balance sheet (or
disclosed in the notes to the financial statement) that reduces or increases the carrying
amount of an asset or a liability. It is neither an asset nor a liability in its own right; it is
merely a mechanism used to adjust the carrying amount of the related asset or liability. For
example, an estimate of uncollectible amounts reduces the carrying amount of an account
receivable, while a bond premium increases the carrying amount of bonds payable.
CONCEPTS, RULES, AND EXAMPLES
Limitations of a Balance Sheet
Although a balance sheet shows an enterprise’s financial position at a point in time, it
does not purport to report the value of the enterprise at that date. There are several reasons
why this is so. One limitation of the balance sheet is that many assets and liabilities are reported
at historical transaction prices (referred to as “historical cost”), that are used because
they are objective and capable of being independently verified. Historical costs, however,
will only equal fair value at the time of the actual transaction; thereafter, the two will almost
always differ.
Many accountants and analysts believe that the balance sheet would be more useful if
the assets were restated to reflect current values. These current values might or might not be
market related, and might simply be presented as historical cost adjusted for the changing
value of the dollar due to inflation. However, for some assets and liabilities, cost already
closely approximates current fair value. The cost of monetary assets such as cash, short-term
investments, and receivables closely approximates their current fair values. The cost of current
liabilities, which are liabilities that require either a current asset or another current liability
to liquidate, is payable in a short period and closely approximates current values. If
they were to be discounted to their present value, any discount amount would likely be immaterial
because of the short time period before payment is due.
For other assets and liabilities, cost can significantly differ from current value. Productive
assets such as property, plant, equipment, and amortizable intangibles are reported at
cost net of accumulated depreciation, depletion, or amortization. Those amounts may differ
from their current values to the enterprise (value in use) or to others (exit or net realizable
values). Long-term liabilities are recorded as the discounted value of future payments to be
made under contract. On the issuance date of fixed-rate debt, the interest rate equals the
market rate and current value equals balance sheet cost. However, as time passes and the
market interest rate fluctuates, the recorded cost will differ from the current value.
Although assets are often stated at historical cost, if events or changes in circumstances
indicate a permanent and material decline in fair value, generally accepted accounting prin48
Wiley GAAP 2009 Codification Edition
ciples usually require immediate recognition of the economic loss. In contrast, appreciation
in fair value is normally recognized for accounting purposes only when actually realized in
an arm’s-length transaction (e.g., a sale). However, the recent trend in newly issued financial
accounting standards has been to reflect increases as well as decreases in the fair values of
assets and liabilities in the financial statements. ASC 320 and ASC 815 require that debt securities,
most equity securities, and derivative financial instruments be reported at fair value.
Reporting liabilities at fair value is less common under current GAAP, but there are certain
exceptions, including mandatorily redeemable preferred stock, which is classified as debt per
ASC 480 and measured initially and subsequently at fair value.
Another limitation of the balance sheet is that, with respect to the presentation of certain
assets and liabilities, it ignores the effects of the time value of money. Although certain receivables
and payables may be discounted (ASC 835), most assets and liabilities are stated at
carrying amounts that are not determined by reference to the expected timing of the related
cash inflows or outflows that will ultimately occur.
In the historical cost balance sheet, estimates are frequently used to determine the
carrying/book values of many of the assets. Estimates are used in determining the collectibility
of receivables, salability of inventory, and useful lives of long-term assets. All of these
estimates affect the amount presented in the balance sheet; for example, estimated uncollectible
accounts are deducted from accounts receivable to reflect the estimated net realizable
value displayed in the balance sheet. While estimates are necessary in order to record the
effects of economic events in the appropriate accounting period, these estimates require informed,
good-faith judgments for which there is little practical guidance provided in authoritative
accounting literature.
A final limitation of the balance sheet is that it ignores items that are of financial value
to the enterprise but that cannot be objectively determined. For example, internally generated
goodwill, a skilled and trained workforce, and secret processes are potential sources of
substantial financial value sometimes, in our knowledge-based economy, far exceeding the
recorded value of recognized assets. However, because these values are not objectively and
verifiably measurable, current accounting principles and practices prohibit their presentation
on the balance sheet. Presently, only assets obtained in market transactions are recorded in
the accounting records of an enterprise.
Form of Balance Sheet
The format of a balance sheet is not specified by any authoritative pronouncement. Instead,
formats and titles have developed as a matter of tradition and, in some cases, through
industry practice.
Two basic formats are used.
1. The balanced format, in which the sum of the amounts for liabilities and equity are
added together on the face of the statement to illustrate that assets equal liabilities
plus equity
2. The less frequently presented equity format, which shows totals for assets, liabilities,
and equity but no sums illustrating that assets less liabilities equals equity
Those two formats can take one of two forms.
1. The account form, presenting assets on the left-hand side of the page and liabilities
and equity on the right-hand side
2. The report form, which is a top-to-bottom or running presentation
The three elements customarily displayed in the heading of a balance sheet are
1. The legal name of the enterprise whose financial position is being presented
Chapter 2 / Balance Sheet 49
2. The title of the statement (e.g., balance sheet or statement of financial position)
3. The date of the statement (or statements, if multiple dates are presented for comparative
purposes)
The enterprise’s legal name appears in the heading exactly as specified in the document
that created it (e.g., the certificate of incorporation, partnership agreement, LLC operating
agreement, etc.). The legal form of the enterprise is often evident from its name when the
name includes such designations as “incorporated,” “LLP,” or “LLC.” Otherwise, the legal
form is either captioned as part of the heading or disclosed in the notes to the financial statements.
A few examples are as follows:
ABC Company
(a general partnership)
ABC Company
(a sole proprietorship)
ABC Company
(a division of DEF, Inc.)
The use of the titles “balance sheet,” “statement of financial position,” or “statement of
financial condition” infer that the statement is presented using generally accepted accounting
principles. If, instead, some other comprehensive basis of accounting, such as income tax
basis or cash basis is used, the financial statement title must be revised to reflect this variation.
The use of a title such as “Statements of Assets and Liabilities—Income Tax Basis” is
necessary to differentiate the financial statement being presented from a GAAP balance
sheet.
The last day of the fiscal period is used as the statement date. Usually, this is a monthend
date unless the enterprise uses a fiscal reporting period always ending on a particular day
of the week such as Friday or Sunday. In these cases, the balance sheet would be dated
accordingly (i.e., December 26, October 1, etc.).
Balance sheets generally are uniform in appearance from one period to the next with
consistently followed form, terminology, captions, and patterns of combining insignificant
items. If changes in the manner of presentation are made when comparative statements are
presented, the prior year’s information is to be restated to conform to the current year’s presentation.
Assets
Assets, liabilities, and shareholders’ equity are separated in the balance sheet so that important
relationships can be shown and attention can be focused on significant subtotals.
Current assets. Per the Master Glossary, current assets are cash and other assets that
are reasonably expected to be realized in cash or sold or consumed during the normal operating
cycle of the business. When the normal operating cycle is less than one year, a oneyear
period is used to distinguish current assets from noncurrent assets. When the operating
cycle exceeds one year, the operating cycle will serve as the proper period for purposes of
current asset classification. When the operating cycle is very long, the usefulness of the concept
of current assets diminishes. The following items are classified as current assets:
1. Cash and cash equivalents include cash on hand consisting of coins, currency,
undeposited checks; money orders and drafts; demand deposits in banks; and certain
short-term, highly liquid investments. Any type of instrument accepted by a bank
for deposit would be considered to be cash. Cash must be available for withdrawal
on demand. Cash that is restricted as to withdrawal, such as certificates of deposit,
would not be included with cash because of the time restrictions. Also, cash must
50 Wiley GAAP 2009 Codification Edition
be available for current use in order to be classified as a current asset. Cash that is
restricted in use would not be included in cash unless its restrictions will expire
within the operating cycle. Cash restricted for a noncurrent use, such as cash designated
for the purchase of property or equipment, would not be included in current
assets. Per the Master Glossary, cash equivalents include short-term, highly liquid
investments that (1) are readily convertible to known amounts of cash and (2) are so
near their maturity (maturities of three months or less from the date of purchase by
the enterprise) that they present negligible risk of changes in value because of
changes in interest rates. US Treasury bills, commercial paper, and money market
funds are all examples of cash equivalents. Chapter 7 discusses cash in more detail.
2. Short-term investments are readily marketable securities acquired through the use
of temporarily idle cash. To be classified as current assets, management must be
willing and able to sell the security to meet current cash needs or the investment
must mature within one year (or the operating cycle, if longer). These securities are
accounted for under ASC 320. Securities classified as trading securities under
ASC 320 must be reported as current assets. Securities classified as held-tomaturity
or available-for-sale are reported as either current or noncurrent depending
upon management’s intended holding period, the security’s maturity date (if any),
or both. It is not necessary to show the ASC 320 classification on the face of the
balance sheet. Short-term investments can be combined into a single line if the
classification details appear in the notes to the financial statements. The balance
sheet presentation might be as follows:
Marketable securities $xxx
Chapter 8 discusses short-term investments in more detail.
3. Receivables include accounts and notes receivable, receivables from affiliated enterprises,
and officer and employee receivables. The term “accounts receivable” is
generally understood to represent amounts due from customers arising from transactions
in the ordinary course of business (sometimes referred to as “trade receivables”).
Valuation allowances, if any, are to be clearly stated. Estimates of needed
allowances for uncollectibility may be based on historical correlations of bad debt
experience as a percentage of sales or based on a direct credit quality analysis of the
receivables. Valuation allowances to reflect the time value of money (discounts)
are reported with the related receivable. If material, the different components that
comprise receivables are to be separately stated. Receivables pledged as collateral
are to be disclosed in the notes to the financial statements. The receivables section
of a balance sheet might be presented as follows:
Receivables:
Accounts $xxx
Notes xxx
xxx
Less allowance for uncollectible accounts (xxx)
xxx
Affiliated companies xxx
Officers and employees xxx
$xxx
Chapter 7 discusses receivables in more detail.
4. Inventories are goods on hand and available for sale. The basis of valuation and
the method of pricing are to be disclosed. One form of presentation is as follows:
Inventories—at the lower of cost or market
(specific identification) $xxx
Chapter 2 / Balance Sheet 51
In the case of a manufacturing concern, raw materials, work in process, and finished
goods are stated separately on the balance sheet or disclosed in the notes to the
financial statements. Customarily, the components of manufacturing inventories are
stated in order of their readiness for sale and ultimate conversion to cash—that is,
finished goods are ready for sale, work in process is closer to being finished than
raw materials and, of course, raw materials have not yet been placed into
production. A sample form of presentation is as follows:
Inventories:
Finished goods $xxx
Work in process xxx
Raw materials xxx
$xxx
Chapter 9 discusses inventories in more detail.
5. Prepaid expenses are amounts paid in advance to secure the use of assets or the receipt
of services at a future date. Prepaid expenses will not be converted to cash,
but they are classified as current assets because, if not prepaid, they would have required
the use of current assets during the coming year (or operating cycle, if
longer). Prepaid rent and prepaid insurance are the most common examples of prepaid
expenses. Chapter 7 discusses prepaid expenses in more detail.
Noncurrent assets. Excluded from the classification of current assets are assets that
will not be realized in cash during the next year (or operating cycle, if longer). The following
assets would be classified as noncurrent assets:
1. Long-term investments are investments that are intended to be held for an extended
period of time (longer than one operating cycle). The following are the three
major types of long-term investments:
a. Debt and equity securities are stocks, bonds, and long-term notes receivable.
Securities that are classified as available-for-sale or held-to-maturity investments
under ASC 320 would be classified as long-term if management intended
to hold them for more than one year. Under ASC 320, the categories of these
securities (held-to-maturity versus available-for-sale) need not be reported on
the face of the balance sheet if they are reported in the notes to the financial
statements. The securities section of the balance sheet could be presented as
follows:
Long-term investments:
Investments in A company common stock $xxx
Notes receivable $ xxx
Less discount on notes receivable (xxx) xxx
Investment in B company bonds xxx
$xxx
b. Tangible assets not currently used in operations (e.g., land purchased as an
investment and held for sale).
c. Investments held in special funds (e.g., sinking funds, pension funds, amounts
held for plant expansion, and cash surrender values of life insurance policies).
Chapter 12 describes investments in more detail.
2. Property, plant, and equipment are assets of a durable nature that are used in the
production or sale of goods, sale of other assets, or rendering of services rather than
being held for sale (e.g., machinery and equipment, buildings, furniture and fixtures,
natural resources, and land). These are disclosed with related accumulated
depreciation/depletion as follows:
52 Wiley GAAP 2009 Codification Edition
Property, plant, and equipment $xxx
Less accumulated depreciation (xxx)
or $xxx
Property, plant, and equipment (net of $xxx accumulated depreciation) $xxx
Accumulated depreciation may be shown in total or by major classes of depreciable
assets. In addition to showing this amount on the balance sheet, the notes to the financial
statements are to disclose the amounts of major classes of depreciable assets,
by nature or function, at the balance sheet date. Assets under capital leases are
separately disclosed. A general description of the method or methods used in computing
depreciation with respect to major classes of depreciable assets (ASC 360-
10-50) is also to be included in the notes to financial statements. Chapter 11 discusses
property, plant, and equipment and Chapter 16 discusses capital leases in
more detail.
3. Intangible assets include legal and/or contractual rights that are expected to provide
future economic benefits and purchased goodwill. The technical definition of
goodwill is that it represents the excess of the cost of an acquired enterprise over the
net of the fair values assigned to its identifiable assets and liabilities. Practically,
goodwill represents the amount by which the acquirer believes the acquiree enterprise’s
fair value as a whole exceeds the net fair value of its assets and liabilities.
Goodwill is only recognized as an asset when acquired in a business combination;
internally generated goodwill is not recognized. Patents, copyrights, logos, and
trademarks are examples of rights that are recognized as intangible assets. Intangible
assets with finite useful lives are amortized to expense over those lives. Generally,
the amortization of an intangible asset is credited directly to the recorded
amount of the asset although it is acceptable to use an accumulated amortization
valuation allowance. Intangible assets with indefinite economic useful lives are
tested for impairment at least annually. Chapter 13 discusses goodwill in more detail.
Chapter 11 discusses other intangible assets.
4. Other assets. Other assets is an all-inclusive heading which incorporates assets that
do not fit neatly into any of the other asset categories (e.g., long-term prepaid expenses,
deposits made to purchase equipment, deferred income tax assets (net of any
required valuation allowance), bond issue costs, noncurrent receivables, and restricted
cash).
Liabilities
Liabilities are displayed on the balance sheet in the order of expected payment. The
distinction between current and noncurrent assets and liabilities generally rests upon both the
ability and intent of the enterprise to liquidate or not to liquidate within the traditional oneyear
time frame or the operating cycle, if longer.
Current liabilities. Per ASC 210-10-45, obligations are classified as current if their
liquidation is reasonably expected to require the use of existing resources properly classifiable
as current assets or to create other current obligations. Obligations that are due on demand
or that are callable at any time by the lender are classified as current regardless of the
intent of the enterprise or lender. The following items are classified as current liabilities:
1. Accounts payable. Accounts payable is normally comprised of amounts due to
suppliers (vendors) for the purchase of goods and services used in the ordinary
course of running a business.
2. Trade notes payable are also obligations that arise from the purchase of goods and
services. They differ from accounts payable because the supplier or vendor fiChapter
2 / Balance Sheet 53
nances the purchase on terms longer than the customary period for trade payables.
The supplier or vendor generally charges interest for this privilege. If interest is not
charged, it is imputed in accordance with ASC 835. (Imputed interest is discussed
further in Chapter 15.) A valuation allowance is used to reduce the carrying amount
of the note for the resulting discount as follows:
Notes payable, net of imputed interest of $xx $ xxx
or
Notes payable $ xxx
Less discounts (xxx) $ xxx
3. Dividends payable are obligations to distribute cash or other assets to shareholders
that arise from the declaration of dividends by the enterprise’s board of directors.
4. Advances and deposits are collections of cash or other assets received in advance
to ensure the future delivery of goods or services. Advances and deposits are classified
as current liabilities if the goods and services are to be delivered within the next
year (or the operating cycle, if longer). Advances and deposits include such items
as advance rentals and customer deposits. Certain advances and deposits are
sometimes captioned as deferred or unearned revenues.
5. Agency collections and withholdings are liabilities that arise because the enterprise
acts as an agent for another party. Employee tax withholdings, sales taxes,
and wage garnishments are examples of agency collections.
6. Current portion of long-term debt is the portion of a long-term obligation that
will be settled during the next year (or operating cycle, if longer) by using current
assets. Generally, this amount includes only the payments due within the next year
under the terms of the underlying agreement. However, if the enterprise has violated
a covenant in a long-term debt agreement and, as a result, the investor is legally
entitled to demand payment, the entire debt amount is classified as current
unless the lender formally (in writing) waives the right to demand repayment of the
debt for a period in excess of one year (or one operating cycle, if longer). In two
cases, obligations to be paid in the next year are not classified as current liabilities.
Debt expected to be refinanced through another long-term issue and debt that will
be retired through the use of noncurrent assets, such as a bond sinking fund, are
treated as noncurrent liabilities because the liquidation does not require the use of
current assets or the creation of other current liabilities.
7. Accrued expenses represent estimates of expenses incurred on or before the balance
sheet date that have not yet been paid and that are not payable until a succeeding
period within the next year. Examples of accrued expenses include salaries,
vacation pay, interest, and retirement plan contributions.
Chapter 14 discusses current liabilities in more detail.
Noncurrent liabilities. Obligations that are not expected to be liquidated within one
year (or the current operating cycle, if longer) are classified as noncurrent. The following
items would be classified as noncurrent:
1. Notes and bonds payable are obligations that will be paid in more than one year
(or one operating cycle, if longer). Most notes and bonds require periodic payments
of interest, and some require periodic payments of principal. If the stated rate of
interest on a note or bond is different than the market rate on the day the note or
bond is issued, the proceeds from issuance will differ from the face amount of the
note or bond. If the market rate is higher than the stated rate, the bonds will be issued
at a discount, which means that the proceeds are less than the face amount. If
the market rate is lower than the stated rate, the bonds will be issued at a premium,
54 Wiley GAAP 2009 Codification Edition
which means that the proceeds exceed the face amount. Valuation allowances are
used to adjust the carrying value of the debt to reflect the resulting discount or
premium, as shown below.
Notes payable, including premium of $xx $xxx
or
Notes payable $xxx
Plus premium $xxx $xxx
Discounts and premiums are amortized using the effective-interest-rate method,
which results in a constant interest rate over the life of the debt. Chapter 15 discusses
notes and bonds payable in more detail.
2. Capital lease obligations are contractual obligations that arise from obtaining the
use of property or equipment via a capital lease contract. Chapter 16 discusses lease
obligations.
3. Written put options on the option writer’s (issuer’s) equity shares and forward
contracts to purchase an issuer’s equity shares that require physical or net
cash settlement are classified as liabilities on the issuer’s balance sheet. The obligation
is classified as noncurrent unless the date at which the contract will be settled
is within the next year (or operating cycle, if longer). These contracts are discussed
further in Chapter 15.
4. Certain financial instruments that embody an unconditional obligation to issue
a variable number of equity shares and financial instruments other than outstanding
shares that embody a conditional obligation to issue a variable number
of equity shares are classified as a liability in the issuer’s balance sheet. The
obligation is classified as noncurrent unless the date at which the financial instrument
will be settled is within the next year (or operating cycle, if longer). Chapter
15 discusses these financial instruments.
5. Contingent obligations are recorded when it is probable that an obligation will occur
as the result of a past event. In most cases, a future event will eventually confirm
the amount payable, the payee, or the date payable. Examples of contingent
obligations are lawsuits that have not been settled, product warranty obligations,
guarantees of indebtedness (other than the obligation to stand ready to perform,
which is a noncontingent liability), and agreements to repurchase an asset or make
future payments. The classification of a contingent liability as current or noncurrent
depends on when the confirming event will occur and how soon afterwards payment
must be made. Contingencies are discussed further in Chapter 14.
6. Mandatorily redeemable shares are recorded as liabilities per ASC 480. A mandatory
redemption clause requires common or preferred stock to be redeemed (retired)
at a specific date(s) or upon occurrence of an event which is uncertain as to
timing although ultimately certain to occur. This feature is in contrast to callable
preferred stock, which may be redeemed at the issuing corporation’s option and
which is appropriately categorized as equity. The obligation is classified as noncurrent
unless the date at which the shares must be redeemed is within the next year (or
operating cycle, if longer). See Chapters 15 and 19 for additional discussion of
these securities.
7. Other noncurrent liabilities include defined benefit pension obligations, postemployment
obligations, and postretirement obligations. These reflect the long-term
obligations of the enterprise to provide future retirement, insurance, or other benefits
to employees as a result of their past service. Those obligations are described in
more detail in Chapter 18. Deferred income taxes are liabilities to pay income taxes
Chapter 2 / Balance Sheet 55
in the future that result from differences between the carrying amounts of assets and
liabilities for income tax and financial reporting purposes. Chapter 17 discusses deferred
income taxes.
Offsetting Assets and Liabilities
In general, assets and liabilities are not permitted to be offset against each other unless
certain specified criteria are met. ASC 210-20-45 permits offsetting only when all of the
following conditions are met that constitute a right of setoff:
1. Each of the two parties owes the other determinable amounts (although they may be
in different currencies and bear different rates of interest).
2. The enterprise has the right to set off the amount it owes against the amount owed to
it by the other party.
3. The enterprise intends to set off the two amounts.
4. The right of setoff is legally enforceable.
In particular cases, state laws or bankruptcy laws may impose restrictions or prohibitions
against the right of setoff. Furthermore, when maturities differ, only the party with the nearest
maturity can offset, because the party with the later maturity must settle in the manner
determined by the party with the earlier maturity.
The offsetting of cash or other assets against a tax liability or other amounts due to governmental
bodies is acceptable only under limited circumstances. When it is clear that a purchase
of securities is in substance an advance payment of taxes payable in the near future and
the securities are acceptable for the payment of taxes, amounts may be offset. Primarily this
occurs as an accommodation to governmental bodies that issue tax anticipation notes in order
to accelerate the receipt of cash from future taxes.
For forwards, interest rate swaps, currency swaps, options, and other conditional or exchange
contracts, the conditions for the right of offset must exist or the fair value of contracts
in a loss position cannot be offset against the fair value of contracts in a gain position. Nor
can accrued receivable amounts be offset against accrued payable amounts. If, however,
there is a master netting arrangement, then fair value amounts recognized for forwards, interest
or currency swaps, options, or other such contracts may be offset without being subject to
the conditions previously specified.
ASC 210-20-45 permits the offset of amounts recognized as payables in repurchase
agreements against amounts recognized as receivables in reverse repurchase agreements with
the same counterparty. If certain conditions are met, an enterprise may, but is not required
to, offset the amounts recognized. The additional conditions are
1. The repurchase agreements and the reverse repurchase agreements must have the
same explicit settlement date.
2. The repurchase agreements and the reverse repurchase agreements must be executed
in accordance with a master netting agreement.
3. The securities underlying the repurchase agreements and the reverse repurchase
agreements exist in “book entry” form.
4. The repurchase agreements and the reverse repurchase agreements will be settled on
a securities transfer system that transfers ownership of “book entry” securities, and
banking arrangements are in place so that the enterprise must only keep cash on
deposit sufficient to cover the net payable.
5. The same account at the clearing bank is used for the cash inflows of the settlement
of the reverse repurchase agreements and the cash outflows in the settlement of the
repurchase agreements.
56 Wiley GAAP 2009 Codification Edition
Stockholders’ Equity
Owners’ equity represents the residual interest in the assets of the enterprise after liabilities
are subtracted from assets. In a corporation, shareholders’ equity arises from three
sources: contributed (paid-in) capital, retained earnings, and accumulated other comprehensive
income. Shareholders’ equity is discussed further in Chapter 19.
Contributed capital. Contributed, or paid-in capital is the amount of equity invested in
a corporation by its owners. It consists of capital stock and additional paid-in capital. Contributed
capital arises from the issuance of common and preferred stock to investors, from
transactions by the corporation in its own stock (for example, treasury stock, stock dividends,
conversion of convertible bonds) and from the donation of assets or services.
Capital stock. Capital stock is the par or stated value of preferred and common shares.
In the past, capital stock was the legal capital of the corporation—the amount that could not
be distributed to shareholders so that the interest of creditors would be protected. In recent
years, some states have changed their laws so that legal capital includes additional paid-in
capital (i.e., in those states the distinction between the capital stock and additional paid-in
capital is not recognized). The face of the balance sheet often provides information about the
type of issues, the par or stated value per share, and the number of shares authorized, issued,
and outstanding. For preferred stock, the liquidation preferences and features (e.g., whether
participating, cumulative, convertible, or callable) are also shown, as follows:
6% cumulative preferred stock, $100 par value, callable at $115, 10,000 shares
authorized and outstanding, aggregate liquidation preference in liquidation of $xxx $xxx
Common stock, $10 par value per share, 2,000,000 shares authorized, 1,500,000 shares
issued and outstanding $xxx
Additional paid-in capital. There are two major categories of additional paid-in capital.
1. Paid-in capital in excess of par/stated value, which is the difference between the actual
issue price of the shares and the shares’ par/stated value. Amounts in excess
are disclosed separately for common stock and each issue of preferred stock as follows:
Additional paid-in capital—6% preferred stock $xxx
Additional paid-in capital—common stock $xxx
2. Paid-in capital from other transactions, which includes treasury stock, retirement of
stock, stock dividends recorded at market, lapse of stock purchase warrants, conversion
of convertible bonds in excess of the par value of the stock, and any other additional
capital from the company’s own stock transactions.
Retained earnings. Retained earnings are the cumulative net income of the corporation
from the date of its inception (or reorganization) to the date of the financial statements, less
the cumulative distributions to shareholders either directly (dividends) or indirectly (treasury
stock).
In the past, the board of directors of a corporation would appropriate (set aside) a portion
of retained earnings for a special purpose and indicate on the face of the balance sheet or in
the notes to the financial statements that the appropriated amount was unavailable for dividends.
That practice is uncommon today.
Accumulated other comprehensive income. Other comprehensive income is the
change in equity of a business enterprise during a period that arises from sources other than
net income and transactions with its owners. Under current accounting standards, its accumulated
components include net unrealized holding gains and losses on investments classified
as available-for-sale securities (ASC 320), the effective portion of the gain or loss on
Chapter 2 / Balance Sheet 57
derivative instruments designated and qualified as either cash-flow hedges or hedges of forecasted
foreign-currency-denominated transactions (ASC 815), the excess of minimum pension
liability over unrecognized prior service cost (ASC 715-30), and unrealized gains
(losses) on foreign currency translations (ASC 830). The components of accumulated other
comprehensive income are shown either in the statement of changes in shareholders’ equity
or in the shareholders’ equity section of the balance sheet, as follows:
Accumulated other comprehensive income
Foreign currency translation adjustments $xxx
Pension liability adjustment xxx
Unrealized gains on securities xxx xxx
Treasury stock. Treasury stock represents shares of the corporation’s stock that have
been issued, repurchased by the corporation, and that have not been retired or canceled.
These shares have no voting rights and are not entitled to receive dividends. Treasury stock
is traditionally shown as the last item (a deduction) within the shareholders’ equity section.
(In very limited circumstances involving employee compensation plans, treasury stock can
be shown as an asset.) The number of shares and the method of valuation are generally
shown, as follows:
Treasury stock, 1,000 shares at cost $ xxx
Partners’ Capital
Partnership balance sheets are the same as corporate entities except for the equity section.
In a partnership, this section is usually referred to as partners’ capital. Although each
individual partner’s capital need not be displayed, the totals for each class of partner, general
or limited, are separately presented. Loans to or from partners are displayed as assets and
liabilities of the partnership and not as reductions of or additions to partners’ capital. Payments
of interest to partners on loans are properly classified as expenses on the income
statement. Payments to partners representing a distribution of partnership earnings computed,
in accordance with the partnership agreement, as a percentage of the partner’s capital
are analogous to corporate dividends and are therefore reflected as distributions of capital
rather than as interest. Similarly, because a partner is not an employee of the partnership,
amounts allocated to that partner in exchange for services rendered are considered capital
distributions rather than expenses. However, in an attempt to emulate corporate financial
reporting, some partnerships, with adequate disclosure, do display such payments as expenses.
Members’ equity. A limited liability company (LLC) presents its equity using the caption
“members’ equity.” In accordance with ASC 272, the equity attributable to each class of
member is to be separately stated on the face of the balance sheet or disclosed in the notes to
the financial statements. Notwithstanding the legal limits on the members’ liability, in the
event that the LLC’s cumulative losses and distributions exceed its members’ collective capital
investment, a deficit in members’ equity is to be reflected. ASC 272 permits presentation
by the LLC of components of members’ equity that are similar to those of corporate entities
such as accumulated undistributed earnings (analogous to retained earnings).
Alternative Balance Sheet Segmentation
Besides classifying balance sheets into current and noncurrent assets and liabilities, there
are other segmentation schemes that GAAP requires for various reporting purposes, depending
upon the circumstances. Since these requirements do not utilize a common taxonomy,
the following explanation will be referenced throughout Wiley GAAP.
58 Wiley GAAP 2009 Codification Edition
Classification of assets (and sometimes liabilities also) may be required for the presentation
of segment information under ASC 280. This requirement only applies to publicly
held entities, although nonpublic companies may also elect to make segment disclosures.
Under ASC 280, it will be necessary to identify operating segments and reportable segments
of the business. (Terms are defined below.)
A different classification strategy is required for purposes of testing for impairment of
goodwill, under ASC 350. This standard created the concept of the reporting unit as a basis
for making an impairment evaluation.
Yet another term, a business, was defined in the Master Glossary and was often used as
a threshold criterion of what could not be considered a special-purpose entity (as addressed
in various standards, including ASC 860).
Finally, another classification system is invoked under ASC 360 in assessing the realizability
of long-lived assets for the purpose of determining whether those assets are impaired.
This standard established the concepts of asset groups and disposal groups.
The graphic below has been developed to illustrate how these different classification
schemes overlap. It is possible that a given enterprise, if it reports segment data and if it has
goodwill from a business combination on its balance sheet, may be required to apply most or
all of these taxonomies in meeting its financial reporting obligations—to disclose segment
information, to test for goodwill impairment, and to test for impairment of long-lived assets
other than goodwill.
Definitions (with references to professional standards and the chapter of Wiley
GAAP that addresses the associated topic).
Operating segment (ASC 280, Chapter 22)—A component of an enterprise engaged in
business activity for which it may earn revenues and incur expenses, about which separate
financial information is available that is evaluated regularly by the chief operating decision
makers in deciding how to allocate resources and in assessing performance.
Reportable segment (ASC 280, Chapter 22)—A segment is considered to be reportable
if it is significant to the enterprise as a whole. A segment is regarded as significant if it satisfies
any one of the three quantitative tests prescribed by ASC 280.
Reporting unit (ASC 350, Chapter 11)—A reporting unit is an operating segment or
one level below an operating segment (referred to as a component). A component of an operating
segment is a reporting unit if the component constitutes a business for which discrete
financial information is available and segment management regularly reviews the operating
results of that component. However, two or more components of an operating segment are to
be aggregated and deemed a single reporting unit if the components have similar economic
characteristics. An operating segment is deemed to be a reporting unit if all of its components
are similar, if none of its components is a reporting unit, or if it comprises only a single
component.
Business (ASC 805, Chapter 13)—A business is an integrated set of activities and assets
that is capable of being conducted and managed for the purpose of providing a return in the
form of dividends, lower costs, or other economic benefits directly to investors or other owners,
members, or participants.
Asset group (ASC 360, Chapter 11)—The lowest level of assets to be held and used, for
which identifiable cash flows are largely independent of the cash flows of other groups of
assets and liabilities.
Disposal group (ASC 360, Chapters 3 and 11)—Assets to be disposed of together as a
group in a single transaction and the liabilities directly associated with those assets that will
be transferred in the transaction.
The Parent Holding Company
Owns subsidiaries, land and headquarters building that they all use
Subsidiary 1
Division a
Business i
Subsidiary 2
Business iv
Subsidiary 3
Business v
2 Product Lines
Asset Group (a)
Asset Group (d)
with Primary
Asset
Asset Group (e) and
Disposal Group (f)
Division b
Business ii Business iii
Asset
Group
(b)
Asset
Group
(c)
Operating Segment A Operating Segment B
Reportable Segment I
Asset Group (i) Asset Group (j)
Operating Segment D
Reportable Segment III
Subsidiary 5
Business viii
Subsidiary 6
Business ix
2 Similar Businesses
Asset Group (g)
Asset Group (h)
Subsidiary 4
2 Similar Businesses
Business vii
Business vi
Operating Segment C
Reportable Segment II
Subsidiary 7
2 Nonsimilar Businesses
Business xi
Business x
Operating Segment E
Reportable Segment IV
Asset Group (1)
Reporting Unit (7)
Asset Group (k)
Reporting Unit (6)
Reporting Unit (3) Reporting Unit (4) Reporting Unit (5)
Reporting
Unit (2)
Reporting Unit (1)
60 Wiley GAAP 2009 Codification Edition
Disclosures
In addition to the measurement accounting principles that guide the values placed on the
elements included in the balance sheet, there are accounting principles specifying the
informative disclosures that are necessary because, without the information they provide, the
financial statements would be misleading.
The following five disclosure techniques are used in varying degrees in contemporary
financial statements:
1. Parenthetical explanations
2. Notes to the financial statements
3. Cross-references
4. Valuation allowances (sometimes referred to as “contra” amounts)
5. Supporting schedules
Parenthetical explanations. Information is sometimes disclosed by means of parenthetical
explanations appended to the appropriate balance sheet caption. For example
Common stock ($10 par value, 200,000 shares authorized, 150,000 issued) $1,500,000
Parenthetical explanations have an advantage over both notes to the financial statements and
supporting schedules. Parenthetical explanations place the disclosure prominently in the
body of the statement instead of in a note or schedule where it is more likely to be overlooked.
Notes to financial statements. If the information cannot be disclosed in a relatively
short and concise parenthetical explanation, a note disclosure is used. For example
Inventories (see note 1) $2,550,000
The notes to the financial statements would contain the following:
Note 1: Inventories are stated at the lower of cost or market. Cost is determined using the first-in,
first-out (FIFO) method.
Cross-references. Cross-referencing is used when there is a direct relationship between
two accounts on the balance sheet. For example, among the current assets, the following
might be shown if $1,500,000 of accounts receivable were pledged as collateral for a
$1,200,000 bank loan:
Accounts receivable pledged as collateral on bank loan payable $1,500,000
Included in the current liabilities would be the following:
Bank loan payable—collateralized by accounts receivable $1,200,000
Valuation allowances. Valuation allowances are used to reduce or increase the carrying
amounts of certain assets and liabilities. Accumulated depreciation reduces the carrying
value of property, plant, and equipment, and a bond premium (discount) increases (decreases)
the face value of a bond payable as shown in the following illustrations:
Equipment $18,000,000
Less accumulated depreciation (1,625,000) $16,375,000
Bonds payable $20,000,000
Less discount on bonds payable (1,300,000) $18,700,000
Bonds payable $20,000,000
Add premium on bonds payable 1,300,000 $21,300,000
Supporting schedules. A supporting schedule might be used to provide additional detail
about an item in the financial statements. For example, consolidating schedules might be
included in addition to the basic consolidated financial statements or a five-year summary of
Chapter 2 / Balance Sheet 61
selected financial data might be included. In general, supporting schedules are not used to
provide information required by GAAP because those schedules are not part of the basic
financial statements and are typically subjected to only limited procedures by auditors.
Accounting policies. There are many different methods of valuing assets, recognizing
revenues, and assigning costs. Financial statement users must be aware of the accounting
policies used by enterprises so that sound economic decisions can be made. Per ASC 235,
the disclosures are to identify and describe the accounting principles followed by the enterprise
and methods of applying those principles that materially affect the determination of
financial position, changes in cash flows, or results of operations. The accounting policies
disclosure is to encompass those accounting principles and methods that involve the following:
1. Selection from acceptable alternatives
2. Principles and methods peculiar to the industry
3. Unique applications of GAAP
The accounting policies disclosure need not duplicate information provided elsewhere in the
financial statements. The accounting policies usually appear in a separate section called
“Summary of Significant Accounting Policies” or as the first note of the notes to the financial
statements.
Related parties. According to ASC 850, Related-Party Disclosures, financial statements
are required to disclose material related-party transactions other than compensation
arrangements, expense allowances, or other similar items that occur in the ordinary course of
business.
A related party is essentially any party that controls or can significantly influence the
management or operating policies of the company to the extent that the company may be
prevented from fully pursuing its own interests. Related parties include affiliates, investees
accounted for by the equity method, trusts for the benefit of employees, principal owners,
management, and immediate family members of owners or management.
Transactions with related parties are to be disclosed even if there is no accounting recognition
made for such transactions (e.g., a service is performed without payment). Disclosures
are not permitted to assert that the terms of related-party transactions were essentially
equivalent to arm’s-length dealings unless those claims can be substantiated. If the financial
position or results of operations of the reporting enterprise could change significantly because
of common control or common management, disclosure of the nature of the ownership
or management control is required, even if there were no transactions between the entities.
The disclosures are to include
1. The nature of the relationship
2. A description of transactions and the effects of those transactions reflected in the
financial statements for each period for which an income statement is presented
3. The dollar amount of transactions for each period for which an income statement is
presented and the effects of any change in the terms of such transactions as compared
to the terms used in prior periods
4. Amounts due to and from related parties as of the date of each balance sheet presented,
together with the terms and manner of settlement
Comparative statements. In order to increase the usefulness of financial statements,
many enterprises include financial statements for one or more prior years in their annual reports.
Some also include five- or ten-year summaries of condensed financial information.
These comparative financial statements allow investment analysts and other interested readers
to perform comparative analysis of pertinent information. ASC 205-10-45 states the
62 Wiley GAAP 2009 Codification Edition
presentation of comparative financial statements in annual reports enhances the usefulness of
such reports and brings out more clearly the nature and trends of current changes affecting
the enterprise. That presentation emphasizes the fact that the statements for a series of periods
are far more significant than those for a single period and that the accounts for one period
are but an installment of what is essentially a continuous history. (Note that, while
comparative financial statements are presently required under US GAAP, it is highly likely
that this will become a requirement as the FASB moves to converge its standards with those
of IASB, the international standard setter.)
Subsequent events. The balance sheet is dated as of the last day of the fiscal period, but
a period of time usually elapses before the financial statements are issued. During this period,
significant events or transactions may have occurred that materially affect the company’s
financial position. These events and transactions are called subsequent events. The
omission of disclosure of significant events occurring between the balance sheet date and
issuance date of the financial statements could mislead the reader who is otherwise unaware
of those events.
There are two types of subsequent events (which, curiously, are defined not in the
accounting standards, but in the auditing literature, by SAS 1, Subsequent Events). The first
type are events that provide additional evidence about conditions that existed at the date of
the balance sheet and which affect the estimates inherent in the process of preparing financial
statements. The second type are events that provide evidence with respect to conditions that
did not exist at the date of the balance sheet but arose subsequent to that date. The first type
results in adjustments of the financial statements. The second type does not require
adjustment of the financial statements but may require disclosure in order to keep the
financial statements from being misleading. Disclosure can be made in the form of
explanatory notes, sometimes supplemented with pro forma statements.
Examples of subsequent events
1. A loss on an uncollectible trade account receivable that results from a customer’s deteriorating
financial condition, which led to bankruptcy subsequent to the balance sheet date, would
be indicative of conditions existing at the balance sheet date, thereby calling for adjustment
of the financial statements before their issuance. On the other hand, a loss on an uncollectible
trade account receivable resulting from a customer’s major casualty, such as a fire or
flood subsequent to the balance sheet date, would not be indicative of conditions existing at
the balance sheet date, and the adjustment of the financial statements would not be appropriate.
However, if the amount is material, disclosure would be required.
2. A settlement of a lawsuit would require adjustment of the financial statements if the event
that gave rise to the claim occurred prior to the balance sheet date. However, only disclosure
is required if the event that gave rise to the claim occurred after the balance sheet date, and
then only if the amount involved were expected to be material.
3. The second type of events (those not existing at the balance sheet date) that require disclosure
but not adjustment include the following:
a. Sale of a bond or capital stock issue
b. Purchase of a business
c. Loss of plant or inventories as a result of fire or flood
d. Gains or losses on certain marketable securities
Contingencies. A contingency is defined in ASC 450 as an existing condition, situation,
or set of circumstances involving uncertainty as to possible gain or loss. The uncertainty
will ultimately be resolved when one or more future events occur or fail to occur. Resolution
of the uncertainty may confirm the acquisition of an asset, the reduction of a liability, the loss
or impairment of an asset, or the incurrence of a liability.
Chapter 2 / Balance Sheet 63
If it is probable that an asset has been impaired or that a liability has been incurred at the
date of the financial statements and the amount of that loss can be reasonably estimated, the
loss is accrued by a charge to earnings and the recognition of a liability. Contingencies requiring
accrual are discussed more fully in Chapter 14.
However, if it is only reasonably possible that a future event will confirm that an asset
was impaired or a liability had been incurred at the balance sheet date, an enterprise must
disclose the contingency if the amount involved could have a material effect on the financial
statements. The disclosure is to include the nature of the contingency and either an estimate
of the amount of the loss or the range of possible losses. If an estimate of loss cannot be
made, that fact must be disclosed.
If the likelihood is remote that a loss has been incurred, no disclosure is necessary in
most circumstances. However, guarantees of the indebtedness of others, guarantees to repurchase
receivables or other assets, and obligations of commercial banks under standby letters
of credit are always disclosed, irrespective of the likelihood of future performance on the part
of the enterprise. The required disclosure is to include the nature and amount of the guarantee.
ASC 460, Guarantees, explains that guarantees actually embody two separate obligations,
(1) the contingent obligation to perform under the guarantee in the event of nonperformance
by the party whose obligation is guaranteed, and (2) an obligation to be ready to
perform, referred to as a standby obligation, during the period that the guarantee is in effect.
As a result of this bifurcation of the obligation, many guarantees are now required to be recognized
as liabilities on the balance sheet. Discussion of the recognition and disclosure of
guarantees is included in Chapter 14.
An estimated gain from a gain contingency usually is not reflected in the balance sheet
or income statement because doing so might recognize revenue prior to its realization. Adequate
disclosure of the gain contingency is to be made, but care must be taken to avoid misleading
implications as to the likelihood of realization. For example, if the enterprise may be
able to recover some portion of an incurred loss by proceeding against a third party, that fact
might be disclosed.
Commitments. All significant contractual commitments are to be disclosed in the notes
to the financial statements. For example, lease contract provisions, pension obligations, requirements
contracts, bond indenture covenants, commitments to purchase or construct new
facilities, and employee share-based compensation plans are to be clearly disclosed in the
notes.
Risks and Uncertainties
ASC 275-10-50, Risks and Uncertainties, requires disclosure in financial statements
about risks and uncertainties existing as of the date of those statements that could significantly
affect the amounts reported in the near term. Near term is defined as a period of time
not to exceed one year from the date of the financial statements. The four areas of disclosure
required by ASC 275-10-50 are risks and uncertainties relating to the nature of the enterprise’s
operations, use of estimates in the preparation of financial statements, certain significant
estimates, and vulnerability due to certain concentrations.
Nature of operations. ASC 275-10-50 requires that enterprises disclose the major
products or services that they sell or provide, the principal markets that they serve, and the
location of those markets.
If an enterprise operates in more than one industry, it must disclose all industries it is
operating within as well as the relative importance of each industry. The basis for determining
the relative importance of each industry (assets, revenue, or earnings) is also to be dis64
Wiley GAAP 2009 Codification Edition
closed. Quantification is not required in disclosures about the nature of operations. Comparisons
of relative importance for enterprises operating in more than one business can be
conveyed by the use of words such as predominantly, equally, or major.
Use of estimates in the preparation of financial statements. Financial statements
must include an explanation that the preparation of financial statements in accordance with
GAAP requires the use of estimates by management. The purpose of this disclosure is to
clearly alert users to the pervasiveness of estimates.
Certain significant estimates. ASC 275-10-50 requires disclosures regarding estimates
used in valuing assets, liabilities, or gain or loss contingencies if both of the following conditions
are met:
1. It is at least reasonably possible that the estimate of the effect on the financial
statements of a condition, situation, or set of circumstances that existed at the date
of the financial statements will change in the near term due to one or more future
confirming events.
2. The effect of the change would be material to the financial statements.
For the purposes of determining materiality, it is not the amount of an estimate that determines
whether an item is material and must be disclosed, but rather the effect of using a
different estimate that determines materiality.
The disclosure is to indicate the nature of the uncertainty and that it is reasonably possible
that the estimate will change in the near term. ASC 275-10-50 is separate from and does
not change ASC 450, Contingencies. If an estimate is covered under ASC 450 as a loss contingency,
the disclosure also is to include an estimate of the possible range of loss, or state
that an estimate cannot be made. Disclosure of any factors that would make an estimate sensitive
to change is encouraged but not required.
Many enterprises use risk-reduction techniques to mitigate losses. If the effect of a
change in the estimate is unlikely to be material because of risk-reduction techniques, the
enterprise is encouraged, but not required, to disclose the uncertainty as well as the relevant
risk-reduction techniques.
Examples of items that may be based
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