THE FINANCIAL REPORTING FRAMEWORK FOR SMALL- AND …
THE FINANCIAL REPORTING FRAMEWORK FOR SMALL- AND MEDIUM SIZED ENTITIES—PART 3
CPA Firm Support Services, LLC
By Larry L. Perry, CPA
LEARNING OBJECTIVES
• To learn the presentation format for the statements of operations under the FRF for SMEs.
• To understand the basic principles in the FRF for SMEs for presentation and disclosure of certain account classifications in the statements of operations.
• To learn accounting treatment and disclosures for accounting changes and risks and uncertainties.
INTRODUCTION
The AICPA has recognized that many non-public, small- and medium-sized companies are not required to use U.S. GAAP as their reporting framework. These companies are generally those with long-range ownership interests, those in specialized industries and/or those with no intentions to file for public offerings of their securities. While other special purpose frameworks may be appropriate for some of these entities, others are looking for ways to provide more comprehensive financial information to financial statement users that are not as burdensome as U.S. GAAP. Detailed guidance for the FRF for SMEs is available at .
For these reasons, the AICPA has developed this non-authoritative, special-purpose framework to provide simplified, consistent and relevant financial statements. Characteristics of the framework include:
• A combination of traditional accounting methods from special purpose frameworks such as the cash basis and the income tax basis.
• A historical cost basis with some modifications for market values.
• Specific, simplified footnote disclosures.
• Uncomplicated, consistent and principles-based accounting.
• A consolidation model that excludes variable interest entities.
In these materials, part three of a four-part series, we will present these topics for the FRF for SMEs:
• Presentation of the statements of operations.
• Principles of accounting and disclosure for:
o Revenues
o Expenses
o Leases
o Pension and post-employment benefit plans
o Income taxes
o Accounting changes
o Risks and uncertainties
PRESENTATION OF STATEMENTS OF OPERATIONS
Some basic presentation issues under the FRF for SMEs are as follows:
1. The titles of these statements are not limited to a prescribed title. Some common options are:
a. Statement of Operations
b. Statement of Revenues and Expenses
c. Statement of Revenues, Expenses and Retained Earnings
d. Consolidated versions of above statements
2. Each statement should include this reference or other descriptive wording under the statement title: (FRF for SMEs Basis).
3. As with other frameworks, a comparative format is considered the most meaningful but is not required. In fact, for the first period of application of the FRF for SMEs, restating prior period financial statements prepared using another framework will usually be cost-prohibitive. Single period financial statements will usually be the most appropriate in the first period of application.
4. Line item references to footnotes aren’t required but a reference on the bottom of the statement to the notes and an accountant’s report is required. Example: “See Independent Accountant’s Review Report and Notes to Financial Statements.”
STATEMENT OF OPERATIONS
Results of operations should be presented fairly in the statement of operations in accordance with the provisions of the FRF for SMEs. Three basic categories are normally included in the statement:
• Income or loss before discontinued operations—major elements comprising this category include sales and other revenues, costs of sales, operating expenses, income taxes and other expenses.
• Discontinued operations—results of operations of components that are sold, abandoned, otherwise disposed of or held for sale should be classified in this category.
• Net income or loss—when statements are consolidated the portion attributable to non-controlling interests and to the parent should be presented.
Treatment of Major Classifications on the Statement of Operations
Recognizing Revenues
Recognizing revenue under this FRF requires completion of performance of a transaction and reasonable assurance of collection of invoices and billings. Similar to U.S. GAAP, revenue must be earned or realizable to be recognized.
Specifically for the sale of goods, performance is achieved when the seller has transferred ownership of the goods to the buyer and the seller retains no continuing involvement in the goods transferred.
When services are provided under long-term contracts, performance should be determined under the percentage of completion method or the completed contract method. The method that best relates the revenue to the work performed should be used.
Achievement of performance occurs when:
• There is persuasive evidence of an arrangement.
• Goods have been delivered or services have been provided.
• The seller’s price is fixed or determinable.
Evidence of an arrangement: Business practices or prior transactions with a customer, side agreements, consignment sales, the right to return a product or requirements to repurchase a product may be indicators of whether an arrangement exists.
Delivery: Delivery generally occurs when a product is delivered to a customer’s facility or another specified site. As it is when recognizing revenue under other reporting frameworks, consideration of several factors may be necessary. Such factors include bill and hold agreements, required customer acceptance, layaway sales, non-refundable fees, licensing and other fees and who bears the risk of loss.
Seller’s price: Factors that should be considered to determine if a price if fixed or determinable include cancellable provisions, the right of return of a product, price protections or inventory credit arrangements and refundable fees for service agreements.
Generally, performance of a transaction determines when revenue is earned and recognized. For the sale of goods or providing services, performance is considered achieved when a seller has transferred goods to a buyer or provided services, i.e., a point of sale or delivery has occurred, when the buyer assumes the risks and rewards of ownership of a product or accepts the services, when there is reasonable assurance a specified amount of consideration will be received (collectability) in return and when an appropriate allowance for returns of products has been determined. A sale would not be recorded when the seller retains significant risks of ownership, such as in the case of consignment sales. An appropriate allowance for uncollectible accounts should be provided based on the evaluation of collectability.
For long-term contracts or rendering services, performance should be determined under either the percentage of completion method or the completed contract method, whichever best presents revenues in relationship to the work that has been accomplished. Revenue should be recognized under the percentage of completion method base on some systematic, rational and consistent basis such as sales value, related costs, and extent of progress or number of acts. Amounts billed are an appropriate basis only if they are indicative of work completed.
The completed contract method normally should be used when the extent of progress cannot be reasonably estimated. Management may elect to use the completed contract method when it is used for income tax reporting or when the financial position and results of operations are similar to the percentage of completion method. This may occur when an entity performs numerous short-term contracts.
Contract claims may be recorded when amounts have been awarded or received or at times when it becomes probable the claims will result in additional contract revenue (if amounts can be reasonably estimated). In the latter case, revenue should be recorded only to the extent related costs are incurred.
Multiple Deliverable Arrangements
For multiple deliverable arrangements, performance of transactions should be considered separately in accordance with the recognition criteria above. An example would be the sale of software with separately priced installation, training, maintenance and warranty agreements. Revenue from elements such as maintenance and warranty agreements will normally be recognized on a straight-line basis over the term of the agreement unless the services are provided in an identifiable, significantly different pattern.
U.S. GAAP includes provisions for recognizing revenues in connection with arrangements that have multi-deliverables. ASU 2009-13 clarified those requirements by requiring a sales price to be assigned to each of the deliverables at the inception of an arrangement.
Under the FRF for SMEs, similar provisions will apply. When a sales transaction includes the delivery or performance of multiple products, services or rights to use assets, and the delivery or performance occurs at different times, revenue recognition criteria will be applied to each of the deliverables. A vendor of large appliances, for example, will ordinarily sell the product, charge additionally for delivery, and make warranty and/or maintenance agreements available for separate purchase. Separate revenue recognition criteria would be applied to each of these deliverables. For fixed fee warranty or maintenance agreements, revenue would be recognized over the term of the agreement, ordinarily on a straight line basis.
Other Income
Investment income is recognized similar to U.S. GAAP. Interest is recognized over time, royalties are recognized as they accrue under an agreement and dividends are recognized when a shareholder has the right to receive payment.
Principal vs. Agent
Also like U.S. GAAP, an agent in a transaction will report only commissions as revenues.
Companies that conduct business as agents rather than as principals sometimes face a dilemma as to how to record revenues, gross amount of billings or net amounts of commissions. Judgment based on facts and circumstances should guide resolution.
Indicators of gross revenue reporting include whether the entity:
• Is the primary obligor in the arrangement.
• Has general inventory risk.
• Has latitude in establishing price.
• Changes the product or performs part of the service.
• Has discretion in supplier selection.
• Is involved in the determination of product or service specifications.
• Has physical loss inventory risk.
• Has credit risk.
Indicators of net commission reporting include:
• The supplier, not the entity, is the primary obligor in the arrangement.
• The amount the company earns is fixed.
• The supplier has credit risk.
Improper Revenue Recognition
For the FRF for SMEs, improper revenue recognition may occur in any of these and other situations:
• Letters of intent are used in lieu of signed contracts.
• Products are shipped before the scheduled shipment date without the customer’s approval.
• Products can be returned without obligation after a free “tryout” period.
• Customers can unilaterally cancel a sale.
• Obligations to pay for products are contingent on a customer’s resale to a third party or on financing from a third party.
• Sales are billed for products being held by the seller before delivery.
• Products are shipped after the end of the period.
• Products are shipped to a warehouse (or other intermediate location) without the customer’s approval.
• Sales are invoiced before products are shipped.
• Part of a product is shipped and the part not shipped is a critical component of the product.
• Sales are recorded based on purchase orders.
• Obligations to pay for the product depend on the seller fulfilling material unsatisfied conditions.
• Products still to be assembled are invoiced.
• Products are sent to and held by freight companies pending return to the seller for required customer modifications.
• Products require significant continuing vendor involvement (such as installation or debugging) after delivery.
Improper Revenue Recognition in Smaller Entities
Many CPA firms have experienced revenue recognition problems with smaller reporting entities. Here are a few examples:
• A nightclub that continually reports a very low gross margin from beer and liquor sales (Skimming).
• An operator of nursing homes includes numerous relatives on multiple payrolls (Inflating Medicaid reimbursements).
• A construction contractor that purchases all materials for certain contracts to increase actual costs before its year-end (Dumping materials at sites to inflate the percentage of completion).
• A trailer leasing company that bills customers for extra, unused trailers each month (Fraud).
• Products shipped subject to customer approval are recorded before receiving such approval (Improper cutoff).
• Billing customers for products shipped on consignment, or before products are shipped and recording revenue prematurely (Inflating revenues).
• Recording multi-year contracts or revenues benefiting future periods, at the date of the contract or customer order (Improper matching of costs and revenues).
• Recording grant revenues when received rather than as expended (Improper matching costs and revenues).
• An entity that won’t provide inventory quantities and pricing information until the CPA informs management of the taxable income before the inventory adjustment (Fraud).
Disclosures
Basic disclosures under the FRF for SMEs include the following:
• Revenue recognition policies for all types of revenues, including the policies, recognition methods and determination of revenues from multiple deliverable arrangements.
• All major categories of revenue should be disclosed in the statement of operations or in the footnotes.
• When the completed contract method is used, an entity must disclose why the method is used instead of the percentage of completions method.
• Revenue recognized from contract-related claims should be disclosed.
• When management elects to record revenues from contract-related claims only when received or awarded, the amounts of claims due should be disclosed.
Discussion Exercise:
Referring to the Statement of Revenues and Expenses for Always Best Corporation in Appendix A, list below any additional disclosures you consider necessary for a fair presentation of revenue recognition.
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NONMONETARY TRANSACTIONS
Normally, the most reliable market value for the asset given up or the asset received should be the measure for assets received or exchanged in nonmonetary transactions. Exceptions include transactions that lack commercial substance (increases in cash flows), that are exchanges of products in the normal course of business, that have no reliable market values for assets exchanged, that are nonreciprocal transfers to owners and that are between related parties.
When these exceptions apply the carrying amount of the asset given up, adjusted for any monetary consideration in the transaction, should be used for measurement purposes. The party paying the monetary consideration values the nonmonetary asset received at the carrying amount of the asset given up plus the monetary consideration paid. The party receiving the nonmonetary asset values it at the carrying amount of the asset given up less the monetary consideration received. If the monetary consideration exceeds the asset’s carrying amount, a gain is recognized.
Other matters
• Nonreciprocal transfers to owners that are spin-offs or other forms of restructuring in liquidation should be valued at the carrying amounts of nonmonetary assets or liabilities transferred.
• Gains and losses from nonmonetary transfers should be reported in net income at the date of the transfer.
• Restructuring or spin-off distributions do not result in gains or losses to the transferor.
• Disclosures include the nature and amount of the transaction, the basis for measurement and the method of valuation used and any gains or losses.
OPERATING EXPENSES
The matching of costs with revenues in the same reporting period is a basic principle underlying the presentation of operating expenses. Costs of goods sold and other operating expenses should be recorded in the same period related revenues are recognized.
Generally, operating expenses are recognized on an accrual basis, when an expense is incurred. Fixed assets are depreciated over their useful lives. Intangible assets are amortized over their useful lives (or contractual periods as in the case of asset retirement obligations) or periods specified in the FRF for SMEs (goodwill is amortized over the period specified by the Internal Revenue Code or 15 years).
LEASE ACCOUNTING
The FRF provides guidance for lessees’ accounting for capital and operating leases, and for lessors’ accounting for sales-type, direct financing and operating leases. The principles are based on the view that property has benefits and risks related to ownership. Further, the FRF takes the position that when a lease transfers substantially all the ownership benefits and risks it is essentially an acquisition of an asset and the incurrence of an obligation and should be accounted for as a capital lease by the lessee and either a sales-type or direct financing lease by the lessor.
This guidance does not apply to copyrights, patents and other licensing agreements which are account for as intangible assets. Following is a discussion of basic lease accounting principles under the FRF.
One or more criteria in a lease agreement indicating transfers of substantially all the benefits and risks of ownership to lessees, similar to currently applicable U.S. GAAP, includes:
1. Transfer of ownership at the end of the lease term or a bargain purchase option (that would cause the lessee to purchase).
2. A lease term that will enable the lessee to receive substantially all the economic benefit from the asset. This would normally be a term that is 75% or more of the remaining useful life of the asset. This criteria normally would not apply to land unless there is reasonable assurance ownership will transfer at the end of the lease term.
3. The lessor has some assurance of recovering the cost of the assets and earning a return on that investment. This assurance exists if, at the inception of the lease, the present value of the minimum lease payments excluding executory costs is 90% or more of the market value of the asset. The discount rate that should be used to determine present value is the lower of the lessee’s incremental borrowing rate or the interest rate implicit in the lease if it can be obtained or estimated (the implicit rate will be used by a lessor).
For lessors, the benefits and risks of ownership normally are transferred when:
1. Any one of the criteria above is met.
2. Credit risk is similar to other receivables.
3. Non-reimbursable costs likely to be incurred by the lessor can be estimated to determine if substantial risks are retained, thereby preventing capitalization of the lease
A lease of an asset that transfers substantially all the benefits and risks of ownership should be accounted for as a capital lease by the lessee and a sales-type or direct financing lease by the lessor.
Lessee’s Accounting
Capital Leases:
A capital lease should be accounted for by a lessee as the acquisition of an asset and the creation of an obligation. The amount of the asset and obligation to be recorded at the inception of the lease is the present value of the minimum lease payments over the lease term, excluding any known or estimated executory costs (such as insurance, maintenance and taxes) in the lease payments. The calculated value of the asset, of course, cannot be greater than it’s market value.
The lessor’s interest rate implicit in the lease would be used to discount minimum lease payments if it can be obtained and is lower than the lessee’s incremental borrowing rate.
The capitalized value of a leased asset should be amortized over the expected period of use with rates and methods used for other similar assets. If ownership passes to the lessee at the end of the lease, or if there is a bargain purchase option sufficient to induce a lessee to buy, the asset should be amortized over its economic life. Otherwise, it should be amortized over its lease term. Interest expense on the obligation is calculated using the discount rate applied when calculating the present value of the minimum lease payments.
Capitalized lease assets and obligations should be presented separately in the statement of financial position or in the footnotes.
Operating Leases:
Rental expenses for operating leases (those for which substantially all benefits and risks are not transferred to the lessee) are accounted for on a straight-line basis over the lease term, unless another method is more representative of the lessee’s use of benefits.
Land and Building Leases:
When a capital lease allows ownership to be transferred at the end of the lease term or provides a bargain purchase option sufficient to induce the lessee to purchase the asset, land should be capitalized separately from buildings in proportion the their market values at the inception of the lease. When such provisions are not included in the lease, and the market value of the land is minor compared to the total market value of the land and buildings, the assets are considered a single unit. The economic life of the building would ordinarily be the economic life of the single unit. If the market value of the land is significant, the portion of applicable to the land would be accounted for as an operating lease by both the lessee and the lessor.
Disclosure:
Disclosures for each major category of capitalized leased assets include:
• Cost
• Accumulated amortization, including any write-downs of asset values
• The amortization method, including the period and rate used
Capitalized leased obligations disclosures include:
• Interest rate
• Maturity date
• Outstanding balance
• Any collateral under the leases
• Interest expense disclosed separately or as part of interest on long-term debt
• Payments for each of the next five years in accordance with terms of the lease
Operating leases disclosures should include future minimum lease payments in the aggregate and for each of the five succeeding years. Short term leases of one year or less are excluded from this disclosure requirement.
Lessor’s Accounting
The FRF permits three methods of accounting for lessors::
• Direct financing lease
• Sales-type lease
• Operating lease
Direct Financing Lease:
Direct financing leases normally provide financing between a manufacturer or dealer and a lessee and generate financing income. Income from such leases is comprised of the difference between total net minimum lease payments and the carrying amount of the leased asset.
The lessor’s investment in the lease is comprised of the net amount of:
• Minimum lease payments receivable, net of any executory costs (insurance, maintenance and taxes) and any profit on the sale.
• The unguaranteed residual value of the leased asset.
• Unearned finance income, net of any initial direct costs to be allocated over the lease term.
• Any investment tax credits to be allocated over the lease term.
Initial direct costs should be expensed as incurred with an equal portion of unearned income recognized in the same period. Unearned finance income should be deferred and recognized in income so that a constant rate of return on the investment is included in the statement of revenues and expenses.
The estimated residual value of the asset should be reviewed annually to determine if its value has declined. For permanent declines, the accounting for the transactions should be revised. Any reduction in the investment should be recorded as a loss in the period of decline.
Sales-Type Lease:
Sales-type leases are used by manufacturers and dealers to sell products. Income from these leases consists of a profit or loss on the sale and finance income over the lease term. Sales revenue is determined by discounting the minimum lease payments, net of any executory costs and included profit, using the interest rate implicit in the lease. The cost of sale is the carrying amount of the leased asset reduced by the present value of the unguaranteed residual, also calculated using the interest rate implicit in the lease.
Finance income is calculated as the difference between total net minimum less payments plus any unguaranteed residual and the aggregate of the present value of minimum lease payments determined using the interest rate implicit in the lease.
Initial direct costs are recognized as an expense at the inception of the lease. Profit or loss is recognized at the date of the transaction. Unearned finance income is deferred and recognized in income to produce a constant rate of return over the term of the lease. The estimated residual value will be reviewed annually and adjusted for a permanent decline in value.
All leases should be reviewed annually for collectability and/or recoverability issues. When a significant adverse change has occurred the carrying amount of the asset should be reduced to the highest of the discounted value of expected cash flows (discounted at a current market rate) from holding the asset or the net amount of sales proceeds that could be realized at the reporting date.
Operating Lease:
Rental revenue from an operating lease should be recognized on a straight-line basis over the term of the lease unless another method more appropriately reflects income earned. Initial direct costs should also be deferred and amortized in the same manner.
Presentation and Disclosure:
The lessor’s net investment in a capital lease is a long-term receivable that should be presented separately from other assets. The net investment in the lease includes:
• The net minimum lease payments receivable.
• Any unguaranteed residual value.
• Unearned finance income
The lessor’s net investment should be presented as both current and long-term amounts in the statement of financial position. Footnote disclosure should include the net investment in direct-financing and sales-type leases along with interest rates implicit in the leases.
Discussion Exercise:
A health care organization leases all of its medical and patient-room equipment directly from a manufacturer. The manufacturer structures its leases as short-term operating leases with no renewal terms or bargain purchase options. Historically, the health care organization has renewed these leases annually, each for at least 10 renewal terms, and then purchased each piece of leased equipment for one dollar. Since you have attended webcasts on the new FRF for SMEs and are now the expert in your community, the health care organization has asked you how these leases should be treated in their financial statements under the FRF for SMEs.. For simplicity, they want to account for these leases as operating leases. How would you advise them? What are your reasons?
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PENSION AND POST-RETIREMENT BENEFIT PLANS
The principles for recognition, measurement and disclosure of the cost of retirement and other post-retirement benefits in the FRF for SMEs generally require cost recognition of the plans in the periods in which employees perform services.
Pension and other retirement benefits may include pension income, health care benefits, life insurance and other benefits provided to employees after their retirement. Post-employment benefits provided to employees during employment and after retirement include long- and short-term disability income, severance benefits, salary continuance, supplemental unemployment benefits, job training and counseling and health care and life insurance benefits. If deferred compensation contracts as a group are similar to a pension plan they should be accounted for similarly.
These principles apply to any arrangement that is a benefit plan regardless of its form or funding provisions. It is assumed that past practice will extend into the future and applies to benefits for which an entity pays all or part of the cost.
An obligation for payment of benefits under these plans meets the defined characteristics of a liability:
• An entity has a responsibility to pay the benefits at a specified future time.
• While the obligation may not be practical in some cases, the entity has little or no choice but to pay it.
• The rendering of service by the employee or the employee’s applying for certain benefits such as long-term disability obligates an entity.
Defined Contribution Plans
Pension cost should be recognized as an expense for a period. Pension cost should normally be the accrual basis contribution to a plan for a period.
Footnote disclosures should include a general description of each plan and the cost recognized for a period.
Multiemployer Plans
Pension cost in these plans is also recognized as a period expense. Pension cost normally includes the contribution to the plan. In addition to the disclosure requirements for defined contribution plans, any obligation for a probable or reasonably possible withdrawal from a plan should be disclosed.
Individual Deferred Compensation Contracts
Only accruals of benefits attributable to current employment should be recognized. Future benefits attributable to more than one year of service should be accrued at present value over the employee’s period of service.
Defined Benefit Plans
Management of an entity can chose either (1) a current contribution payable method or (2) an accrued benefit obligation method to account for these plans. Under the first method, the current plan contribution is expensed. Disclosure include a plan description including participants, the method of determining benefits, information about the funded status of the plan, the contributions for the current and the future years (expected), the expected plan rate of return and the obligation discount rate.
Selecting an accrued benefit obligation permits an entity to use an immediate recognition approach or a deferral and amortization approach. For the immediate recognition approach, the obligation is determined by an actuarial valuation report prepared for funding purposes. The deferral and amortization approach requires recognition of the accrued benefit obligation or asset representing the sum of the current and prior years’ benefit costs, less the accumulated contributions to the plan. Prior service costs are deferred and amortized over future periods, normally along with actuarial gains and losses. Any market value of plan assets and the accrued benefit obligation are disclosed in the footnotes.
INCOME TAXES
Here is some major good news! The FRF for SMEs offers entities subject to income taxes a choice of two methods for accounting for income taxes:
1. The taxes payable method.
2. The deferred income taxes method.
A brief summary of the two methods follows. A detailed discussion of the deferred income taxes method will be included in my next blog.
Taxes Payable Method
An asset or liability will be recognized to the extent of refundable and unpaid income taxes, which unpaid taxes should include any from prior years. Carrybacks of tax losses should be recognized as a current asset and tax benefit in the period the tax loss occurs. Income taxes refundable or payable are calculated in accordance with the applicable capital gains or ordinary income tax rates and laws in effect at the date of the statement of financial position.
Deferred Income Taxes Method
Similar to U.S. GAAP, deferred tax assets and deferred tax liabilities are recognized for future deductible amounts and future taxable amounts, respectively. Differences in the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes are called temporary differences. Temporary differences may be future taxable or deductible differences. Deferred tax assets result from amounts that will be deductible for tax reporting in the future. Deferred tax liabilities result from amounts that will be taxable in the future.
Common Book/Tax Differences
| | |
|ACCOUNTING TREATMENT |TAX RETURN TREATMENT |
|1. Installment sale—Not recognized unless collectability of |1. Installment sale—Prorata portion of gain is recognized as |
|receivable is in doubt. |payments are received. |
|2. Bad debts—Allowance method is required to measure |2. Bad debts—Only the direct write off method is allowed for tax |
|uncollectibility |purposes. |
|3. Overhead in inventories—Only manufacturing overhead can be |3. Overhead in inventories—IRC Section 263(a) allows allocation |
|allocated to work-in-process and finished goods. |of certain general and administrative expenses to inventories. |
|4. Depreciation methods and rates—Must be comparable to the |4a. Depreciation methods and rates—Accelerated methods can be |
|useful lives of assets. |elected. |
| |4b. IRC Section 179 property—Listed property can be written off |
| |within limits. |
|5. Construction contracts—Percentage of completion method may be |5. Construction contracts—Large contracts on percentage of |
|used for long-term contracts. |completion; small contracts on accrual or cash methods. |
|6. Rent received in advance—Deferred until it is earned. |6. Rent received in advance—Taxable in the year received under |
| |cash or accrual methods. |
|7. Estimated litigation expenses—Recognized when they become |7. Estimated litigation expenses—Deductible when actual expenses |
|known and subject to estimation. |are paid or accrued. |
Temporary Differences
As illustrated above, differences in the tax bases of assets and liabilities compared to carrying amounts in financial statements give rise to temporary differences, i.e., differences that will reverse and/or be recovered in future periods. The temporary difference determines the amounts of deferred tax assets or liabilities.
When the carrying amount of an asset is greater than its tax basis, the recovery of the carrying amount for accounting purposes will result in an amount greater than the future amount deductible for tax reporting. This is a temporary difference that will result in a deferred tax liability.
When the carrying amount of an asset is less than its tax basis, the future deductible amount for tax reporting will be greater. This temporary difference results in a deferred tax asset that will be recoverable in future periods.
If the carrying amount of a liability is equal to its tax basis, there is no temporary difference. Amounts related to liabilities that are deductible for future tax reporting have a tax basis of zero and are deductible when settled. This book/tax difference results in a deferred tax asset.
Future realization of a deferred tax asset, unused tax losses and unused income tax deductions will result in a tax benefit. The amount recognized as a deferred tax asset should be limited to the amount that is more likely than not to be realized. The potential realization of a deferred tax asset will be based on an evaluation of the sufficiency of future expected taxable income. A valuation allowance should be recognized to the extent that it is more likely than not that some or all of the deferred tax asset will not be realized.
Illustration of the Deferred Tax Method
ABC Company Facts
• Deferred tax account balances at their 2012 yearend:
o Deferred tax asset—current $ 75
o Deferred tax asset—non-current 300
o Deferred tax liability—current 200
o Deferred tax liability—non-current 1,200
• Temporary differences: 2013 2014
o Installment sale receivable—tax balance greater;
no allowance; future taxable amount (DTL) $1,000 $ 0
o Inventory—tax balance less due to IRC 263(a) adjustments;
future deductible amount (DTA) (1,000) (1,500)
o Depreciable assets—tax balance less due to impairment
losses, exit and disposal activities; future deductible amount
(DTA) (1,500) (1,500)
o Accumulated depreciation—tax balance greater due to
accelerated depreciation methods; future taxable amount
(DTL) 6,000 7,500
• The enacted tax rate for federal and state taxes for all years is 20%.
• At the end of 2013, a $5,000 tax credit carryforward was available which was earned in 2013. It is expected to be used in 2014.
• No valuation allowances are necessary for deferred tax assets since all are expected to be realized because of sufficient future income.
Calculations for 2013
| | Current | Non-Current |
| | Taxable | Deductible | Taxable | Deductible |
|Temporary Differences | DTL | DTA | DTL | DTA |
| | | | | |
|Installment sale receivable |$1,000 | | | |
|Inventory | |$1,000 | | |
|Depreciable assets | | | |$1,500 |
|Accumulated depreciation | | |$6,000 | |
|Tax rate |20% |20% |20% |20% |
| | | | | |
|Deferred tax liability | 200 | | 1,200 | |
|Deferred tax asset | | 200 | | 300 |
|Deferred tax asset from tax credit carryforward | | 5,000 | | |
| | | | | |
|Totals | 200 | 5,200 | 1,200 | 300 |
|Less beginning balances from 2009 | (200) | (75) | (1,200) | (300) |
| | | | | |
|2010 Adjustments | $0 | $5,125 | $0 | $0 |
| | | | | |
|Adjusting entry: | | | | |
| | | | | |
|DR--Deferred tax asset--current $5,125 | | | | |
|CR--Deferred tax benefit $5,125 | | | | |
| | | | | |
|Balance Sheet Classification: | | | | |
| | | | | |
|Net current amount: | | | | |
| Deferred tax asset--current $5,200 | | | | |
| Deferred tax liability--current (200) | | | | |
| Net current deferred tax asset $5,000 | | | | |
| | | | | |
|Net non-current amount: | | | | |
| Deferred tax asset--non-current $ 300 | | | | |
| Deferred tax liability--non-current 1,200 | | | | |
| Net non-current deferred tax liablility $ (900) | | | | |
| | | | | |
|Footnote Disclosures: | | | | |
| | | | | |
|Deferred tax asset: | | | | |
| Current $5,200| | | | |
| Non-current 300 | | | | |
| Total deferred tax asset $5,500 | | | | |
| | | | | |
|Deferred tax liability: | | | | |
| Current $ 200| | | | |
| Non-current 1,200 | | | | |
| Total deferred tax liability $1,400 | | | | |
| | | | | |
Measurement, Presentation and Disclosure
Income tax assets or liabilities should be measured based on enacted income tax rates and income tax laws. Deferred tax assets and liabilities are not discounted to present value.
Intraperiod allocation of income tax expense or benefit, both current and deferred, should be made to income or loss before discontinued operations, discontinued operations, certain capital and other transactions.
The provision for income tax expense and income tax benefit, current and deferred, included in the determination of net income or loss before discontinued operations should be presented on the face of the statement of operations.
Disclosures should include the choice of method for accounting for income taxes. Under the taxes payable method, disclosures include:
• The expense or benefit included in income or loss before discontinued operations.
• A discussion of differences between current period tax rates or expense and statutory rates.
• Amount of unused tax loss carryforwards and tax credits.
• Any portion of tax expense or benefit applying to transactions charged to equity.
These disclosures are necessary for the deferred income tax method alternative:
• Current and deferred income tax expense or benefit included in net income or loss before discontinued operations.
• Any portion of tax expense or benefit applying to transaction charged to equity.
• Any portion of unused tax losses, income tax reductions or deductible temporary differences not recognized as a deferred tax asset.
• A discussion of differences between current period tax rates or expense and statutory rates.
• Amount of unused tax loss carryforwards and tax credits.
Discussion Exercise:
As CFO of your organization, you are planning to select the FRF for SMEs as your applicable financial reporting framework. The user of your financial statements, a commercial bank, has agreed to your use of the FRF for SMEs and plans to use the financial statements to determine if they can offer loan the funds to finance your construction of a new office facility. Having used U.S. GAAP as your reporting framework in the past, the deferred income tax method was required. As a result of using this method, you have accumulated a large net balance of deferred tax assets, both current and long-term. These deferred tax assets are material in comparison to retained earnings. Should you continue using the deferred income tax method or change to the income taxes payable method based on these limited facts? What are your reasons?
________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
ACCOUNTING CHANGES
Changes in accounting policies, accounting estimates and correction of errors are treated similarly to U.S. GAAP.
Accounting Policies
Accounting policies should be consistent among periods and should be changed only if the change is required by the FRF for SMEs or the results of the change produce more reliable and relevant financial information. Changes in accounting policies should be presented retrospectively by restating the opening balance of the appropriate equity account in the earliest period presented and by restating all comparative amounts in the financial statements. Unless comparative statements are required by users of the financial statements, it will usually be more cost efficient to present only the current period balances in the first period of application of the FRF for SMEs.
Accounting Estimates
Estimates based on current facts and circumstances are necessary for determining certain amounts presented in financial statements, such as:
• The allowance for uncollectible accounts.
• Inventory write-downs to net realizable value.
• Depreciation and amortization.
• Accounts arising from application of the percentage of completion method of revenue recognition.
• Allowances for sales discounts and returns.
• Warranty and maintenance obligations.
New information may require revision of accounting estimates. Such revisions are not corrections of an error and should be accounted for prospectively.
Errors
Errors related to prior periods financial statements should be corrected by restating the opening balances of the earliest period presented that is affected by the error and by restating all comparative amounts in prior periods presented.
Disclosures
Initial Application of the FRF for SMEs Policies:
• Explanation that changes are made for transition to the FRF for SMEs, if applicable, and a description of such changes.
• Nature of the changes in accounting policies.
• Changes to current period line items in financial statements, to the extent practical. If not practical, an explanation of conditions causing the changes and how they were applied.
• Amounts of adjustments to prior periods’ statements not presented.
Voluntary Changes in Policies:
• Nature of the change in accounting policy.
• Reasons why the changes provides more reliable and relevant information.
• Line item adjustments to the extent practical.
• Amounts of adjustments to prior periods’ statements not presented, if practical. If not practical, an explanation of conditions causing the changes and how they were applied.
Changes in Estimates:
• Nature and amount of material changes in the normal course of business (allowance for uncollectible accounts, inventory obsolescence, useful lives of assets, etc.) affecting the current period.
Errors:
• Nature and amounts of prior period errors.
• Amount of correction at the beginning of the earliest period presented (adjustment to opening balance of retained earnings).
RISKS AND UNCERTAINTIES
The first note to the financial statements should include descriptions of recurring accounting policies to enable users to properly evaluate an entity’s financial position and results of operations. Major products and services and the entity’s principal markets should be disclosed in the accounting policies note. This disclosure, along with the organizational structure of an entity, is normally presented first in this note.
Other items that should be disclosed in footnotes include:
• Discussion of management’s use of estimates and that the estimates are based on circumstances that exist at the date financial statements are available for issue and may change in the future. Common examples of estimates are allowances for uncollectible accounts, sales returns and allowances, warranty costs, and compensated absences.
• Descriptions of concentrations and any risk of loss in the near-term future. Common concentrations include bank deposits over insured limits, material amounts of key person life insurance from a single company, major customers and vendors, geographic market concentration or material amounts of revenue from a single product.
APPENDIX A--ILLUSTRATIVE STATEMENT OF OPERATIONS
Following is an illustrative, basic set of financial statements and footnotes prepared under the FRF for SMEs. A brief review of these statements will reinforce the concepts discussed in this presentation.
Illustrations of comparative, detailed financial statements for this framework, U.S. GAAP basis and the income tax basis are available in the FRF for SMEs section of the AICPA’s website ().
When management and users of an entity’s financial statements agree upon use of the FRF for SMEs as the applicable reporting framework, financial statement and footnote preparation and audit will often be most efficient choice among the alternatives.
ALWAYS BEST CORPORATION
STATEMENT OF ASSETS, LIABILITIES AND EQUITY
(FRF for SMEs Basis)
December 31, 2014
ASSETS
CURRENT ASSETS
Cash $ 13,000
Accounts receivable—trade 488,000
Accounts receivable—related parties 55,000
Inventories 400,000
Prepaid expenses 1,300
Total Current Assets 957,300
INVESTMENTS 260,000
PROPERTY AND EQUIPMENT
Land 5,000
Buildings 90,000
Machinery and equipment 85,000
Office furniture and equipment 6,000
186,000
Less accumulated depreciation (108,000)
Net Property and Equipment 78,000
OTHER ASSETS
Note receivable 36,000
Deposits 5,800
Total Other Assets 41,800
TOTAL ASSETS $1,337,100
LIABILITIES AND EQUITY
CURRENT LIABILITIES
Current portion of long-term debt $ 75,000
Accounts payable 410,000
Accrued expenses 10,500
Income taxes payable 24,000
Payroll tax liabilities 1,100
Total Current Liabilities 520,600
LONG-TERM DEBT, net of current portion 125,000
TOTAL LIABILITIES 645,600
EQUITY
Common stock—no par value, 450 shares authorized, issued
and outstanding 45,000
Retained earnings 646,500
TOTAL EQUITY 691,500
TOTAL LIABILITIES AND EQUITY $.1,337,100
See Independent Accountant’s Review Report and Notes to Financial Statements.
ALWAYS BEST CORPORATION
STATEMENT OF REVENUES AND EXPENSES
(FRF for SMEs Basis)
Year Ended December 31, 2014
NET SALES $ 4,185,000
COST OF SALES 3,700,000
GROSS PROFIT 485,000
OPERATING EXPENSES
Selling, general and administrative 543,900
Interest expense 17,000
Total operating expenses 560,900
OPERATING INCOME (LOSS) ( 75,900)
OTHER INCOME
Vending machine franchise income 121,000
Interest and dividends on investments 24,000
Gain on sale of fully-depreciated assts 8,900
Cell towers rent 24,000
Miscellaneous income 14,100
Total Other Income 192,000
PROVISION FOR INCOME TAXES 21,000
NET INCOME 95,100
RETAINED EARNINGS, January 1, 2014 551,400
RETAINED EARNINGS, December 31, 2014 $ 646,500
See Independent Accountant’s Review Report and Notes to Financial Statements.
ALWAYS BEST CORPORATION.
STATEMENT OF CASH FLOWS
(FRF for SMEs Basis)
Year Ended December 31, 2014
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 95,100
Adjustments to reconcile net income to net cash
provided by operating activities
Depreciation 32,000
Increase in accounts receivable (137,000)
Decrease in inventories 100,000 Decrease in prepaid expenses 900
Increase in accounts payable and accrued expenses 30,100
Decrease in income taxes payable (11,100)
Net Cash Provided by Operating Activities 110,000
CASH FLOWS USED BY INVESTING ACTIVITIES
Purchase of machinery and equipment (20,000)
Purchase of marketable securities (10,000)
Cash Used By Investing Activities (30,000)
CASH FLOWS USED BY FINANCING ACTIVITIES
Payments on debt obligations (100,000)
NET DECREASE IN CASH (20,000)
CASH AT BEGINNING OF YEAR 33,000
CASH AT END OF YEAR $ 13,000
See Independent Accountant’s Review Report and Notes to Financial Statements.
ALWAYS BEST CORPORATION
NOTES TO FINANCIAL STATEMENTS
(FRF for SMEs Basis)
Year Ended December 31, 2014
NOTE A—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of the Organization
The Corporation manufactures precast concrete products, including various types of blocks and patio and yard decorations. Its business is located in Anywhere, USA.
The Corporation is wholly-owned and is classified as a “C” corporation for income tax purposes. The sole shareholder of the Corporation has controlling investments in several other corporations that purchase its products. All transactions with affiliates are at fair market values and the Corporation has no monetary investment in, or significant influence over, the affiliated corporations.
Basis of Accounting and Financial Statement Presentation
Financial statement presentation is based on the American Institute of Certified Public Accountants’ Financial Reporting Framework for Small- and Medium-Size Entities (FRF), which is a special purpose framework. This FRF differs from U.S. generally accepted accounting principles. For example, this FRF does not require the consolidation of variable interest entities and, instead of tests of impairment of goodwill, permits its amortization.
Accounts Receivable and Revenue Recognition
Revenues consist primarily of sales of concrete constructions blocks, patio blocks and various landscaping precast products. Sales are made to construction contractors, governmental organizations and private parties. There is no economic dependency on any one, or a group, of customers.
The Corporation records all trade receivables at gross amounts billed to customers. A direct-write-off method is used for bad debts due to insignificant uncollectible accounts in the past. Management continually analyzes accounts with slow-paying customers and they are written off as bad debts if they are deemed uncollectible.
Inventories of Raw Materials and Finished Goods
The inventory consists of raw materials (sand, gravel and cement), concrete construction blocks, patio blocks and various landscaping precast products. The inventory is stated at the lower of cost or net realizable value and accounted for on an average cost basis.
Property and Equipment
Property and equipment expenditures of $1,000 or more are capitalized at cost and depreciated over the estimated useful lives of the respective assets on a straight-line basis. Buildings are depreciated over 30 years, 7 years for machinery and equipment and 5 years for office furniture and equipment. Routine repairs and maintenance are expensed as incurred.
Income Taxes
The Corporation has elected the taxes payable method for recording income taxes. Current income taxes payable or refundable are recorded as a liability or asset and are based on income tax rates and laws enacted and effective at the reporting date. Statutory rates do not differ significantly from the effective tax rates used to calculate the provision for income taxes. There are no unused tax loss or tax credit carryforwards.
Use of Estimates
The preparation of financial statements in conformity with the Financial Reporting Framework for Small- and Medium-Sized Entities requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Concentrations Risk
Concentrations risk consists of cash deposits. The Corporation maintains its cash in various bank deposit accounts that, at times, may exceed federally insured and other insured limits. The Corporation currently has no deposits in excess of insured limits, has not experienced any losses in such accounts and does it expect to incur any such losses in the future.
Cash
Cash consists of funds on deposit at financial institutions. The Corporation has no cash equivalents.
Subsequent Events
Management of the Corporation has evaluated subsequent events through April 30, 2015, the date financial statements are available to be issued.
NOTE B—INVESTMENTS
The Corporation has invested in various marketable equity securities. All of the investments are accounted for at cost since the Corporation does not have significant influence over the iinvestee companies.
Description Shares Ownership % Carrying Amount
Dorcus, Intl. 100 .00001 $ 25,000
Pork Belly Feeds 390 .00005 40,000
Shovels, Inc. 510 .0001 80,000
Bean Bagger Co. 10,105 .0007 75,000
U.S. Motors 215 .00001 40,000
$ 260,000
NOTE C—RELATED PARTY TRANSACTIONS
The Corporation sells products to companies that are wholly or partially owned by its President and sole shareholder. Transactions with these companies are at sales prices charged other customers.
Sales Volume Accounts Receivable at December 31, 2014
Pine Tree Lumber Co. $ 275,000 $ 22,000
Open Space Development Co. $ 430,000 33,000
$ 55,000
A note balance of $36,000 is receivable from the Corporation’s President and sole shareholder. The note bears interest at 7% compounded annually and payments are due on demand.
NOTE D—DEBT OBLIGATIONS
Debt obligations as of December 31, 2014 consist of:
Note payable to bank, payable in monthly installments of
$ 8,000 including interest at 5.0%, collateralized
by inventories $ 200,000
Less current portion (75,000)
Long-term debt $ 125,000
Principal maturities on these obligations are:
Year Ending December 31,
2015 $ 75,000
2016 85,000
2017 40,000
$146,098
Interest paid during the year ended December 31, 2014 amounted to $ 17,000.
NOTE E—CHANGES IN EQUITY
Common Retained
Stock Earnings
Balance at January 1, 2014 $ 45,000 $ 551,400
Net income 95,100
Balance at December 31, 2014 $ 45,000 $ 646,500
NOTE F—OPERATING LEASE
The Corporation leases three GMC delivery trucks under an operating lease for a 36 month period which provides for all vehicle maintenance and repairs. The residual value at the end of the lease term is the fair market value of the vans; there is no bargain purchase option. This lease is classified as an operating lease because the risks and rewards of ownership are retained by the lessor. Rent expense classified in costs of goods for the period ended December 31, 2014 was $72,000. Future lease payments are as follows:
Years Ending December 31,
2015 $ 72,000
2016 72,000
Discussion Exercise:
While discussing the FRF for SMEs with the user of your financial statements, you were asked to point out the policy differences on the illustrative statement of revenues and expenses above from U.S. GAAP. Write your answers below.
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