FAR 1

Sources of GAAP & Basic Framework and Concepts

The power to establish GAAP rests with the SEC, but they have allowed the accounting
profession to mostly self-regulate.
1. Committee on Accounting Procedure (CAP) [1939-1959]: Accounting
Research Bulletins
2. Accounting Principles Board (APB) [1959-1973]: APB Opinions and APB
Interpretations
3. Financial Accounting Standards Board (FASB) [1973-today]:
a. Statements on Financial Accounting Standards (SFAS)
b. FASB Interpretations (clarify GAAP)
c. Technical Bulletins (expand, further clarify GAAP)
d. Statements on Financial Accounting Concepts (SFAC, establish
concepts but does NOT establish GAAP!)
e. Emerging Issues Task Force (EITF): addresses emerging issues
f. FASB Implementation Guides (Q&A Format)

Hierarchy = BOSSII (Bulletins, Opinions, SFAS, Staff Positions, Interpretations,

Implementation Issues)

Objectives of Financial Reporting (SFAC 1): provide info useful in investment & credit
decisions, assessing future cash flow prospects, assessing an enterprise’s resources, &
debt/equity claims to those resources
Qualitative Characteristics of Accounting Information (SFAC 2):
1. Understandable – U – to a wide variety of users with reasonable
knowledge about economy
2. Relevant –Primary – PFT
a. Predictive Value – assist in evaluating past/present/future
b. Feedback Value – enables to confirm prior expectations or
adjust/correct the assessment made
c. Timeliness - available while it still has an effect on decision-
making
3. Reliable – Primary – Nobody Relies on Financials unless Verified
a. Neutrality – free from bias
b. Representational Faithfulness – information is valid
c. Verifiability – same results could be duplicated with same
techniques
4. Comparable – Secondary – should be able to compare similar
information amongst various business enterprises
5. Consistent – Secondary – consistent accounting policies should be
used (unless a new method would more fairly present the info)
6. Material – Threshold for recognition (constraint)
7. Benefits > Cost – B (constraint)

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SFAC 3: Full sets of financials include 5 statements: Financial Position (Balance Sheet),
Earnings (Income Statement), Comprehensive Income, Cash Flows, and Changes in
Owner’s Equity

Assumptions:
1. Entity – economic activity can be accounted for an identifiable set of activities
2. Going Concern – entity will continue into the foreseeable future
3. Monetary Unit – money can measure economic activity (do NOT account for
inflation in financial statements)
4. Periodicity – activity can be divided into meaningful time periods
5. Historical Cost – information is accounted for based on cost, not market value
6. Revenue Recognition – revenue is recognized when earned and realized or
realizable
7. Matching – expenses are accounted for in the period in which they generated
revenue
8. Accrual Accounting – revenues/expenses are recorded without the exchange
of cash
9. Full Disclosure – user should have enough information to make decisions
(notes)
10. Conservatism – GAAP methods that don’t understate liabilities or overstate
assets should be used
Elements of Financial Statements (SFAC 6):
1. Comprehensive Income = Net Income + PUFE (NON-owner transactions)
2. Revenues – recurring operations
3. Expenses – recurring operations
4. Gains – where Selling Price (net realizable value) > BV, generally non-
operating, “peripheral” transactions
5. Losses – SP/NRV < BV, non-operating (unusual or infrequent), “peripheral”
6. Assets – probable future economic benefits
7. Liabilities – probable future sacrifices
8. Net Assets/Equity
9. Investments by Owners – excluded from comprehensive income, NOT a
revenue/gain
10. Distributions to Owners – excluded from comprehensive income, NOT an
expense/loss

Cash Flow Information (SFAC 7): provides a framework for accountants to employ when
using future cash flows as a measurement basis for assets and liabilities
Elements: Estimated future cash flows, expectations about timing variances of
future cash flows, time value of money (risk-free rate), price of risk, other (liquidity
issues, market imperfections)
- Traditional approach is used when there are scheduled known cash
payments, the Expected Cash Flow Approach is used for uncertain
future payments (i.e. warranties)

Reporting Net Income

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The income statement is useful in determining profitability, value for investment
purposes, and credit worthiness
- “Costs” can be expenses immediately or capitalized. If it is capitalized,
it is considered “unexpired”. All expensed costs are “expired”.
i. Revenues & Expenses are reported separately and at GROSS
amounts, and Gains & Losses are reported at their NET
amounts (R&E are typically operating, G&L are non-
operating).
- Presentation of Income Stmt/Retained Earnings Statement: IDEA
(Income from continuing operatings [both operating AND non-
operating activities], Discontinued operations, Extraordinary items
[unusual AND infrequent], and Accounting Principle changes)
i. The I is shown gross of tax, and the DEA are shown net of tax
ii. The A is shown on the statement of retained earnings, and is
only relevant for changes from one GAAP method to another
GAAP method

Single-Step statements: show all revenues and all expenses (with operating and non-
operating amounts together) to get to net income
- Cost of Goods Sold includes freight-in, selling expenses include freight-out, and
interest expense and depreciation expense are shown on separate line-items (not
included with SG&A)

Multiple-Step Income Statement: reports operating revenues and expenses separately

from non-operating revenues and expenses.
- “Net Sales” is gross sales less returns and discounts, depreciation and interest
expenses are still separately disclosed (however, depreciation expense is
operating, while interest expense is non-operating), and income/loss from
operations is separately disclosed also

Discontinued Operations – reported separately from continuing operations in the

income statement (the D in the IDEA mnemonic), and reported net of tax. Loss on
discontinued operations can consist of: impairment loss, gain/loss from actual operations
until the date of sale, and gain/loss on disposal on the date of sale. They are to be
included in the income statement as discontinued operations ONLY in the period which
they occur (not booked when anticipated, but when actually incurred).
- For an entity to be considered “held for sale”, the following conditions
have to be met:
i. Entity: operations/cash flows can be clearly distinguished
ii. The asset must really be prepared, committed to, and
attempting to be sold
- Operating expenses can be considered discontinued operations if the
asset has been disposed of or if it is “held for sale”. It must also being
eliminated from ongoing operations and the entity will have no
significant continuing involvement
i. Assets should no longer be depreciated or amortized!

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 ii. You can write down impairment losses if selling price is <
book value, reported in the period held for sale, but if fair value
subsequently increases, you can only write the asset back up to
its original book value

Extraordinary Items: defined as unusual AND infrequent, and must be material in

nature. They must be disclosed separately in the income statement, net of tax.
- Early retirement of LT debt is NOT extraordinary, unless the facts specifically
say that doing so is unusual and infrequent
- If unusual OR infrequent (not both), the item is presented in the non-
operating section of the income statement and reported GROSS of tax
(i.e. large writedowns/write-offs of receivables, intangibles, inventory,
securities, gain/loss on sale of PP&E, gain/loss on foreign currency
transactions, losses from employee strikes, etc).

Accounting Changes and Prior Period Adjustments: there are 3 main accounting
changes:
1. Changes in Estimate  prospective
2. Changes in Principle  retrospective
3. Changes in Entity  restate

1. Changes in Accounting Estimate: this is NOT an error, and estimates are made
using the best available information at the time so you would NOT restate, you
would only use the changes going forward (prospective).
a. Examples include: change in fixed asset life, adjustment of accruals for
bonuses at year-end, write-downs of obsolete inventory, non-recurring IRS
adjustments, settlement of litigation, etc.
i. Material, infrequent changes in estimate should be disclosed
further in the notes to the financials

2. Changes in Accounting Principle: this only for changes from GAAP to GAAP,
and the change is only permitted if the new principle more fairly presents the
information in the financial statements
a. If non-comparative financials: cumulative effect of change = beg. R/E in
period of change – what beg. R/E would have been if the change had been
retroactively applied to all periods
b. If comparative financials: cumulative effect of change = beg R/E in the
first period presented – what R/E would have been if the new principle had
been applied to all prior periods
i. Application is retrospective UNLESS you’re changing TO LIFO or
changing depreciation methods  then propespective

3. Changes in Accounting Entity: occurs when the entity being reported has changed
composition (i.e. consolidated or combined financials). If comparative financial
statements are presented, they must be restated. Also, full disclosure must be
made regarding the change.

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 4. Prior Period Adjustments (ERRORS): changes from Non-GAAP to a GAAP
method. All years presented must be restated, and adjust the beginning retained
earnings of the earliest year presented if the error occurred further back than the
earliest period presented

Comprehensive Income: the change in equity of a business from non-owner sources.

They are considered “direct to equity” adjustments because they are not reported on the
income statement, only on the B/S.
“PUFE”:
P – Pension changes in Funded Status
U – Unrealized gains/losses (changes in value of AFS securities)
F – Foreign Currency Items (gains/losses on foreign currency transactions
that are designated and effective as economic hedges
E – Effective portions of cash flow hedges

Accumulated OCI is a component of equity that includes the TOTAL of OCI for the
current and previous periods, which is shown in Stockholder’s Equity. OCI is not
reported on a per-share basis.
- Single Statement approach: display OCI below the income statement,
and total NI and PUFE to get comprehensive income
- Two-Statement approach: Statement of Comprehensive Income is a
separate statement starting w/ NI.
- Accumulated OCI, showing the in the Statement of Changes in
Stockholder’s Equity, shows only PUFE from prior years, PUFE in the
current year, and total

Required Disclosures: tax effect of each component of OCI, accumulated balances of

each component of OCI, total accumulated OCI has an item of equity, and an
reclassification adjustments (where prior period PUFE is now included in current year net
income)

Interim Financial Reporting: public companies must report quarterly. GAAP used in
most recent annual report should be used for the quarterly report. Revenues/expenses
should be matched by quarter. Timeliness is prioritized over reliability, so the statements
are NOT audited (only reviewed).
- Income tax expense should be estimated each quarter, using the
estimated average effective tax rate that will apply for the ENTIRE
year (using best available information)

Segment Reporting: segments must be disclosed along with segment profit/loss, assets,
and certain other related items. The same accounting principles used in the main
financial statements should be used in entity financial statements. Intercompany
transactions are NOT eliminated. Segment reporting applies to public companies only.

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 - Considered a segment if: the component earns revenues/incurs expenses,
operating results are regularly reviewed by management, and they have traceable
cash flows/revenues/expenses.
- Pension plans/corporate headquarters are NOT operating segments
- Thresholds for Segment Reporting:
1. 10% Size Test: must meet one of the following:
a. Reported revenue (including intercompany) is > 10% of
combined revenue of all operating segments
b. Reported profit/loss is > 10% of the GREATER of combined
reported profit of all segments that did not report a loss, or the
combined reported loss of all segments that did report a loss
c. Assets are > 10% of the combined assets of all segments

2. 75% Reporting Sufficiency Test: if total external (consolidated

revenue) reported by operating segments is < 75% of all external revenue,
more segments must be identified and reported until the 75% threshold is
met

3. 90% Single Industry Dominance Test: No segment reporting is

required if 1 segment accounts for > 90% of all revenue, profit/loss, or
assets

Formula for segment reporting; Segment Revenues – Directly Traceable Costs –

Reasonably Allocated Costs = Operating Profit (Loss)

Development-Stage Enterprises: start-ups and pioneering development, where expenses

are high and revenues are low. Start up/organizational costs are expensed immediately
under GAAP. The financial statements are the same, but they require additional
disclosures while in the developmental stage. (They must be identified, net losses are
described as “deficit accumulated during the developmental stage”, revenues/expenses
must be shown for current period AND cumulative amount since inception, cumulative
amount of cash inflows/outflows, equity disclosures, etc.)

Fair Value Measurements: the fair value is the price to sell an asset/transfer a liability
in an orderly transaction (planned, not a “fire sale”) between market participants on a
certain date. Fair value is measured in the most principle, or most advantageous market.
The fair value does not include transaction costs (but may include transportation costs),
and assumes the highest and best use of the asset.
1. Principal Market: the market with the greatest volume or level of activity
2. Advantageous Market: used only if there is no principal market. The most
advantageous market is the market with the best price for the asset/liability,
AFTER considering transaction costs! Transaction costs are used to determine
the most advantageous market, but are then disregarded when determining
final fair value

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Valuation Techniques: Market Approach [uses prices from market transactions
involving identical/comparable assets], Income Approach [converts future cash flows to
a single discounted current value], Cost Approach [uses current replacement cost]

Hierarchy of Inputs: Level 1 [quoted prices in active markets for identical

assets/liabilities], Level 2 [inputs other than quoted prices that are observable, i.e. quoted
prices for similar assets/liabilities, inputs derived from observable market data, etc.],
Level 3 [unobservable inputs, reflect reporting entity assumptions].

Fair Value disclosures vary depending on if the asset measures fair value on a recurring
or non-recurring basis. Recurring disclosures must include level in fair value hierarchy
used, reconciliation of beg/end balance if Level 3 is used, gains/losses, and valuation
techniques. Non-recurring disclosures should show level of hierarchy, description of
inputs if Level 3 is used, valuation techniques, and reasons for fair value measurements.

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