UPDATE MATERIALS INTERMEDIATE ACCOUNTING, 10 TH EDITION

UPDATE MATERIALS INTERMEDIATE ACCOUNTING, 10 TH EDITION This document contains several discussions of the effects of new accounting standards as they relate to the materials in Intermediate Accounting, 10th Edition by Kieso, Weygandt, and Warfield. Topics addressed are: SECTION 1: Business Combinations (SFAS No. 141) SECTION 2: Intangible Assets (SFAS No. 142) SECTION 3: Asset Retirement Obligations (SFAS No. 143) SECTION 4: Cash Flows and Present Value in Accounting Measurements (Concepts Statement No. 7) SECTION 5: Goodwill Associated with Investments Accounted for Under the Equity Method (application of SFAS No. 142) SECTION 6: Impairments of Long-Lived Assets (SFAS No. 144) SECTION 1: BUSINESS COMBINATIONS Statement of Financial Accounting Standard No. 141, Business Combinations (Business combinations are not covered in Intermediate Accounting. However, under this new standard, many more intangible assets will be recognized on companies balance sheets. Intangible assets are covered in Chapter 12, pages 599-621 with Update material presented in Section 2 below.) Overview Prior to this standard, business combinations were accounted for under one of two approaches, the pooling of interests method (often referred to as the pooling method) or the purchase method. The pooling method was required if a complex set of criteria were met. If one of these criteria was not met, the purchase method was to be used. The user community found the use of two different approaches to account for business combinations confusing. It was very difficult, for example, to compare the financial results of companies that used different methods to account for business combinations. In addition, users wanted more information related to the intangibles purchased in a business combination. Unfortunately, the pooling of interests method recorded only intangible assets that the company presently reported. In other words, under poolings, only the book value of the existing net assets of the acquired company was recorded in the merger. Under purchase accounting, all net assets of the acquired company (including intangibles) were recognized and recorded at fair value. Finally, many users indicated that the diversity in practice for mergers often left companies at a competitive disadvantage. For example, companies that used poolings often were able to report higher 1

earnings numbers because the assets acquired were recorded at book value, not fair value. As a result, companies that used poolings did not have to depreciate or amortize the higher fair value amounts against revenues. Because of these user concerns, the FASB issued Statement of Financial Accounting Standard No. 141, Business Combinations, which requires that all business combinations be accounted for using the purchase method. In other words, pooling of interests accounting is now prohibited. Recognition of Intangible Assets Standard No. 141 also provides guidelines for how to recognize intangible assets in a business combination. Prior to SFAS No. 141, the criterion to recognize intangible assets other than goodwill was whether they could be identified and named. As a result, many intangible assets were simply recorded as part of goodwill and not reported separately. Many users were not concerned with this approach because all intangible assets (goodwill or otherwise) were amortized in a similar fashion (over a period not to exceed their useful life or 40 years, whichever was shorter.) The new rules will result in more intangible assets being separated from goodwill than presently occurs in practice today. To help identify these intangible assets, the statement provides a list of 29 different types of intangibles that might be recognized separately from goodwill in a business combination. Some of the intangible assets that must be separately recognized under the new rules are: Trademarks and trade names Non-compete agreements Customer lists Order or production backlogs Copyrights and patents Secret formulas and processes Licensing agreements Supply contracts It should be noted that amortization rules for intangible assets have also changed (see Section 2 in this update document). As a result, certain types of intangibles have indefinite lives and are no longer amortized. It therefore has become more important to make sure that all intangibles acquired in a business combination are separately identified. Under the new standard, an acquired intangible asset should be separately recognized if the benefit of the intangible asset is obtained through contractual or 2

other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer s intent to do so. Recognition of Negative Goodwill In rare cases, negative goodwill may result. Negative goodwill arises when the fair value of the assets acquired is higher than the purchase price of the assets. In the past, if negative goodwill arose, it was classified as a deferred credit and was amortized systematically to revenue over the periods estimated to be benefited, but not in excess of 40 years. Under the new rules, if negative goodwill arises, it should be recognized immediately as an extraordinary gain. Initial Measurement It should be noted that SFAS No. 141 carries forward the provisions in the previous accounting standards for applying the purchase method of accounting. Specifically, the new statement does not change in any fundamental way the guidance for determining the cost of the acquired entity and allocating that cost to assets acquired and liabilities incurred. Finally, SFAS No. 141 does not change the requirement to write off certain research and development assets in a business combination--also known as in-process research and development (IPR&D). Financial Statement Disclosures under SFAS No. 141 SFAS No. 141 carries forward and expands on the financial statement disclosure requirements for business combinations. Some of the more significant new disclosures related to material business combinations are summarized below. The primary reasons for the acquisition, including a description of the factors that contributed to a purchase price that results in recognition of goodwill A condensed balance sheet disclosing the amounts assigned to each major asset and liability caption at the acquisition date. The amount of IPR&D assets acquired and written off and the line item in the income statement in which that amount is included. If the purchase price allocation has not been finalized, that fact and the reasons for it should be explained. In subsequent periods, the nature and amount of any material adjustments that were made to the purchase price allocation must be disclosed. If the amounts assigned to goodwill or other intangible assets acquired are significant in relation to the total cost of the acquired entity: (1) disclosures, in total and by major intangible 3

asset class, of (a) the amounts assigned to amortizable and indefinite-lived intangibles and (b) the estimated residual value and weighted-average amortization period for limited-life intangibles; and (2) the total amount of goodwill and the amount expected to be deductible for tax purposes (these disclosures are also applicable to aggregated disclosures of individually immaterial business combinations). Detailed disclosures about material business combinations completed after the balance sheet date, but before the financial statements are issued (unless not practicable). Concluding Remarks SFAS No. 141 significantly affects the accounting for business combinations. By requiring all companies to follow purchase accounting, comparability among companies will be significantly enhanced. In addition, more realistic balance sheet amounts, reflecting the acquisition cost of the net assets acquired in a business combination, will be reported. 4

SECTION 2: INTANGIBLE ASSETS Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangibles (Updates material in Chapter12, pages 599-621) Overview Recently the FASB issued Statement of Financial Accounting Standards No. 142. This standard changes the accounting for intangibles in a number of areas. The key provisions of this standard are discussed below. Definition of Intangible Assets According to the FASB, intangibles have two main characteristics. 1. They lack physical existence Unlike tangible assets such as property, plant, and equipment, intangible assets derive their value from the rights and privileges granted to the company using them. 2. They are not financial instruments Assets such as bank deposits, accounts receivable, and longterm investments in bonds and stocks lack physical substance but are not classified as intangible assets. These assets are financial instruments and derive their value from the right (claim) to receive cash or cash equivalents in the future. Amortization of Intangibles Intangibles have either a limited (finite) useful life or an indefinite useful life. An intangible asset with a limited life is amortized; an intangible asset with an indefinite life is not amortized. Limited-Life Intangibles Limited-life intangibles should be amortized by systematic charges to expense over their useful lives. The useful life should reflect the periods over which these assets will contribute to cash flows. The amount of amortization expense for a limited-life intangible asset should reflect the pattern in which the asset is consumed or used up if that pattern can be reliably determined. Indefinite-Life Intangibles If no legal, regulatory, contractual, competitive, or other factors limit the useful life of an intangible asset, the useful life is considered indefinite. Indefinite means that there is no foreseeable limit on the period of time over which the intangible asset is expected to provide cash flows. 5

Indefinite-life intangibles should be tested for impairment at least annually. The impairment test compares the fair value of an intangible asset with its carrying amount. This impairment test is different from the one used for a limited-life intangible. That is, there is no recoverability test related to indefinite-life intangibles. Only a fair value test is used to test for impairment. The reason: Indefinite-life intangible assets might never fail the undiscounted cash flows recoverability test because cash flows could extend indefinitely into the future. In summary, the accounting treatment for intangible assets is shown below. Illustration 12-1 Accounting Treatment for Intangibles Type of Intangible Purchased Internally Created Amortization Impairment Test Limited-life intangibles Capitalize Expense* Amortize over useful life Recoverability test and then fair value test Indefinite-life intangibles Capitalize Expense* Do not amortize Fair value test *Except for direct costs, such as legal costs. Goodwill Amortization Goodwill acquired in a business combination is considered to have an indefinite life and therefore should not be amortized. The Board s position is that investors find the amortization charge of limited usefulness in evaluating financial performance. In addition, although goodwill may decrease over time, predicting the actual life of goodwill and an appropriate pattern of amortization is extremely difficult. Negative Goodwill Negative goodwill arises when the fair value of the assets acquired is higher than the purchase price. This situation is extremely rare. The FASB requires that this remaining excess be recognized as an extraordinary gain. The Board noted that extraordinary treatment is appropriate to highlight the fact that the excess exists and to reflect the unusual nature and infrequent occurrence of the item. Impairment of Intangible Assets The rules that apply to impairments of long-lived assets also apply to limited-life intangibles. Indefinite-life intangibles other than goodwill should be tested for impairment at least annually. The impairment test for an indefinite life asset other than goodwill is a fair value test. The test compares the fair value of the intangible asset with the asset s carrying amount. If the fair value of the intangible 6

asset is less than the carrying amount, impairment is recognized. This one-step test is used because it would be relatively easy for many indefinite-life assets to meet the recoverability test because cash flows may extend many years into the future. As a result, the recoverability test is not used. Goodwill The impairment test for goodwill is a two-step process. First, the fair value of the reporting unit should be compared to its carrying amount including goodwill. If the fair value of the reporting unit is greater than the carrying amount, goodwill is considered not to be impaired and the company does not have to do anything else. To illustrate, assume that Kohlbuy Corporation has three divisions in its company. One division, Pritt Products, was purchased four years ago for $2 million. Unfortunately it has experienced operating losses over the last three quarters, and management is reviewing the division for purposes of recognizing impairment. The Pritt Division s net assets including the associated goodwill of $900,000 from the purchase are listed below. Cash $ 200,000 Receivables 300,000 Inventory 700,000 Property, plant, and equipment (net) 800,000 Goodwill 900,000 Less: Accounts and notes payable (500,000) Net assets $2,400,000 ======== It is determined that the fair value of Pritt Division is $2,800,000. As a result, no impairment is recognized because the fair value of the division is greater than the carrying amount of the net assets. However, if the fair value of the Pritt Division is less than the carrying amount of the net assets, then a second step must be performed. In the second step, the fair value of the goodwill (often called the implied value of goodwill) must be determined and compared to its carrying amount. To illustrate, assume that the fair value of the Pritt Division was $1,900,000 instead of $2,800,000. In this case the implied fair value of the goodwill is computed as follows. 7

Fair value of Pritt Division $1,900,000 Net identifiable assets (excluding goodwill) ($2,400,000 $900,000) (1,500,000) Implied value of goodwill $ 400,000 ======== The implied value of the goodwill is then compared to the recorded goodwill to determine whether impairment has occurred, as shown below. Carrying amount of goodwill $900,000 Implied value of goodwill (400,000) Loss on impairment $500,000 ======== The following table summarizes the impairment tests for various intangible assets. Type of Intangible Asset Limited life Indefinite life Goodwill Impairment Test Recoverability test, then fair value test Fair value Fair value test on reporting unit, then fair value test on implied goodwill. Concluding Remarks These new guidelines have important implications for financial reporting. No longer will all intangible assets be amortized against income. Impairment tests to determine the appropriate decline in value will become more pervasive. As a result, there may be more volatility in reported income numbers than under previous standards. It is likely under the new guidelines that more intangible assets other than goodwill will be recognized in the financial statements. Finally, this new standard requires much more extensive disclosures related to both goodwill and other intangible assets. 8

SECTION 3: ASSET RETIREMENT OBLIGATIONS Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (Add this material as a separate section under Dispositions of Plant Assets, Chapter 10, pages 522-523) Overview In many industries, the construction and operation of long-lived assets involve obligations associated with the retirement of those assets. For example, when a mining company opens up a strip mine, it may also make a commitment to restore the land on which the mine is located once the mining activity is completed. Similarly, when an oil company erects an offshore drilling platform, it may be legally obligated to dismantle and remove the platform at the end of its useful life. There has been diversity in practice in the accounting for such asset retirement obligations. For example, some companies created contra-asset accounts for their obligations; others, relying on the accounting guidance for contingencies, recorded no obligation. The FASB was concerned that it was difficult for users of financial statements to compare the financial positions and results of operations of companies that have asset retirement obligations but account for them differently. To address this diversity in practice, the FASB recently issued Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations. Accounting Recognition of Asset Retirement Obligations Under SFAS No. 143, a company must recognize an asset retirement obligation (ARO) when the company has an existing legal obligation associated with the retirement of a long-lived asset and when the amount of the liability can be reasonably estimated. The ARO should be recorded at fair value. Obligating Events Examples of existing legal obligations, which would require recognition of a liability include, but are not limited to, the following. Decommissioning nuclear facilities. Dismantling, restoring, and reclamation of oil and gas properties. Certain closure, reclamation, and removal costs of mining facilities. Closure and post-closure costs of landfills. 9

In order to capture the benefits of these long-lived assets, the company is generally legally obligated for the costs associated with retirement of the asset, whether the company hires another party to perform the retirement activities or whether the company performs the activities with its own workforce and equipment. AROs give rise to various recognition patterns, in which the obligation may arise at the outset of the assets use (e.g., erection of an oil-rig) or may build over time (e.g., a landfill that expands over time). Measurement of AROs An ARO is initially measured at fair value, which is defined as the amount that the company would be required to pay in an active market to settle the ARO. Although active markets do not exist for many AROs, an estimate of fair value should be based on the best information available. Such information could include market prices of similar liabilities, if available. Alternatively, fair value can be estimated based on present value techniques, using expected cash flows. This represents an example of applying the concepts discussed in FASB Concepts Statement 7, Using Cash Flow Information and Present Value in Accounting Measurements, (see Section 4 of this Update). Recognition and Allocation To record an ARO in the financial statements, the ARO s cost is included in the carrying amount of the related long-lived asset, and a liability is recorded for the same amount. An asset retirement cost is recorded as part of the related asset because these costs are considered a cost of operating the asset and are necessary to prepare the asset for its intended use. Therefore, the carrying value of the specific asset (e.g., mine, drilling platform, nuclear power plant) should be increased because the future economic benefit comes from the use of this productive asset. The capitalized asset retirement costs should not be recorded in a separate account because there is no future economic benefit that can be associated with these costs alone. In subsequent periods, the cost of the ARO is allocated to expense over the period of the related asset s useful life. The straight-line method is acceptable for this allocation, and other systematic and rational allocations also are permitted. Illustration of ARO Accounting Provisions To illustrate the accounting for AROs, assume that on January 1, 2003, Wildcat Oil Company erected an oil platform in the Gulf of Mexico. Wildcat is legally required to dismantle and remove the platform at the end of its useful life, which is estimated to be 5 years. Because there is significant drilling activity in this area, there is an active market for dismantling and removal services. Based on 10

data from this market, Wildcat has determined that the initial fair value of the liability is $195,000. Wildcat would make the following journal entry to record this ARO. January 1, 2003 Drilling Platform (asset retirement cost) 195,000 Asset Retirement Obligation 195,000 During the life of the asset, the asset retirement cost would be allocated to expense. Using the straight-line method, Wildcat would make the following entry to record this expense. December 31, 2003, 2004, 2005, 2006, 2007 Depreciation Expense (asset retirement cost) 39,000 Accumulated Depreciation 39,000 On January 10, 2008, Wildcat contracts with Rig Reclaimers, Inc. to dismantle the platform at a contract price of $193,000. Wildcat would make the following journal entry to record settlement of the ARO. January 10, 2008 Asset Retirement Obligation 195,000 Gain on Settlement of ARO 2,000 Cash 193,000 Change in Estimates Following initial recognition, there can be changes in estimates of the fair value of the ARO. These changes may arise from changing market conditions or from changes in assumptions used to estimate cash flows required to settle the ARO. Increases (decreases) in the ARO should be recorded as an adjustment to the liability with an offsetting entry to the asset retirement costs. Depreciation on the new asset cost will be adjusted on a prospective basis. For example, assume that on January 1, 2005, Wildcat receives new market information indicating that the fair value of the dismantling contract for its platform has increased $15,000, to $210,000. In this case, Wildcat makes the following entry. 11

January 1, 2005 Drilling Platform (asset retirement cost) 15,000 Asset Retirement Obligation 15,000 The new basis of the drilling platform is now $132,000, computed as follows. ($195,000 $39,000 $39,000 + $15,000) = $132,000 Assuming no other changes in the fair value of the ARO over the following three years, the following table shows the amounts recorded for the ARO liability and the related asset retirement cost at 2005, 2006, 2007. Year Expense Carrying value of ARO drilling platform (asset retirement cost) Balance 12/31/04 $ 39,000 $ 117,000 $ 195,000 Increase in ARO -- 15,000 15,000 Balance 1/1/2005 -- 132,000 210,000 12/31/05 44,000 88,000 210,000 12/31/06 44,000 44,000 210,000 12/31/07 44,000 0 210,000 The entry to record depreciation expense for the asset retirement cost in each of the final three years would be: December 31, 2005, 2006, 2007 Depreciation Expense (asset retirement cost) 44,000 Accumulated Depreciation 44,000 ($132,000 3) The entry to settle the ARO on January 10, 2008 would be as follows. January 10, 2008 Asset Retirement Obligation 210,000 Cash 210,000 12

In summary, recognition and measurement of the asset retirement obligation is based on the measurement of the liability at fair value. The amount of the obligation increases the capitalized cost of the related asset, which is allocated to expense over the related asset s useful life. Disclosures Required disclosures for AROs include: 1. Description of the ARO and the related long-lived asset. 2. The fair value of any assets dedicated to satisfy the liability. 3. A reconciliation of the beginning and ending aggregate amounts of the liability arising from liabilities incurred during the period, liabilities settled during the period, interest expense, and significant revisions in expected cash flows. Concluding Remarks The provisions of SFAS No. 143 take effect for financial statements issued for fiscal years beginning after June 15, 2002, although earlier application is encouraged. The initial application should be as of the beginning of a company s fiscal year, with any adjustments recorded as a cumulative-effect accounting change. The provisions of the new standard improve financial reporting by recognizing retirement obligations when incurred and by capitalizing the cost as part of the related asset s carrying amount, with expense allocated to periods of future use. This accounting combined with expanded disclosure requirements will provide enhanced information about long-lived assets. 13

SECTION 4: CASH FLOWS AND PRESENT VALUE IN ACCOUNTING MEASUREMENTS Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements (Updates material in Chapter 6, pages 270-273) Overview As indicated in Chapter 6, financial reporting uses different measurements in different situations. Present value is one of those measurements, and its usage has been increasing. Recognizing that fact, the FASB issued Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements to provide a framework for using expected future cash flows and present values as a basis for measurement. It should be noted that the FASB has already incorporated the concepts developed in this new statement into its latest pronouncements on business combinations, goodwill and other intangibles, asset retirement obligations, and impairments. Expected Cash Flows In the past, most accounting calculations of present value were based on the most likely cash flow amount. Concepts Statement No.7 introduces an expected cash flow approach that uses a range of cash flows and incorporates the probabilities of those cash flows to provide a more relevant measurement of present value. To illustrate the expected cash flow model, assume that there is a 30% probability that future cash flows will be $100, a 50% probability that they will be $200, and a 20% probability that they will be $300. In this case, the expected cash flow would be $190 [($100 X 0.3) + ($200 X 0.5) + ($300 X 0.2)]. Under traditional present value approaches, the most likely estimate ($200) would be used, but that estimate does not consider the different probabilities of the possible cash flows. After determining expected cash flows, the proper interest rate must then be used to discount the cash flows. The interest rate used for this purpose has three components. THREE COMPONENTS OF INTEREST 1. Pure Rate of Interest (2%-4%). This would be the amount a lender would charge if there were no possibilities of default and no expectation of inflation. 2. Expected Inflation Rate of Interest (0% -?). Lenders recognize that in an inflationary economy, they are being paid back with less valuable dollars. As a result, they increase their interest rate to compensate for this loss in purchasing power. When inflationary expectations are high, interest rates are high. 3. Credit Risk Rate of Interest (0% - 5%). The government has little or no credit risk (i.e. risk of nonpayment) when it issues bonds; a business enterprise, however, depending upon its financial stability, profitability, etc., can have a low or a high credit risk. 14

The FASB takes the position that after the expected cash flows are computed, they should be discounted by the risk-free rate of return, which is defined as the pure rate of return plus the expected inflation rate. The Board notes that the expected cash flow framework adjusts for credit risk because it incorporates the probability of receipt or payment into the computation of expected cash flows. Therefore the rate used to discount the expected cash flows should consider only the pure rate of interest and the inflation rate. Fair Value As part of the discussion in Concepts Statement No. 7, the Board explained the concept of fair value. Fair value is defined as the amount at which an asset (or liability) could be bought (or incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Put more simply, fair value is the price at which two parties would agree to in an exchange transaction. In determining fair value, a number of assumptions are made. 1 These are: The buyer of an asset (or the entity that is assuming a liability) has a use for the item in its current state and the ability to put it to use. If the item is a backhoe, for example, we assume that the buyer is in the construction trade or used-equipment business. Buyers who don t understand the item are not part of the market. The buyer of an asset will put the item to its highest and best use. This assumption is especially important for fixed assets like real estate. For example, an entity may own land now being used in agriculture. However, buyers of land in this area are interested in its potential for residential or commercial development and set prices accordingly. Fair value of this piece of land should incorporate assumptions about development, rather than continued operation in agriculture. The buyer of an asset can obtain reasonable information about the item s condition and uncertainties surrounding the potential cash flows. If the item is a backhoe, for example, we assume that the buyer can learn that it has an oil leak and several thousand hours of past use. The buyer of an asset is interested in the specific item in question. If the item is a backhoe, the buyer is interested in this particular make, model, age, and physical condition, rather than a market average asset. 1 Adapted from: Understanding the Issues, Measuring Fair Value, (FASB, 2001), p. 2. 15

The buyer and seller of an asset (or the entity seeking to extinguish or assume a liability) will transact in the market that is most advantageous, provided it has the ability to enter that market. This assumption is especially important when considering the fair value of groups of assets or liabilities. If the entity can obtain a better price (or incur lower costs) by transacting for the group of assets, and the entity has the ability to enter that market, we assume that the transaction will take place in that market. In the absence of a ready market, these are the assumptions that underlie the fair value computation. Fair Value of A Liability How should the fair value of a liability be determined? In its simplest terms, the fair value is the present value of the expected cash flows to be paid, discounted at the risk-free rate of interest. Some believe that the calculation of the fair value of a liability is complicated because it is not clear how to account for: 1. the profit element in a liability. 2. the credit standing of the borrower. Here we look at each of these issues. Profit Element To illustrate the profit element, assume that Carson Repair Inc. is in the repair business and sells service contracts to Niger Inc. The service contract stipulates that for $1,000,000, Carson will repair all of Niger s electrical appliances if they become defective any time within the next three years. In this case, Carson would make the following entry at the time the contract is sold: Cash 1,000,000 Warranty Liability 1,000,000 In this situation, the fair value of the liability is easily measurable because a transaction related to the service contract has just occurred. It follows that the profit that Carson will receive on the service contracts is incorporated into the liability measurement. This profit will be recognized when the services are performed or when Carson is released from its obligation. The profit element in this 16

case involves a future cash flow and should be reflected in the computation of the amount of the liability. Some disagree with this approach. They note that if Carson is going to settle a transaction using only its own internal resources, the liability is for the costs incurred (cost accumulation approach) to repair these appliances absent any profit. The problem, however, with the cost accumulation approach is that the fair value of the liability is then not reported. Concepts Statement No.7 notes that any third party that would settle the obligation would demand a profit and therefore the profit should be included in the fair value of the liability. Credit Standing Another contentious issue involving the valuation of a liability relates to the credit standing of the borrower. To understand this point, assume that Horton Corporation issues a zero-coupon, 5-year, $100,000 note to First City Bank. Horton has an AAA-rated credit standing and therefore the note s interest rate is 8%. The entry to record the note payable is as follows. Cash 68,058 Note Payable 68,058 ($100,000 X.68058) Assume that the same day, Cendar Corporation also issues a zero-coupon, 5-year, $1,000 note to First City Bank. Cendar has a double-b rated credit standing and the note interest rate is 11%. The entry to record the note payable is as follows. Cash 59,345 Note Payable 59,345 ($100,000 X.59345) The reason Horton receives more cash, given the same terms as Cendar, is that it has a better credit rating. In short, this example demonstrates that liability measurement on initial recognition must include the company s credit standing. Some have argued otherwise, but that argument does not appear to have economic merit. 17

Comprehensive Illustration To illustrate application of the concepts introduced in Concepts Statement No. 7, assume Al s Appliance Outlet offers a two-year warranty on all products sold. In 2001, Al sold $250,000 of a particular type of clothes dryer. Al s Appliance has entered into an agreement with Ralph s Repair to provide all warranty service on the dryers sold in 2001. Al s Appliance wishes to measure the fair value of the agreement to determine the warranty expense to record in 2001 and the amount of warranty liability to record on the 12/31/2001 balance sheet. Since there is not a ready market for these warranty contracts, Al s Appliance uses expected cash flow techniques to value the warranty obligation. Based on prior warranty experience, Al s Appliance estimates the following expected cash outflows associated with the dryers sold in 2001. Expected Cash Outflows Warranties Cash Flow Estimate X Probability Assessment = Expected Cash Flow 2002 $3,800 20% $ 760 6,300 50% 3,150 7,500 30% 2,250 Total $6,160 ===== 2003 $5,400 30% $1,620 7,200 50% 3,600 8,400 20% 1,680 Total $6,900 ===== Applying expected cash flow concepts to this data, Al s Appliance estimates warranty cash outflows of $6,160 in 2002 (the first year of the warranty) and $6,900 in 2003 (the second year of the warranty). The present value of these cash flows, assuming a risk-free rate of 5%, is shown in the following schedule. Year Present Value of Cash Flows (Risk-Free Rate = 5%) Expected Cash Flow X PV Factor, i = 5% = Present Value 2002 $6,160 0.95238 $ 5,870 2003 6,900 0.90703 6,260 Total $ 12,130 ======= Al s Appliance would make the following entry to record warranty expense and the related warranty liability in 2001. 18

December 31, 2001 Warranty Expense 12,130 Warranty Liability 12,130 By applying the expected cash flow concepts, Al s Appliance records a fair value estimate of the warranty expense and liability that incorporates probabilities of the future cash outflows, discounted at the appropriate risk-free rate. Concluding Remarks A present value measurement that fully captures all the relevant information should include the following items: 2 (a) To the extent possible, estimated cash flows and interest rates should reflect assumptions about future events and uncertainties that would be considered in deciding whether to acquire an asset or group of assets in an arm s length transaction for cash. (b) Interest rates used to discount cash flows should reflect assumptions that are consistent with those inherent in the estimated cash flows. Otherwise, the effect of some assumptions will be double counted or ignored. For example, an interest rate of 12 percent might be applied to contractual cash flows of a loan. That rate reflects expectations about future defaults from loans with particular characteristics. That same 12 percent rate should not be used to discount expected cash flows because those cash flows already reflect assumptions about future defaults. (c) Estimated cash flows and interest rates should be free from both bias and factors unrelated to the asset, liability, or group of assets or liabilities in question. For example, deliberately understating estimated net cash flows to enhance the apparent future profitability of an asset introduces a bias in the measurement. (d) Estimated cash flows or interest rates should reflect the range of possible outcomes rather that a single most likely, minimum, or maximum possible amount. 2 Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements (FASB 2001), para. 41. 19

losses. 3 SFAS No. 144 supersedes SFAS No. 121. The new standard carries forward the measurement SECTION 5: GOODWILL ASSOCIATED WITH INVESTMENTS ACCOUNTED FOR UNDER THE EQUITY METHOD Application of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangibles (Updates material in Chapter 18, pages 930-935) The new standard for goodwill and other intangibles (SFAS No. 142) also addresses the accounting for investments in common stock, which are accounted for using the equity method. As discussed in Chapter 18 (pp. 930-935) of Intermediate Accounting, the equity method is used for equity investments when the investor company has significant influence, but not control, over the investee company. Such a level of control is generally presumed when the investor holds between 20% and 50% of the investee s common shares. According to SFAS No. 142, goodwill arising from these investments should not be amortized. However, goodwill recorded on equity-method investments will continue to be tested for impairment in accordance with the provisions of APB Opinion No. 18, The Equity Method of Accounting for Investments of Common Stock. SECTION 6: IMPAIRMENTS OF LONG-LIVED ASSETS Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. (Updates material in Chapter 4, pages 154-160 and Chapter 11, pages 561-566) Prior standards addressing impairment of long-lived assets (SFAS No. 121) did not address the impairment and disposal of a segment of a business. As a result, two accounting models existed for the impairments of long-lived assets to be disposed of by sale. Under SFAS No. 121, impairments of assets held for sale were measured based on the lower of book value or the fair value less costs to sale. In contrast, impairments of assets in a discontinued operation (according to APB Opinion No. 30) were measured at the lower of book value or net realizable value, adjusted for expected future operating model in SFAS No 121, applying a single model to long-lived assets to be disposed of by sale, whether previously held and used, or newly acquired. Consequently, discontinued operations are no longer 3 APB Opinion No. 30, Reporting the Results of Operations Reporting the Effects of Disposal of a Segment of a Business, Extraordinary, Unusual, and Infrequently Occurring Events, (APB, 1973). 20

measured on a net realizable value basis, and future operating losses are no longer recognized before they occur. By using a single measurement model, the accounting for similar events and circumstances will be the same. The discussion in Chapter 11 of Intermediate Accounting (pp. 561-565) illustrates the application of the impairment measurement model introduced in SFAS No. 121 and continued in the new standard. In addition, SFAS No. 144 retains the reporting provisions of APB Opinion 30 and broadens the presentation of discontinued operations to include more disposal transactions. For example, disposal of groups of assets may now receive discontinued operations presentation in financial statements. Under prior standards, such special presentation was allowed only for disposal of a segment of the business. Again, the Board felt that reporting is improved when disposal transactions with similar characteristics are reported in a similar fashion. 21