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Table of Contents for

Financial Accounting Theory and Analysis:
Text and Cases, 11th Edition

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Prev Previous Chapter
CHAPTER 9: Long-Term Assets I: Property, Plant, and Equipment

Next Next Chapter
CHAPTER 11: Long-Term Liabilities
Companies invest in the securities of other business entities for a variety of reasons, such as obtaining
additional income, creating desirable relationships with suppliers, obtaining partial or full control over related
companies, or adding new products. The decision to classify these investments as long-term rather than as
current assets is based on the concept of managerial intent. When management intends to use the securities for
long-term purposes, they are separately classified on the balance sheet as long-term investments rather than as
temporary investments.
As discussed in Chapter 6, the balance sheet category of investments includes investments in equity and debt
securities of other business entities, assets not currently in use, and special funds. This chapter discusses
investments in equity and debt securities. Detailed discussion of equity investments is to those that do not result
in consolidated financial statements. The topic of intangible assets is also addressed.

Investments in Equity Securities

The term equity security is defined in SFAS No. 115 (see FASB ASC 320-10-20) as
Any security representing an ownership interest in an enterprise (for example, common, preferred, or
other capital stock) or the right to acquire (for example, warrants, rights, and call options) or dispose
of (for example, put options) an ownership interest in an enterprise at fixed or determinable prices. 1
Equity securities do not include redeemable preferred stock or convertible bonds.
Equity securities may be acquired on an organized stock exchange, over the counter, or by direct sale. In
addition, warrants, rights, and options may be attached to other securities (bonds or preferred stock), or they
may be received from the issuer, cost-free, to enable the acquiring company or individual investor to maintain
its present proportionate share of ownership. 2 The recorded cost of investments in equity securities includes the
purchase price of the securities plus any brokerage fees, transfer costs, or taxes on transfer. When equity
securities are obtained in a nonmonetary transaction, the recorded cost is based on the fair market value of the
consideration given. If the fair market value of the consideration is unavailable, cost is based on the fair market
value of the marketable equity security received.
Subsequent to acquisition, six methods of accounting and financial statement presentation are used under
current generally accepted accounting principles (GAAP) for the various types of equity securities: (1)
consolidation, (2) the equity method, (3) the cost method, (4) fair value accounting under SFAS No. 115 (see
FASB ASC 320), (5) the market value method, and (6) the fair value option under SFAS No. 159 (see FASB
ASC 825-10-10). Except for the fair value option, these methods are not alternatives for recording investments
in equity securities. As a general rule, they are applied on the basis of the investee's percentage of ownership,
taking into consideration the surrounding circumstances. Each method and the circumstances under which it is
applicable are described in the following paragraphs. The fair value option may be selected for all equity
investments except those that must be accounted for as consolidations. In addition to the above six accounting
methods, we discuss the theoretical merits of another method that was required in the past: lower of cost or
market.

Consolidation
Consolidated financial statements are required when an investor owns enough common stock to obtain control
over the investee. Control was defined in SFAS No. 94 as ownership of a majority voting interest (over 50
percent) unless the parent company is precluded from exercising control or unless control is
temporary.3 Consolidation requires that at the balance sheet date, the investment account (accounted for during
the year under the equity method described below) be replaced by the assets and liabilities of the investee
company. In the consolidation process the investee's assets, liabilities, and income statement accounts are
consolidated with (added to) those of the controlling parent company. Consolidated financial statements are
discussed in detail in Chapter 16.

The Equity Method

The equity method is used when an investor has the ability to significantly influence the financing and
operating decisions of an investee, even though that investor holds less than 50 percent of the voting stock.
Ability to exercise significant influence can be determined in a number of ways, including

 Representation on the board of directors

 Participation in policymaking processes
 Material intercompany transactions
 Interchange of managerial personnel
 Technological dependency
 The percentage of ownership the investor has in relation to other holdings 4
Under the equity method, adjustments are made to the recorded cost of the investment to account for the
profits and losses of the investee and for distributions of earnings. These adjustments are based on the investor's
percentage of ownership of the investee. For example, if the investee reports a profit, the investor will report as
income its pro rata ownership share of the investee profit and simultaneously increase the carrying value of the
investment account by the same amount. Conversely, dividends received decrease in the carrying value of the
investment account for the amount of the dividend received or receivable. Dividends are not reported as
income, because the investor reports the income of the investee as the investee earns it. In other words, under
the equity method, dividends are viewed as distributions of accumulated earnings. Because the accumulation of
earnings increases the investment account, the distribution of earnings decreases the investment account.
Consequently, the investment account represents the investee's equity in the investment.
The Committee on Accounting Procedure (CAP) originally described the equity method 5 in ARB No. 51,
stating that it is the preferred method to account for unconsolidated subsidiaries. 6 In 1971, the Accounting
Principles Board (APB) reported its conclusions on a study of accounting for long-term investments in stocks
by issuing APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” 7 (see
FASB ASC 323). This opinion clarified the applicability of the equity method to investments of common stock
in subsidiaries; however, it noted that the equity method is not a valid substitute for consolidation. 8
Additionally, the Board noted that determining the investor's ability to influence the investee is not always
clear; and “in order to achieve a reasonable degree of uniformity in application,” 9 an investment of 20 percent
or more of the voting stock of the investee is deemed to constitute evidence of a presumption of the ability to
exercise significant influence. Conversely, ownership of less than 20 percent of the voting stock leads to the
presumption that the investor does not have significant influence unless an ability to exercise significant
influence can be demonstrated.10 Thus the APB concluded that significant influence is normally attained when
an investor holds 20 percent or more of the voting stock of an investee unless the surrounding circumstances
indicate otherwise.
On the other hand, not all investments of 20 percent or more are accounted for by using the equity
method. FASB Interpretation No. 3511 (see FASB ASC 323-10-15-10) suggested that the following facts and
circumstances might preclude an investor from using the equity method even if an investment of 20 percent or
more is held:

 Opposition by the investee, such as litigation or complaints to government

regulatory authorities, challenges the investor's ability to exercise significant
influence.
  The investor and investee sign an agreement under which the investor
surrenders significant rights as a shareholder.
 Majority ownership of the investee is concentrated among a small group of
shareholders who operate the investee without regard to the views of the
investor.
 The investor needs or wants more financial information to apply the equity
method than is available to the investee's other shareholders (e.g., the
investor wants quarterly financial information from an investee that publicly
reports only annually), tries to obtain that information, and fails.
 The investor tries and fails to obtain representation on the investee's board
of directors.
The APB's decision to embrace the equity method was based on the objectives of accrual accounting—
reporting transactions when they occur rather than as cash is collected or paid. When the investor can exercise
significant influence over the investee, the results of operating decisions better reflect the periodic outcomes
resulting from making the investment, rather than distributions of the investor's share of accumulated profits
(which, in and of themselves, may be unrelated to performance). The Board apparently believed that the cash
flow needs of investors and other users of financial information can be satisfied by the significant influence test
and that reporting needs are of primary importance.
Despite some speculation at the time APB Opinion No. 18 was issued that it might require fair value, APB
Opinion No. 18 did little to add to the acceptability of this approach. The use of fair value is a departure from
the historical cost principle. The APB apparently was not prepared to take the radical step of endorsing a
departure from historical cost even though the information needed to determine the fair values for most
investments is readily available. However, the FASB reversed this position in SFAS No. 115 (see FASB ASC
320) at least for certain equity investments, and now the fair value option may be selected under  SFAS No.
159 (see FASB ASC 825-10-10). The specifics of when and how to apply fair value accounting to investments
are discussed later in the chapter.

The Cost Method

When there is a lack of significant influence or control, investments in common stocks may be accounted for
under either the cost method or a fair value method. When the fair value option is not selected, or when there is
no readily determinable market price for equity securities and neither the equity method nor consolidation is
required, the cost method must be used.
Under the cost method, an investment in equity securities is carried at its historical cost. Dividends received
or receivable are reported as revenue. The cost method can be criticized because it does not measure current fair
value. Historical cost provides information relevant for determining recovery when the securities are acquired.
Current fair market value would provide a similar measure for the current accounting period. If the purpose of
financial statements is to provide investors, creditors, and other users with information useful in assessing
future cash flows, the current assessment of recoverable amounts (current market values) would be relevant.
Even for equity securities that are not actively traded, an estimate of current fair value may be more relevant
than cost.

The Lower of Cost or Market Method

In 1975, the FASB issued SFAS No. 12 (since superseded). This release required that equity securities having
readily determinable market values that were not accounted for under the equity method or consolidation be
accounted for by applying the lower of cost or market (LCM). Under SFAS No. 12, marketable equity
securities were separated into current and long-term portfolios. Each portfolio was carried on the balance sheet
at the lower of that portfolio's aggregate cost or market value. For temporary investments in marketable equity
securities, unrealized losses in market value as well as any subsequent recoveries of those losses were
recognized in the income statement. In contrast, for long-term investments in marketable equity securities, the
cumulative effect of unrealized losses and loss recoveries was reported as negative stockholders' equity.
The FASB's advocacy of the LCM method in SFAS No. 12 was not a strict departure from historical cost.
Rather, it was simply further evidence of the overriding concern for conservatism (see Chapter 5 for a
discussion of the concept of conservatism). LCM for marketable equity securities can be defended on the
grounds that the recording of cost implies recovery of that cost. It is reasonable to assume that management
would not invest in assets that are not recoverable. By the same token, when recovery has declined temporarily
through decline in market value, it is reasonable to reduce the book value of assets to the lower market value.
The LCM method was criticized because it did not result in consistent treatment of all marketable equity
securities. Gains were treated differently from losses, and temporary investments were treated differently from
long-term investments with no rational explanation. Furthermore, it is inconsistent to recognize market value
increases up to cost but not to market. Opponents of SFAS No. 12 argued that the consequent recognition of
unrealized gains is so arbitrary that no recognition of these gains would be preferable.
Finally, the determination of LCM on an aggregate basis may be deceptive. Unrealized losses are offset
against unrealized gains. In a subsequent period when a security was sold, prior cumulative unrecognized gains
and losses were recognized, causing a mismatching of gain and loss recognition for the period in which it
actually occurred.

The Fair Value Method under SFAS No. 115

SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (see FASB ASC 320),
describes the current GAAP for equity securities that have readily determinable fair values and that are not
subject to the equity method under APB Opinion No. 18 or to consolidation.12 It has been modified by SFAS
No. 159 (see FASB ASC 825-10-10) as described in the subsequent section. According to SFAS No. 115, the
fair value of an equity security is readily determinable if

 The sales prices or bid–ask quotations are currently available on a securities

exchange registered with the Securities and Exchange Commission (SEC) or
in the over-the-counter market when they are publicly reported by the
National Association of Securities Dealers Automated Quotations systems
or by the National Quotation Bureau
 The security is traded only in foreign markets, and if the foreign market is of
a breadth and scope comparable to one of the U.S. markets mentioned above
 The investment is in a mutual fund that has a fair value per share (unit) that
is published and is the basis for current transactions
Under the SFAS No. 115 fair value method, at acquisition, equity securities are classified as either trading or
available for sale. As discussed in Chapter 8, trading securities are defined as “securities that are bought and
held principally for the purpose of selling them in the near term (thus held for only a short period of
time).”13 Trading securities are actively and frequently bought and sold, generally with the objective of
generating profits from short-term price movements. Available-for-sale securities are equity securities that have
readily determinable market prices and that are not considered trading securities. 14 All trading securities are
classified as current assets. Available-for-sale securities are classified as current or long term depending on
whether they meet the ARB No. 43 definition of current assets. Accordingly, these securities should be
classified as current if they are reasonably expected to be realized in cash or sold or consumed during the
normal operating cycle of the business or one year, whichever is longer. All other available-for-sale securities
should be classified as long-term investments.
At each balance sheet date, current and long-term equity securities subject to the SFAS No. 115 provisions
are reported at fair value. Unrealized holding gains and losses for available-for-sale securities are excluded
from earnings. The cumulative unrealized holding gains and losses for these securities should be reported as a
separate component of accumulated other comprehensive income. Dividend income for available-for-sale
securities will continue to be included in earnings.
When an equity security is transferred from the trading to the available-for-sale category or vice versa, the
transfer is accounted for at the security's fair value on the date of transfer. In these cases, the treatment of
unrealized holding gains is as follows:

 For a transfer from trading to available for sale, the unrealized holding gain
or loss is recognized in income up to the date of transfer. It is not reversed.
  For a transfer from available for sale to trading, the unrecognized holding
gain or loss at the date of transfer is reported immediately in earnings. 15
The FASB's primary impetus for requiring fair value accounting for investments in equity securities is
relevance. The advocates of fair value accounting for investments in equity securities believe that fair value is
useful in assisting investors, creditors, and other users in evaluating the performance of the accounting entity's
investing strategies. According to SFAC No. 8, users of financial information are interested in assessing the
amount, timing, and risk associated with expected net cash inflows to the enterprise. These assessments aid
users in evaluating the potential outcome of their own personal investing strategies because the expected cash
flows to the enterprise are the main source of expected cash flows from the enterprise to them. Fair value is
determined by the market. It reflects the market's consensus regarding the expected future resource flows of a
security discounted by the current interest rate adjusted for the risk associated with that security.
In addition, the fair value method partially eliminates the inequitable treatment that SFAS No. 12 afforded to
gains and losses. All unrealized gains and unrealized losses are now treated the same for asset-valuation
purposes. For trading securities, the gains and losses are recognized in the periods when they occur; for these
assets, the method is consistent with other accrual accounting requirements. It is also consistent with the SFAC
No. 6 definition of comprehensive income, because comprehensive income is based on changes in net assets
and would include changes in the market values of assets. For trading securities, there is no further masking of
gains against losses that occurred under the aggregate valuation approach of SFAS No. 12.
However, inconsistent income statement treatment for equity securities will continue. Unrealized gains and
losses for available-for-sale securities are not recognized in earnings until they are reclassified as trading
securities and sold. Thus, for these securities, there is no accrual accounting-based matching of market gains
and losses in the period when they are incurred. The result is a distortion of reported earnings.
Finally, the readily determinable criterion precludes fair value accounting for securities that are not actively
traded—a criticism that is alleviated when investors elect the fair value option offered by SFAS No. 159. Some
advocates of fair value argue that for securities not included within the scope of SFAS No. 115, reporting other
estimates of fair value would be more meaningful than historical cost. Nevertheless, by limiting the scope of
fair value accounting for investments in equity securities to those whose fair values are readily determinable in
the securities market, the market-based measures provided under SFAS No. 115 are reliable. They do not rely
on imprecise measures that subjective judgments regarding market values would entail.

The Market Value Method

SFAS No. 115 excludes investments that are already accounted for using the market value method. As with the
fair value method, the market value method follows the cost method by recognizing income when dividends
are received. However, under the market value method, all equity securities that are neither consolidated nor
reported as equity method investments are treated the same way with respect to reporting unrealized gains and
losses. All unrealized gains and losses are recognized in earnings; none are included as a component of other
comprehensive income. As with trading securities, all upward and downward changes in market value of the
investment shares are reported as income or losses, and changes in the market value of the investment require
adjustment to the carrying value of the investment. Thus, the market value method is analogous to the fair
value method for trading securities described above. It has become accepted industry practice for certain
industries, such as mutual funds, where it has attained the status of GAAP.
Exhibit 10.1 summarizes the approaches that are considered current GAAP for investments in equity
securities.

EXHIBIT 10.1   Accounting for Investments in Equity Securities

Recent Developments
On May 26, 2010, the FASB issued a proposed Accounting Standards Update, Accounting for Financial
Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities (PASU),
outlining a proposed approach to financial instrument classification and measurement based on their
characteristics and how assets are used in the business. The PASC would require

 Classification to be determined at acquisition or issuance, with

reclassification not permitted.
 Financial assets that have variable cash flows or that are regularly traded to
be accounted for at fair value, with value changes reflected in net income
(regardless of business strategy); this would include all derivatives.
 Changes in the fair value of equity securities, certain hybrid instruments,
and financial instruments that can be contractually prepaid in such a way
that the holder would not recover substantially all of its investment to be
recognized in net income each reporting period (regardless of business
strategy).
 For financial assets that are held for the collection of cash.
 Both amortized cost and fair value measures would be presented in the
balance sheet.
 Fair value changes arising from interest accruals, credit impairments and
reversals, and realized gains and losses would be recognized in net income.
 Other fair value changes would be recognized in other comprehensive
income.
Financial assets for which other comprehensive income treatment or amortized cost is elected would be subject
to a single credit impairment model. A credit impairment would be recognized in net income when an entity
does not expect to collect all of the contractually promised cash flows. An entity no longer would wait for a
probable event to recognize a loss; instead, it would need to consider the impact of past events and existing
conditions on the collectability of contractual cash flows over the remaining life of the asset(s) without regard
to the probability threshold. The proposal provides latitude in measuring credit impairment, including whether
on an individual asset or pooled basis. An entity would determine its best estimate of the amount of credit
impairment at the end of each reporting period.

The Fair Value Option

SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” permits companies to
measure most financial assets and liabilities that are recognized in financial statements at fair value.
Companies may not opt for fair value reporting for the following financial items: investments that must be
consolidated, assets and obligations representing postretirement benefits, leases, demand deposits reported by
banks, and financial instruments classified as components of stockholder's equity. The objective of the fair
value option is “to improve financial reporting by providing entities with an opportunity to mitigate volatility
in reported earnings caused by measuring related assets and liabilities differently without having to apply
complex hedge accounting.”16 However, because the pronouncement is not limited to related assets and
liabilities, it is apparent that the FASB is attempting to broaden the use of fair value accounting to areas where
it was not previously allowed, most notably to liabilities.
The long-standing GAAP rule under the historical cost model has been to capitalize as historical cost all
costs associated with the acquisition of an asset. Moreover, GAAP for debt instruments has been to defer up-
front costs associated with their issuance. SFAS No. 159 changed these rules for those assets and liabilities
within its scope. It requires that up-front cost related to items for which the fair value option is elected be
expensed as incurred and not deferred.
The election to opt for fair value reporting may be applied by instrument. It may be elected for a single
eligible debt or equity security without electing it for other identical items. Moreover, the option need not be
applied to all instruments issued or acquired in a single transaction. An exception to being able to apply by
instrument is that when electing fair value for an investment that would otherwise be accounted for under the
equity method, the investor must apply fair value to all financial interests in the same entity, including its
eligible debt and equity instruments.
Election to opt for fair value for a reporting must be made only on one of the following election dates: 17

 The investor first recognizes the eligible item.

 Financial assets that are reported at fair value under specialized accounting
rules cease to quality for the specialized accounting.
 The accounting treatment for the financial instrument changes, such as an
investment that becomes subject to the equity method.
 The date of the adoption of SFAS No. 159.
Once the fair value option has been made for a financial instrument, it is irrevocable unless a new election date
occurs.
After making the fair value election, all subject items are reported in the balance sheet at fair value. Fair
value is to be measured using exit prices on the balance sheet date. SFAS No. 159 defined fair value as the price
that the reporting entity would receive to sell an asset or pay to transfer a liability in an orderly transaction
between market participants. All unrealized holding gains and losses are to be reported in earnings.
The reporting entity must separately disclose assets and liabilities pursuant to electing fair value in a manner
that clearly separates them from the carrying values of other assets and liabilities, either parenthetically by a
single line that includes both values or on separate lines in the balance sheet. Moreover, if the fair value option
is elected for available-for-sale and/or held-to-maturity securities when SFAS No. 159 (see FASB ASC 825-10)
is adopted, these investments are to be reported as trading securities. The cumulative effect of the gains and
losses for these securities is to be reported as an adjustment to retained earnings.

Investments in Debt Securities

Investments in debt securities, such as bonds or government securities, for which the fair value option is not
elected are initially recorded at cost, including up-front cost to acquire the securities. Typically, the purchase
price of a debt instrument differs from its face value. This difference reflects the fluctuations in market interest
rates that have occurred since the time the debt instrument was initially offered for sale to the present. Thus,
debt instruments are usually sold at a premium or discount (for a detailed discussion of how the amount of a
bond premium or discount is determined and how this affects interest, see Chapter 11). The SFAS No.
115 accounting guidelines also apply to all investments in debt securities.
Before the issuance of SFAS No. 115, all debt securities that were classified as long term were accounted for
by amortizing the premium or discount over the term of the bond, regardless of the intent or ability of the
investing entity to hold the investment to maturity or whether the investment had a readily determinable fair
value. Regulators and others expressed concerns that the recognition and measurement of investments in debt
securities, particularly those held by financial institutions, should better reflect the intent of the investor to hold,
make available to sell, or trade these securities. Moreover, the provisions of SFAS No. 12 did not apply to
investments in debt securities. Some companies applied LCM debt securities; others accounted for them under
the cost method. The result was that the accounting treatment for these securities was inconsistent from one
entity to the next, making it difficult to compare their performance across companies.
SFAS No. 115 required that at acquisition, individual investments in debt securities be classified as trading,
available for sale, or held to maturity (see FASB 320-10-25-1). Debt securities classified as trading or available
for sale are to be treated in the same manner as equity securities that are similarly classified. That is, the fair
value method described above for trading and available-for-sale equity securities also applies to trading and
available-for-sale debt securities. Thus, the discussion that follows is limited to debt securities classified as held
to maturity.
Debt instruments must be classified as held to maturity “only if the reporting enterprise has the positive
intent and ability to hold those securities to maturity.” 18 Debt securities that are classified as held to maturity
must be measured at amortized cost. When these debt securities are sold at a premium or discount, the total
interest income to the investing enterprise over the life of the debt instrument from acquisition to maturity is
affected by the amount of the premium or discount. Measurement at amortized cost means that the premium or
discount is amortized each period to calculate interest income (Chapter 11 illustrates how a premium or
discount affects interest over the life of a bond). Amortization of the premium or discount is treated as an
adjustment to interest income and to the investment account.
Two methods of debt premium or discount amortization are considered GAAP: straight-line and effective
interest. Under the straight-line method, the premium or discount is divided by the number of periods
remaining in the life of the debt issue. In each subsequent period, an equal amount of premium or discount is
written off as an interest income adjustment. The rationale underlying the use of the straight-line method is its
ease of computation and the belief that its use results in premium or discount amortization amounts that are not
materially different from the amounts resulting from the use of other measurement methods.
When the effective interest method is used to measure interest income, the market rate of interest on the debt
instrument at the time the investment is acquired is applied to the carrying value of the investment at the
beginning of each interest period. This step determines the amount of interest income for that period. Using the
effective interest method reflects the fact that the investor earns a uniform rate of return over the life of the
investment. Thus, the use of this method is based on the belief that the investment was acquired at a certain
yield and that the financial statements issued in subsequent periods should reflect the effects of that decision.
When it is evident that the investor has changed intent to hold a debt security to maturity, the security is
transferred to either the trading or the available-for-sale category. The transfer is accounted for at fair value. If
the security is transferred to the trading category, the unrealized gain or loss at the date of transfer is recognized
in income. If the security is transferred to the available-for-sale category, the unrealized  gain or loss at the date
of transfer is recognized as a component of other comprehensive income. When a change from the available-
for-sale category to the held-to-maturity category occurs, the amount of accumulated unrealized holding gains
and losses that exists at the date of transfer continues to be included as a component of other comprehensive
income, which is reported in the stockholders' equity section of the balance sheet, and that amount is amortized
over the remaining life of the debt security as an adjustment to interest income. The effect of this treatment is
that interest income each period will be what it would have been under the amortized cost method, but the
carrying value of the debt security on the balance sheet in subsequent periods will reflect the amortized market
value at the date of transfer, rather than amortized cost.
According to SFAS No. 115, a change in circumstances may result in the change of intent to hold a debt
security to maturity, but it may not call into question the classification of other debt as held to maturity if the
change in circumstances is caused by one or more of the following:

1. Evidence of significant deterioration in the issuer's creditworthiness

2. A tax law change that eliminates or reduces the tax-exempt status of interest
on the debt security
 3. A major business combination or disposition (such as sale of a segment of
the business) that necessitates the sale or transfer of the debt security in
order to maintain the enterprise's existing interest rate risk position or credit
risk policy
4. A change in statutory or regulatory requirements that significantly modifies
either what constitutes a permissible investment or the maximum level of
investment that the enterprise can hold in certain kinds of securities
5. A change in regulatory requirements that significantly increases the
enterprise's industry capital requirements that causes the enterprise to
downsize
6. A significant increase in the risk weights of debt securities used for
regulatory risk-based capital purposes
A debt security should not be classified as held to maturity if the enterprise intends to hold the security for
an indefinite period. An indefinite holding period is presumed if, for example, the debt security would be
available to be sold in response to these conditions:

1. Changes in market interest rates and related changes in the security's

prepayment risk
2. Needs for liquidity (e.g., for financial institutions, the withdrawal of
deposits or the increased demand for loans; for insurance companies, the
surrender of insurance policies or the payment of insurance claims)
3. Changes in the availability and yield on alternative investments
4. Changes in funding sources and terms
5. Changes in foreign currency risk
SFAS No. 115 addressed issues concerning the relevance of fair value to investors, creditors, and other users.
However, in allowing the continued use of amortized cost for debt securities that are intended to be held to
maturity, it did not address concerns that the use of the amortized cost method permits the recognition of
holding gains through the selective sale of appreciated debt instruments recorded at amortized cost at the date
of sale. This affords management the opportunity to engage in gains trading and to selectively manage reported
earnings. Moreover, it did not address the criticism that accounting for debt securities is based on management's
plan for holding or disposing of the investment, rather than on the characteristics of the asset itself. In allowing
three distinct categories, the same company could conceivably give three different accounting treatments to
three otherwise identical debt securities. Critics argue that these issues can be resolved only by reporting all
debt and equity securities that have determinable fair values at fair value and by including all unrealized gains
and losses in earnings as they occur.
The FASB countered that the procedures outlined in SFAS No. 115 reflect the economic consequences of
events and transactions. The FASB's logic for this contention is as follows. The reporting requirements better
reflect the way enterprises manage their investments and the impact of economic events on the overall
enterprise. Moreover, the following disclosure requirements should provide fair value information that should
prove useful to investor decision making in addition to the reporting requirements outlined above. For securities
classified as available for sale and separately for securities classified as held to maturity, the enterprise is to
report

 Aggregate fair value

 Gross unrealized holding gains
 Gross unrealized holding losses
 The amortized cost basis by major security type
Permanent Decline in Fair Value
When a decline in the fair value of a long-term investment that is classified as available for sale is determined
to be other than temporary, an other-than-temporary impairment is considered to have occurred. In this case
the investment account balance for the security is written down to fair value, a loss is included in earnings, and
a new cost basis is established. The new cost basis for recognition of gain or loss on reclassification or sale will
not be adjusted for subsequent recoveries of the recognized loss. All subsequent increases in fair value will be
reported as components of other comprehensive income, in the same manner as subsequent unrealized
losses.19 Similar treatment is given for other-than-permanent declines in investments in debt securities that are
classified as held to maturity.

Impairment of Investments in Unsecuritized Debt

Investments in unsecuritized debt, for example mortgages, are subject to the provisions of SFAS No. 114,
“Accounting by Creditors for Impairment of Loans.”20 Loans are “impaired when, based on current information
and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual
terms of the loan agreement,” including interest. 21 To reiterate, in these cases, impairment is measured based on
the present value of expected future cash flows discounted at the loan's effective interest rate as determined at
the origin or acquisition of the loan. Alternatively, impairment may be measured using the market price for the
loan or, if the loan is collateralized, the fair value of the collateral. If the resulting measurement of impairment
is less than the carrying value of the loan (including interest and unamortized loan fees, premium or discount),
the impairment is recognized by creating a valuation allowance and making a corresponding charge to bad debt
expense.
In subsequent accounting periods, for impairments that were calculated by discounting cash flows,
impairment is remeasured to reflect any significant changes (positive or negative) in the cash-flow expectations
used to calculate the original loan impairment. For impairments that were measured using fair values, similar
remeasurements are made to reflect subsequent significant changes in fair value. However, the loan carrying
value may not be written up to a value that exceeds the recorded investment in the loan. For balance sheet
purposes, the changes are reflected in the valuation allowance account.
For income statement purposes, changes in the present value of the expected future cash flows of an
impaired loan may be treated in one of two ways:

1. Increases that are attributable to the passage of time are reported as interest
income; the balance of the change in present value is an adjustment to bad
debt expense.
2. The entire change in present value is reported as an adjustment to bad debt
expense.
At each balance sheet date, the following disclosures are required:

1. The recorded investment in the impaired loans

2. The beginning and ending balance in the allowance account and the activity
occurring during the period in that account
3. The income recognition policy, including the amount of interest income
recognized due to changes in the present value of the impaired loan
SFAS No. 114 is intended to address whether present-value measures should be used to measure loan
impairment. The pronouncement clarifies present GAAP for loan impairments by specifying that both principal
and interest receivable should be considered when calculating loan impairment. The prescribed measurement
methods should reflect the amount that is expected to be recovered by the creditor so that investors, creditors,
and other users can better assess the amount and timing of future cash flows. The initial present value recorded
for the loan reflected the expectations at that time regarding expected future cash flows. Because the loan was
originally recorded at a discounted amount, ongoing assessment for impairment should be treated in a similar
manner. The added uncertainty associated with expectations regarding the future cash flows from impaired
loans should not preclude the use of discounted cash flows. The impairment represents deterioration in quality
as reflected in the change in cash-flow expectations. Thus the impairment itself does not indicate that a new
loan has replaced the old one. Rather, the old loan is continuing, but expectations about future cash flows have
changed; consequently, the contractual effective interest rate is the appropriate rate to discount those cash
flows.
Critics argue that the effect of impairment is a change in the character of the loan that should be measured
directly. If so, the contractual effective interest rate is no longer relevant. The most desirable direct measure of
an impaired loan is fair value. If no market value exists, the creditor should discount the expected future cash
flows using an interest rate that is commensurate with the risk involved. Moreover, allowing the use of a fair
value alternative is inconsistent with requiring the original loan interest rate to be used when the discounting
alternative is selected. To be consistent in approach, the discounting should require an interest rate
commensurate with the risk associated with the current status of the loan; such a rate is implicit in the fair value
of the loan. In addition, SFAS No. 114 allows three alternative measures of loan impairment with no guidance
on when to use one method over the other. Allowing alternatives in this manner enables companies to use the
provisions of this pronouncement to manage their financial statements.

Transfers of Financial Assets

Financial assets include investments in debt and equity securities. Accounting for financial assets was first
outlined in SFAS No. 125,22 which was superseded by SFAS No. 140.23 This statement adopts a financial
consequences approach, which requires an entity to recognize the financial assets it controls and the liabilities
it has incurred and to derecognize financial assets when control has been surrendered and to derecognize
financial liabilities when they are extinguished.
According to SFAS No. 140, the investor transfers or surrenders control over transferred assets if and only if
all of the following conditions are met:

1. The transferred assets have been isolated from the transferor—put beyond
the transferor's reach as well as the reach of its creditors.
2. Each transferee (or, if the transferee is a qualifying special-purpose entity,
each holder of its beneficial interests) has the right to pledge or exchange the
assets (or beneficial interests) it received, and no condition both constrains
the transferee (or holder) from taking advantage of its right to pledge or
exchange and provides more than a trivial benefit to the transferor.
3. The transferor does not maintain effective control over the transferred asset
by having an agreement that obligates it to repurchase or redeem the asset
before maturity or by having an agreement that allows it to repurchase or
redeem assets that are not readily obtainable.
A transfer of financial assets is accounted for as a sale to the extent that consideration other than beneficial
interests in the transferred asset is received in exchange. Liabilities and derivatives incurred in a transfer of
financial assets are initially measured at their fair market values. Servicing assets and liabilities 24 are measured
by amortization over the period of servicing income or loss, and assessment for asset impairment or increased
obligation is based on their fair market values. Liabilities are derecognized only when repaid or when the debtor
is legally relieved of the obligation. That is, in-substance defeasance is not permitted.

Intangibles
It is difficult to define the term intangibles adequately. Kohler defined intangibles as capital assets having no
physical existence and whose value depends on the rights and benefits that possession confers to the
owner.25 However, Paton had previously noted that the lack of physical existence test was not particularly
helpful and suggested that intangibles are assets more closely related to the enterprise as a whole than to any
components.26 It should also be noted that many intangibles convey a sort of monopolistic right to their owners.
Examples of intangibles are patents, copyrights, franchises, leaseholds, and goodwill.
Intangible assets derive their value from the special rights and privileges they convey, and accounting for
these assets involves the same problems as accounting for other long-term assets. Specifically, an initial
carrying amount must be determined and then systematically and rationally allocated to the periods that receive
benefit. Companies must also account for the effects of impairment. These problems are magnified in the case
of intangibles because their very nature makes evidence elusive. Both the value and the useful lives of
intangibles are difficult to determine.
These issues were initially addressed by the APB, which noted that intangible assets might be classified on
several bases:

1. Identifiability. Assets may be separately identifiable or may lack specific

identification.
2. Manner of acquisition. Assets may be acquired singularly, in groups, or in
business combinations, or they may be developed internally.
3. Expected period of benefit. The period of benefit for an asset may be limited
by law or contract, may be related to human or economic factors, or may
have indefinite or indeterminate duration.
4. Separability from an entire enterprise. The rights to an asset may be
transferable without title, salable, or inseparable from the enterprise or a
substantial part of it.27
Today, the cost of internally developed intangibles, such as patents, are considered costs of research and
development and are expensed as incurred under SFAS No. 2 (discussed later in the chapter).
The foregoing definitions suggest that intangibles may be classified according to whether they are externally
acquired (purchased from outsiders) or internally developed. Additionally, they may be classified
as identifiable or unidentifiable. These last two classifications, which relate to the Type (a) and Type (b)
classifications originally identified in ARB No. 43, are discussed later in the chapter.

Accounting for Cost

The initial valuation process for intangible assets generally follows the same standards employed for other
long-lived assets. Cost includes all expenditures necessary to acquire an individual asset and make it ready for
use. When intangibles are purchased from outsiders, assigning cost is fairly easy, and the methods used in
allocating cost to groups of assets and by exchanges of other assets are similar to those discussed for tangible
fixed assets.
However, companies often develop intangible assets internally. The APB addressed the problems inherent in
accounting for internally developed intangibles in Opinion No. 17. The Board's conclusions were based on the
identifiability characteristic defined earlier:
A company should record as assets the costs of intangible assets acquired from other enterprises or
individuals. Costs of developing, maintaining, or restoring intangible assets which are not specifically
identifiable, have indeterminate lives, or are inherent in a continuing business and related to the
enterprise as a whole—such as goodwill—should be deducted from income when incurred. 28
The identifiability criterion alleviated much of the problem in accounting for the cost of intangible assets and
is yet another example of the APB's attempts to narrow alternatives. Where a specific cost could be assigned to
a specific asset, intangibles were carried forward at recorded values. Where either a specific asset or specific
amount was indeterminable, no attempt was made to carry values forward. As stated above, internally
developed intangibles are no longer reported as assets under SFAS No. 2.

Amortization
The matching principle dictates that the cost of intangible assets be apportioned to the expected periods of
benefit. In ARB No. 43, it was noted that this process involved two separate types of intangibles.

1. Those having a term of existence limited by law, regulation, or agreement,

or by their nature (such as patents, copyrights, leases, licenses, franchises for
a fixed term, and goodwill as to which there is evidence of limited duration)
2. Those having no such term of existence and as to which there is, at the time
of acquisition, no indication of limited life (such as goodwill generally,
 going value, trade names, secret processes, subscription lists, perpetual
franchises, and organization costs)29
This release resulted in the adoption of a classification scheme that identified intangibles as either (1) Type
(a) or (2) Type (b), and these terms became widely used in discussing the issues associated with recording and
amortizing intangible assets. In APB Opinion No. 17, the terms Type (a) and Type (b) were not specifically
used; the terms identifiable and unidentifiable were substituted. In this release, the APB noted that then-current
practices allowed the following variations in treatment of unidentifiable intangibles: (1) retention of cost until a
reduction of value was apparent, (2) amortization over an arbitrary period, (3) amortization over estimated
useful life with specified minimum and maximum periods, and (4) deduction from equity as acquired. 30
In Opinion No. 17, the APB concluded that intangible assets should be amortized by systematic charges to
income over the estimated period to be benefited. The Board also suggested that the following factors should be
considered in estimating the useful lives of intangibles:

1. Legal, regulatory, or contractual provisions may limit the maximum useful

life.
2. Provisions for renewal or extension may alter a specific limit on useful life.
3. Effects of obsolescence, demand, competition, and other economic factors
may reduce a useful life.
4. A useful life may parallel the service life expectancies of individuals or
groups of employees.
5. Expected actions of competitors and others may restrict present competitive
advantages.
6. An apparently unlimited useful life may in fact be indefinite, and benefits
cannot be reasonably projected.
7. An intangible asset may be a composite of many individual factors with
varying effective lives.
APB Opinion No. 17 indicated that the period over which the cost of intangibles is amortized should be
determined from a review of the foregoing factors, but it should not exceed 40 years. The straight-line method
of amortization was required to be used unless another method could be demonstrated to be more appropriate.
As noted earlier, the release of APB Opinion No. 17 narrowed the accounting treatment available for similar
transactions; however, whether or not it created the desired result is subject to question. APB Opinion No.
17 was criticized by some because it placed values on the balance sheet that relate to future expectations (for
example, purchased goodwill), and others disagreed with the Board's conclusions because it assigned costs to
arbitrary periods where there is no evidence that costs have expired (for example, perpetual franchises). Further
evidence of the lack of acceptability of this pronouncement lies in the fact that originally it was part of APB
Opinion No. 16, “Business Combinations”; however, since enough members of the APB objected to various
provisions of both opinions, it was necessary to separate the provisions to obtain the required majority for
passage. In 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets” (see FASB ASC
350), which changed the method of accounting for intangible assets.31
Under SFAS No. 142, intangible assets other than goodwill are divided into two groups: those with indefinite
lives and those with finite lives. SFAS No. 142 does not presume that intangibles are wasting assets. An
acquired intangible asset's useful life is determined by reviewing various factors such as its expected use,
related assets, legal regulatory or contractual provisions, the effects of obsolescence, and the level of required
maintenance. If no legal, regulatory, contractual, or other factor limits the useful life of an intangible asset, it is
considered to have an indefinite life. Intangible assets that are not amortized must be tested for impairment at
least annually by comparing the fair values of those assets with their recorded amounts and/or amortized over
their remaining useful lives. Intangible assets that have finite useful lives will continue to be amortized over
their useful lives. SFAS No. 142 did not change the accounting treatment for internally developed intangibles or
research and development activities.

Goodwill
The topic of goodwill has been of interest for many years. As initially conceived, goodwill was viewed as good
relations with customers. Such factors as a convenient location and habits of customers were viewed as adding
to the value of the business. Yang described goodwill as everything that might contribute to the advantage an
established business possessed over a business to be started anew. 32 Since that time, the concept of goodwill
has evolved into an earning power concept in which its value is approximated by attributing to goodwill all
future earnings that are expected to be in excess of those that a similar company would generate and then
discounting the expected excess earnings stream to its present value.
Catlett and Olson summarized the characteristics of goodwill that distinguish it from other elements of
value:

1. The value of goodwill has no reliable or predictable relationship to costs that

may have been incurred in its creation.
2. Individual intangible factors that may contribute to goodwill cannot be
valued.
3. Goodwill attaches only to a business as a whole.
4. The value of goodwill may, and does, fluctuate suddenly and widely
because of the innumerable factors that influence that value.
5. Goodwill is not utilized or consumed in the production of earnings.
6. Goodwill appears to be an element of value that runs directly to the investor
or owner in a business enterprise.33
In theory the value of goodwill is equal to the discounted present value of expected superior earnings
(expected future earnings less normal earnings for the industry). Thus the process of estimating the value of
goodwill involves forecasting future earnings and choosing an appropriate discount rate.
Forecasting future earnings is a risky proposition. Because the best indicator of the future is the past, prior
and current revenue and expense figures are typically used. However, the following points are relevant to this
process:

1. The use of too few or too many years can distort projections.
2. Trends in earnings should be considered.
3. Industry trends are important.
4. Overall economic conditions can be significant.
In choosing the discount rate to be used in making goodwill calculations, the objective is to approximate the
existing cost of capital for the company. This approximation must take into consideration existing and expected
risk conditions as well as earnings potential.
Although goodwill may exist at any time, in practice goodwill is recognized for accounting purposes only
when it is acquired through the purchase of an existing business. 34 Only then is the value of goodwill readily
determinable, because the purchase embodies an arm's-length transaction wherein assets, often cash or
marketable securities, are exchanged. The value of the assets exchanged indicates a total fair value for the
business entity acquired. The excess of total fair value over the fair value of identifiable net assets is considered
goodwill. This practice fulfills the stewardship function of accounting and facilitates the accountability of
management to stockholders.
When goodwill is recorded, it is considered an intangible asset. Under APB Opinion No. 17, goodwill was
amortized over its useful life or 40 years, whichever came first. 35 The case for amortization was based on
accrual accounting. That is, the company had paid for the goodwill, and it will presumably generate future
earnings; thus, its cost should be matched against those future earnings as they arise. However, in the case of
goodwill, it is difficult if not impossible to estimate what that useful life will be. If goodwill measures excess
earning power, how long can it be expected to last? An economist would say that it would not last very long,
because competition would drive it away. If so, it should be written off over a relatively short period. On the
other hand, if the goodwill is attributable to some ability associated with the enterprise, its employees, or
management that would be difficult for others to duplicate, then it may have an indefinite useful life. In that
case, it may be inappropriate to amortize goodwill at all.
 Some accountants have argued that goodwill should be written off when it is acquired, because it would then
receive the same treatment as inherent goodwill (goodwill that exists but is not paid for in a business
combination). There are costs associated with developing inherent goodwill. These costs are written off as they
are incurred. Moreover, when goodwill is acquired, further costs will be incurred to continue excess earnings
ability. Hence, to amortize the cost of goodwill acquired over future periods represents a double counting of
cost. The immediate write-off of purchased goodwill could be treated as an extraordinary item because it
represents a transaction outside the normal trading activity of the acquiring or investee enterprise.
Opponents of immediate write-off of goodwill contend that the purchase of goodwill implies future
profitability; thus, it is inconsistent and perhaps misleading to investors to write off the cost of goodwill
because it represents an asset having future service potential. This is particularly true for investments in people-
intensive companies—for example, in service industries. For these investments, the amount of goodwill
acquired relative to other assets is high; thus, the immediate write-off would be material and would have a
major and misleading impact on financial ratios, particularly debt to equity and return on investment. Moreover,
future profits would be inflated because they would not be matched against the cost of the investment.

SFAS No. 142

In 1996, the FASB put the issue of accounting for business combinations and the related topic of goodwill on
its agenda in response to growing concerns voiced by constituents about the need for improved standards to
account for business combinations. In September 1999, the FASB published an exposure draft titled “Business
Combinations and Intangible Assets.” The exposure draft proposed that the pooling of interests method be
eliminated in favor of the purchase method for business combinations (see Chapter 16) and that goodwill
should be amortized over no more than 20 years, in contrast to the previously required amortization period of
up to 40 years.
The two proposals drew considerable interest and some vocal opposition, which resulted in a series of
meetings between the FASB and its constituents as well as testimony before committees of the U.S. House of
Representatives and Senate. The opposition was based on the contention that recording large amounts of
goodwill and subsequently amortizing goodwill over a 20-year period would result in a large drain on reported
earnings. Subsequently, the Board issued a revised exposure draft, “Business Combinations and Intangible
Assets—Accounting for Goodwill,” in early 2001; this draft proposed that goodwill not be amortized, but rather
that it be tested for impairment.
In June 2001, the FASB issued SFAS No. 141, “Business Combinations”36 (see FASB ASC 805), and SFAS
No. 142, “Goodwill and Other Intangible Assets” 37 (see FASB ASC 350). These statements changed the
accounting for business combinations and goodwill. SFAS No. 141 now requires that the purchase method of
accounting be used for all business combinations.38 SFAS No. 142 changes the accounting treatment for
goodwill from an amortization period not to exceed 40 years to an approach that requires, at a minimum, annual
testing for impairment. The goodwill impairment test is to be performed at the reporting unit level, which is
defined as an operating segment or one level below an operating segment (also known as a component). 39
Under the provisions of SFAS No. 142, the test for goodwill impairment is a two-step process:

1. Compare the fair value of the reporting unit to its carrying value. In the
event fair value exceeds carrying value, no further testing is required.
However, if the carrying value of the reporting unit exceeds its fair value,
step 2 is required.
2. Calculate the implied fair value of goodwill by measuring the fair value of
the net assets other than goodwill and subtracting this amount from the fair
value of the reporting unit.
In determining fair value, the FASB noted that the fair value of a reporting unit is the amount at which the
whole unit could be bought or sold in a current transaction. As a result, quoted market prices in active markets
were described as the best evidence of fair value. The FASB further indicated that if quoted market prices are
not available, fair value should be based on the best available information, such as the present value
measurements outlined in SFAC No. 7. These procedures now fall under the guidance provided at FASB ASC
820 for measuring fair value.
In determining whether to record an impairment loss, the FASB stated that certain indications suggest when
an impairment exists, including significant underperformance relative to historical or projected future operating
results, significant changes in the manner of the company's use of underlying assets, and significant adverse
industry or market economic trends. The goodwill impairment test requires companies to assess whether the
cash flows their reporting units are expected to generate can support the values assigned to those units. If the
carrying value of assets is determined to be unrecoverable, the company must estimate the fair value of the
assets of the reporting unit and record an impairment charge for the excess of the carrying value over the fair
value. The estimate of fair value requires management to make a number of assumptions and/or projections,
such as future revenues, future earnings, and the probability of outcomes in contingency situations.
A company can identify reporting units in many ways. Possibilities include categorizing operations by
products, operating units, geographical area, legal entity, and significant customers. Prior guidance had been
provided in SFAS No. 131, “Segment Reporting” (see FASB ASC 280), which defined segments through a
“management approach” to segment reporting.40 Under this approach, management reports segment information
based on the way segments are organized within the company for internal decision-making purposes and
assessing performance. If, for example, management makes decisions on and assesses the performance of
certain product lines, then it must report segment information based on those product lines.
Specifically, SFAS No. 131 defined an operating segment as a component of an enterprise

1. That engages in business activities that earn revenues and incur expenses
2. Whose operating results are regularly reviewed by the organization's chief
operating decision maker, who makes decisions about resource allocation
and assesses its performance
3. For which discrete financial information is available
Because many firms have different operations and operate in multiple geographical areas, financial
statement users often need specific information concerning the operating units or geographic segments to help
them better assess financial performance or prospects for future cash flows. By providing specific information
about various segments, companies can help users make better-informed judgments about the firm as a whole.
Because SFAS No. 142 required the goodwill analysis to be performed at the reporting unit level, the standard
gave companies the option to offer more transparent financial information—that is, how well a company and its
acquisitions have been performing, as well as which of the individual reporting units have been able to meet
their own expectations. In addition, SFAS No. 142 required companies to provide specific information on the
facts and circumstances that led to the recorded impairment. The guidance provided at FASB ASC 350 retains
these features.

Disclosure Requirements of SFAS No. 142

The disclosure requirements of SFAS No. 142 include the following (see FASB ASC 350-20-50):

1. The total aggregative amount of goodwill is to be disclosed as a separate

line item on the balance sheet.
2. Any transitory impairment loss is to be reported as a change in accounting
principle.
3. Any annual impairment loss is to be disclosed as a separate line item on the
income statement.
4. A description of the impaired asset and the facts and circumstances that led
to the impairment is to be disclosed.
5. The amount of the impairment loss and a description of the method used to
determine the fair value of its reporting units are to be disclosed.

Research and Development Costs

Large corporations are continually attempting to improve their product lines, develop new products, improve
manufacturing methods, and develop improved manufacturing facilities. Accounting for the cost of the
activities of the research department is a complicated process, because some costs might never result in future
benefits. For costs that will provide future benefit, an asset exists, but owing to the uncertainty surrounding the
present determination of which costs will result in future benefits and over what periods those future benefits
will be realized, many accountants view such determinations as too subjective and unreliable. In the past, many
corporations recognized the importance of developing accounting procedures to allow such costs to be
capitalized and amortized on a reasonable basis. For example, one study suggested that such costs might be
classified as follows:41

1. Basic research. Experimentation that has no specific commercial objective

2. New product development. Experimental effort to develop new products
3. Product improvement. Attempting to improve the quality or performance of
current product lines
4. Cost and/or capacity improvement. The development of new and improved
processes, manufacturing equipment, etc., to reduce operational costs or
expand capacity
5. Safety, health, and convenience. The improvement of working conditions
for purposes related to employee welfare, community relations, and so forth.
This classification scheme would make it easier to identify the costs that should be deferred and those that
should be expensed. The authors of this study suggest that categories 1, 2, and 3 should generally be deferred
and amortized, whereas 4 and 5 should be charged to expense because of the difficulty in determining the future
periods expected to receive benefit.
APB Opinion No. 17 required the immediate expensing of intangible assets that are not specifically
identifiable, because these costs do not specifically generate revenue and have dubious future service potential.
This provision was adopted to discourage the manipulation of research and development expenses. (Many
companies were capitalizing research and development costs in low-profit years and writing them off in a lump
sum in high-profit years.)
Later the FASB restudied the issue of research and development (R&D) costs and issued  SFAS No. 2 (see
FASB ASC 730). This release requires all R&D costs to be charged to expense as incurred. To distinguish
R&D costs from other costs, SFAS No. 2 provided the following definitions:
Research is planned search or critical investigation aimed at discovery of new knowledge with the
hope that such knowledge will be useful in developing a new product or service or new process or
technique or in bringing about a significant improvement to an existing product or process.

Development is the translation of research findings or other knowledge into a plan or design for a new
product or process or for a significant improvement to an existing product or process whether
intended for sale or use. It includes the conceptual formulation, design and testing of product
alternatives, construction of prototypes, and operation of pilot plants. It does not include routine or
periodic alterations to existing products, production lines, manufacturing processes, and other ongoing
operations even though these alterations may represent improvements and it does not include market
research or market testing activities.42
Because many costs have characteristics similar to R&D costs, SFAS No. 2 also listed activities that would
and would not be included in the category of R&D costs as follows:

Research and Development Activities Activities Not Considered Research and Development

Laboratory research aimed at discovery of a Engineering follow-through in an early phase of commercial

new knowledge production

Searching for applications of new research Quality control during commercial production including routine
findings testing

Conceptual formulation and design of Troubleshooting breakdowns during production

possible product or process alternatives

Testing in search for or evaluation of Routine, ongoing efforts to refine, enrich, or improve the qualities
 Research and Development Activities Activities Not Considered Research and Development

product or process alternatives of an existing product

Modification of the design of a product or Adaptation of an existing capability to a particular requirement or

process customer's need

Design, construction, and testing of Periodic design changes to existing products

preproduction prototypes and models

Design of tools, jigs, molds, and dies Routine design of tools, jigs, molds, and dies
involving new technology

Design, construction, and operation of a Activity, including design and construction engineering, related to
pilot plant not useful for commercial the construction, relocation, rearrangement, or start-up of facilities
production or equipment

Engineering activity required to advance Legal work on patent applications, sale, licensing, or litigation
the design of a product to the
manufacturing stage

The disclosure of R&D costs in annual reports was the subject of a research study. Entwistle (1999) 43 found
that only 1 percent of the firms he surveyed made R&D disclosures in the financial statements, and that such
disclosures were located throughout the annual report. Following is Hershey's discussion of its R&D activities:
We expense research and development costs as incurred. Research and development expense was
$32.2 million in 2011, $30.5 million in 2010 and $28.1 million in 2009. Research and development
expense is included in selling, marketing and administrative expenses.
Tootsie Roll's annual report states that the company “does not expend material amounts of money on
research or development activities.”

Financial Analysis of Investments and Intangibles

There are no specific financial analysis issues associated with investments and intangibles. As noted in Chapter
6, Hershey does not disclose any long-term investments on its balance sheet, but it discloses a goodwill net
balance of $516,745,000 and other intangibles of $111,913,000. Tootsie Roll discloses long-term investments
of $96,161,000, goodwill of $73,237,000, and trademarks of $175,024,000 in the other assets section of its
balance sheet.

International Accounting Standards

The International Accounting Standards Board (IASB) has issued pronouncements on the following issues:

1. Accounting for investments in associates in a revised IAS No. 28,

“Accounting for Investments in Associates.”
2. Accounting for financial assets in IAS No. 32, “Financial Instruments:
Presentation.”
3. Accounting for intangibles in IAS No. 38, “Intangible Assets.”
4. The recognition and measurement of financial assets in a reissued IAS No.
39, “Financial Instruments: Recognition and Measurement.”
 5. Accounting for goodwill in IFRS No. 3, “Business Combinations,” which
replaced IAS No. 22.
6. The disclosure of information on financial instruments in IFRS No. 7,
“Financial Instruments: Disclosures.”
7. Accounting for financial assets in IFRS No. 9, “Financial Instruments,” as a
first step in its project to replace IAS No. 39.
IAS No. 28 applies to all investments in which an investor has significant influence but not control or joint
control except for investments held by a venture capital organization, mutual fund, unit trust, and similar entity
that are designated under IAS No. 39 to be at fair value with fair value changes recognized in profit or loss. In
the revised IAS No. 28, the IASB did not change the fundamental accounting for associates in using the equity
method. The Board's main objective for the revision was to reduce alternatives. The original IAS No.
28 addressed accounting for investments where the investor does not own a majority interest but has the ability
to significantly influence the investee. The reporting requirements contained in this statement are quite similar
to U.S. GAAP discussed in APB Opinion No. 18.
The major changes in the revised IAS No. 28 were as follows:

1. It added additional guidance and disclosures for when it is appropriate to

overcome the presumption that an investor has significant influence if it
holds 20 percent or more of the voting power. An example would be when
an investee is in legal reorganization or bankruptcy or operating under
severe long-term restrictions on its ability to transfer funds to the investor.
2. It required the investor and equity method associates to use uniform
accounting policies for like transactions and events in similar circumstances.
3. It required additional disclosures, including the fair values of investments in
associates for which there are published price quotations, summarized
financial information of associates, reasons for a departure from the 20
percent presumption of significant influence, differences in reporting dates,
restrictions on an associate's ability to transfer funds, unrecognized losses of
an associate, and the investor's contingent liabilities with respect to the
associate.
The title of IAS No. 32 was originally “Financial Instruments Disclosure and Presentation,” but its disclosure
provisions were replaced by IFRS No. 7 in 2007. IAS No. 32 main objectives are to provide additional guidance
on selected matters such as the measurement of the components of financial statements on initial recognition
and the classification of derivatives based on an entity's own shares; it also aimed to put all disclosures relating
to financial instruments in one standard. The fundamental approach to the presentation and disclosure of
financial statements was not changed in the revision. Under IAS No. 32, financial assets are defined as cash, a
right to receive cash or other financial assets from another enterprise, or a contractual right to exchange
financial assets with another enterprise under potential favorable conditions or equity instruments of other
enterprises.
IAS No. 38, “Intangible Assets,” applies to all intangible assets that are not specifically dealt with in other
International Accounting Standards. It specifically applies to expenditures for advertising, training, start-up, and
research and development (R&D) activities. Specifically, IAS No. 38 indicates that an intangible asset should be
recognized initially, at cost, in the financial statements if it meets these three conditions:

1. The asset meets the definition of an intangible asset. Particularly, there

should be an identifiable asset that is controlled and clearly distinguishable
from an enterprise's goodwill.
 2. It is probable that the future economic benefits that are attributable to the
asset will flow to the enterprise.
3. The cost of the asset can be measured reliably.
These requirements apply whether an intangible asset is acquired externally or generated internally. If an
intangible item does not meet both the definition and the criteria for the recognition of an intangible asset, it is
expensed when incurred. All expenditures on research are to be immediately recognized as expenses, and
internally generated intangibles such as goodwill cannot be recognized as assets.
After initial recognition in the financial statements, IAS No. 38 indicates that an intangible asset should be
measured under one of the following two treatments:

1. Benchmark treatment. Historical cost less any amortization and impairment

losses
2. Allowed alternative treatment. Revalued amount (based on fair value) less
any subsequent amortization and impairment losses. The main difference
from the treatment for revaluations of property, plant, and equipment
under IAS No. 16 is that revaluations for intangible assets are permitted only
if fair value can be determined by reference to an active market. Active
markets are expected to be rare for intangible assets.
The statement requires intangible assets to be amortized over the best estimate of their useful life, and it
includes the presumption that the useful life of an intangible asset will not exceed 20 years from the date when
the asset is available for use. In rare cases, where persuasive evidence suggests that the useful life of an
intangible asset will exceed 20 years, an enterprise should amortize the intangible asset over the best estimate of
its useful life as well as perform these steps:

1. Test the intangible asset for impairment at least annually in accordance

with IAS No. 36, “Impairment of Assets.”
2. Disclose the reasons why the presumption that the useful life of an
intangible asset will not exceed 20 years is rebutted and also the factor(s)
that played a significant role in determining the useful life of the asset.
With respect to goodwill, IFRS No. 3 requires goodwill to be recognized by the acquirer as an asset from the
acquisition date and to be initially measured as the excess of the cost of the business combination over the
acquirer's share of the net fair values of the acquiree's identifiable assets, liabilities, and contingent
liabilities. SFRS No. 3 prohibits the amortization of goodwill. Instead, goodwill must be tested for impairment
at least annually in accordance with IAS No. 36, “Impairment of Assets.”
If the acquirer's interest in the net fair value of the acquired identifiable net assets exceeds the cost of the
business combination, that excess (referred to as negative goodwill) must be recognized immediately in the
income statement as a gain. Before concluding that negative goodwill has arisen, however, SFRS No. 3 requires
that the acquirer reassess the identification and measurement of the acquiree's identifiable assets, liabilities, and
contingent liabilities and the measurement of the cost of the combination. These requirements bring
international accounting standards in line with U.S. GAAP.
The IASB indicated that its main objective in reissuing IAS No. 39 was to provide additional guidance on
selected matters such as when financial assets and financial liabilities may be measured at fair value, how to
assess impairment, how to determine fair value, and some aspects of hedge accounting. 44 IAS No. 39 indicates
that an entity should recognize a financial asset or its statement of financial position when, and only when, the
entity becomes a party to the contractual provisions of the instrument.
All financial assets are to be recognized on the balance sheet. They are initially measured at cost, which is
the fair value of whatever was paid or received to acquire the financial asset. An entity records normal
purchases of financial assets on either the trade date or the settlement date, and certain value changes between
trade and settlement dates are recognized if settlement date accounting is used. Transaction costs are to be
included in the initial measurement of all financial instruments.
 Subsequently, most financial assets and liabilities are to be measured at fair value, except for the following,
which should be carried at amortized cost:

1. Loans and receivables originated by the enterprise and not held for trading
2. Other fixed maturity investments, such as debt securities and mandatorily
redeemable preferred shares, that the enterprise intends, and is able, to hold
to maturity
3. Financial assets whose fair value cannot be reliably measured (generally
limited to some equity securities with no quoted market price and forwards
and options on unquoted equity securities)
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable,
willing parties in an arm's-length transaction.
Additionally, an entity is required to assess, at each balance sheet date, whether there is objective evidence
of asset impairments. Any impairment losses are measured as the difference between the asset's carrying
amount and the present value of estimated cash flows discounted at the financial asset's original effective
interest rate.
If, in a subsequent period, the amount of the impairment loss relating to a financial asset carried at amortized
cost or a debt instrument carried as available for sale decreases owing to an event occurring after the
impairment was originally recognized, the previously recognized impairment loss is reversed; however,
impairments relating to investments in available-for-sale equity instruments are not reversed.
If an entity has neither retained nor transferred substantially all of the risks and rewards of a financial asset,
then the entity must assess whether it has relinquished control of the financial asset or not. If the entity does not
control the financial asset, then derecognition is appropriate; however, if the entity has retained control of the
asset, then the entity continues to recognize the asset to the extent to which it has a continuing involvement in
the asset.
If an asset is to be derecognized, the entity must first determine whether the asset under consideration for
derecognition is

1. An asset in its entirety

2. Specifically identified cash flows from an asset
3. A fully proportionate share of the cash flows from an asset
4. A fully proportionate share of specifically identified cash flows from a
financial asset
The steps to determine if derecognition is appropriate are summarized in Figure 10.1 as a decision tree.
In 2008 the IASB issued a revised IFRS No. 3. Among the changes was an option to permit an entity to
recognize 100 percent of the goodwill of an acquired entity, not just the acquiring entity's portion of the
goodwill, with the increased amount of goodwill also increasing the noncontrolling interest (minority interest)
in the net assets of the acquired entity. This is termed the full goodwill method. Noncontrolling interest is to be
reported as a part of consolidated equity. The full goodwill option may be elected on a transaction-by-
transaction basis.

FIGURE 10.1   Derecognition Decision Tree

 Source: Adapted from IAS No. 39, “Financial Instruments: Recognition and Measurement. Technical
Summary,” IASC Foundation Education, [Link]
8D26DFA726FB/0/[Link].

The primary objective of IFRS No. 7 is to provide risk management and financial instrument disclosures that
enable users to evaluate the significance of financial instruments to an entity's financial position and
performance. Specifically, IFRS No. 7 requires the following disclosures:

1. The significance of an entity's financial instruments entity

2. The nature and extent of risks arising from financial instruments to which an
entity is exposed and how those risks have been managed
The following balance sheet and income statement disclosures are required to provide information about the
significance of an entity's assets:

 Financial assets measured at fair value

 Held-to-maturity investments
 Loans and receivables
 Available-for-sale assets
IFRS No. 7 requires quantitative disclosures that are to be based on information provided internally to key
management personnel as defined in IAS No. 24, “Related Party Disclosures.” These disclosures include

 Risk exposures for each type of financial instrument

 Management's objectives, policies, and processes for managing those risks
 Changes from the prior period
 Summary quantitative data about exposure to each risk at the reporting date
IFRS No. 7 also seeks to provide risk-based disclosures from an entity's perspective and requires an entity to
communicate the nature and extent of risks, the significance of financial instruments, and how it manages
financial risks to its stakeholders by explaining its risk objectives, policies, and processes. These disclosures
include

 Maximum amount of exposure, a description of any collateral, information

about the credit quality of its financial assets that are neither past due nor
impaired, and information about credit quality of financial assets whose
terms have been renegotiated
 Certain analytical disclosures for financial assets that are past due or
impaired
 Information about collateral or other credit enhancements obtained or called
On November 12, 2009, the IASB issued IFRS No. 9, “Financial Instruments,” as the first step in a project to
replace IAS No. 39. This project was undertaken in response to vicious concerns expressed by the European
Commission (The council of the European Union) over the impact of IAS No. 39.
IFRS No. 9 introduces new requirements for classifying and measuring financial assets that must be applied
January 1, 2013, with early adoption permitted. The IASB intends to expand IFRS No. 9 during 2010 to add
new requirements for classifying and measuring financial liabilities, derecognition of financial instruments,
impairment, and hedge accounting. By the end of 2010, IFRS No. 9 will be a complete replacement for IAS No.
39. The requirements of IFRS No. 9 relating to financial assets are summarized in the following paragraphs.
 All financial assets are initially measured at fair value plus, in the case of a financial asset not at fair value
through profit or loss, transaction costs. Subsequently, IFRS No. 9 divides all financial assets that are currently
under the scope of IAS No. 39 into two classifications:

1. Those measured at amortized cost

2. Those measured at fair value
This classification is made at the time the financial asset is initially recognized—that is, when an entity
becomes a party to the contractual provisions of the instrument.
A financial asset debt instrument that meets the following two conditions is to be measured at amortized cost
(net of any write-down for impairment):

1. Business model test. The objective of the entity's business model is to hold

the financial asset to collect the contractual cash flows (rather than to sell
the instrument before its contractual maturity to realize its fair value
changes).
2. Cash flow characteristics test. The contractual terms of the financial asset
give rise on specified dates to cash flows that are solely payments of
principal and interest on the principal outstanding.
All other debt instruments must be measured at fair value through profit or loss (FVTPL). However, even if
an instrument meets the two amortized cost tests, IFRS No. 9 contains an option to designate a financial asset as
measured at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency
(sometimes referred to as an accounting mismatch) that would otherwise arise from measuring assets or
liabilities or recognizing the gains and losses on them on different bases. These requirements eliminate the  IAS
No. 39 available for sale and held-to-maturity categories.
All equity investments that fall under the scope of IFRS No. 9 are to be measured at fair value on the balance
sheet. Fair value changes are recognized as income, except for equity investments for which the entity has
elected to report fair value changes in other comprehensive income. If an equity investment is not held for
trading purposes, an entity can make an irrevocable election at initial recognition to measure it at fair value
through other comprehensive income (FVTOCI) with only dividend income recognized in profit or loss.
All derivatives, including those linked to unquoted equity investments, are to be measured at fair value. Fair
value changes are recognized as income unless the entity has elected to treat the derivative as a hedging
instrument in accordance with IAS No. 39, in which case the requirements of IAS No. 39 apply. The embedded
derivative concept of IAS No. 39 is not included in IFRS No. 9. Consequently, embedded derivatives that
under IAS No. 39 would have been separately accounted for at FVTPL because they were not closely related to
the financial host asset will no longer be separated. Instead, the contractual cash flows of the financial asset are
assessed in their entirety, and the asset as a whole is measured at FVTPL if any of its cash flows do not
represent payments of principal and interest.
A debt instrument may be reclassified between FVTPL and amortized cost, or vice versa, if and only if the
entity's business model objective for its financial assets changes so its previous model assessment would no
longer apply. If reclassification is appropriate, it must be done prospectively from the reclassification date. An
entity does not restate any previously recognized gains, losses, or interest.

Cases

 Case 10-1 Investment Classification

Qtip Corp. owns stock in Maxey Corp. The investment represents a 10 percent interest, and Qtip is unable to
exercise significant influence over Maxey.
The Maxey stock was purchased by Qtip on January 1, 2013, for $23,000. The stock consistently pays an
annual dividend to Qtip of $2,000. Qtip classifies the stock as available for sale. Its fair value at December 31,
2013, was $21,600. This amount was properly reported as an asset in the balance sheet. Owing to the
development of a new Maxey product line, the market value of Qtip's investment rose to $27,000 at December
31, 2014.
The Qtip management team is aware of the provisions of SFAS No. 115. The possibility of changing the
classification from available for sale to trading is discussed. This change is justified, the managers say, because
they intend to sell the security at some point in 2015 so they can realize the gain.

Required:

a. Discuss the role that managerial intention plays in the accounting treatment
of equity securities that have a readily determinable fair value under SFAS
No. 115.
b. What income statement effect, if any, would the change in classification
have for Qtip?
c. Discuss the ethical considerations of this case.
d. Opponents of SFAS No. 115 contend that allowing a change in classification
masks effects of unrealized losses and results in improper matching of
market-value changes with accounting periods. Describe how the accounting
treatment and the proposed change in classification would result in this sort
of mismatching.

 Case 10-2 Income Effects of Investments

Victoria Company has both current and noncurrent equity securities portfolios. All of the equity securities have
readily determinable fair values. Equity securities in the current portfolio are considered trading securities. At
the beginning of the year, the market value of each security exceeded cost.
During the year, some of the securities increased in value. These securities (some in the current portfolio and
some in the long-term portfolio) were sold. At the end of the year, the market value of each of the remaining
securities was less than original cost.
Victoria also has investments in long-term bonds, which the company intends to hold to maturity. All of the
bonds were purchased at face value. During the year, some of these bonds were called by the issuer before
maturity. In each case, the call price was in excess of par value. Three months before the end of the year,
additional similar bonds were purchased for face value plus two months' accrued interest.

Required:

a. How should Victoria account for the sale of the securities from each
portfolio? Why?
b. How should Victoria account for the marketable equity securities portfolios
at year-end? Why?
c. How should Victoria account for the disposition before their maturity of the
long-term bonds called by their issuer? Why?
d. How should Victoria report the purchase of the additional similar bonds at
the date of acquisition? Why?

 Case 10-3 Equity Method and Disclosures

On July 1, 2014, Dynamic Company purchased for cash 40 percent of the outstanding capital stock of Cart
Company. Both Dynamic and Cart have a December 31 year-end. Cart, whose common stock is actively traded
in the over-the-counter market, reported its total net income for the year to Dynamic and also paid cash
dividends on November 15, 2014, to Dynamic and its other stockholders.
Required:

a. How should Dynamic report the foregoing facts in its December 31, 2014,
balance sheet and its income statement for the year then ended? Discuss the
rationale for your answer.
b. If Dynamic should elect to report its investment at fair value, how would its
balance sheet and income statement differ from your answer to part (a)?

 Case 10-4 Research and Development

The Thomas Company is in the process of developing a revolutionary new product. A new division of the
company was formed to develop, manufacture, and market this product. As of year-end (December 31, 2014),
the product has not been manufactured for resale; however, a prototype unit was built and is in operation.
Throughout 2014 the division incurred certain costs. These costs include design and engineering studies,
prototype manufacturing costs, administrative expenses (including salaries of administrative personnel), and
market research costs. In addition, $500,000 in equipment (estimated useful life: 10 years) was purchased for
use in developing and manufacturing the preproduction prototype and will be used to manufacture the product.
Approximately $200,000 of this equipment was built specifically for the design and development of the
product; the remaining $300,000 of equipment will be used to manufacture the product once it is in commercial
production.

Required:

a. What is the definition of research and development as defined in Statement

of Financial Accounting Standards No. 2?
b. Briefly indicate the practical and conceptual reasons for the conclusion
reached by the FASB on accounting and reporting practices for R&D costs.
c. In accordance with SFAS No. 2, how should the various costs of Thomas
just described be reported in the financial statements for the year ended
December 31, 2014?

 Case 10-5 Trading versus Available-for-Sale Securities

The FASB issued SFAS No. 115 to describe the accounting treatment that should be afforded to equity
securities that have readily determinable market values that are not accounted for under the equity method or
consolidation. An important part of the statement concerns the distinction between trading securities and
available-for-sale securities.

Required:

a. Compare and contrast trading securities and available-for-sale securities.

b. How are the trading securities and available-for-sale securities classified in
the balance sheet? In your answer, discuss the factors that should be
considered in determining whether a security is classified as trading or
available for sale and as current or noncurrent.
c. How do the above classifications affect the accounting treatment for
unrealized losses?
d. Why does a company maintain an investment portfolio containing current
and noncurrent securities?
 e. If a company elects to adopt fair-value accounting for securities that are
classified as available for sale simultaneously with the adoption of SFAS
No. 159, what effect would the election have on its financial statements?

 Case 10-6 Accounting for Investments

Presented below are four unrelated situations involving equity securities that have readily determinable fair
values.

Situation 1
A noncurrent portfolio with an aggregate market value in excess of cost includes one particular security whose
market value has declined to less than half of the original cost. The decline in value is considered to be other
than temporary.

Situation 2
The balance sheet of a company does not classify assets and liabilities as current and noncurrent. The portfolio
of marketable equity securities includes securities normally considered to be trading securities that have a net
cost in excess of market value of $2,000. The remainder of the portfolio is considered noncurrent and has a net
market value in excess of $5,000.

Situation 3
A marketable equity security, whose market value is currently less than cost, is classified as a noncurrent
security that is available for sale but is to be reclassified as a trading security.

Situation 4
A company's noncurrent portfolio of marketable equity securities consists of the common stock of one
company. At the end of the prior year the market value of the security was 50 percent of original cost, and the
effect was properly reflected in the balance sheet. However, at the end of the current year the market value of
the security had appreciated to twice the original cost. The security is still considered noncurrent at year-end.

Required:
Determine the effect on classification, carrying value, and earnings for each of the preceding situations.
Complete your response to each situation before proceeding to the next situation.

 Case 10-7 Equity Securities: GAAP versus IASB Standards

SFAS No. 115 prescribes the accounting treatment for investments in equity securities having readily
determined fair values for which the equity method and consolidation do not apply. IAS No. 39 prescribes
international accounting practice for similar securities.

Required:

a. Compare and contrast U.S. GAAP for investments in equity securities

under SFAS No. 115 with the provisions of IAS No. 39.
b. Discuss whether U.S. GAAP under SFAS No. 115 or the requirements
of IAS No. 25 are more consistent with the following concepts:
i. Conservatism
ii. Comparability
iii. Relevance
iv. Neutrality
v. Representational faithfulness
vi. Physical capital maintenance
  Case 10-8 Accounting for Goodwill
Kallus Corp. is an industry leader in the manufacture of toys. Each year, its design staff comes up with new
ideas that are a great success. As a result, Kallus's sales and profits consistently exceed those of other toy
manufacturers. Over the past 10 years, Kallus has earned average net profits of $189 million, compared to
$122 million for the typical company in the toy industry.

Required:
Answer the following questions:

a. Does Kallus have goodwill? Explain.

b. Is goodwill an asset? Explain. (Does it meet the definition of an asset found
in SFAS No. 6?)
c. If you believe Kallus has goodwill, how would you go about measuring it?
Explain.
d. Should Kallus Corp. report goodwill in the balance sheet? Why, or why not?

FASB ASC Research

For each of the following research cases, search the FASB ASC database for information to address the issues.
Copy and paste the FASB paragraphs that support your responses. Then summarize briefly what your
responses are, citing the pronouncements and paragraphs used to support your responses.

 FASB ASC 10-1 Debt and Equity Investments

A variety of authoritative accounting pronouncements have addressed accounting for debt and equity
investments.

1. Summarize the current accounting treatment for investments in debt and

equity securities.
2. The EITF has addressed many implementation issues for accounting for
investments in debt and equity securities. List five of these issues.

 FASB ASC 10-2 Research and Development

In addition to the FASB's statement on accounting for research and development activities, the EITF has
addressed three implementation issues. List and briefly summarize each of these issues.

 FASB ASC 10-3 Best-Efforts Basis, Research and Development Cost-Sharing

Arrangements
The FASB ASC provides guidance on accounting for best-efforts basis, research and development cost-sharing
arrangements by federal government contractors. Find, cite, and copy that guidance.

 FASB ASC 10-4 Direct-Response Advertising

The FASB ASC contains guidance on accounting for direct-response advertising that can result in reported
assets. Search the FASB ASC and find answers to the following questions:

1. How are such assets to be measured initially?

 2. How will the amounts ascribed to such assets be amortized?
3. How can the realizability of such assets be assessed?
4. What financial statement disclosures will be made about advertising?
(Be sure to cite the appropriate FASB ASC paragraph in answering each question.)

 FASB ASC 10-5 Accumulated Losses on Equity Method Investments

The FASB ASC contains guidance on how to account for equity investments when accumulated losses by the
investee have resulted in the investment account of the investor being reduced to zero. Find, cite, and copy that
guidance.

 FASB ASC 10-6 Intangible Costs

The FASB ASC contains guidance on various intangible costs incurred by entities in the cable television
industry. Search the FASB ASC for answers to the following questions:

1. What is the prematurity period for these entities?

2. How are programming costs recorded during the prematurity period?
3. How should franchise application costs be recorded by these entities?
4. How should capitalized costs be amortized by these entities?

Room for Debate

 Debate 10-1 SFAS No. 115

SFAS No. 115 (see FASB ASC 320) was issued in response to concerns by regulators and others regarding the
recognition and measurement of investments in debt securities. For the following debate, you may consider
tying your arguments to theories of capital maintenance and/or the conceptual framework.

Team Debate:

Team Present arguments supporting the provisions of SFAS No. 115, now contained in FASB ASC 320.
1:

Team Present arguments describing the deficiencies of SFAS No. 115, now contained in FASB ASC 320.
2:

 Debate 10-2 Goodwill

Under current GAAP, goodwill is recorded when purchased. For the following debate, you may consider tying
your arguments to theories of capital maintenance and/or the conceptual framework.

Team Debate:

Team Present arguments in favor of the capitalization of “purchased” goodwill.

1:

Team Present arguments against the capitalization of “purchased” goodwill.

2:
  Debate 10-3 The Fair Value Option
Under current GAAP, companies may opt to report financial assets and liabilities at fair value.

Team Debate:

Team Present arguments in favor of the fair value option for financial assets and liabilities.
1:

Team Present arguments against the fair value option for financial assets and liabilities.
2:
1. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 115, “Accounting for Certain
Investments in Debt and Equity Securities” (Stamford, CT: FASB, 1993), para. 137.
2. Allowing investors to maintain their proportionate share of ownership is one of the basic rights of common stock
ownership. This is referred to as the preemptive right.
3. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 94, “Consolidation of All
Majority Owned Subsidiaries” (Stamford, CT: FASB, 1988), para. 13.
4. Accounting Principles Board, Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock”
(New York: AICPA, 1971). Para. 17 (see FASB ASC 323-10-15-6).
5. ARB No. 51 did not refer to the equity method by name.
6. Committee on Accounting Procedure, Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (New
York: AICPA, 1959), para. 19. The APB reiterated this position in APB Opinion No. 10, “Omnibus Opinion of 1966” (para.
3) and referred to the procedure described in ARB No. 51 as the equity method.
7. Accounting Principles Board, Opinion No. 18.
8. Ibid., para. 14.
9. Ibid.
10. Ibid.
11. Financial Accounting Standards Board, Interpretation No. 35, “Criteria for Applying the Equity Method of Accounting
for Investments in Common Stock” (Stamford, CT: FASB, 1981), para. 4.
12. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 115, “Accounting for Certain
Investments in Debt and Equity Securities” (Stamford, CT: FASB, 1993). (See FASB ASC 320-10-20.)
13. Ibid., para. 12 (see FASB ASC 320-10-20).
14. Ibid. (see FASB ASC 320-10-20).
15. Ibid., para. 15 (see FASB ASC 320-10-35-10).
16. SFAS No. 159, para. 1.
17. Eligible items also include firm commitments and insurance company riders, which are not discussed here (see FASB
ASC 825-10-25-4).
18. Ibid., para. 7 (see FASB 320-10-25-3).
19. Ibid., para. 16 (see FASB ASC 320-10-35-30).
20. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 114, “Accounting by Creditors
for Impairment of a Loan” (Stamford, CT: FASB, 1993). (See FASB ASC 310-10-35.)
21. Ibid., para. 8 (see FASB ASC 310-10-35-2.)
22. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 125, “Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (Stamford, CT: FASB, 1996).
23. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 140, “Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—A Replacement of FASB Statement No.
125” (Stamford, CT: FASB, 2000), 17 (see FASB ASC 860-10-05).
24. Servicing of financial assets typically includes the following: collecting principal, interest, and escrow payments from
borrowers; paying taxes and insurance from escrowed funds; monitoring delinquencies; executing foreclosures, if necessary;
temporarily investing funds pending distributions; remitting fees to guarantors, trustees, and others providing services; and
accounting for and remitting principal and interest payments to the holders of beneficial interests in the financial assets.
FASB ASC 850-50-30 requires the recording of a servicing asset when the benefits of servicing are expected to be more than
adequate compensation to a servicer for performing the servicing; however, if the benefits of servicing are not expected to
adequately compensate a servicer for performing the servicing, a servicing liability is recorded.
25. Eric L. Kohler, A Dictionary for Accountants, 3rd ed. (Englewood Cliffs, NJ: Prentice-Hall, 1963), 269.
26. William A. Paton and William A. Paton, Jr., Asset Accounting (New York: Macmillan, 1952), 485–490.
27. Accounting Principles Board, APB Opinion No. 17, “Intangible Assets” (New York: AICPA, 1970) (superseded.)
28. Ibid., para. 24.
29. Committee on Accounting Procedure, Accounting Research Bulletin No. 43, “Restatement and Revision of Accounting
Research Bulletins” (New York: AICPA, 1953), 6019 (superseded.)
30. APB Opinion No. 17.
31. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 142, “Goodwill and Other
Intangible Assets” (Norwalk, CT: FASB, 2001).
32. J. M. Yang, Goodwill and Other Intangibles (New York: Ronald Press, 1927), 29.
33. George R. Catlett and Norman O. Olson, Accounting for Goodwill (New York: AICPA, 1968), 20–21.
34. In certain cases, goodwill is recognized when a new partner is admitted to a partnership or when a partner leaves a
partnership.
35. The Revenue Reconciliation Act of 1993 allows goodwill to be written off over a 15-year period for income tax
purposes. Consequently, a new income tax temporary difference was created by this legislation, and the previous permanent
difference has been eliminated. See Chapter 12 for a discussion of this issue.
36. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 141, “Business Combinations”
(Norwalk, CT: FASB, 2001).
37. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 142, “Goodwill and Other
Intangible Assets” (Norwalk, CT: FASB, 2001).
38. This issue is discussed in Chapter 16.
39. See FASB ASC350-20-20.
40. FASB ASC 280-10-50 (see Chapter 16 for a further discussion of this issue).
41. Donald L. Madden, Levis D. McCullers, and Relmond P. Van Daniker, “Classification of Research and Development
Expenditures: A Guide to Better Accounting,” CPA Journal (February 1972): 139–4.
42. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 2, “Accounting for Research
and Development Costs” (Stamford, CT: FASB, 1974), para. 8 (see FASB ASC 730-10-20).
43. Gary M. Entwistle, “Exploring the R & D Disclosure Reporting Environment,” Accounting Horizons 14, no. 4
(December 1999): 323–341.
44. The discussion of accounting for financial liabilities under IAS No. 39 is contained in Chapter 11.
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