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Companies must follow a common set of rules when reporting sales, earnings, profit margins, and company growth.
As management of publicly traded companies fall under greater pressure to please Wall Street, the rules are sometimes compromised. Though most company executives go out of their way to avoid any misrepresentation of financial statements, a slate of accounting scandals has shown a greater and greater tendency to exaggerate earnings and growth in spectacular fashion – from much publicized Enron, Worldcom, and Tyco, to less prominent but equally flagrant accounting scams, companies have taken creative accounting to a new level.
Quarterly earnings are broadcast worldwide on cable news media and the internet with swift action on stock prices, while long-term vision and performance too often run a distant second but build the backbone of truly strong businesses.
Each accounting scandal seems to grow larger, with more reckless fraud than the scandal before it. Enron
Top Bankruptcies of All Time
| Company | Assets | Date | Auditor |
| Lehman Brothers |
$691 billion | Sept. 15, 2008 | Ernst & Young |
| Washington Mutual | $327.9 billion | Sept. 26, 2008 | Deloitte |
| Worldcom | $104 billion | July 21, 2002 | Arthur Andersen |
| GM | $91 billion | June 1, 2009 | Deloitte |
| Cit Group | $80.4 billion | Nov. 1, 2009 | PricewaterhouseCoopers |
| Enron |
$66 billion | Dec. 2, 2001 | Arthur Andersen |
Just as Bernie Madoff could not realistically bring consistent returns of 12% per year to investors, so companies cannot show strong growth in perpetuity without a strong possibility that something is amiss.
Growing and successful companies face tough times like everyone else. This leads to some years of inevitable underperformance, slow or disrupted growth, or disappointing earnings. Successful management responds to business challenges by creating an even stronger business poised for long-term growth, though the short-term returns will inevitably suffer with some bumps and bruises along the way.
Consistent, unrealisitc growth quarter after quarter and year after year is one of the more glaring signs of fraud. When Enron grew to $100 billion in revenues, it was almost unheard of for a company to reach that level of growth in only a few short years. It takes most companies many years, and even decades, to reach that level of success. Enron reported revenue topping $100 billion, placing it in the ranks of GE, Exxon and Wal-Mart in a fraction of the time it took other companies to reach this milestone.
Another sign of fraud is when expected earnings just meet Wall Street expectations quarter after quarter and year after year. Usually this is done on paper to align earnings with earnings expectations. In reality analysts estimates are just that – estimates that rarely predict with precision business outcomes and events from period to period. You are more likely to see some periods that exceed estimates, and some periods that disappoint Wall Street from quarter to quarter, and from year to year, even if the long-term trend is moving in a healthy pattern of growth.
Just hitting estimates from period to period is a warning sign that accountants are “rounding up,” and sometimes way up, to conveniently meet analysts expectations.
In the past 20 years accounting firms have gone from the Big Eight to the Big Six to the Big Four. The consolidation creates an oligopoly of auditing firms controlling just about every audit in public companies.
In the UK, for example, the Big Four accounting firms of PwC, Deloitte, KPMG, and Ernst & Young earned 99% of all audit fees paid by top companies. According to John Fingleton, chief executive of the Office of Fair Trading, this creates an environment that does not work well for customers due to limited competition and barriers to entry. The European Commission came to the same conclusion (Croft, Jane, “Big Four Auditors Face Competition Inquiry,” Financial Times, October 21, 2011).
The U.S. General Accounting Office, on the other hand, in its July 2003 report mandated by Sarbanes-Oxley Act to study independence and competition among Big Four auditing firms in the wake of the Enron scandal, did not find any significant problems in this marketplace, though the Big Four also represent 99% of public company audit sales in the U.S.
Consolidation of power breeds complacency and accounting fraud when partners spend years in relationships with clients that go unchecked and unchanged. Most employees of accounting firms execute due diligence and strict independence to detect any accounting fraud, but in cases where close partner relationships exist with the client, the relationships can transition from independence to concurrence and finally complicity in accounting fraud.
Here are just a few examples of missed accounting frauds:
and Worldcom, two of the biggest accounting frauds in history. from hiding massive losses on its balance sheet, and is currently being sued by New York for helping its client “engage in a massive accounting fraud.”Yes, financial statements are audited, but as an investor you must be aware of the signs of accounting fraud. After all, the biggest accounting frauds in history all had a Big Four auditing firms sign off on the financial statements.
GAAP permits two methods for estimating the bad debt expense and the allowance for doubtful accounts:
Whereas the percentage of credit sales emphasizes matching the bad debt estimate with the same credit sales for the period, the percentage of ending accounts receivable emphasizes reporting accounts receivable at the net realizable value.
For example, if Sunny estimates that 3% of his ending accounts receivable balance of $21,900 is uncollectible, the ending balance in the allowance account should be 21,900 x 3% = 657. Note that this balance is maintained from year to year. Since this is Sunny’s first year in business, the entry is for the full amount:
To record estimated bad debt expense for the year:
| Date | Account and Explanation | Reference | Debits | Credits |
| Dec. 31 | Bad Debt Expense | 525 | $657 | |
| Dec. 31 | Allowance for Doubtful Accounts | 111 | $657 |
If, on the other hand, the balance in the allowance account was already $500 from previous years, the additional amount to increase the allowance account to match the percentage of accounts receivable would be:
To record estimated bad debt expense for the year:
| Date | Account and Explanation | Reference | Debits | Credits |
| Dec. 31 | Bad Debt Expense | 525 | $157 | |
| Dec. 31 | Allowance for Doubtful Accounts | 111 | $157 |
Note that the percentage of sales journal entry is for the full amount of the percentage of credit sales from year to year, while the percentage of accounts receivable journal entry is made to adjust the balance to the new required balance as determined by the percentage of ending accounts receivable.
Similar to the percentage of accounts receivable, aging of accounts receivable estimates the amount of uncollectible accounts based on the accounts receivable ending balance. Aging considers that the longer an account is outstanding, the more likely it is that it will not be collected. Aging of accounts receivable therefore prepares an estimate based on the length of time each account is outstanding. The following table demonstrates aging of accounts receivable:
Aging of Accounts Receivable
| Age (Days) | Amount | Percent Estimated Uncollectible | Required Ending Balance in Allowance Account |
| Less than 30 | 12,045 | 1% | $120 |
| 30-90 | 7,884 | 3% | $237 |
| Over 90 days | 1,971 | 15% | $296 |
| Total | $21,900 | $653 |
Sunny would make the following entry to estimate the bad debt based on the aging of accounts receivable:
To record estimated bad debt expense for the year:
| Date | Account and Explanation | Reference | Debits | Credits |
| Dec. 31 | Bad Debt Expense | 525 | $653 | |
| Dec. 31 | Allowance for Doubtful Accounts | 111 | $653 |
The $653 is the amount required in the allowance account. Since this was Sunny’s first year in business, the full amount is entered. However, similar to the percentage of ending accounts receivable, had a balance already existed in the allowance account, the amount required would be an adjustment to arrive at the final balance of $653. Assuming a debit balance of $500 in the allowance account, the entry would then be as follows:
To record estimated bad debt expense for the year:
| Date | Account and Explanation | Reference | Debits | Credits |
| Dec. 31 | Bad Debt Expense | 525 | $1,153 | |
| Dec. 31 | Allowance for Doubtful Accounts | 111 | $1,153 |
When Sunny knows the accounts receivable balance will not be paid by a customer, he debits allowance for doubtful accounts and credits accounts receivable. The estimate was already carried on the income statement in bad debt expense to match the sales with the estimated bad debt. For example, if a customer goes bankrupt and does not pay $500, Sunny would make the following entry.
To write off accounts receivable balance:
| Date | Account and Explanation | Reference | Debits | Credits |
| Jan. 5 | Allowance for Doubtful Accounts | 111 | ||
| Jan. 5 | Accounts Receivable | 110 | $500 |
The net realizable value of accounts receivable is not affected since allowance for doubtful accounts carried the estimate for bad debt as a contra account to accounts receivable on the balance sheet.
If the customer previously written off under accounts receivable sends in a check for $500, the entry to restore the account is similar to restore the accounts and record the cash received.
To restore accounts receivable and record payment:
| Date | Account and Explanation | Reference | Debits | Credits |
| Feb. 15 | Accounts Receivable | 110 | $500 | |
| Feb. 15 | Allowance for Doubtful Accounts | 111 | $500 | |
| Feb. 20 | Cash | 100 | $500 | |
| Feb. 20 | Accounts Receivable | 110 | $500 |
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For accounts receivable, for example, net realizable value refers to the amount of cash the company expects to receive from its accounts receivable, which is the balance net of estimates for bad debts.
Inventory items are recorded at historical cost at the time of purchase. Like other asset examples in GAAP’s mixed rules, however, historical cost is only the starting point of recording the asset’s book value.
Fixed assets are subject to depreciation, goodwill and land are subject to write-downs from impairment, and accounts receivable values are subject to write downs due to estimates for bad debt. Assets are therefore recorded at historical cost, and adjusted to the net realizable value on the balance sheet. (Note that these assets are never written up under current U.S. GAAP. However, the transition to replace historical cost recognition with fair value recognition is currently under review as part of the convergence to international accounting standards).
Similarly, recognizing inventory at the net realizable value is a departure from historical cost. Inventory items are especially subject to lost value due to damage, spoilage, obsolescence, or lower demand resulting in discounted items. GAAP requires an annual test to adjust the balance to the lower of cost or market, or LCM. The test is required so that losses on inventory are matched with earnings for the same period. This prevents the reporting of inflated earnings for the same period discounted inventory items are sold.
At year end, remaining inventory items are measured at the lower of cost or market, or LCM. This means that any items remaining are compared to the current replacement value. If the current replacement value is less than the historical cost, the items are adjusted down to the replacement cost, or market, to account for the lost value. If the current replacement cost is greater than the historical cost, the items remain at historical cost, acquiring the name Lower of Cost or Market.
In the context of inventory valuation and lower of cost or market, net realizable value takes on a meaning very specific to inventory. It is defined as the estimated selling price minus all estimated selling costs and costs to complete the product. For example, if Sunny sells sunglasses for $50 and estimates that each sale costs $1.18 in advertising costs, the net realizable value for a pair of sunglasses is equal to $48.82.
Net realizable value is then used to calculate the ceiling and floor on the replacement cost (market).
| 1). Determine the historical cost of inventory (typically based on LIFO, FIFO, average cost, etc.). 2). Obtain the market value, or the replacement cost of the inventory item. 3). Calculate the net realizable value of the inventory item, used as the ceiling for the market price. 4). Calculate the net realizable value less the normal profit margin for inventory, used as the floor for the market price. 5). Determine the market value of the inventory.
6). Compare the historical cost from Step 1 with the market value in Step 5, and use the lowest amount for the inventory item (LCM). |
For example, if Sunny sells sunglasses for $50 and incurs no additional selling expenses, the NRV equals the selling price of $50 as in Item A below. If Sunny estimates that each sale costs $1.18 in advertising costs, and also offers custom fitting that costs $5 per sale, the NRV equals $43.82 (50 – 1.18 – 5) (see item B below).
For Item A, the market price of $16 is within the range of the $50 ceiling and the $15 floor. Consequently, the replacement cost of $16 is compared to the historical cost of $15 to determine LCM. Because the historical cost of $15 is less than the replacement cost of $16, LCM is $15.
For Item B, the market price of $14 is within the range of the NRV ceiling of $43.82 and the NRV floor of $8.82, so the market price of $14 is compared to the cost. Since the original cost is $15, the LCM equals $14.
| Inventory Item | Historical Cost (LIFO, FIFO, etc.) | Replacement Cost (market) | Estimated Selling Price | Cost to Complete (to calculate NRV) | Normal Profit Margin % | Normal Profit Amount (to calculate floor) |
| A | $15 | $16 | $50 | $0 | 70% | $35 |
| B | 15 | 14 | 50 | 6.18 | 70% | 35 |
| C | 25 | 10 | 100 | 15 | 70% | 70 |
| D | 40 | 35 | 60 | 30 | 40% | 24 |
| Inventory Item | Historical Cost |
Replacement Cost (market) | NRV (Ceiling) | NRV less profit (floor) | Market | LCM | |
| A | $15 | $16 | $50 (50-0) | $15 (50-35) | $16 | $15 | |
| B | 15 | 14 | 43.82 (50-6.18) | 8.82 (50-6.18-35) | 14 | 14 | |
| C | 25 | 10 | 85 (100-15) | 15 (100-15-70) | 15 | 15 | |
| D | 40 | 35 | 30 (60-30) | 6 (60-30-24) | 30 | 30 | |
Notice that item C uses the floor for the market replacement value, since the replacement cost of $10 falls below the NRV floor of $15. Similarly, Item D uses the NRV ceiling of $30 since the replacement cost of $35 exceeded the NRV ceiling limitation of $30.
Determing Market Value in LCM
| Market value in LCM is the current replacement cost not exceeding the ceiling of net realizable value (selling price less costs) and not below the floor of NRV adjusted for a normal gross profit margin (NRV – normal profit margin). |
Generally falling replacement costs indicate loss of inventory utility which transfer to falling selling prices. Rising replacement costs indicate increasing selling prices, which is the underlying logic of LCM valuation.
In cases where the selling price falls disproportionately to the replacement cost, the gross profit relationship, typically 70% for Sunny Sunglasses Shop, is no longer valid. The ceiling prevents additional losses from occurring in the future when the selling price is falling faster than the replacement cost. For example, Sunny would not pay $35 to sell an item for $30 as in item D, so the value of inventory would not be greater than its NRV of $30 in future periods when the items is sold.
Similarly, a floor is put in place to prevent unrealistic profits in the future when the replacement cost is falling faster than the selling price. Normally, Sunny would receive 70% gross profit on average for Item C. The replacement cost fell below the normal profit margins of 70%, so the NRV “floor” is put in place as a more accurate measure of inventory utility. When the items are sold in the future, unrealistic profits over the normal profit margin are prevented. The ceiling and floor maintain normal profit margins and prevent the reporting of exaggerated losses and gains in the future respectively when the newly valued inventory items are later sold.
Inventory write downs may be recorded in COGS, or, if material, recorded as a debit to a loss account, and a credit either directly to the inventory account, or a valuation inventory account, a contra account, for inventory.
Firms try to avoid carrying excess inventory while meeting current demand to avoid inventory obsolescence that would lead to write downs and lost value.
This is especially important for retailers of fashion goods, seasonal goods, and goods that rely on rapidly changing technologies like PC’s, microprocessors, and other hardware. Companies use the inventory turnover ratio to monitor appropriate inventory levels.
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| Fixed assets are recorded at historical cost per US GAAP requirements. |
The main difference between land and other property plant and equipment is that land is not subject to a depreciation expense, but retains its value at its historical cost for years or even decades.
Land is recorded on a company’s balance sheet at historical cost. As many years or even decades go by, the market value of the land may be substantially different from the value originally recorded. In real estate markets like New York, Chicago, or San Francisco where companies acquired land for a fraction of what the market would demand even today, the balance sheet still reflects the purchase of land at its historical cost.
Permanent land improvements can increase the recorded value of land, such as landscaping, sewer installation, and other permanent improvements. Improvements that are not permanent, however, such as fences and parking lots, are recorded in a separate account and depreciated similar to plant and equipment.
Like other property plant and equipment, write-downs may occur for impairments to land, such as the detection of a toxic waste site nearby or on the land. Otherwise, land remains on the balance sheet at the original or historical cost the company paid for it.
Buildings, plant, and equipment are recorded at historical cost and depreciated over the useful life of the asset. This includes vehicles, trucks, computers, plants, equipment, and other assets that are considered “used up” over time. The historical cost recorded also includes freight charges, in-transit insurance, applicable taxes, assembly, installation, testing, and any other costs necessary to get the equipment operational. Depreciation then aims to measure the consumption of the asset over time, eventually reducing the value to zero.
For example, an asset acquired for $10,000 with a ten year useful life and depreciated evenly over time, called the “straight – line method,” would incur a $1,000 depreciation expense annually until the asset value is zero on the balance sheet. The $1,000 depreciation expense is a real expense that reduces net income each year.
Therefore, buildings, machinery, and equipment are recorded at historical costs but adjusted for depreciation over time. The asset may still produce and have value after it is fully depreciated, but the asset value will not be reflected on the balance sheet after it is fully depreciated.
If Sunny sold the asset recorded at $10,000 less $5,000 depreciation expense after five years for $5,500, Sunny would recognize a realized gain of $500 against the fair value of $5,500.
Sale of Equipment
| Account and Explanation | Debits | Credits |
| Cash | $5,500 | |
| Accumulated Depreciation | ||
| Equipment | $10,000 | |
| Gain on Sale of Equip. | $500 | |
| To record sale of asset at original cost less depreciation. |
Therefore, assets on the balance sheet are recorded at historical cost less depreciation until sold.
Once the asset is sold, a realized gain or loss is recognized for the fair value of the asset against its book value (historical cost less depreciation).
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| Accountants in the U.S. are required to measure financial information using the historical cost principle. |
Reporting at historical cost is only the starting point. Asset values on the balance sheet follow a mixed set of accounting rules and regulations. This currently makes financial reporting somewhere in between reliable and relevant.
The current practice of applying different rules to different assets, liabilities, and equities is what US GAAP calls the “Mixed Matrix Model.”
For example, companies record accounts receivable based on the historical cost principle, which shows the amount originally owed to the company by customers who purchased products or services on credit. As the accounts receivable balance ages for any customers, it becomes more unlikely that the company will collect the amount owed. GAAP requires that companies estimate and report an amount for uncollected accounts receivable. Therefore, companies report accounts receivable using the historical cost principle, adjusted to the net realizable value, or the accounts receivable balance less estimates for uncollectible amounts.
As we have seen, Sunny estimated 1% of his receivables as uncollectible. This amount is subtracted from the account receivable balance to arrive at the reportable amount of receivables on the balance sheet. He records the same amount in an expense account to show the bad debt expense on the profit and loss statement associated with uncollectible receivables. Therefore, uncollectible receivables reduces both the accounts receivable asset on the balance sheet and the net earnings on the income statement for the period.
Estimates for Bad Debts Affects the Balance Sheet and Income Statement
| Estimates for uncollectible receivables reduces both the account receivable asset on the balance sheet, and net earnings on the income statement. |
Companies use the accounts receivable turnover ratio to measure whether or not the company is effectively collecting payments for sales on credit.
Inventory is recorded based on the historical cost principle. At year end, however, items remaining in ending inventory are measured at the lower of cost or market. This means that any items remaining are compared to the current replacement value. If the current replacement value is less than the historical cost, the items are adjusted down to account for the lost value in inventory. Inventory may lose value due to damage, spoilage, obsolescence, or lower demand resulting in discounted items.
In the retail industry, holding inventory for too long can lead to inventory write-downs due to seasonality. Companies use the inventory turnover to monitor appropriate inventory levels.
Buildings, plant and equipment are recorded based on the historical cost principle, and, unlike land, are depreciated over the useful life of the asset. This includes office furniture and equipment, computer systems, vehicles, heavy machinery, buildings, and other assets that are considered “used up” over time. Depreciation aims to measure the consumption of the asset over time, eventually reducing the value to zero. For example, an asset acquired for $10,000 with a ten-year useful life and depreciated evenly over time, called the straight-line method, would incur a $1,000 depreciation expense annually until the asset value is zero on the balance sheet. The $1,000 depreciation expense is a real expense that reduces net income each year.
Therefore, buildings, machinery, and equipment are recorded at historical costs but adjusted for depreciation over time. The asset may still produce and have value after it is fully depreciated, but the asset value will not be reported on the balance sheet after it is fully depreciated.
Land is also recorded on a company’s balance sheet based on the historical cost principle. As many years or even decades go by, the market value of the land may be substantially different from the value originally recorded. In markets like New York, Chicago, or San Francisco where companies acquired land for a fraction of what the market would demand today, the balance sheet still reflects the purchase of land at its historical cost.
Land improvements can increase the recorded value of land, such as landscaping, sewer installation, and other permanent improvements. Improvements that are not permanent, such as fences and parking lots, are recorded in a separate account and depreciated similar to plant and equipment.
Though land is not subject to depreciation, land write-downs may occur for impairments. An example of an impairment to land would be a toxic waste site. With the exception of impairments, land remains on the balance sheet at the original cost that the company paid for it.
Similar to land, goodwill is recorded at based on the historical cost principle. It is not written up to the fair value, but is tested for impairment annually, meaning the company writes down any goodwill in excess of its current value.
The transition to fair value will affect some of these accounting methods as GAAP and IASB aim to converge accounting standards worldwide.
Accounts receivable is a current asset because it represents a claim to cash that a company expects to receive within one year.
An extension of credit is offered from one company to another. For example, if one of Sunny’s customers purchases sunglasses by cash or credit card, Sunny reports the earnings as a cash sale since the store did not extend credit directly to the customer.
When the store issues credit to the customer directly, on the other hand, usually to another company, the sale is recorded in accounts receivable as opposed to cash.
Most companies do not charge interest on accounts receivable unless the account becomes past due. An extension of credit is then essentially an interest free loan to customers, and not collecting payments on time creates opportunity costs for the company. For example, the company could use the cash from sales to invest the money and earn interest, pay down debt from which the company is incurring interest expenses, or finance growth opportunities instead of having money tied up in accounts receivable in lieu of cash sales.
So why sell products on credit in the first place?
Firms expect that by selling on credit, they can achieve better sales and profits than they would if their sales were on a cash basis only. Even though a firm runs the risk of not being able to collect on some receivables, it expects that these uncollectible accounts and associated costs of credit sales will be sufficiently offset by an increase in sales and, in turn, an increase in net income.
To encourage prompt payment, companies may offer sales discounts. For example, a company may offer “2%/10, net 30.” This means if a customer purchases products and pays within 10 days, they can take 2% off the total price.
| It is always in the company’s best interest to take advantage of purchase discounts. When a company offers payment terms of “2%/10, net 30,” for example, this means if the customer purchases products and pays within 10 days, they can take 2% off the total price!
Otherwise, full payment is due within 30 days.The loss of the 2% discount in exchange for an additional 20 days to pay is equivalent to paying an annual interest rate of 36%! 360/additional days to make payment * discount rate, 360/20 * 2% = 36%! |
The reasons may vary, from economic downturns, company cash flow problems, or product or payment term disputes. Therefore, GAAP requires that companies properly estimate and report the bad debt expense from sales on credit.
| Mark-to-market is a subset of fair value accounting. Fair value accounting refers to valuing assets and liabilities on the balance sheet at fair or market value. Mark-to-market is used interchangeably with fair value accounting, though technically it means bringing gains and losses of certain financial instruments onto the income statement. |
A spotlight shined on mark-to-market accounting as the financial storm was growing and its headwinds were felt by the world economy, investment banks, insurance firms, and traditional lending banks. Financial institutions argued that mark-to-market accounting exacerbated the financial crisis by forcing holders of distressed assets such as mortgage backed securities to report items far below what they would receive in a normal market.
Banks in particular argued that writing down mortgage backed securities (MBS) and related assets put undo stress on their capital requirements, and contributed to the freezing credit markets and the overall credit crisis.
For example, when a bank must write down $100 billion in assets in mark-to-market accounting, then it removes $1 trillion in lending capacity when the bank is allowed to lend ten times their capital per regulatory requirements.
Investors have noted that the real cause of the credit crisis was not mark-to-market accounting, but highly leveraged banks, fraudulent lending, lax loan requirements, and the creation of highly risky financial instruments such as derivatives and MBS where loans were securitized and sold instead of held by the bank. There were $1.2 trillion sub-prime mortgages that were securitized and sold, about $200 – $300 billion held by FDIC insured banks, and the rest sold to the world.
Banks traditionally held loans to maturity, so lending requirements were much stricter resulting in loans of higher quality. It was in the bank’s best interest to seek high quality borrowers to maximize returns and minimize bad debts and defaults since loans were held on the books for years and even decades.
Securitization allowed banks to sell loans worldwide, thus reducing lending standards since they no longer held the loans on their own balance sheet until maturity, while creating a profitable source of loan fees and bonuses based on loan volume instead of loan quality. Mark-to-market accounting only reflected rapidly declining loan values of mortgage – backed securities due to increasingly lax lending standards made possible by selling the securities worldwide.
Blaming fair value accounting, some argued, is similar to shooting the messenger after reckless lending practices came home to roost in the form of deteriorating economic conditions of financial institutions.
Nevertheless, clarification of mark-to-market accounting was in order during market turmoil, and the SEC and Congress recommended that FASB clarify fair value accounting and specifically mark-to-market accounting (taken to earnings). In 2008 the SEC and FASB issued clarification of FAS 157 where market values in a disorderly market were not determinative when measuring fair value, and that distressed and forced liquidation sales are not orderly transactions.
| Under pressure from Congress, on April 2, 2009 FASB voted to suspend mark-to-market rules for bank assets. The ruling allows banks to ignore market prices for assets if they determine that the market is illiquid and that the most recent sales are by distressed sellers at fire-sale prices. This also increased the banks lending capacity based on newly stated capital that is no longer based on mark-to-market accounting. |
This essentially means that banks do not need to report actual losses that they are incurring from bad mortgages under pressure from Congress.
FASB released FAS No 157 effective in November of 2007 just as the financial crisis was bearing down on financial markets. FAS 157 further defined how to value financial instruments. However, FASB had been moving to fair value accounting as early as the 70’s. Although U.S. standards had stressed historical cost, the partial merge into fair value accounting created a mixed accounting model that emphasized historical cost for some assets and fair value accounting for others. For example, prior accounting standards relating to fair value include:
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FAS 157 did not add any new items requiring fair value reporting, nor does it change which assets are reported at fair value. FAS 157 clarified previous provisions that were scattered in different statements in GAAP to provide consistency and comparability for fair value accounting reporting methods. In essence, FAS 157 clarified fair value reporting under one summary statement in order to apply fair value accounting consistently.
The controversy surrounding FAS 157 , however, was that it was released just when financial markets faced enormous downward market pressure due to the housing crisis.
FAS 157 defines fair value as the price to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date.
FAS 157 establishes a hierarchy of inputs to value financial instruments:
Level 1 inputs have the highest priority and are considered the most reliable, while level 3 inputs have the lowest priority.
In the case of highly illiquid markets where level 1 inputs are no longer available, level 2 inputs may be driven by forced sales, in which case FAS 157 allows companies to use level 3 model-based fair values. However, in order to do this, firms must show that transactions are not orderly and that sales are driven by forced sales in illiquid markets under level 2. If they cannot show this, then firms must use level 2 fair values which can lead to substantial unrealized losses.
However, as previously mentioned, Congress pressured FASB to suspend mark-to-market rules for bank assets due to massive losses they would incur from mortgage-backed securities.
Thanks to the Small Business Jobs Act (SBJA) of 2010, qualifying businesses can now expense up to $500,000 of section 179 property for tax years beginning in 2010 and 2011.
For example, if you purchased a computer in 2010, you can deduct the entire cost of the computer, including sales tax, set-up fees, and shipping costs. It does not matter whether you paid cash or financed the computer. Unlike depreciation, however, you must use the asset over 50% of the time for business, and continue to use the asset over 50% during the years the asset would have been depreciated.
If you purchased a computer for $5,000 and use if for business 70% of the time, you can take a Section 179 deduction for $3,500. The remaining $1,500 is not deductible. If you used the computer 40% of the time, then you cannot take a Section 179 deduction. You can, however, depreciate the computer over 5 years based on 40% of the value of the computer ($2,000 spread over 5 years).
Click tax depreciation and section 179 for a complete discussion of section 179 tax deductions.
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