To record, disclose or neither — that is the question
By Ayushi Jain
Sometimes the toughest part of an accounting transaction is not “how” to record it, but “whether” you need to record and/or disclose it.
Different types of transactions have different presentation and disclosure requirements, and thus this analysis requires sound professional judgement and knowledge of GAAP. Depending upon the specific situation, it can sometimes change a company’s financial statements by millions of dollars.
Below are six examples of such circumstances. As you will notice, each yields a slightly different result.
At times, your company may fall into a condition, situation or set of circumstances that involves uncertainty, resulting in a possible gain or loss that will ultimately be determined when a future event occurs or fails to occur. Technically, these are called contingent events.
The relevance of a contingent liability depends on the likelihood of the contingency becoming an actual liability and the accuracy with which the amount associated with it can be estimated. Accuracy here may be defined in terms of probable ranges as well.
How should you handle contingent events?
If the future event is likely to occur and confirms a contingent loss, you will record a liability. For example, if it’s probable that, as of the date of a financial statement, a situation exists where an asset has been impaired or a liability will be incurred due to lawsuit and based on the information available prior to the issuance of the financial statement and the amount of loss can be reasonably estimated, you will record the liability at the balance sheet date.
If the future event is more than remote, but less than likely to occur, you will simply disclose the contingent liability in footnotes. This disclosure does need to provide the reader details on the situation and possible loss or range of loss, or a statement that an estimate cannot be made.
If the future event has a remote chance of occurring, you will generally not record or disclose such events. Examples of events you do not record or disclose would be frivolous lawsuits. If the company and the company’s attorney agree that the chance of trial or settlement is slight, no adjustment or disclosure is made.
An event or transaction that occurs after the balance sheet date but before the financial statements are issued or are available to be issued are subsequent events that a financial statement preparer and auditor need to take into consideration before issuing the audit report.
When should you record and when should you disclose?
If the event provides additional information about conditions that existed at balance sheet date, you will recognize the subsequent event by recording the transaction at the balance sheet date and disclosing details surrounding the transaction.
Here’s an example: Company A is involved in litigation with a former customer. At 12/31/x1, the Company finds it probable that there will be a settlement, and the best estimate of that liability is $100,000. However, on 2/14/x2, the settlement is completed, and the final amount is $250,000. The financial statements have not yet been finalized, and since the litigation existed at the balance sheet date (12/31/x1), this subsequent information provides information about that litigation and Company A will adjust the accrual to $250,000 on the 12/31/x1 financial statements.
Another example of a recognized subsequent event is when an allowance for doubtful accounts exists for a particular customer and then after year-end, you find out that the customer filed for bankruptcy. Even if the bankruptcy was filed after year-end, it gives more information about a circumstance that already existed at the balance sheet date (the doubt of the customer’s ability to pay).
If the event provides additional information about conditions that did not exist at balance sheet date, you will not recognize the subsequent event. You will only disclose a description of the event (if material) in the footnotes.
Some examples of nonrecognized subsequent events include business combinations, issuance or restructuring of debt, loss of plant or inventory due to fire or natural disaster, significant change in fair value of asset or liability, or decisions to liquidate the company or certain segments of the company (among others).
What qualifies as a related party?
The Financial Accounting Standards Board (FASB) codification provides examples of related parties that are not limited to but include:
- Principal owners and management of a company and members of their immediate families
- Relationships in which either party can (directly or indirectly) significantly control or influence (i.e., affiliates) the other party
- Entities that the company owns an equity interest in
- Pension or profit-sharing trusts managed or under the trusteeship of management for the benefit of employees’
What are examples of related-party transactions that require disclosure?
Typical related-party transactions that require disclosure are sales and purchases, amounts owed to or due from at year-end, transfer of real and personal property, services received and furnished, leases of property, borrowing an lending, guarantees and many others.
How do you handle the disclosure of related party transaction?
In general, any related-party transaction should be disclosed if it is material or would impact the decision making of the users of the company’s financial statement. However, compensation arrangements, expense allowances and other similar items carried in the ordinary course of business do not need disclosure. Also, transactions that are eliminated in the preparation of consolidated or combined financial statements are also not required to be disclosed.
Did you know?
An entity may receive services from a related party without charge and not record receipt of the services. While recording of these transactions depend on several circumstances, GAAP requires their disclosure, nonetheless. Additionally, when disclosing related party information, do not state or imply that the transactions were on arm’s-length basis, unless you can substantiate the claim.
Variable interest entities
Sometimes related-party relationships between entities can elevate that relationship into required consolidation of one entity into another. While the examples in the previous section focused on disclosure only, if it is determined your relationship qualifies as a variable interest entity (VIE), it may require consolidation, regardless of ownership.
In order to identify whether an entity is a VIE, the FASB focused primarily on two main features: insufficiency of equity at risk and lack of control by the apparent voting shareholders.
Read more: What is a VIE, and do you have one?
Let’s say you changed your inventory accounting from LIFO to FIFO. Do you need to disclose that? Do you need to retroactively record the effects of that change? How about a change in estimate? Does that need to be recorded back to a prior year?
Changes in accounting and financial reporting are inescapable. Most happen because in preparing periodic financial statements, companies must make many estimates and judgements. Other changes arise from management decisions about the appropriate accounting methods for preparing the statements. And sometimes, you simply find an error in a prior year.
When the change is due to “the change in accounting principle”: Newly issued accounting standard updates (ASUs) prescribe the transition and disclosure guidance for the period of adoption. Voluntary changes should always be applied retroactively to the beginning of the earliest period presented in the financial statements. The disclosure for the same must include description of change, reason for change, why the change is preferable, method for applying the change and summary of financial statement line item(s) that changed.
When the change is due to “the change in accounting estimate”: Apply the effect of the new estimate prospectively by adjusting the current year numbers without any change in prior period numbers. If the change affects net income, other appropriate captions or related per share amount in current year, those impacts must be disclosed.
When the change is due to “error correction”: It may have to be reported in the current and prior year financial statements, depending on the nature and magnitude of the error.
Read more: AA-ASC 250 correcting financial statement errors
Your first reaction here might be, “Well, that’s an auditor thing.” However, GAAP actually requires management to correctly assess and disclose potential going concern based on the facts and circumstances present.
A fundamental decision management has to make in preparing annual financial statements is whether to prepare them on a going concern basis. Generally, the entity is assumed to be going concern in absence of significant information to the contrary.
The dilemma: substantial doubt about an entity’s ability to continue as going concern
There is no perfect answer to this dilemma, but some of the scenarios that create substantial doubt about an entity’s ability to continue as going concern are:
- Negative trends in operating results
- Loan defaults by the company
- Denial of trade credit to the company by its suppliers
- Uneconomical long-term commitments to which the company is subjected
- Legal proceedings against the company
How do you handle the disclosure of substantial doubt?
If there is substantial doubt about an entity’s ability to continue as going concern, but the substantial doubt is alleviated as a result of management’s plans, the financial statements should include disclosure stating primary conditions or events that raise substantial doubt, management’s evaluation of significance and the plan that alleviated substantial doubt.
If there is substantial doubt about an entity’s ability to continue as going concern, but the substantial doubt is not alleviated as a result of management’s plans, the financial statement disclosures must state that there is substantial doubt about entity’s ability to continue as going concern within one year of the financial statement issuance date.
How Wipfli can help
Making a professional judgement can be difficult, and there is not always a clear-cut correct answer. Being able to make good judgements is the essence of each profession and hinders on the ability to correctly interpret the hundreds of thousands of pages of GAAP guidance. If you have questions, please reach out to Wipfli for assistance.
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Wipfli Editorial Team