USA Accounting Terminologies


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What do the terms “economic substance“ and “ economic consequence” mean?
 
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Werner Reisacher

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use the following google search term:

define:economic substance
define:economic consequence

don't put a space after define:

The first term is mainly used by Tax layers in their appeals against tax assessments and related penalties and during court hearings. since the outcome largely depends on whether the financial transactions in question have or don't have economic substance or a business purpose.

The second term is mainly used in connection with the impact on economies such as wars, and depressions, and the various possibilities to mitigate such impacts.
 
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Too broad. Use in a sentence.
An example of economic substance is “action refers to the substance of the transaction—the actual earning of the revenue or using the expense item. A customer buys on credit and agrees to pay later. The action of making the sale—the economic substance of the transaction—takes place before dollars are exchanged in payment.“

An example of economic consequence is “That is not to say that politics in establishing GAAP is a negative force. Considering the economic consequences of many accounting rules, special interest groups should vocalize their reactions to proposed rules.”
 

kirby

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OK, got it now.
"Substance" is an accounting term of art. Usually used in the phrase "substance over form". Substance over form boils down to asking the accountant to look at the true colors- the "guts" of a transaction, even if the legal form tries to tell you otherwise, and to account for it based on its substance, i.e. its reality.
So in the example you gave, it says the guts of the sale is the agreement to buy and not the settlement payment later on. In this case, it is why the accountant will use accrual accounting to record sale on day of agreement and not record the sale on date of payment, which is cash accounting.

Economic consequences is a term used when discussing how a new accounting rule or a change in an existing accounting rule will affect financial statements (e.g. now cause accounting income to decrease or increase) and the further affect on people, particularly shareholders of affected companies.
I attached a great Harvard Business article on the topic. Years ago, the FASB made a rule change which affected the pocketbooks of the corporate types. The corporate types lobbied Congress to try to get FASB to revoke the rule. Seriously!

 
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So in this sense, legal form is when cash is paid, rather than the substance form when revenue is earned and expense is incurred, is that right?
 
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OK, got it now.
"Substance" is an accounting term of art. Usually used in the phrase "substance over form". Substance over form boils down to asking the accountant to look at the true colors- the "guts" of a transaction, even if the legal form tries to tell you otherwise, and to account for it based on its substance, i.e. its reality.
So in the example you gave, it says the guts of the sale is the agreement to buy and not the settlement payment later on. In this case, it is why the accountant will use accrual accounting to record sale on day of agreement and not record the sale on date of payment, which is cash accounting.

Economic consequences is a term used when discussing how a new accounting rule or a change in an existing accounting rule will affect financial statements (e.g. now cause accounting income to decrease or increase) and the further affect on people, particularly shareholders of affected companies.
I attached a great Harvard Business article on the topic. Years ago, the FASB made a rule change which affected the pocketbooks of the corporate types. The corporate types lobbied Congress to try to get FASB to revoke the rule. Seriously!

I read the article you posted in this message. I wonder why FASB wants to have companies recognize an expense when the compensation hasn’t actually given out to the recipients? They recognize the compensation expense when the employees earned it. What is the theory behind this?
 

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Theory is accrual accounting. FASB said when the comp was earned then recognize the cost because the company now has an obligation to pay.
There is more to this story. The SEC actually issued staff accounting bulletin #107, which required accrual accounting for options, a year BEFORE FASB had to take a similar action.
 

Werner Reisacher

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Very interesting discussion. Let me add some more input to my previous posting.

  • The word “substance” really goes back to the fundamental difference between interpreting the law strictly by the letter, or by its spirit. In countries that are ruling under the common law, selling a house for $ 1 is legally correct, as long as all legal formalities are adhered to. The IRS rules under the Internal Revenue Code based on which they would declare such a transaction as “having no substance” – or short, does not make any common sense. The purpose of the transaction was to gain a fiscal benefit and not to fulfil a business purpose.
  • Stock-option: At the beginning of the New Economy, stock options got out of control. Founders and other top executives of public companies used “stock options” as “funny money” to fill their pockets. Before the law changed, such payments were booked directly against retained earnings, and did not affect the current years profit, did not impacted the financial analysis and ratios of the current year, and unless the shareholder did his due diligent work, he was not really aware of the magnitude of these payments.
  • Having to book these “give a way” against current year profit, the shareholders do have now visibility and these payments are now reflected in the financial ratios of the current year.
  • In addition, companies have to set up provisions for the accumulating debts under these plans.
  • The result is a transparent situation about what is going on.
 
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In the case of Chen Company, assume that the expected period of benefit is two years, starting with the grant date.

To record compensation expense for 2017 (December 31, 2017)

Compensation Expense 110,000
Paid-in Capital—Stock Options 110,000

($220,000 ÷ 2)

What if the company did not spent all of its $220,000 stock options, does the company go back and adjust the expense that they estimated in the beginning?

Why is paid-in capital—stock options credited? Paid-in Capital is the investment of owners. So owners have made investments in stock option?
 
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kirby

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Depends if option holder was still employed. See your acctg book under "Expiration of Options" as to the two possibilities. C'mon acctg student! Ya got the answers right near you (the book).

The journal entry credit side amounts related to stock options are always a part of equity. Sometimes someone buys a stock option and the credit side of the entry increases Paid in Capital - stock options account. When options are granted to employees, the Company "pays for the stock option itself" - that is it records the expense - and the credit side of the entry as usual goes to Paid in Capital - Stock Options. So yes in that sense the owners have made investments in stock options.
 

Werner Reisacher

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I take it for granted that we are all students since learning is a life long process. Thank you for reminding us.
Here is a good example of the process:
 
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Economic substance refers to a transaction that has a purpose besides the reduction of tax liability. The concept is used in the examination of tax shelters to see if they are abusing the tax laws.

Economic Consequence involves adjustments to demands and supplies of factors and goods which affect market prices and thereby shift tax burdens forwards (to consumers or producers further up the production chain)
 
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Werner Reisacher

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Anya, just to make sure that you did not get the wrong idea about the principal reason why companies started to grant stock options.
Apart from the first round in "going public" where the founders intend to exercise their rights to actually purchase the share at the offered price, stock options were granted in lieu of "bonus payments" in addition to a salary. There are two reasons why companies originally preferred this way of remuneration:
- If they promise a cash bonus, the level of the bonus is always subject to a defined target that must be met. These targets can usually be directly influenced by the employee (sales volume, # of new customers, etc.). Consequently, the person who is entitled to that bonus has an incentive to concentrate his efforts on this area only, often at the detriment of other areas that are equally important for the overall profitability of the company. (offering discounts, adding special services to large customers, etc.) All issues that are not in the sense of teamwork.
- If the target is not achieved, the person who expected the bonus is often upset and argues about the reasons why the target was unfair and could not be achieved. Not in the original spirit of granting an incentive to create loyalty.
- Bonus payments were added to the payroll expenses and consequently affected the current year's results.
- Originally, stock option payments were booked directly against the retained earnings and got, therefore, kind of buried in the Balance Sheet details.
- Stock option payments depend on the company's bottom line performance, which includes all individual targets and goals, a much better tool to sponsor teamwork.

To conclude, the word "stock" is somewhat misleading to somebody who is no familiarity with the system. Technically, an employee can actually purchase the shares offered at a price from the company and pay cash for the purchase. (Debit: Cash Credit: paid-in capital) In 98 % + of stock option exercises, individuals opt for a payout of the difference between the price offered and the market price. Consequently, the employee does not have to come up with cash to buy and sell the shares, the transaction is handled internally by the company. All the employee sees is a cash payment.
 

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