1. External Financial Statement

Question 1

Why management needs FS

Answer 1

1. Assess financial strength and weaknesses
2. Evaluate performance results and past decisions
3. Plan for the future financial goals and steps

Question 2

Overall review on BS

Answer 2

• It represents proprietary point of view whereas assets are items of value, liabilities are obligations and Equity are net worth.
• Classification between current and noncurrent whether the asset is expected to be realized/settled in an operating cycle OR 1 year which is LONGER
• Intangible assets are NON FINANCIAL assets WITHOUT physical substance
• Treasury stocks are reported either at cost or at par
• Short term obligations can be refinanced through issuance of long terms bond AFTER year end but BEFORE issuance of FS and they are considered post BS transaction. The entity should have the ability and intent to do so.
• Limitations of BS:
  1) Shows company financial position at a single point of time
  2) At historical cost
  3) Required management estimates and judgement.
• Off BS transaction are used to lower borrowing rates, way of managing risk and improve debt to equity ratios, examples:
  1) Operating lease
  2) Factoring of AR with recourse
  3) Special purpose entity
  4) Joint venture

Question 3

Overall review on IS

Answer 3

• Matching principle is synonymous with cause and effect, Liquidation value is NOT consistent with matching principle
• Shared based payments:
  1) Call option: employees have the right to purchase entity shares in exchange to his services
  2) Share appreciation plan: employee is entitled to cash payment by reference to the increase in market price on the entity shares
  3) Share ownership plan: employees receives entity shares in exchange for their services
• Inventory and AR write off are considered activities from continuous operations.
• Discontinued and Extra operations should be presented net of TAX after continued operations
• Component of Discontinued operations:
  1) Income/loss from component that has been disposed or held available for sale from the 1st day of the reporting period until date of disposal OR the end of the reporting period if it is classified as held for sale.
  2) Gain or loss on the disposed item
  3) Impairment loss
• To be classified as Extra Ordinary it must be unusual and infrequent
• Limitations of IS:
  1) Does not show all items of income and expenses as some of them are reported under comprehensive income
  2) Uses accrual basis whereas the company recognizes revenue before it is actually collected
  3) Requires management judgement and estimates
  4) Under single step IS , gross profit CANT be calculated
  5) Should be reviewed in conjunction with other statements such as BS
• Component of OCI: PUFER
  1) Pension plan adjustments
  2) Unrealized gains/losses from available for sale securities
  3) Foreign currency translation
  4) Effective portion of cash flow hedges
  5) Revaluation assets surplus - under IFRS only
• Comprehensive income shows the change in net assets excluding owners transaction
• Benefits of multiple step comprehensive income:
  1) It shows gross profit
  2) Match operating income with operating expenses separately from non operating
  3) Commonly used by companies

Question 4

Overall review on Equity and Retained Earnings

Answer 4

• RE reconciles beginning and ending balances of the accounts
• RE consists of:
  1) RE beginning balance
  2) Income/loss of the period
  3) Dividends declared (minus)
  4) Prior period adjustments (plus or minus)
  5) Quasi Re organisation (minus)
• Types of prior period adjustments:
  1) Change in accounting principle and correction or error, mistakes in FS which must be accounted for retrospectively ( change in inventory valuation method)
  2) Change in accounting estimates must be accounted for prospectively - affects the current and future periods ( change in the % of credit sales or estimation of bad debt )
• RE might be appropriated ( Restricted ) for special account other than dividend. Appropriation RE does not set aside assets only it limits the availability of dividends. It must be disclosed in notes
• Common stocks features:
  1) Not entitled to dividends UNLESS declared by BOD
  2) Entitled to receive liquidation distributions AFTER all other claims including preferred stocks
  3) Have the right to elect BOD (voting rights)
  4) Have preemptive rights
• Preferred stock features:
  1) Receives dividends at fixed charge prior to common stocks
  2) Entitled to receive liquidation distributions BEFORE common stocks
  3) Cumulative preferred stocks (dividends in arrears)
  4) Convertible preferred stock - usually to common stocks at predetermined rate
• Direct cost of issuing stocks must NOT be expensed, it is REDUCED from net proceeds or paid in capital
• Types of Equity transactions:
  1) Issuance of Stock - affect cash (debit), common stock and additional paid in capital (credit).
  2) Cash dividends - at date of declaration RE (debit), dividends payable (credit). At date of payment Dividends payable (debit), Cash (credit)
  3) Property dividend - at date of declaration the property is measured at FV, any gain or loss is recognized in IS. RE is decreased by the FV of the property / RE (debit) , Property dividend payable (credit). At date of payment Property dividend payable (debit), Property (credit)
  4) Stock dividend - It is reclassification of different equity accounts, NOT as liabilities. If the issuance of shares is less than 20-25% it is recorded at FV, if the issuance is more than 20-25% of previously outstanding shared it is recorded at par.
• Stock split reduces the par value of EACH stock and increases the number of shares outstanding. It does not impair company ability to pay dividends. No entry is made & no transfer from RE.
• Limitations of Statement of Equity:
  1) FS are prepared using accrual basis
  2) Prepared based on specific time period

Question 5

Overall review on Cash Flow

Answer 5

• The primary purpose is to provide relevant information about cash receipt and cash payments of an entity during period. It asses Liquidity, Solvency and Financial Flexibility
• Consists of operating, investing and finance activities
• Operating activities :
  1) Cash receipt from operational activities
  2) Cash received from interests and dividends
  3) Cash payment from operational activities
  4) Cash payment of interest on debt
• Investing activities :
  1) Cash payment of purchase of PP&E, intangible assets - Gain/ Loss on sale is NOT part of investing activity, it should be treated as part of operating activities
  2) Cash payments to acquire equity debt instruments for investment purposes (purchase of bonds)
  3) Cash advances and loans made to other parties
• Financing activities:
  1) Cash proceeds from issuance of shares, notes, bonds.
  2) Cash payment on amounts borrowed (principle amount)
  3) Cash payment of dividends and treasury stocks
• Non cash investing and financing activities:
  1) Conversion of debt to equity
  2) Acquisition of assets by assuming directly liability in means of capital lease
  3) Exchange of noncash asset or liability for another
• Cash RECEIVABLE from the issuance of stock is NOT part of cash flow
• Limitations of Cash flow statement:
  1) Not sufficient for forecasting the profitability of a firm
  2) May not represent the true liquid position of an entity
  3) Information can be manipulated by management
• Under direct method we must disclose major classes of gross cash receipts and gross cash payments

Question 6

Revenue from contracts with customers

Answer 6

• The core principle is that an entity recognizes revenue for the transfer of promised goods or services to customers in a amount that reflects the consideration to which the entity expects to be entitled in the exchange
• Five step model:
  1) identify the contract
  2) Identify the performance obligation
  3) Determine the transaction price
  4) Allocate the transaction price to the performance obligation
  5) Recognize revenue when performance obligation is satisfied
• Identify a contract - A contract is an agreement between 2 or more parties that creates enforceable rights and obligations. Revenue is recognized for a contract with a customer if ALL the following criteria are met:
  1) The contract was approved by the parties
  2) The contract has commercial substance
  3) Each party rights regarding goods and service to be transferred and the payment terms can be identified
  4) It is probable that the entity will collect substantially all the consideration
• If the criteria above are NOT MET, the consideration received is recognized as LIABILITY and NO REVENEUE is recognized. However, even when the criteria not met, revenue in the amount of nonrefundable consideration received is recognized if at least one of the following has occurred:
  1) The contract has been terminated
  2) Control over the goods was transferred to the customer and the entity has stopped transferring additional goods or services
  3) The entity has no obligation to transfer goods or service and has received ALL consideration from the customer
• A contract modification exists when parties approve a change in the SCOPE or PRICE. It is accounted for separate contract if the following criteria are met:
  1) The scope has increased because of the addition of promised goods or service
  2) The price has increased to reflect the entity standalone price of the additional promised goods or services
• Identify the performance obligation - A performance obligation is a promise in the contract to transfer to a customer a good or service that is DISTINCT or SERIES of distinct goods or services that are substantially the SAME and have the SAME pattern to transfer.
• Promised goods or services are distinct if:
  1) The customer can benefit from them either at their own or together with other resources readily available
  2) The entity promise to transfer them to the customer is separately identifiable from other promises in the contract
• Determine the transaction price - The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. it excludes amounts collected on behalf of 3rd party (sales tax)
• To determine transaction price , an entity should consider the effects of Time Value Of Money and Variable Consideration. Any consideration payable to the customer such as coupon, discount, credit should reduce the transaction price
• The revenue recognized must reflect the price that the customer would have paid for the promised goods or service if cash payment has been made when they were transferred to the customer; thus:
  1) The transaction price is adjusted for the effect of the time value of money when the contract includes a Significant Finance Component.
  2) The following factors should be assessed whether a contract includes a Significant Finance Component:
  A. The difference between 1) the Cash selling price and
  2) the amount of consideration received
  B. The combined effect of the 1) Expected time between they payment and the delivery and 2) Market interest rates
• The transaction price should NOT be adjusted for the effect of the time value of money if:
  1) The time between the payment and delivery of the promised goods or service is 1 year or less.
  2) The customer paid in advance and the transfer of goods or services is at the customer discretion
  3) A substantial amount of the consideration promised is Variable and its timing varies with future circumstances that are NOT within the Control of the entity or the customer
• Interest income or expense is recognized using effective interest method. Is must be presented Separately from revenue from contracts with customers
• Variable consideration - If a contract includes a variable amount an entity must estimate the consideration to which it will be entitled in exchange for transferring the promised goods or service to a customer. A variable consideration is Estimated using one of the following methods:
  1) The expected value - is the sum of probability weighted amounts in the range of Possible consideration amounts. May be appropriate if an entity has many contracts with Similar Characteristics
  2) The most likely amount - is the single most likely amount is a range of possible consideration amounts. May be appropriate if the contract has Only Two possible outcomes
  The estimated transaction price MUST be Updated at the END of each reporting period
• Volume discount offered as in incentive to increase future sales requires to the customer and have 2 kinds:
  1) Prospective volume discount that provides a Material Right to the customer is accounted for a Separate Performance Obligation in the contract
  2) Retrospective volume discount are account for a Variable Consideration
• Allocate the transaction price to the performance obligation - A standalone selling price is the price at which an entity would sell a promised goods or service separately to a customer. The best evidence for standalone selling price is the observable price of a goods or service when it is:
  1) Sold separately
  2) Sold in similar circumstances
  3) Sold to a similar customer
  If the standalone price is not directly Observable, it MUST be Estimated through the following approaches:
  1) Adjusted market assessment - the entity evaluates the market in which it sell the goods or service and estimate the price
  2) Expected cost plus an appropriate margin- the entity forecasts its expected costs of satisfying performance obligation and adds an appropriate margin for the cost
  3) Residual - It is only used in Limited Circumstances
• Recognize revenue when performance obligation is satisfied - An entity recognizes revenue when it satisfies its performance obligation by transferring a promised good or service (asset) to a customer. An asset is transferred when the customer obtains Control of the asset. Control means that the entity has the ability to direct use the asset and obtains substantially all the remaining benefits from the asset (potential cash flow)
• A performance obligation can be satisfied either Over time or At a Point of time.
• Revenue is recognized over time if ONE of the following criteria is met:
  1) The customer substantially receives and consumes the benefits provided by the entity eg: cleaning services
  2) The entity performance creates or enhances an asset that the customer controls as the asset is created or enhanced eg: a construction company
  3) The asset created has no alternative use to the entity and the entity has an enforceable right to receive payment for the performance completed eg: an aerospace company contracts to build a satellite designed for the unique needs of a specific customer
• If the performance obligation is NOT satisfied over time an entity satisfies the performance obligation at a point of time. Revenue is recognized At a Point Of Time when the customer obtains Control over the promised asset, the following indications of transfer of Control should be considered:
  1) Present right to receive payment
  2) Legal title passes to the customer
  3) Transfer of physical possession to the customer
  4) Risk and rewards ownership to customer
  5) The customer accepted the asset
• Balance sheet presentation - A contract Liability is recognized for an entity obligation to transfer goods or service to a customer for which the entity has received consideration from the customer. A contract Asset is recognized for an entity right to receive consideration to a goods or service transferred to a customer, the entity MUST have UNCONDITIONAL right to the consideration to recognize a Receivable. A right to consideration is UNCONDITIONAL if only the Passage Of Time is required before payment of that consideration is due.
• Contract Asset and Contract Liability resulting from different contract MUST NOT be presented NET in the statement of financial position

Question 7

Recognition of revenue Over Time

Answer 7

• For each performance obligation satisfied Over Time, an entity must recognize revenue Over Time. For this purpose, the entity measures the progress toward complete satisfaction using the Output Method or the Input Method. To determine the appropriate method an entity must consider the NATURE of the goods or service.
• At the end of each reporting period, the progress toward complete satisfaction of the performance obligation MUST be Remeasured and updated for any changes. Such change must be accounted for Prospectively as a Change in Accounting Estimate.
• The Input method recognizes revenue on the basis of:
  1) The entity inputs to the satisfaction of the performance obligation relative to
  2) The total expected inputs to the satisfaction of the performance obligation
• In long term construction contracts, cost incurred relative to total estimated costs often are used to measure the progress toward completion. This method is the Cost to Cost method, the following costs are excluded from this method:
  1) Costs incurred that relate to significant inefficiencies such as abnormal amounts of wasted materials that were not chargeable to the customer under the contract
  2) G&A costs not directly related to the contract
  3) Selling and marketing costs
• The Output Method recognizes revenue based on direct measurement of:
  1) The value of good or service transferred to the customer To Date relative to
  2) The remaining goods or service promised under the contract
• Under Output Method revenue may be recognized at the amount to which the entity has the right to invoice the customer
• An entity recognizes revenue for a performance obligation satisfied OVER TIME using Input and Output methods ONLY IF progress toward complete satisfaction of the performance obligation can be reasonably measured
• An entity can recognize revenue to the EXTENT OF COST INCURRED based on Zero Profit Margin IF:
  1) The entity is UNABLE to reasonably measure the outcome of performance obligation or its progress toward satisfaction
  2) The entity expects to recover the costs incurred in satisfying the performance obligation

Question 8

Rules for calculations

Answer 8

• Raw material purchased = Beg Inv + End Inv - Material used in productions
• Gain/Loss on disposal = Selling price - Carrying value
• To calculate Net income and only RE and pay out ratio is given = RE / (1-payout ratio)
• Depreciation Exp = End ACC dep - Beg ACC dep + Dep expenses for equipment sold
• Cash provided/Used = Ending Cash balance - Beg cash balance - if positive then its cash provided and vice versa
• Revenue of the contract for each year = (Cost incurred to date / Total estimated cost) * Contract Price
• Revenue of the contract at last year:
  1) Calculate revenue at the year before the last year = (Cost incurred to date / Total estimated cost) * Contract Price
  2) Contract price minus step 1
• Gross profit on last year of the contract =
  1) Cost incurred to date - contract price = total gross profit
  2) Total gross profit of the contract - previously recognized gross profit
• Completed contract recognized income @ specific year = Contract price - Costs incurred to date for that year

Percentage of completion income = Contract price - (cost incurred to date + cost expected in the future)

• Percentage of Completion = Cost incurred to date / Total estimated cost
• Notes of financial statements is considered as part of complete set of it