300455 Recognition 3C

Question 1

At the beginning of the current year, Hayworth Co. sold equipment with a 2-year service contract for a single payment of $60000. The fair value of the equipment was $57000. Hayworth recorded this transaction with a debit of $60000 to cash and a credit of $60000 to sales revenue. Which of the following statements is correct regarding Hayworth’s current-year financial statements?

Net income will be overstated.

Total assets will be overstated.

The financial statements are correct.

Total liabilities will be overstated.

Question #300455

Answer 1

Net income will be overstated.

Revenue has been received in advance of earning the revenue. Revenue from the second year of the service contract cannot be recognized until the second year. Consequently, revenue and net income have been overstated in the first year.

Question 2

FASB ASC 605-20-25-3 to 25-6

Question 3

Contract

Answer 3

A contract is an agreement between two or more persons that establishes an enforceable legal relationship between the parties. The essential elements of a contract are:

• an agreement (offer and acceptance),
• consideration,
• valid subject matter, and
• legal capacity.

A void contract never had any legal status. A voidable contract is valid only until one party exercises a right to void the contract. An unenforceable contract is valid when made but is made unenforceable by some later event, such as the statute of limitations, discharge of the contract in bankruptcy, or involuntary destruction of the subject matter.

Question 4

Prepaid Asset

Answer 4

A prepaid asset is a cost paid in advance that entitles the entity to receive service in the current and future accounting periods. It is a current asset. Examples include insurance or rent paid in advance. A prepaid asset is usually amortized over interim (e.g., monthly) accounting periods.

Question 5

Recognition

Answer 5

Recognition is the process of formally recording or incorporating an item in the financial statements of the entity. (SFAC 6.143)

Four fundamental recognition criteria are (subject to the pervasive cost-benefit constraint and the materiality threshold):

1. Definitions: The item must meet the definition of an element of financial statements.
2. Measurability: The item has a relevant attribute that can be quantified with sufficient reliability.
3. Relevance: The information about it is capable of making a difference in user decisions.
4. Faithful representation: The information is representationally faithful, complete, unbiased, and error-free.

SFAC 5.63-.87

Revenues and gains are recognized when they are:

• realized or realizable or
• earned.

SFAC 5.83

Expenses and losses are recognized when one of the following has occurred:

• Consumption (using up) of benefit
• Occurrence or discovery of loss of future economic benefit

SFAC 5.85

“Realized” and “recognized” are not synonymous.

There are seven accepted criteria for revenue recognition:

1. Point of sale.
2. Production and delivery—recognize prepayment (magazine subscription)
3. Percentage of completion—long-term contract
4. With passage of time—rent, interest
5. Completion of production (before sale)—when product is readily salable at determinable prices without significant effort
6. Completed transaction—in exchange for noncash assets
7. Installment basis—when cash is collected

Question 6

Revenue Principle

Answer 6

The revenue principle is a generally accepted accounting principle that provides guidelines for the measurement and timing of the recording (recognition) of revenues. The revenue principle requires accrual accounting and that the recognition criteria be met. (SFAC 5.63-.77)

Revenue is realized when noncash resources and rights are converted into money. Revenue is measured at the exchange values of the assets or liabilities involved, usually the market value of the resources given up (SFAC 5.83). Revenue should be recognized when it is earned, measurable, and collectible.

Revenue has been earned when the entity has substantially completed what it must do to be entitled to the benefits represented by the revenues, related expenses can be reasonably estimated, and collection is reasonably assured. The earning process is then said to be complete.

There are seven accepted criteria for revenue recognition:

1. Point of sale
2. Production and delivery—recognize prepayment (magazine subscription)
3. Percentage of completion—long-term contract
4. With passage of time—e.g., rent, interest
5. Completion of production (before sale)—when product is readily salable at determinable prices without significant effort
6. Completed transaction—in exchange for noncash assets
7. Installment basis—when cash is collected (because of the inability to estimate collectibility)

Question 7

Revenues

Answer 7

Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. (FASB ASC Glossary)

Revenues are similar to gains; the distinction depends on the nature of the entity, its operations, and its other activities. The primary purpose of distinguishing between revenues and gains is presentation and display.

Revenues must be earned and realized/realizable before they can be recognized.

Question 8

2331.47

Answer 8

Revenue is recognized over time, in proportion to the amount of the performance obligation that has been satisfied, if:

• the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
• the entity’s performance creates or enhances an asset (i.e., work in process) that the customer controls as the asset is created or enhanced.
• the entity’s performance does not create an asset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed to date.