56 VOCABULARY

Question 2

Accounting Change

Answer 2

An accounting change is a change in (1) an accounting principle, (2) an accounting estimate, or (3) the reporting entity. The correction of an error in previously issued financial statements is not an accounting change.

FASB ASC 250-10-20

Question 3

Accounting Profit

Answer 3

Accounting profit is the difference between total revenues and measurable or estimable expenses paid to outsiders to acquire and use all necessary factors of production. Accounting profit does not include those implicit costs that are not measurable, such as opportunity costs and return to the owner for use of owner’s capital and entrepreneurial skills (the normal profit). It is the profit in excess of actual costs of production. The residual accrues to the owners.

Gross revenue from sales XXX
Less:
Direct materials xx
Direct labor xx
Factory overhead xx
Cost of goods sold XX
Equals Gross Profit XXX
Less: Nonmanufacturing costs XX
Equals ACCOUNTING PROFIT
(before income taxes) XX
Less: Income tax X
Equals ACCOUNTING PROFIT after tax XX
Less: NORMAL PROFIT (imputed
return to owner for
the use of capital and
for risk-taking) X
Equals ECONOMIC PROFITS X
===

As a general rule, accounting profit is greater than normal profit, and normal profit is greater than economic profit because implicit costs are considered in the determination of normal and economic profits. (Income tax is basically applied to accounting profit that has been adjusted to taxable income per tax rules and regulations.)

Accounting profit is the basis for the financial statements of individual firms and is often extrapolated to the industry. It is not used when referring to the entire market.

Question 4

Accounts Receivable

Answer 4

Accounts receivable are amounts the entity is entitled to receive that arise in the normal course of business (e.g., from the credit sales of goods or services). Receivables are claims against others for money, goods, or services, usually on “open” accounts after credit approval is granted. There is no formal written agreement, and they are usually classified as current assets. Normally, accounts receivable are expected to be received within 30 to 90 days. Accounts receivable are contrasted with notes receivable, which are of a longer term (e.g., 3 to 24 months) and accrue interest at a stated rate. Nontrade receivables are those that arise outside of the normal course of business (e.g., loans to employees or receivables from affiliated entities) and may be recorded net or gross. They are reported at net realizable value (i.e., the amount expected to be collected) and are offset by a valuation allowance account (a contra asset account).

Factors responsible for a net realizable value less than the amount billed are cash discounts, sales returns, and uncollectible amounts.

Question 5

Accrued

Answer 5

If an item has been accrued, it has been entered in the accounting records by an adjusting journal entry. Accrual accounting requires that the effect of a future cash transaction be reflected in the current period’s financial statements, not in the following period or periods when the cash transaction will occur if its occurrence is certain (contractual) or the result of the passage of time.

From the income statement point of view, the adjusting journal entry is recorded because either the revenue is earned (e.g., interest earned but not received) and should be recognized in the current period—even if payment has not yet been received, or the expense (e.g., interest owed but not paid) should be matched against the current period’s revenue—even if payment for the expense has not yet been made. From the balance sheet perspective, either an asset (e.g., interest receivable) or a liability (e.g., interest payable) should be reported on the balance sheet, but the item has not yet been recorded.

Question 6

Additional Paid-in Capital
Additional paid-in capital (APIC) is an increase in equity (net assets) in excess of par or stated value arising from transactions involving the enterprise’s own stock. Usually, it is reported for each class of stock or each type of transaction (e.g., APIC from common, from preferred, from treasury stock (both par and cost methods), from conversion of convertible shares, from retirement of callable or redeemable shares from payment of a liquidating dividend, and from quasi-reorganization).

Additional paid-in capital is sometimes called “paid-in capital in excess of par” or “contributed capital in excess of par.”

Question 7

Asset Group

Answer 7

An asset group is the unit of accounting for a long-lived asset or assets to be held and used, which represents the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities.

FASB ASC Glossary

Question 8

Assets

Answer 8

Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. They describe levels or amounts of resources at a moment in time.

SFAC 6.25–.34 and .172–.191

Essential characteristics, all three of which must be present, are as follows:

1. Embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows
2. A particular entity can obtain the benefit and control others’ access to it.
3. The transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred.

Economic benefits derive from the ability of assets to be exchanged for cash or other goods or services, by being used to produce goods or services to increase the value of other assets, or by being used to settle liabilities.

Services provided by other entities cannot be stored and are received and used simultaneously. Rights to receive services for specified or determinable future periods can be assets.

Assets are changed by transactions, activities, and events that happen to the entity, both those directly controlled by the entity (receipt and transfer of cash and other assets or adding value to noncash assets through operations by using, combining, and transforming goods into other goods) and those beyond its control (changes in prices, interest rates, and technology; impositions of taxes and regulations; discovery; growth or accretion; shrinkage; vandalism; theft; expropriations; and natural disasters).

“Valuation accounts” that increase or decrease the carrying value of assets are part of the related asset and are not assets, or liabilities, in their own right. These valuation accounts are either adjunct accounts (increase the related asset) or contra accounts (decrease the related asset).

In governmental accounting: Assets are defined as resources with present service capacity that the government presently controls. (GASB Concepts Statement 4.8)

Question 9

Balance Sheet

Answer 9

Also called a statement of financial position, a balance sheet is a summary of assets, liabilities, and owner’s equity for a company as of a specific date. It is considered to be a snapshot of the organization’s financial position at a point in time.

Question 10

Billings

Answer 10

A billing is a periodic interim invoicing for progress payments on long-term contracts. It is a contra asset (construction in process) account, netted against the construction in process asset account and recorded as either an asset (construction costs in excess of billings) or as a liability (billings in excess of construction costs).

Question 11

Bond

Answer 11

A bond is a type of debt instrument or debt security in the name of the issuing party (a government or corporation) usually issued in denominations of $1,000. It is a legal document representing a long-term obligation to pay interest at a specified rate at specified intervals and to repay a specified amount (the principal) on a specified future date (at maturity). A bond represents a liability or debt to the issuer and is senior to (paid before) capital stock. A bond carries less risk than capital stock. The holder is the creditor, and the maker or issuer is the borrower or debtor. A bond is usually negotiable and can be sold or transferred, with the transferee becoming the holder in due course.

Bonds are classified in the following ways:

1. Character of the issuer: Federal, municipal (the interest received from which is tax-exempt), or corporate (industrial)
2. Character of the security: Secured, unsecured (debenture), or guaranty
3. Payment of interest: Ordinary, income, participating, registered, bearer, or coupon
4. Maturity of principal: Ordinary, callable, redeemable, convertible, or serial

In the United States, new corporate bond issues must be registered for tax reporting purposes, so bearer or coupon bonds are no longer issued by U.S. corporations.

Question 12

Business Segment

Answer 12

The following terms and descriptions of business segments are taken from FASB ASC 280-10-50:

Operating segment. This is a component of a public entity (FASB ASC 280-10-50-1):

• that engages in business activities where it earns revenues and incurs expenses,
• whose operating results are regularly reviewed by chief operating decision makers, and
• for which discrete financial information is available.

Reportable segment. Operating segments that meet one of the following quantitative tests are reportable segments (FASB ASC 280-10-50-12):

• Segment revenue (both to external customers and intersegmental) is at least 10% of total revenue of all operating segments.
• The absolute amount of segment profit (or loss) is at least 10% of all operating segments with a profit (or loss).
• Operating segment assets are at least 10% of total assets.
  Reportable segments must report their revenue, profit (or loss), assets, and other related items. (FASB ASC 280-10-50-22)

Enterprises must report the extent of reliance on major customers—those who comprise at least 10% of sales. (FASB ASC 180-10-50-42)

Question 13

Cash Dividend

Answer 13

A cash dividend is the distribution of cash to stockholders in proportion to the number of outstanding shares held. Accounting for dividends involves a disbursement (credit) from the cash account and a reduction (debit) to Retained Earnings.

The entry to record would be:
When declared: DR Retained Earnings xx
CR Dividends Payable xx
or
DR Dividends Declared xx
CR Dividends Payable xx

 When paid:      DR  Dividends Payable     xx
                 CR    Cash                     xx If a corporation uses the temporary account Dividends Declared, it is closed to Retained Earnings at the end of the accounting year.

A cash dividend represents a return on investment to shareholders.

Question 14

Cash Equivalents

Answer 14

Cash equivalents are short-term, highly liquid investments that have both of the following characteristics: they are readily convertible to known amounts of cash AND are so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Generally, only investments with original maturities of three months or less qualify under that definition. Original maturity means original maturity to the entity holding the investment. For example, both a three-month U.S. Treasury bill and a three-year U.S. Treasury note purchased three months from maturity qualify as cash equivalents. However, a Treasury note purchased three years ago does not become a cash equivalent when its remaining maturity is three months.

Examples of items commonly considered to be cash equivalents are Treasury bills, commercial paper, money market funds, and federal funds sold (for an entity with banking operations).

FASB ASC Glossary

Question 15

Cash Flow

Answer 15

Cash flow is the amount of net cash that was generated by an entity during an accounting period. It is the difference between total cash inflows and total cash outflows.

Question 16

Change in Accounting Principle

Answer 16

A change in accounting principle is a change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. It is expected that accounting pronouncements normally will provide specific transition requirements. However, in the unusual instance that there are no transition requirements specific to a particular accounting pronouncement, a change in accounting principle effected to adopt the requirements of that accounting pronouncement must be reported as a retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Retrospective application requires the following:

• The cumulative effect of the change to the new accounting principle on periods prior to those presented must be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
• An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
• Financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new accounting principle.

A change in the method of applying an accounting principle also is considered a change in accounting principle.

FASB ASC 250-10-20

Question 17

Comparative Financial Statements

Answer 17

Comparative financial statements are financial statements presented together for one or more prior periods as well as the current period. Notes, explanations, and auditor qualifications should be retained to the extent that they continue to be of significance. Any change which affects comparability should be disclosed.

Statements for a series of periods are far more significant than those for a single period. They enhance the usefulness of financial reports and show more clearly the nature and trends of current changes affecting the enterprise.

FASB ASC 205-10-45-1

Question 18

Component of an Entity

Answer 18

A component of an entity comprises operations and cash flows that can be clearly distinguished, both operationally and for financial reporting purposes, from the rest of the entity. A component of an entity may be a reportable segment or an operating segment, a reporting unit, a subsidiary, or an asset group.

FASB ASC Glossary

Question 19

Contra

Answer 19

An item that is contra is one that is offset or the opposite of another item. In accounting, a contra account is one whose balance is offset against its related account.

Example: The Allowance for Doubtful Accounts is contra to the account Accounts Receivable and the account Bond Discount is contra to the account Bonds Payable.

Assets, liabilities, revenues, and expenses can have contra accounts. Asset contra accounts include Allowance for Uncollectible Accounts Receivable, Allowance for Uncollectible Property Taxes Receivable, Accumulated Depreciation, and Accumulated Depletion. The most common liability contra accounts are discount accounts that adjust the carrying value of the liability such as Discount on Bonds Payable. The common revenue contra accounts are Sales Discounts and Sales Returns and Allowances. The common expense contra accounts are Purchase Discounts and Purchase Returns and Allowances.

Question 20

Contributed Capital

Answer 20

Contributed capital is increases in net assets received from outside the corporation, from transactions related to capital stock or donated assets, from financing provided in exchange for ownership interest, and from paid-in capital.

Sources of contributed capital:

1. Capital stock at par
   * Common stock
   * Preferred stock
   2.Contributed capital in excess of par (CCEP)
2. Contributed capital from treasury stock
3. Contributed capital from donation of assets

Question 21

Cost of Goods Sold

Answer 21

The cost of goods sold is all costs that were included in the value of the units of finished product sold during the period.

• Beginning finished goods inventory + Cost of goods manufactured = Cost of goods available for sale - Ending finished goods inventory = Cost of goods sold

Question 22

Criteria

Answer 22

Criteria are the benchmarks used to measure or evaluate the subject matter.

Question 23

Cumulative

Answer 23

Cumulative is a desirable provision of preferred stock that dividends not declared in a prior year accumulate at the preference rate and must be paid before any dividend can be paid to common stock. Unpaid cumulative dividends are said to have been “passed” and are called “dividends in arrears.”

Noncumulative stock does not possess this provision. Dividends that are passed (i.e., not declared) for any prior year are permanently lost to the preferred stockholder. Preference is to current-year’s dividends only.

In general, “cumulative” refers to the current sum of a series of additions over time, such as the accumulation of annual depreciation or the current total of a sequence of changes to previously reported financial numbers.

Question 24

Current Assets

Answer 24

Current assets are cash and other assets that can be expected to be used, sold, or converted to cash during the current business cycle, generally one year.

Examples of current assets include cash, raw materials, trade accounts receivable, and marketable securities.

Question 25

Current Liability

Answer 25

A current liability is payable within one year, or the operating cycle if longer. It is likely to be paid with current assets or require the incurrence of another current liability.

Question 26

Date of Declaration

Answer 26

The date of declaration is the date on which the corporation’s board of directors formally announces that a dividend will be paid. The formal declaration of a cash, property, or script dividend constitutes a legally enforceable contract between the corporation and the shareholders; thus, the debit to retained earnings should be recorded on this date—the credit can be to Dividends Payable until the date of payment. Stock dividends are not legally enforceable until paid; therefore, no entry is made on the date of declaration.

Question 27

Depreciation

Answer 27

Depreciation is the process of systematic, rational allocation of the cost of operational assets to the accounting periods benefited. Depreciation is not a process of valuation (FASB ASC 360-10-35-4), does not represent a reserve to replace the asset, and does not mean that cash will be available to replace the asset. Depreciation allowed for tax purposes often differs from depreciation allowed for accounting.

Accounting depreciation attempts to match the cost of the asset to the revenues generated over the life of the asset. It represents accrual accounting and has no effect on cash flows (a noncash expense). Depreciation expense must be added back to accounting income when reconciling to cash from operations using the indirect method.

Computation of depreciation requires the following:

1. Acquisition cost
2. Estimated useful life
3. Estimated residual (salvage) value
4. Depreciation method (four GAAP alternatives):

• Straight-line
• Sum-of-the-years’-digits
• Double-declining balance
• Units of production—units of product and machine hours

Factors which cause the need for depreciation include the following:

1. Physical factors:

• Wear and tear
• Effects of time and other elements
• Deterioration and decay

2. Functional factors:

• Inadequacy of capacity
• Obsolescence

In the macroeconomic sense, depreciation is the part of business earnings/gross profit that is considered the replacement of capital stock used or worn out during the period. It is not included in net profit and is not a factor payment. (It is not a claim on the value of output by a factor of production.) Depreciation represents replacement investment, the amount that must be reinvested to maintain the existing level of capital stock, and the amount by which capital contributes to current production. It is a component of GNP (approximately 10%) and is computed by the income approach to national income accounting. Depreciation is the difference between gross and net investment.

In the foreign exchange sense, depreciation is the decline in the value of one currency against or in relation to another, in the sense that it now takes more of a particular currency to buy a unit of a foreign currency. Devaluation is the official change in the value of a country’s currency.

Example: Country A has an inflation rate of 5% and Country B has an inflation rate of 10%. The goods of Country A become relatively cheaper because the relative prices have changed, thus:

• increasing the demand in Country B for Country A’s goods,
• increasing the demand for Country A’s currency (to be able to import Country A’s goods), and
• decreasing the demand for (i.e., depreciating) Country B’s currency by approximately 5% (10%–5%).

Question 28

Direct Effects of a Change in Accounting Principle

Answer 28

Direct effects of a change in accounting principle are those recognized changes in assets or liabilities necessary to effect a change in accounting principle (e.g., an adjustment to an inventory balance to effect a change in inventory valuation method.)

FASB ASC Glossary

Question 29

Discontinued Operations

Answer 29

Discontinued operations are the gains (losses) and the operating results from discontinuing a business segment. The business segment must be a separate line of business or class of customers.

To be reported as discontinued operations, a disposal must represent a strategic shift—which has a major effect on the entity’s operations and financial results.

Example: Disposal of the manufacturing assets for shoes in Maine, but continuing to manufacture shoes in Italy is a discontinued segment only if the sale represents a substantial portion (20% or more) of the entity’s assets. Discontinuing the manufacture of shoes and continuing to manufacture mobile homes is the discontinuance of a separate line of business. Discontinuing sales to customers in Europe and continuing sales in the United States is not a discontinued operation, but discontinuing selling products retail throughout the world and continuing to sell products wholesale is a discontinuance of a separate class of customers.

To qualify as a discontinued operation, the assets, results of operations, and activities of the business segment must be clearly distinguishable from the other business activities.

The results of discontinued operations are reported separately net of the related income tax expense following operating income. The reporting varies depending on when management commits itself to dispose of the segment (the measurement date) and when the actual disposal occurs (disposal date):

• The operating results (revenues and expenses) from the beginning of the period included in the income statement to the measurement date are reported as the gain (loss) from operation of a discontinued segment net of income taxes. This includes not only the current year, but all the prior years included in the income statement with each in the year realized.
• If the measurement date and the disposal date are either the same date or are within the same year, the segment’s operating results from the measurement date to the disposal date and the gain (loss) from the disposal of the net assets of the segment are summed and reported as either the gain or loss on disposal net of income taxes. The amount of operating results and the amount of gain (loss), however, are disclosed in the description of the disposal.

If a time lag (phaseout period) exists between the measurement date and the disposal date, two types of phaseout periods can occur in the same accounting period and extending over two or more accounting periods (extended phaseout period). If an extended phaseout period occurs, FASB ASC 205-20 applies conservatism to the reporting of the sum of the realized and estimated unrealized operating results and realized and estimated unrealized gains and losses on disposal of the net assets. During the phaseout period, if the sum of all the realized and unrealized amounts is a gain, the net gain is recognized when realized net of income taxes.

Realized operating results and realized gains and losses are therefore recognized in the year they occur.

Question 30

Dividend Declared

Answer 30

The dividend declared is the per share amount set by a corporation’s board of directors to be paid to stockholders. The sum of these per share amounts (dividends declared) is recorded in a nominal (temporary) retained earnings account, Dividends Declared, on the date (date of declaration) that the corporation’s board of directors decides to pay the dividend because at that point in time it becomes a legal liability of the corporation. The dividend can be cash, other assets, or the corporation’s own preferred or common stock.

Question 31

Dividends

Answer 31

Dividends are the distributions of cash, other corporate assets or property, or the corporation’s own stock to stockholders in proportion to the number of outstanding shares held. Accounting for dividends represents a debit to retained earnings and the establishment of a liability at the date of declaration. Dividends must meet the preferences of preferred stock first and then may be extended to common stock.

There are two types of dividends:

1. Common, such as cash, stock (treasury or newly issued shares), and property
2. Special, such as scrip and liquidating
   Four dates are relevant to dividends: date of declaration, record, ex-dividend, and distribution (payment).

Date of declaration is the date whereby the dividend amount is decided by the board of directors for those shareholders owning stock on the date of record (usually 1 month later) and to be paid on the date of distribution. Ex-dividend date is a date prior to the date of record (see ex-dividend date).

Question 32

Earnings

Answer 32

Earnings are a measure of the performance of the enterprise during the period. Earnings measure the extent to which asset inflows (revenues and gains) associated with cash-to-cash cycles substantially completed during the period exceed (or are less than) asset outflows associated, directly or indirectly, with the same cycles. (SFAC 5.33–.38)

Similar to net income (earnings do not include the cumulative effect of certain accounting adjustments of earlier periods that are recognized in the current period), earnings are a measure of the performance for the current period and to the extent feasible excludes items that belong primarily to other periods. It is narrower, or less than, comprehensive income.

Earnings are also called “net income” (loss) or “profits” in common practice. “Earnings” are not strictly the same as “net income.”

Question 33

Equity

Answer 33

Equity is ownership interest. It is the residual interest in the business entity that remains after deducting its liabilities. Equity is affected by all events that increase or decrease total assets by a different amount than they increase or decrease total liabilities.

SFAC 6.49–.65 and 6.212–.214

Distinctions within equity (common, preferred, etc.) are matters of presentation and display, not of definition.

Equity stems from ownership rights and involves a relation between the enterprise and its owners as owners rather than as employees, lenders, suppliers, customers, or other nonowner roles. Stockholders, partners, proprietors, investors, and participants are also terms used in defining owners.

The distinction between liability and equity depends on the nature of the claim, not the identity of the claimant—equity ranks after liabilities as a claim to or interest in the assets of the enterprise (the residual interest). Generally, the enterprise is not obligated to transfer interest to owners except under liquidation. Distributions to owners are at the discretion of the owners or their representatives.

The distinguishing characteristic of the equity of a business (compared to the equity of not-for-profit entities, termed “net assets”) is that it may be increased through investments by owners and decreased by distributions to owners.

See SFAC 6.64–.65 for details regarding changes in equity.

Question 34

Expense

Answer 34

An expense is the outflow or other using up of assets or incurring of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations (SFAC 6.80–.81). Expenses are recorded under the accrual method of accounting, in government called the “economic resources measurement focus.”

GASB 1600

Question 35

Fair Value

Answer 35

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants at the measurement date.

Question 36

Financial Statements

Answer 36

A financial statement is a structured representation of historical financial information, including related notes, intended to communicate an entity’s economic resources and obligations at a point in time or the changes therein for a period of time in accordance with a financial reporting framework.

Financial statements ordinarily refer to a complete set of financial statements as determined by the requirements of the applicable financial reporting framework.

Question 37

Gains

Answer 37

Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners. (SFAC 6.82–.89)

Gains are similar to revenues—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.

Question 38

General Long-Term Debt

Answer 38

General long-term debt encompasses all the long-term liabilities of a government not directly related to or to be paid from proprietary or fiduciary funds or business-type resources. General obligation bonds are included along with other forms of long-term indebtedness such as pensions, long-term finance leases, and landfill closure and postclosure care.

GASB 1500.103

Question 39

Generally Accepted Accounting Principles (GAAP)

Answer 39

Generally accepted accounting principles (GAAP) are basic accounting principles and standards and specific conventions, rules, and regulations that define accepted accounting practice at a particular time by incorporation of consensus and substantial authoritative support.

The Financial Accounting Standards Board (FASB) Accounting Standards Codification (Codification) is the source of authoritative generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. In addition to the SEC’s rules and interpretive releases, the SEC staff issues Staff Accounting Bulletins that represent practices followed by the staff in administering SEC disclosure requirements, and it utilizes SEC Staff Announcements and Observer comments made at Emerging Issues Task Force (EITF) meetings to publicly announce its views on certain accounting issues for SEC registrants. (FASB ASC 105-10-05-1)

Accounting and financial reporting practices not included in the Codification are nonauthoritative. Sources of nonauthoritative accounting guidance and literature include, for example, the following:

• Practices that are widely recognized and prevalent either generally or in the industry
• FASB Concepts Statements
• American Institute of Certified Public Accountants (AICPA) Issues Papers
• International Financial Reporting Standards (IFRS) of the International Accounting Standards Board
• Pronouncements of professional associations or regulatory agencies
• Technical Information Service Inquiries and Replies included in AICPA Technical Practice Aids
• Accounting textbooks, handbooks, and articles

The appropriateness of other sources of accounting guidance depends on its relevance to particular circumstances, the specificity of the guidance, the general recognition of the issuer or author as an authority, and the extent of its use in practice. (FASB ASC 105-10-05-3)

Question 40

Gross Margin

Answer 40

Gross margin is the sales minus cost of goods sold, the “first stage” profit from the manufacture of goods for sale, and profit before selling and administrative expenses. Gross margin results from using absorption costing. It is also known as gross profit.

Gross margin analysis involves the evaluation of the gross margin variance (the difference between actual and budgeted gross margin). Gross margin variance can be caused by the following:

• Sales price variance: The difference between planned sales price and the actual sales price
• Sales mix variance: The difference between the planned sales mix and the mix actually achieved
• Sales volume variance: The difference between the planned volume of sales and the actual volume achieved
• Cost price variance: Differences between planned and actual manufacturing costs

Question 41

Impairment

Answer 41

Impairment is the condition that exists when the amount of a long-lived asset (asset group) carried on an organization’s books exceeds its fair value. An impairment loss shall be recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group). That assessment is based on the carrying amount of the asset (asset group) at the date it is tested for recoverability, whether in use or under development. An impairment loss is measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value.

FASB ASC 360-10-35-15; GASB 1100.107

Question 42

Income Statement

Answer 42

The income statement is a financial statement that shows an organization’s revenues and expenses for a defined period of time. The income statement is the financial statement used most often by investors as it provides information concerning the firm’s ability to sustain ongoing operations profitably. The income statement is also the statement that is most readily understood.

The single-step income statement displays the net income from ordinary operations without intermediate calculations. The multi-step income statement uses intermediate steps such as gross profit in displaying the net income from ordinary operations.

Question 43

Indirect Effects of a Change in Accounting Principle

Answer 43

Indirect effects of a change in accounting principle are any changes to current or future cash flows of an entity that result from making a change in accounting principle that is applied retrospectively. An example of an indirect effect is a change in a nondiscretionary profit-sharing or royalty payment that is based on a reported amount such as revenue or net income.

FASB ASC 250-10-20

Question 44

Indirect Method for Statement of Cash Flows

Answer 44

The indirect method is one of the two optional methods of presentation of the statement of cash flows (SCF). It presents a reconciliation of net income to net cash provided by operating activities in all major classes of adjustments: accruals of expected future operating cash receipts and payments (receivables and payables), deferrals of past cash receipts and payments (inventory, prepaids, deferred income and expenses), noncash income/expenses (depreciation, amortization, provisions for bad debts), and gains and losses from transactions classified as investing or financing activities (sale of productive assets, sale of debt, liquidating dividend, retirement of debt). (FASB ASC 230-10)

The indirect method is allowed by the Financial Accounting Standards Board (FASB) for the statement of cash flows (but the direct method is preferred by the FASB). When the indirect method is used, interest and income taxes paid must be separately disclosed.

In governmental accounting, the direct method for stating cash flows is used and not the indirect method. (GASB 2450)

Question 45

Interest

Answer 45

Interest is the charge for the use of money over time. It is the time value of money. Interest is the amount paid (or received) in excess of the amount borrowed (loaned). Interest is a financing expense (income) and is dependent on the interest rate, the principal amount, and the number of interest periods.

• Interest = Principal × Interest rate × Time periods
• Interest = Amount to be repaid - Amount received (loaned)

Simple interest: Interest is computed on the same principal amount each time period, regardless of the amount of interest accrued to date.

Compound interest: Interest is charged on the principal plus all interest previously accrued (interest computed on interest).

In macroeconomics, interest is a factor payment or factor income. It is a component of gross national product (GNP) (approximately 10%) and is used in the income approach to national income accounting. Interest includes payments received from banks on savings, from firms on loans, and other miscellaneous income.

Interest is analogous to wages, rent, and profit as a component of factor payments or factor income.

Question 46

Inventory

Answer 46

The aggregate of items of tangible personal property owned by the business (to which the firm has legal title) intended either for internal consumption in the production of goods for sale or for sale is considered inventory. The balance of costs applicable to goods on hand, including raw materials (for use in the production process), intermediate products and parts still in the production process (work-in-process), and finished goods is also considered inventory.

The major objective of accounting for inventories is to facilitate the determination of income. This is achieved through the proper valuation of inventories—the measurement of the value of the current assets and inventories, and the measurement of the related expense and cost of goods sold.

The basis of inventory accounting is cost. Inventories are valued at acquisition or production cost, which is generally held to be the sum of the purchase price plus indirect acquisition costs (freight, insurance, and handling) for purchased goods and the sum of direct materials, direct labor, and allocated factory overhead (i.e., the appropriate general and administrative costs that are clearly related to production) for manufactured goods. Selling, general, and administrative costs not directly related to production should be expensed rather than included in the valuation of inventory, which involves the use of judgment.

Standard costs may be used for inventory pricing so long as they are adjusted at reasonable intervals to reflect current conditions.

Valuation (pricing) of inventories involves:

• determination of physical quantity (number of units) and
  unit cost (in dollars).
• Unit cost depends on the choice from among various alternative pricing (cost flow) assumptions:
• last-in, first-out (LIFO),
• first-in, first-out (FIFO),
• weighted average, and
• specific identification.

Consideration must also be given to the cost principle (i.e., the lower-of-cost-or-market rule (LCM)).

Inventories must be compiled periodically (physical count) and valued and compared to the amounts recorded in the accounts. Accounting records can be maintained under a periodic or perpetual system.

FASB ASC 330-10

Question 47

Liabilities

Answer 47

Liabilities are probable future sacrifices of economic benefits arising from present obligations of the entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. (SFAC 6.35–.42 and .192–.211)

Essential characteristics, all three of which must be present, are as follows:

1. A present duty or responsibility to one or more other entities entails settlement by probable future transfer or use of assets at a specified determinable date, on occurrence of a specified event, or on demand.
2. The duty or responsibility obligates the entity, leaving it little or no discretion to avoid the future sacrifice.
3. The transaction or event obligating the entity has already occurred.
   Most liabilities stem from human inventions—financial instruments, contracts, laws—that are commonly embodied in legal obligations and rights with no existence apart from them. Liabilities permit delay—delay in payment, delay in delivery, etc.

Liabilities are changed both by the entity’s transactions and activities and by events that happen to it.

“Valuation accounts,” which increase or decrease the carrying value of assets, are part of the related asset and are not liabilities, or assets, in their own right.

In governmental accounting: Liabilities are defined as present obligations to sacrifice resources that the government has little or no discretion to avoid. (GASB Concepts Statement 4.17)

Question 48

Liability

Answer 48

Liability is the state of being legally responsible for making good, making right, or making whole the wronged or owed party. Liability may include payment for debts, reimbursement for losses or damage, or payment of penalties.

Question 49

Liquidity

Answer 49

Liquidity is the convertibility of an entity’s assets into ready cash to meet current obligations. Liquid assets are cash on hand and in banks and marketable securities readily convertible into cash.

Question 50

Long-Term Contracts

Answer 50

A long-term contract is a contract for the construction of a specific project over an extended period of time (more than one accounting period), such as ships, airplanes, bridges, roads, and buildings. Accounting issues include revenue/profit recognition and valuation of construction-in-process. There are two alternative GAAP methods available: completed-contract and percentage-of-completion.

FASB ASC 605-35-05-5

Question 51

Long-Term Obligation

Answer 51

Long-term obligations are those obligations whose liquidation is reasonably not expected to require the use of existing resources properly classified as current assets, or the creation of another current liability. The maturity exceeds one year. Long-term obligations include long-term notes payable, bonds, and other obligations (e.g., under finance leases). Short-term obligations that are expected to be refinanced (and which meet specific conditions) are also classified as long term.

FASB ASC Glossary

Question 52

Losses

Answer 52

Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses of regular operations or investments by owners.

SFAC 6.82–.89

Losses are similar to expenses—the distinction depends on the nature of the entity, its operations, and its other activities. The primary purpose of distinguishing between expenses and losses is presentation and display.

Question 53

Net Assets

Answer 53

Net assets are the excess or deficiency of assets over liabilities of a not-for-profit entity, which is divided into two mutually exclusive classes according to the existence or absence of donor-imposed restrictions.

FASB ASC Glossary

Question 54

Net Income

Answer 54

Net income is operating income plus non-operating revenues minus non-operating expenses minus taxes.

Question 55

Not-for-Profit Entity

Answer 55

According to the FASB ASC Glossary, a not-for-profit entity is distinguished from a business entity by three characteristics: contribution of significant resources from providers who do not expect proportionate return, operating purposes other than to provide goods or services for profit, and absence of ownership interests like business enterprises. In addition, the IRS stipulates that no part of the organization’s net earnings can inure for the benefit of any specific person or persons.

FASB ASC Glossary

IRS Form 1023

AICPA Audit and Accounting Guide Not-for-Profit Entities, Section 15.09

Relevant Terms
Accounting Change
Component of an Entity
Impairment
Not-for-Profit Entity

Reference
2112.08

Authorities
FASB ASC 205-20-45-3
FASB ASC 360-10-35-43

Question 56

Operating Cycle

Answer 56

The operating cycle is the average period of time between the disbursement of cash to acquire materials or services used in the earning process and the receipt of cash upon completion of the process. It is a continuous repetitive process or cycle of operations by which goods are acquired and sold, and further goods are acquired for additional sales. The operating cycle is the period of time between the expenditure of cash for goods and services and their conversion back to cash (from cash to inventories, to accounts receivable, and back to cash). It usually ranges from a few weeks to a few months, but may be longer than one year for long-term construction contracts. The cycle is used in the determination of “short term”: i.e., the longer of one calendar year or the normal operating cycle.

Question 57

Other Comprehensive Income

Answer 57

Other comprehensive income includes revenues, expenses, gains, and losses that, in accordance with generally accepted accounting principles, are included in comprehensive income but excluded from net income.

FASB ASC 220-10-20

Question 58

Pension

Answer 58

A pension is an agreement whereby the employer undertakes to provide to retired employees benefits that can be estimated or determined in advance, based on the provisions of the plan and established company practice. A pension is a form of deferred compensation in which the employee receives a portion of earned compensation after retirement. A pension involves three parties: the employer, the employee, and the trustee. Pensions are accounted for under accrual accounting.

FASB ASC 715-10

Question 59

Prepaid Asset

Answer 59

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 60

Reportable Segment

Answer 60

The following terms and descriptions are taken from FASB ASC 280-10-50:

Operating segments that meet one of the following quantitative tests are reportable segments (FASB ASC 280-10-50-12):

Segment revenue (both to external customers and intersegmental) is at least 10% of total revenue of all operating segments.
The absolute amount of segment profit (or loss) is at least 10% of all operating segments with a profit (or loss).
Operating segment assets are at least 10% of total assets.
Reportable segments must report their revenue, profit (or loss), assets, and other related items (FASB ASC 280-10-50-22).

Enterprises must report the extent of reliance on major customers—those who comprise at least 10% of sales (FASB ASC 280-10-50-42).

Question 61

Retained Earnings

Answer 61

Retained earnings are an increase in net assets from results of operations, retained by the corporation for use in the enterprise. They are internally generated financing or the corporation’s undistributed earnings. They are accumulated earnings, less accumulated losses and dividends paid, from inception. Retained earnings are a major source of owners’ equity and can be viewed as additional investments by the owners as foregone dividends.

Negative balance is called a deficit.

Retained earnings may also be decreased by purchase of treasury stock at a price higher than the amount originally received for the stock.

Retained earnings may be appropriated (i.e., restricted as to use) by:

• contractual specification (e.g., bond covenants),
• legal requirement (e.g., by state law), or
• management discretion (e.g., for future expansion).

Retained earnings are increased by net income, prior-period adjustments, and quasi-reorganization. Retained earnings are decreased by net loss, prior-period adjustments, cash, property, scrip, stock dividends, and treasury stock and stock retirement transactions.

Question 62

Revenues

Answer 62

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 63

Sale

Answer 63

A sale is the transfer of title from one party to another for a price. Sales of goods are governed by Uniform Commercial Code (UCC) Article 2. A sale may be a present sale (consummated by the making of the contract for sale) or an agreement for a future sale (a contract to sell). (UCC 2-106)

The general obligations of the parties to a sale are that the seller is to transfer and deliver the goods and the buyer is to accept the goods and pay in accordance with the contract. (UCC 2-301)

Elements of a sale include the following:

1. Parties must have legal capacity to contract
2. Price
3. Valid subject matter (i.e., the goods to be sold) have the following:

• Validity—i.e., goods are not illegal or against public policy
• Actual existence and identity—i.e., existing goods are identified to the contract for present sale, and goods are not existing, identified to the contract, and represent a contract to sell for sale of future goods

4. Subjective good faith (honesty in fact)—merchants must also meet the objective standard of good faith.

Question 64

Segment

Answer 64

A segment is a functional or responsibility area within a business that can be reported upon separately. FASB ASC 280-10-50-1 requires that general-purpose financial statements include selected information reported on a single basis of segmentation. The method the Financial Accounting Standards Board (FASB) chose for determining what information to report is referred to as the management approach. The management approach is based on the way that management organizes the segments within the enterprise for making operating decisions and assessing performance. Consequently, the segments are evident from the structure of the enterprise’s internal organization, and financial statement preparers should be able to provide the required information in a cost-effective and timely manner.

FASB ASC 280-10-50-1

Question 65

Short-Term Obligation

Answer 65

Short-term obligations are those obligations whose liquidation is reasonably expected to require either the use of existing resources properly classified as current assets or the creation of other current liabilities (FASB ASC 210-10-45-6). Maturity is within one year for a short-term obligation, or the operating cycle, if it is longer. Obligations for those items that have entered into the operating cycle (e.g., materials), collections received in advance of delivery of goods or performance of services, and debts that arise from operations directly related to the operating cycle (e.g., wages, commissions, rents, royalties, taxes) (FASB ASC 470-10-45-13) are considered short-term obligations, as well as those long-term obligations that are or will be callable (due on demand) by the creditor (FASB ASC 470-10-45-13).

Short-term obligations include accounts (trade) payable, short-term notes payable, current maturity amounts of long-term obligations, unearned revenue, accrued expenses (salaries, interest, and taxes), and obligations that by their terms are callable.

Question 66

Single-Step

Answer 66

A single-step income statement has all of the expenses subtracted from all of the revenues for income from continuing operations. It does not show gross margin (profit) and does not classify revenues, expenses, gains, and losses into various categories. This income statement does not separate operating results from other nonoperating activities—other revenues and gains and other expense and losses. This income statement may classify expenses by function—manufacturing, selling, and administrative. The alternative is a multiple-step income statement.

Question 67

Statement of Cash Flows

Answer 67

The statement of cash flows is one of the required financial statements. Cash receipts and cash payments are classified into three categories:

1. Operating activities—all transactions and other events that are not investing or financing; generally include transactions that enter into the determination of net income. These include production and delivery of goods and services, interest and dividends received, and payment of interest.
2. Investing activities—all transactions related to the making or collecting of loans and the acquiring and disposing of debt, equity instruments, or property, plant, and equipment.
3. Financing activities—all transactions related to obtaining resources from owners and providing them with a return on, and a return of, their investment, and to obtaining and repaying debt.

Separate disclosure of noncash investing and financing activities is also required. Examples of such activities include obtaining an asset by entering into a finance lease, by exchange for another asset, or by the issuance of stock or debt.

The statement of cash flows can be prepared using either the direct or the indirect method.

FASB ASC 230-10-45 and 10-55

In governmental accounting, cash flow statements are presented for proprietary funds and governmental entities engaged in business-type activities. The direct method must be used and there are four headings in the statement: cash flows from operating activities, from noncapital financing activities, from capital and related financing activities, and from investing activities. (GASB 2450)

FASB ASC 230-10-45 and 10-55

Question 68

Statement of Earnings and Comprehensive Income

Answer 68

Statements of earnings and comprehensive income together indicate the extent to which and the ways in which the equity of the entity increased or decreased from all sources other than transactions with owners during the period. They provide information about the causes of changes in assets and liabilities, including the results of ongoing major or central operations, the results of incidental or peripheral transactions, and the effects of other events and circumstances stemming from the environment.

SFAC 5.30

Question 69

Statement of Financial Position

Answer 69

The statement of financial position provides information about the entity’s assets, liabilities, and equity and their relationships to one another at a particular point in time. A statement of financial position shows a snapshot of the firm’s financial position on a given date, delineates the enterprise’s resource structure (major classes and amount of assets) and its financing structure (major classes and amount of liabilities and equity), and provides users with information to assess the entity’s liquidity, financial flexibility, profitability, and risk.

SFAC 8.1, OB12

The statement is based on the fundamental accounting model Assets = Liabilities + Equity.

SFAC 8.1, OB12

Question 70

Stockholders’ Equity
Stockholders’ equity is total residual ownership interest in the corporation: net assets and total assets in excess of total liabilities. The source of equity should be specified and segregated:

Contributed capital (paid-in capital):
Capital stock, at par:
Common
Preferred
Less: Treasury stock (under the par value method)
Other contributed capital:
Contributed capital in excess of par (CCEP) (also called Additional paid-in capital (APIC)) on both common and preferred
Contributed capital from treasury stock (under the par value method or cost method)
Donated capital
Retained earnings (earned capital):
Appropriated
Unappropriated
Unrealized capital
Less: Treasury stock (under the cost method)
SFAC 6.60

Answer 70

Question 71

Stockholders’ Equity

Answer 71

SFAC 6.60

Question 72

Term: Capital Stock
Capital stock is an ownership interest in an incorporated business enterprise, represented by stock certificates that may be bought and sold or otherwise transferred. It conveys the right to influence management via participation in and voting at stockholders’ meetings, to participate in earnings through dividends, and to share in the distribution of net assets upon liquidation. There may be different classes of stock with different rights in the same corporation.

Capital is specified in state law and the entity’s articles of incorporation.

Capital stock is that portion of contributed capital equal to the par, or stated, value of stock outstanding. The issue price of stock is allocated between the par value and the price in excess of par (e.g., $5 par common stock is issued for $20—$5, the par value, is recorded as capital stock and $15 is recorded as contributed capital in excess of par (CCEP, common)). Each class of common stock is recorded separately.

Treasury stock is recorded as a contra, or negative, element of capital stock under the par value method (with the excess price paid over par to reacquire the stock recorded as CCEP, treasury stock).

Question 73

Term: Dividends
Dividends are the distributions of cash, other corporate assets or property, or the corporation’s own stock to stockholders in proportion to the number of outstanding shares held. Accounting for dividends represents a debit to retained earnings and the establishment of a liability at the date of declaration. Dividends must meet the preferences of preferred stock first and then may be extended to common stock.

There are two types of dividends:

Common, such as cash, stock (treasury or newly issued shares), and property
Special, such as scrip and liquidating
Four dates are relevant to dividends: date of declaration, record, ex-dividend, and distribution (payment).

Date of declaration is the date whereby the dividend amount is decided by the board of directors for those shareholders owning stock on the date of record (usually 1 month later) and to be paid on the date of distribution. Ex-dividend date is a date prior to the date of record (see ex-dividend date).

Question 74

Term: Retained Earnings
Retained earnings are an increase in net assets from results of operations, retained by the corporation for use in the enterprise. They are internally generated financing or the corporation’s undistributed earnings. They are accumulated earnings, less accumulated losses and dividends paid, from inception. Retained earnings are a major source of owners’ equity and can be viewed as additional investments by the owners as foregone dividends.

Negative balance is called a deficit.

Retained earnings may also be decreased by purchase of treasury stock at a price higher than the amount originally received for the stock.

Retained earnings may be appropriated (i.e., restricted as to use) by:

contractual specification (e.g., bond covenants),
legal requirement (e.g., by state law), or
management discretion (e.g., for future expansion).
Retained earnings are increased by net income, prior-period adjustments, and quasi-reorganization. Retained earnings are decreased by net loss, prior-period adjustments, cash, property, scrip, stock dividends, and treasury stock and stock retirement transactions.

Question 75

Treasury Stock

Answer 75

Treasury stock is shares of the issuing corporation’s own stock (common or preferred) that were issued and were later reacquired in the open market by the issuing corporation and are still held by the issuing corporation. Treasury stock is considered issued but not outstanding. It may be obtained through purchase, settlement of an obligation, or donation, and it may be retired or resold. Treasury stock does not carry voting, dividend, preemptive, or liquidation rights.

Treasury stock may be accounted for under the par value or the cost method of accounting. Both methods are considered GAAP. Treasury stock is not an asset and does not affect income. It is a contra (negative) element of stockholders’ equity—it decreases total equity. Treasury stock may increase or decrease contributed capital and may also decrease (but rarely increases) retained earnings.

FASB ASC 505-30

Question 76

Unconditional

Answer 76

“Unconditional” is said of the promise or order on commercial paper. It is not subject to, or limited by, any modifying circumstance or prerequisite. A promise or order is conditional if the instrument states that it is “subject to” or “governed by” another agreement or is to be paid “only” out of a particular fund or source (for a nongovernmental unit).

An order or promise is not conditional although the instrument:

• states its consideration.
• refers to the transaction out of which it arose.
• states that it is secured by a mortgage or other security device.
  indicates a particular account, fund, or source from which payment may be drawn.
• states that it is to be paid “only” out of a particular fund or source (for a governmental unit).
• is payable only out of the entire assets of a partnership, trust, estate, or unincorporated association.
• states that it is drawn under a letter of credit.

UCC 3-106

UCC 3-106

Question 77

Valuation Allowance

Answer 77

The valuation allowance represents the difference between cost and fair value. Valuation allowance is an adjunct or contra account of marketable equity securities and accounts receivable. The valuation allowance may be a debit or credit balance—since marketable equitable securities are recorded at fair value per FASB ASC 320-10, value can exceed cost.

The accounting treatment for changes in the valuation allowance depends upon the classification of the assets to which it refers:

• Accounts Receivable and Securities Classified as Trading Securities—included in the determination of net income of the period in which the changes occur
• Securities Classified as Available-for-Sale—included as a separate component of stockholders’ equity