Acct 351 Chapter 06

Question 1

arm’s length

Answer 1

A phrase that indicates a transaction was between two independent parties and that the resulting amount is a fair representation of the value

Question 2

balance sheet approach

Answer 2

An approach used to estimate uncollectible accounts receivable whereby the receivables are reported on the balance sheet at their net realizable value

Question 3

Barter or non-monetary transactions

Answer 3

These are transactions where little or no monetary assets are received as consideration when goods or services are purchased or sold

Question 4

billings

Answer 4

Long-term contracts such as construction-type contracts, which provide that the seller may bill the purchaser at intervals, as various points in the project are reached

Question 5

bundled sales

Answer 5

Contracts involving the sale of both goods and services for one price

Question 6

collectibility

Answer 6

When there is reasonable assurance as to the ultimate collection of a sale and revenues are therefore recognized

Question 7

commercial substance

Answer 7

A quality of transactions that create a significant change in a company’s expected future cash flows and therefore its value

Question 8

Completed-Contract Method

Answer 8

The revenue recognition method in which revenues and gross profit are recognized only when the contract is completed

Question 9

concessionary (or abnormal) terms

Answer 9

Terms of a contract that are more lenient than normal arising when one party is in a better bargaining position than the other

Question 10

Consideration

Answer 10

In a transaction, the item or rights acquired. Can be monetary or non-monetary

Question 11

consignment

Answer 11

Goods that are sold on consignment yet remain the consignor’s property and therefore must be included in inventory

Question 12

constructive obligation

Answer 12

A type of performance obligation not stated in a contract that is created through a past practice or by signalling something to potential customers, such as a “100% satisfaction guaranteed” policy

Question 13

continuous earnings process

Answer 13

A process whereby performance of a sale requires numerous ongoing acts. (Synonym: continuous sale)

Question 14

continuous sale

Answer 14

A sale that occurs as work progresses on a contract where the buyer and seller have enforceable rights. The seller buyer has a legal right to require performance on the contract and the seller has the right to require progress payments as the work occurs

Question 15

contract-based approach

Answer 15

An approach to revenue recognition that measures the rights and obligations under sales contracts and recognizes revenues when these rights and obligations change. The contract is recognized when the entity becomes party to the contract, the contractual rights are collectible and measurable, and the performance obligation is measurable

Question 16

cost-to-cost basis

Answer 16

The process by which the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract

Question 17

credit risk

Answer 17

The risk that one of the parties to the contract will fail to fulfill its obligation under the contract and cause the other party loss

Question 18

critical event

Answer 18

An action or main event in a sales transaction that signifies substantial completion or performance under the terms of the contract, allowing revenues to be recognized under accrual accounting

Question 19

discrete earnings process

Answer 19

Where the earnings process has a critical event

Question 20

earnings approach

Answer 20

An approach to revenue recognition whereby revenues are recognized when performance is substantially complete and collection is reasonably assured

Question 21

Earnings process

Answer 21

The cash-to-cash cycle where goods and services are purchased, and when they are sold and converted into cash, or a claim to cash, the earnings process is said to be substantially complete

Question 22

FOB destination

Answer 22

The legal title of an asset does not pass to the buyer until the goods reach the customer’s location

Question 23

FOB shipping point

Answer 23

The legal title of an asset belongs to the buyer when the goods leave the shipping dock

Question 24

income statement approach to accounting for revenues

Answer 24

The process where costs are matched with revenues because they relate to the charge in the period in which the sale is recorded

Question 25

Input measures

Answer 25

Costs incurred that measure efforts devoted to a contract

Question 26

legal title

Answer 26

Where a good is legally owned. Legal title is not the same as possession

Question 27

Measurement uncertainty

Answer 27

This is when there is a variance between the recognized amount and other reasonably possible amount

Question 28

multiple deliverable

Answer 28

Contracts involving the sale of both goods and services for one price

Question 29

net contract position

Answer 29

The difference or net amount between an entity’s contractual rights and obligations for a specific contract

Question 30

onerous

Answer 30

A term describing a contract that is no longer profitable for a company. In such a case, consideration should be given to remeasuring the contract and recording a loss in the income statement.

Question 31

Output measures

Answer 31

The output of a contract, or the process that is used to measure results

Question 32

Percentage-of-Completion Method

Answer 32

A revenue recognition method that recognizes revenue, costs, and gross profit as progress is made towards completion of a long-term contract

Question 33

Performance

Answer 33

The process whereby the company earns the revenue and the revenue is measurable

Question 34

point of delivery

Answer 34

The point in time where the risks and rewards of ownership pass from the seller to the buyer

Question 35

possession

Answer 35

When the entity has physical control over the good, but not the legal title to the good

Question 36

price risk

Answer 36

The risk that an instrument’s price or value will change

Question 37

Realization

Answer 37

is the process of converting noncash resources and rights into money.

Question 38

realized

Answer 38

Revenue from assets received or sold can be readily converted into cash or claims to cash

Question 39

reciprocal

Answer 39

Describing an exchange where an entity gives something up and receives something in return

Question 40

relative fair value method

Answer 40

A method of allocating a price to each unit of a transaction involving multiple units. It involves determining the fair value of each item and allocating the purchase price based on the relative fair values

Question 41

residual value method

Answer 41

The leased property’s estimated fair value at the end of the leased term

Question 42

revenue

Answer 42

Increases in economic resources, either by inflows or other enhancements of an entity’s assets or settlement of its liabilities resulting from an entity’s ordinary activities

Question 43

risks and rewards of ownership

Answer 43

A concept of financial reporting that helps establish ownership and when ownership passes from one party to another

Question 44

Understand the economics and legalities of selling transactions from a business perspective

Answer 44

It is critical to understand a transaction from a business perspective before attempting to account for it. The analysis should begin with what is being sold to the customer (goods or services) and note also the nature and amount of the consideration. When one party is in a better bargaining position than the other, it may be able to negotiate concessions such as more lenient payment terms. These concessions often complicate the accounting as they introduce measurement uncertainty in many cases.

Selling transactions are based on contractual arrangements between a buyer and a seller. Contracts create rights and obligations under law that must be considered when accounting for the transactions. In addition to contractual law, rights and obligations may exist under other forms of the law, e.g., common law or statutory law. These should also be considered

Question 45

Understand the conceptual difference between an earnings approach and a contract-based approach for accounting purposes

Answer 45

The earnings approach focuses on the earnings process and how a company adds value whereas the contract-based approach focuses on the creation of contractual rights and obligations created by sales contracts

Question 46

Identify and apply revenue recognition principles under the earnings approach

Answer 46

Under this approach, revenue is recognized when performance is substantially complete (risks and rewards have passed and the earnings process is substantially complete and measurable) and collection is reasonably assured

Question 47

Identify and apply revenue recognition principles under the contract-based approach

Answer 47

Under this approach, there are two recognition points: (1) when to recognize the net contract position, and (2) when to recognize the related revenue in the income statement. The net contract position is first recognized when the contract is entered into. Revenue is recognized when performance occurs. This is when control passes if goods are involved or when the service is provided/performance obligation is extinguished. The accounting should also take into account measurement and collection uncertainty

Question 48

Discuss issues relating to measurement and measurement uncertainty

Answer 48

Revenue may only be recognized when measurable. There are many reasons that measurement uncertainty exists including inability to measure the revenue itself (e.g., barter transactions or price protection clauses) and inability to measure costs or uncertainty relating to the outcome of the contract itself (contingencies). In the latter case, extreme uncertainty may indicate that the contract or business deal has not yet been completed. Where the sale involves more than one element, e.g., goods and services, then the selling price must be allocated to the respective parts of the sale using an allocation method such as the relative fair value method or residual method

Question 49

Understand how to account for sales where there is collection uncertainty

Answer 49

Collectibility issues also create measurement uncertainty and must be considered when recognizing and measuring sales transactions. When collectibility cannot be assured and/or the related revenue is not measurable in terms of collection or credit risk, then no sale is booked

Question 50

Prepare journal entries for consignment sales under the earnings and contract-based approaches

Answer 50

Under the earnings approach, the risks and rewards remain with the seller and, therefore, a real sale does not occur until the goods are sold to a third party. Special accounts separate inventory on consignment. Under the contract-based approach, the consignor contracts with the consignee for selling services. The consignee would book the net contract position and recognize revenues when the services are provided (upon sale to the customer). The consignor would book the sales contract when the contract is entered into by the customer and the revenues when the control to the goods passes to the customer. This would likely result in the same journal entries as under the earnings approach, assuming that the contract is entered into at the same time as when control over the goods sold is passed to the customer.

Question 51

Apply the percentage-of-completion method under the earnings and contract-based approaches

Answer 51

To apply the percentage-of-completion method to long-term contracts, a basis is needed for measuring the progress toward completion at particular interim dates. One of the most popular input measures that is used to determine the progress toward completion is the cost-to-cost basis. Using this basis, the percentage of completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract. The percentage of the total estimated costs that the costs incurred amount to is applied to the total revenue or the estimated total gross profit on the contract to arrive at the revenue or the gross profit amounts to be recognized to date. The journal entries would differ under the earnings approach as compared with the contract-based approach since the net contract position would be recognized when the contract is initially entered into under the latter. There is no need to separately account for billings under the contract-based approach

Question 52

Apply the completed-contract method under the earnings and contract-based approaches

Answer 52

Under the earnings approach, revenue and gross profit are recognized only when the contract is completed. Costs of long-term contracts in process and current billings are accumulated, but there are no interim charges or credits to income statement accounts for revenues, costs, and gross profit. The annual entries to record costs of construction, progress billings, and collections from customers would be identical to those for the percentage-of-completion method, with one significant exception: revenue and gross profit are not recognized until the end of the contract.

Under the contract-based approach, this method is not relevant since the net contract would be booked when the contract is entered into and if a customer has been identified, the revenues would be recognized as the services were performed and control over the asset was passed to the customer. Where legal title to the asset being constructed is not passed over to the customer until the end of the contract, the transaction is treated like a sale of goods, with revenue being booked at the end when the goods are “sold.” Therefore, the journal entries would be essentially the same as under the percentage-of-completion method (contract-based approach) except for the revenue recognition entries

Question 53

Understand how to present sales transactions in the income statement

Answer 53

Transactions where the seller is acting as principal in the sale should be accounted for on a gross basis. Where the seller is acting as an agent (putting buyers and sellers together), the transaction should be booked on a net basis. Consideration should be given to whether the seller has the risks and rewards of ownership of the product being sold.

Transactions are treated as revenues when they relate to ordinary activities of the entity. They are treated as gains when they deal with ancillary activities. In general, revenues and gains are booked to net income except in very limited circumstances. These will be reviewed in later chapters

Question 54

Identify differences in accounting between accounting standards for private enterprises (private entity GAAP) and IFRS

Answer 54

The main differences are identified in the chart on page 352

Question 55

Understand the impact of accounting choices on key numbers/ratios

Answer 55

“Revenues” is a key number on the financial statements. It is used to judge management’s job performance and is an indicator of sustainable growth potential. For this reason, revenues are sometimes manipulated in the financial statements. Care should be taken to ensure that the revenues recognized reflect economic reality. Having said this, there are differing conceptual views on when and how revenues should be recognized

Question 56

Discuss current trends in standard setting for revenue recognition

Answer 56

IASB and FASB are currently studying a new model for revenue recognition—the contract-based model, which is felt to be conceptually superior