Book 3 - FRA - Income Statement

Question 1

What are revenue recognition methods for installment sales?

Answer 1

• Normal revenue recognition at time of sale if collectability is reasonably assured.
• Installment sales method if collectability cannot be reasonably estimated.
• Cost recovery method if collectability is highly uncertain.

Question 2

What is Income Statement?

Answer 2

The income statement shows an entity’s revenues, expenses, gains and losses during a reporting period.

Question 3

What is a multi-step income statement?

Answer 3

A multi-step income statement provides a subtotal for gross profit and a single step income statement does not.

Question 4

How can expenses be grouped on IS?

Answer 4

Expenses on the income statement can be grouped by the nature of the expense items or by their function, such as with expenses grouped into cost ofgoods sold.

Question 5

Methods for accounting for long-term contracts include?

Answer 5

• Percentage-of-completion - recognizes revenue in proportion to costs incurred.
• Completed-contract-recognizes revenue only when the contract is complete.

Question 6

According to the International Accounting Standards Board (IASB), revenue is recognized from the sale of goods when:

Answer 6

1. The risk and reward of ownership is transferred.
2. There is no continuing control or management over the goods sold.
3. Revenue can b e reliably measured.
4. There i s a probable flow o f economic benefits.
5. The cost can be reliably measured.

Question 7

According to the International Accounting Standards Board (IASB), revenue is recognized from services rendered, revenue is recognized when:

Answer 7

1. The amount of revenue can be reliably measured.
2. There is a probable flow of economic benefits.
3. The stage o f completion can b e measured.
4. The cost incurred a n d cost o f completion can b e reliably measured.

Question 8

What is the difference in accounting for long term progects under IFRS and GAAP?

Answer 8

When the outcome of a long-term contract can be reliably estimated, the percentage­ of-completion method is used under both IFRS and U.S. GAAP. Accordingly, revenue, expense, and therefore profit, are recognized as the work is performed. The percentage of completion is measured by the total cost incurred to date divided by the total expected cost of the project.

Under International Financial Reporting Standards (IFRS), if the firm cannot reliably measure the outcome of the project, revenue is recognized to the extent of contract costs, costs are expensed when incurred, and profit is recognized only at completion. Under U.S. GAAP, the completed-contract method is used when the outcome of the project cannot be reliably estimated. Accordingly, revenue, expense, and profit are recognized only when the contract is complete.

If a loss is expected, the loss must be recognized immediately under IFRS and U.S. GAAP.

Question 9

How does barter transactions accounted for?

Answer 9

Revenue from barter transactions can only be recognized if its fair value can be estimated from historical data on similar non-barter transactions.

Question 10

What is the difference between gross and net revenue reporting?

Answer 10

Gross revenue reporting shows sales and cost of goods sold, while net revenue reporting shows only the difference between sales and cost of goods sold and should be used when the firm is acting essentially as a selling agent and does not stock inventory, take credit risk, or have control over supplier and price.

Question 11

Users of financial information must consider two points when analyzing a firm’s revenue:

Answer 11

1. how conservative are the firm’s revenue recognition policies (recognizing revenue sooner rather than later is more aggressive)
2. the extent to which the firm’s policies rely on judgment and estimates.

Question 12

What is the matching principle?

Answer 12

The matching principle requires that firms match revenues recognized in a period with the expenses required to generate them. One application of the matching principle is seen in accounting for inventory, with cost of goods sold as the cost of units sold from inventory that are included in current-period revenue. Other costs, such as straight-line depreciation of fixed assets or administrative overhead, are period costs and are taken without regard to revenues generated during the period.

Question 13

Depreciation methods:

Answer 13

1. Straight-line: Equal amount of depreciation expense in each year of the asset’s useful life.
2. Declining balance: Apply a constant rate of depreciation to the declining book value until book value equals residual value.

Question 14

Inventory valuation methods:

Answer 14

1. FIFO: Inventory reflects cost of most recent purchases, COGS reflects cost of oldest purchases.
2. LIFO: COGS reflects cost of most recent purchases, inventory reflects cost of oldest purchases.
3. Average cost: Unit cost equals cost of goods available for sale divided by total units available and is used for both COGS and inventory.
4. Specific identification: Each item in inventory is identified and its historical cost is used for calculating COGS when the item is sold.

Question 15

How are intangible assets amortized?

Answer 15

Intangible assets with limited lives should be amortized using a method that reflects the flow over time of their economic benefits. Intangible assets with indefinite lives (e.g., goodwill) are not amortized.

Question 16

Why are changes in estimates important to analysts?

Answer 16

Users of financial data should analyze the reasons for any changes in estimates of expenses and compare these estimates with those of peer companies.

Question 17

How are discontinued operations reported on IS?

Answer 17

Results of discontinued operations are reported below income from continuing operations, net of tax, from the date the decision to dispose of the operations is made. These results are segregated because they likely are non-recurring and do not affect future net income.

Question 18

How are unusual or infrequent items reported on IS?

Answer 18

The definition of these items is obvious-these events are either unusual in nature or infrequent in occurrence, but not both. Examples of unusual or infrequent items include:

• Gains or losses from the sale of assets or part of a business.
• Impairments, write-offs, write-downs, and restructuring costs.

Unusual or infrequent items are included in income from continuing operations and are reported before tax.

Analytical implications: Even though unusual or infrequent items affect net income from continuing operations, an analyst may want to review them to determine whether they truly should be included when forecasting future firm earnings.

Question 19

How are extraordinary items reported on IS?

Answer 19

Under U.S. GAAP, an extraordinary item is a material transaction or event that is both unusual and infrequent in occurrence. Examples of these include:

• Losses from an expropriation of assets.
• Gains or losses from early retirement of debt (when it is judged to be both unusual and infrequent).
• Uninsured losses from natural disasters that are both unusual and infrequent.

Extraordinary items are reported separately in the income statement, net of tax, after income from continuing operations.

IFRS does not allow extraordinary items to be separated from operating results in the income statement.

Analytical implications: Judgment is required in determining whether a transaction
or event is extraordinary. Although extraordinary items do not affect income from continuing operations, an analyst may want to review them to determine whether some portion should be included when forecasting future income. Some companies appear to be accident-prone and have “extraordinary” losses every year or every few years.

Question 20

How are changes in accounting standards are reflected on IS?

Answer 20

Changes in accounting standards, changes in accounting methods applied, and corrections of accounting errors require retrospective restatement of all prior-period financial statements included in the current statement. A change in an accounting estimate, however, is applied prospectively (to subsequent periods) with no restatement of prior-period results.

Analytical implications: Accounting estimate changes typically do not affect cash flow. An analyst should review changes in accounting estimates to determine the impact on future operating results. Prior-period adjustments usually involve errors or new accounting standards and do not typically affect cash flow. Analysts should review adjustments carefully because errors may indicate weaknesses in the firm’s internal controls.

Question 21

When should EPS reported?

Answer 21

When a company has potentially dilutive securities, it must report diluted EPS.

Question 22

Basic EPS?

Answer 22

Question 23

Diluted EPS?

Answer 23

Question 24

Things to know about the weighted average shares outstanding calculation:

Answer 24

• The weighting system is days outstanding divided by the number of days in a year, but on the exam, the monthly approximation method will probably be used.
• Shares issued enter into the computation from the date of issuance.
• Reacquired shares are excluded from the computation from the date of reacquisition.
• Shares sold or issued in a purchase of assets are included from the date of issuance.
• A stock split or stock dividend is applied to all shares outstanding prior to the split or dividend and to the beginning-of-period weighted average shares. A stock split or stock dividend adjustment is not applied to any shares issued or repurchased after the split or dividend date.

Question 25

What is treasury stock method and when to use it?

Answer 25

Stock options and warrants are dilutive only when their exercise prices are less than the average market price of the stock over the year. If the options or warrants are dilutive, use the treasury stock method to calculate the number ofshares used in the denominator.

• The treasury stock method assumes that the funds received by the company from the exercise of the options would be used to hypothetically purchase shares of the company’s common stock in the market at the average market price.
• The net increase in the number of shares outstanding (the adjustment to the denominator) is the number of shares created by exercising the options less the number of shares hypothetically repurchased with the proceeds of exercise.

Question 26

What is vertical common-size income statement?

Answer 26

A vertical common-size income statement expresses each item as a percentage of revenue. The common-size format standardizes the income statement by eliminating the effects of size. Common-size income statements are useful for trend analysis and for comparisons with peer firms.

Question 27

What are two popular profitablility ratios?

Answer 27

Two popular profitability ratios are gross profit margin (gross profit I revenue) and net profit margin (net income I revenue). A firm can often achieve higher profit margins by differentiating its products from the competition.

Question 28

What is comprehensive income statment?

Answer 28

Comprehensive income is a more inclusive measure that includes all changes in equity except for owner contributions and distributions. That is, comprehensive income is the sum of net income and other comprehensive income. Other comprehensive income includes transactions that are not included in net income, such as:

1. Foreign currency translation gains and losses.
2. Adjustments for minimum pension liability.
3. Unrealized gains and losses from cash flow hedging derivatives.
4. Unrealized gains and losses from available-for-sale securities.

Available-for-sale securities are investment securities that are not expected to be held
to maturity or sold in the near term. Available-for-sale securities are reported on the balance sheet at fair value. The unrealized gains and losses (the changes in fair value before the securities are sold) are not reported in the income statement but are reported directly in stockholders’ equity as a component of other comprehensive income.

Under IFRS, firms can choose to report certain long-lived assets at fair value rather than historical cost. In this case, the changes in fair value are also included in other comprehensive income.