F1 Flashcards
2 fundamental characteristics of useful financial information
- Relevance
- Faithful Representation
3 elements of Relevance
- Predictive value
- Confirmatory value
- Materiality
3 elements of Faithful Representation
- Completeness
- Neutrality (Free from Bias)
- Free from error
4 enhancing characteristics of useful financial info
- Comparability
- Verifiability
- Timeliness
- Understandability
Constraint on Fin Reporting
Cost Constraint - benefits of reporting must outweigh the cost
What are the 5 Financial Statements
Statement of…
1. Financial Position
2. Earnings
3. Comprehensive Income
4. Cash Flows
5. Changes in Owner’s Equity
What does a ‘classified’ balance sheet do
Separates Current and Non-Current assets/liabilities
What are the steps to set an Accounting Standard?
FASB:
1. adds to agenda
2. research and issue discussion memo
3. public hearings
4. evaluate research and issue an Exposure Draft (1st version of new standard)
5. solicit new comments and modify draft
6. finalize new standard by vote (4 out of 7 FASB members)
7. issue Accounting Standard Update
Current Ratio
Current Assets over Current Liabilities
Quick Ratio
(Current Assets - Inventories - Prepayments) over Current Liabilities
Debt to Equity
Total Liabilities over Shareholder’s Equity
Income Statement Organized
Sales
COGS
=Gross Income
Selling, general & admin (Selling can be separate)
Depreciation
=Operating Income
Non-operating items (unusual & infrequent)
=Income before tax/Income from Operations
Income tax
=Income from continuing operations
Income from Discontinued Operations (report net of tax)
=Net Income
2 distinctions on an Income Statement
Continuing Operations
- Operating + unusual & infrequent
Discontinued Operations (net of tax)
Gross margin
Gross profit over Sales
Net margin
Net profit over Sales
EPS/Earnings Per Share
Net income over weighted average of common shares outstanding
Revenue is reported net of what
Discounts and Returns (anything else in another line item, e.g. recovery of bad debt, purchase discounts)
5-step approach to Revenue Recognition
ISTAR (I am a STAR)
1. Identify contract with customer
2. Separate performance obligations
3. Transaction price (determine)
4. Allocate the transaction prices to separate performance obligations
5. Recognize revenue when the entity satisfies each performance obligation
Rule of Conservatism and Combination of Contracts
The overarching rule of conservatism suggests that we recognise revenue only when the job is done.
Lawyers might separate contracts (e.g. 1 for building the machine, 1 for installing, 1 for ongoing support) but we apply substance over form and look at all contracts as one.
‘when two or more contracts are entered into with the same customer or related parties at or near the same time, the contracts should be combined…. consideration for one contract is tied to the performance of another contract’
When is a Performance Obligation satisfied
A good/service is transferred when the customer obtains control of it
Examples of when Performance Obligations are not separately identifiable
- when the goods/services are highly interrelated
- when the entity provides significant service of integrating goods/services into a bundle that represents a combined output
When Transaction Price is variable
Take the range of possible amounts and use either one of these, which ever is a better predictor:
1. Weighted average
2. Most likely amount (mode)
When there are few options use option 2 because 1 won’t correspond to a real outcome
When Transaction Price has noncash consideration
Measure the fair value at the contract inception (when it was signed)
When a Transaction Price has financing
If < 1 year then discounting is unnecessary
Otherwise adjust transaction price by time value of money.
Recognise revenue for discounted amount then recognise interest income each year.
Allocating the Transaction Price
Allocate Proportionally according to Stand Alone prices.
Discounts - apply proportionally to all obligations
Two methods of Recognizing Revenue
- Output method - e.g. newspapers - based on output to customer
- Input method - e.g. CPA firm - based on inputs to satisfaction of performance obligation
When to Recognize Revenue over time vs at a point in time
Recognize over time if meeting the following critieria:
1. Good/service enhances an asset that the customer controls
2. Customer consumes entity performance benefit as it performs it
3. Entity is not creating an asset for itself and has enforceable right to receive payment for performance as it performs it
Example - building a house for a customer.
- If the upfront payments (security deposit, instalment payments etc) are non-refundable and the entity can’t direct the unit to another customer - Over Time
- If the upfront payments etc are refundable - Point in Time
Recognize at a point in time if it doesn’t meet above criteria
Two methods of Recognizing Revenue over time
- Output method - e.g. newspapers - based on output to customer
- Input method - e.g. CPA firm - based on inputs to satisfaction of performance obligation
What is a contract modification?
A change in the price or scope (or both).
Modification is treated as a new contract if the scope increases because of new goods/services and change in contract price represents stand-alone prices
Deferred vs Unearned Revenue
They are both liabilities on the Balance Sheet but Unearned Revenue is for services (e.g. service element of a contract) and Deferred Revenue is for Goods.
Similarly, Sales Revenue is for Goods and Earned Revenue is for services.
What are Incremental Costs of obtaining a contract?
Costs that would not otherwise have been incurred if the contract hadn’t been obtained
How to account for incremental costs of a contract
If entity expects to recover costs: capitalise as asset and amortize (e.g. Commissions to sales employees only on successful pitch, legal fees on drawing up the contract)
If costs incurred regardless of whether contract was obtained then expense them (e.g. Travel Costs to make the pitch)
Eligible costs to Fulfill a Contract
Meet all of these criteria. Will be recognised as an asset and released as COGS when performance obligation is met:
- Relate directly to a contract (e.g. direct labor, materials, allocated costs)
- Generate or enhance the resources of an entity (e.g. existing employee providing tech support does not fulfill this)
- Expected to be recovered (expect revenue)
Contract costs that should be expensed when incurred
Selling, general and Admin costs, wasted labor and material costs
Revenue Recognition when an entity is an Agent (as opposed to Principal)
Agents recognise the net revenue (i.e. just the commission) in the revenue line and a liability for monies due to the Principals.
A company is the principal if it controls the good or service being sold. If so it recognises gross sales and rest as COGS
What is a Repurchase Agreement and what are the types
The sale of a good with the right of return. The Customer has the right to return the product for a refund. There are three types
- A Forward - the seller is obliged to repurchase the asset (buyer has no choice)
- A Call Option - the seller has the right to repurchase the asset (buyer has no choice)
- A Put Option - the seller is obliged to repurchase the asset at the customer’s request (buyer has the choice)
Accounting for a Forward or Call Option Repurchase Agreements (situations where the buyer has no choice)
If the Forward or Call Option repurchase commitment is equal to or more than the original price paid then it constitutes a Financing Arrangement. The difference between original price and repurchase price is treated as interest expense.
If it’s less than original selling price then treat as a lease
Finance journal entries
On original sale, Dr Cash, Cr Financial Liability
Over period recognise interest: Dr Interest exp, Cr Financial Liability
If Option lapses, recognise sale: Dr Financial Liability, Cr Sale (including interest)
Accounting for a Put Option Repurchase Agreements (situations where the buyer has the choice)
Where the buyer has the choice to exercise the Repurchase Agreement then also need to consider whether the buyer has significant economic incentive to exercise the right:
If repurchase prices is less than original selling price and:
- If there is significant incentive - a lease
- If no significant incentive - a sale with right of return
If repurchase prices is more than original selling price and:
- repurchase is more than the expected MV of the asset - Financing Arrangement
- repurchase price is less than (or =) the repurchase price of asset and no significant economic incentive to exercise - a sale with right of return
Accounting for Bill and Hold arrangements
Revenue can’t be recognised until the customer obtains control of the product. For control in a Bill and Hold, all of the following criteria must be met:
- Must be a substantive reason for the arrangement (e.g. customer requested)
- Product has been separately identified as belonging to the customer
- Product is ready for delivery
- Entity cannot direct the product to another customer
Accounting for Consignments
When the dealer/distributor does not have control of the product.
Recognise revenue when the dealer/distributor sells the product (or when it obtains control).
Accounting for Warranties
A warranty that comes as standard (e.g. 1 year at time of purchase) is not a separate performance obligation and so not accounted for separately. If the law requires a warranty etc then not separate.
If you the option to buy an extended warranty then that is a separate performance obligation. Beyond normal assurance that the product will comply with agreed specs.
Refund Liabilities and Right of Return
Refund Liability reflects the amount the entity expects not to be entitled to receive.
Journal on original sale
Dr Cash
Cr Revenue
Cr Refund Liability (amount entity expects not to be entitled to receive)
When receive returned products
Dr Refund Liability
Cr Cash
Recognising Revenue for Long-Term Construction contracts
2 methods allowed:
- Percentage-of-Completion Method = revenue over time
This is the standard method and required most of the time - Completed Contract Method = at a point in time
Only allowed in some circumstances and only allowed in US GAAP (not IFRS)
Under what circumstances must you use the Percentage-of-Completion method for long term contracts?
When you can:
- Reasonably estimate profits
- Provide a reliable measure of progress towards completion
Accounts used in Percentage-Completion Method accounting
Balance Sheet:
Current Assets:
- Accounts Receivable (for due on account payments)
- Construction in Progress account. An inventory account where construction costs and Gross Profit are accumulated. So period GP journal would be:
Dr COGS (cost of LT construction contracts) for portion of inventory used in period
Dr Construction in Progress for Gross Profit
Cr Revenue from LT construction contracts for sales to recognised
Current Liabilities:
- Progress Billings - Billings on construction are accumulated here.
For Balance Sheet reporting, the Construction in Progress account and the Progress Billings account are netted against each other.
How to calculate percentage of Gross Profit to date in Percentage-of-Completion method
N.B. an estimated loss on total contract must be recognised in full immediately. Previous profit recognised reversed out
When to apply the Completed Contract Method for Long-term contracts
U.S. GAPP only. Can only use when:
1. Difficult to estimate
2. Many contracts
3. Contracts are of a short duration
Accounting for Completed Contract Method for Long-term contracts
Same accounts as in Percentage Completion Method. But you don’t have the periodic journal recognising Gross Profit. No Gross Profit is recognised until the contract is completed.
Exception to this is if you see there will be an overall loss on the contract. In which case recognise this in full immediately.
When to report a loss from a Discontinued Operation
Report all amounts in the period in which they happen. Ignore future estimates including losses
Accounting for discontinued operations held for sale
You treat an operations component ‘held for sale’ the same as a disposed of operation:
Recognised profit/loss from full year regardless of when ‘held for sale’ or sold
When to treat a component disposal as discontinued operation?
When disposal:
- represents a strategic shift
- it has a major effect on a company’s operations
Things to calculate for a Discontinued Operation
- Results of operations for that period only (no estimates for future periods)
- Gain or loss on disposal (in year of sale)
- Impairment loss (and subsequent impairment reversal) - impair when made held for sale, then reverse later if necessary. Selling Price - Costs to Sell = NRV. If NRV < Book Value then impaired. If NRV increases to more than book value later then reverse previous impairment but don’t recognise a gain.
Accounting for Changes in Accounting Estimates
- Prospective application (not an error, no restatement)
- When a change in acc’g priniciple is considered inseparable from estimate use propsective approach. E.g. Changes in Depreciation Method or changing to LIFO inventory valuation.
- If a change in estimate affects lots of future periods then disclose in the notes.
Accounting for Changes in Accounting Principle
- Retrospective Application (restatement)
- Has to be justified: either required by GAAP or it’s preferable (more fairly represent my situation - no income smoothing)
- Calculate cumulative effect of prior adjustment. Multiply this by (1-Tax) and adjust b/f Retained Earnings for this (b/f of comparatives, if applicable)
- Exceptions - changes in Depreciation Method (straight line etc) or change to LIFO - handled like an change in estimate (prospective)
Situations that require Restatement (other than change in Acc’g Principle)
- Changes in the companies included in Consolidation
- Error correction (material, e.g. non-GAAP to GAAP)
Comprehensive Income =
Net Income + Other Comprehensive Income
Other Comprehensive Income rolls up into which equity account?
Accumulated OCI (not Retained Earnings)
Other Comprehensive Income examples
PUFI:
- Pension Adjustments
- Unrealised Gains/Losses on available-for-sale debt securities, cash-flow hedges (n.b. unrealised gains/losses on investments securities go through IS)
- FX translation method (not remeasurement method, which goes to IS)
- Instrument specific credit risk (e.g. Fair Value option)
Reclassifications between OCI and IS
OCI is like a holding tank until the transaction is ready to be reported in Income Statement. Reclassification Adjustments necessary to move from Accumulated OCI to Retained Earnings.
E.g. recongnize unrealised gains on held-for-sale securities in OCI. When gain realized you move from OCI to IS.
Disclosures on OCI
Tax
OCI items are either reported net of tax, or before tax with one line for tax.
But you do have to report the tax associated with each line and this can be done either on the statement or in a note.
Components
Changes in accumulated balances of each component (PUFI) have to be disclosed either in the face of the statement (as a Matrix) or in a note
Reclassifications
Have to be disclosed separately from current-period OCI
