FAR SEC 2 Flashcards
1
Q
What is a functional currency?
A
The functional currency is the currency of the primary economic environment in which the entity operates. Normally, that environment is the one in which it primarily generates and expends cash.
2
Q
What is a foreign currency?
A
A foreign currency is any currency other than the entity’s functional currency.
3
Q
How are foreign currency transactions stated?
A
Foreign currency transaction terms are stated in a currency different from an entity’s functional currency.
-For example, if an entity whose functional currency is the U.S. dollar purchases inventory on credit from a German entity, payment is to be in euros.
4
Q
What causes a foreign currency transaction gain or loss?
A
A foreign currency transaction gain or loss results from a change in the exchange rate between the date the transaction was recognized, the date of the financial statements, and the date the transaction is settled.
5
Q
In what period is a gain or loss on a foreign currency transaction included in the income statement?
A
This gain or loss is included in the income statement in the period the exchange rate changes.
6
Q
If a foreign currency transaction results in an accrual such that the monetary aspect hasn’t yet been settled as of the end of the reporting period, how is the transaction measured?
A
If the monetary aspect of the transaction has not yet occurred at the end of the reporting period, monetary items (accounts payable and accounts receivable) are measured at the period-end exchange rate.
7
Q
What is earnings per share (EPS)?
A
Earnings per share (EPS) is the amount of current-period earnings that can be associated with a single share of a corporation’s common stock.
8
Q
For which entities must the guidance for reporting EPS be followed?
A
The guidance regarding calculation and presentation of EPS must be followed by public entities and by other entities that choose to report EPS.
8
Q
What is EPS calculated for?
A
EPS is calculated only for common stock.
8
Q
Is EPS calculated for preferred stock?
A
No.
8
Q
What is basic earnings per share?
A
All corporations must report two BEPS amounts on the face of the income statement. Their numerators are income from continuing operations and net income, respectively.
8
Q
What condition must apply in order for the entity to not have to report two BEPS amounts?
A
If an entity has no discontinued operations, the income from continuing operations equals net income. Thus, one amount of BEPS for net income available to common shareholders is presented on the face of the income statement.
9
Q
What is the BEPS equation?
A
BEPS = [Income Available to Common Shareholders]/[Weighted-average number of common shares outstanding]
9
Q
What is the BEPS numerator?
A
Income available to common shareholders is the BEPS numerator.
9
Q
What are the EPS reporting requirements if a discontinued operation is reported?
A
If a discontinued operation is reported, basic and diluted EPS amounts for the discontinued operation are presented on the face of the income statement or in the notes.
9
Q
What two BEPS amounts must be reported by all corporations on the face of the income statement.
A
1) Continuing Operations BEPS
2) Net Income BEPS
10
Q
For calculating the BEPS numerator, can the amount be calculated directly by using the amounts on the income statement for income from continuing operations or net income?
A
No. Income in the BEPS numerator is reduced by dividends, so the income statement amounts for income from continuing operations or net income must be adjusted for the effect of dividends.
10
Q
Which two adjustments are made to income statement amounts when calculating the BEPS numerator?
A
1) DECLARED NONCUMULATIVE PREFFERED DIVIDENDS. Dividends declared in the current period on preferred stock (whether or not paid) are deducted from income.
2) CUMULATIVE PREFERRED DIVIDENDS. Dividends accumulated for the current period on cumulative preferred stock (whether are not declared) are deducted from income.
11
Q
Are dividends on common stock ever deducted from the BEPS numerator?
A
No.
12
Q
Are dividends paid in the current period for undistributed accumulated preferred dividends from prior years deducted from income in the BEPS numerator?
A
No. Dividends paid in the current period for undistributed accumulated preferred dividends for prior years do not affect the calculation. They were included in BEPS of prior years.
13
Q
What is the equation for calculating Income Available to Common Shareholders, the BEPS numerator?
A
Income statement amount
– Dividends on preferred stock for the current period (cumulative or declared noncumulative)
= Income available to common shareholders
14
Q
What is another name for the BEPS numerator?
A
Income available to common shareholders.
15
Q
What is another name for the BEPS denominator?
A
The weighted-average number of common shares outstanding.
16
Q
Are preferred shares ever added to the BEPS denominator?
A
No, unless they are somehow converted to common shares, which could happen if there is preferred stock convertible to preferred shares.
17
Why is a weighted average necessary for the BEPS denominator?
Weighting is necessary because some shares may have been issued or reacquired during the period.
18
How is the BEPS denominator calculated?
The weighted-average number of common shares outstanding is determined by relating the portion of the period that the shares were outstanding to the total time in the period, i.e., a weighted-average of the number of common shares outstanding is taken across the time period, with increments of time being the weights.
19
How do stock dividends and stock splits effect the calculation of the weighted-average of common shares outstanding, i.e., the BEPS denominator? (2 elements)
1) RETROACTIVE ADJUSTMENT TO CAPITAL STRUCTURE USED IN WEIGHTED-AVERAGE. EPS amounts for all periods presented are adjusted retroactively to reflect the change in capital structure as if it had occurred at the beginning of the first period presented.
3) MAKE ADJUSTMENT EVEN IF STOCK DIVIDEND/SPLIT OCCURS AFTER REPORTING PERIOD (BUT BEFORE STATEMENTS ISSUED).
Adjustments are made for such changes even if they occur after the end of the current reporting period but before issuance (or the availability for issuance) of the financial statements.
20
What are contingently issuable shares? How do they effect calculation of the BEPS denominator?
21
What kind of entity is exempt from reporting DEPS?
An entity with only common stock outstanding (a simple capital structure) must report only BEPS amounts but not DEPS.
22
What is a simple capital structure?
A simple capital structure means an entity with only common stock outstanding - there can be no preferred shares or other potential common shares.
23
Which entities must report DEPS?
An entity that does not have a simple capital structure must report DEPS as well as BEPS.
24
What defines the calculation of diluted earnings per share (DEPS) and distinguishes it from BEPS?
The DEPS calculation includes the effects of dilutive potential common shares (PCS), whereas BEPS does not include the effects of PCS.
25
What are potential common shares (PCS)?
PCS are securities or other contracts that may entitle the holder to obtain common stock.
26
What are the two types of PCS?
PCS can be either dilutive or antidilutive.
27
What is the criterion for including PCS in DEPS calculations?
PCS are included in the DEPS calculation only if they are dilutive.
28
What is dilution?
Dilution is a reduction in BEPS (or an increase in loss per share) resulting from the assumption that convertible securities (preferred stock or debt) were converted and/or stock options were exercised.
29
What assumption is invoked to determine whether PCS are dilutive or antidilutive?
The assumption that convertible securities (preferred stock or debt) were converted and/or stock options were exercised.
30
What circumstance indicates PCS are antidilutive?
If under the assumption that convertible securities (preferred stock or debt) were converted and/or stock options were exercised the resulting new common shares do not decrease EPS, the PCS being analyzed is deemed antidilutive.
31
What is diluted earnings per share (DEPS)?
DEPS measures performance after considering the effect on the numerator and denominator of dilutive PCS.
32
Does DEPS calculation involve adjustments to the BEPS denominator only?
No, DEPS can involve adjustments to both numerator and denominator.
33
In DEPS calculation, how is the BEPS denominator adjusted?
The BEPS denominator is increased to include the weighted-average number of additional shares of common stock that would have been outstanding if dilutive PCS had been issued.
34
In DEPS calculation, how is the BEPS numerator adjusted?
The BEPS numerator is adjusted to add back any dividends on convertible preferred stock and the after-tax interest expense (an amount that includes amortization of discount or premium) related to any convertible debt.
35
In DEPS calculation, which two things are added back to the BEPS numerator?
1) Any dividends on convertible preferred stock.
2) The after-tax interest expense (an amount that includes amortization of discount or premium) related to any convertible debt.
36
For DEPS calculations involving convertible debt PCS, what factors are important?
1) The interest expense must be deducted from the numerator.
2) The interest expense must be calculated as an after-tax amount.
3) The amortization of any discount or premium must be calculated and appropriately reflected in the numerator.
37
What is the equation for calculating DEPS?
DEPs = [BEPS numerator + Effect of dilutive PCS]/[BEPS denominator + Effect of dilutive PCS]
38
How does the effect of dilutive PCS influence an adjustment to the BEPS numerator?
Dilutive PCS may INCREASE the amount of income available to common shareholders by decreasing preferred dividends payable or interest expense payable.
39
How does the effect of dilutive PCS influence an adjustment to the BEPS denominator?
Dilutive PCS always increases the weighted-average number of common shares outstanding during a period.
40
When calculating the DEPS numerator, does the adding back of preferred dividends have to be adjusted for tax?
No.
41
Could dividends ever be reported net of tax? Why or why not?
Dividends are calculated on after-tax income available to shareholders, so dividends could NEVER be reported net of tax.
42
How must antidilutive PCS be treated during the calculation of DEPS?
The calculation of DEPS does not assume the conversion or exercise of antidilutive securities, i.e., securities that increase EPS or decrease loss per share. Thus, including antidilutive PCS in a DEPS calculation always results in a wrong answer.
43
How are dilutive PCS issued (but not converted) during a period included in the DEPS calculation?
Dilutive PCS issued during a period are included in the DEPS denominator for the period they were outstanding.
44
How are dilutive PCS that were actually converted during a period included in the DEPS calculation?
Dilutive convertible securities that were actually converted are included for the period before conversion. Common shares actually issued are included for the period after conversion.
45
Is previously reported DEPS ever retroactively adjusted for subsequent conversions or changes in the market price of the common stock?
Previously reported DEPS is not retroactively adjusted for subsequent conversions or changes in the market price of the common stock. Other accounting errors unrelated to DEPS calculations could result in the retroactive restatement of BEPS and DEPS.
46
How does treatment of dilutive PCS vary depending on whether the dilutive PCS are issued or actually converted/realized? (4 elements)
1) Dilutive PCS issued during a period are included in the DEPS denominator for the period they were outstanding. This would apply for convertible preferred stock, options/warrants, and contingently issuable common shares.
2) Dilutive convertible securities that were actually converted are included for the period before conversion.
3) Common shares actually issued are included for the period after conversion. This means contingently issuable common shares would go into the current period DEPS calculation unless they are actually issued, in which case they go in the after period's DEPS calculation.
4) It is unclear how the before/during/after periodization applies for the exercise of options and warrants.
47
What are the three methods used to determine the dilutive effect of PCS?
1) The if-converted method for convertible securities,
2) The treasury stock method for call options, and
3) The reverse treasury stock method for put options.
48
What are the two basic assumption of the if-converted method for calculating DEPS?
1) The if-converted method calculates DEPS assuming the conversion of all dilutive convertible securities at the beginning of the period or at the time of issue, if later.
2) The conversion of antidilutive securities (those whose conversion increase EPS or decrease loss per share) is not assumed. Thus, convertible PCS are antidilutive if the current dividend or after-tax interest per common share issuable exceeds BEPS.
49
What calculation determines whether a PCS is antidilutive?
Convertible PCS are antidilutive if the current dividend or after-tax interest per common share issuable exceeds BEPS.
[dividend OR after-tax interest]/[common shares issuable] > BEPS => ANTIDILUTIVE
50
[dividend OR after-tax interest]/[common shares issuable] > BEPS => DILUTIVE OR ANTIDILUTIVE
=> ANTIDILUTIVE
51
[dividend OR after-tax interest]/[common shares issuable] => DILUTIVE OR ANTIDILUTIVE
=> DILUTIVE
52
What is the algorithm for computing DEPS under the If-converted method? (5 steps)
1) SEPARETELY TEST EACH PCS FOR DILUTIVENESS. In determining whether PCS are dilutive, each issue or series of issues of PCS are considered separately (rather than in the aggregate) and in sequence from the most dilutive to the least dilutive. The goal of this process is to maximize the dilution of BEPS (lowest possible DEPS).
2) CHOOSE INITIAL CONTROL #. The control number to establish whether PCS are dilutive or antidilutive is the BEPS for the period.
-If a discontinued operation is reported, the control number is BEPS from continuing operations.
3) 1ST TRIAL DEPS CALCULATION ON MOST HIGHLY DILUTIVE PCS. The issue with the lowest earnings per incremental share is included in DEPS before issues with higher earnings per incremental share. If the issue with the lowest earnings per incremental share is found to be dilutive with respect to BEPS, it is included in a trial calculation of DEPS.
4) ITERATIVE TRIAL DEPS CALCULATIONS ON EACH OF THE REMAINING PCS GOING IN ORDER OF DECREASIING DILUTIVENESS. If the issue with the next lowest earnings per incremental share is dilutive with respect to the first trial calculation of DEPS, it is included in a new DEPS calculation that adjusts the numerator and denominator from the prior calculation.
5) TERMINATION WHEN A TRIAL CALCULATION FAILS. This process continues until all issues of PCS have been tested. A failure of the test calculation is when the resulting earnings per incremental share is less than the current control number.
53
In the If-converted method, what is the control number?
The control number to establish whether PCS are dilutive or antidilutive is the BEPS for the period.
54
What is the control number if there are discontinued operations?
If a discontinued operation is reported, the control number is BEPS from continuing operations.
55
For the If-converted method, how are control numbers updated?
The trial DEPS value from the previous iteration of the If-converted method becomes the control number for the subsequent trial DEPS calculation until the process terminates.
56
How does the control number indicate termination of the If-converted method?
If the value of the current trial DEPS calculation is greater than the current control number, the process terminates, with the current control number being the value of DEPS to be reported. All remaining PCS groups are rejected as antidilutive.
57
How does the existence of a discontinued operation effect the If-converted method?
If a discontinued operation is reported, the same number of shares used to adjust the denominator for income from continuing operations is used to adjust the DEPS denominator for income from discontinued operations. This rule applies even if the effect on the other amounts is antidilutive.
58
What is a call option?
A call is an option contract giving the owner the right, but not the obligation, to buy an underlying security at a specific price within a specified time. The specified price is called the strike price, and the specified time during which the sale can be made is its expiration (expiry) or time to maturity. A call seller must sell the asset if the buyer exercises the call.
59
What is the Treasury Stock Method?
The second method used to determine the dilutive effect of PCS is the treasury stock method. It is used to determine the dilutive effect of outstanding call options.
60
Under what condition are call options dilutive?
Call options are dilutive only if the average market price for the period of the common shares is greater than the exercise price of the options (they are in the money).
61
What are the three assumptions of the Treasury Stock Method?
1) The options are exercised at the beginning of the period (or time of issuance, if later),
2) Common shares are issued, and
3) The proceeds of exercise are used to purchase common stock at the period’s average market price.
62
Is the BEPS numerator ever effected under the Treasury Stock Method?
No. If the options are dilutive, their exercise affects only the denominator in the computation of DEPS. Any additional number of common shares outstanding (incremental shares) is added as an adjustment of the BEPS denominator.
63
What are the most dilutive PCS?
Because the numerator in the computation of DEPS is not affected, the earnings per incremental share is $0 for call options. Thus, options are generally the most dilutive PCS. They should be included first (before other series of PCS) in the trial calculation of DEPS.
64
Which PCS should always be assumed to have zero earning per incremental share and be included first in the If-converted Method?
Call Options. Call options are the most dilutive PCS because they don't result in adding to the BEPS numerator.
65
How is the number of incremental shares from dilutive call options that must be included in the DEPS denominator computed? (3 steps)
The number of incremental shares from dilutive call options that must be included in the denominator of the DEPS computation is calculated as follows:
1) Proceeds from exercising the options (Number outstanding × Exercise price).
2)Number of shares assumed purchased (Proceeds from exercise ÷ Average market price for the period of common shares).
3) Number of incremental shares (Number of common shares assumed issued – Number of common shares assumed purchased).
-The number of common shares assumed issued is the amount of common shares that would have been issued assuming all the options were exercised.
66
Under the Treasury Stock Method assumptions, what is the number of common shares assumed issued?
The number of common shares assumed issued is the amount of common shares that would have been issued assuming all the options were exercised.
67
Treasury Stock Method:
Proceeds from Exercising the Options = ?
Number Outstanding * Exercise Price
68
Treasury Stock Method:
Number of Shares Assumed Purchased = ?
[Proceeds from the Exercise]/[Average Market Price for the Period of Common Shares]
69
What is the system of equations for the Treasury Stock Method?
Is = Ci – Cp
Cp = P/Ap
Is = Cs – P/Ap
P = No*Ep
Is = Cs – (No*Ep)/Ap
Where
Is = # incremental shares
Cs = # common shares assumed issued
Cp = # common shares assumed purchased
P = Proceeds from Exercise
Ap = Average Price of Common Shares
No = # call options outstanding
Ep = Exercise Price
70
Treasury Stock Method:
Number of Incremental Shares = ?
Number of Common Shares Issued - Number of Common Shares Assumed Purchased
71
What is the basic Treasury Stock Method equation? What are the 5 variables in the equation?
Is = Cs – (No*Ep)/Ap
Where
Is = # incremental shares
Cs = # common shares assumed issued
Cp = # common shares assumed purchased
P = Proceeds from Exercise
Ap = Average Price of Common Shares
No = # call options outstanding
Ep = Exercise Price
72
What are the three Treasury Stock identities in words?
Incremental Shares = Common Shares Assumed Issued – Common Shares Assumed Purchased
Common Shares Assumed Purchased = [Proceeds from Exercise]/[Average Price of Common Shares]
Proceeds from Exercise = Call Options Outstanding*Exercise Price
73
For the Treasury Stock Method, how does the number of common shares assumed issued relate to the number of common shares assumed purchased?
The number of common shares assumed purchased =
[#Call Options]*[Strike Price]/Average Price of Common Shares in Period
The Treasury Stock Method assumes all common shares will be issued for all call options, so for:
Is = Cs – (No*Ep)/Ap
Assume Cs = No to solve the equation.
74
What is the Reverse Treasury Stock Method?
The third method used to determine the dilutive effect of PCS is the reverse treasury stock method. It is used when the entity has entered into contracts to repurchase its own stock, for example, when it has written put options held by other parties.
75
What are the steps of the Reverse Treasury Stock Method? (4 elements)
1) When the contracts are in the money (the exercise price exceeds the average market price), the potential dilutive effect on EPS is calculated by
2) Assuming the issuance at the beginning of the period of sufficient shares to raise the proceeds needed to satisfy the contracts,
3) Assuming those proceeds are used to repurchase shares, and
4) Including the excess of shares assumed to be issued over those assumed to be repurchased in the calculation of the DEPS denominator.
76
What kind of options contracts are associated with the Reverse Treasury Stock Method?
Put options.
77
Do the put options have to be in the money to be dilutive and therefore eligible for calculation of DEPS via the Reverse Treasury Stock Method?
Yes. When the contracts are in the money (the exercise price exceeds the average market price), the potential dilutive effect on EPS is calculated by the Reverse Treasury Stock Method.
78
When calculating the amount of the BEPS denominator, which is the weighted-average number of common shares outstanding during the period, when should a stock dividend be assumed to take effect in terms of defining the time period weights?
For the purpose of calculating BEPS, the stock dividend is assumed to have occurred at the beginning of the period.
79
What is ASC 606?
The guidance for recognition of revenue from contracts with customers (ASC 606) provides a single, principles-based model for all contracts with customers regardless of the industry-specific or transaction-specific fact pattern.
80
What is the core principle of ASC 606?
The core principle is that an entity recognizes revenue for the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in the exchange.
81
Which 4 categories of contracts with customers are EXCLUDED form coverage by ASC 606?
1) Leases
2) Financial instruments
3) Contractual rights and obligations within the scope of specific topics, such as receivables, derivatives and hedging, insurance, and guarantees (other than product or service warranties)
4) Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers
82
What are those "specific topics" whose scope excludes them from ASC 606? (4 elements)
1) Receivables
2) Derivatives and hedging
3) Insurance
4) Guarantees (other than product or service warranties
83
Which guarantees are included in ASC 606?
The only guarantees included in ASC 606 are product and service warrantees. All other guarantees are excluded.
84
What are the 5 steps of the 5 Step Model for recognizing contracts with customers?
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) a performance obligation is satisfied.
85
What is a contract?
A contract is an agreement between two or more parties that creates enforceable rights and obligations.
86
What are the 4 criteria for accounting for a contract under ASC 606?
A contract is accounted for under ASC 606 if all of the following criteria are met:
1) The contract was approved by the parties.
2) The contract has commercial substance.
3) Each party’s rights can be identified regarding
-Goods or services to be transferred and
-The payment terms.
4) It is probable that the entity will collect substantially all of the consideration to which it is entitled according to the contract.
-Probable means the future event is likely to occur.
87
Must all of the 4 criteria for contract existence be satisfied for ASC 606 to be invoked to account for a contract with customers.
Yes, all 4 criteria must be satisfied.
88
If a contract is covered by ASC 606, what is the result?
The result of invoking ASC 606 is that revenue is recognized.
89
Which two rights must be identifiable for both parties for a contract to exist under ASC 606?
1) Rights regarding goods and services to be transferred.
2) Rights regarding payment terms.
90
What is the outcome if any one of the four criteria for contract existence under ASC 606 fails to obtain?
If the criteria described above are not met (e.g., if collectibility cannot be reliably estimated), the consideration received is recognized as a liability, and no revenue is recognized until the criteria are met.
91
Under any one of which three conditions can revenue be recognized under ASC 606 if the contract existence criteria are not fully satisfied?
1) The contract has been terminated.
2) Control over the goods or services was transferred to the customer and the entity has stopped transferring (and has no obligation to transfer) additional goods or services to the customer.
3) The entity (1) has no obligation to transfer goods or services and (2) has received substantially all consideration from the customer.
92
How much revenue can be recognized in instances where contract existence criteria fail but at least one of the three criteria for partial revenue recognition obtain?
Revenue in the amount of nonrefundable consideration received from the customer is recognized.
Even when the four criteria for ASC 606 contract existence are not met, revenue in the amount of nonrefundable consideration received from the customer is recognized if at least one of the three conditions for partial revenue recognition is met.
93
When does a contract modification exist?
A contract modification exists when the parties approve a change in the scope or price of a contract.
94
Which two conditions must both be met in order to account for a contract modification as a separate contract?
1) DISTINCT GOODS/SERVICES ARE ADDED.
The scope of the contract increases because of the addition of promised goods or services that are distinct, and
2) PRICE CHANGES REFLECT STANDALONE SELLING PRICES FOR THE ADDITIONAL GOODS/SERVICES. The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services.
95
What is a performance obligation?
A performance obligation is a promise in a contract with a customer to transfer to the customer
-A good or service that is distinct or
-A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer.
96
Which two categories of things could be promised to be transferred to a customer under a performance obligation?
1) A good or service that is distinct or
2) A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer.
97
What are the two criteria that both must be met in order for promised good and services to be distinct?
1) CAPABLE OF BEING DISTINCT. The customer can benefit from them either on their own or together with other resources that are readily available (capable of being distinct) and
2) DISTINCT WITHIN THE CONTEXT OF THE CONTRACT. The entity’s promise to transfer them to the customer is separately identifiable from other promises in the contract (distinct within the context of the contract). A separately identifiable good or service
-Does not significantly modify or customize another good or service promised in the contract and
-Is not highly dependent on, or highly interrelated with, other goods or services promised in the contract.
98
Which two criteria must both be met for a separately identifiable good or service?
A separately identifiable good or service
1) Does not significantly modify or customize another good or service promised in the contract and
2) Is not highly dependent on, or highly interrelated with, other goods or services promised in the contract.
99
What are customer options to acquire additional goods or services for free or at a discount?
Customer options to acquire additional goods or services for free or at a discount have many forms, such as sales incentives, coupons, customer award points, or other discounts on future goods or services.
100
What is a material right?
A material right is an option that the customer would not receive without entering into that contract. An example is a discount in addition to the range of discounts typically given for those goods or services.
101
Under what condition does an option to acquire additional goods or services in a contract create a separate performance obligation under that contract?
When there is a material right to the option under the contract. When the option to acquire additional goods or services (e.g., a coupon or discount voucher) provides a material right to the customer, it results in a separate performance obligation in the contract.
102
What criterion determines whether an option to acquire additional goods or services in a contract provides a material right?
An option to acquire an additional good or service at a price that reflects its standalone selling price does not provide a material right.
103
What is the transaction price?
The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.
104
Which 3 elements effect the transaction price?
1) It excludes amounts collected on behalf of third parties (e.g., sales taxes).
2) Any consideration payable to the customer, such as coupons, credits, or vouchers, reduces the transaction price.
3) To determine the transaction price, an entity should consider the effects of the time value of money and variable consideration.
105
The transaction price must reflect what circumstances of payment amount and timing?
TRANSACTION PRICE/REVENUE RECOGNIZED SHOULD BE AT PRESENT VALUE. The revenue recognized must reflect the price that a customer would have paid for the promised goods or services if the cash payment had been made when they were transferred to the customer (i.e., the cash selling price).
106
When is the transaction price adjusted for the effect of the time value of money?
The transaction price is adjusted for the effect of the time value of money when the contract includes a significant financing component. This is because the transaction price must reflect the cash value the customer would have paid had they paid in full at the time they acquired goods/services, which would be the PRESENT VALUE.
107
Which two factors should be considered in assessing whether a contract includes a significant financing component?
1) The difference between
the cash selling price of the promised goods or services and the amount of consideration to be received.
2) The combined effect of
i) The expected time between the payment and the delivery of the promised goods or services and
ii) Market interest rates
108
If any of which 3 conditions apply, the transaction price should not be adjusted for the effect of the time value of money:
1) The time between the payment and the delivery of the promised goods or services to the customer is 1 year or less
2) The customer paid in advance and the transfer of goods or services is at the discretion of the customer
-An example is a bill-and-hold contract in which the seller provides storage services for goods it sold to the buyer.
3) A substantial amount of the consideration promised is variable and its amount or timing varies with future circumstances that are not within the control of the entity or the customer
-An example is consideration in the form of a sales-based royalty.
109
What is the practical consequence of including time value of money effects in revenue recognition?
The excess of the cash to be received in the future over the present value of goods/services is recognized separately on the income statement as interest income. Thus, revenue from customers is recognized at the present value, and the excess of payments is recognized as interest expense.
110
For time value of money effects on contracts with customers revenue recognition, how is interest income recognized?
Interest income or expense is recognized using the effective interest method.
-It must be presented in the income statement separately from revenue from contracts with customers.
111
How is interest income recognized on the income statement?
It must be presented in the income statement separately from revenue from contracts with customers.
112
What must be done for contract with customers recognition if there is variable consideration?
If a contract includes a variable amount, an entity must estimate the consideration to which it will be entitled in exchange for transferring the promised goods or services to a customer.
113
What are 4 examples of circumstances that could cause variable consideration?
1) Refunds due to a right of return provided to customers (Study Unit 6, Subunit 1)
2) Prompt payment discounts (Study Unit 5, Subunit 1)
3) Volume discounts
4) Other uncertainties in contract price based on the occurrence or nonoccurrence of some future event
114
What are the two available methods for estimating variable consideration?
Variable consideration is estimated using one of the following methods:
1) EXPECTED VALUE. The expected value is the sum of probability-weighted amounts in the range of possible consideration amounts. This method may provide an appropriate estimate if an entity has many contracts with similar characteristics.
2) MOST LIKELY AMOUNT. The most likely amount is the single most likely amount in a range of possible consideration amounts. This method may provide an appropriate estimate if the contract has only two possible outcomes. For example, a construction entity either will receive a performance bonus for finishing construction on time or will not.
115
When is most likely amount likely to be an appropriate amount for estimating variable consideration?
This method may provide an appropriate estimate if the contract has only two possible outcomes. For example, a construction entity either will receive a performance bonus for finishing construction on time or will not.
116
If there is variable consideration, when should the estimated transaction price be updated?
The estimated transaction price must be updated at the end of each reporting period.
117
What is the constraint on recognizing revenue from contracts with variable consideration?
2.3 REVENUE FROM CONTRACTS WITH CUSTOMERS
The guidance for recognition of revenue from contracts with customers (ASC 606) provides a single, principles-based model for all contracts with customers regardless of the industry-specific or transaction-specific fact pattern.
The core principle is that an entity recognizes revenue for the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in the exchange.
This guidance applies to all contracts with customers except the following:
Leases
Financial instruments
Contractual rights and obligations within the scope of specific topics, such as receivables, derivatives and hedging, insurance, and guarantees (other than product or service warranties)
Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers
Below is the five-step model for recognizing revenue from contracts with customers.
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) a performance obligation is satisfied.
Step 1: Identify the Contract with a Customer
A contract is an agreement between two or more parties that creates enforceable rights and obligations.
A contract is accounted for under ASC 606 if all of the following criteria are met:
The contract was approved by the parties.
The contract has commercial substance.
Each party’s rights can be identified regarding
Goods or services to be transferred and
The payment terms.
It is probable that the entity will collect substantially all of the consideration to which it is entitled according to the contract.
Probable means the future event is likely to occur.
If the criteria described above are not met (e.g., if collectibility cannot be reliably estimated), the consideration received is recognized as a liability, and no revenue is recognized until the criteria are met.
However, even when the criteria described above are not met, revenue in the amount of nonrefundable consideration received from the customer is recognized if at least one of the following has occurred:
The contract has been terminated.
Control over the goods or services was transferred to the customer and the entity has stopped transferring (and has no obligation to transfer) additional goods or services to the customer.
The entity (1) has no obligation to transfer goods or services and (2) has received substantially all consideration from the customer.
A contract modification exists when the parties approve a change in the scope or price of a contract.
It is accounted for as a separate contract if the following conditions are met:
The scope of the contract increases because of the addition of promised goods or services that are distinct, and
The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services.
Step 2: Identify the Performance Obligations in the Contract
A performance obligation is a promise in a contract with a customer to transfer to the customer
A good or service that is distinct or
A series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer.
Promised goods or services are distinct if
The customer can benefit from them either on their own or together with other resources that are readily available (capable of being distinct) and
The entity’s promise to transfer them to the customer is separately identifiable from other promises in the contract (distinct within the context of the contract). A separately identifiable good or service
Does not significantly modify or customize another good or service promised in the contract and
Is not highly dependent on, or highly interrelated with, other goods or services promised in the contract.
Customer options to acquire additional goods or services for free or at a discount have many forms, such as sales incentives, coupons, customer award points, or other discounts on future goods or services.
When the option to acquire additional goods or services (e.g., a coupon or discount voucher) provides a material right to the customer, it results in a separate performance obligation in the contract.
A material right is an option that the customer would not receive without entering into that contract. An example is a discount in addition to the range of discounts typically given for those goods or services.
But an option to acquire an additional good or service at a price that reflects its standalone selling price does not provide a material right.
Step 3: Determine the Transaction Price
The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer.
It excludes amounts collected on behalf of third parties (e.g., sales taxes).
Any consideration payable to the customer, such as coupons, credits, or vouchers, reduces the transaction price.
To determine the transaction price, an entity should consider the effects of the time value of money and variable consideration.
The revenue recognized must reflect the price that a customer would have paid for the promised goods or services if the cash payment had been made when they were transferred to the customer (i.e., the cash selling price).
Thus, the transaction price is adjusted for the effect of the time value of money when the contract includes a significant financing component.
The following factors should be considered in assessing whether a contract includes a significant financing component:
The difference between
The cash selling price of the promised goods or services and
The amount of consideration to be received
The combined effect of
The expected time between the payment and the delivery of the promised goods or services and
Market interest rates
The transaction price should not be adjusted for the effect of the time value of money if
The time between the payment and the delivery of the promised goods or services to the customer is 1 year or less
The customer paid in advance and the transfer of goods or services is at the discretion of the customer
An example is a bill-and-hold contract in which the seller provides storage services for goods it sold to the buyer.
A substantial amount of the consideration promised is variable and its amount or timing varies with future circumstances that are not within the control of the entity or the customer
An example is consideration in the form of a sales-based royalty.
Interest income or expense is recognized using the effective interest method.
It must be presented in the income statement separately from revenue from contracts with customers.
Example 2-10Significant Financing Component
On January 1, Year 1, BIF Co. sold and transferred a machine to a customer for $583,200 that is payable on December 31, Year 2. Other customers pay $500,000 upon delivery of the same machine at contract inception. The cost of the machine to BIF is $400,000. BIF determined that the contract includes a significant financing component because of the difference between the consideration ($583,200) and the cash selling price ($500,000). The contract includes an implicit interest rate of 8%. The following entries are recorded by BIF:
January 1, Year 1
Accounts receivable $500,000 Cost of goods sold $400,000
Revenue $500,000 Machine inventory $400,000
December 31, Year 1
Accounts receivable ($500,000 × 8%) $40,000
Interest income $40,000
December 31, Year 2
Accounts receivable ($540,000 × 8%) $43,200 Cash $583,200
Interest income $43,200 Accounts receivable $583,200
Example 2-11Significant Financing Component -- Advance Payment
On January 1, Year 1, Eva Co. received a payment of $100,000 for delivering a machine to a customer at the end of Year 2. The cost of the machine to Eva is $70,000. Eva determined that (1) the contract includes a significant financing component and (2) a financing rate of 10% is an appropriate discount rate. The following entries are recorded by Eva:
January 1, Year 1 December 31, Year 1
Cash $100,000 Interest expense ($100,000 × 10%) $10,000
Contract liability $100,000 Contract liability $10,000
December 31, Year 2
Interest expense ($110,000 × 10%) $11,000 Contract liability $121,000
Contract liability $11,000 Revenue $121,000
Cost of goods sold 70,000
Machine inventory 70,000
Variable Consideration
If a contract includes a variable amount, an entity must estimate the consideration to which it will be entitled in exchange for transferring the promised goods or services to a customer. For example, the contract price may vary because of the following:
Refunds due to a right of return provided to customers (Study Unit 6, Subunit 1)
Prompt payment discounts (Study Unit 5, Subunit 1)
Volume discounts
Other uncertainties in contract price based on the occurrence or nonoccurrence of some future event
Variable consideration is estimated using one of the following methods:
The expected value is the sum of probability-weighted amounts in the range of possible consideration amounts. This method may provide an appropriate estimate if an entity has many contracts with similar characteristics.
The most likely amount is the single most likely amount in a range of possible consideration amounts. This method may provide an appropriate estimate if the contract has only two possible outcomes. For example, a construction entity either will receive a performance bonus for finishing construction on time or will not.
The estimated transaction price must be updated at the end of each reporting period.
Constraint. Revenue from variable consideration is recognized only to the extent that it is probable that a significant reversal will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
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What is a volume discount?
A volume discount offered as an incentive to increase future sales requires the customer to purchase a specified quantity of goods or services to receive a discount. The discount may be applied (1) prospectively on additional goods purchased in the future or (2) retrospectively on all goods purchased to date.
119
In what two ways may a volume discount be applied?
The discount may be applied (1) prospectively on additional goods purchased in the future or (2) retrospectively on all goods purchased to date.
120
How are prospective volume discounts accounted for?
A prospective volume discount that provides a material right to the customer is accounted for as a separate performance obligation in the contract (Study Unit 9, Subunit 4).
121
How are retrospective volume discounts accounted for?
Retrospective volume discounts are accounted for as variable consideration. The uncertainty of the contract price for current goods sold is based on the occurrence or nonoccurrence of some future event (i.e., whether the customer completes the specified volume of purchase).
122
What distinguishes prospective volume discounts from retrospective volume discounts?
Prospective volume discounts impart a material right to the customer to invoke a volume discount option, whereas retrospective volume discounts impart no material right and are dependent on the occurrence or nonoccurrence of some uncertain future event.
123
What is consideration payable to a customer?
Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer).
124
How is consideration payable to a customer recognized?
Consideration payable to a customer is recognized as a reduction of the transaction price and therefore of revenue.
125
At what time is revenue reduced for consideration payable to a customer?
Revenue is reduced for consideration payable to a customer at the later of when the entity
i) Recognizes revenue for the transfer of the related goods or services to the customer or
ii) Promises to pay the consideration to the customer.
126
What is the basis for allocating the transaction price to contract performance obligations?
The basis is relative standalone selling prices. After separate performance obligations are identified and the total transaction price is determined, the transaction price is allocated to performance obligations on the basis of relative standalone selling prices.
127
What is a standalone selling price?
A standalone selling price is the price at which an entity would sell a promised good or service separately to a customer.
128
What is the best evidence of standalone selling price? Which 3 attributes does the evidence have?
The best evidence of a standalone selling price is the observable price of a good or service when it is (1) sold separately (2) in similar circumstances and (3) to similar customers (e.g., the list price of a good or service).
129
What is done when the standalone selling price is unobservable?
If the standalone price is not directly observable, it must be estimated.
130
What are the three approaches to estimating an unobservable standalone selling price?
1) Adjusted market assessment. An entity evaluates the market in which it sells goods or services and estimates the price that a customer in that market would be willing to pay for them.
-For example, the prices of competitors for similar goods or services adjusted for the entity’s costs and margins are estimates of standalone selling prices.
2) Expected cost plus an appropriate margin. An entity forecasts its expected costs of satisfying a performance obligation and adds an appropriate margin for that cost.
3) Residual. An entity estimates the standalone selling price by reference to the total transaction price minus the sum of the observable standalone selling prices of other goods or services promised in the contract. The residual approach may be used only in limited circumstances.
131
When does an entity recognize revenue for a performance obligation satisfied?
An entity recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised good or service (an asset) to a customer.
132
How is an asset transferred to a customer?
An asset is transferred when (or as) the customer obtains control of that asset.
133
Which two conditions must be met for a customer to gain control of an asset transferred to them?
Control of an asset is transferred when the customer
1) Has the ability to direct the use of the asset and
2) Obtains substantially all of the remaining benefits (potential cash flows) from the asset.
134
In which two temporal modalities can a performance obligation be satisfied?
A performance obligation can be satisfied either
1) over time or
2) at a point in time.
135
What is recognizing revenue over time?
Recognizing revenue over time requires transfer of the control of goods or services to a customer over time and therefore satisfaction of a performance obligation over time.
136
Revenue is recognized over time if any one of the following three criteria are met:
The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. -For example, cleaning services are provided to a customer’s offices every day throughout the accounting period.
2) The entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. For example, a construction company erects a building on the customer’s land.
3) The asset created has no alternative use to the entity, and the entity has an enforceable right to payment for the performance completed to date. For example, an aerospace company contracts to build a satellite designed for the unique needs of a specific customer.
-An entity does not have an alternative use for an asset if the entity is restricted contractually or limited practically from directing the asset for another use.
136
What condition applies when an entity has no alternative use for an asset?
An entity does not have an alternative use for an asset if the entity is restricted contractually or limited practically from directing the asset for another use.
137
What does it mean for a contract to be satisfied at a point in time?
If a performance obligation is not satisfied over time, an entity satisfies the performance obligation at a point in time. Revenue is recognized at a point in time when the customer obtains control over the promised asset.
138
Which 5 indicators of the transfer of control should be considered for recognizing revenue at a point in time?
1) The entity has a present right to payment for the asset.
2) The customer has legal title to the asset.
3) The entity has transferred physical possession of the asset.
4) The customer has the significant risks and rewards of ownership of the asset.
5) The customer has accepted the asset.
139
When is a contract liability presented on the balance sheet?
A contract liability is recognized for an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration from the customer. Deposits and other advance payments by the customer, such as sales of gift certificates, are recognized as contract liabilities (Study Unit 9, Subunit 4).
140
When is a contract asset recognized on the balance sheet?
A contract asset is recognized for an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer. However, the entity must have an unconditional right to the consideration to recognize a receivable. A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due.
141
Which condition must apply to recognize z contract asset on the balance sheet?
However, the entity must have an unconditional right to the consideration to recognize a receivable.
142
When is a right to consideration unconditional?
A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due.
143
Can contract assets and contract liabilities resulting from DIFFERENT contracts be presented net in the statement of financial position?
No. Contract assets and contract liabilities resulting from different contracts must not be presented net in the statement of financial position.
144
If the entity expects to recover the incremental costs of obtaining a contract, may it capitalize the costs?
Yes. The incremental costs of obtaining a contract with a customer must be capitalized (recognized as an asset) if the entity expects to recover them.
145
What does it mean to capitalize a cost?
Capitalized costs are recognized as assets on some basis.
146
What is the basis for recognizing the capitalized cost (asset) associated with incremental costs of obtaining contracts that are expected to be recovered?
The asset recognized must be amortized on a systematic basis consistent with the transfer to the customer of the goods or services to which the asset relates.
147
Under what condition can the cost of obtaining a contract be expensed as incurred?
The cost of obtaining a contract may be expensed as incurred if its amortization period is 1 year or less.
148
Which costs of obtaining contracts must be expensed as incurred?
Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained must be expensed as incurred.
-But costs explicitly chargeable to the customer regardless of whether the contract is obtained are capitalized.
149
For those costs of obtaining contracts that must be expensed as incurred, what portion are capitalized?
Costs explicitly chargeable to the customer regardless of whether the contract is obtained are capitalized.
150
Under what 2 conditions are costs of obtaining contracts expensed as incurred?
1) The cost of obtaining a contract may be expensed as incurred if its amortization period is 1 year or less.
2) Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained must be expensed as incurred.
151
Costs incurred to fulfill a contract must be capitalized (recognized as an asset) only if they meet all of the following criteria: (3 elements)
1) The costs relate directly to a current or anticipated contract.
2)The costs generate or enhance resources of the entity that will be used in satisfying performance obligations in the future.
3) The costs are expected to be recovered.
152
What is the basis of recognizing assets for those costs incurred to fulfill a contract that must be capitalized?
The asset recognized for eligible costs incurred to fulfill a contract must be amortized on a systematic basis consistent with the transfer to the customer of the goods or services to which the asset relates.
153
What is the distinction between costs incurred to obtain a contract and costs incurred to a fulfill a contract?
Costs incurred to obtain a contract are all of those costs leading up to the existence of a contract, whereas the costs incurred to fulfill a contract are those costs of keeping promises in the contract or delivering the promised obligations to the customer.
154
What is the recognition of revenue over time?
For each performance obligation satisfied over time, an entity must recognize revenue over time. For this purpose, the entity measures the progress toward complete satisfaction using the output method or the input method.
-To determine the appropriate method, an entity must consider the nature of the good or service that it promised to transfer to the customer.
-The chosen method should describe the entity’s performance in transferring control of the promised asset to the customer.
155
How does the entity determine the appropriate method for recognition of revenue over time? (2 elements)
1)To determine the appropriate method, an entity must consider the nature of the good or service that it promised to transfer to the customer.
2) The chosen method should describe the entity’s performance in transferring control of the promised asset to the customer.
156
When is revenue recognition over time remeasured?
At the end of each reporting period, the progress toward complete satisfaction of the performance obligation must be remeasured and updated for any changes in the outcome of the performance obligation.
157
How are periodic remeasurements of revenue recognized over time treated from an accounting standpoint?
Such changes must be accounted for prospectively as a change in accounting estimate.
158
What are the three major methods for recognizing revenue over time?
1) Input Method
2) Cost-to-Cost Method (subset of input method)
3) Output Method
159
What is the input method?
The input method recognizes revenue on the basis of (1) the entity’s inputs to the satisfaction of the performance obligation relative to (2) the total expected inputs to the satisfaction of that performance obligation.
160
What are the two bases of revenue recognition for the input method?
(1) the entity’s inputs to the satisfaction of the performance obligation relative to
(2) the total expected inputs to the satisfaction of that performance obligation.
161
What are 5 examples of inputs used in the input method?
1) Costs incurred,
2) Labor hours expended,
3) Resources consumed,
4) Time elapsed, or
5) Machine hours used.
162
What is the Cost-to-Cost method of recognizing revenue over time?
In long-term construction contracts, costs incurred relative to total estimated costs often are used to measure the progress toward completion. This method is the cost-to-cost method.
163
Which kind of costs are used in the Cost-to-Cost method?
Only costs that contribute to progress in satisfying the performance obligation are used in the cost-to-cost method.
164
Only costs that contribute to progress in satisfying the performance obligation are used in the cost-to-cost method. Thus, the following costs must not be included in measuring the progress: (3 elements)
1) Costs incurred that relate to significant inefficiencies in the entity’s performance (e.g., abnormal amounts of wasted materials or labor) that were not chargeable to the customer under the contract
2) General and administrative costs not directly related to the contract
3) Selling and marketing costs
165
When is the straight-line basis appropriate for the Input Method of recognizing revenue from contracts with customers?
When an entity’s inputs are incurred evenly over time, recognition of revenue on a straight-line basis may be appropriate.
166
What is the output method of recognizing revenue from contracts with customers?
The output method recognizes revenue based on direct measurement of (1) the value of goods or services transferred to the customer to date relative to (2) the remaining goods or services promised under the contract.
166
What are 4 examples of output methods?
Examples of output methods include (1) appraisals of results achieved, (2) milestones reached, (3) units produced, and (4) units delivered.
166
What are the two possible bases for recognizing revenue over time that could be used by the Output Method?
(1) the value of goods or services transferred to the customer to date relative to
(2) the remaining goods or services promised under the contract.
166
What is revenue recognition to the extent of cost incurred?
However, revenue can be recognized to the extent of the cost incurred (zero profit margin) when an entity
-Is not able to reasonably measure the outcome of a performance obligation or its progress toward satisfaction of that obligation but
-Expects to recover the costs incurred in satisfying the performance obligation.
166
167
What is the right to invoice the customer?
An entity may have a right to consideration from a customer in an amount corresponding directly with the value to the customer of performance to date. Using a practical expedient, revenue may be recognized at the amounts to which the entity has a right to invoice the customer.
167
Which two conditions must both apply in order for revenue to be recognized to the extent of cost incurred?
1) The entity is not able to reasonably measure the outcome of a performance obligation or its progress toward satisfaction of that obligation but
2) The entity expects to recover the costs incurred in satisfying the performance obligation.
167
How must estimated losses be recognized for contracts with customers?
As soon as an estimated loss on any project becomes apparent, it must be recognized in full, regardless of the methods used.
167
What condition must apply in order for an entity to recognize revenue for performance of an obligation satisfied over time?
The performance must be REASONABLY MEASURED. An entity recognizes revenue for a performance obligation satisfied over time only if progress toward complete satisfaction of the performance obligation can be reasonably measured.
168
Does the method use effect criteria for recognizing losses on contracts with customers?
No. As soon as an estimated loss on any project becomes apparent, it must be recognized in full, regardless of the methods used.
169
Under the Cost-to-Cost method, how does the ratio used to recognize revenue in a period contribute to calculating the revenue for the period?
The ratio used is [total cost incurred to date]/[total estimated costs]. This ratio is multiplied times the contract price to determine the total amount of revenue recognized up until a point in time. To get the period revenue, previously recognized revenue is deducted from the product of this ratio and the contract price.
170
What is the Cost-to-Cost Method formula to compute revenue in a given period?
Revenue Recognized in Period = ([Total cost incurred to date]/[Total estimated costs])*[Contract Price] – [Previously Recognized Revenue]
171
An entity recognizes revenue from a long-term contract over time. However, early in the performance of the contract, it cannot reasonably measure the outcome, but it expects to recover the costs incurred. Revenue should be recognized based on ________.
A zero profit margin. When the outcome of the contract is not reasonably measurable but the costs incurred in satisfying the performance obligation are expected to be recovered, revenue must be recognized only to the extent of the costs incurred. Revenue recognized is based on a zero profit margin until the entity can reasonably measure the outcome of the performance obligation.
172
Net Expense Payable =
Accrued Expense - Prepaid Expense
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