FAR SEC 3 Flashcards

Question

What are the temporal restrictions on adjustments due to Change in Accounting Estimate?

Answer 1

For a change in estimate, the entity must not Restate or retrospectively adjust prior-period statements or Report pro forma amounts for prior periods. Essentially, retrospective adjustments are disallowed.

Answer 2

A change in estimate inseparable from a change in principle is accounted for as a change in estimate, i.e., prospective application. An example is a change in a method of depreciation, amortization, or depletion of long-lived, nonfinancial assets.

Answer 3

A change in the reporting entity results in statements that are effectively those of a different entity. Most such changes occur when 1) Consolidated or combined statements replace those of individual entities, 2) Consolidated statements include different subsidiaries, or 3) Combined statements include different entities. A business combination or consolidation of a variable interest entity is not a change in the reporting entity. A change in the reporting entity is retrospectively applied to interim and annual statements.

Answer 4

Most such changes occur when Consolidated or combined statements replace those of individual entities, Consolidated statements include different subsidiaries, or Combined statements include different entities.

Answer 5

A variable interest entity (VIE) refers to a legal business structure in which an investor has a controlling interest despite not having a majority of voting rights. Characteristics include a structure where equity investors do not have sufficient resources to support the ongoing operating needs of the business. In most cases, the VIE is used to protect the business from creditors or legal action. A business that is the primary beneficiary of a VIE must disclose the holdings of that entity as part of its consolidated balance sheet.

Answer 6

A business combination or consolidation of a variable interest entity is not a change in the reporting entity. Note that business combinations or consolidations of entities other than VIEs would be considered changes of reporting entity.

Answer 7

A merger or acquisition is a business combination. A business combination is defined as a transaction or other event in which an acquirer (an investor entity) obtains control of one or more businesses.

Answer 8

A change in the reporting entity is retrospectively applied to interim and annual statements.

Answer 9

An error in prior statements results from A mathematical mistake, A mistake in the application of GAAP, or An oversight or misuse of facts existing when the statements were prepared. A change to a generally accepted accounting principle from one that is not generally accepted is an error correction, not an accounting change.

Answer 10

A change to a generally accepted accounting principle from one that is not generally accepted is an error correction, not an accounting change or "change in accounting principle".

Answer 11

Error corrections must be reported in single-period statements as adjustments of the opening balance of retained earnings. If comparative statements are presented, corresponding adjustments must be made to net income (and its components) and retained earnings (and other affected balances) for all periods reported. Corrections of prior-period errors must not be included in net income UNLESS there are comparative financial statements that show multiple periods on one statement.

Answer 12

A correcting journal entry combines the reversal of the error with the correct entry. Thus, it requires a determination of the Journal entry originally recorded, Event or transaction that occurred, and Correct journal entry. Error analysis addresses Whether an error affects prior-period statements, The timing of error detection, Whether comparative statements are presented, and Whether the error is counterbalancing.

Answer 13

No. An error affecting prior-period statements may or may not affect prior-period net income. For example, misclassifying an item as a gain rather than a revenue does not affect income and is readily correctable. No prior-period adjustment to retained earnings is required.

Answer 14

An error that affects prior-period net income is counterbalancing if it self-corrects over two periods. However, despite the self-correction, the financial statements remain misstated. They should be restated if presented comparatively in later periods. The flowcharts on inventory errors in Study Unit 7, Subunit 7, illustrate this concept. An example of a noncounterbalancing error is a misstatement of depreciation. Such an error does not self-correct over two periods. Thus, a prior-period adjustment will be necessary.

Answer 15

Entities can only make voluntary changes in accounting principle if they can be justified as "preferable". The reason for this is that unnecessary changes in principle would reduce comparability and consistency.

Answer 16

1) change in accounting principle. 2) change in accounting estimate. 3) change in reporting entity.

Answer 17

A change in accounting principle occurs when an entity (1) adopts a generally accepted principle different from the one previously used, (2) changes the method of applying a generally accepted principle, or (3) changes to a generally accepted principle when the principle previously used is no longer generally accepted.

Answer 18

A change in principle does not include the initial adoption of a principle because of an event or transaction occurring for the first time.

Answer 19

Retrospective application is required for all direct effects and the related income tax effects of a change in principle. An example of a direct effect is an adjustment of an inventory balance to implement a change in the method of measurement. Retrospective application must not include indirect effects. These are changes in current or future cash flows from a change in principle applied retrospectively. An example of an indirect effect is a required profit-sharing payment based on a reported amount that was directly affected (e.g., revenue). Indirect effects are recognized and reported in the period of change.

Answer 20

Direct effects are changes to the current period statements from the Cumulative Effect (CE) of the retrospectively applied adjustments for change in principle. Indirect effects are those effects of the change in cash flow that have a bearing on current or future cash flows. Indirect effects are recognized and reported in the period of change.

Answer 21

Retrospective application requires the carrying amounts of (1) assets, (2) liabilities, and (3) retained earnings (or other components of equity or net assets) at the beginning of the first period reported to be adjusted for the cumulative effect (CE) of the new principle on the prior periods. All periods presented must be individually adjusted for the period-specific effects (PSE) of the new principle.

Answer 22

It is reported for the BEGINNING OF THE PERIOD in the statements for the current period in which the change of principle is being implemented.

Answer 23

All periods presented must be individually adjusted for the period-specific effects (PSE) of the new principle.

Answer 24

1) It may be impracticable to determine the CE of a new principle on any prior period. The new principle then must be applied as if the change had been made prospectively at the earliest date practicable. 2) Prospective application is warranted if the change in principle is inseparable from a change in estimate.

Answer 25

It may be practicable to determine the CE of applying the new principle to all prior periods but not the PSE. In these circumstances, CE adjustments must be made to the beginning balances for the first period to which the new principle can be applied.

Answer 26

Prospective application.

Answer 27

A change in accounting estimate results from new information. It is a reassessment of the future status, benefits, and obligations of assets and liabilities. Its effects must be accounted for only in (1) the period of change and (2) any future periods affected (prospectively). The prospective application must be applied from the beginning of the accounting period in which the accounting estimate was changed. For a change in estimate, the entity must not Restate or retrospectively adjust prior-period statements or Report pro forma amounts for prior periods.

Answer 28

A change in estimate inseparable from a change in principle is accounted for as a change in estimate, i.e., prospective application. An example is a change in a method of depreciation, amortization, or depletion of long-lived, nonfinancial assets.

Answer 29

For DEPS, the dilutive action is always assumed, so conversion of the bonds is assumed. If the bonds are converted, the interest isn't paid, so it is added back net of tax effects.

Answer 30

There is a conversion ratio from preferred to common shares, and the dividend rate for common shares usually differs from the preferred dividend rate.

Answer 31

PCS is dilutive potential common shares (PCS).

Answer 32

Earnings per incremental share are the earnings per share calculated for blocks of shares being considered under the If-Converted Method for DEPS.

Answer 33

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.

Answer 34

This guidance applies to all contracts with customers except the following: -Leases -Financial instruments -SPECIAL TOPICS. 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) -COOPERATIVE SALES AGREEMENTS. Nonmonetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers

Answer 35

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.

Answer 36

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.

Answer 37

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.

Answer 38

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.

Answer 39

A contract modification exists when the parties approve a change in the scope or price of a contract. 1) It is accounted for as a separate contract if the following conditions are met: i) The scope of the contract increases because of the addition of promised goods or services that are distinct, and ii) 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.

Answer 40

A performance obligation is a promise in a contract with a customer to transfer to the customer 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.

Answer 41

Promised goods or services are distinct if 1) 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) 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 a) Does not significantly modify or customize another good or service promised in the contract and b) Is not highly dependent on, or highly interrelated with, other goods or services promised in the contract.

Answer 42

A separately identifiable good or service a) Does not significantly modify or customize another good or service promised in the contract and b) Is not highly dependent on, or highly interrelated with, other goods or services promised in the contract.

Answer 43

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. 1) 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) 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. b) 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.

Answer 44

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. 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.

Answer 45

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.

Answer 46

The following 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 -The expected time between the payment and the delivery of the promised goods or services and -Market interest rates

Answer 47

The transaction price should not be adjusted for the effect of the time value of money if 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.

Answer 48

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.

Answer 49

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 7, Subunit 1) -Prompt payment discounts (Study Unit 6, Subunit 1) -Volume discounts -Other uncertainties in contract price based on the occurrence or nonoccurrence of some future event

Answer 50

Variable consideration is estimated using one of the following methods: 1) 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) 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.

Answer 51

The estimated transaction price must be updated at the end of each reporting period.

Answer 52

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.

Answer 53

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 (a) prospectively on additional goods purchased in the future or (b) retrospectively on all goods purchased to date. 1) 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 10, Subunit 4). 2) 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).

Answer 54

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). 1) Consideration payable to a customer is recognized as a reduction of the transaction price and therefore of revenue. 2) Revenue is reduced for consideration payable to a customer at the later of when the entity a) Recognizes revenue for the transfer of the related goods or services to the customer or b) Promises to pay the consideration to the customer.

Answer 55

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). -Consideration payable to a customer is recognized as a reduction of the transaction price and therefore of revenue.

Answer 56

Revenue is reduced for consideration payable to a customer at the later of when the entity 1) Recognizes revenue for the transfer of the related goods or services to the customer or 2) Promises to pay the consideration to the customer.

Answer 57

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.

Answer 58

Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract 1) MULTIPLY TOTAL CONSIDERATION BY RELATIVE STANDALONE 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. 2) A standalone selling price is the price at which an entity would sell a promised good or service separately to a customer. -The best evidence of a standalone selling price is the observable price of a good or service when it is (a) sold separately (b) in similar circumstances and (c) to similar customers (e.g., the list price of a good or service). 3) If the standalone price is not directly observable, it must be estimated. The following are suitable approaches: a) DEFINITION OF STANDALONE PRICE. 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. b) 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. c) 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.

Answer 59

A standalone selling price is the price at which an entity would sell a promised good or service separately to a customer. -The best evidence of a standalone selling price is the observable price of a good or service when it is (a) sold separately (b) in similar circumstances and (c) to similar customers (e.g., the list price of a good or service).

Answer 60

If the standalone price is not directly observable, it must be estimated. The following are suitable approaches: 1) PRICES OF COMPARABLE GOODS. -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) COST + MARGIN. 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.

Answer 61

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.

Answer 62

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.

Answer 63

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.

Answer 64

(Standalone Price of Item X)/(Sum of Standalone Selling Prices, All Items) * [Actual Total Consideration = Allocation of the Contract Price to Item X See Example 3-16

Answer 65

An entity recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised good or service (an asset) to a customer. -An asset is transferred when (or as) the customer obtains control of that asset.

Answer 66

Control of an asset is transferred when the customer satisfies both of conditions (1-2): 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.

Answer 67

A performance obligation can be satisfied either over time or at a point in time.

Answer 68

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. One of the three following criteria must be met: 1) THE GOOD/SERVICE IS CONSUMED SIMULTANEOUSLY IN PERIODIC INCREMENTS AS IT IS RECEIVED BY THE CUSTOMER. 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) GOOD/SERVICE CREATES OR ENHANCES AN ASSET THAT CUSTOMER CONTROLS DURING THE TIME IT IS BEING BUILT. 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 CREATED GOOD/SERVICE HAS NO ALTERNATE USE (IS ONLY USEABLE BY THE CUSTOMER). 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.

Answer 69

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. The following indicators of the transfer of control should be considered: -The entity has a present right to payment for the asset. -The customer has legal title to the asset. -The entity has transferred physical possession of the asset. -The customer has the significant risks and rewards of ownership of the asset. -The customer has accepted the asset. NOTE: Textbook is VAGUE on how these would be necessary/sufficient conditions for satisfying at a point in time. They are INDICATORS.

Answer 70

Recognition "AT A POINT IN TIME" works for situations where an identifiable asset has its control transferred from the entity to the customer. Recognition "OVER TIME" applies in any instance where the customer already controls the asset that is serviced. Recognition "OVER TIME" also applies if the entity is entitled to immediate payment for services rendered prior to the expected time that control of an asset will be transferred to the customer.

Answer 71

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 10, Subunit 4).

Answer 72

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.

Answer 73

Contract assets and contract liabilities resulting from different contracts must not be presented net in the statement of financial position.

Answer 74

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.

Answer 75

1) CAPITALIZED COSTS. If the incremental costs are expected to be recovered, they should be capitalized (recognized as an asset). 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. 2) EXPENSED AS INCURRED. The cost of obtaining a contract may be expensed as incurred if its amortization period (under cost capitalization) is 1 year or less. 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 (or expensed as incurred if the ammortizatin period is one year or less.

Answer 76

For each performance obligation satisfied over time, an entity must recognize revenue over time.

Answer 77

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. -output method -input method

Answer 78

The entity measures the progress toward complete satisfaction using the output method or the input method. 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.

Answer 79

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. -Such changes must be accounted for prospectively as a change in accounting estimate.

Answer 80

The input method recognizes revenue on the basis of (a) the entity’s inputs to the satisfaction of the performance obligation relative to (b) the total expected inputs to the satisfaction of that performance obligation. Examples of input include -Costs incurred, -Labor hours expended, -Resources consumed, -Time elapsed, or -Machine hours used. Two variations of the input method are: 1) cost-to-cost method; and 2) straight-line basis.

Answer 81

1) Cost-to-cost method. (if revenue recognition is uneven OVER TIME. 2) Straight-line basis (if the revenue recognition occurs evenly OVER TIME".

Answer 82

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. 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: 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 Selling and marketing costs

Answer 83

1) Costs due to egregious wastage of time and materials. 2) Costs due to general and administrative expenses not directly related to the contract (overhead). 3) Selling and marketing costs.

Answer 84

When an entity’s inputs are incurred evenly over time, recognition of revenue on a straight-line basis may be appropriate.

Answer 85

Cost-to-Cost Method Current Period Revenue Recognized = [Cumulative Period Costs]/[Current Estimated Total Project Cost]*[Total Expected Project Revenue] – [Revenue Recognized in Prior Periods] Period Gross Profit = Current Period Revenue Recognized – [Current Period Cost Recognized] [SEE EXAMPLE 3-18]

Answer 86

When progress toward completion is measured using the cost-to-cost method, as in the example above, the cost of goods sold recognized for the period equals the costs incurred during that period.

Answer 87

The output method recognizes revenue based on direct measurement of (a) the value of goods or services transferred to the customer to date relative to (b) the remaining goods or services promised under the contract. Examples of output methods include -Appraisals of results achieved, -Milestones reached, -Units produced, and -Units delivered. 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.

Answer 88

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.

Answer 89

However, revenue can be recognized to the extent of the cost incurred (zero profit margin) when 1) An entity is not able to reasonably measure the outcome of a performance obligation or its progress toward satisfaction of that obligation, but 2) An entity expects to recover the costs incurred in satisfying the performance obligation.

Answer 90

Theoretical basis of Treasury Stock Method. For "stock options" or warrants to be exercised, a certain amount of new shares are issued. Treasury Stock Method accounts for the potentially dilutive effect of call options or warrants written by the entity and covered by the entity’s ability to issue additional common shares from “treasury stock”. Upon exercise of the call option, the entity receives a cash payment from the counterparty who is exercising their write to buy shares at the strike price. The entity uses the proceeds to buy shares at a price that is assumed to be the “average market price for the period”, and this price is always more than the strike price if a call option is exercised. The proceeds of call option exercise are exhausted buying existing shares, thus DEPS numerator does not change. The deficit between shares available on the open market in exchange for the proceeds of call option exercise and the total number of shares owed to the counterparty to the options contract is the number of shares issued by the entity, and this number of shares is added to the DEPS denominator. Subtract the total number of shares purchasable using the proceeds at average market price from the total number of shares owed to the counterparty to calculate the incremental number of new shares issued, which is added to DEPS denominator.

Answer 91

A capitalized cost is an expense added to the cost basis of a fixed asset on a company's balance sheet. Capitalized costs are incurred when building or purchasing fixed assets. Capitalized costs are not expensed in the period they were incurred but recognized over a period of time via depreciation or amortization. KEY TAKEAWAYS -With capitalized costs, the monetary value isn’t leaving the company with the purchase of an item, as it is retained in the form of a fixed or intangible asset. -Capitalized costs are depreciated or amortized over time instead of being expensed immediately. -The purpose of capitalizing costs is to better line up the cost of using an asset with the length of time in which the asset is generating revenue. -Companies each have a dollar value threshold for what it considers an expense versus a capitalizable cost. -Employee salaries and bonuses may be capitalized in certain situations.

Answer 92

What Is a Pro Forma Financial Statement? Pro forma financial statements incorporate hypothetical numbers or estimates. They are built into the data to give a picture of a company's profits if certain nonrecurring items are excluded. These are often intended to be preliminary or illustrative financials that do not follow standard accounting practices. Companies use their own discretion in calculating pro forma earnings, including or excluding items depending on what they feel reflects the company's true performance or future performance. As pro forma forecasts are hypothetical in nature, they can deviate from actual results, sometimes significantly. A pro forma amount is an amount on a pro forma statement or an otherwise hypothetical amount.

Answer 93

A combined financial statement shows financial results of different subsidiary companies from that of the parent company. Consolidated financial statements aggregate the financial position of a parent company and its subsidiaries. This allows an investor to check the overall health of the company in a holistic manner rather than viewing the individual company's financial statements separately. Combined Financial Statements A combined financial statement shows financial results of different subsidiary companies from that of the parent company. The complete financial statement of one subsidiary is shown separately from another as a stand-alone company. The benefit of combined financial statements is that it allows an investor to analyze the results and gauge the performance of the individual subsidiary companies separately. Consolidated Financial Statements Consolidated financial statements aggregate the financial position of a parent company and its subsidiaries. This allows an investor to check the overall health of the company in a holistic manner rather than viewing the individual company's financial statements separately. In other words, the consolidated financial statements agglomerates the results of the subsidiary businesses into the parent company's income statement, balance sheet and cash flow statement.

Answer 94

1) Determine the journal entry originally recorded, 2) Determine the event or transaction that occurred, and 3) Enter the correct journal entry. A correcting journal entry combines the reversal of the error with the correct entry.

Answer 95

1) Whether an error affects prior-period statements. 2) The timing of error detection. 3) Whether comparative statements are presented. 4) Whether the error is counterbalancing (self-correcting over two periods).

Answer 96

A combined financial statement shows financial results of different subsidiary companies from that of the parent company. Unlike a consolidated statement, combined statements report separate results for each subsidiary.

Answer 97

Consolidated financial statements aggregate the financial position of a parent company and its subsidiaries. Unlike the disaggregated combined statements, consolidated statements give totals as if parent and subsidiaries are one entity.

Answer 98

Statement of Financial Position = Balance Sheet

Answer 99

If financial information is to be comparable and consistent, entities must not make voluntary changes in accounting principles unless they can be justified as preferable.

Answer 100

An adopted accounting principle must be applied consistently in preparing financial statements.

Answer 101

1) A change in accounting principle, 2) A change in accounting estimate, and 3) A change in the reporting entity.

Answer 102

1) Retrospective 2) Prospective

Answer 103

A change in accounting principle occurs when an entity (1) adopts a generally accepted principle different from the one previously used, (2) changes the method of applying a generally accepted principle, or (3) changes to a generally accepted principle when the principle previously used is no longer generally accepted.

Answer 104

A change in principle does not include the initial adoption of a principle because of an event or transaction occurring for the first time.

Answer 105

A direct effect of a change in accounting principle is a recognized change in an asset or liability that is required in order to effect the change in principle. An example of a direct effect is an adjustment of an inventory balance to implement a change in the method of measurement.

Answer 106

These are changes in current or future cash flows from a change in principle applied retrospectively. An example of an indirect effect is a required profit-sharing payment based on a reported amount that was directly affected (e.g., revenue). -Indirect effects are recognized and reported in the period of change.

Answer 107

The direct effects are the first order effects of the change in accounting principle - the accounting changes required to immediately implement the change in principle. Indirect effects are second order effects during the current or future periods as a result of an accounting change being applied retrospectively.

Answer 108

Indirect effects are recognized and reported in the period of change.

Answer 109

No. Retrospective application must not include indirect effects.

Answer 110

1) Retrospective application requires the carrying amounts of (1) assets, (2) liabilities, and (3) retained earnings at the beginning of the first period reported to be adjusted for the cumulative effect (CE) of the new principle on the prior periods. 2) All periods presented must be individually adjusted for the period-specific effects (PSE) of the new principle.

Answer 111

Retrospective application requires the carrying amounts of (1) assets, (2) liabilities, and (3) retained earnings at the beginning of the first period reported to be adjusted for the cumulative effect (CE) of the new principle on the prior periods.

Answer 112

All periods presented must be individually adjusted for the period-specific effects (PSE) of the new principle.

Answer 113

It may be impracticable to determine the CE of a new principle on any prior period. The new principle then must be applied as if the change had been made prospectively at the earliest date practicable.

Answer 114

It may be practicable to determine the CE of applying the new principle to all prior periods but not the PSE. In these circumstances, CE adjustments must be made to the beginning balances for the first period to which the new principle can be applied.

Answer 115

CE practicable for all prior periods => ? Yes => ASK: PSE practicable for all periods presented? NO => Apply new principle as if the change had been made prospectively at the earliest practicable date.

Answer 116

PSE practicable for all periods presented (YES/NO) => ? YES => (1) apply cumulative effect of change in principle to beginning balances of the first period reported and (2) apply period-specific effects to all periods reported. NO => apply cumulative effect of change in accounting principle to the earliest period to which the principle can be applied.

Answer 117

A change in accounting estimate results from new information. It is a reassessment of the future status, benefits, and obligations of assets and liabilities. Its effects must be accounted for only in (1) the period of change and (2) any future periods affected (prospectively).

Answer 118

Prospectively

Answer 119

Its effects must be accounted for only in (1) the period of change and (2) any future periods affected (prospectively).

Answer 120

The prospective application must be applied from the beginning of the accounting period in which the accounting estimate was changed.

Answer 121

For a change in estimate, the entity must not 1) Restate or retrospectively adjust prior-period statements or 2) Report pro forma amounts for prior periods.

Answer 122

A change in estimate inseparable from a change in principle is accounted for as a change in estimate, i.e., prospective application. An example is a change in a method of depreciation, amortization, or depletion of long-lived, nonfinancial assets.

Answer 123

A change in the reporting entity results in statements that are effectively those of a different entity.

Answer 124

1) Consolidated or combined statements replace those of individual entities, 2) Consolidated statements include different subsidiaries, or 3) Combined statements include different entities.

Answer 125

No. A business combination or consolidation of a variable interest entity is not a change in the reporting entity.

Answer 126

A change in the reporting entity is retrospectively applied to interim and annual statements.

Answer 127

1) A mathematical mistake, 2) A mistake in the application of GAAP, or 3) An oversight or misuse of facts existing when the statements were prepared.

Answer 128

A change to a generally accepted accounting principle from one that is not generally accepted is an error correction, not an accounting change.

Answer 129

Retrospective. Any error related to a prior period discovered after the statements are, or are available to be, used must be reported as an error correction by restating the prior-period statements. In addition to the revision of the previously issued financial statements, restatement requires the same adjustments as retrospective application of a new principle.

Answer 130

1) Any error related to a prior period discovered after the statements are, or are available to be, used must be reported as an error correction by restating the prior-period statements. 2) In addition to the revision of the previously issued financial statements, restatement requires the same adjustments as retrospective application of a new principle. 3) The carrying amounts of (1) assets, (2) liabilities, and (3) retained earnings at the beginning of the first period reported are adjusted for the cumulative effect of the error on the prior periods. 4) Corrections of prior-period errors must not be included in current period net income.

Answer 131

No. Corrections of prior-period errors must not be included in current period net income.

Answer 132

In addition to the revision of the previously issued financial statements, restatement requires the same adjustments as retrospective application of a new principle.

Answer 133

-Error corrections must be reported in single-period statements as adjustments of the opening balance of retained earnings. -If comparative statements are presented, corresponding adjustments must be made to net income (and its components) and retained earnings (and other affected balances) for all periods reported.

Answer 134

A correcting journal entry combines the reversal of the error with the correct entry.

Answer 135

Thus, it requires a determination of the 1) Journal entry originally recorded, 2) Event or transaction that occurred, and 3) Correct journal entry.

Answer 136

1) Whether an error affects prior-period statements, 2) The timing of error detection, 3) Whether comparative statements are presented, and 4) Whether the error is counterbalancing.

Answer 137

An error affecting prior-period statements may or may not affect prior-period net income. For example, misclassifying an item as a gain rather than a revenue does not affect income and is readily correctable. No prior-period adjustment to retained earnings is required.

Answer 138

An error that affects prior-period net income is counterbalancing if it self-corrects over two periods. Figures 6-2 and 6-3 in Study Unit 6, Subunit 7, illustrate self-correction of inventory errors. However, despite the self-correction, the financial statements remain misstated. They should be restated if presented comparatively in later periods.

Answer 139

An example of a noncounterbalancing error is a misstatement of depreciation. Such an error does not self-correct over two periods. Thus, a prior-period adjustment will be necessary.

Answer 140

The following are changes in the reporting entity: (1) presenting consolidated or combined statements in place of statements of individual entities, (2) changing the specific subsidiaries included in the group for which consolidated statements are presented, and (3) changing the entities included in combined statements.

Answer 141

Subsequent events are events or transactions that occur after the balance sheet date and prior to the issuance or availability for issuance of the financial statements.

Answer 142

1) An SEC filer evaluates subsequent events through the date the statements are issued (become widely available for general use). 2) Other entities evaluate subsequent events through the date statements are available for issuance (are complete in accordance with GAAP and approved).

Answer 143

Yes. The entity must disclose the date through which subsequent events have been evaluated.

Answer 144

1) Recognized subsequent events 2) Unrecognized subsequent events

Answer 145

Recognized subsequent events provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in statement preparation.

Answer 146

Yes. This type of event must be recognized in the financial statements.

Answer 147

Subsequent events 1) affecting the realization of assets (such as receivables and inventories) or 2) the settlement of estimated liabilities ordinarily require recognition.

Answer 148

They usually reflect the resolution of conditions that existed over a relatively long period.

Answer 149

1) The settlement of litigation for an amount differing from the liability recorded in the statements, 2) A loss on a receivable resulting from a customer’s bankruptcy, and 3) Changes in the data used in inventory valuation at the lower of cost or NRV.

Answer 150

Yes. Adjustments to earnings per share (EPS) are made as a result of stock dividends and stock splits that occurred after the balance sheet date but prior to the issuance of the financial statements (discussed in Study Unit 2, Subunit 2).

Answer 151

Unrecognized subsequent events provide evidence about conditions that did not exist at the date of the balance sheet. These events do not require recognition, but some of them do require disclosure.

Answer 152

Recognized subsequent events are always recognized in the financial statements, whereas unrecognized subsequent events are always unrecognized (but may or may not be disclosed in some manner).

Answer 153

Examples of nonrecognized subsequent events requiring disclosure only include 1) Sale of a bond or capital stock issue 2) A business combination 3) Settlement of litigation when the event resulting in the claim occurred after the balance sheet date 4) Loss of plant or inventories as a result of a fire or natural disaster 5) Losses on receivables resulting from conditions (e.g., a customer’s major casualty) occurring after the balance sheet date 6) Classification of long-lived assets as held for sale 7) Extinguishment of debt after the balance sheet date

Answer 154

Some events of the second type may be so significant that the most appropriate disclosure is to supplement the historical statements with pro forma financial data.

Answer 155

Certain subsequent events may provide additional evidence about conditions at the date of the balance sheet, including estimates inherent in the preparation of statements. These events require recognition in the statements at year end. Other subsequent events provide evidence about conditions not existing at the date of the balance sheet but arising subsequent to that date and before the issuance of the statements or their availability for issuance. These events may require disclosure but not recognition in the statements. Thus, the loss must not be recognized in Zero’s statements, but disclosure must be made.

Answer 156

Accounting policies are the specific principles and the methods of applying them used by the reporting entity. Management selects these policies as the most appropriate for fair presentation of financial statements.

Answer 157

Management selects these policies as the most appropriate for fair presentation of financial statements.

Answer 158

Business and not-for-profit entities must disclose all significant accounting policies as an integral part of the financial statements.

Answer 159

Not unless there has been an accounting policy change in the interim period. Disclosure of accounting policies in unaudited interim financial statements is not required when the reporting entity has not changed its policies since the end of the preceding fiscal year.

Answer 160

The preferred presentation is a summary of accounting policies in a separate section preceding the notes or in the initial note.

Answer 161

The disclosure should include accounting principles adopted and the methods of applying them that materially affect the financial statements.

Answer 162

Disclosure extends to accounting policies that involve 1) A selection from existing acceptable alternatives, 2) Policies unique to the industry in which the entity operates, even if they are predominantly followed in that industry, and 3) GAAP applied in an unusual or innovative way.

Answer 163

1) Basis of consolidation 2) Depreciation methods 3) Amortization of intangibles 4) Inventory pricing 5) Recognition of revenue from contracts with customers 6) Recognition of revenue from leasing operations

Answer 164

No. Disclosure of accounting policies should not duplicate details presented elsewhere. For example, the summary of significant policies should not contain the composition of plant assets or inventories or the maturity dates of noncurrent debt.

Answer 165

Credit risk is the risk of accounting loss from a financial instrument because of the possible failure of another party to perform.

Answer 166

With certain exceptions, for example, (1) instruments of pension plans, (2) certain insurance contracts, (3) warranty obligations and rights, and (4) unconditional purchase obligations, an entity must disclose significant concentrations of credit risk arising from financial instruments, whether from one counterparty or groups.

Answer 167

Credit risk is concentrated when an inordinate share of the entity's credit instruments are with one counterparty or a group of interconnected counterparties whose failure to perform their obligations would be mutually correlated.

Answer 168

Group concentrations arise when multiple counterparties have similar activities and economic characteristics that cause their ability to meet obligations to be similarly affected by changes in conditions.

Answer 169

(1) instruments of pension plans, (2) certain insurance contracts, (3) warranty obligations and rights, and (4) unconditional purchase obligations

Answer 170

Disclosures (in the body of the statements or the notes) should include 1) Information about the shared activity, region, or economic characteristic that identifies the concentration. 2) The maximum loss due to credit risk if parties failed completely to perform and the security, if any, proved to be of no value. 3) The policy of requiring collateral or other security, information about access to that security, and the nature and a brief description of the security.

Answer 171

They should appear in the body of the financial statements or in the notes.

Answer 172

Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets. -Market risk, or systematic risk, affects the performance of the entire market simultaneously. -Market risk cannot be eliminated through diversification. -Specific risk, or unsystematic risk, involves the performance of a particular security and can be mitigated through diversification. -Market risk may arise due to changes to interest rates, exchange rates, geopolitical events, or recessions.

Answer 173

No, but entities are encouraged to disclose quantitate information about their market risk management approach.

Answer 174

An entity is encouraged, but not required, to disclose quantitative information about the market risks of instruments that is consistent with the way the entity manages those risks.

Answer 175

GAAP establish a framework for fair value measurements (FVMs) required by other pronouncements.

Answer 176

No. They do not determine when FVMs are required

Answer 177

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

Answer 178

1) Define fair value, 2) Discuss valuation techniques, 3) Establish a fair value hierarchy of inputs to valuation techniques, and 4) Require expanded disclosures about FVMs.

Answer 179

The FVM is for a particular asset or liability that may stand alone (e.g., a financial instrument) or constitute a group (e.g., a business). The definition also applies to instruments measured at fair value that are classified as equity.

Answer 180

The price is an exit price paid or received in a hypothetical transaction considered from the perspective of a market participant.

Answer 181

1) Market participants are not related parties. 2) They are independent of the reporting entity. 3) They are knowledgeable (i.e., they have a reasonable understanding based on all available information). 4) They are willing and able (but not compelled) to engage in transactions involving the asset or liability. 5) The FVM is market-based, not entity-specific.

Answer 182

1) An orderly transaction is not forced, and 2) time is assumed to be sufficient to allow for customary marketing activities. 3) The transaction is assumed to occur in the reporting entity’s principal market for the asset or liability. 4) In the absence of such a market, it is assumed to occur in the most advantageous market. This market is the one in which the specific reporting entity can -Maximize the amount received for selling the asset or -Minimize the amount paid for transferring the liability, after considering transaction costs.

Answer 183

No. Given a principal (or most advantageous) market, the FVM is the price in that market without adjustment for transaction costs.

Answer 184

Suppose there are two markets, a principal market and a lesser market that is not the principal market. If one of the two stock exchanges is a principal market, the quoted stock price on this stock exchange is the fair value.

Answer 185

Suppose the asset being valued trades in two markets. If neither of the two markets is a principal market, the most advantageous market is the market in which the entity using FVM can receive the maximum proceeds from selling the shares

Answer 186

1) The FVM is based on the highest and best use (HBU) by market participants. 2) The HBU is in-use if the value-maximizing use is in combination with other assets in a group. An example is machinery in a factory. 3) The HBU is in-exchange if the value-maximizing use is as a stand-alone asset. An example is a financial asset.

Answer 187

The FVM assumes transfer, not settlement.

Answer 188

The following valuation techniques (approaches) are used to measure fair value: 1) The market approach is based on information, such as multiples of prices, from market transactions involving identical or comparable items. 2) The income approach uses valuation methods based on current market expectations about future amounts, e.g., earnings or cash flows. -It converts future amounts to one present discounted amount. -Examples are present value methods and option-pricing models. 3) The cost approach is based on current replacement cost. It is the cost to buy or build a comparable asset.

Answer 189

Inputs to valuation techniques are the pricing assumptions of market participants.

Answer 190

1) Observable inputs are based on market data obtained from independent sources. 2) Unobservable inputs are based on the entity’s own assumptions about the assumptions of market participants that reflect the best available information.

Answer 191

Observable inputs are based on market data obtained from independent sources.

Answer 192

Unobservable inputs are based on the entity’s own assumptions about the assumptions of market participants that reflect the best available information.

Answer 193

The market approach is based on information, such as multiples of prices, from market transactions involving identical or comparable items.

Answer 194

The income approach uses valuation methods based on current market expectations about future amounts, e.g., earnings or cash flows. -It converts future amounts to one present discounted amount. -Examples are present value methods and option-pricing models.

Answer 195

The cost approach is based on current replacement cost. It is the cost to buy or build a comparable asset.

Answer 196

An entity should maximize the use of relevant observable inputs and minimize the use of unobservable inputs.

Answer 197

1) Level 1 inputs are the most reliable. They are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. EXAMPLE: If the entity has an investment in securities that are traded in an active market, the investment is measured within 2) Level 1. The FVM equals the quantity of securities held times the securities’ quoted price. Level 2 inputs are observable. But they exclude quoted prices included within Level 1. The following are examples: Quoted prices for similar items in active markets, Quoted prices in markets that are not active, and Observable inputs that are not quoted prices. 3) Level 3 inputs are the least reliable. They are unobservable inputs that are used given no observable inputs. They should be based on the best available information in the circumstances. An example of a Level 3 input is the reporting entity’s own data (e.g., present value of future cash flows).

Answer 198

1) Level 1 inputs are the most reliable. They are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. EXAMPLE: If the entity has an investment in securities that are traded in an active market, the investment is measured within Level 1. The FVM equals the quantity of securities held times the securities’ quoted price.

Answer 199

Level 1 inputs are the most reliable. They are unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. EXAMPLE: If the entity has an investment in securities that are traded in an active market, the investment is measured within Level 1. The FVM equals the quantity of securities held times the securities’ quoted price.

Answer 200

Level 2 inputs are observable. But they exclude quoted prices included within Level 1. The following are examples: Quoted prices for similar items in active markets, Quoted prices in markets that are not active, and Observable inputs that are not quoted prices.

Answer 201

Level 3 inputs are the least reliable. They are unobservable inputs that are used given no observable inputs. They should be based on the best available information in the circumstances. An example of a Level 3 input is the reporting entity’s own data (e.g., present value of future cash flows).

Answer 202

Quantitative disclosures in a tabular format are made for each class of assets and liabilities measured at fair value in the balance sheet after initial recognition.

Answer 203

1) Fair value measurement at the end of the reporting period 2) The level of the fair value hierarchy within which the fair value measurements are categorized (Level 1, 2, or 3) 3) A description of the valuation technique(s) and the inputs used in the fair value measurements categorized within Level 2 and Level 3 4) Quantitative information about the significant unobservable inputs used in the fair value measurements categorized within Level 3