FAR SEC 3 Flashcards
When the outcome of the contract is not reasonably measurable but the costs incurred in satisfying the performance obligation are expected to be recovered, how should revenue be recognized?
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.
Should earnings per share (EPS) be reported on the face of the income statement for cumulative effect of a change in accounting principle?
No.
Should earnings-per-share data be reported on the face of the income statement for income from continuing operations?
EPS data for income from continuing operations and net income must be reported on the face of the income statement. EPS data for a discontinued operation may be disclosed on the face of the income statement or in a note.
Should earnings-per-share data be reported on the face of the income statement for income from discontinued operations?
EPS data for a discontinued operation may be disclosed on the face of the income statement or in a note.
A company’s convertible debt securities are both a potential common stock and potentially dilutive in determining earnings per share. What would be the effect of these securities on the calculation of basic earnings per share (BEPS) and dilutive earnings per share (DEPS)?
Securities classified as potential common stock should be included in the computation of the number of common shares outstanding for DEPS if the effect of the inclusion is dilutive. Dilutive potential common stock decreases DEPS. BEPS is not affected by potential common stock.
Basic Earnings per Share (BEPS)
Basic EPS = (Net income - preferred dividends) ÷ weighted average of common shares outstanding during the period.
OR
BEPS = (Income Available to Common Shareholders)/(Weighted-average Number of Common Shares Outstanding)
Basic earnings per share does not factor in the dilutive effects of convertible securities.
Formula for Diluted Earnings per Share
The Formula for Diluted Earnings per Share
DEPS= (BEPS numerator + Effect of dilutive PCS)/(BEPS denominator + Effect of dilutive PCS)
What are the 4 criteria for considering that a contract exists from an accounting standpoint under ASC 606 Contracts with Customers?
A contract is accounted for under the revenue recognition standard if all the following criteria are met: (1) The contract was approved by both parties, (2) the contract has commercial substance, (3) each party’s rights regarding (a) goods or services to be transferred and (b) the payment terms can be identified, and (4) it is probable that the entity will collect the consideration to which it is entitled according to the contract.
When are share options antidilutive?
If the average price of the share options over the period is “out of the money”, the share options are antidilutive. Antidilutive shares cannot be added to the BEPS denominator as the Effect of PCS in the denominator for calculating DEPS.
The correction of an error in the financial statements of a prior period should be reported, net of applicable income taxes, in the current
Retained earnings statement as an adjustment of the opening balance.
Which of the following describes the appropriate reporting treatment for a change in accounting estimate?
All changes in accounting estimates are made prospectively. No changes are made in prior financial statements, and the beginning balances are not adjusted. The effects of all changes in accounting estimate are accounted for in the period of the change and future periods if the change affects both.
Under the guidance for recognition of revenue from contracts with customers (ASC 606), a contract modification is accounted for as a separate contract if the additional promised goods are _________(1) and the price for these additional goods is __________ (2).
A contract modification exists when the parties approve a change in the scope or price of a contract. A contract modification is accounted for as a separate contract if (1) it results in the addition to the contract of promised goods or services that are distinct and (2) the price for these additional goods or services is their standalone selling price.
Preferability Criterion - When to Change Accounting Principle?
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.
The three types of accounting changes are
A change in accounting principle,
A change in accounting estimate, and
A change in the reporting entity.
What are the three situations that fit the definition of a change in accounting principle?
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.
Is the initial adoption of an accounting principle the same as a change in principle?
No. A change in principle does not include the initial adoption of a principle because of an event or transaction occurring for the first time.
What is the temporal scope of changes in accounting principle?
Direct effects (including on income tax) are applied retrospectively, whereas indirect effects are recognized and reported in the period of change.
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).
What are direct effects (from a change in accounting principle)?
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.
What are indirect effects (from a change in accounting principle)?
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.
How does retrospective application work for a change in accounting principle?
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.
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.
Impracticability Exceptions. 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.
For retrospective application of a change in accounting principle, which balance sheet items are adjusted at the beginning of the first period reported for the cumulative effect (CE) of the change?
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.
For retrospective application of a change of accounting principle, what are the Impracticability Exceptions?
Normal Case is full Retrospective Application (Not Exception): 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.
Exception (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.
Exception (2): 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 (meaning the first period when PSE can be stated???).
What is prospective adjustment?
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.
What is a Change in Accounting Estimate?
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).
What are the temporal restrictions on adjustments due to Change in Accounting Estimate?
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.
How are changes in estimate inseparable from changes in principle treated?
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.
Change in Reporting Entity
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.
The three main causes of changes in reporting entity are _______________.
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.
What is a variable interest entity?
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.
What circumstances definitely are not changes in reporting entity?
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.
What is a business combination?
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.
What is the temporal scope of application for a Change in Reporting Entity?
A change in the reporting entity is retrospectively applied to interim and annual statements.
What are the 3 causes of Error Correction?
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.
How is a change from non-GAAP to GAAP principle treated?
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”.
How are error corrections reported on the financial statements?
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.
What is Error Analysis (correcting journal entry)?
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.
Are prior period restatements always required for errors affecting prior-period statements?
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.
Counterbalancing vs. Noncounterbalancing Errors
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.
How can entities make voluntary changes in accounting principles?
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.
What are the types of accounting changes?
1) change in accounting principle.
2) change in accounting estimate.
3) change in reporting entity.
When does a change in accounting principle occur?
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.
What is the major exceptional case for a change in accounting principle?
A change in principle does not include the initial adoption of a principle because of an event or transaction occurring for the first time.
When is retrospective application required for changes in accounting principle?
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.
For changes in accounting principle, what distinguishes direct effects from indirect effects?
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.
What is retrospective application?
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.
When is the cumulative effect of the retrospective adjustments reported?
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.
How should all periods presented in the statements at the time of change in principle be adjusted?
All periods presented must be individually adjusted for the period-specific effects (PSE) of the new principle.
In what 2 cases would prospective application of a change in accounting principle be warranted?
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.
What is the exception to the requirement to individually adjust for the period-specific effects (PSE) of the new principle in each period presented?
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.
What is the application method for a change in accounting estimate?
Prospective application.
What is a change in accounting estimate?
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.
What happens when a change in estimate is inseparable from a change in accounting principle?
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.
Why would interest expense on convertible bonds be added back when calculating DEPS?
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.
In computing DEPS, why is dividend income adjusted for the conversion of preferred stock to common shares?
There is a conversion ratio from preferred to common shares, and the dividend rate for common shares usually differs from the preferred dividend rate.
What is PCS?
PCS is dilutive potential common shares (PCS).
What are earnings per incremental share?
Earnings per incremental share are the earnings per share calculated for blocks of shares being considered under the If-Converted Method for DEPS.
What is the core principle for recognizing revenue from contracts with customers?
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.
What are the 4 categories of contracts that exceptional to the core principles of contracts with customers revenue recognition?
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
What are the steps of 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.
What are the Step 1 criteria (five-step contract revenue model) for a contract to be identified 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.
How is revenue from a purported contract treated if the (4) criteria for Step 1 (five-step contract revenue model) are not met?
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.
If a contract cannot be identified but consideration has been received, what 3 sufficient conditions would need to apply in order for the revenue to be recognized?
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.
What is a contract modification?
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.
What are contract performance obligations?
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.
What conditions make promised goods or services distinct?
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.
What are the conditions for separately identifiable goods or services?
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.
What is a material right?
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.
How is the transaction price determined (Step 3, five-step revenue recognition model)?
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.
At step 3 (five-step model, contract revenue recognition), how does revenue recognized relate the transaction price to the time factor?
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.
Which factors determine whether a contract includes a significant financing component?
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
When should the transaction price definitely not be adjusted for the effect of the time value of money?
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.
How should interest income or expense be recognized in relation to step 3 (five-step model, contract revenue recognition)?
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.
What causes may result in contact price varying (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 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
What are the methods for estimating variable consideration?
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.
When must the estimated transaction price be updated (if there is variable consideration)?
The estimated transaction price must be updated at the end of each reporting period.
What is the constraint on recognizing revenue from variable consideration?
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.
Define volume discounts.
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).
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).
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.
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).
-Consideration payable to a customer is recognized as a reduction of the transaction price and therefore of revenue.
When 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
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.
What happens in Step 4 of the five step model for contracts with customers revenue recognition?
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.
What is the method for Step 4 of the five step model of contracts with customers revenue recognition?
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.
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.
-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).
What should be done in step 4 of the five step model for contracts with customers revenue recognition if the standalone price is not observable?
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.
What is the adjusted market assessment method for estimating unobservable standalone costs?
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.
What is the Expected Cost Plus an Appropriate Margin method for estimating unobservable standalone cost?
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.
What is the Residual method for estimating unobservable standalone cost?
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.
How are relative standalone prices used to estimate the cost allocation in Step 4 of the five step model of contracts with customers revenue recognition?
(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
When and how is revenue recognized in step 5 of the five step model for contracts with customers revenue recognition?
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.
What is the definition of transferring control of the asset to the customer?
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.
What are the two temporal modalities in which a performance obligation can be satisfied?
A performance obligation can be satisfied either over time or at a point in time.
In which 3 situations is contracts with customers revenue satisfied “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. 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.
How is a performance obligation satisfied “AT A POINT IN TIME”? (5 indicators)
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.
What is the distinction between recognizing revenue “OVER TIME” as opposed to “AT A POINT IN TIME”?
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.
What is a contract liability?
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).
What is a contract asset?
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.
How are contract assets and liabilities presented in the statement of financial position?
Contract assets and contract liabilities resulting from different contracts must not be presented net in the statement of financial position.
What condition must obtain for the entity to recognize a contract asset as a receivable?
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.
Explain the accounting for incremental costs of OBTAINING a contract.
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.
If a performance obligation is satisfied over time, how does the entity recognize the revenue?
For each performance obligation satisfied over time, an entity must recognize revenue over time.
To recognize revenue “OVER TIME”, what methods are used?
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
For recognizing revenue “OVER TIME”, how does the entity choose between the output method and the input method?
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.
How is revenue recognition for revenue recognized “OVER TIME” periodically adjusted to reflect the passage of time?
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.
What is the input method?
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.
What are the two versions of the input method for revenue recognition “OVER TIME”?
1) Cost-to-cost method. (if revenue recognition is uneven OVER TIME.
2) Straight-line basis (if the revenue recognition occurs evenly OVER TIME”.
Define the cost-to-cost version of the input method for revenue recognition “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.
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
Under the cost-to-cost version of the input method for revenue recognition “OVER TIME”, which three cost types are excluded from the basis used to calculate the amount of revenue recognized in a period?
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.
What is the straight-line version of the input method for revenue recognition “OVER TIME”?
When an entity’s inputs are incurred evenly over time, recognition of revenue on a straight-line basis may be appropriate.
What are the key formulas for the cost-to-cost method?
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]
Under the cost-to-cost version of the input method for revenue recognition, how is cost of goods sold recognized for the current period?
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.
What is the output method for revenue recognition “OVER TIME”?
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.
Assuming it is correct to recognize revenue OVER TIME, what additional restriction applies to the ability of the entity to recognize the revenue?
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.
What is the exception to the rule that, “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”?
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.
Theoretical Basis of Treasury Stock Method
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.
Capitalized Cost
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.
What is a Pro Forma Statement or Amount?
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.
What is the difference between Combined & Consolidated Statements?
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.
What are the three steps of making a correcting journal entry?
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.
What four topics are addressed by error analysis?
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).
Combined Statements
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.
Consolidated Statements
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.
What is a statement of financial position?
Statement of Financial Position = Balance Sheet
What is the valid justification for an entity to voluntarily change their accounting principles?
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.
How are accounting principles applied in preparing accounting statements? Hint: which enhancing qualitative characteristic should be maximized?
An adopted accounting principle must be applied consistently in preparing financial statements.
What are the three types of accounting changes?
1) A change in accounting principle,
2) A change in accounting estimate, and
3) A change in the reporting entity.
What are the two temporal modalities for applying accounting changes?
1) Retrospective
2) Prospective
What are three situations by which a change in accounting principle can occur?
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.
How does initial adoption of a principle differ from a change in principle?
A change in principle does not include the initial adoption of a principle because of an event or transaction occurring for the first time.
What are direct effects from a change in accounting principle?
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.
What are indirect effects of a change in accounting principle?
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.
What is the difference between direct and indirect effects of a change in accounting principle.
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.
When are indirect effects recognized and reported?
Indirect effects are recognized and reported in the period of change.
Can a change in accounting principle (retrospective application) include indirect effects?
No. Retrospective application must not include indirect effects.
How a change in accounting principle implemented via retrospective application? (2 elements)
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.
Which 3 accounting elements are adjusted for the cumulative effect of the new accounting principle on prior periods when there is retrospective application of a change in accounting principle?
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.
Which periods presented are adjusted for the period-specific effects (PSE) of the new accounting principle resulting from a change in accounting principle?
All periods presented must be individually adjusted for the period-specific effects (PSE) of the new principle.
What happens if it is impracticable to determine the cumulative effect of a new accounting principle on any prior period for a change in accounting principle?
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.
What happens if it is practicable to determine the cumulative effect of applying the new principle to all prior periods but it is impracticable to determine the period-specific effects?
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.
What is shown on the Impracticability Exceptions flow chart?
CE practicable for all prior periods (YES/NO) => ?
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.
PSE practicable for all periods presented (YES/NO) => ?
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.
What is a change in accounting estimate?
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).
By what temporal modality is a change in accounting estimate applied?
Prospectively
How are the effects of a change in accounting estimate applied? (2 elements)
Its effects must be accounted for only in (1) the period of change and (2) any future periods affected (prospectively).
In what period does prospective application of a change in accounting estimate begin?
The prospective application must be applied from the beginning of the accounting period in which the accounting estimate was changed.
For a change in accounting estimate, what 2 restrictions exist?
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.
What is the accounting treatment for a change in estimate inseparable from a change in principle?
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.
What is a change in the reporting entity?
A change in the reporting entity results in statements that are effectively those of a different entity.
What are the main situations that cause a change in the reporting entity? (3 elements)
1) Consolidated or combined statements replace those of individual entities,
2) Consolidated statements include different subsidiaries, or
3) Combined statements include different entities.
Is a business combination or consolidation of a variable interest entity a change in the reporting entity?
No. A business combination or consolidation of a variable interest entity is not a change in the reporting entity.
What is the temporal modality for applying a change in the reporting entity?
A change in the reporting entity is retrospectively applied to interim and annual statements.
What are the three main causes of an error in a prior statement?
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.
Is changing from a non-GAAP principle to a GAAP principle a change in principle or an error correction?
A change to a generally accepted accounting principle from one that is not generally accepted is an error correction, not an accounting change.
What is the temporal modality for applying an error correction?
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.
What is the procedure for applying an error correction? (4 elements)
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.
Are corrections of prior period errors included in current period net income?
No. Corrections of prior-period errors must not be included in current period net income.
How does error correction compare to a change in accounting principle in terms of the temporal modality of application?
In addition to the revision of the previously issued financial statements, restatement requires the same adjustments as retrospective application of a new principle.
How are error corrections reported on single-period statements? How are they reported on comparative statements (statements with multiple periods)?
-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.
What work is done by a correcting journal entry?
A correcting journal entry combines the reversal of the error with the correct entry.
What three objectives are achieved by a correcting journal entry?
Thus, it requires a determination of the
1) Journal entry originally recorded,
2) Event or transaction that occurred, and
3) Correct journal entry.
What four topics are addressed by error analysis?
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.
How do errors affecting prior-period statements impact prior-period net income?
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.
What are counterbalancing errors?
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.
What are noncounterbalancing errors?
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.
What are three examples of changes in the reporting entity?
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.
What are subsequent events?
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.
What are the two types of entities and their respective dates through which they must evaluate subsequent events?
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).
Must the entity disclose the date through which subsequent events have been evaluated?
Yes. The entity must disclose the date through which subsequent events have been evaluated.
What are the two types of subsequent events?
1) Recognized subsequent events
2) Unrecognized subsequent events
What are recognized subsequent events?
Recognized subsequent events provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in statement preparation.
Must recognized subsequent events be recognized (reported) in the financial statements?
Yes. This type of event must be recognized in the financial statements.
Which two situations ORDINARILY result in a recognized subsequent event?
Subsequent events
1) affecting the realization of assets (such as receivables and inventories) or
2) the settlement of estimated liabilities
ordinarily require recognition.
What is the typical timeframe for the preconditions for a recognized subsequent event?
They usually reflect the resolution of conditions that existed over a relatively long period.
Give three examples of recognized subsequent events.
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.
Is EPS adjusted for subsequent recognition of stock dividends and stock splits that occurred after the balance sheet date but prior to the issuance of the financial statements?
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).
What are unrecognized subsequent events?
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.
What differs in treatment between recognized and unrecognized subsequent events?
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).
What are seven examples of unrecognized subsequent events requiring disclosure only?
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
What is done for the disclosure of certain highly significant unrecognized subsequent events?
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.
What criteria are used to distinguish recognized from unrecognized subsequent events?
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.
What are accounting policies?
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.
Who selects accounting policies? Why?
Management selects these policies as the most appropriate for fair presentation of financial statements.
What are the accounting policy disclosure requirements for businesses and not-for-profit entities?
Business and not-for-profit entities must disclose all significant accounting policies as an integral part of the financial statements.
Is disclosure of accounting policy required in interim financial statements?
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.
What is the title of the accounting policies disclosure section of the financial statements? Where is this disclosure located in the financial reporting?
The preferred presentation is a summary of accounting policies in a separate section preceding the notes or in the initial note.
What kinds of details are about the accounting policies are provided in the summary of accounting principles?
The disclosure should include accounting principles adopted and the methods of applying them that materially affect the financial statements.
Which three types of accounting policies relating to the unique accounting principles adopted by a particular entity have required disclosures?
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.
Which disclosures about the accounting policies of business entities are commonly required? (6 elements)
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
Should information unrelated to accounting policies that was presented elsewhere in the financial statements be included in the summary of accounting polices?
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.
What is credit risk?
Credit risk is the risk of accounting loss from a financial instrument because of the possible failure of another party to perform.
Should an entity disclose its concentrations of credit risk?
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.
What are concentrations of credit risk?
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.
What are group concentrations of credit risk?
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.
What are the four exceptions to the general requirement of the entity to disclose its concentrations of credit risk?
(1) instruments of pension plans,
(2) certain insurance contracts,
(3) warranty obligations and rights, and
(4) unconditional purchase obligations
What should be included in disclosures for concentrations of credit risk? (3 elements)
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.
Where should the disclosures for concentrations of credit risk be placed in the financial statements?
They should appear in the body of the financial statements or in the notes.
What is market risk?
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.
Is the entity required to make disclosures about market risk?
No, but entities are encouraged to disclose quantitate information about their market risk management approach.
What kind of disclosures about market risk are encouraged (not required)?
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.
Who established the framework for fair value measurements (FVMs)?
GAAP establish a framework for fair value measurements (FVMs) required by other pronouncements.
Does GAAP determine when fair value measurements are required?
No. They do not determine when FVMs are required
What is fair value?
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.
What four objectives are achieved in GAAP’s fair value measurement framework?
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.
What is the scope of applicability for the FVM definition?
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.
In the GAAP FVM, what is the exit price?
The price is an exit price paid or received in a hypothetical transaction considered from the perspective of a market participant.
In the GAAP FVM framework, who are market participants? What 5 attributes do they have.
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.
In the GAAP FVM, what are the 4 attributes of an orderly transaction?
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.
Does the FVM adjust for transaction costs?
No. Given a principal (or most advantageous) market, the FVM is the price in that market without adjustment for transaction costs.
How does “principal market” status affect which price should be used under FVM?
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.
What is the advantageous market? When should its valuations be used under FVM?
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
How does highest and best use relate to FVM? (3 elements)
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.
How does the GAAP FVM treat liabilities?
The FVM assumes transfer, not settlement.
What are the three valuation techniques used under the GAAP FVM?
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.
What are inputs to valuation techniques?
Inputs to valuation techniques are the pricing assumptions of market participants.
What are the two types of inputs to valuation techniques for the GAAP FVM?
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.
What are observable inputs?
Observable inputs are based on market data obtained from independent sources.
What are unobservable inputs?
Unobservable inputs are based on the entity’s own assumptions about the assumptions of market participants that reflect the best available information.
What is the market approach?
The market approach is based on information, such as multiples of prices, from market transactions involving identical or comparable items.
What is the income approach?
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.
What is the cost approach?
The cost approach is based on current replacement cost. It is the cost to buy or build a comparable asset.
How should an entity prioritize its use of observable and unobservable inputs?
An entity should maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
What are the three levels of the Fair Value Hierarchy for GAAP FVM?
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).
What are Level 1 inputs to the Fair Value Hierarchy?
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.
What are Level 1 inputs to the fair value hierarchy?
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.
What are level 2 inputs to the fair value hierarchy?
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.
What are level 3 inputs to the fair value hierarchy?
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).
What disclosures are made for fair value? How are they made?
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.
What are the four main examples of quantitative fair value disclosures made in tabular format?
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
