Income Statement

Question 1

Percentage of completion method

Answer 1

When the outcome of a contract can be reliably measured, both US GAAP and IFRS use ‘percentage of completion method’. This means that revenue/expenses and profit are recognized as the work is performed.

To calculate:
%age of completion = (total cost incurred thus far)/(total expected cost of project)

revenue = (%age of completion) * (total contract cost) - (past revenues accounted for [if not calculating for y1))

%age of completion method is considered more aggressive than completed contract method. Upside is better matching

Question 2

When the outcome of a long term contract can’t be reliably measured

Answer 2

Under US GAAP, you would use completed contract method

Under IFRS, you would recognize revenues/expenses over the project’s life but no profit may be recorded until the project is completed. (Revenue would obviously equal cost)

Question 3

Completed contract method

Answer 3

Only applicable under US GAAP. Under completed contract method, you don’t recognized revenues/expenses and profits until the project is completed.

Completed contract method is considered more conservative since you’re delaying recognition of revenue/expenses and profit. Downside is poor matching

Question 4

If a loss is expected on the contract

Answer 4

Under IFRS and US GAAP, you have to report the loss immediately, not upon completion, regardless of the method you use

Question 5

Installment sales

Answer 5

proceeds are paid in installments over an extended (multiple accounting periods) of time

Under US GAAP, if:

• seller has completed significant activities in the earning process
• assured of collecting, or able to estimate what will not be completed

then: normal revenue recognition (in the period incurred)
else: some of the profit is deferred

Installment method = ($Collected/selling price) x Total profit

or

Cost recovery method -> not until (total payment)>Cost

Question 6

Barter transaction

Answer 6

Goods exchanged w/out cash payment

Very difficult to record b/c barter rarely reflects actual market value

Under IFRS: record revenue at ‘fair value’ of revenues from similar nonbarter transactions w/unrelated products

Under GAAP: record revenue at fair value only if the company has a history of making/receiving cash payments for such goods.

else: recorded at carrying amount of asset given up

Question 7

Gross revenue reporting and net revenue reporting

Answer 7

Remember, gross revenue = revenue prior to any deductions.

Under gross revenue reporting, the selling firm reports sales revenue and COGS separately. Under net revenue reporting, only the differences in sales and cost is reported

For example, consider a travel agent who arranges a first-class ticket for a customer flying to Singapore. The ticket price is $10,000, and the travel agent receives a $1,000 commission. Using gross reporting, the travel agent would report $10,000 of revenue, $9,000 of expense, and $1,000 of profit.

Under net reporting, the travel agent would report $1K revenue, $0 expense and $1K profit.

You use gross revenue reporting under US GAAP only if the company :

• is the primary obligor (the co. obligated to deliver goods and services)
• bears inventory and credit risk
• can choose its suppliers
• has reasonable latitude to establish price

Question 8

Core principle of revenue recognition (by IASB and FASB)

Answer 8

Revenue should be recognized in order to depict the “transfer of promised goods and services” to customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods and services

Question 9

5 steps in recognizing revenue

Answer 9

1. ID the contract(s) w/customer
2. ID the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligation
5. Recognize revenue when (or as) the entity satisfies its performance obligation

Question 10

Expenses

Answer 10

Under the accrual principle of accounting, expenses are matched with their revenue. This means that the expense incurred to generate revenue is recognized in the same period as when revenue is recognized (matching principle)

Not all expenses is directly tied to revenue generation -> these costs are known as period costs (e.g. administrative costs) and they’re expensed in the period incurred

Question 11

Double declining depreciation

Answer 11

double-declining balance depreciation applies double the straight line depreciation rate to the carrying value.

DDB depreciation = (2/useful life) x (cost - accumulated depreciation)

Question 12

Intangible assets w/indefinite lives are…

Answer 12

not amortized. But they must be tested for impairment at least annually. If the asset is impaired, an expense equal to the impairment amount is recognized on the income statement

Question 13

Discontinued operations

Answer 13

• A non-recurring item. Same rules for IFRS and US GAAP

A discontinued operation is one that management has decided to dispose of, but either has not yet done so, or has disposed of in the current year after the operation had generated income or losses.

• It’s reported as a separate line item
• Shown net of taxes, below ‘Income of continuing operations’

Question 14

Analysis implication of discontinued operations

Answer 14

• Discontinued operations do not affect net income from continuing operations.
• Discontinued operations should be excluded by the analyst when forecasting future earnings. The actual event of discontinuing a business segment or selling assets may provide information about the future cash flows of the firm, however.

Question 15

Unusual/infrequent items

Answer 15

E.g: restructuring charges, staff termination, gains/losses on disposal of assets

Shown as part of a company’s continuing operations but are presented separately

Question 16

Change in accounting principle

Answer 16

e.g. LIFO to FIFO

A change in accounting principle requires retrospective application - meaning past financial statements have to be changed to preserve comparability

Question 17

Change in accounting estimate

Answer 17

E.g. change in salvage value, useful life

Question 18

basic EPS

Answer 18

basic EPS = (NI - preferred dividends)/(weighted average # of common shares outstanding)

Question 19

Diluted EPS effect regarding convertible preferred shares

Answer 19

Diluted EPS assumes that all convertible preferred shares are converted at the beginning of the period

2 effects:

• numerator becomes larger (because you no longer have preferred dividends to subtract from the net income after you convert the convertible pref. shares)
• denominator becomes larger (because you have more common stock outstanding)

diluted EPS when involving convertible preferred shares = (NI)/(weighted average # of common share) + (new common shares converted from the convertible security)

Question 20

Diluted EPS effect regarding convertible debt

Answer 20

Diluted EPs assumes that all convertible debt is converted at the beginning of the period

2 effects:

• numerator becomes larger (b/c no interest expense, so you’d add the after-tax interest expense back)
• denominator becomes larger (b/c you have more common shares outstanding)

diluted EPS when involving convertible debt =
(NI - preferred dividends + (1-t)x(interest expense))/(weighted avg # of common shares) = (new shares from conversion)

Question 21

Diluted EPS effect regarding options/warrants (Treasury Stock Method)

Answer 21

Stock options/warrants are dilutive only when their exercise prices < avg market price of the stock over the year

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

Net effect: share count always increases (b/c companies will always receive less than what the shares actually cost since you wouldn’t exercise your options/warrants if the market price = strike price)

The share increase is weighted by date.

• If options/warrants exercised prior to the period, full amount
• if options/warrants exercised during the period, weighted by time

Question 22

Stock dividends effect on weighted avg # of outstanding shares

Answer 22

Shares outstanding are weighted by the portion of the year the shares were outstanding. Any shares that were outstanding before the stock dividend must be adjusted for it. Transactions that occur after the stock dividend don’t need to be adjusted.