Module 9: Basic Theory and Financial Reporting Flashcards
Accounting Standards Codification (ASC)
The single source for all US GAAP
Accrual
Recognition precedes cash receipt/expenditure
Accrual basis
Expenses are recognized as related revenues are recognized
Cash basis
Recognizes income when cash is received and expenses when cash is disbursed
Current cost
The amount of cash, or its equivalent, that would be paid if the same asset were to be acquired currently
Current market value
The amount of cash, or its equivalent, that could be obtained by selling as asset in orderly liquidation
Deferral
Cash receipt/expenditure precedes accrual-basis recognition
Fair value
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 under current market conditions
Historical cost
The amount of cash, or its equivalent, paid to acquire an asset
-can be used only where collection of the sale price is not reasonably assured
Installment sales
Revenue is recognized as cash is collected
Net realizable value
The nondiscounted amount of cash, or its equivalent, into which an asset is expected to be converted during the normal course of business less direct costs to make the conversion
Period costs
Costs not particularly or conveniently assignable to a product
Present value
The current measure of an estimated future cash inflow or outflow, discounted at an interest rate for the number of period between today and the date of the estimated cash outflow
Product costs
Costs which can be associated with particular sales
Realized (realizable)
When related assets received or held are readily convertible into known amounts of cash or claims to cash
Risk adverse
Market place participants prefer situations with less uncertainty relative to an expected outcome
Start-up costs
The costs incurred during the course of undertaking on-time activities related to opening a new facility
What is the objective of general-purpose financial reporting?
To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. (management does not rely on this because info can be obtained internally)
What are the two fundamental qualitative characteristics of accounting information?
Relevance and faithful
(1) Relevance has predictive value, confirmatory value, or both
- Predictive value requires that info be used to predict future outcomes
- Confirmatory value requires that info either confirms or changes prior evaluations
(2) Faithful representation depicts what is purports to represent; should be complete, neutral and free from error
- Completeness requires info is presented or depicted in way users can understand
- Neutrality requires that item is depicted w/o bias
- Free from error means that there are no errors or omissions in info reported
What are the four enhancing qualitative characteristics of accounting information?
(1) Comparability
- understand similarities and diff b/w items
- consistency of accounting methods in diff perioods
(2) Verifiability
- diff sources reach consensus or agreement on an amount of rep of an item
- direct of indirect
(3) Timeliness
- info available to a decision maker when useful
(4) Understandability
- classifying, characterizing and presenting information clearly and concisely
What are the two conceptual view of earnings?
(1) Asset-liability view
- earnings are measured by the change (other than investments or withdrawals) in the net economic resources of an enterprise during a period
(2) Revenue-expense view
- earnings are a measure of an enterprise’s effectiveness in using its inputs to obtain and sell outputs
What are the 5 different attributes used to measure assets and liabs?
(1) Historical cost
- PP&E and most inventories are reported at their historical cost
- Liabs that involve obligations to provide goods/services to customers are generally reported at historical proceeds
(2) Current cost
- some inventories reported at current (replacement) cost (amount of cash, or equivalent, that would have to be paid if thee same or an equiv. asset were acquired currently)
(3) Current Market Value
- some investments in marketable securities are reported at their current market value, which is the amount of cash or its equivalent, that could be obtained by selling an asset in orderly liquidation
- also used for assets expected to be sold at prices lower than previous carrying amounts
- aka fair value
(4) Net realizable value (settlement value)
- short-term receivables and some inventories are reported at this value
- nondiscounted amount of cash or its equivalent, into which an asset is expected to be converted in due course of business less direct costs, if any, necessary to make that conversion
- liabs that involve known or estimated amounts of money payable at unknown future dates, e.g. trade payables or warranty obligations, generally are reported at their net settlement value, which is the nondiscounted amount of cash, or its equiv, expected to be paid to liquidate an obligation in the due course of business, incl. direct costs
(5) Present (or discounted) value of future cash flows
- LT receivables are reported at the value
- PV of future cash inflows into which an asset is expected to be converted in due course of business less present values of cash outflows necessary to obtain those inflows
- LT payables are also reported at their present or discounted value
How is well-offness measured?
(1) financial capital
- capital to be maintained is measured by the amount of cash invested by owners
- earnings may not be recognized until the dollar investment in net assets, measured in units of money or purchasing power, is returned
- traditional view which is reflected in most present financial statements
(2) physical capital
- capital to be maintained is the physical productive capacity of the enterprise
- earnings may not be recognized until the current replacement costs of assets with the same productive capabilities of the assets used up are returned
- this concept supports current cost accounting
When are revenues recognized?
When realized or realizable and earned (when related assets received or held are readily convertible to known amounts of cash or claims to cash)
When are gains recognized?
When realized or realizable
When are expenses recognized?
When economic benefits are consumed in revenue-earning activities, or when future economic benefits are reduced or eliminated
When economic benefits are consumed, what are the ways the expense can be recognized?
(1) matching - e.g. COGS
(2) immediate recognition - e.g. selling and admin salaries
(3) systematic and rational allocation - e.g. depreciation
When are losses recognized?
When future economic benefits are reduced or eliminated
What are revenues, expenses, gains and losses used to compute?
EARNINGS
What are earnings?
Revenues and gains associated with cash to cash cycles substantially completed during the period exceed expenses and losses directly or indirectly associated with those cycles
What is comprehensive income?
Earnings adjusted for cumulative accounting adjustments and other non-owner changes in equity (foreign currency translation adjustments)
What are fresh-start adjustments?
Defined by FASB as measurements in periods following initial recognition that establish a new carrying amount unrelated to previous amounts and accounting conventions
What is the objective of present value, when used in accounting measurements at initial recognition and fresh-start measurements?
To estimate fair value.
An estimate of fair value should include an adjustment for what?
Risk
-the adjustment is the price that marketplace participants are able to receive for bearing the uncertainties in cash flows
Under what conditions does present value measurements occur?
Conditions of uncertainty
-uncertainty refers to the fact that the cash flows used in a PV measurement are estimates
What is risk?
Refers to any exposure to uncertainty in which that exposure has potential negative consequences
What is risk premium?
Marketplace participants seek compensation for accepting uncertainty
What is the objective of including uncertainty and risk in accounting measurements?
To imitate the market’s behavior toward assets and liabs with uncertain cash flows
What is the interest methods of allocation?
periodic reporting conventions; in principle, the purpose of all accounting allocations is to report changes in the value, utility, or substance of assets and liabs over time
What is the primary objective of accounting?
To measure income, which is a measure of management’s efficiency in combining the factors of production into desired g/s
What produces revenue?
The entire process of acquiring the factors of production, processing them and selling the resulting g/s
When is revenue recognized under the accrual basis of accounting?
Revenue is recognized at the point of sale or as service is performed.
What is considered the point of sale?
(1) FOB shipping - when seller ships
(2) FOB destination - when buyer receives
What are the 3 exceptions to the general revenue recognition rule?
(1) during production
(2) at the point where production is complete
(3) at point of cash collection
Describe the recognition basis: During Production Basis
(1) Accounting method - % of completion
(2) Criteria - LT construction, property, or service contract; dependable estimates of extent of progress and cost to complete; reasonable assurance of collectibility of contract price
(3) Reason(s) for departing from sale basis - availability of evidence of ultimate proceeds; better measure of periodic income; avoidance of fluctuations in revenues, expenses, and income
Describe the recognition basis: Completion of production basis
(1) Accounting method - net realizable value
(2) Criteria - immediate marketability at quoted prices; unit interchangeability; difficulty of determining costs
(3) Reason(s) for departing from sale basis - known or determinable revenues; inability to determine costs and thereby defer expense recognition until sale
Describe the recognition basis: Cash collection basis
(1) Accounting method - installment and cost recovery methods
(2) Criteria - absence of a reasonable basis for estimating degree of collectibility
(3) Reason(s) for departing from sale basis - level of uncertainty with respect to collection of the receivable precludes recognition of gross profit cash is received
Accrual accounting basis - revenues and expenses
Expenses are recognized as related revenues are recognized, that is, (product) expenses are matched with revenues
Some (period) expenses, cannot be associated with particular revenues
What are product costs?
Those which can be associated with particular sales; attach to a unit of product and become an expense only when the unit to which they attach is sold (cause and effect)
What are period costs?
Not particularly or conveniently assignable to a product; become expenses due to the passage of time by:
(1) immediate recognition if future benefit cannot be measured (e.g. advertising)
(2) Systematic and rational allocation if benefits are produced in certain future periods (asset depreciation)
What is cash basis of accounting?
Recognizes income when cash is received and expenses when cash is disbursed. Subject to mgmt manipulation
-Why adopt accrual basis accounting? Economic transactions have become more involved and multiperiod; expenditure for fixed asset may produce revenue for years and years
What is an accrual?
Accrual basis recognition precedes (leads to) cash receipt/expenditure
- revenue: recognition of revenue earned, but not received
- expense: recognition of expense incurred, but not paid
What is a deferral?
Cash receipt/expenditure precedes (leads to) accrual basis recognition
- revenue: postponement of recognition of revenue; cash is received, but revenue is not earned
- expense: postponement of recognition of expense; cash is paid, but expense is not incurred
- deferral postpones recognition of revenue or expense by placing the amount in a liability or asset account
2 methods are possible for deferring revenues and expenses depending on whether real or nominal accounts are originally used to record the cash transaction
Who issued SFAC 7 and what is it?
- Issued by FASB
- Provides a framework for using future cash flows as the basis of accounting measurement
- Does not specify WHEN fresh-start measurements are appropriate
What are fresh-start measurements?
Defined by the FASb as measurements in periods following initial recognition that establish a new carrying amount unrelated to previous amounts and accounting conventions
SFAC 7 applies only to measurements at what?
- Initial recognition, fresh-start measurements, and amortization techniques based on future cash flows
- Does not apply to measurements based on the amount of cash or other assets paid or received, or an observation of FV in mrktplace
What is the objective of present value in accounting measurements?
- To incorporate the time value of money in a measurement.
- FASB definition: current measure of an estimated future cash inflow or outflow, discounted at an interest rate for the number of periods between today and date of estimated cash flow.
- PV that incorporates uncertainty in estimated cash flows always provides more relevant info than a measurement based on the undiscounted sum of those cash flows, or a discounted measurement that ignores uncertainty.
Who is the final judge of asset and liability values?
The final judge is the marketplace. Entity is required to pay the market’s price when it acquires and asset or settles a liab in a current transaction
According to SFAC 7, a PV measurement that is able to capture the economic differences between various assets and liabs would include the following elements:
- estimate of the future cash flow
- Expectations about possible variations in the amount of timing of those cash flows
- The time value of money, represented by the risk free rate of interest
- The price for bearing the uncertainty inherent in the asset or liab
- Other factors such as illiquidity and market imperfections
SFAC 7: 2 approaches to calculating the PV
- EXPECTED CASH FLOW APPROACH - only time value of money, represented by the risk-free rate of interest, is included in the discount rate
- TRADITIONAL APPROACH - adjustments to expectations about possible variations in amount of timing of cash flow, time value of money, price for bearing inherent uncertainty and other factors are embedded in the discount rate (approach does not provide tools to address more complex problems)
Why is the expected cash flow approach a more effective measurement tool than discount rate adjustment?
Uses all expectations about possible cash flows instead of the single most likely cash flow.
Use the following example and calculate expected present value using the expected cash flows approach:
Cash flow of $1,000 may be received in 1, 2, or 3 years with probs. 10%, 60% and 30%
- PV of $1,000 in one year at 5% = 952.38
- PV of $1,000 in two years at 5.25% = 902.73
- PV of $1,000 in three years at 5.50% = 851.61
-Take PVs and multiple by probs then total all together. Answer is: 892.36
When would present value measurements not be needed?
If the prices for an asset or liab can be observed in the marketplace
What is the most relevant measure of a liability?
The credit standing of the entity obligated to pay
In principle, what is the purpose of all accounting allocations?
To report changes in the value, utility, or substance of assets and liabs over time
Interest methods of allocation
- Relates changes in the reported amount with changes in the PV of a set of future cash inflows or outflows
- Not measurements of an asset or liab
Income is:
The net effect of inflows of revenue and outflows of expense
Difference between real and nominal accounts.
- Real accounts are those reported on the balance sheet (assets, liabs, owner’s equity)
- Nominal accounts are those reported on the income statement
Cash to accrual - who usually uses it?
Small business - revenue is recognized when cash is received and expenses incurred when cash is paid.
- Current balance = cash basis
- Correct balance = accrual basis
- When adjusting a balance sheet account from cash to accrual, the other half of the entry will generally be to the related income statement account
Under installment sales, what happens to gross profit?
It is deferred to future periods and recognized proportionately to collection of the receivables. Installment receivables and deferred gross profit accounts must be kept separate by year, because the GP rate differs from year to year
How is gross profit and gross margin calculated?
GP = Net sales - COGS GM = GP/Net sales
What is the cost recovery method?
Similar to the installment sales method in that GP on the sale is deferred but the difference is that no profit is recognized until the cumulative receipts exceed the cost of the asset sold
Franchise agreements?
Initial franchise fee be recognized as revenue by the franchiser only upon substantial performance of their initial service obligation
-Direct franchise costs are deferred until the related revenue is recognized
Real Estate Transactions - when can profits be recognized?
- Recognized in full, provided the profit is determinable and the earnings process is virtually complete. Four criteria must be met to recognize profit in the full at point of sale:
1. A sale is consummated
2. Buyer’s initial and continuing investments are adequate to demonstrate a commitment to pay for the property
3. Seller’s receivable is not subject to future subordination
4. Seller has transferred to the buyer usual risks and rewards of ownership and does not have a substantial continuing involvement in the property
What is the deposit method?
Payments received are recorded as a liability until the contact is canceled or a sale is archived.
What is the reduced profit method?
Seller recognizes a portion of profit at the time of sale with the remaining portion recognized in future periods.
Describe the recognition of profit in the reduced profit method.
Profit recognized at time of sale is determined by calculating the PV of the buyer’s receivable and applying a formula. The reduced profit recognized at the time of sale is the GP - PV of receivable.
What is the Multiple - Deliverable Revenue Arrangement?
Description: Entity has revenue generating activities to provide multiple products or services at different times.
- 2 conditions must be met:
1. Delivered item has value on a stand-alone basis (sold separately to customer or vendor)
(2) if arrangement includes a right of return for the delivered item, the undelivered item must be substantially in control of the vendor
Research or Development Accounted for on the Milestone basis
- Revenue (payments) to the vendor is contingent on achieving one of more substantive milestones related to deliverables or units of accounting
1. Substantive milestone is an uncertain event that can be only achieved based on the vendor’s performance - Commensurate with the vendor’s performance of enhancement of value resulting from performance
- Relates solely on past performance
- It is reasonable relative to all of the deliverables and payment terms
What should be disclosed in the financial statements for milestone payments?
- Description of overall arrangement
- Description of each milestone and related contingent consideration
- Determination of whether each milestone is considered substantive
- Factors considered in determining whether milestones are substantive
- Amount of consideration recognized during the period for milestone
Software Revenue Recognition
- Software products that are included with tangible products (hardware) and are required for the product’s functionality are excluded from these software revenue recognition rules
- Software products that do not require significant production, modification or customization should recognize revenue when all of the following are met:
1. Persuasive evidence of an arrangement exists
2. Delivery has occurred
3. Vendor’s fee is fixed or determinable
4. Collectibility is probable
Fee Recognition for Software Revenue Recognition
- Delivery of an element is considered not to have occurred if other elements essential to the function of it are undelivered
- No portion of the fee meets the criterion of collectibility if the portion of the fee allocable to delivered elements is subject to forfeiture , refund or other concession if undelivered elements are not delivered
Fee allocation for multiple elements for Software Revenue Recognition
Arrangement that includes multiple elements should allocate the fee to the elements based on vendor-specific objective evidence of FV, regardless of stated prices in contracts
Arrangements consisting of multiple software deliverables including:
- software products
- upgrades/enhancements
- Postcontract customer service
- Services
- elements deliverable on a when and if available basis
Software Revenue Recognition continued - what happens if there is vendor specific objective evidence of FV?
It is limited to:
- price charged when same element sold separately
- price established by mgmt if not sold separately yet; probable that price does not change
Software Revenue Recognition continued - what happens if there is insufficient vendor specific objective evidence of FV?
- Defer revenue until whichever one occurs first:
1. sufficient vendor specific objective evidence does exist
2. all elements have been delivered
Software Revenue Recognition continued - what are the exceptions to insufficient vendor specific objective evidence of FV?
- The PCS (postcontract customer service)is the only undelivered element - recognize fee ratably
- Only undelivered element is services that don’t require significant production, modification or customization - recognize fee over the period in which the services will be performed
- Arrangement is a subscription in substance - recognize fee ratably
- Fee based on the number of copies
Software Revenue Recognition continued - when would separate accounting be needed for service element of an arrangement be required?
- services not essential to functionality of any other element
- services are described in contract such that total price of arrangement would be expected to vary as result of inclusion or exclusion of services
What are factors that should be considered before recognizing revenue on a sale basis for: sale with a right of return?
- whether economic substance of the transaction is a sale or a financing arrangement
- Determination of sales price
- probability of collection of sales price
- seller’s future obligations
- predictability of returns
What are conditions that would cause recognition of a sale with a right of return be delayed beyond time of sale?
- sales price is not fixed or determinable
- payment excused until product is sold
- payment excused if property stolen or damaged
- buyer without separate economic substance
- seller’s obligation to bring about resale of property
- inability to predict future returns
What are factors that should be considered before recognizing revenue on a sale basis for: product financing arrangement?
Whether risks and rewards of ownership are transferred
What are conditions that would cause recognition of a product financing arrangement to be delayed beyond time of sale?
Agreement requires repurchases at specified prices or provides compensation for losses
What is a product financing agreement?
Transaction in which an enterprise sells and agrees to repurchase inventory with the repurchase price equal to the original sale price plus carrying and financing costs. This Statement requires that a product financing arrangement be accounted for as a borrowing rather than as a sale.
What are factors that should be considered before recognizing revenue on a sale basis for: real estate sale?
- probability of collection
- seller’s continued involvement
- whether economic substance of the transaction is a sale of real estate or another type of transaction such as a service contract
What are conditions that cause recognition of a real estate to be delayed beyond time of sale?
- inadequate buyer investment in the property
- seller’s continuing obligations such as participation in future losses, responsibility to obtain financing, construct buildings or support operations
What is a sales-type lease?
Type of capital lease where the present value of minimum lease payments i.e. the lease receivable for a lessor is higher than the carrying amount of the leased asset.
What are factors that should be considered before recognizing revenue on a sale basis for: sales-type lease?
- probability of collection
- transfer of benefits and risks of ownership
- predictability of future unreimburseable costs
What are conditions that cause recognition of a sales-type lease to be delayed beyond time of sale?
- Seller’s continuing obligations
- inadequate buyer investment in the property
- inability to indicate transfer of benefits and risks of ownership
- uncertainty about future unreimbursable costs
What is recourse?
The legal right to collect. A legal agreement by which the lender has a right tot pledge collateral in the event that buyer is unable to satisfy debt obligations
What are factors that should be considered before recognizing revenue on a sale basis for: sale of receivables with recourse?
- isolation of transferred assets
- right to pledge or exchange transferred assets
- control of receivables
What are conditions that cause recognition of a sale of receivables with recourse to be delayed beyond time of sale?
- transferred assets can be reached by transferor or its creditors
- transferee’s inability to pledge or exchange transferred assets
- control of receivables not surrendered due to repurchase or redemption agreement
What is a redemption agreement?
An agreement in which the seller reserves the right to take back what was sold at the same price or more
What are factors that should be considered before recognizing revenue on a sale basis for: nonmonetary exchange?
transaction has commercial substance
What are conditions that cause recognition of a nonmonetary exchange to be delayed beyond time of sale?
- FV is not determinable
- Exchange transaction to facilitate sales to customers
- transaction lacks commercial substance
What is a sales-leaseback transaction?
An arrangement in which the seller of an asset leases back what was sold to the purchaser.
What are factors that should be considered before recognizing revenue on a sale basis for: sales-leaseback transaction?
- substance of the transaction
- portion of property leased back
- length of leaseback period
What are conditions that cause recognition of a sales-leaseback transaction to be delayed beyond time of sale?
all sales-leaseback transactions are financing transactions and not sales unless leaseback covers only a small part of the property or is for a short period of time
What the Accounting Standards Codification (ASC) say about start-up costs?
They should be expensed rather than capitalized. Examples include: opening a new facility, introducing a new product or service, conducting business in a new territory, new business with new class of customer; new process
Who are the primary users of financial reporting?
Investors, lenders and other creditors. Management does not rely on general-purpose reports because information can be obtained internally.
What does financial reporting provide?
- Info that is useful to potential and existing investors, lenders, and other creditors
- Info about the reporting entity’s economic resources and claims against the reporting entity
- Changes in economic resources and claims
- Financial performance reflected by accrual accounting
- Financial performance reflected by past cash flow
- Changes in economic resources and claims not resulting from financial performance
What are the 2 fundamental qualitative characteristics of accounting information?
Relevance & faithful representation
Relevant info is capable of making a difference in a user’s decision. Financial info is relevant if it has predictive value, confirmatory value or both
