Module 9: Basic Theory and Financial Reporting

Question 1

Accounting Standards Codification (ASC)

Answer 1

The single source for all US GAAP

Question 2

Accrual

Answer 2

Recognition precedes cash receipt/expenditure

Question 3

Accrual basis

Answer 3

Expenses are recognized as related revenues are recognized

Question 4

Cash basis

Answer 4

Recognizes income when cash is received and expenses when cash is disbursed

Question 5

Current cost

Answer 5

The amount of cash, or its equivalent, that would be paid if the same asset were to be acquired currently

Question 6

Current market value

Answer 6

The amount of cash, or its equivalent, that could be obtained by selling as asset in orderly liquidation

Question 7

Deferral

Answer 7

Cash receipt/expenditure precedes accrual-basis recognition

Question 8

Fair value

Answer 8

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

Question 9

Historical cost

Answer 9

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

Question 10

Installment sales

Answer 10

Revenue is recognized as cash is collected

Question 11

Net realizable value

Answer 11

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

Question 12

Period costs

Answer 12

Costs not particularly or conveniently assignable to a product

Question 13

Present value

Answer 13

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

Question 14

Product costs

Answer 14

Costs which can be associated with particular sales

Question 15

Realized (realizable)

Answer 15

When related assets received or held are readily convertible into known amounts of cash or claims to cash

Question 16

Risk adverse

Answer 16

Market place participants prefer situations with less uncertainty relative to an expected outcome

Question 17

Start-up costs

Answer 17

The costs incurred during the course of undertaking on-time activities related to opening a new facility

Question 18

What is the objective of general-purpose financial reporting?

Answer 18

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)

Question 19

What are the two fundamental qualitative characteristics of accounting information?

Answer 19

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

Question 20

What are the four enhancing qualitative characteristics of accounting information?

Answer 20

(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

Question 21

What are the two conceptual view of earnings?

Answer 21

(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

Question 22

What are the 5 different attributes used to measure assets and liabs?

Answer 22

(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

Question 23

How is well-offness measured?

Answer 23

(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

Question 24

When are revenues recognized?

Answer 24

When realized or realizable and earned (when related assets received or held are readily convertible to known amounts of cash or claims to cash)

Question 25

When are gains recognized?

Answer 25

When realized or realizable

Question 26

When are expenses recognized?

Answer 26

When economic benefits are consumed in revenue-earning activities, or when future economic benefits are reduced or eliminated

Question 27

When economic benefits are consumed, what are the ways the expense can be recognized?

Answer 27

(1) matching - e.g. COGS (2) immediate recognition - e.g. selling and admin salaries (3) systematic and rational allocation - e.g. depreciation

Question 28

When are losses recognized?

Answer 28

When future economic benefits are reduced or eliminated

Question 29

What are revenues, expenses, gains and losses used to compute?

Answer 29

EARNINGS

Question 30

What are earnings?

Answer 30

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

Question 31

What is comprehensive income?

Answer 31

Earnings adjusted for cumulative accounting adjustments and other non-owner changes in equity (foreign currency translation adjustments)

Question 32

What are fresh-start adjustments?

Answer 32

Defined by FASB as measurements in periods following initial recognition that establish a new carrying amount unrelated to previous amounts and accounting conventions

Question 33

What is the objective of present value, when used in accounting measurements at initial recognition and fresh-start measurements?

Answer 33

To estimate fair value.

Question 34

An estimate of fair value should include an adjustment for what?

Answer 34

Risk -the adjustment is the price that marketplace participants are able to receive for bearing the uncertainties in cash flows

Question 35

Under what conditions does present value measurements occur?

Answer 35

Conditions of uncertainty | -uncertainty refers to the fact that the cash flows used in a PV measurement are estimates

Question 36

What is risk?

Answer 36

Refers to any exposure to uncertainty in which that exposure has potential negative consequences

Question 37

What is risk premium?

Answer 37

Marketplace participants seek compensation for accepting uncertainty

Question 38

What is the objective of including uncertainty and risk in accounting measurements?

Answer 38

To imitate the market's behavior toward assets and liabs with uncertain cash flows

Question 39

What is the interest methods of allocation?

Answer 39

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

Question 40

What is the primary objective of accounting?

Answer 40

To measure income, which is a measure of management's efficiency in combining the factors of production into desired g/s

Question 41

What produces revenue?

Answer 41

The entire process of acquiring the factors of production, processing them and selling the resulting g/s

Question 42

When is revenue recognized under the accrual basis of accounting?

Answer 42

Revenue is recognized at the point of sale or as service is performed.

Question 43

What is considered the point of sale?

Answer 43

(1) FOB shipping - when seller ships | (2) FOB destination - when buyer receives

Question 44

What are the 3 exceptions to the general revenue recognition rule?

Answer 44

(1) during production (2) at the point where production is complete (3) at point of cash collection

Question 45

Describe the recognition basis: During Production Basis

Answer 45

(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

Question 46

Describe the recognition basis: Completion of production basis

Answer 46

(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

Question 47

Describe the recognition basis: Cash collection basis

Answer 47

(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

Question 48

Accrual accounting basis - revenues and expenses

Answer 48

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

Question 49

What are product costs?

Answer 49

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)

Question 50

What are period costs?

Answer 50

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)

Question 51

What is cash basis of accounting?

Answer 51

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

Question 52

What is an accrual?

Answer 52

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

Question 53

What is a deferral?

Answer 53

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

Question 54

Who issued SFAC 7 and what is it?

Answer 54

- 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

Question 55

What are fresh-start measurements?

Answer 55

Defined by the FASb as measurements in periods following initial recognition that establish a new carrying amount unrelated to previous amounts and accounting conventions

Question 56

SFAC 7 applies only to measurements at what?

Answer 56

- 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

Question 57

What is the objective of present value in accounting measurements?

Answer 57

- 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.

Question 58

Who is the final judge of asset and liability values?

Answer 58

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

Question 59

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:

Answer 59

1. estimate of the future cash flow 2. Expectations about possible variations in the amount of timing of those cash flows 3. The time value of money, represented by the risk free rate of interest 4. The price for bearing the uncertainty inherent in the asset or liab 5. Other factors such as illiquidity and market imperfections

Question 60

SFAC 7: 2 approaches to calculating the PV

Answer 60

1. EXPECTED CASH FLOW APPROACH - only time value of money, represented by the risk-free rate of interest, is included in the discount rate 2. 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)

Question 61

Why is the expected cash flow approach a more effective measurement tool than discount rate adjustment?

Answer 61

Uses all expectations about possible cash flows instead of the single most likely cash flow.

Question 62

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

Answer 62

-Take PVs and multiple by probs then total all together. Answer is: 892.36

Question 63

When would present value measurements not be needed?

Answer 63

If the prices for an asset or liab can be observed in the marketplace

Question 64

What is the most relevant measure of a liability?

Answer 64

The credit standing of the entity obligated to pay

Question 65

In principle, what is the purpose of all accounting allocations?

Answer 65

To report changes in the value, utility, or substance of assets and liabs over time

Question 66

Interest methods of allocation

Answer 66

- 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

Question 67

Income is:

Answer 67

The net effect of inflows of revenue and outflows of expense

Question 68

Difference between real and nominal accounts.

Answer 68

- Real accounts are those reported on the balance sheet (assets, liabs, owner's equity) - Nominal accounts are those reported on the income statement

Question 69

Cash to accrual - who usually uses it?

Answer 69

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

Question 70

Under installment sales, what happens to gross profit?

Answer 70

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

Question 71

How is gross profit and gross margin calculated?

Answer 71

``` GP = Net sales - COGS GM = GP/Net sales ```

Question 72

What is the cost recovery method?

Answer 72

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

Question 73

Franchise agreements?

Answer 73

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

Question 74

Real Estate Transactions - when can profits be recognized?

Answer 74

- 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

Question 75

What is the deposit method?

Answer 75

Payments received are recorded as a liability until the contact is canceled or a sale is archived.

Question 76

What is the reduced profit method?

Answer 76

Seller recognizes a portion of profit at the time of sale with the remaining portion recognized in future periods.

Question 77

Describe the recognition of profit in the reduced profit method.

Answer 77

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.

Question 78

What is the Multiple - Deliverable Revenue Arrangement?

Answer 78

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

Question 79

Research or Development Accounted for on the Milestone basis

Answer 79

- 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

Question 80

What should be disclosed in the financial statements for milestone payments?

Answer 80

1. Description of overall arrangement 2. Description of each milestone and related contingent consideration 3. Determination of whether each milestone is considered substantive 4. Factors considered in determining whether milestones are substantive 5. Amount of consideration recognized during the period for milestone

Question 81

Software Revenue Recognition

Answer 81

- 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

Question 82

Fee Recognition for Software Revenue Recognition

Answer 82

- 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

Question 83

Fee allocation for multiple elements for Software Revenue Recognition

Answer 83

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: 1. software products 2. upgrades/enhancements 3. Postcontract customer service 4. Services 5. elements deliverable on a when and if available basis

Question 84

Software Revenue Recognition continued - what happens if there is vendor specific objective evidence of FV?

Answer 84

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

Question 85

Software Revenue Recognition continued - what happens if there is insufficient vendor specific objective evidence of FV?

Answer 85

- Defer revenue until whichever one occurs first: 1. sufficient vendor specific objective evidence does exist 2. all elements have been delivered

Question 86

Software Revenue Recognition continued - what are the exceptions to insufficient vendor specific objective evidence of FV?

Answer 86

1. The PCS (postcontract customer service)is the only undelivered element - recognize fee ratably 2. 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 3. Arrangement is a subscription in substance - recognize fee ratably 4. Fee based on the number of copies

Question 87

Software Revenue Recognition continued - when would separate accounting be needed for service element of an arrangement be required?

Answer 87

1. services not essential to functionality of any other element 2. services are described in contract such that total price of arrangement would be expected to vary as result of inclusion or exclusion of services

Question 88

What are factors that should be considered before recognizing revenue on a sale basis for: sale with a right of return?

Answer 88

1. whether economic substance of the transaction is a sale or a financing arrangement 2. Determination of sales price 3. probability of collection of sales price 4. seller's future obligations 5. predictability of returns

Question 89

What are conditions that would cause recognition of a sale with a right of return be delayed beyond time of sale?

Answer 89

1. sales price is not fixed or determinable 2. payment excused until product is sold 3. payment excused if property stolen or damaged 4. buyer without separate economic substance 5. seller's obligation to bring about resale of property 6. inability to predict future returns

Question 90

What are factors that should be considered before recognizing revenue on a sale basis for: product financing arrangement?

Answer 90

Whether risks and rewards of ownership are transferred

Question 91

What are conditions that would cause recognition of a product financing arrangement to be delayed beyond time of sale?

Answer 91

Agreement requires repurchases at specified prices or provides compensation for losses

Question 92

What is a product financing agreement?

Answer 92

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.

Question 93

What are factors that should be considered before recognizing revenue on a sale basis for: real estate sale?

Answer 93

1. probability of collection 2. seller's continued involvement 3. whether economic substance of the transaction is a sale of real estate or another type of transaction such as a service contract

Question 94

What are conditions that cause recognition of a real estate to be delayed beyond time of sale?

Answer 94

1. inadequate buyer investment in the property 2. seller's continuing obligations such as participation in future losses, responsibility to obtain financing, construct buildings or support operations

Question 95

What is a sales-type lease?

Answer 95

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.

Question 96

What are factors that should be considered before recognizing revenue on a sale basis for: sales-type lease?

Answer 96

1. probability of collection 2. transfer of benefits and risks of ownership 3. predictability of future unreimburseable costs

Question 97

What are conditions that cause recognition of a sales-type lease to be delayed beyond time of sale?

Answer 97

1. Seller's continuing obligations 2. inadequate buyer investment in the property 3. inability to indicate transfer of benefits and risks of ownership 4. uncertainty about future unreimbursable costs

Question 98

What is recourse?

Answer 98

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

Question 99

What are factors that should be considered before recognizing revenue on a sale basis for: sale of receivables with recourse?

Answer 99

1. isolation of transferred assets 2. right to pledge or exchange transferred assets 3. control of receivables

Question 100

What are conditions that cause recognition of a sale of receivables with recourse to be delayed beyond time of sale?

Answer 100

1. transferred assets can be reached by transferor or its creditors 2. transferee's inability to pledge or exchange transferred assets 3. control of receivables not surrendered due to repurchase or redemption agreement

Question 101

What is a redemption agreement?

Answer 101

An agreement in which the seller reserves the right to take back what was sold at the same price or more

Question 102

What are factors that should be considered before recognizing revenue on a sale basis for: nonmonetary exchange?

Answer 102

transaction has commercial substance

Question 103

What are conditions that cause recognition of a nonmonetary exchange to be delayed beyond time of sale?

Answer 103

1. FV is not determinable 2. Exchange transaction to facilitate sales to customers 3. transaction lacks commercial substance

Question 104

What is a sales-leaseback transaction?

Answer 104

An arrangement in which the seller of an asset leases back what was sold to the purchaser.

Question 105

What are factors that should be considered before recognizing revenue on a sale basis for: sales-leaseback transaction?

Answer 105

1. substance of the transaction 2. portion of property leased back 3. length of leaseback period

Question 106

What are conditions that cause recognition of a sales-leaseback transaction to be delayed beyond time of sale?

Answer 106

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

Question 107

What the Accounting Standards Codification (ASC) say about start-up costs?

Answer 107

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

Question 108

Who are the primary users of financial reporting?

Answer 108

Investors, lenders and other creditors. Management does not rely on general-purpose reports because information can be obtained internally.

Question 109

What does financial reporting provide?

Answer 109

1. Info that is useful to potential and existing investors, lenders, and other creditors 2. Info about the reporting entity's economic resources and claims against the reporting entity 3. Changes in economic resources and claims 4. Financial performance reflected by accrual accounting 5. Financial performance reflected by past cash flow 6. Changes in economic resources and claims not resulting from financial performance

Question 110

What are the 2 fundamental qualitative characteristics of accounting information?

Answer 110

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