READING 28 ANALYZING INCOME STATEMENTS Flashcards
If a sale of goods is made on credit, revenue can be recognized at the time of sale, and an asset is created on the balance sheet.
What is the asset?
Accounts receivable
True or false
As a general rule, revenue is recognized in the period in which it is earned, which may not necessarily be the same as the period in which cash is collected from the customer.
True
If payment for the goods is received before the transfer of the goods or services, a liability, is created when the cash is received (offsetting the increase in the asset cash).
What is the liability?
Unearned revenue
True or false
Revenue is recognized as the goods are transferred to the buyer.
True
Consider a magazine subscription. When the subscription is purchased, an unearned revenue liability is created, and as magazine issues are delivered, revenue is recorded, and the liability is decreased
The converged standards identify a five-step process for recognizing revenue, what are they?
- Identify the contract with the customer
- Identify the distinct performance obligation
- Determine the transaction price
- Allocate the transaction price to the performance obligation
- Recognize revenue when the customer is satisfied
An agreement between two or more parties that specifies their obligations and rights.
Contract
Promise to deliver a distinct good or service.
Performance obligation
A distinct good or service is one that meets the following criteria.
The customer can benefit from the good or service on its own or combined with other resources that are readily available.
Example: If you buy Microsoft Office software, you can use it without needing extra products. It’s distinct because it provides value on its own.
The promise to transfer the good or service can be identified separately from any other promises.
Example: If a phone company sells you a phone and a service plan, these are separate obligations because you can buy a phone without the service plan or vice versa.
The amount a firm expects to receive from a customer in exchange for transferring a good or service to the customer.
Transaction price
True or false
A transaction price is usually a fixed amount, but it can also be variable (e.g., if it includes a bonus for early delivery).
True
A firm should recognize revenue only when it is highly probable that it will not have to reverse it.
If revenue from a sale cannot be estimated reliably. What should the firm do?
Recognize a liability, refund obligation (and an offsetting asset for the right to returned goods)
For … contracts, revenue is recognized based on a firm’s progress toward completing a performance obligation over a period of time.
For long-term contracts, revenue is recognized based on a firm’s progress toward completing a performance obligation over a period of time.
Progress towards completing a performance obligation can be measured from the … (e.g., using the percentage of completion costs incurred as of the statement date). Progress can also be measured from the … using engineering milestones or the percentage of total output delivered to date.
Progress towards completing a performance obligation can be measured from the input side (e.g., using the percentage of completion costs incurred as of the statement date). Progress can also be measured from the output side using engineering milestones or the percentage of total output delivered to date.
A performance obligation is satisfied over a period of time if any of the following three criteria are met?
- The customer receives and benefits from the good or service over time as the supplier meets the obligations of the contract (e.g., service and maintenance contracts).
- The supplier enhances an existing asset or creates a new asset that the customer controls over the period in which the asset is created or enhanced.
- The asset has no alternative use for the supplier, and the supplier has the right to enforce payment for work completed to date (e.g., constructing equipment specific to the needs of a single customer).
True or false
The costs to secure a long-term contract, such as sales commissions, must be expensed.
False
The costs to secure a long-term contract, such as sales commissions, must be capitalized, that is, the expense for these costs is spread over the life of the contract.
Consider a fast-food company that both operates restaurants and grants franchisees rights to operate restaurants using its brand name under license and supplies franchisees with some products used in daily operations. As well as charging a license fee, the company also receives a royalty fee of 2% of the franchisee’s turnover.
Accounting standards require revenue to be split into categories that have similar characteristics (nature, amounts, timings, and risk factors).
The fast-food company would disaggregate revenue into these categories:
- Revenue from owned company
- Franchise royalty and fees
- Revenue from supplies to franchises
Franchise fees often grant the franchisee the right to operate over numerous periods and would initially be treated?
Deferred revenue. Subsequently, it would be amortized to revenue in the income statement over the life of the franchise contract period.
Consider a software supplier that allows customers to purchase a license and install the software on their own machines or subscribe to a cloud-based solution with access over the internet.
If customers purchase a license and install the software on their own systems, IFRS allows for two treatments?
(If customers access the software without taking physical possession of the software (i.e., cloud-based access), the contract is for a service and NOT A LICENSE, and revenue should be recognized over the life of the contract.)
A. The software supplier will report revenue over the life of the contract.
Criteria:
The software supplier will continue to update and enhance the software
Customers will be exposed to potential benefits or negative impacts from updates and enhancements.
Updates and enhancements do not result in a transfer of goods or services.
B. The software supplier will report revenue at the outset of the contract.
Criteria:
The license grants the customer the right to use the software as it exists at the start of the contract (“sold as is”).
A separate contract exists for enhancements and updates to the software. The revenue for support services will be recognized when provided (typically over the life of the contract)
Type of sales agreement that involves the customer paying for goods ahead of shipping.
Bill-and-hold
Typically, when a customer pays ahead of delivery, the revenue is treated as deferred, but revenue may be recorded before shipping if the supplier can demonstrate that its performance obligations are complete, and the customer has control over the good.
IFRS criteria include the following:
The customer asked for the arrangement, the goods are identified as belonging to the customer, the goods are complete and ready for transfer to the customer, and the goods cannot be redirected to another customer.
Required disclosures under the converged standards for revenue recognition include the following:
- Contracts with customers by category
- Assets and liabilities related to contracts,
- Outstanding performance obligations and the transaction prices allocated to them
- Management judgments used to determine the amount and timing of revenue recognition, including any changes to those judgment
Expenses to generate revenue are recognized in the same period as the revenue.
The matching principle
Assume that inventory is purchased during the fourth quarter of one year and sold during the first quarter of the following year. Using the matching principle, when are the revenue and expense recognized?
Revenue and expense (COGS) are recognized during the first quarter of the second year, when the inventory is sold—not the period in which the inventory was purchased.
Application of the matching principle whereby costs are initially capitalized as assets on the balance sheet and then expensed, using depreciation or amortization, to the income statement over the asset’s life as its benefits are consumed.
Property, plant, and equipment (PP&E) and intangible assets with finite lives are examples of this.
Capitalization
Not all expenses can be directly tied to revenue generation. These costs are known as?
Period costs, such as administrative costs, are expensed in the period incurred.
For example, if a firm has occupied a leased premise, one year’s worth of rent should be expensed to the income statement regardless of whether the rent has been paid.
An accounting policy that recognizes expenses later rather than sooner is.
Aggressive
An accounting policy that recognizes expenses sooner than later is.
Conservative, Expensing is, therefore, more conservative than capitalization.
As a general rule, an expenditure that is expected to provide a future economic benefit over multiple accounting periods is.
Capitalized
if the future economic benefit is unlikely or highly uncertain, the expenditure is.
Expensed in the period incurred
An expenditure that is capitalized is initially recorded where?
An asset on the balance sheet at cost, which is typically its fair value at acquisition plus any costs necessary to prepare the asset for use.
Except for land and intangible assets with indefinite lives (such as acquisition goodwill)
An expenditure that is capitalized is initially recorded as an asset on the balance sheet at cost, which is typically its fair value at acquisition plus any costs necessary to prepare the asset for use.
The cost is then allocated to the income statement over the life of the asset as … expense (for tangible assets), … (for natural resources), or … expense (for intangible assets with finite lives).
The cost is then allocated to the income statement over the life of the asset as depreciation expense (for tangible assets), depletion (for natural resources), or amortization expense (for intangible assets with finite lives).
Once an asset is capitalized, subsequent related expenditures that provide more future economic benefits (e.g., rebuilding the asset) are?
Capitalized
Once an asset is capitalized, Subsequent expenditures that merely sustain the usefulness of the asset (e.g., regular maintenance) are?
Expensed when incurred
When a firm constructs an asset for its own use or, in limited circumstances, for resale, the interest that accrues during the construction period is.
Capitalized as a part of the asset’s cost
What is the reason for capitalizing interest?
To accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset.
True or false
Capitalized interest is reported in the income statement as interest expense.
False
Once construction interest is capitalized, the interest cost is allocated to the income statement through depreciation expense (if the asset is held for use) or COGS (if the asset is held for sale).
Capitalizing interest results in it being reported in the cash flow statement as an out flow from?
Investing activities
This contrasts with the usual treatment of interest paid, which is reported as an out flow from operating activities under U.S. GAAP and can be an operating or financing out low under IFRS.
With some exceptions, costs to create intangible assets are expensed as incurred. what are the important exceptions?
Development and research costs under IFRS
Under IFRS, research costs, which are costs aimed at the discovery of new scientific or technical knowledge and understanding, are expensed as incurred. However, development costs may be capitalized.
Costs that are incurred to translate research findings into a plan or design of a new product or process.
Development costs
How to recognize an intangible asset in development?
A firm must show that it can complete the asset and intends to use or sell the completed asset
Under U.S. GAAP, both research and development costs are generally expensed as incurred. with an exception.
Costs of creating software for sale to others are treated in a manner similar to the treatment of research and development costs under IFRS.
Costs incurred to develop software for sale to others are expensed as incurred until the product’s technological feasibility has been established, after which the costs of developing a salable product are capitalized
To make the financial statements comparable for a company that capitalizes development costs with one that expenses such costs
The income statement should be adjusted to include development costs as an expense.
And any current amortization of development cost capitalized in the past should be removed. In the balance sheet, capitalized development costs should be removed, resulting in lower assets and equity. Adjusting the cash flow statement will require capitalized costs to be removed from CFI and included in CFO, which will decrease CFO.
If a firm sells goods or services on credit or provides a warranty to the customer, when should the bad debt or warranty expense recorded?
the firm recognizes the warranty expense or bad debt in the period of the sale, rather than a later period
If a company reduces its bad debt expense, it reports higher net income. as an analyst what should you ask yourself?
- Is this due to better collections?
- Is the company manipulating earnings?
If a company’s warranty expense is much lower than industry peers. as an analyst what should you ask yourself?
- Is the company producing higher-quality products?
- Or is it understating warranty costs to inflate profits?
How can analysts detect manipulation?
- Compared to its industry peers
- Check the company’s financial statements footnotes
Events are either unusual in nature or infrequent in occurrence and are material (significant enough to affect the opinions of financial statement users).
Unusual or infrequent items
What are examples of unusual or infrequent items?
- Gains or losses from the sale of assets or part of a business, if these activities are not a firm’s ordinary operations
- Impairments, write-offs, and write-downs
- Restructuring costs
Where are Unusual or infrequent items recorded in the income statement?
Within EBIT and before tax
An operation 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.
Discontinued operation
To be accounted for as a discontinued operation, the business must be?
Physically and operationally distinct from the rest of the firm, in terms of assets, operations, and investing and financing activities.
The date when the company develops a formal plan for disposing of an operation is referred to as the?
Measurement date
The time between the measurement period and the actual disposal date is referred to as the?
Phaseout period
What should analysts do for unusual items or infrequent items?
Analysts should review unusual or infrequent items to determine whether they truly should be excluded when forecasting a firm’s earnings. Some companies appear to be accident-prone and have “unusual or infrequent” losses every year or every few years
What should analysts do for discontinued operations?
Analysts should exclude discontinued operations when forecasting future earnings. However, the actual event of discontinuing a business segment or selling assets may provide information about the future cash flows of the firm.
Any prior-period financial statements presented in a firm’s current financial statements must be restated, applying the new policy to those statements as well as future statements.
Retrospective application
Prior statements are not restated, and the new policies are applied only to future financial statements.
Prospective application
This application does not require restatement of prior-period statements; however, beginning values of affected accounts are adjusted for the cumulative effects of the change.
Modified retrospective application
Generally, a change in accounting estimate is the result of a change in.
Management judgement
For example, management may change the estimated useful life of an asset because new information indicates that the asset has a longer or shorter life than originally expected.
Sometimes, a change from an incorrect accounting method to one that is acceptable under GAAP or IFRS is required. A correction of an accounting error made in previous financial statements is reported as?
Prior-period adjustment and requires retrospective application
True or false
Accounting standards require firms to disclose the impact on their financial statements of changes in scope or exchange rates.
False
Accounting standards do not require firms to disclose the impact on their financial statements of changes in scope or exchange rates, but analysts must be alert to their effects. In this context, “changes in scope” refer to how acquiring another company affects the size of the combined entity.
One of the most commonly used corporate profitability performance measures for publicly traded firms (nonpublic companies are not required to report EPS data). It is reported only for shares of common stock (also known as ordinary stock).
EPS
A structure that contains no potentially dilutive securities. contains only common stock, nonconvertible debt, and nonconvertible preferred stock.
Simple capital structure
A structure that contains potentially dilutive securities such as employee stock options, warrants, or convertible securities
A complex capital stucture
Distribution of additional shares to each shareholder in an amount proportional to their current number of shares.
Stock dividend
Refers to the division of each “old” share into a specific number of “new” (post-split) shares.
Stock split
Stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock
Dilutive securities
Stock options, warrants, convertible debt, or convertible preferred stock that would increase EPS if exercised or converted to common stock
Antidilutive securities
