Unit 1: External Financial Statements and Revenue Recognition

Question 1

Objective of General-Purpose Financial Reporting

Answer 1

1. To report financial information that is useful in making decisions to the reporting entity
2. Information about economic resources and claims to evaluate liquidity, solvency, financing needs, and the probability of obtaining financing
3. Information about entity’s performance
4. Return on economic resources, its variability, and its components
5. Evaluating management
6. Predicting future returns

Question 2

Users of Financial Statements

Answer 2

Users with direct interests usually invest in or manage the business, and users with indirect interests advise, influence, or represent users with direct interests.

1. Users with direct interests include: - Investors or potential investors - Suppliers and creditors - Employees - Management
2. Users having indirect interests include: - Financial advisors and analysts - Stock markets or exchanges - Regulatory authorities

Question 3

Features of Financial Statements

Answer 3

Financial statements are the primary means of communicating financial information to external parties. The notes are considered an integral part of Financial statements and they should not be used to correct improper presentation.

Full set of financial statements includes:

1. Statement of financial position (balance sheet)
2. Income statement
3. Statement of comprehensive income
4. Statement of changes in equity
5. Statement of cash flows

To enhance the usefulness, the information should be comparable with similar information for (1) other entities and (2) the same entity for another period or date. Thus, “comparability” allows users to understand similarities and differences.

Financial statements are prepared under the going-concern assumption, which means that the entity is assumed to continue operating indefinitely.

Question 4

Accrual Basis of Accounting

Answer 4

Financial statements are prepared under the accrual basis of accounting. Accrual accounting records the financial effects of transactions and other events when they occur rather than when their associated cash is paid or received.

1. Revenues are recognized in the period in which they were earned even if the cash will be received in a future period.
2. Expenses are recognized in the period in which they were incurred even if the cash will be paid in a future period.

NOTE: Under GAAP, financial statements cannot be prepared under the cash basis of accounting.

Question 5

Statement of Financial Position

(Balance Sheet)

Answer 5

1. Balance sheet reports the amounts of assets, liabilities, equity “at a moment” in time, such as at the end of the fiscal year.
   
   • It helps users to assess liquidity, financial flexibility, and risk.
2. The “basic accounting equation” presents a perfect balance between the entity’s resources and its capital structure.
   
   • The entity’s resources consist of the assets the entity deploys in its attempts to earn a return.
   • The capital structure consists of the amounts contributed by outsiders (liabilities) and insiders (equity).

Assets = Liabilities + Equity

Question 6

Current and Noncurrent Assets

Answer 6

1. An asset is classified as ‘current’ on the statement of financial position if it is expected to be realized in cash or sold or consumed within the entity’s operating cycle or 1 year, whichever is longer.
2. Noncurrent assets are those not qualifying as current. e.g.
   
   • Investments in securities made to control or influence another entity and other noncurrent securities.
   • Funds restricted as to withdrawal or use for other than current operations, for example, to retire long-term debt, satisfy pension obligations, or pay for the acquisition or construction of noncurrent assets.
   • PPE include Land and natural resources subject to depletion, e.g., oil and gas.

Intangible assets are nonfinancial assets without physical substance. Examples are patents and goodwill.

Question 7

Current and Noncurrent Liabilities

Answer 7

1. Current liabilities are expected to be settled or liquidated in the ordinary course of business during the longer of the next year or the operating cycle.
2. Following are the major categories of current liabilities:
   
   • Trade payables for items entering into the operating cycle, e.g., for materials and supplies.
   • Other payables arising from operations, such as accrued wages, salaries, rentals, royalties, and taxes.
   • Unearned revenues arising from collections in advance e.g., ticket sales revenue.
   • Other obligations expected to be liquidated in the ordinary course of business. These include:
     
     • Short-term notes given to acquire capital assets;
     • Long-term obligations that are or will become callable by the creditor because of the debtor’s violation of a provision of the debt agreement at the balance sheet date.
3. Current liabilities do not include short-term debt if an entity
   
   • Intends to refinance them on a noncurrent basis and
   • Demonstrates an ability to do so. (The ability to refinance may be demonstrated by entering into a refinancing agreement before the balance sheet is issued.)
4. Noncurrent liabilities are those not qualifying as current.
   
   • Noncurrent notes and bonds
   • Liabilities under capital leases
   • Most postretirement benefit obligations
   • Deferred tax liabilities arising from interperiod tax allocation
   • Obligations under product or service warranty agreements
   • Advances for noncurrent commitments to provide goods or services
   • Deferred revenue

Question 8

Equity

Answer 8

1. Any recognized transaction that does not have equal and offsetting effects on total assets and total liabilities changes equity.
2. The following are the major items of equity:
   
   • Capital contributions by owners (par value of common and preferred stock issued and additional paid-in capital).
     
     • Additional paid-in (contributed) capital is the amount received in excess of par value at the time stock was sold.
   • Retained earnings are the accumulated net income not yet distributed to owners. Retained earnings can be restricted or unrestricted depending on the board of directors’ intent.
     
     • Restriction of retained earnings indicates their unavailability for disbursement as dividends.
   • Treasury stock is the firm’s own stock that has been repurchased.
     
     • Treasury stock is reported either at cost (as a deduction from total equity) or at par (as a direct reduction of the relevant contributed capital account).
     • Treasury stock is reported as a reduction of equity.
   • Accumulated other comprehensive income items not included in net income.

Question 9

Limitations of Balance Sheet

Answer 9

1. The balance sheet shows a company’s financial position at a single point in time; accounts may vary significantly a few days before or after the publication of the balance sheet.
2. Many balance sheet items, such as fixed assets, are valued at historical costs, which may bear no resemblance to the current value of those items. Even those assets reported at their current fair values may not always faithfully represent what a company could sell those items for on an open market.

Question 10

Income Statement

Answer 10

1. The income statement reports the results of an entity’s operations over a period of time, such as a year.
2. The following are the elements of income statement:
   
   • Revenues are inflows or other enhancements of assets or settlements of liabilities from activities that qualify as ongoing central operations.
   • Gains are increases in equity (or net assets) other than from revenues or investments by owners.
   • Expenses are outflows or other usage of assets or incurrences of liabilities from activities that qualify as ongoing central operations.
   • Losses are decreases in equity (or net assets) other than from expenses or distributions to owners.
3. All transactions affecting the net change in equity during the period are included in income except
   
   • Transactions with owners
   • Prior-period adjustments (such as error correction or a change in accounting principle)
   • Items reported initially in other comprehensive income
   • Transfers to and from appropriated retained earnings
4. income or loss for the period (a nominal or temporary account) is closed to retained earnings (a real account) at the end of the reporting period.

Question 11

Expense Recognition Principles

(Matching Principle)

Answer 11

The expense recognition principles are:

1. associating cause and effect
2. systematic and rational allocation
3. immediate recognition.

Matching is essentially synonymous with associating cause and effect. Such a direct relationship is found when the cost of goods sold is recognized in the same period as the revenue from the sale of the goods.

Question 12

Cost of Goods Sold

(For a retailer)

Answer 12

Question 13

Cost of Goods Sold

(For a manufacturer)

Answer 13

Question 14

Reporting Irregular Items

Answer 14

1. When an entity reports a discontinued operation or an extraordinary item, it must be presented in a separate section after income from continuing operations.
   
   • Because these items are reported after the presentation of income taxes, they must be shown net of tax.
   • The term “continuing operations” is used only when a discontinued operation is reported.
2. Discontinued operations, if reported, may have two components:
   
   • Income or loss from operations of the component that has been disposed of or is classified as held for sale from the first day of the reporting period until the date of disposal (or the end of the reporting period if it is classified as held for sale)
   • Gain or loss on the disposal of this component
3. Extraordinary items are income statement items that meet the following two criteria:
   
   • Unusual in nature and
   • Infrequent in occurrence in the environment in which the entity operates
     
     • If an item meets only one of the criteria, it should be presented separately as a component of income from continuing operations.
4. IFRS Difference:
   No items are classified as extraordinary, either on the statement of comprehensive income or in the notes.

Question 15

Reporting Irregular Items

(Example)

Answer 15

Question 16

Major Note Disclosures and schedules specifically related to the income statement

Answer 16

Note disclosures and schedules specifically related to the income statement include the following:

1. Earnings per share
2. Depreciation schedules
3. Components of income tax expense
4. Components of pension expense

Question 17

Limitations of the Income Statement

Answer 17

1. The income statement does not always show all items of income and expense. Some of the items are reported on a statement of other comprehensive income and not included in the calculation of net income.
2. The financial statements report accrual-basis results for the period. The company may recognize revenue and report net income before any cash was actually received.
3. Data from the income statement itself is not sufficient enough for assessing liquidity. This statement must be viewed in conjunction with other financial statements such as the balance sheet and statement of cash flows.

Question 18

Statement of Comprehensive Income

Answer 18

1. Comprehensive income includes all changes in equity (net assets) of a business during a period except those from investments by and distributions to owners. Certain income items are excluded from the calculation of net income and instead are included in comprehensive income
2. Total Comprehensive income consists of:
   
   • net income or loss (the bottom line of the income statement) and
   • other comprehensive income (OCI).
3. The following are the major items included in OCI:
   
   • The effective portion of a gain or loss on a hedging instrument in a cash flow hedge
   • Unrealized gains and losses due to changes in the fair value of available-for-sale securities
   • Translation gains and losses for financial statements of foreign operations
   • Certain amounts associated with accounting for defined benefit postretirement plans
4. All items of comprehensive income are recognized for the period in either:
   
   • One continuous financial statement that has two sections, net income and OCI, or
   • Two separate but consecutive statements.
     
     • The first statement (the income statement) presents the components of net income and total net income.
     • The second statement (the statement of OCI) is presented immediately after the first. It presents a total of OCI with its components; and a total of comprehensive income.

Question 19

Statement of Comprehensive Income

(Example)

Answer 19

Example of a separate statement of comprehensive income:

Question 20

Statement of Changes in Equity

Answer 20

1. A statement of changes in equity presents a reconciliation for the accounting period, of the beginning balance for each component of equity to the ending balance.
2. Each change is disclosed separately in the statement:
   
   • Net income (loss) for the period, which increases (decreases) the retained earnings balance.
   • Distributions to owners (dividends paid), which decreases the retained earnings balance.
   • Issuance of common stock, which increases the common stock balance.
     
     • If the amount paid for the stock is above the par value of stock, the balance of additional paid-in capital is also increased.
   • Total change in other comprehensive income during the period.

Question 21

Statement of Changes in Equity

(Example)

Answer 21

Question 22

Statement of Retained Earnings

& Retained Earnings

Answer 22

1. A statement of retained earnings reconciles the beginning and ending balances of the account. This statement is reported as part of the statement of changes in equity in a separate column.
2. The following is a common example of retained earnings reconciliation:

• Retained earnings beginning balance*
• • Net income (loss) for the period*
• – Dividends distributed during the period*
• • Positive (negative) prior-period adjustments*
• Retained earnings ending balance*
• Prior-period adjustments include the cumulative effect of changes in accounting principle, and corrections of prior-period financial statement errors.
  
  • These items require retrospective application, i.e., adjustment of the beginning balance of retained earnings for the prior period’s cumulative effect on the income statement.
  • Thus, corrections of prior-period errors and the cumulative effect of changes in accounting principle must not be included in the calculation of current-period net income.

1. Retained earnings are sometimes appropriated (restricted) to a special account to disclose that earnings retained in the business (not paid out in dividends) are being used for special purposes. An appropriation must be clearly displayed within equity.
2. Purposes include:
   
   • compliance with a bond indenture (bond contract),
   • retention of assets for internally financed expansion
   • anticipation of losses
   • adherence to legal restrictions.
3. The appropriation does not set aside assets. It limits the availability of dividends. A formal entry (debit retained earnings, credit retained earnings appropriated) or disclosure in a note may be made.
4. Transfers to and from an appropriation do not affect net income.

Question 23

Common and Preferred Stock

Answer 23

• The most widely used classes of stock are common and preferred. The following basic terminology is related to stock.
  
  • Stock authorized is the maximum amount of stock that a corporation is legally allowed to issue.
  • Stock issued is the amount of stock authorized that has actually been issued by the corporation.
  • Stock outstanding is the amount of stock issued that has been purchased and is held by shareholders. (Outstanding shares will decrease if the company buys back its shares under a share repurchase program.)
• The common shareholders are the owners of the firm. They have voting rights, and they select the firm’s board of directors and vote on resolutions. Common shareholders are not entitled to dividends unless so declared by the board of directors. A firm may choose not to declare any.
  
  • Common shareholders are entitled to receive liquidating distributions only after all other claims have been satisfied, including those of preferred shareholders.
  • Common shareholders ordinarily have preemptive rights. Preemptive rights give current common shareholders the right to purchase any additional stock issuances in proportion to their ownership percentages. This way the preemptive rights safeguard a common shareholder’s proportionate interest in the firm.
• Preferred stock has features of debt and equity. It is classified as an equity instrument and presented in the equity section of the firm’s balance sheet. Preferred stock has a fixed charge, but payment of dividends is not an obligation. The payment of dividends is at the firm’s discretion. Preferred shareholders tend not to have voting rights.
• Preferred shareholders have the right to receive:
  
  • Dividends at a specified fixed rate before common shareholders may receive any.
  • Distributions before common shareholders, but after creditors, in the event of firm bankruptcy (liquidation).
• The following are common features of preferred stock:
  
  • Cumulative preferred stock accumulates unpaid dividends (called dividends in arrears). Dividends in arrears must be paid before any common dividends can be paid.
  • Holders of convertible preferred stock have the right to convert the stock into shares of another class (usually common stock) at a predetermined ratio.

Question 24

Equity Transactions

(Issuance of Stock)

Answer 24

• Cash is increased (debited), the appropriate stock account is increased (credited) for the total par value of stock issued, and additional paid-in capital (paid-in capital in excess of par) is increased (credited) for the difference.
• Direct costs of issuing stock (underwriting, legal, accounting, tax, registration, etc.) must not be recognized as an expense. Instead, they reduce the net proceeds received and additional paid-in capital.

Question 25

Equity Transactions

(Cash Dividend)

Answer 25

• On the date of declaration, the board of directors formally approves a dividend. A declaration of a dividend decreases (debits) the retained earnings account.
• All holders of the stock on the date of record are legally entitled to receive the dividend.
• The date of payment is the date on which the dividend is paid.

Question 26

Equity Transactions

(Property Dividend)

Answer 26

When an entity declares a dividend consisting of tangible property:

• First, the property is remeasured to fair value as of the date of declaration, and any gain or loss on the remeasurement is recognized in the statement of income
• Second, the carrying amount of retained earnings is decreased for the fair value of the property to be distributed
• Third, the property is distributed as a dividend

Question 27

Equity Transactions

(Stock Dividend and Stock Split)

Answer 27

• A stock dividend involves no distribution of cash or other property.
• Stock dividends are accounted for as a reclassification of different equity accounts, not as liabilities.
• The recipient does not recognize income. It has the same proportionate interest in the entity and the same total carrying amount as before the stock dividend.
• The accounting for stock dividends depends on the percentage of new shares to be issued.
  
  • An issuance of shares less than 20% to 25% of the previously outstanding common shares should be recognized as a stock dividend.
  • An issuance of more than 20% to 25% of the previously outstanding common shares should be recognized as a stock split in the form of a dividend.
• In accounting for a stock dividend, the fair value of the additional shares issued is reclassified from retained earnings to common stock (at par value) and the difference to additional paid-in capital.
• For a stock dividend that is accounted for as a stock split in the form of a dividend, the par value of the additional shares issued is reclassified from retained earnings to common stock.
• Stock splits are issuances of shares that d_o not affect any aggregate par value of shares issued and outstanding or total equity_. Stock split reduces the par value of each stock and increases the number of shares outstanding.
• No entry is made, and no transfer from retained earnings occurs.