CPA FAR F2

Overview & Scope of Revenue Recognition

• Occurs when an entity satisfied a performance obligation by transferring either

  • Good or a service to a customer

• Revenue should be recognized at an amount that reflects consideration that entity is entitled to receive in exchange for good/service provided

• All entities that enter into contracts with customers to transfer goods, services, or nonfinancial assets are subject to revenue recognition standard

• Other standards cover certain contracts like

  • Leases, Insurance, Non-warranty guarantees; and Financial instruments

Five-step Approach to Revenue Recognition

• To properly apply revenue recognition standard, entity should implement five-step approach (ISTAR)

  • Step 1: Identify contract

  • Step 2: Identify Separate performance obligations

  • Step 3: Determine Transaction price

  • Step 4: Allocate the transaction price to the separate performance obligations

  • Step 5: Recognize revenue when or as entity satisfies each obligation

Combination of Contracts

• When two more contracts are entered into with the same customer or with related parties of the customer at or near the same time, contracts should be combined and accounted for as a single contract if either:

  • The contracts are negotiated as a packaged with a single commercial objective

  • Consideration for one contract is tied to the performance or price of another contract

  • Goods/service promised to represent a single performance obligation

Contract Modification

• Represents a change in price or scope of a contract approved by both parties

• When modification occurs, it is either treated as 

  • New contract

  • Modification of existing contract

• Modification treated as new contract if

  • Scope increases

  • Price increases

• If not accounted for as a new contract, modification is treated as part of existing contract with an adjustment to revenue to reflect the change in the transaction price

Contract Presentation

• Contract asset or liability should be presented in the B/S when either party has performed in a contract

  • Reflect entity’s right to consideration for goods or services that the entity has transferred to the customer

  • Essentially, the entity has performed prior to the customer paying or prior to the payment due date

  • So it’s a contract asset. Not quite a receivable at this point in time

• Contract Liability

  • May be booked when an entity has an obligation to transfer goods or services to a customer

  • In this situation, entity has either already received consideration from customer or the customer owes consideration and is unconditional 

Construction Contract Revenue Recognized Over Time

• Revenue on a construction contract is recognized over time if any one of the criteria below is met

  • Entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced

  • Entity’s performance does not create an asset with alternative use to the entity and the entity has an enforceable right to receive payment for performance completed to date

Construction Contract Revenue Using Input Method

• When a long-term construction contract meets the criteria for recognizing revenue over time and it is expected to be profitable, it is appropriate to use an input method such as cost-to-cost if the entity’s account system can

  • Reasonable estimate profitability; and

  • Provide a reliable measure of progress toward completion

Accounting for Construction Revenue Recognized Over Time

• Journal entries and interim B/S treatment are the same as they are for construction contract revenue recognized at a point in time, except that the amount of estimated gross profit earned in each period is recorded by:

  • Charging the construction in progress account; and

  • Crediting realized gross profit

• Estimated loss on the total contract is recognized immediately in the year it is discovered

• However, any previous gross profit or loss reported in prior years must be adjusted for when calculating the total estimated loss

Construction Contract Revenue Recognized at a Point in Time (B/S Presentation)

• Construction costs are accumulated in the construction in progress account (as inventory account)

• Billings on construction are accumulated in the progress billings account (a contra-inventory account)

• The two accounts are netted against each other for B/S reporting

• Current Asset Accounts

  • Due on accounts (receivable)

  • Cost of uncompleted contracts in excess of progress billings (sometimes called construction in progress)

• Current Liability Account

  • Progress billings on uncompleted contracts in excess of cost

Accounting for Construction Revenue Recognized at a Point in Time

• Estimated gross profit is not recognized each period as part of construction in progress

  • Unless a loss is recognized on the contract, no gross profit is recognized until the contract is completed

• At completion of the contract, gross profit or loss is recognized

• At interim B/S dates, the excess of either the construction in progress account or the progress billings account over the other is classified as a current asset or liability

• Losses should be recognized in full in the year they are discovered

Incremental Costs of Obtaining a Contract

• Incremental costs of obtaining a contract are:

  • Costs incurred that wouldn’t have been incurred if the contract had not been obtained

  • Recognized as an asset (capitalized and amortized) if the entity expects that it will recover these costs

• Entity will recognize an expense if the costs would have been incurred regardless of whether the contract was obtained

Costs to Fulfill a Contract

• Costs that are incurred to fulfill a contract that are not within the scope of another standard will be recognized as an asset if they meet the following criteria

  • Relate directly to a contract

  • Generate or enhance the resources of the entity

  • Are expected to be recovered

• Cost to be expensed include

  • Selling, general, administrative costs

  • Wasted labor and material costs

  • Costs tied to satisfied performance obligations

Principal vs Agent

• Agent

  • Entity arranges for the other party to provide good or service to the customer

  • Revenue recognized is equal to the fee or commission for performing the agent function

• Principal

  • Entity controls the good or service before it is transferred to the customer

  • Revenue recognized is equal to the gross consideration an entity expects to receive

Repurchase Agreements

• Contract by which an entity sells an asset and also either promises to or has the option to repurchase the asset

  • Sale with right of return

  • Financing arrangement

• Three main forms of repurchase agreements include

  • An entity’s obligation to repurchase the asset (a forward)

  • An entity’s right to repurchase the asset (a call option)

  • An entity’s obligation to repurchase the asset at the customer’s request (a put option)

Forward or Call Option

• Entity’s accounting for the contract will be based on whether it must (forward) or can (call) repurchase the asset for either:

  • Less than OG selling price (lease)

  • Equal to/more than OG price (financing arrangement)

• If contract is financing arrangement

  • Recognize the asset

  • Recognize a financial liability for any consideration received from the customer

  • Recognize as interest expense the difference between the amount of consideration received from the customer and the amount of consideration to be paid by the customer

Put Option

• If the entity has an obligation to repurchase the asset at the customer’s request for less than OG selling price, entity will account for the contract as either

  • Lease (if customer has significant economic incentive to exercise the right)

  • A sale with a right of return (if customer doesn’t have significant economic incentive)

• If repurchase price is equal to or greater than the OG selling price, the entity accounts for the contract as either:

  • A financing arrangement (if repurchase price is more than expected FMV of asset)

  • A sale with a right of return (if repurchase price is less than or equal to expected FMV and customer doesn’t have significant economic incentive to exercise right)

Bill-and-Hold Arrangements

• Contracts in which the entity bills a customer for a product that has not yet been delivered to customer

• Revenue can’t be recognized in a bill-and-hold arrangement until after customer obtains control of product

• Generally, control is transferred to the customer when the product is shipped to or delivered to the customer (depending on terms of contract)

Refund Liabilities

• An entity should recognize a refund liability if:

  • It receives or will receive consideration from a customer

  • Anticipates having to refund a portion or all that consideration

• For products with a right of return, an entity should recognize

  • Revenue for transferred products equaling the amount of consideration the entity expects to be entitled to receive (revenue will not be recognized for products that entities anticipate having to return)

  • A refund liability

  • An asset related to the subsequent recovery of products when the refund liability is settled

Changes in Accounting Estimate

There are 3 points to note when there is a change in accounting estimate

1. It is not an error

2. Don’t restate prior years

3. Follow prospective approach

Changes in estimate should be disclosed in notes to the financial statements

Changes affecting future periods don’t need to be disclosed unless they are material

Events Resulting in Estimate Changes

• Changes in the lives of fixed assets

• Adjustments of year-end accrual of officers’ salaries and/or bonuses

• Write-downs of obsolete inventory

• Economic conditions

• Product demand

• Settlement of litigation

• Change in accounting principle that is inseparable from a change in estimate

  • To LIFO

  • Depreciation method

• Revisions of estimates regarding discontinued operations

Changes in Accounting Principle (Retrospective)

• Changes in accounting principle or accounting entity

  • General rule = Retrospective approach

  • Exceptions exist

• Always adjust beginning retained earnings, net of tax

• Change in accounting principle is

  • Going from one acceptable accounting method to another acceptable accounting method

Rule of Preferability

• Cannot change accounting principles without justification

• An accounting principle may be changed only if

  • Required by GAAP

  • Alternative principle is preferred and presents the information more fairly

Income Smoothing

• Income smoothing is not allowed

• Cannot switch accounting methods in order to show lower expenses or lower COGS

• Change in accounting principle should be justified

• Change should more fairly present results

Change in Accounting Principle (Noncomparative Financial Statements)

1. Use new method in year presented

2. Calculate what earnings would have been if new method had always been used

3. Adjust beginning retained earnings net of tax

Change in Accounting Principle (Comparative Financial Statements)

1. Use new method in all years presented

2. Calculate the cumulative effect

   1. Difference between beginning retained earnings in first period presented and what retained earnings would have been if new principle had been applied to all prior periods

3. Present cumulative effect net of tax as an adjustment to beginning retained earnings in the statement of stockholders’ equity

Reporting Changes in Accounting Principle

General Rule

• Retrospective approach

• For comparative financial statements, adjust beginning retained earnings for earliest year presented

Exceptions to the General Rule

• Impracticable to estimate

  • If it is considered “impractical” to accurately calculate this cumulative effect adjustment, the change is handled prospectively

• Change in depreciation method

  • Change in the method of depreciation, amortization, or depletion is considered to be both a change in accounting principle and a change in estimate

  • These changes should be accounted for as changes in estimate and are handled prospectively

Change in Accounting Entity (Prospective)

• Changes may be the result of

  • Mergers

  • Acquisition

  • Divestitures

Restatement (Comparative Financial Statements)

If a change in accounting entity occurs in the current year:

• Restate all previous financial statements presented in comparative financial statements along with the current year to reflect the information for the new reporting entity

Error Corrections (Prior Period Adjustments)

• Correction of errors in recognition, measurement, presentation, or disclosure in financial statements resulting from:

  • Mathematical mistakes

  • Mistakes in application of GAAP

  • Oversight or misuse of facts that existed at the time the financial statements were prepared

• Changes from a non-GAAP method of accounting to a GAAP method of accounting (cash basis to accrual)

Matching Revenues & Related Expenses

• Accrual basis accounting:

  • In accordance with GAAP

  • Matches revenues with expense

• In order to match revenues with expenses in the period they occur, sometimes it is necessary to defer or accrue revenues or expenses

Rules for Recording Adjusting Journal Entries

• Must be recorded by the end of the entity’s fiscal year, before the preparation of financial statements

• Never involve cash account

• All AJEs will hit one income statement account and one balance sheet account

Summary of Significant Accounting Policies

• Measurement bases used in the financial statements

• Specific accounting principles and methods used during the period including

  • Depreciation methods

  • Amortization of intangibles

  • Inventory Pricing

  • Use of estimates

  • Fiscal year definition

  • Special revenue recognition

Accounting Policies Footnote

• Items not included in Significant Accounting Policies footnote

  • Composition and detailed dollar amounts of account balances

  • Details relating to changes in accounting policies

  • Date of maturity and amounts of long-term debt

  • Yearly computation of depreciation, depletion, and amortization

Remaining Notes to the Financial Statements

• Remaining notes contain all other information relevant to decision makers

• Notes are used to disclose facts not presented in the body of the financial statements or in the Summary of Significant Accounting Policies

• Exs:

  • Material information about specific assets or liabilities

  • Information about nature of changes in stockholders’ equity

  • Information about the required marketable securities disclosure

  • Fair value estimates

  • Information about contingency losses, gains, commitments and contractual obligations

Disclosure of Risks & Uncertainties

• US GAAP requires the disclosure of risks and uncertainties that could be relevant to decision makers

• Footnotes should describe

  • RIsks & uncertainties around major operations, products, and geographic distributions

  • Relative importance of each business, if entity operates multiple businesses

  • Use of accounting estimates in preparation of financial statements

Certain Significant Estimates

• Along with estimates in general, examples of certain significant estimates sensitive to change include

  • Deferred tax asset valuation allowance

  • Inventory or equipment subject to rapid technological obsolescence

  • Loan valuation allowances

• When it is reasonably possible that an estimate will materially change in the near term, an estimate and the effect of the change should be disclosed

Recognized Subsequent Events

• Referred to as a type 1 subsequent event

• Provides additional info about conditions that existed as of the B/S date

• Must be recognized or adjusted in the financial statements

Nonrecognized Subsequent Events

• Referred to as type 2 subsequent events

• An entity should not recognize subsequent events that provide information about conditions that did not exist at B/S date

• Financial statements are not required to be adjusted

• The event should be disclosed if disclosure is necessary to keep the financial statements from being misleading

• Ex: Sale of bond or capital stock

Subsequent Event Evaluation Period

• It depends on the kind of company

  • Public?

  • Private?

• Public companies must evaluate subsequent events through the date that the financial statements are issued

• Private companies must evaluate subsequent events through the date the financial statements are available to be issued

Revised Financial Statements

• Financial statements that have been revised to correct an error or to reflect the retrospective application of US GAAP

• Revised financial statements are considered reissued financial statements

  • Disclosure not required for SEC filers

  • If an entity isn’t an SEC filer, entity should disclose in its revised financial statements the date through which subsequent events have been evaluated, in both its issued/available to be issued financial statements and its revised financial statements

Nonfinancial Assets

• The fair value measurement of a nonfinancial asset takes into account the market participant’s ability to generate economic benefits

  • By using the asset in its highest and best use; or

  • By selling it to another market participant that would use the asset in its highest and best use

• A reporting entity’s current use of a nonfinancial asset is presumed to be its highest and best use, unless market or other factors suggest that a different use by market participants would maximize the value of the asset

• The highest and best use of a nonfinancial asset may be to use the asset:

  • In combination with other assets

  • With other assets and liabilities

  • On a stand-alone basis

Liabilities & Financial Assets

• Highest and best use concept is not relevant when measuring the fair value of financial assets or the fair value of liabilities because:

  • Such items don’t have alternative uses

  • Their fair values don’t depend on their use within a group of other assets or liabilities 

Market Approach (Fair Value Valuation Techniques)

• Use price and other relevant information from market transactions involving identical or comparable assets or liabilities to measure fair value

Income Approach (Fair Value Valuation Techniques)

• Converts future amounts, including cash flows or earnings, to a single discounted amount to measure fair value

• Can be applied to assets or liabilities

Cost Approach (Fair Value Valuation Techniques)

• Uses current replacement cost to measure the fair value of assets

Level 1 Inputs (Hierarchy of Inputs)

• Quoted price in active markets for identical assets or liabilities that the reporting entity has access to on the measurement date

• May be obtained for exchange markets (NYSE), dealer markets, brokered markets, and principal-to-principal markets

• Most reliable measures of FV

Level 2 Inputs (Hierarchy of Inputs)

• Inputs other than quoted market prices (level 1) that are directly or indirectly observable for the asset or liability

• Include:

  • Quoted prices for similar assets or liabilities in active markets

  • Quoted prices for identical or similar assets in markets that are not active

  • Quoted prices for identical liabilities when traded as assets, if adjustments to the quoted market price of the assets are required

  • Quoted prices for similar liabilities when traded as assets

Level 3 Inputs (Hierarchy of Inputs)

• Unobservable inputs for the asset or liability

• Reflect the reporting entity’s assumptions and should be based on the best available info

• Should only be used:

  • When there are no observable inputs or

  • When undue cost and effort is required to obtain observable inputs

Exception to Fair Value Measurements

• Exemptions to the requirement to measure fair value exist when:

  • It is not practicable to measure fair value

  • Fair value cannot be reasonably determined

  • Fair value cannot be measured with sufficient reliability

Fair Value Disclosures

• Valuation techniques and inputs the entity use to arrive at its measures of fair value, including judgements and assumptions the entity makes

• The uncertainty in the fair value measurements as of the reporting date; and

• How changes in fair value measurement affect the entity’s performance and cash flows

• Quantitative information about significant unobservable inputs

• Information about nonfinancial assets and liabilities for which measurement differ from and highest best used

• Hierarchy for items that are not measured on the balance sheet but are disclosed in the notes to the financial statements

• Discussion of the sensitivity of level 3 measurements to changes in inputs disclosed

Special Purpose Framework

• Several accounting frameworks are outside GAAP and are collectively known as special purpose frameworks

• Non-GAAP presentations that have widespread understanding & support

• OCBOA (Other Comprehensive Basis of Accounting) is a widely understood special purpose framework

OCBOA Presentation Guidelines

• Financial statement titles should differentiate OCBOA financial statements from accrual ones

• Required financial statements

  • B/S & I/S + explanation of changes in equity accounts

• Statement of cash flows not required

• Disclosures should be similar to the disclosures in GAAP financial statements and include:

  • Summary of significant accounting policies

  • Informative disclosures similar to those required by GAAP financial statements

  • Disclosures related to items not shown on the face of the financial statements, such as related party transactions, subsequent events, uncertainties

Users of Cash Basis Financial Statements

• Estates & trusts

• Civic ventures

• Political campaigns & committees

Modified Cash Basis Financial Statements

• Used by most for-profit and not-for-profit organizations that produce cash basis financial statements 

• Includes elements of cash basis and accrual basis accounting

• Avoid extensive modifications; the modified cash basis should not become accrual basis financial statements

Common Modifications for Modified Cash Basis

• Capitalizing and depreciating fixed assets

• Accrual of income taxes

• Recording liabilities for long-term and short-term borrowings and the related interest expense

• Reporting investments at fair value and recognizing unrealized gains & losses

Presentation for Modified Cash Basis

• In addition to statement of cash & equity, financial statements include

  • Statement of assets & liabilities (modified cash basis)

  • Statement of assets and liabilities arising from cash transactions

  • Statement of revenues and expenses and retained earnings (modified cash basis)

  • Statement of revenues collected and expenses paid

• Specific elements included in these financial statements depend on the modifications made by the entity

Income Tax Basis Financial Statements

• Well-suited for entities having complex operations in comparison to cash basis financial statements

• Prepared based on the methods and principles used to prepare the entity’s tax return

• Amount of taxable income (per tax return) isn’t required to be shown or match net income in tax basis financial statements

• Material, nontaxable revenues and expenses must be recognized in the period received or paid for cash-basis taxpayers and in the period accruable for accrual-basis taxpayers

• Nontaxable revenues & expenses may be reported as:

  • Separate line items in the statement of operations (income tax basis)

  • Additions and deductions to existing line items

Income Tax Basis Disclosures

• Disclosing the specific amounts of nontaxable income and expenses is allowed by not required

• Treatment for nontaxable income and expenses is allowed but not required

• Treatments for nontaxable income and expenses should be disclosed in the significant accounting policies footnote

Converting from Cash Basis to Accrual Basis (Balance Sheet)

• All assets and liabilities existing at year-end that are not already included on the B/S must be added to the B/S

• Equity equals the difference between total assets and total liabilities

Converting from Cash Basis to Accrual Basis (Income Statement)

• Cash basis revenue to accrual basis revenue

• Cash paid for purchases to accrual basis COGS

• Cash paid for operating expenses to accrual basis operating expenses

Potential Adjustments When Converting from Cash to Accrual Basis

• Recognize noncash expenses (i.e., depreciation and amortization)

• Capitalize purchases of fixed assets (fixed asset purchases are cash disbursements under the cash basis)

• Reduce the fixed asset balance for assets sold during the period (fixed asset sales are cash receipts under the cash basis) and recognize gains/losses on the sale

• Record debt proceeds received during the period as liabilities (debt proceeds are cash receipts under the cash basis)

• Record debt repayments as reductions in liabilities (debt repayments are cash disbursements under the cash basis)

Gross Profit Margin Ratio

(Net sales - COGS) / Net Sales

Return on Sales

Income before interest income, interest expense, and taxes / Net sales

Return on Assets

Net income / Average total assets

Dupont Return on Assets

Profit Margin x Assets Turnover

Return on Equity

Net income / Average total equity

Operating Cash Flow Ratio

Cash flow from operations / Current liabilities

Current Ratio

Current assets / Current liabilities

Quick Ratio

[Cash & Cash equivalents + Short-term marketable securities + Net receivables] / Current liabilities

Accounts Receivable Turnover

Net sales / Net average accounts receivable

Days sales in Accounts Receivable

Ending accounts receivable (net) / [Net sales / 365]

Inventory Turnover

COGS / Average inventory

Days Sales in Inventory

Ending inventory / [COGS/365]

Accounts Payable Turnover

COGS / Average accounts payable

Days of Payables Outstanding

Ending accounts payable / [COGS / 365]

Cash Conversion Cycle

Days sales in A/R + Days in Inventory - Days of Payables Outstanding

Debt-to-Equity Ratio

Total liabilities / Total Equity

Total Debt Ratio

Total Liabilities / Total Assets

Equity Multiplier

Total Assets / Total Equity

Times Interest Earned

EBIT / Interest Expense

Earnings Per Share

Income available to common shareholders / Weighted average common shares outstanding

Price-to-Earnings Ratio

Price per share / Basic EPS

Dividend Payout

Cash dividends / Net income

Asset Turnover

Sales (net) / Average total assets