18. Intermediate Accounting Chapter 18

Earned revenues

Revenue recognition criterion indicating that a company has substantially accomplished what it must do to be entitled to the benefits represented by the revenues—that the earnings process is complete or virtually complete.

The Billings on Construction in Process account is reported:

in either the current asset or current liability section.

complex capital structure

includes securities that could have a dilutive effect on earnings per common share

Earnings per share

indicates the income earned by each share of common stock (reported only for common stock)

Two Different types of methods for long-term construction contracts:

(1) Percentage of Completion Method (2) Completed Contract Method

Percentage of Completion Method:

Companies recognize revenues and gross profits each period based on progress of the construction

Input Measures:

Ex: Costs incurred, labor hours worked

Completion-of-production basis

Revenue recognition method in which companies recognize revenue at the completion of production (e.g., mining of metals or harvesting of crops) even though no sale has been made.

Earnings per share =

(Net Income - Preferred Dividends) / (Weighted Average Number of Shares Outstanding)

dilutive securities

securities that can be converted to common stock

Deferred Gross Profit consists of 3 Elements:

(1) Income tax liability to be paid when the sales are reported as realized income (currently liability) (2) Allowance for collection expense, bad debt, and repossession losses (deduction from installment accounts receivable) (3) Net income (retained earnings, restricted as to dividend availability)

Two Methods to defer revenue recognition until the company receives cash:

(1) Installment Sales Method (2) Recovery Method

Revenue Recognition Principle says companies should recognize revenue when:

(1) It is realizable or realized (2) When is it earned

Two types of Losses under Long-Term contracts:

(1) Loss in current period on Profitable Contract (2) Loss on Unprofitable Contract

Sales Transactions

(1) Selling Products (2) Providing Services

Changes in the accounting principle- Employ the retrospective approach by:

1. Changing the financial statements of all prior periods presented 2. disclosing in the year of the change the effect on net income and earnings per share for all prior periods presented 3. reporting an adjustment to the beginning retained earnings balance in the statement of retained earnings in the earliest year presented.

Changes in accounting estimate- Employ the current and prospective approach by:

1. Reporting current and future financial statements on the new basis 2. Presenting prior period financial statements as previously reported 3. Making no adjustments to current-period opening balances for the effects in prior periods

Impracticability: Companies should not use retrospective application if one of the following conditions exist:

1. The company cannot determine the effects of the retrospective application 2. Retrospective application requires assumptions about management's intent in a prior period 3. Retrospective application requires significant estimates for a prior period and the company cannot objectively verify the necessary information to develop these estimates.

Disclosures for reporting a change in principle:

1. The nature and reason for the change in accounting principle including why the newly adopted accounting principle is preferable. 2. The method of applying the change and: a. A description of the prior-period information that has been retrospectively adjusted, if any. b. The effect of the change on income from continuing operations, net income, any other affected line item and any affected per-share amounts for the current period and for any prior periods retrospectively adjusted. c. The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the earliest period presented.

Changes due to error- Employ the restatement approach by:

1. correcting all prior period statements presented 2. Restating the beginning balance of retained earnings for the first period presented when the error effect occur in a period prior to that one

Complex capital structures and dual presentation of earnings per share require these five disclosures in note form:

1. description of pertinent rights and privileges of the various securities outstanding. 2. A reconciliation of the numerators and denominators of the basic and diluted per share computations, including individual income and share amount effects of all securities that affect EPS. 3. The effect given preferred dividends in determining income available to common stockholders in computing basic EPS. 4. Securities that could potentially dilute basic EPS in the future that were excluded in the computation because they would be antidilutive. 5. Effect of conversions subsequent to year-end, but before issuing statements

Changes in accounting principle- If impracticable to determine the prior period effect:

1. do not change prior years' income 2. use opening inventory in the year the method is adopted as the base-year inventory for all subsequent LIFO computations 3. Disclose the effect of the change on the current year and the reasons for omitting the computation of the cumulative effect and pro forma amounts for prior years

Accounting estimates change when:

1. new events occur 2. a company acquires more experience 3. a company obtains additional information

Account for the effects of all changes in estimates in:

1. the period of change if the change affects that period only 2. the period of change and future period if the change affects both (do not use retrospective treatment, only prospective treatment)

Companies must estimate the effects of future conditions and events of these items:

1. uncollectible receivables 2. inventory obsolescence 3. useful lives and salvage values of assets 4. liabilities for warranty costs and income taxes 5. change in depreciation methods

High rate of returns

A high ratio of returned merchandise to sales, which results in companies needing to postpone revenue recognition until the return privilege has substantially expired. (p. 1071).

Statement of shareholders' equity

A statement of shareholders' equity reports the transactions that cause changes in its shareholders' equity account balances.

Accumulated other comprehensive income (AOCI)

AOCI is reported in the balance sheet.

Completed Contract Method:

Companies recognize revenues and gross profits only when the contract is completed

Cost Recovery Method:

Company recognizes no profit until cash payments by the buyer exceed the cost of the merchandise sold

Main Difference between Percentage of Completion and Completed Contract Method:

Completed Contract Method makes annual entries to record costs, progress, and collections but does not make entries to recognize revenue and gross profit

Comprehensive income

Comprehensive income includes net income as well as other gains and losses that change shareholders' equity but are not included in traditional net income.

Major difference between installment sales and cost recovery method and deposit method:

Contract performance. In installment sales and cost recovery methods it is assumed the seller has performed on the contract but cash collection is highly uncertain. In deposit method, seller has not performed and no legitimate claim exists. Deposit method is not a revenue recognition method

FASB in SFAC No. 6 says:

Deferred gross profit on installment sales is an asset valuation which is a reduction of an asset

Disclosure of a change in estimate useful lives:

Do not disclose changes made as part of normal operations unless they are material; or if they affect several periods disclose the effect on income from continuing operations and related per-share amounts of the current period

If company has deferred gross profit on installment sales;

It treats it as unearned revenue and classifies it as current liability

Output Measures:

Ex: tons produced, floors of a building completed, miles of a highway completed

Input measures

Measures of the extent of progress based on efforts devoted to the contract (costs incurred, labor hours worked, etc.). (p. 1082).

Output measures

Measures of the extent of progress based on results or achievements (tons of output, floors of a building completed, etc.). (p. 1082).

Repossessions

Merchandise that the seller has taken back when the purchaser failed to meet payment requirements. The seller would remove both the account receivable and the applicable deferred gross profit from the ledger, using a Repossessed Merchandise (inventory) account. (p. 1097).

Cost to Cost Basis:

Most popular input measure used to determine progress toward completion. It measures percentage of completion by comparing costs incurred to date with the most recent estimate of total costs required to complete the contract

OCI

OCI is reported in the statement of comprehensive income.

Substantial Performance

Occurs when franchisor has no remaining obligation to refund any cash received or excuse any nonpayment of a note and has performed all the initial services under the contract

Revenue recognition principle

One of the basic principles of accounting, which dictates that companies recognize revenue when it is realized or realizable and when it is earned-that is, when assets are salable or interchangeable in an active market at readily determinable prices without significant additional cost and when the company substantially accomplishes what it must do to be entitled to the benefits represented by the revenues. Generally, recognition at the time of sale provides a uniform and reasonable test. (p. 1067).

Realizable revenues

Part of the first test of the revenue recognition principle, revenues are realizable when assets received or held are readily convertible into cash or claims to cash—that is, when they are salable or interchangeable in an active market at readily determinable prices without significant additional cost. (p. 1067).

Realized revenues

Part of the first test of the revenue recognition principle, revenues are realized when a company exchanges goods and services for cash or claims to cash (receivables). (p. 1067).

Initial Franchise Fee

Payment for establishing the franchise relationship and providing some initial services

Companies usually recognize revenue at:

Point of Sale (usually meaning delivery)

Installment Sales Method:

Recognizes income in periods of collection rather than in the period of sales Ex: home furnishings farm/home equipment

Retained earnings

Retained earnings represents earned capital.

Which type of revenue or gain is generally recognized as time passes?

Revenue from interest, rents, and royalties

Installment-sales method

Revenue recognition method in which companies recognize income in the periods of collection rather than in the period of sale. "Installment sales" generally describes any type of sale for which payment is required in periodic installments over an extended period of time. Theoretically, the installment-sales method is not generally preferred, except for some sales of real estate; a better approach generally is for a company to recognize a sale when completed and keep a bad debt account to estimate uncollectibles. (p. 1092).

Cost-recovery method

Revenue recognition method in which companies recognize profit only when cash collections exceed the total cost of the goods sold. Any additional cash collection after the seller has recovered all costs is recorded as income. This method is required under GAAP for franchises and real estate where a high degree of uncertainty exists related to the collection of receivables.

Completed-contract method

Revenue recognition method in which companies recognize revenue and gross profit only at the point of sale—the point at which a contract is deemed completed. Under this method, companies do not record interim charges or credits to income statement accounts for revenues, costs, and gross profit.

Percentage-of-completion method

Revenue recognition method in which companies recognize revenues, costs, and gross profit as progress is made toward completion on a long-term contract, using a basis or standard (such as the cost-to-cost basis) to measure the progress toward completion at interim dates. (pp. 1081, 1082).

Deposit method

Revenue recognition method used in cases when companies receive cash from the buyer before transfer of the goods or property. Under this method, the seller reports the cash received from the buyer as a deposit on the contract and classifies it on the balance sheet as a liability, while continuing to report the property as an asset. The seller recognizes revenue and income only when the sale is complete.

Paid-in capital

Several other events also affect paid-in capital.

Computation of Incremental shares

Shares issued - [(shares issued x exercise price per share) / market price per share] OR [(Market price- Option Price) / Market Price) x Number of options = number of shares

Consignment

Specialized type of marketing in which manufacturers (or wholesalers) deliver goods but retain title to the goods until they are sold.

Cost-to-cost basis

Technique that measures the percentage of completion on a contract by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract.

Model Business Corporation Act

The Model Business Corporation Act serves as the model for the corporation statutes of most states.

Consignee

The dealer who acts as an agent for the consignor in selling the merchandise.

Consignor

The manufacturer or the wholesaler who provides the consigned goods.

Point of sale (delivery)

The point at which companies deliver products or merchandise or render services to customers. For revenue recognition, the point of sale or delivery is the point at which companies commonly recognize revenues from manufacturing and selling activities (p. 1070).

In a bill-and-hold arrangement, which of the following is not one of the criteria which must be met for the customer to have obtained control of the product?

The product must be physically located in the seller's warehouse

Trade Loading:

Trying to show sales, profits, and market share a company does not actually have

Billings account

Under the percentage-of-completion method, when a company records a receivable from a sale, it must subtract the balance from this account from Construction in Process to avoid double-counting inventory.

Channel Stuffing:

When a company needs to make financial results look good, it gives deep discounts to distributors to overbuy and then record revenue when the software leave the dock

Deposit Method:

When a company receives cash from the buyer before it transfers the goods. There is not enough transfer of ricks and rewards of ownership for sales to be recorded

Principal-agent arrangement

When amounts collected on behalf of the principal are not revenue of the agent, e.g., when a travel agent sells airline tickets. (p. 1074).

Deposit Method:

When company receives cash prior to delivery or transfer of property

Multiple-deliverable arrangements

When multiple products or services are provided to a customer as part of a single arrangement. In accounting for MDAs, all units of an MDA are considered separately if each unit has standalone value, includes a general right of return, and delivery or performance is probable and substantially in the control of the seller. (p. 1078).

Completion of Production Basis:

When revenue is recognize though no sale has been made. Examples include precious metals or agricultural products with assured prices

Change in Accounting Principle

a change from one generally accepted accounting principle to another one (ex. LIFO to average cost)

Change in Reporting Entity

a change from reporting as one type of entity to another type of entity (ex.changing the subsidiaries for which it prepares consolidated financial statements)

Change in Accounting Estimate

a change that occurs as the result of new information or additional experience (ex. changing the estimate of useful lives of depreciable assets)

Correction of an error

a change to a generally accepted accounting principle due to following an accounting principle that was not acceptable or applying a principle incorrectly

The new standard, Revenue from Contracts with Customers

adopts an asset-liability approach for revenue recognition

prior period adjustments

an adjustment to the beginning balance of retained earnings in the current period to record corrections of errors from prior periods

Treasury stock method

assumes the company exercises the options or warrants at the beginning of year/date of issue and that it uses those proceeds to purchase common stock treasury

For an unprofitable contract, the entire expected loss is recognized in the current period when using

both the percentage-of-completion method and the completed contract method

The seller of a good or service should recognize revenue when

each performance obligation is satisfied.

Three types of accounting changes

change in accounting principle, accounting estimate, and reporting entity

Careful estimates that later prove to be incorrect are considered _____.

changes in estimate

simple capital structure

consists only of common stock or includes no potential common stock that upon conversion or exercise could dilute earnings per common share

Errors in Financial Statements

errors result from mathematical mistakes, mistakes in applying accounting principles, or oversight or misuse of facts that existed when preparing the financial statements

One criteria that indicates the company should disregard revenue guidance to contracts is

each party can unilaterally terminate the contract without compensation

A contract should be treated as having multiple performance obligations if

each performance obligation is not highly dependent on other promises in the contract.

If the exercise price of the option or warrant is ____(lower, higher) than the market price of the stock, antidilution occurs.

higher; reduces common shares thus increasing earnings per share

If the exercise price of the option or warrant is ____(lower, higher) than the market price of the stock, dilution occurs.

lower; increases common shares thus decreasing earnings per share

In a consignment sale, the consignee

only recognizes revenue associated with commissions

Adoption of a new principle

recognition of events that have occurred for the first time or that were previously immaterial; not an accounting change

When using the percentage of completion method, the company

recognizes revenues and gross profit each period during the contract

Reporting for a complex capital structure with diluted EPS

report both basic and diluted earnings per share

Which method of measuring the fair value of a performance obligation is dependent on the standalone selling prices of other goods or services promised in the contract?

residual value.

Antidilutive securities

securities that upon conversion or exercise increase earnings per share or reduce loss per share

The best measure of the fair value of a performance obligation is:

standalone selling price

Retrospective application

the application of a different accounting principle to recast previously issued financial statements- as if the new principle had always been used; adjust prior years' statements consistent with newly adopted principle

An indication that the customer has not taken control of the good or service is

the customer has no significant risks or rewards of ownership.

An indication that the customer has taken control of the good or service is

the selling company has transferred legal title to the asset

In determining the transaction price, the company must consider

variable consideration, time value of money, non-cash consideration, and consideration payable

A change in estimate effected by a change in accounting principle

when it is impossible to determine whether a change in principle or a change in estimate has occurred; ex. changes in depreciation, amortization, or depletion methods