CFA STUDY SESSION 7 Reading 24

4 types of items treated as other comprehensive income under both IFRS and GAAP

-Foreign currency translation adjustments -Unrealized gains or losses on derivatives contracts accounted for as hedges -Unrealized holding gains and losses on a certain category of investment securities, namely, available-for-sale securities -Certain costs of a company's defined benefit post-retirement plans not recognized in current period

Net Profit Margin

Measures the amount of income that a company was able to generate for each dollar of revenue

Net profit margin formula

Net Income / Revenue

A higher level of net profit margin indicates higher profitability and is thus more desirable.

Net profit margin can also be found directly on the common-size income statements.

A Basic EPS Calculation (1) For the year ended 31 December 2009, Shopalot Company had net income of $1,950,000. The company had 1,500,000 shares of common stock outstanding, no preferred stock, and no convertible financial instruments. What is Shopalot's basic EPS?

Shopalot's basic EPS is $1.30 ($1,950,000 divided by 1,500,000 shares).

other comprehensive income

are those revenues, expenses, gains, and losses under GAAP and IFRS that are excluded from the income statement

operating profit

can sometimes be referred ad EBIT

Change in accounting policies

changes in accounting policies (e.g., from one acceptable inventory costing method to another) are made for other reasons, such as providing a better reflection of the company's performance. Changes in accounting policies are reported through retrospective application

earnings per share

is an input into ratios such as the price/earnings ratio Required on the face of the income statement

double declining balance

it depreciates the asset at double the straight-line rate. Using the 200 percent acceleration factor, the diminishing balance rate would be 40 percent (20 percent × 2.0). This rate is then applied to the remaining undepreciated balance of the asset each period (known as the net book value).

gross profit margin

measures the amount of gross profit that a company generated for each dollar of revenue

percentage-of-completion method

revenue is recognized based on the stage of completion of a transaction or contract and is, thus, recognized when the services are rendered. Contract costs are expensed against revenue for the period therefore net income is reported each year. EX: construction contracts

gross profit (margin)

revenue less cost of sales

amortisation

term commonly applied to this process for intangible long-lived assets with a finite useful life. Examples of intangible long-lived assets with a finite useful life include an acquired mailing list, an acquired patent with a set expiration date, and an acquired copyright with a set legal life.

IFRS criteria for recognizing interest, royalties, and dividends

that it is probable that the economic benefits associated with the transaction will flow to the entity and the amount of the revenue can be reliably measured.

Residual Value (Salvage Value)

the amount that the company expects to receive upon sale of the asset at the end of its useful life.

IFRS: total comprehensive income

the change in equity during a period resulting from transaction and other events, other than those changes resulting from transactions with owner in their capacity as owners

completed contract method

the company does not report any income until the contract is substantially finished (the remaining costs and potential risks are insignificant in amount), although provision should be made for expected losses

cost model

the depreciable amount of that asset (cost less residual value) is allocated on a systematic basis over the remaining useful life of the asset. Under the cost model, the asset is reported at its cost less any accumulated depreciation

IFRS specify that revenue from the sale of goods is to be recognized (reported on the income statement) when the following conditions are satisfied

the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; ◾the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; ◾the amount of revenue can be measured reliably; ◾it is probable that the economic benefits associated with the transaction will flow to the entity; and ◾the costs incurred or to be incurred in respect of the transaction can be measured reliably.

Book value formula

Cost - Accumulated depreciation

Operating profit margin formula

Operating Income / Revenue

Alternative Inventory Costing Methods

Specific Identification Method FIFO Method Weighted Average Cost Method

*Under IFRS, revenue from barter transactions must be measured based on the fair value of revenue from similar non-barter transactions with unrelated parties (parties other than the barter partner).

*US GAAP state that revenue can be recognized at fair value only if a company has historically received cash payments for such services and can thus use this historical experience as a basis for determining fair value; otherwise, the revenue from the barter transaction is recorded at the carrying amount of the asset surrendered

accelerated methods of depreciation

allocate a greater proportion of the cost to the early years of an asset's useful life. These methods are appropriate if the plant or equipment is expected to be used up faster in the early years

A Basic EPS Calculation (3) Assume the same facts as in Example 13 except that on 1 December 2009, a previously declared 2 for 1 stock split took effect. Each shareholder of record receives two shares in exchange for each current share that he or she owns. What is the company's basic EPS?

For EPS calculation purposes, a stock split is treated as if it occurred at the beginning of the period. The weighted average number of shares would, therefore, be 2,250,000, and the basic EPS would be $1.02 [= ($2,500,000 - $200,000)/2,250,000].

LIFO Layer Liquidation

Occurs when the volume of sales exceeds the volume of purchases in the period so that some sales are assumed to be made from existing, relatively low priced inventory rather than more recent purchases.

Why would US company choose to use LIFO?

Some companies choose to use LIFO to reduce taxes. when prices and inventory quantities are rising LIFO will result in higher cost of goods sold and lower income as well as taxes. If company uses LIFO must also use on annual financial statements

Goodwill

The amount by which the price to purchase an entity exceed the amount of net identifiable assets required.

Example 1 Revenue Recognition Long-term Contracts: Prorate Basis New Era Network Associates has a five-year license to provide networking support services to a customer. The total amount of the license fee to be received by New Era is $1 million. New Era recognizes license revenue on a prorated basis regardless of the time at which cash is received. How much revenue will New Era recognize for this license in each year?

For this license, New Era Network Associates will recognize $200,000 each year for five years (calculated as $1 million divided by 5).

Trading Securities

If company intends to actively trade the securities then they should recognize the unrealized gains and losses on its income statements

straight line formula

(Cost−Residual value)/ (Estimated useful life)

Gross Profit margin formula

Revenue - cost of goods sold = gross profit Gross profit / revenue = gross profit margin

IFRS allows two alternative models for valuing property, plant, and equitment

cost model (allowed) and revaluation model (Not permitted in US GAAP)

Diluted EPS Calculation formula using the treasury stock method for option

(Net Income - Preferred Dividends) / [(Weighted average number of share outstanding + (New shares that would have been issued at option exercise - Shares that could have been purchased with cash received upon exercise) x (Proportion of year during which the financial instruments were outstanding)]

Net income

(i) revenue minus expenses in the ordinary activities of the business, plus (ii) other income minus other expenses, plus (iii) gains minus losses.

Revenue Recongition Accounting Standards Issued May 2014: 5 steps in recognizing revenue

1. Identify the contract(s) with a customer 2.Identify the performance obligations in the contract 3.Determine the transaction price 4.Allocate the transaction price to the performance obligations in the contract 5.Recognize revenue when (or as) the entity satisfies a performance obligation

A Basic EPS Calculation (2) For the year ended 31 December 2009, Angler Products had net income of $2,500,000. The company declared and paid $200,000 of dividends on preferred stock. The company also had the following common stock share information: Shares outstanding on 1 January 20091,000,000Shares issued on 1 April 2009200,000Shares repurchased (treasury shares) on 1 October 2009(100,000)Shares outstanding on 31 December 20091,100,000 1.What is the company's weighted average number of shares outstanding? 2.What is the company's basic EPS?

1. The weighted average number of shares outstanding is determined by the length of time each quantity of shares was outstanding: 1,000,000 × (3 months/12 months) =250,000 1,200,000 × (6 months/12 months) =600,000 1,100,000 × (3 months/12 months) =275,000 Weighted average number of shares outstanding 1,125,000 2. Basic EPS = (Net income - Preferred dividends)/Weighted average number of shares = ($2,500,000 - $200,000)/1,125,000 = $2.04

Multi-Step Format vs Single-Step Format (Income Statement)

A multi-step format includes gross profit subtotal while a single-step skips this process and goes right to the operating income

Depreciation rate formula

Accelerator × Straight Line Rate

Companies must disclose their revenue recognition policies in the notes to their financial statements (sometimes referred to as footnotes).

Analysts should review these policies carefully to understand how and when a company recognizes revenue, which may differ depending on the types of product sold and services rendered

Intangible Assets

Assets lacking physical substances ex: Trademark

Weighted Average Cost Method

Assigns the average cost of goods available for sale to the units sold and remaining in inventory. (total cost of goods available for sale / total units available for sale) Approved by both IFRS and GAAP

Which of the following statements best describes other comprehensive income? Income earned from diverse geographic and segment activities. Income that increases stockholders' equity but is not reflected as part of net income. Income earned from activities that are not part of the company's ordinary business activities.

B is correct. Answers A and C are not correct because they do not specify whether such income is reported as part of net income and shown in the income statement.

Assume a company's beginning shareholders' equity is €200 million, its net income for the year is €20 million, its cash dividends for the year are €3 million, and there was no issuance or repurchase of common stock. The company's actual ending shareholders' equity is €227 million. What amount has bypassed the net income calculation by being classified as other comprehensive income? €0. €7 million. €10 million.

C is correct. If the company's actual ending shareholders' equity is €227 million, then €10 million [€227- (€200 + €20 - €3)] has bypassed the net income calculation by being classified as other comprehensive income.

Diluted EPS

EPS that would result if all dilutive financial instruments were converted into common stock

Grouping by nature

Grouping expenses such as manufacturing depreciation and equipment depreciation as a single line item called depreciation

Two difference between IFRS and US GAAP

IFRS require each component of an asset to be depreciated separately and US GAAP do not require component depreciation; and IFRS require an annual review of residual value and useful life, and US GAAP do not explicitly require such a review.

Diluted EPS, by definition, is always equal to or less than basic EPS

If a company has a simple capital structure (in other words, one that includes no potentially dilutive financial instruments), then its basic EPS is equal to its diluted EPS

Available-for-sale securities

If the company does not plan to actively trade the securities. The company would not recognize gains or losses on the income statement but would bypass this and go directly to shareholder's equity through other comprehensive income No longer appears in IFRS as of 2010 takes effect 2018

How are Intangible Assets depreciated?

Intangible assets usually are depreciated using straight line and if they have indefinite life (ex: Goodwill) they do not depreciate.

Specific Identification Method

Inventory and cost of goods sold are based on their physical flow. Identifies which inventory was sold and what would be carried to the next period. Not usually used and required by GAAP & IFRS to use cost formula or cost flow assumption.

direct write-off method

Recognizing credit losses on accounts receivable when the customer defaults on the payments and only recognizes the loss when they default. Not consistent with GAAP principles

Horizontal common-size analysis

States items in relation to a selected base year value.

Where do companies disclose their revenue recognition policies?

The notes to their financial statements often referred to as footnotes

Complex Capital Structure

When a company has issued any financial instruments that are potentially convertible into common stock

BASIC EPS

calculated using the reported earnings available to common shareholders of the parent company and the weighted average number of shares outstanding.

Common-size analysis of the income statement

can be performed by stating each line item on the income statement as a percentage of revenue. Common-size statements facilitate comparison across time periods (time series analysis) and across companies (cross-sectional analysis) because the standardization of each line item removes the effect of size.

Financial instruments convertible to common stock

convertible bonds, convertible preferred stock, employee stock options, and warrants. These cause complex capital structure

IASB Conceptual Framework: expenses

decreases in economic benefits during the accounting period in the form of outflows or depletion of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants

Pretax Margin formula

earnings before taxes / Revenue

period costs

expenditures that less directly match revenues, are reflected in the period when a company makes the expenditure or incurs the liability to pay. Administrative expenses are an example of period costs.

grouping by function

grouping together expenses into a category such as cost of goods sold, which may include labour and material costs, depreciation, some salaries (e.g., salespeople's), and other direct sales related expenses

IFRS defines income as

increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants

US GAAP:comprehensive income

is defined as "the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.

Vertical common-size analysis of the income statement

is particularly useful in cross-sectional analysis—comparing companies with each other for a particular time period or comparing a company with industry or sector data.

diminishing balance method

known as the declining balance method

Higher level of gross profit

margin indicates higher profitability and thus is generally more desirable, although differences in gross profit margins across companies reflect differences in companies' strategies

Retrospective application

means that the financial statements for all fiscal years shown in a company's financial report are presented as if the newly adopted accounting principle had been used throughout the entire period. Notes to the financial statements describe the change and explain the justification for the change.

barter transaction

non-monetary exchanges ex: Trading advertisement for Free-Wifi or services

If goods are delivered to a retail store to be sold on consignment (agreement to pay a supplier of goods after the goods are sold) and title is not transferred the revenue would __________

not be recognized

operating profit (income)

profit results from deducting operating expenses such as selling, general, administrative, and research and development expenses from gross profit. Reflects a company's profits on its usual business activities before deducting taxes, and for non-financial companies, before deducting interest expense. for financial companie, interest expense is included in operating expenses and subtracted in arriving at operating profit because it relates to the operating activities

net profit margin (definition and formula)

return on sales Net Income / Revenue

net revenue

the revenue number is reported after adjustments (e.g., for cash or volume discounts, or for estimated returns). Revenue may be called sales or turnover

IASB Conceptual Framework for Financial Reporting (2010)

Conceptual Framework, further defines and discusses these income statement items(sales, gains, losesses, net income). The Framework explains that profit is a frequently used measure of performance and is composed of income and expenses

Depreciation formula

Depreciation = Depreciation Rate × Book Value of Asset

Diluted EPS formula for when a company has convertible debt outstanding

DilutedEPS= (Net income+After-tax interest on convertible debt−Preferred dividends) / (Weighted average number of shares outstanding+Additional common-shares that would have been issued at conversion)

installment method

the portion of the total profit of the sale that is recognized in each period is determined by the percentage of the total sales price for which the seller has received cash.

cost recovery method

the seller does not report any profit until the cash amounts paid by the buyer—including principal and interest on any financing from the seller—are greater than all the seller's costs of the property.

Why does Revenue Recognition matter to Analysts?

the sooner a company recognizes revenue typically they are less conservative. Allows qualitative assessment how differences in policies may affect financial ratios.

Revenue

to amounts charged (and expected to be received) for the delivery of goods or services in the ordinary activities of a business

Example 2 Revenue Recognition Long-Term Contracts: Percentage of Completion Method Stelle Technology has a contract to build a network for a customer for a total sales price of €10 million. The network will take an estimated three years to build, and total building costs are estimated to be €6 million. Stelle recognizes long-term contract revenue using the percentage-of-completion method and estimates percentage complete based on expenditure incurred as a percentage of total estimated expenditures. 1.At the end of Year 1, the company had spent €3 million. Total costs to complete are estimated to be another €3 million. How much revenue will Stelle recognize in Year 1? 2.At the end of Year 2, the company had spent an additional €2.4 million for an accumulated total of €5.4 million. Total costs to complete are estimated to be another €0.6 million. How much revenue will Stelle recognize in Year 2? 3.At the end of Year 3, the contract is complete. The company spent an accumulated total of €6 million. How much revenue will Stelle recognize in Year 3?

1. Stelle has spent 50 percent of the total project costs (€3 million divided by €6 million), so in Year 1, the company will recognize 50 percent of the total contract revenue (i.e., €5 million). 2. Because Stelle has spent 90 percent of the total project costs (€5.4 million divided by €6 million), by the end of Year 2, it will need to have recognized 90 percent of the total contract revenue (i.e., €9 million). Stelle has already recognized €5 million of revenue in Year 1, so in Year 2, the company will recognize €4 million revenue (€9 million minus €5 million). 3. Because Stelle has spent 100 percent of the total project costs, by the end of Year 3, it will need to have recognized 100 percent of the total contract revenue (i.e., €10 million). Stelle had already recognized €9 million of revenue by the end of Year 2, so in Year 3, the company will recognize €1 million revenue (€10 million minus €9 million).

Warrant

A call option typically attached to securities issued by a company, such as bonds. Gives the holder the right to acquire the company's stock from the company at a specified price within a specified time period.

Matching Principle: Doubtful Accounts

At the time revenue is recognized on a sale, a company is required to record an estimate of how much of the revenue will ultimately be uncollectible. Estimates are made based on previous experience with uncollectible accounts.

Extraordinary Items

Both unusual in nature and occur infrequently were presented separately on an income statement and not seen as part of a company's operating activities. IFRS prohibits this classification and Sine December 2015 US GAAP will no longer include this concept

An Antidilutive Security For the year ended 31 December 2009, Dim-Cool Utility Company had net income of $1,750,000. The company had an average of 500,000 shares of common stock outstanding, 20,000 shares of convertible preferred, and no other potentially dilutive securities. Each share of preferred pays a dividend of $10 per share, and each is convertible into three shares of the company's common stock. What was the company's basic and diluted EPS?

If the 20,000 shares of convertible preferred had each converted into 3 shares of the company's common stock, the company would have had an additional 60,000 shares of common stock (3 shares of common for each of the 20,000 shares of preferred). If the conversion had taken place, the company would not have paid preferred dividends of $200,000 ($10 per share for each of the 20,000 shares of preferred). The effect of using the if-converted method would be EPS of $3.13, as shown in Exhibit 15. Because this is greater than the company's basic EPS of $3.10, the securities are said to be antidilutive and the effect of their conversion would not be included in diluted EPS. Diluted EPS would be the same as basic EPS (i.e., $3.10).

A Diluted EPS Calculation Using the If-Converted Method for Preferred Stock For the year ended 31 December 2009, Bright-Warm Utility Company had net income of $1,750,000. The company had an average of 500,000 shares of common stock outstanding, 20,000 shares of convertible preferred, and no other potentially dilutive securities. Each share of preferred pays a dividend of $10 per share, and each is convertible into five shares of the company's common stock. Calculate the company's basic and diluted EPS.

If the 20,000 shares of convertible preferred had each converted into 5 shares of the company's common stock, the company would have had an additional 100,000 shares of common stock (5 shares of common for each of the 20,000 shares of preferred). If the conversion had taken place, the company would not have paid preferred dividends of $200,000 ($10 per share for each of the 20,000 shares of preferred). As shown in Exhibit 12, the company's basic EPS was $3.10 and its diluted EPS was $2.92.

A Diluted EPS Calculation Using the If-Converted Method for Convertible Debt Oppnox Company reported net income of $750,000 for the year ended 31 December 2009. The company had a weighted average of 690,000 shares of common stock outstanding. In addition, the company has only one potentially dilutive security: $50,000 of 6 percent convertible bonds, convertible into a total of 10,000 shares. Assuming a tax rate of 30 percent, calculate Oppnox's basic and diluted EPS.

If the debt securities had been converted, the debt securities would no longer be outstanding and instead, an additional 10,000 shares of common stock would be outstanding. Also, if the debt securities had been converted, the company would not have paid interest of $3,000 on the convertible debt, so net income available to common shareholders would have increased by $2,100 [= $3,000(1 - 0.30)] on an after-tax basis. Exhibit 13 illustrates the calculation of diluted EPS using the if-converted method for convertible debt.

Diluted EPS for Options under IFRS Assuming the same facts as in Example 17, calculate the weighted average number of shares outstanding for diluted EPS under IFRS.

If the options had been exercised, the company would have received $1,050,000. If this amount had been received from the issuance of new shares at the average market price of $55 per share, the company would have issued 19,091 shares. IFRS refer to the 19,091 shares the company would have issued at market prices as the inferred shares. The number of shares issued under options (30,000) minus the number of inferred shares (19,091) equals 10,909. This amount is added to the weighted average number of shares outstanding of 800,000 to get diluted shares of 810,909. Note that this is the same result as that obtained under US GAAP; it is just derived in a different manner.

Expense Recognition: warranties

If the product proves deficient in some respect that is covered under the terms of the warranty, the company will incur an expense to repair or replace the product Under the matching principle, a company is required to estimate the amount of future expenses resulting from its warranties, to recognize an estimated warranty expense in the period of the sale, and to update the expense as indicated by experience over the life of the warranty

Revenue Recognition Accounting Standards Issued May 2014

Key aspects of standards: The core principle, the five steps in recognizing revenue, treatment of some related costs, and disclosure requirements.

Basic EPS formula

Net Income - Preferred Dividends / Weighted average number of share outstanding

Diluted EPS formula when a company has convertible preferred stock outstanding

Net Income / (Weighted average of number of share outstanding + New common shares that would have been issued at conversion)

Assume all facts from Part 3. In the beginning of year two, Builder Co. and Customer Co. agree to change the building floor plan and modify the contract. As a result the consideration will increase by $150,000, and the allowable time for achieving the bonus is extended by 6 months. Builder expects its costs will increase by $120,000. Also, given the additional 6 months to earn the completion bonus, Builder concludes that it now meets the criteria for including the $200,000 bonus in revenue. How should Builder account for this change in the contract?

Note that previous standards did not provide a general framework for contract modifications. The converged standard provides guidance on whether a change in a contract is a new contract or a modification of an existing contract. To be considered a new contract, the change would need to involve goods and services that are distinct from the goods and services already transferred. In this case, the change does not meet the criteria of a new contract and is therefore considered a modification of the existing contract, which requires the company to reflect the impact on a cumulative catch-up basis. Therefore, the company must update its transaction price and measure of progress. Builder's total revenue on the transaction (transaction price) is now $1.35 million ($1 million original plus the $150,000 new consideration plus $200,000 for the completion bonus). Builder Co.'s progress toward completion is now 51.2% ($420,000 costs incurred divided by total expected costs of $820,000). Based on the changes in the contract, the amount of additional revenue to be recognized is $91,200, calculated as (51.2% × $1.35 million) minus the $600,000 already recognized. The additional $91,200 of revenue would be recognized as a "cumulative catch-up adjustment" on the date of the contract modification

Example: The Installment and Cost Recovery Methods of Revenue Recognition Assume the total sales price and cost of a property are $2,000,000 and $1,100,000, respectively, so that the total profit to be recognized is $900,000. The amount of cash received by the seller as a down payment is $300,000, with the remainder of the sales price to be received over a 10-year period. It has been determined that there is significant doubt about the ability and commitment of the buyer to complete all payments. How much profit will be recognized attributable to the down payment if: 1.The installment method is used? 2.The cost recovery method is used?

Solution to 1: The installment method apportions the cash receipt between cost recovered and profit using the ratio of profit to sales value; here, this ratio equals $900,000/$2,000,000 = 0.45 or 45 percent. Therefore, the seller will recognize the following profit attributable to the down payment: 45 percent of $300,000 = $135,000. Solution to 2: Under the cost recovery method of revenue recognition, the company would not recognize any profit attributable to the down payment because the cash amounts paid by the buyer still do not exceed the cost of $1,100,000.

Gross versus Net Reporting of Revenues Flyalot has agreements with several major airlines to obtain airline tickets at reduced rates. The company pays only for tickets it sells to customers. In the most recent period, Flyalot sold airline tickets to customers over the internet for a total of $1.1 million. The cost of these tickets to Flyalot was $1 million. The company's direct selling costs were $2,000. Once the customers receive their ticket, the airline is responsible for providing all services associated with the customers' flights. 1.Demonstrate the reporting of revenues under: A.gross reporting. B.net reporting. 2.Determine and justify the appropriate method for reporting revenues.

Solution to 1: The table below shows how reporting would appear on a gross and a net basis: A. Gross Reporting Revenues $1,100,000 Cost of sales 1,002,000 Gross margin $ 98,000 B. Net Reporting Revenues $100,000 Cost of sales 2,000 Gross margin$ 98,000 Solution to 2: Flyalot should report revenue on a net basis. Flyalot pays only for tickets it sells to customers and thus does not bear inventory risk. In addition, the airline—not Flyalot—is the primary obligor under the contract. Revenues should be reported as $100,000.

For the calculation of diluted EPS using this method, the assumed exercise of these financial instruments would have the following effects:

The company is assumed to receive cash upon exercise and, in exchange, to issue shares. ◾The company is assumed to use the cash proceeds to repurchase shares at the weighted average market price during the period.

Revenue Recongition Accounting Standards Issued May 2014: Core Principle

The core principle of the converged standard is that revenue should be recognized to "depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods or services."

LIFO Method

The newest goods purchased (or manufactured) are assumed to be sold first and the oldest goods purchased are assumed to remain in inventory. Approved by US GAAP but not IFRS

FIFO Method

The oldest goods purchased (or manufactured) are assumed to be sold first and the newest goods purchased are assumed to remain in inventory. Approved by both IFRS and GAAP

straight-line method

allocates evenly the cost of long-lived assets less estimated residual value over the estimated useful life of an asset.

EX 10: Builder Co. enters into a contract with Customer Co. to construct a commercial building. Builder Co. identifies various goods and services to be provided, such as pre-construction engineering, construction of the building's individual components, plumbing, electrical wiring, and interior finishes. With respect to "Identifying the Performance Obligation," should Builder Co. treat each specific item as a separate performance obligation to which revenue should be allocated?

The standard provides two criteria, which must be met, to determine if a good or service is distinct for purposes of identifying performance obligations. First, the customer can benefit from the good or service either on its own or together with other readily available resources. Second, the seller's "promise to transfer the good or service to the customer is separately identifiable from other promises in the contract." In this example, the second criterion is not met because it is the building for which the customer has contracted, not the separate goods and services. The seller will integrate all the goods and services into a combined output and each specific item should not be treated as a distinct good or service but accounted for together as a single performance obligation.

EX: 8 Builder Co.'s contract with Customer Co. to construct the commercial building specifies consideration of $1 million. Builder Co.'s expected total costs are $700,000. The Builder incurs $420,000 in costs in the first year. Assuming that costs incurred provide an appropriate measure of progress toward completing the contract, how much revenue should Builder Co. recognize for the first year?

The standard states that for performance obligations satisfied over time, revenue is recognized over time by measuring progress toward satisfying the obligation. In this case, the Builder has incurred 60% of the total expected costs ($420,000/$700,000) and will thus recognize $600,000 (60% × $1 million) in revenue for the first year. This is the same amount of revenue that would be recognized using "percentage-of-completion," but that term is not used in the converged standard. Instead, the requirement is to measure progress toward complete satisfaction of the performance obligation.

Anti-dilutive securities

Their inclusion in the computation would result in an EPS higher than the company's basic EPS. Are not included in Diluted EPS for both IFRS and GAAP

Revenue Recognition for Long-Term Contracts: Outcome Cannot Be Reliably Measured Kolenda Technology Group has a contract to build a network for a customer for a total sales price of $10 million. This network will take an estimated three years to build, but considerable uncertainty surrounds total building costs because new technologies are involved. In other words, the outcome cannot be reliably measured, but it is probable that the costs up to the agreed upon price will be recovered. Assuming the following expenditures, how much revenue, expense (cost of construction), and income would the company recognize each year under IFRS and using the completed contract method under US GAAP? The amounts periodically billed to the customer and received from the customer are not necessarily equivalent to the amount of revenue being recognized in the period. For simplicity, assume Kolenda pays cash for all expenditures. 1.At the end of Year 1, Kolenda has spent $3 million. 2.At the end of Year 2, Kolenda has spent a total of $5.4 million. 3.At the end of Year 3, the contract is complete. Kolenda spent a total of $6 million.

Under IFRS, revenue may be recognized to the extent of contract costs incurred if the outcome of the contract cannot be measured reliably and it is probable that costs will be recovered. In this example, the outcome is uncertain but it is probable that Kolenda will recover the costs up to $10 million. Under US GAAP, the company would use the completed contract method. No revenue will be recognized until the contract is complete. Year 1. Under IFRS, Kolenda would recognize $3 million cost of construction, $3 million revenue, and thus $0 income. Under US GAAP, Kolenda would recognize $0 cost of construction, $0 revenue, and thus $0 income. The $3 million expenditure would be reported as an increase in the inventory account "construction in progress" and a decrease in cash. Year 2. Under IFRS, Kolenda would recognize $2.4 million cost of construction, $2.4 million revenue, and thus $0 income. Under US GAAP, Kolenda would recognize $0 cost of construction, $0 revenue, and thus $0 income. The $2.4 million expenditures would be reported as an increase in the inventory account "construction in progress" and a decrease in cash. Year 3. Under IFRS, Kolenda would recognize the $0.6 million cost of construction incurred in the period. Because the contract has been completed and the outcome is now measurable, the company would recognize the remaining $4.6 million revenue on the contract, and thus $4 million income. Under US GAAP, because the contract has been completed, Kolenda would recognize the total contract revenue (i.e., $10 million). Kolenda would recognize $6 million cost of construction and thus $4 million income. The inventory account "construction in progress" would be eliminated.

matching principle (Matching concept or matching costs with revenue)

Under matching, a company recognizes some expenses (e.g., cost of goods sold) when associated revenues are recognized and thus, expenses and revenues are matched. Associated revenues and expenses are those that result directly and jointly from the same transactions or events.

A Diluted EPS Calculation Using the Treasury Stock Method for Options Hihotech Company reported net income of $2.3 million for the year ended 30 June 2009 and had a weighted average of 800,000 common shares outstanding. At the beginning of the fiscal year, the company has outstanding 30,000 options with an exercise price of $35. No other potentially dilutive financial instruments are outstanding. Over the fiscal year, the company's market price has averaged $55 per share. Calculate the company's basic and diluted EPS.

Using the treasury stock method, we first calculate that the company would have received $1,050,000 ($35 for each of the 30,000 options exercised) if all the options had been exercised. The options would no longer be outstanding; instead, 30,000 shares of common stock would be outstanding. Under the treasury stock method, we assume that shares would be repurchased with the cash received upon exercise of the options. At an average market price of $55 per share, the $1,050,000 proceeds from option exercise, the company could have repurchased 19,091 shares. Therefore, the incremental number of shares issued is 10,909 (calculated as 30,000 minus 19,091). For the diluted EPS calculation, no change is made to the numerator. As shown in Exhibit 14, the company's basic EPS was $2.88 and the diluted EPS was $2.84.

discontinued operations

When a company disposes of or establishes a plan to dispose of one of its component operations and will have no further involvement in the operation, the income statement reports separately the effect of this as a "discontinued operation"

treasury stock method EPS

When a company has stock options, warrants, or their equivalent outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from exercise to repurchase as many shares of common stock as possible at the average market price of common stock during the period. The weighted average number of shares outstanding for diluted EPS is thus increased by the number of shares that would be issued upon exercise minus the number of shares that would have been purchased with the proceeds

unearned revenue

a liability. when the cash is initially received, and revenue would be recognized as being earned over time as products and services are delivered. An example would be a subscription payment received for a publication that is to be delivered periodically over time.

long-lived assets

are assets expected to provide economic benefits over a future period of time greater than one year. Examples are land (property), plant, equipment, and intangible assets (assets lacking physical substance) such as trademarks

US GAAP: Common stock or common shares IFRS: ordinary shares

are those equity shares that are subordinate to all other types of equity. The ordinary shareholders are basically the owners of the company—the equity holders who are paid last in a liquidation of the company and who benefit the most when the company does well

non-operating items

are typically reported separately from operating income because they are material and/or relevant to the understanding of the entity's financial performance

Diluted EPS is converted using IF-Converted Method

is based on what EPS would have been if the convertible preferred securities had been converted at the beginning of the period.

long-term contract

one that spans a number of accounting periods. Such contracts raise issues in determining when the earnings process has been completed and revenue recognition should occur.

Expenses

outflows, depletion of assets, and incurrences of liabilities in the course of the activities of a business.

depreciation

process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benefits. "Depreciation" is the term commonly applied to this process for physical long-lived assets such as plant and equipment (land is not depreciated)

revaluation model

reported at fair value. NOT allowed in US GAAP

Installment sales: IFRS

sales in which proceeds are to be paid in installments over an extended period. For installment sales, IFRS separate the installments into the sale price, which is the discounted present value of the installment payments, and an interest component. Revenue attributable to the sale price is recognized at the date of sale, and revenue attributable to the interest component is recognized over time

US GAAP specify that revenue should be recognized

when it is "realized or realizable and earned." -There is evidence of an arrangement between buyer and seller -The product has been delivered, or service has been rendered -The price is determined, or determinable -The seller is reasonably sure of collecting money

Installment Sales: US GAAP

when the seller has completed the significant activities in the earnings process and is either assured of collecting the selling price or able to estimate amounts that will not be collected, a sale of real estate is reported at the time of sale using the normal revenue recognition conditions. When those two conditions are not fully met, under US GAAP some of the profit is deferred.