Outlines of Accounting Pronouncements
As indicated previously, this manual consists of 14 modules designed to facilitate your study for the Financial Accounting and Reporting section of the Uniform CPA Examination. The table of contents at the right describes the content of each module.
Module 9: Basic Theory and Financial Reporting
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A. Basic Concepts
- Key Terms
- Multiple-Choice Questions (1-83)
- Multiple-Choice Answers
- Simulation Solutions
B. Error Correction
- Multiple-Choice Questions (1-29)
- Multiple-Choice Answers
- Simulation Solutions
C. Accounting Changes
- Key Terms
- Multiple-Choice Questions (1-29)
- Multiple-Choice Answers
- Simulation Solutions
D. Financial Statements
- Key Terms
- Multiple-Choice Questions (1-115)
- Multiple-Choice Answers
- Simulation Solutions
This module covers basic concepts such as the conceptual framework and revenue recognition, error correction such as counterbalancing and classification errors, accounting changes such as changes in principle and changes in estimates, and financial statements such as the income statement and balance sheet.
US GAAP is the basis for financial reporting but it does not constitute a cohesive body of accounting theory. Concept Statements were issued to provide a theoretical framework for accounting standard development and a basis for financial reporting.
As of July 1, 2009, the Accounting Standards Codification (ASC) became the single source for US GAAP. The relevant Accounting Standards Codification topic is indicated in the discussion with a cross-reference to the previous accounting literature (i.e., ARB, APB, SFAS, and SFAC). Appendix A of this text includes an outline of the pre-Codification standards with a cross reference to the appropriate Codification topics to help candidates transition to the FASB’s Accounting Standards Codification. Note these outlines appear in the following sequence: ARB, APB, SFAS, and SFAC. Turn to each outline as directed and study the outline while reviewing the related journal entries, computations, etc.
Read also about Threshold Capabilities
The AICPA began testing International Financial Reporting Standards (IFRS) on January 1, 2011. Coverage of international standards and outlines of the differences between US GAAP and IFRS are located at the end of each module.
A. Basic Concepts
Basic concepts include theory, income determination, accruals, deferrals, and revenue recognition.
1. Basic Accounting Theory
Effective July 1, 2009, the FASB’s Accounting Standards Codification became the single source of US GAAP for nongovernmental entities.
a. The Accounting Standards Codification (ASC) replaced all previously issued nonSEC accounting literature. The Codification did not change GAAP, but merely restructured the existing accounting standards to provide one cohesive set of accounting standards.
- Included in the Codification is all GAAP, as well as relevant literature issued by the SEC.
- The FASB issues Accounting Standards Updates (ASUs) to update the Codification.
NOTE: To help the CPA candidate transition to the Accounting Standards Codification, the Codification citation is shown first, and the cross-reference to previous GAAP citations are shown in parentheses.
b. Theory can be defined as a coherent set of hypothetical, conceptual, and pragmatic principles forming a general frame of reference for a field of inquiry; thus, accounting theory should be the basic principles of accounting rather than its practice (which GAAP describes or dictates).
Although GAAP is the current basis for financial reporting, it does not constitute a cohesive body of accounting theory. Generally, authoritative pronouncements have been the result of a problem-by-problem approach that have dealt with specific problems as they occur and are not predicated on an
underlying body of theory.
- Accounting has a definite need for conceptual theoretical structure if an authoritative body such as the FASB is to promulgate consistent standards.
- A body of accounting theory should be the foundation of the standard-setting process and should provide guidance where no authoritative GAAP exists.
- The FASB issued concept statements to develop a theoretical framework. As of December 2011, the FASB had issued eight concept statements to develop a frame of reference.
The purpose of the concept statements is “to set forth objectives and fundamental concepts that will be the basis for development of financial accounting and reporting guidance” (SFAC 8). In other words, the SFAC attempt to organize a framework that can serve as a reference point in formulating financial accounting standards. NOTE: The SFAC do not constitute authoritative GAAP and therefore are not part of the Codification.
Three concept statements have been superseded by other concept statements: SFAC 1 and SFAC 2 were superseded by SFAC 8, and SFAC 3 was superseded by SFAC 6. The remaining concept statements are as follows: SFAC 4, Objectives of Financial Reporting of Nonbusiness Organizations; SFAC 5, Recognition and Measurement in Financial Statements; SFAC 6, Elements of Financial Statements; SFAC 7, Using Cash Flow Information and Present Value in Accounting Measurements; and SFAC 8, Conceptual Framework for Financial Reporting.
SFAC 8 is the most recent attempt to develop accounting theory as a joint project between the FASB and the International Accounting Standards Board (IASB). 1] SFAC 8 contains two chapters of the revised conceptual framework and replaces SFACs 1 and 2.
Chapter 1, The Objective of General-Purpose Financial Reporting replaces SFAC 1.
Chapter 3, Qualitative Characteristics of Useful Financial Information, replaces SFAC 2.
As additional phases of the joint project between the FASB and the IASB are completed, the revised concept statements will be included as new
chapters to SFAC 8.
Financial Reporting. “The objective of general-purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity” (SFAC 8).
NOTE: Not all informational needs are met by accounting or financial reporting.
- The following diagram from SFAC 5 describes the information spectrum.
d. Components of the Conceptual Framework. The components of the conceptual framework for financial accounting and reporting include objectives, qualitative characteristics, elements, recognition, measurement, financial statements, earnings, funds flow, and liquidity.
The relationship between these components is illustrated in the following diagram from Financial Statements and Other Means of Financial Reporting, a FASB Invitation to Comment.
1. In the diagram below, components to the left are more basic and those to the right depend on components to their left. Components are closely related to those above or below them.
2. The most basic component of the conceptual framework is the objectives.
1.. The objectives underlie the other phases and are derived from the needs of those for whom financial information is intended.
2.. The objectives provide a focal point for financial reporting by identifying what types of information are relevant.
Conceptual Framework For Financial Accounting and Reporting
The qualitative characteristics also underlie most of the other phases.
- They are the criteria to be used in choosing and evaluating accounting and reporting policies.
d. Elements of financial statements are the components from which financial statements are created. They include assets, liabilities, equity,
investments by owners, distributions to owners, comprehensive income, revenues, expenses, gains, and losses.
e. In order to be included in financial statements, an element must meet criteria for recognition and possess an attribute which is relevant and can be reliably measured. (f) Finally, reporting and display considerations are concerned with what information should be provided, who should provide it, and where it should be displayed.
g. How the financial statements (financial position, earnings, and cash flow) are presented is the focal point of this part of the conceptual framework project.
2. Objectives of Financial Reporting. (See outline of SFAC 8, Chapter 1.) The objectives of general-purpose financial reporting focus on users of financial information.
a. The primary users of financial reporting are investors, lenders, and other creditors who must rely on reporting entities to provide information to them.
1. Although management is also interested in financial information, management does not rely on general-purpose reports because information can be obtained internally.
2. In addition, although other parties such as regulators and members of the public may use financial information, they are not considered primary users according to SFAC 8.
(b) SFAC 8, Chapter 1, states that the objective of financial reporting is to provide
- Information that is useful to potential and existing investors, lenders, and other creditors (primary users)
- Information about the reporting entity’s economic resources and claims against the reporting entity
- Changes in economic resources and claims
- Financial performance reflected by accrual accounting
- Financial performance reflected by past cash flow
- Changes in economic resources and claims not resulting from financial performance
Chapter 3.) The qualitative characteristics also underlie the conceptual framework, but in a different way. While the objectives provide an overall basis, the qualitative characteristics establish criteria for selecting and evaluating accounting alternatives which will meet the objectives. In other words, information must possess the qualitative characteristics if that information
is to fulfill the objectives.
(a) SFAC 8 views these characteristics as a hierarchy of accounting qualities, as represented in the diagram below.
1] The diagram below reveals many important relationships. At the top is the costbenefit constraint. If the benefits of information do not exceed the costs of providing that information, it would not be reported. At the bottom of the diagram is the materiality threshold. An item that is not material is not required to be disclosed. Although an item may possess the other qualitative characteristics for disclosure, it is not disclosed if it does not fall within the cost-benefit constraint or the materiality threshold.
A Hierarchy Of Accounting Qualities
The two fundamental qualitative characteristics of accounting information are relevance and faithful representation.
- Relevant information is capable of making a difference in a user’s decision. Financial information is relevant if it has predictive value, confirmatory value, or both.
a] Predictive value requires that information be used to predict future outcomes.
b] Confirmatory value requires that information either confirms or changes prior evaluations.
c] An item is material if omitting it or misstating it could influence a user’s decision. Therefore, the materiality threshold relates to the qualitative characteristic of relevance.
2. Information has the quality of faithful representation if the information depicts what it purports to represent. A faithful representation should be complete, neutral, and free from error.
a] Completeness requires that information is presented or depicted in a way that users can understand the item being depicted.
b] Neutrality requires that the item is depicted without bias either favorably or unfavorably to users.
c] Free from error means that there are no errors or omissions in the information reported.
(c) The enhancing qualitative characteristics of accounting information are comparability, verifiability, timeliness, and understandability.
1. Comparability enables users to identify and understand similarities and differences between items.
a] Consistency refers to the use of the same accounting methods in different periods. Consistency, therefore, helps achieve comparability because it helps the user make comparisons across different time periods.
2. Verifiability occurs when different sources reach consensus or agreement on an amount of representation of an item. Direct verification occurs through direct observation; indirect verification occurs by using techniques such as checking formulas or recalculating amounts. Although forward-looking information cannot be verified, the underlying assumptions, methods, facts, and circumstances can be disclosed to help users determine if the information is useful.
3. Timeliness requires that information is available to a decision maker when it is useful to make the decision.
4. Understandability involves classifying, characterizing, and presenting information clearly and concisely. Understandability assumes that a user has a reasonable knowledge of business and economic activities to comprehend financial reports.
4. Basic Elements
Elements of financial statements are the ten basic building blocks from which financial statements are constructed. These definitions are based upon the objectives of SFAC 8. They are intended to assure that users will receive decision-useful information about enterprise resources (assets), claims to those resources (liabilities and equity), and changes therein (the other seven elements). In order to be included in the statements, an item must qualify as an element, meet recognition criteria, and be measurable.
The meaning of financial statement elements depends on the conceptual view of earnings which is adopted. Two basic views are the asset-liability view and the revenueexpense view.
- Under the asset-liability view, earnings are measured by the change (other than investments or withdrawals) in the net economic resources of an enterprise during a period. Therefore, definitions of assets and liabilities are the key under this view, and definitions of revenues, expenses, gains, and losses are secondary and are based on assets and liabilities.
- The revenue-expense view holds that earnings are a measure of an enterprise’s effectiveness in using its inputs to obtain and sell outputs. Thus, definitions of revenues and expenses are basic to this view, and definitions of assets, liabilities, and other elements are derived from revenues and expenses.
- The definitions of all ten elements are contained in the outline of SFAC 6. Let us examine one definition in more detail.
“Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” This definition is based on the objectives and qualities of SFAC 8. The overall thrust of the objectives—predicting and evaluating future cash flows—is reflected in the phrase “probable future economic benefits.”
“Control by a particular entity” is crucial if reporting an item as an asset is to have decision usefulness (or relevance). The quality of reliability is assured by the phrase “as a result of past transactions.” Information is more verifiable, valid, and neutral (the components of reliability) if based on past transactions. A similar analysis can be applied to liabilities, equity, investments by owners, distributions to owners, comprehensive income, revenues, expenses, gains and losses. Read also which property classification would include tools
(c) SFAC 6 also defines some other concepts in addition to the ten elements. Especially important among these eleven additional concepts are accrual accounting, realization, recognition, and matching.
- Realization and recognition are addressed by the FASB in SFAC 5.
- The definition of accrual accounting is important because SFAC 8 stated that accrual accounting should be used since it provides a better indication of future cash flows than the cash basis. This is true because accrual accounting records transactions with cash consequences (involving future cash flows) as they occur, not when the cash actually moves.
- Matching is referred to in most accounting literature as a principle, or fundamental law, of accounting.
- Recognition and Measurement. (See outline of SFAC 5.)
Recognition principles establish criteria concerning when an element should be included in the statements, while measurement principles govern the valuation of those elements.
(a) SFAC 5 established four fundamental recognition criteria: definitions, measurability, relevance, and reliability. If an item meets the definition of an element, can be reliably measured, is capable of making a difference in user decisions, and is verifiable, neutral, and representationally faithful, it should be included in the financial statements.
(b) Five different attributes are used to measure assets and liabilities in present practice. These are discussed below in an excerpt from SFAC 5.
- Historical cost (historical proceeds). Property, plant, and equipment and most inventories are reported at their historical cost, which is the amount of cash, or its equivalent, paid to acquire an asset, commonly adjusted after acquisition for amortization or other allocations. Liabilities that involve obligations to provide goods or services to customers are generally reported at historical proceeds, which is the amount of cash, or its equivalent, received when the obligation was incurred and may be adjusted after acquisition for amortization or other allocations.
- Current cost. Some inventories are reported at their current (replacement) cost, which is the amount of cash, or its equivalent, that would have to be paid if the same or an equivalent asset were acquired currently.
- Current market value. Some investments in marketable securities are reported at their current market value, which is the amount of cash or its equivalent, that could be obtained by selling an asset in orderly liquidation. Current market value is also generally used for assets expected to be sold at prices lower than previous carrying amounts. Some liabilities that involve marketable commodities and securities, for example, the obligations of writers of options or sellers of common shares who do not own the underlying commodities or securities, are reported at current market value. Current market value is now referred to as fair value.
- Net realizable (settlement) value. Short-term receivables and some inventories are reported at their net realizable value, which is the nondiscounted amount of cash, or its equivalent, into which an asset is expected to be converted in due course of business less direct costs, if any, necessary to make that conversion. Liabilities that involve known or estimated amounts of money payable at unknown future dates, for example, trade payables or warranty obligations, generally are reported at their net settlement value, which is the nondiscounted amount of cash, or its equivalent, expected to be paid to liquidate an obligation in the due course of business, including direct costs, if any, necessary to make that payment.
- Present (or discounted) value of future cash flows. Long-term receivables are reported at their present or discounted value (discounted at the implicit or historical rate), which is the present value of future cash inflows into which an asset is expected to be converted in due course of business less present values of cash outflows necessary to obtain those inflows. Long-term payables are similarly reported at their present or discounted value (discounted at the implicit or historical rate), which is the present or discounted value of future cash outflows expected to be required to satisfy the liability in due course of business.
(c) SFAC 5 states that each of these attributes is appropriate in different situations and that all five attributes will continue to be used in the future.
(d) Similarly, SFAC 5 states that nominal units of money will continue to be the measurement unit. However, if inflation increases to a level where the FASB feels that financial statements become too distorted, another unit (such as units of constant purchasing power) could be adopted.
(e) SFAC 5 is based on the concept of financial capital maintenance. Two basic concepts of capital maintenance (financial and physical) can be used to separate return on capital (earnings) from return of capital (capital recovery). Remember, any capital which is “used up” during a period must be returned before earnings can be recognized. In other words, earnings is the amount an entity can distribute to its owners and be as well-off at the end of the year as at the beginning.
- One way “well-offness” can be measured is in terms of financial capital. This concept of capital maintenance holds that the capital to be maintained is measured by the amount of cash (possibly restated into constant dollars) invested by owners. Earnings may not be recognized until the dollar investment in net assets, measured in units of money or purchasing power, is returned. The financial capital maintenance concept is the traditional view which is reflected in most present financial statements.
- An alternative definition of “well-offness” is expressed in terms of physical capital. This concept holds that the capital to be maintained is the physical productive capacity of the enterprise. Earnings may not be recognized until the current replacement costs of assets with the same productive capabilities of the assets used up are returned. The physical capital maintenance concept supports current cost accounting. Again, the physical productive capacity may be measured in nominal or constant dollars.
Suppose an enterprise invests $10 in an inventory item. At year-end, the enterprise sells the item for $15. In order to replace the item at year-end, they would have to pay $12 rather than $10. To further simplify, assume the increase in replacement cost is due to specific price changes, and there is no general inflation. The financial capital concept would maintain that the firm is as well-off once the dollar investment ($10) is returned. At that point, the financial capital is maintained and the remaining $5 is a return on capital, or income. The physical capital concept maintains that the firm is not as well-off until the physical capacity (a similar inventory item) is returned. Therefore, the firm must reinvest $12 to be as well-off. Then physical capital is maintained, and only the remaining $3 is a return on capital or income.
(f) SFAC 5 also gives specific guidance as to recognition of revenues and gains, and expenses and losses, as indicated below.
- Recognize revenues when realized or realizable (when related assets received or held are readily convertible to known amounts of cash or claims to cash) and earned
- Recognize gains when realized or realizable
- Recognize expenses when economic benefits are consumed in revenue-earning activities, or when future economic benefits are reduced or eliminated
a. When economic benefits are consumed during a period, the expense may be recognized by matching (such as cost of goods sold), immediate recognition (such as selling and administrative salaries), or systematic and rational allocation (such as depreciation).
- Recognize losses when future economic benefits are reduced or eliminated
(g) Revenues, expenses, gains, and losses are used to compute earnings.
- Earnings is the extent to which revenues and gains associated with cash-to-cash cycles substantially completed during the period exceed expenses and losses directly or indirectly associated with those cycles.
- Earnings adjusted for cumulative accounting adjustments and other nonowner changes in equity (such as foreign currency translation adjustments) is comprehensive income.
a. Per SFAC 5, comprehensive income would reflect all changes in the equity of an entity during a period, except investments by owners and distributions to owners. However, accounting standards only go part way in implementing this concept.
Now Review Multiple-Choice Questions 1
(6) Cash Flow Information and Present Value. (See outline of SFAC 7.) As discussed earlier, the attributes most often used to measure assets and liabilities include observable marketplace-determined amounts. These observable marketplace amounts (such as current cost) are generally more reliable and are determined more efficiently than measurements which employ estimates of future cash flows. However, when observable amounts are unavailable, accountants often turn to estimated cash flows to determine the carrying amount of an asset or liability. Since those cash flows often occur in one or more future periods, questions arise regarding whether the accounting measurement should reflect the present value or the undiscounted sum of those cash flows.
(a) In February 2000, the FASB issued SFAC 7, Using Cash Flow Information and Present Value in Accounting Measurements.
1] SFAC 7 provides a framework for using future cash flows as the basis of an accounting measurement.
NOTE: SFAC 7 addresses measurement issues, not recognition questions.
- SFAC 7 does not specify when fresh-start measurements are appropriate. Fresh-start measurements are defined by the FASB as measurements in periods following initial recognition that establish a new carrying amount unrelated to previous amounts and accounting conventions.
- SFAC 7 applies only to measurements at initial recognition, fresh-start measurements, and amortization techniques based on future cash flows.
- SFAC 7 does not apply to measurements based on the amount of cash or other assets paid or received, or on observation of fair values in the marketplace.
a] If such observations or transactions are present, the measurement would be based on them, not on future cash flows. The marketplace assessment of present value is already embodied in the transaction price.
(b) The framework provides general principles governing the use of present value, especially when the amount of future cash flows, their timing, or both, are uncertain. The framework provided by SFAC 7 also describes the objective of present value in accounting measurements.
- The present value formula is a tool used to incorporate the time value of
money in a measurement. Thus, it is useful in financial reporting whenever an item is measured using estimated future cash flows.
- The FASB defines present value as the current measure of an estimated future cash inflow or outflow, discounted at an interest rate for the number of periods between today and the date of the estimated cash flow.
- The objective of using present value in an accounting measurement is to capture, to the extent possible, the economic difference between sets of future cash flows. (c) Assets with the same cash flows are distinguished from one another by the timing and uncertainty of those cash flows.
NOTE: Accounting measurement based on undiscounted cash flows would measure assets with the same cash flows at the same amount.
An asset with a contractual cash flow of $28,000 due in ten days would be equal to an asset with an expected cash flow of $28,000 due in ten years.
- Present value helps to distinguish between cash flows that might otherwise appear similar.
- A present value measurement that incorporates the uncertainty in estimated cash flows always provides more relevant information than a measurement based on the undiscounted sum of those cash flows, or a discounted measurement that ignores uncertainty.
(d) To provide relevant information for financial reporting, present value must represent some observable measurement attribute of assets or liabilities. This attribute is fair value. Fair value is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under market conditions.”
(e) The only objective of present value, when used in accounting measurements at initial recognition and fresh-start measurements, is to estimate fair value.
- In the absence of observed transaction prices, accounting measurements at initial recognition and fresh-start measurements should attempt to capture the elements that taken together would comprise a market price if one existed.
a] Marketplace participants attribute prices to assets and liabilities. In doing so they distinguish the risks and rewards of one asset or liability from those of another. An observed market price encompasses the consensus view of all marketplace participants about an asset’s or liability’s utility, future cash flows, the uncertainties surrounding those cash flows, and the amount that marketplace participants demand for bearing those uncertainties.
b] While the expectations of an entity’s management are often useful and informative in estimating asset and liability values, the marketplace is the final judge of asset and liability values. An entity is required to pay the market’s price when it acquires an asset or settles a liability in a current transaction, regardless of the intentions or expectations of the entity’s management. Therefore, for measurements at initial recognition or for fresh-start measurements, fair value provides the most complete and representationally faithful measurement of the economic characteristics of an asset or a liability.
(f) A present value measurement that is able to capture the economic differences between various assets and liabilities would include the following elements according to SFAC 7:
- An estimate of the future cash flow, or in more complex cases, series of future cash flows at different times.
- Expectations about possible variations in the amount or timing of those cash flows.
- The time value of money, represented by the risk-free rate of interest.
- The price for bearing the uncertainty inherent in the asset or liability.
- Other, sometimes unidentifiable factors, including illiquidity and market imperfections.
- SFAC 7 contrasts two approaches to computing present value. Either approach may be used to estimate the fair value of an asset or a liability, depending on the circumstances.
1] In the expected cash flow approach only the time value of money, represented by the risk-free rate of interest, is included in the discount rate; the other factors cause adjustments in arriving at risk-adjusted expected cash flows.
- In a traditional approach to present value, adjustments for factors  –  are embedded in the discount rate.
- While techniques used to estimate future cash flows and interest rates vary due to situational differences, certain general principles govern any application of present value techniques in measuring assets. These are discussed in the outline of SFAC 7.
Traditionally, accounting applications of present value have used a single set of estimated cash flows and a single interest rate, often described as “the rate commensurate with risk.”
The discount rate adjustment approach assumes that a single interest rate convention can reflect all of the expectations about future cash flows and the appropriate risk premium. While the traditional approach may be adequate for some simple measurements, the FASB found that it does not provide the tools needed to address more complex problems.
The expected cash flow (present value) approach was found to be a more effective measurement tool than the discount rate adjustment approach in many situations. The expected cash flow approach uses all expectations about possible cash flows instead of the single most-likely cash flow. The expected cash flow approach focuses on direct analysis of the cash flows in question and on explicit assumptions about the range of possible estimated cash flows and their respective probabilities.
A cash flow might be $100, $200, or $300 with probabilities of 10%, 60%, and 30%, respectively. The expected cash flow is $220 ($100 × .1) + ($200 × .6) + ($300 × .3) = $220. However, the traditional approach would choose $200 as the best estimate or most-likely amount. When the timing of cash flows is uncertain, the expected cash flow approach allows present value techniques to be utilized. The following example is from SFAC 7.
A cash flow of $1,000 may be received in one year, two years, or three years with probabilities of 10%, 60%, and 30%, respectively. Notice that the expected present value of $892.36 differs from the traditional notion of a best estimate of $902.73 (the 60% probability). The following shows the computation of expected present value:
a] An interest rate in a traditional present value computation is unable to reflect any uncertainties in the timing of cash flows.
b] By incorporating a range of possible outcomes (with their respective timing differences), the expected cash flow approach accommodates the use of present value techniques when the timing of cash flows is uncertain.
(j) An estimate of fair value should include an adjustment for risk.
1] The risk adjustment is the price that marketplace participants are able to receive for bearing the uncertainties in cash flows.
2] This assumes that the amount is identifiable, measurable, and significant.
3] Present value measurements occur under conditions of uncertainty. In SFAC 7, the te rm uncertainty refers to the fact that the cash flows used in a present value measurement are estimates, rather than known amounts. Uncertainty has accounting implications because it has economic consequences. Business and individuals routinely enter into transactions based on expectations about uncertain future events. The outcome of those events will place the entity in a financial position that may be better or worse than expected, but until the uncertainties are resolved, the entity is at risk.
4] In common usage, the word risk refers to any exposure to uncertainty in which that exposure has potential negative consequences. Risk is a relational concept. A particular risk can only be understood in context. In most situations, marketplace participants are said to be risk adverse. They prefer situations with less uncertainty relative to an expected outcome. Marketplace participants seek compensation for accepting uncertainty. This is referred to as a risk premium. They demand more compensation (a higher premium) to assume a liability with expected cash flows that are uncertain, than to assume a liability with cash flows of the same expected amount but no uncertainty. This phenomenon can be described with the financial axiom, “the greater the risk, the greater the return.” The objective of including uncertainty and risk in accounting measurements is to imitate, to the extent possible, the market’s behavior toward assets and liabilities with uncertain cash flows.
(k) If prices for an asset or liability or an essentially similar asset or liability can be observed in the marketplace, there is no need to use present value measurements. The marketplace assessment of present value is already embodied in the price. However, if observed prices are unavailable, present value measurements are often the best available technique with which to estimate what a price would be.
(l) The measurement of liabilities sometimes involves problems different from those encountered in the measurement of assets. Thus, measurement of liabilities may require different techniques in arriving at fair value. Liabilities can be held by individuals who sell their rights differently than they would sell other assets. Liabilities are sometimes settled through assumption by a third party. To estimate the liability’s fair value, accountants must estimate the price necessary to pay the third party to assume the liability.
1] The most relevant measure of a liability always reflects the credit standing of the entity obligated to pay. An entity’s credit standing affects the interest rate at which it borrows in the marketplace. The initial proceeds of a loan, therefore, always reflect the entity’s credit standing at that time. Likewise, the price at which others buy and sell the entity’s loan includes their assessment of the entity’s ability to repay. The failure to include changes in credit standing in the measurement of a liability ignores economic differences between liabilities.
(m) Present value techniques are also used in periodic reporting conventions knows
collectively as interest methods of allocation. Financial statements usually attempt to represent changes in assets and liabilities from one period to the next. In principle, the purpose of all accounting allocations is to report changes in the value, utility, or substance of assets and liabilities over time.
1] Accounting allocations attempt to relate the change in an asset or liability to some observable real-world phenomenon. An interest method of allocation relates changes in the reported amount with changes in the present value of a set of future cash inflows or outflows. However, allocation methods are only representations. They are not measurements of an asset or liability. The selection of a particular allocation method and the underlying assumptions always involves a degree of arbitrariness. As a result, no allocation method can be demonstrated to be superior to others in all circumstances. The FASB will continue to decide whether to require an interest method of allocation on a project-by-project basis. Refer to the outline of SFAC 7 for further information regarding the interest method of allocation.
Now Review Multiple-Choice Questions 18
2. Income Determination (See outlines of SFAC 5, 6, and 8.)
a. The primary objective of accounting is to measure income. Income is a measure of management’s efficiency in combining the factors of production into desired goods and services.
(1) Efficient firms with prospects of increased efficiency (higher profits) have greater access to financial capital and at lower costs. Their stock usually sells at a higher priceearnings ratio than the stock of a company with less enthusiastic prospects. The credit rating of the prospectively efficient company is probably higher than the prospectively less efficient company. Thus, the “cost of capital” will be lower for the company with the brighter outlook (i.e., lower stock dividend yield rates and/or lower interest rates).
b. The entire process of acquiring the factors of production, processing them, and selling the resulting goods and services produces revenue. The acquisition of raw materials is part of the revenue-producing process, as is providing warranty protection.
c. Under the accrual basis of accounting, revenue is generally recognized at the point of sale (ASC Topic 605) or as service is performed. The point of sale is when title passes: generally when seller ships (FOB shipping point) or when buyer receives (FOB destination).
(1) Three exceptions exist to the general revenue recognition rule: during production, at the point where production is complete, and at the point of cash collection. The table below compares the three exceptions with the general revenue recognition rule (point of sale).
(2) Under accrual accounting, expenses are recognized as related revenues are recognized, that is, (product) expenses are matched with revenues. Some (period) expenses, however, cannot be associated with particular revenues. These expenses are recognized as incurred.
(a) Product costs are those which can be associated with particular sales (e.g., cost of sales). Product costs attach to a unit of product and become an expense only when the unit to which they attach is sold. This is known as associating “cause and effect.”
(b) Period costs are not particularly or conveniently assignable to a product. They become expenses due to the passage of time by
1] Immediate recognition if the future benefit cannot be measured (e.g., advertising)
2] Systematic and rational allocation if benefits are produced in certain future periods (e.g., asset depreciation)
(c) Thus, income is the net effect of inflows of revenue and outflows of expense during a period of time. The period in which revenues and expenses are taken to the income statement (recognized) is determined by the above criteria.
(3) Cash basis accounting, in contrast to accrual basis accounting, recognizes income when cash is received and expenses when cash is disbursed. Cash basis accounting is subject to manipulation (i.e., cash receipts and expenses can be switched from one year to another by management). Another reason for adopting accrual basis accounting is that economic transactions have become more involved and multiperiod. An expenditure for a fixed asset may produce revenue for years and years.
Now Review Multiple-Choice Questions 26
3. Accruals and Deferrals
a. Accrual—accrual-basis recognition precedes (leads to) cash receipt/expenditure
(1) Revenue—recognition of revenue earned, but not received
(2) Expense—recognition of expense incurred, but not paid
b. Deferral—cash receipt/expenditure precedes (leads to) accrual-basis recognition
(1) Revenue—postponement of recognition of revenue; cash is received, but revenue is not earned
(2) Expense—postponement of recognition of expense; cash is paid, but expense is not incurred
(3) A deferral postpones recognition of revenue or expense by placing the amount in liability or asset accounts.
(4) Two methods are possible for deferring revenues and expenses depending on whether real or nominal accounts are originally used to record the cash transaction.
c. Entries are reversed for bookkeeping expediency. If accruals are reversed, the subsequent cash transaction is reflected in the associated nominal account. If accruals are not reversed, the subsequent cash transaction must be apportioned between a nominal and real account.
(earned in current period)
Revenue receivable (accrual at last year-end)
(1) Accruals do not have two methods, but can be complicated by failure to reverse adjusting entries (also true for deferrals initially recorded in nominal accounts).
4. Cash to Accrual
a. Many smaller companies use the cash basis of accounting, where revenues are recorded when cash is received and expenses are recorded when cash is paid (except for purchases of fixed assets, which are capitalized and depreciated). Often the accountant is called upon to convert cash basis accounting records to the accrual basis. This type of problem is also found on the CPA examination.
b. When making journal entries to adjust from the cash basis to the accrual basis, it is important to identify two types of amounts:
(1) The current balance in the given account (cash basis) and (2) The correct balance in the account (accrual basis).
(a) The journal entries must adjust the account balances from their current amounts to the correct amounts.
c. It is also important to understand relationships between balance sheet accounts and income statement accounts.
(1) When adjusting a balance sheet account from the cash basis to the accrual basis, the other half of the entry will generally be to the related income statement account. Thus, when adjusting accounts receivable, the related account is sales; for accounts payable, purchases; for prepaid rent, rent expense; and so on.
Assume a company adjusts to the accrual basis every 12/31; during the year,
they use the cash basis. The 12/31/10 balance in accounts receivable, after adjustment, is $17,000. During 2011, whenever cash is collected, the company debits cash and credits sales. Therefore, the 12/31/11 balance in accounts receivable before adjustment is still $17,000. Suppose the correct 12/31/11 balance in accounts receivable is $28,000. The necessary entry is
Accounts receivable 11,000
This entry not only corrects the accounts receivable account, but also increases sales since unrecorded receivables means that there are also unrecorded sales. On the other hand, suppose the correct 12/31/11 balance of accounts receivable is $12,500. The necessary entry is Sales
Sales is debited because during 2011, $4,500 more cash was collected on account than should be reported as sales. When cash is received on account the transaction is recorded as a credit to sales, not accounts receivable. This overstates the sales account.
Some problems do not require journal entries, but instead a computation of accrual amounts from cash basis amounts, as in the example below.
The rent expense can be computed using either T-accounts or a formula. T-accounts are shown below.
The use of a formula is illustrated next.
(2) Formulas for conversion of various income statement amounts from the cash basis to the accrual basis are summarized in the following equations. (a) Since the accrual-basis numbers can be derived with T-accounts, you should not have to memorize the formulas.
Now Review Multiple-Choice Questions 29
5. Installment Sales
a. Revenue is recognized as cash is collected. Thus, revenue recognition takes place at the point of cash collection rather than the point of sale. Installment sales accounting can only be used where “collection of the sale price is not reasonably assured” (ASC Topic 605) (APB 10).
b. Under the installment sales method, gross profit is deferred to future periods and recognized proportionately to collection of the receivables. Installment receivables and deferred gross profit accounts must be kept separate by year, because the gross profit rate usually varies from year to year.
c. Summary of accounts used in installment sales accounting BALANCE SHEET
Explanation of Journal Entries Made in Year Two
(A) To record installment sales
(B) To record cash collected from year one and year two installment receivables (C) To record cost of goods sold (perpetual or periodic)
(D) To close installment sales and cost of installment sales accounts (E) To remove gross profit realized through collections from the deferred gross profit account
(Gross profit rate for year one × Cash collections from year one receivables)
(Gross profit rate for year two × Cash collections from year two receivables) (F) To close realized gross profit at year-end
6. Cost Recovery Method
a. The cost recovery method is similar to the installment sales method in that gross profit on the sale is deferred. The difference is that no profit is recognized until the cumulative receipts exceed the cost of the asset sold.
In our installment sales example, the entire profit from year one sales ($75,000) would be recognized in year three. Profit on year three sales will be recognized in year four to the extent that in year four cash collections on year three sales exceed the $60,000 ($160,000 cost – $100,000 cash collected) unrecovered cost on year three sales.
b. If interest revenue was to be earned by the seller, it would likewise be deferred until the entire cost was recovered.
c. The cost recovery method is used when the uncertainty of collection is so great that even use of the installment method is precluded.
Now Review Multiple-Choice Questions 54
7. Franchise Agreements
a. ASC Topic 952 (SFAS 45—see outline) provides that the initial franchise fee be recognized as revenue by the franchiser only upon substantial performance of their initial service obligation.
b. The amount and timing of revenue recognized depends upon whether the contract contains bargain purchase agreements, tangible property, and whether the continuing franchise fees are reasonable in relation to future service obligations. c. Direct franchise costs are deferred until the related revenue is recognized. 8. Real Estate Transactions
a. Accounting treatment for real estate sales is provided by ASC Topics 360
and 976 (SFAS 66). Due to the variety of methods of financing real estate transactions, determining when the risks and rewards of ownership have been clearly transferred and when revenue should be recognized becomes very complex.
b. Profit from real estate sales may be recognized in full, provided the profit is determinable and the earnings process is virtually complete. Additionally, the following four criteria must be met to recognize profit in full at the point of sale: (1) A sale is consummated.
(2) The buyer’s initial and continuing investments are adequate to demonstrate a commitment to pay for the property.
(3) The seller’s receivable is not subject to future subordination. (4) The seller has transferred to the buyer the usual risks and rewards of ownership in a transaction that is, in substance, a sale and does not have a substantial continuing involvement in the property.
c. Depending on which combination of criteria is met, the real estate sales will be recorded using one of the following methods:
(2) Cost recovery.
(4) Reduced profit.
(6) Full accrual.
(a) The deposit and reduced profit methods require explanation. In accordance with the deposit method, payments received are recorded as a liability until the contract is canceled or a sale is achieved.
(b) Under the reduced profit method, the seller recognizes a portion of profit at the time of sale with the remaining portion recognized in future periods. Profit recognized at the time of sale is determined by calculating the present value of the buyer’s receivable and applying a formula. The reduced profit recognized at the time of sale is the gross profit less the present value of the receivable as determined above. The remaining profit is
recognized in future periods. See the outline of SFAS 66.
9. Multiple-Deliverable Revenue Arrangements
Another exception to the general revenue recognition principles is for multiple-deliverable revenue arrangements.
a. If an entity has revenue generating activities to provide multiple products or services at different times, the arrangement should be evaluated to determine if there are separate units being delivered. Two conditions must be met for an item to be considered a separate unit of accounting:
(1) The delivered item has value on a stand-alone basis (i.e., it can be sold separately by the vendor or customer) and
(2) If the arrangement includes a right of return for the delivered item, the undelivered item must be substantially in control of the vendor.
(3) If it meets both requirements, the revenue arrangement is divided into separate units based on the relative selling prices. Revenue recognition criteria are then applied to each of the separate units.
10. Research or Development Accounted for on the Milestone Basis a. The milestone method of accounting may be used in accounting for research and development arrangements in which revenue (payments) to the vendor is contingent on achieving one or more substantive milestones related to deliverables or units of accounting.
(1) A substantive milestone is an uncertain event that can only be achieved based on the vendor’s performance and
(a) It is commensurate with the vendor’s performance or enhancement of value resulting from the vendor’s performance.
(b) It relates solely to past performance.
(c) It is reasonable relative to all of the deliverables and payment terms.
(2) If all of these circumstances are met, the vendor may recognize the contingent revenue in its entirety in the period in which the milestone is achieved. b. The notes to the financial statements should disclose its accounting policy for the recognition of milestone payments. In addition the
following should be disclosed: (1) A description of the overall arrangement.
(2) A description of each milestone and related contingent consideration. (3) A determination of whether each milestone is considered substantive. (4) The factors considered in determining whether the milestones are substantive. (5) The amount of consideration recognized during the period for the milestone or milestones.
11. Software Revenue Recognition
a. Software products that require significant production, modification, or customization should be accounted for using ASC Topic 605 (ARB 45, Long-Term Construction-Type Contracts).
(1) Software products that are included with tangible products (i.e., hardware) and are required for the product’s functionality are excluded from these software revenue recognition rules.
b. Software products that do not require significant production, modification, or customization should recognize revenue when all of the following criteria are met: (1) Persuasive evidence of an arrangement exists.
(2) Delivery has occurred.
(3) Vendor’s fee is fixed or determinable.
(4) Collectibility is probable.
c. The portion of the fee allocated to an element should be recognized using the same list of criteria.
(1) Delivery of an element is considered not to have occurred if other elements essential to the functionality of it are undelivered.
(2) No portion of the fee meets the criterion of collectibility if the portion of the fee allocable to delivered elements is subject to forfeiture, refund, or other concession if undelivered elements are not delivered.
d. Arrangement that includes multiple elements should allocate the fee to the elements based on vendor-specific objective evidence of fair value, regardless of stated prices in a contract.
(1) Multiple elements
(a) Arrangements consisting of multiple software deliverables including 1]
3] Postcontract customer service (PCS).
5] Elements deliverable on a when-and-if-available basis.
(2) Vendor-specific objective evidence of fair value
(a) Limited to
1] Price charged when the same element is sold separately.
2] Price established by management if not sold separately yet. It should be probable that the price will not change before being sold separately. (b) Amount allocated to an undelivered element should not be adjusted. If it is probable that the amount allocated will result in a loss, ASC Topic 450, Contingencies (SFAS 5), should be followed.
(3) Insufficient vendor-specific objective evidence of fair value (a) Defer revenue until whichever one of the following occurs first: 1] Sufficient vendor-specific objective evidence does exist. 2] All elements have been delivered.
1] The PCS is the only undelivered element—recognize entire fee ratably. 2] Only undelivered element is services that don’t require significant production, modification, or customization—recognize the entire fee over the period in which the services will be performed.
3] Arrangement is a subscription in substance—recognize entire fee ratably. 4] Fee based on the number of copies.
e. Separate accounting for service element of an arrangement is required if both of following criteria met
(1) Services not essential to functionality of any other element of the transaction. (2) Services are described in the contract such that total price of the arrangement would be expected to vary as result of inclusion or exclusion of the services. 12. Sales Basis Criteria for Selected Transactions
a. Under GAAP, specific rules have been developed which are stated in the
form of conditions which must be met before it is acceptable to recognize profit from “a sale in
the ordinary course of business.” Unfortunately, these rules represent a patchwork set of criteria for applying the sales basis of revenue recognition. This patchwork set of criteria contains many inconsistencies either in the results obtained or in the rationale justifying the criteria.
b. The table below summarizes the criteria which have been devised for applying the sales basis to selected transactions involving the sale of assets. Recognition
Factors to be considered before
Conditions that cause recognition to be delayed
recognizing revenue on the sale basis beyond time of sale
• Whether economic substance of the
transaction is a sale or a financing
• Sale with a right of arrangement
• Determination of sales price
605 (SFAS 48)
• Probability of collection of sales price
• Seller’s future obligations
• Predictability of returns
• Product financing
• Whether risks and rewards of
ownership are transferred
Topic 470 (SFAS 49)
• Probability of collection
• Seller’s continued involvement
• Real estate sale/
• Whether economic substance of the
ASC Topics 360 and
transaction is a sale of real estate or
976 (SFAS 66)
another type of transaction such as a
• Sales price not fixed or determinable
• Payment excused until product is sold
• Payment excused if property stolen or damaged
• Buyer without separate economic substance
• Seller’s obligation to bring about resale of the property • Inability to predict future returns
• Agreement requires repurchase at specified prices or
provides compensation for losses
• Inadequate buyer investment in the property
• Seller’s continuing obligations, such as participation in future losses, responsibility to obtain financing,
construct buildings, or initiate or support operations
• Sales-type lease/
ASC Topic 840
• Transfer of benefits and risks of
• Probability of collection
• Predictability of future unreimbursable
• Inability to meet conditions specified above for real
• Inability to meet specified conditions (four criteria)
indicating transfer of benefits and risks of ownership
• Collectibility not predictable
• Uncertainty about future unreimbursable costs
• Sale of receivables
with recourse/ ASC
Topic 860 (SFAS
• Isolation of transferred assets
• Right to pledge or exchange
• Control of receivables
• Transferred assets can be reached by transferor or its
• Transferee’s inability to pledge or exchange
• Control of receivables not surrendered due to
repurchase or redemption agreement
Topic 845 (APB 29
and SFAS 153)
• Fair value not determinable
• Transaction has commercial substance • Exchange transaction to facilitate sales to customers • Transaction lacks commercial substance
• Substance of the transaction
• Portion of property leased back
Topic 840 (SFAS 13) • Length of leaseback period
• All sale-leaseback transactions are financing
transactions and not sales transactions unless
leaseback covers only a small part of the property or is
for a short period of time
SOURCE: Adapted from Henry R. Jaenicke, Survey of Present
Practices in Recognizing Revenues, Expenses, Gains, and
Losses, FASB, 1981.
13. Reporting Start-up Costs
ASC Topic 720-15 (Statement of Position (SOP) 98-5) provides the guidance for accounting for a company’s start-up costs. These costs include those incurred during the course of undertaking one-time activities related to opening a new facility, introducing a new product or service, conducting business in a new territory, conducting business with a new class of customer or beneficiary, initiating a new process in an existing facility, commencing some new operation, or organizing a new entity. ASC Topic 720-15 requires start-up costs to be expensed rather than capitalized.
Now Review Multiple-Choice Questions 67
14. Research Component—Accounting Standards Codification
a. Basic concepts are included in the Financial Accounting Concepts (SFACs). However, the concept statements are not considered authoritative literature, and, therefore, are not included in the Accounting Standards Codification (ASC). b. The Accounting Standards Codification database uses the following categories on the main menu: Presentation, Assets, Liabilities, Equity, Revenue, Expenses, Broad Transactions, Industry, and Master Glossary. Under each of these main categories are Topics. Topics are further divided into subtopics, sections, and subsections. c. Citations in this text for information on a certain topic are cited as ASC Topic XXX. Complete citations for a specific rule are referenced by topic-subtopic-sectionsubsection. An example of a full research citation is ASC 350-10-25-1. d. The following table lists the topical areas within the Codification.
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