Basic Accounting Theory 1
CPA review Accounting Basics Module 9
Terms in this set (192)
What is the basis for Financial Reporting in the USA?
US GAAP is the basis for Financial reporting but does not...
Constitute a cohesive body of accounting theory
Issued to provide a theoretical framework for accounting standard development and basis for financial reporting
ASC and where is it contained
Accounting Standards Codification is the single source for US GAAP.
Contained by FASB
this codification did not change GAAP but restructured the existing accounting standards providing a single cohesive set of accting standards
GAAP, Relevant literature issued by the SEC, FASB issues Accounting Standards Updates to Update the codification
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 practices (which GAAP describes or dictates)
GAAP does not constitute
a cohesive body of accounting theory
FASB issued concept statements to
develop a theoretical framework; has issued 8 concept statements to develop a frame of reference
Purpose is to set forth objectives and fundamental concepts that will be the basis for development of financial accounting and reporting guidance (SFAC 8)...SFAC attempt to organize a framework that can serve as a reference point in formulating financial accounting standards
Statement of Financial Accounting Concepts...these are produced by FASB
"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).
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 objectives underlie the other phases and are derived from the needs of those for whom financial information is intended.
Objectives of Financial Reporting.
Focus on users of financial information
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 ofthe public may use financial
information, they are not considered primary users according to SFAC 8.
Provide the BASIS
SFAC 8, Chapter 1, states that the objective of financial reporting is to provide
1] Information that is useful to potential and existing investors, lenders, and other creditors (primary users)
2] Information about the reporting entity's economic resources and claims against the reporting entity
3] Changes in economic resources and claims
4] Financial performance reflected by accrual accounting
5] Financial performance reflected by past cash flow
6] Changes in economic resources and claims not resulting from financial performance
Elements of financial statements are the components from which financial statements are created. They include (GAAP)
assets, liabilities, equity, investments by owners, distributions to owners, comprehensive income,
revenues, expenses, gains, and losses. (10) GAAP
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.
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.
(Info must have qualitative characteristics if that information is to fulfill the needs of the users)
Describe the Hierarchy of Accounting Qualities
The two fundamental qualitative characteristics of accounting information
are relevance and faithful representation.
Why is relevant information important
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.
Financial information is relevant
if it has predictive value, confirmatory value, or both
Predictive value requires that information be used to predict future outcomes. And is under Relevant Information on the Hierarchy of Accounting Qualities.
Confirmatory value requires that information either confirms or changes prior evaluations. And is under Relevant Information on the Hierarchy of Accounting Qualities.
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.
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.
Completeness requires that information is presented or depicted in a way that users can understand
the item being depicted.
Neutrality requires that the item is depicted without bias either favorably or unfavorably to users
Faithful Representation-Free From Error
Free from error means that there are no errors or omissions in the information reported.
The enhancing qualitative characteristics of accounting information
(Hierarchy of Accounting Qualities)
timeliness, and understandability.
enhancing qualitative characteristic-Comparability
Comparability enables users to identify and understand similarities and differences between items.
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
enhancing qualitative characteristic-Verifiability
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.
What are the two types of Verifiability
Direct verification occurs through direct observation;
Indirect verification occurs by using techniques such as checking formulas or recalculating amounts.
enhancing qualitative characteristic-Timeliness
Timeliness requires that information is available to a decision maker when it is useful to make the decision.
enhancing qualitative characteristic-Understandability
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
SFAC 6 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.
What are the Ten Basic Elements (SFAC 6)
assets, liabilities, equity, investments by
owners, distributions to.owners, comprehensive income, revenues, expenses, gains, and losses.
SFAC 6 Basic Elements of Financial Statements
Statement contains definitions of FS elements
Possessing characteristics of a definition of an element is necessary but
not sufficient condition for including an
item in FS
To qualify for inclusion in FS an item must
(1) Meet recognition criteria (e.g., revenue recognition tests)
(2) Possess a relevant attribute which can be measured reliably (e.g., historical cost/historical proceeds)
Remember when you recognize you journalize which means the information is then recorded in the FS
SFAC 6- ASSET
1. Assets are probable future economic benefits controlled by a particular entity as a result of past transactions or
a. Characteristics of assets
(1) Probable future benefit by contribution to future net cash inflows (Will provide benefits in the future)
(2) Entity can obtain and control access to benefit-(Control it today)
(3) Transaction or event leading to control has already occurred (Occurred as a result of a past transaction)
b. Asset continues as an asset until collected, transferred, used, or destroyed.
c. Valuation accounts are part of related asset.
SFAC 6- Liabilities
Liabilities are probable future sacrifices of economic benefits, arising from present obligations of a particular
entity that result from past transactions or events.
a. Characteristics of liabilities
(1) Legal, equitable, or constructive duty to transfer assets in future (Owe it today)
(2) Little or no discretion to avoid future sacrifice (you will sacrifice something in the future)
(3) Transaction or event obligating enterprise has already occurred (result of a past transaction)
b. Liability remains a liability until settled or discharged.
c. Valuation accounts are part of related liability.
SFAC 6- Equity
Equity is the owner's residual interest in the assets of an entity that remains after deducting liabilities.
a. Business enterprises
(1) Characteristics of equity
(a) The source of distributions by enterprise to its owners
(b) No unconditional right to receive future transfer
of assets; depends on future profitability
(c) Inevitably affected by enterprise's operations
and circumstances affecting enterprise
(2) Transactions or events that change owners' equity include revenues and expenses; gains and losses; investments by owners; distributions to owners; and changes within owners' equity (does not change total amount)
SFAC 6- Revenues
Revenues are increases in assets or decreases in liabilities during a period from delivering goods, rendering
services, or other activities constituting the entity's major or central operations.
a. Characteristics of revenues
(1) Accomplishments of the earning process
(2) Actual or expected cash inflows resulting from central operations (this is key)
(3) Inflows reported. gross
SFAC 6- Expenses
Expenses are decreases in assets or increases in liabilities during a period from delivery of goods, rendering of
services, or other activities constituting the entity's major or central operations.
a. Characteristics of expenses
(1) Sacrifices involved in carrying out earnings process
(2) Actual or expected cash outflows resulting from central operations (this is key)
(3) Outflows reported gross
SFAC 6- Gains or Loss
Gains (losses) are increases (decreases) in equity from peripheral transactions of entity excluding revenues
(expenses) and investment by owners (distribution to owners).
a. Characteristics of gains and losses
(1) Result from peripheral transactions and circumstances that may be beyond control (Key)
(2) May be classified according to sources or as operating and non operating
(3) Change in equity reported net
SFAC 6- Investments by Owners
Investments by owners are increases in net assets resulting from transfers by other entities of something of value
to obtain ownership.
SFAC 6- Distributions to owners
Distributions to owners are decreases in net assets resulting from transferring assets, rendering services, or
incurring liabilities by the enterprise to owners.
SFAC 6- Comprehensive Income
Comprehensive income is the change in equity of an entity during a period from transactions and other events of
non-owner sources (i.e., all equity amount changes except investment and distributions).
(all equity changes except investments by owners and distributions to owners)
(Changes in Share Holders Equity (SHE) from regular operations)
Economic Entity Assumption
Economic activity can be identified with a particular unit of accountability
Note: however you can define the entity at a higher level(parent) or lower level (subsidiary)
Going Concern Assumption
The business enterprise will have a long life. the going concern assumption does not apply if liquidation of the business appears to be imminent
Noe the fair value of an asset is irrelevant if we are going to concern and we need the asset in our operations; this is another reason to use historical cost instead of fair value
Monetary Unit Assumption
Money (USD) is the common denominator of economic activity and provides an appropriate basis for accounting measurement and analysis
The economic activity of an enterprise can be divided into artificial time periods. we report financial information periodically to apprise users of performance and economic status (intrim reporting)
Historical cost principle:
GAAP requires that most assets and liabilities be accounted for and reported on the basis of acquisition price because it is the most reliable valuation. Note there are exceptions (impairment, LCM)
Revenue Recognition Principle
Revenue is generally recognized
1. when it is realized or realizable
Revenue are considered earned when the entity has substantially accomplished what it mus do to be entitled to the benefits represented by the revenues
Recognition at the time of sale provides a reasonable test
Exceptions to this rule are
1. recognition during production (eg % complete accounting for construction
2. recognition upon receipt of cash (installment sales method or cost recovery method of accounting)
3. multiple deliverable revenue arrangements
4. milestone method of recognition on research and development contracts
Expenses are to be matched to the revenues whenever it is reasonable and practicable to do so (it is not revenues matched to expenses!!!!)
Full Disclosure Principle
Accountants use their judgement in deciding what gets reported on financial statements. if something does not appear on the statements then it may appear in the footnotes or in supplementary information
generally amplify or explain the items in the main body of the statements
contains other information that may be highly relevant but less reliable
what are the three constraints
Cost Benefit Relationship
Cost Benefit RElationship
Information is expensive. The cost of providing the information must not out weight the benefits that can be derived from using the information
An items is material if its inclusion or omission would influence or change the judgement of a reasonable person
when in doubt choose the solution that will be lease likely to overstate assets and income
Financial Accounting Concepts
the concept statements are not considered authoritative literature, and, therefore, are not included in the Accounting Standards Codification
Accounting Standards Codification
The single source for all US GAAP
SFAC 7 Cash Flow Information and Present Value
provides a framework for using future cash flows as the basis of an accounting measurement.
Applies to measurement at initial recognition, fresh start measurements, amortization techniques based on future cash flow
Does Not apply to measurement of cash or other assets paid or received, observation of fair values in the market
When you cant value it you use the pv of 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 un-discounted sum of those cash flows.
However does not prescribe when Fresh Start are appropriate
When to use PV (SFAC 7)
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.
1] 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.
2] 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
3] 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.
Assets with the same cash flows are distinguished from one another by the timing and uncertainty of
those cash flows.
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..
1] Present value helps to distinguish between cash flows that might otherwise appear similar.
2] 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.
Multiple-Deliverable Revenue Arrangements
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 for Multiple-Deliverable Revenue Arrangements
(1) The delivered item has value on a stand-alone basis (i.e., it can be sold separately by the vendor or customer)
(2) If the arrangement includes a right of return for the delivered item, the undelivered item must be substantially
in control of the vendor.
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.
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.
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.
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
(b) It relates solely to past performance.
(c) It is reasonable relative to all of the deliverables and payment terms.
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.
IFRS Vs GAAP
International Financial reporting standards committee
Major difference between IFRS and GAAP
(1) Vocabulary or definition differences. Although the concepts of US GAAP and IFRS may be similar,
vocabulary and definitions are often somewhat different.
(2) Recognition and measurement differences. Differences may exist in when and how an item is recognized
in the financial statements. Alternative methods may be acceptable in USGAAP whereas only one method
may be allowed for IFRS (or vice versa). In some instances, either IFRS or US GAAP may not require an
item to be recognized in the financial statements. In addition, the amount recognized (measurement of the
item) may be different in the two set of standards.
(3) Presentation and disclosure differences. Presentation refers to the presentation of items on the financial
statements, whereas disclosure refers to the additional information contained in the notes to financial statements.
Again, differences exist as to whether an item must be presented in the financial statements or disclosed
in the footnotes, as well as the types of information that must be disclosed.
Financial Statement Presentation GAAP VS IFRS
No specific requirement regarding comparative information.
Comprehensive income may be presented as a stand-alone
statement or at the bottom of the income statement and changes in equity may be presented in the notes.
Presentation of certain items as extraordinary is required.
Requires comparative information for prior year.
Requires a separate statement of comprehensive income and
statement of changes in equity.
Extraordinary items arc not allowed.
Revenue Recognition GAAP VS IFRS
Construction contracts are accounted for using the percentage-of completion method if certain criteria are met. Otherwise the completed-contract method is used.
Construction contracts are accounted for using the
percentage-of-completion method if certain criteria are met.
Otherwise, revenue recognition is limited to the costs incurred.
The completed-contract method is not allowed.
Consolidated Financial Statements GAAP VS IFRS
No exemption from consolidating subsidiaries in general-purpose
Non controlling interest measured at fair value.
Under certain restrictive situations a subsidiary (normally
required to be consolidated) may be exempt from the requirement.
Non Controlling interest may be measured either at fair value
or the proportionate share of the value of the identifiable assets and liabilities of the acquire,
Monetary Current ASsets and Current LIabilities GAAP VS IFRS
Short-term obligations expected to be refinanced can be classified as noncurrent if the entity has the intent and ability to refinance.
Contingencies that are probable and can be reasonably estimated are accrued.
Short-term obligations expected to be refinanced can be
classified as non current only if the entity has entered into an
agreement to refinance prior to the balance sheet date.
Contingencies that are probable and measurable are considered provisions and accrued.
Inventory GAAP VS IFRS
LIFO cost flow assumption is an acceptable method.
Inventories are valued at lower of cost of market (between a floor
and a ceiling). Any impairment write-downs create a new cost basis; previously recognized impairment losses are not reversed.
The LIFO cost now assumption is not allowed.
Inventories are valued at lower of cost or net realizable
Previously recognized impairment losses are reversed.
Fixed Assets GAAP VS IFRS
No separate accounting for investment property,
Unless the assets are "held for sale" they are valued using the cost model.
Biological assets are not a separate category.
There is no requirement to account for separate components of an asset.
Impairment losses are not reversed.
Revaluation of assets is permitted as an election for an
entire class of assets but must be done consistently.
Separate accounting is prescribed for investment property
versus property, plant, and equipment.
Investment property may be measured at fair value.
Biological assets are a separate category and not included in
property, plant, and equipment.
If the major components of an.asset have significantly
different patterns of consumption or economic benefits, the entity must allocate the costs to the major components and
depreciate them separately.
Impairment losses may be reversed in future periods.
Financial Investments GAAP VS IFRS
Compound (hybrid) financial instruments are not split into debt and equity components unless certain requirements are met, but they may be bifurcated into debt and derivative components.
Declines in fair value below cost may result in impairment loss solely based on a change in interest rate unless entity has the ability andintent to hold the debt till maturity.
When impairment is recognized through the income statement, a new cost basis is established and such losses cannot be reversed. Unless the fair value option is elected. loans and receivables are
classified as either (1) held for investment which is measured at amortized cost, or (2) held for sale, which is measured at lower of cost or fair value.
Compound financial interests (e.g., convertible bonds) are
split into debt, equity and, if applicable, derivative components.
Generally, only evidence of a credit default results in
impairment loss for an available-for-sale debt instrument.
Impairment losses in available-for-sale investments may be
reversed in future periods.
Loans and receivables are measured at amortized cost unless classified into the Fair Value Through Profit or Loss
category or the Available-for-Sale category, both of which
are carried at fair value.
Leases GAAP VS IFRS
Operating leased assets are never recorded on the balance sheet.
A lease for land and building that transfers ownership to the lessee or contains a bargain purchase option would be classified as a
capital lease regardless of the relative value of the land. If the fair value of the.landat inception represents 25%or more of the total fair value, the lessee must consider the components separately when evaluating the lease,
Assets held by lessee under operating leases may be capitalized on the balance sheet if they meet certain requirements.
When land and buildings are leased, elements of the lease
are considered separately when evaluating the lease unless
the amount for the land element is immaterial
Income Taxes GAAP VS IFRS
Deferred tax assets are recognized in full but valuation allowances reduce them to the amount that is more likely than not to be realized.
Deferred tax assets are recognized only to the extent it is
probable that they will be realized.
IASB Framework for the Preparation and Presentation of Financial Statements
The IASB Framework for the Preparation and Presentation of Financial Statements establishes the underlying concepts for preparing financial statements.
The IASB Frame...vork is not considered an accounting standard and therefore does not override any accounting treatment required by the International Accounting Standards (lAS) or International Financial Reporting Standards (IFRS). The Framework exists to assist in the development of future international accounting standards and to assist prepares in accounting for topics that do not have guidance in an existing
Five elements of IASB
assets, liabilities, equity income expenses
An asset is a resource controlled by the entity as a result of past events-and from which future economic benefits are expected to flow to the entity
A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Income is 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.
Important includes REVENUES AND GAINS
Expenses are decreases in economic benefits during the accounting period in the form of l outflows or depletion of assets or incurrence of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants
Important includes EXPENSES and LOSSES
The IASB Framework provides for capital maintenance adjustments.
When assets or liabilities are revalued or restated, and there is a corresponding increase or decrease to equity, the definition of income or expense
may not be met.
Therefore, certain items may be included in equity as revaluation reserves.
The lASB Framework defines recognition
as the process of incorporating into the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition.
(a) The two criteria for recognition are
(1) it is probable that a future economic benefit will flow to the entity,
(2) the item has a cost or value that can be measured reliably.
The lASB Framework Outlines various bases of measurement
historical cost current cost, realizable (settlement) value
Current Cost IASB
Current cost is the amount of cash or cash equivalent that would be paid if the same or equivalent asset were acquired currently.
Realizable (Settlement) IASB
Realizable (settlement) value is the amount of cash that could be currently obtained by settling (e.g .. selling) the asset in an orderly disposal.
IRFS Revenue Recognition (5 Criteria)
(a) The significant risks and rewards of ownership of the goods are transferred to the buyer,
(b) The entity does not retain either a continuing managerial involvement or control over the goods,
(c) The amount of revenue can be measured reliably,
(d) It is probable that economic benefits will flow to the entity from the transaction, and
(e) The costs incurred can be measured reliably.
IRFS and Revenue Recognition for rendering services can be estimated reliably
IFRS does not allow Completed Contract method
IFRS If the outcomes cannot be estimated reliably
cost recovery method.
I] The cost recovery method recognizes revenue only to the extent that the expenses recognized are
IFRS does not allow the completed contract method
IFRS Barter Transaction
Barter transactions are not recognized if the exchanged goods are similar in nature and value. If the goods are dissimilar, revenue is recognized at fair value of the goods received. If the fair value of the goods received cannot be measured, revenue is recognized at the fair value of goods or services given up.
Interest income is recognized using the effective interest method. Royalties should be accrued as provided
for in the contractual agreement. Dividends should be recognized when the shareholder has a right to receive
the dividend payment
First Time Adoption of the IRFS
1. General Adoption
2. Business Combinations
(1) Generally the adoption involves restating assets, liabilities, and equity using IFRS principles.
-The "date of transition to IFRS" is defined as the beginning of the earliest period for which an entity presents full comparative information under IFRSs in its first IFRS financial statements. -The "first IFRS reporting period" is defined as the latest reporting period covered by an entity' s first lFRS financial statements.
(Important to know difference between date of transition and first reporting period)
(2) Business combinations. With respect to business combinations, the first-time adopter has the option of
retrospectively adopting IFRS 3 for all periods presented, or adjusting the assets and liabilities through retained
earnings in the period of adoption
(Important the adjustment through RE)
(3) Plant, property, and equipment. Unless an entity decides to use a fair value election, it will need to recalculate the life-to-date depreciation or amortization of any PPE or intangible assets under IFRS. This can be quite time-consuming. Alternatively, the entity may use various methods to determine the fair value of the assets and use those amounts as the deemed cost at the time of adoption. IFRS would then be used
going forward. ' The,fair value election may be applied on an individual item basis.
SFAC 5 Recognize Revenues
When realized or relizable (when related assets received or held are readily convertable to known amount of cash or claims to cash) and earned
SFAC 5 Recognize Gains
When realized or realizable
SFAC 5 Recognize Expenses
when economic benefits are consumed in revenue-earning activities or when future economic benefits are reduced ore eliminated.
SFAC 5 Recognize loss
when future economic benefits are reduced or eliminated
Recognition and measurement SFAC 5
Recognition principles establish criteria concerning when element should be included in the statements, while measurement principles govern the valuation of those elements
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.
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).
Three exeptions to Point of Sale revenue recognition
Net Relizable Value
Installment and cost recovery
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"
Period costs are not panicularly 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)
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.
Cash Basis Accounting
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.
Accrual-accrual-basis recognition precedes (leads to) cash receipt/expenditure
(I) Revenue-recognition of revenue earned, but not received
(2) Expense-recognition of expenseincurred, but not paid
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.
Cash to Accrual
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.
Cash Accounting is NOT GAAP
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
When converting from Cash to Accrual what relationship is important to keep in mind?
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.
Installment sales accounting can only be used where "collection of the sale price is not reasonably assured" (ASC Topic 605) (APB 10).
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.
(Selling items on credit, must be put in a provision for collectability)
When you do not know the collect-ability of these receivables you must use the installment method
Installment Sales Forumlas
Cash collection*installment gross profit%=Realized Income
Gross profit % =GP/Installment net sales
(GP=Installment net sales-Installment COGS)
End AR x Installment %GP= Deferred gp after income
Revenue is recognized as cash is received rather than point of sale
Gross profit is deferred to future periods and recognized proportionality to collections of receivables
Cost Recovery Method
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.
(recognize revenue after you collect the cost)
1. What are the Statements of Financial Accounting Concepts intended to establish?
a. Generally accepted accounting principles in financial reporting by business enterprises.
b. The meaning of "Present fairly in accordance with
generally accepted accounting principles."
c. The objectives and concepts for use in developing
standards of financial accounting and reporting,
d. The hierarchy of sources of generally accepted accounting principles.
1. (c) The Statements of Financial Accounting Concepts
(SFAC) were issued to establish a framework from
which financial accounting and reporting standards could be
developed. The SFAC provide the theory behind accounting
and reporting and provi~e guidance when no GAAP exists.
The SFAC are not included as GAAP,
2. According to the FASB conceptual framework, the
objectives of financial reporting for business enterprises are
a. Generally accepted accounting principles.
b. Reporting for regulators.
c. The need for conservatism.
d. The needs of the users of the information.
2. (d) Per SFAC 8, the objectives of financial reporting
focus on providing present.and potential investors and creditors with information useful in making investment decisions.Financial statement users do not have the authority to prescribe the data they desire. Therefore, they must rely on external financial reporting to satisfy their information needs,
and the objectives must be based on the needs of those users.
5. According to Statements of Financial Accounting Concepts,neutrality is an ingredient of
Faithful Representation Relevance
A Yes Yes
b Yes No
c No Yes
d No No
5. (b) SFAC 8 defines neutrality as the quality of information
which requires freedom from bias toward a predetermined result. Unbiased information would always be
more faithfully represented than biased information. Other
components of faithful representation include information to
be verifiable and free from error. Neutrality is not an ingredient
of relevance because relevance requires information to
have predictive value and confirmatory value, or both.
6. According to the FASH conceptual framework, which of the following is an enhancing quality that relates to both relevance and faithful representation?
b. Confirmatory value.
c. Predictive value.
d. Freedom from error.
6. (a) Per SFAC 8, comparability is an enhancing quality
official reporting which relates to both relevance and
faithful representation. Confirmatory value and predictive
value only relate to relevance. .Freedom from error only relatesto faithful representation.
12. What is the underlying concept that supports estimating a fixed asset impairment charge?
a. Substance over form.
d. Faithful representation.
12. (d) An estimate of an impairment charge to a fixed
asset can only be a faithful representation if the entity has
applied impairment rules properly, disclosed the process of
arriving at the impairment estimate and disclosed any
uncertainties that affect the impairment estimate. Assuming
the above IS true, and no other estimate is better than the
derived estimate, then the estimate is comprised of the best
available information. Therefore, it is a faithful representation.
16. According to the FASH conceptual framework, which of the following is an essential characteristic of an asset?
a. The claims to an asset's benefits are legally enforceable.
b. An asset is tangible.
c. An asset is obtained at a cost.
d. An asset provides future benefits.
16. (d) Per SFAC 6, the common quality shared by all
assets is "service potential" or "future economic benefit."
PerSFAC 6,assets commonly have other distinguishing
features, such as being legally enforceable, tangible or acquired at a cost. These features, however, are not essential
characteristics of assets.
9. Under FASB Statement of Financial Accounting Concepts 5, comprehensive income excludes changes in equity
resulting from which of the following? ,
a. Loss from discontinued operations.
b. Prior period error correction.
c. Dividends paid to stockholders.
d. Unrealized loss on securities classified as
9. (c) PerSFAC 6, comprehensive income includes all
chances in equity during a period except those resulting
from Investments by owners and distributions to owners.
dividends paid to stockholders is a change in equity resulting
from a distribution to owners, so it is excluded from
comprehensive income. Answers (a), (b), and (d) are all included in comprehensive income because they are chances
in equity, but are not investments by, or distributions to~
7. According to the FASB conceptual framework, the
process of reporting an item in the financial statements of an
7. (d) Per SFAC 5, recognition is the processofformally
recording or incorporating an item into the financial
statements as an asset, liability, revenue, expense, or the
like. According to SFAC 6, allocation is the process of assigning or distributing an amount according to a plan or
formula, matching is the simultaneous recognition of revenues
with expenses that are related directly or jointly to the
same transactions or events, and realization is the process of
converting noncash resources .and rights into money.
15. According to the FASB conceptual framework, an entity's revenue may result from
a. A decrease in an asset from primary operations.
b. An increase in an asset from incidental transactions.
c. An increase in a liability from incidental transactions.
d. A decrease in a liability from primary operations.
15. (d) Per SFAC 6. revenues are inflows of assets or
settlements of liabilities, or both, during a period as a result
of an entity's major or primary operations. Two essential
characteristics of revenues are that revenues (1) arise from a
company's primary earnings activities and (2) are recurring
or continuing in nature. Therefore, answer (d) is correct
because it meets the above criteria. Answers (b) and (c) are
incorrect because they result from incidental transactions.
Answer (a) is incorrect because a decrease of an asset is not
25. Which of the following accounting literature is not included in the FASB Accounting Standards Codification?
a. AICPA Statements of Position.
b. FASB Statements.
c. Accounting Research Bulletins.
d. Statements of Auditing Standards.
25. (d) The FASB Accounting Standards Codification
includes all previous level A-D GAAP. The Codification
includes the authoritative literature of the Financial
Accounting Standards Board, the Emerging Issues Task
Force Abstracts, Accounting Principles Board Opinions,
Accounting Research Bulletins, Accounting Interpretations,
AICPA Statements of Position, AICPA Audit and
Accounting Guides, and Practice Bulletins. The FASB
Accounting Standards Codification does not include the
AICPA Statements of Auditing Standards. The auditing
standards are included in the Professional Standards issued
by the AICPA.
19. Which of the following is not covered by SFAC 7, Using Cash Flow Information and Present Value in Accounting Measurements?
a. Measurements at initial recognition.
b. Interest method of amortization.
c. Expected cash flow approach.
d. Determining when fresh-start measurements are
19. (d) SFAC 7 provides a framework for using future
cash flows as the basis for accounting measurements at initial recognition or fresh-start measurements and for the interest method ofamortization. FASB limited SFAC 7 to
measurement issues (how to measure) and chose not to
address recognition questions (when to measure). SFAC 7
introduces the expected cash flow.approach, which differs
from the traditional approach by focusing on explicit assumptions about the range of possible estimated cash flows and their respective probabilities.
20. In calculating present value in a situation with a range of possible outcomes all discounted using the same interest rate, the expected present value would be
a. The most-likely outcome.
b. The maximum outcome.
c. The minimum outcome.
d. The sum of probability-weighted present values.
20. (d) The expected cash flow approach uses all expectations about possible cash flows in developing a measurement. rather than just the single most-likely cash flow. 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. Thus, the expected cash flow is likely to provide a better estimate offair
value than the minimum, most-likely, or maximum taken
alone. According to SFAC 7. expected present value refers
to the.sum of probability-weighted present values in a range
of estimated cash flows, all discounted using the same interest rate convention.
21. A cash flow of $200,000 may be received by Lydia Nickels, Inc. in one year, two years, or three years, with probabilities of 20%,50%, and 30%. respectively. The rate of interest on default risk-free investments is 5%. The present value factors are
PVof 1, at 5%, for I year is .95238
PY of 1, at 5%, for 2 veal's is .90703
PV of I, at 5%, for 3 years is .86384
What is the expected present value of Lydia Nickels' cash flow (in whole dollars)?
c. $ 90,703
d. $ 89,925
21~ (b) The computation of expected present value using
a single interest rate is as follows:
31. An analysis of Thrift Corp.'s unadjusted prepaid expense account at December 31,2010, revealed the following:
-An opening balance of $1500 for Thrift's comprehensive insurance policy. Thrift had paid an annual premium of $3,000 on July 1,2009.
-A $3,200 annual insurance premium payment made July 1, 2010.
-A $2,000 advance rental payment for a warehouse Thrift leased for one year beginning January 1,2011.
In its December 31, 2010 balance sheet, what amount should Thrift report as prepaid expenses?
31. (b) The opening balance in prepaid expenses
($1,500) results from a one-year insurance premium paid on
711/09. Since this policy would have expired by 6/30/10, no
part of the $1,500 is included in 12/31/10 prepaid expenses.
The insurance premium paid on 7/l/10 ($3,200) would be
partially expired (6/12) by 12/3]/1 O. The remainder (6/12 x $3,200 =$1.600) would be a prepaid expense at year-end.
The entire advance rental payment ($2,000) is a prepaid expense at 12131/10 because it applies to 2011. Therefore,
total 12/31/10 prepaid expenses are $3,600.
Prepaid insurance ($3,200 x 6/12) 1600
Prepaid rent 2000
Total prepaid expenses 36000
33. Aneen's Video Mart sells one- and two-year mail order subscriptions for its video-of-the-month business. Subscriptions are collected in advance and credited to sales. Analysis of the recorded sales activity revealed the following:
Sales 420,000 500,000
Less Cancellations 20,000 30,000
Net Sales 400,000 470,000
20 155,000 130,000
2011 125.000 200,000
Sum $400,000 $470,000
In Aneeri's December 31, 2010 balance sheet, the balance for unearned subscription revenue should be
33. (c) At 12131110,the liability account unearned subscription
revenue should have a balance which reflects all
unexpired subscriptions. Of the 2009 sales, $125,000 expires
during 2011 and would still be a liability at 12/31/10.
Of the 2010 sales, $340,000 ($200,000 + $140,000) expires
during 20 II and 2012; and therefore is a liability at
12/31/10. Therefore, the total liability is $465,000
($125,000 +$340,000). This amount would have to be removedfrom the sales account and recorded as a liability in a
12/31/10 adjusting entry.
34. Regal Department Store sells gift certificates, redeemable for store merchandise, that expire one year after their issuance. Regal has the following information pertaining to its gift certificates sales and redemptions:
Unredeemed at 12/31/09 75,000
2010 sales 250,000
2010 redemptions of prior year sales 25,000
2010 redemptions of current year sales 175,000
Regal's experience indicates that. I0% of gift certificates sold will not be redeemed. In its December 31,2010 balance sheet, what amount should Regal report as unearned revenue?
d. $ 50,000
34. (d) Regal's unredeemed gift certificates at 12131109
are $75.000. During 201 0, these certificates are either redeemed ($25,000) or expire by 12131/10 ($75,000 - $25,000
= $50,000). Therefore, none of the $75,000 affects the
12/31'110 unearned revenue amount. During 2010,
additional certificates totaling $250,000 were sold. Of this
amount, $225,000 is expected to be redeemed in the future
[$250,000 - (10% x $250,000)J. Since $175,000 of 2010
certificates were redeemed in 2010, 12/31/10 unearned
revenue is $50,000 ($225,000 - $175,000).
38. Decker Company assigns some of its patents to other enterprises under a variety of licensing agreements. In some instances advance royalties are received when the agreements are signed, and in others. royalties are remitted within sixty days after each license year-end. The following data
are included in Decker's December 31 balance sheet:
Royalties Receivable $90,000 85,000
Unearned Royalties $60,000 40,000
During 2010 Decker received royalty remittances of
$200,000. In its income statement for the year ended December 31, 2010, Decker should report royalty income of
b) The requirement is to calculate the amount of
royalty income to be recognized in 2010. Cash collected for
royalties totaled $200.000 in 2010. However, this amount
must be adjusted for changes in the related accounts. as follows:
2010 cash received 200000
Royalties receivable 12/31109 (90000)
Royaltiesreceivable 12/31/10 85000
Unearned royalties 12/31/09 60000
Unearned royalties 12/31/10 (40,000)
Royalty income 215,000
The beginning receivable balance ($90,000) is subtracted
because that portion of the cash collected was recognized as
revenue last year. The ending receivable balance ($85,000)
is added because that amount is 2010 revenue, even though
it has not yet been collected. The beginning balance of unearned royalties ($60,000) is added because that amount is
assumed to be earned during the year. Finally, the ending
balance or unearned royalties ($40.000) is subtracted since
this amount was-collected, but not earned as revenue. by
39. Cooke Company acquires patent rights from other enterprises and pays advance royalties in some cases, and in others, royalties are paid within ninety days after year-end.
The following data are included in Cooke's December 31 balance sheets:
Prepaid Royalties $55,000 45,000
Royalties Payable $80,000 75,000
During 2010 Cooke remitted royalties of $300,000. In its income statement for the year ended December 31, 2010, Cooke should report royalty expense of
(b) The requirement is to determine the amount of
royalty expense to be recognized in 2010. Cash paid for
royalties totaled $300,000 in 2010. However, this amount
must be adjusted for changes in the related accounts, as follows:
2010 cash paid 300000
Royalties payable 12/31/09 (80000)
Royalties payable 12/31110 75000
Prepaid royalties 12/31/09 55000
Prepaid royalties 12/31/10 (45000)
The beginning payable balance ($80,000) is subtracted because that portion of the cash paid was recognized as expense during the previous year. The ending payable balance ($75,000) is added because that amount has been accrued as 2010expense, even though it has not yetbeen paid. The beginning balance of prepaid royalties ($55.000) is added because that amount is assumed to have expired during the year. Finally, the ending balance of prepaid royalties .($45,000) is subtracted since this amount was paid, but not
incurred as an expense, by 12/31/2010
42. A retail store received cash and issued gift certificates that are redeemable in merchandise. The gift certificates lapse one year after they are issued. How would the deferred revenue account be affected by each of the following transactions?
Redemptions of Certificates Lapse of Certificate
A No Effect Decrease
b Decrease Decrease
c Decrease No effect
d No Effect No effect
42. (b) At the time the gift certificates were issued, the
following entry was made, reflecting the store's future obligation to honor the certificates:
Deferred revenue xx
Upon redemption of the certificates, the obligation recorded
in the deferred revenue account becomes satisfied and the
revenue is earned. Similarly, as the certificates expire, the
store is no longer under any obligation to honor the certificates
and the deferred revenue should be taken into income.
In both instances, the deferred revenue account must be reduced(debited) to reflect the earning of revenue. This is
done through the following entry:
Deffered Revenue xx
43. Jersey, Inc. is a retailer of home appliances and offers a service contract.on each appliance sold. Jersey sells appliances on installment contracts, but all service contracts must be paid in full at the time of sale. Collections received for service contracts should be recorded as an increase in a
a. Deferred revenue account.
B. Sales contracts receivable valuation account.
c. Stockholders' valuation account.
d. Service revenue account.
43. (a) The revenues from service contracts should be
recognized on a pro rata basis over the term of the contract.
This treatment allocates the contract revenues to the period(s) in which they are earned. Since the sale of a service contract does not culminate in the completion of the
earnings process (i.e .. does not represent the seller's
performance of the contract), payments received for such a
contract should be recorded initially in a.deferred revenue
44. Ward, a consultant, keeps her accounting records on a cash basis. During 2010, Ward collected $200,000 in fees from clients. At December 31,2009, Ward had accounts receivable $40,000 At December 31,2010, Ward had
accounts receivable of $60,000, and unearned fees of $5,000. On an accrual basis, what was Ward's service revenue for 2010
45. Zeta Co. reported sales revenue of $4,600,000 in its income statement for the year ended December 31, 2010.
Additional information is as follows:
Accounts receivable $1,000,000 1,300,000
Allowance for noncollectable (60,000) (110,000)
Zeta wrote off noncollectable accounts totaling $20,000 during 2010. Under the cash basis of accounting, Zeta would have reported 2010 sales of
46. Marr Corp. reported rental revenue of $2,210,000 in its cash basis federal income tax return for the year ended november 30,20.10. Additional information is as follows:
Rents receivables-November 30,2010 1,060,000
Rents receivable-November 30, 2009 800,000
Uncollectible rents written off during the 30,000
Under the accrual basis, Marr should report rental revenue of
54. Gant Co., which began operations on January 1,2010, appropriately uses the installment method of accounting. The following information pertains to Gant' s operations for the year 2010:
Installment sales 500,000
Regular sales 300,000
Cost of installment sales 250,000
Cost of regular sales 150,000
General and administrative expenses 50,000
Collections on installment sales 100,000
In its December 31, 2010 balance sheet, what amount should Gant report as deferred gross profit?
d.· $ 75,000
54. (b) Under the installment method, gross profit is
deferred at the time of sale and is recognized by applying the
gross profit rate to subsequent cash collections. At the time
(if sale, gross profit of $250,000 is deferred ($500,000 installment sales less 5250,000 cost of installment sales). The gross profit rate is 50% ($250,0007 $500.000). Since 2010 collections on installment sales were $100,000, gross profit of $50,000 (50% x $100,(00) is recognized in 2010. This
would decrease the deferred gross profit account to a
12/31/10 balance of $200,000 ($250,000 - $50,000). Note
that regular sales, cost of regular sales, and general and administrative expenses do not affect the deferred gross profit
56. Luge Co., which began operations on January 2. 2010, appropriately uses the installment sales method of accounting. The following information is available for 2011:
Installment accounts receivable, December
Deferred gross profit, December 31, 2011
(before recognition of realized gross
profit for 2011) 560,000
Gross profit on sales 40%
For the year ended December 31, 2011, cash collections and realized gross profit on sales should be
Cash Collections Realized Gross profit
A 400,000 320,000
b 400,000 240,000
c 600,000 320,000
d 600,000 240,000
56. (d) Under the installment sales method, gross profit
is deferred to future periods and is recognized proportionately
as cash is collected. To determine cash collections in
this case, first compute the 2011 installment sales by dividing
deferred gross profit by the gross profit percentage
($560,000 + 40% = $1,400,000). Then, the 12/31/11 installment accounts receivable is subtracted to determine cash collections ($1,400,000 - $800,000 = $600,000). Realized gross profit is then computed by multiplying cash
collections by the gross profit percentage ($600,000 x 40%
58. On December 31, 20ID, Mill Co. sold construction equipment to Drew, Inc. for $1,800,000. The equipment had a carrying amount of $1,200,000. Drew paid $300,000 cash on December 31, 2010, and signed a $1 ,500,000 note bearing.
interest.at 10%, payable in five annual installments of . $300,000. Mill appropriately accounts for the sale under the installment method, On December 31, 2011, Drew paid $300,000 principal and $150,000 interest. For the year ended December 31, 201 I, what total amount of revenue should Mill recognize from the construction equipment sale and financing?
58. (a) The equipment sale is accounted for using the
installment method. The gross profit percentage on the sale
is 33 1/3% ($600,000 profit +$1,800,000 selling price).
Since $300,000 of the sales price is collected in 2011, gross
profit of $100,000 is recognized (33 1/3% x $300,000). The
total revenue recognized is $250,000 ($100,000 gross profit
+$150,000 interest revenue).
60. For financial statement purposes, the installment
method of accounting may be used if the
a. Collection period extends over more than twelve
b. Installments are due in different years.
c. Ultimate amount collectible is indeterminate.
d. Percentage-of-completion method is inappropriate.
60. (c) The profit on a sale in the ordinary course of
business is considered to be realized at the time of sale unless it is uncertain whether the sale price will be collected.
The Board concluded that use of the installment method of
accounting is not acceptable unless this uncertainty exists,
Answers (a), (b), and (d)are incorrect because they do not
involve the element of uncertainty regarding the collectibility
of the sale price.
64. The following information pertains to a sale of real estate by Ryan Co. to Sud Co. on December 31, 2010:
Carrying Amount $2,000,000
Purchase Money Mortgage $2,700,000
The mortgage is payable in nine annual installments of $300,000 beginning December 31, 2011, plus interest of 10%. The December 3 J, 201 J, installment was paid as scheduled, together with interest of $270,000. Ryan uses the cost recovery method to account for the sale. What amount
of income should Ryan recognize in 2011 from the real estate sale and its financing?
64. (d) Under the cost recovery method no profit of
any type is recognized until the cumulative receipts
(principal and interest) exceed the cost of the asset sold.
This means that the entire gross profit ($3.000,000$
2,000,000 = $1,000,000) and the 2011 interest received
($270,000) will be deferred until cash collections exceed
$2.000,000. Therefore, no income is recognized in 2011.
66. According to the cost recovery method of accounting, gross profit on an installment sale is recognized in income
a. After cash collections equal to the cost of sales
have been received. .
b. In proportion to the cash collections.
c. On the date the final cash collection is received.
d. On the date of sale.
66. (a) Installment methods of recognizing revenue are
appropriate only when "collection of the sale price is not
reasonably assured." Under the cost recovery method, gross
profit is deferred and recognized only when the cumulative
receipts exceed the cost of the asset sold.
67. On December 31, 2010, Rice, Inc. authorized Grafto operate as a franchisee for an initial franchise fee of $150,00.Ofthis amount, $60,000 was received upon signing the agreement and the balance, represented by a note, is due in three annual payments of $30,000 each beginning
December 31, 2011. The present value on December 31,2010, of the three annual payments appropriately discounted is $72,000. According to the agreement, the nonrefundable down payment represents a fair measure of the services already performed by Rice; however, substantial
future services are required of Rice. Collectibility of the note is reasonably certain. In Rice's December 31,2010 balance sheet, unearned franchise fees from Grafs franchise should be reported as
c. $ 90,000
d. $ 72,000
67. (d) Franchise fee revenue is-recognized when all
material services have been substantially performed by the
franchiser. Substantial performance means the franchiser
has performed substantially all of required initial services
and has no remaining obligation to refund any cash received.
The $60,000 nonrefundable down payment applies to the
initial services already performed by Rice. Therefore, the
$60,000 may be recognized as revenue in 2010. The three
remaining $30,000 installments relate to substantial future
services to be performed by Rice. The present value of these
payments ($72,000) is recorded as unearned franchise fees
and recognized as revenue once substantial performance of
the future services has occurred.
71, Which of the following is one of the conditions that must exist for a company to recognize revenue on separate units under a multiple-deliverables arrangement?
a. The delivered item has value on a stand-alone basis and can be sold separately.
b. The delivered item is not returnable.
c. Collection has occurred for all of the separate
d. The separate units must be delivered within 90
days of the end of the accounting period.
71. (a) The requirement is to identify the condition that
must be met to apply separate accounting. For a multiple deliverables arrangement, 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, and (2) if
the arrangement includes a right of return for the delivered
item, the undelivered item must be substantially in the
control of the vendor. Therefore answer (a) is correct.
72. The milestone method of accounting may be used to recognize revenue for
a. Multiple-deliverable products or services.
b. Research and development arrangements.
c. Long-term construction contracts.
d. Franchise arrangements
72. (b) The requirement is to identify the subject matter
of milestone accounting. Answer (b) is correct because the
milestone method of.accounting may be used to recognize
revenue for research and development arrangements. Note
that the milestone method is an option, but it is not required.
73. The milestone method of revenue recognition provides that if a substantive milestone is achieved, what amount of revenue is recognized?
a. Revenue. is recognized up to the amount of cash
b. A provisions rata share of revenue based upon the percentage delivered to date.
c. Contingent revenue is recognized in its entirety.
d. A percentage of total revenue based on the separate units delivered.
73. (c) The requirement is to identify the amount of
revenue recognized under the milestone method. Answer (c)
is correct because contingent revenue may be recognized in
its entirety in the period the milestone is achieved.
76. According to the lASB Framework, the financial statement element that is defined 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; is
76. (b) The requirement is to identify the element that is
defined as increases in economic benefits in the form of
inflows or enhancements of assets or decreases of liabilities
that result in increases in equity other than those resulting
from contributions from equity participants. Answer (b) is
correct because the IASB Framework has five elements:
asset, liability, equity, income, and expense. The definition
given is that of.income. Note that income includes both
revenues and gains.
78. If the outcome of rendering services cannot be estimated reliably, IFRS requires the use of which revenue recognition method?
a. Percentage-of-completion method.
b. Completed contract method.
c. Cost recovery method.
d. Installment method.
78. (c) The requirement is to identify the revenue recognition
method that' must be used if the outcome of rendering
services cannot be estimated reliably. Answer (c) is correct
because if the outcome of rendering services cannot be
measured reliably, IFRS requires use of the cost recovery
method. Answer (a) is incorrect because the percentage-of completion method is used when reliable estimates can be
made. Answer (b) is incorrect because the completed contract method is not permissible under IFRS. Answer (d) is
incorrect because the installment method is a revenue recognition method used under US GAAP, not IFRS.
79. Which of the following is not one of the criteria for revenue recognition for sales of goods under IFRS?
a. The significant risks and rewards of ownership of
goods are transferred.
b. Payment has been received.
c. The entity does not retain either a continuing
managerial involvement or control over the goods.
d. The costs incurred can be measured reliably.
79. (b) The requirement is to identify the item that is not
one of the criteria for revenue recognition for sales of goods
under IFRS. Answer (b) is correct because it is not required
that payment has been received.
80. Upon first-time adoption ofIFRS, an entity may elect to use fair value as deemed cost for
a. Biological assets related to agricultural activity for
which there is no active market.
b. Intangible assets for which there is no active market.
c. Any individual item of property, plant, and equipment.
d.Financial liabilities that are not held for trading
80. (c) The requirement is to identify the assets for
which the entity may use fair value as deemed cost upon
adoption ofIFRS. Answer (c) is correct because the' entity
may use fair value as deemed cost for any individual item of
property plant and equipment
81. Under IFRS, which of the following is the first step within the hierarchy of guidance to which management refers, and whose applicability it considers, when selecting accounting policies?
a. Consider the most recent pronouncements of other standard-setting bodies to the extent they do not cnflictt with the lFRS or the IASB Framework.
b. Apply a standard from IFRS if it specifically relates to the transaction, other event, or condition.
c. Consider the applicability of the definitions, recognition criteria, and measurement concepts in the IASB Framework.
d. Apply the requirements in IFRS dealing with similar and related issues.
81. (b) The requirement is to identify the first step
within the hierarchy of guidance to which management refers
when selecting accounting policies. Answer (b) is correct
because the highest level in the hierarchy is an IFRS
standard applicable to the transaction. Answer (a), (c), and
(d) are incorrect because they all represent lower levels in
82. On July 1, year 2, a company decided to adopt IFRS. The company's first IFRS reporting period is as of and for the year ended December 31, year 2. The company will present one year of comparative information. What is the company's date of transition to IFRS?
a. January 1, year 1.
b. January 1, year 2.
c. July], year 2.
d. December 31, year 2.
82. (a) The requirement isto identify the transition date.
Answer (a) is correct because the "date of transition to
IFRS"is defined as the beginning of the earliest period for which an entity presents full comparative information under
83. How should a first-time adopter of lFRS recognize the adjustments required to present its opening IFRS statement
of financial position?
a. All of the adjustments should be recognized in
profit or loss.
b. Adjustments that are capital in nature should be
recognized in retained earnings and adjustments
that are revenue in nature should be recognized in
profit or loss.
c. Current adjustments should be recognized in profit or loss and noncurrent adjustments should be recognized
in retained earnings.
d. All of the adjustments should be recognized directly in retained earnings or, if appropriate, in
another category of equity.
83. (d) The requirement is to identify how adjustments
are reflected upon adoption of IFRS. Answer (d) is correct
because upon first-time adoption of IFRS, any adjustments
required to present the opening balances of the statement of
financial position should be recognized directly in retained
earnings or, if appropriate, in another category of equity.
3. According to the FASB conceptual framework, the
relevance of providing information in financial statements is subject to the constraint of '
d. Faithful representation.
3. (b) The FASB conceptual framework has identified
the cost-benefit constraint to the relevance of providing financial reports. Information is not disclosed if the costs of
disclosure outweigh the benefits of providing the information.
Comparability is an enhancing qualitative characteristic.
Reliability is no longer part of the conceptual framework
according to SFAC 8. Faithful representation is a
fundamental qualitative characteristic
4. The enhancing qualitative characteristics of financial reporting are
a. Relevance, reliability, and faithful representation.
b. Cost-benefit and materiality.
c. Comparability, verifiability, timeliness, and
d. Completeness, neutrality, and freedom from error.
4. ,(c) The enhancing qualitative characteristics of financial
reporting are comparability (including consistency),
verifiability, timeliness, and understandability. Answer (a)
is incorrect because relevance and faithful representation are
fundamental qualitative characteristics of financial information.
Reliability is no longer listed as a fundamental quality.
Answer (b) is incorrect because cost-benefit is a constraint,
and materiality is a threshold for reporting useful information.
Answer (d) is incorrect because completeness, neutrality,
and freedom from error are characteristics of faithful
representation, a fundamental qualitative characteristic.
8. Under FASB Statement of Financial Accounting Concepts 5, which of the following items would cause earnings to differ from comprehensive income for an enterprise in an industry not having specialized accounting principles'?
a. Unrealized loss on investments classified as
b.. Unrealized loss on investments classified as trading
c. Loss on exchange of similar assets.
d. Loss on exchange of dissimilar assets.
8. (a) Per SFAC 5, earnings and comprehensive income
have the same broad components-revenues, expenses,
gains, and losses-but are not the same because
certain classes of gains and losses are excluded from earnings. Changes in market values of investments in marketable equity securities classified as available-for-sale securities arc included in comprehensive income, but are excluded from earnings until realized. Answers (b). (c), and (d) are incorrect because they would be included in both earnings and comprehensive income. Note that unrealized gains and losses on marketable equity securities classified as trading securities are included in earnings. This treatment is in accordance with SFAS 115.
10. The fundamental qualitative characteristic of faithful representation has the components of
a. Predictive value and confirmatory value.
b. Comparability, consistency, and confirmatory
c. Understandability, predictive value, and reliability.
d. Completeness, neutrality, and freedom from error.
10. (d) The fundamental qualitative characteristic of
faithful. representation has the components of completeness,
neutrality, and freedom from error. Answer (a) is.incorrect
because predictive value and confirmatory value are the
components of relevance, Answer (b) is incorrect because
comparability and consistency are enhancing characteristics,
and confirmatory value is a component of relevance. Answer
(c) is incorrect, because understandability is an enhancing
characteristic, predictive value isa component of relevance,
and reliability is no longer a characteristic in the
11. According to the FASB conceptual framework, which of the following statements conforms to the,realization concept?
a. Equipment depreciation was assigned to a production department and then to product unit costs.
b. Depreciated equipment was sold in exchange for a note receivable.
c. Cash was collected on accounts receivable.
d. Product unit costs were assigned to cost of goods sold when the units were sold.
It. (b) According to SFAC 6, realization is the process
of converting noncash resources and rights into money
through the sale of assets for cash or claims to cash. When
equipment is sold for a note receivable, money is realized
since a note qualifies as a claim to cash. Answers (a) and (d)
relate to cost allocation. Answer (c) is incorrect because
accounts receivable represents a claim to cash. Realization
occurs at the time of sale rather than when cash is collected.
13. What is the concept that supports the issuance of interim reports?
d. Faithful representation.
13. (a) Relevant financial information is capable of
making a difference if it has predictive value, confirmatory,
value, or both. Predictive value requires information to be
used to predict future outcomes. Confirmatory value
requires that information either confirm or change prior
expectations. An interim report provides both predictive
value and confirmatory value because it provides a basis to
forecast future earnings and it provides feedback about prior
performance expectations. Therefore, interim reporting is
14. FASB's conceptual framework explains both financial and physical capital maintenance concepts. Which capital maintenance concept is applied to currently reported net income, and which is applied to comprehensive income?
reported net income Comprehensive income
a. Financial capital Physical capital
b. Physical capital Physical capital
c. Financial capital Financial capital
d. Physical capital Financial capital
14. (c) Per SFAC 6, the major difference between financial
and physical capital maintenance is related to the effects
of~rice c-hangeso~ assets held and liabilities owed during a
penod. The financial capital concept is applied in current
GAAP. Under this concept, the effects ofthe price changes
described above are considered "holding gains and losses."
and are included in computing retum on capital. Comptehensive
income, which is described in SFAC 5, is "the
~hange in eq~ity of a business enterprise during a period
from transactions and other events and circumstances from
nonowner sources." It is also a measure of return on financial
capital. The concept of physical capital maintenance
seeks to measure the effects of price changes that are not
currently captured under GAAP (e.g., replacement costs of nonmonetary. assets). Under this concept, holding gains and
losses are considered "capital maintenance adjustments"
which would be included directly' in equity and excluded
from return on capital.
17. According to the FASB conceptual framework, which of the following attributes would notbe used to measure inventory?
a. Historical cost.
b. Replacement cost.
c. Net realizable value.
d. Present value of future cash flows.
17. (d) Per SFAC 5, five different attributes are used to
measure assets and liabilities in present practice: historical
cost, current (replacement) cost, current market value net
realizable value•. and present value of future cash flows.
Three of these (historical cost, replacement cost, and net
realizable value) are used in measuring inventory at lower of
cost or market. Present value of future cash flows is not
used to measure inventory.
18. According to SFAC 7, Using Cash Flow Information and Present Value in Accounting Measurements, the most relevant measurement of an entity's liabilities at initial recognition and fresh-start measurements should always reflect
a. The expectations of the entity's management.
b. Historical cost.
c. The credit standing of the entity.
d. The single most-likely minimum or maximum possible amount.
18. (c) The most relevant measure of a liability always
reflects the credit standing of the entity obligated to pay,
according to SFAC 7. Those who hold the entity's obligations.
a~ assets j~corporate the entity's credit standing in determining the prices they are willing to pay..
24. On December 31, 20 10, Brooks Co. decided to end operations
and dispose of its assets within three months. At
December 31,2010, the net realizable value of the equipment was below historical cost. What is the appropriate measurement basis for equipment included in Brooks' December
31, 201 0 balance sheet?
a. Historical cost.
b. Current reproduction cost.
c. Net realizable value.
d. Current replacement cost.
24. (c) The Codification provides guidance on the
determination of gain or loss on disposal of a component of
a business. According to this guidance, such determination
should be based on estimates of the net realizable value of
the component. Since Brooks Co. plans to discontinue its
entire operations, the appropriate measurement basis for its
equipment is net realizable value. Historical cost and
current reproduction and replacement costs are not
appropriate measurement bases for assets once an entity has decided to discontinue its operations because these amounts do not reflect the entity's probable future benefit, which is a characteristic of assets per SFAC 6.
74, Which of the following organizations is responsible for
setting International Financial Reporting Standards?
a. Financial Accounting Standards Board.
b. International Accounting Standards Committee.
c. Financial Accounting Committee.
d. International Accounting Standards Board.
14. (d) The requirement is to identify the body that sets
international accounting standards. Answer (d) is correct
because the International Accounting Standards Board
ClASB)issues International Financial Reporting Standards
75. According to the lASB Frame work for the Preparation and Presentation of Financial Statements. the fundamental qualitative characteristic of relevance includes
a. Predictive value and feedback value.
b. Verifiability, neutrality. and representational faithfulness.
c. Predictive value and confirmatory value.
d. Comparability and timeliness.
75. (c) The requirement is to identify the qualitative
characteristics of relevance. Answer (c) is correct because
the lASB Framework provides that relevance includes the
qualities of predictive value and confirmatory value. Answer
(a) is incorrect because feedback value is not a characteristic
of relevance. Answer (b) is incorrect because
these qualities are the characteristics of reliability in FASB
Concept Statement 1, which is superseded by SFAC 8.
Answer (d) is incorrect because comparability and
timeliness are enhancing characteristics in the IASB
77. Ac~ording to the IASB Framework, the two criteria required for inccrporating items into the income statement or statement of financial position are that
77. (b)' The requirement is to identify the criteria under
IFRS that must be met for an item to be included in financial
statements. Answer (b) is correct because in order for an
item to be recognized in the financial statements, IFRS
requires that it meet the definition of an element and can be
SFAC 6 Financial capital maintenance concept vs. physical capital maintenance concept
(1) Financial capital maintenance-objective is to maintain purchasing power
(2) Physical capital maintenance-objective is to maintain operating capacity
Comprehensive income is return on what type of capital? Physical or Financial?
Concept of capital maintenance or recovery of cost is needed in order to
separate return on capital from return of capital.
SFAC Sis based on the concept of financial capital maintenance, Two basic concepts of capital maintenance can be used...
Financial and Physical
Can be used to separate return on capital (earnings) from return of capital (capital recovery)
One way "well-offness" can be measured is in terms oi financial capital. (SFAC 5)
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
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
physical capital is not GAAP
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.
What is the Financial capital and the Physical Capital
The financial capital concept would maintain that the finn 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.
SFAC 6 Transaction
Transaction--extemal event involving transfer of something of value between two or more entities
SFAC 6 Event
Event-a happening of consequence to an entity (internal or external)
SFAC 6 Circumstances
Circumstances-e-a set of conditions developed from events which may occur imperceptibly and create possibly
SFAC 6 Accrual Accounting
Accrual accounting-recording "cash consequence" transactions as they occur rather than with movement of
cash; deal s with process of cash movement instead of beginning or end of process (per SFAC I)
(1) Based on cash and credit transactions, exchanges, price changes, changes in form of assets and liabilities
SFAC 6 Accrual
Accrual-recognizing revenues and related asset increases and expenses and related liability increases as they
occur; expected future cash receipt or payment follows recognition of revenue (expense)
SFAC 6 Deferral
Deferral-recognizing liability for cash receipt with expected future revenue or recognizing asset for cash
payment with expected future expense; cash receipt (payment) precedes recognition ofrevenues (expenses)
SFAC 6 Allocation
Allocation-e-process of assigning or distributing an amount according to a plan or formula
(1) Includes amortization
SFAC 6 Amortization
Amortization-process of systematically reducing an amount by periodic payments or write-downs
SFAC 6 Realization
Realization-c-process of converting noncash resources and rights into money; refers to sales of assets for cash
or claims to cash
(1) Realized-s-identifies revenues or gains or losses on assets sold
(2) Unrealized-identifies revenues or gains or losses on assets unsold
SFAC 6 Recognition
Recognition-process of formally recording an item in financial statements
(1) Major differences between accrual and cash basis accounting is timing of recognition of income items
SFAC 6 Matching
Matching-simultaneous recognition of revenues with expenses which are related directly or jointly to the
same transaction or events
Statementof Earnings and Comprehensive Income SFAC 5
(1) Shows how the equity of an entity increased or decreased from all sources (other than from transactions
with owners) during period
(2) Item "earnings" is similar to present net income term but does not include certain accounting adjustments
recognized in current period (i.e., change in accounting principle).
(3) Earnings is a perfonnance measure concerned primarily with cash-to-cash cycles.
(4) Comprehensive income includes all recognized changes in equity except those from transactions with
owners (SFAC 6).
(5) The terms "gains" and "losses" are used for those items included in earnings.
(6) The terms "cumulative accounting adjustments" and "other nonowner changes in equity" are used for those
items excluded-from earnings but included in comprehensive income.
Earnings: what types of Gains and Losses are excluded
Changes in market values of investments in marketabel equity securities classified as available for sale securities are excluded from earnings until realized
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