Financial Accounting & Reporting 2 Financial Accounting

76 Pages·2008·0.59 MB·English

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1. Timing issues: Matching of revenue and expenses, correcting and adjusting accounts..............3
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2. Long-term construction contracts...................................................................................27 i
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3. Accounting for installment sales.....................................................................................34
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4. Accounting for nonmonetary exchanges..........................................................................37
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5. Partnerships...............................................................................................................41
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6. Financial reporting and changing prices...........................................................................49 A

7. Foreign currency accounting (SFAS 52)...........................................................................52
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8. Homework reading: Expanded examples of exchanges lacking commercial substance............61 i
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9. Homework reading: Installment liquidation......................................................................64 n
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10. Homework reading: Personal financial statements............................................................67
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11. Class questions...........................................................................................................69 i
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F2-2
Becker CPA Review Financial Accounting & Reporting 2

TIMING ISSUES: MATCHING OF REVENUE AND EXPENSES,
CORRECTING AND ADJUSTING ACCOUNTS

I. TERMINOLOGY AND BASIC CONCEPTS
A. ASSETS
Assets are probable future economic benefits that are obtained or controlled by a particular
entity as a result of past events or transactions.
1. Event
An event is something that happens to an entity, and it can occur either externally or
internally.
2. Transaction
A transaction is an event that occurs external to the entity and typically involves a
transfer of value from one entity (or entities) to another.
B. LIABILITIES
Liabilities are probable future sacrifices of economic benefits that an entity faces for
obligations to provide services or transfer assets due to past events or transactions.
C. REVENUES
Revenues are increases of assets or reductions of liabilities (and possibly both) during a
period of time. They stem from the rendering of services, delivering of goods, or any other
activities that may constitute the major ongoing or central operations of an entity.
1. Revenue is Recognized When a "Sale" Takes Place
a. Requirements
Revenue should be recognized when it is realized (or realizable) and when it is
earned.
(1) All four criteria must be met for each element of the contract before any
revenue can be recognized:
(a) Persuasive evidence of an arrangement exists,
(b) Delivery has occurred or services have been rendered,
(c) The price is fixed and determinable, and
(d) Collection is reasonably assured.
(2) Revenue from the sales of products or the disposal of other assets is
recognized on the date of sale of the product or other asset (i.e., the
delivery date).
Generally, the following criteria apply for a sale (exchange) to take place:
(a) Delivery of goods or setting aside goods ordered (which would result
in a simultaneous recognition of revenue and expense), and/or
(b) Transfer of legal title.
(3) Revenue that stems from allowing others the use of the entity's assets
(e.g., interest revenue, royalty revenue, and rental revenue) is recognized
when the assets are used (i.e., as the time passes).
(4) Revenue from the performance of services is recognized in the period the
services have been rendered and are able to be billed by the entity.
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Financial Accounting & Reporting 2 Becker CPA Review

b. Objectivity
The reason for waiting for the sale to take place is "objectivity," to minimize
tentativeness.
2. Exceptions and Other Special Accounting Treatments
a. Deferred Credits
Certain revenue items are "deferred credits" (unearned revenue) when cash is
received in advance. They are recognized as income through the passage of
time. For example:
(1) Prepaid interest income
(2) Prepaid rental income
(3) Prepaid royalty income
b. Installment Sales (not GAAP)
Revenue is recognized as collections are made. It is used when ultimate
realization of collection is in doubt. (Discussed later in this chapter.)
c. Cost Recovery Method (not GAAP)
No profit is recognized on a sale until all costs have been recovered. (Discussed
later in this chapter.)
d. Nonmonetary Exchanges
The recognition of revenue depends upon the type of exchange. (Discussed
later in this chapter.)
e. Involuntary Conversions
The involuntary conversion due to fire, theft, etc., of a nonmonetary asset to cash
would result in a gain or loss for financial accounting purposes. (Discussed later
in this chapter.)
f. Net Method of Accounting for Trade (Sales) Discounts
Sales are recorded net of any discounts; therefore, accounts receivable at year-
end does not include the discount offered. If the discount is not earned, the
sales discount amount is recorded as "other income," and cash or accounts
receivable is debited at that time (discussed in detail in F4).
g. Percentage-of-Completion Contract Accounting
Revenue is recognized as "production takes place" for long-term construction
contracts having costs that can be reasonably estimated. If costs cannot be
reasonably estimated, then the "completed contract method" must be used.
(Discussed later in this chapter.)
D. EXPENSES
Expenses are reductions of assets or increases of liabilities (and possibly both) during a
period of time. They stem from the rendering of services, delivering of goods, or any other
activities that may constitute the major ongoing or central operations of an entity.
Expenses should be recognized according to the matching principle (see later in this lecture)
utilizing association of cause and effect, systematic and rational approach, or expense when
no future benefit can be measured.
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Becker CPA Review Financial Accounting & Reporting 2

E. REALIZATION
Realization occurs when the entity obtains cash or the right to receive cash (i.e., from the
sale of assets) or has converted a noncash resource into cash.
F. RECOGNITION
Recognition is the actual recording of transactions and events in the financial statements.
G. MATCHING
One of the most important principles in financial accounting is the matching principle, which
indicates that expense must be recognized in the same period in which the related revenue is
recognized (when it is practicable to do so). Matching of revenues and costs is the
simultaneous or combined recognition of the revenues and expenses that results directly and
jointly from the same transactions or events.
For those expenses that do not have a cause and effect relationship to revenue, another
systematic and rational approach to expense recognition should be used (e.g., amortization
and depreciation of long-lived assets and the immediate expensing of certain administrative
costs, referred to as period costs (e.g., no future benefit)).
H. ACCRUAL
Accrual accounting is required by GAAP and is the process of employing the matching
principle to the recognition of revenues and expenses. It records the transactions and events
as they occur, not when the cash is received or expended. Accrual accounting recognizes
revenue when it is earned and expenses when the obligation is incurred (i.e., typically when
the expenses relate to the earned revenue).
I. DEFERRAL
Deferral of revenues or expenses will occur when cash is received or expended but is not
recognizable for financial statement purposes. Deferral typically results in the recognition of
a liability or a prepaid expense.
J. ACCRUED ASSETS AND LIABILITIES
1. Accrued Assets (or Accrued Revenues)
The recognition of an accrued asset (e.g., interest receivable) represents revenue
recognized or earned through the passage of time (or other criteria) but not yet paid to
the entity.
2. Accrued Liabilities (or Accrued Expenses)
Accrued liabilities and the related recognition of expense represent ACCRUED
expenses recognized or incurred through the passage of time (or other LIABILITY
criteria) but not yet paid by the entity (e.g., accrued interest payable,
accrued wages, etc.).
3. Estimated Liabilities
ESTIMATED
Estimated liabilities represent the recognition of probable future charges LIABILITIES
that result from a prior act (e.g., the estimated liability for warranties, OR
CONTINGENCIES
trading stamps, or coupons).
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Financial Accounting & Reporting 2 Becker CPA Review

K. COSTS MAY BE APPLICABLE TO PAST, PRESENT, OR FUTURE PERIODS
1. Expired Costs
Expired costs (expenses) are costs that expire during the period and have no future
benefit (e.g., the residual value or right to certain future revenues).
a. Insurance expense (e.g., the pro rata portion of a three year policy) is an indirect
expense and is systematically allocated to the period for which benefit is
received.
b. Costs of goods sold are directly allocated to the periods in which the sales take
place, which matches the cause and effect of the transaction.
c. Period costs are costs expiring in the period incurred (e.g., selling, general, and
administrative expenses).
2. Unexpired Costs
Unexpired costs (e.g., fixed assets and inventory) should be capitalized and matched
against future revenues. If future revenues are not certain or there is no residual value,
then those costs should be expensed as expired costs.
L. PREPAID EXPENSES (CURRENT ASSETS)
1. Residual Value
Prepaid expenses relate to expenditures with a residual value (e.g., prepaid insurance
with a cancellation value).
2. Future Right to Services
Prepaid expenses may also occur where there exists a future right to services (e.g., a
service contract with no cancellation value).
M. DEFERRED CHARGES
1. Not Charges to a Tangible Asset
Deferred charges result from expenditures or accruals that cannot be charged to a
tangible asset, but that do pertain to future operations (e.g., bond issue costs).
2. Intangible Assets and Non-Current Prepaid Items
Deferred charges may include intangible assets (covered later in this lecture) and non-
current prepaid items.
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Becker CPA Review Financial Accounting & Reporting 2

II. REVENUE RECOGNITION (MEASUREMENT): DEFERRED CREDITS (DEFERRED INCOME OR
UNEARNED REVENUE)
A. BASICS
1. Deferred credits represent future income contracted for and/or collected in advance
(e.g., rental income, gift certificates, and magazine subscriptions
REVENUE
collected in advance).
OR
2. Deferred credits have not yet been earned by the passing of time or other REVENUE
RECOGNITION
criteria.
3. Deferred credits are located in the liability section of the balance sheet, just above
Shareholders' Equity.
B. ROYALTY INCOME
Royalty revenue is recognized when earned. Royalty revenues can be earned in a variety of
ways (e.g., royalties received on patents sold or royalties received from publications sold). In
the latter case, a company usually earns royalties based on a stated percentage of sales.
Reporting royalty revenue requires accrual of the provision for revenues based on estimated
sales.

Accrual of Royalty Revenue
TAG Company wrote a textbook and sold it to Fox Company for royalties of 25% of sales. Royalties
are payable semiannually on April 30 (for July through December sales of the previous year) and on
October 31 (for January through June sales of the same year). During Year 8 and Year 9, TAG
Company received the following checks from Fox Company:

E April 30 October 31
L
MP Year 8 $14,000 $17,000
A
X Year 9 $12,000 $15,000
E

TAG estimated that textbook sales would total $80,000 for the last half of Year 9. How much royalty
revenue should TAG Company report in its Year 9 income statement for the year ended December 31,
Year 9?

October 31, Year 9 check (for January 1 – June 30) $15,000
Earned July 1 through December 31, Year 9 (25% x $80,000) 20,000
Royalty revenue for Year 9 $35,000

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Financial Accounting & Reporting 2 Becker CPA Review

Royalties Received in Advance
TAG Company receives royalties on its patents in two ways. In some cases, advance royalties are
received and in other cases royalties are remitted within sixty days after year end. These data are
included in TAG Company's December 31 balance sheets:

Year 8 Year 9 Difference
Royalties receivable $100,000 $95,000 ($ 5,000)

Unearned royalties 70,000 45,000 25,000

During Year 9, TAG Company received royalty remittances of $180,000. In its income statement for the
year ended December 31, Year 9, what should TAG Company's royalty income be?

E Cash receipts $180,000
L
P Receipts in Year 9 applied to 12/31/Yr 8 receivables (100,000)
M
A Cash remaining 80,000
X
E
Unearned royalties, 12/31/Yr 9 (45,000)
Preliminary Year 9 royalty income 35,000
Unearned royalties, 12/31/Yr 8 70,000
Receivables balance, 12/31/Yr 9 95,000
Royalty income, Year 9 $200,000

The net method way to calculate royalty income would be:

Royalty collections $180,000
Plus: Reduction in unearned royalties ($70,000 - $45,000) 25,000
Less: Reduction in royalties receivable ($100,000 - $95,000) (5,000)
Year 9 royalty income $200,000

PASS KEY
The examiners frequently test journal entry concepts. The correct journal entries for the collection and recognizing of earned
royalties are:
DR Cash $XXX
CR Unearned royalty $XXX

DR Unearned royalty $XXX
CR Earned royalty $XXX

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Becker CPA Review Financial Accounting & Reporting 2

C. UNEARNED REVENUE UNEARNED
REVENUES
Revenue received in advance is recorded as a liability because it is an
OR
obligation to perform a service in the future and is reported as revenue in the ADVANCES
period in which it is earned, that is, when no further future service is required.
Examples include rent received in advance, interest received in advance on notes receivable,
and subscriptions received in advance.
Unearned Magazine Subscription Revenue

Kristi Company sells magazine subscriptions for one- to three-year periods. The magazine
subscriptions collected in advance account had a balance of $1,200,000 at December 31, Year 8.
Information for the Year 9 is:

Cash receipts from subscribers $1,400,000
Magazines subscription revenue 1,000,000

E In its December 31, Year 9 balance sheet, how much should Kristi Company report as the
L
MP balance for magazine subscriptions collected in advance?
A
X
E
The ending balance in the magazine subscriptions collected in advance is calculated as follows:

Balance at December 31, Year 8 $1,200,000
Cash receipts 1,400,000
2,600,000
Revenue recognized (1,000,000)
Balance at December 31, Year 9 $1,600,000

D. REVENUE RECOGNITION WHEN THE RIGHT OF RETURN EXISTS RIGHT OF
RETURN
Revenue from a sales transaction where the buyer has the right to return the
product shall be recognized at the time of sale only if all required conditions are met. If the
following conditions are not met, then the recognition of revenue shall be deferred (delayed):
1. The sales price is substantially fixed at the date of sale,
2. The buyer assumes all risks of loss (e.g., fire or theft) because the goods are
considered in the buyer's possession,
3. The buyer has paid some form of consideration, AND
4. The amount of future returns can be reasonably estimated.
E. FRANCHISES FRANCHISING
Franchise operations include a franchisee that receives the right to operate one or more units
of a franchisor's business for one or both of two types of fees.
1. Initial Franchise Fees
These fees are paid by the franchisee for receiving initial services from the franchisor.
Such services might include site selection, supervision of construction, bookkeeping
services, and quality control.
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Financial Accounting & Reporting 2 Becker CPA Review

2. Continuing Franchise Fees
These fees are received for ongoing services provided by the franchisor to the
franchisee. Usually, such fees are calculated based on a percentage of franchise
revenues. Such services might include management training, promotion, and legal
assistance. Fees should be reported by the franchisor as revenue when they are
earned.
3. Franchisor Accounting (Franchise Fee Revenue)
a. Unearned Revenue
The present value of any contract amounts relating to future services (to be
performed by the franchisor) should be recorded as unearned revenue.
Unearned revenue is recognized once substantial performance on such future
services has occurred.
b. Earned Revenue
The franchisor should report revenue from initial franchise fees when all material
conditions of the sale have been "substantially performed." Generally,
"substantial performance" means that the following conditions have been met:
(1) Franchisor has no obligation to refund any payment (cash or otherwise)
received.
(2) Initial services required of the franchisor have been performed.
(3) All other conditions of the sale have been met.
Generally, the conditions of the sale are not considered to be substantially
performed until the franchisee's first day of operations, unless the
franchisor can demonstrate otherwise.
c. Other Recognition Methods
(1) Installment or cost recovery percentage methods may be used under
certain circumstances.
(2) These methods shall be used for earlier recognition of the initial franchise
fee revenue only when:
(a) Revenue is collectible over an extended period of time, and
(b) There is no reasonable basis for estimating collectibility.

Franchisor's Fee Revenue

Facts:
On January 1, Year 1, Foxy Enterprises, Inc. authorized Olinto Company to operate as a franchisee over a
12-year period for a nonrefundable initial franchise fee of $50,000 (received on January 1, Year 1). Olinto
E
L Company started operations on June 30, Year 1. By this time, Foxy Enterprises had performed all of the
P
M required initial services. How much revenue from franchise fees should Foxy Enterprises report in its income
A
EX statement for the six months ended June 30, Year 1?

Solution:
Since Foxy Enterprises has fulfilled its obligation to Olinto Company, Foxy Enterprises can recognize the full
$50,000 as revenue.

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