READING 28 ANALYZING INCOME STATEMENTS

Question 1

If a sale of goods is made on credit, revenue can be recognized at the time of sale, and an asset is created on the balance sheet.

What is the asset?

Answer 1

Accounts receivable

Question 2

True or false

As a general rule, revenue is recognized in the period in which it is earned, which may not necessarily be the same as the period in which cash is collected from the customer.

Answer 2

True

Question 3

If payment for the goods is received before the transfer of the goods or services, a liability, is created when the cash is received (offsetting the increase in the asset cash).

What is the liability?

Answer 3

Unearned revenue

Question 4

True or false

Revenue is recognized as the goods are transferred to the buyer.

Answer 4

True

Consider a magazine subscription. When the subscription is purchased, an unearned revenue liability is created, and as magazine issues are delivered, revenue is recorded, and the liability is decreased

Question 5

The converged standards identify a five-step process for recognizing revenue, what are they?

Answer 5

1. Identify the contract with the customer
2. Identify the distinct performance obligation
3. Determine the transaction price
4. Allocate the transaction price to the performance obligation
5. Recognize revenue when the customer is satisfied

Question 6

An agreement between two or more parties that specifies their obligations and rights.

Answer 6

Contract

Question 7

Promise to deliver a distinct good or service.

Answer 7

Performance obligation

Question 8

A distinct good or service is one that meets the following criteria.

Answer 8

The customer can benefit from the good or service on its own or combined with other resources that are readily available.

Example: If you buy Microsoft Office software, you can use it without needing extra products. It’s distinct because it provides value on its own.

The promise to transfer the good or service can be identified separately from any other promises.

Example: If a phone company sells you a phone and a service plan, these are separate obligations because you can buy a phone without the service plan or vice versa.

Question 9

The amount a firm expects to receive from a customer in exchange for transferring a good or service to the customer.

Answer 9

Transaction price

Question 10

True or false

A transaction price is usually a fixed amount, but it can also be variable (e.g., if it includes a bonus for early delivery).

Answer 10

True

Question 11

A firm should recognize revenue only when it is highly probable that it will not have to reverse it.

If revenue from a sale cannot be estimated reliably. What should the firm do?

Answer 11

Recognize a liability, refund obligation (and an offsetting asset for the right to returned goods)

Question 12

For … contracts, revenue is recognized based on a firm’s progress toward completing a performance obligation over a period of time.

Answer 12

For long-term contracts, revenue is recognized based on a firm’s progress toward completing a performance obligation over a period of time.

Question 13

Progress towards completing a performance obligation can be measured from the … (e.g., using the percentage of completion costs incurred as of the statement date). Progress can also be measured from the … using engineering milestones or the percentage of total output delivered to date.

Answer 13

Progress towards completing a performance obligation can be measured from the input side (e.g., using the percentage of completion costs incurred as of the statement date). Progress can also be measured from the output side using engineering milestones or the percentage of total output delivered to date.

Question 14

A performance obligation is satisfied over a period of time if any of the following three criteria are met?

Answer 14

1. The customer receives and benefits from the good or service over time as the supplier meets the obligations of the contract (e.g., service and maintenance contracts).
2. The supplier enhances an existing asset or creates a new asset that the customer controls over the period in which the asset is created or enhanced.
3. The asset has no alternative use for the supplier, and the supplier has the right to enforce payment for work completed to date (e.g., constructing equipment specific to the needs of a single customer).

Question 15

True or false

The costs to secure a long-term contract, such as sales commissions, must be expensed.

Answer 15

False

The costs to secure a long-term contract, such as sales commissions, must be capitalized, that is, the expense for these costs is spread over the life of the contract.

Question 16

Consider a fast-food company that both operates restaurants and grants franchisees rights to operate restaurants using its brand name under license and supplies franchisees with some products used in daily operations. As well as charging a license fee, the company also receives a royalty fee of 2% of the franchisee’s turnover.

Accounting standards require revenue to be split into categories that have similar characteristics (nature, amounts, timings, and risk factors).

The fast-food company would disaggregate revenue into these categories:

Answer 16

1. Revenue from owned company
2. Franchise royalty and fees
3. Revenue from supplies to franchises

Question 17

Franchise fees often grant the franchisee the right to operate over numerous periods and would initially be treated?

Answer 17

Deferred revenue. Subsequently, it would be amortized to revenue in the income statement over the life of the franchise contract period.

Question 18

Consider a software supplier that allows customers to purchase a license and install the software on their own machines or subscribe to a cloud-based solution with access over the internet.

If customers purchase a license and install the software on their own systems, IFRS allows for two treatments?

(If customers access the software without taking physical possession of the software (i.e., cloud-based access), the contract is for a service and NOT A LICENSE, and revenue should be recognized over the life of the contract.)

Answer 18

A. The software supplier will report revenue over the life of the contract.
Criteria:
The software supplier will continue to update and enhance the software
Customers will be exposed to potential benefits or negative impacts from updates and enhancements.
Updates and enhancements do not result in a transfer of goods or services.

B. The software supplier will report revenue at the outset of the contract.
Criteria:
The license grants the customer the right to use the software as it exists at the start of the contract (“sold as is”).
A separate contract exists for enhancements and updates to the software. The revenue for support services will be recognized when provided (typically over the life of the contract)

Question 19

Type of sales agreement that involves the customer paying for goods ahead of shipping.

Answer 19

Bill-and-hold

Question 20

Typically, when a customer pays ahead of delivery, the revenue is treated as deferred, but revenue may be recorded before shipping if the supplier can demonstrate that its performance obligations are complete, and the customer has control over the good.

IFRS criteria include the following:

Answer 20

The customer asked for the arrangement, the goods are identified as belonging to the customer, the goods are complete and ready for transfer to the customer, and the goods cannot be redirected to another customer.

Question 21

Required disclosures under the converged standards for revenue recognition include the following:

Answer 21

1. Contracts with customers by category
2. Assets and liabilities related to contracts,
3. Outstanding performance obligations and the transaction prices allocated to them
4. Management judgments used to determine the amount and timing of revenue recognition, including any changes to those judgment

Question 22

Expenses to generate revenue are recognized in the same period as the revenue.

Answer 22

The matching principle

Question 23

Assume that inventory is purchased during the fourth quarter of one year and sold during the first quarter of the following year. Using the matching principle, when are the revenue and expense recognized?

Answer 23

Revenue and expense (COGS) are recognized during the first quarter of the second year, when the inventory is sold—not the period in which the inventory was purchased.

Question 24

Application of the matching principle whereby costs are initially capitalized as assets on the balance sheet and then expensed, using depreciation or amortization, to the income statement over the asset’s life as its benefits are consumed.

Property, plant, and equipment (PP&E) and intangible assets with finite lives are examples of this.

Answer 24

Capitalization

Question 25

Not all expenses can be directly tied to revenue generation. These costs are known as?

Answer 25

Period costs, such as administrative costs, are expensed in the period incurred. For example, if a firm has occupied a leased premise, one year’s worth of rent should be expensed to the income statement regardless of whether the rent has been paid.

Question 26

An accounting policy that recognizes expenses later rather than sooner is.

Answer 26

Aggressive

Question 27

An accounting policy that recognizes expenses sooner than later is.

Answer 27

Conservative, Expensing is, therefore, more conservative than capitalization.

Question 28

As a general rule, an expenditure that is expected to provide a future economic benefit over multiple accounting periods is.

Answer 28

Capitalized

Question 29

if the future economic benefit is unlikely or highly uncertain, the expenditure is.

Answer 29

Expensed in the period incurred

Question 30

An expenditure that is capitalized is initially recorded where?

Answer 30

An asset on the balance sheet at cost, which is typically its fair value at acquisition plus any costs necessary to prepare the asset for use. Except for land and intangible assets with indefinite lives (such as acquisition goodwill)

Question 31

An expenditure that is capitalized is initially recorded as an asset on the balance sheet at cost, which is typically its fair value at acquisition plus any costs necessary to prepare the asset for use. The cost is then allocated to the income statement over the life of the asset as ... expense (for tangible assets), ... (for natural resources), or ... expense (for intangible assets with finite lives).

Answer 31

The cost is then allocated to the income statement over the life of the asset as depreciation expense (for tangible assets), depletion (for natural resources), or amortization expense (for intangible assets with finite lives).

Question 32

Once an asset is capitalized, subsequent related expenditures that provide more future economic benefits (e.g., rebuilding the asset) are?

Answer 32

Capitalized

Question 33

Once an asset is capitalized, Subsequent expenditures that merely sustain the usefulness of the asset (e.g., regular maintenance) are?

Answer 33

Expensed when incurred

Question 34

When a firm constructs an asset for its own use or, in limited circumstances, for resale, the interest that accrues during the construction period is.

Answer 34

Capitalized as a part of the asset's cost

Question 35

What is the reason for capitalizing interest?

Answer 35

To accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset.

Question 36

True or false Capitalized interest is reported in the income statement as interest expense.

Answer 36

False Once construction interest is capitalized, the interest cost is allocated to the income statement through depreciation expense (if the asset is held for use) or COGS (if the asset is held for sale).

Question 37

Capitalizing interest results in it being reported in the cash flow statement as an out flow from?

Answer 37

Investing activities This contrasts with the usual treatment of interest paid, which is reported as an out flow from operating activities under U.S. GAAP and can be an operating or financing out low under IFRS.

Question 38

With some exceptions, costs to create intangible assets are expensed as incurred. what are the important exceptions?

Answer 38

Development and research costs under IFRS Under IFRS, research costs, which are costs aimed at the discovery of new scientific or technical knowledge and understanding, are expensed as incurred. However, development costs may be capitalized.

Question 39

Costs that are incurred to translate research findings into a plan or design of a new product or process.

Answer 39

Development costs

Question 40

How to recognize an intangible asset in development?

Answer 40

A firm must show that it can complete the asset and intends to use or sell the completed asset

Question 41

Under U.S. GAAP, both research and development costs are generally expensed as incurred. with an exception.

Answer 41

Costs of creating software for sale to others are treated in a manner similar to the treatment of research and development costs under IFRS. Costs incurred to develop software for sale to others are expensed as incurred until the product’s technological feasibility has been established, after which the costs of developing a salable product are capitalized

Question 42

To make the financial statements comparable for a company that capitalizes development costs with one that expenses such costs

Answer 42

The income statement should be adjusted to include development costs as an expense. And any current amortization of development cost capitalized in the past should be removed. In the balance sheet, capitalized development costs should be removed, resulting in lower assets and equity. Adjusting the cash flow statement will require capitalized costs to be removed from CFI and included in CFO, which will decrease CFO.

Question 43

If a firm sells goods or services on credit or provides a warranty to the customer, when should the bad debt or warranty expense recorded?

Answer 43

the firm recognizes the warranty expense or bad debt in the period of the sale, rather than a later period

Question 44

If a company reduces its bad debt expense, it reports higher net income. as an analyst what should you ask yourself?

Answer 44

1. Is this due to better collections? 2. Is the company manipulating earnings?

Question 45

If a company’s warranty expense is much lower than industry peers. as an analyst what should you ask yourself?

Answer 45

1. Is the company producing higher-quality products? 2. Or is it understating warranty costs to inflate profits?

Question 46

How can analysts detect manipulation?

Answer 46

1. Compared to its industry peers 2. Check the company's financial statements footnotes

Question 47

Events are either unusual in nature or infrequent in occurrence and are material (significant enough to affect the opinions of financial statement users).

Answer 47

Unusual or infrequent items

Question 48

What are examples of unusual or infrequent items?

Answer 48

1. Gains or losses from the sale of assets or part of a business, if these activities are not a firm’s ordinary operations 2. Impairments, write-offs, and write-downs 3. Restructuring costs

Question 49

Where are Unusual or infrequent items recorded in the income statement?

Answer 49

Within EBIT and before tax

Question 50

An operation that management has decided to dispose of, but either has not yet done so, or has disposed of in the current year after the operation had generated income or losses.

Answer 50

Discontinued operation

Question 51

To be accounted for as a discontinued operation, the business must be?

Answer 51

Physically and operationally distinct from the rest of the firm, in terms of assets, operations, and investing and financing activities.

Question 52

The date when the company develops a formal plan for disposing of an operation is referred to as the?

Answer 52

Measurement date

Question 53

The time between the measurement period and the actual disposal date is referred to as the?

Answer 53

Phaseout period

Question 54

What should analysts do for unusual items or infrequent items?

Answer 54

Analysts should review unusual or infrequent items to determine whether they truly should be excluded when forecasting a firm’s earnings. Some companies appear to be accident-prone and have “unusual or infrequent” losses every year or every few years

Question 55

What should analysts do for discontinued operations?

Answer 55

Analysts should exclude discontinued operations when forecasting future earnings. However, the actual event of discontinuing a business segment or selling assets may provide information about the future cash flows of the firm.

Question 56

Any prior-period financial statements presented in a firm’s current financial statements must be restated, applying the new policy to those statements as well as future statements.

Answer 56

Retrospective application

Question 57

Prior statements are not restated, and the new policies are applied only to future financial statements.

Answer 57

Prospective application

Question 58

This application does not require restatement of prior-period statements; however, beginning values of affected accounts are adjusted for the cumulative effects of the change.

Answer 58

Modified retrospective application

Question 59

Generally, a change in accounting estimate is the result of a change in.

Answer 59

Management judgement For example, management may change the estimated useful life of an asset because new information indicates that the asset has a longer or shorter life than originally expected.

Question 60

Sometimes, a change from an incorrect accounting method to one that is acceptable under GAAP or IFRS is required. A correction of an accounting error made in previous financial statements is reported as?

Answer 60

Prior-period adjustment and requires retrospective application

Question 61

True or false Accounting standards require firms to disclose the impact on their financial statements of changes in scope or exchange rates.

Answer 61

False Accounting standards do not require firms to disclose the impact on their financial statements of changes in scope or exchange rates, but analysts must be alert to their effects. In this context, “changes in scope” refer to how acquiring another company affects the size of the combined entity.

Question 62

One of the most commonly used corporate profitability performance measures for publicly traded firms (nonpublic companies are not required to report EPS data). It is reported only for shares of common stock (also known as ordinary stock).

Answer 62

EPS

Question 63

A structure that contains no potentially dilutive securities. contains only common stock, nonconvertible debt, and nonconvertible preferred stock.

Answer 63

Simple capital structure

Question 64

A structure that contains potentially dilutive securities such as employee stock options, warrants, or convertible securities

Answer 64

A complex capital stucture

Question 65

Distribution of additional shares to each shareholder in an amount proportional to their current number of shares.

Answer 65

Stock dividend

Question 66

Refers to the division of each “old” share into a specific number of “new” (post-split) shares.

Answer 66

Stock split

Question 67

Stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock

Answer 67

Dilutive securities

Question 68

Stock options, warrants, convertible debt, or convertible preferred stock that would increase EPS if exercised or converted to common stock

Answer 68

Antidilutive securities