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FINANCIAL 2Matching (Revenue & Expenses), Partnerships and Foreign Currency Accounting

1. Timing issues: Matching of revenue and expenses, correcting and adjusting accounts 3

2. long-term construction contracts ." , 28

3. Accounting for installment sales 33

4. Accounting for nonmonetary exchanges 36

5. Partnerships 42

6. Financial reporting and changing prices " 53

7. Foreign currency accounting 56

8. Other financial statement presentations 64

9. Appendix: The Codification 69

10. Appendix: IFRS vs. U.s. GAAP 93

11. Class questions 95

Financial 2

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NOTES

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TIMING ISSUESMatching of Revenue and Expenses, Correcting and Adjusting Accounts

I. TERMINOLOGY AND BASIC CONCEPTSA. Assets

Assets are probable future economic benefits that are obtained or controlled by a particularentity as a result of past events or transactions.

1. EventAn event is something that happens to an entity, and it can occur either externally orinternally.

2. TransactionA transaction is an event that occurs external to the entity and typically involves atransfer of value from one entity (or entities) to another.

B. LiabilitiesLiabilities are probable future sacrifices of economic benefits that an entity faces forobligations to provide services or transfer assets due to past events or transactions.

C. RevenuesRevenues are increases of assets or reductions of liabilities (and possibly both) during aperiod of time. They stem from the rendering of services, delivering of goods, or any otheractivities that may constitute the major ongoing or central operations of an entity.1. Revenue Recognition (U.S. GAAP)

a. RequirementsRevenue should be recognized when it is realized (or realizable) and when it isearned.

(1) All four criteria must be met for each element of the contract before anyrevenue 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 isrecognized on the date of sale of the product or other asset (i.e., thedelivery 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.

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(3) Revenue that stems from allowing others the use of the entity's assets(e.g., interest revenue, royaily revenue, and rental revenue) is recognizedwhen the assets are used (i.e., as the time passes).

(4) Revenue from the performance of services is recognized in the period theservices have been rendered and are able to be billed by the entity.

b. ObjectivityThe reason for waiting for the sale to take place is "objectivity," to minimizetentativeness.

2. Revenue Recognition (IFRS)Under IFRS, revenue transactions are divided into the following four categories. Eachcategory has its own revenue recognition rules.

a. Sale of GoodsRevenue from the sale of goods is recognized when all of the followingconditions have been met:

(1) Revenue and costs incurred for the transaction can be measured reliably.(2) It is probable that economic benefits from the transaction will fiow to the

entity.

(3) The entity has transferred to the buyer the significant risk and rewards ofownership.

(4) The entity does not retain managerial involvement to the degreeassociated with ownership or control over the goods sold.

b. Rendering of ServicesRevenue from the rendering of services is recognized using the percentage ofcompletion method when the outcome of the transaction can be estimatedreliably. The outcome of the transaction can be estimated reliably when all of thefollowing conditions have been met:

(1) Revenue and costs incurred for the transaction can be measured reliably.(2) It is probable that economic benefits from the transaction will fiow to the

entity.

(3) The stage of completion of the transaction at the end of the reportingperiod can be measured reliably.

c. Revenue from Interest, Royalties, and DividendsRevenue from interest, royalties and dividends that arise from the use by othersof the entity's assets is recognized when all of the following conditions have beenmet:

(1) Revenue can be measured reliably.(2) It is probable economic benefits from the transaction will flow to the entity.Interest revenue is recognized using the effective interest method, royalties arerecognized on the accrual basis, and dividends are recognized when theshareholders' right to receive payment is established.

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FinancialZ

d. Construction ContractsContact revenue and contract costs are recognized as revenue and expensesusing the percentage of completion method when the outcome of theconstruction contract can be estimated reliably. The outcome of the constructioncontract can be estimated reliably when all of the following conditions have beenmet:

(1) The contract revenue and contracts costs attributable to the transactioncan be measured reliably.

(2) It is probable that economic benefits from the transaction will flow to theentity.

(3) Both the contract costs to complete the contract and the stage of contractcompletion at the end of the reporting period can be measured reliably.

An expected loss on a construction contract is recognized immediately as anexpense.

3. Multiple Element ArrangementsWhen a sales contract includes multiple products or services, the fair value of thecontract must be allocated to the separate contract elements. Revenue is thenrecognized separately for each element based on the revenue recognition criteriaappropriate for each element.

4. Exceptions and Other Special Accounting Treatmentsa. Deferred Credits

When cash is received before it is earned, a deferred credit (unearned revenueor deferred revenue) is reported. A deferred credit is recognized as revenue as itis earned. For example:

(1) Prepaid interest income.(2) Prepaid rentai income.(3) Prepaid royalty income.

b. Installment Sales (not GAAP)Revenue is recognized as collections are made. It is used when ultimaterealization 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 (discussedlater in this chapter).

d. Nonmonetary ExchangesThe recognition of revenue depends upon the type of exchange (discussed laterin this chapter).

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e. Involuntary ConversionsThe involuntary conversion due to fire, theft, etc., of a nonmonetary asset to cashwould result in a gain or loss for financial accounting purposes (discussed later inthis chapter).

f. Net Method of Accounting for Trade (Sales) DiscountsSales 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 salesdiscount amount is recorded as "other income," and cash or accounts receivableis debited at that time (discussed in detail in F4).

g. Percentage-of-Completion Contract AccountingRevenue is recognized as "production takes place" for long-term constructioncontracts having costs that can be reasonably estimated. If costs cannot bereasonably estimated, then the "completed contract method" must be used(discussed later in this chapter).

D. ExpensesExpenses are reductions of assets or increases of liabilities (and possibly both) during aperiod of time. They stem from the rendering of services, delivering of goods, or any otheractivities that may constitute the major ongoing or central operations of an entity. Expensesshould be recognized according to the matching principle

E. RealizationRealization occurs when the entity obtains cash or the right to receive cash (i.e., from thesale of assets) or has converted a noncash resource into cash.

F. RecognitionRecognition is the actual recording of transactions and events in the financial statements.

G. Matching PrincipleOne of the most important principles in financial accounting is the matching principle, whichindicates that expense must be recognized in the same period in which the related revenue isrecognized (when it is practicable to do so). Matching of revenues and costs is thesimultaneous or combined recognition of the revenues and expenses that results directly andjointly from the same transactions or events.For those expenses that do not have a cause and effect relationship to revenue, anothersystematic and rational approach to expense recognition should be used (e.g., amortizationand depreciation of long-lived assets and the immediate expensing of certain administrativecosts, referred to as period costs (e.g., no future benefit)).

H. Accrual AccountingAccrual accounting is required by GAAP and is the process of employing the revenuerecognition rule and the matching principle to the recognition of revenues and expenses. Itrecords the transactions and events as they occur, not when the cash is received orexpended. Accrual accounting recognizes revenue when it is earned and expenses when theobligation is incurred (i.e., typically when the expenses relate to the earned revenue).

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I. DeferralDeferral of revenues or expenses will occur when cash is received or expended but is notrecognizable for financial statement purposes. Deferral typically results in the recognition ofa liability or a prepaid expense.

J. Accrued Assets and Liabilities1. Accrued Assets (or accrued revenues)

The recognition of an accrued asset (e.g., interest receivable) represents revenuerecognized or earned through the passage of time (or other criteria) but not yet paid tothe entity.

2. Accrued Liabilities (or accrued expenses)

Accrued liabilities represent expenses recognized or incurred through thepassage of time (or other criteria) but not yet paid by the entity (e.g., accrued interestpayable, accrued wages, etc.).

3. Estimated Liabilities

Estimated liabilities represent the recognition of probable future chargesthat result from a prior act (e.g., the estimated liability for warranties,trading stamps, or coupons).

K. Costs May be Applicable to Past, Present, or Future Periods1. Expired Costs

Expired costs (expenses) are costs that expire during the period and have no futurebenefit (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 isreceived.

b. Costs of goods sold are directly allocated to the periods in which the sales takeplace, which matches the cause and effect of the transaction.

c. Period costs are costs expiring in the period incurred (e.g., selling, general, andadministrative expenses).

2. Unexpired CostsUnexpired costs (e.g., fixed assets and inventory) should be capitalized and matchedagainst 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 insurancewith a cancellation value).

2. Future Right to ServicesPrepaid expenses may also occur where there exists a future right to services (e.g., aservice contract with no cancellation value).

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.1.2.

3.

II.

M. Deferred Charges1. Not Charges to a Tangible Asset

Deferred charges result from expenditures or accruals that cannot be charged to atangible asset, but that do pertain to future operations (e.g., bond issue costs).

2. Intangible Assets and Noncurrent Prepaid ItemsDeferred charges may include intangible assets (covered later in this lecture) andnoncurrent prepaid items.

REVENUE RECOGNITION

A. Deferred Credits (unearned revenue or deferred revenue)Deferred credits represent future income contracted for and/or collected in advance(e.g., rental income, gift certificates, and magazine subscriptions collected in advance).Deferred credits have not yet been earned by the passage of time or other criteria.

Deferred credits are located in the liability section of the balance sheet, just aboveshareholders' equity.

B. Royalty Revenue

Royalty revenue is recognized when earned. Royalty revenues can be earned in a variety ofways (e.g., royalties received on patents sold or royalties received from publications sold). Inthe 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 estimatedsales.

EXAMPLE - ACCRUAL OF ROYALTY REVENUE

TAG Company wrote a textbook and sold it to Fox Company for royalties of 25% of sales. Royalties arepayable 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 1 and Year 2, TAG Company received thefollowing checks from Fox Company:

Year 1Year 2

Apri/30$14,000$12,000

October 31$17,000$15,000

TAG estimated that textbook sales would total $80,000 for the last half of Year 2. How much royalty revenueshould TAG Company report in its Year 2 income statement for the year ended December 31, Year 2?

October 31, Year 2 check (for January 1- June 30) $15,000Earned July 1 through December 31, Year 2 (25% x $80,000) 20,000Royalty revenue for Year 2 $35000

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EXAMPLE - ROYALTIES RECEIVED IN ADVANCE

TAG Company receives royalties on its patents in two ways. In some cases, advance royalties are received andin other cases royalties are remitted within sixty days after year end. Cash receipts for the year were $18,000.These data are included in TAG Company's December 31 balance sheets:

Year 1 Year 2 DifferenceRoyalties receivable $100,000 $95,000 ($5,000)Unearned royalties 70,000 45,000 25,000

During Year 2, TAG Company received royalty remittances of $180,000. In its income statement for the yearended December 31, Year 2, what should TAG Company's royalty income be?

Cash receipts $ 18,000Receipts in Year 2 applied to 12/31/Year 1 receivables (100.000)Cash remaining 80,000Unearned royalties, 12/31/Year 2 (45.000)Preliminary Year 2 royalty income 35,000Unearned royalties, 12/31/Year 1 70,000Receivables balance, 12/31/Year 2 95.000Royalty income, Year 2 $ 200000

The net method way to calculate royalty income would be:

Royalty collections $180,000Plus: Reduction in unearned royalties ($70,000 - $45,000) 25,000Less: Reduction in royalties receivable ($100,000-$95,000) (5.000)Year 2 royalty income $ 200 000

PASS KEY

The examiners frequently test journal entry concepts. The correct journal entries for the collection andrecognizing of earned royalties are:

!!Ill Cash $XXX ~l!lil Unearned royalty $XXX!!Ill Unearned royalty $XXXl!lil Earned royalty $XXX

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c.

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E. Franchises 1&9;1 ~~Franchise operations include a franchisee that receives the right to operate one or more units _of a franchisor's business. Franchise accounting involves 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, bookkeepingservices, and quality control.

2. Continuing Franchise FeesThese fees are received for ongoing services provided by the franchisor to thefranchisee. Usually, such fees are calculated based on a percentage of franchiserevenues. Such services might include management training, promotion, and iegalassistance. Fees shouid be reported by the franchisor as revenue when they areearned.

3. Franchisor Accounting (franchise fee revenue)a. Unearned Revenue

The present value of any contract amounts relating to future services (to beperformed by the franchisor) should be recorded as unearned revenue.Unearned revenue is recognized as revenue once substantial performance onsuch future services has occurred.

b. Earned RevenueThe franchisor should report revenue from initiai franchise fees when all materialconditions of the sale have been "substantially performed." Generaliy,"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 substantiallyperformed until the franchisee's first day of operations, unless the franchisor candemonstrate 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 franchisefee revenue only when:

(a) Revenue is collectible over an extended period of time; and(b) There is no reasonable basis for estimating collectability.

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EXAMPLE

Peter signed an agreement on July 1, Year 1 with Disco Records to operate as a franchisee in New York City. Theinitial franchise fee was $75,000 and was paid by a $25,000 down payment with the balance payable in five equalannual payments of $10,000 beginning July 1, Year 2. The present value of the five annual payments is $37,908.Disco Records must perform substantial future services to earn the initial franchise fee. Disco Records must recordunearned franchise fee revenue of $62,908 ($25,000 + $37,908) on July 1, Year 1.

Franchisor's journal entry to record fees on July 1, Year 1:

!!ll! Cash $25,000!!ll! Notes receivable 50,000tom Discount on notes receivable (contra asset) $12,092tom Unearned franchise fee revenue 62,908

III. EXPENSE RECOGNITION (measurement)A. Intangible Assets - Overview, Valuation, and Characteristics

Intangible assets are long-lived legal rights and competitive advantages developed oracquired by a business enterprise. They are typically acquired to be used in operations of abusiness and provide benefits over several accounting periods.

Intangible assets differ considerably in their characteristics, useful lives, and relationship tooperations of an enterprise and are classified accordingly.

1. Classification of Intangible Assetsa. Identifiability

(1) Patents, copyrights, franchises, trademarks, and goodwill are the commonintangible assets tested on the CPA examination.

(2) Intangible assets may be either specifically identifiable (e.g., patents,copyrights, franchise, etc.) or not specifically identifiable (e.g., goodwill).

b. Manner of Acquisition(1) Purchased Intangible Assets

Intangible assets acquired from other enterprises or individuals should berecorded as an asset at cost. Legal and registration fees incurred to obtainan intangible asset shouid also be capitalized.

(2) Internally Developed Intangible Assets(a) Under U.S. GAAP, the cost of internally intangible assets not

acquired from others (i.e., developed internally) should be expensedagainst income when incurred because U.S. GAAP prohibits thecapitalization of research and development costs.

(b) Examples (must be expensed)(i) Trademarks (except for the capitalizable costs identified

below);(il) Goodwill from advertising; and(iii) The cost of developing, maintaining, or restoring goodwill.

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Financial 2

(c) The exception is that certain costs associated with intangibles thatare specifically identifiable can be capitalized, such as:

(i) Legal fees and other costs related to a successful defense ofthe asset;

(ii) Registration or consulting fees;(iii) Design costs (e.g., of a trademark); and(iv) Other direct costs to secure the asset.

c. Expected Period of BenefitClassification of the intangible asset depends upon whether the economic lifecan be determined or is indeterminable.

d. SeparabilityThe classification of the intangible asset depends upon whether the asset can beseparated from the entity (e.g., a patent) or is SUbstantially inseparable from it(e.g., a trade name or goodwill).

U s. G A A P V s. I FRS

Under IFRS, research costs related to an internally developed intangible asset must beexpensed, but an intangible asset arising from development is recognized if the entity candemonstrate aU of the following:

Technological feasibility has been established.

The entity intends to complete the intangible asset.

The entity has the ability to use or sell the intangible asset.

The intangible asset will generate future economic benefits.

Adequate resources are available to complete the development and sell or use the asset.

The entity can reliably measure the expenditure attributable to the development of theintangible asset.

2. Capitalization of CostsA company should record the cost of intangible assets acqUired from other enterprisesor individuals in an "arm's length" transaction as assets.a. Cost is measured by:

(1) The amount of cash disbursed or the fair value of other assets distributed;(2) The present value of amounts to be paid for liabilities incurred; and(3) The fair value of consideration received for stock issued.

b. Cost may be determined either by the fair value of the consideration given or bythe fair value of the property acquired, whichever is more clearly evident.

c. The cost of unidentifiable intangible assets is measured as the differencebetween the cost of the group of assets or enterprise acquired and the sum ofthe costs assigned to identifiable assets acquired, less liabilities assumed.

d. The cost of identifiable assets should not include goodwill.

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3.


Amortization

The value of intangible assets eventually disappears; therefore, the cost of each type ofintangible asset (except for goodwill and assets with indefinite lives) should beamortized by systematic charges to income over the period estimated to be benefited.

A patent is amortized over the shorter of its estimated life or remaining legal life.

a. MethodThe straight-line method of amortization should be applied unless a companydemonstrates that another systematic method is more appropriate. The methodand estimated useful lives of intangible assets should be adequately disclosed inthe notes to the financial statements. Expenses that increase the useful life ofthe intangible asset require an adjustment to the calculation of the annualamortization.

b. Goodwill (impairment approach)Amortization of purchased goodwill is not permitted. The required approach is totest goodwill for impairment at least annually.

c. Miscellaneous Rules

(1) WorthlessWrite off the entire remaining cost to expense if an intangible assetbecomes worthless during the year (e.g., due to a technologicalobsolescence or due to an unsuccessful patent defense lawsuit).

(2) ImpairmentWrite down the intangible asset and recognize an impairment loss if anintangible asset becomes impaired (e.g., due to a change in circumstancesthat indicate that the full carrying amount of the asset may not berecoverable).

(3) Change in Useful LifeIf the life of an existing intangible asset is reduced or extended, theremaining net book value is amortized over the new remaining life.

(4) SaleIf an intangible asset is sold, simply compare its carrying value at the dateof sale with the selling price to determine the gain or loss.

d. Income Tax Effect

Amortization of acquired intangible assets that are not specifically identifiable(e.g., goodwill) is deductible over a 15-year period in computing income taxespayable. This may create a temporary difference, and interperiod allocation ofincome taxes is appropriate (discussed in detail in F6).

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Financial 2

4. Valuationa. U.S. GAAP

Under U.S. GAAP, finite life intangible assets are reported at cost lessamortization and impairment. Indefinite life intangible assets are reported at costless impairment.

b. IFRSUnder IFRS, intangible assets can be reported under either the cost model or therevaluation model.

(1) Cost ModelUnder the cost model, intangible assets are reported at cost adjusted foramortization (finite life intangible assets only) and impairment.

(2) Revaluation ModelUnder the revaluatiCln model, intangible assets are initially recognized atcost and then revaluated to fair value at a subsequent revaiuation date.Revaluated intangible assets are reported at the fair value on therevaluation date adjusted for subsequent amortization (finite life intangibleassets only) and subsequent impairment.

Revaluation model carrying value::: Fair value on revaluation date - Subsequentamortization - Subsequent impairment

Revaluations must be performed regularly so that at the end of eachreporting period the carrying value of the intangible asset does not differmaterially from fair value. If an intangible asset is accounted for using therevaluation model, all other assets in its class must aiso be revalued uniessthere is no active market for the intangible assets.

(a) Revaluation LossesRevaluation losses (fair value on revaluation date < carrying valuebefore revaluation) are reported on the income statement, unless therevaluation loss reverses a previously recognized revaluation gain.A revaluation loss that reverses a previously recognized revaluationgain is recognized in other comprehensive income and reduces therevaluation surplus in accumulated other comprehensive income.

(b) Revaluation GainsRevaluation gains (fair value on revaluation date> carrying valuebefore revaluation) are reported in other comprehensive income andaccumulated in equity as revaluation surplus, unless the revaluationgain reverses a previously recognized revaluation loss. Revaluationgains are reported on the income statement to the extent that theyreverse a previously recognized revaluation loss.

(e) ImpairmentIf revalued intangible assets subsequently become impaired, theimpairment is recorded by first reducing any revaluation surplus inequity to zero with further impairment losses reported on the incomestatement.

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EXAMPLE - IFRS INTANGIBLE ASSET REVALUATION

On December 31, Year 2 an entity that had adopted the IFRS revaluation model in Year 1 adjusted its patentsto fair value. On that date, the patents had the following carrying value and fair value:

PatentsCarrying Value

$8,200,000Fair Value

$9,100,000

2.

F2-16

The entity had recorded a revaluation loss of $500,000 in Year 1. Compute the revaluation gains to bereported in Year 2 net income and other comprehensive income.

Total revaluation gain = $9,100,000 - $8,200,000 = $900,000

$500,000 of this gain will be reported on the income statement as a reversal of the $500,000 revaluation lossreported in Year 1. The remaining $400,000 ($900,000 - $500,000) gain will be reported in othercomprehensive income as revaluation surplus.

B. Franchisee Accounting1. Initial Franchise Fees

The present value of the amount paid (or to be paid) by a franchisee is recorded as anintangible asset on the balance sheet and amortized over the expected period ofbenefit of the franchise (i.e., the expected life of the franchise).Continuing Franchise FeesThese fees are received for ongoing services provided by the franchisor to thefranchisee (often referred to as franchise royalties). Usually, such fees are calculatedbased on a percentage of franchise revenues. Such services might includemanagement training, promotion, and legal assistance. Fees should be reported by thefranchisee as an expense and as revenue by the franchisor, in the period incurred.

EXAMPLE - FRANCHISEE'S INTANGIBLE ASSETS

Peter signed an agreement on July 1, Year 1 with Disco Records to operate as a franchisee inNew York City. The initial franchise fee was $75,000 and was paid by a $25,000 down paymentwith the balance payable in five equal annual payments of $10,000 beginning July 1, Year 2. Thepresent value of the five annual payments is $37,908. The amount to be capitalized as anintangible franchise asset on July 1, Year 1 is $62,908 ($25,000 + $37,908).

Franchisee's journal entry to record the franchise at July 1, Year 1:

Illl! Franchises $62,908Illl! Discount on notes payable (contra liability) 12,092[iIil Notes payable $50,000[iIil Cash 25,000

The discount will be recognized as interest expense by the franchisee over the payment period on aneffective interest basis. The franchise account would appear in the franchisee's intangible assetssection of the balance sheet and would be amortized over the expected life of the franchise:

Year 1 Amortization = (Franchise balance / Expected life) x Months= ($62,908/10) x 6/12 (July through December, Year 1)= $3145

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.llI01-

Goodwill

C.

D.

Start-up CostsExpenses incurred in the formation of a corporation (e.g., legal fees) are consideredorganizational costs.

1. For Book PurposesStart-up costs, including organizational costs, should be expensed when incurred.

a. Start-up costs include costs of the one-time activities associated with:(1) Organizing a new entity (e.g., legal fees for preparing a charter,

partnership agreement, bylaws, original stock certifications, filing fees,etc.).

(2) Opening a new facility.(3) Introducing a new product or service.(4) Conducting business in a new territory or with a new class of customer.(5) Initiating a new process in an existing facility.

b. Start-up costs do not include costs associated with:(1) Routine, ongoing efforts to refine, enrich, or improve the quality of existing

products, services, processes, or facilities.

(2) Business mergers or acquisitions.(3) Ongoing customer acquisition.

2. For Income Tax PurposesA business may elect to deduct up to $5,000 each of organizationai expenditures andstart-up costs. Each $5,000 amount is reduced by the amount by which theorganizational expenditures or start-up costs exceeds $50,000, respectively. Anyexcess organizational expenditures or start-up cost is amortized over 180 months(beginning with the month in which the active trade or business begins). This maycreate a temporary difference, and interperiod allocation of income taxes is appropriate(see F6).

PASS KEY

Remember that organizational expenses are not capitalized as an intangible asset. Rather, they areexpensed immediately.

1--1Goodwili is the representation of intangible resources and elements connected with an entity(e.g., management or marketing expertise or technical skill and knowledge that cannot beidentified or valued separately). Goodwill means capitalized excess earnings power.1. Calculation of Goodwill

a. Acquisition MethodUnder the acquisition method, goodwill is the excess of an acquired entity's fairvalue over the fair value of the entity's net assets, including identifiable intangibleassets. See lecture F3.

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b. Equity MethodThe equity method involves the purchase of a company's capital stock. Goodwillis the excess of the stock purchase price over the fair value of the net assetsacquired. See lecture F3.

2. Maintaining GoodwillCosts associated with maintaining, developing, or restoring goodwill are not capitalizedas goodwill (they are expensed). In addition, goodwill generated internally or notpurchased in an arm's length transaction also is not capitalized as goodwill.

Research and Development CostsResearch is the planned efforts of a company to discover new information that will help eithercreate a new product, service, process, or technique or significantly improve the one incurrent use. Development takes the findings generated by research and formulates a plan tocreate the desired item or to improve significantly the existing one.

1. Accounting for Research and Development Costs (U.S. GAAP)Under U.S. GAAP, the only acceptable method for accounting for research anddevelopment costs is a direct charge to expense, except for:

a. Materials, equipment, or facilities (i.e., tangible assets) that have alternate futureuses.

(1) Capitalize and depreciate the assets over their useful lives (not the life ofthe research and development project).

b. Research and development costs of any nature undertaken on behalf of othersunder a contractual arrangement.

(1) The purchaser (buying the R&D) will expense as research anddevelopment the amount paid; and the provider (performing the R&D forthe purchaser) will expense the costs incurred as cost of sales.

(2) The conclusion for charging most research and development costs toexpense under U.S. GAAP is the high degree of uncertainty of any futurebenefits.

(3) Disclosure is required in the financial statements or notes of the amount ofresearch and development charged to expense for the period.

2. Items Not Considered Research and Developmenta. Routine periodic design changes to old products or troubleshooting in production

stage (these are manufacturing costs, not research and development expenses)

F2-18

b.

c.

d.

Marketing research.

Quality control testing.

Reformulation of a chemical compound.

U.S GAAP VS IFRS

Under IFRS, research costs must be expensed but development costs may be capitalized ifcertain criteria are met, as stated in the discussion of intangible assets.

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Becker Professional Education I CI)A FXJli1 Hevic'w~------_..--~ ------ ------

Financial 2

EXAMPLE

Facts:

Julile Co. incurred research and development costs in the current year as follows:

Materials used in research and development projects $ 400,000Equipment acquired that will have alternate future uses in future research and

development projects 2,000,000Depreciation on above equipment 500,000

Personnel costs of persons involved in research and development projects 1,000,000Consulting fees paid to outsiders for research and development projects 100,000Indirect costs reasonably allocable to research and development projects 200,000

Solution:

The following items would qualify as research and development costs and shOUld be expensedin the current year:

Materials used in research and development projects $ 400,000Depreciation on equipment used in research and development 500,000Personnel costs of persons involved in research and development projects 1,000,000Consulting fees paid to outsiders for research and development projects 100,000Indirect costs reasonably allocable to research and development projects 200,000Total >-2200.009

The equipment is not charged to research and development costs because it has alternativefuture uses. It should be capitalized as a tangible asset and depreciated over the useful life ofthe equipment. The depreciation expense should be charged to research and development.

F. Computer Software Development Costs

IUS.G A A P V S, I FRS

IFRS does not provide separate guidance regarding computer software development costs. Under IFRS,computer software development costs are internally generated intangibles. Research costs must be expensedand development costs may be capitalized if certain criteria are met (see the discussion of intangible assets).

(2)

b.

Computer Software Developed to be Sold, Leased or Licenseda. Technological Feasibility

Technological feasibility is established upon completion of:(1) A detailed program design, or(2) Completion of a working model.Accounting for Costs(1) Expense costs (planning, design, coding, and testing) incurred until

technological feasibility has been established for the product.

Capitalize costs (coding, testing, and producing product masters) incurredafter technological feasibility has been established up to the point that theproduct is released for sale.

1.

t!')2010 DeVry{Becker ~duc~tional De~elopment Corp. All rights reserved. F2~19

Financial 2 Becker Professional Education I CPf\ Exam Revipw------- ------------~._-_.__. --------~---~----_.__._------_._.._---_._-----------

(a) Amortization of Capitalized Software CostsAnnual amortization (on a product by product basis) is theGREATER of:

Total capitalized Current gross revenue for periodPercentage of revenue = x ---,---'-=-'-------'---'-'---,--

amount Total projected gross revenue for product

Total capitalized _--,-_--,-_l__--,-cc:-Straight line = x _amount Estimate of economic life

(3) Inventory - Costs incurred to actually produce the product are productcosts charged to inventory.

ACCOUNTING FOR COSTS

Program design,planning, coding,testing

TECHNOlOGICALFEASIBILITY

ESTABLISHED

Producing productmasters, includingadditional coding/testing

RELEASE PRODUCTFOR SALE

Duplicatepackaging

tAmortization Inventory Costs

Expense Begins of Goods Sold

c.

2.

c. Balance SheetCapitalized software costs are reported at the lower of cost or market, wheremarket is equal to net realizable value.

Computer Software Developed Internally or Obtained for Internal Use Onlya. Expense costs incurred for the preliminary project state and costs incurred for

training and maintenance.

b. Capitalize costs incurred after the preliminary project state and for upgrades andenhancements, including:

(1) Direct costs of materials and services,(2) Costs of employees directly associated with project, and(3) Interest costs incurred for the project.Capitalized costs should be amortized on a straight-line basis.

F2-20

d. If software preViously developed for internal use is subsequently sold tooutsiders, proceeds received (e.g., from the license of computer software, net ofincremental costs) should be applied first to the carrying amount of the software,then recognized as revenue (after the carrying amount of the software hasreached zero).

2010 DeVryjBecker Educational Development Corp_ All rights reserved.


The carrying amount of intangibles (inciuding goodwill) and fixed assets held for use and to bedisposed of needs to be reviewed at ieast annually or whenever events or changes incircumstances indicate that the carrying amount may not be recoverable. Impairment of fixedassets will be discussed in lecture F4.

A. Impairment of Intangible Assets Other than Goodwill - U.S. GAAPUnder U.S. GAAP, the impairment test applied to an intangible asset other than goodwili isdetermined by the asset's life. An intangible asset has a finite i1fe when it is possible toestimate the useful life of the asset. If it is not possible to determine the useful i1fe of anintangible asset, then the asset has an indefinite (not infinite) life. If an intangible asset has afinite i1fe, it is amortized over that i1fe. If it has an indefinite life, it is not amortized.

1. Intangible Assets with Finite Lives (two step impairment test)An intangible asset with a finite life is tested for impairment using a two step impairmenttest.

IV. IMPAIRMENT IUW.$iWI

Step 1 - The carrying amount of the asset is compared to the sum of the undiscountedcash fiows expected to result from the use of the asset and its eventual disposition.

Step 2 - If the carrying amount exceeds the total undiscounted future cash flows, thenthe asset is impaired and an impairment loss equal to the difference between thecarrying amount of the asset and its fair value is recorded.

PASS KEY

It is important to note the following when testing a fixed asset or an intangible asset with a finite lifefor impairment:

Determining the impairment - use undiscounted future net cash flows

Amount of impairment - use fair value (FV)

2. Intangible Assets with Indefinite Lives (one-step impairment test)When testing an intangibie asset with an indefinite i1fe (including goodwill) forimpairment, it is generally not possible to estimate total future cash flows expected toresult from the use of the assets and its disposition. As a result, an intangible assetwith an indefinite i1fe is tested for impairment by comparing the fair value of theintangible asset to its carrying amount. If the asset's fair value is less than its carryingamount, an impairment loss is recognized in an amount equal to the difference.

201O DeVry/Bec~er Educationa' Development Corp, All righl. reselVed F2-21

Financial 2 Becker Professional Education I CPA F.xam Revie'.11------------ ------_._,_..- -- -- - --- ---._------_.

3. Reporting an Impairment LossAn impairment loss is reported as a component of income from continuing operationsbefore income taxes. The carrying amount of the asset is reduced by the amount ofthe impairment loss. Restoration of previously recognized impairment losses isprohibited, unless the asset is held for disposal.

US GAAP VS IFRS

Under IFRS, an impairment loss for an intangible asset other than goodwill is calculated uS"lng a one-step model in which the carrying value of the intangible asset is compared to the intangible asset'srecoverable amount. IFRS define the recoverable amount as the greater of the asset's fair value lesscosts to sell and the asset's value in use. Value in use is the present value of the future cash flowsexpected from the intangible asset. IFRS allow the reversal of impairment losses.

FINITE liFE INDEFINITE LIFE

Characteristics

Amortization

Impairment test

Useful life is limited

Over useful economic life

Two-step test:

Undiscounted net cash flows

Fair value

Life extends beyond the foreseeablefuture or cannot be determined

None

One-step test: Fair value

F2-22

Undiscounted future net cash flows*< Net carrying value>

~ NegativeT

I---r

I No impairment loss I Impairment I

Assets held Assets heldfor use for disposal

I,--

.~-

Fair value Fair value< Net carrying value> < Net carrying value>

Impairment loss Impairment loss+ Cost of disposal

L Write asset down Total impairment loss2. Depreciate new cost3. Restoration not permitted L Write asset down

2. No depreciation taken3. Restoration permitted

* When testing indefinite life intangible assets for impairment, fair value must be used instead ofundiscounted future net cash flows:

Fair value - Net carrying value'" Positive (no 'Impairment) or Negative Ompairment).

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EXAMPLE 1

Facts:

Assets net carrying value is $900,000

Net future cash flows are projected as $1,000,000

$1,000,000< 900,000 >

$100,000t

1 No impairment lo~

EXAM PLE 2

Facts:

Assets net carrying value is $1,200,000

Net future cash flows are projected as $1,000,000

Assumption 1 - Asset held for use, and

0 FV/PV net cash flows are $700,000

Assumption 2 - Asset;s held for disposal, and

0 FV/PV net cash flows are $700,000

0 Cost of disposal will be $100,000

$1,000,000< $1,200,000 >

, 201'00>

I Impairment I

Assets held Assets heldfor use for disposal

I I$ 700,000 $ 700,000

$ 500 000. 500,000

lOO QQQ1. Write asset down.

--------.S...QOO 0002 Depreciate new cost3. Restoration not permitted. L Write asset down.

,. No depreciation taken.3. Restoration is permitted

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Financial 2 Becker Professional Education I CYi\ I;-:,Hn i{,".'iC\'i

B. Goodwill Impairment - U.S. GAAPGoodwill impairment is determined using a different approach. Goodwill impairment iscalculated at a reporting unit level. Impairment exists when the carrying amount of thereporting unit goodwill exceeds its fair value.

1. Definition of Reporting UnitA reporting unit is an operating segment, or one level below an operating segment.The goodwill of one reporting unit may be impaired, while the goodwill for otherreporting units mayor may not be impaired.

2. Evaluation of Goodwill ImpairmentThe evaluation of goodwill impairment involves two major steps.a. Step 1 - Identify potential impairment by comparing the fair value of each

reporting unit with its carrying amount, including goodwill.

(1) Assign assets acquired and liabilities assumed to the various reportingunits. Assign goodwill to the reporting units.

(2) Determine the fair values of the reporting units and of the assets andliabilities of those reporting units.

(3) If the fair value of a reporting unit is less than its carrying amount, there ispotential goodwill impairment. The impairment is assumed to be due to thereporting unit's goodwill since any impairment in the other assets of thereporting unit will already have been determined and adjusted for (otherimpairments are evaluated before goodwill).

(4) If the fair value of a reporting unit is more than its carrying amount, there isno goodwill impairment and Step 2 is not necessary.

b. Step 2 - Measure the amount of goodwill impairment loss by comparing theimplied fair value of the reporting unit's goodwill with the carrying amount of thatgoodwill.

(1) Allocate the fair value of the reporting unit to all assets and liabilities of theunit. Any fair value that cannot be assigned to specific assets andliabilities is the implied goodwill of the reporting unit.

(2) Compare the implied fair value of the goodwill to the carrying value of thegoodwill. If the implied fair value of the goodwill is less than its carryingamount, recognize a goodwill impairment loss. Once the goodwillimpairment loss has been fUlly recognized, it cannot be reversed.

F2-24 2010 DeVry/BeckN Educational Development Corp. All rights reserved

Becker Professional Education I CPh Exam f{evicw

EXAMPLE - GOODWILL IMPAIRMENT (U.S. GAAP)

Financial 2

Omega Inc. has two reporting units, Alpha and Beta, which have book values including goodwill of $500,000and $675,000, respectively. Alpha reports goodwill of $50,000 and Beta reports goodwill of $75,000. As partof the company's annual review for goodwill impairment, Omega determined that the fair values of Alpha andBeta were $480,000 and $700,000, respectively, at December 31, Year 1. Determine whether the reportingunits' goodwill is potentially impaired.

Alpha:Beta:

Solution:

Reporting Unit FV - Reporting Unit BV = $480,000 - 500,000 = ($20,000)Reporting Unit FV - Reporting Unit BV = $700,000 - 675,000 = $25,000

Because Alpha's fair value is less than its book value, there is potential goodwill impairment. Beta's goodwillis not impaired.

To determine the amount of Alpha's goodwill impairment loss, Omega assigned $460,000 of Alpha's $480,000fair value to Alpha's assets and liabilities. The $20,000 difference ($480,000 - 460,000) cannot be assigned tospecific assets or liabilities and is Alpha's implied goodwill. Calculate Alpha's impairment loss at December 31,Year 1.

Impairment Loss =Goodwill Implied FV - Goodwill BV =$20,000 - 50,000 =($30,0001

Journal entry to record goodwill impairment at December 31, Year 1:

I!1i! Loss due to impairment[!liJ Goodwill

$30,000

U.s GAAP VS. lFRS

$30,000

Under IFRS, goodwill impairment testing is done at the cash-generating unit (CGU) level. A cash~generatingunit is defined as the smallest identifiable group of assets that generates cash inflows that are largelyindependent ofthe cash inflows from other assets or groups of assets. The goodwill impairment test is a one-step test in which the carrying value of the CGU is compared to the CGU's recoverable amount, which is thegreater of the CGU's fair value less costs to sell and its value in use. Value in use is the present value of thefuture cash flows expected from the CGU. An impairment loss is recognized to the extent that the carryingvalue exceeds the recoverable amount. The impairment loss is first allocated to goodwill and then allocatedon a pro rata basis to the other assets of the CGU.

V. CORRECTING AND ADJUSTING ACCOUNTSA. Objective is to Match Expenses Against Related Revenues

The objective of an income statement presentation is to match related expenses with theirrevenues. This exercise includes typical aUdit-type adjustments related to the matChing ofexpenses with revenues that the examiners have tested on the CPA exam.

(&)2010 DeVry!Becker Educational Development Corp. All rights reserved F2-25

Financial 2

B.

Becker Professional Education I CPA bam Review

Exercise - Three-year Net Income and Ending Balance SheetThis exercise is designed to illustrate the effect on income of the following transactions.

Net Income Per Books

1. The company purchased a $300, 3-year 'Insurance policy on 1/1/Year2 and expensed it all in Year 2.

2. $2,000 of credit sales made in Year 2 were not recorded untiicollected in Year 3.

3. $3,000 of Year 3 sales and related accounts receivable outstanding on12/31/Year 3 was not recorded.

4. $1,500 of accounts payable {for expenses incurred) during Year 3were omitted at 12/31!Year 3 and expensed when paid in Y4.

5. $400 was paid in Year 3 and was charged to rent expense. Thispayment covers rent for December Year 4 in a lease ending12/31/Year 4.

6. The direct write off method (non-GAAP method) was used to write offa $650 bad debt in Year 3. The original sale was made in Year 1.

7. Two identical inventory purchases were made by two separateoperating divisions - Division A and Division B. Both $1,300 purchasesof raw materials were purchased FOB shipping point and were intransit on 12/31/Year 3. They were not included in the actual12/31/Year 3 inventory count (the effect of this correction on thefinancial statements is the same whether the perpetual or periodicinventory system is used).

a. Division A: Inventory and liability not recorded.

b. Division B: Inventory not recorded, but liability and "cost of sales"were recorded.

Correct net income

Balance sheet adjustments

3 Year Income Statement" Balance Sheet 12/31/Year 3

Year 1 Year 2 Year 3 DR CR Ale Title

(5,000) (8,000) (10,000)

(Unexpired ins.)(200) 100 100 prepaid insurance

(2,000) 2,000

Accounts(3,000) 3,000 receivable

1,500 1,500 Accounts payable

(400) 400 Prepaid rent

650 (650)

1,300 Inventory

-0- 1,300 Accounts payable

(1,300) 1,300 Inventory

(4,750) (10,200) (11,350)

6,100 2,800

3,300 Retained earnings

" Note: The brackets under the Years 1, 2, and 3 columns represent income, not losses. Thus Year 1 net income per books is $5,000 and the subsequent$400 adjustment would increase income by $400.

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Becker Professional Education I CPA FX(lrn f{eview._-~-_._.._-----_._~-

Explanations:

Financial 2

1. The $300 paid for insurance in Year 2 should have been debited to prepaid insurance. At year-end of Year 2, twoyears of insurance coverage are left and one year has expired. The ($200) is a credit to income in Year 2. Thiscombined with the $300 insurance expense already charged in Year 2, results in the proper $100 charge toincome. The $100 charge to income for Year 3, represents the correct amount of Insurance expense for Year 3,$100 per year. The $100 debit under balance sheet 12i31/Year 3, reflects the correct balance of prepaidinsurance as of that date. As of 12i31IYear 3, one year of insurance coverage remains.

2. According to the revenue recognition principle and accrual accounting, sales should be recorded in the period therevenue is earned. The Year 2 ($2,000) credit to income, properly records the credit sales. The Year 3, $2,000charge to income removes the revenue recorded in that period.

3. The rationale for the income statement adjustment is the same as in #2. The credit saies should be reflected inthe period of sale, Year 3, and the 12/31IYear 3 balance sheet should reflect the correct $3,000 accountsreceivable balance.

4. Expenses should be recorded in the period "incurred." The Year 3, $1,500 charge to income, records the correctexpense incurred. The 12/311Year 3 balance sheet will now show the $1,500 as accounts payable.

5. The $400 paid in Year 1 represents prepaid rent. The ($400) adjustment to Year 1 removes the incorrect chargeto income, and the 12/31IYear 3 balance sheet is adjusted to properly reflect the asset prepaid rent.

6. According to the matching principle, expenses should be recorded in the same period as the related revenue.Since the sale was made in Year 1, the related expense of the saie (the bad debt expense) should be recorded inYear 1. The adjustment here ($650) removes the charge from Year 3 income and puts it in the proper year, Year1.

7. The correct journai entry for either division would have been:

I!1i1 Inventory (perpetual system), or

I!1i1 Purchases (periodic system)

r!rn Accounts payable

$1,300

$1,300

Since division A did not make any entry, the correction entry for division A is just the correct original entry. Sincedivision B charged cost of sales instead of inventory or purchases, the correction here removes the charge toYear 3 income and sets up the proper inventory balance. Accounts payable is already correctly stated.

The final $3,300 increase to retained earnings, reflects all cumulative adjustments to income through Year 3:

($200) + 100 (2,000) + 2,000 (3,000) + 1,500 (400) + 650 (650) (1,300) = ($3,300)

Remember: In this schedule, ($) are credits or increases to income.

2010 DeVry/Becker Educational Development Corp_ All rights reserved F2-27

Financial 2 Becker Professional Education I CPA E:


Percentage of-Completion Method

4. At interim balance sheet dates, the excess of either the construction in progressaccount or the advances account over the other is classified as a current asset or acurrent liability. It is classified as current because of the current operating cycleconcept.

5. Losses should be recognized in fuli in the year they are discovered. An expected losson the total contract is determined by:

a. Adding estimated costs to complete to the recorded costs to date to arrive at totalcontract costs.

b. Adding to advances any additionai revenue expected to arrive at total contractrevenue.

c. Subtracting (b) from (a) to arrive at total estimated loss on contract.D. Advantagesl Disadvantages

The primary advantage of the completed-contract method is that it is based on final resultsrather than on estimates.

The primary disadvantage of the completed-contract method is that it does not properlyreflect the matching principle when the period of the contract extends over more than oneaccounting period.

U 5 G A A P V 5. IF R 5

Under IFRS] the completed contract method is not permitted. The percentage of completion method must be EJused unless the final outcome of the project cannot be reliably estimated] in which case the cost recovery ~method is required. Under the cost recovery method] revenue can only be recognized to the extent of costsincurred.

II. PERCENTAGE-OF-COMPLETION METHOD (U.S. GAAP and IFRS)A. Requirements

It is appropriate to use the percentage-of-compietion method when collection is assured andthe entity's accounting system can:

1. Reasonably estimate profitability; and2. Provide a reliable measure of progress toward completion.

B. Revenue RecognitionThe realization principle requires that revenue be earned before it is recognized.

1. Revenues are generally recognized when:a. The earnings process is complete or virtually complete; and

b. An exchange has taken place.

2. The percentage-of-completion method recognizes income as work progresses on thecontract.

3. Accounting for long-term construction contracts by the percentage-of-completionmethod is an exception to the basic realization principle. This exception is based onthe evidence that the ultimate proceeds are available and the consensus that a bettermeasure of periodic income results (principle of matching revenues and costs).

() 2010 DeVry/Becker Educational Development Corp. All rights reserved. "-29


C.

F2-30

Determination of Revenues RecognizedIncome recognized is the percentage of estimated total income either:

1. That incurred costs to date bear to total estimated costs based on the most recent costinformation, or

2. That may be indicated by such other measure of progress toward completionappropriate to the work performed.

D. Material and Subcontract CostsDuring the early stages of a contract, all or a portion of items such as material not used andsubcontract costs may be excluded in determining the percentage of completion if it appearsthat the exclusion would produce a more meaningful allocation of periodic income.

E. Losses

A provision for the loss on the entire contract should be made when current estimates of thetotal contract costs indicate a loss.

1. However, when a loss is indicated on a total contract that is part of a related group ofcontracts, the group may be treated as a unit in determining the necessity of providingfor losses.

2. Income to be recognized under the percentage-of-completion method at various stagesshould not ordinarily be measured by interim billings.

F. Balance Sheet Presentation"Progress billings" and "construction-In-progress" are merely different accounts representingthe same contract asset and should be shown net of their related contra accounts.

1. Current Asset Accountsa. Due on accounts (receivable).b. Costs and estimated earnings of uncompleted contracts in excess of progress

billings (sometimes called "construction in progress").

2. Current Liability AccountProgress billings in excess of cost and estimated earnings on uncompleted contracts.

G. Advantages/DisadvantagesThe principal advantages of the percentage-of-completion method are the accurate reportingof the status of the uncompleted contracts and the periodic recognition of income currently(rather than irregUlarly) as contracts are completed.The principal disadvantage of the percentage-of-completion method is the necessity ofrelying on estimates of the ultimate costs.

2010 DeVryj6ecker Educational Development Corp. All rights reserved


H. Accounting for the Percentage-of-Completion MethodThe following are important points to remember in accounting for contracts under thepercentage-of-completion method:

1. Journal entries and interim balance sheet treatment are the same as the completedcontract method except that the amount of estimated gross profit earned in each periodis recorded by charging the construction in progress account and crediting realizedgross profit.

2. Gross profit or loss is recognized in each period by the following steps:

Step 1: Compute gross profit of completed contract:

Step 2: Compute "% of completion":

Step 3: Compute gross profit earned (profit to date)

Step 4: Compute gross profit earned for current year:

Contract price

< Estimated total cost>

Gross profit

Total cost to date

Total estimated cost of contract

Slep 1 x Slep 2 = PTD

PTO at current FYE

< PTO at beginning of period>

Current year-to~dateGP

3. An estimated loss on the total contract is recognized immediately in the year it isdiscovered. However, any preVious gross profit or loss reported in prior years must beadjusted for when calculating the total estimated loss.

2010 DeVry/6ec~erEducalional Development Corp. All righls reserved. F2-31


I. Long-term Contract Gross Profit Computation Worksheet

Facts: Year 1 Year 2 Year 3 Year 4

Sales Price $4,000,000 $4,000,000 $4,000,000 $4,000,000Total (estimated) cost of contract 3,000,000 3,200,000 4,200,000 4,300,000Costs incurred to date 1,500,000 2,400,000 3,600,000 4,300,000

Compute GP earned each y~ar:'" "Completed contl:act-method":

PERCENTAGE OF COMPLETION

Yead Year 2 . Year 3 Year 4STEP 1- Compute GP of Completed Contract:

Total contract sales price $ 4.000 $4.000 $4.000 $4,000Less: Total estimated cost of contract ( 3.000) (3,000) ( 3.000) ( 3.000)Total gross profit $1,000 $ 800 i.illQ) i.flQQ)

STEP 2 - Compute "% of completion":

Costs incurred to date $ 1,500 $2.400 $3,600 $ 4.300Total estimated cost of contract $ 3,000 $3,200 $4,200 $ 4.300

Percentage of completion --2Q% ~% -----.1QQ% ----.!QQ%(loss Rule)

STEP 3 - Compute GP earned to date:

Total Contract GP $ 1,000 $ 800 i@Q) i.@QQ)x % of completion ---..2Q%

----.l.S.% -.-lQ.Q% -.-lQ.Q%GP earned to date (cum) L2QQ S-.QQ i@Q) i.@QQ)

STEP 4 - Compute GP earned each year-"% of completion method":

Previously recognized.L-..:Q: i2QQ L..QQ $ (200)

Current year gross profit $ 500 $ 100 ~) $ !l00)COMPLETED CONTRACT

~) ~)COMPUTATIONS

III. OTHER CONSIDERATIONSA. Change in Method

A change in the method of accounting for long-term construction-type contracts is a changein accounting principle. The general rule for presenting changes in accounting principle isthat changes are reported retrospectively. This type of change is reported retrospectively.

B. Disclosure

Generally, long-term construction contracts require no special disclosure because they are, infact, the nature of the contractor's business. However, unusual extraordinary commitmentsshould be fully disclosed in the financial statements or footnotes thereto.

F2-32 2010 DeVry!Becker Educational Development Corp. All rights re,erved


ACCOUNTING FOR INSTALLMENT SALES ~---';>'

I. ACCOUNTING FOR INSTALLMENT SALES

IIProblem Solving FormulasGross profit = Sale - Cost of goods soldA.The installment method of accounting is used only when there is no reasonable basis for estimatingthe degree of collectibiiity. Under installment accounting, revenue is not recognized at the time asale is made but rather when cash is actually collected.

Gross profit percentage = Gross profit / Sales price

Earned revenue = Cash collections x Gross profit percentage

Deferred revenue = Installment receivable x Gross profit percentage

EXAM PLE

Assume that TAG Company began operations on January 1, Year 1, had $400,000 in installment sales inYear 1 and a December 31, Year 1, balance in installment accounts receivable of $150,000. If the TAGCompany had $300,000 as its cost of goods sold, it would calculate realized profit and deferred profitin Year 1 as follows:

Step 1: Gross ProfitSale on installmentCost of goods soldTotal gross profit

Year 1$ 400,000

1300,000)$ 100,000

Step 2: Gross Profit PercentageGross profitSale on installment

$100,000400,000

=25%

Step 3: Earned Gross ProfitSale on installmentEnding installment accounts receivableCollectionsGross profit percentageGross profit earned

$ 400,000(150.000)

$ 250,00025%

$ 62500

Step 4: Deferred Gross ProfitEndings installment accounts receivableGross profit %Deferred gross profit

$ 150,00025%

$ 37 500

2010 DeVryfBecke, Educational Development Corp_ All rights reserved F233


PASS KEY

Examiners require candidates to determine balance sheet presentation.Bolonce Sheet Presentotlon

Accounts receivable $ 150,000Less: Deferred gross profit' 37,500Balance S 112.500

The deferred gross profit Is acontra asset.

EXAMPn: - INSTALLMENT SALE JOURNAL ENTRIES

TAG Company would record the following journal entries during Year 1.

journal entry to record the instaflment sale:Installment sale accounts receivable $400,000

InventoryDeferred gross profit (contra-receivable)

$300,000100,000

journal entry to recognize cash collection:

I:!.m Cash~ Installment sale accounts receivable

journal entry to record profit on collection:

$250,000$250,000

COST RECOVERY METHOD

A. GeneralIII.

.. :....

,,34

I!li! Oeferred gross profit $62,500~ Realized gross profit on installments sales $62,500

Under the cost recovery method, no profit is recognized on a sale until all costs have beenrecovered. At the time of sale, the expected profit on the sale is recorded as deferred grossprofit. Cash collections are first applied to the recovery of product costs. Collections after allcosts have been recovered are recognized as profit.

2010 DeVry{Becker Educational Development Corp. All richts reserved.


EXAMPLE

Financial 2

Assume that TAG Company began operations on January 1, Year 1, had $400,000 in cost recovery sales in Year1 and a December 31, Year 1, balance in cost recovery accounts receivable of $150,000. If the TAG Companyhad $300,000 as its cost of goods sold, it would calculate realized profit and deferred profit in Year 1 and Year2 as follows:

Cost recovery saleCost of goods soldTotal gross profit

Cash collections:

Year 1Year 2

$ 400,000(300,000)

$100,000

$ 250,000150,000

Journal entry to record the sale under the cost recovery method:

l!m Cost recovery receivable~ Inventory~ Deferred gross profit

Journal entry to record the Year 1 coflection:

l!m Cash~ Cost recovery receivable

$400,000

$250,000

$300,000100,000

$250,000Year 1: All ofthe $250,000 collected is treated as recovery of the $300,000 cost of the inventory.

Journal entries to record the Year 2 collection:

I!m Cash(!Ii] Cost recovery receivable

and

$150,000$150,000

!iE.l Deferred gross profit $100,000(!Ii] Realized gross profit on cost recovery sales $100,000

Year 2: The first $50,000 collected is treated as recovery of cost of the inventory. The remaining $100,000collected is gross profit.

B. COMPARISON TO OTHER METHODSThe cost recovery method is simiiar to the installment sales method In that it may only beused when receivables are collected over an extended period and there is no reasonablebasis for estimating their collectibility,

Because no profit is recognized until all costs have been recovered, the cost recoverymethod Is the most conservative method of revenue recognition,

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ACCOUNTING FOR NONMONETARY EXCHANGES

I. EXCHANGES HAVING COMMERCIAL SUBSTANCEU.S. GAAP requires that exchanges of nonmonetary assets be categorized into one of two groups:

Those that have "commercial substance," and

Those that lack "commercial substance."

An exchange has commercial substance if the future cash flows change as a result of thetransaction. The change can either be in the areas of risk, timing, or amount of cash flows. In otherwords, if the economic position of the two parties changes because of the exchange, then theexchange has "commercial substance." A fair value approach is used.

PASS KEY

The fair value of assets given up is assumed to be equal to the fair value of assets received, including any cash givenor received in the transaction. A simple solution framework for a journal entry is as follows:

lim New asset (FV of consideration given)lim Accumulated depreciation of asset given uplim Cash receivedI!Ii! Loss (if any)[!GJ Old asset at historical cost[!ill Cash given[!ill Gain (if any)

A. Recognizing Gains and LossesGains and losses are always recognized in exchanges having commercial substance and arecomputed as the difference between fair value and book value of the asset given up.

EXAMPLE

Foxy Company exchanged used cars for a building that could possibly become Foxy Company's storage space.Future cash flows will significantly change. The book value of the cars totals $40,000 (cost of $102,000-accumulated depreciation of $62,000). The cars' fair value is $45,000. In addition, Foxy must pay $20,000cash as part of the exchange. Calculate the gain to be recognized on the exchange.

Fair value of carsBook value of cars:

Cost of carsAccumulated depreciation

Book value

Gain on disposal of cars

$102,000162,0001

$ 45,000

140.000)$ 5000

F2-36

The cash given up does not enter into the calculation of gain on exchange, which is fair value less book value.

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B. Calculation of Basis of Acquired AssetThe cash given up in the exchange is used to calculate the building's basis on Foxy's books.

EXAM PLE

Given the same facts as in the previous example, what would be the basis of the new building on FoxyCompany's books?

Fair value of cars given upPlus: Cash paidBuilding cost (basis)

$ 45,00020.000

$ 65000

Journal entry to record the exchange and the gain on the exchange:

Iilll BuildingI!ll.1 Accumulated depreciation - carsI!!


II. EXCHANGES LACKING COMMERCIAL SUBSTANCEIf projected cash flows after the exchange are not expected to change significantly, then theexchange lacks commercial substance. The following accounting treatment is used (note that thismethod must also be used in any exchange in which fair values are not determinable, or if theexchange is made to facilitate sales to customers):A. Gains

1. No Boot is Received = No GainIf the exchange lacks commercial substance and no boot is received, no gain isrecognized.

2. Boot is Paid = No GainIf the exchange lacks commercial substance and boot is paid, no gain is recognized.

3. Boot is Received = Recognize GainIf the exchange lacks commercial substance and boot is received, all of the gain or aproportional part of the gain is recognized.

a. Recognize All of the Gain (~25% rule)When the boot received equals or exceeds 25% of the total considerationreceived (including the boot), the transaction is viewed as a monetary exchange,and all of the gain is recognized.

b. Recognize Proportional Gain 25% rule)When the boot received is less than 25% of the total consideration received, aproportional amount of the gain is recognized. A ratio (the total boot received Ithe total consideration received) is calculated, and that proportion of the totalgain realized is recognized.

B. LossesIf the transaction lacks commercial substance and a loss is indicated, the loss should berecognized.

EXAMPLE - NO BOOT NO GAIN

Assume: Machine A is exchanged for Machine B Machine A, carrying value (BV) = $10,000 Machine A, fair value (FVI = $12,000 Machine B, fair value (FV) = $12,000 (FV given = FV received)Calculate the total gain as follows:

FV of asset given - BV of asset given

$12,000 -10,000 = $2,000 gainThe gain is not recognized because the exchange lacks commercial substance and boot is not included in thetransaction. As a result, the basis of the acquired asset is equal to the basis of the old asset, which is alsoequal to the assets fair value less the deferred gain.

Journal entry to record the above transaction:

F2-38

I!rn Machine Br!li.l Machine A

$10,000$10,000

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EXAMPLE - BOOT IS PAID NO GAIN

Assume:

Machine A and $2,500 is exchanged for Machine B Machine A, carrying value 18V) = $10,000 Machine A, fair value (FV) = $12,000 Machine B, fair value (FV) = $14,500 IFV given = FV received)

Calculate the total gain as follows:

FV of asset given* - BV of asset given*

$14,500 -12,500 = $2,000 gain* Note that the assets given include Machine A plus $2,500.

The gain is not recognized because the exchange lacks commercial substance and boot is paid. As a result, thebasis of the acquired asset is equal to the basis of the old asset plus the cash paid.

journal entry to record the above transaction:

lim Machine B(!Ii] Machine A[iii Cash

$10,000$10,000

2,500

EXAMPLE - BOOT IS RECEIVED 25% RULE) PROPORTIONAL GAIN RECOGNIZED

Assume:

Machine A is exchanged for Machine Band $2,500 Machine A, carrying value (8V) = $10,000 Machine A, fair value IFV) = $12,000 Machine 8, fair value (FV) =$9,500 IFV given =FV received)

Calculate the total gain as follows:


$12,000 -10,000 = $2,000 total gain

The $2,500 cash is 21% of the consideration received ($2,500/$12,OOO =21%), so a proportional amount ofthe gain is recognized:

Recognized gain = Realized gain x (Boot received/FV received)= $2,000 x ($2,500/$12,000) = $417


!!.Ii! Machine BlID! Cash

~ Machine Ar!Ii1 Gain on exchange

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$7,917 (plug)2,500

$10,000417

F2-39


EXAMPLE - BOOT RECEIVED (~2:5" RULE) = ALL GAIN RECOGNIZED

Assume:

Machine A is exchanged for Machine Band $6,000 Machine A, carrying value (BV) = $10,000 Machine A, fair value (FV) =$12,000 Machine B, fair value (FV) = $6,000 (FV given = FV received)Calculate the total gain as follows:


$12,000 -10,000 =$2,000 total gain

The $6,000 cash is 50% of the consideration received ($6,000/$12,000 =50%), so the entire gain is recognizedand the machine acquired is recognized at fair value.

journal entry to record the above transaction:I!m Machine BI!Iil Cash[!IJl Machine A[il1 Gain on exchange

$6,000 (piug)6,000

$10,0002,000

EXAMPLE - LOSSES RECOGNIZED IN FULL

Assume: Machine A is exchanged for Machine B Machine A, carrying value (BV) = $10,000 Machine A, fair value (FV) = $8,000 Machine B, fair value (FVI = $8,000 (FV given = FV received)Calculate the total gain as follows:


$8,000 - 10,000 = $(2,000)losses are recognized in full in all exchanges lacking commercial substance.


F240

I!m Machine BI!m loss on exchange[!IJl Machine A

$8,0002,000

$10,000

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AN CILL A R Y MAT E R I A L (for Independent Review)

III. INVOLUNTARY CONVERSIONSA. Overview

Whenever a nonmonetary asset is involuntarily converted (e.g., fire loss, theft, orcondemnation) to cash, the entire gain or loss is recognized for financial accountingpurposes.

EXAMPLE - GAIN ON CONDEMNATION

Facts:On 12/1/Yr 1, Sykes Company received a condemnation award of $100,000 for the forced sale of SykesCompany's factory building. At that time, Sykes Company's building had a book value of $75,000. Computethe gain or loss.

Solution:Proceeds from condemnation $ 100,000Less: Book value of nonmonetary asset (factory building) 175.000)Gain on condemnation $ 25 000

Journal Entry to record the above transaction

illi! Cash $100,000[!Ii1 Building $75,000Si! Gain on involuntary conversion 25,000

B. Tax TreatmentThe rules for involuntary conversions are different for tax purposes. If a gain is recognizedfor financial purposes in one period and for tax purposes in another period, a temporarydifference will result. Interperiod tax allocation will be necessary (the interperiod taxallocation is covered in lecture F-6).

END OF ANCILLARY MATERIAL o

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PARTNERSHIPS

I. ADMISSION OF A PARTNERI_I A new partner may be admitted by the purchase of an existing partnership interest or by

investing additional capital into the partnership.

A. By Purchase or Sale of Existing Partnership InterestA partner, with the consent of all partners, may sell his partnership interest to a new partner.Payment for the partnership interest by the new partner wouid go directly to the sellingpartner. The retiring partner could sell his interest in the same manner to the remainingpartners.

1. No Journal EntryNo entries are made on the partnership books, except for the change of name on thecapital account. Transactions of this type do not affect the assets, liabilities, or totalcapital of the partnership.

B. Formation of a PartnershipContributions to a partnership are recorded as follows:

1. Assets are valued at fair value.

2. Liabilities assumed are recorded at their present value.

3. Partner's capital account therefore equal the difference between the fair value of thecontributed assets less the present value of liabilities assumed.

PASS KEY

It is important to distinguish the tax and GMP rules relating to the formation of a partnership:

GMP Rule = Use FV of asset contributed

Tax Rule = Use NBV of assets contributed

C. Creation of a New Partnership Interest with Investment of Additional CapitalWhen a new partnership interest is created by the investment of additional capital into thepartnership, the total capital of the partnership does change, and the purchase price can beequal to, more than, or less than book value.

1"fibNWI1. Exact Method (equal to book value)

When the purchase price is equal to the book value of the capital account purchased,no goodwill or bonuses are recorded.

a. Rules (problem solving steps)(1) Determine the exact amount a new partner will have to pay to get his

capital account in the exact proportional interest to the new net assets ofthe partnership.

(2) There is no goodwill or bonus.(3) Old partners' capital account "dollars" stay the same.

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(4) Old partners' "'Yo ownership" changes, but that change is generally not arequirement on the CPA exam.

PASS KEY

Problems lhat deal with the exact method will always ask, "How much should the new partner ,contribute in order to have an x% interest in the new partnership?ll and will not include 'breferences to goodwill or bonuses in the transaction.

EXAMPLE - NEW PARTNER PAYS BOOK VALUE

Facts:

A, B, and C are partners in a three-person partnership. They have capital accounts of $20,000,$30,000, and $50,000, respectively. A, B, and Cdecide to admit Das a new partner with a 25%interest in the new partnership. If D pays book value, how much should Dcontribute in orderto have a 25% interest in the partnership?

Solutions:

Equity of new partnership = $20,000 + $30,000 + $50,000 + D's contribution

Since Dwill contribute an amount equal to 25% of the total book value of the new partnership,D's contribution can be shown as 25% of total new equity.

Total new equity = $100,000 + .25 Total new equity

$ I $100,000 I .100,000 =.75 Tota new equity; = Tota new equity0.75

Total new equity = $133,333.25 total new equity = $33,333

Thus, D should pay $33,333 for a 25% interest.

2. Bonus Method I_IWhen the purchase price is more or less than the book value of the capitalaccount purchased, bonuses are adjusted between the old and new partners' capitalaccounts and do not affect partnership assets.

Bonus Method - Recognize intercapital transfer.

a. Rules (problem-solving steps)(1) Determine total capital and the interest to the new partner.(2) If interest iess than amount contributed, bonus to old partner(s).(3) If interest greater than amount contributed, bonus to new partner.

o ::: ~onus =~alance in total capital accounts controls the capital account allocation.

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PASS KEY

Under the bonus method, the bonus will be credited to the following partner:

Existing partners - when new partner pays more than NBV New partner - when new partner pays less than NBV

EXAMPLE - BONUS TO EXISTING PARTNERS

A and Bshare profits and losses 60:40, and have capital accounts of $30,000 and $10,000,respectively. C has agreed to invest $35,000 for a one-third interest in the new ABCpartnership. Since the partnership has decided not to recognize goodwill, the total capital ofthe resulting partnership is $75,000 ($30,000 + $10,000 + $35,000), C has purchased a one-third interest, so the balance in C's capital account should equal one-third of $75,000 or$25,000. The extra $10,000 paid by C is recorded as a bonus to the old partners and is sharedaccording to their profit and loss ratio.

Journal entry to record the admission of Cinto the partnership and recognize the bonus toexisting partners:

Cash $35,000A, Capital ($10,000 x 60%)B, Capital ($10,000 x40%)C, Capital (30,000 + 10,000 + 35,000 = 75,000 x 1/3)

EXAMPLE - BONUS TO NEW PARTNER

$6,0004,000

25,000

It is possible for the existing partners to credit a bonus to a new partner. In the exampleabove, if C had invested $14,000 for a one-third interest in the resulting partnership, C wouldhave received a bonus from A and B, because the one-third interest in the partnership is$18,000 [1/3 ($30,000 + $10,000 + $14,000)] and exceeds C's contribution of $14,000, The$4,000 ($18,000 - $14,000) is a bonus credited to C by A and B, and is charged to A's and B'scapital accounts according to their profit and loss ratio (60:40).Journal entry to record the partnership and recognize the bonus to new partners:

CashA, CapitaIIS4,000' 60%)B, Capital ($4,000 x 40%)

C, Capital (30,000 + 10,000 + 14,000 =54,000 x 1/3)

$14,0002,4001,600

$18,000

Iimiiiil~3. Goodwill Method (recognized intangible asset)

Goodwill is recognized based upon the total value of the partnership implied by the newpartner's contribution,

a. Rules (problem-solving steps)(1) Compute new "net assets before GW" (before goodwill) after admitting new

(or paying old) partner.(2) Memo: Compute new "capitalized" net assets (= total net worth) and

compare "Capitalized Net Assets" with "Net Assets before Goodwill," and

F2-44 2010 DeVry/Be


(3) "Difference" is "Goodwill" to be allocated to old partners according to theirold partnership profit ratios.

PASS KEY

@ = oodwill = oing in investment (doliars) controls capital account aliocation &goodwili calculation.

EXAMPLE - GOODWILL CREDITED TO CAPITAL ACCOUNTS OF EXISTING PARTNERS

A and B share profits and losses 60:40, and have capital accounts of $30,000 and $10,000,respectively. On the basis of A and B's present total capital, Chas agreed to invest $35,000 fora one-third interest in the new ABC partnership. The partnership decides to recognizegoodwill.

Cpays $35,000 for a one-third interest in the partnership, goodwill is recognized as thedifference between the implied value of the business and the total of the tangible net assetsrepresented by the partners' capital account.

Implied value ($35,000 x 3 = $105,000)Total partner's capital accounts ($35,000 + $10,000 + $30,000 =$75,000)Goodwili

$ 105,000(75,000)

$ 30000

Journal entry to record the admission of Cinto the partnership and recognize goodwill:

I!Ii1 Cash~ Goodwill[!ffi A, Capital (60% x $30,000)l!fi! S, Capital (40% $30,0001r!Ij C, Capital (equals amount contributed by C)

PASS KEY

$35,00030,000

$18,00012,00035,000

The following summary will help you remember the differences among the above approaches:

EXACT METHOD

Incoming partner's capital account is their actual contribution. (You must calculate.) No adjustment to the existing partner's capital accounts is required.

BONUS METHOD

Balance in total capital accounts controls the computation.

Incoming partner's capital account is their percentage of the partnership total NBV (after theircontribution).

Adjust the existing partner's capital accounts to balance.GOODWILL METHOD

Going in investment (dollars) controls the computation. Incoming partner's capital account is their actual contribution. Goodwill (implied) is determined based upon the incoming partner's contribution, and

shared by the existing partners.

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Financial Z

II. PROFIT AND LOSS DISTRIBUTION


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Becker Profess

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