978-0078025679 Chapter 2 Lecture Note

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Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

CHAPTER 2

ACCRUAL ACCOUNTING AND INCOME DETERMINATION

CHAPTER OVERVIEW

This chapter highlights the key differences between cash and accrual income measurement,

and why the latter generally provides a better measure of operating performance. In most cases,

accrual–basis revenues do not equal cash receipts, nor do accrual expenses equal cash

disbursements. The principles that govern expense recognition under accrual accounting are

designed to alleviate the mismatching of effort and accomplishment that occurs under cash-basis

accounting.

Revenue is recognized when both the critical event and measurability conditions are met. The

critical event establishes when the entity has done something to fiearn” the asset being received,

and measurability is established when the revenue can be measured with a reasonable degree of

assurance. These conditions may be satisfied before, on, or after the point of sale.

The matching principle determines how and when the assets fiused up” in generating the

revenue, or that expire with the passage of time, are expensed. Relative to current operating cash

flows, accrual earnings generally provide a more useful benchmark for predicting future cash

flows.

Predicting future cash flows and earnings is critical to assessing the value of a firm’s shares

and its creditworthiness. Multiple-step income statements are designed to facilitate this

forecasting process by isolating the more recurring or sustainable components of earnings from

the nonrecurring or transitory earnings components.

GAAP disclosure requirements for various types of accounting changes also facilitate the

analysis of company performance over time. All publicly traded companies must report EPS

numbers on the income statement. The basic EPS is based on the weighted average number of

shares actually outstanding during the period, while the diluted EPS is based on the fias if” all

potentially dilutive securities were converted into common shares.

Occasionally, changes in assets and liabilities resulting from incomplete or open transactions

bypass the income statement and are reported as direct adjustments to stockholders’ equity and

are called other comprehensive income components.

Joint deliberations of the FASB and IASB resulted in a recent Exposure Draft on financial

statement presentation that calls for displaying revenue and expense components for operating,

investing, and financing sources. The proposed changes in presentation format are designed to

enhance the predictive ability and decision usefulness of information presented in firms’

statement of comprehensive income.

CHAPTER OUTLINE

I. CASH VERSUS ACCRUAL INCOME MEASUREMENT

A. Accrual-basis income measurement is the cornerstone of income measurement.

1. Revenues are recorded in the period when they are fiearned” and become

fimeasurable.”

a. Revenues are fiearned” when the seller has performed a service or conveyed

an asset to a buyer.

b. Revenues are fimeasurable” when the value to be received for that service or

asset is reasonably assured and can be measured with a high degree of

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

reliability.

i. Deferred revenue exists when a liability to provide a good or service is

created because the entity received cash or other assets in advance.

ii. Accrued revenue is recorded when you provide a good or service but will

not receive cash or other assets until a later time.

2. Expenses are the Expired costs or assets fiused up” in producing those

revenues and they are recorded in the same accounting period in which the

revenues are recognized using the fimatching principle.”

a. Deferred expenses exist when an organization makes a payment in advance

for a product or service that will be used in several periods to create

revenue or cost offsets.

b. Accrued expenses gradually build during the earnings process and are paid

or used after the close of the accounting period.

3. Accrual accounting decouples measured earnings (i.e., revenues less expenses)

from the amount of cash generated from operations because of both deferrals

(payments or receipts postponed) and accruals (payments or receipts

recognized).

a. Accrual accounting revenues generally do not correspond to cash receipts for

the period, nor do reported expenses always correspond to cash outlays of the

period.

b. As a result, accrual accounting can produce large discrepancies between

measured earnings and the amount of cash generated from operations.

c. However, accrual accounting earnings provide a more accurate measure

of the economic value added during the period than do operating cash

flows.

B. Cash–basis income measurement is straightforward.

1. Revenues are recorded when cash is received.

2. Expenses are recorded when cash is paid.

3. Because of differences in the timing of when cash inflows and cash outflows

occur, cash-basis income determination may distort one’s view of operating

performance.

a. Cash-basis income fails to properly match effort and accomplishment.

b. Cash-basis income may not provide a reliable benchmark for predicting

future operating results.

C. The Canterbury Publishing example demonstrates the differences noted above.

1. There are several fifacts” to consider.

a. Canterbury sells three-year subscriptions of a quarterly publication to

subscribers, who prepay the full subscription price.

b. Canterbury takes out a three-year loan at the beginning of the three-year

subscription period, but interest is payable at maturity of the loan.

c. Costs to publish and distribute the magazine are paid in cash at the

time of publication.

2. Cash-basis income determination distorts Canterbury’s operating performance.

a. The entire cash inflow from subscription receipts would be treated as revenue

in the first year when the subscriptions were sold.

b. Operating expenses for publishing and distributing the magazine are

recorded in equal amounts in each of the three years.

c. The entire cost of financing the operations (i.e., interest expense) is recorded

in year three.

d. Consequently, Canterbury would report relatively high profits in year one

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

when the subscriptions are sold and collected, followed by operating filosses”

in years two and three.

e. None of the cash-basis earnings figures provide a reliable benchmark for

predicting future operating results.

3. Accrual-basis income determination is designed to alleviate the mismatching

problems that exist under cash-basis accounting, making accrual earnings a more

useful measure of a firm’s performance.

a. Accrual-basis accounting allocates subscription revenue to each of the years

as the magazine is delivered to the subscriber and the revenues are fiearned.”

b. Likewise, accrual accounting recognizes interest expense in each year the

bank loan is outstanding, not just when the interest is paid.

c. These modifications to the cash-basis results are made via a series of

fideferral” and fiaccrual” adjusting entries.

4. Accrual accounting better matches economic benefit with economic effort,

thereby producing a measure of operating performance that provides a more

realistic picture of past economic activities.

Teaching Tip: For-profit entities adopt accrual accounting because of its ability to provide

investors and creditors with a more realistic picture of relevant economic events and their effects on

firm activities. Just the same, accrual accounting does not capture all of an entity’s relevant

economic events as they occur. In addition, entities that do not have a profit motive may prefer a

cash–basis accounting system because of its simplicity.

II. MEASUREMENT OF PROFIT PERFORMANCE: REVENUE AND EXPENSES

A. Income is earned as the result of several (complex, multiple-stage processes) activities.

1. The critical issue then becomes the timing (stage) of income recognition.

2. The accounting process of recognizing income is comprised of two distinct steps.

a. The revenue recognition principle establishes when revenue is recorded.

b. The recognition of revenue then triggers the second step—matching against

revenue the costs that expired (were used up) in generating that revenue.

c. The difference between revenues and expired costs (expenses) is the net

income (profit) recognized for the period.

3. Due to the double-entry, self-balancing nature of accounting, important changes

occur in net assets (that is, assets minus liabilities) on the balance sheet.

a. The basic accounting equation (Assets = Liabilities + Owners’ Equity) can

be used to illustrate this point.

i. Owners’ equity increases by the amount of the net income recognized

ii. Net assets (that is, gross assets minus gross liabilities) increase by an

identical amount.

ii. Expense matching decreases net assets and owners’ equity by

identical amounts.

b. As a result, net asset valuation and net income determination are

inextricably intertwined.

B. A closer look at the revenue recognition criteria. Both the following conditions must be

satisfied:

1. The ficritical event” (fiCondition 1”) in the process of earning the revenue has

taken place (revenue has been earned). It may vary from industry to industry.

2. (fiCondition 2”) – The amount of revenue that will be collected is reasonably

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

assured and is measurable with a reasonable degree of reliability. Measurability

must be based on objective and verifiable evidence.

3. In most instances the point of sale is the earliest moment in time at which both

conditions 1 and 2 are satisfied. This is the dominant practice in most retail and

manufacturing industries.

4. Under the percentage-of–completion method (see Chapter 3), Conditions 1 and 2

are satisfied prior to the point of sale (i.e., transfer of title).

a. Condition 1 (critical event) is satisfied over time as the project progresses.

b. Condition 2 (measurability) is satisfied since a firm contract with a known

buyer at a set price exists.

Teaching Tip: Normally, once gross revenues for the period are determined, the next step in

determining net income is to accumulate and record the costs associated with generating the

revenue. However, under the percentage–of–completion method, it is the recognition of

expenses that drives the recognition of revenue.

5. Under the installment sales method (see Chapter 3), Conditions 1 and 2 may not be

satisfied until after the point of sale—for instance, until cash is collected.

6. Revenue earned is recognized during the production phase when:

a. A specific customer is identified and an exchange price is agreed upon.

b. A significant portion of the services to be performed has been performed, and

the expected costs of future services can be reliably estimated.

c. An assessment of the customer’s credit standing permits a reasonably accurate

estimate of the amount of cash that will be collected.

7. Revenue earned may be recognized on completion of production when:

a. The product is immediately saleable at quoted market prices.

b. The units are homogeneous.

c. No significant uncertainty exists regarding the costs of distributing the

product.

8. Revenue earned is r ecognized after the point of sale when one or more of the

following conditions are present:

a. Extreme uncertainty exists regarding the amount of cash to be collected

from customers. This uncertainty may be attributable to:

i. The precarious financial position of the customer.

ii. Contingencies in the sales agreement that allow the buyer or seller to

terminate the exchange.

iii. The customer has (and frequently exercises) the right to return the

product.

b. Future services to be provided are substantial, and their costs cannot be

estimated with reasonable precision.

9. Regardless of which basis of revenue recognition is used, the recognition of

expenses must always adhere to the matching principle.

C. Matching expenses with revenues earned.

1. The recognition of expenses generally follows the recognition of revenue.

2. Traceable (product) costs are costs that contribute directly to a particular sale

or to revenues of a particular period.

a. These costs are recorded as expenses in the same period that revenues are

recognized.

b. An example of product costs is costs of goods sold.

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

3. Period costs are important in generating revenue, but their contribution to a specific

sale or to revenues in a particular period is more difficult to quantify.

a. These costs are associated with the time period in which they occur.

b. An example of period costs is advertising expense.

III. INCOME STATEMENT FORMAT AND CLASSIFICATION

A. The multiple-step income statement is intended to subdivide income in a manner that

facilitates the forecasting of future cash flows.

1. Virtually all decision models in modern corporate finance are based on future cash

flows.

2. The intent of the multiple-step format is to classify separately income components

that are fitransitory” and to clearly differentiate them from income components

believed to be fisustainable” or likely to be repeated in future reporting periods.

3. This format isolates a key figure called income from continuing operations.

a. Ideally, this component of income should include only the normal,

recurring, presumably more sustainable, ongoing operating activities of

the organization.

b. This income number sometimes includes gains and losses that occurs

infrequently—called special or unusual items—but that arise from a firm’s

ongoing, continuing operations.

c. Therefore, income from continuing operations is intended to serve as a starting

point for forecasting future profits.

4. Nonrecurring items are transitory and are disclosed separately below the income

from continuing operations line.

B. Nonrecurring items, including discontinued operations, and extraordinary items,

are reported below income from continuing operations net of income tax effects.

1. This finet of tax treatment” is called intraperiod income tax allocation.

a. If income tax were not matched with the item giving rise to it, then total

reported income tax expense would combine taxes arising from both items

that were transitory as well as from other items that were more sustainable.

b. Mixing together the tax effect of continuing activities with the tax effect of

single occurrence events would make it difficult for statement readers to

forecast future tax outflows arising from ongoing events.

2. Income tax associa ted with sus tainable income fro m continuin g operations is

separately disclosed from taxes arising from the transitory items.

C. As defined in the U.S. GAAP, discontinued operations is a component of an entity,

which comprises operations and cash flows that can be clearly distinguished,

operationally and for financial reporting purposes, from the rest of the entity. Two

conditions must be met for an entity to report discontinued operations:

a. The operations and cash flows have been (will be) eliminated from the firm’s

ongoing operations.

b. The firm will not have any significant continuing involvement in the

operations of the component after the disposal transaction.

Failure to meet above conditions results in a firm reporting the component’s operating

results as part of the continuing operations and prior year’s results are not restated.

1. Two components of discontinued operations are reported:

a. Operating income or loss from operating the component from the beginning

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

of the reporting period to the disposal date, net of related tax effects.

b. fiGain or loss on disposal (net of tax)” has two components: (1) expected

gain or loss on operations from the date a formal plan to discontinue

operations is adopted by a firm’s board of directors to the disposal date, and

(2) expected gain or loss on the sale of assets.

i. Expected net losses are always recorded.

ii. Expected net gains can be recorded to the extent that they offset

realized losses.

2. A firm must disclose the identity of segment and details of disposal in the

footnotes.

3. As recently proposed by FASB (April 2013), discontinued operations is a

component of a business that has either been disposed of, or is classified as held for

sale and represents a separate major line of business or major geographical area of

operations, and is part of a single plan to dispose of a separate major line of business

or geographical area of operation or is a business that meets the criteria for

classification as held for sale upon acquisition.

D. Extraordinary items.

1. Extraordinary items must meet both of the following criteria:

a. The underlying event or transaction must be unusual in nature, i.e., possess a

high degree of abnormality, considering its environment.

b. The underlying event or transaction must be infrequent in occurrence, i.e., it

would not reasonably be expected to recur in the foreseeable future.

2. Events that meet one, but not both, of these criteria, are reported as

income from continuing operations.

3. FASB ASC Paragraph 470-50–45–1 covers the reporting of gains or

losses from retirement of debt. This standard now allows for companies

that routinely retire debt to record this economic event as part of pre-tax

income from continuing operations with a separate line-item disclosure.

a. If material in amount (i.e., of sufficient magnitude to make a difference in

the decision-making process) then the item must be disclosed as a separate

item in the fiSpecial or unusual items” section of the income statement.

b. Alternatively, a separate disclosure in the footnotes to the financial

statements is allowed.

E. Frequency and magnitude of various categories of transitory income statement items.

1. In the period between 2001-2011, about 60% of firms reported at least one of the

transitory earnings components on their income statement. Theses items tend to

be significant components of earnings.

2. About 57% of the firms reported fispecial or unusual items” in 2011 compared

to 52.5% in 2002.

3. Discontinued operations appeared in about 13.5% of earnings statements in

2011 compared to 12% in 2002.

4. Firms reporting extraordinary items decreased from 13% in 2002 to less than

0.2% in 2011.

5. The majority of special or unusual items and extraordinary items (75.9% in

2011) were losses.

6. Special or unusual items are potential fired flags” for possible earnings

management. Managers have an incentive to label losses as firesults from

special or unusual circumstances” than they do gains.

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

Teaching Tip: In forecasting future cash flows, a reader of the financial statements must

determine whether the fispecial or unusual items” are sustainable or transitory. The

increased occurrence of these items heightens the speculative nature of these forecasts. It is

important to remember that financial statements are designed to measure the economic

conditions (micro and macro) and financial management of the company to assist users in

determining future cash flows. Companies doing well in a great economic environment

may be in trouble during the next economic turn while a company that exceeds the

competition results during a recession may emerge as a market leader.

IV. REPORTING ACCOUNTING CHANGES – Although difficult to always achieve,

consistency (using the same accounting methods from period to period), is a desired accounting

outcome. Firms do switch methods or revise estimates when such changes better reflect the

firm’s underlying economics. These changes fall into three categories.

A. GAAP specifies to approaches for reporting accounting changes.

Retrospective Approach is used for a change in accounting principle and change in

reporting entity. Numbers in financial statements from prior years are revised to show

the impact of the change. This enhances comparability and consistency over time.

Prospective Approach is used for changes in accounting estimates. No adjustments

are made to prior year numbers on the financial statements. The new estimated

amounts are used in the year of change and future reporting periods.

B. Changes in accounting principles occurs when a firm voluntarily changes from one

acceptable accounting method to another (voluntary change) or a new standard is

promulgated by GAAP that must be implemented (mandatory change).

1. GAAP requires the use of the retrospective approach unless it is impractical.

a. Prior years’ financial statements that are presented for comparative purposes

in the year of the change are revised to reflect the impact of the change in

accounting principle using the same basis of accounting.

2. The new principle is applied in computing income from continuing operations in

the year of the change.

3. A journal entry is made to adjust all account balances to reflect what those amounts

would have been under the new method as of the beginning of the current year.

4. An adjustment is also made to the beginning balance of retained earnings to reflect

the cumulative effect of the accounting principle change on all prior periods.

5. Disadvantage of this approach is that firms may use an aggressive accounting

method in earlier years that overstates income and asset values in an effort to lower

new debt or equity financing costs and later change to a more conservative method.

6. When the cumulative effect cannot be determined, the new method is applied

prospectively beginning with year of change and to all future years.

Teaching Tip: Changes in accounting principles generally do not result in direct changes in

cash flows. The only exception is a change from the LIFO method of accounting for

inventory (because of the LIFO conformity rule). Since changes in accounting principles

generally do not affect the tax return, a change in principles used for financial reporting

purposes affects only income tax expense and deferred income taxes.

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

C. Accounting changes.

1. Changes in accounting estimates (revisions of estimates because new

information or new experience)

a. Changes in accounting estimates are handled prospectively—i.e., accounted for

in the year of change and in future periods – prior year income is not adjusted.

b. A change occurs concurrently with a change in the economic

circumstances underlying an accounting estimate.

2. Change in reporting entity (change in economic units that comprise the

reporting entity).

a. Comparative financial statements for prior years must be restated for

comparative purposes to reflect the new reporting entity as if it had been in

existence during all of the years presented.

D. Earnings per share (EPS) data present the financial statement reader earnings data

using a ficommon size” number. The basic EPS and the diluted EPS should be

presented for the various components of earnings (income from continuing operations;

discontinued operations; extraordinary items; and net income).

V. Comprehensive Income is a change in equity (net assets) of a business entity that occurs

during a reporting period from transactions or events from nonowner sources.

A. Selected unrealized gains (or losses) arising from incomplete (or open) transactions

sometimes bypass the income statement and are reported as direct adjustments to

owners’ equity.

1. Such items, called fiother comprehensive income,” include unrealized gains

(losses) on fiavailable-for-sale” marketable securities, foreign currency

translation gains (losses), unrealized losses resulting from minimum pension

obligations, unrealized actuarial gains and losses on pension assets and

liabilities, and unrealized gains and losses on certain derivatives.

2. Other Comprehensive Income components frequently arise from using fair value

measurements for selected assets or liabilities.

3. Items included in net income are considered to be closed transactions.

4. Open transactions occur when balance sheet carrying amounts are changed even

though the transaction is not yet closed. For example, unrealized gains and losses

on marketable securities are not closed because the securities have not been sold.

B. Comprehensive income is the net income from the traditional income statement plus or

minus fiother comprehensive income components.”

C. GAAP requires firms to report comprehensive income in a statement with equal

prominence as other financial statements. Comprehensive income is reported either as

a separate statement or as part of a statement combined with the income statement.

VI. GLOBAL VANTAGE POINT

A. Both FASB and IASB enacted changes in presentation of comprehensive income. IAS 1

allows firms to present a single statement of comprehensive income or alternatively

present a net income statement and a statement of comprehensive income. Under GAAP,

the option to report component of other comprehensive income as part of the statement of

changes in stockholders’ equity is eliminated. GAAP requires a reclassification

adjustment from other comprehensive income to net income on the face of the financial

statements.

VII. APPENDIX: REVIEW OF ACCOUNTING PROCEDURES AND T-ACCOUNT

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

ANALYSIS

A. The basic accounting equation is the foundation of financial reporting.

1. A = L + OE.

2. At all times the dollar sum of a firm’s assets (A) must be equal to the dollar sum of

the firm’s liabilities (L) plus its owners’ equity (OE).

3. Creditors or owners finance assets.

4. The total resources a firm owns or controls (its assets) must by definition be equal

to the total of the financial claims against those assets held by either creditors or

owners.

B. Revenue and expense accounts that appear on the income statement are owners’

equity accounts.

1. Revenues are owners’ equity increases since the owners benefit from the inflow of

assets resulting from a sale.

2. Expenses are owners’ equity decreases since the owners’ claims against the assets

of the company are reduced because the firm must relinquish an asset, inventory, in

making the sale.

C. Debit and credit basics.

1. Assets Liabilities Equity Revenues Expenses

debit credit debit credit debit credit debit credit debit credit

+ – – + – + – + + –

2. The normal balance for an account is always the same as the increase side.

a. Assets and expenses generally have debit balances.

b. Liabilities, equity, and revenues generally have credit balances.

3. For each transaction, the dollar total of the debits must equal the dollar total of the

credits.

4. Assets always equal liabilities plus owners’ equity.

D. Adjusting entries are made whenever financial statements are prepared.

1. Insures that economic events that have occurred are reflected in the accounts.

2. There are four types of adjusting entries.

a. Adjustments for prepayments are required because of the passage of time.

i. Entries of this type generally require a debit to an expense account and a

credit to an asset or contra-asset account.

ii. Examples include prepaid rent, prepaid insurance, and

depreciation or amortization of long-term assets.

b. Adjustments for unearned revenue recognize that amounts

paid in advance have been earned. Entries of this type generally

require a debit to a liability account and a credit to a revenue or

sales account.

c. Adjustments for accrued expenses recognize that expenses are incurred

when the underlying economic event occurs, not necessarily when the cash

flows out. Entries of this type generally require a debit to an expense account

and a credit to a liability account.

d. Adjustments for accrued revenue recognize that revenue is earned when the

underlying services have been performed or when goods are exchanged, not

necessarily when cash is received. Entries of this type generally require a debit

to an asset account and a credit to a revenue or sales account.

3. The financial statements are prepared after all adjusting entries have been made.

E. Financial statement preparation

1. The income statement is prepared first so that the net income amount can be

determined.

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

2. Net income is used to update the owners’ equity section in the balance sheet.

F. Closing entries are required to reset the revenue and expense accounts to zero in

order to prepare the accounts for the next period’s transactions.

1. All income statement accounts with debit balances are credited so that their

balances are reset to zero.

2. All income statement accounts with credit balances are debited so that their balances

are reset to zero.

3. The debit or credit amount that is required to balance the two entries above is made

to retained earnings.

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

CHAPTER QUIZ

1. Thousand Trails, Inc. owns and operates membership resort campgrounds in the U.S.

Memberships allow a member’s family unlimited use of the company’s present and proposed

campgrounds over the lifetime of the member for an initial membership fee. Under the terms

of the membership sales agreement, no refunds are available once memberships are sold, even

if additional campgrounds or additional facilities at existing sites are not completed. How

should Thousand Trails recognize membership revenue?

a. Membership sales should be recognized as revenue over the life of each member.

b. Membership sales should be recognized as revenue over the estimated life of an

fiaverage member,” based on a membership profile.

c. Membership sales should be recognized as revenue when the membership agreement is

signed.

d. Membership sales should be recognized based on members’ actual use of the facilities.

2. A local ski club offers membership for a two-year period under the following terms:

• Applicants pay the entire membership fee in four quarterly installments (i.e., $250 every

three months) during the first year of the contract;

• Applicants are entitled to discounted lift tickets and hotel room accommodations during

the two-year membership period (including off-season room accommodations and lift

tickets for mountain biking).

Based on experience, the club is able to estimate with reasonable accuracy its uncollectible

receivables. If the club prepares quarterly income statements, what amount of membership

revenue will be reported in the first quarter during the first year of each membership?

a. $125

b. $250

c. $1,000

d. $2,000

3. The matching principle encourages:

a. The recognition of expenses when cash is paid for supplies.

b. The recognition of depreciation expense for property, plant, and equipment over their

useful lives.

c. The reconciliation of net income and comprehensive income in a separate financial

statement.

d. The recording of period costs on the balance sheet.

4. TJX is a retailer that offers filayaway” sales to its customers. TJX retains the merchandise,

sets it aside in its inventory, and collects a cash deposit from the customer. The merchandise

generally is not released to the customer until the customer pays the full purchase price.

When may TJX recognize revenue for merchandise sold under its layaway program?

a. TJX should recognize revenue under its layaway program upon delivery of the

merchandise to the customer.

b. TJX should recognize revenue under its layaway program as cash deposits are

collected.

c. TJX should recognize revenue under its layaway program when the inventory is set

aside.

d. TJX should recognize revenue under its layaway program in equal amounts each month

during the layaway period.

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

5. A biotechnology firm provides research and development activities for a customer for a

specified term. The customer needs to use certain technology owned by the biotechnology

firm for use in its research and development activities. The technology is not sold or licensed

separately without the research and development activities. Under the terms of the

arrangement, the customer is required to pay a nonrefundable fitechnology access fee” in

addition to periodic payments for research and development activities over the term of the

contract. When is the technology access fee recognized as revenue?

a. When the agreement is signed.

b. When the research activity begins.

c. When the research activity is completed.

d. Systematically over the periods that the research is performed.

6. Under the current GAAP, gains and losses from retirement of debt for companies that

routinely retire and reissue debt is treated as income from continuing operations.

Companies retiring material amount of debt could account for these retirements as

follows:

a. A separate item in the fispecial or unusual items” section of the income statement

ownership.

b. A special disclosure in the footnotes to the financial statements.

c. As an extraordinary item if meets the criteria of being unusual in nature and

occurs infrequently.

d. All of the above.

7. Extraordinary items, unusual gains and losses, and discontinued operations illustrate the

difficulty of deciding what constitutes income from continuing operations. In developing an

estimate of a firm’s fiearning power,” analysts normally exclude all items that are unusual

or nonrecurring in nature. As an analyst, is income from continuing operations your best

estimate of future earnings?

a. Yes. Since income from continuing operations excludes nonrecurring items, it is

the best estimate of future earnings.

b. No. One’s best estimate of future earnings should begin with income from

continuing operations, but should exclude all of the unusual items as well.

c. No. One’s best estimate of future earnings should begin with income from

continuing operations, but should exclude all of the unusual items and the

nonrecurring non-operating items as well.

d. No. Net income is the best starting point for estimating future earnings.

8. The purpose of reporting nonrecurring items, net of related income taxes, below income

from continuing operations is:

a. These items help explain deviations in current year net income from past trends.

b. These items assist in the task of predicting the timing and amount of future cash flows.

c. Neither a. nor b.

d. Both a. and b.

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

9. On November 1, 2015, Key Co. paid $7,200 to renew its insurance policy for three

years. On December 31, 2015, Key’s unadjusted trial balance showed $180 for prepaid

insurance and $8,820 for insurance expense. Given that Key prepares financial statements

quarterly, what amounts should Key report for prepaid insurance and insurance expense

in its December 31, 2015, financial statements?

Prepaid Insurance Insurance Expense

a. $6,600 $2,400

b. $6,800 $2,400

c. $6,800 $2,200

d. $6,980 $2,020

10. Other comprehensive income components:

a. Are shown net of their related tax effects.

b. Include all changes in equity that do not affect the income statement.

c. Include realized gains and losses.

d. Eliminate the effects that unrealized gains and losses have on the financial statements.

QUIZ ANSWERS:

1. c. Under the terms of the membership sales agreement, no refunds are available once

memberships are sold and the company is not obligated to provide additional facilities.

Therefore, it is appropriate to recognize revenue at the time the membership agreement is

signed.

Financial Reporting and Analysis 6e Accrual Accounting and Income Determination

RECOMMENDED EXHIBITS

1. Figure 2.1—Canterbury Publishing comparison of accrual and cash-basis income.

2. Figure 2.2—The revenue recognition process.

3. Figure 2.5—Proportion of firms reporting nonrecurring items (2002-2011).

4. Exhibit 2.4- Types of Accounting Changes