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The Vest Pocket CPA

John Wiley & Sons

Chapter One

The reporting requirements of the income statement, balance sheet, statement of changes in cash flows, and interim reporting guidelines must be carefully examined. Individuals preparing personal financial statements have to follow certain unique reporting requirements, also true in accounting for a partnership. Points to note are:

* Income statement preparation involves proper revenue and expense recognition. The income statement format is highlighted along with the earnings per share computation.

* Balance sheet reporting covers accounting requirements for the various types of assets, liabilities, and stockholders' equity.

* The Statement of Cash Flows presents cash receipts and cash payments classified according to investing, financing, and operating activities. Disclosure is also provided for certain noncash investment and financial transactions. A reconciliation is provided between reported earnings and cash flow from operations. * Interim financial reporting allows for some departures from annual reporting such as the gross profit method to estimate inventory. The tax provision is based on the effective tax rate expected for the year.

* Personal financial statements show the worth of the individual. Assets and liabilities are reflected at current value in the order of maturity.

* This chapter will dealwith the reporting requirements on the income statement. Chapter 2 will deal with the balance sheet, and Chapter 3 will cover the remaining statements.

INCOME STATEMENT FORMAT

With respect to the income statement, the CPA's attention is addressed to:

* Income statement format * Comprehensive income

* Extraordinary items

* Nonrecurring items

* Discontinued operations

* Revenue recognition methods

* Accounting for research and development costs

* Presentation of earnings per share

How are items on the income statement arranged?

In the preparation of the income statement, continuing operations are presented before discontinued operations.

Starting with income from continuing operations, the format of the income statement is as follows:

Income from continuing operations before tax Less: Taxes Income from continuing operations after tax Discontinued operations: Income from discontinued operations (net of tax) Loss or gain on disposal of a division (net of tax) Income before extraordinary items Extraordinary items (net of tax) Cumulative effect of a change in accounting principle (net of tax) Net income

NOTE Earnings per share is shown on the above items as well.

COMPREHENSIVE INCOME

What is comprehensive income?

Comprehensive income is the change in equity occurring from transactions and other events with nonowners. It excludes investment (disinvestment) by owners.

What are the two components of comprehensive income?

Comprehensive income consists of two components: net income and "other comprehensive income." Net income plus "other comprehensive income" equals comprehensiveincome.

What does "other comprehensive income" include?

As per FASB Statement No. 130 (Reporting Comprehensive Income), "other comprehensive income" includes the following:

* Foreign currency translation gain or loss

* Unrealized gain or loss on available-for-sale securities

* Minimum pension liability adjustment (excess of additional pension liability over unamortized prior service cost)

* Change in market value of a futures contract that is a hedge of an asset reported at present value

How is comprehensive income reported?

FASB Statement No. 130 has three acceptable options of reporting comprehensive income and its components. We present the best and most often used option which is an income statement-type format as follows:

STATEMENT OF INCOME AND COMPREHENSIVE INCOME

Net Income $400,000 Other Comprehensive Income Foreign currency translation gain $20,000 Unrealized loss on available-for-sale securities (2,000) Minimum pension liability adjustment (1,000) 17,000 Comprehensive Income $417,000

The "other comprehensive income" items reported in the income statement are for the current year amounts only. The total "other comprehensive income" for all the years is presented in the stockholders' equity section of the balance sheet as "accumulated other comprehensive income."

EXTRA ORDINARY ITEMS

What are extraordinary items?

Extraordinary items are those that are both unusual in nature and infrequent in occurrence.

* "Unusual in nature" means the event is abnormal and not related to the typical operations of the entity.

* "Infrequent in occurrence" means the transaction is not anticipated to take place in the foreseeable future, taking into account the corporate environment.

* The environment of a company includes consideration of industry characteristics, geographic location of operations, and extent of government regulation.

* Materiality is considered by judging the items individually and not in the aggregate. However, if they arise from a single specific event or plan, they should be aggregated.

Extraordinary items are shown net of tax between income from discontinued operations and cumulative effect of a change in accounting principle.

What are some typical extraordinary items?

Extraordinary items include:

* Casualty losses

* Losses on expropriation of property by a foreign government

* Gain on life insurance proceeds.

* Gain on troubled debt restructuring

* Loss from prohibition under a newly enacted law or regulation

NONRECURRING ITEMS

What are nonrecurring items?

Nonrecurring items are items that are either unusual in nature or infrequent in occurrence. They are shown as a separate line item before tax in arriving at income from continuing operations. EXAMPLE: The gain or loss on the sale of a fixed asset.

DISCONTINUED OPERATIONS

How is a discontinued operation defined?

A discontinued operation is an operation that has been discontinued during the year or will be discontinued shortly after year-end. A discontinued operation may be a business segment that has been sold, abandoned, or spun off.

The two components of discontinued operations are:

1. Income or loss from operations 2. Loss or gain on disposal of division

What disclosure requirements apply to a discontinued activity?

Footnote disclosure regarding the discontinued operation should include:

* An identification of the segment

* Disposal date

* The manner of disposal

* Description of remaining net assets of the segment at year-end

(A business segment is a major line of business or customer class.) Even though it may be operating, a formal plan to dispose exists.

How do we present discontinued operations?

In an annual report, the income of a component classified as held-for-sale is presented in discontinued operations in the year(s) in which they occur. Phase-out losses are not accrued.

The income of a component of a business that either has been disposed of or is held-for-sale is reported in discontinued operations only when both the following criteria have been satisfied:

* The profit and cash flows of the component have been (or will be) eliminated from the ongoing operations of the company due to the disposal decision.

* The company will not have any major ongoing involvement in the activities of the component subsequent to the disposal decision.

In general, gain or loss from operations of the discontinued component should include operating gain or loss incurred and the gain or loss on disposal of a component taking place in the current period. Gains should not be recognized until the year actually realized.

REVENUE RECOGNITION

What are the various ways of recording revenue?

Revenue, which is associated with a gross increase in assets or a decrease in liabilities, may be recognized under different methods depending on the circumstances. (Special revenue recognition guidelines exist for franchisors and in sales involving a right of return. A product financing arrangement may also exist.) The basic methods of recognition include:

* Realization

* Completion of production

* During production

* Cash basis

Realization

When is revenue normally realized?

Revenue is recognized when goods are sold or services are performed. It results in an increase in net assets. This method is used almost all of the time. At realization, the earnings process is complete. Further, realization is consistent with the accrual basis, meaning that revenue is recognized when earned rather than when received. Realization should be used when:

* The selling price is determinable

* Future costs can be estimated

* An exchange has taken place that can be objectively measured

Three other methods of revenue recognition are used in exceptional situations, as discussed below.

At the completion of production

When can revenue be recognized upon completion of production?

Revenue is recognized prior to sale or exchange.

REQUIREMENTS

There must be

* A stable selling price

* Absence of material marketing costs to complete the final transfer.

* Interchangeability in units

This approach is used:

* With agricultural products, byproducts, and precious metals when the aforementioned criteria are met.

* In accounting for construction contracts under the completed contract method.

During Production

When can I recognize revenue during production?

In the case of long-term production situations, revenue recognition is made when:

* An assured price for the completed item exists by contractual agreement, and

* A reliable measure of the degree of completion at various stages of the production process is possible.

EXAMPLE: The percentage of completion method used in accounting for long-term construction contracts.

Which is preferable-completed contract or percentage of completion method?

Under the completed contract method, revenue should not be recognized until completion of a contract. In general, the completed contract method should be used only when the use of the percentage of completion method is inappropriate.

How is revenue matched with costs in the percentage of completion method?

Under the percentage of completion method, revenue is recognized as production activity is occurring. The gradual recognition of revenue levels out earnings over the years and is more realistic since revenue is recognized as performance takes place.

Using the cost-to-cost method, revenue recognized for the period equals:

Actual Costs to Date / Total Estimated Costs x Contract Price

= Cumulative Revenue

Revenue recognized in prior years is deducted from the cumulative revenue to determine the revenue in the current period.

Cash Basis

When is cash basis, rather than accrual, preferable or required? In the case of a company selling inventory, the accrual basis is used. However, the cash basis of revenue recognition is used under certain circumstances, namely, when revenue is recognized upon collection of the account. The cash basis instead of the accrual basis must be used when one or more of the following exist:

* Inability to objectively determine selling price at the time of sale

* Inability to estimate expenses at the time of sale

* Risks as to collections from customers

* Uncertain collection period

How do I compute revenue under the installment method?

Revenue recognition under the installment method equals the cash collected times the gross profit percent. Any gross profit not collected is deferred on the balance sheet until collection occurs. When collections are received, realized gross profit is recognized by debiting the deferred gross profit account. The balance sheet presentation is:

Accounts Receivable (Cost + Profit) Less: Deferred Gross Profit Net Accounts Receivable (Cost)

How is revenue recognized if the buyer can return the goods?

When a buyer has a right to return the merchandise bought, the seller can only recognize revenue at the time of sale in accordance with FASB 48 provided that all of the following conditions are satisfied:

* Selling price is known.

* Buyer has to pay for the goods even if the buyer is unable to resell them. EXAMPLE: A sale of goods from a manufacturer to wholesaler. No provision must exist that the wholesaler has to be able to sell the items to the retailer.

* If the buyer loses the item or it is damaged in some way, the buyer still has to pay for it.

* Purchase by the buyer of the item has economic feasibility.

* Seller does not have to render future performance in order that the buyer will be able to resell the goods.

* Returns may be reasonably estimated.

If any of the above criteria are not met, revenue must be deferred along with deferral of related expenses until the criteria have been satisfied or the right of return provision has expired. As an alternative to deferring the revenue, record a memo entry as to the sale.

What factors affect the ability of a company to predict future returns?

The following considerations may be used in predicting returns:

* Predictability is hampered when there is technological obsolescence risk of the product, uncertain product demand changes, or other material external factors.

* Predictability is lessened when there is a long time period involved for returns.

* Predictability is enhanced when there exists a large volume of similar transactions.

* The seller's previous experience should be weighed in estimating returns for similar products.

* The nature of customer relationship and types of product involved need to be evaluated.

What is the definition of a financing arrangement?

Per FASB 49, the arrangement involving the sale and repurchase of inventory is, in substance, a financing arrangement. It mandates that the product financing arrangement be accounted for as a borrowing instead of a sale. In many cases, the product is stored on the company's (sponsor's) premises. Further, often the sponsor will guarantee the debt of the other entity.

Typically, the sponsor eventually uses or sells most of the product in the financing arrangement. However, in some cases, the financing entity may sell small amounts of the product to other parties.

The entity that gives financing to the sponsor is usually an existing creditor, nonbusiness entity, or trust. It is also possible that the finansor may have been established for the only purpose of providing financing for the sponsor.

What are some types of financing arrangements?

Types of product financing arrangements include:

* Sponsor sells a product to another business and agrees to reacquire the product or one basically identical to it. The established price to be paid by the sponsor typically includes financing and holding costs.

* Sponsor has another company buy the product for it and agrees to repurchase the product from the other entity.

* Sponsor controls the distribution of the product that has been bought by another company in accord with the aforementioned terms.

(Continues...)

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Excerpted from The Vest Pocket CPA by Joel G. Siegel Excerpted by permission.
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