Cpa Fin Su3 Outline

8/9/2019 Cpa Fin Su3 Outline

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STUDY UNIT THREE

INCOME STATEMENT ITEMS

3.1 Discontinued Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

3.2 Extraordinary Items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33.3 Accounting Changes and Error Corrections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53.4 Earnings per Share (EPS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83.5 Long-Term Construction Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163.6 Revenue Recognition after Delivery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193.7 Fair Value Measurements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

The first four subunits of this study unit concern the presentation of certain items on the income

statement. The next two subunits address various revenue recognition issues. The seventh subunit

addresses the tools available for the application of fair value to financial statement items.

3.1 DISCONTINUED OPERATIONS

1. Overview

a. The operating results of adiscontinued operationare reported separately net of taxin the income statement (or statement of activities of a not-for-profit entity) if threeconditions are met:

1) A component of the entity has beendisposed ofor isclassified as held forsale.

2) The operations and cash flows of this component are or will be eliminated fromthe entitys operations.

3) The entity will have no significant continuing involvement in the operations of thecomponent after the disposal.

b. Acomponentof an entity has operations and cash flows that are clearlydistinguishable for operating and financial reporting purposes. A component may bea(n)

1) Reportable segment,2) Operating segment,3) Reporting unit,4) Subsidiary, or5) Asset group.

c. If a long-lived asset isnot a component, it cannot be reported as a discontinuedoperation. In this case, a gain or loss on its sale is included in income from continuingoperations before income taxes.

2. Adjustments

a. Amounts reported in discontinued operations may require adjustment. If theadjustmentdirectly relatesto aprior-period disposalof a component, it isreported currently and separatelyin discontinued operations. Its nature andamount are disclosed. Adjustments may include the following:

1) Contingencies arising under the terms of the disposal transaction may beresolved, for example, by purchase price adjustments.

2) Contingencies directly related to the pre-disposal operations of the componentmay be resolved. Examples are the sellers environmental and warrantyobligations.

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3) Employee benefit plan obligations for pensions and other postemploymentbenefits may be settled. Reporting in discontinued operations is required if thesettlement is directly related to the component disposed of.

3. Income Statement Presentation

a. The operating results of a component that has been disposed of or is classified as held

for sale are reported in discontinued operations. This section is presentedaftercontinuing operations but before extraordinary items.

b. When a component isclassified as held for sale, it is measured at the lowerof itscarrying amountor fair value minus cost to sell.

1) Operating results reported in discontinued operations include any income earnedor loss incurred during the entire reporting period (before or after thecomponent was classified as held for sale).

2) Operating results also include any loss for a writedown to fair value minus cost tosell. They also include a gain arising from an increase in fair value minus costto sell (limited to losses previously recognized).

3) From the moment the component is classified as held for sale, operating resultsdo not include depreciation or amortization.

4) If the component is disposed of during the period, anygain or loss on disposalmust be disclosed on the face of the income statement or in the notes.

c. The results of discontinued operations are reportedminus/plus income tax/benefit.

EXAMPLE

On July 1, Year 1, Emkay Co. approved a plan to dispose of Segment X on October 1, Year 1. As a result, Segment X(a component of the entity) was properly classified as held for sale. It was sold on October 1, Year 1, for $480,000. Emkaysincome tax rate is 40%. The following data pertain to Segment X:

Operating losses were $110,000 for the period January 1 to June 30, Year 1.

Operating losses were $100,000 for the period July 1 to October 1, Year 1.

The operating losses presented above do not include a loss on disposal or a write-down to fair value minus cost

to sell. The carrying amount on July 1, Year 1, was $600,000.

Fair value minus cost to sell on July 1, Year 1, was $450,000.

The following are Emkays Year 1 income statement items excluding Segment Xs operating results:

Revenues $950,000Cost of goods sold 380,000General and administrative

expenses 90,000Interest expense 50,000

Year 1 operating results of Segment X are reported in discontinued operations. The loss from discontinued operations forthe year ended December 31, Year 1, includes all of the following:

Operating losses incurred during the entire reporting period were $210,000 ($110,000 + $100,000).

The loss on write-down to fair value minus cost to sell on July 1 was $150,000 ($600,000 carrying amount $450,000 fair value minus cost to sell).

The gain on disposal of the segment on October 1 was $30,000 ($480,000 $450,000).

The total Year 1 loss from discontinued operations before tax is $330,000 ($210,000 + $150,000 $30,000). The loss ondiscontinued operations (net of tax) reported in the income statement is $198,000 [$330,000 (1 40%)].

-- Continued on next page --

2 SU 3: Income Statement Items



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EXAMPLE -- Continued

The following format may be used by Emkay to present its Year 1 income statement:

Emkay Co.Income Statement

For the Year Ended 12/31/Yr 1

Revenues $950,000Cost of goods sold (380,000)

Gross profit $570,000General and administrative expenses 90,000Interest expense 50,000 (140,000)

Income from continuing operations before income taxes $430,000Income taxes (172,000)

Income from continuing operations $258,000

Discontinued operationsLoss from operations of component unit Segment X

(including gain on disposal of $30,000) $(330,000)Income tax benefit 132,000

Loss of discontinued operations (198,000)

Net income $ 60,000

1) Basic and diluted EPSamounts for a discontinued operation are presented onthe face of the income statement or in the notes.

2) The caption Income from continuing operations should be revised to Incomefrom continuing operations before extraordinary item if an extraordinary item isreported.

IFRS Difference

Net cash flows from operating, investing, and financing activities of a discontinued operationmust be disclosed in the notes or the statements.

3.2 EXTRAORDINARY ITEMS

1. Overview

a. A material transaction or event that isunusual in nature and infrequent inoccurrencein the environment in which the entity operates is an extraordinary item.

1) A transaction or event isunusualif it has a high degree of abnormality and is ofa type clearly unrelated to, or only incidentally related to, the ordinary andtypical activities of the entity.

EXAMPLE

A warehouse fire is clearly unrelated to an entitys ordinary and typical activities.

2) A transaction or event isinfrequentif it is not reasonably expected to recur inthe foreseeable future.

EXAMPLE

An earthquake in Florida (but not in California) is not reasonably expected to recur.

b. Sometimes a pronouncement specifically classifies an item as extraordinary even ifthese criteria are not met.

SU 3: Income Statement Items 3



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2. Items Not Considered Extraordinary

a. The following are examples:

1) Write-downs of receivables, inventories, intangible assets, etc.

2) Gains and losses from exchange or translation of foreign currencies, includingthose resulting from major devaluations and revaluations

3) Gains and losses on disposal of a component of an entity

4) Other gains and losses from sale or abandonment of property, plant, andequipment used in the business

5) Effects of a strike, including those against competitors and major suppliers

6) Adjustments of accruals on long-term contracts

b. However, an extraordinary event or transaction may occur that includes a gain or losslisted just above. In one of these rare cases, gains or losses, such as those in 2.a.1)and 2.a.4) above, may be classified as extraordinary.

1) The gains or losses that qualify are those directly resulting from a(n)

a) Major casualty(e.g., flood),

b) Expropriation, orc) Prohibition under a new law or regulation.

2) Disposal of a component of an entity, item 2.a.3), is accounted for and presentedin the income statement as discontinued operations even if the criteria ofextraordinary item is met.

c. Any portion of the losses described in 2.b. above that would have resulted frommeasurement of assets on a going-concern basis (e.g., writing down assets to fairvalue) is not included in the extraordinary items.

3. Adjustments of Estimates

a. Adjustments of estimates included in extraordinary items previously reported areseparately presented and disclosed in the current statements. They are classified inthe same way as the original items.


a. Extraordinary items should be reported individually in a separate section in the incomestatement,net of tax, after results of discontinued operations. However, disclosure inthe notes of individual items included in this section also is acceptable.

1) Basic and diluted EPSamounts for extraordinary items are presented on theface of the income statement or in the notes (discussed in Subunit 3.4).

b. If a material transaction or event isunusual or infrequent but not both, it is not anextraordinary item. Thus, it is reported as a separate component of income fromcontinuing operations butnot net of tax. No EPS disclosure is made on the incomestatement.

IFRS Difference

No items are classified as extraordinary, either on the face of the statement of comprehensiveincome or in the notes.

c. The following memory aid is helpful for learning the order of items on the incomestatement:

I = Income from Continuing Operations ID = Discontinued Operations DoE = Extraordinary Items Excel




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3.3 ACCOUNTING CHANGES AND ERROR CORRECTIONS

The AICPA traditionally tests candidates knowledge of how to account for the effects of a change inaccounting principle, a change in accounting estimate, and the correction of errors. Be prepared to seequestions that ask how to handle each of these situations, either by describing the accounting, calculatingthe requested amounts, or choosing the correct journal entries.

1. Accounting Changes -- Overview

a. If financial information is to have the qualities of comparability and consistency, entitiesmust not make voluntary changes in accounting principles unless they can bejustified as preferable.

1) Thus, thegeneral presumptionis thata principle once adopted must beapplied consistentlyin preparing financial statements.

b. The threetypes of accounting changes are a change in accounting principle, achange in accounting estimate, and a change in reporting entity.

2. Change in Accounting Principle (Retrospective Application)

a. A change in accounting principle occurs when an entity (1) adopts a generallyaccepted principle different from the one previously used, (2) changes the methodofapplying a generally accepted principle, or (3) changes to a generally acceptedprinciple when the principle previously used is no longer generally accepted.

1) A change in principle does not include the initial adoption of a principle becauseof an event or transaction occurring for the first time or that previously had animmaterial effect.

2) It also does not include adoption of a principle to account for an event ortransaction that clearly differs in substance from a previously occurring event ortransaction.

b. Retrospective applicationis required for all direct effects and the related income tax

effects of a change in principle.1) An example of a direct effect is an adjustment of an inventory balance to

implement a change in the method of measurement.

2) Retrospective application mustnot include indirect effects. These are changesin current or future cash flows from a change in principle appliedretrospectively.

a) An example of an indirect effect is a required profit-sharing payment basedon a reported amount that was directly affected (e.g., revenue).

b) Indirect effects are recognized and reported in the period of change.

c. Retrospective application requires the carrying amounts of (1) assets, (2) liabilities,and (3) retained earnings (or other components of equity or net assets) at the

beginning of the first period reported to be adjusted for the cumulative effect (CE) ofthe new principle on the prior periods.

1) All periods presented must be individually adjusted for theperiod-specificeffects (PSE)of the new principle.

d. It may beimpracticableto determine thecumulative effectof a new principle on anyprior period.

1) In that case, the new principle must be applied as if the change had been madeprospectively at the earliest date practicable.




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4. Change in Reporting Entity

a. A change in reporting entity results in statements that are effectively those of adifferent entity.

1) Most such changes occur when (a) consolidated or combined statementsreplace those of individual entities, (b) consolidated statements include different

subsidiaries, or (c) combined statements include different entities.2) A change in reporting entity does not result from abusiness combinationor

consolidation of a variable interest entity.

3) This change is retrospectively applied to interim and annual statements.

5. Error Correction

a. An error in prior statements results from (1) a mathematical mistake, (2) a mistake inthe application of GAAP, or (3) an oversight or misuse of facts existing when thestatements were prepared. A change to a generally accepted accounting principlefrom one that is not is an error correction, not an accounting change.

1) Any error related to a prior period discovered after the statements are, or areavailable to be, used must be reported as an error correction by restating the

prior-period statements.Restatementrequires the same adjustments asretrospective applicationof a new principle.

a) The carrying amounts of (1) assets, (2) liabilities, and (3) retained earningsat the beginning of the first period reported are adjusted for thecumulative effect of the error on the prior periods.

b) Corrections of prior-period errorsmust notbe included in net income.

EXAMPLE

On January 1, Year 1, Entity E acquired a machine at a cost of $240,000. The freight-in and site preparation costs for themachine of $30,000 were mistakenly expensed as incurred by the bookkeeper. The machine was depreciated on thestraight-line basis over a 6-year period with no residual value. During Year 3, Entity Es controller discovered the error madeby the bookkeeper in Year 1.

All the costs necessarily incurred to bring the machine to the condition and location necessary for its intended use ($30,000)must be capitalized as part of the historical cost of the machine and depreciated in future periods. Ignoring the tax effect,the following error correction should be made by Entity E in Year 3.

The carrying amount of the machine on January 1, Year 3, with the error is$160,000[$240,000 historical cost ($40,000 annual depreciation 2 years elapsed)].

The carrying amount of the machine on January 1, Year 3, without the error should have been$180,000[$270,000 historical cost ($45,000 annual depreciation 2 years elapsed)].

The cumulative effect of the error for the two prior periods on the carrying amount of retained earnings is$20,000. This amount is the difference between (1) cumulative expenses actually recognized for Years 1 and2 of $110,000 ($30,000 freight-in and site preparation costs + $80,000 depreciation expense in the first2 years) and (2) cumulative expenses that should have been recognized without the error of $90,000. Thecarrying amount of retained earnings should be credited (i.e., decreased) for the cumulative effect (anoverstatement of expenses).

The error correction journal entry in Year 3 is

Machine -- cost ($270,000 $240,000) $30,000Retained earnings January 1, Year 3 $20,000Accumulated depreciation ($90,000 $80,000) 10,000

The annual depreciation expense recognized in Years 3 to 6 is$45,000($270,000 historical cost 6 years ofuseful life).

2) Error corrections must be reported in single-period statements as adjustments ofthe opening balance of retained earnings.

a) If comparative statements are presented, corresponding adjustments mustbe made to net income (and its components) and retained earnings (andother affected balances) for all periods reported.




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6. Error Analysis

a. A correcting journal entry combines the reversal of the error with the correct entry.Thus, it requires a determination of the (1) journal entry originally recorded, (2) eventor transaction that occurred, and (3) correct journal entry.

EXAMPLEIf the purchase of a fixed asset on account had been debited to purchases:

Incorrect Entry Correct Entry Correcting Entry

Purchases Fixed asset Fixed assetPayables Payables Purchases

If cash had been incorrectly credited:

Incorrect Entry Correct Entry Correcting Entry

Purchases Fixed asset Fixed AssetCash Payables Cash

PurchasesPayables

b. Error analysis addresses (1) whether an error affects prior-period statements, (2) thetiming of error detection, (3) whether comparative statements are presented, and(4) whether the error is counterbalancing.

c. An error affectingprior-period statementsmay or may not affect prior-period netincome. For example, misclassifying an item as a gain rather than a revenue doesnot affect income and is readily correctable. No prior-period adjustment to retainedearnings is required.

d. An error that affects prior-period net income iscounterbalancingif it self-correctsover two periods. However, despite the self-correction, the financial statementsremain misstated. They should be restated if presented comparatively in laterperiods. The flowchart on inventory errors in Study Unit 7, Subunit 7 illustrates thisconcept.

e. An example of anoncounterbalancingerror is a misstatement of depreciation. Suchan error does not self-correct over two periods. Thus, a prior-period adjustment willbe necessary.

IFRS Difference

A prior-period error must be corrected by restatement unless it is impracticable to do so. Theindirect effects of a change in accounting policy are not addressed by IFRS.

3.4 EARNINGS PER SHARE (EPS)

1. Overview

a. Earnings per share (EPS)is the amount of current-period earnings that can beassociated with a single share of a corporations common stock.

1) The guidance regarding calculation and presentation of EPS must be followed bypublic entitiesand by other entities that choose to report EPS.

a) The common stock or other equity securities of public entities are traded ina public market or stock exchange.




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b. EPS is calculatedonly for common stock because common shareholders are theresidual owners of a corporation.

1) Because preferred shareholders have a superior claim to the entitys earnings,amounts associated with preferred stock must be removed during thecalculation of EPS.

Over the years, the topic of earnings per share has been continually tested on CPA exams, often throughcalculations. Expect to see one or two questions testing earnings per share on your exam.

2. Basic Earnings per Share (BEPS)

a. All corporations must report two BEPS amounts on the face of the income statement.Their numerators areincome from continuing operations and net income,respectively.

EXAMPLE

At year end, an entitys capital structure consisted of 10,000,000 shares of $1 par-value common stock. The entity issuedno new shares during the year. Its income from continuing operations and net income for the year were $1,278,000 and$1,141,000, respectively.

BEPS calculations:Income from continuing operations: $1,278,000 10,000,000 = $0.128Net income: $1,141,000 10,000,000 = $0.114

b. If an entity has no discontinued operations, the income from continuing operationsequals net income. Thus, one amount of BEPS for net income available to common

shareholders is presented on the face of the income statement.3. Calculation of the BEPS Numerator

a. Income available to common shareholdersis the BEPS numerator.

1) Thus, neither BEPS amount (income from continuing operations or net income)is calculated directly from the amount reported for that line item on the incomestatement.

a) Income in the BEPS numerator is reduced by dividends

i) Declared in the current period on preferred stock (whether ornot paid)and

ii) Accumulated for the current period on cumulative preferred

stock (whether or not earned).b) Dividends paid in the current period for undistributed accumulated

preferred dividends for prior years do not affect the calculation. They areincluded in BEPS of prior years.

2) The following calculation is performed for net income and income fromcontinuing operations (or other number):

Income statement amountMinus: Dividends on preferred stock for the current period

(cumulative or declared noncumulative)

Equals: Income available to common shareholders




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EXAMPLE

An entity has two classes of preferred stock. It declared a 4% dividend on its $100,000 of noncumulative preferred stock.The entity did not declare a dividend on its $200,000 of 6% cumulative preferred stock. Undistributed dividends for the past4 years have accumulated on this stock. The following is an excerpt from the entitys condensed income statement for theyear:

Income from continuing operations before income taxes $1,666,667Income taxes (666,667)

Income from continuing operations $1,000,000

Discontinued operations:Income from operations of component unit --Pipeline Division (including gain on disposal of $2,897) $15,283Income tax expense (5,283) 10,000

Income before extraordinary item $1,010,000Loss from volcano damage, net of applicable income taxes of $52,221 (140,000)

Net income $ 870,000

The numerators for income from continuing operations and for net income are calculated as follows:

Income from

ContinuingOperations Net Income

Income statement amounts $1,000,000 $870,000Declared or accumulated preferred dividends:

Dividends declared on noncumulative preferred stock in the current period (4,000) (4,000)Dividends accumulated on cumulative preferred stock in the current period (12,000) (12,000)

Income available to common shareholders $ 984,000 $854,000

b. Given an extraordinary item but no discontinued operation, BEPS is reported forincome before extraordinary items, not income from continuing operations.

4. Calculation of the BEPS Denominator

a. Theweighted-average number of common shares outstanding is determined by

relating the portion of the period that the shares were outstanding to the total time inthe period.

1) Weighting is necessary because some shares may have been issued orreacquired during the period.

EXAMPLE

In the previous example, assume the following common stock transactions during the year just ended:

Times: Equals:

Common Shares Portion WeightedDate Stock Transactions Outstanding of Year Average

Jan 1 Beginning balance 240,000 2 12 40,000Mar 1 Issued 60,000 shares 300,000 5 12 125,000

Aug 1 Repurchased 20,000 shares 280,000 3 12 70,000Nov 1 Issued 80,000 shares 360,000 2 12 60,000

Total 295,000

TheBEPSamounts for income from continuing operations and net income are$3.336($984,000 295,000) and$2.895($854,000 295,000), respectively.




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d. The number of incremental shares from dilutive call options or warrants that must beincluded in the denominator of the DEPS computation is determined as follows:

1) Calculate the proceeds from exercising the options or warrants (numberoutstanding exercise price).

2) Calculate the number of shares assumed purchased (proceeds from exercise

average market price for the period of common shares).3) Calculate the number of incremental shares (number of common shares

assumed issued number of common shares assumed purchased).

a) The number of common shares assumed issued is the amount of commonshares that would have been issued assume all the options or warrantswere exercised.

EXAMPLE

Troupe Companys current-year BEPS is $11 ($440,000 net income 40,000 weighted-average number of common sharesoutstanding). Unexercised call options to purchase 20,000 shares of Troupes common stock at $20 per share wereoutstanding at the beginning and end of the year. For the year, the average market price per share of Troupes commonstock was $25. The DEPS for the current year is calculated as follows:

1) The call options are dilutive because the exercise price ($20) is less than the average market price ($25).2) The proceeds from exercising the options are $400,000 (20,000 number of call options outstanding $20

exercise price of the options).

3) The number of shares assumed purchased is 16,000 ($400,000 proceeds from exercising the options $25average market price).

4) The number of incremental shares is4,000(20,000 number of common shares assumed issued 16,000number of common shares assumed purchased).

5) The number of incremental shares is added to the BEPS denominator in the computation of DEPS.

Thus, DEPS for the current year is

9. Reverse Treasury Stock Method

a. The third method used to determine the dilutive effect of PCS is the reverse treasurystock method. It is used when the entity has entered into contracts to repurchase itsown stock, for example, when it haswritten put optionsheld by other parties.

1) When the contracts arein the money (the exercise price exceeds the averagemarket price), the potential dilutive effect on EPS is calculated by

a) Assuming the issuance at the beginning of the period of sufficient shares toraise the proceeds needed to satisfy the contracts,

b) Assuming those proceeds are used to repurchase shares, and

c) Including the excess of shares assumed to be issued over those assumedto be repurchased in the calculation of the DEPS denominator.

b. Options held by the entity on its own stock, whether they are puts or calls, are notincluded in the DEPS denominator because their effect is antidilutive.


a. An entity withonly common stock outstanding(a simple capital structure) mustreport BEPS but not DEPS for income from continuing operations and net income ontheface of the income statement.

1) All other entitiesmust present BEPS and DEPS for income from continuingoperations and net income with equal prominence on the face of the incomestatement.

2) An entity that reports adiscontinued operation, anextraordinary item, or bothmust report BEPS and DEPS for those line items on the face of the incomestatement or in the notes.




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2. The Percentage-of-Completion Method

a. Percentage-of-completion is the preferable method. It records (1) all contract costs inconstruction in progress and (2) all amounts billed in progress billings. However, thepercentage-of-completion method differs from the completed-contract methodbecause it recognizes revenue on long-term contracts when the

1) Extent of progress toward completion, contract revenue, and contract costs arereasonably estimable;

2) Enforceable rights regarding goods or services to be provided, the considerationto be exchanged, and the terms of settlement are clearly specified; and

3) Obligations of the parties are expected to be fulfilled.

b. Theamount of gross profit recognized in a period is calculated as follows:

1) Calculate the estimated total gross profit on the project.

EXAMPLE

A contractor is constructing an office complex for a real estate developer. The agreed-upon contract price was $75 million.As of the close of Year 4 of the project, the contractor had incurred $44 million of costs. By its best estimates as of that

date, costs remaining to finish the project were $19 million.Contract price $75,000,000

Minus: costs incurred to date (44,000,000)Minus: estimated costs to complete (19,000,000)

Estimated total gross profit $12,000,000

2) Calculate the percentage of the project completed as of the reporting date,determined by the ratio of costs incurred thus far to estimated total costs.

EXAMPLE

Total estimated costs for the project as of the end of Year 4 are calculated as follows:

Costs incurred to date $44,000,000

Estimated costs to complete 19,000,000Total estimated costs $63,000,000

The project is therefore 69.8% complete ($44,000,000 $63,000,000).

3) Subtract the gross profit recognized so far.

EXAMPLE

The contractor will recognize $2,151,000 in gross profit for Year 4, calculated as follows:

Estimated total gross profit $12,000,000Times: percentage complete 69.8%

Gross profit earned to date $ 8,376,000

Minus: gross profit recognized in prior periods (given) (6,225,000)Gross profit for current period $ 2,151,000

c. When estimated revenue and costs are revised, a change in accounting estimate isrecognized. Recognition of the change is in

1) The period of change if only that period is affected or2) The period of change and future periods if both are affected.

d. As soon as anestimated losson any project becomes apparent, it is recognized infull, under both the completed-contract and percentage-of-completion methods.




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3. Comparative Journal Entries

EXAMPLE

A contractor agrees to build a bridge that will take 3 years to complete. The contract price is $2 million and expected totalcosts are $1.2 million.

Year 1 Year 2 Year 3Costs incurred during each year $300,000 $600,000 $550,000Costs expected in future 900,000 600,000 0

By the end of Year 1, 25% ($300,000 $1,200,000) of expected costs has been incurred. Using percentage-of-completion,the contractor will recognize 25% of the revenue or gross profit that will be earned on the project. The total gross profit isexpected to be $800,000 ($2,000,000 $1,200,000), so $200,000 ($800,000 25%) of gross profit should be recognized inYear 1.

Percentage-of-Completion Completed-Contract

Year 1: Construction in progress $300,000 $300,000Cash or accounts payable $300,000 $300,000

Construction in progress $200,000 --

Construction gross profit $200,000 --

At the end of Year 2, total costs incurred are $900,000 ($300,000 + $600,000). Given that $600,000 is expected to beincurred in the future, the total expected cost is $1,500,000 ($900,000 + $600,000), and the estimate of gross profit is$500,000 ($2,000,000 contract price $1,500,000 costs). If the project is 60% complete ($900,000 $1,500,000),$300,000 of cumulative gross profit should be recognized for Years 1 and 2 ($500,000 60%) under percentage-of-completion. Because $200,000 was recognized in Year 1, $100,000 should be recognized in Year 2.



Construction in progress $100,000 --

Construction gross profit $100,000 --

At the end of the third year, total costs are $1,450,000. Thus, the total gross profit is known to be $550,000. Because a totalof $300,000 was recognized in Years 1 and 2, $250,000 should be recognized in Year 3, using percentage-of-completion. *



Cash $2,000,000 $2,000,000Construction in progress $1,750,000 $1,450,000Construction gross profit 250,000 550,000

* This is the first recognition of gross profit under the completed-contract method.

4. Progress Billings

a. Ordinarily, progress billings are made and payments are received during the term ofthe contract. The entries are

The customer is billed:

Accounts receivable $XXXProgress billings $XXX

The customer pays:

Cash $XXXAccounts receivable $XXX

1) Neither billing nor the receipt of cash affects gross profit. Moreover, billing,receipt of payment, and incurrence of cost have the same effects under bothaccounting methods.




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EXAMPLE

A TV costing $600 is the only item sold on the installment basis in Year 1. The TV was sold for a price of $1,000 onNovember 1, Year 1. Thus, the gross profit percentage is 40% [($1,000 $600) $1,000]. A down payment of $100 wasreceived, and the remainder is due in nine monthly payments of $100 each. Because all payments are due within 1 year,no interest is charged. The entry for the sale is

Cash $100Installment receivable, Year 1 900Cost of installment sales 600

Inventory $ 600Installment sales 1,000

d. At the end of the period, a portion of deferred gross profit is realized.

EXAMPLE

In December, when the first installment is received, the entry is

Cash $100Installment receivable, Year 1 $100

At December 31, installment sales and cost of installment sales are closed, and deferred gross profit is recognized.Moreover, deferred gross profit must be adjusted to report the portion that has been earned. Given that $200 of the totalprice has been received, $80 of the gross profit ($200 40%) has been earned. The entry is

Installment sales $1,000Cost of installment sales $600Deferred gross profit 400

Deferred gross profit (Year 1) $80Realized gross profit $80

Net income should include only the $80 realized gross profit for the period. The balance sheet should report a receivable of$800 minus the deferred gross profit of $320. Thus, the net receivable is $480.

Balance sheet:

Installment receivable(net of deferred gross profit of $320) $480

e. The gross profit percentage for the period of the sale continues to be applied to therealization of deferred gross profit from sales of that period.

EXAMPLE

In Year 2, the remaining $800 is received, and the $320 balance of deferred gross profit is recognized. If only $400 werereceived in Year 2 (if payments were extended), the December, Year 2, statements would report a $400 installmentreceivable and $160 of deferred gross profit.

f. If goods sold are repossessed due to nonpayment, their fair value, remaining deferredgross profit, and any loss are debited. The remaining receivable is credited.

EXAMPLE

Assume that the TV is repossessed because no payments other than the down payment were made. The realized grossprofit at December 31 is therefore $40 ($100 40%). Assume also that the used TV is recorded at its fair value at the timeof repossession of $400.

Inventory of used merchandise $400Deferred gross profit 360Loss on repossession 140

Installment receivable $900

The loss on repossession is the difference between the $400 fair value and the $540 carrying amount [$900 remainingreceivable ($400 deferred gross profit $40 realized gross profit)] of the receivable.




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2. Definitions

a. Fair valueis the price that would be receivedto sell an asset or paid to transfer aliability in anorderly transaction between market participantsat the measurementdate.

b. The FVM is for a particular asset or liability that may stand alone (e.g., a financial

instrument) or constitute a group (e.g., a business). The definition also applies toinstruments measured at fair value that are classified as equity.

1) The price is anexit pricepaid or received in a hypothetical transactionconsidered from the perspective of a market participant.

2) The FVM considers attributes specific to the asset or liability, e.g., restrictions onsale or use, condition, and location.

3) The unit of account is what is measured.

a) For example, a component of an entity may be classified as held for saleand remeasured at fair value minus cost to sell. Thus, the component isthe unit of account.

c. Market participants arenot related parties. They are independent of the reporting

entity.1) They are knowledgeable (i.e., they have a reasonable understanding based on

all available information).

2) They are willing and able (but not compelled) to engage in transactions involvingthe asset or liability.

3) The FVM is market-based, not entity-specific.

d. An orderly transaction is not forced, and time is assumed to be sufficient to allow forcustomary marketing activities.

e. The transaction is assumed to occur in the reporting entitys principal market for theasset or liability.

1) In the absence of such a market, it is assumed to occur in the most

advantageous market. This market is the one in which the specific reportingentity can (a) maximize the amount received for selling the asset or(b) minimize the amount paid for transferring the liability, after consideringtransportation and transaction costs.

2) Given a principal (or most advantageous) market, the FVM is the price in thatmarket without adjustment for transaction costs.

a) However, if location is an attribute of the asset or liability, the price includestransportation costs.

f. Assets.The FVM is based on the highest and best use (HBU) by marketparticipants.

1) The HBU is in-use if the value-maximizing use is in combination with other

assets in a group. An example is machinery in a factory.2) The HBU is in-exchange if the value-maximizing use is as a stand-alone asset.

An example is a financial asset.

g. Liabilities.The FVM assumes transfer, not settlement.

1) The liability to the counterparty is unaffected.2) Nonperformance risk is unaffected and is included in the FVM.




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