FSA MODULE 28

Question 1

28.1 Describe what revenue is in the income statement?

Answer 1

Revenue can go by ‘turnover’, ‘sales’, ‘net sales’

Need to deduct goods that may be returned within a period of time.

We cannot predict warranties and returns - so requires estimates

Question 2

28.1 What is the accruals concept?

Answer 2

That sales are recognised in the period they are earned, not necessarily when customer pays.

Or if on credit, when the transfer of ownership has transferred to the buyer

Question 3

28.1 What is the IFRS.U.S. GAAP converged standard on revenue recognition?

(what is the 5 step process)

Answer 3

contract = does not have to be written. you have a contract when you present groceries to the cashier and they request payment, for example

identify performance obligations = that legal ownership of the goods/services is transferred

transaction price = marked price

allocate price = add up in till

recognise = sell has satisfied obligations under contract and recognises revenue
- seller has the right to payment
- customer has legal title
- transfer of risk and benefits are transferred from the seller to the buyer

Question 4

28.1 Physically, when is the obligation satisfied?

Answer 4

Typically, when the good is shipped to the buyer - the it leaves the warehouse.

Or alternatively, when the customer received them.

Question 5

28.1 What happens if the customer has paid before the seller satisfies the obligation?

Answer 5

Then revenue cannot be recorded

(deferred revenue, unearned revenue) - to go into the balance sheet

When obligation satisfied, it moves over to the income statement

Question 6

28.1 What would make you the ‘principal’ seller?

Answer 6

If you own the risk and reward of the item

(you hold the good in your ownership)

Question 7

28.1 What would make you the ‘agent’ of the sale of the product.

Answer 7

passing on the obligation to a third party to deliver a product, therefore transferring all of the risks and rewards to them.

In this situation you are acting as an agent.

Question 8

28.1 Which revenue items would there be in this example?

Answer 8

supply chain revenues - selling food to the franchises, eg

Question 9

28.1 For a subscription service, should we report revenue when the license is granted, or do we defer the revenue and spread it over the life of the license?

Answer 9

Typically depends whether we are providing updates and enhancements (transfer of new goods and services) over the life of the license

Difference between upfront sale and ongoing service

Question 10

28.1 Long-term contracts: What are the IFRS standards for them?

Answer 10

Top one is most likely to be in the exam.

There also has to be NO ALTERNATE use of the product

REMEMBER - any of those not all of those

Question 11

28.1 How do we recognise revenue in long-term contracts?

Answer 11

two methods:

1) output method - looks at the total contract selling price, and the proportion of output delivered so far. So if 70% of weapons have been delivered, then you would bring in 70% of the weapons revenue so far.

2) input method - often used more in the construction/infrastructure industry. allows us to bring in revenue in proportion to the total cost we have incurred to date. Contracted selling price multiplied by costs to date/EST total cost

Question 12

28.1 Given this scenario, how do you compute revenue and profit for each year? Just describe the process.

Answer 12

For the revenue in each year, have to do costs to date/estimated cost

Cost, by definition, is the estimated cost. multiplied by amount of goods in the contract produced (60% here)

Gross profit is profit each year added -

Question 13

28.1 What is a bill and hold contract?

Answer 13

where you enter an agreement with a customer to sell some goods, and you are going to record it as a sale, event hough you haven’t physically dispatched the goods yet.

But we are going to record the sale before we dispatch them.

NORMALLY - revenue is only realised when the delivery is made (performance obligation is realised) - but this is an EXCEPTION to the rule !

Ownership of risk and return is also transferred to the customer pre-shipping in this case.

Question 14

28.1 in bill and hold arrangements, what are the 4 IFRS criterion for revenue recognition?

Answer 14

Question 15

28.1 What is included in the revenue recognition disclosure?

Answer 15

(normally in the footnotes)

Question 16

28.1 In expense recognition, how is the accruals concept applied?

Answer 16

Accrual basis - matching principle

WE MATCH COSTS AGAINST ASSOCIATED REVENUES - record at the same time.

Dep/Amort - we store the cost of the assets in the balance sheet - then release this cost through the income statement to match is across the benefits. Use Dep for PP&E and use Amort for intangibles

Warranty - don’t know the future cost of the warranty is (make an estimate and account for that at the cost of the sale)

SO ALL OF THESE COSTS ARE MATCHED AGAINST THE ASSOCIATED REVENUES

same amount of units of cost and sales !

Question 17

28.1 What about the expenses that don’t match associated revenues?

Answer 17

period expenses - costs that less directly match the timing of revenues (eg administrative costs - renting head office) - but we match them against a time period

Question 18

28.2 What is capitalising?

Answer 18

Storing cost on the balance sheet and releasing it to the income statement over future periods.

We do this when we incur a cost but the benefits are going to be realised over multiple future periods

EG PP&E - you buy the machinery, so you store the cost in the balance sheet - and then release it to match against benefits over future periods (depreciation)
- dep for long-life assets
- amor for intangibles

Question 19

28.2 What is expensing?

Answer 19

If you incur a cost that is unlikely to lead to higher future benefits then we expense it immediately (like wages)

(unlikely or highly uncertain)
- EXAMPLE - r&d - research - only leads to benefits if it pays off - so we must take a prudent approach and expense. development - IFRS says we can either capitalise and expense (if we think it will lead to higher future benefit)

Question 20

28.2 What is the difference between capitalising and expensing?

Answer 20

Question 21

28.2 How do you calculate the depreciation expense p.a?

Answer 21

SIMPLE!

Question 22

28.2 What is special about depreciation?

Answer 22

IT IS NOT TAXED - so you add to net income for CFO

Question 23

28.2 How do we calculate PP&E value?

Answer 23

cost of asset - total depreciation of the asset that has passed through the income statement

So carrying value of our pp&e is going to be costs less accumulated depreciation

Question 24

28.2 If you expense something it goes through…

Answer 24

CFO

No CFI if you expense - only if you capitalise

Question 25

28.2 What is the effect on ROE when you expense vs capitalise?

Answer 25

Expensing takes a big hit to ROE in year one, but then increases later on compared to capitalising - which is more consistent

Question 26

28.2 Tell me how these metrics will react (higher/lower) for capitalising/expensing:

Answer 26

note - assets and equity under cap and exp will be the same int he final year D/E - because in cap, E is higher, it makes the ratio lower

Question 27

What is ROA?

Answer 27

net income/total assets

Question 28

28.2 When the company constructs assets itself (rather than purchasing - a machine for example), how is interest expense treated?

Answer 28

CAPITALIZED INTEREST

Question 29

28.2 What is interest coverage?

Answer 29

It is often built into loan agreements EBIT/interest paid

Question 30

28.2 What issue can happen then when constructing our own asset?

Answer 30

If we construct our own asset, there is interest that is not appearing in the income statement. Instead, it is being added to the cost of the asset in the balance sheet.

Question 31

28.2 How does capitalised interest impact the interest coverage metric?

Answer 31

interest paid is lessened as it is added to the cost of the asset rather than being in the income statement EBIT - additional depreciation - so it can be artificially low

Question 32

28.2 What happens to the interest on the construction of the assets once they are built?

Answer 32

They then pass through to the income statement

Question 33

28.2 How do you adjust the interest coverage equation to account for the distortion of capitalised interest?

Answer 33

add the additional depreciation to the EBIT, and add the capitalised interest to the interest in the income statement ton the denominator

Question 34

28.3 How is the expenditure treated on internally created intangible assets?

Answer 34

Typical the intangible asset expenditure needs to be expensed to the income statement as we incur it. BUT there are exceptions! - R&D, software development costs

Question 35

28.3 What are internally created intangible assets?

Answer 35

non tangible goods - that the company develops It has no physical form

Question 36

28.3 What do RESEARCH and DEVELOPMENT costs include?

Answer 36

Question 37

28.3 What does IFRS and US GAAP say about the treatment of research and development costs?

Answer 37

so IFRS and US GAAP differ in this way

Question 38

28.3 how is the development of software created internally treated in accounting? Please differentiate between software created for sale and software created for internal use:

Answer 38

So slightly less strict for internal use

Question 39

28.3 What are some other areas of significant judgement here? (6 points)

Answer 39

(to be expanded on more in later modules)

Question 40

28.3 Where are unusual or infrequent items reported in the income statement?

Answer 40

Reported above the tax line but after EBIT typically reported pre tax before net income from continuing operations - so they are included in the continuing operations They are reported gross

Question 41

28.3 What can be included in unusual or infrequent items?

Answer 41

Question 42

28.3 What are discontinued operations?

Answer 42

Question 43

28.3 How are discontinued operations reflected in the income statement?

Answer 43

Any earnings etc are displayed in a 'discontinued operations' line - separate IT COMES AFTER THE TAX EXPENSE - performance is reported net of taxes after income from continuing operations Assets, operations and financing activities must be physically and operationally distinct from the firm; assets and liabilities reclassified as held for sale before disposal

Question 44

28.3 What marks the difference between assets held for use and assets held for sale?

Answer 44

held for use when they are in operation - longtime assets, reclassified as held for sale as soon as the decision to dispose them has been made

Question 45

28.3 What is a retrospective application of a change in accounting policy? And is this a change in accounting principle or accounting estimate?

Answer 45

AP - if you apply an accounting principle, you have to go back to all the prior years and adjust as if you always used this accounting principle

Question 46

28.3 What is a prospective application of a change in accounting policy? And is this a change in accounting principle or accounting estimate?

Answer 46

seems like this should be a change in accounting principle, but this is a change in accounting estimate ! SO DO NOT NEED TO CHANGE PRIOR YEARS - but do need to be disclosed in the footnotes

Question 47

28.3 What is a modified retrospective application of a change in accounting policy? And is this a change in accounting principle or accounting estimate?

Answer 47

just means we do not need to go back and restate the prior years - we just adjust the beginning balance sheet values (eg the 5 step process discussed previously as to revenue recognition)

Question 48

28.3 What is a correction of a prior-period error?

Answer 48

disclosure in the footnotes

Question 49

28.3 How do we calculate EPS?

Answer 49

Question 50

28.3 What is diluted EPS? And what makes the difference between dilute and anti-diluted stock

Answer 50

includes instruments that the company has in issue which could be converted into common stock INCLUDED even if the instruments cannot be converted for a number of years if they all were converted - and the eps rises, then they are called anti-dilutive and we ignore it. If we include them and EPS falls, we call it diluted and we include the figure

Question 51

28.3 If some shares are issues midway through the year - how do we adjust calculations? How do we treat 'shares repurchased'?

Answer 51

Needs to become time-weighted How many months of the year have the shares been issues for, and multiply by this Shares repurchased - in the same way, but keep it negative and multiply by how many months of the year they had been repurchased for

Question 52

28.3 What is a stock dividend?

Answer 52

Increases the number of shares someone has by a certain percentage

Question 53

28.3 What is a stock split?

Answer 53

eg: a 2 for 1 stock split means that you now have 2 when you did have 1 (increases shares outstanding by 10%) So the total shares outstanding increases by 100%

Question 54

28.3 There is a 10% stock dividend enacted halfway through the year - how do we treat this scenario?

Answer 54

1. It impacts all of the shares BEFORE the stock dividend - but not AFTER the date 2. The do the usual time weighting of issuance for the amount of shares in which to calculate EPS with

Question 55

28.3 What is the difference between simple and complex capital structures in terms of the effect on dilutive EPS?

Answer 55

Question 56

28.3 what are potentially dilutive securities?

Answer 56

ONLY EMPLOYEE STOCK OPTIONS !!!! Warrants - companies usually issue a warrant alongside issued debt to make it more attractive - Works like a call option. The difference is, if they are excersixed, the company must make new shares

Question 57

28.3 What is a preferred stock?

Answer 57

Preferred stock is a hybrid security combining features of debt and equity, offering investors fixed dividends and higher claims on assets/earnings than common shareholders. It is generally less volatile than common stock, typically lacks voting rights, and is prioritized during bankruptcy, making it attractive for income-focused investors

Question 58

28.3 When convertible preferred stock is converted into common stock, what must we also remember?

Answer 58

That dividend might not be paid

Question 59

28.3 What do we need to do if there are multiple potentially dilutive securities in a question?

Answer 59

We must make a middle step - where we measure for impact of each one, BEFORE the final calculation (step 2 in the example attached.) IMPACT < basic EPS = DILUTIVE If we don't do this then we can miss some anti dilutive securities - we need to do the impact equation to ignore it from our computation.

Question 60

28.3 When calculating eps, what is the difference we need to consider?

Answer 60

Compared to dividends, debt has a tax shield!

Question 61

28.3 If you have the potentially dilutive security: $50,000 of 6 percent convertible bonds, convertible into a total of 10,000 shares, how do we calculate the impact on EPS assuming a tax rate of 30%?

Answer 61

If the bond is converted into equity, we would save the coupon of 3000 (50000 x 0.06), but we would lose the tax shield x(0.7). SAVE THE COUPON LOSE THE TAX SHIELD

Question 62

28.3 When is a treasury stock dilutive? And what is the method if how to calculate the impact of this if true?

Answer 62

QUESTION WILL GIVE YOU THE AVERAGE PRICE FIGURE IF THEY GIVE YOU END OF YEAR - USE AVERAGE

Question 63

28.3 Name three income statement ratios (common size statements): And their formulae: (ones that we can use to compare companies)

Answer 63

operating profit = EBIT

Question 64

28.3 Red Company immediately expenses its development costs, while Black Company capitalizes its development costs. All else equal, Red Company will:

Answer 64

Report higher asset turnover than Black company

Question 65

28.3 Changing an accounting estimate:

Answer 65

is reported prospectively

Question 66

28 What are period costs?

Answer 66

Period costs are expenses that are charged to the income statement in the period they are incurred, rather than being tied directly to the production of goods. They are not included in inventory.

Question 67

28 how do we calculate the earnings available to common shareholders?

Answer 67

NET INCOME - PREFERRED STOCK DIVIDEND

Question 68

28 Are costs of producing inventory likely to be reported as an expense in the current account period?

Answer 68

NO Inventory costs are expensed when items are sold under the matching principle. As an extreme example, if no sales are made, no costs of inventory production are expensed for the period. Period costs are expensed during the period. Under the accrual method, interest accrued during the period is expensed, regardless of whether it has been paid during the period. (Module 28.2, LOS 28.b)

Question 69

28 What are the different methods of depreciation?

Answer 69

Straight-line depreciation spreads the asset’s cost evenly over its useful life, while double-declining balance depreciation is an accelerated method that records higher depreciation in early years and lower depreciation in later years.