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Financial Statement Analysis: 7.1.A. Accounting Income and Assets: The Accrual Concept
Financial Statement Analysis: 7.1.A. Accounting Income and Assets: The Accrual Concept
Financial Statement Analysis: 7.1.A. Accounting Income and Assets: The Accrual Concept
REVENUE RECOGNITION
In general, a company may recognize revenue if:
a) payment is fairly certain,
b) it is measurable (i.e. there's no ambiguity with respect to its amount), and
c) the service or the good has to a large extend, been completed or delivered.
Question:
Which one of the following conditions would not constitute the realization of revenue?
A) Ownership of the good is effectively transferred from the seller over to the buyer even though
delivery has not occurred yet.
B) The customer has paid for a full year's worth of products with the first shipment going out
immediately.
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C) The resulting sales and expenses associated with the good being sold can be measured fairly
accurately.
D) The selling company has substantially fulfilled its obligations to produce and deliver the
goods.
Answer:
B
Explanation:
When a customer pays in advance for goods and services to be received at a later date, it does not
constitute revenue to the selling firm. In fact, this advance payment becomes a liability to the firm
until it performs its task as required by the buyer-seller agreement. Only then can the company
realize revenue.
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Also note that the cost of inventory is not recognized until the item is sold. This too is a result of
the matching principle rule.
REVENUE RECOGNITION METHODS
In general, three methods may be used to recognize revenue:
a) accrual method: recognizes an expense in the period in which its associated revenue was
generated
b) installment method: recognizes that proportion of expense which is equal to the
proportion of the total payment that is received for the period.
c) cost recovery method: all initial revenue is used to offset the cost of the project. In other
words, until all the costs have been accounted for, the company has a profit of nil.
Afterwards, profit will equal revenue.
MANIPULATING EARNINGS
Accounting rules allow management to choose among the various acceptable accounting
practices. Consequently, by choosing among the various accounting policies, management will
have an impact on reported financial statements. In addition to the choice of accounting policy,
management may also time certain expenditures or time the recognition of certain revenues so as
to "smooth" out reported earnings.
Question:
Which of the following is not a common method used by management in order to manipulate
earnings?
A) Increase expenditures into research and development during abnormally good years and
reduce those expenditures during bad years.
B) Increase or decrease the number of shares outstanding so that earnings per share data can seem
more stable.
C) Increase provisions for uncollectable receivables during good years.
D) Classify gains and losses either as an extra-ordinary event or as a recurring event, so that
operating income seems more stable.
Answer:
B
Explanation:
Manipulative techniques are those that are not easily observable. Changing the number of shares
outstanding would be very visible event and would therefore not be able to fool most investors.
On the other hand, the remaining answers illustrate how difficult it is to distinguish between
management decisions that are taken in the best interests of shareholders and those that are
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The "Percentage of Completion" method requires an upfront estimation of the total costs and thus
total profits expected from a project. Therefore, every year of the project, the amount of profit
that is recognized is equal to the proportion of the total project cost that is recognized in that year.
The "Completed Contract" method does not recognize any revenues, costs, or profits until the
project has been completed. As a result, all receipts are regarded as unearned revenues (or
advances), which is a liability account, and all cost incurred are regarded as work-in-process, an
inventory like account. Once the project is completed, the net of these cumulative advances and
work-in-process will determine the income that will be reported at that point.
Question:
Which of the following are not motives for managers to prefer the Percentage-of-Completion to
the Completed Contract Method?
A) The Percentage of Completion method results in higher asset values, which helps to strengthen
the balance sheet position of the company.
B) Earnings fluctuations tend to be smoother over time by using the Percentage of Completion
method.
C) Equity figures are higher under the Percentage of Completion method, thus resulting in lower
debt-to-equity ratios.
D) Since income is higher during the earlier periods under the Percentage of Completion method,
profitability ratios will seem higher.
Answer:
A
Explanation:
It is the completed contract method that results in the higher asset values. This is so because all
costs incurred in the production process are capitalized.
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