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FAR 2 Notes

Timing Issues - Revenue should be recognized when it is earned and realized/realizable.

To be recognized, a signed contract/arrangement must exist, risks/rewards must be
transferred, price is fixed & determinable (no price contingencies), and there are standard
collection terms/collection is reasonably assured.
- Revenue should be recognized on the date of sale, or if revenue stems from
allowing others to use entity assets, revenue is recognized as time passes.
Services should be recognized once rendered/able to be billed.
- Deferred Credits/Revenue exists when cash is received in advance. Income
is recognized as time passes. Until recognized, they are considered a liability.

Expenses: should be recognized according to the matching principle (should be

recognized in the same period that the related revenue is recognized).
- To employ the matching principle, entities must accrue for transactions/events
on the I/S
- If cash has been received in advance, entities must defer the transaction/events
on the B/S
Realization: when an entity really obtains cash or right to receive cash
Recognition: the recording of a transaction/event in the financial statements

Expired Costs Prepaid Expenses: costs that expire during the period and have NO
future benefit (i.e. insurance expense, COGS, period costs)
Unexpired Costs  Deferred Charges: capitalized and matched against future revenues
- Royalty Income: recognized when earned. When royalty cash has been
received in advance, it should be deferred on the B/S (booked to the I/S once
- Revenue recorded in advance is always recorded as a liability, because you
must earn it or return the money

If the buyer has the right to return the product, revenue can be recognized as long as all
the following conditions are met: sales price is fixed, buyer has assumed all risk of loss,
buyer has paid consideration, and the amount of future returns can be reasonably

1. Initial Franchise Fees: fees paid by the franchisee for services to be performed
by the franchisor.
a. Revenue can be recognized by franchisor once services have been
substantially performed.
b. The present value of the amount paid should be recorded as an
intangible asset by the franchisee and amortized over the expected life
of the franchise.
i. If present value of payments is < initial stated fee, the PV
becomes the Franchise (asset), and the difference is discount on

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notes payable. BOTH the asset and the discount should be
amortized over the life of the asset. The discount should be
booked to interest expense.
2. Continuing Franchise Fees: revenue to the franchisor as the fees have been
earned. All of these fees must be recorded as unearned revenue (liability) by
the franchisor until the services are performed.
a. For “Substantial Performance” to be met, all of the following must be
met: franchisor has no obligation to refund payment, initial required
services have been performed, and all other conditions of the sale have
been met (typically all of these are met on the first day of the
franchise’s operations).
b. The franchisee should expense these fees as incurred.

Intangibles: may be either specifically identifiable (i.e. patents) or not identifiable (i.e.
- Purchased intangible assets: recorded at cost (if in an “arms-length”
o Amortized straight-line over the life of the asset (for intangibles that
are not goodwill, and the do not have indefinite lives)
 Patents: life is the lesser of remaining legal life and estimated
- Internally-Developed intangible assets: expensed (i.e. trademarks, goodwill)
o EXCEPTION: capitalize costs if related to – legal fees incurred in the
successful defense of the asset or to obtain the asset,
registration/consulting fees, design costs, other direct costs to secure
the asset
o Cost should be measured by cash paid/FMV of assets given up, PV of
liabilities assumed, or FV of consideration received for issuing stock
 How to determine non-identifiable intangibles: the residual
dollars resulting from cost of group of assets acquired less
costs assigned to identifiable assets net of liabilities
o Goodwill is not amortized, it is impaired and should be tested annually
- General Rules: if intangible becomes worthless, expense any additional costs.
Impairments are expensed. If the life of an existing intangible is impacted,
recalculate amortization going forward. If an intangible is sold, calculate

Start-Up Costs: all start-up costs, including organizational costs, should be expensed
Goodwill: excess of costs paid for FV of net assets obtained, costs to maintain GW are

Research & Development Costs: Generally expensed, except for the following
1. PP&E that have alternate future uses (depreciated over useful lives)
a. Depreciation expense is considered part of the R&D costs
2. R&D costs undertaken on behalf of others under contractual arrangement

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3. NOT considered R&D: design changes in manufacturing, marketing research,
quality control testing, reformulation of a chemical compound

Computer Software Development Costs:

1. To be sold/leased/licensed: expense costs incurred up until technological
feasibility, then capitalize WITHOUT amortizing until product is released for
sale, and then begin amortizing.
a. Technological feasibility: a detailed program design or completion of
working model
b. Amortization is the GREATER of: % of Revenue method or Straight-
Line method
i. % of Revenue: Capitalized amount x (Gross Rev/Period)/(Total
projected gross revenue for product)
ii. Capitalized costs are recorded at lower of cost or market
2. To be used internally: same as software for sale, but “technological
feasibility” wording is not used (instead, called “preliminary project state).
Capitalized costs should only be amortized using straight-line method
a. If you then decide to sell to outsiders, proceeds must be first applied to
carrying amount of software, and THEN recognized as revenue (cost-
recovery method).

Impairment Testing: long-lived assets to be held and used, or slated for disposal, must
be tested for impairment. Testing process depends on if the asset has finite or indefinite
1. Finite: Future cash flows and disposition costs must be estimated (NOT
a. If undiscounted future cash flows > Book value, impairment exists
2. Indefinite: Compare FV of asset to BV of asset

If an impairment has been identified, then the procedure varies based on the purpose of
the asset. Though undiscounted future cash flows is used for determining impairment,
discounted future cash flows SHOULD be used for determining the amount of
1. Assets Held for Use: Write asset down, depreciate new cost, restoration not
2. Assets Held for Disposal: In impairment loss should be cost of disposal.
Write asset down, no depreciation taken, and restoration is permitted.
a. For both methods, when writing down: don’t forget the accumulated
depr. impact

Goodwill Impairment Test: is determined on the reporting unit level (meaning separate
cash flows, and management regularly reviews it). You should identify potential
impairment by comparing FV of each reporting unit with their carrying values (including
goodwill). Other impairments should be evaluated BEFORE goodwill.
- To calculate the amount of impairment, write down goodwill by the difference
of the entity’s FV > specifically assignable fair values and the current book

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value of GW. Initial impairment test indicator is NOT relevant in determining
the actual amount of goodwill.

Impairment Loss = component of income from continuing operations (IDEA).

Long-Term Construction Contracts:

1. Completed Contract Method: recognizes income ONLY on completion (or
substantial completion) of contract. Can only use this method when: it is
difficult to estimate in-progress costs, collections are not assured, large
number of contracts in progress.
a. Excess of accumulated costs incurred over progress billings is
reflected in the B/S as a current asset (vice versa creates a current
i. Wording: “Costs (billings) of uncompleted contracts in excess
of related billings (costs)”
ii. Current Asset  done more work than billed, due on A/R.
iii. Current Liability  billed more (deposits, retainers) than
iv. Applicable OH and direct costs are included in the CIP asset
v. Always recognize losses immediately as discovered
2. Percentage of Completion Method: used when collection is assured, and the
accounting system can easily estimate profitability and provide a reliable
measure of progress.
a. Formula: % of Completion = Costs Incurred/Total Expected Costs
(based on most recent cost information).
b. A provision for loss on the ENTIRE contract should be made as soon
as a loss is apparent.
i. Good because it is consistent with accrual method

Accounting for Installment Sales = Cash method, can only be used when there is no
reasonable basis for estimating the degree of collectability. Revenue is recognized when
cash is actually received.
- Earned Revenue = Cash Collections x Gross Profit % (Gross Profit/Sales
o Moves deferred gross profit from B/S to earned gross profit on I/S
- Deferred Revenue (contra asset) = Installment Receivable x Gross Profit %
(Deferred Gross Profit is recorded when the receivable is initially recorded)

Cost Recovery Method: no profit is recognized on a sale until all costs have been
recovered. At the time of sale, the expected profit on the sale is recognized as deferred
gross profit (same as above).
- Like Installment sales, can only be used when receivables are collected over
an extended period and there is no reasonable basis for estimating

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Accounting for Non-Monetary Exchanges: FV vs. BV determines gain/loss! Method
depends on exchanges with or without commercial substance:
1. Having Commercial Substance: future cash flows change as a result of the
transaction. The change can be in either the risk, timing, or amount of cash
a. Gain/Loss Recognized!
i. New asset cost is = the FV of all assets given up (if an asset is
given up, must also write off the asset at historical cost AND
all associated depr.)
ii. The gain/loss is considered the FV over/under the book value
given up
2. NOT Having Commercial Substance: ONLY recognize gains if BOOT IS
RECEIVED. ALWAYS recognize losses.
a. If no boot is received, or boot is paid  no gain recognized
b. If boot is received:
i. If boot >= 25% of total consideration received, recognize ALL
of the gain
ii. If boot < 25% of total consideration received, a proportion of
the total gain realized is recognized
1. Proportion = Total Boot Received / Total Consideration
3. Involuntary Conversions: recognize entire gains and losses

Partnerships: purchase or sale of an existing partnership interest directly between the

partners does not result in a journal entry.
- Contributions to the partnership – assets are recorded at fair value, liabilities
are recorded at their present value.

Admission of a Partner - 3 Methods:

1. Exact Method (Equal to Book Value) – no goodwill or bonuses recorded
a. Determine the exact amount a new partner must contribute to get his
capital account to the exact proportional interest to the new net assets
of the partnership (old partners’ accounts stay the same)

2. Bonus Method: bonus goes to either the new partner (if new partner pays less
than BV of capital account purchased), or to the old partners (if new partner
pays more than BV of capital account purchased)
a. Bonus is prorated based on partners’ share of profits and losses (if new
partner gets bonus, old partners’ capital accounts are reduced ratably
by bonus as well)

3. Goodwill Method: recognized based upon total value of the partnership

implied by new contribution
a. Compute “Net assets before GW” after admitting new partner, and
compare that to total net worth (aka “Capitalized Net Assets”). The

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difference is Goodwill and is allocated to the old partners
i. If the new partner pays $XX for 25% interest, the implied value
is the $XX times 4 (to get to 100%), and then subtract total
actual capital accounts

Withdrawal of a Partner – 2 Methods: (1st, always revalue the assets to fair value)
1. Bonus Method: difference b/t the withdrawing partner’s capital account and
what he’s paid. The bonus is allocated ratably among the remaining partners’
capital accounts.
2. Goodwill Method: record implied goodwill based on payment to withdrawing
partner. The amount of implied goodwill is allocated to ALL partners ratably

Liquidation of a Partnership: Creditors (including partners who are creditors) are paid
first, and the partner’s capital accounts are paid second. Noncash assets must be
converted to cash assets until all liabilities are paid, and the conversion could result in
gains/losses on realization, and could result in a capital deficiency
- Capital deficiency: a debit balance in a partner’s capital account. In this case,
if the partnership owes the partner on the loan, they can legally offset that
liability to satisfy the deficiency. If the deficiency still exists, the remaining
partners must absorb the loss based on their P/L ratios.
Distributions: pay out all established distributions, and the remaining income in the
p’ship is distributed to the partners based on their P/L ratios.

Financial Reporting and Changing Prices – means “price level”

- Difference between historic cost and current cost = appreciation of currency
- Difference between nominal dollars and constant dollars = inflation
o The GAAP method is Historic Cost/Nominal Dollars: NO adjustment
for inflation or appreciation
- Monetary assets/liabilites are fixed (cannot be changed), Non-Monetary
assets/liabilities are fluctuating with inflation and deflation.
o When determining if something is monetary/non-monetary, any
contra-accounts are always treated the same as their related accounts
(i.e. AFDA, accumulated depr.)
o Monetary assets lose purchasing power during inflation, liabilities gain

Foreign Currency Accounting: SFAS 52

- fx Rate: if direct method, the domestic price of one unit of foreign currency
(i.e. how much a euro costs in US$). The indirect method is the vice versa
(how much 1 US$ is in euros).
Current Exchange Rate = “spot rate”, year-end rate
Forward Exchange Rate = the rate you bet on for exchanging currencies in the future
Historical Exchange Rate = the rate in effect at the date of purchase (issuance of
stock/purchase of asset)

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Weighted Average Rate = used for the I/S, takes into account fx rate fluctuations during
the period
- Reporting currency is ALWAYS U.S. $, Functional currency is the currency
of the primary economic environment in which the entity operates

Foreign Currency Remeasurement (aka Temporal Method): must be done prior to

translation, the financial statements must be remeasured from a foreign currency into the
domestic currency.
- Must be performed in economies w/ hyperinflation, or where the functional
currency is not used
- Balance Sheet and THEN Income Statement
o Balance Sheet = Monetary  Spot Rate, Non-Monetary  Historical
o Income Statement = Weighted Avg. for all accounts EXCEPT balance
sheet expenses (i.e. depreciation, COGS, amortization on
o Plug “Currency Gain/Loss” to get NI from continuing operations to
agree to the B/S!

Foreign Currency Translation: restating the financial statements from the functional
currency into U.S. $.
- Income Statement and THEN Balance Sheet
o Income Statement = uses weighted-avg rate, transfer NI to retained
o Assets/Liabilities = current rate (“spot rate”)
o Common Stock/APIC = Historical Rate
o Retained Earnings is Rolled Forward!
o Plug the remaining difference into Accumulated Translation
Adjustment (equity), is considered part of PUFE (OCI)

Foreign Currency Transactions: a gain/loss will result if the FX rate changes b/t time of
purchase and time of payment. If transaction is not settled at the balance sheet date, the
gain/loss must be computed in current net income.

Deferred Crediteentity assets, revenue s/Revenue: exists

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