Unit 02 Section - A - Recognition, - Measurement

Part 1: Financial Reporting, Planning, Performance, and Control
Section A) External Financial Reporting Decisions

Unit 2. Recognition, measurement, valuation and disclosure
Unit 2. Recognition, measurement, valuation and

disclosure:
Subunits:
a. Basic accounting principles
b. Assets valuation
c. Valuation of liabilities
d. Equity transactions
e. Revenue recognition
f. Income measurement
g. Major differences between US GAAP and IFRS
A. basic accounting principles:

We generally use four basic principles of accounting to record and report
transactions:
1. Measurement principle
2. Revenue recognition principle
3. Expenses recognition principle
4. Full disclosure principle
1. Measurement:
The most commonly used measurements are based on historical cost and fair value.
1. Historical cost:
Many assets and liabilities are measured on the basis of acquisition price
(Historical Cost). Historical cost has an important advantage is that It is
generally thought to be verifiable. While one of its disadvantages is that
historical cost does not provide a good presentation of asset’s or liability’s
current cash value
2. Fair Value:
Fair value in practice mean to be a market-based measure, the advantage of
using fair value is that it can provide better information about the company’s
financial position and its future cash flow prospects, while that the
implementation of fair-value principle depends primly on existence of an
active market, which might not be the case always.
Instructor, Tarek Naiem, CMA 1 of 93

‫ﻟﻺﻳﻀﺎح ﻓﻘﻂ‬
Kieso

2. Revenue recognition principle:

The revenue recognition principle requires that companies recognize revenue in
the accounting period in which their performance obligation is satisfied. Which
means the revenue is recognized and recorded to the company’s accounting books
when the service is provided, or the item is sold, regardless of the cash collection.
3. Expenses recognition principle:

Expenses are defined as outflows or other using up of assets or incurring of
liabilities or both, as a result of delivering or producing goods and/or performing
services.
The expenses recognition principle is based on the matching to revenues basis,
which means that company should recognize expenses following recognition of the
related revenue, so companies should not recognize expenses when they get paid,
while instead when the product or the service actually contributes to the revenue
value, this principle is also referred to as “matching efforts (expenses) with
accomplishment (revenue)
While not always expenses can be matched, or tied up directly to revenues, for
example:
1- The assets depreciation that are depreciated during the useful life of the asset
which is expected to generate revenue during this period and that’s the logic of it.
2- Another example of this matching dilemma, is the allocation of the
administration expenses directly to the period, regardless of the revenue
recognition, since it is not directly related to a specific revenue achievement
Costs are related directly to revenue recognition are classified as product

costs, such as material, labor, and overhead. While other costs that cannot be
directly connected to a specific revenue classified as period costs, such as
officers’ salaries and other administrative expenses and are expensed as
incurred.

4. Full disclosure principle:

The full disclosure principle is the general practice of providing information that is
of sufficient importance to influence the judgment and decisions of an informed
user. Bear in mind the costs of preparing and using the information.
Information are available in one of three areas:
1. The main body of the financial statements:
In order to be recognized in the main body of the financial statements, an item
should meet the definition of a basic element of financial statements, be
measurable with sufficient certainty, and be relevant and reliable. (FASB C5, P63)
The basic elements of financial statements are assets, liabilities, equity,
investments by owners, distributions to owners, comprehensive income,
revenues, expenses, gains, and losses.
2. The notes to the financial statements: are used to explain the information
presented in the main body of the statements.
3. Supplementary information: it may be quantifiable information that is high
in relevance, or it may include management’s explanation of the financial
information

In process of studying unit 2, we should follow the LOS (Learning Outcome

Statement) issued by IMA, we will need to cover in detail the following subtopics:
LOS CSO
1) Assets b. Assets valuation
a. Cash
b. Accounts Receivable
c. Inventory
d. Investments
e. Fixed Assets
f. Intangible Assets
2) Liabilities c. Valuation of liabilities

a. Warranty Expenses
b. Off-balance Sheet Financing
c. Accounting for Income Taxes
d. Leases
3) Equity Transactions d. Equity transactions
4) Income Statement
a. Revenue Recognition e. revenue recognition
b. Income Measurement f. income measurement
5) GAAP and IFRS differences g. Major differences between

GAAP and IFRS

B. Assets valuation:
1) Assets – A) Cash
Cash is usually the first item on the balance sheet as it is the most liquid asset:
Items included in cash Items not included in cash
Cash consists of coin and currency Legally restricted deposits
Saving accounts
Checking accounts
Bank drafts
Cash equivalents:
Some companies present first line of their balance sheet as “cash and cash
equivalents”, and cash equivalents are very short term and highly liquid
investments such as bonds, usually less than three months from the date the
company acquired that asset, such as CDs Certificate of Deposits less than 3 months
(that has no restrictions in case of withdraw) and money market mutual funds.
1) Assets – B) accounts receivable
The main issues with respect to receivables are:

1) Valuing the accounts receivable.
2) Calculating the Allowance for Uncollectible Accounts under the percentage-of-
sales method and the percentage-of-receivables methods.
3) The factoring of receivables with and without recourse.
Receivables: balance sheet account, which present money held against customers
(trade receivables) or others (nontrade receivables), others such as advances to
employees, deposits, etc. it could be oral promise (accounts receivables) or written
promise (notes receivables), also could be for short term (current) [the current
accounts receivables are the majority or most common] or long term (noncurrent),
to remember about the current A/R: because they are expected to be collected
within one year or the company’s operating cycle.
These quick views of classifications to summaries all about receivables definitions.
Will be studying mainly the short-term accounts receivables against customers, and
we are more concerned about the valuation of accounts receivables and the
uncollected balances.

Accounts receivable are reported in the balance sheet at the net realizable value
(NRV), net accounts receivable, which means the net amount of cash that is
expected to be received
Allowance for uncollectable
Accounts receivable NRV = Gross accounts receivable –
accounts
Amounts to be deducted from Gross Accounts Receivables, could be:

a. Allowance for bad debts “allowance for uncollectable accounts”
b. Allowance for sales returns
c. Billing adjustments
‫ﻣﺒﺪأ اﻻﺳﺘﺤﻘﺎق اﳌﺤﺎﺳﺒﻲ‬
The recording of accounts receivables using the accrual accounting method is also
coincides with revenue recognition, evaluating the expected uncollectable amount
based on estimation, relates to being sure not to overstate the company’s assets,
‫ﻣﺒﺪأ اﻟﺤﻴﻄﻪ واﻟﺤﻈﺮ‬
which is the principle of conservatism
The valuation account is a contra-asset account called “Allowance for Uncollectible

Receivables” or “Allowance for Doubtful Debts”. The allowance account should
have a minus (credit) balance, which should decrease the value of net accounts
receivable. The estimated collectible amount is called “net receivables “.
Allowance for Customers’ Sales Return:

Goods could be returned if products are defects or due to customer dissatisfaction,
etc., therefore an allowance for sales returns should be estimated.
And entries are as follow:
1) Recognition of revenue from sale:
Dr. Cash/accounts receivable XXX
Cr. Sales XXX
2) Recognition of allowance for sales returns:

Dr. Sales returns (contra revenue) XXX
Cr. Allowance for sales returns (contra asset) XXX

Allowance for Uncollectible Accounts / Bad Debt Expense:
It is unlikely to collect full amounts from accounts receivables; therefore, we must

recognize an allowance for uncollectible accounts, bear in mind matching the
expenses (bad debt) with the revenue (related sales).
The main measurement issue here is that we need to consider the estimation of
the NRV of accounts receivable for the balance sheet presentation and the related
uncollectable account which is the bad debt expenses account for the income
statement presentation. The recognized bad debt expense for the period increases
the allowance for uncollectible accounts. Which is a contra account to accounts
receivable. Accordingly, we can say that the recognition of bad debt expense
decreases the balance of accounts receivable.
The main aim is to measure the accounts receivable net realizable value, to that
there two common methods, in order to measure the bad debt expense and
accordingly the allowance for uncollectible accounts:
(1) (2)
Income statement approach Balance sheet approach
The percentage-of-sales method the percentage-of-receivables method
Main journal entry:

Dr. Bad debt expense XXX
Cr. Allowance for uncollectible accounts XXX
Or (allowance for bad debt)
Income Statement Approach (Percentage of credit Sales):
In the income statement approach we start by calculating the bad debt expenses
for the period and add it to the allowance of doubtful debt balance, based on
estimated percentage of expected uncollectable revenue.
Credit sales on income statement X estimated percentage % = bad debt expenses

EXAMPLE:
A company’s trial balance demonstrates the following amounts:

Gross accounts receivable $50,000
Allowance for uncollectible accounts (beginning balance) 1,000
Sales on credit 100,000
According to previous experience, 1% of the company’s credit sales have been
usually uncollectible.
The bad debt expense recognized for the year is $1,000 ($100,000 × 1%).
The journal entry:
Dr. Bad debt expense $1,000
Cr. Allowance for doubtful debts $1,000
The total adjusted balances of allowance for uncollectible accounts $2,000 ($1,000
+ $1,000) and bad debt expense $1,000.
Reporting:
Net accounts receivable of $48,000 ($50,000 – $2,000) in the balance sheet and
bad debt expense of $1,000 in the statement of income.
Balance sheet presentation:
Accounts receivable, net of allowance for uncollectible accounts of $2,000 $48,000
Or:
- allowance for uncollectable accounts 2,000
Net accounts receivable $48,000
Balance-Sheet Approach (Percentage of Receivables):
In the balance sheet approach, we start by calculating the required ending balance
in the allowance account, based on percentage of accounts receivables ending
balance, and then calculate the bad debt expenses that should be charged to the
period.

A. Single estimated percentage:
Ending Balance Gross Accounts receivable on balance sheet X estimated

percentage % = allowance for uncollectible accounts ending balance
EXAMPLE

That we already have in previous balance

According to previous experience, 5% of accounts receivable are considered to be
uncollectible.
The ending balance of the allowance for uncollectible accounts $2,500 ($50,000 ×
5%), while remember that the ending allowance balance has already $1,000
So the journal entry: That we need to reach
Dr. Bad debt expense $1,500 ($2,500-$1,000)
The ending balances of allowance for uncollectible accounts $2,500 ($1,500 +
$1,000) and bad debt expense $1,500.
Reporting:
Or:

B. Multiple estimated percentages:
Usually entities have multiple rates of un-collectability for all accounts. Thus, these
entities prepare an aging schedule for accounts receivable.
EXAMPLE

Aging period Balance Estimated Ending
uncollectible Allowance
Less than 30 days $30,000 2% $600
30-60 days 5,000 5% 250
61-90 days 10,000 13% 1,300
Over 90 days 5,000 20% 1,000
Total $50,000 $3,150
The ending balance of the allowance for uncollectible accounts $3,150, while
remember that the ending allowance balance has already $1,000
So, the journal entry:
Dr. Bad debt expense $2,150 ($3,150-$1,000)
The ending balances of allowance for uncollectible accounts $3,150 ($2,150 +
$1,000) and bad debt expense $2,150.
Reporting:
Or:

Write-Off of Accounts Receivable:

At a final step, some customers are unwilling or unable to satisfy their debts. A
write-off of a specific debt is recorded:
Dr. Allowance for uncollectible accounts $XXX
Cr. Accounts receivable $XXX
According to this entry:
1) The write-off of debts has no effect on expenses (bad debt expenses).
2) Write-offs do not affect the balance of net accounts receivable because the
reduction is the same amount from both, accounts receivable and allowance
for doubtful debts, so accordingly also no effect on working capital.
Collecting a Previously Written-off Receivable

If a customer pays on an account previously written off.
Dr. Cash $XXX
Cr. Allowance for uncollectible accounts $XXX
According to this entry:
Bad debt expense is not affected when an account receivable is written off or when
an account previously written off becomes collectible.
Sales / Revenue X % Income Statement approach

Its goal is to match expenses incurred with related revenues
Receivables X % Balance Sheet approach
Its goal is to value the ending accounts receivable
The T-account for that Allowance for Doubtful Debts account:
√ DR. Allowance for Doubtful Debts
XXX Amount written off

XXX
CR.
Beginning balance 1
XXX Collection of previously written-off bad debts 3
as bad debts for the year 2 XXX Bad debt expense(amount to be charged) 4
XXX Ending balance 5
1, 2 and 3 will be given in the problem, question will ask for 4 or 5, or both, calculate one of them based on
given information this calculate the last number using simple +/- equation

The allowance for doubtful debts T-account in form of equation:

Beginning balance of allowance for doubtful debts XXX
+ Bad debt expenses (amount to be charged/recognized) XXX
- Amount written off as bad debts for the year (XXX)
+ Collection of previously written-off bad debts XXX
Ending allowance for uncollectible accounts XXX
Under the income statement approach, bad debt expense is a percentage of credit
In other words
sales, and the ending balance of the allowance is calculated using the equation
above.
Under the balance sheet approach, the ending balance of the allowance is a
percentage of the ending balance of accounts receivable, and bad debt expense is
calculated using the equation above.
Factoring of Accounts Receivable:

Factoring is a transfer or selling of receivables to a third party (a factor) which is a
commercial finance company, to provide cash immediately using the factored
receivable balance as guaranteed, whom the factor should collect latter.
Example, if we have account receivable balance to be collected in 50 days, we could

factor it now at a discount price and sort out some cash issue immediately.
Factoring accounts receivables has two forms:

Factoring “without recourse” and “with recourse.”
Remember: the seller or the transferor is the company originally owns the
accounts receivable.
The factor is the purchaser or the transferee
Factoring without recourse:

Without recourse means no guarantee given by the seller, as the factor (purchaser)
assumes the risk of any inability to collect the receivables, and he has no obligation
against the seller in case if he couldn’t collect these balances at latter date. That’s
why some companies factor their receivables to transfer the bad debt risk in this
manner. Accordingly, the receivables are no longer reported on the seller’s books,
so if the sale is without recourse, any allowance for bad debts already recorded for
the receivables by the seller needs to be reversed.

Bear in mind that the greater the risk of bad debt, the less cash the selling company
will receive from the factor.
Factoring with recourse:

This means that if any of the receivable accounts does not pay their debt, the seller
will be obliged to cover any uncollectible amount to the factor. The involved parties
account for the transaction as a secured borrowing with a pledge of noncash
collateral. Accordingly, the receivables are still on the seller’s books and it must
recognize a liability for cash received from the factor.
Because of the lower level of risk to the factor in case buying the debt with
recourse, the purchaser will pay more to the seller when buying receivables with
recourse, which means that the factor fee with recourse is less than the factor fee
without recourse.
EXAMPLE
A factor charges a 2% fee plus an interest rate of 18% on all cash advanced to a seller of accounts
receivable. Monthly sales are $50,000, and the factor advances 90% of the receivables submitted
after deducting the 2% fee and the interest.
Credit terms are net 60 days. What is the cost to the seller of this arrangement?
Amount of receivables submitted (face value) $50,000

Minus: 2% factor’s fee (% of face value) (1,000)
Minus: 10% reserve (% of face value) (5,000)
Amount accruing to the transferor $ 44,000
Minus: 18% interest for 60 days (% of net amount) (1,320) [$44,000 × 18% × (60 ÷ 360)]
Amount to be received immediately (net proceeds) $ 42,680
The transferor also will receive the $5,000 reserve at the end of the 60-day period, so the total
cost to the transferor to factor the receivables for the month is $2,320 ($1,000 factor fee +
interest of $1,320). Assuming that the factor has approved the customers’ credit in advance (the
sale is without recourse), the transferor will not absorb any bad debts.
The journal entry to record the preceding transaction is:

Dr. /
Cash $42,680 (received amount immediately)
Loss on sale of receivables 1,000 (factoring fee)
Prepaid interest 1,320
Receivable from factor 5,000 (reserve – Held amount)
Cr. Accounts receivable $50,000

% Of face value
Advantages of factoring receivable accounts:

For the factor:
 Receives a high financing fee on the deposit plus the factoring fee, because
the factor often operates more efficiently than its clients as they are
specialized.
For the seller

 Speed up its collections.
 It can eliminate its credit department and accounts receivable staff.
 Bad debts are eliminated from the financial statements in case of factoring
without recourse.
 These reductions in costs can offset the fee charged by the factor.
A very common form of factoring is the Credit card. The retailer benefits by
immediate receipt of cash and avoidance of bad debts. In return, the credit card
company charges a fee.

1) Assets – C) Inventory
Classification of inventory:
Retailer or wholesaler: Merchandise inventory: goods inventory for resell
(This is will be covered in this section)
Manufacturer: Raw materials: parts and pieces that will make the finished goods
Work-in-process: unfinished production
Finished goods: completed production
(This will be covered in section D)
Inventories are classified as current assets in the financial statements, as they are
expected to be converted into cash or sold or consumed in less than one year or
during the normal operating cycle of the business.
Sales revenue – cost of goods sold = gross profit
Cost Basis of Inventory – valuing the inventory when it is purchased:

(initial measurement)
The cost of inventory includes all costs incurred in getting the inventory ready and
available for sale.
The cost of purchased inventories includes:
1) The purchase price of the inventory (net of trade discounts, rebates, etc.)
2) Shipping cost, handling, insurance, freight-in, taxes and tariffs, duties and all
other costs related to receiving the inventory.
Dr. Inventory XXX
Cr. Cash XXX
Inventory’s physical count: (Inventory Period-End Physical Count)

This physical count is required by US GAAP for annual reporting purposes.
A period-end inventory physical count done annually is necessary under both the
perpetual and periodic inventory accounting systems.
The amount of inventory reported in the annual financial statements should be
matching the results of the physical count.

Goods included in inventory:

For more accuracy during the inventory physical count, the entity should include
only items considered to be inventory. Items to be counted as inventory include
the following:
1) Goods in transit:
Inventories that on the physical count date are not delivered yet and shipped to its
location (on the way)
The owner of the goods, who has the right to count the goods part of his inventory,
and also responsible for any losses or risks during the shipment process, is
determined by the shipping terms:
a) FOB shipping point – the owner is the buyer when once the seller delivers
the goods to the carrier. Therefore, the buyer must include the goods in
inventory during shipping process.
b) FOB destination – the owner is the seller until the buyer receive the
shipment, accordingly, the seller must include the goods in inventory during
shipping process.
FOB = Free on Board
2) Goods out on consignment (Consigned Goods):
Consigned goods are transferred by the goods owner (consignor) to an agent
(consignee) for possible sale.
For the consignor:
1. Goods out on consignment are included in the consignor’s inventory at cost
2. Costs of transporting the goods to the consignee are inventoriable costs, not
selling expenses, because they are costs of making the goods available for
sale to the end customer.
3. Records sales only when the goods are sold to another third parties by the
consignee.
For the consignee:
Never records the consigned goods as an inventory.
3) Goods Out on Approval:
Goods out on approval are goods that are currently held by the customer but not
yet purchased, as the customer has some period of time to decide either to
purchase it or return it.
These goods should be recorded at the seller inventory, until either the customer
accepts the goods or the time to return the goods expires, then the sale will be
recognized, and the goods removed from the seller’s inventory.
(Could be such as online markets for example)

Calculations related to Inventory:
COGS is calculated using the following formula:

Beginning finished goods inventory Finished
+ Purchases (for a reseller) or cost of goods manufactured (for a manufacturer)
− Ending finished goods inventory
= Cost of Goods Sold
COGM is calculated using the following formula:
Direct Materials Used
+ Direct Labor Used
+ Manufacturing Overhead Applied
= Total Manufacturing Costs
+ Beginning Work-in-Process Inventory
− Ending Work-in-Process Inventory
= Cost of Goods Manufactured
Finished
Inventory Estimation:
An estimate of inventory may be used when it is not feasible to make a certain
inventory count, for example, interim reporting purposes or when inventory
records have been destroyed or lost.
Can use the gross profit method for inventory estimation:
Gross profit margin (gross profit percentage):
Gross profit margin % = Gross profit / sales

COGS = sales X (1-Gross profit margin)
Frequency of making inventory entries (updating inventory accounts):

This is to answer how often a company makes the calculation of its ending
inventory and cost of goods sold, there are two inventory systems to cover this
aspect:

(1) The perpetual inventory system: ‫ﻧﻈﺎم اﻟﺠﺮد اﳌﺴﺘﻤﺮ‬

Updates inventory accounts after each purchase or sale. This system is more
suitable for expensive and heterogeneous goods that requires continuous
monitoring of inventory and cost of goods sold accounts, for example vehicles
traders.
Process of the perpetual inventory system are based on:
1) Purchases and other inventory costing items are directly charged to inventory,
no use of intermediate or control account such as purchase account.
2) Inventory and cost of goods sold are adjusted at every sales transaction.
Advantage:
The inventory balance and the cost of goods sold can be determined at any time.
Disadvantage:
The bookkeeping is more complex and expensive, to register every single
transaction when it occurs
Inventory Physical Count Under the perpetual system:

The physical count is basically used as controlling tool, intending to monitor
misstatements in the records and thefts. The inventory shortages and overages are
recorded in a separate line in the current period income statement.
(2) The periodic inventory system: ‫ﻧﻈﺎم اﻟﺠﺮد اﻟﺪوري‬

Inventory and cost of goods sold entries and calculations are updated at the end of
the period, such as monthly, quarterly or annually, based on the results of a
physical count.
It mainly works well with goods that are relatively inexpensive and homogeneous,
such as supermarkets, that have no need to continuously monitor their inventory
and cost of goods sold with every single sales transaction.
Process of the periodic inventory system are based on:

1) Purchases and other inventory costing items are tracked during the period in a
separate temporary (intermediate) account (purchases).
2) The beginning inventory balance remains unchanged until the end of the period
when the purchases account is closed into the inventory account.
3) Changes in inventory and cost of goods sold are recorded only at the end of the
period, based on the physical count, as previously mentioned

Inventory Physical Count under the periodic system:

The amounts of inventory and cost of goods sold can be determined based only on
the results of a physical count, so opposite of the inventory under the perpetual
system, the inventory physical count under the periodic system provide
information of:
(a) Cost of goods sold and (b) Inventory shortages and overages.
EXAMPLE:
In January 1st, 20X1, inventory consists of 1,000 units with a cost of $7 per unit. The
following are 20x2 transactions:
April 1st: sold 800 inventory units for $6,400 in cash.

May 1st: purchased 250 inventory units for $7 in cash per unit.
The year-end result of the physical count was 450 inventory units. The following
are the journal entries under the perpetual and periodic systems:
Perpetual System Periodic System
Inventory sale April 1st
Cash $6,400 Cash $6,400
Sales $6,400 Sales $6,400
Cost of goods sold $5,600
(800 × $7)
Inventory $5,600
Inventory purchase May 1st
Inventory (250 × $7) $1,750 Purchases $1,750
Cash $1,750 Cash $1,750
After the physical count on December 31 st
No journal entry is needed year-end inventory $3,150

the physical count Inventory (450*7)
equals the amount COGS (difference) 5,600
of inventory on the books Inventory (beginning) $7,000
(1,000 – 800 + 250 = 450). Purchases 1,750
Beginning inventory $7,000
Purchases of inventory 1,750
during the period
Ending inventory (3,150)
Cost of goods sold $5,600
The perpetual and periodic systems have the same result. While, under the periodic
system, the amounts of inventory and cost of goods sold are updated only at the
end of the period (most commonly end of the year) after the physical count.
Inventory Errors:
The most important about the inventory errors is to understand the effect of those
errors and how to correct them, errors generally can happen in one or more of
inventory accounts, beginning or ending inventory or purchases, and we need to
understand the effect of these errors on the ending inventory balance and cost of
goods sold
Best way to calculate for the effect and correction of these errors is through three
steps:
1. Make the calculation including the mistake (the amounts actually used)
2. Make the correct calculation after finding the mistake (the amounts that
should have been used)
3. The difference between step 1 and step 2 = the effect of the error
Most of the scenarios related to this issue in the exam mainly about the effect of
these errors on ending inventory and on cost of goods sold, and to calculate that
we could use the following formulas:
Ending inventory Cost of Goods sold

Beginning inventory Beginning inventory
+ Purchases + Purchases
= Cost of goods available for sale = Cost of goods available for sale
− Cost of goods sold − Ending inventory
= Ending inventory = Cost of goods sold
Note: If COGS is overstated, then profits are understated.

If COGS is understated, then profits are overstated.
A self-correcting error:
Is the one that corrects itself in the right time, even if it is not discovered, for
example of self-correcting error is the miscounting of inventory, since the error in
ending inventory will have an effect on two balance sheets and two income
statements, if inventory is correctly counted at the end of the next year then there
will be no carried forward errors as a result of the miscounting, so the error will
eliminate itself in the next ending period right count.
INVENTORY -- COST FLOW METHODS:
1. First-in, First-out (FIFO)

This method assumes that the first goods purchased are the first sold, so
accordingly it assume that the most recently (newest) purchased items are still in
the ending balance inventory, therefore if the goods’ prices are rising (in inflation
time) so the cost of goods sold includes the earliest goods purchased (lowest-price)
that will result in a lower cost of goods sold (lower older historical cost) - compared
to LIFO - and therefor higher profit, and on the other hand a higher ending
inventory (because it includes the newest highest priced items) current cost (or
replacement cost) so the balance sheet has current values.
Under the FIFO method, year-end inventory and cost of goods sold for the period
are the same regardless of whether the perpetual or the periodic inventory
accounting system is used.
Advantage of FIFO:
The ending inventory approximates current replacement cost
Disadvantage
The current revenues are matched with older costs.
2. Last-in, First-out (LIFO)

This method assumes that the last goods purchased are the first sold, so
accordingly it assume that the oldest purchased items are still in the ending balance
inventory, therefore if the goods’ prices are rising so the cost of goods sold includes
the latest (newest) goods purchased (highest-priced) that will result in a higher cost
of goods sold (current cost or replacement cost) - compared to FIFO – and therefore
lower profit as the income statement has current higher values, and on the other
hand a lower ending inventory balance (because it includes the oldest lowest priced
items – historical cost).

Under the LIFO method, the perpetual and the periodic inventory accounting
systems may result in different values for end inventory balance and cost of goods
sold.
1) Under the periodic inventory accounting system, the calculation of inventory and
cost of goods sold are made at the end of the period.
2) Under the perpetual inventory accounting system, cost of goods sold is
calculated every time a sale happens and includes the most recent (newest)
purchases.
Under LIFO, management can affect net income with a major late purchase that
immediately changes cost of goods sold value, while last-minute FIFO purchase has
no such effect because it will be included in the ending inventory.
Under LIFO, if fewer units are purchased than sold that means that Part or all of the
beginning inventory is sold.
Advantages of LIFO:
1. LIFO matches current costs against current revenues in the year’s income
statement, which provides a better measure of current earnings.
2. In case of inflation and price raises LIFO results in higher COGS, accordingly
lower net income, which results in lower income tax and savings in cash
outflow, so it’s a very good reason to be used for tax purposes
Disadvantages of LIFO:
1. As a down side of using LIFO for tax benefits, the US law forces entities using
LIFO for tax reports, is obliged to use LIFO for financial reporting, which will
lead to report lower earnings than other methods in case of inflation,
obviously that’s not the best reporting decision that management will take
in some cases
2. Since ending inventory on the balance sheet consists mainly of oldest items,
which mean lower value of inventory than it should be in case of price’s rise,

which considered to be a valuation distortion of inventory being evaluated

lower than the current market prices or close to it
3. If entity sales are more than purchases during a period, that means we will
take part of or all of the beginning inventory for example, which was rated
using old price, which will mean to use old cost against current revenue,
which will increase the income for this period.
GAAP IFRS
Costing LIFO is an acceptable method. LIFO is prohibited.
methods
In inflation Period Cost of Goods Ending Inventory Gross Profit (Net

Sold Income)
FIFO Lowest Highest Highest
LIFO Highest Lowest Lowest
Which Method should be used:

In general, LIFO is preferable under the following circumstances:
• Selling prices and revenues are increasing faster than costs and thus distorting
net income
• LIFO has traditionally been used, such as in department stores and in industries
where a fairly constant core inventory remains on hand, such as refining, chemicals,
and glass.
3. Average Method
The average method tends to balance between FIFO and LIFO as it measures at an
average of the costs incurred to be used for the calculation of ending inventory and
COGS.
The average may be calculated on the periodic basis or as each additional purchase
occurs (perpetual basis).
1) The perpetual inventory accounting system:
To determine a new weighted-average inventory cost after each purchase, this cost
is used for every sale until the next purchase.
Total cost of the purchase

Weighted average cost = ‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬
Number of purchased units
2) The periodic inventory accounting system:

The average cost is determined only at the end of the period, which is used to
calculate the ending inventory and the cost of goods sold for the period.
Cost of beginning inventory + Cost of purchases during the period

Weighted average cost = ‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬
Units in beginning inventory + Number of units purchased
4. Specific Identification Method

Specific identification requires determining COGS and Inventory value of each
particular item, this system is appropriate for low quantity and high valued items,
such as Jewelry, automobiles or heavy equipment, so generally it is more useful
when items are not identical and item by item has its own characteristics and
serialized.
INVENTORY MEASUREMENT IN THE FINANCIAL STATEMENTS:

Lower of Cost or Market (LCM):
In case of inventory obsolete, damage, or any other market factors price of
inventory can fall below its original balance sheet cost (over estimation), in this case
the inventory should be written down to a lower value, so at the end of each period,
company should evaluate its inventory to be sure that its utility is more than its
cost at future, the difference (write-down) should be recognized as a loss in a
separate line item or cost of goods sold in the current-period income statement, at
later time reversals of write-downs of inventory are prohibited (according to
GAAP). So, the evaluation is done by comparing the cost of the inventory on the
balance sheet:
1- To its market value (if inventory cost is measured using LIFO or retail method)
2- or to its net realizable value (if inventory is measured by any costing
measurement system other than LIFO or retail method) such as FIFO or Weighted
average.
The value of the inventory reported on the balance sheet should be the lower of its
cost or its net realizable value or the lower of its cost or its designated market value.
While remember that the market value here means the market where to buy the
inventory not where to sell the inventory, so we mean by market value is the current
cost if to be replaced, the cost to replace the inventory.

If the net realizable value or the designated market value (whichever is appropriate,
depending on the inventory method being used) is lower than the historical cost of
the inventory, the difference (loss) must be written off. U.S. GAAP does not specify
what account should be debited for the write-down. Two accounts are acceptable:
COGS or a loss account.
1- Inventories measured using LIFO or the Retail Method:

For inventories valued using either LIFO or the Retail method, the inventory should
be measured at the lower of cost or market (abbreviated as LCM), using a
“designated market value” as the market value.
Market value: LIFO & Retail Method

Market value is also called designated market value is the middle (not the average)
value of the following three figures:
(1) Ceiling: equal to net realizable value (NRV) (Maximum market value)
Net Realizable Value = estimated selling Price - the Cost to Complete and Dispose
(2) Current replacement cost: the cost to purchase the inventory immediately
(usually given number in the CMA exam)
(2) Floor: equal to NRV reduced by an allowance for an approximately normal profit
margin.
Floor = Net Realizable Value (Ceiling) - a Normal Profit Amount

2- Inventories measured using any method other than LIFO or the Retail Method:
NET realizable value (NRV):
Inventories measured using any method other than LIFO or the Retail Method are
measured at the lower of cost or net realizable value. Net realizable value is
defined as the estimated selling price in the ordinary course of business, minus
reasonably predictable costs of selling, including costs of completion, disposal, and
transportation.
Applying LCM or NRV:

If the designated market value (or NRV) is lower than the cost of the inventory on
the balance sheet, the difference (or loss) must be written off to a loss account in
the income statement.
Dr. Inventory Loss or Cost of Goods SoldXXX
Cr. Inventory XXX
LCM (or NRV) rule may be applied directly to each item or to the total of inventory
group, while applying it to each item individually will provide the lowest amount
for ending inventory, because in groups of inventories, it is very likely that a
reduction in one item maybe offset by an increase in another item
Afterwards once inventory is written down, the reduced amount is the new cost
basis for the following period according to GAAP.

GAAP IFRS
Measurem In U.S. GAAP, inventories Inventory is measured (carried) at
ent measured using any method the lower of cost or net realizable
other than LIFO or the retail value.
method should also be No calculation of market value
measured at the lower of cost or
net realizable value. (similar to
IFRS)
However, in U.S. GAAP,
inventory valued using LIFO or
the Retail Method is valued at
the lower of cost or market
value (different to IFRS)
Reversal of prohibits any reversal of write- previous write-downs of inventory

inventory down. may be recovered up to the
write- original cost of the inventory.
downs Gains cannot be recognized on
appreciated inventory, but
previous losses can be reversed

1) Assets – D) Investments
CLASSIFICATION OF INVESTMENTS
Investments in Debt securities and Equity securities:
‫اﳌﻔﻬﻮم اﻟﻌﺎم أوراق ﻣﺎﻟﻴﻪ‬ Only read for information
A security is a share, participation, or other interest in property or in an enterprise

of the issuer or an obligation of the issuer that has the following three
characteristics. (1) It either is represented by an instrument issued in bearer or
registered form or, if not represented by an instrument, is registered in books
maintained to record transfers by or on behalf of the issuer. (2) It is commonly
traded on securities exchanges or markets or, when represented by an instrument,
is commonly recognized in any area in which it is issued or dealt in as a medium for
investment. (3) It either is one of a class or series or by its terms is divisible into a
class or series of shares, participations, interests, or obligations.
FASB Codification section (page 1005).
INVESTMENTS IN DEBT SECURITIES:
The debt security:
A creditor relationship with the issuer (examples, U.S. government securities,
municipal securities, corporate bonds, convertible debt, and commercial paper) the
purpose of the investor: is to gain interests + realizing capital gains when resell,
Debt Investment Classifications
Category Criteria
Held-to-maturity Debt securities that the investor has a positive intent and
ability to hold to maturity, note: equity securities
(ownership) have no maturity.
Trading Debt securities that bought primarily to be sold in the
near term
Available-for-sale Debt securities that are not held-to-maturity or trading
Next table shows each category required accounting and reporting (presentation)
treatment:

Category Valuation Unrealized holding gains Other income

and losses effects
Held-to- Amortized Not recognized
maturity cost
Interest when
Trading Fair value Recognized in net income
earned +
(income statement)
gains and losses
Available-for- Fair value Recognized as other
from sale.
sale comprehensive income
component of stockholders’
equity
Only read for info.

Amortized cost is the acquisition cost adjusted for the amortization of discount or
premium, if appropriate.
Fair value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement
date.
Held-to-Maturity Securities:
Only debt securities can be classified as held-to-maturity, as for sure equity
securities have no maturity date (it is an ownership form), a debt security is
classified as held-to-maturity only if it has both (1) the positive intent and (2) the
ability to hold those securities to maturity, companies account for held-to-maturity
securities at amortized cost, not fair value, and therefore these securities do not
increase the volatility of either reported earnings or reported capital as do trading
securities and available-for-sale securities.

Held-to-maturity securities are presented net of any unamortized premium or
discount. No valuation account is used.
1) Amortization of any discount or premium is reported by a debit (credit) to held-
to-maturity securities and a credit (debit) to interest income.
2) No re measurement to fair value at the end of the reporting period is required.
Income statement presentation:

Realized gains and losses and interest income (including amortization of premium
or discount) are included in earnings.

Example: No calculation required for this study area

Only read for information
X Company purchased $100,000 of 8 percent bonds of entity Y on January 1, 2013, at a discount,

paying $92,278. The bonds mature January 1, 2018 and yield 10%. Interest is payable each July 1
and January 1.
X the investor records the investment as follows:
January 1, 2013 (recording the investment)
Dr. Investments 92,278
Cr. Cash 92,278
8% BONDS PURCHASED TO YIELD 10%
Bond Carrying
Cash Interest Discount Amount
Date Received Revenue Amortization of Bonds
1/1/13 $ 92,278
7/1/13 $ 4,000 $ 4,614 $ 614 92,892
1/1/14 4,000 4,645 645 93,537
7/1/14 4,000 4,677 677 94,214
1/1/15 4,000 4,711 711 94,925
7/1/15 4,000 4,746 746 95,671
1/1/16 4,000 4,783 783 96,454
7/1/16 4,000 4,823 823 97,277
1/1/17 4,000 4,864 864 98,141
7/1/17 4,000 4,907 907 99,048
1/1/18 4,000 4,952 952 100,000
$40,000 $47,722 $7,722
Cash received = $100,000 X .08 X 6/12 = $4,000
Interest revenue = $92,278 X .10 X 6/12 = $4,614
Bond discount amortization = $4,614 - $4,000 = $614
Carrying amount of bond = $92,278 + $614 = $92,892
July 1, 2013 (receipt of first semiannual interest payment)

Dr. Cash 4,000
Dr. Debt Investments 614
Cr. Interest Revenue 4,614
December 31, 2013 (accrue for interest and amortize the discount)
Dr. Interest Receivable 4,000
Dr. Debt Investments 645
Cr. Interest Revenue 4,645
X reports its investment in Y’s bonds in its December 31, 2013, financial statements, as follows:
Balance Sheet Income Statement
Current assets Other revenues and gains
Interest receivable $ 4,000 Interest revenue $ 9,259
Long-term investments
Debt investments (held-to-maturity) $93,537

Available-for-Sale Securities:
Securities that are not classified as held-to-maturity or trading, initially recorded at
cost, reporting available-for-sale securities at fair value at each balance sheet, by
recording the unrealized gains and losses (net of taxes) related to the evaluation of
securities based on the changes in its fair value in a separate account under other
comprehensive income (OCI) for the period, which is shown as a separate
component of stockholders’ equity at the balance sheet, until realized (when the
security is sold) to be reclassified to the income statement.
Note: companies report available-for-sale securities at fair value on the balance
sheet but do not report changes in fair value as part of net income because they
are not realized gains or losses until after selling the security, which means that
unrealized gains or losses does not affect the entity’s income statement until it
become real (realized) gains or losses by actually selling them, this approach
reduces the volatility of net income.
EXAMPLE:
On April 1, Year 1, X Co. purchased 1,000 shares of Y Co. bonds for their fair value. X classified
this investment as available-for-sale securities. On May 1, Year 3, X sold all of its investment in Y
for its fair value on that day. The following are the fair values per share of Y common stock:
Date Fair Value
April 1, Year 1 $25
December 31, Year 1 32
May 1, Year 3 31
April 1, Year 1 Journal Entry

Dr. Available-for-sale securities (1,000 × $25) $25,000
Cr. Cash $25,000
December 31, Year 1 Journal Entry –

At each balance sheet date, available-for-sale securities are re-measured at fair value.
Unrealized holding gains and losses are included in OCI.
Dr. Available-for-sale securities fair value adjustment [1,000 × ($32 – $25)] $7,000
Cr. Unrealized holding gain (OCI item) $7,000
Presentation in X’s December 31, Year 1 financial statements:

Balance sheet: Assets section - Available-for-sale securities (1,000 × $32) $32,000
Equity section: Accumulated OCI 7,000
Statement of comprehensive income: Unrealized holding gain (OCI) 7,000

December 31, Year 2 Journal Entry

Dr. Unrealized holding loss [1,000 × ($27 – $32)] $5,000
Cr. Available-for-sale securities fair value adjustment $5,000
Presentation in X’s December 31, Year 2 financial statements:

Balance Sheet: Assets section - Available-for-sale securities (1,000 × $27) $27,000
Equity section -- Accumulated OCI ($7,000 – $5,000) 2,000
Statement of comprehensive income -- Unrealized holding loss (OCI) 5,000
May 1, Year 3 Journal Entry

Dr. Cash (1,000 × $31) $31,000
Dr. Accumulated OCI 2,000
Cr. Available-for-sale securities $27,000
Cr. Realized gain on disposal of available-for-sale securities 6,000
Trading Securities: “Trading” means frequent buying and selling

Companies hold trading securities with the intention of selling them in a short
period of time usually less than three months, companies use trading securities to
generate profits from short-term differences in price, companies report trading
securities at fair value (net change in the fair value of a security from one period
to another), initially recorded at cost, then adjustment (remeasurement) at fair
value must be done at each balance sheet, results in unrealized holding gains and
losses to be reported as part of net income (earnings) not other comprehensive
income, exactly as held-to-maturity or available for sale investments, companies
are required to amortize any discount or premium.
EXAMPLE:
On October 1, Year 1, X Co. purchased 5,000 shares of Z Co. common stock for their fair value. X
classified this investment as trading securities. On March 1, Year 2, X sold all of its investment in
Larson for its fair value on that day. The following are the fair values per share of Z common
stock:
Date Fair Value
October 1, Year 1 $15
March 1, Year 2 20
October 1, Year 1
Dr. Trading securities (5,000 × $15) $75,000
Cr. Cash $75,000

December 31, Year 1

At each balance sheet date, trading securities are re-measured at fair value. Unrealized holding
gains and losses are reported in earnings.
Dr. Unrealized holding loss [5,000 × ($15 – $13)] $10,000
Cr. Trading securities fair value adjustment $10,000
In X’s December 31, Year 1 balance sheet, the investment in Z is reported in the current assets
section as trading securities.
It is measured at year-end fair value of $65,000 (5,000 × $13).
March 1, Year 2
Dr. Cash (5,000 × $20) $100,000
Cr. Trading securities ($75,000 – $10,000) $65,000
Cr. Gain on disposal of trading securities 35,000
INVESTMENTS IN EQUITY SECURITIES:

The equity security represents ownership interests such as common, preferred, or
other capital stock, they also include rights to acquire or dispose of ownership
interests at an agreed-upon or determinable price, such as in warrants, rights, and
call or put options.
Companies do not treat convertible debt securities as equity securities, also the
redeemable preferred stock (which must be redeemed for common stock) they
don’t treat it as equity security, and the investor’s gains should be to receive
dividends + realizing capital gains when resell
The classification of such investments depends on the percentage of the

investment held by the investor:
1. Less than 20 % investor has little or no influence (fair value method), equity
securities classified as for trading or holding for sale.
2. Between 20 % and 50 % investor has significant influence (equity method).
3. More than 50% investor has controlling interest (consolidated statements).
Category Valuation Unrealized Other Income

Holding gains or effects
Losses
Holdings less
than 20%
1. Available- for- Fair value Recognized in Dividends
sale “Other declared gains
comprehensive and losses from
income” and as sale.
separate
component of
stockholders’
equity
2. Trading Fair value Recognized in net
income
Holdings between Equity Not recognized Proportionate
20% and 50% share of
investee’s net
income.
Holdings more Consolidation Not recognized Not applicable
than 50%
Briefly, investors calculate and present information of their investments depending

on the type of security:
Security type Management plan Recognize Valuation method

unrealized
gains
Debt Hold-to-maturity No recognition Amortized cost
(no plan to sell)
Trading (planning to Earnings Fair value
sell)
Available-for-sale OCI Fair value
Equity Own less than 20% Trading – Fair value
And little or no Earnings
influence Available for Fair value
sale - OCI
Own between 20%- Equity method
50%
And significant
influence
Own between 50%- Consolidation
100% method
Presume control

Equity Method: (this method can’t be applicable for debt securities)

Used when the investor has significant influence over the investee by owning
between 20% and 50% of the outstanding voting stock (Common stock shares).
Application of the Equity Method:

(1) Initial Recording at original cost:
Dr. Investment in Company ….. (Balance sheet) XXX
Cr Cash (balance sheet) XXX
Corporation subsequently adjusts the balance in the investment account for
changes in the investee’s net assets.
(2) Investor’s Share of Investee Profit or Loss:

The investment account will be increased or decreased for the investor’s portion of
the investee’s reported earnings or losses.
Profit:
Dr. Investment in Company ….. (Balance sheet) XXX
Cr. Income from Investment in Company …. (Income statement) XXX
Loss:
Dr. Loss from Investment in Company … (Income statement) XXX
Cr. Investment in Company … (Balance sheet) XXX
The investor’s share of the investee’s earnings or losses is recognized only for the
portion of the year that the investment was held under the equity method, as not
necessarily that investor will buy investments from first day to last day of the year.
(3) Dividends Received from Investee:

The investor company decreases its carrying amount for the investment by its
proportionate share of dividends declared and paid. When a dividend is received,
the investor’s net income is not affected because investor already recognized
income from the investment based on the profits of the investee, not the
distribution of profits, while dividends will increase cash and reduce investment.
Dr. Cash XXX

Cr. Investment in Company … (balance sheet) XXX

If losses experienced by the investee company exceed the value of the investment
that will cause the balance to become negative, the investor then should stop using
the equity method and begin using the fair value method in order to not recognize
losses greater than their investment value.
Consolidation Method: (Used for investments in equity securities only no way to

use it for debt securities)
Consolidated financial statements are usually required for a fair presentation when
one of the companies in a group of companies directly or indirectly has a controlling
financial interest in the other companies. (ASC 810-10-10-1)
A business combination is a position when an acquirer obtains control of a

businesses, controlling financial interest is the direct or indirect ability to determine
the direction of management and policies of the investee, the parent is an entity
that controls one or more subsidiaries, The usual condition for a controlling
financial interest is ownership by one reporting entity, wither direct or indirect
relationship ( when a subsidiary holds a majority interest in another subsidiary) of
more than 50% of the outstanding voting shares of the acquire, while remember
that it is possible for an owner to have control with a smaller ownership percentage
or to have no control with a higher ownership percentage.
The parent company will present the financial statements of the consolidated
companies as being single economic entity (one financial statements), even if the
two entities remain legally separate, the financial statements are more meaningful
to demonstrate the effects of control over the subsidiaries.
At the acquisition date, the parent company must recognize and measure
1- Identifiable assets acquired,
2- Liabilities,
3- Any noncontrolling interest (NCI), and
4- Goodwill or a gain from a bargain purchase (difference between purchase value
and the net assets fair value.
A noncontrolling interest (NCI) is the portion of equity in a subsidiary that is not

related at all to the parent, it is reported in the equity section of the consolidated
balance sheet separately from the parent’s shareholders’ equity, there is no NCI
recognized if the parent holds all the outstanding common stock of the subsidiary.

‫ﻟﻺﻳﻀﺎح ﻓﻘﻂ‬
Goodwill is recognized only in a business combination. It is an intangible asset

reflecting the future economic benefits arising from those assets, the goodwill
recognized in the parent’s consolidated balance sheet as an intangible asset under
the noncurrent assets section, opposite of a goodwill is an account named gain
from bargain purchase (when amount paid to invest in the subsidiary less than its
net assets fair value only when preparing the consolidated accounts)
Consolidated Financial Statements:

The consolidation process begins with the parent and subsidiary adjusted trial
balances separately in a columnar format and an additional column is created for
adjusting or eliminating entries (the trial balance represents balance sheets and
income statements of parent company and each of its subsidiaries).
Steps of preparing consolidated financial statements:

1. Add all line items one by one of assets, liabilities, revenues, expenses, gains,
losses, and other comprehensive income OCI items of a subsidiary to those
of the parent
2. The periodic net income or loss of a consolidated subsidiary related to the
non-controlling interest NCI is presented separately from the periodic net
income or loss related to the shareholders of the parent accounts, It must be

adjusted for its proportionate share of (a) the subsidiary’s net income
(increase) or net loss (decrease) for the period, (b) dividends declared by the
subsidiary (decrease), and (c) items of OCI recognized by the subsidiary.
3. The main adjustments are:
Intercompany transactions: are resulted from conducted business among
the consolidating entities with each other, this effect must be eliminated in
full (as if it never been occurred) during the preparation of the consolidated
financial statements, while eliminating journal entries for intercompany
transactions must be presented at the consolidated financial statements.
1) Eliminating intercompany receivables and payables.
2) Eliminating the effect of intercompany sales of inventory.
3) Eliminating the effect of intercompany sales of fixed assets.
4) Eliminating the parent’s investment account.
4. Goodwill recognized at the acquisition date is presented separately as an
intangible asset.

1) Assets – E) Fixed assets

Property, plant, and equipment (PPE), also called fixed assets or capital assets,
including lands, buildings and equipment, are tangible property expected to benefit
the entity for more than 1 year, they are held for the production or supply of goods
or services, rental to others, or administrative purposes, and are not acquired for
resale.
(1) Fixed assets- Initial recording of fixed assets:

PPE are initially measured at historical cost, which consists of all the costs incurred
to bring the asset to the condition and location necessary to get the asset ready for
use. The historical (initial) cost includes
1) Net purchase price = total purchase price - trade discounts and rebates, purchase
taxes and import duties.
2) The directly related costs of getting the asset ready to use, such as architects’
and engineers’ fees, site preparation, delivery and handling, installation, assembly,
and testing, also the related interest costs (borrowing costs) related to the
preparation of the asset to get it ready to be used.
(2) Depreciation:
Depreciation is the process of systematically and rationally allocating the
depreciable base of fixed assets over its expected useful life, which is a match of
the expense of acquiring the asset with the revenues that it will generate over its
useful life by spreading the recognition of acquisition expense (which is the
depreciation) over the time period that the asset will be useful (provide revenue),
the depreciation expenses are recognized in the income statement, accumulated
depreciation is a contra-asset account at the balance sheet.
The entry is:
Dr. Depreciation expense $XXX
Cr. Accumulated depreciation $XXX
GAAP IFRS
Revaluation Revaluation Revaluation is a permitted (which means increase the
of assets not value of the fixed asset according to the new fair
permitted. market value) accounting policy election for two
conditions 1- an entire class (grouping of assets of
similar nature and use)

2- requiring revaluation to fair value on a regular

basis.
The increase in the value is recognized in Other
Comprehensive Income and carried in the equity
section of the balance sheet as a Revaluation Surplus.
Component component if individual components of a large fixed asset have
depreciation depreciatio different usage patterns and useful lives, then the
n is allowed individual components should be depreciated
but not separately. For example, if the engine on a machine
required. has a 5-year life while the rest of the machine has a
15-year life, the engine must be depreciated over 5
years and the remaining cost of the machine must be
depreciated over 15 years
(3) Fixed assets – Net Book Value (NBV):

The carrying amount of an item of PPE is the amount (presented in the balance
sheet), which is equal to the historical cost minus accumulated depreciation.
Fixed assets (NBV) = Initial cost (historical Cost) - accumulated depreciation
The historical cost recorded in the fixed asset account initially will remain
unchanged until disposal, unless there are subsequent capitalized expenditures.
The accounting issue of the expenditures for fixed assets subsequent to initial
recognition is to determine whether they should be
1) Capitalized at cost and depreciated in future periods (a capital expenditure)
2) Or simply expensed when they occur (a revenue expenditure).
Capital expenditures provide additional benefits by improving the quality of

services rendered by the asset, extending its useful life, or increasing its output,
these expenditures are added to the value of the asset and are capitalized at cost.
Periodic Expenses (Revenue expenditures) maintain an asset’s normal service

capacity, these costs are recurring, not expected to benefit future periods, and
expensed as they occur, such as routine checkup and maintenance expenses.
Calculation of Depreciation:
The asset’s depreciable base (the amount to be allocated) is calculated as follows:
Depreciable Amount or (Depreciable base) = historical cost – salvage value
Rule: there is no depreciation for lands as they don’t have estimated useful life.
Definitions: Estimated useful life: (Service life): is an estimated length of time over
which the asset is expected to be useful, and it’s the same period used to recognize
depreciation expenses of that asset, whereas at the end of the asset’s useful life
the book value of the asset should equal to the expected salvage value.
Estimated salvage value (residual value): is the value expected to be obtained from
disposal of the asset at the end of the asset’s useful life, some companies assume
salvage value is always $0 at the end of the asset life, also the book value will not
be depreciated below the salvage value.
Depreciable amount (depreciable base): This is the amount to be depreciated over

the asset’s useful life, calculated as per previous equation.
Depreciation Methods:
No matter the chosen depreciation method is the basic depreciation entry
mentioned before is always the same, the method will only change the value XXX
in the journal entry.
❶ Straight-line depreciation (SLD):

This method represents the easiest and simplest depreciation calculation, it
calculates an equal amount of depreciation to be charged to each period of the
asset’s useful life.
Periodic depreciation = Depreciable Amount / Estimated Useful Life
Other depreciation methods result in greater depreciation in the early years of an

asset’s life and lesser depreciation in the latter years.
❷ Accelerated depreciation methods:

Are time-based methods, they result in decreasing depreciation charges over the
life of the asset, the two major time-based methods are declining balance and sum-
of-the-years’-digits.
1) Double Declining balance (DDB)

Use a rate that is maybe 200% of straight-line method, also the percentage is
applied to the net book value of the asset at the beginning of each year not the
original depreciation base, which means that we must calculate the depreciation
rate of Y3 for example in order to reach the assets NBV for Y4 if we want to calculate
depreciation of Y4, in other words, calculation of depreciation of any year
dependent on the previous year depreciation and NBV calculation, opposite to all
other methods when we calculate the depreciation of each year regardless of the
other years calculations
The annual depreciation expense = Double declining rate × book value of the
asset at the beginning of the year
Salvage value is not taken into account when calculating the annual depreciation
charge, but the asset is not depreciated below salvage value, some companies use
DDB for the first few years then switch to straight-line for the remaining years of
the asset’s life.
2) The sum-of-the-years’-digits (SYD)
Periodic expenses = depreciable base X (remaining years of useful life / sum of all
years in useful life)
In the equation the constant depreciable base is used (cost minus salvage value)
multiplied by a declining fraction (a declining rate) (a declining-charge method).
If the number of years too large to calculate the sum of the years number (fraction)
the following equation could be used
The sum the years digits = n (n + 1)/2
N = number of useful life of the asset you can try it now to examine the
equation for 3 or 4 years for example
❸ Units of production method (Usage-centered activity methods):

Under the units of production method, it depends mainly on determining the
number of units that the asset will be able to produce over it’s useful, instead of
using the asset useful time as basis of calculation
Periodic depreciation = depreciable base X (units produced during current period

/ total units of production during the estimated life time)
Group and composite depreciation methods

Apply straight-line accounting to a collection of group of assets, similar assets
(group of assets) or dissimilar assets but still combined in one group (composite
assets), depreciated as if they were a single asset, that would be an efficient way
to account for large numbers of depreciable assets.
What is the best depreciation method to be used?

Entity should choose depreciation method that will accomplish the matching to
revenue accounting principle, matching the depreciation expenses to the revenue
generated from particular asset during the same period, such as:
1. If expected revenues from particular asset are constant over the asset’s
useful life so using the straight-line depreciation would be suitable to
allocate a constant depreciation expenses values.
2. If revenue will be higher during the beginning period of using the asset so
the accelerated methods will be beneficial for that purpose, and if the
production is lower at the beginning of the asset usage so production
method could be used then to match the low revenue at the beginning of the
asset life
Impairment of fixed assets:

Impairment asset: when the carrying amount of the asset may not be recoverable,
such as when the market price has decreased significantly, or the physical condition
of the asset has a major change adversely, it worth to refer that according to GAAP
the opposite is not true, which means if market price of an asset has increased so
fixed assets value in books are not written up to recognize that increase.
The two-step test for impairment: applicable for fixed assets and intangible assets
1) Recoverability test:
Entity should compare the carrying value of the fixed asset with the sum of the
estimated undiscounted future cash flows expected from the use and the
disposition of the asset, so if the carrying value exceeds the expected sum of the
undiscounted future cash flows so it is not recoverable.
Carrying amount of an asset > total undiscounted cash flows

If the asset’s book value is less than the future cash flows, the asset is not impaired,
and no adjustments are needed
2) If last condition is applicable and the carrying amount is not recoverable, then
the entity should recognize an impairment loss as follow:
Impairment loss = asset’s carrying value – asset’s current fair value

The recognition should be done immediately in income from continuing

operations.
The journal entry:
Impairment loss $XXX
Accumulated depreciation $XXX
The adjusted carrying value (asset book value) for impairment loss - which is the
original cost of fixed asset minus accumulated depreciation including the
impairment loss based on the last entry - is used as new depreciation base for
following periods depreciation cost calculations.
Disposal of fixed Assets (long-lived assets):
When fixed asset is sold
Gain or loss on disposal = net proceeds – asset’s carrying amount (NBV)
Dr. Cash $XXX amount received

Dr. Depreciation XXX to the date of sale (if any)
Dr. Accumulated depreciation XXX amount on books
Dr. /Cr. Loss/Gain on disposal XXX balance
Cr. Fixed assets XXX historical cost of asset
Disposal by Donation:
Dr. Donation expense XXX fair value of donated asset
Dr. Depreciation XXX to the date of sale (if any)
Dr. Loss on donation XXX balancing amount
Dr. Accumulated depreciation XXX amount on books
Cr. Fixed Asset XXX historical cost of asset

GAAP IFRS
calculation The amount by which the The impairment process is a one-
carrying amount of the asset step process. The carrying value of
exceeds its fair value (carrying the asset is compared to the
amount of the asset is compared recoverable amount. The
with the sum of future recoverable amount is the higher
undiscounted cash flows of 1) the fair value of the asset, if
generated through use and sold, minus any costs of sale, or 2)
eventual disposition) the Discounted future cash flows it
will generate
Reversal of Prohibited. No reversal after If the revaluation is the recovery of
loss impairment made a previously recognized loss when
the asset was impaired, the
revaluation gain is reported on the
income statement to reverse or
recover previous transaction
Notice from last to points for IFRS:
Revaluation gains happen first to an asset, so gains go to OCI, if subsequent
impairment so losses goes to OCI also to recover previous increase, and extra
losses will be in income statement.
While if impairment happen first so losses go to income statement, then if
subsequent gain due to revaluation after impairment it will go to income
statement to recover previous losses.

1) Assets – F) Intangible assets
Intangible assets:
Assets that are not physical, in other words assets that cannot be touched, for
example patents, copyrights, franchises, trademarks, etc.
Initial Recognition
Intangible external acquired assets like fixed assets are initially recorded at original
cost paid to acquire that asset, plus any additional costs required to make the asset
ready for use, such as legal fees and all transfer costs of the asset during the
acquiring process.
Internally developed intangible assets are not recorded or capitalized because it is

originally having no identified value, but instead recording and capitalizing the
additional costs such as registration fees, while research and development
expenses R&D are directly expensed as incurred and therefore can’t be capitalized.
Amortization Intangibles
(1) The asset has a determined limited life (finite useful life):
It is amortized over that useful life (also known as amortized intangible assets), such
as Purchased patent, internally developed patents, franchises, trademark, and
copyrights, and most of it additional costs that could be capitalized with the original
cost of the intangible asset, such as legal fees, registration fees, cost of defending
one of the previously mentioned examples, such as court arguments, and other
related costs.
Journal entry of amortization:

Dr. amortization expenses $XXX
Cr. Accumulated amortization $XXX
The amortizable amount = initial original cost - residual value.

The amortization methods are like the depreciation methods used in the
calculations related to the fixed assets, accordingly the carried forward balances of
an intangible asset with a finite useful life equals its historical cost minus
accumulated amortization and any impairment losses, similarly the impairment
tests used in case of intangible amortized assets are the same that are used for
fixed assets.
(2) The asset with no determinable useful life (indefinite useful life):
That asset is not amortized, but instead it must be tested regularly for impairment
at least annually, known also as nonamortized intangible assets
Carried forward balances of intangible asset with indefinite useful life

= historical original cost – impairment losses
Accounting for intangible assets:

1- Patents for example, new technology or new design
It’s the exclusive right of granted use by government (usually 20 years in the US).
The amortization period for a patent is the shorter of:
1) Its economic useful life or
2) Legal life.
A) Purchased patent historical cost to be amortized

B) Internally generated patent only registration and legal fees
to be capitalized and amortized
while all other costs are expensed
including R&D.
Most likely that the economic useful life is shorter than the legal life because of
changes in technologies, consumer tastes, and development of substitutes.
Defending the patent legally:

Main issue about the patent are court cases and legal expenses related to defensing
the patent

Company could succeed to while if the company fails to

defense its patent, so court defense its patent so the court
costs are capitalized for the costs should be all expenses as
remaining life of the patent incurred + any remaining value
of the patent is also written
and amortized over its useful
off as a loss because if we loss
life (costs goes to the the case it means that we
Balance sheet) don’t really own the patent
2- Trademarks & Trade names: (income statement).
It is a distinctive sign, word, or symbol
it should be amortized over its useful life but not longer than 40 years.
3- A copyright (©) for example, music composition and literatures (original work)
It is effective for the life of the author plus 70 years
for publishers for example:
A) for a publisher: a purchased copyright is recorded at its original purchase price
+ additional transfer costs of the purchased rights.
B) for the writer: own developed copyright can be recorded only at its registration
costs as usual in similar intangible assets developed internally.
4- Franchises best example are the international chain restaurants

The franchisee will operate a specific business using the franchisor’s name
according to a written contract
A) for a finite franchise: the franchisee should capitalize the costs of acquiring the
franchise and amortize them over the franchise’s useful life.
B) for an indefinite franchise: it should be carried at cost and should not be
amortized but should be tested annually for impairment, as per all other intangible
assets with indefinite life
5- Goodwill intangible asset – indefinite useful life

Goodwill can be acquired or developed internally, but the only goodwill recognized
in the accounting records is purchased goodwill, the amount of goodwill purchased
is equal to the difference between the purchase price paid for a business and the
fair value of the net assets received.
Goodwill = paid price for a business – fair value of its net assets

The purchased goodwill (the one is purchased in a business combination) is the only
recognized in the financial statements (recorded), while internally generated
goodwill not recorded.
Maintaining goodwill:
Developing and maintaining purchased goodwill are expensed as incurred, such as
training employees or hiring employees from the company that was purchased.
Presentation of intangible assets: Disclosure

Two lines for intangible assets on the balance sheet:
1- All intangible assets are presented in one line
2- Only Goodwill is presented in a separate line
As well as the income statement:

Amortization expenses and impairment losses are reported in the continuing
operations section in two lines:
1- all intangible assets except goodwill
2- Goodwill
Intangible assets impairment:

The goal of impairment of intangible assets (such as fixed assets) is to be sure that
intangible assets are not overstated (overvalued) in the balance sheet, by being
sure that the intangibles are going to provide as much value as its carrying value on
the balance sheet.
3 different treatments for intangibles impairment:

1. Definite (limited) life intangibles impairment
2. Indefinite intangibles impairment other than goodwill
3. Goodwill impairment
1. Definite life intangibles impairment: very similar to the fixed assets

Company should evaluate an intangible asset whenever there is any indication that
the carrying amount of the asset may not be recoverable
2 steps process
1- recoverability test: intangible asset to be impaired if
Carrying value (Book value) > sum (total) undiscounted future cash flows
Including its disposal (selling value)
2- impairment step is to write down the book value of the intangible to its fair value
Impairment loss = carrying value – fair value

Fair value = present value (discounted) future cash flows (same amount of future
cash flows but discounted)
2. Indefinite intangibles Not including goodwill:

Indefinite intangibles are not amortized but should be tested on at least an annual
basis for impairment.
3 steps process
1- Qualitative (optional – according to standards entity is allowed, not must use it)
initial qualitative assessment to determine whether it is more likely than not that
the asset is impaired (i.e., probability greater than 50%), if the qualitative results
indicate that the indefinite life asset is not impaired, then the entity does not need
to calculate the fair value continue the rest of the process.
2- Quantitative impairment test: if a determination is made that the intangible

asset is impaired after performing the initial qualitative assessment, the asset’s fair
value must be calculated and compared with the carrying value to determine
whether an impairment loss should be recognized.
Carrying value (Book value) > intangible asset fair value (asset to be impaired)
3- write down the carrying amount of intangible asset to its fair value and loss
should be recognized under the continuing operations section in the income
statement, and as mentioned in the disclosure it should be reported in a separate
line from any goodwill impairment losses.
3. Goodwill impairment:
Goodwill not amortized but should be tested on at least an annual basis for
impairment, impairment testing of the goodwill must be done in the context of the
value of the business to which the goodwill is related
3 steps process
1- Qualitative (optional)
As with other intangible assets that are not being amortized, the company has the
option to first perform a qualitative assessment to determine if it is more likely than
not that the fair value of the reporting unit is more than its carrying amount, then
the company does not need to go further. However, if the company concludes that
it is more likely than not that the fair value of the reporting unit is less than its net
carrying amount, the company proceeds to the quantitative, two-step impairment
test.
2- Quantitative analysis:
Carrying amount of reporting unit’s >
Fair value of reporting purchased
net assets including goodwill unit that created the goodwill
Potential loss but not sure yet
If carrying amount < fair value so company can stop here and not go further.
3- 3rd step test

compare implied fair value of the goodwill to the carrying amount of the goodwill
unit’s implied fair value: fair value of the reporting unit’s assets and liabilities as if
the unit were newly acquired in a business combination.
Carrying amount of the goodwill > Goodwill implied fair value = the
fair value of the reporting unit –
implied fair value of net assets
Carrying amount of the goodwill is written down to its implied fair value and
impairment loss is recognized in a separate line in income statement, the loss
recognized cannot be greater than the carrying amount of the goodwill, only to
bring goodwill carrying amount to zero maximum and it is said then that goodwill
is written off.
GAAP IFRS
Developme Generally, development Development costs are capitalized as an
nt costs costs are expensed as intangible asset item if the entity can
incurred. demonstrate the technical feasibility of
(may be capitalized only if a
specific U.S. GAAP standard
completion of the asset.
allows capitalization for that
asset)
Revaluation Revaluation is not Revaluation to fair value of intangible
permitted. assets other than goodwill is a permitted
accounting policy, for a class of intangible
assets. can be applied only if the
intangible asset is traded in an active
market.
Reversal of prohibits any reversal of a previously recognized impairment loss
loss write-down. on an intangible asset may be reversed if
the estimates of the recoverable amount
have changed.

2) Liabilities – A) Warranty liability
A warranty is a written promise, guaranteeing to fix or replace a defective product

during a specific period, there are two types of warranties:
1) Inseparable expense warranty is a warranty given along with the sale of the
product. It requires no additional payment from the customer.
2) A separable sales warranty it is an extended warranty that is sold separately from
the product, sales warranties may be sold by the manufacturer, a reseller, or a third
party.
(1) Inseparable warranties: (Expense warranty)

Accounting recording
In order to apply the matching to revenue accounting principle, entity should
accrue for its warranty expenses when the sale of the item is executed, which
means when the revenue is recognized, that’s if the company could reasonable
estimate the amount of the expense maybe using past experience or best
reasonable estimation, this treatment called the expense warranty approach, the
estimation could be dollar amount per unit sold or percentage of the sale price,
even though the warranty expenses will cover a long period of time (warranty for
one year or two years for example), still the recognition should be done on the day
the product is sold.
Dr. Warranty expense XXX (to the period of sale)
Cr. Warranty liability XXX
When there is a warranty cover claim by customer, which might require spending
money to repair or replace the item:
Dr. Warranty liability XXX
Cr. Cash XXX
Evaluation of warranty liability balance is required at the end of each year to write
it up or down if needed, depending on the period end evaluation.
This GL can be used to answer the number questions
Warranty liability GL for exam purposes
XX Beginning balance
XX warranty expenses recognized (current period)
XX warranty payments (current period)
XX Ending balance
Current and noncurrent warranty liability:

1) Current warranty liability: when the warranty term extends only into the next
accounting period.
2) Noncurrent warranty liability: when the warranty term extends beyond the next
period, liability estimated balance is divided into a current portion and a long-term
portion.
The warranty liability on the balance sheet is calculated as:

Total warranty expenses recognized (accrued) in the past on warranties that
are still open
− All payments that have been made on warranty claims on those warranties
= Warranty liability on the balance sheet
(2) Separable warranty: (Sales warranty)

The seller will be recognizing the sale of the warranty separately from the sale of
the sold item subject to this warranty, the revenue is deferred and is usually
recognized on the straight-line basis over the term of the warranty, some sellers
sell warranties that starts after the manufacturer’s warranty expires, then the
recognition of the extended warranty revenue will begin after the manufacturer’s
warranty has expired. and this accounting treatment is sometimes called the sales
warranty approach.
Since the revenue for sales warranties is recognized throughout the warranty
agreed period, so the related expenses to cover the warranty obligations should be
expensed as period costs. Furthermore, if service costs are not incurred on a
straight-line basis, then the revenue should be recognized over the contract period
in proportion to the expected costs.
Thus, the liability for a sales warranty is the unearned revenue on the balance
sheet. Estimated future costs are not accrued as liabilities

2) Liabilities – B) off-balance sheet financing
It is a form of funding that are not recorded to the owners’ equity, liabilities, or
assets on a firm’s balance sheet, main purpose of some forms of off-balance
sheet financing is to decrease the reported debt on the company’s balance
sheet, which can make the company’s capital structure ratios appear more
favorable, when off-balance sheet financing is used to hide major financial
information, such actions are not appropriate or ethical, forms of off-balance sheet
financing:
• Operating leases to finance acquisition of assets by paying installments for a long

period of time to own the asset at the end of this period, an operating lease is
accounted for as rent expenses, the lessee is not recoding the asset on its balance
sheet and does not account for any liability connected to the future lease
payments, these bases should be changed under GAAP and IFRS standards, for CMA exam
Jan./Feb. 2020
• Selling (factoring) receivables also called factoring, discussed earlier, in which the
company can receive cash immediately in exchange for giving up the right to collect
its receivables, to avoid the cost of having to collect and possibly avoid the risk of
bad debts, this transaction is not recorded into the company’s balance sheet but
instead as discussed before it is recognized as receivables collection.
• A joint venture which is a partnership created for a limited purpose and/or for
limited period, sometimes it is formed to fulfill a large or risky contract that one
contractor alone cannot perform, a separate set of accounting records is presented
for the joint venture, and it is recorded as a single line for each participating
contractor report.
• Non-consolidated subsidiaries if the parent company does not have control when
its ownership is less than 50% in a subsidiary, it does not report the assets and
liabilities of the subsidiary on its own balance sheet.

2) Liabilities – C) Income taxes

What we want to pay What we must pay
There are two sets of calculations of income in any entity:
Book income (financial income) calculated based on the GAAP standards and
which represents the income reported in the financial statement before applicable
taxes (pre-tax income) and which is different than taxable income (tax income)
which is the basis used to compute the income tax payable to the government, in
other words what the government says that the entity should pay for in a certain
period, so it is calculated in accordance with the applicable tax law in each country,
taxable income = taxable revenues – taxable expenses.
Deferred taxes:
Deferred tax is the difference between book income & taxable income
Dr. Income tax expense (want to pay) 90
Dr. Prepaid taxes (or deferred tax asset) 10
Cr Cash (must pay) 100
Dr. Income tax expense (want to pay) 100

Cr. Cash (must pay) 90
Cr. Taxes payable (or deferred tax liability) 10
Possible cases that will cause a difference between financial income and taxable
income, temporary Timing Differences, which will lead to deferred taxes:
Deferred tax liability:

Book income > taxable income
1) Revenues recognized in the accounting records before it is recognized in as a
taxable income: for example, income of equity securities are recognized when
earned for financial reporting, while for tax purposes only when distributed -
dividends.
2) An expense item is deductible from taxable income before it is deducted in the

accounting records: for example, when using the Modified Accelerated Cost
Recovery System (MACRS) for calculating depreciation for tax purposes and using
depreciation method such as straight-line for financial reporting purposes,
depreciation expensed will be greater for tax purposes than for book purposes in
the early years of the asset’s life).
Deferred tax liability DTL = future taxable amount X tax rate

Known also as taxes payable or future taxable amounts
Deferred tax assets:

Book income < taxable income
1) Revenues recognized as taxable income before it is recognized in the
accounting records: for example, prepaid rental income and service contract
revenue are recognized for tax purposes when received, while for financial
reporting they are recognized when they are earned
2) Expenses deducted in accounting records before it is deducted from taxable

income: for example when expense accrued for financial reporting purposes for
estimated liability for warranties which is accrued on the date of sale and pending
litigation – accrual method of accounting, which is not allowed as a tax deduction
until the amounts are paid – cash bases, also bad debt expense is recognized in the
financial statements under the allowance method, which is different for tax
purposes as bad debt expense is recognized when the debts are determined to be
uncollectible using the direct write-off method.
Deferred tax assets DTA = future deductible amount X tax rate

Known also as prepaid taxes or future deductible amounts
Table of temporary timing Differences and Their Results

Included in taxable income Included in book income
first first
Revenues and gains Deferred tax asset Deferred tax liability
Expenses and losses Deferred tax liability Deferred tax asset
So deferred taxes are resulting from taxable (or deductible) temporary differences,
which results from the differences between the GAAP basis and the tax basis (tax
code) of an asset or liability, as explained in the previous examples, those
differences exist when items of income and/or expense are recognized in different
periods under GAAP standards compared to the tax code, the effect is that a
taxable or deductible amount will occur in future years when the asset is recovered
(collected) or the liability is settled (paid), therefore the deferred tax valuation is
based on using the enacted tax rate(s) expected to apply when the liability or asset
is expected to be settled or realized, in other words deferred taxes are the
differences between what the company wants to pay based on the income the
company defines as taxable (book income) and what the company has to pay
calculated by the government according to the tax code, that different could be on
the debit side with the assets or in the credit side with the liabilities
Presentation on income statement:

Require two tax expenses account on the income statement:
1. Current Income Tax Expense: the amount payable to the government, based
on taxable income used for the payable tax calculation of the current period.
Current tax expenses / benefit = taxable income X tax rate.
Current income tax expense is recorded as follows:

Dr. Income tax expense -- current XXX
Cr. Income tax payable XXX
2. Deferred Income Tax Expense or Benefit: The tax effect of timing differences
between book and taxable income, as explained before, this deferred
income tax item may be either a reduction to current income tax expense,
which is a benefit, or an increase to current income tax expense, which is an
expense.
The calculation of the deferred tax is based on the connotation: It is the amount of
change in the total deferred tax asset and liability position of the company during
the period, entity could have both deferred tax liability and asset in the same
period, so total of both items will result to the final deferred tax value for the period
in the direction of the larger amount, wither liability or asset.

Deferred tax expenses or benefit = Beginning Balance of DTA (DTL) - Ending

Balance of DTA (DTL)
Total of 1 + 2 equal to Total Income Tax Expense as calculated on the basis of

financial income according to GAAP and shown on the income statement:
current income tax expenses (amount payable based on taxable income)

+ deferred tax expenses OR
– deferred tax benefit
Total income tax expense on income statement
Journal entries:
DTL balance increased during the year
Income tax expense -- deferred $XXX IS
Deferred tax liability $XXX BS
DTL balance decreased during the year:

Deferred tax liability $XXX BS
DTA balance increased during the year

Deferred tax asset $XXX BS
DTA balance decreased during the year

Deferred tax asset $XXX BS

A Single Period of Creation and Multiple Periods of Reversal with Changing Future
Tax Rates
When the temporary timing difference is created in a single period but will reverse
over a number of future periods that have different enacted tax rates, the
calculation of the deferred tax amount is fundamentally the same. Instead of
making one calculation, a separate calculation must be made for each year in which
the temporary timing difference will reverse. The process involves three steps:
1) Determine the amount of the temporary difference and how much of that
difference will reverse in each future period.
2) Multiply each amount of the temporary timing difference that will reverse in
each future period by the enacted tax rate for that future period.
3) Sum all of the results from Step 2 to calculate the amount of increase in the
balance of the deferred tax asset or liability at the end of the year in which it was
created.
The amount of increase in the asset or liability account representing that particular
deferred tax item at the end of the year will be equal to the related deferred tax
benefit or expense for the year.
Note: The enacted tax rate is the rate that has been enacted into law by the
government as the rate for the future period in question. If no laws have been
passed that change the tax rates in the future, assume that the current tax rate will
be the enacted rate for any future periods.

Different cases and Examples:

Single period of creation and single period of reversal:

Multiple Periods of Reversal and a Constant Future Tax Rate:
A Single Period of Creation and Multiple Periods of Reversal with Changing Future
Tax Rates:

Part 1: Financial Reporting, Planning, Performance, and Control From January 2018 for exam
Section A) External Financial Reporting Decisions purposes the deferred taxes will be
only noncurrent assets or liabilities
Presentation of Deferred Tax Assets and Liabilities on the Balance Sheet:

Deferred tax assets and liabilities are to be classified on the balance sheet as either
a net non-current asset or a net non-current liability.
The net amount and whether it is to be presented as an asset or a liability is
determined by subtracting the deferred tax liability amounts from the deferred tax
asset amounts. If the net result is positive (a debit), the net amount is reported on
the balance sheet as a non-current asset. If the net result is negative (a credit), the
net amount is reported on the balance sheet as a non-current liability.
Valuation needed:
In case of probability of more likely that some portion of asset will not be realized,
then it is required to use a valuation allowance to reduce the deferred tax asset, in
order to reduce the deferred tax asset to the amount that is more likely than not
to be realized.
Permanent difference:
If an income or expense item is recognized only for book purposes or only for tax
purposes but not both (which is the case in temporary time differences), it is a
permanent difference, which will never generate a deferred tax asset or liability,
examples: Municipal Bond Interest (Tax exempted), The Dividends-Received
Deduction, Expenses incurred in the process of earning tax-exempt income, Life
insurance premiums paid by the corporation (The life insurance expense is not
deductible and in the same time proceeds are not taxable), and Expenses incurred
as a result of violating the law which involve governmental fines (for book purpose
are expensed but for tax purpose is not allowed to be deducted)
Operating Loss Carryback and Carryforward For tax purposes

Entities that incur net operating losses (NOLs) have two options for obtaining the
tax benefit of the loss:

1) Carry the loss back 2 years and/or

2) Carry the loss forward 20 years.
(1) Loss carryforward:

The entity carries the entire loss forward 20 years, which will require recognition
of a deferred tax asset, the deferred tax asset reduces the amount of income tax
payable in future periods and does not affect the total amount of income tax
expense recognized.
Year 1
Dr. Deferred tax asset (=loss X tax rate) (BS acc.)
Cr. Income tax benefit from loss carryforward (IS acc.)
(below operating loss before income tax line)
Year 2
Dr. Income tax expense - current
Dr. Income tax expense - deferred
Cr. Income tax payable
Cr. Deferred tax asset
Tax planning strategies may dictate that it is better for the company to carry the
loss forward instead of back if the expected tax rate for the future is higher.
(2) Loss carryback:

1. The entity files an amended tax return that carries the loss back to the
second prior year, offsetting some or all of that year’s tax expense
The balance sheet and income statement are affected.
Income tax refund receivable (tax offset by carryback) (BS acc.)

Income tax benefit from loss carryback (IS acc.)
2. If any of the current-year loss remains after the 2-year carryback, the entity
is allowed to carry it forward 20 years.
same entries like carryforward point (1)

2) Liabilities – D) Leases
Definition of a Lease:
A lease is a long-term contract in which the owner of asset (the lessor) allows the
lessee (the person who is going to use the asset wither by buying it or renting it) to
use the asset for an agreed period in exchange for a specific payment.
There are two types of leases:

1. Capital lease: a purchase/sale agreement, where the lessor transfers all the
benefits and risks of ownership of the asset to the lessee
2. Operating lease: rental contract, it does not transfer all the benefits and risks
of ownership of the asset to the lessee, at the end of the lease contract the
asset will be returned to the lessor.
Capital lease:
The lessee buys the asset from the lessor, through financing the purchase with a
loan from the lessor, and therefore the lessee will:
1) Record a fixed asset on its books
2) Depreciate that asset
3) Record a payable representing its obligation to make future lease payments and
record a reduction of that payable as a portion of each lease payment made
4) Recognize interest expense as part of the lease payment each period because
the lease is essentially a loan financing the purchase of the asset by the lessee from
the lessor.
Note: The amount of interest expensed on the income statement is calculated
based on the principal amount of the lease liability still outstanding each period.
Each period when a payment is made, part is a payment of interest and part is the
reduction of the principal.
On the other hand, the lessor should:

1. Remove the fixed asset from the lessor’s books
2. Recognize revenue from the sale of the asset to their income statement.
3. Recognize a gain or a loss on the sale, which is the difference between the
sales price and the remaining NBV of the asset.
4. Record a receivable for the remaining due amount expected to be received
from the lessee in future periods.
5. Record interest revenue each time a payment is received from the lessee

A lease is said to be capital lease in ONE of the following cases: (what differentiate
capital lease from operating lease).
1) The lease provides for the transfer of ownership of the asset to the lessee at the
end of the lease.
2) The lease includes a written bargain purchase option (BPO) by which the lessee
may purchase the asset at the end of the lease for an amount expected to be less
than the fair value of the asset at the end of the lease.
3) The present value of the minimum lease payments is equal to or more than 90%
of the fair value of the asset at the time the lease is entered into.
4) The lease term is 75% or more of the remaining estimated economic useful life
of the asset at the time the lease is entered into.
Minimum lease payments

1- The minimum rental payments
2- Any guaranteed residual value, the amount the lessee guarantees the lessor will
receive for selling the asset at the end of the lease.
3- Any penalty for the lessee’s failure to renew or extend the lease, if included in
the lease terms.
4- Any bargain purchase option
‫ﻣش ﻣﮭﻣﮫ‬
PV of minimum lease payment = PV of minimum rental payment (PV of an annuity
table) + (PV of residual value will be paid by lessee + PV of nonrenewal penalty) or
PV of BPO.
GAAP IFRS
Capital One criterion under U.S. GAAP is Has a similar condition but refers to
lease that a capital lease exists if the a “major part” of the asset’s
(regarding lease term is equal to or greater economic life rather than a specific
determinin than 75% of the asset’s economic percentage which is 75% under
g if the life. GAAP.
lease is a
capital U.S. GAAP also refers to 90% of IFRS refers to “substantially all” of
lease) the asset’s economic fair value the fair value which is 90% under
GAAP.

Operating Lease:
The lessee reports periodic rental expenses, but does not recognize the asset on
the balance sheet, also the lessee doesn’t recognize any related liability for any
future lease payments, for this reason not recording the asset or the liability related
to it to the balance sheet report, the operating lease is a form of off-balance-sheet
financing as previously mentioned in the off-balance-sheet financing subject.
The lessee records the following journal entry:
Rent expense $XXX
Cash or rent payable $XXX
If rental payments changing from one month to another, for example if the first
month is free, rent expense must be recognized over the full lease term on the
straight-line basis.
Lessees may prefer to account for or use an operating lease instead of as a capital
lease to avoid recognition of:
(a) a liability for future lease payments, not to effect balance sheet
liquidity ratios for example
(b) avoid interest expenses which will reduce income
(c) depreciation of the leased asset which also will reduce the operating
income of the lessee
While on the other hand, the lessor reports periodic rental revenue for the rent
received and will continue to recognize and depreciate the leased asset in its
financial statements, as although he does not hold the property, but he still owns
it.
after January 1, 2019, leases accounted for under IFRS can no longer be classified
as operating leases.

3) Equity transactions unit 1 G
Owners’ equity (shareholders’ equity)

Owners’ equity = Assets – Liabilities
So equity is the balancing of the balance sheet for assets and liabilities, and owners’
equity represents what the company owes to the owners of the company, more
formally, owners’ equity is defined as the residual interest in the assets of an entity
after deducting its liabilities, depending on the entity’s form the equity’s accounts
are different from each other, for example a sole proprietorship will have one
capital account for the owner of this company, while in a partnership company
there will be many capital accounts, one for each partner.
Owners’ equity consists of the following accounts:

❶Contributed capital:
The fair value of what is received from owners in exchange for the shares, whether
cash or another asset
1. Capital stock account: registering in the balance sheet the par value of sold
shares, that’s why company might have many capital stock accounts one for
each type of issued shares.
2. Additional-paid-in-capital (APIC) account: the above the par value that is
received when shares were sold, so balance sheet might have different APIC
accounts, classified by type of shares or by transactions.
❷Retained earnings: “undistributed earnings” that were reinvested.

❸other comprehensive income: not discussed in this study unit
Types of equity financing:

Depending the registration of the stock and the characteristics of it
1. Common shares
2. Preferred shares
Common and Preferred Stock:

Basic terms related to stock:
1) Authorized stock: maximum number of shares that a company is allowed to
legally issue.
2) Issued stock: amount of stock authorized that has been issued by the
corporation, it might be held by owners or by the company itself in the form of
“treasury shares”
3) Outstanding stock: is the amount of stock issued that has been sold to
shareholders and they still hold it.
Outstanding shares = issued shares – treasury shares
4) Par value: (stated value) is the stated specific amount of the stock which is
printed on the share itself (not all shares have par value), most of companies they
use a very small amount for the par value, it is only used at the registration of the
shares, and it does not impact the selling price of the stock, the par value also
represents the legal capital of the company that cannot be distributed
Common Stock: represents the general form of ownership

It has two types:
Common stock with par value: as the par value is the legal capital of the company
that can’t be distributed as dividends.
Common stock with no par value: the legal capital here is the total amount received
when issued.
Common shareholders are called residual owners, because if the company is

liquidated, they are going to receive the residual money after paying everybody
else, creditors, preferred shares, etc.
Common shareholders have the highest risk as company don’t have to pay
dividends (no obligation) and share price may go down
Rights of common shareholders:

1. Voting: vote to select BODs, merger decisions, and other significant issues at
annual meetings.
2. Dividend: common shareholders have a right to dividend if it is declared by the
board of directors, as the entity might choose not to declare dividends.
3. Preemptive right: (stock rights) it allows the shareholders to have the right to
purchase the same percentage of a newly additional issued shares in proportion to
their ownership percentage, this way the preemptive rights safeguard a common
shareholder’s ownership and interest proportion.
4. Right of distribution of residual assets in liquidation

In the middle
Preferred stock:
Bonds preferred shares common shares
Like with the common stock preferred share is an equity instrument and included
in the equity section of the balance sheet, it said to be in the middle between debts
and equity since it has features of debt (bonds) and equity (common shares)
How similar to debts:

1. Generally don’t vote.
2. The preferred dividends are usually a fixed percentage of a par value (fixed
charge).
3. Preference over common shareholders in a liquidation.
4. Preference over common shareholders in receiving dividends, although payment
of dividend still not an obligation.
5. It may have some characteristics such as callable, convertible and may have
sinking fund requirements.
How similar to common stock:

1. No commitment against the company in paying dividends.
2. Preferred dividends are paid after interest and tax, so they are not tax deductible.
3. They are below debt in liquidation.
Two types of preferred dividends:

❶Noncumulative preferred dividends:
undeclared dividends in a year are lost Cumulative preferred dividends: every year
it is earned even if it is not paid, so if it is not declared for a year it will be
accumulated and carried forward, which will be called then “dividend in arrears”,
while no legal liability for not paying.
❷cumulative preferred stock: refers to the cumulative dividend in arrears

A cumulative dividends are earned every year no need for declaration, and if not
declared the dividend will accumulates and will be paid in the future (that’s why its
is called divided in arrears)
Company will not be able to pay common dividend before paying all previous and
current cumulative preferred dividends.
Dividends in arrears must be disclosed in financial statements so that potential
investors could make an investment decision in the company or not.

Characteristics that might exist in preferred shares:

1. Can be callable by issuer, buys it back
2. Can be redeemable by shareholders, tell company to buy it back from them.
3. Can be convertible into common shares.
4. Can be participating in common dividends not only preferred dividends.
5. In some cases, they can vote, such as preferred cumulative shares if their
dividends haven’t been declared for two, three or some set of years.
Equity Transactions
(1) Issuance of Stock
Dr. Cash (or other asset received) XXX fair value received
Cr. Common shares XXX par value issued stock
Cr. preferred shares XXX par value issued stock
Cr. Additional paid-in capital –common shares XXX in excess of par
Cr. Additional paid-in capital –preferred shares XXX in excess of par
Direct costs of issuing stock (underwriting, legal, accounting, tax, registration, etc.)
are not recognized as expenses, while instead, they reduce the net proceeds
received and additional paid-in capital (contra accounts).
Dr. APIC XXX Paid Costs

Cr. Cash XXX
Issuing shares NOT for cash:

The transaction should be recorded at the fair market value of the property or the
market value of the stock whichever is more readily determinable

(2) Dividends
Dividends are the distribution of current profits and/or the retained earnings of the
company to its owners, the declaration of dividends reduces total stockholders’
equity.
(A) Cash Dividend the most common form of dividend

Three important dates related to the cash dividends
a. Date of declaration:
The board of directors formally approves a dividend for declaration, and on the
same day the record date and the date of payment are announced, while
remember that the declaration entry reduces the company’s working capital, since
working capital is current assets minus current liabilities.
Dr. Retained earnings XXX
Cr. Dividend payable XXX
b. Record date:
All holders of the shares on the date of record are legally entitled to receive the
dividend, no entry required on that date, while company could make entry on
record date to correct the estimation made to the dividend payable on the date of
declaration.
c. Date of Payment:
The date of payment is the date on which the dividend is paid.
Dr. Dividends Payable XXX
Cr. Cash XXX
(B) Property Dividend

When an entity declares a dividend consisting of property rather than cash, this
property could be inventory, asset, shares in another company, property dividend
might be declared because company need cash for major expansions for example,
in this situation the property is remeasured to fair value as of the date of
declaration, and any gain or loss on the remeasurement is recognized in the income
statement
Dr. Equity – Property name XXX
Cr. Gain XXX
(Different between property balance and its fair value which could be gain or
loss)

And the carrying amount of retained earnings is decreased for the total fair value
of the distributable property.
Dr. Retained Earnings XXX
Cr. Property Dividends Payable XXX
Then the property is distributed as a dividend:

Dr. Property Dividends Payable XXX
Cr. Equity – Property name XXX
(C) Liquidating Dividends

Liquidating dividends are those dividends that are a return of capital rather than a
return on capital, which is the case when the dividend distributed is greater than
the balance of the retained earnings.
The journal entry if no balance in retained earnings and all dividend is liquidating
dividends (if there is no balance in the Retained Earnings account):
Dr. APIC XXX
Cr. Cash XXX
While entry could be as follow: in case there is a balance in retained earnings which
we bring it down to zero and then the liquidating dividends are excess of that
balance
Dr. Retained earnings XXX reduced to zero
Dr. APIC XXX liquidating amount
Cr. Cash XXX dividend amount

(D) Stock Dividend and Stock Split
❶ Stock dividend
Involves no distribution of cash or property, while distribution is in the form of
additional shares instead, the total value of the equity of the company is not
changed by a stock dividend, so stock dividends are accounted for as a
reclassification of different equity accounts
An issuance of shares maximum is 25% of the previously outstanding common

shares should be recognized as a small stock dividend, are valued at the fair value
of the shares on the date of declaration, and no adjustment is required for any
change in the fair value on the date of issuance.
Dr. Retained earnings XXX Fair value of shares distributed

Cr. Common shares – issuable as a dividend XXXPar value of shares
Cr. Additional paid-in capital – common shares XXXBalancing amount
An issuance of more than 25% of the previously outstanding common shares should
be recognized as a large stock dividend, and the entry is based on the par value of
the shares.
Dr. Retained earnings XXX par value

Cr. Common shares – issuable as a dividend XXX par value
❷ Stock split
Simply the stock split is to reduces the share’s market price, by increasing number
of issued shares (in doubles, triples, etc.) the company essentially cuts its shares
into smaller pieces, therefor more shares are outstanding and each has a lower
market price, for example in a 2-for-1 stock split, the owner of one share becomes
the owner of two shares, in proportion of total shares owned, but each share will
have a market price that is half what it was before the split, also the par value of
each share of the stock is reduced in the same ratio, no journal entries are made
that’s why the balances of the shareholders’ equity accounts are not changed,
while instead there is a memo entry, For example, for a 2-for-1 split, a memo will
note that there are now twice as many shares and the par value of each share is
lower

Reverse stock split:

A company can also announce a reverse stock split, when the company
consolidates shares so that there are fewer outstanding shares (the opposite to the
stock split story), which will lead to a higher market value for each share, while the
investor’s total market value will be unchanged.
Treasury Stock:
Are shares that have been bought back from shareholders by the company, so the
company is the holder of its treasury stock shares, treasury shares do not receive
dividends, do not vote, and are not classified as outstanding, company could decide
to retire them or sell them later, in this case the company’s entry is to make a
contra-account to the owner’s equity by the treasury stock account.
Reasons of why company would buy treasury stocks:
1. In case if there is a slow treading transaction of the company’s shares at the
market, so company could temporarily provide a market for its shares
2. Maybe company’s BODs are willing to reconsolidate ownership, so they buy
treasury stock by the company to resell them to family only and make it
closed company ownership for example
3. An investment if the company thinks its shares are undervalued, expecting
market value to increase at some point.
4. Treasury stock shares could be used for different purposes, such as a stock
dividend.
Effect of stock splits, stock dividends and treasury stock over the various types of
shares (that are explained earlier in this study section):
Stock split Stock dividend Treasury stock
Authorized stock X X X
Issued stock √ √ X
Outstanding stock √ √ √

2019 ‫ﻓﱪاﻳﺮ‬/‫ وﻳﻨﺪو ﻳﻨﺎﻳﺮ‬CMA
4) Revenue recognition & Income measurement Unit 1 in G.
Revenues are inflows of assets and/or settlements of liabilities from delivering or
producing goods, providing services, or other earning activities that constitute a
company’s ongoing major or central operations during a period.
primary issue related to revenue recognition is when to recognize the revenue, and
recognizing revenue related to recognizing the COGS (to comply with the expenses
recognition principle)
Revenues should be recognized when:

(1) Realized: when product have been exchanged for cash or claims to cash (A/R).
(2) Realizable: when product have been exchanged to assets that can quickly and
easily be converted to cash or claims to cash
And (3) Earned: when the entity completes the earning process and is entitled to
the resulting benefits or revenues
That all mean that revenue can be realized in income statement even if cash form
sales is not received yet.
Revenue recognition options:
At point of sale Before Delivery After Delivery

(Delivery) Earlier recognition is appropriate if Delayed recognition is
there is a high degree of certainty appropriate if the
degree of uncertainty
concerning the
amount of either
revenue or costs is
sufficiently high
General Rule Before During At At cash After costs
production Production completion collection are
of recovered
Production
Revenue is usually recognized at the point-of-sale; however, some other factors are
involved in the recognition of revenue, so revenue is not recognized at the point of
sales, these situations could be one or all the following for an entity:
1. Sales with a buyback agreement at point of sale
2. Sales when the right of return exists at point of sale

3. Channel stuffing or trade loading at point of sale
4. Long-term contracts Before Delivery
5. The installment method (including profit recognition) After Delivery
6. The cost recovery method (including profit recognition) After Delivery
7. The deposit method After Delivery
Kieso
Mentioned in G not in H
GAAP IFRS
Sale of Generally, the guidance focuses Revenue is recognized only when 5
goods on revenue being (1) either conditions are met:
realized or realizable and (2) ●risks and rewards of ownership
earned. Revenue recognition is have been transferred
considered to involve an ●the seller retains neither
exchange transaction; that is, continuing managerial involvement
revenue should not be to the degree usually associated
recognized until an exchange with ownership nor effective
transaction has occurred. control over the goods sold
●revenues can be measured
reliably
●it is probable that the economic
benefits will flow to the entity
●the costs incurred or to be
incurred in respect of the
transaction can be measured

reliably
Rendering Same as goods if the outcome can be reliably
of services estimated, service revenue is
recognized based on the stage of
completion (the percentage-of-
completion method). The outcome
can be reliably estimated when (1)
revenue can be reliably measured,
(2) it is probable that the economic
benefits will flow to the entity, (3)
the stage of completion can be
reliably measured, and (4) the
costs incurred and the costs to
complete can be reliably
measured.
In another word:
Revenue may be recognized in
accordance with long-term
contract accounting whenever
revenues, costs and the stage of
completion can be measured
reliably, and it is probable that
economic benefits will flow to the
company.
1) Sales with a buyback agreement: not in G but LOS (at point of sale)
Sometimes a company may sell its product in one period and at the same time
agree to buy it back in a later period, wither by market value at that time, or for an
agreed price today, even though legal title to the product is transferred, the seller
may actually retain the risks of ownership. The terms of the agreement need to be
analyzed to determine whether or not the seller has transferred the risks and
rewards of ownership to the buyer.
a) If the seller has fulfilled its performance obligation to buyer, the risks and
rewards of ownership have been transferred to buyer, and buyer has no
restrictions on its use of the equipment. Therefore, a sale has taken place and

Seller should record sales revenue, debit cost of the equipment to cost of goods
sold, and credit the same amount of cost to inventory.
b) If buyer is required to maintain the equipment in good condition and insure it
and seller has agreed to repurchase it at a set price, many of the risks and rewards
of ownership have remained with the seller, this transaction is not a sale but rather
is a financing transaction, the equipment should remain on the balance sheet of
Seller Corporation and no revenue should be recognized.
2) Sales when the right of return exists: not in G but LOS (at point of sale)
If a company grants its customers the right of return—that is, allowing customers
to return an item— the issue here is to recognize the proper accounting treatment
of the returned items and its relation to previously recognized revenues.
A) If returns rarely occur, the company can account for a return individually when
it occurs, returns are usually entered in an account separate from the sales revenue
account so that management can see how much has been returned, the account is
called “sales returns and allowances” and it generally follows the sales revenue
account in the chart of accounts, it carries a debit balance (a negative balance).
B) If returns take place frequently and are material, the company should set up an
allowance account, that is calculated based on estimations in advanced, the
allowance account for returns is handled in the same manner as “allowance for
doubtful accounts.”
In order to recognize revenue, company has two options with regard to the sale
with the right of return:
1- To recognize revenue at the date of sale but that’s connected to 6 conditions as
per FASB, while note that the seller must meet all 6 conditions:
 The amount of future returns can be estimated.
 The price of the transaction is substantially fixed or determinable at the time
of the sale.
 The buyer has paid for the item or is obligated to pay for the item, and this
obligation is not contingent upon the resale of the item.
 The buyer’s obligation is not changed in the case of theft, destruction or
damage.
 The buyer is a separate entity from the seller.
 The seller does not have future obligations to assist in the resale of the item.

2- Option two is that the seller can’t meet one of the option 1 conditions, and in
this case the seller can’t recognize revenue at the date of sale, while revenue to be
recognized only when the right of return has expired.
3) Channel stuffing or trade loading: not in G but LOS (at point of sale)
when a manufacturer offer large discounts or major incentives, that will force
wholesaler to buy much more than they could sell for that period, just to benefit
from this discount or incentives, that’s why it is called trade loading, as customers
(wholesalers) are loaded with larger amounts that they could sell for a certain
period, manufacturer use these procedures, in order to recognize additional
increase in revenue and profits in the current period, while trade loading and
channel stuffing should not be done because the manufacturer is reporting next
period’s revenues in the current period at the expense of future period profits, so
committing such action considered to be a serious breach of ethics, because it
results in misleading financial statements.
While if a manufacturer offers incentives to convince its wholesalers or distributors
to purchase more product, it should record an appropriate allowance for sales
returns.
4) Long-term contracts: (Before delivery)

most common example construction contracts
Long term contracts are contracts that take longer than one year to be finished, the
main issue is when to recognize the revenue and therefore the profit and how much
profit to recognize per period.
Two methods are generally used for recognizing the profit in long term contracts,
while the company must use the same method for all long-term contracts.
①The Completed-Contract Method

The completed-contract method is used to account for a long-term contract in
order to recognize the total revenue, costs and net profit at the end of the contract
upon completion.
Profit recognized = contract price – total cost of completed project
It uses a contracting in progress account as an inventory account to recognized paid

costs, and uses progress billing account as a contra-account to inventory.

Recognition of Losses Under the Completed Contract Method

At the end of each period, the company needs to determine the final expected
profit or loss on the contract:
Contract price
− Costs actually incurred to date
− Costs expected to be incurred in the future
= Expected profit (loss) on the project
Under the completed contract method, any expected losses must be recognized
in the period when they become known.
In subsequent periods, losses will be recognized only to the extent that the
expected loss exceeds losses that have been previously recognized.
GAAP IFRS
Constructi Similarity between GAAP and IFRS: Construction contracts are
on accounted for using the percentage-of-completion method if certain
contracts criteria are met.
Otherwise, the completed Otherwise, 1) The completed
contract method must be used. contract method is not permitted
(prohibited).
2) If the company is unable to
estimate (reliably estimated) the
future costs of the contract,
revenue recognition is limited to
recoverable costs incurred, 3)
which means contract costs must
be recognized as an expense in the
period in which they are incurred.
②The Percentage-of-Completion Method

Percentage-of-completion is a preferable method than complete contract method
(for the accounting matching principles), under the percentage-of-completion
method, profit is recognized as it is earned. Three calculations must be made at the
end of each period:
1) Calculation of expected profits (total gross profit on the project).
2) Calculate the percentage of the project completed as of the reporting date.
3) Calculation of the profit to be recognized in the current period.

Details of previously mentioned steps:

1) Calculation of expected profits.
Contract Price XX
− Costs actually incurred to date (XX)
− Costs expected to be incurred in the future (XX)
= Expected Profit (Loss) XX
This represents the expected profit (loss) from entire project until it is completed,
while the project is not completed yet, so the total expected profits are not all
recognized yet as well, while the amount to be recognized is depending the
completion percentage of the project up till the current period.
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
- costs incurred to date (44,000,000)
- 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.

Cost-to-Cost Method
This calculation is required to determine what percentage have the project been
completed up to the current period
Total costs incurred to date (including prior periods)
Percentage of completion = ‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬
Cost incurred to date + expected cost to completion
Total expected cost

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 19,000,000
Total estimated costs $63,000,000
The project is therefore 69.8% complete ($44,000,000 / $63,000,000).
3) Calculation of the profit to be recognized in the current period:

In order to calculate recognized profits for the current period
1- Total profits to be recognized to date = expected profit X completion percentage

(Step 1) (step 2)
2- Profits to be recognized for the current period = total profits to be recognized to

date – profits previously recognized
Previous formulas could be combined in one following formula:
Profit to recognize for the current period =

Cost incurred to date
‫ ــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬X expected profits – profit previously recognized
Total incurred costs to date
+ estimated costs to complete
In a situation where the level of expected profit falls from one period to the next
using the previous formula, the formula above will result in a negative number,
which is the loss the company needs to recognize in the current period. If the
contract in total is not expected to result in a loss, however, the company is not
recognizing a loss having taken place in the period in which estimated profit falls.
Rather, the company is “derecognizing” some of the gain that was recognized in a
previous period.
Recognition of Losses Under the Percentage-of-Completion Method
As soon as an estimated loss on any project (total project) becomes apparent, it is

recognized in full, under both the completed-contract and percentage-of-
completion methods, all losses are immediately recognized, no matter which
method is used.
that means in previous formula, costs incurred to date / total expected costs = 1
If in the early years of the project a profit is expected on the contract, under the
percentage-of-completion method a percentage of that profit is recognized in each

period. If, however, in later years the amount of estimated profit decreases or
becomes an estimated loss, previously recognized profit must be derecognized.
The company does this by recognizing a large loss in the period when the estimated
loss becomes known.
Example:
The contractor will recognize $2,151,000 in gross profit for Year 4, calculated as
follows:
Estimated total gross profit $12,000,000
X percentage, complete X 69.8%
Gross profit earned to date $ 8,376,000
- gross profit recognized in prior periods (given) (6,225,000)
Gross profit for current period. $2,151,000
5) The Installment Method (after delivery at cash collection)

The installment method is only acceptable when sales are on credit, and
receivables are collectible over some period and no reasonable estimating or
certainty of cash collections, while in installment method there is a partial profit
recognition for each collected installment in cash.
The sales journal entry:

Dr. Installment receivable XXX total amount to be received
Cr. Inventory XXX carrying value
Cr. Deferred gross profit XXX profit (asset section on BS)
The cash collection entry and profit recognition:

While recognition of deferred gross profit will be effective based on each
installment in cash, based on profit margin percentage of the collected amount:
Realized gross profit = cash received X profit margin percentage
Gross profit margin percentage = (total sales value – cost of sales) / Total sales value
Dr. Cash XXX amount received

Dr. Deferred gross profit XXX as calculated
Moved from balance Cr. Installment receivables XXX amount received
sheet to income Cr. Realized gross profit XXX as calculated
statement

Presentation of deferred gross profit in balance sheet:

Deferred gross profit is a contra-account of the installment receivable asset
account
Installments receivable XX 12 months collection
- Deferred gross profit (XX) current assets, more than
Equals Net installments receivable XX that is noncurrent assets
Represents due receivable amount that still needs

to be collected just to cover the COGS.
Note: underline accounts in previous entries are specific for the installment
method of revenue recognition
The most common questions on the exam:

How much profit should be recognized in a given year?
Multiply the cash received during this period by the profit margin.
What is the remaining deferred profit?
Calculate the total amount of profit from the sale and then subtract all
of the profit that has been recognized in all periods since the sale was made
(not just this period) by multiplying the profit margin by the total amount
of cash that has been collected.
What balance of receivables is remaining (and usually this will ask for the total
amount of remaining receivables)?
Subtract the receivables collected to date from the total sales. If the
question asks for the net receivables it will be the remaining receivables minus
the remaining deferred profit.
Example:
Jeffrey Electronics manufactures computers at a cost of $3,000 each and sells them
for $5,000 each.
Jeffrey usually sells for cash. However, on October 1, 20X0, Jeffrey sells a computer
and agrees to a deferred payment plan although it is uncertain about the
collectability of all the amounts. The payment plan is a $1,000 down payment with
the balance payable in 4 quarterly installments of $1,000 each.
Gross profit on the sale is $2,000 ($5,000 − $3,000), so $2,000 will ini ally be
recognized as deferred gross profit. The gross profit percentage on the sale is 40%
($2,000 / $5,000) = 40% of the $1,000 down payment equal $400, will immediately
be debited to deferred gross profit, reducing deferred gross profit to $1,600. Every
time that Jeffrey receives a payment, it will recognize 40% of the amount received
as profit by moving that amount out of the deferred profit account into the realized
profit account.
The journal entries are as follows:

October 1, 20X0 when the sale is made, and the down payment collected
Dr. Cash 1,000

Dr. Installment accounts receivable – 20X0 4,000
Cr. Inventory 3,000
Cr. Deferred gross profit – 20X0 2,000
To record the sale, the collection of the down payment, the receivable, and the
deferred gross profit.
Dr. Deferred gross profit – 20X0 400

Cr. Realized gross profit 400
To recognize as gross profit 40% of the cash received from the down payment.
December 31, 20X0 when the first quarterly payment is received

Dr. Cash 1,000
Cr. Installment accounts receivable – 20X0 1,000
To record the collection of quarterly payment.
Dr. Deferred gross profit – 20X0 400

Cr. Realized gross profit 400
To recognize 40% of all of the cash received as profit.
At December 31, 20X0, Jeffrey’s balance sheet should report the following:
Installment receivable 3,000
Deferred gross profit (1,200)
Net installment receivables 1,800
When payments are received on March 31, June 30, and September 30 of 20X1,
the same two sets of entries will be posted as are shown above for December 31,
20X0.

‫ﻃﺮﻳﻘﺔ إﺳﱰداد اﻟﺘﻜﻠﻔﻪ‬

6) Cost-Recovery Method (after delivery at cost coverage – more conservative)
This method is similar to the installment method, even more conservative than
installment method and any other revenue recognition method, it is also used
when sales are credit but there is no basis to determine the collectability of future
payments, it is similar to installment method in opening a deferred account in the
balance sheet at the time of the sale, but it is different from installment method in
that there is no profit is recognized until collections cover first the cost of the item
sold (not like the installment method that recognizes profits started from first
collection), then following receipts are treated entirely as revenues.
Example:
The journal entries for the above example using the cost recovery method would
be as follows:
October 1, 20X0 when the sale is made, and the down payment collected
Dr. Cash 1,000
Dr. Cost recovery accounts receivable – 20X0 4,000
Cr. Inventory 3,000
Cr. Deferred gross profit 2,000
To record the sale, the collection of the down payment, the receivable, and the
deferred gross profit.
December 31, 20X0 and March 31, 20X1 quarterly payments received
Dr. Cash 1,000
Cr Cost recovery accounts receivable – 20X0 1,000
To record the collection of the first two quarterly payments and reduce the
receivable. There is no recognition of profit because after the first two quarterly
payments the cash received is only equal to the cost of sales.
June 30 and September 30, 20X1 quarterly payments received

Dr. Cash 1,000
Dr. Cost Recovery Deferred Profit – 20X0 1,000
Cr. Cost Recovery Accounts Receivable – 20X0 1,000
Cr. Realized Gross Profit 1,000
To record the collection of the last two quarterly payments, reduce the receivable,
and recognize the profit on the income statement.

Note: The cost recovery method is very rarely used, but in cases where it is, its use
will be disclosed individually in the notes to the financial statements. Also, in a
situation using the cost recovery method, it is most certain that the title to the
goods will not transfer until complete payment has been made.
7) Deposit Method (after delivery)

This method is used when cash is received, but the criteria for a sale have not been
met, such as moving the property or its related risks and benefits to the buyer, for
example when the seller is applying general rule recognizing revenue upon delivery
but still received partial payment in advanced as a deposit from the total payment,
the seller continues to account for the property in the same way as an owner, not
recognizing revenue or profit from this sale yet, until the revenue is earned by
moving the responsibility of the property or being held by the new buyer, or the
deal is totally finalized
Dr. Cash $XXX
Cr. Customer deposits (liability) $XXX

5) GAAP and IFRS differences

Because differences and differences between GAAP and IFRS are vast amount of
information, I will copy here the related part from the LOS and go through them
only in a way that matches the LOS, for exam purposes, ignoring (II) expense
recognition with respect to share-based payments and employee benefits.
U.S. GAAP: Generally Accepted Accounting Principles

Financial Accounting Standards Board (FASB).
IFRS: International Financial Reporting Standards
International Accounting Standards Board (IASB).
(I) Revenue recognition, with respect to the sale of goods, services, deferred
receipts and construction contracts
GAAP IFRS
Sale of Generally, the guidance focuses Revenue is recognized only when 5
goods on revenue being (1) either conditions are met:
realized or realizable and (2) ●risks and rewards of ownership
earned. Revenue recognition is have been transferred
considered to involve an ●the seller retains neither
exchange transaction; that is, continuing managerial involvement
revenue should not be to the degree usually associated
recognized until an exchange with ownership nor effective
transaction has occurred. control over the goods sold
●revenues can be measured
reliably
●it is probable that the economic
benefits will flow to the entity
●the costs incurred or to be
incurred in respect of the
transaction can be measured
reliably
Rendering Same as goods Revenue may be recognized in
of services accordance with long-term
contract accounting whenever
revenues, costs and the stage of
completion can be measured
reliably, and it is probable that

economic benefits will flow to the

company.
Constructi Similarity between GAAP and IFRS: Construction contracts are

on accounted for using the percentage-of-completion method if certain
contracts criteria are met.
Otherwise, the completed Otherwise, 1) The completed
contract method must be used. contract method is not permitted
(prohibited).
2) If the company is unable to
estimate (reliably estimated) the
future costs of the contract,
revenue recognition is limited to
recoverable costs incurred, 3)
which means contract costs must
be recognized as an expense in the
period in which they are incurred.
(III) Intangible assets, with respect to development costs and revaluation

GAAP IFRS
Developme Generally, development costs Development costs are capitalized
nt costs are expensed as incurred. as an intangible asset item if the
(may be capitalized only if a specific
U.S. GAAP standard allows
entity can demonstrate the
capitalization for that asset) technical feasibility of completion
of the asset.
Revaluation Revaluation is not permitted. Revaluation to fair value of

intangible assets other than
goodwill is a permitted accounting
policy, for a class of intangible
assets. can be applied only if the
intangible asset is traded in an
active market.
Reversal of prohibits any reversal of write- a previously recognized
loss down. impairment loss on an intangible
asset may be reversed if the
estimates of the recoverable
amount have changed.
(IV) Inventories: with respect to costing methods, valuation and write-downs

(e.g., LIFO)
GAAP IFRS
Costing LIFO is an acceptable method. LIFO is prohibited.
methods
Measurem In U.S. GAAP, inventories Inventory is measured (carried) at
ent measured using any method the lower of cost or net realizable
other than LIFO or the retail value.
method should also be No calculation of market value
measured at the lower of cost or
net realizable value. (similar to
IFRS)
However, in U.S. GAAP,
inventory valued using LIFO or
the Retail Method is valued at
the lower of cost or market
value (different to IFRS)
Reversal of prohibits any reversal of write- previous write-downs of inventory

inventory down. may be recovered up to the
write- original cost of the inventory.
downs Gains cannot be recognized on
appreciated inventory, but
previous losses can be reversed
(V) Leases, with respect to leases of land and buildings

GAAP IFRS
Capital One criterion under U.S. GAAP is Has a similar condition but refers to
lease that a capital lease exists if the a “major part” of the asset’s
(regarding lease term is equal to or greater economic life rather than a specific
determinin than 75% of the asset’s economic percentage which is 75% under
g if the life. GAAP.
lease is a
capital U.S. GAAP also refers to 90% of IFRS refers to “substantially all” of
lease) the asset’s economic fair value the fair value which is 90% under
GAAP.

(VI) Fixed Assets (long lived assets): with respect to revaluation, depreciation,
and capitalization of borrowing costs
GAAP IFRS
Revaluation Revaluation Revaluation is a permitted (which means increase
of assets not the value of the fixed asset according to the new
permitted. fair market value) accounting policy election for
two conditions 1- an entire class (grouping of assets
of similar nature and use)
2- requiring revaluation to fair value on a regular
basis.
The increase in the value is recognized in Other
Comprehensive Income and carried in the equity
section of the balance sheet as a Revaluation
Surplus.
Component component if individual components of a large fixed asset have
depreciation depreciation different usage patterns and useful lives, then the
is allowed but individual components should be depreciated
not required. separately. For example, if the engine on a machine
has a 5-year life while the rest of the machine has a
15-year life, the engine must be depreciated over 5
years and the remaining cost of the machine must
be depreciated over 15 years
(VII) Impairment of assets, with respect to determination, calculation and

reversal of loss
GAAP IFRS
calculation The amount by which the The impairment process is a one-
carrying amount of the asset step process. The carrying value of
exceeds its fair value (carrying the asset is compared to the
amount of the asset is compared recoverable amount. The
with the sum of future recoverable amount is the higher
undiscounted cash flows of 1) the fair value of the asset, if
generated through use and sold, minus any costs of sale, or 2)
eventual disposition) the Discounted future cash flows it
will generate
Reversal of Prohibited. No reversal after If the revaluation is the recovery of
loss impairment made a previously recognized loss when
the asset was impaired, the
revaluation gain is reported on the

income statement (notice the
increase for reevaluation goes to
OCI)
Notice from last to points for IFRS:
Re-evaluation gains happen first to an asset, so gains go to OCI, if subsequent
impairment so losses goes to OCI also.
While if impairment first so losses go to income statement, then if subsequent
re-evaluation gain after impairment it will go to income statement.

Unit 02 Section - A - Recognition, - Measurement

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Unit 02 Section - A - Recognition, - Measurement

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Part 1: Financial Reporting, Planning, Performance, and Control

Section A) External Financial Reporting Decisions

Unit 2. Recognition, measurement, valuation and

A. basic accounting principles:

Instructor, Tarek Naiem, CMA 1 of 93

Instructor, Tarek Naiem, CMA 2 of 93

2. Revenue recognition principle:

3. Expenses recognition principle:

Costs are related directly to revenue recognition are classified as product

Instructor, Tarek Naiem, CMA 3 of 93

4. Full disclosure principle:

Instructor, Tarek Naiem, CMA 4 of 93

In process of studying unit 2, we should follow the LOS (Learning Outcome

2) Liabilities c. Valuation of liabilities

3) Equity Transactions d. Equity transactions

5) GAAP and IFRS differences g. Major differences between

Instructor, Tarek Naiem, CMA 5 of 93

1) Assets – B) accounts receivable

The main issues with respect to receivables are:

Instructor, Tarek Naiem, CMA 6 of 93

Amounts to be deducted from Gross Accounts Receivables, could be:

The valuation account is a contra-asset account called “Allowance for Uncollectible

Allowance for Customers’ Sales Return:

2) Recognition of allowance for sales returns:

Instructor, Tarek Naiem, CMA 7 of 93

Allowance for Uncollectible Accounts / Bad Debt Expense:

It is unlikely to collect full amounts from accounts receivables; therefore, we must

Main journal entry:

Credit sales on income statement X estimated percentage % = bad debt expenses

Instructor, Tarek Naiem, CMA 8 of 93

A company’s trial balance demonstrates the following amounts:

Balance-Sheet Approach (Percentage of Receivables):

Instructor, Tarek Naiem, CMA 9 of 93

A. Single estimated percentage:

Ending Balance Gross Accounts receivable on balance sheet X estimated

A company’s trial balance demonstrates the following amounts:

That we already have in previous balance

Instructor, Tarek Naiem, CMA 10 of 93

B. Multiple estimated percentages:

A company’s trial balance demonstrates the following amounts:

Instructor, Tarek Naiem, CMA 11 of 93

Write-Off of Accounts Receivable:

Collecting a Previously Written-off Receivable

Sales / Revenue X % Income Statement approach

The T-account for that Allowance for Doubtful Debts account:

√ DR. Allowance for Doubtful Debts

XXX Amount written off

Instructor, Tarek Naiem, CMA 12 of 93

The allowance for doubtful debts T-account in form of equation:

Factoring of Accounts Receivable:

Example, if we have account receivable balance to be collected in 50 days, we could

Factoring accounts receivables has two forms:

Factoring without recourse:

Instructor, Tarek Naiem, CMA 13 of 93

Factoring with recourse:

Amount of receivables submitted (face value) $50,000

The journal entry to record the preceding transaction is:

Instructor, Tarek Naiem, CMA 14 of 93

Advantages of factoring receivable accounts:

For the seller

Instructor, Tarek Naiem, CMA 15 of 93

Sales revenue – cost of goods sold = gross profit

Cost Basis of Inventory – valuing the inventory when it is purchased: