Question

1. Explain Revenue Recognition methods (percentage of completion, completed production, traditional, installment)

2. Explain Expense Recognition methods (cause & effect, rational & systematic, immediate recognition)

3. Describe Fair value hierarchy: Level 1 - observable (quoted prices), Level 2 (prices of similar items observable), Level 3 (non-observable – must base value on assumptions)

4. Identify the four basic assumptions of accounting: Economic entity, monetary unit, periodicity, and going concern

5. Recognize the two fundamental qualitative characteristics of financial reporting: Relevance and Faithful representation

Answer 1

1.

Percentage of Completion Method

The percentage of completion method for recognizing revenue is typically used in large or long-term projects. Firms that provide construction services, engineering services or other services with long projects are most likely to use this method. Providers of these services need to be able to demonstrate that they are generating revenue even though projects are not yet complete.

The percentage of completion method may only be used if both of the following requirements are met:

• There is a long-term contract in place that is enforceable by law.
• The project is set up in a way that allows for the percentage of completion to be estimated in order to allocate both revenue and expenses.

The percentage of completion method can be computed in two ways:

• Revenue may be recognized at specific milestones. For a building, that could be a specific number of square feet, or a web design firm may have milestones of a specific number of pages for a website.
• The percentage of completion may also be calculated based on cost. For example, if a firm expects costs to total $1,000,000 and they have incurred $300,000 in cost, the project would be seen as 30 percent complete.

While this revenue recognition method provides an alternative for long-term contracts, revenues may be overstated if the timing for expenses and completion of work are not properly aligned.

Completed Contract Method

When the completed contract method is used, revenue is recognized only once the project is complete and the contract is fulfilled. This method applies to both revenue and expenses. The only time this revenue recognition method is used is when the requirements of the percentage of completion method are unable to be met. For example, if a contract is not enforceable or if completion percentage cannot be calculated.

Since revenues are not recognized until a project is complete, the completed contract method runs the risk of under-reporting revenue at the time it is earned and overstating revenue once it is recognized.

Traditional:

The revenue recognition principle states that, under the accrual basis of accounting, you should only record revenue when an entity has substantially completed a revenue generation process; thus, you record revenue when it has been earned

Installment Method

When companies cannot rely on their customer’s ability to pay in a timely manner, the installment revenue recognition method may be best suited for the organization. With the installment method, revenue is only recorded once the organization has received payment.

For example, if a car is sold for $5,000 on an installment plan, the revenue from that sale is only recognized as payments are received. If a $1,000 down payment is made, the $1,000 revenue is recorded at the time of receipt. Each of the subsequent payments of $1,000 will generate an equal amount of revenue, and then be offset by related costs.

2.

Association of cause and effect

The first way to implement the matching principle is the associating cause and effect method. In accordance with this method, some expenses are presumably directly associated with specific revenues. In this case, transactions simultaneously result in both revenues and expenses, and as a result, these revenues and expenses are directly related to each other. For example, cost of goods sold is directly associated with the sales revenue. Sales commissions can also be directly matched against sales revenues. The association of cause and effect principle can be applied to transportation costs incurred to deliver goods to customers.

Systematic and rational allocation

When there is no cause and effect relationship, some expenses can be allocated to the accounting period benefited in a systematic and rational manner. For example, the cost of manufacturing equipment is difficult to allocate to specific inventory sale transactions. As the result, the cost of equipment is systematically allocated as depreciation expense among the periods in which the equipment provides the benefit (i.e., generates revenue). The allocation scheme is based on the expected benefit. The systematic and rational allocation method can also be used to amortize intangibles and allocate prepaid costs such as insurance and rent.

Immediate recognition

When both the associating cause and effect and systematic and rational allocation methods cannot be used, expenses are recognized immediately. For example, it can be difficult to identify future benefits of some costs incurred, or for some costs no rational allocation scheme can be devised. Period costs are usually immediately recognized. Examples of costs that might be immediately recognized include utilities, routine maintenance costs, officers’ salaries, and most selling and administrative costs.

3.

Level 1 inputs

Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. [IFRS 13:76]

A quoted market price in an active market provides the most reliable evidence of fair value and is used without adjustment to measure fair value whenever available, with limited exceptions. [IFRS 13:77]

If an entity holds a position in a single asset or liability and the asset or liability is traded in an active market, the fair value of the asset or liability is measured within Level 1 as the product of the quoted price for the individual asset or liability and the quantity held by the entity, even if the market's normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price. [IFRS 13:80]

Level 2 inputs

Level 2 inputs are inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. [IFRS 13:81]

Level 2 inputs include:

• quoted prices for similar assets or liabilities in active markets
• quoted prices for identical or similar assets or liabilities in markets that are not active
• inputs other than quoted prices that are observable for the asset or liability, for example
  • interest rates and yield curves observable at commonly quoted intervals
  • implied volatilities
  • credit spreads
• inputs that are derived principally from or corroborated by observable market data by correlation or other means ('market-corroborated inputs').

Level 3 inputs

Level 3 inputs inputs are unobservable inputs for the asset or liability. [IFRS 13:86]

Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. An entity develops unobservable inputs using the best information available in the circumstances, which might include the entity's own data, taking into account all information about market participant assumptions that is reasonably available. [IFRS 13:87-89]

4.

The economic entity assumption is an accounting principle that states that all transactional data associated with a specific entity is assumed to be clearly attributed to the entity, and does not include other transactional data associated with the entity’s owners or business partners.

The monetary unit concept is an accounting principle that assumes business transactions or events can be measured and expressed in terms of monetary units and the monetary units are stable and dependable.

The periodicity assumption states that an organization can report its financial results within certain designated periods of time. This typically means that an entity consistently reports its results and cash flows on a monthly, quarterly, or annual basis. These time periods are kept the same over time, for the sake of comparability.

The going concern principle is the assumption that an entity will remain in business for the foreseeable future. Conversely, this means the entity will not be forced to halt operations and liquidate its assets in the near term at what may be very low fire-sale prices. By making this assumption, the accountant is justified in deferring the recognition of certain expenses until a later period, when the entity will presumably still be in business and using its assets in the most effective manner possible.

5.

The fundamental qualitative characteristics:

Relevance – financial information is regarded as relevant if it is capable of influencing the decisions of users.

Faithful representation – this means that financial information must be complete, neutral and free from error.