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Study guide · Area III

Select Transactions

25 to 35% of FAR · 7 groups · 26 tasks

Select Transactions covers events that cut across the statements: accounting changes and errors, contingencies, revenue and contributions, income taxes, fair value, lessee accounting and subsequent events. Each one turns on a recognition rule, so learn the trigger first, then the measurement, then the entry and the note.

A study feature written by ExamDragon, not part of the real exam. Each heading is one of the AICPA's content groups for this area, in our own words. US GAAP as codified in the FASB Accounting Standards Codification, cited by topic; for-profit business entities unless a section says otherwise.

At a glance

Area III
25 to 35%

of the FAR section (AICPA)

Groups
7
Tasks
26
Key terms
23

What this guide covers, group by group

  1. AAccounting changes and errors
  2. BContingencies and commitments
  3. CRevenue and contributions
  4. DIncome taxes
  5. EFair value
  6. FLeases for the lessee
  7. GSubsequent events

AAccounting changes and errors

  • A change in accounting principle is applied retrospectively: prior periods presented are adjusted and the cumulative effect on earlier years goes to opening retained earnings of the earliest period shown, unless impracticable (ASC 250).
  • A change in estimate is prospective: the current and future periods absorb it, with no restatement.
  • A change in depreciation, amortization or depletion method is a change in estimate effected by a change in principle, so it is applied prospectively.
  • A change in reporting entity is retrospective. An error correction is a restatement: a prior period adjustment to opening retained earnings, net of tax, with disclosure of the nature of the error and its effect on each line and on EPS.
  • Some errors counterbalance: an ending inventory overstatement overstates this year's income and understates next year's, so retained earnings is right after two years, but the statements presented are still restated.
  1. Worked exampleBrookline Freight bought a machine on January 1, Year 1 for $600,000, depreciating it straight line over 10 years with no salvage ($60,000 a year). At the start of Year 4 it revises the remaining life to 4 years and salvage to $40,000. Carrying amount = $600,000 - $180,000 = $420,000; new annual depreciation = ($420,000 - $40,000) / 4 = $95,000.
  2. Where questions turnRestating prior years for a change in estimate, or treating a switch from straight line to an accelerated method as a retrospective change in principle.
Retrospective application
Presenting prior periods as if the new principle had always been used.
Prospective application
Applying a change only to the current and future periods.
Prior period adjustment
A correction of an error in earlier statements through opening retained earnings.
The 2 tasks of this group, in our words
  1. TX.1.1Measure a change or correction and choose retrospective or prospective
  2. TX.1.2Trace how a change or correction alters statements and notes
Practise group A

BContingencies and commitments

  • A loss contingency is accrued when a loss is probable and reasonably estimable (ASC 450-20). If a range has a best estimate, accrue it; if no amount in the range is better, accrue the minimum and disclose the range.
  • A reasonably possible loss is disclosed with an estimate of the possible loss or a statement that it cannot be made; a remote loss is not disclosed, apart from guarantees.
  • Gain contingencies are not recognized until realized, and their disclosure must not mislead about the likelihood (ASC 450-30).
  • Assurance warranties are accrued as an expense when the product is sold; a warranty sold separately or giving a service beyond assurance is a performance obligation under ASC 606. Guarantees are recognized at fair value at inception (ASC 460).
  • Unconditional purchase obligations are disclosed (ASC 440). A loss on a firm, noncancelable purchase commitment is recognized when the market price falls below the contract price (ASC 330).
  1. Worked exampleWestmark Appliances sells 10,000 units with a one-year assurance warranty; it expects 3% to need repair at $150 each. Warranty expense and liability = 10,000 x 3% x $150 = $45,000. It spends $12,000 on repairs during the year, leaving a liability of $33,000.
  2. Where questions turnAccruing the midpoint of a range when no amount is a better estimate. Accrue the low end and disclose the possible additional loss.
Probable
The future event is likely to occur.
Reasonably possible
More than remote but less than likely.
Assurance-type warranty
A promise that the product works as agreed; accrued as a cost, not a separate obligation.
The 3 tasks of this group, in our words
  1. TX.2.1Know when contingencies and commitments are booked or disclosed
  2. TX.2.2Measure contingencies and record the entries
  3. TX.2.3Read the evidence to decide booking or disclosure
Practise group B

CRevenue and contributions

  • The five steps (ASC 606): identify the contract, identify the distinct performance obligations, set the transaction price, allocate it on relative standalone selling prices, and recognize revenue when or as each obligation is satisfied.
  • Variable consideration is estimated by expected value or most likely amount and included only to the extent a significant reversal is not probable. Revenue is recognized over time if the customer receives the benefit as the work is done, controls the asset as it is built, or the asset has no alternative use and the seller has an enforceable right to payment for work to date.
  • Incremental costs of obtaining a contract, such as commissions, are capitalized if expected to be recovered; they may be expensed when the amortization period would be one year or less. Fulfillment costs are capitalized when they relate directly to a contract, create resources used to satisfy it and are recoverable (ASC 340-40).
  • A nonprofit recognizes an unconditional promise to give when received, at fair value (present value for multiyear pledges). A conditional promise has a barrier and a right of return or release and is not recognized until the barrier is overcome; cash received early is a refundable advance (ASC 958-605).
  • Contributed services are recognized only if they create or enhance nonfinancial assets, or require specialized skills, are provided by people who have them and would otherwise be purchased.
  • Gifts of nonfinancial assets are recognized at fair value and presented apart from cash gifts. A nonprofit acting as agent, trustee or intermediary records a liability, not contribution revenue, unless the donor gives it variance power.
  1. Worked exampleLakeshore Fitness Tech sells a machine and two years of service for $5,400 on January 1. Standalone prices are $4,800 and $1,200 ($6,000), so the machine gets $5,400 x 80% = $4,320 and service gets $1,080 ($45 a month). Year 1 revenue = $4,320 + $540 = $4,860; the remaining $540 is a contract liability.
  2. Where questions turnRecognizing a conditional pledge as revenue because the donor paid early. Until the barrier is met the cash is a refundable advance, a liability.
Performance obligation
A promise to transfer a distinct good or service, or a series of them.
Standalone selling price
The price at which the entity would sell the item separately.
Conditional promise to give
A pledge with a barrier to overcome and a right of return or release.
Variance power
A recipient's unilateral power to redirect a gift to another beneficiary.
The 7 tasks of this group, in our words
  1. TX.3.1Know the five steps of contract revenue
  2. TX.3.2Know when a nonprofit books conditional or unconditional pledges
  3. TX.3.3Spot pass-through gifts a nonprofit does not book as contributions
  4. TX.3.4Measure and time contract revenue, with entries
  5. TX.3.5Capitalize and amortize costs to win or fulfill contracts
  6. TX.3.6Book donated services at a nonprofit, with entries
  7. TX.3.7Measure gifts of cash and other assets to a nonprofit
Practise group C

DIncome taxes

  • Uncertain tax positions use two steps: recognize a benefit only if the position is more likely than not to be sustained on its technical merits, then measure it as the largest amount more than 50% likely to be realized on settlement. The rest is a liability for unrecognized tax benefits (ASC 740-10).
  • A valuation allowance reduces a deferred tax asset when it is more likely than not that some or all of it will not be realized. Weigh reversing taxable differences, future taxable income, carrybacks and tax planning strategies; cumulative losses in recent years are strong negative evidence.
  • Deferred taxes = temporary differences x the enacted rate for the years they reverse. Accelerated tax depreciation gives a deferred tax liability; accrued warranties, credit loss allowances and revenue taxed in advance give deferred tax assets.
  • Permanent differences (tax-exempt municipal interest, fines, the nondeductible part of meals) change current tax only and create no deferred tax.
  • Total tax expense = current tax + deferred tax (the change in deferred tax liabilities less the change in deferred tax assets net of allowance). Deferred tax balances are noncurrent; a rate change is recognized in the period it is enacted.
  1. Worked exampleFairmont Corp. has pretax income of $800,000, including $20,000 of municipal interest. Tax depreciation exceeds book by $60,000 and accrued warranties exceed deductions by $15,000; the rate is 25%. Taxable income = $800,000 - $20,000 - $60,000 + $15,000 = $735,000; current tax = $183,750. The deferred tax liability rises $15,000 and the asset $3,750, so total expense = $183,750 + $11,250 = $195,000. Entry: debit income tax expense $195,000 and deferred tax asset $3,750; credit taxes payable $183,750 and deferred tax liability $15,000.
  2. Where questions turnRecording deferred tax on a permanent difference, or using today's rate when a different rate has already been enacted for the reversal years.
Temporary difference
A gap between book and tax basis that reverses and creates taxable or deductible amounts later.
Valuation allowance
A reduction of deferred tax assets not more likely than not to be realized.
Unrecognized tax benefit
The part of a tax position taken on a return that is not recognized in the statements.
The 5 tasks of this group, in our words
  1. TX.4.1Know how uncertain tax positions are handled
  2. TX.4.2Know when a deferred tax asset needs a valuation allowance
  3. TX.4.3Compute tax expense and the current tax payable
  4. TX.4.4Compute deferred taxes from temporary differences
  5. TX.4.5Record the income tax provision
Practise group D

EFair value

  • Fair value is the price to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date: an exit price (ASC 820).
  • Use the principal market (greatest volume and activity); without one, the most advantageous market after transaction and transport costs. Transaction costs are not deducted from fair value; transport costs are.
  • A nonfinancial asset is valued at its highest and best use by market participants (physically possible, legally permissible, financially feasible), even if the entity uses it differently.
  • Three approaches: market (prices of identical or comparable items), income (discounted cash flows, option models) and cost (current replacement cost).
  • Hierarchy: Level 1 quoted prices for identical items in active markets; Level 2 other observable inputs; Level 3 unobservable inputs. Maximize observable inputs; a measurement takes the level of its lowest significant input. A Level 1 position is price x quantity, with no blockage discount.
  1. Worked exampleAn asset trades in Market A at $26 (transaction costs $3, transport $1) and in Market B at $25 (transaction costs $1, transport $1). If Market A is the principal market, fair value = $26 - $1 = $25. With no principal market, the net amounts are $22 in A and $23 in B, so B is most advantageous and fair value = $25 - $1 = $24.
  2. Where questions turnDeducting transaction costs from fair value. They only help pick the most advantageous market; transport costs are the ones deducted.
Exit price
The price received to sell an asset or paid to transfer a liability.
Principal market
The market with the greatest volume and level of activity for the item.
Highest and best use
The use by market participants that maximizes an asset's value.
Level 3 input
An unobservable input based on the entity's own assumptions about market participants.
The 2 tasks of this group, in our words
  1. TX.5.1Name the market, income and cost approaches to fair value
  2. TX.5.2Measure fair value with market participant inputs and levels
Practise group E

FLeases for the lessee

  • A lessee's lease is a finance lease if any one test is met: ownership transfers; a purchase option is reasonably certain to be exercised; the term is a major part of the remaining economic life; the present value of payments plus any guaranteed residual equals or exceeds substantially all of fair value; or the asset is so specialized it has no alternative use to the lessor. Otherwise it is an operating lease (ASC 842).
  • The lease liability is the present value of unpaid lease payments at the rate implicit in the lease if readily determinable, otherwise the incremental borrowing rate (a nonpublic entity may elect a risk-free rate). The right-of-use asset = liability + initial direct costs + prepaid rent - incentives received.
  • Lease payments include fixed and in-substance fixed payments, payments tied to an index or rate (at the commencement rate), a purchase option reasonably certain to be exercised, amounts probable of being owed under a residual value guarantee and termination penalties reflected in the term. Variable payments based on usage or sales are expensed when incurred.
  • Finance lease: interest on the liability plus straight-line amortization of the asset, so cost is higher early. Operating lease: one straight-line lease cost, with the asset amortization as the balancing figure.
  • A lessee may elect not to recognize leases of 12 months or less with no purchase option reasonably certain to be exercised; the cost is straight-line.
  1. Worked exampleCalloway Co. leases equipment for 5 years at $50,000 at the start of each year; its incremental borrowing rate is 6% (annuity due factor 4.4651). Liability and asset = $223,255. After the first payment the liability is $173,255, so Year 1 interest = $10,395. As a finance lease, Year 1 cost = $10,395 + $44,651 amortization = $55,046; as an operating lease, the lease cost is $50,000.
  2. Where questions turnPutting usage-based or sales-based rent into the lease liability. Only fixed payments and those tied to an index or rate are measured at commencement.
Right-of-use asset
The lessee's right to use the underlying asset over the lease term.
Incremental borrowing rate
The rate the lessee would pay to borrow on a collateralized basis over a similar term.
Residual value guarantee
A lessee's promise that the asset will be worth at least a stated amount at the end of the lease.
The 4 tasks of this group, in our words
  1. TX.6.1Know how guarantees, purchase options and variable rent work for lessees
  2. TX.6.2Know the tests that make a lessee's lease a finance lease
  3. TX.6.3Measure the lessee's right-of-use asset and liability, with entries
  4. TX.6.4Compute the lessee's lease cost for the period
Practise group F

GSubsequent events

  • Subsequent events occur after the balance sheet date but before the statements are issued (SEC filers) or available to be issued (other entities); non-SEC entities disclose the date through which they evaluated (ASC 855).
  • Recognized events give more evidence about conditions that existed at the balance sheet date, such as settling a lawsuit over a prior-year event or a customer's bankruptcy from long-running decline: adjust the statements.
  • Nonrecognized events arise from conditions after the balance sheet date, such as a fire, a business combination or a new stock or bond issue: disclose the nature and an estimate of the effect when needed to keep the statements from misleading, sometimes with pro forma figures.
  • A stock dividend or split after year end but before issuance is reflected retroactively in shares and EPS (ASC 260).
  1. Worked exampleYear end is December 31, Year 1 and the statements are issued March 1, Year 2. A lawsuit over a Year 1 accident was accrued at $200,000 and settles on February 10 for $260,000: increase the Year 1 accrual and expense by $60,000. A February 20 warehouse fire causes a $500,000 uninsured loss: disclose it, with no adjustment to Year 1.
  2. Where questions turnAdjusting the year-end figures for an event whose cause arose after the balance sheet date, such as a fire or a storm.
Recognized subsequent event
An event that confirms a condition existing at the balance sheet date; it is adjusted for.
Nonrecognized subsequent event
An event from a condition arising after the balance sheet date; disclosed only.
Available to be issued
Complete in form and format with all approvals obtained, for entities that are not SEC filers.
The 3 tasks of this group, in our words
  1. TX.7.1Spot a subsequent event and how it is treated
  2. TX.7.2Adjust or disclose for a subsequent event
  3. TX.7.3Trace how a subsequent event alters statements and notes
Practise group G

After this guide: Check yourself: can you tell a change in estimate from a change in principle, decide accrue, disclose or ignore for a contingency, allocate a contract price, book the tax provision, pick the market that sets fair value, classify and measure a lease and sort subsequent events into adjust or disclose?

Practise Select Transactions

ExamDragon is independent exam preparation. It is not affiliated with, endorsed by or reviewed by the American Institute of Certified Public Accountants (AICPA), the National Association of State Boards of Accountancy (NASBA), any state board of accountancy or Prometric. Uniform CPA Examination and CPA Exam are names of the AICPA, used here only to name the exam. Every question and simulation here is our own, written from the AICPA's published Blueprints; none is adapted from the AICPA's released questions or any review course.