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Accounting Income and Assets: Accrual Concept

Accounting Income and Assets: Accrual Concept

22 Chapter Chapter

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Chapter Objectives• Discuss the accrual principle of accounting

• Review the format and classification of the income statement

• List and discuss the components of the income statement

• Describe the criteria for revenue and expense recognition

• Discuss major issues in revenue and expense recognition, and how they affect reported earnings.

• Discuss the revenue recognition method used for selected industries.

• Review the types of nonrecurring items, including extra ordinary items, discontinued operations, the cumulative effect of accounting changes, and prior period adjustments.

• Discuss the significance of nonrecurring items to firm valuation.

• Discuss the concept of earning quality.

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Income, Cash Flow, and Assets:Definition And Relationship

In a world of certainty, the interrelationship among income, cash

flow, and assets is captured by the concept of economic earnings.

Economic Earning, defined as net cash flow plus the change in

market value of the firm’s net assets.

The market value of the firm’s assets in this certain world is equal to

the present value of their future cash flows discounted at the (risk

free) rate .

In this world of uncertainty, income (however measured) is, at best,

only a proxy for economic income.

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Distributable Earnings, defined as the amount of earnings that

can be paid out as dividends without changing the value of the

firms.

Sustainable Income, refers to the level of income that can be

maintained in the future given the firm’s stock of capital

investment (e.g., fixed assets & inventory)

Permanent Earnings, used by analysts for valuation purposes is

the amount that can be normally earned given the firm’s assets and

equals the market value of those assets times the firm’s required

rate of return.

Income, Cash Flow, and Assets:Definition And Relationship, contt..

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As a result of these difficulties, the financial reporting concept of

income- accounting income – is often quite different. The analyst,

therefore, needs to relate accounting income to the economic

income.

Accounting Income, is measured using the accruals concept and

provides information about the ability of the enterprise to generate

future cash flows.

Income, Cash Flow, and Assets:Definition And Relationship, contt..

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The Accrual Concept of Income

Accounting and economic income both define income as the sum

of cash flows and changes in net assets. However, in financial

reporting, the determinants of

• Which cash flows are included in income and when

• Which changes in asset and liability values are included in income

• How and when the selected changes in assets and liability values are measured

Are based on accounting rules and principles – (GAAP)

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The Matching Principle

Revenue and expense recognition are also governed by the

Matching Principle, which states that operating performance can

be measured only if related revenues and expenses are accounted

for during the same time period. It is the matching principle that

requires the expense (cost of goods sold) of inventory to be

recognized in the same period in which the sale of that inventory is

recorded.

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Income Statement Format & Classification

Actual formats vary across companies, especially in the reporting of

the gain or loss on sale of assets, equity in earnings of affiliates and

other non-operating income and expense. In some cases, income

statement detail appears in financial statement footnotes.

IAS Presentation Requirements:

IAS 1 specifically allows for presentation of the income statement

in either of two formats:

1. Classification of expenses by function.

2. Classification of expenses based on their nature. Under this alternative, the company reports expenditures using categories such as raw materials, employees, and changes in inventories.

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General Format of I/S

Revenues from sale of Goods & services

(+) Other income & Revenues

(-) Operating Expenses

(-) Finance cost

(+/-) Unusual or infrequent items

= Pretax earnings from continuing operations

(-) Income tax expense

= Net income from continuing operations

(+/-) Income from discontinued operations ( net of tax)

(+/-) Extraordinary items ( net of tax)

(+/-) Cumulative effect of accounting changes (net of tax)

= Net income

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Components of Net Income

The format typically found in actual statement may not be the most

useful for analytical purposes. It is important for the analyst to be

cognizant of the various categories or groupings into which the

income statement components can be combined. These grouping do

not necessarily coincide with the classifications presented in actual

financial statements.

We shall follow the suggested grouping presentation. These

grouping provide information about different aspects of a firm’s

operations:

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Suggested Format I/S

Revenues from sale of Goods & services

(-) Operating Expenses

= Operating income from continuing operations

(+) Other income & Revenues

= Recurring income before interest and taxes from continuing operations

(-) Finance cost

= Recurring (pretax) income from continuing operations

(+/-) Unusual or infrequent items

= Pretax earnings from continuing operations

(-) Income tax expense

= Net income from continuing operations

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Suggested Format, cont,

= Net income from continuing operations

(+/-) Income from discontinued operations ( net of tax)

(+/-) Extraordinary items ( net of tax)

(+/-) Cumulative effect of accounting changes (net of tax)

= Net income

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Recurring Versus Nonrecurring Items

Income from a firm’s recurring operating activities is considered

the best indicator of future income. The predictive ability of

reported income is enhanced if it excludes the impact of transitory

or random components, which are not directly related to operating

activities and are generally more volatile.

Segregation of the results of normal, recurring operations from the

effects of nonrecurring items facilitates the forecasting of future

earnings and cash flows, Financial reporting defines nonrecurring

by the type of transaction or event .

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Accounting Income Revenue & Expenses Recognition

When accrual accounting is used to prepare financial statements,

two revenue and expense recognition issues must be addressed:

1. TIMING: When should revenue and expense be recognized?

2. MEASUREMENT: How much revenue and expense should be recognized?

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Statement of Financial Accounting Concepts (SFAC) 5, recognitionand measurement in Financial Statements of Business Enterprises,specifies two conditions that must be met for revenue recognitionto take place. These conditions are:

1. Completion of the earning process2. Assurance of payment

To satisfy the first condition, the firm must have provided all orvirtually all the goods or services for which it is to be paid., and itmust be possible to measure the total expected cost of providing the goods and services; that is, the seller must have no remainingsignificant contingent obligation.

Revenue recognition also requires a second condition: thequantification of cash or assets expected to be received for the

goodsand services provided.

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Departures from the sales basis of Revenue Recognition

• Revenue may be recognized prior to sale or delivery when the earnings process is substantially complete and the proceeds of sale can be reasonably measured. For example revenue is recognized at the completion of production in the case of commodities, such as oil and agricultural products.

• Alternatively, revenues may not be recognized even at the time of sale if there is significant uncertainty regarding the seller’s ability to collect the sales price or to estimate remaining costs.

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Percentage – of – Completion and Completed Contract Methods

You may have a contract of constructing a building. As a

contractor. You will construct the building. During the construct

period cost will incure, as well as some cash will be required. How

to recognized these revenue and cost.

Should these be shown at the time of construction or at the end of

completion. Two method can be followed-

1. Percentage-of-completion method

2. Completed contract method

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Percentage – of – Completion and Completed Contract Methods; contt..

Percentage-of-Completion Method:

The percentage of completion method recognizes revenues and costs

in proportion to and as work is completed: production activity is

considered the critical event in signaling the completion of the earning

process rather than delivery of cash collections.

This method is used when –• There is a long-term contract, and• If production activities, revenue and expenses can be reasonably

estimated.

Measurement of progress towards completion can be estimated by

using either-

(1) Engineering estimation; or (2) Ratio of cost incurred to total cost.

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Percentage – of – Completion and Completed Contract Methods; contt..

Completed Contract Method:

The completed contract method recognizes revenues and expenses

only at the end of the contract

It must be used when any of the conditions required for the use of

the percentage-of-completion method is not met. Generally when

no contract exists or estimates of the selling price or collectibility

are not reliable. It must be used for short – term contracts.

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Installment Method of Revenue Recognition

Revenues should not be recognized at the time of sale or delivery

when there is no reasonable basis to estimate collectibility of the

sales proceeds.

The Installment method recognizes gross profit in proportion to

cash collections, resulting in delayed recognition of revenues and

expenses as compared with full recognition at the time of sale.

This method is sometimes used to report income from sales of

noncurrent assets and real estate transactions.

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Cost Recovery Method

Revenue recognition on sale or delivery is also precluded when the

costs to provide goods or services cannot be reasonably determined.

In many cases, there is also substantial uncertainty about revenue

realization since only small down payments may be required with

nonrecourse financing provided by the seller. With both future costs

and collection uncertain, the cost recovery method requires that all

cash receipts be first accounted for as a recovery of costs.

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Nonrecurring Items

Events or transactions that infrequently happens. These items

should be separately reported, because it will not occur in every

period.

Types of Nonrecurring Items:

The income statement contains four categories of nonrecurring

income:

1. Unusual or infrequent items

2. Extraordinary items

3. Discontinued operations

4. Accounting changes

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Unusual or Infrequent Items: Transaction or events that are either unusual in nature or infrequent

in occurrence but not both may be disclosed separately (as a single –

line item) as a component of income from continuing operations.

These items must be reported pretax in the income statement: the tax

impact ( or the net – of – tax amount ) may be disclosed separately.

Common Examples are:• Gains or losses from disposal of a portion of a business segment• Gains or losses from sales of assets or investments in affiliates

or subsidiaries• Provisions for environmental remediation • Impairments, write-offs, writedowns, and restructuring costs• Expenses related to the integration of acquired companies

Nonrecurring Items, cont.

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Extraordinary Items: Extraordinary items as transactions and events that are unusual in

nature and infrequent in occurrence and are material in amount.

Extraordinary items must be reported separately, net of income tax.

Firms are also required to report per – share amounts for these items

and encouraged to provide additional footnote disclosures.

Nonrecurring Items, cont.

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Discontinued Operations:The discontinuation or sale of a business may indicate that it:• Has inadequate or uncertain markets or prospects • Has an unsatisfactory contribution to earnings and cash flows• Is no longer considered by management to be a strategic fit• Can be sold at a significant profit

Operating income from discontinued operations and any gains or

losses (net of taxes) from their sale are segregated in the income

statement, since these activities will not contribute to future income

and cash flows.

Nonrecurring Items, cont.

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Accounting Changes:

Accounting changes fall into two general categories:

1. Those undertaken voluntarily by the firms and those mandated by new accounting standards. Generally, accounting changes do not have direct cash flow consequences.

2. The changes from one acceptable accounting method to another

acceptable method is reported net of tax after extraordinary items and discontinued operations on the income statement.

Nonrecurring Items, cont.

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The Balance SheetThe balance sheet (statement of financial position) reports the

categories and amounts of assets (firm resources), liabilities (claims

on those resources), and stockholders’ equity at specific points in time.

Format and Classification:

Assets and liabilities are classified according to liquidity, that is, their

expected use in operations or conversion to cash in the case of assets

and time to maturity for liabilities.

Assets expected to be converted to cash or used within one year (or one

operating cycle, if longer that one year) are classified as current assets.

Current liabilities include obligations the firm expects to settle within

one year (or one operating cycle, if longer).

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Assets expected to provide benefits and services over periods

exceeding one year and liabilities to be repaid after one year are

classified as long – term assets and liabilities. Tangible assets and

liabilities are generally reported before intangibles and other assets

and liabilities measurement is less certain.

Uses of Balance Sheet: The reported balance sheet is one starting point for the analysis of a

firm. It provides information about a firm’s resources (assets) and

obligations (liabilities), including liquidity and solvency. For

creditors, the balance sheet provides information about the nature of

assets that the firm uses as debt collateral.

The Balance Sheet, cont.

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The balance sheet also reports on a firm’s earnings-generating ability

in two ways:

1. Assets are defined as economic resources that are expected to provide future benefits. Consistent with the long run going - concern perspective of the firm, these future benefits are not only cash flows but also the ability to generate earnings.

Receivables are forecasts to cash collections. Fixed assets and inventory, on the other hand, are assets that generate future sales. Increase and decrease in such assets assist forecasts of the firm’s sales and profitability.

2. Proper evaluation of a firm’s profitability must consider the amount of resources, that is, the level of investment, for a specified level of sales or profitability.

The Balance Sheet, cont.

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Limitation of Balance Sheet:The usefulness of the balance sheet is limited by the following three

factors:

1. Selective Reporting: Important assets and liabilities may be omitted from the balance sheet because GAAP does not require their inclusion.

2. Measurement: Some assets and liabilities are carried at historical cost, others at market value. Historical costs may bear little relationship to their real market value. Example: Inventories.

3. Delayed Recognition: GAAP permits companies to delay recognition of value changes. Example: Employee benefit plan.

The Balance Sheet, cont.

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Statement of Stockholder’s Equity

Companies generally report components of stockholder’s equity in

order of preferences upon liquidation. For each class of shares, firms

report the number of shares authorized, issued and outstanding at

each balance sheet date.

Preferred (preference) stock has priority for liquidation and

dividends.

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Common characteristics and related discloser requirements include

but are not limited to:

• Cumulative rights to dividends that may be:FixedFloating rateTied to amounts declared for common stock

• Callable by issuer; call price must be disclosed

• Convertible into common stock at option of holder; specified prices must be disclosed.

• Mandatory conversion into common shares at a specified date or

under certain condition; terms must be disclosed.

Statement of Stockholder’s Equity, cont.