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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.