accrual accounting and income determination revsine/collins/johnson: chapter 2
TRANSCRIPT
Accrual Accounting and Income
Determination
Revsine/Collins/Johnson: Chapter 2
2RCJ: Chapter 2 © 2005
Learning objectives
1. Cash-basis versus accrual income measurement.
2. How profit performance is measured: revenues, expenses, and the matching principle.
3. Income statement format and classification
4. The difference between basic and diluted earnings per share (EPS).
5. What is comprehensive income and why it is important.
6. Review basic accounting procedures and T-account analysis.
3RCJ: Chapter 2 © 2005
Accrual accounting: The cornerstone of income measurement
Under accrual accounting:
Revenues are “recognized” (recorded) as soon as they are both: Earned, meaning the seller has performed a service or conveyed an
asset to the buyer; Measurable, meaning the value to be received for that service or
asset is reasonably assured and can be measured with a high degree of reliability.
Expenses are expired costs—the assets used up to produce revenues—and are recorded in the same accounting period in which the revenues are recognized. Expenses are “matched” to revenues!
Net income = Revenues - Expenses
4RCJ: Chapter 2 © 2005
Accrual accounting illustratedFebruary: Buys 2 antique carpets on eBay for $500 cash each.
March: Both carpets are sold for $1,200 each. One customer pays cash. The other pays $1,000 down with the remaining amount due next month.
April: The credit customer pays the $200 due.
February March April
Cash Flow ($1,000) $2,200 $200
$2,400
($1,000)
Earned &
Measurable
Expense
Revenue
Matching
5RCJ: Chapter 2 © 2005
Understanding accrual accounting
Accrual accounting decouples measured earnings (i.e., revenues minus expenses) from the amount of cash generated from operations.
Accrual accounting revenues generally do not correspond to cash receipts for the period, nor do accrual expenses always correspond to cash outlays for the period.
Accrual accounting can produce large discrepancies between measured earnings and the amount of cash generated from operations.
Accrual earnings is a more accurate measure of the economic value added during the period than is operating cash flow.
6RCJ: Chapter 2 © 2005
Canterbury Publishing
In January 2005, Canterbury sells a three-year subscription to its quarterly magazine to 1,000 customers.
Customers pay the full subscription price ($300 = 12 x $25) up front.
Canterbury takes out a $100,000 three-year loan. Interest at 10% per year is payable at maturity in 2007.
The cost of publishing and distributing the magazine is $60,000 each year, and is paid in cash at the time of publication.
Operating Cash Flow:
2006 20072005
Subscriptions $300,000
Loan interests ($30,000)
(60,000)Magazine costs (60,000) (60,000)
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Canterbury: Cash-basis income
Cash-basis entries for 2005:
DR Cash $300,000
CR Subscription Revenues $300,000
To record collection of 1,000 three-year subscription at $300 each for Windy City
Living.
DR Publishing and distribution expenses $60,000
CR Cash 60,000
To record publishing and distribution expense paid in cash.
Operating Cash Flow:
2006 20072005
Subscriptions $300,000
Loan interests ($30,000)
(60,000)Magazine costs (60,000) (60,000)
8RCJ: Chapter 2 © 2005
Canterbury: Cash-basis income
Cash-basis entries for 2006:
DR Publishing and distribution expense $60,000
CR Cash $60,000
To record publishing and distribution expense paid in cash.
Cash-basis entries for 2007:
DR Publishing and distribution expense $60,000
CR Cash $60,000
To record publishing and distribution expense paid in cash.
DR Interest expense $30,000
CR Cash $30,000
To record interest expense paid on three-year loan.
($100,000 X .10 X 3 years= $30,000).
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Canterbury: Cash-basis summary
Cash-Basis Income Determination
2006 20072005
Cash inflows
Cash outflows for production and distribution
Cash outflow for loan interest
Net Income(loss)-Cash Basis
$300,000
(60,000)
0
$240,000
$0
(60,000)
0
($60,000)
$0
(60,000)
(30,000)
($60,000)
10RCJ: Chapter 2 © 2005
2006 20072005
Expenses:
(60,000) (60,000) (60,000)Magazine costs
Canterbury: Accrual-basis summary
(10,000) (10,000) (30,000)Interests accrued
20,000
Net Income $240,000 $240,000 $240,000
Subscriptions $300,000
Deferred to future years (200,000)
Revenues recognizedas earned $100,000 $100,000 $100,000
11RCJ: Chapter 2 © 2005
Canterbury: Accrual adjusting entries
Adjusting entries on December 31,2005DR Subscription revenue $200,000 CR Deferred subscription revenue $200,000
DR Interest expense $10,000 CR Interest payable $10,000
Adjusting entries on December 31,2006DR Deferred subscription revenue $100,000 CR Subscription revenue $100,000
DR Interest expense $10,000 CR Interest payable $10,000
Adjusting entries on December 31,2007DR Deferred subscription revenue $100,000 CR Subscription revenue $100,000
DR Interest expense $10,000DR Interest payable $20,000 CR Cash $30,000
12RCJ: Chapter 2 © 2005
Canterbury: Lessons learned
Accrual accounting decouples measured earnings from operating cash flows;
Better links economic benefit (revenue) with economic effort (expenses, or the cost of producing the revenue);
Provides a more realistic picture of past economic activities.
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Measuring Profit Performance:Revenues and Expenses
According to GAAP, when are revenues and expenses to be recognized?
It’s a two step process!
Step 1: Revenue recognition
Step 2: Expense matching
Revenue recognition and expense matching both produce changes to the balance sheet.
Operating Cycle
Market the
product
Collect cash
Deliver product
Manufacture product
Order material
Negotiate production
contract
Receive order
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Balance sheet effects
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Balance sheet effects: Concluded
Two things happen when income is recognized in the financial statements:1. Net assets (i.e., gross assets minus gross liabilities) are increased by
an identical amount.2. Owner’s equity is increased by the amount of the income.
Thus there are two identical ways of thinking about income recognition:
Net asset valuation and income determination are inextricably intertwined.
ASSETS – LIABILITES
Income increases net assets
OWNERS’ EQUITY
Income (revenues minus expenses) increases owners’ equity
=
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Criteria for revenue recognition
Condition 1: The critical event in the process of earning the revenue has taken place.
Condition 2: The amount of revenue that will be collected is reasonably assured and is measurable with a reasonable degree of reliability.
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Revenue recognition: Time of sale
In most instances, the time of sale turns out to be the earliest moment at which both Conditions 1 and 2 are satisfied.
Example: Howard’s TV and Appliance Store
Revenue is recognize at the time of sale (June) because that’s when Condition 1: The revenue has been “earned” (critical event). Condition 2: The amount of revenue is reasonably assured
and is measurable.
May June July
Buy 3 TV sets ($160 each)
Sells and delivers 2 sets ($200 each) One customer pays cash
The other customer pays
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Revenue recognition: Percentage of completion
Sometimes, revenue is recognized as production takes place.
Example: Weld Shipyards
Condition 1 (critical event) is satisfied over time as the project progresses. Condition 2 (measurability) is satisfied because a firm contract with a known buyer at a set price exists.
??
2005 2006Two-year
total
(18) (27)
$60 million
(45) million
40% 60% 100%
Contract Revenue
Construction costs
Income
Percentage
? $15 million?
$24
$ 6
$60 x 40%
$36
$ 9
$60 x 60%
19RCJ: Chapter 2 © 2005
Revenue recognition recap
Criteria for recognizing revenue during production: A specific customer must be identified and an exchange price agreed
upon. Usually a formal contract must be signed. A significant portion of the services to be performed has been performed,
and the expected costs of future services can be reliably estimated. An assessment of the customer’s credit standing permits a reasonably
accurate estimate of the amount of cash that will be collected.
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Revenue recognition recap
Criteria for recognizing revenue on completion of production: The product is immediately saleable at quoted market prices. Units are homogeneous. No significant uncertainty exists regarding the cost of distributing
the product.
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Revenue recognition recap
Time of sale is the dominant practice in most industries. However, sometimes revenue is not recognized until after the time of sale because:
Extreme uncertainty exists regarding the amount of cash to be collected from customers (customer credit risk, contingencies,
right-of-return). Future services to be provided are substantial, and their costs
cannot be estimated with reasonable precision.
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Matching expenses with revenues: Traceable costs (Cory TV and Appliance)
This example illustrates how product (traceable) costs are matched to revenues.
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Expenses : Period costs
Suppose Cory TV also buys radio advertising for a monthly cost of $120 beginning in February. This is a period cost (not product cost).
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Step 1: Determine the amount of revenue to be recorded (revenue recognition).
Step 2: “Matching” then associates expired traceable costs (expenses) with the revenues recognized in a period.
Expired period costs (e.g., advertising) are expensed in the period when they are consumed.
Matching expenses with revenues: Recap
25RCJ: Chapter 2 © 2005
Income statement format and classification
Multi-step income statements subdivide income in a manner that helps analysts to forecast future operating cash flows.
Virtually all decision models in modern corporate finance are based on future cash flows.
Accordingly, the FASB says …”financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows..” [SFAC No. 1].
The multi-step income statement separates “transitory” income items from those believed to be “sustainable” (likely to be repeated).
26RCJ: Chapter 2 © 2005
Income statement format:Income from continuing operations
Ideally, this includes only the normal, recurring, “sustainable” ongoing operating activities of the firm.
Serves as a starting point for forecasting future profits.
However, gains and losses that occur infrequently—called “special”, “nonrecurring”, or “unusual” items—but that arise from ongoing operating activities are sometimes included “above the line”.
27RCJ: Chapter 2 © 2005
Income statement format:Nonrecurring items
Nonrecurring items are “transitory”.
Nonrecurring items include: Special or unusual items Discontinued operations Extraordinary losses and gains Accounting changes
“Below the line” nonrecurring items are always shown net of tax.
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Income statement format:Special or unusual items
Shown above the line because they arise from the firm’s ongoing operating activities.
They are “unusual” or “infrequent”, but not both.
Examples: Asset write-downs and write-
offs Gains and losses from selling
assets. Corporate restructuring
charges.
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Income statement format:Discontinued operations
Involves the disposal of assets for :
Separate line of business Separate class of customers Separate “component” as
defined in SFAS 144.
Shown “below the line” because they will not generate future operating cash flows.
While gray areas exist, the rules preclude treating losses (and gains) on normal asset sales as “below the line” discontinued operations.
30RCJ: Chapter 2 © 2005
Income statement format:Discontinued operations details
May involve asset group that has been sold or is held for sale.
Two components of discontinued operations are reported:
Gain or loss from operations Disposal (impairment) gain or
loss
Firm cannot have any significant continuing involvement in group operations after disposal.
Identify of business segment and details of disposal must be disclosed in footnotes.
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Income statement format: Extraordinary items
Must be both: Unusual in nature Infrequent in occurrence
Like discontinued operations, they are reported net of tax.
Examples: Losses from natural disasters. Losses from new laws.
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UAL Corporation
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Frequency of nonrecurring items
Sample: NYSE/AMEX firms for 1992-2001
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How common are nonrecurring losses?
Conservative bias of accrual accounting.
Firms’ incentives to separately disclose and clearly label
losses (but not gains)
Sample: NYSE/AMEX firms for 1992-2001
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Magnitude of nonrecurring items
Sample: NYSE/AMEX firms for 1992-2001
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Nonrecurring items: final comments
When undisclosed nonrecurring gains and losses are included as part of “Income from continuing operations”, analysts may tend to:
Overestimate future income (undisclosed gains) Underestimate future income (undisclosed losses)
Disclosed gains and losses (including “special” items) may not just be one time events. Check to see if they are likely to repeat.
Firms tend to sell off unprofitable operating segments. This leads to a high frequency of losses in the “Discontinued operations” category.
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Changes in accounting principles
Mythical changed depreciation methods effective January 1, 2005.
The current year (2005) effect is included in “Income from continuing operations”.
Any prior year (2004 and earlier) effects are shown in the current period income statement as a “Cumulative effect”.
Pro forma (“as if”) disclosures are also required.
Most (but not all) changes in accounting principles are handled this way.
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Frequency and magnitude of “Cumulative effects”
Sample: NYSE/AMEX firms for 1992-2001
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Retroactive changes in accounting principles
Some accounting changes require retroactive adjustments:
Prior year effects are shown in those periods.
No cumulative effect in the current period.
No pro forma disclosure
Examples: Change from LIFO to any other
inventory method. Change in accounting for long-
term construction projects. Some new accounting principles.
Some prior period effects are indeterminate.
40RCJ: Chapter 2 © 2005
Changes in accounting estimates
Require “prospective” adjustment to the current period and future periods.
Past income is never adjusted.
Examples: Uncollectible accounts
receivable. Depreciation lives. Warranty cost estimates.
Estimate changes are sometimes hard to spot because they are not always disclosed in footnotes.
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Accounting changes: Summary
Accounting changes can distort year-to-year comparisons.
GAAP requires special disclosures to improve comparability and to help statement users understand what effect the accounting change has had.
Three basic types of accounting changes:1. Change in accounting principle.
2. Change in accounting estimate.
3. Change in reporting entity (see Chapter 16 for details).
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Earnings per share
Basic EPS uses average common shares outstanding.
Diluted EPS allows for possible conversion of dilutive securities into common shares.
Chapter 15 has the details.
Income available to common shareholder
Weight-average common share outstanding
=
43RCJ: Chapter 2 © 2005
Comprehensive income
Gains and losses associated with “closed” transactions flow to the income statement.
But unrealized gains and losses from “open” transactions flow directly to owners’ equity as “other comprehensive income”.
There are four types of “other comprehensive income” items:1. Unrealized gains and losses on “available for sale” marketable
securities (see Chapter 16).2. Unrealized foreign currency translation gains and losses (also
Chapter 16).3. Some losses related to minimum pension obligations (see Chapter
14).4. Unrealized gains and losses associated with hedging certain risks
(see Chapter 11).
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Comprehensive income: Single statement format
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Comprehensive income: Two-step statement format
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Comprehensive income: Stockholders’ equity statement format
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Summary
Differences between cash and accrual income measurement. Accrual revenues and expenses better reflect effort and
accomplishment. Accrual income is useful in predicting future operating cash flows.
Revenue is recognized when two conditions are satisfied: “Critical event”—firm has earned the revenue. “Measurability”—amount and collectability are reasonably assured. Time of sale is the most common point when revenue is recognized.
Product costs are matched to their traceable revenues, period costs are expensed as the assets are used up.
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Summary concluded
Multi-step income statements highlight nonrecurring (“transitory”) items.
GAAP disclosures for accounting changes aid comparisons of performance over time.
All firms must report “Basic EPS”, and those with complex capital structures must also report “Diluted EPS”.
Unrealized gains (losses) from “open” transactions flow directly to stockholders’ equity as Other comprehensive income.