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CHAPTER 5
INCOME CONCEPTS
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The Purpose of IncomeReporting
Income is used1 as the basis of one of the principal forms of taxation.
1 in public reports as a measure of the success of a corporationsoperations.
1 as a criterion for the determination of the availability of dividends.1 by rate-regulating authorities for investigating whether those rates are
fair and reasonable.
1 as a guide to trustees charged with distributing income to a life tenantwhile preserving the principal for a remainderman.
1 as a guide to management of an enterprise in the conduct of its affairs.
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Importance of Income
Reporting The EMH and stock prices Economic Vs. Accounting Income
Related sciences concerned with the activities of business firms
use similar variables
differences over the timing and measurement of income
Relative importance of income statement (accounting) and
balance sheet (economics)
Incom
e
Statem
ent
BalanceSheet
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In an Attempt toReconcile
What is thenature of
income?
When shouldincome be
reported?
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What is the Nature ofIncome?
Three possibilities
Psychic Satisfaction of human wants
Real
Increase in economic wealth
Money Increases in monetary value
The concept of well-offness or capital maintenance
Problems Because of the difficulties in measuring real income - Accountants have
adopted a transactions approach to income recognition
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Capital MaintenanceConcepts
Financial
capital
maintenance
- money
amount-transaction
s based
Physicalcapital
maintenance
- productivecapacity
Difference is in the treatment of holding gains
VS
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Current ValueAccounting
The concept of physical capital maintenance
requires assets and liabilities to be stated at
their current values
Approaches:1Entry price or replacement cost
1Exit value or selling price
1Discounted present value
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Income Recognition
Criticisms of the transactions approach
Possible alternatives
Edwards and Bell Current operating profit
Realizable cost savings
Realized cost savings
Realized capital gains
Sprouse
The concept of measurable change
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Measurement
What is measurement?
Problems with the measurement unitArbitrary decisions
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Accounting for Inflation
Instability of the accounting
measuring unit is due to the
effects of inflation or
deflation
General purchasing power
adjustments
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Revenue Recognition
The income producing activities cycle Revenue recognition criteria
1. The revenue has been earned
2. The revenue has been realized or is realizable
SAB No. 101 criteria1. Persuasive evidence of an arrangement exists2. Delivery has occurred3. The vendors fee is fixed or determinable4. Collectibility is probable.
Recognition RealizationVS
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Revenue Recognition
The crucial event test
As a result revenue is generally recognized atthe point of sale
may be advanced or delayed due to surroundingcircumstances
1During production1At close of production1
Services performed1Cash1Occurrence of some event5 Special recognition circumstances
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Recent Developments
FASB-IASB Short-term InternationalConvergence Project
Conflicts in SFAC Nos. 5 and 6
Practical and conceptual reasons to addressrevenue recognition
Project approach based on changes in assetsand liabilities consistent with SFAC No. 6
SEC Staff Accounting Bulletin No. 101
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Recent Developments: OtherIssues
Delayed or advanced revenue recognition
Revenue recognized
During production processAt completion of productionAs services are performedAs cash is received
On occurrence of some event
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Matching
Cost
Loss
Expense
Product
VS PeriodCosts
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Matching
Cost
Leads to or
Results In
Asset
Used upResulting in
Revenue
Used upResulting in No
Revenue
Expense Loss
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Concepts Affecting RevenueRecognition
Conservatism
Materiality
Earnings Qualit Earnings
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Earnings Quality, EarningsManagement and Fraudulent
Financial Reporting
Earnings quality The correlation between a companys
accounting and economic income
The existence of the previously discussed issues has
led some to the conclusion that economic income is a
better predictor of cash flows.
Assessing earnings quality
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Earnings Quality, EarningsManagement and FraudulentFinancial Reporting Assessing earnings quality:
1 Compare the accounting principles employed by thecompany with those generally used in the industryand by competitions.
1 Do the principles used by the company inflate earnings?
1 Review recent changes in accounting principles andchanges in estimates to determine if they inflateearnings.
1 Determine if discretionary expenditures,such as advertising, have been postponed
by comparing them to previous periods.1Attempt to assess whether some expenses, such as
warranty expense, are not reflected on the incomestatement.
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5 Determine the replacementcost of inventories and otherassets. Assess whether thecompany generatingsufficient cash flow toreplace its assets?
1 Review the notes to financialstatements to determine ifloss contingencies exist thatmight reduce future earningsand cash flows.
,Management and FraudulentFinancial Reporting
7 Review the relationship betweensales and receivables to determineif receivables are increasing morerapidly than sales.
8 Review the managementdiscussion and analysis section ofthe annual report and the auditor'sopinion to determinemanagement's opinion of thecompany's future and to identify
any major accounting issues
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Earnings Quality, EarningsManagement and Fraudulent
Financial Reporting Earnings management
The attempt to influence short-term reported income
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Earnings Quality, EarningsManagement and Fraudulent
Financial Reporting Arthur Levitt has outlined five earnings management
techniques that he described as threatening the integrity
of financial reporting:1. Taking a bath
2. Creative acquisition accounting3. Cookie jar reserves
4. Abusing the materiality concept
5. Improper revenue recognition
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Distinction Between Conservative,Neutral, Aggressive and Fraudulent
Earnings Management1. Conservativeaccounting
2. Neutral
earnings
3. Aggressive accounting
4. Fraudulent accounting
Overly aggressive recognition of loss or
reserve provisions
Overvaluation of acquired in process
research and development activities
Earnings that result from using a neutral
perspective
Understating loss or reserve provisions
Recording sales before they satisfy the
earned and measurability criteria
Recording fictitious sales
Backdating sales invoices
Overstating inventory
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Red flags of possiblefraudulent reporting:
A predominantly insider board of
directors
Management compensation tied to its stock price
Frequent changes of auditors
Rapid turnover of key personnel
Deteriorating earnings
Unusually rapid growth
Lack of working capital
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Red flags of possiblefraudulent reporting:
The need to increase the stock price to
meet analysts earnings projections
Extremely high levels of debt
Cash shortages
Significant off-balance sheet financing arrangements
Doubt about the companys ability to continue as a going concern
SEC or other regulatory investigations Unfavorable industry economic conditions
Suspension or delisting from a stock exchange
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Copyright 2009 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written consent of the copyright owner is unlawful. Request
for further information should be addressed to the Permissions
Department, John Wiley & Sons, Inc. The purchaser may make back-
up copies for his/her own use only and not for distribution or resale.
The Publisher assumes no responsibility for errors, omissions, or
damages, caused by the use of these programs or from the use of the
information contained herein.
Prepared by Kathryn Yarbrough, MBA
End of Chapter 5