accrual accounting and income determination revsine/collins/johnson: chapter 2

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.


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


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


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.


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)


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


Loan interests ($30,000)

(60,000)Magazine costs (60,000) (60,000)


Canterbury: Cash-basis income


DR Publishing and distribution expense $60,000

CR Cash $60,000



DR Publishing and distribution expense $60,000

CR Cash $60,000


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).


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)


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


Deferred to future years (200,000)

Revenues recognizedas earned $100,000 $100,000 $100,000


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


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.


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


Balance sheet effects


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

=


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.


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


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%


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.



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.



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.


Matching expenses with revenues: Traceable costs (Cory TV and Appliance)

This example illustrates how product (traceable) costs are matched to revenues.


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).


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


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).


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”.


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.


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.


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.


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.


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.


UAL Corporation


Frequency of nonrecurring items

Sample: NYSE/AMEX firms for 1992-2001


How common are nonrecurring losses?

Conservative bias of accrual accounting.

Firms’ incentives to separately disclose and clearly label

losses (but not gains)



Magnitude of nonrecurring items



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.


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.


Frequency and magnitude of “Cumulative effects”



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.


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.


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).


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

=


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).


Comprehensive income: Single statement format


Comprehensive income: Two-step statement format


Comprehensive income: Stockholders’ equity statement format


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.


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.

accrual accounting and income determination revsine/collins/johnson: chapter 2

Documents

dr cash

cr cash

cash outlays

cash receipts

accrual accounting revenues

accrual expenses

accrual earnings

accounting period