* Accounting Income and Assets: The Accrual ConceptCHAPTER 02

* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome StatementBook Recommended Format

Unusual or Infrequent Items:

Definition is obvious from title-these events are either unusual or infrequent in occurrence but not both unusual and infrequent.

E.g. includesGains or losses from the disposal of a portion of a business segmentGains or losses from the sale of assets or investments in subsidiaryImpairments, write-offs

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Analytical ImplicationAs an analyst, you need to review unusual or infrequent items and THINK whether it should be included in forecasting future income.

Management buries these items in other income or operating expenses

A careful examination of Management Discussion & Analysis along with footnotes should allow you to determine these items in greater detail

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Definition is similar to unusual or infrequent items, EXCEPT extraordinary items are events that are BOTH unusual and infrequent in occurrence AND material in nature

Gains or losses from early retirement of debtUninsured losses from natural disasters that are both unusual and infrequentExtraordinary items are reported net of tax after net income from continuing operations

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DO are the ones which management has decided to dispose of but either has not done so or did so in the current year after it had generated loss or income.

Income and losses from DO are reported net of taxes after net income from continuing operations

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Two types:A change in accounting principle

Change in accounting principle refers to the change in one GAAP method to another GAAP method. E.g. changing inventory method from LIFO to FIFO. When change in accounting principle occurs, a firm is required to restate its financial statements. A change in accounting estimate

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* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome StatementIn analyzing income statements, the goal is to determine future cash flow. Therefore, the income statements is looked at as a predictor of future income, which in general it is not. However, the income statement must have predictive value.

* ACTG 500 Financial Accounting AnalysisIncome StatementIn analyzing income statements, the goal is to determine future cash flow. Therefore, the income statements is looked at as a predictor of future income, which is general it is not. The income statement must have predictive value. Recurring versus non-recurring items must be analyzed.

* ACTG 500 Financial Accounting AnalysisIncome StatementIn analyzing income statements, the goal is to determine future cash flow. Therefore, the income statements is looked at as a predictor of future income, which is general it is not. The income statement must have predictive value. Recurring versus non-recurring items must be analyzed.Thus, look for above the line and below the line non- recurring items

* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome StatementOther non-recurring items may be hidden

* ACTG 500 Financial Accounting AnalysisIncome StatementOther non-recurring items may be hiddenAbove the Line Items

* ACTG 500 Financial Accounting AnalysisIncome StatementOther non-recurring items may be hidden

* ACTG 500 Financial Accounting AnalysisIncome StatementOther non-recurring items may be hiddenBelow the Line

* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome Statement

* ACTG 500 Financial Accounting AnalysisIncome StatementRecurring operating activities is the best indicator of future incomeThe concept of recurring income is similar to permanent or sustainable income in the sense that it is persistent.With recurring income, the level or rate of growth is relatively more predictable.

* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense Recognition

Cash Accounting is that revenue or income that is recognized when cash is received, and expenses are recognized when firm pays out cash

Firms cash flow is measured as cash in less cash out

Results in highly volatile, less predictable cash flows and income streams

Not desirable for firms with complex operation and financing strategies.

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Accrual accounting allows us to allocate revenues and expenses to time periods other than those in which cash flows occurred.

One result is smoothed earnings streams

Empirical evidence highlights two benefitsEnhanced predictability of future cash flowsGiven cash flow from operations, accrual accounting provides incremental information to a firms profitability

However, accrual accounting can be confusing

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Accounting for revenues and expenses is based on matching principle

Means that revenues and expenses incurred to generate those revenues must be accounted for in the same time period.

When accrual accounting is used to prepare financial statements, two revenue and expense recognition issues must be addressed:Timing: When should revenue and expense be recognized?Measurement: How much revenue and expense should be recognized?

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* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionWhen accrual accounting is used to prepare financial statements, two revenue and expense recognition issues must be addressed:Timing

When?Measurement

How much?

* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionWhen accrual accounting is used to prepare financial statements, two revenue and expense recognition issues must be addressed:In Practice: Management has discretion with respect to both revenue and expense recognition.

* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionWhen accrual accounting is used to prepare financial statements, two revenue and expense recognition issues must be addressed:In Practice: Management has discretion with respect to both revenue and expense recognition. Remember: It must be consistent!

* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense Recognition Recognition and measurement of financial statements: Two conditions must be met for revenue recognition:1. Completion of the earnings process2. Assurance of paymentThe Work was gone; Product Delivered; Service CompetedUnder specific contracts: Portion recognized when condition metPayment is expectedDo not recognize if customer is insolvent and payment not expected

* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense Recognition Recognition and measurement of financial statements: Two conditions must be met for revenue recognition:1. Completion of the earnings process2. Assurance of paymentThe Work was gone; Product Delivered; Service CompetedUnder specific contracts: Portion recognized when condition metPayment is expectedDo not recognize if customer is insolvent and payment not expectedRevenue recognition includes the concept of realization: Revenue, measured as the amount expected to be collected, can be recognized when goods or services have been provided and their cost can be reliably determined

NOTE: If a firm recognizes REVENUE prior to fulfilling the two conditions of revenue recognition, then its current asset will be overstated. Due to overstatement of A/R at sales price LESS understatement of inventory at cost.

Similarly, RETAINED EARNINGS will be overstated by the NET INCOME that should not have been recorded.

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* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionRevenue Recognition Methods or Income Determination Methods:1. Sales basis (most common) 2. Percentage of completion 3. Completed contract method 4. Installment method 5. Cost recovery method Accounting Method Under accrual accounting, revenue is generally recognized at the point of sales. Criteria for use of basis: - Exchange has taken place - Earnings process is (virtually) complete

Sales basis method: goods or services are provided when the sale is made, and the sale is for cash or credit to a customer with a high probability of repayment If cash is received before goods or services are provided, the revenue is not recognized until it is earned for e.g. Rev from sale of magazines is not recognized until deliveryCredit card fees received in advance are not revenue until time passes

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* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionExceptions to Revenue Recognition Methods or Income Determination Methods:1. Sales basis (most common) 2. Percentage of completion 3. Completed contract method 4. Installment method 5. Cost recovery methodCriteria for the use of basis: - Long-term construction, property, or service - Dependable estimates of estimate of extent of progress and cost to complete - Reasonable assurance of collectibility of contract priceReasons for departing from sales basis: - Availability of evidence of ultimate proceeds - Better measure of periodic income - Avoidance of fluctuations in revenues in revenue, expenses, and income

Percentage-of-completion method: Used for long term projects when there is a contract and there are reliable estimates of the revenues, costs and completion time.

Recognize revenues and corresponding costs in proportion to work completed

Two methods to measure the proportion of work completedAn engineering estimate Ratio on incurred cost to total estimated costs

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* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionGeneral formula: Goods and services provided to date Total goods and Services to be providedTotal expected revenue X E.g.: Contract to construct building for $10,000,000. It is estimated to cost $5,600,000 to build. At the fiscal year, $1,300,000 was expended. Revenue recognized:$1,300,000 x $10,000,000 = $2,321,429 $5,600,000

* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionException to Revenue Recognition Methods or Income Determination Methods:1. Sales basis (most common) 2. Percentage of completion 3. Completed contract method 4. Installment method 5. Cost recovery method Completed Contract Method - Recognition of revenue and profit at contract completion. All related costs are deferred until completion and then matched to revenues.

Completed Contract Method: Used for long term projects, when there is NO contract or estimates of revenues and costs are UNRELIABLE.

Rev and Exps are not recognized until entire project is completed

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* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionGeneral formula: Goods and services provided to date Total goods and Services to be providedTotal expected revenue X E.g.: Contract to construct building for $10,000,000. It is estimated to cost $5,600,000 to build. At the fiscal year, $1,300,000 was expended. Revenue recognized:No Revenue and expense recognized until contract completed

* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionVarious Revenue Recognition Methods or Income Determination Methods:1. Sales basis (most common) 2. Percentage of completion 3. Completed contract method 4. Installment method 5. Cost recovery method Criteria for use of basis: - Absence of a reasonable basis for estimating degree of collectability.

Installment Sales Method: Used when there is no way to estimate the likelihood of collecting the sales proceeds, but the costs of goods/services are knownRecognizes sales and COGS as proportions of cash collected each period, based on GPM

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* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionGeneral formula: Goods and services provided to date Total goods and Services to be providedTotal expected revenue X E.g., The magazine company sold a 1-year magazine subscription for $50.00. How much revenue should be recognized each month? 1-month x $50.00 = $4.17 12-months

* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionVarious Revenue Recognition Methods or Income Determination Methods:1. Sales basis (most common) 2. Percentage of completion 3. Completed contract method 4. Installment method 5. Cost recovery method Criteria for use of basis: - Absence of a reasonable basis for estimating degree of collectability.

Cost Recovery Method: Used when costs to provide goods or services are not known or when there are uncertanities surrounding collection of proceeds from the sale.

Sales are recognized when cash is received

But no gross profit is recognized until the sellers COGS is fully recovered by buyers cash payment.

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* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionVarious Revenue Recognition Methods or Income Determination Methods:1. Sales basis (most common) 2. Percentage of completion 3. Completed contract method 4. Installment method 5. Cost recovery method Reason for departure from sales basis: - Level of uncertainty with respect to collection of the receivable preclude recognition of gross profit before cash is receivedCriteria for use of basis: - Absence of a reasonable basis for estimating degree of collectibility.

* ACTG 500 Financial Accounting AnalysisAccounting Income: Revenue and Expense RecognitionVarious Revenue Recognition Methods or Income Determination Methods:1. Sales basis (most common) 2. Percentage of completion 3. Completed contract method 4. Installment method 5. Cost recovery method Reason for departure from sales basis: - Level of uncertainty with respect to collection of the receivable preclude recognition of gross profit before cash is receivedCriteria for use of basis: - Absence of a reasonable basis for estimating degree of collectibility.

Gross profit is deferred, until the cumulative cash receipts exceeds the costs.

End of Chapter!!

Jazak-um-Allah-al-Khair

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