FINANCIAL ACCOUNTING

RICHARD G. SCHROEDER

MYRTLE W. CLARK

JACK M. CATHEY

THEORY AND ANALYSIS: TEXT AND CASES11TH EDITION

CHAPTER 5

INCOME CONCEPTS

The Purpose of Income Reporting

Income is used… 1 as the basis of one of the principal forms of taxation.2 in public reports as a measure of the success of a corporation’s

operations.3 as a criterion for the determination of the availability of dividends.4 by rate-regulating authorities for investigating whether those rates are

fair and reasonable.5 as a guide to trustees charged with distributing income to a life tenant

while preserving the principal for a remainderman.6 as a guide to management of an enterprise in the conduct of its affairs.

Importance of Income Reporting

FASB Purpose of financial accounting…

To provide information to financial statement users that will assist them in assessing the amount, timing, and uncertainty of future cash flows

Conflicting assertion… Corporate earnings information is better predictor of performance than

cash-flow information

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)

“Whisper” numbers

Income

Statement

Balance Sheet

In an Attempt to Reconcile

What is the nature of income?

When should income be reported?

What is the Nature of Income?

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

Capital Maintenance Concepts

Difference is in the treatment of holding gains & losses

Current Value Accounting

The concept of physical capital maintenance requires assets and liabilities to be stated at their current values

Approaches:1 Entry price or replacement cost

2 Exit value or selling price

3 Discounted present value

Entry Price or Replacement Cost

Replacement costAssets stated at cost to replace them Income determining by matching revenues against

current cost of replacing operating assets

Possible alternatives– Edwards and Bell

1 Current operating profit

2 Realizable cost savings

3 Realized cost savings

4 Realized capital gains

Exit Value or Selling Price

Selling PriceAssets stated at anticipated disposal price

Holding gains and losses receive immediate recognitionAbandons revenue recognition principle

Measurement problemsDetermining selling price of assets for which there is

no ready market (PP&E)Assumption of sales in normal market rather than

forced liquidation

Discounted Present Value

Relevant value on balance sheet:PV of future cash flows expected to be received from

assetPV of future cash flows expected to be disbursed for

a liability

3 measurement problemsDepends on estimate of future cash flows

Both cash flows and timing must be determined

Selection of appropriate discount rateFirm’s assets are interrelated

Income Recognition

Transactions approachElements of financial statements should be

reported when there is evidence of arms-length transaction

Realization principle: income should be recognized when earnings process is essentially complete (an exchange transaction has taken place)

Makes no attempt to place expected value on firm or report on expected changes in values of assets and liabilities

Criticized for not reporting all relevant information

Measurement

What is measurement?Problems with the measurement unitArbitrary decisions

Accounting for Inflation

Instability of the accounting measuring unit is due to the effects of inflation or deflation

General purchasing power adjustments

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 exists 2. Delivery has occurred 3. The vendor’s fee is fixed or determinable 4. Collectibility is probable.

Revenue Recognition

The crucial event testAs a result revenue is generally recognized at

the point of salemay be advanced or delayed due to surrounding

circumstances 1 During production2 At close of production3 Services performed4 Cash5 Occurrence of some event5 Special recognition circumstances

Recent Developments

Preliminary Views on Revenue Recognition in Contracts with CustomersDecember 2008FASB and IASB joint discussion paperSingle, contract-based model for recognizing

revenueSimilar to current GAAP

Exposure Draft: Revenue from Contracts with Customers, June 2010Basic principle in original proposal: an entity

should recognize revenue from contracts with customers when it transfers goods or services

Exposure Draft: Revenue from Contracts with Customers, June 2010Standard improves both IFRS and

Us GAAP byRemoving inconsistenciesProviding a more robust revenue-recognition

framework Improving comparability across companies,

industries, and capital marketsRequiring enhanced disclosureClarifying accounting for contract costs

Other Issues

Delayed or advanced revenue recognitionRevenue recognized

During production process At completion of production As services are performed As cash is received On occurrence of some event

Matching

Cost

Loss

Expense

Product VS Period

Costs

Matching

Cost

Leads to or Results In

Asset

Used up Resulting in

Revenue

Used up Resulting in No

Revenue

Expense Loss

Concepts Affecting Revenue Recognition

Conservatism

Materiality

Earnings Quality, Earnings Management and Fraudulent Financial Reporting

Earnings quality The correlation between a company’s

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

Earnings Quality, Earnings Management and Fraudulent Financial Reporting Assessing earnings quality:

1 Compare the accounting principles employed by the company with those generally used in the industry and by competitions. Do the principles used by the company inflate

earnings?2 Review recent changes in accounting principles and

changes in estimates to determine if they inflate earnings.

3 Determine if discretionary expenditures, such as advertising, have been postponed by comparing them to previous periods.

4 Attempt to assess whether some expenses, such as warranty expense, are not reflected on the income statement.

5 Determine the replacement cost of inventories and other assets. Assess whether the company generating sufficient cash flow to replace its assets?

6 Review the notes to financial statements to determine if loss contingencies exist that might reduce future earnings and cash flows.

Earnings Quality, Earnings Management and Fraudulent Financial Reporting

7 Review the relationship between sales and receivables to determine if receivables are increasing more rapidly than sales.

8 Review the management discussion and analysis section of the annual report and the auditor's opinion to determine management's opinion of the company's future and to identify any major accounting issues

Earnings Quality, Earnings Management and Fraudulent Financial Reporting

Earnings management The attempt to influence short-term reported income

Earnings Quality, Earnings Management 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 bath2. Creative acquisition accounting3. Cookie jar reserves4. Abusing the materiality concept5. Improper revenue recognition

Lehman Brothers fraud

Repo 105 transactionsDecreased leverage and increased liquidity

Lehman misused the ruleAuditors (E&Y) were aware of nondisclosure

Manipulated financial statementsSept. 12, 2008, Lehman reported $41 billion

in cash; 3 days later actual amount only $2 billion

Distinction Between Conservative, Neutral, Aggressive and Fraudulent Earnings Management1. Conservative accounting

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

Red flags of possible fraudulent reporting:1. A predominantly insider board of

directors

2. Management compensation tied to its stock price

3. Frequent changes of auditors

4. Rapid turnover of key personnel

5. Deteriorating earnings

6. Unusually rapid growth

7. Lack of working capital

Red flags of possible fraudulent reporting:

8. The need to increase the stock price to meet analysts’ earnings projections

9. Extremely high levels of debt

10. Cash shortages

11. Significant off-balance sheet financing arrangements

12. Doubt about the company’s ability to continue as a going concern

13. SEC or other regulatory investigations

14. Unfavorable industry economic conditions

15. Suspension or delisting from a stock exchange

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Prepared by Kathryn Yarbrough, MBA