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Chapter: 02

Accounting Income and

Assets: The Accrual
ECONOMIC EARNING: Defined as net cash
flow plus the change in market value of the
firms net assets. The market value of the firms
assets in a certain world is equal to the present
value of their future cash flows discounted at
the (risk-free) rate .

In this world of uncertainty, income (however

measured) is, at best, only a proxy for economic
the amount of earnings that can be paid out as
dividends without changing the value of the firms.
This concept is derived from the Hacksian
definition of income.

SUSTAINABLE INCOME: Refers to the level of

income that can be maintained in the future given
the firms stock of capital investment (e.g., fixed
assets & inventory)

PERMANENT EARNINGS: Used by analysts for

valuation purposes is the amount that can be
normally earned given the firms assets and
equals the market value of those assets times the
firms required rate of return.
ACCOUNTING INCOME: Is measured using
the accruals concept and provides information
about the ability of the enterprise to generate
future cash flows.
Accounting and economic income both define
income as the sum of cash flows and changes in
net assets. However, in financial reporting, the
determinants of
Which cash flows are included in income and when
Which changes in asset and liability values are
included in income
How and when the selected changes in assets and
liability values are measured

Are based on accounting rules and principles


Revenue and expense recognition are also

governed by the Matching Principle, which
states that
operating performance can be
measured only if related revenues and
expenses are accounted for during the
same time period.
Actual formats vary across companies,
especially in the reporting of the gain or loss on
sale of assets, equity in earnings of affiliates and
other nonoperating income and expense. In
some cases, income statement detail appears in
financial statement footnotes.
IAS presentation Requirements
IAS 1 specifically allows for presentation
of the income statement in either of two
1. Classification of expenses by function.
2. Classification of expenses based on their
nature. Under this alternative, the
company reports expenditures using
categories such as raw materials,
employees, and changes in inventories.

The format typically found in actual

statement may not be the most useful for
analytical purposes. It is important for the
analyst to be cognizant of the various
categories or groupings into which the
income statement components can be
combined. These grouping do not
necessarily coincide with the classifications
presented in actual financial statements.
Sample Income Statement Format
Sample Format Suggested Format
Revenues from sale of Goods & Revenues from sale of Goods &
services services
+ Other Income & Revenues (-) Operating Expenses
- Operating expense = Operating income from
- Financing Cost continuing operations
+/- Unusual or infrequent items (+) Other income & Revenues
= Pretax Earning from continuing = Recurring income before
operations interest and taxes from
- income tax expense continuing operations
= Net income from continuing (-) Finance cost
operations* = Recurring (pretax) income from
+/- Income from discontinued continuing operations
operations (net of tax)* (+/-) Unusual or infrequent items
+/- Extraordinary items (net of tax)* = Pretax earnings from continuing
Sample Income Statement Format
Sample Format Suggested Format
=Pretax earnings from continuing
+/- Cumulative effect of accounting operations
changes (net of tax)*
(-) income tax expense
= NET INCOME =Net income from continuing
(+/-) Income from discontinued
operations ( net of tax)
(+/-) Extraordinary items ( net of
(+/-)Cumulative effect of
accounting changes (net of
Income from a firms recurring
operating activities is considered the best
indicator of future income.
The predictive ability of reported
income is enhanced if it excludes the impact
of transitory or random components, which
are not directly related to operating activities
and are generally more volatile.
Segregation of the results of normal,
recurring operations from the effects of
nonrecurring items facilitates the
forecasting of future earnings and cash

Financial reporting defines nonrecurring

by the type of transaction or event .

When accrual accounting is used to prepare

financial statements, two revenue and expense
recognition issues must be addressed:
1. TIMING: When Should revenue and expense
be recognized?
2. MEASUREMENT: How much revenue and
expense should be recognized?
Statement of Financial Accounting
Concepts (SFAC) 5, recognition and
measurement in Financial Statements of
Business Enterprises, specifies two
conditions that must be met for revenue
recognition to take place. These
conditions are:

1. Completion of the earning process

2. assurance of payment
The general rule for revenue
recognition includes this concept of

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.
Departures from the sales basis
of Revenue Recognition
Revenue may be recognized prior to sale
or delivery when the earnings process is
substantially complete and the proceeds of
sale can be reasonably measured.
Alternatively, revenues may not be
recognized even at the time of sale if there
is significant uncertainty regarding the
sellers ability to collect the sales price or to
estimate remaining costs.
Percentage of Completion and
Completed Contract Methods
The percentage of completion method
recognizes revenues and costs in proportion to
and as work is completed: production activity is
considered the critical event in signaling the
completion of the earning process rather than
delivery or cash collections.

The completed contract method recognizes

revenues and expenses only at the end of the
Installment Method of
Revenue Recognition

The Installment method recognizes gross

profit in proportion to cash collections,
resulting in delayed recognition of revenues
and expenses as compared with full
recognition at the time of sale
Cost Recovery Method
Revenue recognition on sale or delivery is also
precluded when the costs to provide goods or
services cannot be reasonably determined.
In many cases, there is also substantial
uncertainty about revenue realization since only
small down payments may be required with
nonrecourse financing provided by the seller.
With both future costs and collection
uncertain, the cost recovery method requires
that all cash receipts be first accounted for as a
recovery of costs.
Issues in Revenue Recognition
Sales incentives
Barter arrangement
Recording license fees or membership fee
Companies that act as agent
Project which is not yet fully installed and
Shipping and handling cost
Issues in Expense Recognition
Deferral of marketing expenses
Deferral of the cost of periodic
maintenance cost
Bad debt expense
Warranty expense
Types of Nonrecurring Items
The income statement contains four
categories of nonrecurring income:
1. Unusual or infrequent items
2. Extraordinary items
3. Discontinued operations
4. Accounting changes
Unusual or Infrequent Items:

Transaction or events that are either Unusual in

nature or infrequent in occurrence but not both
may be disclosed separately (as a single line
item) as a component of income from continuing
These items must be reported pretax in the
income statement: the tax impact ( or the net
of tax amount ) may be disclosed separately.
Common Examples are:
Gains or losses from disposal of a portion
of a business segment
Gains or losses from sales of assets or
investments in affiliates or subsidiaries
Provisions for environmental remediation
Expenses related to the integration of
acquired companies
Extraordinary Items:

Extraordinary items are transactions and

events that are unusual in nature and
infrequent in occurrence and are material in
Extraordinary items must be reported
separately, net of income tax.
Firms are also required to report per
share amounts for these items and
encouraged to provide additional footnote
Discontinued Operations

The discontinuation or sale of a business may

indicate that it:
Has inadequate or uncertain markets or
Has an unsatisfactory contribution to earnings
and cash flows
Is no longer considered by management to be
a strategic fit
can be sold at a significant profit
Operating income from discontinued
operations and any gains or losses (net of
taxes) from their sale are segregated in
the income statement, since these
activities will not contribute to future
income and cash flows.
Accounting Changes

Accounting changes fall into two general categories:

Those undertaken voluntarily by the firms and
those mandated by new accounting standards.

Generally, accounting changes do not have direct

cash flow consequences.
The changes from one acceptable accounting
method to another acceptable method is reported net
of tax after extraordinary items and discontinued
operations on the income statement.
The balance sheet (statement of
financial position) reports the categories
and amounts of assets (firm resources),
liabilities (claims on those resources), and
stockholders equity at specific points in
Format and Classification
Assets and liabilities are classified
according to liquidity,
current assets
current liabilities
Assets expected to provide benefits and
services over periods exceeding one year
and liabilities to be repaid after one year are
classified as long term assets and liabilities.
Tangible assets and liabilities are
generally reported before intangibles and other
assets and liabilities measurement is less certain.
Uses of Balance Sheet
The reported balance sheet is one starting
point for the analysis of a firm. It provides
information about a firms resources (assets)
and obligations (liabilities), including liquidity
and solvency. For creditors, the balance sheet
provides information about the nature of
assets that the firm uses as debt collateral.
The balance sheet also reports on a firms
earnings-generating ability in two ways:
1. Assets are defined as economic resources that
are expected to provide future benefits.
Consistent with the long run going -
concern perspective of the firm, these
future benefits are not only cash flows
but also the ability to generate earnings.

Receivables are forecasts to cash

collections. Fixed assets and inventory,
on the other hand, are assets that
generate future sales. Increase and
decrease in such assets assist forecasts
of the firms sales and profitability.
2. Proper evaluation of a firms profitability
must consider the amount of resources,
that is, the level of investment, for a
specified level of sales or profitability.

Finally, the reported balance sheet is the

starting point for the preparation of an
adjusted balance sheet.

The usefulness of the balance sheet is limited by

the following three factors:

1. Selective Reporting: Important assets and

liabilities may be omitted from the balance
sheet because GAAP does not require their
2. Measurement: Some assets and liabilities are
carried at historical cost, others at market
value. Historical costs may bear little
relationship to their real market value.
Example: Inventories.

3. Delayed recognition: GAAP permits

companies to delay recognition of value
changes. Example: Employee benefit plan.
Statement of Stockholders Equity
Companies generally report components of
stockholders equity in order of preferences
upon liquidation. For each class of shares, firms
report the number of shares authorized, issued
and outstanding at each balance sheet date.

Preferred (preference) stock has priority for

liquidation and Dividends. Common
characteristics and related discloser
requirements include but are not limited to:
Cumulative rights to dividends that may

* Fixed

*Floating rate

*Tied to amounts declared for common


*Callable by issuer; call price must be

*Convertible into common stock at option
of holder;
specified prices must be disclosed.

*Mandatory conversion into common

shares at a specified date or under certain
condition; terms must be disclosed.