accrual accounting and income determination

Accrual Accounting and Income

Determination

Revsine/Collins/Johnson/Mittelstaedt: Chapter 2

RCJM: Chapter 2 © 2012 2

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 formatting it under the joint FASB/IASB proposal.

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


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 2011, 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 2011.

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:

2012 20132011

Subscriptions $300,000

Loan interest ($30,000)

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


Canterbury: Cash-basis income

Cash-basis entries for 2011:

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:

2012 20132011


Loan interest ($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

2012 20132011

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)


2012 20132011

Expenses:

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

Canterbury: Accrual-basis summary

(10,000) (10,000) (30,000)Interest accrued

20,000

Net Income $30,000 $30,000 $30,000


Deferred to future years (200,000)

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


Canterbury: Accrual adjusting entries

Adjusting entries on December 31,2011DR Subscription revenue $200,000 CR Deferred subscription revenue $200,000

DR Interest expense $10,000 CR Interest payable $10,000

Adjusting entries on December 31,2012DR Deferred subscription revenue $100,000 CR Subscription revenue $100,000

DR Interest expense $10,000 CR Interest payable $10,000

Adjusting entries on December 31,2013DR 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. Owner’s equity is increased by the amount of the income.2. Net assets (i.e., gross assets minus gross liabilities) are increased

by an identical amount.

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.


U.S. GAAP vs. IASB

US: Revenues are considered to have

been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.

Revenues and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash.

IASB: Significant risks and rewards of

ownership have been transferred from the seller to the buyer.

Management involvement and control over the asset being transferred has passed from the seller to the buyer.

The seller can reliably measure the amount of revenue or consideration received in the exchange.

It is probable that the seller will receive economic benefits.

The seller can accurately measure the costs (both past and future) of the transaction.


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).


“Transitory” Earnings

1. Special or Unusual items

2. Discontinued Operations

3. Extraordinary items

The second and third must be shown net of taxes, with earnings per share (both basic and diluted) shown separately for each


Special or Unusual

Write-downs or write-offs of receivables, inventory, equipment leased to others, and intangible assets.

Gains or losses from the exchange or translation of foreign currencies.

Gains or losses from the sale or abandonment of property, plant or equipment.

Special on-time charges from corporate restructurings. Gains or losses from the sale of invesments


Discontinued Operations

Company must disclose discontinued operations for: Reportable segment Operating segment Reporting unit Subsidiary Asset group

Must restate all presented periods with the discontinued operations separated out.

Must disclose: Operating income or loss of the segment from the beginning reporting

date until the disposal date Gain or loss from this disposal (sales price less book value).

IFRS rules use the notion of a disposal group for identifying discontinued operations which envisions a larger unit than the component of an entity notion under U.S. GAAP.


Extraordinary Items

Must be BOTH: Unusual Nature

The underlying event or transaction possesses a high degree of abnormality, and considering the environment in which the company operates, that event or transaction is unrelated to the ordinary activities of the business.

Infrequent occurenceThe underlying event or transaction is a type that would not reasonably

be expected to recur in the foreseeable future, again considering the environment in which the company operates.

Note: IFRS rules require separate disclosure of gains (losses) resulting from unusual or infrequent events but does not permit the use of the label “extraordinary.”


Frequency of nonrecurring items

Sample: NYSE/AMEX firms for 1999-2008


How common are nonrecurring losses?

Conservative bias of accrual accounting encourages early recognition of declines in asset values below cost or book value but delays recognition of increases in value until after the asset is sold.

Firms’ incentives to separately disclose and clearly label

losses (but not gains)

Sample: NYSE/AMEX firms for 1999-2008


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.


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).


Types of Changes


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

Weighted-average common share outstanding

=


Comprehensive Income and Other Comprehensive Income

GAAP defines comprehensive income as a change in equity that occurs during a reporting period from transactions or events from non-owner sources.

Other Comprehensive income (OCI) includes transactions that are not yet completed or closed and tare therefore, not reported as part of net income.

RCJM: Chapter 2 © 2012

Comprehensive Income and Other Comprehensive Income

35

Under current GAAP, OCI components fall into the following general categories:


Comprehensive income: Single statement format


Comprehensive income: Two-step statement format


Comprehensive income: Stockholders’ equity statement format


Global Vantage Point

Cohesiveness principle

Firms should present information so that the relationship between items across financial statements is clear and that the statements complement or articulate with each other as much as

possible.

Disaggregation principle

Requires entities to consider disaggregating accounting date displayed in financial statements by

function Nature Measurement basis

39

The FASB had recently issued a staff draft of an Exposure Draft outlining significant changes to the form and content of firms’ financial statements which sets forth two core presentation principles


Global Vantage PointThe sections categories and subcategories proposed for displaying

information in the SFP, SCI, and SCF are summarized in Exhibit 2.12.

40


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”.

Other Comprehensive Income – changes in assets and liabilities resulting from incomplete or open transactions that bypass the income statement and are reported as direct adjustments to stockholders’ equity.

Joint deliberations of the FAST and IASB resulted in a recent Exposure Draft on financial statement presentation.

accrual accounting and income determination

Documents

dr cash

cr cash

cash outlays

cash flow

cash receipts

accrual accounting revenues

accrual expenses

accrual earnings