Chapter 2

Accounting
Concepts: Income
And Performance
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11 Basic Concepts
1. Money measurement.
2. Entity.
3. Going concern.
4. Cost.
5. Dual aspect.
6. Accounting period.
7. Conservatism.
8. Realization.
9. Matching.
10. Consistency.
11. Materiality.
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Concept #1:
Money Measurement
Accounting records are recorded in
monetary terms at value at time
transaction is recorded.
Severe limitation.
Cant be valued, cant be recorded; e.g.
presidents health, affect of strike.
Price changes ignored.

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Concept #2: Entity

For whom accounts are kept.

Distinguish from owner.
May or may not be separate legal entity.
One entity may be part of a larger entity.
General Electric Company presents one set of
financial statements with parent company
operations combined with all subsidiaries
around the world.

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Concept #3: Going Concern

Assumed to continue in operation for an
indefinite period.
Alternative assumption:
Liquidation/bankruptcy.
Only liquidation values would be meaningful.

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Concept #4: Cost

Assets defined:
= economic resources.
= cash or something that helps generate cash.

Assets recorded at cost, that is, price paid.

Fair value = amount for which asset could
be currently purchased or sold.
Book value of asset = recorded value.

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Cost Concept
Non-monetary Assets
Land, buildings, machinery and similar.
Generally, book value = fair value only at
time of acquisition.
Depreciation or amortization = systematic
allocation of cost over life of asset.
B.V. = recorded cost - depreciation to date.
Rationale for cost concept:
Relevance sacrificed for objectivity.
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Cost Concept: Monetary

Assets
Cash, marketable securities.
Initially recorded at cost.
Adjusted to fair value (=market value, if
available).
Rationale: FV is relevant, objective & feasible.
Why is FV relevant & objective for monetary
assets but not for non-monetary assets?

1-8

Cost Concept: Goodwill

Economic goodwill:
Fair value of business fair value of acquired net
asset(s).

Accounting goodwill:
Purchase price - fair value of net assets.
Recorded only when purchased.
Application of cost concept.

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Concept #5: Dual-Aspect

Assets = economic resources.
Equities = claims against assets.
Liabilities = claims of creditors (everyone
other than owners).
Owners equity (Shareholders or
stockholders equity for a corporation).

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Dual Aspect (Continued)

Fundamental accounting equation:
Assets = Equities.
Assets = Liabilities + Owners equity.

For a corporation:
Assets = Liabilities + Stockholders equity.
Assets = Liabilities + Paid-in-capital +
Retained earnings.

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Dual Aspect (Concluded)

Transactions = events that affect
accounting records.
Every transaction has a dual impact on
accounting records.
Dual impact:
Results in maintenance of fundamental
accounting equation.
Double-entry system.
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Basic Concepts Income

Statements

Accounting period.
Conservatism.
Realization.
Matching.
Consistency.
Materiality.

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Nature of Income
Summarizes results of operations for a
period of time.
Flow report.
Flows are continuous.
Focuses on earnings activities (or
operating activities).
Reports nature and magnitude.

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Elements of Income
Statement
Revenues
Inflows or creation of assets that result from
sales of goods or services.

Expenses
Outflows or consumption of resources to
generate revenues.

Revenues - expenses = income = net

income (loss) = earnings = profit = net
earnings (loss).
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Concept #6:
Accounting Period
Net income for life of company:
= Money in - money out.

Accounting period:
Specified arbitrary interval of time.

Accounting year = fiscal year = calendar

year (if fiscal YE is 12/31).
Natural business year (1/31 for retailers).
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Operating and Cash

Conversion Cycles
The operating cycle is the length of time it takes a
companys investment in inventory to be collected in cash
from customers.
The net operating cycle (or the cash conversion cycle)
is the length of time it takes for a companys investment in
inventory to generate cash, considering that some or all of
the inventory is purchased using credit.
The length of the companys operating and cash
conversion cycles is a factor that determines how much
liquidity a company needs.
The longer the cycle, the greater the companys need for
liquidity.
Copyright 2013 CFA

17

Operating and Cash

Conversion Cycles

Operating Cycle

Copyright 2013 CFA

Cash Conversion Cycle

18

Interim Reports
Reports on periods less than fiscal year.
SEC requires quarterly.
Management may require monthly (or
weekly, or daily).

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Income and Owners Equity

Owners equity = Stockholders equity (for a
corporation) = Paid-in-capital + Retained
earnings.
RE = net income - dividends
Net income = Revenues - expenses
Increases RE:
Revenues and net income.

Decreases RE:
Expenses and net losses.
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Terminology Cautions
Read as not necessarily the same as:
Income revenue.
Net income increase in cash.
Retained earnings cash.

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Concept #7:
Conservatism
prudent reporting based on healthy
skepticism builds confidence in the
results....
Preference for understatement rather than
overstatement of assets and earnings
(and Owners equity).
If 2 estimates are equally likely, use the one
that results in smaller assets and earnings.
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Conservatism
More Formally Stated
Recognize revenues when reasonably
certain.
Recognize expenses when reasonably
possible.
Requires judgment.

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Application of Conservatism:
Inventory
How much should the following inventory
items be valued at 12/31:
Cost of item A is $500. We could sell item A
for $800.
Cost of item B is also $500. Because of a
new competitors product on the market, item
B can be sold for only $400.

Example of lower of cost or market (LCM).

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Application of Conservatism:
Revenue Recognition
Earning process is complete.
Sale of goods recognized when :
Goods are shipped.

Revenue from services recognized when:

Services are performed.

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Cash Receipts and

Revenue Recognition
Cash can be collected in the period before,
same as or after revenue is earned.
Precollected
Unearned revenue, a liability.

Collected after recognition

Sale on credit.
Accounts receivable (on BS).

Accrued revenue
E.g., interest receivable = Accrued interest
Earned but not yet received.

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Revenue Recognition
Exercise
For each of the following indicate how much
revenue is earned and the amount of
receivable or liability on the BS.
We sold subscriptions for $1,200. The magazines
will be sent next year.
We shipped goods for which the customer will
pay $1,500 next month.
On 9/30 we loaned $1,000. 8% interest and
principal are to be paid in one year. It is now
12/31.
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Concept #8:
Realization
Indicates amount of revenue that should
be recognized.
Conservatism concept indicates when
revenue should be recognized.

Recognize as revenue:
Amount that is reasonably certain to be
realized.

Realized = cash received.

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Realization Concept
Exercise
For each of the following, how much
revenue should be recorded:
The list price of the product sold to a customer is
$100,000. Because of the large quantity, we agreed
to a 15% discount off of list.
We are a retail store that sells for cash and on credit.
We sold $400,000 on credit last month. Based on
prior experience, we expect that we will eventually
collect about 97% of our sales.
We sold $10,000 of old product on credit. The
customer is very weak financially.
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Summary of
Determination of Revenue
Recognize revenue when:
Earned (Conservatism) and
Realized or realizable (Realization).

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Concept #9:
Matching
When an event affects both revenues and
expenses, the effect should be recognized
in the same accounting period.
First determine revenues for period.
Then expense matching items of cost.

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Terminology Related to
Expenses
Cost = a monetary measurement of the
amount of resources used for some
purpose.
Expenditure = a decrease in an asset or
increase in a liability.
Expense = an item of cost applicable to
the current accounting period.
Disbursement = a payment of cash.
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Criteria for Expense

Recognition
Direct matching: e.g. COGS.
Period costs: items of expense of an
accounting period that cannot be traced to
specific revenue transactions. e.g.
presidents salary.
Costs not associated with future revenue:
e.g. inventory determined to be obsolete
(unsalable).
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Expense Recognition
Exercise
Classify the following as (1) direct matching,
(2) period costs, or (3) costs not associated
with future benefits and indicate when
expensed:

Costs of goods sold.

Controllers salary.
Sales persons commission based on sales.
Inventory that just became obsolete.
Sales persons monthly salary.
Building lost in a fire.
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Expenses and Expenditures

Expenditures
Made by paying cash or incurring a liability.
Occur when acquiring goods or services.
Can be assets and/or expenses.
No necessary relationship between amounts
of expenditures and expenses.
Except over life of entity.

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Types of Expenditure &

Expense Transactions
1 Expenditures and expenses of same year.
2 Expenditures of prior year (assets at
beginning of year) that are expenses of this
year.
3 Expenditures of this year that are expenses
of future years (assets at end of year).
4 Expenses of this year that will be paid for in
future years (liabilities at end of year).
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Exercise
Which type of expenditure are each of the following?
Presidents salary; rent of sales office.
Inventory purchased last year & sold this.
Building purchased several years ago.
Insurance premium paid last year.
Costs of goods purchased or produced this year
but not yet sold.
Equipment purchases.
December salary of president not yet paid.
Interest expense on loan not yet paid.

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Dividends
Distribution of earnings to owners, not an
expense.
Cash dividends reduce cash and Retained
earnings by same amount.

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Gains and Losses

Not associated with routine operations.

Cash received (if any) less costs.
Gains increase RE (similar to revenues).
Losses decrease RE (similar to
expenses).
In practice, no sharp distinction between
gains and revenues and expenses and
losses.
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Concept #10:
Consistency
Once an accounting method is selected
use for all subsequent events of same
character.
Can change if there is sound reason to
change.
Must be disclosed to users.

Consistency overtime not over different

types of transactions.
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Concept #11:
Materiality
Insignificant events may be disregarded.
Amounts need not be exact as long as
inaccuracy would not affect decisions of
users.

Full disclosure of all important info.

Overriding concern: Would knowledge of
event affect decisions of users?
Application of judgment and common
sense.
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Income Statement
Also called: Profit & Loss statement = P&L
statement = statement of earnings =
statement of operations
Technically subordinate to BS.
Shows detail of changes to RE.

Many investors consider IS more

important than BS.
Variations in format.
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Parts of Income Statement

Heading:
1. Name of entity.
2. Name of statement
3. Time period covered.

Revenues.
Cost of Sales.
Gross Margin.
Expenses.
Net Income
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Revenues in Income
Statement
Several separate revenue items or net.
Net sales = gross sales - sales returns
and allowances - sales or cash discounts.
Trade discounts not shown.
Excludes sales or excise taxes collected for
government.
Other revenues (from activities not associated
with sales of entitys goods/services) may be
included in net sales or shown separately.
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Expenses on Income
Statement
Cost of Sales (or cost of goods sold).
Associated with a decrease in the asset inventory.

Gross margin = gross profit = Sales - COGS.

May or may not be shown.

Separate disclosure of:

Research & development expenses.
Interest expense.

1-45

Income Statement Format

Operating income may be shown before
Other revenues and expenses.
Income before taxes = Operating income
adjusted for other revenues and
expenses.
Net income = Income before taxes
Income tax expense.

1-46

Statement of Retained
Earnings
May be presented at bottom of Income
Statement.
Reconciles change in RE from beginning
(i.e. end of last period) to end of this period.
Beg. RE + NI - Div = End. RE
Articulates BS and IS.
NI from IS (less dividends) explains changes in
RE.
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Concepts of Income
Accrual accounting: GAAP, focus of text.
Cash-basis accounting.
Cash receipts (revenues) - cash payments
(expenses).

Modified cash-basis accounting.

E.g. cash basis except for inventory and longlived assets.

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Concepts of Income
(Continued)
Income Tax Accounting
Similar but not identical to accrual/GAAP.
Objectives differ from GAAP.

Pro forma earnings

Alternative to GAAP; excludes item(s) management
deems to be nonrecurring.

Economic Income.
Value at end - value at beginning return on invested
capital.
Considers cost of using owners investment as an
expense.
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Accounting for Changing

Prices
Not required by U.S. GAAP.
Required in some countries with high rates of
inflation.
Used by some multinational companies for internal
performance measurement.
Previously required by U.S. GAAP in supplemental
disclosures.

Ignoring changing prices during periods of

inflation tends to:
Overstate return on investment.
Makes comparisons between companies difficult.
1-50

Approaches to Accounting for

Price Changes
Constant dollar accounting
Adjust for general price changes.
Restates financial statements to purchasing
power equivalent as of a common date.

Current cost accounting

Costs adjusted to their replacement cost or
specific prices.

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