Assets: The Accrual Concept INCOME, CASH FLOW, ANDASSETS: DEFINITION AND RELATIONSHIP 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 income. DISTRIBUTABLE EARNINGS: Are defined as 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. THE ACCRUAL CONCEPT OF INCOME 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
(GAAP) THE MATCHING PRINCIPLE
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. INCOME STATEMENT FORMAT & CLASSIFICATION 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 formats: 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. COMPONENTS OF NET INCOME
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 operations 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 operations (+/-) Income from discontinued operations ( net of tax) (+/-) Extraordinary items ( net of tax) (+/-)Cumulative effect of accounting changes (net of tax) = NET INCOME RECURRRING versus NONRECURRING ITEMS 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. RECURRRING versus NONRECURRING ITEMS Segregation of the results of normal, recurring operations from the effects of nonrecurring items facilitates the forecasting of future earnings and cash flows,
Financial reporting defines nonrecurring
by the type of transaction or event . ACCOUNTING INCOME REVENUE & EXPENSE RECOGNITION
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 realizability:
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 contract 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 operational 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 NONRECURRING ITEMS 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 operations. 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 amount. 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 disclosures. Discontinued Operations
The discontinuation or sale of a business may
indicate that it: Has inadequate or uncertain markets or prospects 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 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 time. 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. LIMITATONS OF THE 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 inclusion. 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. LIMITATONS OF THE BALANCE SHEET
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 be:
* Fixed
*Floating rate
*Tied to amounts declared for common
stock
*Callable by issuer; call price must be
disclosed *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.