Accrual Accounting and Income Determination

Revsine/Collins/Johnson/Mittelstaedt: Chapter 2

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, All Rights Reserved.

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 why it is important. 6. Review basic accounting procedures and T-account analysis.

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Accrual accounting:
Under accrual accounting:

The cornerstone of income measurement

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 coststhe assets used up to produce revenuesand are recorded in the same accounting period in which the revenues are recognized. Expenses are matched to revenues! Net income = Revenues - Expenses

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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.

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Canterbury Publishing
In January 2008, 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 2010. 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: 2008 Subscriptions Loan interest $300,000 ($30,000) 2009 2010

Magazine costs

(60,000)

(60,000)

(60,000)

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Canterbury: Cash-basis income

Operating Cash Flow: 2008 Subscriptions $300,000 2009 2010

Loan interest
Magazine costs (60,000) (60,000)

($30,000)
(60,000)

Cash-basis entries for 2008:

DR Cash CR Subscription Revenues
Living.

$300,000 $300,000

To record collection of 1,000 three-year subscription at $300 each for Windy City

DR Publishing and distribution expenses CR Cash

$60,000 60,000
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To record publishing and distribution expense paid in cash.

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Canterbury: Cash-basis income

Cash-basis entries for 2009:
DR Publishing and distribution expense CR Cash
To record publishing and distribution expense paid in cash.

$60,000 $60,000

Cash-basis entries for 2010:

DR Publishing and distribution expense CR Cash
To record publishing and distribution expense paid in cash.

$60,000 $60,000 $30,000 $30,000

DR Interest expense CR Cash

To record interest expense paid on three-year loan. ($100,000 X .10 X 3 years= $30,000).
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Canterbury:

Cash-basis summary
Cash-Basis Income Determination 2008 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

2009
$0 (60,000) 0 ($60,000)

2010
$0 (60,000) (30,000) ($90,000)

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Canterbury:
Subscriptions

Accrual-basis summary
2008
$300,000
(200,000) $100,000 $100,000 $100,000

2009

2010

Deferred to future years Revenues recognized as earned

Expenses:
Magazine costs Interest accrued
(60,000) (60,000) (60,000)

(10,000)

(10,000)

(30,000) 20,000

Net Income

$30,000

$30,000

$30,000

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Canterbury:

Accrual adjusting entries

Adjusting entries on December 31,2008
DR Subscription revenue CR Deferred subscription revenue DR Interest expense CR Interest payable $200,000

$200,000
$10,000 $10,000 $100,000 $100,000 $10,000 $10,000

Adjusting entries on December 31,2009

DR Deferred subscription revenue CR Subscription revenue DR Interest expense CR Interest payable

Adjusting entries on December 31,2010

DR Deferred subscription revenue CR Subscription revenue
DR Interest expense DR Interest payable CR Cash
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$100,000
$100,000 $10,000 $20,000 $30,000
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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.

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Measuring Profit Performance:

Revenues and Expenses
According to GAAP, when are revenues and expenses to be recognized? Its a two step process! Step 1: Revenue recognition Step 2: Expense matching Revenue recognition and expense matching both produce changes to the balance sheet.
Deliver product
Negotiate production contract Order material

Operating Cycle
Market the product Receive order

Collect cash

Manufacture product

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Balance sheet effects

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Balance sheet effects:

Concluded
Two things happen when income is recognized in the financial statements:
1. Net assets (i.e., gross assets minus gross liabilities) are increased

by an identical amount. 2. Owners equity is increased by the amount of the income.

Thus there are two identical ways of thinking about income recognition:
ASSETS LIABILITES Income increases net assets

OWNERS EQUITY Income (revenues minus expenses) increases owners equity

Net asset valuation and income determination are inextricably intertwined.

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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.

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MSIA FRS-FRS 118 , para .14

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.

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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 customers credit standing permits a reasonably accurate estimate of the amount of cash that will be collected.

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Revenue recognition recap

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. FRS 6 - Exploration for and Evaluation of Mineral Resources
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Revenue recognition recap

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.
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Matching expenses with revenues:

Traceable costs (Cory TV and Appliance)

This example illustrates how product (traceable) costs are matched to revenues.

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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).

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Matching expenses with revenues:

Recap
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.

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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 IASB says financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows.. [IFRS No. 1]. The multi-step income statement separates transitory income items from those believed to be sustainable (likely to be repeated).

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Transitory Earnings
1. Special or Unusual items 2. Discontinued Operations 3. Extraordinary items All three must be shown net of taxes, with earnings per share (both basic and diluted) shown separately for each

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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 investments

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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).

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Extraordinary Items
Must be BOTH: Unusual
The underlying event or transaction possesses a high degree of abnormality, and taking into account the environment in which the company operates, that event or transaction is unrelated to the ordinary activities of the business.

Infrequent
The underlying event or transaction is a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the company operates. NOT APPLICABLE IN MSIA

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Frequency of nonrecurring items

Sample: NYSE/AMEX firms for 1992-2001

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How common are nonrecurring losses?

Conservative bias of accrual accounting.

Firms incentives to separately disclose and clearly label losses (but not gains)
Sample: NYSE/AMEX firms for 1992-2001

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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.

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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).

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Accounting changes
1. Changes in accounting estimates. a. Changes in accounting estimates are handled prospectivelyi.e., accounted for in the change and in future periods. b. A change occurs concurrently with a change in the economic circumstances underlying an accounting estimate. 2. Change in reporting entity. Comparative financial statements for prior years must be restated for comparative purposes to reflect the new reporting entity as if it had been in existence during all of the years presented.

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Accounting changes
Changes in accounting principles occurs when a firm voluntarily changes from one acceptable accounting method to another (voluntary change) or a new standard is promulgated by the MASB that must be implemented (mandatory change).

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Earnings per share

Basic EPS uses average common shares outstanding.

Income available to common shareholder Weighted-average common share outstanding

Diluted EPS allows for possible conversion of dilutive securities into common shares.

Chapter 15 has the details.

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Comprehensive income-starting 1/1/2010 FRS101

Gains and losses associated with closed transactions flow to the income statement. But unrealized gains and losses from open transactions flow directly to owners equity as other comprehensive income. There are five types of other comprehensive income items:
1. Unrealized gains and losses on available for sale marketable 2. 3. 4.

5.

securities (see Chapter 16). Unrealized foreign currency translation gains and losses (also Chapter 16). Some losses related to minimum pension obligations (see Chapter 14). Unrealized actuarial gains and losses on pension assets and liabilities and increases (decreases) in pension obligations due to prior service cost adjustments (see Chapter 14). Unrealized gains and losses associated with hedging certain risks (see Chapter 11).
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Comprehensive income:
Single statement format

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Comprehensive income:
Two-step statement format

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Comprehensive income:

Shareholders equity statement format

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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 eventfirm has earned the revenue. Measurabilityamount 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.

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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.
Unrealized gains (losses) from open transactions flow directly to sthareholders equity as Other Comprehensive Income.

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