Accrual Accounting and Income Determination

1. Accrual Accounting and Income Determination Revsine/Collins/Johnson/Mittelstaedt: Chapter 2

2. Learning objectives • Cash-basis versus accrual income measurement. • How profit performance is measured: revenues, expenses, and the matching principle. • Income statement format and classification • The difference between basic and diluted earnings per share (EPS). • What is comprehensive income and formatting it under the joint FASB/IASB proposal. • Review basic accounting procedures and T-account analysis.

3. 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 expiredcosts—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

4. 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.

5. 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. Market the product Collect cash Receive order Deliver product Negotiate production contract Order material Manufactureproduct Measuring Profit Performance:Revenues and Expenses Operating Cycle

6. 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.

7. 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.

8. 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).

9. “Transitory” Earnings • Special or Unusual items • Discontinued Operations • Extraordinary items • The second and third must be shown net of taxes, with earnings per share (both basic and diluted) shown separately for each

10. 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.

11. 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: • Change in accounting principle. • Change in accounting estimate. • Change in reporting entity (see Chapter 16 for details).

12. Types of Changes

13. 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

14. 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.

15. Comprehensive Income and Other Comprehensive Income • Under current GAAP, OCI components fall into the following general categories:

16. Global Vantage Point 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 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

17. Global Vantage Point The sections categories and subcategories proposed for displaying information in the SFP, SCI, and SCF are summarized in Exhibit 2.12.

18. 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.

19. 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.