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. Operating Cash Flow: 2011 2012 2013 Subscriptions $300,000 Loan interest ($30,000) Magazine costs (60,000) (60,000) (60,000) 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.

6. Operating Cash Flow: 2011 2012 2013 Subscriptions $300,000 Loan interest ($30,000) Magazine costs (60,000) (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.

7. Canterbury: Cash-basis income Cash-basis entries for 2012: DR Publishing and distribution expense $60,000 CR Cash $60,000 To record publishing and distribution expense paid in cash. Cash-basis entries for 2013: DR Publishing and distribution expense $60,000 CR Cash $60,000 To record publishing and distribution expense paid in cash. 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).

8. $0 $0 $300,000 (60,000) (60,000) (60,000) 0 0 (30,000) $240,000 ($60,000) ($60,000) Canterbury: Cash-basis summary Cash-Basis Income Determination 2011 2012 2013 Cash inflows Cash outflows for production and distribution Cash outflow for loan interest Net Income (loss)-Cash Basis

9. Expenses: Magazinecosts (60,000) (60,000) (60,000) Interest accrued (10,000) (10,000) (30,000) 20,000 Net Income $30,000 $30,000 $30,000 Canterbury: Accrual-basis summary 2011 2012 2013 Subscriptions $300,000 Deferred to future years (200,000) Revenues recognized as earned $100,000 $100,000 $100,000

10. Canterbury: Accrual adjusting entries Adjusting entries on December 31,2011 DR Subscription revenue $200,000 CR Deferred subscription revenue $200,000 DR Interest expense $10,000 CR Interest payable $10,000 Adjusting entries on December 31,2012 DR Deferred subscription revenue $100,000 CR Subscription revenue $100,000 DR Interest expense $10,000 CR Interest payable $10,000 Adjusting entries on December 31,2013 DR Deferred subscription revenue $100,000 CR Subscription revenue $100,000 DR Interest expense $10,000 DR Interest payable $20,000 CR Cash $30,000

11. 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.

12. 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

13. Balance sheet effects

14. Balance sheet effects: Concluded • Two things happen when income is recognized in the financial statements: • Owner’s equity is increased by the amount of the income. • 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

15. 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.

16. 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. U.S. GAAP vs. IASB

17. 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.

18. 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.

19. 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.

20. This example illustrates how product (traceable) costs are matched to revenues. Matching expenses with revenues: Traceable costs (Cory TV and Appliance)

21. 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).

22. 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.

23. 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).

24. “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

25. 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

26. 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.

27. 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 occurence The 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.”

28. Frequency of nonrecurring items Sample: NYSE/AMEX firms for 1999-2008

29. 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

30. 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.

31. 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).

32. Types of Changes

33. 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

34. 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.

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

36. Comprehensive income: Single statement format

37. Comprehensive income: Two-step statement format

38. Comprehensive income: Stockholders’ equity statement format

39. 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

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

41. 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.

42. 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.