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CHAPTER 2. ACCRUAL ACCOUNTING AND INCOME DETERMINATION. Authored by Brian Leventhal University of Illinois at Chicago. I. Cash Versus Accrual Income Measurement. A. Accrual-basis income measurement is the cornerstone of income measurement.

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chapter 2

CHAPTER 2

ACCRUAL ACCOUNTING AND INCOME DETERMINATION

Authored by Brian Leventhal

University of Illinois at Chicago

i cash versus accrual income measurement
I. Cash Versus Accrual Income Measurement

A. Accrual-basis income measurement is the cornerstone of income measurement.

  • 1. Revenues are recorded in the period when they are “earned” and become “measurable.”
  • a. Revenues are “earned” when the seller has performed a service or conveyed an asset to a buyer.
  • b. Revenues are “measurable” when the value to be received for that service or asset is reasonably assured and can be measured with a high degree of reliability.
i cash versus accrual income measurement3
I. Cash Versus Accrual Income Measurement

2. Expenses are the expired costs or assets “used up” in producing those Revenues

  • and they are recorded in the same accounting period in which the Revenuesarerecognized.(Matching Principle)
  • Can you think of examples of expenses?
i cash versus accrual income measurement4
I. Cash Versus Accrual Income Measurement
  • 3. Accrual accountingdecouplesmeasuredearnings (e.g., revenues less expenses) from the amount of cash generated from operations.
  • a. Accrual accountingRevenues generally do not correspond to cash receipts for the period, nor do reported Expenses always correspond to cash outlays of the period.
i cash versus accrual income measurement5
I. Cash Versus Accrual Income Measurement

b. Accrual accounting can produce large discrepanciesbetweenmeasured earnings and the amount of cash generated from operations.

3. Accrual accountingdecouplesmeasuredearnings (e.g., revenues less expenses) from the amount of cash generated from operations.

i cash versus accrual income measurement6
I. Cash Versus Accrual Income Measurement

3. Accrual accountingdecouplesmeasuredearnings (e.g., revenues less expenses) from the amount of cash generated from operations.

c. Accrual accounting earnings provide a more accurate measure of the economic value added during the period than do operating cash flows.

i cash versus accrual income measurement7
I. Cash Versus Accrual Income Measurement

B. Cash-basis income measurement is straightforward.1. Revenues are recorded when cash is received.2. Expenses are recorded when cash is paid.

i cash versus accrual income measurement8
I. Cash Versus Accrual Income Measurement
  • 3. Because of differences in the timing of when cash inflows and cash outflows occur, cash-basis income determination may distort one’s view of operating performance.
  • a Cash-basis incomefails to properly matcheffort & accomplishment.
  • b Cash-basis income may not provide a reliable benchmark for predictingfuture operating results
i cash versus accrual income measurement9
I. Cash Versus Accrual Income Measurement

Let’s look at an example:

C. Canterbury Publishing : 1. There are several “facts” to consider.

  • a. Canterbury sells three-year subscriptions of a quarterly publication to subscribers, who prepay the full subscription price. $300,000
  • b. Canterbury takes out a three-year loan at the beginning of the three-year subscription period, but interest is payable at maturity of the loan. ($30,000)
  • c. Costs to publish and distribute the magazine are paid in cash at the time of publication. ($60,000)
i cash versus accrual income measurement10
I. Cash Versus Accrual Income Measurement

Cash Basis Income Determination

2001 2002 2003

What happens in Year 1?

Cash Inflows

Cash outflows

for Prod. & Distr.

Cash Outflow

for interest on loan

Net Income (loss)

Cash Basis

$300,000

(60,000)

What do you think of the results?

0

$240,000

slide11

I. Cash Versus Accrual Income Measurement

Cash Basis Income Determination

2001 2002 2003

What happens in Year 2?

$ 0

$300,000

Cash Inflows

Cash outflows

for Prod. & Distr.

Cash Outflow

for interest on loan

Net Income (loss)

Cash Basis

(60,000)

(60,000)

What do you think of the results?

0

0

$240,000

($60,000)

slide12

I. Cash Versus Accrual Income Measurement

Cash Basis Income Determination

2001 2002 2003

What happens in Year 3?

$ 0

$ 0

$300,000

Cash Inflows

Cash outflows

for Prod. & Distr.

Cash Outflow

for interest on loan

Net Income (loss)

Cash Basis

(60,000)

(60,000)

(60,000)

What do you think of the results?

What might you think of doing to the business?

0

0

(30,000)

$240,000

($60,000)

($90,000)

slide13

I. Cash Versus Accrual Income Measurement

Cash Basis Income Determination

Cash-basis income determination distortsCanterbury’s operating performance.

2001 2002 2003

What happens in Year 3?

Notice total of all 3 years : Net Income is $90,000

$ 0

$ 0

$300,000

Cash Inflows

Cash outflows

for Prod. & Distr.

Cash Outflow

for interest on loan

Net Income (loss)

Cash Basis

(60,000)

(60,000)

(60,000)

Noneof thecash-basis earningsfigures providesareliable benchmarkfor predictingfuture operating results.

0

0

(30,000)

$240,000

($60,000)

($90,000)

slide14

I. Cash Versus Accrual Income Measurement

Now let’s take a look at Income Measurement using Accrual Basis accounting !!

slide15

I. Cash Versus Accrual Income Measurement

$300,000/3 = $100,000 per year

$200,000 of Revenue is deferred

Cash Expenses may also equal Accrual Expenses if used and paid in same period

Accrual Basis Income Determination

2001 2002 2003

What happens in Year 1?

Accrual Revenues

Accrual Expenses

for Prod. & Distr.

Accrual Interest Expense

for the loan

Net Income (loss)

Accrual Basis

$100,000

$30,000/3 = $10,000 per year

(60,000)

(10,000)

What do you think of the results?

$30,000

slide16

$300,000/3 = $100,000 per year

$100,000 of Revenue is still deferred

I. Cash Versus Accrual Income Measurement

Accrual Basis Income Determination

2001 2002 2003

What happens in Year 2?

Accrual Revenues

Accrual Expenses

for Prod. & Distr.

Accrual Interest Expense

for the loan

Net Income (loss)

Accrual Basis

$100,000

$100,000

What do you think of the results?

(60,000)

(60,000)

(10,000)

(10,000)

$30,000

$30,000

slide17

I. Cash Versus Accrual Income Measurement

Accrual Basis Income Determination

2001 2002 2003

What happens in Year 3?

Accrual Revenues

Accrual Expenses

for Prod. & Distr.

Accrual Interest Expense

for the loan

Net Income (loss)

Accrual Basis

What do you think of the results?

What might you think of doing to the business?

$100,000

$100,000

$100,000

(60,000)

(60,000)

(60,000)

(10,000)

(10,000)

(10,000)

$30,000

$30,000

$30,000

slide18

Accrual-basis income determination alleviates the mismatching problems that exist under cash-basis accounting.

I. Cash Versus Accrual Income Measurement

Accrual Basis Income Determination

These modifications to the cash-basis results are made via a series of adjusting entries.

2001 2002 2003

What happens in Year 3?

Accrual Revenues

Accrual Expenses

for Prod. & Distr.

Accrual Interest Expense

for the loan

Net Income (loss)

Accrual Basis

$100,000

$100,000

$100,000

Accrual accounting better matcheseconomic benefit with economic effort thereby producing a measure of operating performance that provides a more realistic picture of past economic activities.

(60,000)

(60,000)

(60,000)

(10,000)

(10,000)

(10,000)

Notice total of all 3 years Net Income is $90,000

$30,000

$30,000

$30,000

ii measuring profit performance rev exp
II. Measuring Profit Performance: Rev & Exp
  • A. Income is earned as the result of several activities.
  • 1. The critical issue then becomes the timing of income recognition.
ii measuring profit performance rev exp20
II. Measuring Profit Performance: Rev & Exp

A. Income is earned as the result of several activities.

  • 2. The accounting process of recognizing income is comprised of two distinct steps.
  • a. The revenue recognition principle establishes when revenue is recorded.
  • b. The recognition of revenue then triggers the second step— the matching against revenue the costs that expired (were used up) in generating revenue.
slide21

II. Measuring Profit Performance: Rev & Exp

A. Income is earned as the result of several activities.

  • 3. Revenue recognition and matchingeffect changes in the asset and liability accounts on the balance sheet.(The Actg. Equation must balance!)
  • a. The basic accounting equation Assets = Liabilities + Owners’ Equity can illustrate this point.
slide22

II. Measuring Profit Performance: Rev & Exp

A. Income is earned as the result of several activities.

  • i. Revenue recognitionincreasesnet assets (i.e., gross assets - gross liabilities) and owners’ equity by identical amounts.
  • 3. Revenue recognition and matchingeffect changes in the asset and liability accounts on the balance sheet.(The Actg. Equation must balance!)

Assets = Liabilities + Owners’ Equity

+Cash $130

+ Sales Rev $130

or

+A/R $130

slide23
ii. Expensematchingdecreasesnet assets and owners’ equity by identical amounts.

II. Measuring Profit Performance: Rev & Exp

A. Income is earned as the result of several activities.

  • 3. Revenue recognition and matchingeffect changes in the asset and liability accounts on the balance sheet.(The Actg. Equation must balance!)

Assets = Liabilities + Owners’ Equity

-Inventory $100

- COGS $130

slide24

II. Measuring Profit Performance: Rev & Exp

A. Income is earned as the result of several activities.

  • b. As a result, net asset valuation and income determination are inextricably intertwined.
  • 3. Revenue recognition and matchingeffect changes in the asset and liability accounts on the balance sheet.(The Actg. Equation must balance!)

Assets = Liabilities + Owners’ Equity

ii measuring profit performance rev exp25
II. Measuring Profit Performance: Rev & Exp

B. A closer look at the revenue recognition criteria.

  • 1. The “critical event”--- (“Condition 1” Revenue has been earned) varies from industry to industry.
ii measuring profit performance rev exp26
II. Measuring Profit Performance: Rev & Exp

B. A closer look at the revenue recognition criteria.

  • 2. Measurability (“Condition 2”) must be based on objective and verifiableevidence.
ii measuring profit performance rev exp27
II. Measuring Profit Performance: Rev & Exp

B. A closer look at the revenue recognition criteria.

  • 3. In most instances the point of sale is the earliest moment in time that the critical event(Earned) in the process of earning the revenue has taken place.
  • The amount that will be collected is reasonably assured and is measurable with a reasonable degree of reliability.
  • This is the dominant practice in most retail and manufacturing industries.
slide28

Figure 2.2 The Revenue Recognition Process: Industries Recognizing Revenue at Indicated Phases

Revenues may also be recognized at other times besides the

point of sale.

ii measuring profit performance rev exp29
II. Measuring Profit Performance: Rev & Exp
  • B. A closer look at the revenue recognition criteria.
  • 4. Under the percentage-of-completion method (see Chapter 3), Conditions 1 and 2 are satisfied prior to the point of sale (i.e., transfer of title).
    • a. Condition 1 (critical event) is satisfied over time as the project progresses.
    • b. Condition 2 (measurability) is satisfied since a firm contract with a known buyer at a set price exists.
ii measuring profit performance rev exp30
II. Measuring Profit Performance: Rev & Exp

B. A closer look at the revenue recognition criteria.

  •   Normally, once gross revenues for the period are determined, the next step in determining income is to accumulate and record the costs associated with generating those revenues.
  • However, under the percentage-of-completion method, it is the recognition of expenses that drives the recognition of revenues.
measuring profit performance rev exp
Measuring Profit Performance: Rev & Exp

B. A closer look at the revenue recognition criteria.

  • 5. Under the installment sales method (see Chapter 3),
  • Conditions 1 and 2 may not be satisfied until after the point of sale
  • —for instance, until cash is collected.
ii measuring profit performance rev exp32
II. Measuring Profit Performance: Rev & Exp
  • B. A closer look at the revenue recognition criteria.
  • 6. Revenue is recognized during the production phase when:a. A specific customer is identified and an exchange price is agreed upon.b. A significant portion of the services to be performed has been performed, and the expected costs of future services can be reliably estimated.c. An assessment of the customer’s credit standing permits a reasonably accurate estimate of the amount of cash that will be collected.
ii measuring profit performance rev exp33
II. Measuring Profit Performance: Rev & Exp

B. A closer look at the revenue recognition criteria.

  • 7. Revenue may be recognized on completion of production when:
  • a. The product is immediately saleable at quoted market prices.
  • b. The units are homogeneous.
  • c. No significant uncertainty exists regarding the costs of distributing the product.
ii measuring profit performance rev exp34
II. Measuring Profit Performance: Rev & Exp

B. A closer look at the revenue recognition criteria.

8. Revenue is recognized after the point of sale when one or more of the following conditions are present:a. Extreme uncertainty exists regarding the amount of cash to be collected from customers. This uncertainty may be attributable to:i. The precarious financial position of the customer.ii. Contingencies in the sales agreement that allow the buyer or seller to terminate the exchange.iii. The customer has (and frequently exercises) the right to return the product.b. Future services to be provided are substantial, and their costs cannot be estimated with reasonable precision.

ii measuring profit performance rev exp35
II. Measuring Profit Performance: Rev & Exp

1. The recognition of expensesgenerallyfollows the recognition of revenue.

C. Matchingexpenses with revenues.

ii measuring profit performance rev exp36
II. Measuring Profit Performance: Rev & Exp

C. Matchingexpenses with revenues.

  • 2. Traceable (product) costs are costs that contributedirectly to a particular sale or to revenues of a particular period.
  • a. These costs are recorded as expenses in the same period that revenues are recognized.
  • b. An example of product costs is costs of goods sold.
slide37

II.Measuring Profit Performance:Rev & Exp

C. Matchingexpenses with revenues.

  • 3. Period costs are important in generatingrevenue, but their contribution to a specific sale or to revenues in a particular period is more difficult to quantify.
  • a. These costs are associated with the time period in which they occur.
  • b. An example of period costs is advertising expense.
slide38

Figure 2.3 Cash Flow Diagram

II.Measuring Profit Performance:Rev & Exp

Example of Matching Expense with Revenue:

Actual Cash Flows

slide39

Figure 2.4 Revenue Recognition and Expense Matching

II.Measuring Profit Performance:Rev & Exp

Example of Matching Expense with Revenue:

Accrual Basis

iii income statement format and classification
III. Income Statement Format and Classification

A. Multiple-step income statement is intended to subdivideincome in a manner that facilitates the forecasting of future cash flows.

1. Virtually all decision models in modern corporate finance are based on future cash flows.

slide41

Income Statement GeographyMythical Corporation

2. The intent of this format is to classify separatelyincome components that are “transitory” and to clearly differentiate them from income components believed to be “sustainable” or likely to be repeated in future reporting periods.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

slide42

Income Statement GeographyMythical Corporation

  • This format isolates a key figure called income from continuing operations.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

  • a. Ideally, this component of income should include only the normal, recurring, presumably more sustainable, ongoing economic activities of the entity.

“Above the line”

“Below the line”

slide43

Income Statement GeographyMythical Corporation

  • This format isolates a key figure called income from continuing operations.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

b. This income number sometimes includesgains and losses that occur infrequently—called special or unusual items—but that arise from a firm’s ongoing, continuing operations.

“Above the line”

“Below the line”

Example:

Restructuring charges

slide44

Income Statement GeographyMythical Corporation

  • This format isolates a key figure called income from continuing operations.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

“Above the line”

c. Therefore, income from continuing operations is intended to serve as a starting point for forecasting future profits.

“Below the line”

slide45

Income Statement GeographyMythical Corporation

4. Nonrecurring items are transitory and are disclosed separatelybelow the income from continuing operations line.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

“Above the line”

“Below the line”

slide46

Income Statement GeographyMythical Corporation

B. Nonrecurring items, including discontinued operations, extraordinary losses, and the cumulative effect of accounting changes, are reported belowincome from continuing operationsnet of income tax effects.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

Before Tax

“Above the line”

Tax Expense

“Below the line”

Net of Tax

slide47

Income Statement GeographyMythical Corporation

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

Before Tax

1.This “net of tax treatment” is called intraperiod income tax allocation.

“Above the line”

Tax Expense

“Below the line”

Net of Tax

slide48

Income Statement GeographyMythical Corporation

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

b. Mixing together the tax effect of continuing activities with the tax effect of single occurrence events would make it difficult for statement readers to forecast future tax outflows arising from ongoing events.

Before Tax

“Above the line”

Tax Expense

“Below the line”

Net of Tax

slide49

Income Statement GeographyMythical Corporation

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

2. Income tax associated with sustainable income from continuing operations is separately disclosed from taxesarising from the transitory items.

Before Tax

“Above the line”

Tax Expense

“Below the line”

Net of Tax

slide50

Income Statement GeographyMythical Corporation

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

C. Discontinued operations is a “separate major line of business or class of customer” whose assets and operating activities “can be clearly distinguished, physically and operationally and for financial reporting purposes”

Not normal disposals

slide51

Income Statement GeographyMythical Corporation

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

1. While gray areas exist, this rule prohibits firms from treatinglosses (and gains) on normal asset sales as discontinued operations.

Not normal disposals

slide52

Income Statement GeographyMythical Corporation

2. Two components of discontinued operations are reported:

a. “Gain or loss from operations (net of tax)” is always recorded, regardless of whether it is a gain or a loss, since the amount has been realized.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

slide53

Income Statement GeographyMythical Corporation

“Gain or loss on disposal (net of tax)” has two components:

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

  • (1) expected gain or loss on operations from the date a formal plan is adopted to discontinue operations to the disposal date, and
  • (2) expected gain or loss on the sale of assets.
slide54

Income Statement GeographyMythical Corporation

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

  • i. Expected net losses are always recorded.
  • Expected net gains can be recorded to the extent that they offset realized losses..
  • (Conservatism principle)
slide55

Income Statement GeographyMythical Corporation

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

3. A firm must disclose the identity of segment and details of disposal in the footnotes.

income statement geography mythical corporation
Income Statement GeographyMythical Corporation

Numbers in the box will not match those reported in the 2000 annual report, though the Net Income figure will match.

(Reclassification)

2001 2000

Net sales $3,957 $3,478

Cost of goods sold (1,364) (1,189)

Gross profit $2,593 $2,289

SG&A (1,093) (949)

Special or unusual charges (251) -----

Income from continuing operations

before tax expense $1,249 $1,340

Income tax expense (406) (436)

Income from continuing operations $843 $904

Discontinued operations:

Income, net of tax 203 393

Gain on disposal, net of tax 98 -----

Income before extraordinary item and

change in accounting principle $1,144 $1,297

Extraordinary loss, net of tax ----- (170)

Cumulative effect of change in accounting

principle, net of tax (118) -----

Net Income $1,026 $1,127

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Income Statement GeographyMythical Corporation

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

1. Extraordinary itemsmust meet both of the following criteria:

a. The underlying event or transaction must be unusual in nature.

b. The underlying event or transaction must be infrequent in occurrence, i.e., it must not reasonably be expected to recur in the foreseeable future.

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Income Statement GeographyMythical Corporation

  • 2. Events that meet one, but not both, of these criteria, are reported asincome from continuing operations.
  • If material in amount then the item must be disclosed as a separate item in the “Special or unusual items” section of the income statement..

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle$1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

Unusual or infrequent, but not both.

Both unusual and infrequent.

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Income Statement GeographyMythical Corporation

  • Analyst Tip:  In forecasting future cash flows, a reader of the financial statements must determine whether the “special or unusual items” are sustainable or transitory.
  • The increased occurrence of these items heightens the speculativenature of these forecasts.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations$843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax -----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

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III. Income Statement Format and Classification

  • b. To merge undisclosed losses as part of the “income from continuing operations” line would cause analysts to underestimate future income.
  • The converse is also true. To merge undisclosed gains as part of the “income from continuing operations” line would cause analysts to overestimate future income.
  • As a result, attention to other financial and nonfinancial information that is available may be useful in evaluating the sustainability of merged gains.
slide61

III. Income Statement Format and Classification

  • 4. A higher frequency of losses in the “discontinued operations” category exists because firms tend to sell off unprofitable operating segments and /or segments that have declined in value because of shifts in consumer demand.
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Income Statement GeographyMythical Corporation

F. Changes in accounting principles.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations $843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax

-----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

  • 1. Prior periods’ income statements generally are not restated to reflect the income effect of changing to a new principle.

“Default” method for changes.

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Income Statement GeographyMythical Corporation

F. Changes in accounting principles.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations $843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax

-----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

  • b. If retroactive adjustment is not made, accounting standards require the disclosure of
  • pro forma income figurescomputed“as if” the new accounting principle had been applied during all past periods that are presented.
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Income Statement GeographyMythical Corporation

F. Changes in accounting principles.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations $843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax

-----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

  • 2. The new principle is applied in computing income from continuing operations in the year of the change.
  • 3. The cumulative effect of the change (net of income tax effects) on all prior years’ income is shown as a separate line item at the bottom of the income statement for the year of change.
income statement geography depreciation change creates comparability problems
Income Statement GeographyDepreciation Change Creates Comparability Problems

Old depreciation

method used

Computed using new depreciation method

2001 2000

Net sales $3,957 $3,478

Cost of goods sold (1,364) (1,189)

Gross profit $2,593 $2,289

SG&A (1,093) (949)

Special or unusual charges (251) -----

Income from continuing operations

before tax expense $1,249 $1,340

Income tax expense (406) (436)

Income from continuing operations $843 $904

Discontinued operations:

Income, net of tax 203 393

Gain on disposal, net of tax 98 -----

Income before extraordinary item and

change in accounting principle $1,144 $1,297

Extraordinary loss, net of tax ----- (170)

Cumulative effect of change in accounting

principle, net of tax (118) -----

Net Income $1,026 $1,127

What conclusions can you make from looking at these numbers?

They are not

comparable because of the Change in

Accounting principle.

That’s why “pro forma”

data is needed!

?

?

income statement geography depreciation change creates comparability problems66
Income Statement GeographyDepreciation Change Creates Comparability Problems

2001 2000

Net sales $3,957 $3,478

Cost of goods sold (1,364) (1,189)

Gross profit $2,593 $2,289

SG&A (1,093) (949)

Special or unusual charges (251) -----

Income from continuing operations

before tax expense $1,249 $1,340

Income tax expense (406) (436)

Income from continuing operations $843 $904

Discontinued operations:

Income, net of tax 203 393

Gain on disposal, net of tax 98 -----

Income before extraordinary item and

change in accounting principle $1,144 $1,297

Extraordinary loss, net of tax ----- (170)

Cumulative effect of change in accounting

principle, net of tax (118) -----

Net Income $1,026 $1,127

?

Pro forma IFCO (new method)

$843 $871

?

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Income Statement GeographyMythical Corporation

F. Changes in accounting principles.

2001

Net sales $3,957

Cost of goods sold (1,364)

Gross profit $2,593

SG&A (1,093)

Special or unusual charges (251)

Income from continuing operations

before tax expense $1,249

Income tax expense (406)

Income from continuing operations $843

Discontinued operations:

Income, net of tax 203

Gain on disposal, net of tax 98

Income before extraordinary item and

change in accounting principle $1,144

Extraordinary loss, net of tax

-----

Cumulative effect of change in accounting

principle, net of tax (118)

Net Income $1,026

a. Retroactive adjustment is allowed when new accounting principles are mandated by a newly issued standard or when the cumulative adjustmentswamps the continuing operations income number.

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III. Income Statement Format and Classification

  • Changes in accounting principles generally do not result in direct changes in cash flows.
  • The only exception is a change from the LIFO method of accounting for inventory (because of the LIFO conformity rule).
  • Since changes in accounting principles generally do not affect the tax return, a change in principles used for financial reporting purposes affects only income tax expense and deferred income taxes.
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III. Income Statement Format and Classification

G. Accounting changes.

  • 1. Changes in accounting estimates.
  • a. Changes in accounting estimates are handled prospectively— i.e., accounted for in the year of change and in future periods.
  • b. A change occurs concurrently with a change in the economic circumstances underlying an accounting estimate.
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III. Income Statement Format and Classification

  • G. Accounting changes.
  • 1. Changes in accounting estimates.
  • Examples of changes in estimates:
    • uncollectible accounts
    • depreciable lives
    • warranty costs
    • pension obligations
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III. Income Statement Format and Classification

  • G. Accounting changes.
  • 1. Changes in accounting estimates.
  • How do we find out about these changes?
    • If material, the change and its effect will be disclosed.
    • No “bright-line” thresholds for materiality
    • We’ll see places where we might look for evidence of changes that are not disclosed.
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III. Income Statement Format and Classification

2. Change in reporting entity.

  • Comparative financial statements for prior yearsmust be restated for comparative purposes
  • to reflect the new reporting entity as if it had been in existence during all of the years presented.
iv comprehensive income
IV. Comprehensive Income
  • A. Selected unrealized gains (or losses) arising from incomplete (or open) transactions
  • sometimes bypass the income statement and are reported as direct adjustments to owners’ equity.
iv comprehensive income74
IV. Comprehensive Income
  • 1.“other comprehensive income,” include :
  • unrealized gains (losses) on “available-for-sale” marketable securities,
  • foreign currency translation gains (losses)
  • unrealized losses resulting from minimum pension obligations
iv comprehensive income75
IV. Comprehensive Income
  • 2. Items included in net income are considered to be closed transactions.
  • 3. Open transactions occur when balance sheet carrying amounts are changed even though the transaction is not yet closed.
    • For example, unrealized gains and losses on marketable securities are not closed because the securities have not been sold.
iv comprehensive income76
IV. Comprehensive Income
  • B. Comprehensive income is the net income from the traditional income statementplus or minus “other comprehensive income components.”
  • Now, Let’s look at an example!
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Example of Comprehensive Income Disclosure

From Intuit’s First Quarter 10Q for Fiscal year 1999:

As of August 1, 1998, Intuit adopted SFAS 130, "Reporting Comprehensive Income." SFAS 130 establishes new rules for the reporting and display of comprehensive net income and its components.

However, it has no impact on our net income or stockholders' equity as presented in our financial statements. SFAS 130requiresforeign currency translation adjustments and changes in the fair value of available for sale securities to be included in comprehensive income.

The components of comprehensive net income, net of tax, are as follows:

Three months ended October 31,

20001999

(In thousands)

Net loss $(12,759) $(49,190)

Unrealized gain (loss) on

marketable securities 58,133 (58,950)

Change in cumulative translation

adjustment 41 (4,409)

Comprehensive net income (loss) $45,415 $(112,549)