Download ACCT303 Chapter 2 teaching pp

Accrual Accounting and Income Determination
(Sources: Financial Reporting & Analysis By Revsine, Collins, Johnson and
Mittelstaedt and Intermediate Accounting by Kieso Weygandt and Warfield)
Learning Objectives
 What is revenue recognition principle under
the accrual-basis accounting?
 How to apply the matching principle to
expense recognition under the accrualbasis? .
 How is income measured under the accrualbasis?
 What is the cash-basis accounting?
1
Learning Objectives (Contd.)





What are the distinctions between cashbasis and accrual-basis earnings?
Why is accrual-basis income generally a
better measure of operating performance?
Income statement format and classification.
How to report a change in accounting
principle, accounting estimate, and
accounting entity.
What is comprehensive income?
2
Learning Objectives :
• What is the revenue recognition principle
under the accrual-basis accounting?
• How to apply the matching principle to
expense recognition under the accrualbasis? .
• How is income measured under the
accrual-basis?
3
Measuring Profit ( Net income) Performance:
When to recognize revenues and expenses under the
GAAP (the accrual-basis)?
Operating Cycle



Step 1: Revenuer ecognition
Step 2: Expense matching
Step 3: Income Recognition
Market
the
product
Collect cash
Deliver
product
Net income =
Revenues - Expenses
Manufacture
product
Receive
order
Negotiate
production
contract
Order
material
4
Accrual Basis Accounting – Income Measurement

Step1: Revenues are “recognized” (recorded)
when:




Earned: The seller has performed a service or
conveyed an asset to the buyer; and
Measurable (Realizable): The value to be
received for that service or asset can be
measured with a high degree of reliability and
the collection is reasonably assured.
Step 2: Expenses are “matched” to revenues.
Step 3: Net income = Revenues - Expenses
5
Step 1: Determine the amount of revenue to be
recorded (revenue recognition).
Time of sale is used in
most industries
Condition 1: The critical event in the process of earning the
revenue has taken place. (Earned)
Condition 2: The amount of revenue that will be collected is
reasonably assured and is measurable with a
reasonable degree of reliability. (Measurability)
6
Step 2: Matching expenses with revenues
 Matching Principle: if revenues are
recognized in x1 period, all related
expenses (including both traceable and
period costs) should be recognized in the
same period.
7
Step 2: Matching expenses with revenues
(contd.)
 Traceable costs : The costs which can be
easily traced to the revenues. These traceable
costs also called product costs (i.e., the
cost of goods sold).
 Period costs: These costs are more difficult
to quantify their contribution to revenues of a
particular period.
Thus, period costs are expensed in the
period when they occur or consume (e.g.,
advertising costs, salary costs).
8
Matching Traceable costs (expenses)
with Revenues: (Cory TV and Appliance )
This example illustrates how product (traceable) costs are matched with
revenues.
9
Expense Period costs when they are
consumed
Suppose Cory TV also buys radio advertising for a monthly cost of
$120 beginning in February. This is a period cost (not product cost).
Period costs are expensed in the period when they are consumed.
10
Learning Objective :
• What is the cash-basis accounting?
• What are the distinctions between
cash-basis and accrual-basis income?
• Why is accrual-basis income generally
a better measure of operating
performance?
11
Cash Basis Income Measurement




Revenues are recognized upon the
receipts of cash.
Expenses are recognized when they are
paid in cash.
Cash flow inflows and outflows do not
reflect the true economic benefits (i.e.,
revenues) or efforts (i.e., expenses).
Revenues and expenses do Not match.
12
Summary of Accrual vs. Cash Basis
Accounting
n
Accrual-basis accounting: Revenues are
recognized when they earned and realizable,
not wait until cash is collected. Expenses are
recognized when they occur or are
consumed, not wait until they are paid for.
n
Cash-basis accounting: The accountant does
not record a transaction until cash is received
or disbursed.
13
Cash Versus Accrual Accounting

Carter Company has sales on account totaling
$100,000 per year for three years. Carter
collected $50,000 in the first year and $125,000
in the second and third years. The company
prepaid $60,000 for three years’ rent in the first
year. Utilities are $10,000 per year, but in the
first year only $5,000 was paid. In the second
year, the total of $15,000 was paid for the
utilities. Payments to employees are $50,000
per year.
Let’s look at the cash flows.
14
Cash Basis Cash
Accounting
flows in any one year may not be a
predictor of future cash flows.
Year 1
Cash receipts from
customers
$ 50,000
Summary of Cash Flows
Year 2
Year 3
$ 125,000
$ 125,000
Total
$ 300,000
Payment of 3
years' rent
(60,000)
-
-
(60,000)
Salaries to
employees
(50,000)
(50,000)
(50,000)
(150,000)
(5,000)
$ (65,000)
(15,000)
$ 60,000
(10,000)
$ 65,000
(30,000)
$ 60,000
Payments for
utilities
Net cash flow
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Accrual Accounting
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Cash Basis vs. Accrual Basis Accounting

Looking at the cash-basis and the
accrual-basis results for Carter Company,
which method would you want to use if
you were asked to make predictions about
future years’ operating performance?

Accrual-basis earnings is a more
accurate measure of performance than
is cash- basis earnings.
17
Cash Basis vs. Accrual Basis Accounting

Information about enterprise
earnings and its components
measured by accrual accounting
generally provides a better
indication of enterprise performance
than does information about current
cash receipts and payments.
( SFAC No. 1)
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Example: Whole Foods Market Inc.
Discrepancies between earnings (net income) and cash flows
Year
Net Income
Total Accruals
Cash Flows
1996
-17.23
17.58
0.35
1997
26.64
11.60
38.24
1998
45.40
30.94
76.33
1999
42.16
59.78
101.93
2000
28.93
57.44
86.36
2001
51.65
97.96
149.61
2002
84.49
89.32
173.81
2003
103.69
122.85
226.53
2004
132.66
145.19
277.85
2005
136.35
150.23
286.58
2006
203.83
208.94
412.76
Note: Amounts are in millions.
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Learning Objective :
Income statement format and
classification
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Income Statement
Usefulness
Evaluate past performance.
Predicting future performance.
Help assess the risk or uncertainty
of achieving future cash flows.
21
LO 1 Understand the uses and limitations of an income statement.
Income Statement
Limitations
Companies omit items that cannot
be measured reliably.
Income is affected by the
accounting methods employed.
Income measurement involves
judgment.
22
LO 1 Understand the uses and limitations of an income statement.
Single-Step Format
The single-step statement
consists of just two
groupings:
Revenues
Expenses
SingleStep
Net Income
No distinction between
Operating and Non-operating
categories.
Income Statement (in thousands)
Revenues:
Sales
Interest revenue
Total revenue
$ 285,000
17,000
302,000
Expenses:
Cost of goods sold
Selling expense
Administrative expense
Interest expense
Income tax expense
Total expenses
149,000
10,000
43,000
21,000
24,000
247,000
Net income
$ 55,000
Earnings per share
$
0.75
23
LO 2 Prepare a single-step income statement.
Multiple-Step Format
The presentation
divides information
into major sections.
1. Operating Section
2. Nonoperating
Section
3. Income tax
Income Statement (in thousands)
Sales
$ 285,000
Cost of goods sold
Gross profit
149,000
136,000
Operating expenses:
Selling expenses
Administrative expenses
Total operating expense
10,000
43,000
53,000
Income from operations
83,000
Other revenue (expense):
Interest revenue
Interest expense
Total other
Income before taxes
Income tax expense
Income from continuting operations
17,000
(21,000)
(4,000)
79,000
24,000
$ 55,000
Earnings per share
$
0.75
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LO 3 Prepare a multiple-step income statement.
Reporting Irregular Items
Irregular items fall into six categories
1. Unusual gains and losses.
2. Discontinued operations.
3. Extraordinary items.
Reported in the
Income Statement
4. Changes in accounting principle.
5. Changes in estimates.
6. Corrections of errors
Unusual gains and losses, discontinued operation results and
extraordinary items are also referred to as transitory items.
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LO 4 Explain how to report irregular items.
Reporting Irregular Items
Unusual Gains and Losses
Material items that are unusual or infrequent, but not
both, should be reported in a separate section just
above “Income from continuing operations before
income taxes” as part of the above the line income.
Examples can include:
Write-downs of inventories, equipment, etc.
Foreign exchange transaction gains and losses
Restructuring charges
Gains or losses from sale of investments
The Board prohibits net-of-tax treatment for these 26
LO 4 Explain how to report irregular items.
items.
Multiple-Step Format
The presentation
divides information
into major sections.
1. Operating Section
2. Nonoperating
Section
Sales
Cost of goods sold
Gross profit
$ 285,000
149,000
136,000
Operating expenses:
Selling expenses
Administrative expenses
Total operating expense
Income from operations
10,000
43,000
53,000
83,000
Other revenue (expense):
Interest revenue
Interest expense
17,000
(21,000)
Unusal Item:
(3,000)
Income before income taxes
76,000
Income tax expense
$ 24,000
Loss from inventory write-down
3. Income tax
Net Income
$ 52,000
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LO 3 Prepare a multiple-step income statement.
Income statement format and
classification


Multi-step income statements subdivide
income in a manner that helps analysts to
forecast future operating cash flows.
This format:
Separates operating from
nonoperating transactions .
 Separates “transitory” income items
from those believed to be
“sustainable” or “ permanent” (likely
to be repeated).

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Operating vs. Non-Operating
Items
 Operating
transactions: relating to the
day-to-day operations.
 Examples: sales, cost of sales, selling,
general and administrative expense,
research and development costs, etc.
 Non-operating: interest revenue,
dividends revenue, interest expense,
unusual items, etc.
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Reporting Irregular Items other than
the Unusual Items
Discontinued Operations occurs when,
(a) company eliminates (discontinues) the
results of operations and
cash flows of a component.
(b) there is no significant continuing involvement
in that component.
Amount reported “net of tax.”
Note: A component of an entity comprises operations and
cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from
LO 144).
4 Explain how to report irregular
the rest of the entity (SFAS
30
items.
Reporting Irregular Items
Discontinued Operations (contd.):
Examples of a component: a reportable
segment, an operating segment, a
reporting unit, a subsidiary, or an
asset group.
•
Other required treatment: 1) must
restate all presented periods with the
discontinued operations separated
reported, 2) the identity of the business
segment and the details of disposal must
be disclosed in footnotes
31
LO 4 Explain how to report irregular items.
Reporting Discontinued Operations –
Component Sold
Illustration: KC Corporation had after tax income from
continuing operations of $55,000,000 in 2008. During 2008, it
disposed of its restaurant division at a pretax loss of
$270,000. Prior to disposal, the division operated at a pretax
loss of $450,000 in 2008. Assume a tax rate of 30%. Prepare
a partial income statement for KC.
Income from continuing operations
$55,000,000
Discontinued operations:
Loss from operations, net of $135,000 tax
315,000
Loss on disposal, net of $81,000 tax
189,000
Total loss on discontinued operations
504,000
Net income
$54,496,000
LO 4 Explain how to report irregular items.
32
Reporting Discontinued Operations –Component
Sold
Discontinued Operations
are reported after
“Income from continuing
operations.”
Previously labeled as
“Net Income”.
Moved to
Income Statement (in thousands)
Sales
Cost of goods sold
$ 285,000
149,000
Other revenue (expense):
Interest revenue
Interest expense
Total other
Income before taxes
Income tax expense
Income from continuing operations
17,000
(21,000)
(4,000)
79,000
24,000
55,000
Discontinued operations:
Loss from operations, net of tax
315
Loss on disposal, net of tax
189
Total loss on discontinued operations
Net income
504
$
54,496
LO 4 Explain how to report irregular items.
33
Reporting Discontinued OperationsComponent Held for Sale
Reporting for Components Held For Sale
Operating income
or loss of the
component from
the beginning of
the reporting
period to the end of
the reporting
period.
An “impairment
loss” if the carrying
value of the assets
of the component
is more than the
fair value minus
cost to sell.
34
Reporting Discontinued Operations – Componet
Held for sale

Two components of
discontinued operations are
reported:


.
Gain or loss from
operations
Impairment loss
35
Reporting Irregular Items
Extraordinary items are nonrecurring material
items that differ significantly from a company’s
typical business activities.
Extraordinary Item must be both of an
Unusual Nature and
Occur Infrequently
Company must consider the environment in which it
operates.
Amount reported “net of tax.”
LO 4 Explain how to report irregular items.
36
Reporting Extraordinary Items
Are these items Extraordinary?
(a) A large portion of a tobacco manufacturer’s
crops are destroyed by a hail storm. Severe
damage from hail storms in the locality where
the manufacturer grows tobacco is rare.
(b) A citrus grower's Florida crop is damaged by
frost.
(c) A company sells a block of common stock of a
publicly traded company. The block of shares,
which represents less than 10% of the publiclyheld company, is the only security investment
the company has ever owned.
YES
NO
YES
LO 4 Explain how to report irregular items.
37
Reporting Extraordinary Items
Are these items Extraordinary?
(d) A large diversified company sells a block of
shares from its portfolio of securities which it
has acquired for investment purposes. This is
the first sale from its portfolio of securities.
NO
(e) An earthquake destroys one of the oil refineries
owned by a large multi-national oil company.
Earthquakes are rare in this geographical
location.
YES
(f) A company experiences a material loss in the
repurchase of a large bond issue that has been
outstanding for 3 years. The company regularly
repurchases bonds of this nature.
NO
LO 4 Explain how to report irregular items.
38
Reporting Extraordinary Items
Illustration: KC Corporation had after tax income from
continuing operations of $55,000,000 in 2007. In addition, it
suffered an unusual and infrequent pretax loss of $770,000
from a volcano eruption. The corporation’s tax rate is 30%.
Prepare a partial income statement for KC Corporation
beginning with income from continuing operations.
Income from continuing operations
Extraordinary loss, net of $231,000 tax
$55,000,000
539,000
Net income
$54,461,000
($770,000 x 30% = $231,000 tax)
LO 4 Explain how to report irregular items.
39
Reporting Extraordinary Items
Extraordinary Items
are reported after
“Income from continuing
operations.”
Previously labeled as
“Net Income”.
Moved to
Income Statement (in thousands)
Sales
Cost of goods sold
$ 285,000
149,000
Other revenue (expense):
Interest revenue
Interest expense
Total other
Income before taxes
Income tax expense
Income from continuing operations
17,000
(21,000)
(4,000)
79,000
24,000
55,000
Extraordinary loss, net of tax
Net income
539
$
54,461
LO 4 Explain how to report irregular items.
40
Reporting Irregular Items
Reporting when both
Discontinued Operations
and
Extraordinary Items
are present.
Income Statement (in thousands)
Sales
Cost of goods sold
Interest expense
Total other
Income before taxes
Income tax expense
$ 285,000
149,000
(21,000)
(4,000)
79,000
24,000
Income from continuing operations
55,000
Discontinued
Operations
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax
189
Total loss on discontinued operations
504
Extraordinary Item
Income before extraordinary item
54,496
Extraordinary loss, net of tax
Net income
539
####
LO 4 Explain how to report irregular items.
41
Income statement format:
Income from Continuing Operations


Ideally, this includes only
the normal, recurring,
“sustainable” ongoing
operating activities of the
firm.
(2) :
Gains and losses that
occur infrequently—
called:
“special” or “unusual”
items
“ The Line“
These items are included as part of income from continuing operations before tax
(sometimes referred to as being reported “ above the line”), they are not disclosed net of tax effects. 42
Income statement format:
Transitory items – below the line

Nonrecurring items
include:
1.
Special or unusual
items ( above the line)
2.
Discontinued
operations
3.
Extraordinary losses
and gains
“Below the line”
transitory items are
always shown net of
tax.
43
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
44
Reporting Irregular Items
Companies are required to report irregular items in
the financial statements so users can
Illustration 4-5
determine the long-run earning power
Number of Irregular
Items Reported in a
of the company.
Recent Year by 600
Large Companies
LO 4 Explain how to report irregular items.
45
Learning Objective :
How to report a change in accounting
principle, accounting estimate, and
accounting entity.
46
Accounting Changes
Type of Accounting
Change
Definition
Change in Accounting
Principle
Change from one GAAP method
to another GAAP method
(2)
Change in Accounting
Estimate
(3)
Change in Reporting
Entity
Revision of an estimate
because of new information or
new experience
Preparation of financial
statements for an accounting
entity other than the entity that
existed in the previous period
(1)
47
(1) Change in Accounting Principle
(SFAS 154)



Occurs when changing from one GAAP
method to another GAAP method
 For example, a change from LIFO to FIFO
Voluntary changes in accounting principles
are accounted for retrospectively by revising
prior years’ financial statements (for
comparability).
Changes in depreciation, amortization, or
depletion methods are accounted for the
same way as a change in accounting
estimate.
48
Retrospective Approach

Prior years’ financial
statements that are
presented for
comparative purposes
are restated.

Adjusted all accounts
balances to reflect what
those accounts would
have been under the new
method.
49
(2) Change in Accounting Estimate

Examples: Changes in the estimates of
 Inventory obsolescence.
 Uncollectible receivables.
 Useful lives and salvage values of assets.
 Liabilities for warranty costs and income
taxes.
 Change in depreciation methods.
50
Change in Accounting Estimate

Require “prospective” adjustment : Use
the new estimates in the current and future
periods (i.e., no restatements).

Past income is never adjusted.
Estimate changes are sometimes hard to
spot because they are NOT always
disclosed in footnotes.

51
Change in Accounting Estimate:
Example:
Change in Estimate: Arcadia HS, purchased equipment for
$510,000 which was estimated to have a useful life of 10 years
with a salvage value of $10,000 at the end of that time.
Depreciation has been recorded for 7 years on a straight-line
basis. In 2010 (year 8), it is determined that the total
estimated life should be 15 years with a salvage value of
$5,000 at the end of that time.
Questions:


What is the journal entry to correct the prior
No years’
Entry
Required
depreciation?
Calculate the depreciation expense for
2010.
52
2. Change in Estimate ExampleAfter 7 years
Equipment cost
Salvage value
Depreciable base
Useful life (original)
Annual depreciation
$510,000
First, establish
- 10,000
NBV at date of
change in estimate.
500,000
10 years
$ 50,000 x 7 years = $350,000
Balance Sheet (Dec. 31, 2009)
Fixed Assets:
Equipment
Accumulated depreciation
$510,000
350,000
Net book value (NBV)
$160,000
53
2. Change in Estimate ExampleAfter 7 years
Net book value
Salvage value (new)
Depreciable base
Useful life remaining
Annual depreciation
$160,000
5,000
155,000
8 years
$ 19,375
Depreciation
Expense calculation
for 2010.
Journal entry for 2010
Depreciation expense
Accumulated depreciation
19,375
19,375
54
Learning Objective :
Comprehensive Income
55
Comprehensive income


The change in equity excluding owner
related transactions such as investments
from owners and dividends distribution.
Components of Comprehensive income:
 Net income.
 Other comprehensive income items:
Gains and losses which bypass income
statement and are reported directly
in the stockholders’ equity of the
balance sheet statement.
56
Comprehensive income(contd.)

Examples of “other comprehensive
income” items:
1. Unrealized gains (losses) from
valuation of investments.
2. Gains (losses) of foreign currency
translation adjustments.
3. Unrealized gains and losses associated
with derivatives.
4. Gains (losses) from amendments to
pension plans.
57
Special Reporting Issues
Three approaches to reporting Comprehensive
Income (SFAS No. 130, June 1997):
1. A second separate income statement;
2. A combined income statement of
comprehensive income; or
3. As part of the statement of stockholders’
equity
LO 8 Explain how to report other comprehensive income.
58
Special Reporting Issues
Comprehensive
Income
Illustration 4-19
Second
income
statement
LO 8 Explain how to report other comprehensive income.
59
Special Reporting Issues
Comprehensive
Income
Combined
income
statement
V. Gill Inc.
Combined Statement of Comprehensive Income
For the Year Ended December 31, 2010
Sales revenue
$ 800,000
Cost of goods sold
600,000
Gross profit
200,000
Operating expenses
90,000
Net income
110,000
Unrealized holding gain, net of tax
30,000
Comprehensive income
$ 140,000
LO 8 Explain how to report other comprehensive income.
60
Special Reporting Issues
Comprehensive Income - Statement of Stockholder’s Equity
Illustration 4-20
LO 8 Explain how to report other comprehensive income.
61
Special Reporting Issues
Comprehensive Income - Balance Sheet Presentation
Illustration 4-21
Regardless of the display format used, the accumulated other
comprehensive income of $90,000 is reported in the stockholders’
equity section of the balance sheet.
LO 8 Explain how to report other comprehensive income.
62
Summary

Differences between cash-basis and
accrual-basis 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.
63
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Summary (contd.)



Product costs are matched to their
traceable revenues, period costs are
expensed as the assets are used up.
Multi-step income statements
highlight nonrecurring (“transitory”)
items.
GAAP disclosures for accounting
changes aid comparisons of
performance over time.
64
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Summary (contd.)


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.
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2-65