A2 - 1 Accounting Income and Assets: Accrual Concept

A2 - 2 Chapter Objectives Discuss the accrual principle of accounting Review the format and classification of the income statement List and discuss the components of the income statement Describe the criteria for revenue and expense recognition Discuss major issues in revenue and expense recognition, and how they affect reported earnings. Discuss the revenue recognition method used for selected industries. Review the types of nonrecurring items, including extra ordinary items, discontinued operations, the cumulative effect of accounting changes, and prior period adjustments. Discuss the significance of nonrecurring items to firm valuation. Discuss the concept of earning quality.

A2 - 3 Income, Cash Flow, and Assets: Definition And Relationship In a world of uncertainty, the relationship among income, cash flow, and assets is captured by the concept of economic earnings. Economic Earning, defined as net cash flow plus the change in market value of the firm’s net assets. The market value of the firm’s assets in this certain world is equal to the present value of their future cash flows discounted at the (risk free) rate. In this world of uncertainty, income (however measured) is, at best, only a proxy for economic income.

A2 - 4 Distributable Earnings, defined as the amount of earnings that can be paid out as dividends without changing the value of the firms. Sustainable Income, refers to the level of income that can be maintained in the future given the firm’s stock of capital investment (e.g., fixed assets & inventory) Permanent Earnings, used by analysts for valuation purposes is the amount that can be normally earned given the firm’s assets and equals the market value of those assets times the firm’s required rate of return. Income, Cash Flow, and Assets: Definition And Relationship, contt..

A2 - 5 As a result of these difficulties, the financial reporting concept of income- accounting income – is often quite different. The analyst, therefore, needs to relate accounting income to the economic income. Accounting Income, is measured using the accruals concept and provides information about the ability of the enterprise to generate future cash flows. Income, Cash Flow, and Assets: Definition And Relationship, contt..

A2 - 6 The Accrual Concept of Income Accounting and economic income both define income as the sum of cash flows and changes in net assets. However, in financial reporting, the determinants of Which cash flows are included in income and when Which changes in asset and liability values are included in income How and when the selected changes in assets and liability values are measured Are based on accounting rules and principles – (GAAP)

A2 - 7 The Matching Principle Revenue and expense recognition are also governed by the Matching Principle, which states that operating performance can be measured only if related revenues and expenses are accounted for during the same time period. It is the matching principle that requires the expense (cost of goods sold) of inventory to be recognized in the same period in which the sale of that inventory is recorded.

A2 - 8 Income Statement Format & Classification Actual formats vary across companies, especially in the reporting of the gain or loss on sale of assets, equity in earnings of affiliates and other non-operating income and expense. In some cases, income statement detail appears in financial statement footnotes. IAS Presentation Requirements: IAS 1 specifically allows for presentation of the income statement in either of two formats: 1. Classification of expenses by function. 2. Classification of expenses based on their nature. Under this alternative, the company reports expenditures using categories such as raw materials, employees, and changes in inventories.

A2 - 9 Components of Net Income The format typically found in actual statement may not be the most useful for analytical purposes. It is important for the analyst to be cognizant of the various categories or groupings into which the income statement components can be combined. These grouping do not necessarily coincide with the classifications presented in actual financial statements.

A Suggested Format Revenues from sale of Goods & services (-) Operating Expenses = Operating income from continuing operations (+) Other income & Revenues = Recurring income before interest and taxes from continuing operations (-) Finance cost = Recurring (pretax) income from continuing operations (+/-) Unusual or infrequent items = Pretax earnings from continuing operations (-) Income tax expense = Net income from continuing operations

A Suggested Format, cont, = Net income from continuing operations (+/-) Income from discontinued operations ( net of tax) (+/-) Extraordinary items ( net of tax) (+/-) Cumulative effect of accounting changes (net of tax) = Net income

A Recurring Versus Nonrecurring Items Income from a firm’s recurring operating activities is considered the best indicator of future income. The predictive ability of reported income is enhanced if it excludes the impact of transitory or random components, which are not directly related to operating activities and are generally more volatile. Segregation of the results of normal, recurring operations from the effects of nonrecurring items facilitates the forecasting of future earnings and cash flows, Financial reporting defines nonrecurring by the type of transaction or event.