4 The Income Statement and Income Recognition Accounting School · Zhongnan University of Economics & Law ntermediate Accounting ntermediate Accounting I 中级会计学

1. Concepts of income Intermediate Accounting 4 The Income Statement and Income Recognition Capital Maintenance Concept Under this concept, corporate income for a period of time is the amount that may be paid to stockholders during that period and still enable the corporation to be as well off at the end of the period as it was at the beginning.

Assume a corporation has net assets of $50,000 at the beginning and $90,000 at the end of the year, and that no additional investments or withdrawals were made. Ending net assets$90,000 Less: Additional investment 0 Ending net assets excluding investment$90,000 Less: Beginning net assets(50,000) Total income for the year$40,000 The corporation could pay out $40,000 to stockholders and still be as well off at year-end. Example of Capital Maintenance Intermediate Accounting 4 The Income Statement and Income Recognition

Transactional Approach Under this concept, a company records its net assets at their historical cost, and it does not record changes in the asset and liabilities unless a transaction, event, or circumstance has occurred that provides reliable evidence of a change in value. Intermediate Accounting 4 The Income Statement and Income Recognition

2. Elements of the Income Statement  In FASB Statement of Concepts No. 6, the FASB defined the elements or "building blocks" of the income statement: Revenues Expenses Gains Losses Intermediate Accounting 4 The Income Statement and Income Recognition

Elements of the Income Statement — Revenues Revenues are inflows of assets of a company or settlement of its liabilities during a period from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major or central operations. Revenue recognition is the process of formally recording and reporting an item in a company’s financial statements. Intermediate Accounting 4 The Income Statement and Income Recognition

Elements of the Income Statement — Expenses Expenses are outflows of assets of a company or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that are the company’s ongoing major or central operations. Intermediate Accounting 4 The Income Statement and Income Recognition

Elements of the Income Statement — Gains Gains are increases in a company’s equity (net assets) from peripheral or incidental transactions of the company and from all other events and circumstances affecting the company during a period except those that result from revenues or investments by owners. Intermediate Accounting 4 The Income Statement and Income Recognition

Elements of the Income Statement — Losses Losses are decreases in a company’s equity (net assets) from peripheral or incidental transactions of the company and from all other events and circumstances affecting the company during a period except those that result from expenses or distributions to owners. Intermediate Accounting 4 The Income Statement and Income Recognition

3. Income statement content Income from continuing operations Results from discontinued operations Extraordinary items (net of income taxes) Cumulative effects of changes in accounting principles (net of income taxes) Net income Earnings per share Intermediate Accounting 4 The Income Statement and Income Recognition

Income from continuing operations  Sales revenue (net)  Cost of goods sold  Operating expenses  Other items  Income tax expense related to continued operations Income from continuing operations summarizes the income from usual and recurring operating activities. It includes : Intermediate Accounting 4 The Income Statement and Income Recognition

Income from continuing operations Determining Subtotals Gross profit: Revenue – Cost of goods sold Operating income: Gross profit – Operating expenses Intermediate Accounting 4 The Income Statement and Income Recognition

Income from continuing operations Determining Subtotals Income from continuing operations before income taxes: Operating income + Other revenues and gain – Other expenses and losses Income from continuing operations: Income from continuing operations before income taxes – Income taxes on continuing operations Intermediate Accounting 4 The Income Statement and Income Recognition

Sales revenue (net) Sales revenue reports the total sales to customers for the period less any sales returns and allowances or discounts. Intermediate Accounting 4 The Income Statement and Income Recognition

Cost of Goods Sold Intermediate Accounting 4 The Income Statement and Income Recognition Beginning inventory +Net purchases +Freight-in +Other inventory acquisition costs =Cost of goods available for sale –Ending inventory =Cost of goods sold

Operating Expenses Intermediate Accounting 4 The Income Statement and Income Recognition Operating expenses may be reported in two parts: 1)Selling expenses 2)General and administrative expenses Operating expenses may be reported in two parts: 1)Selling expenses 2)General and administrative expenses

Other items Intermediate Accounting 4 The Income Statement and Income Recognition  Rent revenue  Interest revenue  Dividend revenue  Gains from the sale of assets  Interest expense  Losses from the sale of assets Other items include recurring revenues and expenses not directly related to the company's primary operations. For example:

“ Below the Line ” Items Intermediate Accounting 4 The Income Statement and Income Recognition  GAAP requires certain items be reported “below the line” and net of tax.  “Below the line,” or following Income from Continuing Operations.  Net of tax requires the tax effect of the event be shown.

“ Below the Line ” Items Intermediate Accounting 4 The Income Statement and Income Recognition Discontinued Operations Extraordinary Items Changes in Accounting Principles

Results from Discontinued Operations Intermediate Accounting 4 The Income Statement and Income Recognition Examples from APB No. 30 The sale by a diversified company of a major division that represented the company ’ s only activities in the electronic industry.

1/1/02 7/1/02 Operating Loss (net of tax) $24,500 Measurement Date Disposal Date 12/31/02 Statement Date Phase-out Period Loss on Disposal (net of tax; includes operating results 7/1 through 11/17 and loss on final disposal) $11,200 11/17/02 Intermediate Accounting 4 The Income Statement and Income Recognition Discontinued Operations - phases

Income statement section consists of two parts: –Income (loss) from operations--disclosed only if decision to discontinue operations is made after beginning of the year. –Gain (loss) on disposal of operations-- consisting of income (loss) during phase- out and gain (loss) from disposal of segment assets. Intermediate Accounting 4 The Income Statement and Income Recognition Discontinued Operations - Disclosure

4/29/02 Disposal Date Loss on Disposal $5,000 (including $2,000 expected operating loss) Phase-out Period 1/1/01 Measurement Date 8/31/01 Operating Loss $4,000 Statement Date 12/31/02 12/31/01 Intermediate Accounting 4 The Income Statement and Income Recognition Discontinued Operations - Discontinued Operations - Disposal Date After Year End

 Special rules when disposal date is in year following measurement date.  A realized “loss on disposal” may be increased by an estimated loss or it may be reduced by an estimated gain.  A realized “gain on disposal” may be reduced by an estimated loss but cannot be increased by an estimated gain. Intermediate Accounting 4 The Income Statement and Income Recognition Discontinued Operations - Discontinued Operations - Disposal Date After Year End

Intermediate Accounting 4 The Income Statement and Income Recognition Extraordinary Items An extraordinary item is an event or transaction that is both unusual in nature and infrequent in occurrence.

Extraordinary Items Intermediate Accounting 4 The Income Statement and Income Recognition Unusual nature—the underlying event or transaction possesses a high degree of abnormality and is of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the company. Infrequency of occurrence—the underlying event or transaction is of a type that is not reasonably expected to recur in the foreseeable future.

Never Extraordinary Intermediate Accounting 4 The Income Statement and Income Recognition Events that the APB Opinion No. 30 identified as not qualifying as extraordinary: 1.The write-down or write-off of receivables, inventories, equipment leased to others, or intangible assets. 2.Gains or losses from exchanges or transactions of foreign currency. 3. Gains or losses from the disposals of a business component. ContinuedContinued

Never Extraordinary Intermediate Accounting 4 The Income Statement and Income Recognition 4. Other gains or losses from the sale or abandonment of property, plant, or equipment. 5.The effects of a strike. 6.The adjustment of accruals on long-term contracts. 7.The effect of a terrorist attack.

Change in Accounting Principle Intermediate Accounting 4 The Income Statement and Income Recognition  A change in accounting principle occurs when a company adopts a generally accepted accounting principle different from the one it has been using in its financial reporting.  Criteria for change-- change only if the new principle is preferable: provides more useful information. is less costly per benefit.  A change in accounting principle occurs when a company adopts a generally accepted accounting principle different from the one it has been using in its financial reporting.  Criteria for change-- change only if the new principle is preferable: provides more useful information. is less costly per benefit. In most instances, a company reports the cumulative effect on prior years’ earnings in its net income for the year in which it makes the change.

Change in Accounting Estimate Intermediate Accounting 4 The Income Statement and Income Recognition When a company changes an accounting estimate, it accounts for the change in the current year, and in future years if the change affects both.

Earnings Per Share Intermediate Accounting 4 The Income Statement and Income Recognition When presenting EPS figures, separate EPS amounts are computed for income from continuing operations and each irregular or extraordinary item.

Earnings Per Share Intermediate Accounting 4 The Income Statement and Income Recognition Formula for Income from Continuing Operations Income from continuing operations Weighted average number of shares of common stock outstanding

4. Income statement formats GAAP requires certain income statement disclosures. Right, but GAAP does not require a specific format. Intermediate Accounting 4 The Income Statement and Income Recognition

Single-Step Income Statement Intermediate Accounting 4 The Income Statement and Income Recognition Revenues Sales revenue$143,700 Interest revenue1,800 Dividend revenue 600 Total revenues$146,100 Expenses Cost of goods sold$ 86,000 Selling expense10,200 General and admin. expense16,000 Depreciation expense7,800 ContinuedContinued

Expenses (continued) Loss on sale of equipment4,000 Interest expense2,100 Income tax expense 6,000 Total expenses(132,100) Income from continuing operations$ 14,000 Results from discontinued operations Income from operations of significant component A (net of $1,950 income taxes)$ 4,550 Loss on disposal of significant component A (net of $3,150 income tax) (7,350) (2,800) Income before extraordinary items $ 11,200 ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Income before extraordinary items$ 11,200 Extraordinary loss from explosion (net of $750 income tax credit)(1,750) Cumulative effect on prior years’ income of change in depreciation method (net of $600 income taxes) 1,400 Net income$ 10,850 Earnings per Common Share (8,000 shares) Components of Income Income from continuing operations$ 2.80 Results from discontinued operations(0.56) Extraordinary loss from explosion(0.35) Cumulative effect on prior years’ income 0.28 Net income$2.17 Intermediate Accounting 4 The Income Statement and Income Recognition

Multiple-Step Income Statement Intermediate Accounting 4 The Income Statement and Income RecognitionContinuedContinued Revenue$xxx Costs of goods sold: Beginning inventory$xxx Net purchasesxxx Cost of goods available for sale$xxx Less ending inventoryxxxxxx Gross profit $xxx Operating expenses: Selling expenses$xxx General expensesxxxxxx Operating income$xxx Other items$xxx

Intermediate Accounting 4 The Income Statement and Income Recognition Income from continuing operations before income taxes$xxx Income taxes on continuing operations(xxx) Discontinued operations: Loss from operations of discontinued business segment (net of tax)$xxx Loss on disposal of segment (net of tax)xxx(xxx) Extraordinary gain (net of tax)xxx Net income$xxx Earnings per Common Share (8,000 shares) Components of Income Income from continuing operations$ XXX Results from discontinued operationsXXX Extraordinary loss from explosionXXX Cumulative effect on prior years’ income XXX Net income$XXX

5. Limitations of the income statement Intermediate Accounting 4 The Income Statement and Income Recognition Could you illustrate limitations of the income statement?

6. Income Statement analysis Evaluating profitability  Stockholder profitability ratios indicate how effectively a company has been meeting the profit objectives of its owners, including: Earnings per share; The price/earnings ratio; The dividend yield ratio  Company profitability ratios indicate how effectively a company has met its overall profit (return) objectives, particularly in relation to the resources invested, including: Profit margin; Return on total assets; Return on stockholders' equity. Intermediate Accounting 4 The Income Statement and Income Recognition

Overall Profitability Intermediate Accounting 4 The Income Statement and Income Recognition Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.” Net Income$ 40 Total Assets400 Stockholders’ Equity160 Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.” Net Income$ 40 Total Assets400 Stockholders’ Equity160 Return on Assets $40$400$40$400 = 10%

McDonald’s 7.8% Microsoft20.2% Disney4.5% Coca-Cola 18.5% Yahoo! 4.1% Coke Return on Assets Intermediate Accounting 4 The Income Statement and Income Recognition

Overall Profitability Intermediate Accounting 4 The Income Statement and Income Recognition Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.” Net Income$ 40 Total Assets400 Stockholders’ Equity160 Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.” Net Income$ 40 Total Assets400 Stockholders’ Equity160 Return on Equity $40$160$40$160 = 25%

McDonald’s 16.4% Microsoft27.0% Disney9.5% Coca-Cola 42.0% Yahoo! 4.8% Coke Return on Equity Intermediate Accounting 4 The Income Statement and Income Recognition

7. Comprehensive Income Intermediate Accounting 4 The Income Statement and Income Recognition Recall that the FASB now requires companies to report their comprehensive income (or loss) for the accounting period. Comprehensive income is the amount that reflects the change in a company’s wealth during the period. In addition to net income, it includes items that, in general, arise from changes in market conditions unrelated to the business operations of a company. Currently, there are four items of a company’s other comprehensive income: ContinuedContinued

1.Any unrealized increases (gains) or decreases (losses) in the market value of investments in available-for-sale securities. 2.Any change in the excess of its additional pension liability over unrecognized prior service costs. 3.Certain gains and losses on “ derivative ” financial instruments. 4.Any transaction adjustment from converting the financial statements of a company ’ s foreign operations into U. S. dollars. Comprehensive Income Intermediate Accounting 4 The Income Statement and Income Recognition

 On the face of its income statement.  In a separate statement of comprehensive income.  In its statement of changes in stockholders ’ equity. Comprehensive Income The FASB allows a company to report its comprehensive income under three alternatives: The company must display the statement containing the comprehensive income as a major financial statement in its annual report. Intermediate Accounting 4 The Income Statement and Income Recognition

8. Conceptual issues of revenue recognition Intermediate Accounting 4 The Income Statement and Income Recognition Recognition: The process of formally recording or incorporating an item in the financial statements of an entity Realization: The process of converting non-cash resources and rights into money refers to sales of assets for cash or claims to cash.

Conceptual Issues Intermediate Accounting 4 The Income Statement and Income Recognition The decision as to when to recognize revenue focuses on three factors:  The economic substance of the event takes precedence over the legal form of the transaction.  The risks and benefits of ownership have been transferred to the buyer.  The collectibility of the receivable from the sale is reasonably assured.  The economic substance of the event takes precedence over the legal form of the transaction.  The risks and benefits of ownership have been transferred to the buyer.  The collectibility of the receivable from the sale is reasonably assured.

9. Revenue recognition alternatives Intermediate Accounting 4 The Income Statement and Income Recognition  Revenue recognition in the period of sale.  Revenue recognition prior to the period of sale.  Revenue recognition after the period of sale.

Earned and Realizable Economic Substance and Transfer of Risks and Benefits of Ownership Collectibility is Not Reasonably Assured Installment Method Cost Recovery Method Percentage-of- Completion Method (for Long-Term Contracts) Completed- Contract Method (for Long-Term Contracts) Accrual Method: “Normal” Revenue Recognition at Sale Not Sufficient Transfer of Risks and Benefits of Ownership Deposit Method Recognition before Physical Transfer Recognition at Physical Transfer Collectibility is Reasonably Assured Revenue Recognized Intermediate Accounting 4 The Income Statement and Income Recognition

 Completed-Contract Method: recognize all income when project is completed.  Percentage-of-Completion Method: recognize revenue throughout the term of the contract.  Completed-Contract Method: recognize all income when project is completed.  Percentage-of-Completion Method: recognize revenue throughout the term of the contract. Intermediate Accounting 4 The Income Statement and Income Recognition Long-Term Construction Contracts-- Recognition Choices GAAP requires percentage-of-completion method unless certain criteria are not met.

Percentage-of-Completion Method Intermediate Accounting 4 The Income Statement and Income Recognition AICPA Statement of Position No requires that a construction company use the percentage-of-completion method for long-term contracts when all the following conditions are met: 1.The company can make reasonably dependable estimates of the extent of progress toward completion, contract revenue, and contract costs. 2.The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by both the company and the buyer, the consideration to be exchanged, and the manner and terms of settlement. 3.The buyer can be expected to satisfy its obligations under the contract. 4.The company expects to perform its contractual obligations.

Percentage-of-Completion Method--General Concepts Intermediate Accounting 4 The Income Statement and Income Recognition  Recognize revenue throughout life of the contract.  Revenue recognized is a function of how complete the project is.  Costs are charged to an inventory account: Construction in Process (CIP).  Profits are charged to CIP.  CIP is valued at net realizable value.  Any anticipated loss is booked for the full amount of the loss when it becomes measurable.  Recognize revenue throughout life of the contract.  Revenue recognized is a function of how complete the project is.  Costs are charged to an inventory account: Construction in Process (CIP).  Profits are charged to CIP.  CIP is valued at net realizable value.  Any anticipated loss is booked for the full amount of the loss when it becomes measurable.

Determine Percentage-of-Completion Intermediate Accounting 4 The Income Statement and Income Recognition  Input measures: Cost-to-cost method where the degree of completion is determined by comparing costs already incurred with the most recent estimates of total expected costs to complete the project. Efforts-expended method where the degree of completion is determined by comparing the work (labor hours, labor dollars, machine hours, material quantities, etc.) performed to date with the total estimated work for the contract  Output measures  Input measures: Cost-to-cost method where the degree of completion is determined by comparing costs already incurred with the most recent estimates of total expected costs to complete the project. Efforts-expended method where the degree of completion is determined by comparing the work (labor hours, labor dollars, machine hours, material quantities, etc.) performed to date with the total estimated work for the contract  Output measures

Percentage-of-Completion Method Construction costs incurred during the year$100,000$186,000$314,000 Estimated costs to complete the contract400,000264, Partial billing to customer80,000350,000270,000 Collections from customer50,000330,000320,000 Total contract price: $700,000 Example ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Percentage-of-Completion Method 1.To record construction costs: Construction in Progress100,000 Accounts Payable, etc.100, To record partial billings: Accounts Receivable80,000 Partial Billings80, To record collections: Cash50,000 Accounts Receivable50,000 ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Percentage-of-Completion Method 4.To record gross profit: Construction Expense100,000 Construction in Progress40,000 Construction Revenue140, ($100,000 ÷ $500,000) x $700,000 ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Percentage-of-Completion Method 1.To record construction costs: Construction in Progress186,000 Accounts Payable, etc.186, To record partial billings: Accounts Receivable350,000 Partial Billings350, To record collections: Cash330,000 Accounts Receivable330,000 ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Percentage-of-Completion Method 4.To record gross profit: Construction Expense186,000 Construction in Progress38,000 Construction Revenue224, [($286,000 ÷ $550,000) x $700,000] – $140,000 Construction costs incurred to date Revised cost = $286,000 + $264,000 Previous year’s construction revenue ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Percentage-of-Completion Method 1.To record construction costs: Construction in Progress314,000 Accounts Payable, etc.314, To record partial billings: Accounts Receivable270,000 Partial Billings270, To record collections: Cash320,000 Accounts Receivable320,000 ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Percentage-of-Completion Method 4.To record gross profit and close out accounts: Construction Expense314,000 Construction in Progress22,000 Construction Revenue336, $700,000 – $140,000 – $224,000 Recognized in 2004 Recognized in 2005 Partial Billings700,000 Construction in Progress700,000 Intermediate Accounting 4 The Income Statement and Income Recognition

Completed-Contract Method Entries 1, 2, and 3 are the same as those used for the percentage-of-completion method. The completed-contract method does not recognize revenue until the project is completed, so there is no Entry 4 until ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition Example

4.To record gross profit and close out accounts: Partial Billings700,000 Construction Revenue700, Completed-Contract Method Construction Expense600,000 Construction in Progress600,000 $100,000 + $186,000 + $314,000 Intermediate Accounting 4 The Income Statement and Income Recognition

Uncertain Collections--Recognition Alternatives Intermediate Accounting 4 The Income Statement and Income Recognition  Installment Sales Method: Recognizes revenues and related expenses as cash is received (used when collection is somewhat uncertain).  Cost Recovery Method: No income is recognized on sale until the cost of the item sold is recovered through cash receipts (used when collection is very uncertain).

Installment Method Intermediate Accounting 4 The Income Statement and Income Recognition The installment sales method is used most commonly in cases of real estate sales.

Installment Method Intermediate Accounting 4 The Income Statement and Income Recognition 1.Total sales, cost of goods sold, and collections are recorded in the normal manner during the year. 2.At the end of the year, installment sales are identified. The revenue and the related cost of goods sold are “ reversed, ” and the deferred gross profit is recognized. 3.At the end of the year, the gross profit rate on installment sales is computed. 4. A portion of the deferred gross profit is recognized as gross profit. 5. In future years the remaining deferred gross profit is reduced and the gross profit is recognized based on the cash collected on the installment sales

Installment Method Intermediate Accounting 4 The Income Statement and Income Recognition Example Consider the following information for ABC for 2005: Total credit sales$500,000 Total cost of goods sold390,000 Installment method sales100,000 Installment method cost of goods sold75,000 Gross profit rate on installment method sales25% Cash receipts on installment method sales20,000 Cash receipts on other credit sales300,000 ABC Company uses a perpetual inventory method. ContinuedContinued

Installment Method Accounts Receivable500,000 Sales500,000 Cost of Goods Sold390,000 Inventory390,000 Credit sales during 2005: Cash320,000 Accounts Receivable320,000 Collected $300,000; $20,000 related to installment sales: ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Installment Method Sales100,000 Cost of Goods Sold75,000 Deferred Gross Profit, ,000 Installment sales and related cost of goods sold identified and “reversed” on December 31, 2005: Deferred Gross Profit, 20055,000 Gross Profit Realized on Installment Method Sales5,000 Recognized a gross profit of 25% of cash collected on installment sales on December 31, 2005: ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Installment Method Consider the following information for ABC for 2006: Total credit sales$600,000 Total cost of goods sold430,000 Installment method sales150,000 Installment method cost of goods sold105,000 Gross profit rate on installment method sales30% Cash receipts on installment method sales: 2005 sales30, sales40,000 Cash receipts on other credit sales480,000 ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Installment Method Accounts Receivable600,000 Sales600,000 Cost of Goods Sold430,000 Inventory430,000 Credit sales during 2006: Cash550,000 Accounts Receivable550,000 Collected $550,000; $70,000 related to installment sales: ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Installment Method Sales150,000 Cost of Goods Sold105,000 Deferred Gross Profit, ,000 Installment sales and related cost of goods sold identified and “reversed on December 31, 2006: ContinuedContinued Intermediate Accounting 4 The Income Statement and Income Recognition

Installment Method Deferred Gross Profit, 20057,500 Deferred Gross Profit, ,000 Gross Profit Realized on Installment Method Sales19,500 On December 31, 2006, recognized a gross profit of 25% of cash collected on installment sales for 2005 and 30% for 2006: Intermediate Accounting 4 The Income Statement and Income Recognition

Cost Recovery Method APB Opinion No. 10 found the cost recovery method of recognizing revenue generally to be unacceptable. However, the Board did agree that this method could be used in exceptional cases where receivables are collected over an extended period and where the terms of the transaction provide no reasonable basis for estimating the degree of collectibility. Recovered Cost Revenue

The End Intermediate Accounting 4 The Income Statement and Income Recognition