RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 11TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY 4

CHAPTER 5 INCOME CONCEPTS

The Purpose of Income Reporting Income is used… as the basis of one of the principal forms of taxation. in public reports as a measure of the success of a corporation’s operations. as a criterion for the determination of the availability of dividends. by rate-regulating authorities for investigating whether those rates are fair and reasonable. as a guide to trustees charged with distributing income to a life tenant while preserving the principal for a remainderman. as a guide to management of an enterprise in the conduct of its affairs.

Importance of Income Reporting FASB Purpose of financial accounting… To provide information to financial statement users that will assist them in assessing the amount, timing, and uncertainty of future cash flows Conflicting assertion… Corporate earnings information is better predictor of performance than cash-flow information

Importance of Income Reporting The EMH and stock prices Economic Vs. Accounting Income Related sciences concerned with the activities of business firms use similar variables differences over the timing and measurement of income Relative importance of income statement (accounting) and balance sheet (economics) “Whisper” numbers Balance Sheet Income Statement

In an Attempt to Reconcile What is the nature of income? When should income be reported?

What is the Nature of Income? Three possibilities Psychic Satisfaction of human wants Real Increase in economic wealth Money Increases in monetary value The concept of well-offness or capital maintenance Problems Because of the difficulties in measuring real income - Accountants have adopted a transactions approach to income recognition

Capital Maintenance Concepts Financial capital maintenance - money amount -transactions based Physical capital maintenance - productive capacity VS Difference is in the treatment of holding gains & losses

Current Value Accounting The concept of physical capital maintenance requires assets and liabilities to be stated at their current values Approaches: Entry price or replacement cost Exit value or selling price Discounted present value

Entry Price or Replacement Cost Assets stated at cost to replace them Income determining by matching revenues against current cost of replacing operating assets Possible alternatives Edwards and Bell Current operating profit Realizable cost savings Realized cost savings Realized capital gains

Exit Value or Selling Price Assets stated at anticipated disposal price Holding gains and losses receive immediate recognition Abandons revenue recognition principle Measurement problems Determining selling price of assets for which there is no ready market (PP&E) Assumption of sales in normal market rather than forced liquidation

Discounted Present Value Relevant value on balance sheet: PV of future cash flows expected to be received from asset PV of future cash flows expected to be disbursed for a liability 3 measurement problems Depends on estimate of future cash flows Both cash flows and timing must be determined Selection of appropriate discount rate Firm’s assets are interrelated

Income Recognition Transactions approach Elements of financial statements should be reported when there is evidence of arms-length transaction Realization principle: income should be recognized when earnings process is essentially complete (an exchange transaction has taken place) Makes no attempt to place expected value on firm or report on expected changes in values of assets and liabilities Criticized for not reporting all relevant information

Measurement What is measurement? Problems with the measurement unit Arbitrary decisions

Accounting for Inflation Instability of the accounting measuring unit is due to the effects of inflation or deflation General purchasing power adjustments

Revenue Recognition VS The income producing activities cycle Realization VS The income producing activities cycle Revenue recognition criteria The revenue has been earned The revenue has been “realized” or is “realizable SAB No. 101 criteria Persuasive evidence of an arrangement exists Delivery has occurred The vendor’s fee is fixed or determinable Collectibility is probable.

Revenue Recognition The crucial event test As a result revenue is generally recognized at the point of sale may be advanced or delayed due to surrounding circumstances During production At close of production Services performed Cash Occurrence of some event Special recognition circumstances

Recent Developments Preliminary Views on Revenue Recognition in Contracts with Customers December 2008 FASB and IASB joint discussion paper Single, contract-based model for recognizing revenue Similar to current GAAP

Exposure Draft: Revenue from Contracts with Customers, June 2010 Basic principle in original proposal: an entity should recognize revenue from contracts with customers when it transfers goods or services

Exposure Draft: Revenue from Contracts with Customers, June 2010 Standard improves both IFRS and Us GAAP by Removing inconsistencies Providing a more robust revenue-recognition framework Improving comparability across companies, industries, and capital markets Requiring enhanced disclosure Clarifying accounting for contract costs

Other Issues Delayed or advanced revenue recognition Revenue recognized During production process At completion of production As services are performed As cash is received On occurrence of some event

Product VS Period Costs Matching Cost Expense Loss Product VS Period Costs

Used up Resulting in Revenue Used up Resulting in No Revenue Matching Cost Leads to or Results In Asset Used up Resulting in Revenue Used up Resulting in No Revenue Expense Loss

Concepts Affecting Revenue Recognition Conservatism Materiality

Earnings Quality, Earnings Management and Fraudulent Financial Reporting The correlation between a company’s accounting and economic income The existence of the previously discussed issues has led some to the conclusion that economic income is a better predictor of cash flows. Assessing earnings quality

Earnings Quality, Earnings Management and Fraudulent Financial Reporting Assessing earnings quality: Compare the accounting principles employed by the company with those generally used in the industry and by competitions. Do the principles used by the company inflate earnings? Review recent changes in accounting principles and changes in estimates to determine if they inflate earnings. Determine if discretionary expenditures, such as advertising, have been postponed by comparing them to previous periods. Attempt to assess whether some expenses, such as warranty expense, are not reflected on the income statement.

Earnings Quality, Earnings Management and Fraudulent Financial Reporting Determine the replacement cost of inventories and other assets. Assess whether the company generating sufficient cash flow to replace its assets? Review the notes to financial statements to determine if loss contingencies exist that might reduce future earnings and cash flows. Review the relationship between sales and receivables to determine if receivables are increasing more rapidly than sales. Review the management discussion and analysis section of the annual report and the auditor's opinion to determine management's opinion of the company's future and to identify any major accounting issues

Earnings Quality, Earnings Management and Fraudulent Financial Reporting The attempt to influence short-term reported income

Earnings Quality, Earnings Management and Fraudulent Financial Reporting Arthur Levitt has outlined five earnings management techniques that he described as threatening the integrity of financial reporting: Taking a bath Creative acquisition accounting Cookie jar reserves Abusing the materiality concept Improper revenue recognition

Lehman Brothers fraud Repo 105 transactions Lehman misused the rule Decreased leverage and increased liquidity Lehman misused the rule Auditors (E&Y) were aware of nondisclosure Manipulated financial statements Sept. 12, 2008, Lehman reported $41 billion in cash; 3 days later actual amount only $2 billion

Distinction Between Conservative, Neutral, Aggressive and Fraudulent Earnings Management Conservative accounting Neutral earnings Aggressive accounting Fraudulent accounting Overly aggressive recognition of loss or reserve provisions Overvaluation of acquired in process research and development activities Earnings that result from using a neutral perspective Understating loss or reserve provisions Recording sales before they satisfy the earned and measurability criteria Recording fictitious sales Backdating sales invoices Overstating inventory

Red flags of possible fraudulent reporting: A predominantly insider board of directors Management compensation tied to its stock price Frequent changes of auditors Rapid turnover of key personnel Deteriorating earnings Unusually rapid growth Lack of working capital

Red flags of possible fraudulent reporting: The need to increase the stock price to meet analysts’ earnings projections Extremely high levels of debt Cash shortages Significant off-balance sheet financing arrangements Doubt about the company’s ability to continue as a going concern SEC or other regulatory investigations Unfavorable industry economic conditions Suspension or delisting from a stock exchange

Prepared by Kathryn Yarbrough, MBA End of Chapter 5 Prepared by Kathryn Yarbrough, MBA Copyright © 2011 John Wiley & Sons, Inc.  All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful.  Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc.  The purchaser may make back-up copies for his/her own use only and not for distribution or resale.  The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.