1. 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

2. CHAPTER 5
INCOME CONCEPTS

3. 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.

4. 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

5. 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

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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

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

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

16. 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.

17. 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

18. 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

19. 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

20. 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

21. 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

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

23. 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

24. Concepts Affecting Revenue Recognition
Conservatism
Materiality

25. 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

26. 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.

27. 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

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

29. 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

30. 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

31. 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

32. 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

33. 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

34. Prepared by Kathryn Yarbrough, MBA
End of Chapter 5
Prepared by Kathryn Yarbrough, MBA
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