ACCRUAL ACCOUNTING AND INCOME DETERMINATION

1
CHAPTER 2

• ACCRUAL ACCOUNTING AND INCOME DETERMINATION

Authored by Brian Leventhal University of
Illinois at Chicago
2
I. Cash Versus Accrual Income Measurement
A. Accrual-basis income measurement is the
cornerstone of income measurement.

• 1. Revenues are recorded in the period when they
  are earned and become measurable.
• a. Revenues are earned when the seller has
  performed a service or conveyed an asset to a
  buyer.
• b. Revenues are measurable when the value to be
  received for that service or asset is reasonably
  assured and can be measured with a high degree of
  reliability.

3
I. Cash Versus Accrual Income Measurement

• 2. Expenses are the expired costs or assets used
  up in producing those Revenues
• and they are recorded
  in the same accounting period
  in which the Revenues are
  recognized.(Matching Principle)
• Can you think of examples of expenses?

4
I. Cash Versus Accrual Income Measurement

• 3. Accrual accounting decouples
  measured earnings
  (e.g., revenues less expenses)
  from the amount of
  cash generated
  from operations.
• a. Accrual accounting Revenues
  generally do not correspond to cash
  receipts for the period, nor do reported
  Expenses always correspond to cash outlays
  of the period.

5
I. Cash Versus Accrual Income Measurement
3. Accrual accounting decouples measured earnings
(e.g., revenues
less expenses) from the
amount of cash generated from
operations.

• b. Accrual accounting can produce large
  discrepancies between measured earnings and the
  amount of cash generated from operations.

6
I. Cash Versus Accrual Income Measurement
3. Accrual accounting decouples
measured earnings
(e.g., revenues less expenses)
from the amount of cash generated from
operations.

• c. Accrual accounting earnings provide a more
  accurate measure of the economic value added
  during the period than do operating cash flows. 

7
I. Cash Versus Accrual Income Measurement

• B. Cash-basis income measurement is
  straightforward.1. Revenues are recorded when
  cash is received.
  2. Expenses are recorded
  when cash is paid.

8
I. Cash Versus Accrual Income Measurement

• 3. Because of differences in the timing of
  when cash inflows and cash outflows occur,
  cash-basis income determination may distort ones
  view of operating performance.

• a Cash-basis income fails to properly match
  effort
  accomplishment.
• b Cash-basis income may not provide a reliable
  benchmark for predicting future operating results

9
I. Cash Versus Accrual Income Measurement
Lets look at an example
C. Canterbury Publishing
1. There are several facts to
consider.

• a. Canterbury sells three-year subscriptions of
  a quarterly publication to subscribers, who
  prepay the full subscription price.
  300,000
• b. Canterbury takes out a three-year loan at
  the beginning of the three-year subscription
  period, but interest is payable at maturity of
  the loan. (30,000)
• c. Costs to publish and distribute the magazine
  are paid in cash at the time of publication.
  (60,000)

10
I. Cash Versus Accrual Income Measurement
Cash Basis Income Determination
2001 2002 2003
What happens in Year 1?
Cash Inflows Cash outflows for Prod.
Distr. Cash Outflow for interest on loan Net
Income (loss) Cash Basis
300,000
(60,000)
What do you think of the results?
0
240,000
11
I. Cash Versus Accrual Income Measurement
Cash Basis Income Determination
2001 2002 2003
What happens in Year 2?
0
300,000
Cash Inflows Cash outflows for Prod.
Distr. Cash Outflow for interest on loan Net
Income (loss) Cash Basis
(60,000)
(60,000)
What do you think of the results?
0
0
240,000
(60,000)
12
I. Cash Versus Accrual Income Measurement
Cash Basis Income Determination
2001 2002 2003
What happens in Year 3?
0
0
300,000
Cash Inflows Cash outflows for Prod.
Distr. Cash Outflow for interest on loan Net
Income (loss) Cash Basis
(60,000)
(60,000)
(60,000)
What do you think of the results? What might you
think of doing to the business?
0
0
(30,000)
240,000
(60,000)
(90,000)
13
I. Cash Versus Accrual Income Measurement
Cash Basis Income Determination
Cash-basis income determination distorts
Canterburys operating performance.
2001 2002 2003
What happens in Year 3?
Notice total of all 3 years
Net Income is 90,000
0
0
300,000
Cash Inflows Cash outflows for Prod.
Distr. Cash Outflow for interest on loan Net
Income (loss) Cash Basis
(60,000)
(60,000)
(60,000)
None of the cash-basis earnings figures provides
a reliable benchmark for predicting future
operating results.
0
0
(30,000)
240,000
(60,000)
(90,000)
14
I. Cash Versus Accrual Income Measurement
Now lets take a look at Income Measurement using
Accrual Basis accounting !!
15
I. Cash Versus Accrual Income Measurement
300,000/3 100,000 per year 200,000 of
Revenue is deferred
Cash Expenses may also equal Accrual Expenses if
used and paid in same period
Accrual Basis Income Determination
2001 2002 2003
What happens in Year 1?
Accrual Revenues Accrual Expenses for Prod.
Distr. Accrual Interest Expense for the
loan Net Income (loss) Accrual Basis
100,000
30,000/3 10,000 per year
(60,000)
(10,000)
What do you think of the results?
30,000
16
300,000/3 100,000 per year 100,000 of
Revenue is still deferred
I. Cash Versus Accrual Income Measurement
Accrual Basis Income Determination
2001 2002 2003
What happens in Year 2?
Accrual Revenues Accrual Expenses for Prod.
Distr. Accrual Interest Expense for the
loan Net Income (loss) Accrual Basis
100,000
100,000
(60,000)
(60,000)
What do you think of the results?
(10,000)
(10,000)
30,000
30,000
17
I. Cash Versus Accrual Income Measurement
Accrual Basis Income Determination
2001 2002 2003
What happens in Year 3?
Accrual Revenues Accrual Expenses for Prod.
Distr. Accrual Interest Expense for the
loan Net Income (loss) Accrual Basis
What do you think of the results? What might you
think of doing to the business?
100,000
100,000
100,000
(60,000)
(60,000)
(60,000)
(10,000)
(10,000)
(10,000)
30,000
30,000
30,000
18
Accrual-basis income determination alleviates the
mismatching problems that exist under cash-basis
accounting.
I. Cash Versus Accrual Income Measurement
Accrual Basis Income Determination
These modifications to the cash-basis results are
made via a series of adjusting entries.
2001 2002 2003
What happens in Year 3?
Accrual Revenues Accrual Expenses for Prod.
Distr. Accrual Interest Expense for the
loan Net Income (loss) Accrual Basis
100,000
100,000
100,000
Accrual accounting better matches economic
benefit with economic effort thereby producing a
measure of operating performance that provides a
more realistic picture of past economic
activities.
(60,000)
(60,000)
(60,000)
(10,000)
(10,000)
(10,000)
30,000
30,000
30,000
Notice total of all 3 years Net Income is 90,000
19
II. Measuring Profit Performance Rev Exp

• A. Income is earned as the result of several
  activities.
• 1. The critical issue then becomes the timing of
  income recognition.

20
II. Measuring Profit Performance Rev Exp
A. Income is earned as the result of several
activities.

• 2. The accounting process of recognizing income
  is comprised of two distinct steps.
• a. The revenue recognition principle establishes
  when revenue is recorded.
• b. The recognition of revenue then triggers the
  second step
  the matching against revenue the
  costs that expired (were used up) in generating
  revenue.

21
II. Measuring Profit Performance Rev Exp
A. Income is earned as the result of several
activities.

• 3. Revenue recognition and
  matching effect changes in the
  asset and liability accounts on
  the balance sheet.(The
  Actg. Equation must balance!)
• a. The basic accounting equation Assets
  Liabilities Owners Equity
  can illustrate this point.

22
II. Measuring Profit Performance Rev Exp
A. Income is earned as the result of several
activities.

• 3. Revenue recognition and matching effect
  changes in the asset and liability accounts on
  the balance sheet.(The Actg. Equation must
  balance!)

• i. Revenue recognition increases net assets
  (i.e., gross assets - gross liabilities)
  and owners equity by identical amounts.

Assets Liabilities Owners Equity
Cash 130
Sales Rev 130
or
A/R 130
23
II. Measuring Profit Performance Rev Exp
A. Income is earned as the result of several
activities.

• 3. Revenue recognition and matching effect
  changes in the asset and liability accounts on
  the balance sheet.(The Actg. Equation must
  balance!)

• ii. Expense matching decreases net assets and
  owners equity by identical amounts.

Assets Liabilities Owners Equity
-Inventory 100
- COGS 130
24
II. Measuring Profit Performance Rev Exp
A. Income is earned as the result of several
activities.

• 3. Revenue recognition and matching effect
  changes in the asset and liability accounts on
  the balance sheet.(The Actg. Equation must
  balance!)

Assets Liabilities Owners Equity

• b. As a result,
  net asset valuation and
  income determination
  are inextricably intertwined.

25
II. Measuring Profit Performance Rev Exp
B. A closer look at the revenue recognition
criteria.

• 1. The critical event---
  (Condition 1
  Revenue has been earned) varies
  from industry
  to industry.

26
II. Measuring Profit Performance Rev Exp
B. A closer look at the revenue recognition
criteria.

• 2. Measurability (Condition 2) must be based on
  objective and verifiable evidence.

27
II. Measuring Profit Performance Rev Exp
B. A closer look at the revenue recognition
criteria.

• 3. In most instances the point of sale is the
  earliest moment in time that the critical
  event(Earned) in the process of earning the
  revenue has taken place.
• The amount that will be collected
  is reasonably assured and is
  measurable with a reasonable
  degree of reliability.
• This is the dominant practice in
  most retail and manufacturing
  industries.

28
Figure 2.2 The Revenue Recognition Process
Industries Recognizing Revenue at Indicated Phases
Revenues may also be recognized at other times
besides the point of sale.
29
II. Measuring Profit Performance Rev Exp

• B. A closer look at the revenue recognition
  criteria.
• 4. Under the percentage-of-completion method (see
  Chapter 3), Conditions 1 and 2 are satisfied
  prior to the point of sale (i.e., transfer of
  title).
• a. Condition 1 (critical event) is satisfied
  over time as the project progresses.
• b. Condition 2 (measurability) is satisfied
  since a firm contract with a known buyer at a set
  price exists.

30
II. Measuring Profit Performance Rev Exp
B. A closer look at the revenue recognition
criteria.

•   Normally, once gross revenues for the period
  are determined, the next step in determining
  income is to accumulate and record the costs
  associated with generating those revenues.
• However, under the
  percentage-of-completion method,
  it is the recognition of expenses
  that drives the recognition
  of revenues.

31
Measuring Profit Performance Rev Exp
B. A closer look at the revenue recognition
criteria.

• 5. Under the installment sales method (see
  Chapter 3),
• Conditions 1 and 2 may not be satisfied until
  after the point of sale
• for instance, until
  cash is collected.

32
II. Measuring Profit Performance Rev Exp

• B. A closer look at the revenue recognition
  criteria.
• 6. Revenue is recognized during the production
  phase whena. A specific customer is identified
  and an exchange price is agreed upon.b. A
  significant portion of the services to be
  performed has been performed, and the expected
  costs of future services can be reliably
  estimated.c. An assessment of the customers
  credit standing permits a reasonably accurate
  estimate of the amount of cash that will be
  collected.

33
II. Measuring Profit Performance Rev Exp

• B. A closer look at the revenue recognition
  criteria.
• 7. Revenue may be recognized on completion of
  production when
• a. The product is immediately saleable at quoted
  market prices.
• b. The units are homogeneous.
• c. No significant uncertainty exists regarding
  the costs of distributing the product.

34
II. Measuring Profit Performance Rev Exp

• B. A closer look at the revenue
  recognition criteria.
• 8. Revenue is recognized after the point of sale
  when one or more of the following conditions are
  presenta. Extreme uncertainty exists regarding
  the amount of cash to be collected from
  customers. This uncertainty may be attributable
  toi. The precarious financial position of the
  customer.ii. Contingencies in the sales
  agreement that allow the buyer or seller to
  terminate the exchange.iii. The customer has
  (and frequently exercises) the right to return
  the product.b. Future services to be provided
  are substantial, and their costs cannot be
  estimated with reasonable precision.

35
II. Measuring Profit Performance Rev Exp
C. Matching expenses with revenues.

• 1. The recognition of expenses generally follows
  the recognition of revenue.

36
II. Measuring Profit Performance Rev Exp
C. Matching expenses with revenues.

• 2. Traceable (product) costs are costs that
  contribute directly to a particular sale or to
  revenues of a particular period.
• a. These costs are recorded as
  expenses in the same period that
  revenues are recognized.
• b. An example of product costs is
  costs of goods sold.

37
II.Measuring Profit Performance Rev Exp
C. Matching expenses with revenues.

• 3. Period costs are important in generating
  revenue, but their contribution to a specific
  sale or to revenues in a particular period is
  more difficult to quantify.
• a. These costs are associated with the time
  period in which they occur.
• b. An example of period costs is advertising
  expense. 

38
Figure 2.3 Cash Flow Diagram
II.Measuring Profit Performance Rev Exp
Example of Matching Expense with Revenue
Actual Cash Flows
39
Figure 2.4 Revenue Recognition and Expense
Matching
II.Measuring Profit Performance Rev Exp
Example of Matching Expense with Revenue
Accrual Basis
40
III. Income Statement Format and Classification 

• A. Multiple-step income statement is intended to
  subdivide income in a manner that facilitates the
  forecasting of future cash flows.
• 1. Virtually all decision models
  in modern corporate finance
  are based on future cash flows.

41
Income Statement GeographyMythical Corporation
2. The intent of this format is to classify
separately income components that are
transitory and to clearly differentiate them
from income components believed to be
sustainable or likely to be repeated in future
reporting periods.
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
42
Income Statement GeographyMythical Corporation

• This format isolates a key figure called income
  from continuing operations.

2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026

• a. Ideally, this component of income should
  include only the normal, recurring, presumably
  more sustainable, ongoing economic activities of
  the entity.

Above the line
Below the line
43
Income Statement GeographyMythical Corporation

• This format isolates a key figure called income
  from continuing operations.

2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
b. This income number sometimes includes gains
and losses that occur infrequentlycalled special
or unusual itemsbut that arise from a firms
ongoing, continuing operations.
Above the line
Below the line
Example Restructuring charges
44
Income Statement GeographyMythical Corporation

• This format isolates a key figure called income
  from continuing operations.

2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
Above the line
c. Therefore, income from continuing operations
is intended to serve as a starting point for
forecasting future profits.
Below the line
45
Income Statement GeographyMythical Corporation
4. Nonrecurring items are transitory and are
disclosed separately below the income from
continuing operations line.
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
Above the line
Below the line
46
Income Statement GeographyMythical Corporation
B. Nonrecurring items, including discontinued
operations, extraordinary losses, and the
cumulative effect of accounting changes, are
reported below income from continuing operations
net of income tax effects.
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
Before Tax
Above the line
Tax Expense
Below the line
Net of Tax
47
Income Statement GeographyMythical Corporation
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
1.This net of tax treatment is called
intraperiod income tax allocation.
Before Tax
Above the line
Tax Expense
Below the line
Net of Tax
48
Income Statement GeographyMythical Corporation
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
b. Mixing together the tax effect of continuing
activities with the tax effect of single
occurrence events would make it difficult for
statement readers to forecast future tax outflows
arising from ongoing events.
Before Tax
Above the line
Tax Expense
Below the line
Net of Tax
49
Income Statement GeographyMythical Corporation
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
2. Income tax associated with sustainable income
from continuing operations is separately
disclosed from taxes arising from the transitory
items.
Before Tax
Above the line
Tax Expense
Below the line
Net of Tax
50
Income Statement GeographyMythical Corporation
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
C. Discontinued operations is a separate major
line of business or class of customer whose
assets and operating activities can be clearly
distinguished, physically and operationally and
for financial reporting purposes
Not normal disposals
51
Income Statement GeographyMythical Corporation
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
1. While gray areas exist, this rule prohibits
firms from treating losses (and gains) on normal
asset sales as discontinued operations.
Not normal disposals
52
Income Statement GeographyMythical Corporation
2. Two components of discontinued operations are
reported a. Gain or loss from operations (net
of tax) is always recorded, regardless of
whether it is a gain or a loss, since the amount
has been realized.
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
53
Income Statement GeographyMythical Corporation
Gain or loss on disposal (net of tax) has two
components
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026

• (1) expected gain or loss on operations from the
  date a formal plan is adopted to discontinue
  operations to the disposal date, and
• (2) expected gain or loss on the sale of assets.

54
Income Statement GeographyMythical Corporation
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026

• i. Expected net losses are always recorded.
• Expected net gains can be recorded to the extent
  that they offset realized losses..
• (Conservatism principle)

55
Income Statement GeographyMythical Corporation
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
3. A firm must disclose the identity of
segment and details of disposal in the
footnotes.
56
Income Statement GeographyMythical Corporation
Numbers in the box will not match those reported
in the 2000 annual report, though the Net Income
figure will match. (Reclassification)
2001 2000 Net sales 3,957 3,478 Cost of goods
sold (1,364) (1,189) Gross profit 2,593 2,289 SG
A (1,093) (949) Special or unusual charges
(251) ----- Income from continuing
operations before tax expense 1,249 1,340 Incom
e tax expense (406) (436) Income from
continuing operations 843 904 Discontinued
operations Income, net of tax 203 393 Gain on
disposal, net of tax 98 ----- Income before
extraordinary item and change in accounting
principle 1,144 1,297 Extraordinary loss, net
of tax ----- (170) Cumulative effect of change in
accounting principle, net of tax (118)
----- Net Income 1,026 1,127
57
Income Statement GeographyMythical Corporation
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
1. Extraordinary items must meet both of the
following criteria a. The underlying event or
transaction must be unusual in nature. b. The
underlying event or transaction must be
infrequent in occurrence, i.e., it
must not reasonably be expected to recur in the
foreseeable future.
58
Income Statement GeographyMythical Corporation

• 2. Events that meet one, but not both, of these
  criteria, are reported as income from continuing
  operations.
• If material in amount then the item must be
  disclosed as a separate item in the Special or
  unusual items section of the income statement..

2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
Unusual or infrequent, but not both.
Both unusual and infrequent.
59

Income Statement GeographyMythical Corporation

• Analyst Tip  In forecasting future cash flows, a
  reader of the financial statements must determine
  whether the special or unusual items are
  sustainable or transitory.
• The increased occurrence of these items heightens
  the speculative nature of these forecasts.

2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
60
III. Income Statement Format and Classification

• b. To merge undisclosed losses as part of the
  income from continuing operations line would
  cause analysts to underestimate future income.
•  The converse is also true. To merge undisclosed
  gains as part of the income from continuing
  operations line would cause analysts to
  overestimate future income.
• As a result, attention to other financial and
  nonfinancial information that is available may be
  useful in evaluating the sustainability of merged
  gains.     

61
III. Income Statement Format and Classification

• 4.      A higher frequency of losses in the
  discontinued operations category exists because
  firms tend to sell off unprofitable operating
  segments and /or segments that have
  declined in value because of shifts in
  consumer demand.

62
Income Statement GeographyMythical Corporation
F. Changes in accounting principles.
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026

• 1. Prior periods income statements generally are
  not restated to reflect the income effect of
  changing to a new principle.

Default method for changes.
63
Income Statement GeographyMythical Corporation
F. Changes in accounting principles.
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026

• b. If retroactive adjustment is not made,
  accounting standards require the disclosure of
• pro forma income figures computed as if the
  new accounting principle had been applied during
  all past periods that are presented.

64
Income Statement GeographyMythical Corporation
F. Changes in accounting principles.
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026

• 2. The new principle is applied in computing
  income from continuing operations in the year of
  the change.
• 3. The cumulative effect of the change (net of
  income tax effects) on all prior years income is
  shown as a separate line item at the bottom of
  the income statement for the year of change.

65
Income Statement GeographyDepreciation Change
Creates Comparability Problems
Old depreciation method used
Computed using new depreciation method
2001 2000 Net sales 3,957 3,478 Cost of goods
sold (1,364) (1,189) Gross profit 2,593 2,289 SG
A (1,093) (949) Special or unusual charges
(251) ----- Income from continuing
operations before tax expense 1,249 1,340 Incom
e tax expense (406) (436) Income from
continuing operations 843 904 Discontinued
operations Income, net of tax 203 393 Gain on
disposal, net of tax 98 ----- Income before
extraordinary item and change in accounting
principle 1,144 1,297 Extraordinary loss, net
of tax ----- (170) Cumulative effect of change in
accounting principle, net of tax (118)
----- Net Income 1,026 1,127
What conclusions can you make from looking at
these numbers?
They are not comparable because of the Change in
Accounting principle. Thats why pro forma
data is needed!
?
?
66
Income Statement GeographyDepreciation Change
Creates Comparability Problems
2001 2000 Net sales 3,957 3,478 Cost of goods
sold (1,364) (1,189) Gross profit 2,593 2,289 SG
A (1,093) (949) Special or unusual charges
(251) ----- Income from continuing
operations before tax expense 1,249 1,340 Incom
e tax expense (406) (436) Income from
continuing operations 843 904 Discontinued
operations Income, net of tax 203 393 Gain on
disposal, net of tax 98 ----- Income before
extraordinary item and change in accounting
principle 1,144 1,297 Extraordinary loss, net
of tax ----- (170) Cumulative effect of change in
accounting principle, net of tax (118)
----- Net Income 1,026 1,127
?
Pro forma IFCO (new method) 843 871
?
67
Income Statement GeographyMythical Corporation
F. Changes in accounting principles.
2001 Net sales 3,957 Cost of goods
sold (1,364) Gross profit 2,593 SGA (1,093) Spec
ial or unusual charges (251) Income from
continuing operations before tax
expense 1,249 Income tax expense (406) Income
from continuing operations 843 Discontinued
operations Income, net of tax 203 Gain on
disposal, net of tax 98 Income before
extraordinary item and change in accounting
principle 1,144 Extraordinary loss, net of
tax ----- Cumulative effect of change in
accounting principle, net of tax (118) Net
Income 1,026
a. Retroactive adjustment is allowed when new
accounting principles are mandated by a newly
issued standard or when the cumulative adjustment
swamps the continuing operations income number.
68

III. Income Statement Format and Classification

•  Changes in accounting principles generally do
  not result in direct changes in cash flows.
• The only exception is a change from the LIFO
  method of accounting for inventory (because of
  the LIFO conformity rule).
• Since changes in accounting principles generally
  do not affect the tax return, a change in
  principles used for financial reporting purposes
  affects only income tax expense and deferred
  income taxes.        

69
III. Income Statement Format and Classification

• G. Accounting changes.

• 1. Changes in accounting estimates.
• a. Changes in accounting estimates are handled
  prospectively
  i.e., accounted for in the year of
  change and in future periods.
• b. A change occurs concurrently
  with a change in the economic
  circumstances underlying an
  accounting estimate.

70
III. Income Statement Format and Classification

• G. Accounting changes.
• 1. Changes in accounting estimates.
• Examples of changes in estimates
• uncollectible accounts
• depreciable lives
• warranty costs
• pension obligations

71
III. Income Statement Format and Classification

• G. Accounting changes.
• 1. Changes in accounting estimates.
• How do we find out about these changes?
• If material, the change and
  its effect will be
  disclosed.
• No bright-line thresholds
  for materiality
• Well see places where we might
  look for evidence of changes
  that are
  not disclosed.

72
III. Income Statement Format and Classification
2. Change in reporting entity.

• Comparative financial
  statements for prior years must be restated for
  comparative purposes
• to reflect the new reporting entity as if it had
  been in existence during all of the years
  presented.

73
IV. Comprehensive Income 

• A. Selected unrealized gains (or
  losses) arising from incomplete (or open)
  transactions
• sometimes bypass the
  income statement and are
  reported as direct adjustments
  to owners equity.

74
IV. Comprehensive Income 

• 1.other comprehensive income, include

• unrealized gains (losses) on available-for-sale
  marketable securities,
• foreign currency
  translation gains (losses)
• unrealized losses resulting
  from minimum pension
  obligations

75
IV. Comprehensive Income 

• 2. Items included in net income are
  considered to be closed transactions.
• 3. Open transactions occur when
  balance sheet carrying amounts
  are changed even though the
  transaction is not yet
  closed.
• For example, unrealized
  gains and losses on marketable
  securities are not closed because
  the securities have not been
  sold.

76
IV. Comprehensive Income

• B. Comprehensive income is the net income from
  the traditional income statement plus or minus
  other comprehensive income components.
• Now, Lets look at an
  example!   

77
Example of Comprehensive Income Disclosure
From Intuits First Quarter 10Q for Fiscal year
1999 As of August 1, 1998, Intuit adopted SFAS
130, "Reporting Comprehensive Income." SFAS 130
establishes new rules for the reporting and
display of comprehensive net income and its
components. However, it has no impact on our net
income or stockholders' equity as presented in
our financial statements. SFAS 130 requires
foreign currency translation adjustments and
changes in the fair value of available for sale
securities to be included in comprehensive
income. The components of comprehensive net
income, net of tax, are as follows Three months
ended October 31, 2000 1999 (In
thousands) Net loss (12,759)
(49,190) Unrealized gain (loss) on marketable
securities 58,133
(58,950) Change in cumulative translation
adjustment 41
(4,409) Comprehensive net income (loss)
45,415 (112,549)