Tài chính doanh nghiệp - Chapter 2: Accrual accounting and income determination

Accrual Accounting and Income DeterminationRevsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 2*Learning objectivesCash-basis versus accrual income measurement.Revenue recognition under accrual accounting.The matching principle and recognizing expenses under accrual accounting.The difference between product and period costs.Income statement format and classification.Distinctions of special items on the income statement.How to report a change in accounting principle, estimate and entity.The distinction between basic and diluted earnings per share (EPS).What comprises comprehensive income and how it is displayed in financial statements.Other comprehensive income differences between IFRS and GAAP.Review basic accounting procedures and T-account analysis.*Accrual accounting: The cornerstone of income measurementUnder accrual accounting:Revenues are “recognized” (recorded) as soon as they are both:Earned, meaning the seller has performed a service or conveyed an asset to the buyer;Measurable, meaning the value to be received for that service or asset is reasonably assured and can be measured with a high degree of reliability.Expenses are expired costs—the assets used up to produce revenues—and are recorded in the same accounting period in which the revenues are recognized. Expenses are “matched” to revenues!Net income = Revenues - Expenses*Understanding accrual accountingAccrual accounting decouples measured earnings (i.e., revenues minus expenses) from the amount of cash generated from operations.Accrual accounting revenues generally do not correspond to cash receipts for the period, nor do accrual expenses always correspond to cash outlays for the period.Accrual accounting can produce large discrepancies between measured earnings and the amount of cash generated from operations.Accrual earnings is a more accurate measure of the economic value added during the period than is operating cash flow.*Canterbury PublishingIn January 2014, Canterbury sells a three-year subscription to its quarterly magazine to 1,000 customers.Customers pay the full subscription price ($300 = 12 x $25) up front.Canterbury takes out a $100,000 three-year loan. Interest at 10% per year is payable at maturity on December 31, 2016.The cost of publishing and distributing the magazine is $60,000 each year, and is paid in cash at the time of publication.Operating Cash Flow:201520162014Subscriptions$300,000Loan interest($30,000)(60,000)Magazine costs(60,000)(60,000)*Canterbury: Cash-basis incomeCash-basis entries for 2014:DR Cash $300,000 CR Subscription Revenues $300,000 To record collection of 1,000 three-year subscription at $300 each for Windy City Living.DR Publishing and distribution expenses $60,000 CR Cash 60,000 To record publishing and distribution expense paid in cash.Operating Cash Flow:201520162014Subscriptions$300,000Loan interest($30,000)(60,000)Magazine costs(60,000)(60,000)*Canterbury: Cash-basis incomeCash-basis entries for 2015:DR Publishing and distribution expense $60,000 CR Cash $60,000 To record publishing and distribution expense paid in cash.Cash-basis entries for 2016:DR Publishing and distribution expense $60,000 CR Cash $60,000 To record publishing and distribution expense paid in cash.DR Interest expense $30,000 CR Cash $30,000 To record interest expense paid on three-year loan. ($100,000 X .10 X 3 years= $30,000).*Canterbury: Cash-basis summaryCash-Basis Income Determination201520162014Cash inflowsCash outflows for production and distributionCash outflow for loan interestNet Income (loss)-Cash Basis$300,000(60,000)0 $240,000$0(60,000)0($60,000)$0(60,000)(30,000)($90,000)*201520162014Expenses:(60,000)(60,000)(60,000)Magazine costsCanterbury: Accrual-basis summary(10,000)(10,000)(30,000)Interest accrued20,000Net Income$30,000$30,000$30,000Subscriptions$300,000Deferred to future years (200,000)Revenues recognizedas earned$100,000$100,000$100,000*Canterbury: Accrual adjusting entriesAdjusting entries on December 31, 2014DR Subscription revenue $200,000 CR Deferred subscription revenue $200,000DR Interest expense $10,000 CR Interest payable $10,000Adjusting entries on December 31, 2015DR Deferred subscription revenue $100,000 CR Subscription revenue $100,000DR Interest expense $10,000 CR Interest payable $10,000 Adjusting entries on December 31, 2016DR Deferred subscription revenue $100,000 CR Subscription revenue $100,000DR Interest expense $10,000DR Interest payable $20,000 CR Cash $30,000*Canterbury: Lessons learnedAccrual accounting decouples measured earnings from operating cash flows;Better links economic benefit (revenue) with economic effort (expenses, or the cost of producing the revenue);Provides a more realistic picture of past economic activities.*Measuring Profit Performance:Revenues and ExpensesAccording to GAAP, when are revenues and expenses to be recognized?It’s a two step process!Step 1: Revenue recognitionStep 2: Expense matchingRevenue recognition and expense matching both produce changes to the balance sheet.Operating CycleMarket the productCollect cashDeliver productManufacture productOrder materialsNegotiate production contractReceive order*Balance sheet effects*Balance sheet effects: ConcludedTwo things happen when income is recognized in the financial statements:Owners’ equity is increased by the amount of the income.Net assets (that is, gross assets minus gross liabilities) are increased by an identical amount.Thus there are two identical ways of thinking about income recognition:Net asset valuation and income determination are inextricably intertwined.ASSETS – LIABILITES Income increases net assets OWNERS’ EQUITY Income (revenues minus expenses) increases owners’ equity=*Criteria for revenue recognitionCondition 1: The critical event in the process of earning the revenue has taken place.Condition 2: The amount of revenue that will be collected is reasonably assured and is measurable with a reasonable degree of reliability.*Revenue Recognition CriteriaU.S. GAAP vs. IASBUS GAAP:Revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.Revenues and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash. IASB:Significant risks and rewards of ownership have been transferred from the seller to the buyer.Management involvement and control over the asset being transferred has passed from the seller to the buyer.The seller can reliably measure the amount of revenue or consideration received in the exchange.It is probable that the seller will receive economic benefits.The seller can accurately measure the costs (both past and future) of the transaction.*Revenue recognition recap Criteria for recognizing revenue during production:A specific customer must be identified and an exchange price agreed upon. Usually a formal contract must be signed.A significant portion of the services to be performed has been performed, and the expected costs of future services can be reliably estimated.An assessment of the customer’s credit standing permits a reasonably accurate estimate of the amount of cash that will be collected.Figure 2.2*Revenue recognition recap Criteria for recognizing revenue on completion of production:The product is immediately saleable at quoted market prices.Units are homogeneous.No significant uncertainty exists regarding the cost of distributing the product.Figure 2.2*Revenue recognition recap Time of sale is the dominant practice in most industries. However, sometimes revenue is not recognized until after the time of sale because:Extreme uncertainty exists regarding the amount of cash to be collected from customers (customer credit risk, contingencies, right-of-return).Future services to be provided are substantial, and their costs cannot be estimated with reasonable precision.Figure 2.2*Matching expenses with revenues: Traceable costs (Cory TV and Appliance)Figure 2.3Figure 2.4*Expenses : Period costsSuppose Cory TV also buys radio advertising for a monthly cost of $700 beginning in February. This is a period cost (not product cost).It’s virtually impossible to match any one month’s advertising expenditure with any specific sale.Thus, this is a period cost and is charged as an expense in the period in which the ad runs.*Revenue is recognized when it isEarned andRealized or realizableMatching expenses with revenues: RecapExpenses are matched with the revenues recognized in a period or with the passage of timeProduct costs – costs directly matched against revenuesPeriod costs – costs matched with the passage of time*Income statement format and classificationMulti-step income statements subdivide income in a manner that helps analysts to forecast future operating cash flows.Virtually all decision models in modern corporate finance are based on future cash flows.Accordingly, the FASB says ”financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows..” [SFAC No. 1].The multi-step income statement separates “transitory” income items from those believed to be “sustainable” (likely to be repeated).*“Transitory” EarningsThese two must be shown net of taxes, with earnings per share (both basic and diluted) shown separately for each*Special or UnusualWrite-downs or write-offs of receivables, inventory, equipment leased to others, and intangibles.Gains or losses from the exchange or translation of foreign currencies.Gains or losses from the sale or abandonment of property, plant or equipment.Special one-time charges from corporate restructurings.Gains or losses from the sale of investments*Discontinued OperationsCompany must disclose discontinued operations for:Reportable segmentOperating segmentReporting unitSubsidiaryAsset groupMust restate all presented periods with the discontinued operations separated out.Must disclose: Operating income or loss of the segment from the beginning reporting date until the disposal dateGain or loss from this disposal (sales price less book value).IFRS rules use the notion of a disposal group for identifying discontinued operations which envisions a larger unit than the component of an entity notion under U.S. GAAP.*Discontinued Operations – Proposed ChangesFASB issued a new Exposure Draft making it harder for a disposition of a major business component to qualify as a discontinued operation. The revised definition of a discontinued operation is a component of a business that has either been disposed of or is classified as held for sale andRepresents a separate major line of business or major geographical area of operationIs a part of a single coordinated plan to dispose of a separate major line of business, orIs a business that meets the criteria for classification as held for sale upon acquisition*Extraordinary ItemsMust be BOTH:Unusual NatureThe underlying event or transaction possesses a high degree of abnormality, and considering the environment in which the company operates, that event or transaction is unrelated to the ordinary activities of the business.Infrequent occuranceThe underlying event or transaction is a type that would not reasonably be expected to recur in the foreseeable future, again considering the environment in which the company operates.Note: IFRS rules require separate disclosure of gains (losses) resulting from unusual or infrequent events but does not permit the use of the label “extraordinary.”*Frequency of nonrecurring itemsSource: Standard and Poor’s Compustat Annual Industrial File as data source*How common are nonrecurring losses?Conservative bias of accrual accounting encourages early recognition of declines in asset values below cost or book value but delays recognition of increases in value until after the asset is sold.Firms’ incentives to separately disclose and clearly label losses (but not gains)*Nonrecurring items: final commentsWhen undisclosed nonrecurring gains and losses are included as part of “Income from continuing operations”, analysts may tend to:Overestimate future income (undisclosed gains)Underestimate future income (undisclosed losses)Disclosed gains and losses (including “special” items) may not just be one time events. Check to see if they are likely to repeat.Firms tend to sell off unprofitable operating segments. This leads to a high frequency of losses in the “Discontinued operations” category.*Accounting changes: SummaryAccounting changes can distort year-to-year comparisons.GAAP requires special disclosures to improve comparability and to help statement users understand what effect the accounting change has had.Three basic types of accounting changes:Change in accounting principle.Change in accounting estimate.Change in reporting entity (see Chapter 16 for details).*Types of Changes*Earnings per shareBasic EPS uses average common shares outstanding. Diluted EPS allows for possible conversion of dilutive securities into common shares.Chapter 15 has the details.Income available to common shareholderWeighted-average common share outstanding*Comprehensive Income and Other Comprehensive IncomeGAAP defines comprehensive income as a change in equity that occurs during a reporting period from transactions or events from non-owner sources.Other Comprehensive income (OCI) includes transactions that are not yet completed or closed and are therefore, not reported as part of net income.Comprehensive Income and Other Comprehensive Income*Under current GAAP, OCI components fall into the following general categories:*Comprehensive income: Single statement format*Comprehensive income: Two-step statement format*Comprehensive income: Two-step statement formatGlobal Vantage Point U.S. GAAP financial reporting standards and IFRS still differ in many respects.* For example, IFRS allows (but U.S. GAAP does not) managers to periodically revalue property, plant, and equipment assets at an appraised fair value which are often reflected in stockholders’ equity account called Revaluation surplus.Global Vantage Point U.S. GAAP financial reporting standards and IFRS still differ in many respects.* IFRS also differs considerably from U.S. GAAP with respect to how firms report their expense associated with defined benefit pension obligations.*SummaryDifferences between cash and accrual income measurement.Accrual revenues and expenses better reflect effort and accomplishment.Accrual income is useful in predicting future operating cash flows.Revenue is recognized when two conditions are satisfied:“Critical event”—firm has earned the revenue.“Measurability”—amount and collectability are reasonably assured.Time of sale is the most common point when revenue is recognized.Product costs are matched to their traceable revenues, period costs are expensed as the assets are used up.*Summary concludedMulti-step income statements highlight nonrecurring (“transitory”) items.GAAP disclosures for accounting changes aid comparisons of performance over time.All firms must report “Basic EPS”, and those with complex capital structures must also report “Diluted EPS”.Other Comprehensive Income – changes in assets and liabilities resulting from incomplete or open transactions bypass the income statement and are reported as direct adjustments to stockholders’ equity.