FINANCIAL ACCOUNTING

THEORY AND ANALYSIS:

TEXT AND CASES
11TH EDITION

RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
CHAPTER 5
INCOME CONCEPTS
 The Purpose of Income Reporting

Income is used…
1 as the basis of one of the principal forms of taxation.
2 in public reports as a measure of the success of a corporation’s
operations.
3 as a criterion for the determination of the availability of dividends.
4 by rate-regulating authorities for investigating whether those rates are
fair and reasonable.
5 as a guide to trustees charged with distributing income to a life tenant
while preserving the principal for a remainderman.
6 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
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
Physical
capital
maintenance capital
- money maintenance
amount - - productive
transactions capacity
based
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:
1 Entry price or replacement cost
2 Exit value or selling price
3 Discounted present value
 Entry Price or Replacement Cost
 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
1 Current operating profit
2 Realizable cost savings
3 Realized cost savings
4 Realized capital gains
 Exit Value or Selling Price
 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

Recognition Realization

 The income producing activities cycle

 Revenue recognition criteria
1. The revenue has been earned
2. The revenue has been “realized” or is “realizable
 SAB No. 101 criteria
1. Persuasive evidence of an arrangement exists
2. Delivery has occurred
3. The vendor’s fee is fixed or determinable
4. 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
1 During production
2 At close of production
3 Services performed
4 Cash
5 Occurrence of some event
5 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
Matching

Cost
Expense
Loss Product
VS
Period
Costs
Matching

Cost

Leads to or
Results In

Asset

Used up Used up
Resulting in Resulting in No
Revenue Revenue

Expense Loss
Concepts Affecting Revenue Recognition

Conservatism
Materiality
Earnings Quality, Earnings Management
and Fraudulent Financial Reporting

 Earnings quality
 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:
1 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?
2 Review recent changes in accounting principles and
changes in estimates to determine if they inflate
earnings.
3 Determine if discretionary expenditures,
such as advertising, have been postponed
by comparing them to previous periods.
4 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
5 Determine the replacement
cost of inventories and other
assets. Assess whether the
company generating
sufficient cash flow to
replace its assets?
6 Review the notes to financial
statements to determine if
loss contingencies exist that
might reduce future earnings 7 Review the relationship between
and cash flows. sales and receivables to determine
if receivables are increasing more
rapidly than sales.
8 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
 Earnings management
 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:
1. Taking a bath
2. Creative acquisition accounting
3. Cookie jar reserves
4. Abusing the materiality concept
5. Improper revenue recognition
Lehman Brothers fraud

 Repo 105 transactions

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
1. Conservative Overly aggressive recognition of loss or
accounting reserve provisions
Overvaluation of acquired in process
research and development activities

2. Neutral Earnings that result from using a neutral

earnings perspective

3. Aggressive Understating loss or reserve provisions

accounting
Recording sales before they satisfy the
4. Fraudulent earned and measurability criteria
accounting Recording fictitious sales
Backdating sales invoices
Overstating inventory
Red flags of possible fraudulent
reporting:
1. A predominantly insider board of
directors
2. Management compensation tied to its stock price
3. Frequent changes of auditors
4. Rapid turnover of key personnel
5. Deteriorating earnings
6. Unusually rapid growth
7. Lack of working capital
 Red flags of possible fraudulent
reporting:
8. The need to increase the stock price to
meet analysts’ earnings projections
9. Extremely high levels of debt
10. Cash shortages
11. Significant off-balance sheet financing arrangements
12. Doubt about the company’s ability to continue as a going
concern
13. SEC or other regulatory investigations
14. Unfavorable industry economic conditions
15. Suspension or delisting from a stock exchange
 End of Chapter 5

Prepared by Kathryn Yarbrough, MBA

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