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CHAPTER 2

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

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CHAPTER 2

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  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 Revenuesarerecognized.(Matching Principle) • Can you think of examples of expenses?

  4. I. Cash Versus Accrual Income Measurement • 3. Accrual accountingdecouplesmeasuredearnings (e.g., revenues less expenses) from the amount of cash generated from operations. • a. Accrual accountingRevenues 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 b. Accrual accounting can produce large discrepanciesbetweenmeasured earnings and the amount of cash generated from operations. 3. Accrual accountingdecouplesmeasuredearnings (e.g., revenues less expenses) from the amount of cash generated from operations.

  6. I. Cash Versus Accrual Income Measurement 3. Accrual accountingdecouplesmeasuredearnings (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 one’s view of operating performance. • a Cash-basis incomefails to properly matcheffort & accomplishment. • b Cash-basis income may not provide a reliable benchmark for predictingfuture operating results

  9. I. Cash Versus Accrual Income Measurement Let’s 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 distortsCanterbury’s 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) Noneof thecash-basis earningsfigures providesareliable benchmarkfor predictingfuture operating results. 0 0 (30,000) $240,000 ($60,000) ($90,000)

  14. I. Cash Versus Accrual Income Measurement Now let’s 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 What do you think of the results? (60,000) (60,000) (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 matcheseconomic 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) Notice total of all 3 years Net Income is $90,000 $30,000 $30,000 $30,000

  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 matchingeffect 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. • i. Revenue recognitionincreasesnet assets (i.e., gross assets - gross liabilities) and owners’ equity by identical amounts. • 3. Revenue recognition and matchingeffect changes in the asset and liability accounts on the balance sheet.(The Actg. Equation must balance!) Assets = Liabilities + Owners’ Equity +Cash $130 + Sales Rev $130 or +A/R $130

  23. ii. Expensematchingdecreasesnet assets and owners’ equity by identical amounts. II. Measuring Profit Performance: Rev & Exp A. Income is earned as the result of several activities. • 3. Revenue recognition and matchingeffect changes in the asset and liability accounts on the balance sheet.(The Actg. Equation must balance!) 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. • b. As a result, net asset valuation and income determination are inextricably intertwined. • 3. Revenue recognition and matchingeffect changes in the asset and liability accounts on the balance sheet.(The Actg. Equation must balance!) Assets = Liabilities + Owners’ Equity

  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 verifiableevidence.

  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 when:a. 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 customer’s 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 present:a. Extreme uncertainty exists regarding the amount of cash to be collected from customers. This uncertainty may be attributable to:i. 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 1. The recognition of expensesgenerallyfollows the recognition of revenue. C. Matchingexpenses with revenues.

  36. II. Measuring Profit Performance: Rev & Exp C. Matchingexpenses with revenues. • 2. Traceable (product) costs are costs that contributedirectly 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. Matchingexpenses with revenues. • 3. Period costs are important in generatingrevenue, 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 subdivideincome 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 separatelyincome 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 SG&A (1,093) Special 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 SG&A (1,093) Special 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 SG&A (1,093) Special 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 includesgains and losses that occur infrequently—called special or unusual items—but that arise from a firm’s 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 SG&A (1,093) Special 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 separatelybelow the income from continuing operations line. 2001 Net sales $3,957 Cost of goods sold (1,364) Gross profit $2,593 SG&A (1,093) Special 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 belowincome from continuing operationsnet of income tax effects. 2001 Net sales $3,957 Cost of goods sold (1,364) Gross profit $2,593 SG&A (1,093) Special 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 SG&A (1,093) Special 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 1.This “net of tax treatment” is called intraperiod income tax allocation. “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 SG&A (1,093) Special 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 SG&A (1,093) Special 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 taxesarising 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 SG&A (1,093) Special 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

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