CHAPTER 2 ACCRUAL ACCOUNTING AND INCOME DETERMINATION

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CHAPTER 2ACCRUAL ACCOUNTING AND INCOME
DETERMINATION
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Roadmap

• Cash vs. Accrual
• Income Statement Formats
• Discontinued operations
• Special items and extraordinary items
• Accounting changes
• changes of principles
• change of estimates
• change of reporting entities
• Comprehensive Income

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I. Cash Vs. Accrual Inc. 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.

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I. Cash Vs. Accrual Inc. Measurement
A. Accrual-basis income
measurement is the cornerstone of 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.

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I. Cash Vs. Accrual Inc. Measurement

B. Cash-basis income
measurement is straightforward.

• 1. Revenues are recorded when cash is received.
• 2. Expenses are recorded when cash is paid.

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Cash Accounting Example

• 1998 1999 2000
• Cash inflows 300 0 0
• Cash outflow (60) (60) (60)
• due to cost
• Cash outflow 0 0 (30)
• due to int.exp
• Net Income 240 (60) (90)

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Accrual Accounting Example

• 1998 1999 2000
• Revenue 100 100 100
• Cost (60) (60) (60)
• Int Expense (10) (10) (10)
• Net Income 30 30 30

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Some simple facts

• Company had division A and division B and it
  decided to discontinue division B in July, 1998.
  By that time, division B had already generated
  net income (net of tax) of 203 millions in 1998.
  Disposing division B yielded additional
  accounting gain of 98 millions.

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Income Statement Format
1998 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
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Income Statement Format
1998 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
Tax Expense
Net of Tax
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Discontinued operations

• Definition 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 (APB Opinion No. 30, AICPA,
  1973, paragraph 13).
• Accounting Treatment previous results are
  restated to reflect discontinued operations.

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Income Statement Geography
1998 1997 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 Numbers in the box
will not match those reported in the 1997 annual
report, though the Net Income figure will.
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Income Statement Geography
1998 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.
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Extraordinary items.

• 1. Extraordinary items must meet both of the
  following criteriaa. The underlying event or
  transaction must be unusual in nature, i.e.,
  possess a high degree of abnormality.
• 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.

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Special Items

• Events that meet one, but not both, of these
  criteria, are reported as income from continuing
  operations.e.g. asset writedown.
• a. If material in amount (i.e., of sufficient
  magnitude to make a difference in the
  decision-making process) then the item must be
  disclosed as a separate item in the Special or
  unusual items section of the income statement.
• b. If not, a separate disclosure in the footnotes
  to the financial statements is allowed.

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Changes in accounting principles

• A. Default setting
• 1. Prior periods income statements generally are
  not restated to reflect the income effect of
  changing to a new principle.
• 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 the change.
  
• Disclose in footnote income figures computed as
  if the new accounting principle had been applied
  during all past periods that are presented.
• Special case When a company switches its
  inventory valuation method to LIFO. No. 3 and 4
  cant be done.

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Changes in accounting principles

• B. Retroactive restatement allowed
• Applies when changes are mandated by FASB (no
  mgmt discretion)
• The new principle is applied in computing income
  from continuing operations in the year of the
  change.
• No need to show the cumulative effect of the
  change (net of income tax effects) on all prior
  years income
• No disclosure of prior years income figures
  computed as if the new principle had been applied

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Income Statement Geography
1998 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
Default method for changes..
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Changes in Accounting Estimates

• Past income is never adjusted
• If the change in estimate has a material effect
  on current and future income, the dollar amount
  of the effect must be disclosed.

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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.

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Comprehensive Income

• There are some events that change the balance
  sheet values for assets and liabilities, but
  dont immediately affect the income statement.
• Dr. Market securities xxx
• Cr. Owners equity xxx
• New standard requires disclosure of Comprehensive
  Income, which equals reported net income plus the
  changes in these shareholders equity adjustment
  accounts.

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Figure 2.7 Elements Comprising Comprehensive
Income
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Roadmap

• Cash vs. Accrual
• Income Statement Formats
• Discontinued operations
• Special items and extraordinary items
• Accounting changes
• changes of principles
• change of estimates
• change of reporting entities
• Comprehensive Income