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 corporations
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
me
o
c
t
In
n
e
tem
a
t
S

B al
an c
She e
et

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

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
2
3
4

Current operating profit

Realizable cost savings
Realized cost savings
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

Firms 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

The income producing activities cycle

Revenue recognition criteria

1.
2.

The revenue has been earned

The revenue has been realized or is realizable

SAB No. 101 criteria

1.
2.
3.
4.

Persuasive evidence of an arrangement exists

Delivery has occurred
The vendors fee is fixed or determinable
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
2
3
4
5
5

During production
At close of production
Services performed
Cash
Occurrence of some event
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
Resulting in
Revenue

Expense

Used up
Resulting in No
Revenue

Loss

Concepts Affecting Revenue

Recognition

Conservatism
Materiality

Earnings Quality, Earnings

Management and Fraudulent
Financial Reporting
Earnings quality
The correlation between a companys
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
Assessing
Financial
Reporting
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
5Financial
Determine the replacement
Reporting
cost of inventories and other
6

assets. Assess whether the

company generating
sufficient cash flow to
replace its assets?
Review the notes to financial
statements to determine if
loss contingencies exist that
might reduce future earnings 7
and cash flows.
8

Review the relationship between

sales and receivables to determine
if receivables are increasing more
rapidly than sales.
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
1.Earnings
ConservativeManagement
Overly aggressive recognition of loss or
accounting

reserve provisions
Overvaluation of acquired in process
research and development activities

2.

Neutral
earnings

Earnings that result from using a neutral

perspective

3.

Aggressive
accounting

Understating loss or reserve provisions

4.

Fraudulent
accounting

Recording sales before they satisfy the

earned and measurability criteria
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 companys 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

Prepared by Kathryn Yarbrough, MBA

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