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
capital
maintenance
- money
amount transactions
based
Physical
capital
maintenance
- productive
capacity
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
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.
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 vendor’s 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 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
6
Determine the replacement
cost of inventories and other
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 Earnings Management
1.
Conservative
accounting
Overly aggressive recognition of loss or
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 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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