Transcript ACCOUNTING THEORY: TEXT AND READINGS

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
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)
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
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
Income Recognition
Criticisms of the transactions approach
Possible alternatives
– Edwards and Bell
1
2
3
4
Current operating profit
Realizable cost savings
Realized cost savings
Realized capital gains
– Sprouse
The concept of measurable change
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
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
3
4
Review recent changes in accounting
principles and changes in estimates to
determine if they inflate earnings.
Determine if discretionary expenditures,
such as advertising, have been postponed
by comparing them to previous periods.
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
7
financial statements to
determine if loss
contingencies exist that
might reduce future
earnings 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
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
Prepared by Kathryn Yarbrough, MBA
Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written consent of the copyright owner is unlawful. Request
for further information should be addressed to the Permissions
Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or
resale. The Publisher assumes no responsibility for errors,
omissions, or damages, caused by the use of these programs or from
the use of the information contained herein.