FINANCIAL ACCOUNTING

THEORY AND ANALYSIS:

TEXT AND CASES
11TH EDITION

RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
CHAPTER 5
INCOME CONCEPTS
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CH05: Income Concepts

I. The Nature of Income:
• Capital Maintenance Concept
• Current-Value Accounting
 Entry Price or Replacement Cost
 Exit Value or Selling Price
 Discounted present value
II. Income Recognition
• Measurement
• Accounting for Inflation
• Revenue Recognition & Realization
• Delayed or Advanced Revenue Recognition
• Matching
• Conservatism
• Materiality
III. Earning Quality, Earning Management, and Fraudulent
• Earning Quality
• Earning Management
• Fraudulent Financial Reporting
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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.

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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

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Importance of Income Reporting

There is a general lack of agreement as to the proper definition of income:

Transaction approach
Economic approach
• Income Statement is more important
• Balance sheet is more importance
than balance sheet
than income statement
• Income is the result of certain
• Income is the increase in net asset
activities that have taken place
that has occurred during a period
during a period

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I. The Nature of Income:

Income may take various forms:

Psychic income
• Refers to the satisfaction of human wants.
• Measurement is difficult because the human wants are not
quantifiable

Money income
• Refers to increases in the monetary valuation of resources
• Easily measured
• Doses not take into consideration changes in the value of
the monetary unit.

Real income
• Refers to increase in economic wealth
• Measured as the change in value of net assets during the
accounting period
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I. The Nature of Income:

Capital Maintenance Concepts:
There are 2 primary concepts of capital maintenance:

Financial Capital maintenance Physical Capital Maintenance

Occurs when the financial amount of
net assets at the end of period exceeds
the financial amount of net assets at
the beginning of the period excluding
transactions with owners
Occurs when physical productive
capacity of the enterprise at the end of
period exceeds its physical productive
capacity at the beginning of the period
excluding transactions with owners
Productive capacity = current value of
net assets

The primary difference lies in the treatment of holding gains and losses
Ex: Increase in the value of land held by a company
Return on Capital Return of Capital

Included in income Direct adjustment to equity (Balance sheet)

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I. The Nature of Income:

Current-Value Accounting:
• The concept of physical capital maintenance requires that all
assets and liabilities be stated at their current value.
• The most common approaches to current-value measurement
are:
1. Entry price or replacement cost.
2. Exit value or selling price
3. Discounted present value

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1. Entry Price or Replacement Cost

 Assets are stated at the cost to replace them with similar assets in
similar condition
 Revenue matched against the current cost of replacing these assets to
determine income
 Income can be distributed to the owners without impairing the
physical capacity to continue operating into the future.
 Problems:
 Easy to determine replacement cost for inventories and certain other
assets, for many other assets especially the physical plant, there may not
be a ready market from which to acquire replacement cost.
 Irrelevant to what could be realized upon sale of those assets, and to their
purchase since they are already owned.

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2. Exit Value or Selling Price:

 Each asset would be valued based on the selling price that would be
realized if the firm chose to dispose of it.
 It is presumed that the asset will be sold in an orderly manner than
forced to liquidation
 Exit prices have decisions relevance because during each accounting
period management decides whether to hold, sell, or replace the
assets.
 Provide users with better information to evaluate liquidity and thus
the ability of the enterprise to adapt to changing economic stimuli.
 Problems:
 Determining selling price for assets such as property, plant, and
equipment, for which there is no ready market.
 Selling prices rather than liquidation may be feasible for assets such as
inventory, but may be impractical for the physical plant since it would not
be disposed in the normal course of business
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3. 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
 Income is equal to the difference between the P.V. of the net assets at
the end of the period and their P.V. at the beginning of the period
excluding transactions with owners
 Problems:
 Depends on an estimate of future cash flows by time periods (amount &
timing)
 Selection of appropriate discount rate.
 Firm’s assets are interrelated, it would not be practical to determine
exactly how much each asset contributed to the firm cash flow.

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II. Income Recognition:

 Due to measurement problem, accountants took the position that a

transactions approach should be used
 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 such as
unrealized holding gains or losses.

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II. Income Recognition:

Measurement:
 Measurement is the assigning of numbers to objects or events
according to rules.
 Process of comparison in order to obtain more precise information
to distinguish one alternative from another in a decision situation.
 Problem of accounting measurement:
1. Change in value of monetary unit (measurement scale)

2. Arbitrary measurements (depreciation, depletion, amortization, …)

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II. Income Recognition:

Accounting for Inflation:
 Instability of the accounting measuring unit is due to the effects of
inflation or deflation.
 Inflation erodes the purchasing power of net monetary assets.
 Financial statement should adjusted to general purchasing power
(GPP).

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II. Income Recognition:

Revenue Recognition and Realization:

Recognition Realization

.. is the formal process of

.. is the process of
reporting a transaction or
converting noncash assets
event in a company’s
to cash or claims to cash
financial statements

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II. Income Recognition:

Revenue Recognition and Realization:

 Accounting recognition relies on determining when realization has

occurred.
 Revenue should realized on the completion of the most crucial task in
the earning process (crucial-event test).
 This test results in the recognition of revenue at various times for
different business organizations.
 In general, companies usually recognize revenues at the time they sell
their product or service (the point of sale).

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II. Income Recognition:

Revenue Recognition and Realization:
 Revenue recognition criteria
1. The revenue has been earned
The firm has accomplished the crucial event in its earning
process.

2. The revenue has been “realized” or is “realizable”.

Revenue can quantified with reasonable degree of
certainty.

Departures from recording revenue at the point of sales arise

because of changes in the degree of certainty surrounding cash
collection
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II. Income Recognition:

Delayed or Advanced Revenue Recognition:
 All companies must decide when the crucial event and
measurability criteria are satisfied.

When a high degree of When a great level of

certainty is associated uncertainty associated
with realization with realization

Revenue
Delay revenue
recognition may
recognition after
precede the
point of sale
point of sale
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II. Income Recognition:

Delayed or Advanced Revenue Recognition:
Revenue recognized:
 During production process:
 When production of the company’s product carries over two or more
periods.
 Percentage of completion method may be used to recognize revenue
 Requires known selling price, and reasonable estimates of total costs.
 Ex: Long-term contract.

 At completion of production:
 When the company’s product can be sold at a determinable price on an
organized market.
 Ex: Gold, some farm products.

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II. Income Recognition:

Delayed or Advanced Revenue Recognition:
 As services are performed:
 In services realization should be connected to the degree of services
performed
 Collection of cash may precede or follow the performance of services.

 As cash is received:
 In certain circumstances, the ultimate collectability of the revenue is in doubt
 Recognition is delayed until cash payment is received.
 Ex: Installment sales

 On occurrence of some event:

 In some cases where binding contract do not exist or rights to cancel are in
evidence.
 Revenue recognition delayed until passage of time. 21
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II. Income Recognition:

Matching
 Once a company has fulfilled its crucial event and recognized revenue, it
must then identify all expenses associated with producing that revenue.
 Determining when costs are of no future benefit and should therefore be
charged against revenue depends on the definition of the terms Cost,
asset, expense and loss.
 Cost: The amount given in consideration of goods received or to be
received, can be classified as:
1. Unexpired (assets)
2. Expired, deducted from revenue
 Expense: Outflows of assets or incurrence of liabilities during a period
from delivering or producing goods, rendering services.

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II. Income Recognition:

Matching

 Assets: Probable future economic benefits obtained or controlled by a

particular entity as a result of past transactions or events.
 Loss: Decreases in equity from peripheral or incidental transactions of an
entity during a period except those that result from expenses or
distributions to owners

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Matching

Cost

Leads to or
Results In

Asset

Used up Used up
Resulting in Resulting in No
Revenue Revenue

Expense Loss 24
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II. Income Recognition:

Conservatism:
 Conservatism holds that when you are in doubt, it is best to choose the
accounting alternative that will be least likely to overstate assets or
income.
 Conservative financial statements are usually unfair to present
stockholders and biased in favor of prospective stockholders because the
net valuation of the firm does not include future expectations.

Materiality:

 Materiality judgments are primarily quantitative in nature. They pose the

question: IS this item large enough for users of the information to be
influenced by it?

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III. 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

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III. Earnings Quality, Earnings Management

and Fraudulent Financial Reporting
Earnings management
 The attempt to influence short-term reported income
 Earnings management occurs for a variety of reasons:
 Influencing the stock market
 Increasing management compensation
 Reducing the likelihood of violating lending agreements
 Avoiding intervention by government regulators.

 Corporate managers often choose accounting policies that

maximize earnings and the firm’s market value.

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III. Earnings Quality, Earnings Management

and Fraudulent Financial Reporting
Earnings management
 Earnings management techniques not outside the scope of GAAP
are legitimate, may involve:
 Revenue & expense recognition issues
 Estimating bad debt allowances
 Doing inventory write-downs
 Estimating the percentage of completion of long-term
construction projects
 Choosing depreciation method
 Earnings management outside the scope of GAAP are illegitimate
 Earnings manipulations that are intended to deceive investors and
creditors constitute financial statement fraud.
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