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
Recent Developments
 FASB-IASB Short-term International
Convergence Project
 Conflicts in SFAC Nos. 5 and 6
 Practical and conceptual reasons to address
revenue recognition
 Project approach based on changes in assets
and liabilities consistent with SFAC No. 6
 SEC Staff Accounting Bulletin No. 101
Recent Developments: 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
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
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