4 The Income Statement
and Income Recognition
Accounting School ·Zhongnan
University of Economics & Law
ntermediate
Accounting
I
中级会计学
1,Concepts of income
Intermediate Accounting 4 The Income Statement and Income Recognition
Capital Maintenance Concept
Under this concept,corporate income for a
period of time is the amount that may be
paid to stockholders during that period and
still enable the corporation to be as well
off at the end of the period as it was at the
beginning.
Assume a corporation has net assets of $50,000 at the
beginning and $90,000 at the end of the year,and that no
additional investments or withdrawals were made.
Ending net assets $90,000
Less,Additional investment 0
Ending net assets excluding investment $90,000
Less,Beginning net assets (50,000)
Total income for the year $40,000
The corporation could pay
out $40,000 to stockholders
and still be as well off at
year-end.
Example of Capital Maintenance
Intermediate Accounting 4 The Income Statement and Income Recognition
Transactional Approach
Under this concept,a company
records its net assets at their
historical cost,and it does not
record changes in the asset and
liabilities unless a transaction,
event,or circumstance has occurred
that provides reliable evidence of a
change in value.
Intermediate Accounting 4 The Income Statement and Income Recognition
2,Elements of the Income Statement
? In FASB Statement of Concepts No,6,the
FASB defined the elements or "building blocks"
of the income statement:
? Revenues
? Expenses
? Gains
? Losses
Intermediate Accounting 4 The Income Statement and Income Recognition
Elements of the Income Statement —
Revenues
Revenues are inflows of assets of
a company or settlement of its
liabilities during a period from
delivering or producing goods,
rendering services,or other
activities that are the company’s
ongoing major or central
operations.
Revenue recognition
is the process of
formally recording
and reporting an item
in a company’s
financial statements.
Intermediate Accounting 4 The Income Statement and Income Recognition
Elements of the Income Statement —
Expenses
Expenses are outflows of
assets of a company or
incurrence of liabilities during
a period from delivering or
producing goods,rendering
services,or carrying out other
activities that are the
company’s ongoing major or
central operations.
Intermediate Accounting 4 The Income Statement and Income Recognition
Elements of the Income Statement — Gains
Gains are increases in a
company’s equity (net assets)
from peripheral or incidental
transactions of the company and
from all other events and
circumstances affecting the
company during a period except
those that result from revenues or
investments by owners.
Intermediate Accounting 4 The Income Statement and Income Recognition
Elements of the Income Statement —
Losses
Losses are decreases in a
company’s equity (net assets)
from peripheral or incidental
transactions of the company and
from all other events and
circumstances affecting the
company during a period except
those that result from expenses
or distributions to owners.
Intermediate Accounting 4 The Income Statement and Income Recognition
3,Income statement content
? Income from continuing
operations
? Results from discontinued
operations
? Extraordinary items (net
of income taxes)
? Cumulative effects of
changes in accounting
principles (net of income
taxes)
? Net income
? Earnings per share
Intermediate Accounting 4 The Income Statement and Income Recognition
Income from continuing operations
? Sales revenue (net)
? Cost of goods sold
? Operating expenses
? Other items
? Income tax expense related to
continued operations
Income from continuing operations summarizes the
income from usual and recurring operating activities,It
includes,
Intermediate Accounting 4 The Income Statement and Income Recognition
Income from continuing operations
Determining Subtotals
Gross profit:
Revenue – Cost of goods sold
Operating income:
Gross profit – Operating expenses
Intermediate Accounting 4 The Income Statement and Income Recognition
Income from continuing operations
Determining Subtotals
Income from continuing operations before
income taxes:
Operating income + Other revenues and gain –
Other expenses and losses
Income from continuing operations:
Income from continuing operations before
income taxes – Income taxes on continuing
operations
Intermediate Accounting 4 The Income Statement and Income Recognition
Sales revenue (net)
Sales revenue reports the
total sales to customers for
the period less any sales
returns and allowances or
discounts.
Intermediate Accounting 4 The Income Statement and Income Recognition
Cost of Goods Sold
Intermediate Accounting 4 The Income Statement and Income Recognition
Beginning inventory
+ Net purchases
+ Freight-in
+ Other inventory acquisition costs
= Cost of goods available for sale
– Ending inventory
= Cost of goods sold
Operating Expenses
Intermediate Accounting 4 The Income Statement and Income Recognition
Operating expenses may be
reported in two parts:
1) Selling expenses
2) General and
administrative expenses
Other items
Intermediate Accounting 4 The Income Statement and Income Recognition
? Rent revenue
? Interest revenue
? Dividend revenue
? Gains from the sale of assets
? Interest expense
? Losses from the sale of assets
Other items include recurring revenues and expenses not
directly related to the company's primary operations,For
example:
“Below the Line” Items
Intermediate Accounting 4 The Income Statement and Income Recognition
? GAAP requires certain items be reported
“below the line” and net of tax.
?,Below the line,” or following Income
from Continuing Operations.
? Net of tax requires the tax effect of the
event be shown.
“Below the Line” Items
Intermediate Accounting 4 The Income Statement and Income Recognition
? Discontinued
Operations
? Extraordinary Items
? Changes in
Accounting Principles
Results from Discontinued Operations
Intermediate Accounting 4 The Income Statement and Income Recognition
Examples from APB No,30
The sale by a
diversified company
of a major division
that represented the
company’s only
activities in the
electronic industry.
1/1/02 7/1/02
Operating Loss
(net of tax)
$24,500
Measurement
Date
Disposal
Date
12/31/02
Statement
Date
Phase-out Period
Loss on Disposal
(net of tax;
includes operating
results 7/1 through
11/17 and loss on
final disposal)
$11,200
11/17/02
Intermediate Accounting 4 The Income Statement and Income Recognition
Discontinued Operations - phases
Income statement section consists of two
parts:
– Income (loss) from operations--disclosed only
if decision to discontinue operations is made
after beginning of the year.
– Gain (loss) on disposal of operations--
consisting of income (loss) during phase- out
and gain (loss) from disposal of segment assets.
Intermediate Accounting 4 The Income Statement and Income Recognition
Discontinued Operations - Disclosure
4/29/02
Disposal
Date
Loss on Disposal
$5,000 (including
$2,000 expected
operating loss)
Phase-out Period
1/1/01
Measurement
Date
8/31/01
Operating Loss
$4,000
Statement
Date
12/31/02
12/31/01
Intermediate Accounting 4 The Income Statement and Income Recognition
Discontinued Operations - Disposal Date
After Year End
? Special rules when disposal date is in year
following measurement date.
? A realized,loss on disposal” may be increased by
an estimated loss or it may be reduced by an
estimated gain.
? A realized,gain on disposal” may be reduced by
an estimated loss but cannot be increased by an
estimated gain.
Intermediate Accounting 4 The Income Statement and Income Recognition
Discontinued Operations - Disposal Date
After Year End
Intermediate Accounting 4 The Income Statement and Income Recognition
Extraordinary Items
An extraordinary item is an event
or transaction that is both unusual
in nature and infrequent in
occurrence.
Extraordinary Items
Intermediate Accounting 4 The Income Statement and Income Recognition
Unusual nature—the
underlying event or
transaction possesses a
high degree of
abnormality and is of a
type clearly unrelated to,
or only incidentally
related to,the ordinary
and typical activities of
the company.
Infrequency of
occurrence—the
underlying event or
transaction is of a type
that is not reasonably
expected to recur in the
foreseeable future.
Never Extraordinary
Intermediate Accounting 4 The Income Statement and Income Recognition
Events that the APB Opinion No,30 identified as not
qualifying as extraordinary:
1,The write-down or write-off of receivables,
inventories,equipment leased to others,or
intangible assets.
2,Gains or losses from exchanges or transactions of
foreign currency.
3,Gains or losses from the disposals of a business
component.
Continued
Never Extraordinary
Intermediate Accounting 4 The Income Statement and Income Recognition
4,Other gains or losses from the sale or
abandonment of property,plant,or equipment.
5,The effects of a strike.
6,The adjustment of accruals on long-term contracts.
7,The effect of a terrorist attack.
Change in Accounting Principle
Intermediate Accounting 4 The Income Statement and Income Recognition
?A change in accounting principle occurs when
a company adopts a generally accepted
accounting principle different from the one it has
been using in its financial reporting.
?Criteria for change-- change only if the new
principle is preferable:
? provides more useful information.
? is less costly per benefit.
In most instances,a company reports the cumulative effect
on prior years’ earnings in its net income for the year in
which it makes the change.
Change in Accounting Estimate
Intermediate Accounting 4 The Income Statement and Income Recognition
When a company changes an accounting
estimate,it accounts for the change in the
current year,and in future years if the
change affects both.
Earnings Per Share
Intermediate Accounting 4 The Income Statement and Income Recognition
When presenting EPS figures,
separate EPS amounts are
computed for income from
continuing operations and each
irregular or extraordinary item.
Earnings Per Share
Intermediate Accounting 4 The Income Statement and Income Recognition
Formula for Income from
Continuing Operations
Income from continuing operations
Weighted average number of shares of
common stock outstanding
4,Income statement formats
GAAP requires
certain income
statement
disclosures.
Right,but GAAP does
not require a specific
format.
Intermediate Accounting 4 The Income Statement and Income Recognition
Single-Step Income Statement
Intermediate Accounting 4 The Income Statement and Income Recognition
Revenues
Sales revenue $143,700
Interest revenue 1,800
Dividend revenue 600
Total revenues $146,100
Expenses
Cost of goods sold $ 86,000
Selling expense 10,200
General and admin,expense 16,000
Depreciation expense 7,800
Continued
Expenses (continued)
Loss on sale of equipment 4,000
Interest expense 2,100
Income tax expense 6,000
Total expenses (132,100 )
Income from continuing operations $ 14,000
Results from discontinued operations
Income from operations of
significant component A
(net of $1,950 income taxes) $ 4,550
Loss on disposal of significant
component A (net of $3,150
income tax) (7,350 ) (2,800 )
Income before extraordinary items $ 11,200 Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Income before extraordinary items $ 11,200
Extraordinary loss from explosion
(net of $750 income tax credit) (1,750 )
Cumulative effect on prior years’
income of change in depreciation
method (net of $600 income taxes) 1,400
Net income $ 10,850
Earnings per
Common Share
(8,000 shares)Components of Income
Income from continuing operations $ 2.80
Results from discontinued operations (0.56 )
Extraordinary loss from explosion (0.35 )
Cumulative effect on prior years’ income 0.28
Net income $2.17
Intermediate Accounting 4 The Income Statement and Income Recognition
Multiple-Step Income Statement
Intermediate Accounting 4 The Income Statement and Income Recognition
Continued
Revenue $xxx
Costs of goods sold:
Beginning inventory $xxx
Net purchases xxx
Cost of goods available for sale $xxx
Less ending inventory xxx xxx
Gross profit $xxx
Operating expenses:
Selling expenses $xxx
General expenses xxx xxx
Operating income $xxx
Other items $xxx
Intermediate Accounting 4 The Income Statement and Income Recognition
Income from continuing operations before
income taxes $xxx
Income taxes on continuing operations (xxx)
Discontinued operations:
Loss from operations of discontinued
business segment (net of tax) $xxx
Loss on disposal of segment (net of tax) xxx (xxx)
Extraordinary gain (net of tax) xxx
Net income $xxx
Earnings per
Common Share
(8,000 shares)Components of Income
Income from continuing operations $ XXX
Results from discontinued operations XXX
Extraordinary loss from explosion XXX
Cumulative effect on prior years’ income XXX
Net income $XXX
5,Limitations of the income statement
Intermediate Accounting 4 The Income Statement and Income Recognition
Intermediate Accounting 4 The Income Statement and Income Recognition
Could you illustrate
limitations of the income
statement?
6,Income Statement analysis
Evaluating profitability
? Stockholder profitability ratios indicate how
effectively a company has been meeting the profit
objectives of its owners,including,Earnings per
share; The price/earnings ratio; The dividend yield
ratio
? Company profitability ratios indicate how effectively
a company has met its overall profit (return)
objectives,particularly in relation to the resources
invested,including,Profit margin; Return on total
assets; Return on stockholders' equity.
Intermediate Accounting 4 The Income Statement and Income Recognition
Overall Profitability
Intermediate Accounting 4 The Income Statement and Income Recognition
Two ratios that measure overall profitability are
“Return on Assets” and,Return on Equity.”
Net Income $ 40
Total Assets 400
Stockholders’ Equity 160Return on Assets
$40
$400
= 10%
McDonald’s 7.8%
Microsoft 20.2%
Disney 4.5%
Coca-Cola 18.5%
Yahoo! 4.1%
Return on Assets
Intermediate Accounting 4 The Income Statement and Income Recognition
Overall Profitability
Intermediate Accounting 4 The Income Statement and Income Recognition
Two ratios that measure overall profitability are
“Return on Assets” and,Return on Equity.”
Net Income $ 40
Total Assets 400
Stockholders’ Equity 160Return on Equity
$40
$160
= 25%
McDonald’s 16.4%
Microsoft 27.0%
Disney 9.5%
Coca-Cola 42.0%
Yahoo! 4.8%
Return on Equity
Intermediate Accounting 4 The Income Statement and Income Recognition
7,Comprehensive Income
Intermediate Accounting 4 The Income Statement and Income Recognition
Recall that the FASB now requires companies to
report their comprehensive income (or loss) for
the accounting period.
Comprehensive income is the amount that reflects the
change in a company’s wealth during the period,In
addition to net income,it includes items that,in general,
arise from changes in market conditions unrelated to the
business operations of a company,Currently,there are
four items of a company’s other comprehensive income:
Continued
1,Any unrealized increases (gains) or decreases
(losses) in the market value of investments in
available-for-sale securities.
2,Any change in the excess of its additional pension
liability over unrecognized prior service costs.
3,Certain gains and losses on,derivative” financial
instruments,
4,Any transaction adjustment from converting the
financial statements of a company’s foreign
operations into U,S,dollars.
Comprehensive Income
Intermediate Accounting 4 The Income Statement and Income Recognition
?On the face of its income statement.
?In a separate statement of comprehensive income.
?In its statement of changes in stockholders’ equity.
Comprehensive Income
The FASB allows a company to report its
comprehensive income under three alternatives:
The company must display the statement containing
the comprehensive income as a major financial
statement in its annual report.
Intermediate Accounting 4 The Income Statement and Income Recognition
8,Conceptual issues of revenue
recognition
Intermediate Accounting 4 The Income Statement and Income Recognition
? Recognition,The process of formally recording
or incorporating an item in the financial
statements of an entity
? Realization,The process of converting non-cash
resources and rights into money refers to sales of
assets for cash or claims to cash.
Conceptual Issues
Intermediate Accounting 4 The Income Statement and Income Recognition
The decision as to when to recognize revenue focuses
on three factors:
? The economic substance of the event takes
precedence over the legal form of the transaction.
? The risks and benefits of ownership have been
transferred to the buyer.
? The collectibility of the receivable from the sale is
reasonably assured.
9,Revenue recognition alternatives
Intermediate Accounting 4 The Income Statement and Income Recognition
? Revenue recognition in the period of sale.
? Revenue recognition prior to the period of
sale.
? Revenue recognition after the period of
sale.
Earned and Realizable
Economic Substance
and Transfer of Risks
and Benefits of
Ownership
Collectibility is
Not Reasonably
Assured
Installment
Method
Cost
Recovery
Method
Percentage-of-
Completion Method
(for Long-Term
Contracts)
Completed-
Contract Method
(for Long-Term
Contracts)
Accrual Method,
“Normal” Revenue
Recognition at Sale
Not Sufficient
Transfer of Risks
and Benefits of
Ownership
Deposit
Method
Recognition before
Physical Transfer
Recognition at
Physical Transfer
Collectibility is
Reasonably
Assured
Revenue Recognized
Intermediate Accounting 4 The Income Statement and Income Recognition
?Completed-Contract Method,recognize
all income when project is completed.
?Percentage-of-Completion Method,
recognize revenue throughout the term of
the contract.
Intermediate Accounting 4 The Income Statement and Income Recognition
Long-Term Construction Contracts--
Recognition Choices
GAAP requires
percentage-of-completion
method unless certain
criteria are not met.
Percentage-of-Completion Method
Intermediate Accounting 4 The Income Statement and Income Recognition
AICPA Statement of Position No,81-1 requires that a
construction company use the percentage-of-completion
method for long-term contracts when all the following
conditions are met:
1,The company can make reasonably dependable estimates of the
extent of progress toward completion,contract revenue,and
contract costs.
2,The contract clearly specifies the enforceable rights regarding
goods or services to be provided and received by both the
company and the buyer,the consideration to be exchanged,and
the manner and terms of settlement.
3,The buyer can be expected to satisfy its obligations under the
contract.
4,The company expects to perform its contractual obligations.
Percentage-of-Completion Method--General
Concepts
Intermediate Accounting 4 The Income Statement and Income Recognition
? Recognize revenue throughout life of the contract.
? Revenue recognized is a function of how complete the
project is.
? Costs are charged to an inventory account,Construction in
Process (CIP).
? Profits are charged to CIP.
? CIP is valued at net realizable value.
? Any anticipated loss is booked for the full amount of the loss
when it becomes measurable.
Determine Percentage-of-Completion
Intermediate Accounting 4 The Income Statement and Income Recognition
?Input measures,
? Cost-to-cost method where the degree of completion is
determined by comparing costs already incurred with the
most recent estimates of total expected costs to complete the
project,
? Efforts-expended method where the degree of completion is
determined by comparing the work (labor hours,labor
dollars,machine hours,material quantities,etc.) performed
to date with the total estimated work for the contract
?Output measures
Percentage-of-Completion Method
2004 2005 2006
Construction costs incurred during
the year $100,000 $186,000 $314,000
Estimated costs to complete the
contract 400,000 264,000 ---
Partial billing to customer 80,000 350,000 270,000
Collections from customer 50,000 330,000 320,000
Total contract price,$700,000
Example
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
1,To record construction costs:
Construction in Progress 100,000
Accounts Payable,etc,100,000
2,To record partial billings:
Accounts Receivable 80,000
Partial Billings 80,000
2004
3,To record collections:
Cash 50,000
Accounts Receivable 50,000
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
4,To record gross profit:
Construction Expense 100,000
Construction in Progress 40,000
Construction Revenue 140,000
2004
($100,000 ÷ $500,000) x $700,000
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
1,To record construction costs:
Construction in Progress 186,000
Accounts Payable,etc,186,000
2,To record partial billings:
Accounts Receivable 350,000
Partial Billings 350,000
2005
3,To record collections:
Cash 330,000
Accounts Receivable 330,000
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
4,To record gross profit:
Construction Expense 186,000
Construction in Progress 38,000
Construction Revenue 224,000
2005
[($286,000 ÷ $550,000) x $700,000] – $140,000
Construction costs
incurred to date
Revised cost =
$286,000 + $264,000
Previous year’s
construction revenueContinued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
1,To record construction costs:
Construction in Progress 314,000
Accounts Payable,etc,314,000
2,To record partial billings:
Accounts Receivable 270,000
Partial Billings 270,000
2006
3,To record collections:
Cash 320,000
Accounts Receivable 320,000
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
4,To record gross profit and close out accounts:
Construction Expense 314,000
Construction in Progress 22,000
Construction Revenue 336,000
2006
$700,000 – $140,000 – $224,000
Recognized in 2004Recognized in 2005
Partial Billings 700,000
Construction in Progress 700,000
Intermediate Accounting 4 The Income Statement and Income Recognition
Completed-Contract Method
Entries 1,2,and 3 are the same as those used
for the percentage-of-completion method,
The completed-contract method does not
recognize revenue until the project is
completed,so there is no Entry 4 until 2006.
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Example
4,To record gross profit and close out accounts:
Partial Billings 700,000
Construction Revenue 700,000
2006
Completed-Contract Method
Construction Expense 600,000
Construction in Progress 600,000
$100,000 + $186,000 + $314,000
Intermediate Accounting 4 The Income Statement and Income Recognition
Uncertain Collections--Recognition
Alternatives
Intermediate Accounting 4 The Income Statement and Income Recognition
? Installment Sales Method,Recognizes revenues and
related expenses as cash is received (used when
collection is somewhat uncertain).
? Cost Recovery Method,No income is recognized on
sale until the cost of the item sold is recovered through
cash receipts (used when collection is very uncertain).
Installment Method
Intermediate Accounting 4 The Income Statement and Income Recognition
The installment sales method is
used most commonly in cases of
real estate sales.
Installment Method
Intermediate Accounting 4 The Income Statement and Income Recognition
1,Total sales,cost of goods sold,and collections are
recorded in the normal manner during the year.
2,At the end of the year,installment sales are
identified,The revenue and the related cost of
goods sold are,reversed,” and the deferred gross
profit is recognized.
3,At the end of the year,the gross profit rate on
installment sales is computed.
4,A portion of the deferred gross profit is recognized
as gross profit.
5,In future years the remaining deferred gross profit is
reduced and the gross profit is recognized based on
the cash collected on the installment sales
Installment Method
Intermediate Accounting 4 The Income Statement and Income Recognition
Example
Consider the following information for ABC for 2005:
Total credit sales $500,000
Total cost of goods sold 390,000
Installment method sales 100,000
Installment method cost of goods sold 75,000
Gross profit rate on installment method sales 25%
Cash receipts on installment method sales 20,000
Cash receipts on other credit sales 300,000
ABC Company uses a perpetual inventory method.
Continued
Installment Method
Accounts Receivable 500,000
Sales 500,000
Cost of Goods Sold 390,000
Inventory 390,000
Credit sales during 2005:
Cash 320,000
Accounts Receivable 320,000
Collected $300,000; $20,000 related to installment sales:
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Sales 100,000
Cost of Goods Sold 75,000
Deferred Gross Profit,2005 25,000
Installment sales and related cost of goods sold
identified and,reversed” on December 31,2005:
Deferred Gross Profit,2005 5,000
Gross Profit Realized on Installment
Method Sales 5,000
Recognized a gross profit of 25% of cash collected on
installment sales on December 31,2005:
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Consider the following information for ABC for
2006:
Total credit sales $600,000
Total cost of goods sold 430,000
Installment method sales 150,000
Installment method cost of goods sold 105,000
Gross profit rate on installment method sales 30%
Cash receipts on installment method sales:
2005 sales 30,000
2006 sales 40,000
Cash receipts on other credit sales 480,000Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Accounts Receivable 600,000
Sales 600,000
Cost of Goods Sold 430,000
Inventory 430,000
Credit sales during 2006:
Cash 550,000
Accounts Receivable 550,000
Collected $550,000; $70,000 related to installment sales:
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Sales 150,000
Cost of Goods Sold 105,000
Deferred Gross Profit,2006 45,000
Installment sales and related cost of goods sold
identified and,reversed on December 31,2006:
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Deferred Gross Profit,2005 7,500
Deferred Gross Profit,2006 12,000
Gross Profit Realized on Installment
Method Sales 19,500
On December 31,2006,recognized a gross profit of 25%
of cash collected on installment sales for 2005 and 30% for
2006:
Intermediate Accounting 4 The Income Statement and Income Recognition
Intermediate Accounting 4 The Income Statement and Income Recognition
Cost Recovery Method
APB Opinion No,10 found the
cost recovery method of
recognizing revenue generally to
be unacceptable,However,the
Board did agree that this method
could be used in exceptional cases
where receivables are collected
over an extended period and where
the terms of the transaction
provide no reasonable basis for
estimating the degree of
collectibility.
Recovered
Cost
Revenue
The End
Intermediate Accounting 4 The Income Statement and Income Recognition
and Income Recognition
Accounting School ·Zhongnan
University of Economics & Law
ntermediate
Accounting
I
中级会计学
1,Concepts of income
Intermediate Accounting 4 The Income Statement and Income Recognition
Capital Maintenance Concept
Under this concept,corporate income for a
period of time is the amount that may be
paid to stockholders during that period and
still enable the corporation to be as well
off at the end of the period as it was at the
beginning.
Assume a corporation has net assets of $50,000 at the
beginning and $90,000 at the end of the year,and that no
additional investments or withdrawals were made.
Ending net assets $90,000
Less,Additional investment 0
Ending net assets excluding investment $90,000
Less,Beginning net assets (50,000)
Total income for the year $40,000
The corporation could pay
out $40,000 to stockholders
and still be as well off at
year-end.
Example of Capital Maintenance
Intermediate Accounting 4 The Income Statement and Income Recognition
Transactional Approach
Under this concept,a company
records its net assets at their
historical cost,and it does not
record changes in the asset and
liabilities unless a transaction,
event,or circumstance has occurred
that provides reliable evidence of a
change in value.
Intermediate Accounting 4 The Income Statement and Income Recognition
2,Elements of the Income Statement
? In FASB Statement of Concepts No,6,the
FASB defined the elements or "building blocks"
of the income statement:
? Revenues
? Expenses
? Gains
? Losses
Intermediate Accounting 4 The Income Statement and Income Recognition
Elements of the Income Statement —
Revenues
Revenues are inflows of assets of
a company or settlement of its
liabilities during a period from
delivering or producing goods,
rendering services,or other
activities that are the company’s
ongoing major or central
operations.
Revenue recognition
is the process of
formally recording
and reporting an item
in a company’s
financial statements.
Intermediate Accounting 4 The Income Statement and Income Recognition
Elements of the Income Statement —
Expenses
Expenses are outflows of
assets of a company or
incurrence of liabilities during
a period from delivering or
producing goods,rendering
services,or carrying out other
activities that are the
company’s ongoing major or
central operations.
Intermediate Accounting 4 The Income Statement and Income Recognition
Elements of the Income Statement — Gains
Gains are increases in a
company’s equity (net assets)
from peripheral or incidental
transactions of the company and
from all other events and
circumstances affecting the
company during a period except
those that result from revenues or
investments by owners.
Intermediate Accounting 4 The Income Statement and Income Recognition
Elements of the Income Statement —
Losses
Losses are decreases in a
company’s equity (net assets)
from peripheral or incidental
transactions of the company and
from all other events and
circumstances affecting the
company during a period except
those that result from expenses
or distributions to owners.
Intermediate Accounting 4 The Income Statement and Income Recognition
3,Income statement content
? Income from continuing
operations
? Results from discontinued
operations
? Extraordinary items (net
of income taxes)
? Cumulative effects of
changes in accounting
principles (net of income
taxes)
? Net income
? Earnings per share
Intermediate Accounting 4 The Income Statement and Income Recognition
Income from continuing operations
? Sales revenue (net)
? Cost of goods sold
? Operating expenses
? Other items
? Income tax expense related to
continued operations
Income from continuing operations summarizes the
income from usual and recurring operating activities,It
includes,
Intermediate Accounting 4 The Income Statement and Income Recognition
Income from continuing operations
Determining Subtotals
Gross profit:
Revenue – Cost of goods sold
Operating income:
Gross profit – Operating expenses
Intermediate Accounting 4 The Income Statement and Income Recognition
Income from continuing operations
Determining Subtotals
Income from continuing operations before
income taxes:
Operating income + Other revenues and gain –
Other expenses and losses
Income from continuing operations:
Income from continuing operations before
income taxes – Income taxes on continuing
operations
Intermediate Accounting 4 The Income Statement and Income Recognition
Sales revenue (net)
Sales revenue reports the
total sales to customers for
the period less any sales
returns and allowances or
discounts.
Intermediate Accounting 4 The Income Statement and Income Recognition
Cost of Goods Sold
Intermediate Accounting 4 The Income Statement and Income Recognition
Beginning inventory
+ Net purchases
+ Freight-in
+ Other inventory acquisition costs
= Cost of goods available for sale
– Ending inventory
= Cost of goods sold
Operating Expenses
Intermediate Accounting 4 The Income Statement and Income Recognition
Operating expenses may be
reported in two parts:
1) Selling expenses
2) General and
administrative expenses
Other items
Intermediate Accounting 4 The Income Statement and Income Recognition
? Rent revenue
? Interest revenue
? Dividend revenue
? Gains from the sale of assets
? Interest expense
? Losses from the sale of assets
Other items include recurring revenues and expenses not
directly related to the company's primary operations,For
example:
“Below the Line” Items
Intermediate Accounting 4 The Income Statement and Income Recognition
? GAAP requires certain items be reported
“below the line” and net of tax.
?,Below the line,” or following Income
from Continuing Operations.
? Net of tax requires the tax effect of the
event be shown.
“Below the Line” Items
Intermediate Accounting 4 The Income Statement and Income Recognition
? Discontinued
Operations
? Extraordinary Items
? Changes in
Accounting Principles
Results from Discontinued Operations
Intermediate Accounting 4 The Income Statement and Income Recognition
Examples from APB No,30
The sale by a
diversified company
of a major division
that represented the
company’s only
activities in the
electronic industry.
1/1/02 7/1/02
Operating Loss
(net of tax)
$24,500
Measurement
Date
Disposal
Date
12/31/02
Statement
Date
Phase-out Period
Loss on Disposal
(net of tax;
includes operating
results 7/1 through
11/17 and loss on
final disposal)
$11,200
11/17/02
Intermediate Accounting 4 The Income Statement and Income Recognition
Discontinued Operations - phases
Income statement section consists of two
parts:
– Income (loss) from operations--disclosed only
if decision to discontinue operations is made
after beginning of the year.
– Gain (loss) on disposal of operations--
consisting of income (loss) during phase- out
and gain (loss) from disposal of segment assets.
Intermediate Accounting 4 The Income Statement and Income Recognition
Discontinued Operations - Disclosure
4/29/02
Disposal
Date
Loss on Disposal
$5,000 (including
$2,000 expected
operating loss)
Phase-out Period
1/1/01
Measurement
Date
8/31/01
Operating Loss
$4,000
Statement
Date
12/31/02
12/31/01
Intermediate Accounting 4 The Income Statement and Income Recognition
Discontinued Operations - Disposal Date
After Year End
? Special rules when disposal date is in year
following measurement date.
? A realized,loss on disposal” may be increased by
an estimated loss or it may be reduced by an
estimated gain.
? A realized,gain on disposal” may be reduced by
an estimated loss but cannot be increased by an
estimated gain.
Intermediate Accounting 4 The Income Statement and Income Recognition
Discontinued Operations - Disposal Date
After Year End
Intermediate Accounting 4 The Income Statement and Income Recognition
Extraordinary Items
An extraordinary item is an event
or transaction that is both unusual
in nature and infrequent in
occurrence.
Extraordinary Items
Intermediate Accounting 4 The Income Statement and Income Recognition
Unusual nature—the
underlying event or
transaction possesses a
high degree of
abnormality and is of a
type clearly unrelated to,
or only incidentally
related to,the ordinary
and typical activities of
the company.
Infrequency of
occurrence—the
underlying event or
transaction is of a type
that is not reasonably
expected to recur in the
foreseeable future.
Never Extraordinary
Intermediate Accounting 4 The Income Statement and Income Recognition
Events that the APB Opinion No,30 identified as not
qualifying as extraordinary:
1,The write-down or write-off of receivables,
inventories,equipment leased to others,or
intangible assets.
2,Gains or losses from exchanges or transactions of
foreign currency.
3,Gains or losses from the disposals of a business
component.
Continued
Never Extraordinary
Intermediate Accounting 4 The Income Statement and Income Recognition
4,Other gains or losses from the sale or
abandonment of property,plant,or equipment.
5,The effects of a strike.
6,The adjustment of accruals on long-term contracts.
7,The effect of a terrorist attack.
Change in Accounting Principle
Intermediate Accounting 4 The Income Statement and Income Recognition
?A change in accounting principle occurs when
a company adopts a generally accepted
accounting principle different from the one it has
been using in its financial reporting.
?Criteria for change-- change only if the new
principle is preferable:
? provides more useful information.
? is less costly per benefit.
In most instances,a company reports the cumulative effect
on prior years’ earnings in its net income for the year in
which it makes the change.
Change in Accounting Estimate
Intermediate Accounting 4 The Income Statement and Income Recognition
When a company changes an accounting
estimate,it accounts for the change in the
current year,and in future years if the
change affects both.
Earnings Per Share
Intermediate Accounting 4 The Income Statement and Income Recognition
When presenting EPS figures,
separate EPS amounts are
computed for income from
continuing operations and each
irregular or extraordinary item.
Earnings Per Share
Intermediate Accounting 4 The Income Statement and Income Recognition
Formula for Income from
Continuing Operations
Income from continuing operations
Weighted average number of shares of
common stock outstanding
4,Income statement formats
GAAP requires
certain income
statement
disclosures.
Right,but GAAP does
not require a specific
format.
Intermediate Accounting 4 The Income Statement and Income Recognition
Single-Step Income Statement
Intermediate Accounting 4 The Income Statement and Income Recognition
Revenues
Sales revenue $143,700
Interest revenue 1,800
Dividend revenue 600
Total revenues $146,100
Expenses
Cost of goods sold $ 86,000
Selling expense 10,200
General and admin,expense 16,000
Depreciation expense 7,800
Continued
Expenses (continued)
Loss on sale of equipment 4,000
Interest expense 2,100
Income tax expense 6,000
Total expenses (132,100 )
Income from continuing operations $ 14,000
Results from discontinued operations
Income from operations of
significant component A
(net of $1,950 income taxes) $ 4,550
Loss on disposal of significant
component A (net of $3,150
income tax) (7,350 ) (2,800 )
Income before extraordinary items $ 11,200 Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Income before extraordinary items $ 11,200
Extraordinary loss from explosion
(net of $750 income tax credit) (1,750 )
Cumulative effect on prior years’
income of change in depreciation
method (net of $600 income taxes) 1,400
Net income $ 10,850
Earnings per
Common Share
(8,000 shares)Components of Income
Income from continuing operations $ 2.80
Results from discontinued operations (0.56 )
Extraordinary loss from explosion (0.35 )
Cumulative effect on prior years’ income 0.28
Net income $2.17
Intermediate Accounting 4 The Income Statement and Income Recognition
Multiple-Step Income Statement
Intermediate Accounting 4 The Income Statement and Income Recognition
Continued
Revenue $xxx
Costs of goods sold:
Beginning inventory $xxx
Net purchases xxx
Cost of goods available for sale $xxx
Less ending inventory xxx xxx
Gross profit $xxx
Operating expenses:
Selling expenses $xxx
General expenses xxx xxx
Operating income $xxx
Other items $xxx
Intermediate Accounting 4 The Income Statement and Income Recognition
Income from continuing operations before
income taxes $xxx
Income taxes on continuing operations (xxx)
Discontinued operations:
Loss from operations of discontinued
business segment (net of tax) $xxx
Loss on disposal of segment (net of tax) xxx (xxx)
Extraordinary gain (net of tax) xxx
Net income $xxx
Earnings per
Common Share
(8,000 shares)Components of Income
Income from continuing operations $ XXX
Results from discontinued operations XXX
Extraordinary loss from explosion XXX
Cumulative effect on prior years’ income XXX
Net income $XXX
5,Limitations of the income statement
Intermediate Accounting 4 The Income Statement and Income Recognition
Intermediate Accounting 4 The Income Statement and Income Recognition
Could you illustrate
limitations of the income
statement?
6,Income Statement analysis
Evaluating profitability
? Stockholder profitability ratios indicate how
effectively a company has been meeting the profit
objectives of its owners,including,Earnings per
share; The price/earnings ratio; The dividend yield
ratio
? Company profitability ratios indicate how effectively
a company has met its overall profit (return)
objectives,particularly in relation to the resources
invested,including,Profit margin; Return on total
assets; Return on stockholders' equity.
Intermediate Accounting 4 The Income Statement and Income Recognition
Overall Profitability
Intermediate Accounting 4 The Income Statement and Income Recognition
Two ratios that measure overall profitability are
“Return on Assets” and,Return on Equity.”
Net Income $ 40
Total Assets 400
Stockholders’ Equity 160Return on Assets
$40
$400
= 10%
McDonald’s 7.8%
Microsoft 20.2%
Disney 4.5%
Coca-Cola 18.5%
Yahoo! 4.1%
Return on Assets
Intermediate Accounting 4 The Income Statement and Income Recognition
Overall Profitability
Intermediate Accounting 4 The Income Statement and Income Recognition
Two ratios that measure overall profitability are
“Return on Assets” and,Return on Equity.”
Net Income $ 40
Total Assets 400
Stockholders’ Equity 160Return on Equity
$40
$160
= 25%
McDonald’s 16.4%
Microsoft 27.0%
Disney 9.5%
Coca-Cola 42.0%
Yahoo! 4.8%
Return on Equity
Intermediate Accounting 4 The Income Statement and Income Recognition
7,Comprehensive Income
Intermediate Accounting 4 The Income Statement and Income Recognition
Recall that the FASB now requires companies to
report their comprehensive income (or loss) for
the accounting period.
Comprehensive income is the amount that reflects the
change in a company’s wealth during the period,In
addition to net income,it includes items that,in general,
arise from changes in market conditions unrelated to the
business operations of a company,Currently,there are
four items of a company’s other comprehensive income:
Continued
1,Any unrealized increases (gains) or decreases
(losses) in the market value of investments in
available-for-sale securities.
2,Any change in the excess of its additional pension
liability over unrecognized prior service costs.
3,Certain gains and losses on,derivative” financial
instruments,
4,Any transaction adjustment from converting the
financial statements of a company’s foreign
operations into U,S,dollars.
Comprehensive Income
Intermediate Accounting 4 The Income Statement and Income Recognition
?On the face of its income statement.
?In a separate statement of comprehensive income.
?In its statement of changes in stockholders’ equity.
Comprehensive Income
The FASB allows a company to report its
comprehensive income under three alternatives:
The company must display the statement containing
the comprehensive income as a major financial
statement in its annual report.
Intermediate Accounting 4 The Income Statement and Income Recognition
8,Conceptual issues of revenue
recognition
Intermediate Accounting 4 The Income Statement and Income Recognition
? Recognition,The process of formally recording
or incorporating an item in the financial
statements of an entity
? Realization,The process of converting non-cash
resources and rights into money refers to sales of
assets for cash or claims to cash.
Conceptual Issues
Intermediate Accounting 4 The Income Statement and Income Recognition
The decision as to when to recognize revenue focuses
on three factors:
? The economic substance of the event takes
precedence over the legal form of the transaction.
? The risks and benefits of ownership have been
transferred to the buyer.
? The collectibility of the receivable from the sale is
reasonably assured.
9,Revenue recognition alternatives
Intermediate Accounting 4 The Income Statement and Income Recognition
? Revenue recognition in the period of sale.
? Revenue recognition prior to the period of
sale.
? Revenue recognition after the period of
sale.
Earned and Realizable
Economic Substance
and Transfer of Risks
and Benefits of
Ownership
Collectibility is
Not Reasonably
Assured
Installment
Method
Cost
Recovery
Method
Percentage-of-
Completion Method
(for Long-Term
Contracts)
Completed-
Contract Method
(for Long-Term
Contracts)
Accrual Method,
“Normal” Revenue
Recognition at Sale
Not Sufficient
Transfer of Risks
and Benefits of
Ownership
Deposit
Method
Recognition before
Physical Transfer
Recognition at
Physical Transfer
Collectibility is
Reasonably
Assured
Revenue Recognized
Intermediate Accounting 4 The Income Statement and Income Recognition
?Completed-Contract Method,recognize
all income when project is completed.
?Percentage-of-Completion Method,
recognize revenue throughout the term of
the contract.
Intermediate Accounting 4 The Income Statement and Income Recognition
Long-Term Construction Contracts--
Recognition Choices
GAAP requires
percentage-of-completion
method unless certain
criteria are not met.
Percentage-of-Completion Method
Intermediate Accounting 4 The Income Statement and Income Recognition
AICPA Statement of Position No,81-1 requires that a
construction company use the percentage-of-completion
method for long-term contracts when all the following
conditions are met:
1,The company can make reasonably dependable estimates of the
extent of progress toward completion,contract revenue,and
contract costs.
2,The contract clearly specifies the enforceable rights regarding
goods or services to be provided and received by both the
company and the buyer,the consideration to be exchanged,and
the manner and terms of settlement.
3,The buyer can be expected to satisfy its obligations under the
contract.
4,The company expects to perform its contractual obligations.
Percentage-of-Completion Method--General
Concepts
Intermediate Accounting 4 The Income Statement and Income Recognition
? Recognize revenue throughout life of the contract.
? Revenue recognized is a function of how complete the
project is.
? Costs are charged to an inventory account,Construction in
Process (CIP).
? Profits are charged to CIP.
? CIP is valued at net realizable value.
? Any anticipated loss is booked for the full amount of the loss
when it becomes measurable.
Determine Percentage-of-Completion
Intermediate Accounting 4 The Income Statement and Income Recognition
?Input measures,
? Cost-to-cost method where the degree of completion is
determined by comparing costs already incurred with the
most recent estimates of total expected costs to complete the
project,
? Efforts-expended method where the degree of completion is
determined by comparing the work (labor hours,labor
dollars,machine hours,material quantities,etc.) performed
to date with the total estimated work for the contract
?Output measures
Percentage-of-Completion Method
2004 2005 2006
Construction costs incurred during
the year $100,000 $186,000 $314,000
Estimated costs to complete the
contract 400,000 264,000 ---
Partial billing to customer 80,000 350,000 270,000
Collections from customer 50,000 330,000 320,000
Total contract price,$700,000
Example
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
1,To record construction costs:
Construction in Progress 100,000
Accounts Payable,etc,100,000
2,To record partial billings:
Accounts Receivable 80,000
Partial Billings 80,000
2004
3,To record collections:
Cash 50,000
Accounts Receivable 50,000
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
4,To record gross profit:
Construction Expense 100,000
Construction in Progress 40,000
Construction Revenue 140,000
2004
($100,000 ÷ $500,000) x $700,000
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
1,To record construction costs:
Construction in Progress 186,000
Accounts Payable,etc,186,000
2,To record partial billings:
Accounts Receivable 350,000
Partial Billings 350,000
2005
3,To record collections:
Cash 330,000
Accounts Receivable 330,000
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
4,To record gross profit:
Construction Expense 186,000
Construction in Progress 38,000
Construction Revenue 224,000
2005
[($286,000 ÷ $550,000) x $700,000] – $140,000
Construction costs
incurred to date
Revised cost =
$286,000 + $264,000
Previous year’s
construction revenueContinued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
1,To record construction costs:
Construction in Progress 314,000
Accounts Payable,etc,314,000
2,To record partial billings:
Accounts Receivable 270,000
Partial Billings 270,000
2006
3,To record collections:
Cash 320,000
Accounts Receivable 320,000
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Percentage-of-Completion Method
4,To record gross profit and close out accounts:
Construction Expense 314,000
Construction in Progress 22,000
Construction Revenue 336,000
2006
$700,000 – $140,000 – $224,000
Recognized in 2004Recognized in 2005
Partial Billings 700,000
Construction in Progress 700,000
Intermediate Accounting 4 The Income Statement and Income Recognition
Completed-Contract Method
Entries 1,2,and 3 are the same as those used
for the percentage-of-completion method,
The completed-contract method does not
recognize revenue until the project is
completed,so there is no Entry 4 until 2006.
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Example
4,To record gross profit and close out accounts:
Partial Billings 700,000
Construction Revenue 700,000
2006
Completed-Contract Method
Construction Expense 600,000
Construction in Progress 600,000
$100,000 + $186,000 + $314,000
Intermediate Accounting 4 The Income Statement and Income Recognition
Uncertain Collections--Recognition
Alternatives
Intermediate Accounting 4 The Income Statement and Income Recognition
? Installment Sales Method,Recognizes revenues and
related expenses as cash is received (used when
collection is somewhat uncertain).
? Cost Recovery Method,No income is recognized on
sale until the cost of the item sold is recovered through
cash receipts (used when collection is very uncertain).
Installment Method
Intermediate Accounting 4 The Income Statement and Income Recognition
The installment sales method is
used most commonly in cases of
real estate sales.
Installment Method
Intermediate Accounting 4 The Income Statement and Income Recognition
1,Total sales,cost of goods sold,and collections are
recorded in the normal manner during the year.
2,At the end of the year,installment sales are
identified,The revenue and the related cost of
goods sold are,reversed,” and the deferred gross
profit is recognized.
3,At the end of the year,the gross profit rate on
installment sales is computed.
4,A portion of the deferred gross profit is recognized
as gross profit.
5,In future years the remaining deferred gross profit is
reduced and the gross profit is recognized based on
the cash collected on the installment sales
Installment Method
Intermediate Accounting 4 The Income Statement and Income Recognition
Example
Consider the following information for ABC for 2005:
Total credit sales $500,000
Total cost of goods sold 390,000
Installment method sales 100,000
Installment method cost of goods sold 75,000
Gross profit rate on installment method sales 25%
Cash receipts on installment method sales 20,000
Cash receipts on other credit sales 300,000
ABC Company uses a perpetual inventory method.
Continued
Installment Method
Accounts Receivable 500,000
Sales 500,000
Cost of Goods Sold 390,000
Inventory 390,000
Credit sales during 2005:
Cash 320,000
Accounts Receivable 320,000
Collected $300,000; $20,000 related to installment sales:
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Sales 100,000
Cost of Goods Sold 75,000
Deferred Gross Profit,2005 25,000
Installment sales and related cost of goods sold
identified and,reversed” on December 31,2005:
Deferred Gross Profit,2005 5,000
Gross Profit Realized on Installment
Method Sales 5,000
Recognized a gross profit of 25% of cash collected on
installment sales on December 31,2005:
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Consider the following information for ABC for
2006:
Total credit sales $600,000
Total cost of goods sold 430,000
Installment method sales 150,000
Installment method cost of goods sold 105,000
Gross profit rate on installment method sales 30%
Cash receipts on installment method sales:
2005 sales 30,000
2006 sales 40,000
Cash receipts on other credit sales 480,000Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Accounts Receivable 600,000
Sales 600,000
Cost of Goods Sold 430,000
Inventory 430,000
Credit sales during 2006:
Cash 550,000
Accounts Receivable 550,000
Collected $550,000; $70,000 related to installment sales:
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Sales 150,000
Cost of Goods Sold 105,000
Deferred Gross Profit,2006 45,000
Installment sales and related cost of goods sold
identified and,reversed on December 31,2006:
Continued
Intermediate Accounting 4 The Income Statement and Income Recognition
Installment Method
Deferred Gross Profit,2005 7,500
Deferred Gross Profit,2006 12,000
Gross Profit Realized on Installment
Method Sales 19,500
On December 31,2006,recognized a gross profit of 25%
of cash collected on installment sales for 2005 and 30% for
2006:
Intermediate Accounting 4 The Income Statement and Income Recognition
Intermediate Accounting 4 The Income Statement and Income Recognition
Cost Recovery Method
APB Opinion No,10 found the
cost recovery method of
recognizing revenue generally to
be unacceptable,However,the
Board did agree that this method
could be used in exceptional cases
where receivables are collected
over an extended period and where
the terms of the transaction
provide no reasonable basis for
estimating the degree of
collectibility.
Recovered
Cost
Revenue
The End
Intermediate Accounting 4 The Income Statement and Income Recognition
