Professor Paul Zarowin - NYU Stern School of Business

Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes

Income Statement, Accrual Accounting ,and Quality of Earnings

accrual accounting

structure of the Income Statement

permanent vs transitory items

special items (restructuring charges, constructive liabilities)

Acookie jar@ reserves

intra-period tax allocation

comprehensive income

earnings management

quality of earnings

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Income Statement, Accrual Accounting ,and Quality of Earnings

Accrual PrincipleGAAP is based on the principal of accrual accounting. This means that recognition of revenues and expenses is not tied to the inflow or outflow of cash. Of course, revenues and expenses can be recognized simultaneously to the flow of cash. In this case, the journal entries are: DR CR DR CR Cash And Expense Revenue Cash

If revenues and expenses are recognized before or after the flow of cash, we have the following 4 combinations of accrual entries. Note that one entry recognizes the revenue or expense, while the other entry records the flow of cash.

1. Unearned revenue (cash received before revenue is earned) - DR CR DR CR Cash And Liability Liability Revenue

The liability is an advance (from customers).

2. Accrued asset (revenue recognized before cash is received) - DR CR DR CR Asset And Cash Revenue AssetThe asset is a (account) receivable.

3. Accrued liability (expense recognized before cash is paid) - DR CR DR CR expense And Liability Liability Cash

The liability is a (account) payable.

4. Prepaid expense (cash paid before expense is recognized) - DR CR DR CR asset And Expense Cash AssetThe asset is a prepayment.

Other revenue and expense entries under the accrual model do not involve transactions, and are based on accounting estimates, such as depreciation expense, bad debts expense, percentage of completion for long term contracts (see the next module, Revenue Recognition - Special Issues), and interest revenue and expense. These are called end of period adjusting entries; these entries affect both the I/S revenue/expense account and its related B/S asset/liability (or contra) account.

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It is important to understand that there is much subjectivity in the revenue/expense recognition process. Thus, managers can make a firm=s accounting conservative (overestimate expenses, underestimate revenues and net assets) or aggressive (underestimate expenses, overestimate revenues and net assets). For example, a given cash outflow can be accompanied by a DR to an expense (conservative) or to an asset or liability (aggressive) account. Likewise, a given cash inflow can be accompanied by a CR to a revenue (aggressive) or to an asset or liability (conservative). As an example, should expenditures on R&D be DR=d to an expense or asset account? What do you think and why? Aggressive revenue recognition is currently a hot issue with the SEC, which believes that many firms might be overstating their income.

Likewise, the choice of accounting estimates can be conservative (short depreciation lives, high bad debt percentages, etc.) or aggressive (long depreciation lives, low bad debt percentages, etc.) We will see many such examples of accounting choices. When evaluating a company=s income, you should be aware of this discretionary aspect. It is often referred to as Aquality of earnings@. Conservative (aggressive) accounting practices produce high (low) quality earnings. RCJ=s discussion of America Online (AOL) on pages 19-21 is a good case study of aggressive financial reporting.

It is also important to understand that management=s conservative vs aggressive choices affect the timing of revenue and expense recognition, but over the Along run@ net income is unaffected (the long run can take a long time!). For example, expensing R&D outlays reduces net income immediately; capitalizing R&D outlays reduces net income in future periods by the periodic amortization of the R&D asset. Over the full amortization period, net income is the same under either method; it is net income for individual years that will be different. Under capitalization, net income is higher in the early years and lower in the later years. If a firm continues to increase its R&D outlays (such as a small growing high-tech firm), then net income under capitalization can be higher than net income under expensing for a long time, due to this accounting choice.

While this class is organized by topics that at first glance might seem to be disparate, managers= ability to affect the financial statements through accounting choices is a central theme that runs through all the topics. It is important to realize that accounting choices simultaneously affect both the income statement and the balance sheet. This is easy to see if we remember that the CR to revenue must be offset by a DR to either an asset or a liability account; likewise, the DR to expense must be offset by a CR to either an asset or a liability.

For example, if a firm recognizes revenue under the percentage of completion method rather than the completed contract method, (see the next module for a discussion of these methods) both its periodic revenue and the asset (inventory) account Aconstruction in progress@ will be higher. As another example, if a firm capitalizes its leases rather than use the operating lease method (see the section on leases later in the semester), both its liabilities and its expenses will be higher.

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By affecting net income, assets or liabilities, and owners= equity, accounting choices affect accounting ratios. For example, leverage ratios such as debt/assets and debt/equity, are affected by these choices. Likewise, rate of return ratios such return on assets (ROA = Net Income/Total Assets) and return on equity (ROE = Net Income/Owners= equity) are also affected. When comparing ratios across firms, analysts must be aware of the firms= accounting choices and how the choices affect the ratios. We=ll see many examples of such choices, and we=ll discuss their affects on the ratios.

Income StatementThe format of the Income Statement isolates current operating performance, separately reporting more peripheral (primarily non-recurring) items:1. Income from Continuing Operationsand income from:2. Discontinued Operations1

3. Extraordinary Items4. Cumulative Effect of a Change in Accounting Principle

The important point of this structure is to separate the permanent, sustainable components from the transitory components. The valuation multiples (impact on share price of a dollar of a given component) are higher for the permanent components (see CRJ, pgs 221-225), and forecasting (and thus valuation) is improved by separating permanent from transitory components.

Net Income is defined as the sum of all 4 categories. The titles are self-explanatory; however, subjectivity and discretion are often involved in determining under which category an income item falls. For example, if a U.S. company divests of a foreign subsidiary, this is clearly a discontinued operation. But, if the same company sells off its factories in the Northwest US, is this a discontinued operation or sale of PPE that would be reported under income from continuing operations (perhaps with a separate line item if material enough)? Often management=s reporting choice is Aopportunistic@. In the above case, if the item were a net loss, management would rather show it as a discontinued operation, to give investors a better picture of the firm=s future, as depicted in income from continuing operations. If the item is a net gain, management would like to Abury@ it in income from continuing operations. All firms in all periods have income from continuing operations. The other 3 items usually do not appear.

Extraordinary Items are both unusual and infrequent. In recent years, an increasingly important (in terms of both frequency and dollar magnitude) type of item appearing on firms income statements is either unusual and infrequent, but not both. These are called special items, and they are part of Income From Continuing Operations. They are (supposed to be) transitory, but firms often report special items for several consecutive years. Sometimes, special items appear as a separate line item on the I/S; other times they are combined with other gains or losses. If

1Income from discontinued operations includes (1) the periodic performance of the division for the fraction of the year that it was used, plus or minus (2) any gain or loss on the sale of the division.

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possible, the analyst should try to separate special items from other charges, because of special items= transitory nature.

Special items can be either gains or losses. Due to accounting conservatism, losses are more common (Figure 2.6, pg. 61). The entries in each case are:

DR CR DR CRasset or liability Loss Gain Asset or liability

Asset writedowns (CR to asset) and restructuring charges (CR to liability) are examples of losses. Such liabilities are called Aconstructive liabilities@; they are created by the firm, rather than from an obligation that the firm has to an outside party.

The SEC is currently focussing on firms= over-accrual of special charges (losses), such as restructuring charges. As shown in the righthand entry, above, firms take a current hit (DR) to income (matched by a CR to a liability for the expected future cash outflows associated with the restructuring). The stock price effect of the hit is minimized by the transitory nature of the charges. Since the charges are temporary, firms may overaccrue, resulting in lower future expenses (borrowing expenses from the future). When income rises in the future, the rise is presumed to be permanent, resulting in a large stock price increase. Clearly, firms= depiction of the charges and their placement on the I/S are important.

The format of the income statement reflects the tension between two different concepts of what net income should measure, the current operating performance concept and the all inclusive income concept. The former focuses on operating performance in the current period, while the latter focusses on all events that changed owners= wealth (except direct transactions with owners, such as stock issuances and repurchases and dividend payments) even if these events are not related to current operating performance.

Under the current operating performance concept, value-relevant events that are not related to current operations do not affect net income; these events are DR=d or CR=d directly to owners= equity, rather than affecting owners= equity indirectly when net income is closed into retained earnings. Advocates of the current operating performance approach argue that periodic net income should reflect how the firm=s operations performed in the current period, and that peripheral items (which are primarily transitory and thus not useful for valuing the entity as a going concern) should be excluded from net income.

Under the all inclusive income concept, all value-relevant events (except direct transactions with owners) affect net income, because they involve DR=s or CR=s to expense, loss, revenue, or gain accounts. Advocates of the all inclusive income approach argue that the operating performance concept excludes many value-relevant events that investors should know about.

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Remember that the purpose of the financial statements is to help investors predict the amount, timing, and uncertainty of future cash flows. Which concept do you think enables investors to do this better?

If all wealth affecting events are included in net income, this is called Comprehensive Income. Income is comprehensive, because it includes all wealth events. Current financial reporting follows a modified clean surplus approach. That is, almost all wealth affecting events are included in income. Some exceptions are changes in the values of marketable securities that are classified as available for sale, and foreign currency translation gains and losses.

GAAP requires firms to report both net income (as defined above) and comprehensive income, and this can be shown in one of three ways: (1) Second I/S - this starts with net income as defined above, and then shows additional line(s) for item(s) that are part of comprehensive income, but not part of net income. (2) Combined I/S - this is almost identical to #1 in that it also isolates Net Income and then adds/subtracts item(s) to get to Comprehensive Income, but in #2, Net Income is a subtotal and Comprehensive Income is the Abottom line@ of the I/S. (3) Statement of Stockholders= Equity - this leaves the I/S alone, showing Comprehensive Income as a separate category in the Statement of Stockholders= Equity (remember that Comprehensive Income affects owners= equity via retained earnings). CRJ compare NI and comprehensive income for the Dow Jones industrials on page 71.

Each of the 4 categories on the I/S is shown with its own tax expense, i.e., net of tax. This is known as intra-period tax allocation, because the firm=s total tax expense for the period is decomposed across the 4 categories.2 Each category is also shown on a per share basis (EPS).

Firms may report income from continuing operations in either a single-step or a multiple-step format. The former shows all revenues (CR items) and their total first, followed by all expenses (DR items) and their total, and then the net income from continuing operations. The latter generally shows sales minus CGS and the subtotal gross margin. This is generally followed by other expenses (perhaps broken down into categories) and the subtotal operating income. This is followed by other revenues and gains and then by other expenses and losses, to get Net Income.

2This is different from inter-period tax allocation, which involves deferred taxes caused by timing differences between tax and financial reporting. Inter-period tax allocation is the subject of chapter 20.

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In addition to Net Income and Income From Continuing Operations, analysts are focussing more and more on additional performance measures such as Economic Value Added (EVA, also called residual income). The reason for this shift in focus is that many analysts believe that current GAAP is often inappropriate for the new high-tech economy. For example, today=s high ratios of market value (of common stock) to book value (of common owners= equity), especially of high tech firms, show that a large share of firms= net assets are not reflected in their financial statements. RCJ briefly discuss EVA on pages 39 and 290. EVA takes reported income (perhaps after making such adjustments as capitalizing all leases and R&D outlays) and subtracts a charge for the cost of capital, where capital can be defined as debt + equity or only equity. The idea is that a firm must first earn enough income to cover the opportunity cost of its shareholders= capital. Only once this level of income is achieved is the firm truly profitable. Thus, a firm have positive net income, and have negative EVA.