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Chapter Objectives
Discuss the accrual principle of accounting
Discuss major issues in revenue and expense recognition, and how they affect reported earnings.
industries.
Discuss the revenue recognition method used for selected Review the types of nonrecurring items, including extra ordinary
items, discontinued operations, the cumulative effect of accounting changes, and prior period adjustments.
Discuss the significance of nonrecurring items to firm valuation. Discuss the concept of earning quality.
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rate of return.
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Which cash flows are included in income and when Which changes in asset and liability values are included in
income
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in either of two formats: 1. Classification of expenses by function. 2. Classification of expenses based on their nature. Under this alternative, the company reports expenditures using categories such as raw materials, employees, and changes in inventories.
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Revenues from sale of Goods & services Other income & Revenues Operating Expenses Finance cost Unusual or infrequent items Pretax earnings from continuing operations Income tax expense Net income from continuing operations Income from discontinued operations ( net of tax) Extraordinary items ( net of tax) Cumulative effect of accounting changes (net of tax) Net income
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= (+/-) = (-) =
Revenues from sale of Goods & services Operating Expenses Operating income from continuing operations Other income & Revenues Recurring income before interest and taxes from continuing operations Finance cost Recurring (pretax) income from continuing operations Unusual or infrequent items Pretax earnings from continuing operations Income tax expense Net income from continuing operations
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or random components, which are not directly related to operating activities and are generally more volatile. Segregation of the results of normal, recurring operations from the effects of nonrecurring items facilitates the forecasting of future earnings and cash flows, Financial reporting defines nonrecurring by the type of transaction or event .
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Statement of Financial Accounting Concepts (SFAC) 5, recognition and measurement in Financial Statements of Business Enterprises, specifies two conditions that must be met for revenue recognition to take place. These conditions are: 1. 2. Completion of the earning process Assurance of payment
To satisfy the first condition, the firm must have provided all or virtually all the goods or services for which it is to be paid., and it must be possible to measure the total expected cost of providing the goods and services; that is, the seller must have no remaining significant contingent obligation. Revenue recognition also requires a second condition: the quantification of cash or assets expected to be received for the goods and services provided.
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Revenue may be recognized prior to sale or delivery when the earnings process is substantially complete and the proceeds of sale can be reasonably measured. For example revenue is recognized at the completion of production in the case of commodities, such as oil and agricultural products. Alternatively, revenues may not be recognized even at the time of sale if there is significant uncertainty regarding the sellers ability to collect the sales price or to estimate remaining costs.
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in proportion to and as work is completed: production activity is considered the critical event in signaling the completion of the earning process rather than delivery of cash collections. This method is used when There is a long-term contract, and If production activities, revenue and expenses can be reasonably estimated. Measurement of progress towards completion can be estimated by using either(1) Engineering estimation; or (2) Ratio of cost incurred to total cost.
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cash collections, resulting in delayed recognition of revenues and expenses as compared with full recognition at the time of sale.
This method is sometimes used to report income from sales of noncurrent assets and real estate transactions.
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realization since only small down payments may be required with nonrecourse financing provided by the seller. With both future costs and collection uncertain, the cost recovery method requires that all cash receipts be first accounted for as a recovery of costs.
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Nonrecurring Items
Events or transactions that infrequently happens. These items
should be separately reported, because it will not occur in every period. Types of Nonrecurring Items: The income statement contains four categories of nonrecurring income: 1. Unusual or infrequent items 2. Extraordinary items 3. Discontinued operations 4. Accounting changes
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Extraordinary items must be reported separately, net of income tax. Firms are also required to report per share amounts for these items and encouraged to provide additional footnote disclosures.
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Has an unsatisfactory contribution to earnings and cash flows Is no longer considered by management to be a strategic fit Can be sold at a significant profit
Operating income from discontinued operations and any gains or losses (net of taxes) from their sale are segregated in the income statement, since these activities will not contribute to future income
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categories and amounts of assets (firm resources), liabilities (claims on those resources), and stockholders equity at specific points in time.
liabilities are generally reported before intangibles and other assets and liabilities measurement is less certain.
creditors, the balance sheet provides information about the nature of assets that the firm uses as debt collateral.
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Cumulative rights to dividends that may be: Fixed Floating rate Tied to amounts declared for common stock Callable by issuer; call price must be disclosed Convertible into common stock at option of holder; specified prices must be disclosed. Mandatory conversion into common shares at a specified date or under certain condition; terms must be disclosed.
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