Intermediate Financial Accounting Exam 2 Vocabulary

operating capability

(efficiency in utilizing assets to generate revenues)

leverage

(the amount of assets relative to the amount of common equity capital). The greater a company's profitability, operating capability, and leverage, the greater should be its total return to common shareholders.

Ratio Analysis

- Coverage ratios provide insights about a company's risk and financial flexibility because they measure the ability to cover the interest charges associated with debt. Companies with lower coverage ratios (i.e., less ability to cover or pay for the interest expenses from debt) typically have greater risk and less financial flexibility. - interest coverage ratio , which can be computed using operating income or cash flows from operations, as follows: - return on common equity, which measures the profitability of the company relative to the amount of equity capital invested by the common shareholders. It is computed as:

sales allowance.

Companies should record the estimated amount of future returns and allowances in the period of sale to correctly report net sales revenue and the net realizable value of accounts receivable.

Other Operating Income Items

Gains and losses from asset sales, inventory write-downs, impairment charges, restructuring charges, litigation charges, or other types of gains and losses that are a consequence of normal operating activities will be reported in this section.

Unusual and Nonrecurring Gains and Losses

Gains and losses that are unusual and nonrecurring and not a consequence of normal operating activities will be reported in this section. These could include, for example, the loss from a flood or a fire, or the gain or loss from the extinguishment of debt.

Association of Cause and Effect

Some expenses are recognized on the basis of a direct association with specific revenues. Some transactions result simultaneously in both a revenue and an expense. Examples include costs of products sold, transportation costs for delivery of goods to customers, and sales commissions.

Revenue Recognition Relative to Cash Flows

Under accrual accounting, a company can recognize revenue when it satisfies performance obligations to customers. Accrual accounting measures and reports when the company generates assets or settles obligations through the revenue-generating process, even though the cash inflows may occur in a different period. Revenue recognition can occur simultaneously with, prior to, or after the receipt of cash flows from customers. Exhibit 5.1shows the timing of revenue recognition as it relates to the timing of cash flows from customers.

accounts receivable conversion (ARC)

for faster processing of checks. In ARC, when paper checks arrive at a lockbox, they are converted into electronic payments, and the check itself is destroyed.

single-step income statement

format, a company classifies its items into two groups, revenues and expenses. The company computes its income from continuing operations in a single step as the difference between the totals of the two groups. A variation in this format involves reporting a subtotal for pretax income from continuing operations and then subtracting income tax expense for continuing operations as a separate line item

Postdated checks

from customers are checks dated in the future so they become payable on a date later than the issue date. Postdated checks are included as receivables until the date they become redeemable for cash.

profitability

generating profits from revenues: net profit margin)

compensating balances

in addition, banks may require a portion of any amount loaned to a company to remain on deposit in the bank (usually earning a low interest rate) for the loan period. These required deposits are called compensating balances because they "compensate" the bank for granting the loan.

operating activities

include all the transactions and other events related to its primary business activities, such as those involved in purchasing, producing, selling, and delivering goods for sale, as well as providing services.

Financing activities

include transactions involved in obtaining cash from owners and paying dividends and repurchasing shares, as well as obtaining cash from lenders and repaying the amounts borrowed. The financing activities section includes all the cash inflows and outflows involved in the financing activities of the company. The most common are: - receipts from the issuance of debt securities (e.g., bonds, mortgages, notes) - cash flows to repay debt obligations - receipts from the issuance of shares - payments to repurchase shares (i.e., treasury stock) - payments of dividends

Investing activities

include transactions involving buying and selling property, plant, and equipment and intangible assets; buying and selling long-term investments; and lending money and collecting on the loans. The investing activities section includes all the cash inflows and outflows involved in the investing activities of the company. The most common are: - receipts from selling and payments for purchasing property, plant, and equipment - receipts from selling and payments for purchasing investments in equity and debt securities (e.g., bonds)

Operating income (loss)

includes sales revenue, minus cost of sales and the various operating expenses and other income items related to operating activities. Financial statement users typically analyze carefully a company's operating income because it represents the company's ability to execute its business strategy and generate profitability from its core, central operations.

Intraperiod tax allocation

involves apportioning a corporation's total income tax expense for a period to the various components of its net income and other comprehensive income items (if any). That is, a portion of the income tax expense is allocated to: - income from continuing operations - income (loss) from the operations of a discontinued component - gain (loss) from the disposal of a discontinued component - any items of other comprehensive income The rationale behind intraperiod tax allocation is to faithfully represent the after-tax impact of each of the major components of income.

Interperiod tax allocation

involves assigning a company's tax obligation as an expense across various accounting periods because of temporary (timing) differences between its taxable income and pretax financial income. Generally, interperiod tax allocation requires that: - annual income tax expense for financial reporting be based on pretax financial income (and items of other comprehensive income, if any) - current income tax obligation (liability) be based on taxable income as reported to the tax authorities on the company's tax return - any temporary differences between them give rise to a deferred tax liability (or deferred tax asset)

Check Clearing for the 21st Century Act (termed Check 21)

is a law that allows merchants to scan checks and transmit the digital images to the bank instead of sending the actual check.

performance obligation

is a promise in the contract to transfer a good or service to the customer. If a company promises in a contract to transfer more than one good or service to the customer, the company should account for each promised good or service as a separate performance obligation only if it is (1) distinct or (2) a series of distinct goods or services that are substantially the same and have the same pattern of transfer. A good or service that is not distinct should be combined with other promised goods or services until the company identifies a bundle of goods or services that is distinct.

contract

is an agreement between two or more parties that creates enforceable rights and obligations. Under the new guidance, a company should apply the revenue recognition requirements to each contract, but only if it is probable that it will collect the consideration to which it will be entitled in exchange for the goods or services that it will transfer to the customer.

Net sales revenues (or net revenues)

re the gross sales revenues minus any sales discounts taken by credit customers (or reasonably estimated). Net sales amounts typically exclude any sales taxes or value added taxes the company may have collected from customers because the company will have to remit them to the taxing authority. To increase the predictive value of the sales revenue information, the FASB advocates disclosing sales volume and sales price information. However, many companies discuss this information in the management's discussion and analysis (MD&A) section of their annual report, rather than in the income statement.

Disclosures

A company is also required to disclose certain information about the sale (or classification as held for sale) of a discontinued operation in the notes to its financial statements. This information includes: - a description of the facts and circumstances leading up to the disposal and, if held for sale, the expected manner and timing of the disposal - the major classes of line items constituting pretax income (loss) of the discontinued operation - if not separately reported on its income statement, the gain (loss) on the sale and the caption on the income statement that includes the gain (loss) either the total operating and investing cash flows of the discontinued operation or the depreciation, amortization, capital -expenditures, and significant operating and investing noncash items of the discontinued operation

What Is Income

Accountants and economists have long debated what "income" is and how it should be measured. In accounting and economics, the capital maintenance concept is important in understanding income measurement. The accounting equation and accrual accounting provide a useful way to measure assets, liabilities, and net income within the capital maintenance concept.

Expense Recognition

Accrual accounting measures and recognizes expenses in the period in which the resources are used up, the outflows of assets occur, or the liabilities are incurred, even though the cash outflows may occur in a different period. Similar to the recognition of revenues, expenses may be recognized in a period simultaneously with cash outflows, prior to cash outflows, or after cash outflows. Some expenses for day-to-day operating activities, such as paying wages to employees, are recognized at essentially the same time (or nearly the same time) as when the company pays cash for the resources. Other types of expenses are accrued and recognized in periods in advance of when the company actually pays cash, sometimes many periods in advance. For example, accrued expenses for pension and retirement benefits are often recognized many years prior to when the company pays cash to the employees for these benefits. Still other types of expenses are recognized after cash flows were paid for those resources, which give rise to deferred or prepaid expenses, such as prepaid expenses for insurance or rent. Similarly, cash payments for a long-lived asset like property, plant, and equipment may occur when the asset is purchased, but expense recognition occurs over many years during the asset's service life. Some types of expenses vary directly with revenues and are recognized in the same periods. However, many expenses cannot be matched directly to revenues, but must be recognized during the periods in which the resources are used up or the liabilities are incurred. The FASB has identified the following three expense recognition principles to properly recognize expenses either by matching to revenues or matching to periods: 1. Association of Cause and Effect. 2. Systematic and Rational Allocation 3. Immediate Recognition.

statement of retained earnings.

Although not a required financial statement, whenever a company issues an income statement and a balance sheet, it may include a schedule that reconciles the beginning retained earnings balance with the ending retained earnings balance. Some smaller companies report this schedule as a separate financial statement, called the statement of retained earnings. More often, companies report this reconciliation within the statement of shareholders' equity, as described in

statement of cash flows

As a result, U.S. GAAP and IFRS require that a company present a statement of cash flows for the accounting period along with its income statement and balance sheet. s to provide relevant information about a company's cash receipts and cash payments during the period. Because this statement is related to the other financial statements and is an integral part of a company's annual report Under U.S. GAAP and IFRS, a company prepares a balance sheet to report financial position at the end of the period and an income statement to show financial performance during the period. External users are also very interested in how a company generates and uses cash. How much cash flow is the company generating from its operations? From what sources? How much cash did the company invest to grow? How was the growth financed? Did the company raise cash by issuing debt or use cash to retire debt? How did the company use the proceeds from the issuance of capital stock?

Internal control systems

As noted earlier, it is important for a company to effectively manage its cash to ensure that it can fulfill its obligations while earning an adequate return on any excess cash. Because cash is a company's most liquid asset, it's important to protect it from theft, loss, and waste re the policies and procedures a company uses to ensure its financial reports are reliable, its operations (including safeguarding its assets) are effective and efficient, and it complies with applicable laws and regulations. These controls are so important that the Sarbanes-Oxley Act of 2002 requires all publicly traded companies to maintain adequate internal control systems (including internal controls for cash) and independent auditors to issue an opinion on the adequacy of the company's internal controls, noting any weaknesses or deficiencies. internal control over cash is enhanced by routine reviews of the accuracy of recorded cash transactions and the separation of employee duties. Cash control systems can be subdivided into two main functions: control over receipts and control over payments.

How are Accounts Receivable Recorded?

Because the recognition of accounts receivable is related to revenue recognition, GAAP requires receivables to be recorded and reported at the amount of consideration a company expects to be entitled to receive in exchange for the goods or services provided. Thus, receivables should be recorded at their present values. However, GAAP excludes accounts receivable from this rule because the short collection period for most trade receivables (generally 60 days or less) usually makes the difference between a receivable's present value and maturity value immaterial. Consequently, most short-term trade receivables are recorded initially at their maturity values. In some cases, the amount of consideration in a revenue contract is variable (depends on other factors or future events). Three items of variable consideration that affect accounts receivable are trade discounts, cash (sales) discounts, and sales returns and allowances.

pretax income from continuing operations

Before reporting the income tax expense for the period, a company will typically report Pretax income from continuing operations is operating income plus or minus interest expense, interest and dividend income, other gains and losses, and any unusual or nonrecurring gains and losses. If the company does not have any discontinued operations, this amount is usually simply labeled either pretax income or income before tax.

Notes receivable:

unconditional written obligations of customers or suppliers to pay a certain sum of money on a specific date for goods or services

comprehensive income

Comprehensive income is the change in equity of a company during a period from transactions, other events, and circumstances relating to nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Following U.S. GAAP and IFRS, companies commonly measure and report two levels of income: net income and comprehensive income The FASB intends comprehensive income to be a broad concept of income that includes changes in the value of shareholders' equity resulting from (1) transactions, events, and circumstances that are traditionally measured and reported in net income and (2) changes in the values of certain types of assets and liabilities that are reported in other comprehensive income. We discuss the reporting of a company's comprehensive income later in the chapter. First, we focus on its primary component, net income.

Immediate Recognition.

Some expenses are recognized in the current accounting period because the costs incurred during the period provide no probable future benefits (i.e., they do not result in assets). Examples include management salaries, research and development expenses, and advertising expenses.

electronic funds transfer (EFT)

EFT transfers cash between companies electronically without the need for a check.

Basic earnings per share

EPS = Net Income Available to Common Shareholders/ weighted average number of common shares outstanding

Explain the purposes of an income statement.

Evaluate the profitability and assess the return on investment in the company. Assess the company's operating capability and financial performance for the current period and over time. Evaluate management's performance. Predict the company's future income and cash flows. Understand the components of income Assess the company's risk Compare performance against other companies. Assess the impact of economic factors on the company. These purposes should guide companies, accountants, and auditors as they measure and report the elements and components of an income statement.

held for sale

It may take some time for a company to complete a sale of a discontinued operation. Because this time may extend over more than one accounting period, GAAP identifies several criteria that must be met for a component to be considered held for sale. A company classifies a component as held for sale at the end of the current accounting period when all of the following criteria are met: - Management has committed to a plan to sell. - The component is available for immediate sale in its present condition. - Management has begun an active program to locate a buyer. - The sale is probable within one year. - The component is being offered for sale at a price that is reasonable in relation to current fair value. - It is unlikely that management will make significant changes to the plan. When a company classifies a component as held for sale, it reports it on its balance sheet at the lower of (1) its book value (book value of assets minus book value of liabilities) or (2) its fair value minus any costs to sell. If the fair value (minus any costs to sell) is less than the book value, the company records a loss and adjusts the book values of the assets of the component. The company reports the loss (after taxes) in the results from discontinued operations section of its income statement. It reports the assets and the liabilities of the component separately in the asset and liability section of its balance sheet. The company must label these assets and liabilities as "held for sale" so that financial statement users understand that these assets and liabilities are associated with the component that is being discontinued. After a company writes down a held-for-sale component to its fair value, there may be subsequent changes (increases or decreases) in this fair value. The company reports these changes as gains or losses on the income statement and as further adjustments (increases or decreases) to the book value of the component, with one exception. The company cannot increase the book value of the component to an amount higher than the component's book value before it was classified as held for sale. These adjustments are made primarily when the company prepares interim (quarterly) financial statements. The company c

How Does Net Income Affect Retained Earnings?

Retained earnings is the link between a company's income statement and its balance sheet. As described in Chapter 4, retained earnings is the total amount of company earnings that has not been returned to shareholders through dividends, and is a major component of shareholders' equity. The net income (loss) from the income statement is added to (subtracted from) beginning retained earnings. All dividends declared during the accounting period, including cash dividends on preferred stock and common stock as well as any stock dividends (dividends involving the distribution of the company's stock), are subtracted to determine the ending retained earnings balance. Typically, the cash dividends per share are disclosed parenthetically on the statement. If a company has any retrospective adjustments or prior period adjustments (which will be described in Chapter 22), these are also included in retained earnings.

revenue recognition

Revenue is recognized when a company satisfies its performance obligation to a customer. Because revenue is normally recognized when a product or service is delivered, credit sales trigger recognition of both an asset (an account or note receivable) and revenue.

What Are the Major Components of the Income Statement?

Revenues - Cost of goods sold - Operating expenses - Other operating income items (gains and losses) Operating income - Interest expense - Interest and dividend income - Unusual and nonrecurring gains and losses - Income taxes associated with continuing operations Income from continuing operations Results from discontinued operations - Income (loss) from operations of discontinued components (net of income taxes) - Gain (loss) from disposals of discontinued components (net of income taxes) Net income Earnings per share For full disclosure, a company's financial statements should disclose all material income information that can influence the judgment of informed external users. However, disclosures may be made in several ways. On the income statement, all material income items of the company should be reported on the face of the statement. However, too much detail detracts from the readability of the statement. Most companies present a condensed income statement. They aggregate and report all income items within the major components directly on the income statement. Then, supporting schedules and note disclosures supplement this information with additional detail. In this section, we first describe the two general approaches to income statement presentation—single-step versus multiple-step. After that, we describe each of the major income statement components.

differences between revenues and expenses and gains and losses are important in communicating information about a company's performance.

Revenues and expenses relate to a company's major operating activities. Gains and losses relate to peripheral activities or to the effects of other events and circumstances, some of which may be beyond its control (e.g., loss from flood or a fire). Revenues and expenses are reported as gross amounts because they reflect the effects of ongoing business activities that determine earnings. Gains and losses are reported "net" because they typically involve a single transaction that triggers a net increase or decrease in an asset or a liability (e.g., gain on sale of land, net of the cost of the land and other selling costs). Revenues are recognized as the company satisfies performance obligations by transferring goods or services to customers, and expenses are recognized as assets are used up or liabilities are incurred. Most gains and losses are recognized in the periods in which the event occurs to trigger the gain or loss, even if the associated cash flows occur in a different period. This could arise, for example, when a company holds a piece of land that appreciates in value over several years. The company will recognize the gain in the period when it sells the land. If it accepts a note receivable from the purchaser of the land, the company will collect the cash flows from the sale over the life of the note.

Diluted Securities

Some companies have complex capital structures that include securities such as convertible preferred stock, convertible bonds, and stock options or warrants that may be converted into shares of common stock. If the conversion of these securities to common stock would dilute the value of the outstanding common shares, they are referred to as Companies with dilutive securities are required to disclose diluted earnings per share information, taking into account the effect of these securities on the denominator (and in certain cases the numerator) of the EPS ratio. All companies are required to report basic and diluted (if applicable) EPS amounts relating to income from continuing operations and net income on their income statements. They are also required to report EPS amounts for the results from discontinued operations on the income statement (or in a note to the financial statements). Some companies disclose an EPS schedule that shows the per-share amounts (after tax) for each of the major components of net income. The schedule often also discloses the number of common shares used in the calculations.

Systematic and Rational Allocation

Some expenses are recognized in a particular accounting period based on a systematic and rational allocation among the periods in which benefits are provided. Many assets provide benefits for several periods. A portion of the cost of each of these assets is rationally recognized as an expense each period. The allocation system should be based on the expected service life and the consumption of the resource. Examples include depreciation of fixed assets, amortization of intangible assets, and the allocation of prepaid costs.Sometimes it is difficult to determine whether an expenditure should be recorded as an expense or as an asset, and, if it is recorded as an asset, when the expense recognition should occur. Exhibit 5.2 is helpful in understanding the relationships among the terms expenditure, asset, and expense.

direct method.

The FASB encourages use of the direct method, but very few companies use this method. This method separates operating cash inflows from operating cash outflows, which may be useful in estimating future cash flows. Under the direct method, a company's operating cash inflows are listed first, and then the operating cash outflows are deducted to determine the net cash provided by (or used in) operating activities. The most common cash inflows and outflows for operating activities are: operating cash inflows - collections from customers - interest and dividends collected operating cash outflows - payments to suppliers and employees - payments of interest - payments of income taxes

operating segment

The FASB, therefore, requires that a company's financial statements include certain disaggregated information about its operating segment - engages in business activities to earn revenues and incur expenses - generates operating results regularly reviewed by the company's chief operating decision makers to make decisions about allocating resources to the segment and assessing its performance - has discrete financial information available

gains and losses may be classified into three categor

The definitions of revenues, expenses, gains, and losses do not distinguish precisely between revenues and gains or between expenses and losses. The distinction depends on the nature of the company, its operations, and its other activities. Items that are revenues (expenses) for one company may be gains (losses) for another. In general, gains and losses may be classified into three categories as being derived from: 1. exchange transactions in which an asset is sold or a liability settled for an amount that differs from the carrying value on the balance sheet. (Examples include a gain or loss on the sale of a piece of used equipment or an investment security.) 2. the holding of resources or obligations while their values change. (Examples include losses resulting from writing down inventory from cost to market; gains or losses from changes in the fair value of certain investment securities; and impairment losses on property, plant, and equipment or intangibles.) 3. nonreciprocal (i.e., "one-way") transfers between a company and nonowners. (Examples include gains or losses from lawsuits, assessments of fines or damages by a court, and natural catastrophes such as earthquakes or fires.)

Operating Income (or Loss) of a Discontinued Operation

The first element in the results from discontinued operations section is the operating income (loss) of the discontinued operation. A company may operate it during part of a year and then sell it before the end of the year, so that it has an operating income or operating loss for part of the year. Therefore, a company reports the operating income (or operating loss) of the discontinued operation from the beginning of the year to the date of sale separately from the income from continuing operations of the rest of the company. The pretax operating income (or loss) of the discontinued operation from the beginning of the year to the date of sale is computed by subtracting the expenses of the discontinued operation from the revenues of the discontinued operation for that period. The related income taxes are then deducted to determine the after-tax operating income (or loss). Note also that if a company reports comparative income statements from prior years with the current year income statement, the prior year income statements are recast so that the operating income (or loss) of the discontinued operation for the prior years are reported separately from the income from continuing operations of the rest of the company.

indirect method.

The operating activities section reports the cash receipts and payments from the operating activities of the company. The most common way to prepare this section is called the indirect method. Under this method, net income is listed first and then adjustments (additions or subtractions) are made to net income: - to eliminate any non-cash income and expense items, such as depreciation expense and amortization expense, that were included in net income but that did not involve a cash inflow or cash outflow for operating activities - to include the cash flow effects triggered by any changes in the assets (other than cash) and liabilities involved in the company's operating activities (such as changes in accounts receivable, inventory, and payables) These adjustments are made to convert the net income to the net cash provided by (or used in) operating activities.

Gain or Loss on Sale

The second element is the gain (loss) on the sale of the discontinued operation. When the sale occurs in the same accounting period that management decided to sell, the calculation of the gain (loss) is straightforward. The company determines the pretax gain (loss) by subtracting the book value of the net assets (assets minus liabilities) of the discontinued operation from the net proceeds received (selling price minus any selling costs, such as broker commissions, legal fees, closing costs). This is similar to accounting for the sale of a single asset. The company then deducts related income taxes from the pretax gain or loss to determine the after-tax gain or loss, which is reported in the results from discontinued operations section.

noncontrolling interests.

This component of equity only arises when a parent company owns a majority of the common shares of a subsidiary company but does not own 100% of the shares. In a situation like this, the parent company will consolidate 100% of the subsidiary company's income statement with its own income statement, including all of the revenues, expenses, and net income of the subsidiary. However, the noncontrolling shareholders are entitled to a minority portion of the subsidiary's earnings. For this reason, the parent corporation subtracts the portion of "Net Income Attributable to Noncontrolling Interests" from the total net income of the company, in order to faithfully represent the amount of net income attributable to the common shareholders.

Reporting Results of Discontinued Operations

To enhance the usefulness of a company's income statement, it is important for the company to report separately the results of its continuing and discontinuing operations and also to highlight the material aspects involving the sale of a discontinued component. When the results from continuing and discontinued operations are reported separately, financial statement users have more useful information to evaluate the company's current period performance and to develop expectations of the company's operations that will be continuing in the future. A company should report separately the results from discontinued operations when the disposal of the business or component represents a strategic shift that will have a major effect on a company's operations and financial results. Examples of a strategic shift include the disposal of a major geographic area or a major line of business.

cost of goods available for sale

Usually, the computation of the cost of goods sold is shown in a supporting schedule. This schedule starts with the beginning inventory, to which net purchases are added to determine the cost of goods available for sale. Net purchases include gross purchases of inventory, plus freight costs and any other costs to acquire and prepare the inventory for sale, and minus any purchases returns, allowances, and discounts. Costs such as shipping, receiving, storing, packaging, and insurance during transport also should be included in net purchases. The ending inventory is subtracted from Cost of Goods Available for Sale to determine Cost of Goods Sold.

common-size analysis

We introduced common-size analysis in Chapter 4. Common-size income statements express all of the amounts in terms of percentages of total revenues. Common-size income statements enable users to identify what proportion of each dollar of revenues is absorbed by various expenses, like cost of goods sold as a percent of sales and operating expenses as a percent of sales. Common-size analysis is also a very useful technique to compute profit margins. Financial statement users evaluate profit margins at various levels, reflecting different aspects of the company's financial performance: - Gross profit margin (gross profit divided by total revenues) indicates a company's ability to generate revenues and control the costs of producing and delivering its products and services. - Operating margin (operating income divided by total revenues) indicates a company's ability to generate a profit from its operating activities after covering all of its operating costs. - Net profit margin (net income as a percent of total revenues) is the bottom line proportion of profit per dollar of total revenues.

sales return.

When the customer returns goods to the seller, the exchange is called a

Gross Price Method

When the selling company expects the customer will not pay within the discount period, it should use the gross price method, which records the total invoice price in both the accounts receivable and the sales revenue accounts at the time of sale. If the customer pays early and takes the allowable cash discount, the company records the difference between the cash received and the original amount of accounts receivable as a reduction in revenue. If the customer does not take the discount, the selling company receives an amount that is equal to the original balance in the accounts receivable account, and no further adjustment is needed.

Net Price method

When the selling company uses the net price method, it assumes the customer will take the discount and records the net invoice price (after deducting the expected cash discount) in both the accounts receivable and the sales revenue accounts at the time of sale. The company estimates this amount using the expected value derived from either a probability-weighted estimate or the most likely amount. When the customer pays and takes the allowable cash discount, the selling company records the cash receipt and reduces the receivable. However, if the customer does not take the cash discount, it pays an amount that is greater than the amount in the selling company's accounts receivable account. The company recognizes the difference between the cash received and the original amount of the accounts receivable as revenue.

IFRS vs U.S. GAAP measuring and reporting net income.

a company is required to report revenues, operating expenses, financing costs, tax expense, net income (loss), results of discontinued operations, and earnings per share. A company is also required to report comprehensive income in either a single continuous statement of comprehensive income or in two separate consecutive statements (an income statement and a statement that begins with net income and displays the components of other comprehensive income). Currently several differences exist between IFRS and U.S. GAAP with regard to the presentation of income statement information. Some of the more significant differences include: - While U.S. GAAP requires either a single-step or multiple-step format for the income statement, there is no prescribed income statement format under IFRS. - Terminology may differ among companies. For example, some IFRS companies use the term "turnover" to refer to sales or revenues. - IFRS, unlike U.S. GAAP, require expenses to be classified by their nature or function. - Under IFRS, if a company has revalued its equipment upward (as discussed in Chapter 4), then it must adjust its related depreciation expense accordingly. - IFRS allow alternative performance measures, such as earnings before interest, taxes, depreciation, and amortization (EBITDA), to be presented on the income statement. Such presentation of non-GAAP performance measures in the financial statements is prohibited by the SEC. - As a result of recent convergence efforts, the measurement and presentation of earnings per share are similar. However, a few differences exist. The FASB is currently working on revising its earnings per share standard to eliminate any major remaining differences with regard to earnings per share.

accrual accounting

a company records the economic effects of transactions, events, and circumstances in the periods when they occur rather than in the periods when it receives or pays cash. The accrual accounting approach to income measures the accomplishments (resources created) and the efforts (resources used up) so that the reported net income measures the results of the company's income-generating activities. In the accrual approach, a corporation's net income for a period is measured as Net Income = Revenues - Expenses + Gains - Losses This approach measures income based on the net assets created during the period (accomplishments like revenues and gains from asset sales) minus the net assets used up during the period (expenses and losses). To provide relevant and faithfully represented information about financial performance and income to investors, lenders, and other creditors, the company must determine what, how, and where to report the elements of the income statement: - What: Identify the elements that must be recognized in income. - When: Determine the timing of the recognition of income elements. - Where: Measure and report (classify) the elements on the income statement. The four elements of the income statement are revenues, expenses, gains, and losses. Each of these elements is defined in FASB Statement of Financial Accounting Concepts No. 6.

Sinking funds

are accounts into which a company deposits cash over an extended period for a specific purpose. At the end of the period, the cash (plus accumulated interest) is used for the specific purpose (e.g., to retire long-term bonds). Sinking funds are normally reported as long-term investments.

Receivables

are amounts owed to the company by customers and other parties arising from the company's operations. Most receivables are settled when the customer or borrower pays cash, although others may be settled through the receipt of other assets or services. Additionally, some receivables go unpaid and must be written off as uncollectible. Companies report receivables that are expected to be collected within one year or the current operating cycle, whichever is longer, on the balance sheet as current assets; the remainder are classified as noncurrent. Also, a company may group receivables within its classified balance sheet as trade receivables and nontrade receivables.

Losses

are decreases in the equity (net assets) of a company from peripheral or incidental transactions and other events and circumstances during a period, except those that result from expenses or distributions to owners.

Certificates of deposit (CDs

are financial instruments issued by banks that allow a company to invest cash for specific periods of time. CDs normally are classified as short-term investments.

Travel advances

are funds or checks given to employees to cover out-of-pocket expenses while traveling on company business. Because travel advances are satisfied when the employee submits receipts for business expenses, they are classified as pre-paid items.

Revenues

are increases in assets or settlements of liabilities from delivering or producing goods, rendering services, or other activities that are the company's ongoing major or central operations. Revenues represent increases in future economic benefits from increases in cash, accounts receivable or other types of assets, or reductions in liabilities by satisfying performance obligations to customers who have paid in advance for goods or services. Revenues measure the accomplishments of the operating activities in producing and delivering goods and services to customers. Various types of transactions result in revenues, depending on the company's operations and when it can recognize revenue

Gross sales revenues (or gross revenues)

are increases in assets or settlements of liabilities from satisfying performance obligations to customers by delivering or producing goods, rendering services, or other activities that are the company's ongoing major or central operations. Gross sales revenue includes the total amounts that the company has generated by delivering goods and services to customers during the period.

Gains

are increases in the equity (net assets) of a company from peripheral or incidental transactions and other events and circumstances during a period, except those that result from revenues or investments by owners.

Interim financial statements

are reports for periods of less than a year. The SEC requires registrants to file interim reports on a quarterly basis (using Form 10-Q). One issue involving interim reports is the difficulty in determining meaningful operating results for intervals of less than a year. Revenues of some businesses are seasonal and fluctuate widely across interim periods. Some companies incur heavy fixed costs in one interim period that benefit the operating activities in other periods. Other companies must estimate costs that will not be paid until later interim periods but that benefit the current one. Estimates also must be made of items such as inventories and income taxes if the interim reports are to be relevant and representationally faithful. In response to these concerns, U.S. GAAP specifies the disclosures needed to present meaningful information for an interim period of less than a year. The FASB adopts the view that each interim period is an integral part of an annual period. Thus, a company must continue to use the GAAP that it used in the preparation of its latest annual report. However, certain principles can be modified for interim reporting purposes so that the results are more informative and articulate better with the annual report results. The FASB has issued additional GAAP to expand and clarify various aspects of interim reporting. The current GAAP focuses primarily on the following income statement items: - Revenues - Operating expenses - Income taxes - Discontinued operations - Earnings per share

Cash equivalents

are short-term, highly liquid investments that are readily convertible into known amounts of cash and so near their maturity that there is little risk of changes in value because of changes in interest rates. Generally, only low risk, highly liquid investments with maturity dates of three months or less from the date acquired by the holder are cash equivalents. Securities such as commercial paper, treasury bills, and money market funds are examples of cash equivalents. Companies combine cash equivalents with cash because of their liquidity and low risk.

Trade receivables

arise from the credit sale of the company's products or services to customers. For instance, manufacturers may sell on credit to retailers (or to distributors or other manufacturers), and retailers may sell on credit to consumers. Companies choose to sell on credit in order to increase sales. However, credit sales result in additional costs in managing the collection process, as well as additional risk from bad debts due to nonpayment by customers. Therefore, when companies consider whether to sell on credit, they must evaluate the trade-off between the additional gross profit received from the expected credit sales and the additional expenses incurred due to these credit sales. Most companies have established credit policies that reflect the degree of risk that they are willing to accept to increase sales. However, some companies believe that they can lower costs and increase profits by selling exclusively (or almost exclusively) to customers for cash. Note that credit card sales involving bank credit cards are treated as cash sales, as we discuss later in the chapter. Trade receivables generally are the majority of a company's total receivables balance. Trade receivables may be sub classified into the following: 1. AR 2. Notes receivable

Nontrade receivables

arise from transactions that are not directly related to the sale of the company's goods and services. Examples include deposits with utilities, advances to executives and employees, loans made by nonfinancial companies, deposits made to guarantee performance, and declared dividends and accrued interest on investments. Nontrade receivables are reported on the balance sheet as current or noncurrent assets, depending upon the length of their collection period

expenses

arise from using up assets or incurring liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that are the company's ongoing major or central operations. Expenses measure and report the efforts or sacrifices made to conduct business activities. Many types of transactions and events trigger expenses, depending on a company's various operations and the way it recognizes expenses.

discontinued operations

arises when a company discontinues or plans to discontinue a business, a component of the business, or a group of components of the business.

capital maintenance concept

corporation's net income for a period of time is the amount that it could distribute to shareholders without depleting the capital the shareholders have invested. It is the amount of money that can be distributed to shareholders as a return on capital, without being a return of capital. This concept asserts that shareholders' capital must be maintained and therefore income is measured as the increase in capital. To use this concept, the company's income is measured by comparing the beginning and ending common equity capital (net assets) after adjusting for any additional investments by owners (e.g., proceeds from additional issues of shares) or distributions to owners (e.g., dividends) during the period. Applying this concept, lifetime income would be computed as the total amount of cash distributed to shareholders (all of the dividends paid over the life of the company plus the final proceeds received from the liquidation of the net assets) minus the total amount of capital invested by shareholders. Applying this concept to a given period of time, company income would be computed as the difference between the beginning and ending net assets, after any adjustments for additional investments by or distributions to shareholder

Liquidity

efers to the availability of a company's liquid assets to settle its obligations. The most common liquid assets (assets that may be quickly converted into cash) are cash, short-term investments, accounts receivable, and notes receivable. In this chapter, we discuss the measurement and valuation procedures for cash, accounts receivable, and notes receivable.

component

f a company involves operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the company. A component of a company may be, for instance, a subsidiary, an operating segment (e.g., division), a separate cash-generating unit (e.g., a restaurant or a store), or an asset group. A component may consist of assets (e.g., inventory and property, plant, and equipment) as well as liabilities (e.g., accounts payable and bonds payable).

Earnings per share (EPS)

is an important ratio in financial statement analysis because investors and analysts often analyze it relative to the market price at which a stock currently is selling to determine the relative attractiveness of that stock. For example, if a company's price-earnings ratio (market price per share divided by earnings per share) is very high (very low) relative to industry average, the company's shares may be viewed as overpriced (underpriced). Earnings per share is the only ratio that GAAP requires companies to disclose. It must be reported on a company's income statement, usually directly below net income. To make net income amounts more useful for common equity shareholders, U.S. GAAP and IFRS require a company to report net income on a per-share basis, known as earnings per share.

transaction price

is the amount of consideration (payment) a company expects to collect in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (i.e., sales taxes). If the payment is variable (e.g., dependent on other factors), the company should determine the best estimate of the transaction price by estimating either the expected value (i.e., probability-weighted amount) or the most likely amount. If the transaction price includes a significant financing component (say, monthly payments over 36 months), then the company should separate the revenue component from the interest component of the transaction price.

Comprehensive income

is the change in equity of a company during a period from transactions, other events, and circumstances relating to nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. A company's comprehensive income consists of two parts: net income and other comprehensive income. Currently, under U.S. GAAP there are three items of other comprehensive income: - unrealized increases (gains) or decreases (losses) in the fair value of available-for-sale investment securities - certain types of gains, losses, and prior service cost adjustments to net pension plan assets and liabilities - fair value gains and losses on derivative financial instruments that hedge future cash flows - translation adjustments from converting the financial statements of foreign subsidiaries into U.S. dollars We discuss the first three items later in the book; the last item is discussed in an advanced accounting book. If a company has no items of other comprehensive income, then it does not have to report comprehensive income. Under U.S. GAAP and IFRS, a company can report its comprehensive income (or loss) under two alternatives: - present net income and comprehensive income in a single continuous performance statement - present net income on the income statement and present comprehensive income on a separate, but consecutive, statement of comprehensive income In reporting its comprehensive income, a company must add its other comprehensive income items to its net income. The other comprehensive income items may be reported at their gross amounts or net of tax. If each item is reported at its gross amount, then the tax effects of each item must be reported parenthetically. If the items are reported net of tax, the amount of tax applicable to each item must be reported in the notes to the financial statements. A company is not required to report earnings per share based on comprehensive income.

Revenue recognition

is the process of formally measuring and reporting revenue in a company's financial statements. In May of 2014, the FASB issued new revenue recognition guidance with Accounting Standards Update 2014-09 "Revenue from Contracts with Customers" (becomes effective for annual reporting periods beginning after December 15, 2017). The Update is the result of a joint project with the IASB, and it is an important step forward in revenue recognition guidance.The core principle of the new guidance is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. To achieve that core principle, a company should apply the following five steps: Step 1. Identify the contract(s) with a customer. Step 2. Identify the performance obligations in the contract. Step 3. Determine the transaction price. Step 4. Allocate the transaction price to the performance obligations in the contract. Step 5. Recognize revenue when (or as) the entity satisfies a performance obligation.

Items Resulting from Financing and Investing Activities

mmediately following the operating income section, companies usually report significant recurring items of income and expense, as well as gains and losses, which are not directly related to the primary operations but result from the financing and investing activities of the company. Financing expenses commonly include interest expense on the company's short-term and long-term debt. Investing income includes dividend income, interest income, and realized gains or losses from sales of investment securities.

Income Tax Expense Related to Continuing Operations

ncome tax expense related to continuing operations represents an accrued expense for the total amount of income tax (federal, state, and foreign) that a company will ultimately have to pay on the income generated during the period. Income tax is typically a significant expense on a company's income statement. However, the amount of income taxes actually paid in cash each period is determined according to the rules of the Internal Revenue Code, as well as state and foreign tax regulations. The tax regulations used for determining the taxable income that a company reports on its income tax return frequently differ from the accounting principles used to determine pretax financial income that the company reports on its income statement. Additionally, pretax financial income consists of several major components. Because of these differences, two types of tax allocation are necessary.

reportable segment

one whose operations are significant enough that its financial activities must be reported separately. An operating segment is significant and is a reportable segment if it passes any of the three following tests: 1. Revenue Test. Reported revenues (including sales to external customers and intersegment sales) are 10% or more of the combined revenues of all the company's operating segments. 2. Profit Test. The absolute amount of its profit (loss) is 10% or more of the combined reported profits of all operating segments that did not report a loss. 3. Asset Test. Segment assets are 10% or more of the combined assets of all operating segments. There is also an overall materiality test, which requires that the reportable segments must be disclosed if their combined revenues are at least 75% of the entire company revenues. The remaining, less significant operating segments are combined and disclosed in an "all other" segment category. If a company has only one operating segment, it does not have disaggregated segment information to report, but it still must disclose the general information and company-wide information discussed next. Information Reported The required disclosures for segment reporting are as follows: - General. A company must (a) identify how it is organized (e.g., by product lines or geographic areas) and the factors it uses to identify its operating segments and (b) describe the types of products and services from which each reportable segment earns its revenues. - Profit or Loss. A company must report its profit or loss for each reportable segment. It must also disclose certain amounts used to compute each segment's profit or loss: (a) revenues (separated into sales to external customers and intersegment sales); (b) interest revenue and interest expense; and (c) depreciation, depletion, and amortization expense. - Information about Assets. A company must report the total assets of each reportable segment. For these assets, a company also must disclose the total capital expenditures for long-lived assets of each reportable segment. - Reconciliations. A company must reconcile the reportable segments' total revenues, total profit or loss, and total assets to the corresponding company totals. The

Bank overdrafts

re overdrawn checking accounts. They are reported as current liabilities and should not be offset against positive checking or savings account balances in other bank accounts. Under IFRS, bank overdrafts are generally treated in a similar manner; however, in some circumstances, overdrafts may be offset against other cash accounts.

Income from continuing operations

reports the company's income from ongoing, recurring business activities. This section of the income statement includes operating income plus (or minus) income items associated with financing and investing activities (such as interest expense and interest income); gains and losses that are not part of normal, ongoing operating activities; and income taxes. Income from continuing operations excludes the income effects of items that are not continuing, because they are components of the business that are being sold or shut down. Financial statement users find income from continuing operations to be useful information because it summarizes the elements of income that are likely to be recurring and persistent in future periods. Note that if a firm does not have any discontinued operations, then it is not necessary to distinguish income from continuing operations, and instead this amount is simply the bottom-line net income.

How Do We Analyze the Information in Income Statements and Cash Flow Statements?

s in Chapter 4, this section describes several analysis techniques for intracompany comparisons (evaluating a company over time) and intercompany comparisons (comparing two or more companies, either at a point in time or over time). These techniques include common-size and profit margin analysis, rate of change analysis, and ratio analysis.

results from discontinued operations

section is included on the income statement directly after income from continuing operations. It includes (1) the income (loss) from the operations of the discontinued component until the date of sale and (2) the gain (loss) from its sale, both of which are reported net of income tax.

Cryptocurrencies

such as bitcoin, litecoin, and ethereum, are digital currencies that are designed to work as a medium of exchange. However, unlike other currencies, cryptocurrencies do not possess the characteristics of cash. While the reporting of cryptocurrencies is subject to debate and variation in practice, they are generally considered as either investments, other current assets, or intangible assets.

cost of goods sold

the cost of the inventory items sold to customers during the period. If a company uses a perpetual inventory system, it records this amount in the cost of goods sold account at the time of each sale and reports the total for the period on its income statement. If a company uses a periodic inventory system, it does not reduce its inventory at the time of the sale and must calculate its cost of goods sold amount based on a physical count of inventory taken at the end of each period.

Cash

the most liquid of all assets, is the resource used to engage in day-to-day business transactions, pay employees, meet a company's debt obligations, and take advantage of business opportunities when they arise. Cash includes the following: coins and currency unrestricted funds on deposit with a bank (such as checking accounts and savings accounts) checks and money orders bank drafts undeposited credit card sales receipts Cash also includes foreign currencies on deposit in foreign banks. For example, a U.S. company may make sales to a European customer, collect the amount owed in Euros, and deposit these funds in a foreign bank until they are needed. These foreign currency amounts are included in cash and are converted to the reporting currency (e.g., U.S. dollar) at each balance sheet date. To be reported as cash in the current assets section of the balance sheet, the amount must be available to pay current obligations. If there are contractual restrictions that prevent the company from using this money to pay its current debts, it cannot be reported as cash. Consider the following examples: 1. Sinking funds 2. Certificates of deposit (CDs) 3. Bank overdrafts 4. Postdated checks 5. Travel advances 6. Cryptocurrencies

earnings management

they are usually referring to the potential for companies to manipulate reported earnings within U.S. GAAP in order to report higher or lower earnings numbers. As the chapter opener points out, earnings numbers trigger important consequences for companies' stock prices and managers' bonuses. Therefore, companies and managers are under great pressure to report earnings results that will satisfy investors, lenders, and other stakeholders. The temptation to manipulate reported earnings can be strong. Even within U.S. GAAP, companies can "manage" to increase (or decrease) earnings in a period by altering such income-related estimates and assumptions as bad debts expense, expected warranty costs, expected pension and retirement benefit costs, and many others. In addition, managers can engage in "real" earnings management transactions by electing to sell available-for-sale securities with accumulated gains; postpone some advertising or research and development expenditures; sale and leaseback transactions involving property, plant, and equipment; or similar tactics. Because of the importance of earnings, and because of the potential for companies to manipulate the reported earnings, financial statement users scrutinize reported earnings very carefully to assess a company's earnings quality and to detect potential earnings management.

Operating expenses

those primary recurring costs (other than the cost of goods sold) incurred to generate sales revenues and conduct business operations. These expenses typically are classified according to functional categories. One way is to show selling expenses separately from general and administrative expenses. Because of their significance, depreciation expense and amortization expense (excluding amounts included in the cost of goods manufactured) may be shown as a separate category. Research and development expense may also be shown as a separate category. Frequently, aggregate amounts are listed on the income statement for the major categories of operating expenses, with supporting schedules that identify the amounts of the individual expenses in each major category in the notes. Example 5.2b shows this supporting schedule for Banner Corporation. The total of the operating expenses is subtracted from the gross profit to determine the operating income, as shown earlier in Example 5.2.

cash discount (or sales discount)

to induce prompt payment. This discount frequently is expressed using terms such as 2/10, n/30. The first component refers to the discount rate and period, and the second component refers to the invoice due date. Therefore, these terms are read as: The purchaser may subtract a 2% discount from the invoice price if payment is made within 10 days; otherwise, the total invoice price is due within 30 days. Net Price Method and Gross Price Method

Trade Discounts(or quantity discounts)

to purchasers as a means to provide incentives to important customers, grant price reductions for large purchases, or to hide real prices from competitors. Trade discounts are usually given as a percentage reduction of the list price of a product, and the transaction price should be recorded at the amount that the company is entitled to receive.

earnings quality

usually refers to the extent to which a company's earnings are relevant and faithful representations of financial performance for the current period and enable financial statement users to develop reasonable expectations of future earnings. High-quality earnings information usually provides relevant and faithful information about the revenues, expenses, gains, and losses of current-period performance. In addition, high-quality earnings information enables users to separate the elements of income that are the result of core operating, investing, and financing activities, which are likely to recur and persist in the future, from those elements that are not likely to recur. When users refer to "earnings quality," they often mean the extent to which earnings numbers of the current period are the results from core, recurring, persistent business activities providing a sound basis to understand the company's performance and forecast future earnings.

Uses of the Statement of Cash Flows

we noted that one of the specific objectives of financial reporting is to provide information to help financial statement users predict the amounts, timing, and uncertainty of a company's future cash flows. Together with the balance sheet and income statement, the statement of cash flows is useful in meeting this objective. Financial statement users analyze the information from the statement of cash flows to assess a company's risk (the uncertainty and variability in the company's future performance), liquidity (its ability to generate cash flows from operations and convert assets into cash), financial flexibility (its ability to adapt to unexpected needs and opportunities), and operating capability (its ability to maintain a given level of efficient operations). When used with a company's other financial statements, the statement of cash flows helps external users assess the company's: - ability to generate positive future cash flows from operations - ability to meet its obligations - use of cash for capital expenditures and investments - capital raised from external financing sources and repayments of external financing - differences between the company's net income and associated cash receipts and payments - sources of cash from issuing shares and uses of cash to pay dividends and repurchase shares from common shareholders U.S. GAAP and IFRS require that a company must provide a statement of cash flows to report on a company's cash inflows, cash outflows, and net change in cash from its operating, investing, and financing activities during the accounting period, in a manner that reconciles the beginning and ending cash balances. This reconciliation causes the statement of cash flows to articulate with the balance sheet. include transactions involved in obtaining cash from owners and paying dividends and repurchasing shares, as well as obtaining cash from lenders and repaying the amounts borrowed.

Rate of Change Analysis

which is frequently used to compute growth rates. Recall (and, if necessary, review) that in Chapter 4 we also described how to compute compound rates of change to determine the average rate of change compounded over several periods. Rate of change analysis enables users to identify which items on the balance sheet and income statement are growing quickly or slowly over time.

multiple-step income statement

which presents income from continuing operations using various categories and subtotals, such as gross profit, operating income, and income from continuing operations.

financial flexibility

which refers to a company's ability to use its financial resources to meet obligations and respond to new business opportunities. These stakeholders are particularly concerned with liquidity.