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

Income Statement, Accrual Accounting ,and Quality of Earnings

Accrual Principle
GAAP 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
Cash
And
Liability
Liability

CR
Revenue

The liability is an advance (from customers).

2. Accrued asset (revenue recognized before cash is received) DR
CR
DR
Asset
And
Cash
Revenue
The asset is a (account) receivable.
3. Accrued liability (expense recognized before cash is paid) DR
CR
DR
expense
And
Liability
Liability

CR
Asset

CR
Cash

The liability is a (account) payable.

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

CR
Asset

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.
2

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.

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 Statement
The format of the Income Statement isolates current operating performance, separately reporting
more peripheral (primarily non-recurring) items:
1. Income from Continuing Operations
and income from:
2. Discontinued Operations1
3. Extraordinary Items
4. 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.

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.
4

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.
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.

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.

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
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
asset or liability

CR
Gain

DR
Loss

CR
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.