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Accrual Accounting and Income Determination

(Sources: Financial Reporting & Analysis By Revsine, Collins, Johnson and


Mittelstaedt and Intermediate Accounting by Kieso Weygandt and Warfield)

Learning Objectives
What is revenue recognition principle under
the accrual-basis accounting?
How to apply the matching principle to
expense recognition under the accrual-
basis? .
How is income measured under the accrual-
basis?
What is the cash-basis accounting?

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Learning Objectives (Contd.)
What are the distinctions between cash-
basis and accrual-basis earnings?
Why is accrual-basis income generally a
better measure of operating performance?
Income statement format and classification.
How to report a change in accounting
principle, accounting estimate, and
accounting entity.
What is comprehensive income?

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Learning Objectives :

What is the revenue recognition principle


under the accrual-basis accounting?
How to apply the matching principle to
expense recognition under the accrual-
basis? .
How is income measured under the
accrual-basis?

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Measuring Profit ( Net income) Performance:
When to recognize revenues and expenses under the
GAAP (the accrual-basis)?
Operating Cycle

Market
Step 1: Revenuer ecognition the
product
Step 2: Expense matching Receive
Collect cash order
Step 3: Income Recognition

Deliver Negotiate
product production
contract
Net income =
Revenues - Expenses Manufacture
product
Order
material

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Accrual Basis Accounting Income Measurement
Step1: Revenues are recognized (recorded)
when:
Earned: The seller has performed a service or
conveyed an asset to the buyer; and
Measurable (Realizable): The value to be
received for that service or asset can be
measured with a high degree of reliability and
the collection is reasonably assured.

Step 2: Expenses are matched to revenues.


Step 3: Net income = Revenues - Expenses

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Step 1: Determine the amount of revenue to be
recorded (revenue recognition).

Time of sale is used in


most industries

Condition 1: The critical event in the process of earning the


revenue has taken place. (Earned)

Condition 2: The amount of revenue that will be collected is


reasonably assured and is measurable with a
reasonable degree of reliability. (Measurability)

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Step 2: Matching expenses with revenues

Matching Principle: if revenues are


recognized in x1 period, all related
expenses (including both traceable and
period costs) should be recognized in the
same period.

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Step 2: Matching expenses with revenues
(contd.)
Traceable costs : The costs which can be
easily traced to the revenues. These traceable
costs also called product costs (i.e., the
cost of goods sold).

Period costs: These costs are more difficult


to quantify their contribution to revenues of a
particular period.
Thus, period costs are expensed in the
period when they occur or consume (e.g.,
advertising costs, salary costs).

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Matching Traceable costs (expenses)
with Revenues: (Cory TV and Appliance )

This example illustrates how product (traceable) costs are matched with 9
revenues.
Expense Period costs when they are
consumed
Suppose Cory TV also buys radio advertising for a monthly cost of
$120 beginning in February. This is a period cost (not product cost).

Period costs are expensed in the period when they are consumed.
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Learning Objective :
What is the cash-basis accounting?

What are the distinctions between


cash-basis and accrual-basis income?

Why is accrual-basis income generally


a better measure of operating
performance?

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Cash Basis Income Measurement

Revenues are recognized upon the


receipts of cash.
Expenses are recognized when they are
paid in cash.
Cash flow inflows and outflows do not
reflect the true economic benefits (i.e.,
revenues) or efforts (i.e., expenses).

Revenues and expenses do Not match.


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Accrual vs. Cash Basis Accounting

n Accrual-basis accounting: Revenues are


recognized when they earned and realizable,
not wait until cash is collected. Expenses are
recognized when they occur or are
consumed, not wait until they are paid for.

n Cash-basis accounting: The accountant does


not record a transaction until cash is received
or paid.

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Cash Versus Accrual Accounting
Carter Company has sales on account totaling
$100,000 per year for three years. Carter
collected $50,000 in the first year and $125,000
in the second and third years. The company
prepaid $60,000 for three years rent in the first
year. Utilities are $10,000 per year, but in the
first year only $5,000 was paid. In the second
year, the total of $15,000 was paid for the
utilities. Payments to employees are $50,000
per year.

Lets look at the cash flows. 14


Cash Basis Accounting
Cash flows in any one year may not be a
predictor of future cash flows.

Summary of Cash Flows


Year 1 Year 2 Year 3 Total
Cash receipts from
customers $ 50,000 $ 125,000 $ 125,000 $ 300,000
Payment of 3
years' rent (60,000) - - (60,000)
Salaries to
employees (50,000) (50,000) (50,000) (150,000)
Payments for
utilities (5,000) (15,000) (10,000) (30,000)
Net cash flow $ (65,000) $ 60,000 $ 65,000 $ 60,000
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Accrual Accounting

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Cash Basis vs. Accrual Basis Accounting
Looking at the cash-basis and the
accrual-basis results for Carter Company,
which method would you want to use if
you were asked to make predictions about
future years operating performance?

Accrual-basis earnings is a more


accurate measure of performance than
is cash- basis earnings.

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Cash Basis vs. Accrual Basis Accounting
Information about enterprise
earnings and its components
measured by accrual accounting
generally provides a better
indication of enterprise performance
than does information about current
cash receipts and payments.
( SFAC No. 1)

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Example: Whole Foods Market Inc.
Discrepancies between earnings (net income) and cash flows
Year Net Income Total Accruals Cash Flows
1996 -17.23 17.58 0.35
1997 26.64 11.60 38.24
1998 45.40 30.94 76.33
1999 42.16 59.78 101.93
2000 28.93 57.44 86.36
2001 51.65 97.96 149.61
2002 84.49 89.32 173.81
2003 103.69 122.85 226.53
2004 132.66 145.19 277.85
2005 136.35 150.23 286.58
2006 203.83 208.94 412.76
Note: Amounts are in millions. 19
Learning Objective :

Income statement format and


classification

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Income Statement
Usefulness

Evaluate past performance.

Predicting future performance.

Help assess the risk or uncertainty


of achieving future cash flows.

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LO 1 Understand the uses and limitations of an income statement.
Income Statement
Limitations
Companies omit items that cannot
be measured reliably.

Income is affected by the


accounting methods employed.

Income measurement involves


judgment.

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LO 1 Understand the uses and limitations of an income statement.
Single-Step Format
The single-step statement Income Statement (in thousands)
Revenues:
consists of just two Sales $ 285,000
groupings: Interest revenue 17,000
Total revenue 302,000
Expenses:
Revenues Single- Cost of goods sold 149,000

Expenses Step Selling expense 10,000


Administrative expense 43,000
Net Income Interest expense 21,000
Income tax expense 24,000
Total expenses 247,000
Net income $ 55,000
No distinction between
Operating and Non-operating
Earnings per share $ 0.75
categories.
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LO 2 Prepare a single-step income statement.
Multiple-Step Format
Income Statement (in thousands)
The presentation Sales $ 285,000
divides information Cost of goods sold 149,000
Gross profit 136,000
into major sections.
Operating expenses:
Selling expenses 10,000
1. Operating Section Administrative expenses 43,000
Total operating expense 53,000
Income from operations 83,000
2. Nonoperating Other revenue (expense):
Section Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
3. Income tax Income tax expense 24,000
Income from continuting operations $ 55,000

Earnings per share $ 0.75


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LO 3 Prepare a multiple-step income statement.


Reporting Irregular Items
Irregular items fall into six categories
1. Unusual gains and losses.
2. Discontinued operations. Reported in the

3. Extraordinary items. Income Statement


4. Changes in accounting principle.
5. Changes in estimates.
6. Corrections of errors
Unusual gains and losses, discontinued operation results and
extraordinary items are also referred to as transitory
items. 25
LO 4 Explain how to report irregular items.
Reporting Irregular Items
Unusual Gains and Losses
Material items that are unusual or infrequent, but not
both, should be reported in a separate section just
above Income from continuing operations before
income taxes as part of the above the line income.
Examples can include:
Write-downs of inventories, equipment, etc.
Foreign exchange transaction gains and losses
Restructuring charges
Gains or losses from sale of investments
The Board prohibits net-of-tax treatment for these 26
LO 4 Explain how to report irregular items.
items.
Multiple-Step Format
Sales $ 285,000
The presentation Cost of goods sold 149,000
divides information Gross profit 136,000
Operating expenses:
into major sections. Selling expenses 10,000
Administrative expenses 43,000
1. Operating Section Total operating expense 53,000
Income from operations 83,000
Other revenue (expense):
2. Nonoperating Interest revenue 17,000
Section Interest expense (21,000)
Unusal Item:
(3,000)
Loss from inventory write-down
Income before income taxes 76,000
3. Income tax Income tax expense $ 24,000

Net Income $ 52,000


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LO 3 Prepare a multiple-step income statement.


Income statement format and
classification
Multi-step income statements subdivide
income in a manner that helps analysts to
forecast future operating cash flows.
This format:
Separates operating from
nonoperating transactions .
Separates transitory income items
from those believed to be
sustainable or permanent (likely
to be repeated).
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Operating vs. Non-Operating
Items
Operating transactions: relating to the
day-to-day operations.
Examples: sales, cost of sales, selling,
general and administrative expense,
research and development costs, etc.
Non-operating: interest revenue,
dividends revenue, interest expense,
unusual items, etc.

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Reporting Irregular Items other than
the Unusual Items
Discontinued Operations occurs when,
(a) company eliminates (discontinues) the
results of operations and
cash flows of a component.

(b) there is no significant continuing involvement


in that component.
Amount reported net of tax.
Note: A component of an entity comprises operations and
cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from
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the rest of the entity (SFASLO 144).
4 Explain how to report irregular items.
Reporting Irregular Items
Discontinued Operations (contd.):
Examples of a component: a reportable
segment, an operating segment, a
reporting unit, a subsidiary, or an
asset group.
Other required treatment: 1) must
restate all presented periods with the
discontinued operations separated
reported, 2) the identity of the business
segment and the details of disposal must
be disclosed in footnotes 31
LO 4 Explain how to report irregular items.
Reporting Discontinued Operations
Component Sold
Illustration: KC Corporation had after tax income from
continuing operations of $55,000,000 in 2008. During 2008, it
disposed of its restaurant division at a pretax loss of
$270,000. Prior to disposal, the division operated at a pretax
loss of $450,000 in 2008. Assume a tax rate of 30%. Prepare
a partial income statement for KC.

Income from continuing operations $55,000,000


Discontinued operations:
Loss from operations, net of $135,000 tax 315,000
Loss on disposal, net of $81,000 tax 189,000
Total loss on discontinued operations 504,000
Net income $54,496,000

LO 4 Explain how to report irregular items.


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Reporting Discontinued Operations Component
Sold
Income Statement (in thousands)
Discontinued Operations Sales $ 285,000
are reported after Cost of goods sold 149,000
Income from continuing
operations. Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
Net Income.
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Moved to
Net income $ 54,496

LO 4 Explain how to report irregular items.


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Reporting Discontinued Operations-
Component Held for Sale

Reporting for Components Held For Sale


Operating income An impairment
or loss of the loss if the carrying
component from value of the assets
the beginning of of the component
the reporting is more than the
period to the end of fair value minus
the reporting cost to sell.
period.

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Reporting Discontinued Operations Componet
Held for sale

Two components of
discontinued operations are
reported:
Gain or loss from
operations
Impairment loss

.
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Reporting Irregular Items
Extraordinary items are nonrecurring material
items that differ significantly from a companys
typical business activities.

Extraordinary Item must be both of an


Unusual Nature and
Occur Infrequently

Company must consider the environment in which it


operates.
Amount reported net of tax.

LO 4 Explain how to report irregular items.


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Reporting Extraordinary Items
Are these items Extraordinary?
(a) A large portion of a tobacco manufacturers
crops are destroyed by a hail storm. Severe
damage from hail storms in the locality where YES
the manufacturer grows tobacco is rare.
(b) A citrus grower's Florida crop is damaged by NO
frost.
(c) A company sells a block of common stock of a
publicly traded company. The block of shares,
which represents less than 10% of the publicly- YES
held company, is the only security investment
the company has ever owned.

LO 4 Explain how to report irregular items.


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Reporting Extraordinary Items
Are these items Extraordinary?
(d) A large diversified company sells a block of
shares from its portfolio of securities which it
has acquired for investment purposes. This is NO
the first sale from its portfolio of securities.
(e) An earthquake destroys one of the oil refineries
owned by a large multi-national oil company. YES
Earthquakes are rare in this geographical
location.
(f) A company experiences a material loss in the
repurchase of a large bond issue that has been NO
outstanding for 3 years. The company regularly
repurchases bonds of this nature.
LO 4 Explain how to report irregular items.
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Reporting Extraordinary Items
Illustration: KC Corporation had after tax income from
continuing operations of $55,000,000 in 2007. In addition, it
suffered an unusual and infrequent pretax loss of $770,000
from a volcano eruption. The corporations tax rate is 30%.
Prepare a partial income statement for KC Corporation
beginning with income from continuing operations.

Income from continuing operations $55,000,000


Extraordinary loss, net of $231,000 tax 539,000
Net income $54,461,000

($770,000 x 30% = $231,000 tax)

LO 4 Explain how to report irregular items.


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Reporting Extraordinary Items
Income Statement (in thousands)
Extraordinary Items Sales $ 285,000
are reported after Cost of goods sold 149,000
Income from continuing
operations. Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
Net Income.
Extraordinary loss, net of tax 539
Net income $ 54,461
Moved to

LO 4 Explain how to report irregular items.


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Reporting Irregular Items
Income Statement (in thousands)
Reporting when both
Sales $ 285,000
Discontinued Operations Cost of goods sold 149,000
and
Extraordinary Items Interest expense (21,000)
are present. Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations
55,000
Discontinued operations:
Discontinued
Loss from operations, net of tax 315
Operations
Loss on disposal, net of tax 189
Total loss on discontinued operations
504
Income before extraordinary item
54,496
Extraordinary Item
Extraordinary loss, net of tax 539
Net income ####

LO 4 Explain how to report irregular items.


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Income statement format:
Income from Continuing Operations
Ideally, this includes only
the normal, recurring,
sustainable ongoing
operating activities of the
firm.

(2) :
Gains and losses that
occur infrequently
called:
special or unusual
items

The Line

These items are included as part of income from continuing operations before tax
(sometimes referred to as being reported above the line), they are not disclosed net of tax effects. 42
Income statement format:
Transitory items below the line
Nonrecurring items
include:
1. Special or unusual
items ( above the line)
2. Discontinued
operations
3. Extraordinary losses
and gains

Below the line


transitory items are
always shown net of
tax.

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How common are nonrecurring
losses?

Conservative bias of accrual accounting encourages early


recognition of declines in asset values below cost or book value
but delays recognition of increases in value until after the asset
is sold.
Firms incentives to separately disclose and clearly label
losses (but not gains)

Sample: NYSE/AMEX firms for 1999-2008


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Reporting Irregular Items
Companies are required to report irregular items in
the financial statements so users can
Illustration 4-5
determine the long-run earning power Number of Irregular
Items Reported in a
of the company. Recent Year by 600
Large Companies

LO 4 Explain how to report irregular items.


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Learning Objective :

How to report a change in accounting


principle, accounting estimate, and
accounting entity.

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Accounting Changes
Type of Accounting
Change Definition
(1)
Change in Accounting Change from one GAAP method
Principle to another GAAP method
Change in Accounting Revision of an estimate
(2) Estimate because of new information or
new experience
Change in Reporting Preparation of financial
(3) Entity statements for an accounting
entity other than the entity that
existed in the previous period

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(1) Change in Accounting Principle
(SFAS 154)
Occurs when changing from one GAAP
method to another GAAP method
For example, a change from LIFO to FIFO

Voluntary changes in accounting principles


are accounted for retrospectively by revising
prior years financial statements (for
comparability).
Changes in depreciation, amortization, or
depletion methods are accounted for the
same way as a change in accounting
estimate.
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Retrospective Approach

Prior years financial


statements that are
presented for
comparative purposes
are restated.

Adjusted all accounts


balances to reflect what
those accounts would
have been under the new
method.

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(2) Change in Accounting Estimate
Examples: Changes in the estimates of
Inventory obsolescence.
Uncollectible receivables.
Useful lives and salvage values of assets.

Liabilities for warranty costs and income


taxes.
Change in depreciation methods.

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Change in Accounting Estimate

Require prospective adjustment : Use the


new estimates in the current and future
periods (i.e., no restatements).

Past income is never adjusted.


Estimate changes are sometimes hard to
spot because they are NOT always
disclosed in footnotes.

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Change in Accounting Estimate:
Example:
Change in Estimate: Arcadia HS, purchased equipment for
$510,000 which was estimated to have a useful life of 10 years
with a salvage value of $10,000 at the end of that time.
Depreciation has been recorded for 7 years on a straight-line
basis. In 2010 (year 8), it is determined that the total
estimated life should be 15 years with a salvage value of
$5,000 at the end of that time.
Questions:
What is the journal entry to correct the prior
No years
Entry
depreciation? Required

Calculate the depreciation expense for


2010.
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2. Change in Estimate ExampleAfter 7 years
Equipment cost $510,000 First, establish
Salvage value - 10,000 NBV at date of
Depreciable base 500,000 change in estimate.
Useful life (original) 10 years
Annual depreciation $ 50,000 x 7 years = $350,000

Balance Sheet (Dec. 31, 2009)


Fixed Assets:
Equipment $510,000
Accumulated depreciation 350,000
Net book value (NBV) $160,000

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2. Change in Estimate ExampleAfter 7 years
Net book value $160,000 Depreciation
Salvage value (new) 5,000 Expense calculation
Depreciable base 155,000 for 2010.
Useful life remaining 8 years
Annual depreciation $ 19,375

Journal entry for 2010

Depreciation expense 19,375


Accumulated depreciation 19,375

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Learning Objective :

Comprehensive Income

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Comprehensive income
The change in equity excluding owner
related transactions such as investments
from owners and dividends distribution.

Components of Comprehensive income:


Net income.
Other comprehensive income items:
Gains and losses which bypass income
statement and are reported directly
in the stockholders equity of the
balance sheet statement.
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Comprehensive income(contd.)
Examples of other comprehensive
income items:
1. Unrealized gains (losses) from
valuation of investments.
2. Gains (losses) of foreign currency
translation adjustments.
3. Unrealized gains and losses associated
with derivatives.
4. Gains (losses) from amendments to
pension plans.

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Special Reporting Issues
Three approaches to reporting Comprehensive
Income (SFAS No. 130, June 1997):
1. A second separate income statement;
2. A combined income statement of
comprehensive income; or
3. As part of the statement of stockholders
equity

LO 8 Explain how to report other comprehensive income.


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Special Reporting Issues
Comprehensive
Illustration 4-19
Income
Second
income
statement

LO 8 Explain how to report other comprehensive income.


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Special Reporting Issues
Comprehensive
Income
V. Gill Inc.
Combined Combined Statement of Comprehensive Income
income For the Year Ended December 31, 2010
statement
Sales revenue $ 800,000
Cost of goods sold 600,000
Gross profit 200,000
Operating expenses 90,000
Net income 110,000
Unrealized holding gain, net of tax 30,000
Comprehensive income $ 140,000

LO 8 Explain how to report other comprehensive income.


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Special Reporting Issues
Comprehensive Income - Statement of Stockholders Equity
Illustration 4-20

LO 8 Explain how to report other comprehensive income.


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Special Reporting Issues
Comprehensive Income - Balance Sheet Presentation
Illustration 4-21

Regardless of the display format used, the accumulated other


comprehensive income of $90,000 is reported in the stockholders
equity section of the balance sheet.
LO 8 Explain how to report other comprehensive income.
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Summary
Differences between cash-basis and
accrual-basis income measurement.
Accrual revenues and expenses better reflect effort and
accomplishment.
Accrual income is useful in predicting future operating cash
flows.
Revenue is recognized when two conditions
are satisfied:
Critical eventfirm has earned the revenue.
Measurabilityamount and collectability are reasonably
assured.
Time of sale is the most common point when revenue is
recognized.

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2-63
Summary (contd.)
Product costs are matched to their
traceable revenues, period costs are
expensed as the assets are used up.
Multi-step income statements
highlight nonrecurring (transitory)
items.
GAAP disclosures for accounting
changes aid comparisons of
performance over time.

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Summary (contd.)
All firms must report Basic EPS, and
those with complex capital structures
must also report Diluted EPS.
Other Comprehensive Income
changes in assets and liabilities
resulting from incomplete or open
transactions that bypass the income
statement and are reported as direct
adjustments to stockholders equity.

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