sections of its ending balance sheet, as discussed in lesson 3 3.3 Extraordinary items In APB Opinion No. 30t, an event is defined as extraordinary if it is both unusual in nature and infrequent in occurrence. The environment in which a company operates is a primary consideration in using judgment to determine whether an item is extraordinary. Examples of events that are treated as extraordinary items, provided that they are both unusual and infrequent for the particular company, include natural disasters, expropriations by a foreign government, and newly enacted prohibitions. Material gains and losses from extraordinary items are reported, net of taxes, in a separate section, following the section reporting results of discontinued operations(if such a section is presented ). When practical, individual extraordinary events should be described and disclosed 3.4 Effects of accounting changes Accounting changes may be classified into four categories: (I)a change in an accounting principle 2)a change in an accounting estimate; (3)a correction of an error; and ( 4)a change in the reporting entity a change in accounting principle occurs when a company changes from one generally accepted accounting principle to another for use in its financial reports. A principle, once adopted, should be used consistently, unless a change results in more informative financial statements. The burden of justifying a change is on the company In most instances, for a change in accounting principle, a company reports the cumulative effect on prior years earnings in net income for the year in which the change is made. This cumulative effect shown, net of taxes, after extraordinary items and before net income. The new principle is applied normally in the period of the change Changes in accounting estimates, which result frequently from new information or events, are accounted for in the period of the change, and in future periods if affected. A note to the financial statements discloses the effects of a material change in estimate on income before extraordinary items, net income, and earnings per share 3.5 Earnings per share Earnings per share ratios are often used in financial analysis to predict future earnings and dividends and to determine the attractiveness of the company's stock. The authors recommend the use of an earnings per share schedule showing earnings per share amounts net of tax for net income and each of its major components. The number of common shares used in the calculations should also be disclosed 4. Income statement formats Two basic formats--single-step and multiple-step--are used in a company s income statement to report income from continuing operations. Under the single-Step format, items are classified as either evenues or expenses. Total expenses are then deducted from total revenues in a single computation to determine income from continuing operations. In the multiple-step format, several subtotals are derived For example, cost of goods sold is typically deducted from net sales to compute the gross profit or gross margin on sales, from which operating expenses are deducted to determine operating income 5. Limitations of the income statement Instructor should also inspire students to think about the limitations of the income statement, enhancing their understanding of income statement 6. Income Statement analysis 6. 1 Stockholder profitability ratios indicate how effectively a company has been meeting the profit objectives of its owners, including: (a)Earnings per share;(b) The price/earnings ratio; (c)The dividend yield ratio
- 15- sections of its ending balance sheet, as discussed in lesson 3. 3.3 Extraordinary items In APB Opinion No. 30t, an event is defined as extraordinary if it is both unusual in nature and infrequent in occurrence. The environment in which a company operates is a primary consideration in using judgment to determine whether an item is extraordinary. Examples of events that are treated as extraordinary items, provided that they are both unusual and infrequent for the particular company, include natural disasters, expropriations by a foreign government, and newly enacted prohibitions. Material gains and losses from extraordinary items are reported, net of taxes, in a separate section, following the section reporting results of discontinued operations (if such a section is presented). When practical, individual extraordinary events should be described and disclosed. 3.4 Effects of accounting changes Accounting changes may be classified into four categories: (1) a change in an accounting principle; (2) a change in an accounting estimate; (3) a correction of an error; and (4) a change in the reporting entity. A change in accounting principle occurs when a company changes from one generally accepted accounting principle to another for use in its financial reports. A principle, once adopted, should be used consistently, unless a change results in more informative financial statements. The burden of justifying a change is on the company. In most instances, for a change in accounting principle, a company reports the cumulative effect on prior years' earnings in net income for the year in which the change is made. This cumulative effect is shown, net of taxes, after extraordinary items and before net income. The new principle is applied normally in the period of the change. Changes in accounting estimates, which result frequently from new information or events, are accounted for in the period of the change, and in future periods if affected. A note to the financial statements discloses the effects of a material change in estimate on income before extraordinary items, net income, and earnings per share. 3.5 Earnings per share Earnings per share ratios are often used in financial analysis to predict future earnings and dividends and to determine the attractiveness of the company's stock. The authors recommend the use of an earnings per share schedule showing earnings per share amounts net of tax for net income and each of its major components. The number of common shares used in the calculations should also be disclosed. 4. Income statement formats Two basic formats--single-step and multiple-step--are used in a company's income statement to report income from continuing operations. Under the pure single-step format, items are classified as either revenues or expenses. Total expenses are then deducted from total revenues in a single computation to determine income from continuing operations. In the multiple-step format, several subtotals are derived. For example, cost of goods sold is typically deducted from net sales to compute the gross profit or gross margin on sales, from which operating expenses are deducted to determine operating income. 5. Limitations of the income statement Instructor should also inspire students to think about the limitations of the income statement, enhancing their understanding of income statement. 6. Income Statement analysis 6.1 Stockholder profitability ratios indicate how effectively a company has been meeting the profit objectives of its owners, including: (a) Earnings per share; (b) The price/earnings ratio; (c)The dividend yield ratio
6.2 Company profitability ratios indicate how effectively a company has met its overall profit (return) Qjectives, particularly in relation to the resources invested, including: (a) Profit margin; (b) Return on total assets; (c)Return on stockholders equi 7. Comprehensive income A company's comprehensive income includes its net income and its other comprehensive income Currently, there are four items of a companys other comprehensive income; an example is any unrealized increase (gain) or decrease(loss)in the market (fair) value of its investments in available-for-sale securities A company may report its comprehensive income: (a)on the face of its income statement, (b)in a separate statement of comprehensive income, or(c)in its statement of changes in stockholders' equity. If it chooses(c), the statement must be included as a major financial statement in its annual report 8. Conceptual issues of revenue recognition A company usually recognizes revenue in the period of sale, when(a) realization has taken place, and (b)the revenues have been earned. There are, however, three revenue recognition alternatives: (a) advanced recognition(e.g, during the period of production),(b) recognition at the time of sale, and(c) deferred recognition(e.g, upon receipt of cash). Advanced or deferred recognition is used to increase the usefulness of the financial statements. The revenue recognition alternative used affects not only a company's income recognition on its income statement but its measurement of net assets(assets minus liabilities)on its balance sheet The following three factors are useful in evaluating revenue recognition issues in specific business situations. The factors may help in determining whether revenue should be recognized at the time of sale, or whether recognition should be advanced or deferre (a) The economic substance of the event takes precedence over the legal form of the transaction Usually a company recognizes revenue at the time of the legal transaction. However, revenue recognition may be advanced or delayed if economic " reality"would otherwise be substantially distorted.An example is the recognition of gross profit on a sales-type lease by the lessor before legal title is passed (b) The risks and benefits of ownership been transferred to the buyer. If the risks and benefits have been substantially transferred, the buyer must recognize revenue. Under a sales-type lease, the lessor must recognize revenue even though no legal sale has occurred because the risks and benefits of ownership have been transferred (c) The collectibility of the receivable from the sale is reasonably assured. If collectibility is not easonably assured, revenue has not been realized and the earning process is not complete so recognition is deferred 9. Revenue recognition alternatives 9.1 Normal revenue recognition Revenue Recognition in the Period of the Sale is used because realization has taken place and revenues have been earned at the time of the sale. Accrual accounting is used, expenses are matched against revenues, inventory is recorded at cost, and accounts receivable are recorded at net realizable value. This nethod is used most often 9. 2 Revenue recognition prior to the period of sale Revenue Recognition Prior to the period of the sale is used to reflect economic substance over legal form. The percentage-of-completion method of accounting for long-term construction contracts and the proportional performance method of accounting for long-term service contracts are examples Long-term construction contracts arise when a company agrees to construct an asset(e.g, buildings
- 16- 6.2 Company profitability ratios indicate how effectively a company has met its overall profit (return) objectives, particularly in relation to the resources invested, including: (a) Profit margin; (b) Return on total assets; (c)Return on stockholders' equity. 7. Comprehensive income A company's comprehensive income includes its net income and its other comprehensive income. Currently, there are four items of a company's other comprehensive income; an example is any unrealized increase (gain) or decrease (loss) in the market (fair) value of its investments in available-for-sale securities. A company may report its comprehensive income: (a) on the face of its income statement, (b) in a separate statement of comprehensive income, or (c) in its statement of changes in stockholders' equity. If it chooses (c), the statement must be included as a major financial statement in its annual report. 8. Conceptual issues of revenue recognition A company usually recognizes revenue in the period of sale, when (a) realization has taken place, and (b) the revenues have been earned. There are, however, three revenue recognition alternatives: (a) advanced recognition (e.g., during the period of production), (b) recognition at the time of sale, and (c) deferred recognition (e.g., upon receipt of cash). Advanced or deferred recognition is used to increase the usefulness of the financial statements. The revenue recognition alternative used affects not only a company's income recognition on its income statement but its measurement of net assets (assets minus liabilities) on its balance sheet. The following three factors are useful in evaluating revenue recognition issues in specific business situations. The factors may help in determining whether revenue should be recognized at the time of sale, or whether recognition should be advanced or deferred. (a) The economic substance of the event takes precedence over the legal form of the transaction. Usually a company recognizes revenue at the time of the legal transaction. However, revenue recognition may be advanced or delayed if economic "reality" would otherwise be substantially distorted. An example is the recognition of gross profit on a sales-type lease by the lessor before legal title is passed. (b) The risks and benefits of ownership been transferred to the buyer. If the risks and benefits have been substantially transferred, the buyer must recognize revenue. Under a sales-type lease, the lessor must recognize revenue even though no legal sale has occurred because the risks and benefits of ownership have been transferred (c) The collectibility of the receivable from the sale is reasonably assured. If collectibility is not reasonably assured, revenue has not been realized and the earning process is not complete so recognition is deferred. 9. Revenue recognition alternatives 9.1 Normal revenue recognition Revenue Recognition in the Period of the Sale is used because realization has taken place and revenues have been earned at the time of the sale. Accrual accounting is used, expenses are matched against revenues, inventory is recorded at cost, and accounts receivable are recorded at net realizable value. This method is used most often. 9. 2 Revenue recognition prior to the period of sale Revenue Recognition Prior to the Period of the Sale is used to reflect economic substance over legal form. The percentage-of-completion method of accounting for long-term construction contracts and the proportional performance method of accounting for long-term service contracts are examples. Long-term construction contracts arise when a company agrees to construct an asset (e.g., buildings
ships, bridges) for another entity over an extended period. The buyer may provide advance payments to help finance construction, but the legal sale does not take place until the asset is complete. Two alternative revenue recognition methods are possible: (1)the percentage-of-completion method in which a company recognizes profit each period during the life of the contract in proportion to the amount of the contract completed during the period, and values its inventory at the costs incurred plus the profit recognized to date, less any partial billings; and (2 )the completed-contract method in which a company recognizes profit only when the contract is complete and records inventory at cost, less any partial billings concluded that long-t and in its Statement of Position No. 81-1 requires that a company use the percentage-of-completion method for long-term contracts when all of the following conditions are met Reasonably dependable estimates can be made of the extent of progress toward completion b. The provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement C. The buyer can be expected to satisfy its obligations under the contract d. The contractor can be expected to perform its contractual obligations When any of the above conditions are not met, the company uses the completed -contract method It is also used on short-term contracts and when the risks of the contract are so great that reasonabl dependable estimates cannot be mad A company can determine the percentage completed by either "input"or" output"measures. The cost-to-cost method or efforts-expended method are two input measures. With the cost-to-cost method the company measures the percentage of completion by comparing the cost incurred to date with the expected total costs for the contract. With the efforts-expended method, the company measures the percentage of completion by comparing the work(labor hours, labor dollars, machine hours, material quantities, etc. ) performed to date with the total estimated work for the contract. Under either method, once the percentage of completion is determined, this percentage is multiplied by the total revenue on the contract to compute the revenue to be recognized to date. The revenue to date minus the revenue recognized in previous years is the revenue to recognize in the current year. The expense to be recognized is determined in the same way. Alternatively, a company can use output measures such as units produced units delivered, value added, or other measures of production to measure the percentage of completion The results achieved to date compared to the total expected results of the contract are used to measure percentage of completion. The revenue and expense are computed in the same way as discussed above for the input measures Under the percentage-of-completion method, a company uses an account titled Construction in Progress to record all the costs incurred on the project as well as the gross profit recognized to date. A Partial Billings account is used to record receipts paid by the buyer during construction. This account is a contra account to Construction in Progress. When there is a net debit balance in the Construction in Progress account, it is reported on the company's balance sheet as an asset, and when there is a net credit balance, it is reported as a liability Examples could be showed to students as to how to use the percentage-of-completion method According to APB Statement No. 4, a company recognizes revenues for services rendered when the services have been performed and are billable. When more than one act is required under a long-term service contract, a company recognizes revenue by the proportional performance method
- 17- ships, bridges) for another entity over an extended period. The buyer may provide advance payments to help finance construction, but the legal sale does not take place until the asset is complete. Two alternative revenue recognition methods are possible: (1) the percentage-of-completion method in which a company recognizes profit each period during the life of the contract in proportion to the amount of the contract completed during the period, and values its inventory at the costs incurred plus the profit recognized to date, less any partial billings; and (2) the completed-contract method in which a company recognizes profit only when the contract is complete and records inventory at cost, less any partial billings. The AICPA concluded that long-term construction contracts may be considered "continuous sales" and in its Statement of Position No. 81-1 requires that a company use the percentage-of-completion method for long-term contracts when all of the following conditions are met: a. Reasonably dependable estimates can be made of the extent of progress toward completion, contract revenues, and contract costs. b. The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement. c. The buyer can be expected to satisfy its obligations under the contract. d. The contractor can be expected to perform its contractual obligations. When any of the above conditions are not met, the company uses the completed-contract method. It is also used on short-term contracts and when the risks of the contract are so great that reasonably dependable estimates cannot be made. A company can determine the percentage completed by either "input" or "output" measures. The cost-to-cost method or efforts-expended method are two input measures. With the cost-to-cost method, the company measures the percentage of completion by comparing the cost incurred to date with the expected total costs for the contract. With the efforts-expended method, the company measures the percentage of completion by comparing the work (labor hours, labor dollars, machine hours, material quantities, etc.) performed to date with the total estimated work for the contract. Under either method, once the percentage of completion is determined, this percentage is multiplied by the total revenue on the contract to compute the revenue to be recognized to date. The revenue to date minus the revenue recognized in previous years is the revenue to recognize in the current year. The expense to be recognized is determined in the same way. Alternatively, a company can use output measures such as units produced, units delivered, value added, or other measures of production to measure the percentage of completion. The results achieved to date compared to the total expected results of the contract are used to measure percentage of completion. The revenue and expense are computed in the same way as discussed above for the input measures. Under the percentage-of-completion method, a company uses an account titled Construction in Progress to record all the costs incurred on the project as well as the gross profit recognized to date. A Partial Billings account is used to record receipts paid by the buyer during construction. This account is a contra account to Construction in Progress. When there is a net debit balance in the Construction in Progress account, it is reported on the company's balance sheet as an asset, and when there is a net credit balance, it is reported as a liability. Examples could be showed to students as to how to use the percentage-of-completion method. According to APB Statement No. 4, a company recognizes revenues for services rendered when the services have been performed and are billable. When more than one act is required under a long-term service contract, a company recognizes revenue by the proportional performance method