7. Ancient Greek Empires - The Birth of Democracy and Western Civilization

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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 44)

I gave up accounting. I went in for about six months writing ad copy. I was fired from that, and then another guy and I did a kind of poor man's Bob and Ray kind of syndicated radio show. Then I decided to stick it out and see what happened. I'd give it a year, a year became two years, and then two years became three years, and then along came the record album.

Bob Newhart

Statements of Net Income and Comprehensive Income (Part B)

by

Charles Lamson

THE CONCEPTUAL FRAMEWORK CONNECTION:

 Usefulness and Limitations of the Income Statements

The income statements provide useful information to financial statement users in three ways:

1. Evaluate past performance. Income statements enable financial statement users to evaluate the entity's past performance. By disclosing separate components of revenues and expenses, income statements provide useful information about the entity's overall past performance (i.e., the earnings) and identify the main factors that influence performance. Income statements provide confirmatory value, which is an aspect of relevant information For example, investors are interested in whether companies meet or beat analysts' forecasts of net income as indicated by the statement of net income.

2. Predict future performance. Income statements have predictive value because they provide a basis for estimating future performance. Predictive value is an aspect of relevance. For example, a firm with a trend of earnings growth over the last 10 years may continue that growth in the future.

3. Assess risks or uncertainties of achieving future cash flows. Income statements provide information that is useful in assessing the risks or uncertainties of achieving future cash flows. Some items of income are more persistent in nature than others, making them strong indicators of future cash flows. For example, revenue from normal sales tends to persist from year to year. However, again from the sale of a specialized piece of equipment is unlikely to reoccur in the following year.

While income statements are quite important to financial statement users, there are three main limitations. Income statements

1. Exclude certain items. Companies cannot measure certain revenues, expenses, gains, and losses reliably and therefore do not report them on the income statements. Unreliable information would result in financial statements that lack faithful representation, one of the fundamental qualitative characteristics identified in the conceptual framework [The Conceptual Framework (or “Concepts Statements”) is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial reporting and the fundamentals are the underlying concepts that help achieve those objectives (fasb.org).]. For example, assume an entity has been sued and the loss is likely. if the firm cannot reasonably estimate the loss, it would not report it on the income statement.

2. Depend on accounting methods selected. The measurement of income is dependent upon the accounting methods selected. For example, identical companies that purchase the same asset but depreciate that asset using different depreciation methods will report a different net income, resulting in reduced comparability.

3. Require extensive judgment and estimation. In general, allowing managers to use judgment when making accounting policy choices that best reflect the economic reality of a transaction will enhance the usefulness of the financial statements. However, due to significant subjectivity and estimation uncertainties involved in financial reporting management can bias their judgments to enhance the entity's financial performance by manipulating revenues, gains, expenses, and losses. Even if management is not intentionally biasing reported earnings, different judgments will lead to different income numbers, resulting in reduced comparability. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., P. 173*

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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 43)

I'm always looking for context in which people tell stories. In "Fight Club" it's these support groups for dying people, and then in "Choke" it's 12-step recovery groups. In one novel it's artists' colonies, in another novel it's a diary form that submariners' wives typically keep so that when their husband comes back from serving on a submarine they have an accounting of their spouse's time. So I'm always looking for, number one, a non-fiction context - because you can tell a more outrageous story if you use a non-fiction form.

Chuck Palahniuk

Statements of Net Income and Comprehensive Income (Part A)

by

Charles Lamson 

Introduction

Net income, revenues, and gains less all expenses and losses, is one of the most important numbers companies report in the financial statements. It represents the return to the shareholders over a given time period---and, everything else being equal, shareholders prefer net income to a net loss. That is, investors prefer increased net income to no growth or decreased net income. In a survey of over 400 executives, 52% indicated that net income was the most important performance measure for a company (John Graham, Campbell Harvey, and Shiva Rajgopal, "The Economic Implications of Corporate Financial Reporting," Journal of Accounting & Economics, 2005, pp. 3-73). 

In analyzing a company, net income is an important measure of financial performance---but it represents only one view of a company's performance. Consider Kimberly-Clark Corporation, the U.S.-based global manufacturer of personal care products, consumer tissues, and healthcare items with brands such as Kleenex, Scott, and Huggies, its bottom line net income increase to $2,166 million in 2016, representing a $1,153 million, or 114%, increase from the prior year (see Kimberly-Clark's annual report at https://www.kimberly-clark.com/-/media/kimberly/pdf/annual-report/kmb-2016-10k_umbracofile.pdf). Why would net income increase by over 100% in one year?

To obtain a complete picture of a company's financial performance, a company will often present steps, or subtotals, to get to net income. Let's consider Kimberly-Clark's gross profit and operating profit, steps to get to net income. During 2016, Kimberly-Clark's gross profit, less revenues less cost of goods sold, of $6,651 million increased only 0.4%, suggesting that Kimberly-Clark's manufacturing performance was relatively steady. However, Kimberly-Clark's operating income increased by $1,704 million, or 106%. Examining Kimberly-Clark's 2016 financial statements further we find Kimberly-Clark reported a one-time expense in the prior year of $1,568 million dollars primarily related to employee pension costs. This one time expense depressed Kimberly-Clark's 2015 net income. In other words, Kimberly-Clark's 2016 net income figures looked much higher because its 2015 net income was unusually low due to a one-time expense. we will examine numerous measures of income---including net income, operating income, and gross profit---that include different aspects of performance and return to the shareholders. 

In the next several parts of this analysis, we will discuss the reporting of income on the income statement and statement of comprehensive income. We begin with an overview and then cover specific presentation and format requirements, including the single-step and multiple-step income statements. Here, we will also discuss discontinued operations. Next, we will present important differences between Generally Accepted Accounting Principles (GAAP or U.S. GAAP) and International Financial Reporting Standards (IFRS) income statements. We then discuss the presentation of other comprehensive income and the statement of comprehensive income. We conclude by providing a discussion of the statement of stockholders equity. 

Overview of the Income Statements

The first step in our discussion of the income statements is outlining important terminology, the requirements for reporting the two components of comprehensive income, and the key advantages and limitations of the income statements. We first present U.S. GAAP requirements, and then discuss similarities and differences between U.S. GAAP and IFRS.

 

Income Statement Terminology

Comprehensive income is the change in a company's equity during a period of time resulting from transactions, events, and circumstances other than transactions with owners. For example, comprehensive income does not include new issues of shares or dividend distributions. Comprehensive income is composed of two parts: net income and other comprehensive income.

Comprehensive income = Net income + Other Comprehensive Income 

1. Net income is a measure of financial performance resulting from the aggregation of revenues, expenses, gains, and losses that are not items of other comprehensive income. Net income is also referred to as net earnings. 

2. Other comprehensive income (OCI) is composed of revenues, gains, and losses that are explicitly excluded from net income and specific accounting standards (FASB ASC 220-10-20). Standard setters specify that other comprehensive income includes unrealized gains and losses on an available-for-sale debt investment portfolio, unrealized gains and losses on cash flow hedges, foreign currency translation adjustments, and certain pension adjustments [FASB ASC 220-45-10A and IASC, International Accounting Standard I, "Presentation of Financial Statements" (London, UK: International Accounting Standards Committee, 1975, Revised), Paragraph 7 (a)-(f) provide lists of items that should be included in OCI that we discuss in more detail later].  

Reporting Income

Income statements are designed to reflect all components of comprehensive income by presenting an entity's financial performance and results of operations over a period of time. Entities may report comprehensive income in two ways:

• In one statement usually called the statement of comprehensive income, or

• In two consecutive statements: The statement of net income and the statement of comprehensive income.

The computation of net income and comprehensive income are the same under either alternative---only the format of the presentation differs. We will discuss both formats in a later post. For consistency, we will refer to the financial statement(s) related to comprehensive income as the income statements throughout the next several posts. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 171-173*

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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 42)

There is a danger in the word someday when what it means is “not this day.”...The scriptures make the danger of delay clear. It is that we may discover that we have run out of time. The God who gives us each day as a treasure will require an accounting. We will weep, and He will weep, if we have intended to repent and to serve Him in tomorrows which never came or have dreamt of yesterdays where the opportunity to act was past. This day is a precious gift of God. The thought “Someday I will” can be a thief of the opportunities of time and the blessings of eternity.

Henry B. Eyring

Review of the Accounting Cycle (Part S)

by

Charles Lamson

Reversing Entries

Companies make reversing entries as an optional step in the accounting cycle at the beginning of the next accounting period to reverse the effects of the adjusting journal entries made in the previous period. Reversing entries simplify the recording of subsequent transactions related to the adjusting journal entries (see Part 29), and they typically apply to adjusting journal entries for accrued revenues and accrued expenses.

Because reversing entries are made in the accounting period following the period in which the adjusting journal entries were made, their use does not change the amounts reported in the previously issued financial statements.

EXAMPLE 4C.1 Reversing Entries

PROBLEM: EO Eleven, Inc. made the following adjusting journal entry on December 31, 2018, to accrue the first week, which is one-half of its bi-weekly $75,000 payroll:

 The related t-accounts follow:

The closing entry for the 2018 salary expense is presented here:

What reversing entry will EO Eleven make related to this adjusting journal entry? What entry will EO Eleven make at the time of its next payroll on January 10th? Provide t-accounts.

SOLUTION: On January 1, 2019, EO Eleven prepares the following reversing entry:

The t-accounts are as follows:

 

At this point, EO Eleven can make its regular entry to record the January 10, 2019, biweekly payroll for $75,000 in the usual way. That is, the accounting information system does not have to be modified and it can process the regular payroll entry as follows:

 The t-accounts are as follows:

EO Eleven reports the correct expense of $37,500 for 2019. 

        

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 168-169*

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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 41)

In the end, alchemy, whether it is metallurgical or financial, fails. A base business can not be transformed into a golden business by tricks of accounting or capital structure. The man claiming to be a financial alchemist may become rich. But gullible investors rather than business achievements will usually be the source of his wealth.

Warren Buffett

Review of the Accounting Cycle (Part R)

by

Charles Lamson 

Example 4B.1 illustrates worksheet preparation.

EXAMPLE 4B.1 Worksheet Preparation

PROBLEM: Enzo Educational Services provided the following unadjusted trial balance as of December 31 of the current year:

In addition, note that:

1. Depreciation for the year is $27,500.

2. $8,000 of wages has accrued for the last pay period of the year to be paid on January 2. 

3. The company rented equipment on account for $3,500 on December 15 and used the equipment for two weeks. The company has not recorded the event as of the date of the trial balance.

4. There should be $30,000 remaining in the prepaid insurance account.

Prepare the worksheet for Enzo Educational Services.

Enzo first enters the unadjusted trial balance on the worksheet, followed by the age in the adjustments column. Enzo then computes the amounts for the adjusted trial balance. For example, the unadjusted balance for prepaid insurance is a debit of $40,000. An adjusting journal entry credits the account for $10,000, leaving a $30,000 debit adjusted balance.

Next, Enzo extends each amount from the adjusted trial balance to either the income statement or balance sheet columns. The income statement columns initially will not balance---the difference (revenues less expense) is the net income on that loss for the period. Likewise, the balance sheet will not balance because the balance in retained earnings is the beginning balance, not the ending balance. Here as well, the difference between the debit and credit columns is the net income or net loss amount. 

SOLUTION:

Letters (a) through (d) are used to cross-reference to the additional information provided in the illustration.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 163-167*

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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 40)

Derivative trading with mark-to-market accounting degenerates into mark-to-model. Two firms make a big derivative trade and the accountants on both sides show a large profit from the same trade.

Charlie Munger

Review of the Accounting Cycle (Part Q)

by

Charles Lamson

Using a Worksheet 

A worksheet is a multiple column form that may be used to simplify the adjustment process and the preparation of the financial statements. It includes columns for the account titles, the unadjusted trial balance, adjusted journal entries (AJEs), adjusted trial balance, income statement, and balance sheet. Exhibit 4B.1 presents the standard form of the worksheet.

EXHIBIT 4B.1 Format of the Worksheet

The unadjusted trial balance and the adjusted trial balance columns reflect the account balances in the ledger at these two points in the accounting cycle. The adjustments column reflects the adjusting journal entries. After the worksheet has been completed, the income statement and balance sheet columns allow for the preparation of financial statements: The income statement is prepared from the income statement columns, and the statement of stockholders' equity and balance sheets are prepared from the balance sheet columns.

The steps in preparing a worksheet are as follows:

1. Prepare an unadjusted trial balance (see part 28). prepare the unadjusted trial balance directly on the worksheet---there is no need for a separate document.

2. Enter the adjusting journal entries (part 29) in the adjustments columns. Note the AJE must also be recorded in the journal. 

3. Compute the adjusted balances (part 32) in the adjusted trial balance columns.

4. Place adjusted trial balance amounts in appropriate income statement and balance sheet columns.

5. Total the statement columns, compute the net income (or loss), and complete the worksheet.

A sample worksheet outlining the five steps is presented in Exhibit 4B.2 

EXHIBIT 4B.2 Sample Worksheet

In Part 41, we will examine Example 4B.1, which illustrates worksheet preparation. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 161-162*

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