15/03/2013

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Income measurement and
reporting
Dr Isabel Gordon
ACCT 3563
Lecture objectives
Understand the overarching asset/liability
approach to income and apply this to revenue
Understand the recognition of revenue within the
entitys operating cycle per AASB 118
Appreciate the standard setters current
transition from an operating cycle (critical events
approach) to the asset/liability approach
Understand the information presented in the
statement of comprehensive income (revision)
Lecture objectives
Understand that income as a performance
measure can encourage incentives to manage it
Gain appreciation of the patterns of earnings
management
Review the earning management models in the
literature to detect earnings management
Gain appreciation of consequences of earnings
management and variability of this across
cultures
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Lecture outline
1. How to measure income or our well-offness?
2. The Framework and the definition of income,
revenue, expense, gain and loss
3. Measurement of revenue
4. What to include in income?
- Australian practice
- International practice: transparency rankings
5. Definition of earnings management what is it?
Lecture outline
6. Why is management motivated to manage
earnings?
7. How do we detect earnings management?
8. What are the patterns of earnings
management? Does this vary across cultures?
9. What are the consequences of earnings
management is it good or bad?
10. Next Week
References
AASB 101 Presentation of Financial Statements
AASB 118 Revenue
Deegan Chapter 16
Additional readings on Blackboard
Leo et.al. Chapter 13, sections 13.4 to 13.5
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1. How to measure income or well-offness?
There are two main approaches to measuring
income:
(i) The balance sheet approach. Income is
measured by comparing the net assets at the
end of the period with the net assets at the
beginning of the period, after adjusting for
dividends and capital contributions from
owners. Income/loss is the excess/deficit.
Example: if net assets of firm at t =0 are $100,000
and at t =1 are $140,000, then net income =
$40,000 (assuming no transactions with
owners).
1. How to measure income or well-offness?
If net assets of firm at t =0 are $100,000 and at t
=1 are $140,000, and capital contributions are
$20,000 and dividends $1,000 then net income
=$40,000 20,000 +1,000 =$21,000
Note how transactions with owners are excluded
1. How to measure income or well-offness?
(ii) The transactions approach. Income is
measured by the matching of expenses with
revenues reported during the period.
Profit is R E. Issues include what transactions
to recognise and at what stage in the operating
cycle to recognise revenue.
Net income or profit is measured as revenue
less expenses
Possible to classify sources of revenue and
expenses
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1. How to measure income or well-offness?
Using the transactions approach, a problem of
timing arises as to when is the most appropriate
time in the earnings cycle to recognise revenue
Income based on accrual accounting rather than
cash accounting is generally considered to be
better/more informative for shareholders
2. The Framework and the definition of
income, revenue, expense, gain and loss
Definition of income includes both revenue and
gains (AASB Framework para 74 )
AASB Framework para 70 defines income as
increases in economic benefits during the
accounting period in the form of inflows or
enhancements of assets or decreases in
liabilities that result in an increase in equity,
other than those relating to contributions from
equity participants
(also refer lecture week 1)
2. The Framework and the definition of income,
revenue, expense, gain and loss
This definition of income uses the asset/liability
model
Income is recognisedin income statement when
an increase in future economic benefits related
to an increase in an asset or decrease in a
liability has arisen that can be measured reliably
So income is recognisedat same time as
recognition of increases in assets or decrease in
liabilities
And it must be measured reliably
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How does this asset/liability model work?
For the sale of goods by company A, before
delivery date:
-Company A has undertaken to deliver
(and Company B has promised to pay after
delivery)
After delivery date:
-Company A has performed so has an asset to
receive payment (a receivable)
How does this asset/liability model work?
This represents income to Company A
Entry is:
Dr asset (recable) 100
Cr income 100
On receipt of payment:
Dr cash 100
Cr asset (recable) 100
How does this asset/liability model work?
We can see that income is recognised in this
case because:
- the increase in future economic benefits relates
to the increase in the asset receivable
- And it can be measured reliably at $100
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How does this asset/liability model work?
On the other hand, if company A also contracted
to maintain the asset for a period so that
company B is entitled to a 20% refund if
company A does not do so, then company A has
obligation to maintain the goods or refund the
money:
Dr asset-recable 100
Cr liability obligation 20
Cr income 80
How does this asset/liability model work?
So can see that there has been an increase in
the asset of $100 but also an increase in a
liability of $20, so income recognised is $80
When company B pays the $100 we record this
When the maintenance period expires then
company A can reduce the liability obligation and
recognise income of $20
How does this asset/liability model work?
We do this by:
Dr cash 100
Cr asset recable 100
Dr liability 20
Cr income 20
Note that the definition of income is met because
there has been a reduction in a liability
(obligation to maintain the asset)
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How does this asset/liability model work?
Income =(revenue expenses) +gains losses
3. Measurement of revenue: AASB 118
Measurement of revenue as the fair value of
consideration received or receivable (AASB 118
para 9)
This amount normally determined by parties to
the transaction such as a retail sale (after taking
into account trade discounts or volume rebates)
Revenue is measured net of volume/trade
discounts
Normally use cash or cash equivalents
swaps of goods and services of similar amount
and nature are not revenue generating
Definition of revenue AASB 118
Definition of revenue AASB 118:
Revenue as gross inflows of economic benefits
during the period arising in the course of
ordinary activities of an entity other than
dealings with equity participants
Revenue arises in the ordinary activities of the
entity and is referred to as names such as sales,
fees, interest, dividend, royalties and rent
Ordinary activities is not defined
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Main categories of revenue
Main categories of revenue include:
-sale of goods
-rendering of services
-interest, royalties, dividends
Entity must disclose accounting policies for
revenue recognition plus separate disclosure of
each significant category of revenue eg sale of
goods, rendering of services, interest
Timing of revenue recognition
Problem: at what stage in the transactions
process or operating cycle should revenue be
recognised?
Operating cycle can include: product planning,
purchasing inventory, receipt of orders, production,
delivery of completed product, receipt of cash
Under cash accounting system, would wait to end of
operating cycle to recognise revenue
Under accrual accounting, can recognise revenue prior
to receipt of cash. But at what stage?
Common for revenue to be recognised when goods are
delivered
Unlikely revenue recognised at time of customer order
Timing of revenue recognition
Objective of AASB 118: to identify timing or
when revenue should be recognised
AASB 118 does not strictly follow asset/liability
model
Steps:
-identify transaction to which recognition criteria applied
-sometimes have to apply recognition criteria to separately
identifiable components of single transaction eg. Qantas
customer loyalty programs (frequent flyer points with
sales transaction plus awards); telecommunications
industry
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4. What to include in income?
Can appreciate (from lecture outline point 1) that
computing net income by annual valuation of net
assets raises questions about the valuation
method to use
On the other hand, can appreciate that
transactions approach poses timing problem and
generally records changes when specific
transactions/events occur and permits GPFR to
summarise these changes according to
operating activities of firm
What to include in income?
Should income include only operating activities
over which management has control, with non-
operating items appropriately labelled?
Should the measurement of income include
more recent and current activities of the firm to
provide timely information for decision-making
by shareholders and creditors on an on-going
basis?
Or should income focus on the overall
measurement of income for the entire life of the
enterprise without the continuous focus on
efficiency but overall focus on transparency?
What to include in income?
Ohlsons (1989) clean-surplus model: this
parallels the all-inclusive and transparent
approach where all changes in assets and
liabilities (excluding transactions with owners)
are processed through profit and loss.
This means that dirty surplus exclusions (due
mainly to the political process of accounting
standard-setting) interrupt articulation of the
balance sheet and the income statement
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Australian practice
With move to IFRS, use comprehensive income
approach with focus on transparency
AASB 101.81: all items of income and expense
recognisedin a period shall be presented :
(a)In single statement of comprehensive income,
or
(b)In two statements separate income statement
and statement beginning with profit/loss and
showing all other components of comprehensive
income
Australian practice
AASB 101.82 requires specific disclosures eg
revenues, expenses including finance costs, tax
expense, gain / loss from disposal of
discontinued operations, profit or loss, total
comprehensive income
AASB 101.99 also permits alternative disclosure
formats based on either nature (eg.
depreciation; wages) or function (eg. by division)
of expenses
Australian practice
Other Comprehensive income includes:
- items of income and expense not recognised in
profit and loss as permitted by other Australian
accounting standards
- examples: changes in revaluation surplus AASB 116
AASB 138
- actuarial gains and losses on defined benefit plans
AASB 119
- gains/losses on remeasuring available-for-sale financial
assets AASB 139
- effective portion of gains/losses on cash flow hedging
instruments (covered later in this course)
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Australian practice
AASB 101.87 prohibits separate identification of
extraordinary items on face of statement of
comprehensive income, separate income
statement (if presented) or in notes
But para 97 provides guidance regarding the
circumstances of disclosure of the nature and
amount of items eg write-downs of inventories
to NRV, restructurings, discontinued operations
AASB 108 requires correction of errors
retrospectively by restating the or changes in
accounting standards
Overseas practice: transparency rankings
Does income statement presentation vary across
countries?
So far, 120 countries (approx.) adopt IFRS
Prima facie, reasonable to expect similar type of income
statement presentation and disclosures across countries
However, due to cultural differences, disclosure levels
specific to profit and loss may vary across countries
International differences in financial reporting is a
growing literature
5. Definition of earnings management what is
it?
Earnings management stems from the purposeful use of
judgement in the external disclosure process to achieve
a specific contractual outcome or private gain, often
misrepresenting the true financial performance of the
company.
Schipper (1989) defines earnings management as the
purposeful intervention in the financial reporting
process, with the intent of obtaining some private gain.
This definition anchors on managerial opportunism.
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5. Definition of earnings management what is
it?
Healy and Whalen (1999) define earnings management
as occurring when managers use judgment in financial
reporting and in structuring transactions to alter financial
reports to either mislead some stakeholders about the
underlying economic performance of the company, or to
influence contractual outcomes that depend on reported
accounting numbers.
Earnings quality decreases with the amount of
judgement permitted if management subversively
implement this judgement to achieve outcomes that
deviate from policy objectives (Schipper and Vincent,
2003).
5. Definition of earnings management what is
it?
Earnings management is usually thought to
decrease earnings quality (Research Foundation
of CFA Institute, 2004)
6. Why is management motivated to manage
earnings?
PAT research shows that:
- management with bonus plans are more likely
to choose income-increasing accounting
policies;
- that the higher the firm debt, the more likely
management are to choose income-increasing
accounting policies;
- and the higher the firms political costs, the
more likely management are to choose income-
decreasing accounting policies.
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6. Why is management motivated to manage
earnings?
Income Smoothing
Other studies show that management make accounting
choices to smooth income or to reduce the variability of
earnings rather than maximise income (Moses, 1987;
Harvey et.al. 2005). For example, management may shift
income across accounting periods (assuming
management tenure is for two periods) (Dye, 1987). This
may take the form of borrowing earnings from the
future for use in the current period (DeFond and Park,
1997).
6. Why is management motivated to manage
earnings?
Smoothing of income around some predetermined target
results in understatements/ overstatements of earnings
relative to the subsequent accounting periods.
Incentives to income smooth (that is, for the manager to,
at times, report a lower value than the largest value as
income) derive from managements desire to minimise
the variability in the firms earnings over time. This is
because large fluctuations in earnings may signal crisis
and draw the attention of regulators (Moses, 1987).
6. Why is management motivated to manage
earnings? Small loss avoidance
Burgstahler and Dichev(1997)
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7. How do we detect earnings
management?
-early single accounting policy choice
-total accrual models:
1. portfolio and random walk models
2. Healy (bonus) model
3. Jones and modified Jones model
4. Industry model
-single accrual models
-small loss avoidance
Early single accounting policy choice
The early single accounting procedure studies use a
dichotomous dependent variable to represent the
accounting choice.
Upon the introduction of a new accounting standard,
firms would choose to either capitalise OR expense
research and development costs; use LIFO OR FIFO.
For example, Daley and Vigeland (1982) model R&D
capitalisers versus expensers and Lee and Hsieh (1985)
model LIFO versus FIFO firms.
The independent variables represent those factors likely
to affect the accounting choice (for example, Daley and
Vigeland (1982) test for leverage and size).
Problems of early single accounting policy
choice
The single accounting policy choices effectiveness as
an earnings management tool is diminished to the extent
that the users of financial statements can undo its
effect on earnings.
In addition, the single accounting policy studies failed to
explain the cross-sectional variation in accounting policy
choice resulting from the use of combinations of
accounting policies.
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Total accrual model: J ones (1991) model
Another well-cited model in the earnings management
literature is the J ones (1991) model
Problem with the random walk and Healy models: they
do not incorporate the effect of changes in a firms
economic circumstances on non-discretionary accruals
J ones model addresses this shortcoming in a
straightforward way: non-discretionary or expected
accruals are modelled as a function of the change in
revenues and the level of property, plant and equipment
scaled by lagged assets
J ones (1991) model
Revenues capture the change in the firms
economic environment to the extent that it does
not contain management bias
The level of property, plant and equipment
controls for the non-discretionary depreciation
expense.
J ones (1991) model (Note: students are not
expected to reproduce the mathematical
models presented in this lecture but to gain
a very general understanding of their
existence)

1 2 3
1 1 1
REV PPE 1
TA ,
A A A
it it
it
it it it
o o o

| | | | | | A
= + + +
| | |
\ . \ . \ .
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J ones (1991) model
where TA represents total accruals in time period
t for firm i ; represents unexpected accruals
while AREV represents the change in revenue in
time period t for firm i and PPE represents the
level of property, plant and equipment in time
period t for firm i.
J ones scales all variables by total lagged assets
to reduce heteroscedasticity(to minimise
evidence of unequal variances over time in firms
economic variables due to inflation and growth).
J ones (1991) model
J ones develops an accrual expectation model using time
series data to estimate non-discretionary accruals
In the event year, cross-sectional tests of the earnings
management hypothesis are applied
J ones (1991) investigates firm incentives to manage
earnings during import relief investigations by the US
International Trade Commission
The aim is to see if managers manipulate earnings
downwards to increase the likelihood of receiving import
relief and/or the dollar amount of relief
J ones (1991) model
J ones reports that firms make accounting
choices to maximise the perceived injury to the
firm by reducing reported earnings during import
relief investigations relative to non-investigation
periods
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modified J ones model
Dechow, Sloan and Sweeney (1995) present a
modified J ones model to relax the assumption of
the J ones model that all revenues are non-
discretionary
The modified J ones model subtracts from the
change in revenue the change in receivables to
control for the possibility revenues are being
managed through income accruals
modified J ones model

1 2 3
1 1 1
REV REC PPE 1
TA ,
A A A
it it it
it
it it it
o o o

| | | | | | A A
= + + +
| | |
\ . \ . \ .
modified J ones model
where TA represents total accruals in time period
t for firm i ; represents unexpected accruals
while AREV represents the change in revenue
in time period t for firm i ; AREC represents the
change in receivables in time period t for firm i
and PPE represents the level of property, plant
and equipment in time period t for firm i
All variables are scaled by total lagged assets
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Small loss avoidance
Burgstahler and Dichev(1997) graphed the
distribution of earnings to show the cluster of
firms just above zero (see earlier slide for graph)
Tendency by firms to avoid losses
Shift a small earnings loss into a (small) gain
8. What are the patterns of earnings
management? Does this vary across
cultures?
Patterns of earnings management cross-
cultural differences?
Earnings management does differ around the
world
Refer Leuz et.al. (2003) graph: shows
propensity for earnings management is
negatively correlated with disclosure
More secretive countries appear to have more
earnings management
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Patterns of earnings management cross-
cultural differences?
Refer tutorial week 1 additional question 2 on
country-level scores for corporate disclosure
Can see that countries with high conservatism
scores (Greece, South Korea, Portugal, Taiwan,
Thailand, Pakistan and Indonesia) also appear
to have higher earnings management
Recall conservatism is a negative bias that tends
to reduce earnings (rather than increase
earnings)
9. What are the consequences of earnings
management? Is it good or bad?
If earnings management reduces the quality of
earnings, then earnings management may be
considered bad
On the other hand, if managing earnings is
motivated to reduce the rigidities of accounting
rules, it could be seen as good if it succeeds in
making the market for financial information more
efficient
9. What are the consequences of earnings
management? Is it good or bad?
But if management is managing earnings for
their private gain and re-distributing wealth away
from the shareholder (and to themselves), then
the information value of earnings may be
compromised
Generally, difficult to cast a value judgement
whether earnings management is a good or
bad thing
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10. Next Week
Accounting for the Environment
With
Dr. Maria Balatbat