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INCOME CONCEPTS FOR

FINANCIAL REPORTING

Presented By:
Dr. Nunung Nuryani, MSi., Ak., CA
Schroeder, Richard G., Myrtle W. Clark and Jack M. Cathey : “Financial Accounting
Theory and Analysis: Text and Cases”, 12th Ed. (Asia Edition) , 2019. (SMJ)
 The Purpose of Income Reporting

Income is used…

1 as the basis of one of the principal forms of

taxation.
2 in public reports as a measure of the success of a
corporation’s operations.
3 as a criterion for the determination of the
availability of dividends.
4 by rate-regulating authorities for investigating
whether those rates are fair and reasonable.
5 as a guide to management of an enterprise in the
conduct of its affairs.
 Importance of Income Reporting

✓ Income reporting as the primary source for investor

decision making
✓ Company’s value is related to its current and future
earnings.
✓ Economic Vs. Accounting Income
• Related sciences
• concerned with the activities of business firms
• use similar variables
• differences over the timing and measurement of income
• Relative importance of income statement (accounting) and balance
sheet (economics)
 In an Attempt to Reconcile

What is the
nature of
income?

When should
income be
reported?
 What is the Nature of Income?
➢ Three possibilities
1. Psychic income
✓Satisfaction of human wants
2. Real income
✓Increase in economic wealth
3. Money income
✓Increases in monetary value
➢ The concept of well-offness or capital maintenance
• Problems

➢ Because of the difficulties in measuring real income -

Accountants have adopted a transactions approach to
income recognition
 Capital Maintenance Concepts

Financial Physical capital

capital maintenance
maintenance
- money - productive capacity
amount -
transactions
based

Difference is in the treatment of holding gains

 Current Value Accounting

➢ The concept of physical capital maintenance

requires assets and liabilities to be stated at
their current values

➢ Approaches:
1 Entry price or replacement cost
2 Exit value or selling price
3 Discounted present value
 Income Recognition

• Criticisms of the transactions approach

• Possible alternatives
– Edwards and Bell
1 Current operating profit
2 Realizable cost savings
3 Realized cost savings
4 Realized capital gains
– Sprouse
The concept of measurable change
 Measurement

• What is measurement?
• Problems with the measurement unit
• Arbitrary decisions
 Measurement

Measurement
Cost is generally thought to be a faithful representation
of the amount paid for a given item.
Fair value is “the amount for which an asset could be
exchanged, a liability settled, or an equity instrument
granted could be exchanged, between knowledgeable,
willing parties in an arm’s length transaction.”

IASB has taken the step of giving companies the option

to use fair value as the basis for measurement of
financial assets and financial liabilities.
 Accounting for Inflation

• Instability of the accounting measuring

unit is due to the effects of inflation or
deflation
• General purchasing power adjustments
 Revenue Recognition
Revenue recognition is a top fraud risk and regardless
of the accounting rules followed (IFRS or U.S. GAAP),
the risk or errors and inaccuracies in revenue reporting is
significant.

Restatements for improper revenue recognition are

relatively common and can lead to significant share price
adjustments.
Result in larger drops in market capitalization than other types of
restatement.
Caused eight of the top ten market value losses in a recent year.
Of the ten companies, the leading three lost $20 billion in market value
in just three days following disclosure of revenue recognition problems.
(PricewaterhouseCoopers, 2002)
 Revenue Recognition

Guidelines for Revenue Recognition

Revenue recognition principle (IFRS):
Revenue is recognized
(1) when it is probable that the economic benefits will flow
to the company and
(2) when the benefits can be measured reliably.

Revenue recognition principle (US GAAP):

Revenue is recognized
(1) when it is realized or realizable and
(2) when it is earned.
 Revenue Recognition

Concepts Affecting Revenue Recognition

Conservatism
Materiality
 Earnings Quality, Earnings Management and
Fraudulent Financial Reporting

➢Earnings quality
• The correlation between a company’s
accounting and economic income
• The existence of the previously discussed
issues has led some to the conclusion that
economic income is a better predictor of
cash flows.

➢Assessing earnings quality

 Earnings Quality, Earnings Management and
Fraudulent Financial Reporting

➢ Assessing earnings quality

1 Compare the accounting principles employed by the
company with those generally used in the industry and by
competitions.
➢Do the principles used by the company inflate earnings?
2 Review recent changes in accounting principles and
changes in estimates to determine if they inflate earnings.
3 Determine if discretionary expenditures,
such as advertising, have been postponed
by comparing them to previous periods.
4 Attempt to assess whether some expenses, such as
warranty expense, are not reflected on the income
statement.
 Earnings Quality, Earnings Management and
Fraudulent Financial Reporting

➢ Assessing earnings quality

5 Determine the replacement
cost of inventories and other
assets. Assess whether the
company generating sufficient 7 Review the relationship
cash flow to replace its assets? between sales and
6 Review the notes to financial receivables to determine if
statements to determine if loss receivables are increasing
contingencies exist that might more rapidly than sales.
reduce future earnings and 8 Review the management
cash flows. discussion and analysis
section of the annual report
and the auditor's opinion to
determine management's
opinion of the company's
future and to identify any
major accounting issues
 Earnings Quality, Earnings Management and
Fraudulent Financial Reporting
What is Earnings Management
“…a purposeful intervention in the external financial reporting process,
with the intent of obtaining some private gain
(Schipper, 1989: “Commentary Earnings Management”, Accounting Horizon).

“Earnings management occurs 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”
(Healy dan Wahlen, 1999: “A Review of the Earnings Management”, Accounting Horizon)

Given that managers can choose accounting policies from a set of

policies (for example, GAAP), it is natural to expect that they will choose
policies so as to maximize their own utility and/or the market value of the
firm. This is called earnings management
(Scott, 2015, “Financial Accounting Theory”)
 Earnings Quality, Earnings Management and
Fraudulent Financial Reporting

Earnings Management Techniques

The most common of earnings management techniques involves
simply using the flexibility that exists in GAAP (include changing
depreciation method, changing the useful lives and the estimates of salvage
value for depreciation, determining the allowance for uncollectible accounts
receivable, estimating the stage of completion of percentage-of-completion
contract, etc)

Earnings management techniques (Giroux, 2004) include:

- Aggressive revenue recognition (recognizing revenues early in the
operating cycle),
- Capitalizing rather than expensing operating cost,
- Allocating costs over longer period (increasing the estimated useful
lives of fixed assets)
 Earnings Quality, Earnings Management and
Fraudulent Financial Reporting

Earnings Management Techniques

Arthur Levitt (Levitt, 1998) has outlined five
earnings management techniques that he described
as threatening the integrity of financial reporting:
1. Taking a bath
2. Creative acquisition accounting
3. Cookie jar reserves
4. Abusing the materiality concept
5. Improper revenue recognition
 Earnings Quality, Earnings Management and
Fraudulent Financial Reporting

The Distinction between Earnings Management

and Fraud
Earnings management includes the whole spectrum, from conservative
accounting through fraud, a huge range for accounting judgment, given
the incentives of management.

Conservative Moderate Aggressive Fraud

Accounting Accounting Accounting

(Giroux, 2004 “Detecting Earnings Management”)

 Accounting Choices “Real” Cash Flow Choices

Within GAAP

“Conservative” Overly aggressive recognition of provisions or Delaying sales

Accounting reserve Accelerating R&D or Advertising
Overvaluation of acquired in-process R&D in expenditures
purchase acquisition
Overstatement of restructuring charges and asset
write-offs

“Neutral” Earnings that result from a neutral operation of the

Earnings process

“Aggressive” Understatement of the provision for bad debts Accelerating sales

Accounting Drawing down provisions or reserves in an overly Postponing R&D or Advertising
aggressive manner expenditures

Violate GAAP
“Fraudulent” Recording sales before they are “realizable”
Accounting Recording fictitious sales
Backdating sales invoices
Overstating inventory by recording fictitious Dechow & Skinner, 2000
inventory
 Earnings Quality, Earnings Management and
Fraudulent Financial Reporting

Red flags of possible fraudulent

1. A predominantly insider board of
directors
2. Management compensation tied to its
stock price
3. Frequent changes of auditors
4. Rapid turnover of key personnel
5. Deteriorating earnings
6. Unusually rapid growth
7. Lack of working capital
 Earnings Quality, Earnings Management and
Fraudulent Financial Reporting

Red flags of possible fraudulent

8. The need to increase the stock price to
meet analysts’ earnings projections
9. Extremely high levels of debt
10. Cash shortages
11. Significant off-balance sheet financing arrangements
12. Doubt about the company’s ability to continue as a
going concern
13. SEC or other regulatory investigations
14. Unfavorable industry economic conditions
15. Suspension or delisting from a stock exchange
 Thank you

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