If for any reason the assumptions are not well-founded, distortions will appear in the income reported. The objectives of the application of generally accepted accounting principles to the income statement are to measure and report the results of operations as they occur for a specified period without recognizing any artificial exclusions or modifications.
Companies that use aggressive accounting policies report higher income numbers in the short-run. In such cases, we say that the quality of earnings is low. Similarly, if higher expenses are recorded in the current period, in order to report higher income in the future, then the quality of earnings is also considered low. The major distinction between revenues and gains or expenses and losses depends on the typical activities of the company. Gains also can arise from many different sources, but these sources occur from peripheral or incidental transactions of an entity.
The same type of distinction is made between expenses and losses. The advantages of the single-step income statement are: 1 simplicity and conciseness, 2 probably better understood by the layperson, 3 emphasis on total costs and expenses, and net income, and 4 does not imply priority of one revenue or expenseover another. The disadvantages are that it does not show the relationship between sales revenue and cost of goods sold and it does not show other important relationships and information, such as income from operations, income before income tax, etc.
Operating items are the expenses and revenues which relate directly to the principal activity of the concern; they are revenues realized from, or expenses which contribute to, the sale of goods or services for which the company was organized. The nonoperating items result from secondary activities of the company.
They are not directly related to the principal activity of the company but arise from incidental activities. The modified all-inclusive income statement includes most items including irregular ones, as part of net income. The retained earnings statement then would include only the beginning balance adjusted for the effects of errors and changes in accounting principle , the net amount transferred from income summary, dividends, and transfers to and from appropriated retained earnings.
Subsequently a number of pronouncements have reinforced this position. Recently, changes in accounting principle are also adjusted through the beginning retained earnings balance. Items considered corrections of errors should be charged or credited to the opening balance of retained earnings. However, in general and in accordance with FASB ASC this transaction would normally not be considered extraordinary, but would be shown in the nonoperating section of a multiple-step income statement.
If unusual or infrequent but not both, it should be separately disclosed in the income statement. Although the basis of computation is a percentage of net income, it is an ordinary operating expense to the company and represents a cost of the service received from employees. If the amount is material, it should be shown in the retained earnings statement as an adjustment to the beginning balance of retained earnings.
One treatment would be to show it in the statement as a deduction from the rent expense, as it reduces an operating expense and therefore is directly related to operations. Another treatment is to show it in the other revenues and gains section of the income statement.
It may be reported as an unusual loss. The change is considered a change in estimate. It should not be shown as an extraordinary item. If a manufacturing concern, may be included in cost of goods sold.
Perlmanand Sheehan shouldnot report the sales in a similarmanner. Either way, the company has the same revenues, gains, expenses, and losses; they are simply organized in a different format. Both formats are acceptable. The amount of detail reported in the income statement is left to the judgment of the company, whose goal in making this decision should be to present financial statements which are most useful to decision makers.
We want to present a simple, understand- able statement so that a reader can easily discover the facts of importance; therefore, a single amount for selling expenses might be preferable. However, we also want to fully disclose the results of all activities; thus, a separate listing of expenses may be preferred. Note that if the condensed version is used, it should be accompanied by a supporting schedule of the eight components in the notes to the financial statements.
Intraperiod tax allocation should not affect the reporting of an unusual gain. Intraperiod tax allocation has no effect on reported net income, although it does affect the amounts reported for various components of income. The effects on these components offset each other so net income remains the same.
Intraperiod tax allocation merely takes the total income tax expense and allocates it to the various items which affect the tax amount. If Neumann has preferred stock outstanding, the numerator in its computation may be incorrect. Therefore, the numerator should be: net income less preferred dividends. The denominator is also incorrect if Neumann had any common stock transactions during the year. Since the numerator represents the results for the entire year, the denominator should reflect the weighted-average number of common shares outstanding during the year, not the shares outstanding at one point in time year-end.
The earnings per share trend is not favorable. Extraordinary items are one-time occurrences which are not expected to be reported in the future. Therefore, earnings per share on income before extraordinary items is more useful because it represents the results of ordinary business activity. Tax allocation within a period is the practice of allocating the income tax for a period to such items as income before extraordinary items, extraordinary items, and prior period adjustments.
The justification for tax allocation within a period is to produce financial statements which disclose an appropriate relationship, for example, between income tax expense and a income before extraordinary items, b extraordinary items, and c prior period adjustments or of the opening balance of retained earnings. Tax allocation within a period intraperiod becomes necessary when a firm encounters such items as discontinued operations, extraordinary items, or corrections of errors.
Such allocation is neces- sary to bring about an appropriate relationship between income tax expense and income from continuing operations, discontinued operations, income before extraordinary items, extraordinary items, etc. Tax allocation within a period is handled by first computing the tax expense attributable to income before extraordinary items, assuming no discontinued operations. This is simply computed by ascertaining the income tax expense related to revenue and expense transactions entering into the determination of such income.
Next, the remaining income tax expense attributable to other items is determined by the tax consequences of transactions involving these items. The applicable tax effect of these items extraordinary, prior period adjustments should be disclosed separately because of their materiality. If the damages are unusual in nature, the damage settlement might be reported as an unusual item. The damages would not be reported as a correction of an error prior period adjustment.
The assets, cash flows, results of operations, and activities of the plants closed would not appear to be clearly distinguishable, operationally or for financial reporting purposes, from the assets, results of operations, or activities of the Linus Paper Company. Therefore, disposal of these assets is not considered to be a disposal of a component of a business that would receive special reporting.
The major items reported in the retained earnings statement are: 1 adjustments of the beginning balance for corrections of errors or changes in accounting principle, 2 the net income or loss for the period, 3 dividends for the year, and 4 restrictions appropriations of retained earnings.
It should be noted that the retained earnings statement is sometimes composed of two parts, unappropriated and appropriated. It should be noted that the Code prohibits use of the cashreceipts and disbursements method as a method which will clearly reflect income in accounting for purchases and sales if inventories are involved. The cash receipts and disbursements method will not usually fairly present income because: 1 The completed transaction, not receipt or disbursement of cash, increases or diminishes income.
Thus, a sale on account produces revenue and increases income, and the incurrence of expense reduces income without regard to the time of payment of cash. In most situations the cash receipts and disbursements method will violate this principle.
The cash receipts and disbursements method permits manipulation of the timing of revenues and expenses and may result in treatments which are not consistent, detracting from the usefulness of comparative statements. Problems arise both from the revenue side and from the expense side. There sometimes may be doubt as to the amount of revenue under our common rules of revenue recognition.
However, the more difficult problem is the determination of costs expired in the production of revenue. During a single fiscal period it often is difficult to determine the expiration of certain costs which may benefit several periods. Business is continuous and estimates have to be made of the future if we are to systematically apportion costs to fiscal periods.
Examples of items which present serious obstacles include such items as institutional advertising costs. Accountants have established certain rules for handling revenues and costs which are applied con- sistently and in a systematic manner. From period to period, application of these rules generally results in a satisfactory matching of costs and revenues unless there are large changes from one period to another. These rules, influenced by conservatism in the face of the uncertainties involved, tend to charge costs to expense earlier than might be ideally desirable if we had more knowledge of the future.
Costs or expenses of the types mentioned above, by their very nature, defy any attempt to relate them to revenues of a specific period or periods. Although it is known that institutional advertising will yield benefits beyond the present, both the amount of such benefits and when they will be enjoyed are shrouded in uncertainty. The degree of certainty with which their time distribution can be forecast is so small and the results, therefore, so unreliable that the accountant writes them off as applicable to the period or periods in which the expense was incurred.
Elements are the basic ingredients which comprise the income statement; that is, revenues, gains, expenses, and losses. Items are descriptions of the elements such as rent revenue, rent expense, etc. In order to predict the future, the amounts of individual items may have to be reported.
Another example is income data that are distorted because of large discretionary expenses. Other comprehensive income must be displayed reported in one of two ways: 1 a single continuous income statement or 2 two separate but consecutive statements of net income and other comprehensive income two statement approach.
The results of continuing operations should be reported separately from discontinued operations, and any gain or loss from disposal of a component of a business should be reported with the related results of discontinued operations and not as an extraordinary item. The following format illustrates the proper disclosure: Income from continuing operations before income tax XXX Income from continuing operations XXX Net income Note: The increase in value of the company reputation and the unrealized gain on the value of patents are not reported.
Income from continuing operations Simplicity and conciseness. Probably better understood by users. Emphasison total costs and expenses and netincome. Does not imply priority of one revenue orexpenseover another. Providesmore information through segregation ofoperating and nonoperatingitems. Expensesare matched with related revenue. However, the discussion supporting the answer should include the previous points. Provides more information through segregation of operating and nonoperatingitems.
However,the discussionsupporting the answer should include the above points. A restriction doesnotaffecttotalretainedearnings;itmerely labelspartofthe retained earningsas being unavailablefor dividenddistribution.
Long-term investments are generally investments in shares and bonds of other companies that are normally held for many years. Property, plant, and equipment are assets with relatively long useful lives that a company is currently using in operating the business. The two accounts and the purpose of each are: 1 Share capital—ordinary is used to record investments of assets in the business by the owners shareholders.
After reversing entries have been made, the balances will be Interest Payable, zero balance; Interest Expense, a credit balance. Filling in the blanks, the answers are 1, 3, 4, 5, 2. Analyze business transactions. Journalize the transactions. Post to ledger accounts. Prepare a trial balance. Journalize and post adjusting entries. Prepare an adjusted trial balance. Prepare financial statements.
Journalize and post closing entries. Prepare a post-closing trial balance. Filling in the blanks, the answers are 4, 2, 8, 7, 5, 3, 9, 6, 1. Service Revenue CHF21, Less: Accumulated depreciation Debit Credit July 31 Commission Revenue Steps 1—3 may occur daily in the accounting cycle. Steps 4—7 are performed on a periodic basis. Closing entries are prepared after financial statements are prepared. Accounts Payable Salaries Expense Titles Dr.
Debit Credit Dec. Debit Credit Balance Jan. Debit Credit Balance Dec. Debit Credit Mar. Debit Credit Balance Mar. The useful life is not the period of time that it would take that entity to internally develop an intangible asset that would provide similar benefits. However, a reacquired right recognized as an intangible asset is amortized over the remaining contractual period of the contract in which the right was granted.
If an entity subsequently reissues sells a reacquired right to a third party, the entity includes the related unamortized asset, if any, in determining the gain or loss on the reissuance. The expected use of the asset by the entity. The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate.
Any legal, regulatory, or contractual provisions that may limit the useful life. The cash flows and useful lives of intangible assets that are based on legal rights are constrained by the duration of those legal rights. Thus, the useful lives of such intangible assets cannot extend beyond the length of their legal rights and may be shorter.
In the absence of that experience, the entity shall consider the assumptions that market participants would use about renewal or extension consistent with the highest and best use of the asset by market participants, adjusted for entity-specific factors in this paragraph. The effects of obsolescence, demand, competition, and other economic factors such as the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels.
The level of maintenance expenditures required to obtain the expected future cash flows from the asset for example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life.
As in determining the useful life of depreciable tangible assets, regular maintenance may be assumed but enhancements may not. Further, if an income approach is used to measure the fair value of an intangible asset, in determining the useful life of the intangible asset for amortization purposes, an entity shall consider the period of expected cash flows used to measure the fair value of the intangible asset adjusted as appropriate for the entity-specific factors in this paragraph.
The term indefinite does not mean the same as infinite or indeterminate. The useful life of an intangible asset is indefinite if that life extends beyond the foreseeable horizon—that is, there is no foreseeable limit on the period of time over which it is expected to contribute to the cashflows of the reporting entity.
Such intangible assets might be airport route authorities, certain trademarks, and taxicab medallions. CE According the FASB ASC Disclosure shall be made in the financial statements of the total research and development costs charged to expense in each period for which an income statement is presented.
Such disclosure shall include research and development costs incurred for a computer software product to be sold, leased, or otherwise marketed. An entity shall charge the costs of overall deals that cannot be identified with specific projects to expenses as they are incurred over the related time period.
That is, expense as incurred. The two main characteristics of intangible assets are: a they lack physical substance. If intangibles are acquired for stock, the cost of the intangible is the fair value of the consideration given or the fair value of the consideration received, whichever is more clearly evident.
Limited-life intangibles should be amortized by systematic charges to expense over their useful life. An intangible asset with an indefinite life is not amortized. When intangibles are created internally, it is often difficult to determine the validity of any future service potential.
To permit deferral of these types of costs would lead to a great deal of subject- tivity because management could argue that almost any expense could be capitalized on the basis that it will increase future benefits. The cost of purchased intangibles, however, is capitalized because its cost can be objectively verified and reflects its fair value at the date of acquisition.
Companies cannot capitalize self-developed, self-maintained, or self-created goodwill. These expen- ditures would most likely be reported as selling expenses. Factors to be considered in determining useful life are: a The expected use of the asset by the entity.
The amount of amortization expensed for a limited-life intangible asset should reflect the pattern in which the asset is consumed or used up, if that pattern can be reliably determined.
If the pattern of production or consumption cannot be determined, the straight-line method of amortization should be used. This trademark is an indefinite life intangible and, therefore, should not be amortized. Amortization Expense Artistic-related intangible assets involve ownership rights to plays, pictures, photographs, and video and audiovisual material.
These ownership rights are protected by copyrights. Contract-related intangible assets represent the value of rights that arise from contractual arrangements. Examples are franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts. Varying approaches are used to define goodwill.
They are a Goodwill should be measured initially as the excess of the fair value of the acquisition cost over the fair value of the net assets acquired. This definition is a measurement definition but does not conceptually define goodwill. Examples of elements of goodwill include new channels of distribution, synergies of combining sales forces, and a superior management team. Another definition is the capitalized value of the excess of estimated future profits of a business over the rate of return on capital considered normal in the industry.
A bargain purchase or negative goodwill occurs when the fair value of the assets purchased is higher than the cost. This situation may develop from a market imperfection. In this case, the seller would have been better off to sell the assets individually than in total. However, situations do occur e. Goodwill is recorded only when it is acquired by purchase.
Goodwill acquired in a business combination is considered to have an indefinite life and therefore should not be amortized, but should be tested for impairment on at least an annual basis. Many analysts believe that the value of goodwill is so subjective that it should not be given the same status as other types of assets such as cash, receivables, inventory, etc. The analysts are simply stating that they believe that presentation of goodwill on the balance sheet does not provide any useful information to the users of financial statements.
Whether this is true or not is a difficult point to prove, but it should be noted that it appears contradictory to pay for the goodwill and then immediately write it off, denying that it has any value. Accounting standards require that if events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable, then the carrying amount of the asset should be assessed.
The assessment or review takes the form of a recoverability test that compares the sum of the expected future cash flows from the asset undiscounted to the carrying amount. If the cash flows are less than the carrying amount, the asset has been impaired.
The impairment loss is measured as the amount by which the carrying amount exceeds the fair value of the asset. The fair value of assets is measured by their fair value if an active market for them exists.
If no market price is available, the present value of the expected future net cash flows from the asset may be used. Under U. GAAP, impairment losses on assets held for use may not be restored. Impairment losses and recovery of losses for assets to be disposed of are similar to other costs that would flow through operations. Thus, gains recoveries of losses on assets to be disposed of should be reported as part of income from continuing operations.
Research and development costs are incurred to develop new products or processes, to improve present products, or to discover new knowledge. If the items have alternative future uses, the materials should be recorded as inventories and allocated as consumed and the equipment should be capitalized and depreciated as used. Also, see Illustration page Each of these items should be charged to current operations.
Advertising costs have some minor exceptions to this general rule. However, the specific accounting is beyond the scope of this textbook. These costs are referred to as start-up costs, or more specifically organizational costs in this case. The accounting for start-up costs is straightforward—expense these costs as incurred. The profession recognizes that these costs are incurred with the expectation that future revenues will occur or increased efficiencies will result.
However, to determine the amount and timing of future benefits is so difficult that a conservative approach—expensing these costs as incurred—is required. There are 30 40 — 10 remaining years for amortization purposes. No entry is necessary. The loss is the difference between the recorded goodwill and the implied goodwill. Becausethe usefullife is indefinite, copyrightNo.
Long-term investments in the balancesheet. Property,plant,and equipmentin the balance sheet. Researchand developmentexpense in the income statement.
Currentasset prepaidrent in the balance sheet. Charge asexpensein the income statement. Operatinglosses in the income statement. Not recorded; any costs relatedto creating goodwillincurred internally mustbe expensed. Long-term investments,or other assets,in the balance sheet. Expensedin the income statement. EXERCISE 10—15 minutes The following items would be classified as an intangible asset: Cable television franchises Film contractrights Music copyrights Customerlists Goodwill Covenants notto compete Internetdomain name Brand names Cash, accounts receivable, notes receivable, and prepaid expenses would be classified as current assets.
Property,plant,and equipment,and land would be classified as non-current assets in the property, plant, and equipment section.
Research and development costs would be classified as an operating expense. Discount on notes payable is shown as a deduction from the related notes payable on the balance sheet. Organizationcosts are start-up costs and should be expensed as incurred. Advertising costs in general are expensed when incurred or when first used.
The computation of accumulated amortization is as follows. Alatorre should amortize the franchise over its estimated useful life.
Becauseitis uncertainthatAlatorrewillbe able to retainthe franchiseat the end of , it should be amortized over 10 years. These costs should be expensed as incurred. Because the license can be easily renewed atnominalcost , it has an indefinite life. Thus, no amortization will be recorded. The license will be tested for impairment in future periods. Restoration of any impairment loss is not permitted for assets held for use.
Therefore,an impairmenthasoccurred. Todeterminethe impair- ment amount, we first find the implied goodwill. We then compare this implied fair value to the carrying value of the goodwill to determine the amount of the impairment to record. After a goodwillimpairmentloss is recognized,the adjusted carrying amount of the goodwill is its new accounting basis. Note to instructor:It is importantthat before conductingthe goodwill impairmenttest that all other long-lived assets are evaluated and adjusted for any impairments.
Payable, etc The student must also be alert to the fact that several transactions require that an adjustment of Retained Earnings be made. The problem provides a good summary of accounting for intangibles. Problem Time 20—30 minutes Purpose—to provide the student with an opportunity to compute the carrying value of a patent at three balance sheet dates.
Computation of amortization is slightly complicated by additions to the account and a change in the estimated useful life of the patents.
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