Level1 FSA Reading34

Slide
34-1
Fortmat
Proper
Income Statement
Heading
Income from
Continuing
Operations
Separately
Reported
Items
EPS Section
FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Slide
34-2
Income
Income from
from Continuing
Continuing Operations
Operations
Revenues Expenses Gains and Income Tax

Losses Expense
Inflows of Outflows of
resources resources Increases or Because of
resulting incurred in decreases in its
from generating equity from importance
providing revenues. peripheral or and size,
goods or incidental income tax
services to transactions expense is a
customers. of an entity. separate
item.
Slide
34-3
Income Statement
Operating Nonoperating
Income vs. Income
Slide
34-4
Income Statement (Single-Step)

Proper Heading
{
Revenues
& Gains {
Expenses
& Losses
{
Slide
34-5
Income Statement (Multiple-Step)

Proper Heading
{
Gross
Margin {
Operating
Expenses {
{
Non-
operating
Items

Slide
34-6
Separately Reported Items

Three types of events are reported separately,
net of taxes:
1.
2.
3.

Slide
34-7
Intraperiod Income Tax
Allocation
Income
Income Tax
Tax Expense
Expense must
must be
be associated
associated with
with
each
each component
component of
of income
income that
that causes
causes it.
it.
Show
ShowIncome
IncomeTax Tax Report
Reporteffects
effectsof
of Discontinued
Discontinued
Expense
Expenserelated
relatedto
to Operations,
Operations, Extraordinary
Extraordinary
Income
Incomefrom
from Items,
Items,and
andCumulative
Cumulative Effect
Effect of
of
Continuing
Continuing Accounting
AccountingChanges
Changes NET
NETOFOF
Operations.
Operations. INCOME
INCOMETAXES.
TAXES.

Slide
34-8
Discontinued Operations
 Sale or disposal of a component

of an entity.
 A component includes:
 Reportable segments
 Operating segments
 Reporting units
 Subsidiaries
 Asset groups

Slide
34-9
 Report results of operations

separately if two conditions are met:
1. The operations and cash flows of the
component have been (or will be)
eliminated from the ongoing
operations.
2. The entity will not have any
significant continuing involvement in
the operations of the component after
the disposal transaction.

Slide
34-10
 Results of operations
include two items:
1. The income or loss stream for
the period from the identifiable
discontinued operation.
2. The actual gain or loss from
disposal of the component
or
an “impairment loss” if the
component is held for resale.

Slide
34-11
 Results of operations
include two items:
The income or loss stream for
1.
the period from the identifiable
discontinued operation.
2. The actual gain or loss from
Carrying Valuedisposal
of Assets > (Fair
of the Value of Assets - Cost to Sell)
component
or
an “impairment loss” if the
component is held for resale.

Slide
34-12
Example
During the year, Apex Co. sold an
unprofitable component of the company. The
component had a net loss from operations
during the period of $150,000 and its assets
sold at a loss of $100,000. Apex reported
income from continuing operations of
$128,387. All items are taxed at 30%.
How will this appear on the income

statement?
Slide
34-13
Example
Computation of Loss from Discontinued Operations
(Net of Tax Effect):

Slide
34-14
Example
Income Statement Presentation:

Slide
34-15
Extraordinary Items
 Material in amount
 Gains or losses that are
 unusual in nature and
 infrequent in occurrence.
 required by GAAP.
 Reported net of related

taxes

Slide
34-16
Extraordinary Items
Example
During the year, Apex Co. experienced a
loss of $75,000 due to an earthquake at one
of its manufacturing plants in Nashville.
This was considered an extraordinary item.
The company reported income before
extraordinary item of $128,387. All gains
and losses are subject to a 30% tax rate.
How would this item appear on the

income statement?
Slide
34-17
Extraordinary Items
Example

Slide
34-18
Unusual or Infrequent Items
Items that are material and are either

unusual or infrequent—but not both—
are included as a separate item in
continuing operations.

Slide
34-19
Accounting Changes
Type of Accounting
Change Definition
Change in Accounting Replaces one GAAP with
Principle another
Change in Accounting Revision of an estimate
Estimate because of new
information or new
experience
Change in Reporting Change from reporting as
Entity one type of entity to
another type of entity

Slide
34-20
Change in Accounting Principle
 Occurs when
 Changing from one GAAP method to another
GAAP method, or
 Changing the method of application of an
existing principle.
 Make a catch-up adjustment known as the
cumulative effect of a change in accounting
principle.
 The cumulative effect is reported net of
taxes and after extraordinary items.

Slide
34-21

Example
During the year, Apex Co. decided to change
from the double-declining balance to the
straight-line method for depreciation. The
effect of this change is an increase in net
income of $65,000. Apex reported income of
$128,387 during the year. All items of
income are subject to a 30% tax rate.
How would this item appear on the

income statement?
Slide
34-22

Example
Computation:

Slide
34-23
Change in Estimates
 Revision of a previous
accounting estimate.
 The new estimate should be
used in the current and future
periods.
 The prior accounting results
should not be be restated.

Slide
34-24
Change in Estimates
Example
On January 1, 2000, we purchased
equipment costing $30,000, with a useful
life of 10 years and no salvage value.
During 2003, we determine that the
remaining useful is 5 years (8-year total
life). We use straight-line depreciation.
Compute the revised depreciation
expense for 2003.

Slide
34-25
Change in Estimates
Example
Asset cost $ 30,000
Accumulated depreciation
12/31/02 - ($3,000 × 3 years) (9,000)
Remaining to be depreciated 21,000
Remaining useful life ÷ 5 years
Revised annual depreciation $ 4,200
Record depreciation expense of $4,200 for

2003 and subsequent years.

Slide
34-26
Change in Reporting Entity
Financial
statements
are prepared
for separate
entities.
Slide
34-27
If two entities
combine, a single
set of consolidated
financial statements
is generally
required.

Slide
34-28

If two entities combine:
1. Prepare a single set of
consolidated financial
statements.
2. Retroactively restate
financial statements of
prior periods.

Slide
34-29
Prior Period Adjustments
 Corrections of errors from a

previous period.
 Appear on the Statement of
Retained Earnings as an
adjustment to beginning
retained earnings.
 Must show the adjustment net
of income taxes.

Slide
34-30

Example
While reviewing the depreciation entries
for 2001-2004, the controller found that
in 2003 depreciation expense was
incorrectly debited for $150,000 when in
fact it should have been debited
$125,000. All items are taxed at 30%.
Prepare the necessary journal entry in
2004 to correct this prior period error.
Slide
34-31

Example
GENERAL JOURNAL Page: 180
Date Description PR Debit Credit
12/31/03 Depreciation Expense 150,000
Accumulated Depreciation 150,000
IfIf this
this was
was the
the original
original
entry,
entry, howhow dodo we
we correct
correct it?
it?
Can
Can we we just
just reverse
reverse it?
it?
Why
Why oror why
why not?
not?

Slide
34-32

Example
2004 Entry
2004 Accumulated Depreciation 25,000
To
To correct
correct the
the 2003
2003 error
error in
in 2004,
2004, we
we can
can
debit
debit Accumulated
Accumulated Depreciation
Depreciation since
since itit is
is
aa permanent
permanent account.
account.

Slide
34-33

Example
2004 Entry
Retained Earnings 17,500
We
We can’t
can’t credit
credit Depreciation
Depreciation Expense
Expense
since
since itit was
was closed
closed in
in 2003,
2003, so
so we
we credit
credit
Retained
Retained Earnings.
Earnings.

Slide
34-34

Example
2004 Entry
Income Taxes Payable 7,500
Retained Earnings 17,500
Remember to consider the tax effects:

$25,000 × 30% = $7,500 taxes payable

Slide
34-35
Basic Earnings Per Share

Slide
34-36
Earnings Per Share Disclosure
Report EPS data separately for:

1. Income from Continuing Operations
2. Discontinued Operations
3. Extraordinary Items
4. Cumulative Effect of a Change in
Accounting Principle
5. Net Income
Slide
34-37
Statement of Cash Flows

 Provides relevant information about a
company’s inflows and outflows of cash.
 Helps investors and creditors to assess
 future net cash flows
 liquidity
 long-term solvency.

Slide
34-38
Cash Flows from Operating
Activities
Inflows
Inflows from:
from:
 Sales
Salesto
tocustomers.
customers.
 Interest
Interest and
anddividends
dividends
received.
received. + Cash
Cash
Flows
Flows
Outflows
Outflows to:
to: from
from
 Purchase
Purchaseof ofgoods
goodsfor
forresale
resale Operating
Operating
and
andservices.
services.
 Salaries _ Activities
Activities
Salariesand
andwages.
wages.
 Interest
Interest on
ondebt.
debt.
 Income
Incometaxes.
taxes.

Slide
34-39
Direct and Indirect Methods of
Reporting
Two Formats for Reporting Operating Activities
Direct Method Indirect Method
Reports the cash Starts with

effects of each accrual net
operating activity income and
converts to cash
basis

Slide
34-40
Cash Flows from Investing
Activities
Inflows
Inflows from:
from:
 Sale
Saleof
ofproperty,
property,plant,
plant,and
and
equipment.
equipment.
 Sale
Saleor
ormaturity
maturityof
ofinvestment
investment + Cash
securities
securities(stocks
(stocksand
andbonds).
bonds). Cash
 Collection
Collectionofofnontrade
nontrade Flows
Flows
receivables.
receivables.
from
from
Outflows
Outflows to:
to: Investing
Purchase
Investing
 Purchaseof ofproperty,
property,plant,
plant,and
and
equipment.
equipment.
_ Activities
Activities
 Purchase
Purchaseof ofinvestment
investment
securities
securities(stocks
(stocksand
andbonds).
bonds).
 Loans
Loanstotoother
otherentities.
entities.
Slide
34-41
Cash Flows from Financing
Activities
Inflows
Inflows from:
from:
 Borrowing
Borrowingononnotes,
notes,
mortgages,
mortgages,bonds,
bonds, etc.
etc.from
from +
creditors.
creditors. Cash
Cash
 Issuing
Issuingstock
stockto
toowners.
owners. Flows
Flows
from
from
Outflows
Outflows to:
to: Financing
Financing
 Repay
Repayprincipal
principaltotocreditors
creditors
(excluding
_ Activities
Activities
(excludinginterest).
interest).
 Repurchase
Repurchasestock
stockfrom
from owners.
owners.
 Dividends
Dividendstotoowners.
owners.

Slide
34-42
Revenue Recognition
Revenue
Revenue should
should be be recognized
recognized in in the
the
period
period or
or periods
periods that
that the
the revenue-
revenue-
generating
generating activities
activities of
of the
the company
company are are
performed.
performed.

Slide
34-43
Realization Principle
Record
Record revenue
revenue when:
when:
The earnings There is
process is reasonable
complete or AND certainty as to the
virtually collectibility of the
complete. asset to be
received (usually
cash).
Slide
34-44
SEC Staff Accounting Bulletin

No. 101
The
The SEC
SEC issued
issued Staff
Staff Accounting
Accounting Bulletin
Bulletin
No.
No. 101
101 to
to crackdown
crackdown on on earnings
earnings
management.
management. The The bulletin
bulletin provides
provides
additional
additional guidance
guidance toto determine
determine ifif the
the
realization
realization principle
principle is
is satisfied:
satisfied:
1.
1. Persuasive
Persuasiveevidenceevidenceof of an
anarrangement
arrangementexists.
exists.
2.
2. Delivery
Deliveryhas hasoccurred
occurredoror services
serviceshave
havebeen
been
performed.
performed.
3.
3. The
Theseller’s
seller’sprice
priceto tothe
thebuyer
buyer isisfixed
fixedor
or
determinable.
determinable.
4.
4. Collectibility
Collectibility isisreasonably
reasonably assured.
assured. © 2006 GlobalQualifications.org
FSA for CFA Level I – June 2007
Slide
34-45
Revenue Recognition
at Delivery
Revenue
Revenue is
is earned
earned and
and realized
realized at
at the
the
point
point of
of sale.
sale.
The
The product
product oror
service
service has
has been
been
delivered
delivered toto the
the
customer
customer andand cash
cash
has
has been
been received
received oror
is
is receivable.
receivable.
Slide
34-46
Significant Uncertainty of
Collectibility
When
When uncertainties
uncertainties about
about
collectibility
collectibility exist,
exist, revenue
revenue
recognition
recognition isis delayed.
delayed.
1.
1. Installment
Installment Sales
Sales Method
Method
2.
2. Cost
Cost Recovery
Recovery

Slide
34-47
Installment Sales Method

Sale and cost of sale recorded as usual.
Compute gross margin rate on the
installment sales.
Recognize gross margin as cash is received.
Gross margin not realized is deferred until a
future period.

Slide
34-48

Clarke, Inc. had the following installment
sales in addition to its regular sales.
2003 2004 2005
Installment sales $200,000 $250,000 $275,000
Cost of sales 155,000 190,000 220,000
Gross profit $45,000 $60,000 $55,000
Gross profit percentage 22.50% 24.00% 20.00%
$45,000 ÷ $200,000 = 22.50%

Slide
34-49

sales in addition to its regular sales.
2003 2004 2005
Cost of sales 155,000 190,000 220,000
Gross profit $45,000 $60,000 $55,000
Cash Collections At Dec. 31, 2005,

2003 2004 2005 Clarke, Inc. is still
Installment sales $ 200,000 $ 250,000 $ 275,000
Cash Collected:
owed $30,000 from
From 2003 Sales (100,000) (50,000) (50,000) the 2004 sales and
From 2004 Sales (195,000) (25,000) $75,000 from the
From 2005 Sales (200,000)
2005 sales.
Slide
34-50

During 2003, Clarke collected $100,000
on its installment sales.
General Journal
Description Debit Credit
Installment sales receivable 2003 200,000
Inventory 155,000
Deferred gross profit 2003 45,000
Cash 100,000
Deferred gross profit is the difference

between the selling price and the cost of the
inventory.

Slide
34-51

This entry records the Realized Gross Profit
by adjusting the Deferred Gross Profit
account.
General Journal
Inventory 155,000
Cash 100,000

Realized gross profit 22,500
($100,000 collected x 22.50%)

Slide
34-52

General Journalon its 2003 installment
sales andDescription
$195,000 on its 2004 installment
Debit sales.
Credit
Inventory 190,000
Cash 245,000


Slide
34-53

General Journalon its 2003 installment
sales andDescription
$195,000 on its 2004 installment
Debit sales.
Credit
Inventory 190,000
Cash
Cash collections
collections -- 2003
2003 $$ 50,000
50,000 22.50%
22.50% $$11,250
11,250
Cash 245,000
Cash
Cash collections
collections -- 2004
2004 195,000
195,000 24.00%
24.00% 46,800
46,800
$$58,050
58,050


Slide
34-54

Cash Collection on Installment Sales in 2005
2003 $ 50,000 22.50% $ 11,250
2004 25,000 24.00% 6,000
2005 200,000 20.00% 40,000
General Journal
$ 275,000 $ 57,250
Inventory 220,000
Cash 275,000

Slide
34-55

Slide
34-56

Balance Sheet

Slide
34-57
Cost Recovery Method

sales in addition to its regular sales. The
company uses the cost recovery method to
account for installment sales.
2003 2004 2005
Cost of sales 155,000 190,000 220,000
Gross profit $45,000 $60,000 $55,000
$45,000 ÷ $200,000 = 22.50%

Slide
34-58

The following schedule shows the pattern of
cash collections for the three year period.
Year
Year of
ofCollection
Collection
Year
Yearof
ofSale
Sale 2003
2003 2004
2004 2005
2005
2003
2003 $100,000
$100,000 $50,000
$50,000 $50,000
$50,000
2004
2004 195,000
195,000 25,000
25,000
2005
2005 200,000
200,000
COGS
COGS $$ 155,000
155,000 $$ 190,000
190,000 $$ 220,000
220,000
Under the cost recovery method

profit is not recognized until the
seller has recovered all of the cost of
FSA for CFA Level I – June 2007 the goods sold. © 2006 GlobalQualifications.org
Slide
34-59

General Journal
Installment receivable 2003 200,000
Inventory 155,000
Cash 100,000
The entries are exactly the same as under the Installment

Method—EXCEPT that there is not an entry to realize gross
profit. Since we have not collected cash in excess of COGS,
no gross profit is recognized in 2003.

Slide
34-60

In 2004, let’s concentrate on the
entries relating to 2003 sales only.
General
GeneralJournal
Journal
Description
Description Debit
Debit Credit
Credit
Cash
Cash 50,000
50,000
Installment
Installmentreceivable
receivable 2003
2003 50,000
50,000
Now can we recognize some profit?

2003
2003
Cost
Cost of
of goods
goodssold
sold $$ 155,000
155,000
Cash
Cash collections
collections-- 2003
2003 (100,000)
(100,000)
Cash
Cash collections
collections-- 2004
2004 (50,000)
(50,000)
Unrecovered
Unrecovered cost
cost 5,000
5,000
We
We have
have not
not fully
fully recovered
recovered the
the
cost,
cost, so
so no
no profit
profit isisrecognized
recognized in
in 2004.
2004.© 2006 GlobalQualifications.org
Slide
34-61

Here are the entries we would make in
2005 relating to 2003 sales.
General Journal
Cash 50,000
Deferred gross profit 45,000

We have fully recovered the $155,000 cost

during 2005, so the entire deferred gross
profit will be recognized.
Slide
34-62
Revenue Recognition Over Time

Completed
Completed
Contract
Contract Method
Method
Long-term
Long-term
Construction
Construction
Contracts
Contracts Percentage-of-
Percentage-of-
Completion
Completion
Method
Method

Slide
34-63
Percentage-of-Completion
Method
Measuring Progress Toward Completion
Cost
Cost incurred
incurredto
to date
date
Estimate
Estimateof
of project’s
project’stotal
total
cost
cost
Gross
Grossprofit
profit estimate
estimate

Slide
34-64
Method
Total costs incurred to date
Percent complete =
Most recent estimate of total
project cost
Let’s look at an
example.

Slide
34-65
Method
Geller Construction entered into a three-
year contract to build a containment vessel
for Southeast Power Company. Presented
below is information about the contract.
Year
Year 11 Year
Year 22 Year
Year 33
Cost
Cost incurred
incurred toto date
date $250,000
$250,000 $800,000
$800,000 $1,200,000
$1,200,000
Estimated
Estimated cost
cost to
to complete
complete 1,000,000
1,000,000 425,000
425,000 00
Progress
Progress billing
billing to
to date
date 250,000
250,000 775,000
775,000 1,400,000
1,400,000
Cash
Cash collections
collections toto date
date 225,000
225,000 695,000
695,000 1,100,000
1,100,000
Contract
Contract price
price $1,400,000
$1,400,000
Let’s see how Geller will account for

the revenues and cost of this project
using the percentage-of-completion
method.
Slide
34-66
Method
$250,000
$250,000 ÷
÷ $1,250,000
$1,250,000 =
= 20%
20%

Slide
34-67
Method

Slide
34-68
Method
General Journal
Construction in progress 250,000
Cash, materials, etc. 250,000
Accounts receivable 250,000

Billings on construction contract 250,000
Cash 225,000
Contra account to CIP

Slide
34-69
Method
General Journal

Construction
Cashin Progress Construction
225,000 in Progress
- Billings on Construction Contract
Accounts receivable - Billings on Construction Contract
225,000
Debit Balance (Unbilled Receivable) Credit Balance (Overbilled Receivable)
Classified as Classified as
an asset a liability

Slide
34-70
Method
General Journal

Cash 225,000
Cost of construction 250,000

Revenue from long-term contract 280,000

Slide
34-71
Method
General Journal

Cash 225,000
Closing Entry


Retained earnings 30,000
© 2006 GlobalQualifications.org
Slide
34-72
Method
$800,000
$800,000 ÷÷ $1,225,000
$1,225,000 == 65.31%
65.31%

Slide
34-73
Method

Slide
34-74
Method
General Journal
$800,000 - $250,000 last year = $550,000

Slide
34-75
Method
General Journal

$775,000 - $250,000 last year = $525,000

Slide
34-76
Method
General Journal

Cash 470,000
$695,000 - $225,000 last year = $470,000

Slide
34-77
Method
General Journal

Cash 470,000


Slide
34-78
Method
General Journal

Cash 470,000
Closing Entry

Slide
34-79
Method
Year 1 Year 2 Year 3
Costs to date $250,000 $800,000 $1,200,000
Cost to complete 1,000,000 425,000 0
Estimated total cost $1,250,000 $1,225,000 $1,200,000
Percent complete to date 20.00% 65.31% 100.00%
Percent completed earlier -20.00%
Percent completed this year 45.31%
Total revenue $ 1,400,000 $ 1,400,000

Percent completed this year 20.00% 45.31%
Revenue this year $ 280,000 $ 634,340
Revenue recorded earlier
Revenue in last year
Costs this year 250,000 550,000
Gross profit $ 30,000 $ 84,340
Slide
34-80
Method
Year 1 Year 2 Year 3
Costs to date $250,000 $800,000 $1,200,000
Cost to complete 1,000,000 425,000 0
Estimated total cost $1,250,000 $1,225,000 $1,200,000
Percent complete to date 20.00% 65.31% 100.00%
Percent completed earlier -20.00%
Percent completed this year 45.31%
Total revenue $ 1,400,000 $ 1,400,000 $ 1,400,000

Percent completed this year 20.00% 45.31%
Revenue this year $ 280,000 $ 634,340
Revenue recorded earlier 914,340
Revenue in last year $ 485,660
Costs this year 250,000 550,000 400,000
Gross profit $ 30,000 $ 84,340 $ 85,660
Slide
34-81
Method
General Journal

Cash 405,000


Slide
34-82
Method
Construction in Progress Billings on Construction Contract
Year 1 250,000 250,000 Year 1
30,000 525,000 Year 2
Year 2 550,000 625,000 Year 3
84,340 1,400,000
Year 3 400,000
85,660
1,400,000
Entry to transfer title to the customer.

General Journal
Billings on construction contract 1,400,000
Construction in progress 1,400,000

Slide
34-83
Completed Contract Method

Geller Construction entered into a three-
year contract to build a containment vessel
for Southeast Power Company. Presented
below is information about the contract.
Year
Year 11 Year
Year 22 Year
Year 33
Cost
Cost incurred
incurred toto date
date $250,000
$250,000 $800,000
$800,000 $1,200,000
$1,200,000
Estimated
Estimated cost
cost to
to complete
complete 1,000,000
1,000,000 425,000
425,000 00
Progress
Progress billing
billing to
to date
date 250,000
250,000 775,000
775,000 1,400,000
1,400,000
Cash
Cash collections
collections toto date
date 225,000
225,000 695,000
695,000 1,100,000
1,100,000
Contract
Contract price
price $1,400,000
$1,400,000
Let’s see how Geller will account for

the revenues and cost of this project
using the completed contract method.
Slide
34-84

General Journal
Description Debit Credit Gross
profit is

not
Billings on construction contract 250,000 recognized
Cash 225,000 until
project is
Entries are identical complete.
to the entries for
percentage of
completion.

Slide
34-85

Gross
General Journal
profit is

not
Billings on construction contract 525,000 recognized
Cash 470,000 until
project is
Entries are complete.

identical to the
entries for
percentage of
completion.
Slide
34-86

General Journal
Description Debit Credit Gross
Construction in progress
Cash, materials, etc.
400,000
400,000
profit is
recognized
Billings on construction contract 625,000 in year 3
Cash 405,000 since
project is
complete.
Cost of construction 1,200,000
Revenue from long-term contract 1,400,000
Revenue from long-term contract 1,400,000

Cost of construction 1,200,000
Slide
34-87

Construction in Progress Billings on Construction Contract
Year 1 250,000 250,000 Year 1
Year 2 550,000 525,000 Year 2
Year 3 400,000 625,000 Year 3
Year 3 200,000 1,400,000
1,400,000
Entry to transfer title to the customer.

General Journal
Billings on construction contract 1,400,000
Construction in progress 1,400,000

Slide
34-88
Software Revenue Recognition

Statement of Position 97-2
If a sale includes multiple elements (software,
future upgrades, postcontract customer
support, etc.), the revenue should be allocated
to the various elements based on the relative
fair value of the individual elements.
This will likely result in the recording of
unearned revenue for future services.

Slide
34-89
Franchise Sales
Initial
Initial franchise
franchise fees
fees can
can be
be recognized
recognized as
as
revenue
revenue only
only after
after the
the
Franchisor
 Franchisor has
has substantially
substantially performed
performed the
the
initial
initial services
services promised
promised in
in the
the franchise
franchise
agreement,
agreement, andand
Collectibility
 Collectibility of
of the
the initial
initial franchise
franchise fee
fee isis
reasonable
reasonable assured.
assured.
Source: SFAS 45

Slide
34-90
End of Chapter 4

Slide
34-91
Earnings Quality
Earnings quality refers to

the ability of reported
earnings to predict a
company’s future.
The relevance of any
historical-based financial
statement hinges on its
predictive value.

Slide
34-92
Manipulating Income and
Income Smoothing
“Most managers prefer to report earnings that follow a
smooth, regular, upward path.”
Two ways to manipulate income:

1. Income shifting
2. Income statement
classification

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FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Revenues Expenses Gains and Income Tax

Income Statement (Single-Step)

Income Statement (Multiple-Step)

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Separately Reported Items

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 Sale or disposal of a component

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 Report results of operations

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FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

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How will this appear on the income

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

 Reported net of related

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

How would this item appear on the

Income Statement Presentation:

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Unusual or Infrequent Items

Items that are material and are either

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Change in Accounting Principle

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Change in Accounting Principle

How would this item appear on the

Change in Accounting Principle

Income Statement Presentation:

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Record depreciation expense of $4,200 for

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Change in Reporting Entity

Change in Reporting Entity

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Change in Reporting Entity

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Prior Period Adjustments

 Corrections of errors from a

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Prior Period Adjustments

Prior Period Adjustments

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Prior Period Adjustments

FSA for CFA Level I – June 2007 © 2006 GlobalQualifications.org

Prior Period Adjustments

Retained Earnings 17,500

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Prior Period Adjustments

Remember to consider the tax effects:

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Basic Earnings Per Share

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