Income Measurement and Reporting

The concept of accounting income poses a double challenge for accountants-its measurement and the reporting of its components in the income statement.  Generally accepted accounting principles rest on a foundation of historical costs and measurable evidence provided by a business transactions and events that is, the accrual basis of accounting.  Accountants have considered and rejected both the cash basis concept and the economic concept of income measurement and adopted the accrual basis of accounting as a reasonable approach to income measurement.

In a rapidly changing and highly competitive business environment, the income for one accounting period probably predicts the income of the next period.  The task of income measurement and reporting are complicated by income tax laws, the effect of extra ordinary items, disposals of business segments, changes in accounting principles, and the inclusion of earnings per share of common stock in the income statement.

Improvements in the measurement and reporting of income are needed if income statements are to be of maximum value to users in predicting, comparing, and evaluating the earning power of business enterprises.

 

There are different views on when to measure and recognize income. Part of the problem stems from the fact that the term income has different meanings to different people.  For example, an economist defines a change in wealth, whether realized or not, as income.  To illustrate, assume a firm owns a parcel of land it acquired at a cost of Br. 10,000 several years ago.  A new interstate highway has recently been built near the property, and several individuals have casually offered to buy the land for something in the range of Br.5, 000.  The firm has not yet agreed to sell.  The economist would say than an increase in wealth has occurred and would call this increase income. This is economic income.

An accountant, however, would not recognize this increase in wealth as income. The accountant would first require reliable verification of the increase in value. If the land is sold to another party in an arm’s – length transaction, the transaction would provide the verification the accountant seeks. Only when would the accountant recognize the increase in wealth as income. This is accounting income.

 

   6.2.1 Lifetime income of a business Enterprise

If we ignore the time value of money and effects of inflation, lifetime income of a business enterprise is measured as:

          Totals proceeds received on liquidation of enterprise -----------XX

Add: Amounts withdrawn by owners during life of enterprise --------XX

Less: Amount of cash invested by owners --------------------------------(XX)

Lifetime income of enterprise --------------------------------------------------XX

In theory, the only direct way to determine how “well off” an enterprise is on a specific date is to compute the present value of its future net cash inflows. This is known as the process of direct valuation.
 

   6.2.2 Periodic Income of a business enterprise

In measuring how “well off” an enterprise is on a specific date in order to measure periodic net income, accountants record only those changes in financial position that may be substantiated by reasonably reliable evidence. Income emerges if the effort (expenses) to generate revenue is less than the accomplishment (revenue) of that effort; a loss emerges if the effort exceeds the accomplishment.
 

   6.2.3The Impact of changing prices

During a period of inflation (an increase in the general price level) a clear understanding of the limitation of the birr as a unit of measurement is required to interpret accounting income and financial statements meaningfully.

 

6.3 Special Problems in the Measurement and Reporting of Income

The measurement and reporting of income has become complex as a result of requirement for the allocation of income taxes, disposals of discounted business segments, extraordinary items, changes in accounting principles and estimates, and the reporting of earnings per shares data in the income statement.

 

   6.3.1 Income Tax Allocation

In general, management has considerably flexible in presenting revenue, expense, gain, and loss items in the income statement. But accounting pronouncement governs the presentation of four items. (1) Extraordinary gains and losses, (2) unusual or infrequent gains and losses, (3) discounted operations, and (4) cumulative effects of changes in accounting principle.

In each case, these items are reported separately on the income statement. All except unusual or infrequent gains and losses are shown net of any related tax effect. Net of related tax effects means the tax consequences of the item have been determined and the reported amount is shown after adjusting for these tax effects.

Determining the tax effects is an intra period tax allocation problem. Intra means that the item, income taxes in this case, is allocated among various items within a given accounting period.

Thus, a portion of the total income taxes are allocated to operations and to other special items in a given period. A related issue, inter period tax allocation is the allocation of tax expense to different reporting periods.

 

Illustration of intra period tax allocation

Consider the following situation for FENOTE Company. Sales for 1998 total Br. 100 million, and expenses before income taxes total Br. 70 million. During 1998 the company experiences an unusual loss of Br. 20 million when an earth quake destroys several of the company’s uninsured warehouses. Assume that the income tax rate is 40% and that the Br. 20 million earthquake loss is deductible for income tax purposes. FENOTE Company’s income statement with and without intra period tax allocation is as follows:

FEENOTE COMPANY Income Statement For the Year ended December 31, 1998 (Amounts in Millions)                                                                       Without intraperiod                      With Intraperiod                                                                          tax allocation                                 tax allocation Sales ----------------------------------------------------Br. 100 ------------------------------Br. 100 Expenses -----------------------------------------------------70                                                 70 Income from operations before extraordinary item Br. 30                                           Br. 30 Income tax expense: On operation *                                                   __                                                  12 On taxable income +                                          4                                                    __ Income before extraordinary loss                           Br. 26                                             Br. 18 Extra ordinary item: loss from earthquake damage: Gross amount                                                (20)                                                    __ Net of tax savings of Br. 8 (Br 20 x 0.4)        __                                                   (12) Net income                                                             Br. 6                                                   Br. 6 * Br. 30 (0.4) + (Br. 30 – Br. 20 (0.4)

In the column labeled “without intra period tax allocation, the tax expense is shown at the actual amount that will be paid, or 40% of the Br. 10 million taxable income (revenues of Br. 100 million less expenses of Br. 70 million and less the loss of Br. 20 million). In the column with intra period tax allocation, the tax effects of the two activities (operations and the earthquake loss) are shown separately. The income tax expense that would be paid if there were no loss from the earthquake would be 40% of Br. 30 million or Br. 12 million. The tax effect of the earthquake loss reduces income tax for the period by 40% of the loss, or Br. 8 million. The Br 8 million tax savings resulting from the loss is subtracted from the gross loss of Br. 20 million to arrive at the after-tax amount of Br. 12 million.

 

Inter period tax allocation

The process of apportioning income tax among two or more accounting period because of temporary differences in the recognition of revenue and expenses. Temporary differences result when revenue or expense items appear in the income tax return. By means of inter period tax allocation, the income taxes expense in the income statement is related to the pre-tax income or loss reported in the income statement rather than on the amount of income or loss reported in the income tax return. Thus, income taxes are allocated among accounting periods as are other expenses.

Taxable income is defined as the income determined by applying the measurement rules found in the tax laws. The only reason taxable income is computed is to determine the amount of income taxes to be paid for a tax period is the product of taxable income and the applicable tax rate.

Pre tax accounting income, on the other hand, is the amount of income before income taxes that is determined under GAAP. Once pre tax accounting income is determined an amount of income tax expense must be computed and deducted to compute net income.

There are two basic types of differences between taxable income and pretax accounting income: permanent differences and temporary differences.

A permanent difference is created when an income element a revenue, gain, expense, or loss-enters the computation of either taxable income or pretax accounting income, but never enters into the computation of the other. For example, interest income received on tax-free municipal bonds is included in pretax accounting income, but not in taxable income.

A temporary difference arises when the measurement rules for financial reporting (GAAP) differ from tax reporting rules as to the timing of recognition of various revenues, gains, expenses, losses, assets or liabilities. Temporary differences affect the computation of either taxable income or pretax accounting income in one period, and in some subsequent period or periods they affect the computation of other type of income. The differences are temporary because they originate in one (or more) periods, and reverse and have the opposite effect in one (ore more) future periods.

 

   6.3.2 Disposal of a Business Segment

A business segment is a component of an entity whose activities represent a separate major line of business or class of customer. A business segment may be a subsidiary, a division, a department, or another part of the entity, provided that its assets, results of operations, and activities are distinguishable physically and operationally, for financial reporting purposes, from the other operations of the company.

Judgment is required in deciding whether a disposal meets the criteria for separate reporting. It appears that firms tend to err on the side of reporting disposals as discontinued operations. We believe this is useful as it provides more complete disclosure.

The disposal of a business segment must be distinguished from other disposals that are incidental to the evolution of the business.

The following are examples of incidental disposals and partial divestitures that do not qualify.

• disposal of part of a line of business
• shifting production and marketing activities of a line of business between locations.
• Phase out of a product line or class of service
• Other changes resulting from technological improvement
• Sale of a major foreign subsidiary in silver mining by a mining company, leaving the company with silver mining operations in other countries
• Discontinuation of design, manufacture, and sale of children’s wear in one geographical area by a manufacturer of children’s wear.
• Sale of the assets used in the manufacture and sale of woolen suits, including the plant by an apparel firm that plans to concentrate its activities in the manufacturing and marketing of suits made from synthetic materials.

The following transactions would be classified as disposals of a business segment

• sale by a diversified company of a major division that represents the company’s only activities in the electronics industry
• sale by a retailing company of its 25 percent interest in a professional football team (all other company activities are in retailing )
• sale by a communications company of its radio stations leaving only the television and publishing divisions.

The assets and operating results of the disposed segment must be clearly identifiable from the other assets and operations of the enterprise.

An income statement is more useful when the effects of material and unusual events and transactions are reported separately from the continuing operations of a business enterprise. Therefore, the operating results of a discontinued business segment for the current accounting period and any gain or loss on the disposal of the segment are reported separately in the income statement, net of the related income tax effects.

Such separate reporting makes successive income statements more comparable and enables users of financial statements to make better estimate of the enterprise’s future earnings.

The accounting for the disposal of a business segment is relatively simple when the decision to discontinue a segment and the actual disposal occur in the same accounting period. When the disposal of the segment is expected to be completed in a subsequent accounting period, estimated results of operating the discontinued segment in the subsequent period are included in the computation of the gain or loss on the disposal. An estimated loss is included in the income statement of the period in which the decision to eliminate the segment is made; an estimated gain is reported in the subsequent period when the disposal takes place.

The income statement for the accounting period in which a business segment is discontinued includes the revenue and expenses from continuing operations only. The operating income (or loss) from the discounted segment for the current period and the gain or loss on the disposal of the segment are reported, net of tax effects, in the income statement below the income (loss) from continuing operations.

The revenue generated by the discontinued segment prior to disposal is disclosed in a note to the financial statements. The presentation in the income statement of a loss from operations of a discontinued business segment and a gain on the disposal of the segment is illustrated below:

Income from continuing operations before income taxes ---------------------------------------------------Br. 2,800,000 Income tax Expense (amount of income tax payable currently is Br. 900,000) ------------------------------1,260,000 Income from continuing operations ----------------------------------------------------------------------------Br. 1,540,000 Discontinued operations: Loss from operations of discontinued business segment, net of income tax credit of Br. 450,000 ----Br. (550,000) Gain on disposal of discontinued business segment, net of income tax effect of Br. 90,000 -----------------110,000 Net income (or income before extraordinary item and cumulative effect of change in accounting principle, if any) -------------------------------------------------------------Br. 1,100,000

 

   6.3.3 Extraordinary items

Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Thus both of the following criteria should be met to classify an event or transaction as an extraordinary item:

1. Unusual nature – the underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to or only incidentally related to the ordinary and typical activities of the entity, taking into account the environment in which the entity operates.
2. Infrequency of occurrences – the underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates.

To be considered unusual in nature, the event or transaction resulting in a gain or loss should be abnormal and unrelated to the ordinary and typical activities of an entity.

In addition to the above two criteria, the environment in which a company operates must be considered in applying these criteria.

A company’s environment includes such factor as

• Characteristics of the industry or industries in which it operates
• Geographic location of operation
• Nature and extent of governmental regulations

A similar event or transaction may be considered extraordinary for one company but not for another because of differences between the companies environment. For example, the two events described below are similar, but the first is treated as an extraordinary event and the second is not:

Extraordinary: A tobacco grower’s crops are destroyed by a hailstorm. Severe damage from hailstorms in the locality where the tobacco grower operates is rare.

Ordinary: A citrus grower’s crop is damaged by frost. The region has a long history of frost damage, which is normally experienced every three to four years.

The first situation is considered extraordinary because given the environment in which the tobacco grower operates, hail storms are both unusual and infrequent. This is not the case in the second situation – frost is not an infrequent event in the environment in which the company operates. A history of losses by frost damage would provide additional evidence that such damage may reasonably be expected to recur.

Material gains and losses that are considered extraordinary items are

• Loss from major casualties (such as earthquakes or severe hailstorm in localities where such events are infrequent)
• Loss from prohibition under newly enacted law or regulation
• Loss expropriation of assets by foreign country
• Gain or loss on disposal of only holding of common stock or land that had been owned for many years
• Gain or loss on extinguishments of debt
• Gain on restructuring of troubled debt
• Write-off of interstate operating rights by a motor carrier

Material gains and losses that are not considered extraordinary items are:

• Write-down or write-off of receivables, inventories, plant assets, or intangible assets
• Gain or loss from exchange or translation of foreign currencies (including major devaluation or revolution)
• Gain or loss on disposal of a business segment
• Gain or loss on disposal or abandonment of plant assets, investments or intangible assets
• Loss from a labor strike or effect of adjustment of accruals on a construction – type contract
• Cumulative effect of a change in accounting principles
• Prior period adjustment.

Extraordinary items are reported as a separate classification on the income statement to alter the reader to their special nature. This prominent placement signals that this gain or loss is not expected to recur regularly; thus readers might treat the item differently when making predictions about future income and cash flows. The presentation of extraordinary item, including the pre-share effect, in the income statement is illustrated below:

Income before income taxes and extraordinary item ------------------------------------------Br. 600,000 Income taxes expense (amount of income taxes payable currently is Br. 175,000) ---------270,000 Income before extraordinary item ---------------------------------------------------------------Br. 330,000 Extraordinary item (loss), net of income tax credit of Br. 99,000 ------------------------------121,000 Net income ------------------------------------------------------------------------------------------Br. 209,000 Earning per share of common stock: Income before extraordinary item -----------------------------------------------------------------Br. 3.30 Extraordinary item (loss) ----------------------------------------------------------------------------(1.21) Net income -----------------------------------------------------------------------------------------Br. 2.09

The amount of a gain or loss is not a factor in determining whether an item should be reported, but only material extraordinary gains and losses must be reported separately. Extraordinary items considered immaterial in amount can be reported as a component of continuing operations.

 A material event or transaction that is unusual in nature or occurs infrequently, but not both, are therefore does not meet both criteria for classification as an extraordinary item, should be reported as a separate component of income from continuing operation. Such items should not be reported net of income taxes.

 

   6.3.4 Accounting Changes

We stated earlier that a consistent application of accounting principles and methods over a number of years increases the usefulness of financial statements. However, management of a business enterprise may justify a change in accounting principles on grounds that it is preferable. There are three types of accounting changes.

1. Change in accounting principle
2. Change in accounting estimate
3. Change in reporting entity
    

     1. Change in accounting principle

Under certain circumstances, a company can change from one generally accepted accounting principle to another, such as from sum-of-years-digits depreciation to straight-line depreciation.

Generally, when this happens, an adjustment amount must be recognized and recorded. This catch-up adjustment is formally known as the cumulative effect of a change in accounting principle and must be reported separately in the income statement in the period in which the change is made. The effect of a change in accounting principle is reported after income from continuing operations after taxes, and after extraordinary items. It is reported net of applicable income taxes.
 

     2. Changes in accounting estimates

Revisions of accounting estimates such as the useful lives or residual values of  depreciable assets, the loss rates for bad debts and warranty costs are considered changes in accounting estimates for reporting purposes.

As a company gains experiences in such areas as depreciable assets, receivables and warrants, it develops a basis for revising one or more of its prior accounting estimates. In such instances, the prior accounting results are not to be disturbed instead the new estimate should be used during the current and remaining periods. Thus, a change in estimate is made on a prospective (future-oriented) basis.
 

     3. A change in reporting entity

A change in reporting entity occurs when the group of business enterprise comprising the reporting entity changes (such as a business combination of two or  more companies accounted for as a pooling of interest)

 

   6.3.5 Earning per share of common stock

The amount of earning per share of common stock for an accounting period is computed by dividing the net income available to common stockholders by the weighted-average number of shares of common stock and potentially dilutive common stock equivalents outstanding during the period. The purpose is to show earnings power on a per-share basis to enable investors to relate the market price of a share to the income per share of common stock.

   6.3.6 Prior Period Adjustments

Current GAAP defines and prescribes the accounting for prior period adjustments in terms of only one item:

Items of gains and loss related to the following shall be accounted for and reported as prior period adjustments and excluded from the determination of net income for the current period: correction of an error in the financial statements of a prior period.

Thus, prior period adjustments are only corrections of errors in the financial statements from a prior period that affect retained earnings. All other items of revenue, expense, gain, and loss recognized during the period must be included in the determination of reported net income for that period.

 

Income reporting is probably the most significant aspect of financial accounting because of the economic consequences it has for a business enterprise, its owners and creditors, and its potential owners and creditors. Net income is the lifeblood of any enterprises organized to earn a return on the capital invested by its owners. The ability of an enterprise organized to compete effectively in its industry, and thus to prosper and survive, depends on its ability to generate income. Profitable operations represent the major source of cash and working capital, and it is unusual for a profitable enterprise to encounter difficulty making timely payments on its debt or to raise capital for expansion purposes.

Income measurement has to be based on sound principles of revenue and expense recognition to be of maximum value to management and other users of financial statements. The quality of a business enterprise earnings depend to a large extent on the revenue and expense recognition practices it uses. A reputation of reporting high quality earnings is a valuable asset to an enterprise. However, income measurement is only one side of the coin; the other is income reporting. The reporting of income must be timely and the sources of income (from continuing and discontinued operations, for example) must be presented in a meaningful and consistent manner. Non-recurring sources of income or loss are “non repeatable” and are not considered as significant as the recurring sources.

A continuing challenge for accountants is to report the components of income in a manner that enhances the predictive value of the income statement. Users of financial statements face a different challenge-to interpret the significance of the reported income in the clear light of a highly complex and inflationary business environment.