Chapter 12: Income Statement Instructor Manual
Accounting Theory (9
th
edition) Page 1 of 14
CHAPTER HIGHLIGHTS
Chapter 12 is intended to be a comprehensive overview of the income statement. However, the focus is not on
detailed issues; rather, fundamental questions of element definitions, recognition, and measurement are
examined. The amount of time spent on Chapter 12 will depend on the background of the class and the
instructor’s interests. At one level, considerable time could be spent reviewing each area covered, in effect
recasting intermediate accounting topics in a more conceptual approach. Alternatively, the chapter could be
examined more for broad generalities.
Accounting theory regarding the recognition of revenue provides accounting practice some practical guidance
in that it states that revenue should be recognized when the earning process is complete. Unfortunately, the
completion of the earnings process frequently does not coincide with the time that objective measurements of
the amount of revenue can be made. As a result, we find that revenue is recognized on the income statement at
different times in different industries, even though the underlying circumstances surrounding the event giving
rise to the revenue are identical or at least similar. The chapter points out several examples, such as revenue
recognition when right of return exists and transfers of receivables with recourse, where inconsistencies exist
today and why they were allowed to evolve.
In general, accounting theory regarding expense recognition, i.e., matching, provides no practical guidance as to
the timing or amount of expense to be recognized on the income statement. Basically, expenses should be
recognized when the benefits from those expenses are received; however, it is difficult, if not impossible, to
objectively determine how and when benefits are received. As a result, most expenses are recognized in
accordance with a systematic and rational method of allocation.
In the specialized areas discussed stock options are of particular interest. We believe that they are not an expense
under the entity theory approach but they are under the proprietary approach.
Earnings management continues to be problematic, it just will not go away despite increased laws and media
attention.
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QUESTIONS
Q-1 Describe how definitions of income, revenues, and expenses have changed in
statements issued by successive standard-setting bodies.
The definitions of income, expenses, and revenues have changed over time. The changes have
Q-2 Four points in the revenue cycle, from production through to cash collection, are
possible events for revenue recognition. What relevant circumstances would justify
finite uniformity rather than rigid uniformity for revenue recognition, and which
approach is used in practice?
While most businesses recognize revenue at the point of sale, there is limited finite uniformity
for certain special industries. The relevant circumstance, of course, is when revenue is judged to
be “earned.” So, by custom, methods have evolved that depart from a sale basis of recognition.
Q-3 What is the matching concept and why is there an implied hierarchy for expense
recognition?
Matching is part of the revenue-expense orientation and has as its goal the assignment of costs
incurred in the earning of income. The hierarchy recognizes that all costs cannot be directly
Q-4 Why is there no matching problem for periodic costs, and what are some examples?
Period costs are not matched to revenues. Examples include insurance, interest, and certain
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Q-5 What types of costs present matching problems, how are they dealt with, and what are
some examples of such costs?
The main problems arise with indirect matching through arbitrary allocation procedures such as
Q-6 There has been a trend toward rigid uniformity in the format of the income statement.
Explain how and why this has occurred.
The trend toward rigid uniformity in the income statement format has occurred primarily in the
nonoperating sections. The reason is that with finite uniformity, many financial statement
Q-7 Why might the distinction between revenues and gains, and between expenses and
losses, be important to report yet unimportant as to how they are reported?
The issue here concerns disclosure. That is, it may be informative to distinguish between
revenues and gains, or expenses and losses, but it may not matter how they are reported, i.e.,
Q-8 Research, while inconclusive, has shown that earnings are manipulated downward
prior to a management buyout. What is the logic of this and why do management
buyouts present a difficult agency theory problem?
The downward manipulation of earnings would be intended to lower the price that managers
would have to pay shareholders for their stock. The conflict of interest arises due to managers
Q-9 Why is comprehensive income an application of proprietary theory?
Q-10 If a separate statement of comprehensive income is presented, do all elements of
comprehensive income appear in this statement?
Some elements of comprehensive income are staying in their regular place on the income
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th
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Q-11 When dealing with earnings per share, why is less really more with SFAS No. 128?
Primary earnings per share, with its common stock equivalent category, was extremely
confusing. Hence its elimination makes earnings per share clearer and more understandable.
Q-12 Describe the incentives that might motivate income smoothing, and the ways it could
be done.
The incentives could be to reduce variance in annual earnings numbers, thus reducing risk
Q-13 Why is income smoothing difficult to research, and what are the research findings to
date?
Q-14 Why may interindustry income uniformity be more difficult to achieve than
intraindustry uniformity, and what are the implications of this in terms of a conceptual
framework project, specific accounting standards, and comparability of accounting
income numbers?
There is a greater tendency (we believe) to see uniformity in accounting procedures within
industry groups. Other things being equal, this should lead to greater uniformity within
Q-15 What is the relationship between earnings management and income smoothing?
Earnings management is the more general term, with income smoothing being a subset of the
former. Earnings management is any type of “purposeful intervention” in the determination and
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Q-16 Is earnings per share an example of finite or rigid uniformity?
The very specific and complex rules underlying EPS indicate an attempt to bring about rigid
Q-17 Why is the handling of troubled debt restructuring under SFAS No. 114 illogical?
The original discount rate is still used, even though it is out of date and no longer applicable.
Q-18 Why are future events so important to the issue of revenue and expense measurement?
The reason is that future events are so pervasive relative to the attempt to measure current
transactions.
Q-19 Which factor discussed under future events is the most important and why?
Q-20 From the standpoint of management, are there any differences between attempting to
control bad debt expense percentages and research and development expenses?
Bad debt expense is a discretionary accrual. The percentage might be changed without a real
Q-21 Why do you think earnings is managed when it appears that actual income might be
less than management’s voluntary forecasts of earnings?
A very crucial test for management is whether actual earnings has exceeded forecast. The results
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Q-22 Evaluate the attempt by the FASB to separate stock options from stock appreciation
rights that are payable in cash?
This could solve the measurement problem for stock options. The credit side difference-liability
Q-23 Should incentive and nonqualified stock options be treated the same on the financials?
We do not believe that the relation between market value and strike price at the date of grant is a
Q-24 In what two different senses is the term pro forma used?
These numbers are presented to financial analysts and are intended to provide a better view of
“sustainable earnings” by leaving out one-time non-representative events. Hence pro forma
Q-25 In SFAS No. 154, changes in accounting principle result in a restatement, whereas
under APB Opinion No. 20, a change in accounting principle is handled in a pro forma
manner. How does a restatement differ from a pro forma presentation?
Restatements change what was reported (actual); pro formas are “what if” presentations.
Q-26 What is classification shifting?
Classification shifting is the placement of data in an inappropriate area of the income statement.
Bottom line net income will not be affected; however, movement of dollars from COGS to S&A
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CASES, PROBLEMS, AND WRITING ASSIGNMENTS
1. Revenue recognition, when the right of return exists, was standardized in 1981 by
SFAS No. 48. Prior to this, SOP 75-1 provided guidance but was not mandatory (which
is why the FASB has brought various SOPs into the accounting standards themselves).
As a result, three methods were widely used to account for this type of transaction: (1)
no sale recognized until the product was unconditionally accepted, (2) sale recognized
along with an allowance for estimated returns, and (3) sale recognized with no
allowance for estimated returns. SFAS No. 48 mandated revenue recognition for such
sales subject to six conditions: (1) price is substantially fixed or determinable at sale
date; (2) buyer has paid or is obligated to pay the seller, and payment is not contingent
on resale of the product; (3) buyer’s obligation would not be changed in the event of
theft or physical damage to the product; (4) buyer acquiring the product for resale has
economic substance apart from the seller; (5) seller has no significant obligations to
bring about resale by the buyer; and (6) future returns can be reasonably estimated.
Required:
a. Discuss the underlying conceptual issues concerning revenue recognition when the
right of return exists. Can any (or all) of the pre-SFAS No. 48 methods be justified?
b. Indicate the rationale for each of the SFAS No. 48 tests before a revenue is
recognized.
c. Is SFAS No. 48 an example of finite uniformity or of circumstantial variables as
developed by Cadenhead (see Chapter 9)?
d. Discuss the role of future events in SFAS No. 48.
(a) Revenue recognition when the right of return exists raises interesting issues
concerning whether or not revenue is “earned” at the conventional point of sale.
Methods 1 and 2 would be plausible under certain circumstances, but Method 3
would be inconsistent (unless returns were simply not material). What SFAS No. 48
did was to create clear rules in an unregulated area where diversity existed, but
presumably was unjustified.
(c) We believe this is a case of circumstantial variables rather than finite uniformity with
[6]; the key issue is that future returns are reasonably estimable. The unusual right of
return situation is an industry-specific custom that is beyond the control of the firm;
hence, it is an environmental condition. A classic example exists in the case of book
publishing, where retailers have the right to return books to the publisher long after
the “sale” has been made. It would be virtually impossible for an individual book
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2. Accounting for the transfer of receivables with recourse has been problematic. At issue
is whether such a transaction is, in substance, a sale, in which case a gain/loss would be
recognized, or a financing transaction, in which case any gain/loss should be amortized
over the original life of the receivable. (The receivable could be long-term; for
example, a sale of an interest-bearing note.) SOP 74-6 concluded that most transfers
with recourse are financing transactions based on the argument that a transfer of risk
(i.e., no recourse) must exist for a sale to have occurred. In 1983, the FASB reached a
different conclusion in SFAS No. 77. A sale is now recognized if (1) the seller
surrenders control of future economic benefits embodied in the receivable and (2) the
seller’s obligation under the recourse provisions can be reasonably estimated. If these
conditions are not met, the proceeds from a transfer are reported on the balance sheet
as a liability.
Required:
a. What is the critical issue in interpreting the nature of this transaction? How
does interpretation of the critical issue lead to the two different viewpoints?
b. Explain why the SOP 74-6 view represents a revenue-expense orientation,
while the SFAS No. 77 represents an asset-liability orientation.
(a) The key issue is whether the existence of recourse is a relevant circumstance to
distinguish the transaction from a normal factoring of receivables in which there is no
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3. In its 1994 monograph on future events, the FASB discussed several orientations that
might be related to asset valuation. As an example of its thinking, assume that we are
assessing future sales of a product for the purpose of determining the value of the asset
which is used to manufacture the product. The product is expected to sell for $25 per
unit. Probability and unit sales are shown here.
Probability
Estimated Sales
.45 0
.10 5000
.30 6000
.15 8000
Required:
Part 1: Determine (a) the modal (most likely individual unit sales), (b) the cumulative
probability (summed probability of sales being either positive or negative), and (c) the
weighted probability number (expected value of probability times estimated sales times
sales price).
Part 2: How might these approaches be utilized to value the asset which is used to
manufacture the product?
Part 1
(a) The most likely event is estimated sales of 0 at 45 percent.
(b) The cumulative probability approach would take into account the fact that there is a
Estimated Selling
Probability × Sales × Price = Valuation
.45 0 $25 = 0
.10 5,000 25 = $12,500
.30 6,000 25 = 45,000
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4. In 1983, a number of computer software companies reported use of an accounting
procedure that was investigated by the SEC. The accounting policy is to capitalize the
cost of developing computer software and amortize it over the life of the software
(usually three to five years). This procedure is used by large and small companies, but
the impact is more pronounced on smaller, new companies, in which a greater portion
of their activity is devoted to software development.
An official of Comserv, a small company that specializes in software, said that small
companies would be in deep trouble because of SFAS No. 86. He said smaller
companies would be under strong pressure to keep costs down if development costs
had to be expensed. He also said, relative to the immediate write-off of these costs that
smaller companies would not be able to put as much cash into their own growth and
development because of SFAS No. 86.
The SEC’s concern was whether this accounting policy was consistent with SFAS No.
2 concerning the expensing of research and development costs as incurred. In 1985,
SFAS No. 86 treated software-related research and development costs the same as in
SFAS No. 2.
Required:
a. Evaluate the software capitalization argument with reference to SFAS No. 2.
b. Why is the choice of accounting policies (expensing vs. capitalization) more
likely to affect smaller companies?
c. Comment on the claim that small companies “wouldn’t be able to invest as
much cash in their own growth if they couldn’t use [capitalization].” Is this a
real economic consequence?
d. If you were a FASB member, how would you have voted on this issue?
(b) Small companies, particularly new ones, are likely to show a wider variation between
the two methods, compared with larger, older, and more diversified companies.
(c) This is the type of non sequitur that one often finds concerning the economic
consequences of accounting policies. Other things being equal, cash flows will be the
same regardless of how the costs are allocated to the income statement. The
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5. Discuss the role of future events in the following revenue and expense recognition
situations.
a. Modification of terms under troubled debt restructuring in SFAS No. 114.
b. Pension accounting relative to measuring current expense in SFAS No. 87.
c. Other postretirement benefits under SFAS No. 106.
d. Full costing and successful efforts in oil and gas accounting as well as the
SEC’s reserve recognition accounting proposal.
(a) The main future event problem concerns to what extent the cash flows from the
modification will be paid. The historical interest rate is used rather than determining
the current rate (see question 18) applicable to the transaction.
(c) Similar to pension benefits, other postretirement benefits encompass numerous future
events. As with pensions, mortality and turnover must be considered. The service
cost component is based upon the amount and timing of future benefits (taking into
account mortality and turnover) to be paid to covered employees computed on the
basis of expected future costs for these services. Since the future benefits are based
upon expected future services to be provided, the verifiability problem is far more
difficult to cope with than in the pension situation. Moreover, some future events that
would help to contain other postretirement benefit costs, such as plan amendments,
employee contributions, and Medicare changes, were not to be considered. Hence,
we have a standard steeped in both predicting future cash flows and the use of
conservatism (resulting in higher expense calculations), a major inconsistency.
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th
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6. Shown below is the bottom part of the income statement of Waste Management, Inc.,
for the year ending December 31, 1998. Also shown below is a note from its financial
statements showing the elements of its comprehensive income items, which were
shown as part of the statement of changes in equity.
Required:
a. Recast the income statement for December 31, 1998, so that it includes
comprehensive income.
b. Even though not allowed by the FASB, compute the EPS for comprehensive
income.
c. Do you think that elements specific to comprehensive income should be shown
only in the statement of changes in equity?
d. Do you think there are circumstances in which Waste Management might
desire to show comprehensive income elements within the income statement
itself?
(a) Net Income (per income statement) (770,702)
Other Comprehensive Income (net of tax)
Foreign currency translation adjustment (77,842)
Minimum pension liability adjustment (59,769) (137,611)
Comprehensive Income $(908,313)
7. Utilizing the stock options proposal made in this chapter, show entity and proprietary
income in the following situation for the Ethan Neil Corporation:
Income before taxes $4,810,000
Interest expense 182,000
Stock options expense (incentive)
240,000
Income tax rate 40%
Entity Income $4,919,200
1
Less: Interest expense $182,000
Tax savings 72,000
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Accounting Theory (9
th
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CRITICAL THINKING AND ANALYSIS
1. The question of the usefulness of cost allocations (discretionary accruals and
management compensation plans) has been introduced in this and previous chapters.
What, if anything, would you do about (fixed) cost allocations? Don’t forget to
consider political costs.
This ties together the whole question of fixed costs. We are presently in a situation of flexibility.
Rigid uniformity, possibly by industry, could increase comparability but corporate managements
would say that their ability to tell their “story” was being impeded. Efficient contracting
2. Moehrle et al. (2010) respond to the FASB regarding possible financial statement
presentation changes. Evaluate their response.
Moehrle, Stephen, Thomas Stober, Karim Jamal, Robert Bloomfield, Theodore E. Christensen,
Robert H. Colson, James Ohlson, Stephen Penman, Shyam Sunder, and Ross L. Watts
(2010). “Response to the Financial Accounting Standards Board’s and the International
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th
edition) Page 14 of 14
3. Liu and Espahbodi (2014) suggest that a firm’s dividend policy affects its propensity to
smooth earnings. How might this finding affect financial statement analysis?
Liu, Nan and Reza Espahbodi (September 2014). “Does Dividend Policy Drive Earnings
Smoothing?” Accounting Horizons: 501-528.
Abstract:
“This paper examines the earnings-smoothing behavior of dividend-paying firms. We show that
dividend-paying firms engage in more earnings smoothing than nonpayers through both real
activities and accrual choices. More specifically, dividend paying firms with positive (negative)
pre-managed earnings changes engage in more downward (upward) earnings management than