CHAPTER 6

ANALYZING OPERATING
ACTIVITIES
 2
TO;CO;PO

TOPIC OUTCOME (TO):

Ability to use this accounting tools or methods for the evaluation of the
company.

COURSE OUTCOMES (CO):

CO 1: Discuss the different types of financial statement analysis.
CO 2: Examine critically the information provided in the financial
statements.

PROGRAM OUTCOMES (PO):

PO 1: Able to apply knowledge and understanding of
accounting and accounting related fields.
PO 3: Able to interpret and analyze financial and non financial
information.
PO 4: Able to assist in financial and managerial accounting reporting
for decision making purposes.
 1. Income Measurement
PREVIEW OF CHAPTER 6 • Income Concept – A
Recap
• Measuring Accounting
Income
• Alternative Income

Classifications &
Measures

2. Revenue Recognition
• Guidelines for Revenue

Recognition
• Analysis Implications of

Revenue Recognition
Income
Net profit, or money that remains
after expenses are subtracted
from revenue.
To be disclose at bottom line on
financial statement

Revenue
Proceeds from the sales of
products and services to
customers, as well as other
activities like investment.
To be disclosed at top line on
financial statement
 Income Measurement
*Income Concepts-A Recap
Economic
Economic Income
Income
Equals
Equalsnet
netcash
cashflows
flows++the
thechange
changeininthe
thepresent
presentvalue
valueofof
future
futurecash
cashflows
flows
Includes
Includesboth
bothrecurring
recurringandandnonrecurring
nonrecurringcomponents—
components—
rendering
renderingititless
lessuseful
usefulfor
forforecasting
forecastingfuture
futureearnings
earningspotential
potential
Permanent
Permanent IncomeIncome
Also
Alsocalled
calledsustainable
sustainableearning
earningpower,
power,ororsustainable
sustainableoror
normalized
normalizedearnings
earnings
Estimate
Estimateof ofstable
stableaverage
averageincome
incomethat
thataacompany
companyis isexpected
expected
to
toearn
earnover
overits
itslife
life
Reflects
Reflectsaalong-term
long-termfocus
focus
Directly
Directlyproportional
proportionalto tocompany
companyvalue
value
 Income Measurement
Income Concepts-A Recap
 Based
Basedon
onaccrual
accrualaccounting
accounting
 Suffers
Suffersfrom
frommeasurement
measurementerror
error

Accounting
Accounting Income
Income consists
consists of:
of:
Permanent
Permanentor orRecurring
RecurringComponent--the
Component--thecomponent
component expected
expected
to
topersist
persistindefinitely.
indefinitely.
Transitory
TransitoryComponent--the
Component--thetransitory
transitory(or
(ornon-recurring)
non-recurring)
component
componentnot notexpected
expectedto
topersist
persist(Note:
(Note:The
Theconcept
conceptofof
economic
economicincome
incomeincludes
includesboth
bothpermanent
permanentandandtransitory
transitory
components.)
components.)
Value
ValueIrrelevant
IrrelevantComponent--value
Component--valueirrelevant
irrelevantfor
forvaluation.
valuation.
 Income Measurement
Measuring Accounting Income
Two main components of accounting income:
1. Revenues (gains)
2. Expenses (losses)
 Measuring Accounting Income

Revenues & Gains

• Revenues (recurring) are earned inflows (cash
sales) or prospective inflows of cash (credit sales).

• Gains (non-recurring) are recognized inflows or

prospective inflows of cash from non-operations.
For example, gain on sale of
discontinued segment & gain from
early extinguishment of debt.
 Measuring Accounting Income
Expenses and Losses

• Expenses are incurred outflows, prospective

outflows, or allocations of past outflows of cash
from operations
• Losses are decreases in a company’s
net assets arising from
non-operations. Examples are loss on
sale of investment securities & impairment
of goodwill.
* Alternatives Income Classification & Measures

INCOME

Operating
Recurring
vs
vs nonrecurring
non operating
 RECURRING INCOME
Income that is highly likely to
continue in the future.
NON RECURRING INCOME
Gain of an infrequent or unique
nature that is unlikely to occur
again in the normal course of
a business.

Predictable, stable and can be Also called extraordinary income.

counted on in the future with a
high degree of certainty.

Example: monthly interest income Example:  gains from

& monthly income received from discontinued operations,
customers for service provided. extraordinary items, and prior
period adjustments (accounting
changes).
Operating Income
Resulting from a
firm's primary business operation.
Also called (EBIT), operating
profit or recurring profit.
Excludes interest expense,
nonrecurring items and items not
directly related to a firm's core
business operations.
Non Operating Income
Gains or losses from sources not
related to the typical activities of
the business.
Includes all components of net
income excluded from operating
income.
Examples are dividend income,
profits (and losses) from
investments, gains (or losses)
incurred due to foreign exchange
& asset write-downs.
 Income Measurement
Alternatives Income Classification & Measures

Two major income dimensions:

1. Recurring versus non-recurring:

- depends on the behavior of the revenue or
expense (whether it is expected to continue or it
is a one-time event)

2. Operating versus non-operating:

- depends on the source of revenue or expense
(operating/investing/financing activities)
* Four alternative income measures:

• Net income—widely regarded as “bottom line” measure of

income. (No 1)

• Comprehensive income--includes most changes to equity that

result from non-owner sources; it is actually the bottom line
measure of income; is the accountant’s proxy for economic
income. (No 2)

• Continuing income (No 3) excludes extraordinary items (No

3a), cumulative effects of accounting changes (No 3b), and the
effects of discontinued operations from net income (No 3c).
Incorrectly referred to as “operating income”.

• Core income--excludes all non-recurring items from net income

 No1
Net Income

No 2
Comprehensive
Income

Continuing Income No 3

Core Income
3

2
 

No 3 a: Extraordinary Items
Criteria
Criteria
Unusual
Unusualininnature
nature
Infrequent
Infrequentin
inoccurrence
occurrence

Examples
Examples
Uninsured
Uninsuredlosses
lossesfrom
fromaamajor
majorcasualty
casualty(earth
(earthquake,
quake,hurricane,
hurricane,
tornado),
tornado),losses
lossesfrom
fromexpropriation,
expropriation,and
andgains
gainsand
andlosses
lossesfrom
from
early
earlyretirement
retirementofofdebt.
debt.

Disclosure
Disclosure & & Accounting
Accounting
Classified
Classifiedseparately
separatelyin
inincome
incomestatement
statement
Excluded
Excludedwhen
whencomputing
computingpermanent
permanentincome
income
Included
Includedwhen
whencomputing
computingeconomic
economicincome
income
 No 3b: Accounting Changes

First Type of Accounting Change is

Accounting Principle Change—involves switch
from one principle to another

 Disclosure includes:
• Nature of and justification for change
• Effect of change on current income and
earnings per share.
• Cumulative effects of retroactive application of
change on income and EPS for income
statement years.
 No 3b: Accounting Changes

Second Type of Accounting Change is:

Accounting Estimate Change—involves
change in estimate underlying
accounting
 
• A change is accounted for in current and
future periods.
• Disclose effects on current income and
EPS.
 No 3c: Discontinued Operations
Dispose of entire division or product line.

Accounting
Accounting treatment
treatment is
is ::

•• Income
Incomestatements
statementsfor forthe
thecurrent
currentand
andprior
priortwo
twoyears
yearsare
are
restated
restatedafter
afterexcluding
excludingthe
theeffects
effectsofofdiscontinued
discontinuedoperations.
operations.
•• Gains
Gainsororlosses
lossesfrom
fromthe
thediscontinued
discontinuedoperations
operationsare
arereported
reported
separately,
separately,net
netof
oftax*
tax*
  
*Reported
*Reportedin intwo
twocategories:
categories:(i)
(i)operating
operatingincome
incomeororloss
lossfrom
from
discontinued
discontinuedoperations
operationsuntil
untilthe
themeasurement
measurementdate,
date,and
and(ii)
(ii)
gains
gainsand
andlosses
lossesonondisposal.
disposal.
 No 3c: Discontinued Operations
 
For
For analysis
analysis of
of discontinued
discontinued operations:
operations:

•• Adjust
Adjustcurrent
currentand
andpast
pastincome
incometo toremove
removeeffects
effectsof
of
discontinued
discontinuedoperations
operations
 Companies
Companiesdisclose
disclosethis
thisinfo
infofor
forthe
thecurrent
currentand
andpast
pasttwo
two
years
years
 For
Forearlier
earlieryears:
years:
 Look
Lookfor
forrestated
restatedsummary
summaryinfoinfoor
orother
othervoluntary
voluntary
disclosures
disclosures
 Take
Takecare
carewhen
whendoing
doinginter-temporal
inter-temporalanalysis
analysis

•• Adjust
Adjustassets
assetsand
andliabilities
liabilitiesto
toremove
removediscontinued
discontinuedoperations.
operations.

•• Retain
Retaincumulative
cumulativegain
gainor
orloss
lossfrom
fromdiscontinued
discontinuedoperations
operationsin
in
equity
equity
MFRS 118 Revenue
Definition
 Revenue is the gross inflow of economic benefits during the
period arising in the course of the ordinary activities.
 Those inflows result in increases in equity.

Measurement
 Revenue shall be measured at the fair value of the
consideration received or receivable.
 Fair value is the amount for which an asset could be
exchanged, or a liability settled, between knowledgeable,
willing parties in an arm’s length transaction.
 Revenues vs Gains
Revenues (recurring)
• Total income of a company resulting from its main
operating activities such as manufacturing , selling
merchandise, providing services.
• Increase in assets or decrease in liabilities on the company’s
books.

Gains (nonrecurring)
• results from non-primary or incidental activity such as gain
on disposal of fixed assets.
Guidelines for Revenue Recognition

MFRS
Sale of goods
Para 14-19

Revenue Rendering of MFRS

Recognition services Para 20-28

Interest, royalties MFRS

and dividends Para 29-34
 Revenue Recognition
Summary of Guidelines
Revenue
Revenue Recognition
Recognition Criteria
Criteria
 Earning
Earningactivities
activitiesare
aresubstantially
substantiallycomplete
completeandandnonosignificant
significant
added
addedeffort
effortisisnecessary.
necessary.
 Risk
Riskof
ofownership
ownershipis iseffectively
effectivelypassed
passedtotothe
thebuyer.
buyer.
 Revenue,
Revenue,andandrelated
relatedexpense,
expense,are
aremeasured
measuredor orestimated
estimatedwith
with
accuracy.
accuracy.
 Revenue
Revenuerecognized
recognizednormally
normally
yields
yieldsan
anincrease
increasein incash,
cash,
receivables
receivablesor orsecurities.
securities.
 Revenue
Revenuetransactions
transactionsare areat
atarm’s
arm’s
length
lengthwith
withindependent
independentparties
parties
 Transaction
Transactionis isnot
notsubject
subjecttotocancellation.
cancellation.
 Revenue Recognition

Guidelines For Special Situation

Some
Somespecial
specialrevenue
revenuerecognition
recognitionsituations
situationsare:
are:
1.
1. Uncertainty
UncertaintyininRevenue
RevenueCollection
Collection
2.
2. Revenue
RevenueWhen
WhenRight
Rightof
ofReturn
ReturnExists
Exists
3.
3. Franchise
FranchiseRevenues
Revenues
4.
4. Revenue
Revenueunder
underContracts
Contracts
1.
1. Percentage-of-completion
Percentage-of-completionmethod
method
2.
2. Completed-contract
Completed-contractmethod
method
5.
5. Unearned
UnearnedRevenue
Revenue
1. Uncertainty In Revenue
Collection

- Used PFDD
- If collectability is no
longer assured, defer
recognition
of revenue until cash is
collected.
2.Revenue When Right of
Return Exists
Revenue is recognize at the
point of sale if:
 Price is fixed at the sale
date.
 Buyer pays the seller or
obligated to pay the
seller.
 Buyer’s obligation to
seller is unchanged if
damage/theft to product.
 Seller has no significant
obligation .
 Returns are estimated.

If not met, revenue

recognition is postponed.
 Recognize when all material
services or conditions
relating to the sale are
substantially performed or
satisfied by the franchisor.

Also applies to :
• Franchise fee
• Continuing franchise fee
& product sales
• Agency sales
• Repossessed franchise
• Franchising costs

3. Franchise Revenues
Often used by construction
companies, engineering firms and
other businesses that operate on
long-term contracts for large
projects.
4. Revenue Under Contracts
Percentage-of-completion
method: If the project is deemed
to be 40 percent complete, the
business would report 40 percent
of its income and 40 percent of
its expenses for a current gross
profit.
Completed-contract method:
consider all income and expenses
directly related to a long-term
contract as received when work is
completed.
 For long-term performance
contract such as product
warranty & software
maintenance contracts.

Revenues are collected in

advance.

Revenues are recognized

consistently over entire period of
the contract.

Unrecognized revenue appear in

the SOFP as a liability known as
unearned revenue.
5. Unearned Revenue
 Analysis Implication of Revenue recognition
 

Revenue
Revenueis isimportant
importantfor:for:
 Company
Companyvaluation
valuation
 Accounting-based
Accounting-basedcontractual
contractualagreements
agreements
 Management
Managementpressure
pressuretotoachieve
achieveincome
incomeexpectations
expectations
 Management
Managementcompensation
compensationlinked
linkedtotoincome
income
 Valuation
Valuationof ofstock
stockoptions
options
  
Analysis
Analysismust
mustassess
assesswhether
whetherrevenue
revenuereflects
reflectsbusiness
businessreality:
reality:
 Assess
Assessrisk
riskofoftransactions
transactions
 Assess
Assessrisk
riskofofcollectability
collectability
  
Circumstances
Circumstancesfueling
fuelingquestions
questionsabout
aboutrevenue
revenuerecognition
recognitioninclude:
include:
 Sale
Saleof
ofassets
assetsor oroperations
operationsnotnotproducing
producingcash
cashflows
flowstotofund
fundinterest
interest
or
ordividends
dividends
 Lack
Lackofofequity
equitycapital
capital
 Existence
Existenceof ofcontingent
contingentliabilities
liabilities