(07 36334) Financial Statement Analysis

and Business Valuation

Lecture 5

Recognition of income & expenses

Week 5

Dr. Chun Yu Mak

Assistant Professor in Accounting & Finance
 Learning objectives
 What is accounting income?

 Accrual concept/matching principle and income

recognition at different contracts?

 IFRS 15 Revenue from contracts with customers

and applications

 Concept of earnings management

 Analysis of restructuring charge

 Learning outcomes
 After this lecture, you must know:
 Concepts of different income figures and their implications
 Accrual accounting concept (matching principle) and revenue
recognition guidelines of IFRS 15
 Application of IFRS 15 at different sales contracts
 What are earning management and techniques?
 What are the effects of non-recurring items on earnings?
 Concepts of accounting income and expenses
收⼊：指在⼀个实体的⽇常活动过
程中流⼊导致权益增加产⽣的经济
According to IFRS 15: 利益的总流⼊，但与权益参与者贡
献有关的增加除外。
 Revenue: is the gross inflow of economic benefits during the period
arising in the course of the ordinary activities of an entity when
those inflows result in increases in equity, other than increases
relating to contributions from equity participants.

 Expenses: are decreases in economic benefits during the accounting

period in the form of outflows or depletions of assets or incurrences
of liabilities that result in decreases in equity, other than those
费⽤：指在会计期间表现为资产外流或消
relating to distributions to equity participants. 耗或负债的发⽣导致权益减少的经济利益
的减少，但与向权益参与⼈分配有关的费
⽤除外。
 Income: is increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or decreases
of liabilities that result in increases in equity, other than those
relating to contributions from equity participants.
收⼊：指在会计期间经济利益的增加，其形式是资产流⼊或增加或负债减少，导致权益增加，但与权益参与⼈出资有关的收⼊除外。

 Gains: inflow of economic benefits that do not result from ordinary

activities.
收益：不是由⼀般活动产⽣的经济利益的流⼊。
 What is accounting income?
 US GAAP, Accounting income (or called earnings & profit)
= revenues + gains – expenses – losses
 It is supported by “accrual accounting concept (matching
principle)”.
 Provides estimation of earnings power.

 “Accrual accounting concept (matching principle)”

“Revenue & costs are accrued (accounted for) as they are
earned or incurred, not as the money is received or paid,
and revenue and profits are matched with associated
costs and expenses by including them in the same
accounting period” (HSG p.10) .
收⼊和成本在赚取或发⽣时应计（记帐），⽽不是在收到或⽀付资⾦时，收⼊
和利润与相关成本和费⽤通过将它们包括在同⼀会计期间相匹配。
 What is accounting income? (cont.)
BirtXfa
Components of accounting income (IFRS, US GAAP)
Operating income Non-operating
income
Recurring income Operating activities Financing/
investing activities
Non-recurring Exceptional items Extraordinary items
income
 Exceptional items
 Material, non-recurring, within ordinary course of business activities.
 i.e. discontinue operations, restructuring/reorganisation charges, asset impairment etc.

 Extraordinary items (US GAAP only)

 Material, non-recurring, out of ordinary course of business activities. i.e. losses caused by
earthquake & fire.
 Disclosure: after “income before extraordinary items” in P&L/income statement
 These items are eliminated implicitly at income statement by UK FRS 3 and IFRS 15.
 What is accounting income? (cont.)
 Core income/Continuing income (IFRS) = income derived by
operating activities. It excludes income derived by financing
activities and those derived by non-recurring items (discontinued
operations, restructuring charges etc.).
- Operating profit –> continuing operation (after tax)

 Continuing income (US GAAP, IFRS) = core income + income derived

by financing activities + exceptional items (such as restructuring
charges.
- Profit on ordinary activities (after tax).

 Net income (UK, US GAAP, IFRS) = core income + exceptional items +

extraordinary items. It is called “bottom line figure” at the income
statement.
- Profit for the year attributable to shareholders.

 Example: see BT’s 2020 annual report

 What is accounting income? (cont.)
 Comprehensive income (US GAAP, IAS1)
= Net income + dirty surplus (Other comprehensive income)

Dirty surplus
= +/- Unrealised holding gain/loss on marketable securities
+/- Foreign currency translation adjustment
+/- Additional minimum pension liability adjustment
+/- Unrealised holding gain or loss on derivative instruments
Comprehensive income is a proxy for the economic income.

 US GAAP: comprehensive income is shown at the Consolidated

Statement of Retained Earnings, Comprehensive Income and Changes
in Capital Accounts.
 IAS 1: it is shown at the Group Statement of Comprehensive Income.
 Concepts of income
Income

Economic Income Permanent Income

Purpose: measuring Purpose: indicating of
change in sustainable earning
shareholder value power
Accounting income
Proxy Purpose: measuring Proxy
operating performance

Comprehensive
Continuing/Core
income
income

Dirty surplus (+,-)

Net income
 Income & expense recognitions
 Economic income (EI)
= net cash flow + present value of future cash flow
(or called: change in fair value of net assets, or called
equity)
= realised gains/losses + unrealised gains/losses
 Includes both recurring and nonrecurring components
 Therefore, it is less useful for forecasting future earnings potential
 Measures change in shareholder value = EI / cost of equity
 Limitations for valuation of shareholder value: (1) fixed assets are recorded
in historical costs, (2) earnings management.

 Permanent income (PI)

Indicates sustainable earning power of a company and its assets
 Equals stable average income that a company is expected to earn over its
economic life
 Reflects a long-term focus, so, it changes if long-term earnings prospects
are altered.
 Changes - due to economic life cycle of a firm.
 Going concern: company value = PI / cost of capital (or called WACC)
 Limitations for valuation for a firm: earnings management
 Economic Income and Permanent Income

2
$ Million

0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51
Years

Permanent Income Economic Income

 How to measure accounting income?

 There are different time points for recognizing

income and expense.
 When customer’s order is received
 When the production process is completed
 When the shipment is made
 When the contract is signed
 When the cash is received
 Accrual accounting concept (cont.)
IFRS 15: revenue recognition guidelines for:
 1. Identify the contract with a customer.
 2. Identify the separate performance obligations in the contract.
 -The customer can benefit from the good or service, either on its own or together with
other resources that are readily available to the customer (that is, the good or service is
capable of being distinct); and
 - The entity’s promise to transfer the good or service to the customer is separately
identifiable from other promises in the contract (that is, the promise to transfer the
good or service is distinct within the context of the contract).
 3. Determine the transaction price.
 4. Allocate the transaction price to the separate performance obligations. – related costs
& profit margin
 5. Recognise revenue when (or as) each performance obligation is satisfied. – customer’s
control over the product or/and services and the right of obtaining benefits.

Revenue is measured in fair value.

 Look at the Accounting Policies at a firm’s annual report in order to

find out its revenue and expense recognition principle. BT example,
notes the account #5.
 Income recognition at different contracts
 Reply to the case of subscriptions to publication
- create “deferred revenue a/c”, matching with related costs.

 Sales when the percentage of return is high

- revenue is recognised due to previous principles provide that seller can
reliably estimate future returns, AND
- recognising contingent liabilities; otherwise
- opportunity for off-BS finance

 Sales & buy-back arrangements (product financing)

- no revenue is recognised, the goods are still belong to seller

 Consignment sales
- The owner can recognise revenue only when the third party sell the
goods to the ultimate customer.
 Income recognition at different contracts (cont.)

Installment sales
(buying automobiles, real estate, air travel etc.)
(1) accrual basis: revenue is recognised when a sale is
made and an enforceable contract is signed

(2) installment basis: revenue is recognised when cash

is collected on the instalment contract.

Condition: Collectibility of instalments is certain.

Earnings management
 It is the use of accounting techniques (i.e. different
accounting policies provided by the accounting standards) to
present corporate performance in a favourable light that
does not properly reflect the underlying commercial reality.
This practice is often driven by a determination to ensure
that analysts’ expectations are met. (O’Regan 2006)

Creative accounting
 The use and misuse of accounting techniques and principles
to achieve financial results which, intentionally, do not
provide a true and fair view. (O’Regan 2006)
 Earning management
 Manager’s motivation of undertaking earning management:
 Manager’s compensation package may link to accounting income (i.e. in
China, a list company will be requested to be delisted if they were loss-making in any one year of the past three years.)

 Manager will choose their favourite accounting principle

 Manager is under pressure to meet investors/analysts’ income
expectations
 Manager may tend to recognise income earlier (See the case of My
Travel, Wild et al. 2003 p.336, Analysis Expert, or the case of
magazine subscription fee)

 Opportunities for earning management:

- Choices of capitalization and expensing (lecture 2)
- Contingent assets or contingent liabilities (lecture 3)
- Increasing ending inventory (lecture 3)
- Misclassification of trading, available for sales, held to maturity (lecture 4)
- Magazine subscription fee – deserve revenue/recognise sales aggressively (today).
- Sales when percentage of return is high – provision for return (today)
- Sales & buy-back arrangements (product financing, lecture 4)
- Sales & leaseback arrangements (lecture 4)
 Corporate restructuring activities in the
post-pandemic period

Source: https://www2.deloitte.com/us/en/pages/consulting/articles/corporate-restructuring-post-pandemic.html
 (i) Restructuring activities and charges

 Restructuring activities
Changes at business strategy:
 Reorganization
 Divesting business units
 Terminating contracts and joint ventures
 Discontinuing product lines
 Cutting labour force
 Management turnover

Restructuring charges:
 These activities involves substantial cash flow
commitments either contemporary or in the future
Example 1. Preserve earnings for the future by big-
bath, cases- restructuring charges

 Method A: writing off a large amount of restructuring charges in

the year of undertaking asset restructuring (event year 0):
Dr. Income statement
Cr. Operating assets (or cash)
 Earnings in subsequent years (i.e. event years 1, 2 and 3) will be
over-stated since no restructuring charges in these years even
though the firm will continue their restructuring activities.
 Example 1 (cont.)

 Method B: setting up provision account of restructuring charges in

the year of undertaking asset restructuring (year 0)
 Year 0:
Dr. Income statement
Cr. Provision account for restructuring

 Year 1: a loss making year

Dr. Provision account for restructuring – decrease at provision for
restructuring charges
Cr. Income statement

 This arrangement increase the net income of year 1.

 This method of manage earnings can also be applied at provision
for bad debts account.
 Example 2. Transitory charge and earnings forecast

Earnings Management with Restructuring Charges—An Illustration

• Company earns $2 per share in perpetuity
• Cost of capital is 10%
• Company valuation is $20 ($2/0.10)
• Company overstates recurring earnings by $1 per share for 4 periods and then
reverses this with a single charge in the fourth year:

($ per share) Year 1 Year 2 Year 3 Year 4

Recurring earnings $2 + $1 $2 + $1 $2 + $1 $2 + $1
restructuring charge -- -- -- (4)
Net Income $3 $3 $3 $(1)

Analysis
(1) Suggests permanent component of $3 per share and a transitory component of
$(4) per share in Year 4
(2) Company stock is valued at $26 ([$3 / 0.10] - $4)
(3) Ignoring special charges (as some analysts advise) yields stock valued at $30 ($3
/0.10)
 Example 2: restructuring charges continue

Earnings Management with restructuring charges-Graphical Illustration

20

10
Earnings per Share ($)

-10

-20
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
Year
 Summary
 What is accounting income?

 Accrual concept/matching principle and income

recognition at different contracts?

 IFRS 15 Revenue from contracts with customers

and applications

 Concept of earnings management

 Analysis of restructuring charge

References:
Text book Ch.6, and Ch.2 pp.79-97, 106-116.

Alfredson, et al. (2009), Applying international financial reporting standards, enhanced Ed., Wiley,
ISBN 0-470-80823-3. Ch.3

Supplementary reading:
Alexander, David & Simon Archer, Miller International Accounting Standards Guide. 2012 Aspen
Publishers, ISBN 978-0-8080-9226-1, Ch.30 , attached with this handout.

Holmes, Sugden & Gee, 2008, Interpreting Company Reports & Accounts, 10th Ed., Prentice Hall
Financial Times, ISBN 978-0-273-71141-4
Ch. 16, pp. 125-130 (Consignment stocks, Long-term contracts),

O’Regan, Philip (2006), Financial Information Analysis, 2nd Ed., Wiley, ISBN 0-470-86572-5, Ch. 13.

Questions for tutorial classes :

Case 6-2.
Canvas
All handouts, tutorial class questions and answers, past exam papers can be downloaded on
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