Handout 05 - INTRODUCTION TO FINANCIAL ACCOUNTING...

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Copyright © 2011 1 You may only share these materials with current term students. I NTRODUCTION TO F INANCIAL A CCOUNTING 33:010:272 S ECTIONS 08 09 |FALL 2011 P ROFESSOR J ULIAN Y EO Class Notes 5: Net Income and Revenue Recognition In this document, we examine the definition of net income, accounting criteria for revenue (and expense) recognition. Specifically, we study the followings: 1. What is Net Income? 2. Revenue Recognition under GAAP 3. Expense recognition under GAAP 4. How companies manipulate revenue recognition and revenue measurement Upon completion of this topic, you should be able to: Understand that in the long run, Total ∆cash = Total Net Income = Total Return Appreciate that accrual Net Income is measured independently of the timing of cash flows (as opposed to ∆cash) and relies on measures that we have a degree of certainty (as opposed to Return) Familiarize with GAAP Revenue Recognition Criteria: Earned, Realized/Realizable Understand implementation issues with revenue recognition criteria o Revenues are reported net of discounts, allowances and returns Trade/promotional coupons o Defer revenue recognition Activation/installation fees o Gross vs Net o Not always clear when we should recognize something as revenue Familiar with GAAP Expense Recognition o Product vs Period Costs Understand why firms have incentives to manipulate revenue recognition and revenue measurement.
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Copyright © 2011 2 You may only share these materials with current term students. 1. What is income? As simple as this question may seem, it might not have a well-defined answer. Dictionary The amount of money or its equivalent received during a period of time in exchange for labor or services, from the sale of goods or property, or as profit from financial investments (The American Heritage Dictionary). What does it mean? Cash based Income The excess of cash inflow over cash outflow (adjusted for owners’ transactions; i.e., - new issued stocks + dividends). Why not use only the cash based definition of income in our accounting system? Economics based Income The maximum amount which can be spent during a period if there is to be an expectation of maintaining intact the capital value of prospective receipts, in money terms (Hicks, Value and Capital - Approximation number 1). From the shareholders’ perspective, this definition could be thought of as changes in prices plus dividends pocketed. Why not use the economic based definition of income in our accounting system? Accrual Accounting based Income Generally, the change in equity (net assets) of an entity during a period from transactions with external parties (other than the owners) (SFAS 3). Alternatively, income is an increase 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 (IASC). Accrual Accounting - A tradeoff between predictability and reliability.
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Handout 05 - INTRODUCTION TO FINANCIAL ACCOUNTING...

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