Discuss GAAP reporting of income transactions

Answer 1

OVERVIEW OF GAAP REPORTING OF INCOME TRANSACTIONS

U.S. GAAP and IFRS require firms to initially report the results of most income transactions in the income statement instead of bypassing the income statement and reporting the amounts in some other shareholders' equity account. This reporting reflects the emphasis most analysts and investors place on the income statement when evaluating a firm's operating performance and the concern that statement users may overlook income transactions reported elsewhere. U.S. GAAP and IFRS recognize that some income transactions are central to a firm's principal business activities and recur, while others are either peripheral or nonrecurring. Firms must report items in their income statements in various categories to inform statement users about the nature of income items.

Changes in the fair values of assets and liabilities affect the value of a firm as they occur. U.S. GAAP and IFRS recognize some of these fair value changes in net income as they occur even though the firm has not yet sold the asset for cash or settled the liability– events that confirm the amount of the value change. Firms must delay reporting fair value changes of other assets and liabilities in net income until confirming events occur. In the meantime, firms include such value changes in Other Comprehensive Income and then close them to Accumulated Other Comprehensive Income, a component of shareholders' equity.

Firms sometimes discover errors in amounts previously reported, change their accounting principles, or change estimates made in applying their accounting principles. U.S. GAAP and IFRS require firms to retrospectively restate previously reported amounts for material corrections of errors and some changes in accounting principles, and to adjust current and future amounts for changes in accounting estimates and some changes in accounting principles.

There are four types of earnings transactions:

1 . Recurring versus nonrecurring.

2 . Central versus peripheral.

3 . Unrealized versus realized gains and losses from changes in the fair values of assets and liabilities.

4 . Adjustments for errors and changes in accounting principles and accounting estimates. The accounting for these four items affects the user's interpretation of reported net income and the forecasting of future net income. U.S. GAAP and IFRS aid this analysis process by requiring firms to classify income transactions in particular ways in the financial statements.

REPORTING RECURRING/NONRECURRING AND CENTRAL/PERIPHERAL ACTIVITIES

An analyst likely asks two questions when using a firm's past profitability to project its likely future profitability:

1 . Does the income item result from an activity in which a firm will likely continue its involvement, or does the income item result from an unusual transaction or event that is unlikely to recur regularly?

2 . Does the income item result from a firm's primary operating activity (creating and selling a good or service for customers) or from an activity incidental or peripheral to the primary operating activity (for example, periodic sales of equipment previously used by the firm in manufacturing)?

MEASUREMENT OF INCOME EFFECT

U.S. GAAP and IFRS distinguish between revenues and expenses on the one hand and gains and losses on the other. Revenues and expenses result from the recurring, primary operating activities of a business. Income items in this first category are the ordinary, recurring operating activities of the firm. Gains and losses result from either peripheral activities or nonrecurring activities. A second distinction is the reporting of revenues and expenses at gross amounts, whereas firms report gains and losses at net amounts.