Accrual Accounting and GAAP Income Statements

Cash vs. Accrual Accounting

• Cash Basis Accounting:

  • Revenues are recognized when cash is received.
  • Expenses are recognized when cash is paid.
  • Used by smaller firms or when not required to follow US GAAP (e.g., CFA, small Italian restaurant).

• Accrual Basis Accounting:

  • Revenues are recognized when earned (when goods or services are provided).
  • Expenses are recognized when incurred (when assets are used up or consumed).
  • Required for larger and publicly held firms following US GAAP.

Key Concepts of Accrual Accounting

• Revenue Recognition:

  • Revenue is recognized when the firm provides goods or services, regardless of when cash is collected.
  • Example: Landlord recognizes rental income at the end of the month, even though they collected cash at the beginning of the month.

• Expense Recognition:

  • Expenses are recognized when they are incurred or consumed, not necessarily when cash is paid.
  • Expenses can be recognized before, after, or at the same time as cash payment.
  • Example: Prepaid insurance is an asset initially, and expense is recognized over the policy term.

Examples of Accrual Accounting

• Automobile Insurance:

  • Paying $1200$ for a six-month auto insurance policy.
  • Initially recorded as an asset (prepaid insurance).
  • Expense recognized monthly ($200$ per month).

• Rent:

  • Paying $2000$ rent at the beginning of the month.
  • Initially recorded as prepaid rent (an asset).
  • Expense recognized at the end of the month.

• Landlord's Perspective:

  • Receives cash at the beginning of the month but recognizes revenue at the end of the month.
  • Sets up a liability called unearned revenue or deferred revenue, which decreases as revenue is earned.

• Starbucks Gift Card:

  • Starbucks doesn't recognize revenue when the gift card is purchased.
  • Revenue is recognized when the gift card is redeemed.
  • If the card is never redeemed, the value is allocated over time.

US GAAP and IFRS

• GAAP (Generally Accepted Accounting Principles):

  • US accounting standards. Income statements must use the accrual basis.
  • Not mandatory for privately held firms unless required by shareholders or banks.

• IFRS (International Financial Reporting Standards):

  • International accounting standards.
  • Rules can differ from US GAAP.

Retained Earnings Reconciliation

• Retained earnings is a shareholder's equity account, not a pool of cash.

• The Retained Earnings Reconciliation equation is:

  $Beginning Balance + Net Income - Dividends Paid = Ending Balance$

• Net income increases retained earnings; dividends paid decrease it.

Analyzing NVIDIA's Financials

• Key Subtotals:

  • Gross Profit
  • Operating Income
  • Income Before Tax
  • Net Income

• Subtotal Composition:

  • Each subtotal includes everything above it in the income statement.

• Evaluating Percentage Changes (Horizontal Analysis):

  • Comparing changes in income statement accounts over time (year-over-year).
  • Formula: $\frac{New - Old}{Old}$
  • Analyzing changes in expenses relative to changes in sales.
  • Large percentage changes may be due to small initial values.

Examination of NVIDIA's Percentage Change Income Statement

• Revenue Increase (20.61%):

  • Revenue for the current year was $97.14$, a $20.61$% increase compared to the previous year.

• Cost of Revenue Increase (16.78%):

  • Cost of revenue increased from $38.92$ to $45.45$, marking a $16.78$% increase.

• Gross Profit Increase (23.17%):

  • Gross profit saw a more significant increase of $23.17$% due to revenue increasing at a higher rate than the cost of revenue.

• Operating Profit Increase (18.5%):

  • Operating profit increased by $18.5$%, less than gross profit due to R&D expenses.

• R&D Increase (32.22%):

  • Research and development expenses rose by $32.22$%, outpacing the revenue increase and impacting operating profit.

• SG&A Increase (21.6%):

  • Selling, general, and administrative expenses increased by $21.6$, prompting further investigation into the causes.

• Income from Continuing Operations Increase (21.9%):

  • Income from continuing operations increased by $21.9$, influenced by other income and interest/debt expenses.

• Other Income Impact:

  • Other income showed a substantial rise of $219$%, but this was due to the small initial values.

• Net Income Increase (35.9%):

  • Net income exhibited an increase of nearly $36$%, largely driven by a tax benefit.

• Tax Benefit Consideration:

  • The tax benefit was a one-time event resulting from tax cuts, offering a non-recurring boost to net income.