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Financial Reporting And Analysis, 7th Edition Class Notes

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    CHAPTER 1 THE ECONOMIC AND INSTITUTIONAL SETTING FOR FINANCIAL REPORTING CHAPTER OVERVIEW Financial statements are an extremely important source of information about a company, its economic health, and its prospects. They help improve decision making and make it possible to monitor managers’ activities.  Equity investors use financial statements to form opinions about the value of a company and its stock.  Creditors use statement information to gauge a company’s ability to repay its debt and to check whether the company is complying with loan covenants.  Stock analysts, brokers, and portfolio managers use financial statements as the basis for their recommendations to investors and creditors.  Auditors use financial statements to help design more effective audits by spotting areas of potential reporting abuses. Investors, creditors, and other interested parties demand financial statements because the information is useful. But what governs the supply of financial information?  Mandatory reporting is a partial answer. Most companies in the United States and other developed countries are required to compile and distribut e financial statements to share holders and to file a copy with a government agency (in the United States, that agency is the SEC). This requirement allows all interested parties to view the statements.  The advantages of voluntary disclosure are the rest of the answer. Financial information that goes beyond the minimum requirements can benefit the company, its managers, and its owners. For example, voluntary financial disclosures can help the company obtain capital more cheaply or negotiate better terms from suppliers. But benefits like these come with potential costs: information collection, processing, and dissemination costs; competitive disadvantage costs; litigation costs; and political costs. This means that two companies with different financial reporting benefits and co sts are likely to choose differ ent accounting policies and reporting strategies. Different companies choose different accounting policies and reporting strategies because financial reporting standards are often imprecise and open to interpretation. This imprecision gives managers an opportunity to shape financial statements in ways that allow them to achieve specific reporting goals.  Most managers use their accounting flexibility to paint a truthful economic picture of the company.  Other managers mold the financial statements to mask weaknesses and to hide problems.

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     Analysts who understand financial reporting, managers’ incentives, and the accounting flexibility available to managers will maintain a healthy skepticism about the numbers and recognize that financial statements sometimes conceal more than they reveal. The accountant’s and analyst’s job is made more difficult w hen financial reporting measure ment and disclosure rules differ across national boundaries. Reporting rules in some countries such as Canada, the United Kingdom, and the United States ev olved to reflect firms’ underly ing economic performance. But reporting rules in many other countries — France, Germany, and Japan, for example — merely complied with taxation or other statutory requirements.  Globalization forced many firms in countries using a commercial or tax law approach to seek foreign capital. In turn, this has led countries around the world to move to IFRS, making it easier for firms in their countries to raise capita l in domestic and foreign finan cial markets.  The FASB and IASB have worked to converge the guidance for numerous accounting issues. However, in many cases, the boards have issued substantially different standards after having worked together originally. CHAPTER OUTLINE I. Why Financial Statements Are Important Teaching Tip: While financial statements are not as timely as press releases, they do provide aneconomic history and are indispensable in developing an accurate profile of ongoing performance and prospects. Teaching Tip: This text does not focus on assisting readers of financial statements in detecting fraud, which is rare. Rather, the purpose of this text is to assist readers in understanding the financial flexibility and discretion inherent in financial accounting rules in order that they may make more informed decisions. II. Economics of Accounting Information A. Demand for Financial Statements B. Disclosure Incentives and the Supply of Financial Information III. A Closer Look at Professional Analysts A. Analysts’ Decisions IV. Fundamental Concepts of Financial Reporting A. Generally Accepted Accounting Principles B. Who Determines the Standards? C. The Politics of Accounting Standards D. FASB Accounting Standards Codification ™ Teaching Tip: It may be a good idea to access the FASB Codification and provide an overview of how to use the system and reinforce that everything in the Codification is a Generally Accepted Accounting Principle.

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    V. Incentive Conflicts and Financial Reporting Teaching Tip: For example, the choice to capitalize, rather than expense amounts, will make firms appear to be larger, mo re profitable, and less risky. Therefore, naive acceptance of financial statement data may be dangerous. Much of the book is devoted to providing students with the skills necessary to become more informed readers of financial statements by making meaningful comparisons between companiesand gaining insight into managers’ incentives. VI. An International Perspective A. International Financial Reporting VII. APPENDIX 1A: GAAP in the United States A. Early Developments B. Emergence of GAAP C. Current Institutional Structure in the United States CHAPTER QUIZ 1. A company’s financial statements reflect information about a. product information and competitive positions. b. future projections of sales, expenses, and other future economic events. c. the general economy of the industry in which the company operates. d. economic events that affect a company that can be translated into accounting numbers. 2. Creditors assess credit risk by comparing a firm’s required principal and interest payments to estimates of the firm’s current and future a. cash flows b. net assets. c. revenue . d. net income. 3. Which is not correct regarding Regul ation Fair Disclosure (Reg FD)? a. It limits what management can say in private conversations with analysts and investors. b. It does not limit what management can say in private conversations with analysts or investors. c. It was passed by the SEC. d. It helps level the playing field between individual and institutional investors. 4. Being verifiable and neutral is part of what makes financial information a. consistent . b. comparable . c. relevant . d. useful

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    5. Financial information capable of making a difference in a decision is a. relevant. b. reliable. c. consistent. d. verifiable. 6. Factors that may influence a decision maker’s judgment as to what accounting information is useful include: a. The decision to be made. b. The information already possessed. c. The decision maker’s capacity to process the information. d. All of the above answers are correct. 7. Which one of the following types of disclosure costs is the cost of disclosing the company’s pricing strategies? a. Political cost b. Litigation cost c. Competitive disadvantage cost d. Information collection, processing, and dissemination cost 8. Employees demand financial statement information because the firm’s performance is often linked to a. Employee stock ownership plans. b. Social security benefits. c. Disability plan benefits. d. Workmen’s compensation benefits. 9. The primary current source of generally accepted accounting principles for publicly traded companies in the United States rests with the: a. Securities and Exchange Commission. b. New York Stock Exchange. c. Financial Accounting Standards Board. d. American Institute of Certified Public Accountants. 10. International accounting standards are established by the a. Securities Exchange Commission b. London Stock Exchange c. Internation a l Accounting Standards Board d. Institute of Chartered Accountants Essay Questions 1. Define the expanded role of the PCAOB in the preparation of consistent and transparent financial statements. 2. Why would it be beneficial to narrow international differences in accounting rules for accounting and reporting?

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    QUIZ ANSWERS: 1. D . The financial statements present historical information about what has happened to the company in the past. 2. A . Creditors are concerned with a firm’s ability to replay principal and interest by projecting cash flows. 3. B . Reg FD was passed to limit what management can say in private to analysts and investors. 4. D . Useful information is verifiable and neutral. 5. A . Relevant information is capable of making a difference in decision making. 6. D . The judgment by a decision maker as to what accounting information can be useful includes the decision to be made, the information already possessed, and the decision maker’s capacity to process the information. 7. C . Competitive disadvantage cost is the cost of disclosing the company’s pricing strategies 8. A . Managers and employees use financial information to monitor employee contracts such as bonus plans, profit – sharing plans, and pension plans. 9. C . The FASB is charged with the responsibility of establishing financial accounting standards. 10. C . The IASB is responsible for establishing IFRS . RECOMMENDED FIGURES AND EXHIBITS 1. Figure 1.1 — Desirable Characteristics of Accounting Information

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    CHAPTER 2 ACCRUAL ACCOUNTING AND INCOME DETERMINATION CHAPTER OVERVIEW  This chapter highlights the key differences between cash and accrual income measurement.  In most instances, accrual - basis revenues do not equal cash receipts and accrual expenses do not equal cash disbursements.  The principles that govern revenue and expense recognition under accrual accounting are designed to alleviate the mismatching of effort and accomplishment that occurs under cash - basis accounting.  The matching principle determines how and when the ass ets that are used up in generat ing the revenue or that expire with the passage of time are expensed.  Relative to current operating cash flows, accrual earnings generally provide a more useful measure of firm performance and serve as a more useful benchmark for predicting future cash flows.  Predicting future cash flows and earnings is critical to assessing the value of a firm’s shares and its creditworthiness.  Multiple - step income statements are designed to facilitate this forecasting process by isolating the more recurring or sustainable components of earnings from the nonrecurring or transitory earnings components.  GAAP disclosure requirements for various types of accounting changes also facilitate the analysis of company performance over time.  This chapter outlines some common ways earnings are managed, some of which have come under SEC scrutiny. Auditors and financial statement users must be aware of the incentives to manage earnings and the ways in which this is accomplished.  Once discovered, accounting errors or irregularities must be corrected and disclosed through restatement.  Public companies must report EPS numbers on the face of their income statements. All firms report basic EPS based on the weighted averag e number of shares actually out standing during the period, while firms with complex capital structures also disclose diluted EPS, which reflects the EPS that would result if all potentially dilutive securities were converted into common shares.  Certain changes in net assets resulting from incomplete or open transactions bypass the income statement and are reported as direct adjustments to stockholders’ equity. These direct adjustments are called other comprehensive income components. Under U.S. GAAP, firms are required to report the components of other comprehensive income in either a single - statement format or a two - statement format. CHAPTER OUTLINE I. Cash Flow Versus Accrual Income Measurement A. Articulation of Income Statement and Balance Sheet B. Revenue Recognition — General Concepts C. Expense Recognition

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    Teaching Tip: For - profit entities adopt accrual accounting because of its ability to provide investors and creditors with a more realistic picture of relevant economic events and their effects on firm activities. On the other hand , entities that do not have a profit motive may prefer a cash - basis accounting system because of its simplicity. II. Income Statement Format and Classification A. Income from Continuing Operations B. Discontinued Operations C. Frequency and Magnitude of Various Categories of Transitory Income Statement Items Teaching Tip: In forecasting future cash flows, a reader of the financial statements must determine whether the “special or unusual items” are sustainable or transitory. The increased occurrence of these items heightens the speculative nature of these forecasts. It is important to remember that financial statements are designed to measure the economic conditions (micro and macro) and financial management of the company to assist users in determining future cash flows. Companies doing well in a great economic environment may be in trouble during the next economic turn while a company that exceeds the competition results during a recession may emerge as a market leader. III. Reporting Accounting Changes A. Change in Accounting Principle B. Change in Accounting Estimate C. Change in Reporting Entity Teaching Tip: Changes in accounting principles generally do not result in direct changes in cash flows. The only exception is a change from the LIFO method of accounting for inventory (because of the LIFO conformity rule). Since changes in accounting principles generally do not affect the tax return, a change in principles used for financial reporting purposes affects only income tax expense and deferred income taxes. IV. Earnings Management A. Popular Earnings Management Devices V. Accounting Errors, Earnings Restatements, and Prior Period Adjustments VI. Earnings per Share VII. Comprehensive Income and Other Comprehensive Income VIII. Global Vantage Point IX. APPENDIX 2A: Review of Accounting Procedures and T - Account Analysis A. Understanding Debits and Credits B. Adjusting Entries C. Posting Journal Entries to Accounts and Preparing Financial Statements D. Closing Entries E. Accounts Analysis as an Analytical Technique

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    Teaching Tip: There are several mnemonic devices available to help students organize the effects of debits and credits on the different types of accounts. CHAPTER QUIZ 1. High Tower , Inc. owns and operates resort campgrounds in the U.S. It sells annual m emberships that allow a member’s family unlimited use of the company’s campgrounds for a one - year period for an annual membership fee. Assuming High Tower produces quarterly financial statements, h ow should it recognize membership revenue? a. Revenue should be recognized when the cash is received. . b. Revenue should be recognized at the end of the membership period. c. Membership sales should be recognized equally over the course of the year. d. Membership sales should be recognized based on members’ actual use of the facilities. 2 . The matching principle encourages: a. The recognition of expenses when cash is paid for supplies. b. The recognition of expenses in the same period as the revenue was recognized. c. The reconciliation of net income and comprehensive income in a separate financial statement. d. The recording of period costs on the balance sheet. 3 . When a company has decided to dispose of a component of its business which of the following is true? a. The income or loss from that component should be reported as a component of operating income. b. The income or loss from that component should be separated as an unusual item. c. The income or loss from that component should not be included on the income statement. d. T he income or loss from that component should be repor ted as a discontinued operation . 4 . If a company adopts a new FASB standard, it should be reported as a. change in accounting principle . b. change in accounting estimate . c. change in accounting entity . d. unusual item . 5 . The use of accounting flexibility to meet earnings benchmarks is called a. i mpression management . b. earnings management . c. profit manipulation . d. accounting irregularities . 6 . Accounting errors or irregularities can occur for which reasons? a. S imple oversight b. M isapplication of GAAP c. management exploitation of the flexibility in GAAP

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    d. A ll of t hese answer choices are correct . 7 . The purpose of reporting nonrecurring items, net of related income taxes, below income from continuing operations is: a. These items help explain deviations in current year net income from past trends. b. These items assist in the task of predicting the timing and amount of future cash flows. c. Neither a. nor b. d. Both a. and b. 8 . On November 1, 201 6 , K ris Co. paid $7,200 to for a one year insurance policy on its equipment . With respect to this policy, w hat amounts should K ris report for prepaid insurance and insurance expense in its December 31, 201 6 , financial statements? Prepaid Insurance Insurance Expense a. $6, 0 00 $ 1,2 00 b. $ 7 , 2 00 $0 c. $0 $ 7 ,200 d. $ 0 $0 9 . Other comprehensive income components: a. Are shown net of their related tax effects. b. Include all changes in equity that do not affect the income statement. c. Include realized gains and losses. d. Eliminate the effects that unrealized gains and losses have on the financial statements. 10 . A debit a. increases Accounts Payable. b. increases Cost of Goods Sold. c. decreases Accounts Receivable. d. decreases Equipment. QUIZ ANSWERS: 1. C . Revenue should be recognized over the life of the contract. 2. B . The matching principle matches the recognition of expenses to the same period as the revenue was recognized. 3. D . I ncome or loss from the disposal of a component of a business should be report ed as a discontinued operation. 4. A . If a company adopts a new FASB standard, it should be reported as a change in accounting principle. 5. B . The use of accounting flexibility to meet earnings benchmarks is known as e arnings management . 6. D . A ll of the se options can lead to accounting errors or irregularities.

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    7. D . The purpose of reporting nonrecurring items, net of related income taxes, below income from continuing operations is to help explain deviations in current year net income from past trends, and to assist in the task of predicting the timing and amount of future cash flows. 8. C . Insurance expense should be $600 per month . As of December 31, there are still 10 months of coverage remaining. Therefore, $6, 0 00 is the balance in prepaid insurance. Insurance expense is $600 per month for 2 months, or $ 1,200. 9. A . Comprehensive income components are shown net of their related tax effects. 10. B . D ebits increas e assets, expenses and losses. RECOMMENDED FIGURES AND EXHIBITS 1. Figure 2.1 — Canterbury Publishing C omparison of Accrual - Based Earnings and Operating Cash Flow 2. Figure 2.2 — Proportion of firms reporting nonrecurring items (2002 – 2014) 3. Exhibit 2.6 — Types of Accounting Changes

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    CHAPTER 3 REVENUE RECOGNITION CHAPTER OVERVIEW Revenue recognition rules are transitioning from a patchwork of guidance that addressed spe cific issues individually. Often the issues addressed were related to a specific industry or the quirks of a particular type of transaction. Beginning in 2018 for calendar - year firms, the new ASC Topic 606 will take effect. It provides a single model that is to be applied by all firms in determining when revenue may be recognized. The model provides a five - step method for evaluating contracts with customers to deter - mine when revenue may be recognized. 1. Identify the contract(s) with a customer 2. Identify the performance obligations in the contract 3. Determine the transaction price 4. Allocate the transaction price to the performance obligations in the contract 5. Recognize revenue when (or as) the entity satisfies a performance obligation Contracts with customers give rise to performance obligations, representing the goods or services a firm has obligated itself to provide. Transaction prices are allocated to performance obligations and revenue is recognized when (or as) the performance obligations are satisfied. Until ASC Topic 606 becomes effective, for fiscal years beginning after December 15, 2017, existing guidance remains in effect. Under existing guidance, revenue is recognized when the earnings process is substantially complete and collection is reasonably assured. In some circumstances, such as for long - term construction contracts, it is sometimes appropriate to recognize revenue as work progresses. When collection is highly uncertain, the installment method is used to recognize revenue. For many firms, the financial statement effects of changing to the new standard will not be material, although the changeover in the rules will certainly affect some financial statements. Until firms begin to disclose their anticipated financial statement effects, it is difficult to quantify what those will be. Under both the existing rules and ASC Topic 606, revenue recognition can be subjective. Financial statement users should be cognizant of how firms apply revenue recognition standards. CHAPTER OUTLINE I. The Five - Step Revenue Recognition Model A. Step 1: Identify the Contract(s) with a Customer B. Step 2: Identify the Performance Obligations in the Contract C. Step 3: Determine the Transaction Price D. Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract E. Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation F. Practical Expedients in Applying the Model G. Applying the Model to Contract Modifications

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    Teaching Tip: Consulting firms use the percentage - of - completion method for fixed price, fixed period contracts. The Information Technology Professional Services sector, for example, uses this method to record approximately 30 % of its revenues. II. Contract Acquisition and Fulfillment Costs A. Amortization and Impairment III. Disclosure Requirements A. Disaggregated Revenue B. Contract Balances C. Performance Obligations and Significant Judgments Teaching Tip: The notes to the financial statements provide important useful information for financial statement users. The new revenue recognition standard requires extensive disclosures. IV. Effective Dates and Transition A. Retrospective Approach B. Cumulative Effect Approach V. Financial Statement Effects of New Standard VI. Global Vantage Point A. The Meaning of Collectibility B. Reversals of Impairments C. Disclosure Requirements VII. Revenue Recognition Prior to the Effective Date of ASC Topic 606 A. Long - Term Construction Contracts B. Installment Sales Method C. Franchise Sales D. Sales with Right of Return E. Bundled (Multiple - Element) Sales CHAPTER QUIZ 1 . The new ASC Topic 606 provides a model for revenue recognition that includes a. Five steps. b. Four steps. c. Three steps. d. Two steps. 2 . Under ASC Topic 606 for revenue recognition, which of the following statements is not accurate regarding performance obligations? a. Firms must disclose warranties provided. b. Firms must disclose qualitative information about their performance obligations. c. Firms are not required to disclose any judgments used to apply the standard. d. Firms must disclose the aggregate amount of the transaction price allocated to unsatisfied performance obligations. 3. Microtex Corporation sells c omputers and accessories. The company’s newest computer has a w holesale price of $ 10 0. In addition, the company sells carrying cases ($25), hard drives ($15), and earbuds ($10) made especially for this c omputer . During

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    the holiday season, Microtex offers the c omputer , carrying case, hard drive and earbuds as a package for $ 1 20 . For each package sold, the transaction price allocated to the c omputer is a. $0 . b. $ 80 . c. $100 . d. $120 4. Under ASC Topic 606 for revenue recognition, a performance obligation is considered satisfied when control over the goods and services is transferred to the customer. Which of the following is not an indicator that control has transferred? a. The customer has legal title of the goods. b. The customer is legally obligated to pay for the goods or services. c. The customer has accepted the goods and has physical possession of the goods. d. All of these are indicators that control has transferred. 5. Under ASC Topic 606 for revenue recognition, which of the following factors is not an indicator of the principal/agent determination? a. Credit risk. b. Inventory risk. c. Shipping terms. d. Control of prices of the goods or services. 6. Which of the following statements is not applicable to contract acquisition costs under ASC Topic 606 guidance for revenue recognition? a. Incremental costs of acquiring a contract must be capitalized and amortized over the life of the contract. b. Costs that would be incurred regardless of whether a contract is obtained are not capitalized. c. The capitalization requirement is subject to a practical expedient. d. Costs must be capitalized even if the amortization period is one year or less. 7. Spalding , Inc. sells, installs and maintains computer equipment. The contract with its customers to purchase equipment includes installation and includes a one - year maintenance contract, renewable for up to three years. Because the useful life of the equipment is expected to be three years, the company can reasonably expect its customers to renew the mainten ance contracts for the full three years. Spalding records the cost of installation of the equipment as a capitalized contract and amortizes the cost over the three - year maintenance agreement period. Be cause of a defect in one of its models , Spalding anticipates that many of its customers will trade in the model and not renew the maint enance contracts. Spalding , Inc. should a. write down the full amount received for mainten ance contracts for the full three years. b. write down the full amount of installation costs. c. write down the contract asset and recognize a loss equal to the difference between the amount of maintenance contracts expected and the carrying amount.

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    d. do nothing until the customers fail to renew the maintenance contracts. 8. Which of the following statements is not true regarding ASC Topic 606? a. Long - term construction contracts is an area where the new standard clearly differs from existing guidance. b. Adoption for calendar reporting entities is first required for calendar 2018. c. Current guidance on long - term contracts gives more flexibility to firms for determining when revenue is recognized. d. The new standard precludes the use of percentage - of - completion method for long - term construction contracts. 9. Assuming the requirements for recognizing revenue over time are met, and using the percentage - of - completion method to recognize revenue, the measure of completion is computed by dividing a. profits earned to date by estimated total profits. b. costs incurred to date by estimated total costs. c. costs incurred to date by the contract price. d. profits earned to date by the contract price. 10. B illy’s Construction entered into the following contracts with Larry ’s Landsca ping, LLP: (1) construct a concrete patio, (2) plant shrubs , and (3) landscape area for a new h ome construction project. Larry’s Landscaping should treat the contracts a. as a single contract. b. as three separate contracts. c. as two contracts — one for hardscaping and one for landscaping. d. None of these. Essay Q uestion 1. Technology companies sell software, hardware, and support in a bundled (mul ti - element sales) transaction. Describe the various methods of earnings management possible for technology companies. QUIZ ANSWERS: 1. A . T he new ASC topic 606 provides a 5 - step model. 2. C . F irms are required to disclose judgments used in applying the standard. 3. B . 66.67% of the price of $120 is allocated to computer, or $80. 4. D . A ll of these are indicators . 5. C . Shipping terms are not indicator of principal/agent determination . 6. D . Costs may be expenses if the amortization period is one year or less. 7. C . A contract asset is written down if it is deemed to be impaired, in which case a loss is rec ognized. A contract asset is impaired if the carrying amount exceeds the recoverable amount.

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    8. D . ASC Topic 606 does allow the use of percentage - of - completion method for long - term construction contracts. 9. B . P ercentage of completion is calculated as costs incurred to date divided by estimated total costs . 10. A . Two or more contracts entered into around the same time with the same customer should be treated as a single contract if the contracts were negotiated together and have a single business purpose.

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