Solution Manual for Financial Reporting and Analysis, 6th Edition
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CHAPTER 1 THE ECONOMIC AND INSTITUTIONAL SETTING F OR FINANCIAL REPORTING CHAPTER OVERVIEW Financial statements contain information about a company, its economic health, and its products that help users in their decision making, and make it possible to monitor managers’ activities. Therein lies the demand for financial statements. Specifically, equity investors, analysts, and brokers use financial statements to form opinions about the value of a company as a basis for their investment decisions or recommendations to others. Creditors use financial information to assess the company’s ability to make its debt payments and comply with loan covenants. Auditors use financial statements to help design more effective audits by identifying areas of potential reporting abuses. Other users that demand financial information include managers, employees, suppliers, customers, and government and regulatory agencies. Flexibility and consistency are both desired when preparing financial statements. The changing economic environment demands the revision of standards and best practices that will best serve these two diverse results. Investors, creditors, and other interested parties demand financial statements because the information is useful. What governs the supply of financial information? Two answers are mandatory reporting and the advantages of voluntary disclosure. Most companies in the U.S. and other developed countries are required to produce, distribute, and file financial reports with a governmental agency — the Securities and Exchange Commission (SEC) in the U.S. — so that interested parties can view the statements. Voluntary financial information that goes beyond the minimum requirements can benefit the company, its managers, and its owners. Voluntary disclosure benefits and costs are likely to affect accounting policies and reporting strategies. Therefore, the flexibility and discretion inherent in financial reporting standards provide managers with opportunities to shape financial statements to achieve specific reporting goals. Users of this information that understand financial reporting, managers’ incentives, and accounting flexibility are better informed and more likely to be able to use financial statements to their advantage in the decision - making process. The accountant’s and analyst’s job is more challenging when financial reporting measurement and disclosure rules differ across countries. Those rules may underscore the reporting culture that may have evolved to reflect firms’ underlying economic performance. The FASB and IASB are working together to converge U.S. GAAP and IFRS. CHAPTER OUTLINE I. WORLDCOM’S CURIOUS ACCOUNTING A There are several “facts” to consider (stepping back in time to May 2002). 1. The market price of WorldCom is $2.00 per share and declining. a. Stock analysts state that WorldCom is doing “surprisingly well despite tough times throughout the industry.” b. The company has $2.3 billion in cash, which translates into $20.50 book value per share . 2. The first - quarter results indicate sales of $8,120 million and $240 million in pre - tax operating profits – a decline of 16% in sales and 40% in profits while other firms in the industry are reporting even steeper sales and earnings decreases. 3. The company has $104 billion in assets and $44 billion in debt. 4. WorldCom’s “line costs” are holding steady at about 42% of sales while other companies are experiencing rising line costs as a percentage of sales. a. Does this suggest that WorldCom is adept at managing its excess capacity
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problems during a period of slack demand? b. Is this a cautionary warning signal of problems at the company? 4. You call your broker and find that the stock has declined to $1.75 per share in early trading. What do you do?
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II. WHY FINANCIAL STATEMENTS ARE IMPORTANT Investors need adequate information to judge risk versus reward factors of investment alternatives. 1. A company’s financial statements are a critical source of information about the financial condition, operating results, and prospects for the future for an organization. 2. Financial statements can be used as an analytical tool, a management report card, an early warning signal, a basis for prediction, and as a measure of accountability. Teaching Tip: While financial statements are not as timely as press releases, they do provide an economic history and are indispensable in developing an accurate profile of ongoing performance and prospects. A. Untangling the Web at WorldCom? 1. An internal audit discovered $3.8 billion in improper transfers of line cost expenses from the income statement to the balance sheet. Without these transfers the company would have reported a loss for 2001 and in the first quarter of 2002. 2. WorldCom stunned investors by announcing that it intended to restate financial statements for 2001 and the first quarter of 2002. . 3. The stock price fell to $.06 per share. 4. Members of management were convicted of fraud and imprisoned. 5. The company defaulted on a $4.25 billion credit line and filed for bankruptcy. 6. The company acknowledged more than $7 billion in accounting errors over the previous years. Teaching Tip: While fraud is different than the flexibility and discretion inherent in financial reporting rules, analytical review of financial statements may help one uncover fraud. Teaching Tip: This text does not focus on assisting readers of financial statements in detecting fraud. 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. III. ECONOMICS OF ACCOUNTING INFORMATION A. Financial statements serve two key functions: 1. To provide a way for company management to transfer information about business activities to people outside of the company, thereby solving the problem of information asymmetry (problem of management having superior information that outsiders) . 2. Financial statement information is often included in contracts between the company and other parties since that improves contract efficiency (e.g. management compensation contracts). B. Demand for Financial Statements - The supply of financial statement information is guided by the costs of producing and disseminating it and the benefits it will provide to the company. Financial statements are demanded because of their value as a source of information about the company’s performance, financial condition, and stewardship of its resources. Below is a short list of outsiders whose decisions require financial statement information as a key input in making decisions: 1. Shareholders and Investors use financial information to decide on a portfolio consistent with their individual preferences for risk, return, dividend yield, and liquidity. a. Financial statements are crucial in fundamental analysis. b. Many analysts look beyond the financial statement numbers to the “meaning behind the numbers,” making footnote disclosures invaluable.
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c. Shareholders and investors use financial statement information to evaluate the performance of the company’s top executives ( stewardship function of financial reports). 2. Managers and Employees use financial information to monitor contracts such as bonus plans, profit - sharing plans, stock ownership plans, and to monitor the health of company - sponsored pension plans along with information that will assist in making decisions concerning the allocation of limited resources. 3. Lenders and Suppliers use financial information to assess the financial strength of a business to determine whether to make a loan (or extend credit), and then the amount, interest rate, and security (if any) that is needed. 4. Customers use financial information to monitor a supplier’s financial health as part of the process of checking out a product and the company that stands behind it. 5. Government and Regulatory Agencies demand financial statement information to assess compliance with laws and standards. a. Taxing authorities may use financial statement information as a basis for establishing tax policies designed to enhance social welfare. b. As customers of businesses, government agencies may use financial statement information to settle contractual payments. c. Regulatory intervention may be another source of demand for financial statement information. C. Disclosure Incentives and the Supply of Financial Information - The supply of financial information is guided by the costs of producing and disseminating it and the benefits it will provide to the company. 1. Voluntary disclosure occurs so long as the incremental benefits to the company from supplying that information exceed the incremental costs of supplying that information. a. Some users, such as creditors, may have enough bargaining power to compel companies to deliver financial information that they need for analysis. b. Regulated financial reporting is designed to ensure that companies meet certain minimum levels of financial disclosure and transparency. 2. Disclosure Benefits : Owners and managers have an economic incentive to supply the amount and type of financial information that will enable them to raise capital at the lowest cost. 3. Disclosure Costs: a. Costs associated with collecting, processing, and disseminating financial information can be large. b. Competitors may use the information against the company providing the disclosure (competitive disadvantage). c. Litigation costs result when financial statement users initiate court actions against the company and its management for financial misrepresentations. d. Highly profitable — but politically vulnerable — firms may be subject to political initiatives designed to impose “taxes” on them. Teaching Tip: Small businesses are often subject to less comprehensive reporting requirements because of the prohibitive costs referred to in (a.) above. Likewise, political costs (d. above) may encourage firms to use accounting methods that appear less profitable. Much of the book is devoted to providing students with the skills necessary to undo accounting methods or to convert from one method to another so that more meaningful comparisons between companies may be made. Therefore, students gain insight into managers’ incentives and become more informed readers of financial statements. IV. A CLOSER LOOK AT PROFESSIONAL ANALYSTS
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A. Financial statement users have diverse information needs because they face different decisions or may use different approaches to making the same kind of decision. The conflicting desired result of flexibility and consistency may be problematic to standard setters. B. The text focuses on “ analysts ” , defined broadly to include investors, creditors, financial advisors, and auditors. C. Analysts’ Decision - Information needs of analysts include: 1. Quarterly and annual financial statements and nonfinancial operating and performance data. 2. Management’s analysis of financial and nonfinancial data, including reasons for change (management discussion and analysis). 3. Information making it possible to identify future opportunities and risks. 4. Footnotes are important to analysts to obtain a transparent accounting of decision alternates for financial statement comparisons. 5. The analyst needs to be able to compare financial results of diverse companies to help investors decide where to allocate scarce resources. V. THE RULES OF THE FINANCIAL REPORTING GAME A. Generally accepted accounting principles (GAAP) are a network of conventions, rules, guidelines, and procedures. 1. The goal of GAAP is to ensure that a company’s financial statements represent its economic condition and performance. 2. Professional analysts are forward looking. GAAP reports what has occurred. 2. Therefore, analysts must first understand the accounting measurement rules used to produce the data before extrapolating financial statement data into the future. B. Financial statements should possess certain qualitative characteristics. 1. Financial information is relevant if it makes a difference in the decision - making process. It is considered relevant if it has both predictive value and confirmatory value. 2. Predictive value: The information improves the decision maker’s ability to forecast the future outcome of past or present events. 3. Confirmatory value: The information confirms or alters the decision maker’s earlier beliefs. 4. Financial information is timely if it reaches decision makers before it loses its capacity to influence their decisions. 5. Financial information is reliable if it is reasonably free of error and bias, and truthfully represents what it purports to represent. 6. Financial information is representationally faithful when the accounting actually represents the underlying transaction or economic event. To achieve faithful representation, the financial information must have the qualities of completeness (including all pertinent information), neutral ity (information cannot be selected to favor one set of interested parties over another), and free from material error (Some minimum level of accuracy is necessary for an estimate to be a faithful representation of an economic event). 7. Financial information is neutral when it does not favor one set of interested parties over another. 8. Other qualitative characteristics that enhance the decision usefulness and representationally faithful information are comparability, verifiability, timeliness, and understandability. 9. Financial information is comparable when it is measured and reported in a similar manner among different companies. 10. Financial information is consistent when the same accounting methods and disclosure practices are used to describe similar events from period to period.
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11. Verifiability means that independent measurers should get similar results when using the same yardstick. 12. Timeliness refers to information that is available to decision makers while it is still capable of influencing their decisions. 13. Understandability is the characteristic of information that enables users to comprehend its meaning. Teaching Tip: Students often want to know which accounting alternative is “best.” Qualitative trade - offs make it difficult to identify “good” accounting methods and disclosure practices. For example, market value may be relevant to the decision at hand, but representational faithfulness may be questionable. C. Two additional conventions affect whether financial statements are complete, understandable, and helpful. 1. Materiality is established when an omission or misstatement is important enough that the judgment of a reasonable person is influenced by the omission or misstatement. 2. Conservatism in accounting involves trying to ensure that business risks and u ncertainties are adequately reflected in the financial reports. D. Who Determines the Rules? 1. The SEC has the ultimate legal authority to determine the rules to be followed in preparing financial statements by publicly traded companies in the Unites States, but has largely delegated its authority to the accounting profession’s Financial Accounting Standards Board (FASB) . 2. GAAP may also evolve from accounting practices over time. 3. The Public Company Accounting Oversight Board (PCAOB) was established by the Sarbanes - Oxley Act of 2002 to provide oversight of auditing procedures two ways a. establish standards for auditing and ethics at public accounting firms b. inspect and investigate auditing practices of public accounting firms 4. Financial reporting standards outside the U.S. are determined in some countries by professional accounting organizations, in other countries by commercial law and/or tax law requirements, and on a worldwide basis by the International Accounting Standards Board (IASB). 5. A convergence project has a goal of providing one set of worldwide accounting standards to reconcile the IASB standards with those of the FASB. 6. Due to the voluminous nature of accounting and financial reporting documents, the AICPA in SAS 69 developed a hierarchy for different types of documents. E . The Politics of Accounting Standards : - Standard setting in the U.S. and most other countries is a political and technical process. 1. Political pressure by interested parties continues to shape the surrounding sensitive and controversial U.S. accounting standards. 2. While the intensity and frequency of political influence will persist in the future, it is important to remember that accounting standards reflect both: a. Sound concepts coupled with independent and objective decision making of standard setters, and b. Compromises necessary to ensure that proposed standards are generally acceptable. F. FASB Accounting Standards Codification TM 1. The growing number of accounting pronouncements made it difficult to find answers to financial accounting and reporting questions. 2. In 2009, the FASB completed a five - year project to distill the existing GAAP literature into a single database now called the Accounting Standards Codification (ASC). 3. The codification does not remove GAAP but reorganizes it for easy accessibility.
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4. ASC Topical Structure and Referencing - The ASC uses a structure that organizes pronouncements into topics, sections, subsections, and paragraphs. i. Topics are the broadest categorization of related guidance and are grouped into four areas: presentation (financial statements or notes); financial statement accounts (such as Receivables, Inventory, etc); broad transactions (e.g. Business combinations and derivatives); and industries (specialized GAAP). ii. Subtopics represent subdivisions of a topic and distinguished by type or scope iii. Sections are subdivisions such as Recognition, Measurement, or Disclosure VII. ADVERS ARIAL NATURE O F FINANCIAL REPORTING . 1. Managers frequently have reasons to exploit the flexibility and discretion allowed by accounting standards since their interests may conflict with the interests of creditors and shareholders. 2. The flexibility of GAAP financial reporting standards provides opportunities to use accounting “tricks” to make a company appear less risky than it really is, or to “smooth” earnings by strategically timing the recognition of revenues and expenses. Teaching Tip: For example, the choice to capitalize, rather than expense amounts, will make firms appear to be larger, more profitable, and less risky. Therefore, naive acceptance of financial statement data may be dangerous. H. Aggressive Financial Reporting: A Case Study - Computer Associates International (CA) embraces aggressive financial reporting practice. 1. The Accounting Issues: There are several facts to the case. a. This company is a global leader in the software market for managing mainframe and computers networks. b. The first accounting controversy regarding revenue recognition occurred when CA changed how it books revenue from software licenses that were renegotiated during the licensing period. The net effect was to double count revenues when the licenses were renegotiated. The impression was given that revenues were increasing over time. c. T he second accounting controversy stemmed from the company’s decision to roll out a subscription based business model and began reporting results using nonstandard pro forma accounting in its earnings announcements. d. The differences between the pro forma disclosures and the GAAP numbers were substantial. Under the pro forma disclosure, revenue was reported as $1.284 billion and operating income was $247 million while the GAAP numbers were $783 million for software revenue and operating income was a loss of $342 million. 2. The discrepancy between the pro forma and GAAP numbers made it tough for the investment community to judge the company 3. The Justice Department and the SEC brought suit against CA leading to lawsuits and charges of fraud and obstruction of justice against company executives. Teaching Tip: Consider breaking the class into small groups and have them discuss the questions posed in the “Questions to Consider” section of this chapter. This may be an excellent way to enforce the need to be consistent with the objectives of financial reporting and the role GAAP plays in meeting those objectives. I . Epilog - CA admitted in October 2003 that some software license contracts had been backdated, to mask declining performance and meet Wall Street forecasts. After an investigation, CA restated $2.2 billion in sales.
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Company spent $30 million on the investigation. CA agreed to pay $225 million in restitution to shareholders. Top executives are serving prison sentences of up to 12 years each. J . Challenges Confronting the Analyst A. Financial statements have become increasingly more complex. B. Service firms and e - commerce companies now represent a major portion of business activities. C. Global competition for products, services, capital, and customers has introduced yet additional diversity into the financial reporting process. D. Benefits from increased use and lower cost of technology to assemble and analyze financial data are muted by the increased complexity and dynamic environment in which firms operate VIII. AN INTERNATIONAL PERSPECTIVE Countries’ reporting philosophy evolves from and reflects the specific legal, political, and financial institutions within the country as well as social customs. A. Multinational companies shift resources around the world to take advantage of labor markets. B. Global competition is prevalent in most industries today, and many companies look outside their borders to establish an expanded customer base. C. Many companies shift resources to take advantage of tax laws and incentives that vary country to country, state to state, and even on a local level. D. International Standards promulgated by the International Accounting Standards Board (IASB) have had an increasing role in the setting of standards that are consistent throughout the global economy. E. W hy Do Reporting Philosophies Differ Across Countries? The financial reporting philosophies of countries have evolved over many years from the legal, political, and financial institutions, as well as social customs. This evolution creates a business culture, which may determine the informational needs of the various stakeholders (market). F. Foreign investors and other potential capital providers demand transparent financial reports that reflect the underlying firm economic performance. G. Sources of financing do shift over time. When this happens, changes in the financial reporting environment occur as well. H. Globalization and the Rise of IFRS - The FASB and the IASB are working toward eliminating differences between U.S. GAAP and IRFS. I. The SEC permits foreign companies to list their securities on a U.S. stock exchange as long as they are registered with the SEC and use IFRS as a basis for their financial statements. Those firms do not have to reconcile their financial statements to U. S. GAAP. J. International Accounting Standards Board (IASB) – Established by the IASB created in July 1973 with four goals: a. To develop a single set of high - quality, understandable, enforceable, and globally accepted international financial reporting standards (IFRS) b. To promote the use and rigorous application of those standards c. To take account of the financial reporting needs of emerging economies and small and medium - sized entities d. To promote and facilitate the adoption of IFRS through the convergence of national accounting standards and IFRS K. IASB has issued 54 standards and 54 interpretations of the standards. Standards in use in 125 countries worldwide. Compared to U.S. GAAP, IASB standards allow firms more flexibility and more of a generalized overview approach. L. Critics of the IASB’s principles - based approach content that IFRS are so general and the implementation guidance so ambiguous that company managers have excessive latitude in accounting choices. M. Supporters of the IFRS argue that rigidity is less with IFRS where there are broad principles and not as detailed as in rules - based U.S. GAAP approach . N. The March Toward Convergence: Cross - border comparisons are difficult without convergence. Some success on convergence has been achieved but some important differences still remain such as:
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a. Reversal of inventory write - downs b. Extraordinary items c. Research and development costs IX. Appendix — GAAP IN THE UNITED STATES A. Early Developments: Corporate financial reporting in the U.S. prior to 1900 were primarily intended to provide accounting information for management’s use. The NYSE, established in 1792, was the primary mechanism for trading ownership in corporations. The securities trading ups and downs led to the need for a standardized accounting policies and practices to be followed by SEC registered companies. B. Emergence of GAAP - The Securities Act of 1933 required companies selling publicly traded stock and debt to provide financial information. 1. The Act was amended in 1934 to create the Securities and Exchange Commission (SEC). 2. Firms with stock or debt listed on organized exchanges were required to file annual financial reports with the SEC. B. The American Institute of Certified Public Accountants (AICPA) Committee on Accounting Procedures issued bulletins between 1938 and 1959 that set forth the framework for what the committee believed to be generally accepted accounting procedures. C. In 1959, the AICPA established the Accounting Principles Board (APB) to develop a conceptual framework and to issue statements to improve external financial reporting and disclosure. 1. The force of these pronouncements depended on general acceptance and persuasion. 2. Critics cited numerous instances where net income could be manipulated by selecting among several methods that were “generally accepted.” D. The Financial Accounting Standards Board (FASB) was created in 1973. It differed from its predecessors in several important ways. 1. There were seven board members (APB had eighteen). 2. All Board members were required to sever ties with their previous employer. 3. Broader representation was achieved since board members did not have to be Certified Public Accountants (CPA) . 4. Staff support was increased substantially. E. Current Institutional Structure in the United States: The SEC still retains broad statutory powers over financial reporting practices, but continues to rely on private sector organizations (currently the FASB) to set accounting standards. 1. The FASB has no authority to enforce compliance with generally accepted accounting principles (GAAP). That responsibility lies with management, the accounting profession, the SEC, and the courts. 2. The FASB follows a “due process” procedure in developing Accounting Standards updates. Most updates issued by the FASB go through three steps: a. Discussion - memorandum stage outlines the key issues involved. b. Exposure - draft stage encourages further public comment that is evaluated. c. Voting stage is when the Board votes whether to issue an ASU describing amendments to the Accounting Standards Codification or to revise the proposed update and reissue a new exposure draft. 3. Public Company Accounting Oversight Board: The Public Company Accounting Oversight Board (PCAOB) has a role in developing transparent financial statement and an increased system of internal control. The PCAOB regulates accounting firms auditing companies that are listed on public exchanges
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4. Sox Compliance: The Sarbanes - Oxley Act (SOX) was enacted to reign in accounting abuses by strengthening auditor independence and improving financial reporting transparency. a. CEOs and CFOs must certify the accuracy of financial statements b. An annual evaluation of internal controls and procedures must be conducted.
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CHAPTER QUIZ 1. During a period when a firm is under the direction of particular management, its financial statements will directly provide information about: a. Both firm performance and management performance. b. Management performance but not directly provide information about firm performance. c. Firm performance but not directly provide information about management performance. d. Neither firm performance nor management performance. 2. Which of the following statements reflects the basic purpose of financial reporting? a. The primary focus of financial reporting is information about a firm’s resources. b. The best indication of a firm’s ability to generate favorable cash flow information is based on previous cash receipts and payments. c. Financial accounting is expressly designed to directly measure the value of a firm. d. Investment and credit decisions often are based, at least in part, on evaluations of the past performance of an enterprise. 3. Which of the following is considered a pervasive constraint under generally accepted accounting principles? a. Benefits/costs. b. Conservatism. c. Timeliness. d. Verifiability. 4. According to the FASB conceptual framework, the qualitative characteristic of neutrality is an ingredient of: Faithful Representation Relevance a. Yes Yes b. Yes No c. No Yes d. No No 5. According to the FASB conceptual framework, which of the following situations violates the qualitative characteristic of faithful representation? a. Financial statements were issued nine months late. b. Data on business segments having the same expected risks and growth rates are reported to analysts estimating future profits. c. Financial statements included property reported at an increased amount that reflects management’s estimate of market value. d. Management reports to stockholders regularly refer to new projects undertaken, but the financial statements never report project results.
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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 the audit of the financial statements? a. Political cost b. Litigation cost. c. Information collection and dissemination cost. d. Competitive disadvantage 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. According to the FASB conceptual framework, the objectives of financial reporting are based on a. The need for conservatism. b. Reporting on management’s stewardship and performance. c. Generally accepted accounting principles. d. The needs of the users of the information. Essay Question 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. c. Financial reporting provides information about an enterprise’s performance during a period, but does not separate the effect of a particular management’s performance from the effects of prior management actions, general economic conditions, the supply and demand for an enterprise’s inputs and outputs, price changes, and other events. 2. d. Although investment and credit decisions reflect expectations about future performance, those expectations are based, in part, on evaluations of past performance. 3. a. All accounting information is subject to two qualitative constraints: materiality and cost/benefit. The cost/benefit constraint states that benefits of information must exceed the cost of obtaining it. 4. b. Faithful representation assures that information is reasonably free from error and bias and faithfully represents what it purports to represent. Its ingredients are completeness, verifiability, and neutrality. Neutrality is the absence of bias intended to reach a predetermined result or induce a certain behavior. 5. c. Faithful representation is defined as the quality of information that provides assurance that the information is reasonably free from error and bias. In accordance with GAAP, the carrying value of property should not be increased to market value. 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. a. Managers and employees use financial information to monitor employee contracts such as bonus plans, profit – sharing plans, and pension plans. 8. c. Audit costs are associated with information collection and dissemination costs. 9. c. The FASB is charged with the responsibility of establishing financial accounting standards. 10. d. According to the conceptual framework, one objective of financial reporting is to provide information that is useful to present and potential investors, creditors, and other users in making investment, credit, and similar decisions. RECOMMENDED EXHIBITS 1. Figure 1.2 — Desirable Characteristics of Accounting Information SUGGESTED READINGS 1. Bartlett, Sarah, 1998. Who can you trust? Business Week (October 5), pp. 135. 2. Beyer, A.; D. Cohen, T. Lys, and B. Walther, 2010. The Financial Reporting Environment: Review of Recent Literature. Journal of Accounting and Economics. 3. Fox, Justin, 1996. The glamorous world of accounting standards: Searching for nonfiction in financial statements. Fortune (December 23), pp. 38 - 40. 4. Kuttner, Robert, 1996. How a corporate watchdog nearly lost its bite. Business Week (May 20), p. 24. 5. McConnell Jr., Donald K; Banks, George Y., 2003. How Sarbanes - Oxley will change the audit process . Journal of Accountancy , Sep. 2003, Vol 196 Issue 3, pp. 49 - 56 . 6. Zweig, Phillip, and Dean Foust, 1997. Corporate America is fed up with FASB. Business Week (April 21), pp. 108 - 110.
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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, and why the latter generally provides a better measure of operating performance. In most cases, accrual - basis revenues do not equal cash receipts, nor do accrual expenses equal cash disbursements. The principles that govern expense recognition under accrual accounting are designed to alleviate the mismatching of effort and accomplishment that occurs under cash - basis accounting. Revenue is recognized when both the critical event and measurability conditions are met. The critical event establishes when the entity has done something to “earn” the asset being received, and measurability is established when the revenue can be measured with a reasonable degree of assurance. These conditions may be satisfied before, on, or after the point of sale. The matching principle determines how and when the assets “used up” in generating 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 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. All publicly traded companies must report EPS numbers on the income statement. The basic EPS is based on the weighted average number of shares actually outstanding during the period, while the diluted EPS is based on the “as if” all potentially dilutive securities were converted into common shares. Occasionally, changes in assets and liabilities resulting from incomplete or open transactions bypass the income statement and are reported as direct adjustments to stockholders’ equity and are called other comprehensive income components . Joint deliberations of the FASB and IASB resulted in a recent Exposure Draft on financial statement presentation that calls for displaying revenue and expense components for operating, investing, and financing sources. The proposed changes in presentation format are designed to enhance the predictive ability and decision usefulness of information presented in firms’ statement of comprehensive income. CHAPTER OUTLINE I. CASH VERSUS ACCRUAL INCOME MEASUREMENT A . Accrual - basis income measurement is the cornerstone of income measurement. 1. Revenues are recorded in the period when they are “earned” and become “measurable.” a. Revenues are “earned” when the seller has performed a service or conveyed an asset to a buyer. b. Revenues are “measurable” when the value to be received for that service or asset is reasonably assured and can be measured with a high degree of
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reliability. i. Deferred revenue exists when a liability to provide a good or service is created because the entity received cash or other assets in advance. ii. Accrued revenue is recorded when you provide a good or service but will not receive cash or other assets until a later time. 2. Expenses are the Expired costs or assets “used up” in producing those revenues and they are recorded in the same accounting period in which the revenues are recognized using the “matching principle.” a. Deferred expenses exist when an organization makes a payment in advance for a product or service that will be used in several periods to create revenue or cost offsets. b. Accrued expenses gradually build during the earnings process and are paid or used after the close of the accounting period. 3. Accrual accounting decouples measured earnings (i.e., revenues less expenses) from the amount of cash generated from operations because of both deferrals (payments or receipts postponed) and accruals (payments or receipts recognized). a. Accrual accounting revenues generally do not correspond to cash receipts for the period, nor do reported expenses always correspond to cash outlays of the period. b. As a result, accrual accounting can produce large discrepancies between measured earnings and the amount of cash generated from operations. c. However, accrual accounting earnings provide a more accurate measure of the economic value added during the period than do operating cash flows. B. Cash - basis income measurement is straightforward. 1. Revenues are recorded when cash is received. 2. Expenses are recorded when cash is paid. 3. Because of differences in the timing of when cash inflows and cash outflows occur, cash - basis income determination may distort one’s view of operating performance. a. Cash - basis income fails to properly match effort and accomplishment. b. Cash - basis income may not provide a reliable benchmark for predicting future operating results. C. The Canterbury Publishing example demonstrates the differences noted above. 1. There are several “facts” to consider. a. Canterbury sells three - year subscriptions of a quarterly publication to subscribers, who prepay the full subscription price. b. Canterbury takes out a three - year loan at the beginning of the three - year subscription period, but interest is payable at maturity of the loan. c. Costs to publish and distribute the magazine are paid in cash at the time of publication. 2. Cash - basis income determination distorts Canterbury’s operating performance. a. The entire cash inflow from subscription receipts would be treated as revenue in the first year when the subscriptions were sold. b. Operating expenses for publishing and distributing the magazine are recorded in equal amounts in each of the three years. c. The entire cost of financing the operations (i.e., interest expense) is recorded in year three. d. Consequently, Canterbury would report relatively high profits in year one
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when the subscriptions are sold and collected, followed by operating “losses” in years two and three. e. None of the cash - basis earnings figures provide a reliable benchmark for predicting future operating results. 3. Accrual - basis income determination is designed to alleviate the mismatching problems that exist under cash - basis accounting, making accrual earnings a more useful measure of a firm’s performance. a. Accrual - basis accounting allocates subscription revenue to each of the years as the magazine is delivered to the subscriber and the revenues are “earned.” b. Likewise, accrual accounting recognizes interest expense in each year the bank loan is outstanding, not just when the interest is paid. c. These modifications to the cash - basis results are made via a series of “ deferral” and “accrual” adjusting entries. 4. Accrual accounting better matches economic benefit with economic effort, thereby producing a measure of operating performance that provides a more realistic picture of past economic activities. 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. Just the same, accrual accounting does not capture all of an entity’s relevant economic events as they occur. In addition, entities that do not have a profit motive may prefer a cash - basis accounting system because of its simplicity. II. MEASUREMENT OF PROFIT PERFORMANCE: REVENUE AND EXPENSES A. Income is earned as the result of several (complex, multiple - stage processes) activities. 1. The critical issue then becomes the timing (stage) of income recognition. 2. The accounting process of recognizing income is comprised of two distinct steps. a. The revenue recognition principle establishes when revenue is recorded. b. The recognition of revenue then triggers the second step — matching against revenue the costs that expired (were used up) in generating that revenue. c. The difference between revenues and expired costs (expenses) is the net income (profit) recognized for the period. 3. Due to the double - entry, self - balancing nature of accounting, important changes occur in net assets (that is, assets minus liabilities) on the balance sheet. a. The basic accounting equation (Assets = Liabilities + Owners’ Equity) can be used to illustrate this point. i. Owners’ equity increases by the amount of the net income recognized ii. Net assets (that is, gross assets minus gross liabilities) increase by an identical amount. ii. Expense matching decreases net assets and owners’ equity by identical amounts. b. As a result, net asset valuation and net income determination are inextricably intertwined. B. A closer look at the revenue recognition criteria. Both the following conditions must be satisfied: 1. The “critical event” ( “Condition 1” ) in the process of earning the revenue has taken place (revenue has been earned). It may vary from industry to industry. 2. ( “Condition 2” ) – The amount of revenue that will be collected is reasonably
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assured and is measurable with a reasonable degree of reliability. Measurability must be based on objective and verifiable evidence. 3. In most instances the point of sale is the earliest moment in time at which both conditions 1 and 2 are satisfied . This is the dominant practice in most retail and manufacturing industries. 4. Under the percentage - of - completion method (see Chapter 3), Conditions 1 and 2 are satisfied prior to the point of sale (i.e., transfer of title). a. Condition 1 (critical event) is satisfied over time as the project progresses. b. Condition 2 (measurability) is satisfied since a firm contract with a known buyer at a set price exists. Teaching Tip: Normally, once gross revenues for the period are determined, the next step in determining net income is to accumulate and record the costs associated with generating the revenue. However, under the percentage - of - completion method, it is the recognition of expenses that drives the recognition of revenue. 5. Under the installment sales method (see Chapter 3), Conditions 1 and 2 may not be satisfied until after the point of sale — for instance, until cash is collected. 6. Revenue earned is recognized during the production phase when: a. A specific customer is identified and an exchange price is agreed upon. b. A significant portion of the services to be performed has been performed, and the expected costs of future services can be reliably estimated. c. An assessment of the customer’s credit standing permits a reasonably accurate estimate of the amount of cash that will be collected. 7. R evenue earned may be recognized on completion of production when: a. The product is immediately saleable at quoted market prices. b. The units are homogeneous. c. No significant uncertainty exists regarding the costs of distributing the product. 8. Revenue earned is recognized after the point of sale when one or more of the following conditions are present: a. Extreme uncertainty exists regarding the amount of cash to be collected from customers. This uncertainty may be attributable to: i. The precarious financial position of the customer. ii. Contingencies in the sales agreement that allow the buyer or seller to terminate the exchange. iii. The customer has (and frequently exercises) the right to return the product. b. Future services to be provided are substantial, and their costs cannot be estimated with reasonable precision. 9. Regardless of which basis of revenue recognition is used, the recognition of expenses must always adhere to the matching principle. C. Matching expenses with revenues earned. 1. The recognition of expenses generally follows the recognition of revenue. 2. Traceable (product) costs are costs that contribute directly to a particular sale or to revenues of a particular period. a. These costs are recorded as expenses in the same period that revenues are recognized. b. An example of product costs is costs of goods sold.
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3. Period costs are important in generating revenue, but their contribution to a specific sale or to revenues in a particular period is more difficult to quantify. a. These costs are associated with the time period in which they occur. b. An example of period costs is advertising expense. III. INCOME STATEMENT FORMAT AND CLASSIFICATION A. The multiple - step income statement is intended to subdivide income in a manner that facilitates the forecasting of future cash flows. 1. Virtually all decision models in modern corporate finance are based on future cash flows. 2. The intent of the multiple - step format is to classify separately income components that are “transitory” and to clearly differentiate them from income components believed to be “sustainable” or likely to be repeated in future reporting periods. 3. This format isolates a key figure called income from continuing operations. a. Ideally, this component of income should include only the normal, recurring, presumably more sustainable, ongoing operating activities of the organization. b. This income number sometimes includes gains and losses that occurs infrequently — called special or unusual items — but that arise from a firm’s ongoing, continuing operations. c. Therefore, income from continuing operations is intended to serve as a starting point for forecasting future profits. 4. Nonrecurring items are transitory and are disclosed separately below the income from continuing operations line. B. Nonrecurring items, including discontinued operations, and extraordinary items, are reported below income from continuing operations net of income tax effects. 1. This “net of tax treatment” is called intraperiod income tax allocation. a. If income tax were not matched with the item giving rise to it, then total reported income tax expense would combine taxes arising from both items that were transitory as well as from other items that were more sustainable. b. Mixing together the tax effect of continuing activities with the tax effect of single occurrence events would make it difficult for statement readers to forecast future tax outflows arising from ongoing events. 2. Income tax associated with sustainable income from continuing operations is separately disclosed from taxes arising from the transitory items. C. As defined in the U.S. GAAP, discontinued operations is a component of an entity , which comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Two conditions must be met for an entity to report discontinued operations: a. The operations and cash flows have been (will be) eliminated from the firm’s ongoing operations. b. The firm will not have any significant continuing involvement in the operations of the component after the disposal transaction. Failure to meet above conditions results in a firm reporting the component’s operating results as part of the continuing operations and prior year’s results are not restated. 1. Two components of discontinued operations are reported: a. Operating income or loss from operating the component from the beginning of the reporting period to the disposal date, net of related tax effects.
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b. “Gain or loss on disposal (net of tax)” has two components: (1) expected gain or loss on operations from the date a formal plan to discontinue operations is adopted by a firm’s board of directors to the disposal date, and (2) expected gain or loss on the sale of assets. i. Expected net losses are always recorded. ii. Expected net gains can be recorded to the extent that they offset realized losses. 2. A firm must disclose the identity of segment and details of disposal in the footnotes. 3. As recently proposed by FASB (April 2013), discontinued operations is a component of a business that has either been disposed of, or is classified as held for sale and represents a separate major line of business or major geographical area of operations, and is part of a single plan to dispose of a separate major line of business or geographical area of operation or is a business that meets the criteria for classification as held for sale upon acquisition. D. Extraordinary items. 1. Extraordinary items must meet both of the following criteria: a. The underlying event or transaction must be unusual in nature, i.e., possess a high degree of abnormality, considering its environment. b. The underlying event or transaction must be infrequent in occurrence, i.e., it would not reasonably be expected to recur in the foreseeable future. 2. Events that meet one, but not both, of these criteria, are reported as income from continuing operations. 3. FASB ASC Paragraph 470 - 50 - 45 - 1 covers the reporting of gains or losses from retirement of debt. This standard now allows for companies that routinely retire debt to record this economic event as part of pre - tax income from continuing operations with a separate line - item disclosure. a. If material in amount (i.e., of sufficient magnitude to make a difference in the decision - making process) then the item must be disclosed as a separate item in the “Special or unusual items” section of the income statement. b. Alternatively, a separate disclosure in the footnotes to the financial statements is allowed. E. Frequency and magnitude of various categories of transitory income statement items. 1. In the period between 2001 - 2011, about 60% of firms reported at least one of the transitory earnings components on their income statement. Theses items tend to be significant components of earnings. 2. About 57% of the firms reported “special or unusual items” in 2011 compared to 52.5% in 2002. 3. Discontinued operations appeared in about 13.5% of earnings statements in 2011 compared to 12% in 2002. 4. Firms reporting extraordinary items decreased from 13% in 2002 to less than 0.2% in 2011. 5. The majority of special or unusual items and extraordinary items (75.9% in 2011) were losses. 6. Special or unusual items are potential “red flags” for possible earnings management. Managers have an incentive to label losses as “results from special or unusual circumstances” than they do gains. Teaching Tip: In forecasting future cash flows, a reader of the financial statements must
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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. IV . REPORTING ACCOUNTING CHANGES - Although difficult to always achieve, consistency (using the same accounting methods from period to period), is a desired accounting outcome. Firms do switch methods or revise estimates when such changes better reflect the firm’s underlying economics. These changes fall into three categories. A. GAAP specifies to approaches for reporting accounting changes. Retrospective Approach is used for a change in accounting principle and change in reporting entity. Numbers in financial statements from prior years are revised to show the impact of the change. This enhances comparability and consistency over time. Prospective Approach is used for changes in accounting estimates. No adjustments are made to prior year numbers on the financial statements. The new estimated amounts are used in the year of change and future reporting periods. B. Changes in accounting principles occurs when a firm voluntarily changes from one acceptable accounting method to another (voluntary change) or a new standard is promulgated by GAAP that must be implemented (mandatory change). 1. GAAP requires the use of the retrospective approach unless it is impractical. a. Prior years’ financial statements that are presented for comparative purposes in the year of the change are revised to reflect the impact of the change in accounting principle using the same basis of accounting. 2. The new principle is applied in computing income from continuing operations in the year of the change. 3. A journal entry is made to adjust all account balances to reflect what those amounts would have been under the new method as of the beginning of the current year. 4. An adjustment is also made to the beginning balance of retained earnings to reflect the cumulative effect of the accounting principle change on all prior periods. 5. Disadvantage of this approach is that firms may use an aggressive accounting method in earlier years that overstates income and asset values in an effort to lower new debt or equity financing costs and later change to a more conservative method. 6. When the cumulative effect cannot be determined, the new method is applied prospectively beginning with year of change and to all future years. 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. C. Accounting changes.
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1. Changes in accounting estimates (revisions of estimates because new information or new experience) a. Changes in accounting estimates are handled prospectively — i.e., accounted for in the year of change and in future periods – prior year income is not adjusted. b. A change occurs concurrently with a change in the economic circumstances underlying an accounting estimate. 2. Change in reporting entity (change in economic units that comprise the reporting entity) . a. Comparative financial statements for prior years must be restated for comparative purposes to reflect the new reporting entity as if it had been in existence during all of the years presented. D. Earnings per share (EPS) data present the financial statement reader earnings data using a “common size” number. The basic EPS and the diluted EPS should be presented for the various components of earnings (income from continuing operations; discontinued operations; extraordinary items; and net income). V. Comprehensive Income is a change in equity (net assets) of a business entity that occurs during a reporting period from transactions or events from nonowner sources. A. Selected unrealized gains (or losses) arising from incomplete (or open) transactions sometimes bypass the income statement and are reported as direct adjustments to owners’ equity. 1. Such items, called “other comprehensive income,” include unrealized gains (losses) on “ available - for - sale” marketable securities, foreign currency translation gains (losses), unrealized losses resulting from minimum pension obligations, unrealized actuarial gains and losses on pension assets and liabilities, and unrealized gains and losses on certain derivatives. 2. Other Comprehensive Income components frequently arise from using fair value measurements for selected assets or liabilities. 3. Items included in net income are considered to be closed transactions. 4. Open transactions occur when balance sheet carrying amounts are changed even though the transaction is not yet closed. For example, unrealized gains and losses on marketable securities are not closed because the securities have not been sold. B. Comprehensive income is the net income from the traditional income statement plus or minus “ other comprehensive income components.” C. GAAP requires firms to report comprehensive income in a statement with equal prominence as other financial statements. Comprehensive income is reported either as a separate statement or as part of a statement combined with the income statement. VI. GLOBAL VANTAGE POINT A. Both FASB and IASB enacted changes in presentation of comprehensive income. IAS 1 allows firms to present a single statement of comprehensive income or alternatively present a net income statement and a statement of comprehensive income. Under GAAP, the option to report component of other comprehensive income as part of the statement of changes in stockholders’ equity is eliminated. GAAP requires a reclassification adjustment from other comprehensive income to net income on the face of the financial statements. VII. APPENDIX: REVIEW OF ACCOUNTING PROCEDURES AND T - ACCOUNT ANALYSIS A. The basic accounting equation is the foundation of financial reporting.
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1. A = L + OE. 2. At all times the dollar sum of a firm’s assets (A) must be equal to the dollar sum of the firm’s liabilities (L) plus its owners’ equity (OE) . 3. Creditors or owners finance assets . 4. The total resources a firm owns or controls (its assets) must by definition be equal to the total of the financial claims against those assets held by either creditors or owners. B. Revenue and expense accounts that appear on the income statement are owners’ equity accounts. 1. Revenues are owners’ equity increases since the owners benefit from the inflow of assets resulting from a sale. 2. Expenses are owners’ equity decreases since the owners’ claims against the assets of the company are reduced because the firm must relinquish an asset, inventory, in making the sale. C. Debit and credit basics. 1. Assets Liabilities Equity Revenues Expenses debit credit debit credit debit credit debit credit debit credit + - - + - + - + + - 2. The normal balance for an account is always the same as the increase side. a. Assets and expenses generally have debit balances. b. Liabilities, equity, and revenues generally have credit balances. 3. For each transaction, the dollar total of the debits must equal the dollar total of the credits. 4. Assets always equal liabilities plus owners’ equity. D. Adjusting entries are made whenever financial statements are prepared. 1. Insures that economic events that have occurred are reflected in the accounts. 2. There are four types of adjusting entries. a. Adjustments for prepayments are required because of the passage of time. i. Entries of this type generally require a debit to an expense account and a credit to an asset or contra - asset account. ii. Examples include prepaid rent, prepaid insurance, and depreciation or amortization of long - term assets. b. Adjustments for unearned revenue recognize that amounts paid in advance have been earned. Entries of this type generally require a debit to a liability account and a credit to a revenue or sales account. c. Adjustments for accrued expenses recognize that expenses are incurred when the underlying economic event occurs, not necessarily when the cash flows out. Entries of this type generally require a debit to an expense account and a credit to a liability account. d. Adjustments for accrued revenue recognize that revenue is earned when the underlying services have been performed or when goods are exchanged, not necessarily when cash is received. Entries of this type generally require a debit to an asset account and a credit to a revenue or sales account. 3. The financial statements are prepared after all adjusting entries have been made. E. Financial statement preparation 1. The income statement is prepared first so that the net income amount can be determined. 2. Net income is used to update the owners’ equity section in the balance sheet. F. Closing entries are required to reset the revenue and expense accounts to zero in
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order to prepare the accounts for the next period’s transactions. 1. All income statement accounts with debit balances are credited so that their balances are r eset to zero. 2. All income statement accounts with credit balances are debited so that their balances are reset to zero. 3. The debit or credit amount that is required to balance the two entries above is made to retained earnings.
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CHAPTER QUIZ 1. Thousand Trails, Inc. owns and operates membership resort campgrounds in the U.S. Memberships allow a member’s family unlimited use of the company’s present and proposed campgrounds over the lifetime of the member for an initial membership fee. Under the terms of the membership sales agreement, no refunds are available once memberships are sold, even if additional campgrounds or additional facilities at existing sites are not completed. How should Thousand Trails recognize membership revenue? a. Membership sales should be recognized as revenue over the life of each member. b. Membership sales should be recognized as revenue over the estimated life of an “average member,” based on a membership profile. c. Membership sales should be recognized as revenue when the membership agreement is signed. d . Membership sales should be recognized based on members’ actual use of the facilities. 2. A local ski club offers membership for a two - year period under the following terms: • Applicants pay the entire membership fee in four quarterly installments (i.e., $250 every three months) during the first year of the contract; • Applicants are entitled to discounted lift tickets and hotel room accommodations during the two - year membership period (including off - season room accommodations and lift tickets for mountain biking). Based on experience, the club is able to estimate with reasonable accuracy its uncollectible receivables. If the club prepares quarterly income statements, what amount of membership revenue will be reported in the first quarter during the first year of each membership? a. $125 b. $250 c. $1,000 d. $2,000 3. The matching principle encourages: a. The recognition of expenses when cash is paid for supplies. b. The recognition of depreciation expense for property, plant, and equipment over their useful lives. c. The reconciliation of net income and comprehensive income in a separate financial statement. d. The recording of period costs on the balance sheet. 4. TJX is a retailer that offers “layaway” sales to its customers. TJX retains the merchandise, sets it aside in its inventory, and collects a cash deposit from the customer. The merchandise generally is not released to the customer until the customer pays the full purchase price. When may TJX recognize revenue for merchandise sold under its layaway program? a. TJX should recognize revenue under its layaway program upon delivery of the merchandise to the customer. b. TJX should recognize revenue under its layaway program as cash deposits are collected. c. TJX should recognize revenue under its layaway program when the inventory is set aside. d. TJX should recognize revenue under its layaway program in equal amounts each month during the layaway period.
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5. A biotechnology firm provides research and development activities for a customer for a specified term. The customer needs to use certain technology owned by the biotechnology firm for use in its research and development activities. The technology is not sold or licensed separately without the research and development activities. Under the terms of the arrangement, the customer is required to pay a nonrefundable “technology access fee” in addition to periodic payments for research and development activities over the term of the contract. When is the technology access fee recognized as revenue? a. When the agreement is signed. b. When the research activity begins. c. When the research activity is completed. d. Systematically over the periods that the research is performed. 6. Under the current GAAP, gains and losses from retirement of debt for companies that routinely retire and reissue debt is treated as income from continuing operations. Companies retiring material amount of debt could account for these retirements as follows: a. A separate item in the “special or unusual items” section of the income statement ownership. b. A special disclosure in the footnotes to the financial statements . c. As an extraordinary item if meets the criteria of being unusual in nature and occurs infrequently. d. All of the above. 7. Extraordinary items, unusual gains and losses, and discontinued operations illustrate the difficulty of deciding what constitutes income from continuing operations. In developing an estimate of a firm’s “earning power,” analysts normally exclude all items that are unusual or nonrecurring in nature. As an analyst, is income from continuing operations your best estimate of future earnings? a. Yes. Since income from continuing operations excludes nonrecurring items, it is the best estimate of future earnings. b. No. One’s best estimate of future earnings should begin with income from continuing operations, but should exclude all of the unusual items as well. c. No. One’s best estimate of future earnings should begin with income from continuing operations, but should exclude all of the unusual items and the nonrecurring non - operating items as well. d. No. Net income is the best starting point for estimating future earnings. 8. 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.
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9. On November 1, 2015, Key Co. paid $7,200 to renew its insurance policy for three years. On December 31, 2015, Key’s unadjusted trial balance showed $180 for prepaid insurance and $8,820 for insurance expense. Given that Key prepares financial statements quarterly, what amounts should Key report for prepaid insurance and insurance expense in its December 31, 2015, financial statements? Prepaid Insurance Insurance Expense a. $6,600 $2,400 b. $6,800 $2,400 c. $6,800 $2,200 d. $6,980 $2,020 10. 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. QUIZ ANSWERS: 1. c. Under the terms of the membership sales agreement, no refunds are available once memberships are sold and the company is not obligated to provide additional facilities. Therefore, it is appropriate to recognize revenue at the time the membership agreement is signed. 2. a. Only $125 per membership will be recognized as revenue each quarter during the first year. The remaining $125 per quarter will be revenue during the second year. This allocation of the cash receipts is necessary since the revenue is earned over the two - year membership period (as services are provided). 3. b. Matching is the expense recognition principle of “associating cause and effect.” While a direct cause and effect relationship between depreciation expense and specific revenues usually cannot be demonstrated, such costs are capable of being related to specific accounting periods on the basis of a systematic and rational allocation among the periods benefited. 4. a. Provided that the other criteria for revenue recognition are met, TJX should recognize revenue from sales made under its layaway program upon delivery of the merchandise to the customer. Until then, the amount of cash received should be recognized as a liability. TJX should not recognize revenue upon receipt of the cash deposit since it retains the risks of ownership of the merchandise, receives only a deposit from the customer, and does not have an enforceable right to the remainder of the purchase price. 5. d. Unless the up - front fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process, the deferral of revenue is appropriate. In the situation described, signing the contract is not a discrete earnings event. The terms, conditions, and amounts of technology access fees typically are negotiated in conjunction with the pricing of all the elements of the R&D arrangement. The fact that the biotechnology firm does not sell the initial rights separately supports deferral of revenue. Further, performing under the terms of the arrangements, not simply originating a revenue - generating arrangement, completes the earnings process.
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6. d. Current GAAP allows for a company to record the gain or loss on extinguishment of debt to be recorded as income from continuing operations if it does not meet the criteria of unusual in nature and infrequency of occurrence . 7. c. No. Operating/unusual items are shown “above the line” in the income statement. Therefore, an analyst would have to adjust the income from continuing operations amount for the effects of nonrecurring non - operating /unusual items. (However, note that some firms that report irregular items seem to be “accident prone” and report irregular items on a regular basis. Keep in mind that although they are infrequent in nature, these events still have implications for the value of the firm and cannot be ignored altogether). 8. 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. 9. c. Given the amounts on the unadjusted trial balance, it is clear that Key debited insurance expense for the entire $7,200 payment made on November 1. As of December 31, there are still 34 months of coverage remaining. Therefore, $6,800 is the balance in prepaid insurance. Insurance expense is the $8,820 from the unadjusted trial balance minus the $6,800 moved into prepaid insurance plus the $180 of prepaid insurance on the unadjusted trial balance. In other words, the cost of the insurance policy went up from $180 per month to $200 per month. Therefore, 2010 has 10 months of coverage under the old policy ($1,800) and two months of coverage under the new policy ($400). 10. a. Comprehensive income components are shown net of their related tax effects. RECOMMENDED EXHIBITS 1. Figure 2.1 — Canterbury Publishing comparison of accrual and cash - basis income. 2. Figure 2.2 — The revenue recognition process. 3. Figure 2.5 — Proportion of firms reporting nonrecurring items (2002 - 2011). 4. Exhibit 2.4 - Types of Accounting Changes SUGGESTED READINGS 1. Hatelstad, L. 1998. Measure for measure: Economic value added theory provides a new way to value companies. Where does high tech fit in? The Red Herring (January), pp. 46 - 48. 2. Kahn, J. 2000. Presto chango! Sales are huge! Fortune (March 20). 3. MacDonald, E. 2000. Fess - uptime. Forbes (September 18). 4. MacDonald, E. 2000. Panel leaves untouched rule letting firms’ book revenue from bartered ads. The Wall Street Journal (January 26).
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CHAPTER 3 ADDITIONAL TOPICS IN INCOME DETERMINATION Chapter Overview This chapter emphasizes the special accounting procedures used when revenue recognition doesn’t occur at the point of sale. The “critical event” and “measurability” conditions for revenue recognition are typically satisfied at the point of sale. However, there are circumstances — long - term construction contracts, production of natural resources, and agricultural commodities — where it is appropriate to recognize revenue prior to sale. Alternatively, revenue (and profit) recognition may be delayed until after the sale — specifically, when cash is collected. This approach is used in instances where there is considerable uncertainty as to the collectability of the sales price or where there are significant costs or uncertainties that may occur following the sale that are difficult to predict. Franchise sales, sales with a right of return, and bundled sales (especially technology sales that bundle software and hardware products along with technical support) pose particularly challenging revenue recognition issues and statement users need to be aware of the potential accounting abuses. The financial reporting must reflect the revenue when it is earned. This earnings process may be as early as technological certainty or as late as when the support for the product expires. The broad criteria for revenue and expense recognition leave room for considerable latitude and judgment. Management can sometimes exploit this flexibility in GAAP to hide or misrepresent the underlying economic performance of a company. Companies sometimes fail to adjust their revenue and expense recognition policies when economic conditions change. In addition, management of an organization may try to reach short - term earnings projections by manipulating the flexibility of income and expense recognition under generally accepted accounting principles. This chapter outlines some of the more common ways of managing earnings that have come under SEC scrutiny. Auditors and financial statement users must be aware of management’s incentives to manage earnings and the various ways it can be accomplished. Once discovered, errors and irregularities must be corrected and disclosed. The errors and irregularities discovered in subsequent periods are corrected through a prior period adjustment to retained earnings. While IFRS and U.S. GAAP rules for revenue recognition and measurement largely overlap, important differences exist for long - term construction contracts and for installment sales contracts. A current Exposure Draft, if adopted, would substantially change current revenue recognition practices, particularly percentage - of - completion for long - term construction contracts and multiple - element sales contracts. CHAPTER OUTLINE I. REVENUE RECOGNITION PRIOR TO SALE A. Revenue recognition prior to sale — Condition 1 (the “critical event”) and Condition 2 (“measurability”) from Chapter 2 are both satisfied prior to the time of the sale. 1. Percentage - of - completion method recognizes revenue, cost, and gross profit as progress toward completion is made and is used primarily for long - term construction contracts. a. This method requires fairly good estimates of progress. b. Cost - to - cost ratio: % complete = costs incurred to date ÷ estimate of total costs. c. Current revenue (gross profit) = % complete x estimated total revenue (gross
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profit) - revenue (gross profit) recognized in previous years. d. A change in cost estimate is accounted for in a cumulative catch - up manner, i.e., accounted for such that the balance sheet is as it would have been if the revised estimate had been the original estimate. e. A current asset results when total costs and recognized profit exceed billings. f. A current liability results when billings exceed total costs and recognized profit. g. Estimated losses on a contract are recognized in their entirety as soon as it becomes known that a loss will ensue. 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. 2. Completed Contract Method is used when it is not possible to determine expected costs with a high degree of reliability. It is not a method that recognizes revenue and profits prior to sale. a. Therefore, no interim revenue, costs, or gross profit are recorded. b. These items are accumulated on the balance sheet, but not reflected on the income statement until the project is completed. 3. Long - term contract losses (regardless of the revenue recognition method) : a. Cost increases require current period adjustment of excess gross profit recognized in earlier periods. b. With unprofitable contracts, the entire expected loss must be recognized in the current period (as well as the recovery of previously recognized revenue and gross profit). 4. Revenue R ecognition on Commodities: a. The Completed - Transaction (Sales) Method recognizes income when the commodities are sold. b. The Market Price (Production) Method recognizes income when the agricultural commodities are harvested or when the natural resources are extracted. i. This alternative assumes that well - organized liquid markets exist for the commodities. ii. Changes in the market value of the commodities while they are held in storage are reflected on both the balance sheet and income statement. c. Comparisons of these two methods: i. The completed transaction (sales) method merges the results of speculative and operating activity and does not reflect the separate results of either. ii. The market price (production) method has the advantage of explicitly recognizing the s eparate results arising from operating and speculative activities. II. REVENUE RECOGNITION SUBSEQUENT TO SALE — Conditions 1 and 2 are both satisfied subsequent to the time of the sale. 1. This treatment is acceptable only under highly unusual circumstances. For example, when the risk of noncollection is unusually high and when there is no reasonable basis for estimating the proportion of installment accounts likely
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