Additional Dimensions of Financial Reporting Chapter 14

Comprehensive Income GAAP mandate that certain changes in the value of assets and liabilities be excluded from net income.

Comprehensive Income Many readers of financial statements believe the exclusion of this information reduces the usefulness of the net income figure.

Comprehensive Income As a result, the FASB now requires firms to report comprehensive income.

Comprehensive Income Comprehensive income is net income plus revenues, expenses, gains, and losses that are excluded from net income.

Accounting Changes There are three types of accounting changes: –A change in accounting principle –A change in accounting estimate –A change in reporting entity

Change in Accounting Principle A company should be consistent from period to period in principles used, but firms do sometimes change from one principle to another.

Change in Accounting Principle The general rule requires a cumulative effect adjustment.

Change in Accounting Principle In the year of change, account balances are restated to show those amounts that would have appeared if the new method had been used all along.

Change in Accounting Principle A common example is in the area of depreciation.

Change in Accounting Principle Assume that a company has used sum-of-the-years'-digits depreciation for two years, resulting in a total in the Accumulated Depreciation account of $5,000

Change in Accounting Principle At the beginning of year three, the company decides to switch to straight- line for the asset.

Change in Accounting Principle If the company had used straight-line for the first two years, then the total in the Accumulated Depreciation account would have been $2,000.

Change in Accounting Principle Remember that Depreciation Expense reduces Retained Earnings; so, Retained Earnings in our example is $3,000 ($5,000 - $2,000) too low, and Accumulated Depreciation is $3,000 too high.

Change in Accounting Principle To adjust in the year of the change, the firm will record a $3,000 increase in the account titled "Cumulative Effect of Change in Accounting Principle" (which will increase Retained Earnings) and a $3,000 decrease in Accumulated Depreciation.

Change in Accounting Principle The "Cumulative Effect..." account will appear as the last item at the bottom of the income statement.

Change in Accounting Principle GAAP requires note disclosure of what net income would have been in the current and prior years had the new method been used, referred to by most accountants as pro forma amounts.

Change in Accounting Principle There is an exception to the general rule.

Change in Accounting Principle Some changes are accounted for retroactively, meaning that prior years' financial statements are restated to reflect the use of the new method.

Change in Accounting Principle Remember that with the general rule, only the current year's statements are restated.

Change in Accounting Principle Restating prior years' statements is done sparingly because the appearance of different sets of numbers may erode public confidence in financial reporting.

The retroactive approach is used in the cases: A change from LIFO to another inventory method.

The retroactive approach is used in the cases: A change in the method of accounting for long-term construction contracts.

The retroactive approach is used in the cases: A change to or from the full-cost method by firms in the extractive industries.

The retroactive approach is used in the cases: A change made by a firm issuing financial statements to the public for the first time.

The retroactive approach is used in the cases: When required as part of the transition process for a new FASB method.

Change in Accounting Estimate Changes in accounting estimates are accounted for currently and prospectively, meaning that they are included in the year of the change and future years, if appropriate.

Change in Accounting Estimate Changes in accounting estimates are accounted for currently and prospectively, meaning that they are included in the year of the change and future years, if appropriate.

Change in Accounting Estimate Prior years' statements are NOT restated.

Change in Accounting Estimate There are so many estimates used in accounting that restating every time a change in estimate occurred would be a nightmare.

Change in Accounting Estimate The effects of changes in accounting estimates on net income must be disclosed in the notes to the financial statements.

Change in Accounting Estimate There are so many estimates used in accounting that restating every time a change in estimate occurred would be a nightmare.

Change in Accounting Estimate If there is a change in an estimate which is part of the depreciation calculation, then the new depreciation expense is calculated by doing the following.

Change in Accounting Estimate Salvage value is subtracted from the book value of the asset, and the difference is divided by the remaining estimated useful life.

Change in Reporting Entity A change in reporting entity occurs when a firm changes the specific subsidiaries included in its consolidated financial statements.

Change in Reporting Entity Such changes are accounted for retroactively, meaning that prior years' financial statements are restated, thus ensuring comparability of the financial statements.

Segment Reporting All publicly held corporations are required to report certain disclosures about segments in notes to the financial statements.

Segment Reporting An industry segment is a component of a firm that provides a product or service, or a group of related products or services, to unaffiliated customers.

Segment Reporting In identifying segments, factors to consider include the underlying nature of the product or service, the production process, markets, and the marketing process.

Segment Reporting Segment data can help users of financial statements to assess risk and future trends.

Operating Segments An operating segment is a component of a firm that does the following: –Engages in business activities from which it can earn revenues and incur expenses. –Has operating results that are regularly reviewed by the firm’s chief operating decision maker. –Has financial information available.

For each major segment, firms must report: Operating profit or loss, calculated by subtracting a segment's operating expenses from its revenue. –This does not include an allocation of general corporate expenses.

For each major segment, firms must report: Identifiable assets, which are assets used exclusively by the segment and a share of the assets used jointly with other segments.

For each major segment, firms must report: Other disclosures, including revenue from external customers and depreciation expense.

Geographic Areas A firms' foreign operations consist of those revenue-producing activities located outside the firm's home country.

Geographic Areas Disclosure of revenue, operating profit or loss, and identifiable assets must be made for both foreign and domestic operations.

Geographic Areas Information about foreign operations and export sales is particularly helpful in assessing a firm's risk.

Major Customers Firms are required to disclose if sales to a single customer exceed 10% of revenue.

Major Customers The customer's industry must be disclosed.

A firm's annual report includes these elements: An introductory letter written by the chief executive officer A review of the firm's types of businesses

A firm's annual report includes these elements: A financial summary for each of the five or ten most recent years

A firm's annual report includes these elements: A financial summary for each of the five or ten most recent years Management's discussion and analysis

A firm's annual report includes these elements: The auditor's report

A firm's annual report includes these elements: The auditor's report Management's statement of responsibility for preparation of financial statements and for maintaining an adequate system of internal controls

A firm's annual report includes these elements: Quarterly financial data

A firm's annual report includes these elements: Quarterly financial data Quarterly stock price and dividend data

A firm's annual report includes these elements: Quarterly financial data Quarterly stock price and dividend data A listing of officers and directors

Annual Reports Two types of forward-looking information are also presented in annual reports. –Management may know of existing circumstances which will have an impact on future operations.

Annual Reports Two types of forward-looking information are also presented in annual reports. –Management might also comment on anticipated trends and their effect on the firm's future.

Interim Statements In an effort to give timely information to users, all publicly held corporations, and many closely held companies, report financial information on an interim basis throughout the year.

Interim Statements Interim statements are highly abbreviated and contain limited note disclosures.

Interim Statements In addition, they are not audited.

Interim Statements Interim statement are prepared based on the same accounting principles as are used in the annual statements.

There are two exceptions: They frequently require use of additional estimates (inventory may be estimated, not counted physically). Some costs expensed in the annual report are not immediately expensed for the interim report if they clearly benefit more than one interim period.

Reports Filed With the SEC Firms must file with the SEC a 10-K report.

Reports Filed With the SEC It contains virtually all the information included in the annual report plus some additional disclosures about litigation, executive compensation, and shareholdings by officers and directors.

Reports Filed With the SEC It includes a firm's quarterly financial statements plus additional disclosures about litigation and defaults on debt securities.

The Efficient Market Hypothesis The efficient market hypothesis ( EMH ) states that publicly available information is fully reflected in share prices.

The Efficient Market Hypothesis Once a corporation releases information, that information is quickly and unbiasedly reflected in share prices.

Implications of EMH The implication is that a trading strategy based on such information will not be particularly successful.

Implications of EMH There is considerable evidence that share prices react very quickly (within hours) to accounting information.

Implications of EMH Several studies have shown that a small portion of the price change associated with an earnings announcement occurs during the 60 days following the announcement.

Implications of EMH The latter price change is smaller than the transaction costs, and a net profit could not be made.

Implications of EMH Managers should realize that they should not attempt to affect share price by using accounting ploys to influence reported earnings.

Implications of EMH Individual investors should realize that they are unable to earn abnormal profits by developing trading strategies based on publicly available information.

Implications of EMH Managers will feel that they can affect share price by using accounting ploys to influence reported earnings.

Implications of EMH Individual investors will feel that share prices do not necessarily reflect all publicly available information and will scour financial statements and other information in order to identify underpriced securities.

Implications of EMH Acceptance of the EMH does not undermine the usefulness of financial statements.

Implications of EMH All investors benefit from disclosure of financial information.

Implications of EMH Financial statements help stock markets identify relatively efficient companies and also can be used in corporate buyouts.

Implications of EMH Financial statements can be very useful in valuing closely held companies which are not publicly traded and can be used in credit- granting decisions and labor negotiations.

The EMH and Price-to- Earnings Ratios Some critics of the EMH recommend purchasing low P/E stocks.

The EMH and Price-to- Earnings Ratios This may or may not be good strategy because P/E ratios vary among firms for several reasons.

The EMH and Price-to- Earnings Ratios First, firms use different accounting principles which affect EPS.

The EMH and Price-to- Earnings Ratios Second, firms have variations in earnings growth which affect EPS.

The EMH and Price-to- Earnings Ratios Third, a firm may have a transitory component of income in a given year, and this will certainly have an effect on EPS.

Two Major Roles of Accounting Financial accounting plays two roles.

Two Major Roles of Accounting The first is to provide information useful for economic decision making.

Two Major Roles of Accounting The second role is to serve as basis for engaging in contracts.

Informational Role This role is emphasized by the FASB when it develops GAAP.

Informational Role The two primary qualities make accounting information useful.

Informational Role The first is relevance, which refers to an item's capacity to make a difference in a decision.

Informational Role The second is reliability, which refers to an item's integrity.

A Basis for Contracting Firms enter into contracts defined in terms of numbers from the financial statements.

A Basis for Contracting Changing the accounting principles used to prepare the statements alters the terms of contracts.

A Basis for Contracting The FASB rejects the approach that it should consider the economic consequences of their accounting principle choices.

A Basis for Contracting The FASB seeks “truth in accounting.”

Role of Corporate Managers Corporate managers play a role in accounting principle selection.

Role of Corporate Managers Managers may seek to enhance their own compensation or to reduce the possibility of violating loan agreements.

Role of Corporate Managers They may also seek to reduce political costs.

Earnings Management Managers are motivated to engage in earnings management, which involves making accounting decisions that result in favorable consequences for themselves and their firms.

Earnings Management The financial well-being of corporations and their managers can be significantly affected by reported accounting earnings.

Motivations for Earnings Management Lending agreements Managers’ bonuses Government intervention Stock market analysis Collective bargaining

Methods of Earnings Management Accounting methods Variety of assumptions Adoption date Restructuring charges Timing of transactions

Additional Dimensions of Financial Reporting End of Chapter 14