FINANCIAL STATEMENT INFLUENCES Chapter 6

CHAPTER 6 OBJECTIVES Indicate how judgment influences financial statement disclosures. Indicate how judgment influences financial statement disclosures. Distinguish between revenue and capital expenditures; product and period costs; fixed and variable costs; and controllable and uncontrollable costs. Distinguish between revenue and capital expenditures; product and period costs; fixed and variable costs; and controllable and uncontrollable costs. Determine how various cost classifications affect financial statement analysis. Determine how various cost classifications affect financial statement analysis.

CHAPTER 6 OBJECTIVES (CONT.) Describe how managerial choices affect reported numbers and discuss ways to validate the integrity of those choices Describe how managerial choices affect reported numbers and discuss ways to validate the integrity of those choices Articulate the value of a standard unqualified audit report to analysis. Understand why adverse reports, disclaimers of opinions, and going concern questions limit analysis. Articulate the value of a standard unqualified audit report to analysis. Understand why adverse reports, disclaimers of opinions, and going concern questions limit analysis.

FINANCIAL REPORTING JUDGMENT Judgments related to financial reporting inputs Judgments related to financial reporting inputs Generally accepted accounting principles (GAAP) Generally accepted accounting principles (GAAP) Regulation by the Securities and Exchange Commission (SEC) Regulation by the Securities and Exchange Commission (SEC) Managerial choices about alternative accounting methods Managerial choices about alternative accounting methods Nominal dollar concept of capital maintenance Nominal dollar concept of capital maintenance

FINANCIAL REPORTING JUDGMENT (CONT.) Judgment related to financial statement analysis Judgment related to financial statement analysis Analytical judgment—the ability to reach informed opinions about financial statements and related disclosures Analytical judgment—the ability to reach informed opinions about financial statements and related disclosures Requires a logical interpretation of economic reality Requires a logical interpretation of economic reality

BASIC COST CONSIDERATIONS Economic sacrifice made to acquire something of value; assists in wealth maximization; and disclosures depend on GAAP (revenue versus capital expenditures) and industry (e.g., manufacturing versus retail businesses) Economic sacrifice made to acquire something of value; assists in wealth maximization; and disclosures depend on GAAP (revenue versus capital expenditures) and industry (e.g., manufacturing versus retail businesses)

BASIC COST CONSIDERATIONS (CONT.) Revenue expenditures Revenue expenditures Costs that produce revenues in the current reporting period Costs that produce revenues in the current reporting period Treated as an expense on the income statement Treated as an expense on the income statement Capital (asset) expenditures Capital (asset) expenditures Costs that produce revenues in the current and future reporting periods Costs that produce revenues in the current and future reporting periods Treated initially as an asset on the balance sheet Treated initially as an asset on the balance sheet Expensed in a systematic manner as a portion of the asset is used in generating periodic revenues Expensed in a systematic manner as a portion of the asset is used in generating periodic revenues

BASIC COST CONSIDERATIONS (CONT.) Capital and revenue expenditures Capital and revenue expenditures Required disclosures sometimes deviates from theoretical basis (e.g., reporting research and development costs as a revenue expenditure) Required disclosures sometimes deviates from theoretical basis (e.g., reporting research and development costs as a revenue expenditure) Managerial behavior sometimes influences disclosures (e.g., adjustment of lease terms so that lessee reports leased assets as revenue expenditures) Managerial behavior sometimes influences disclosures (e.g., adjustment of lease terms so that lessee reports leased assets as revenue expenditures)

BASIC COST CONSIDERATIONS (CONT.) Product and period costs (Exhibit 6-1) Product and period costs (Exhibit 6-1) Product costs—inventory-related costs, reported as capital expenditures Product costs—inventory-related costs, reported as capital expenditures Period costs—noninventoried costs, reported as revenue expenditures Period costs—noninventoried costs, reported as revenue expenditures

BASIC COST CONSIDERATIONS (CONT.) Industry influences reporting for certain product and period costs Industry influences reporting for certain product and period costs Merchants have only one type of inventory: finished goods Merchants have only one type of inventory: finished goods Manufacturers have three types: raw materials, work in process, and finished goods Manufacturers have three types: raw materials, work in process, and finished goods A merchant’s costs incurred with selling inventory (e.g., salaries and depreciation) are period costs A merchant’s costs incurred with selling inventory (e.g., salaries and depreciation) are period costs A manufacturer’s costs incurred in converting inventory to its finished state (e.g., salaries and depreciation) attach to the cost of the inventory and are product costs A manufacturer’s costs incurred in converting inventory to its finished state (e.g., salaries and depreciation) attach to the cost of the inventory and are product costs

OTHER COST FACTORS Cost control Cost control Controllable cost—one that can be controlled or heavily influenced by managerial decisions; also known as discretionary costs Controllable cost—one that can be controlled or heavily influenced by managerial decisions; also known as discretionary costs Uncontrollable cost—one that cannot be controlled in the short run; also known as a discretionary cost Uncontrollable cost—one that cannot be controlled in the short run; also known as a discretionary cost Managerial decisions about discretionary costs influences short and long-term profitability (e.g., spending on research and development or advertising) Managerial decisions about discretionary costs influences short and long-term profitability (e.g., spending on research and development or advertising)

OTHER COST FACTORS (CONT.) Cost behavior Cost behavior Fixed costs—dollar amount remains constant in total, regardless of sales level; cost per unit is inversely related to sales volume Fixed costs—dollar amount remains constant in total, regardless of sales level; cost per unit is inversely related to sales volume Variable costs—dollar amount is constant on per unit basis; total costs change in direct proportion to changes in sales volume Variable costs—dollar amount is constant on per unit basis; total costs change in direct proportion to changes in sales volume

OTHER COST FACTORS (CONT.) Breakeven point—activity level where revenues equal total fixed and variable costs Breakeven point—activity level where revenues equal total fixed and variable costs Capital intensive industries tend to have a higher breakeven point than labor intensive ones, but they tend to reap greater profit on per unit basis once the breakeven point is surpassed. Capital intensive industries tend to have a higher breakeven point than labor intensive ones, but they tend to reap greater profit on per unit basis once the breakeven point is surpassed. Investing decisions (e.g., for plant and equipment) alter an entity’s breakeven point (Exhibit 6-2A and B) Investing decisions (e.g., for plant and equipment) alter an entity’s breakeven point (Exhibit 6-2A and B) Industry specific measures sometimes help with cost-volume-profit analysis (e.g., the airline industry’s disclosures of passenger load Industry specific measures sometimes help with cost-volume-profit analysis (e.g., the airline industry’s disclosures of passenger load

OTHER COST FACTORS (CONT.) Cost composition Cost composition Influenced by the mix of products sold by an entity. Influenced by the mix of products sold by an entity. Different products have different cost structures yielding different profit margins Different products have different cost structures yielding different profit margins Current product composition affects net income Current product composition affects net income Changes in product composition alter profitability Changes in product composition alter profitability

OTHER COST FACTORS (CONT.) Income statements do not disclose costs by level of control, behavior, or composition Income statements do not disclose costs by level of control, behavior, or composition

MANAGERIAL JUDGMENTS AND ESTIMATES Companies should report representationally faithful financial statements; financial reporting latitude allows reporting alternatives; aggressive accounting or fraudulent reporting overstates income and results in a misallocation of resources Companies should report representationally faithful financial statements; financial reporting latitude allows reporting alternatives; aggressive accounting or fraudulent reporting overstates income and results in a misallocation of resources

MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) Accounting methods Accounting methods Primary qualitative characteristics— relevance and reliability Primary qualitative characteristics— relevance and reliability Analytical issue: companies sometimes must trade relevant disclosures for reliable ones or vice-versa Analytical issue: companies sometimes must trade relevant disclosures for reliable ones or vice-versa

MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) Secondary qualitative characteristics— consistency (over time) and comparability (among firms) in financial disclosures Secondary qualitative characteristics— consistency (over time) and comparability (among firms) in financial disclosures Analytical issue: inconsistency or incomparability hinder analysis; data should be adjusted to insure valid benchmarking Analytical issue: inconsistency or incomparability hinder analysis; data should be adjusted to insure valid benchmarking

MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) Estimation of future events Estimation of future events Needed to properly allocate capitalized costs Needed to properly allocate capitalized costs Managerial judgment required in a highly uncertain environment (i.e., the future) Managerial judgment required in a highly uncertain environment (i.e., the future)

MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) Revenue recognition policy Revenue recognition policy Based on two factors: Based on two factors: Revenue realization occurs when goods or services are exchanged for cash or claims to cash Revenue realization occurs when goods or services are exchanged for cash or claims to cash Revenues are earned when an entity has fulfilled its obligations and is entitled to the attendant economic benefits Revenues are earned when an entity has fulfilled its obligations and is entitled to the attendant economic benefits

MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) Revenue recognition policy Revenue recognition policy Problem—judgment is involved as to when revenues are realized and earned Problem—judgment is involved as to when revenues are realized and earned Potential exists for premature revenue recognition (front-end loading of revenues) Potential exists for premature revenue recognition (front-end loading of revenues) Defenses—careful analysis and evaluation of current information Defenses—careful analysis and evaluation of current information

MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) Matching of expenses to revenues Matching of expenses to revenues Expenses should be recognized in the period revenues are earned (i.e., matched against revenues or reported as incurred) Expenses should be recognized in the period revenues are earned (i.e., matched against revenues or reported as incurred) Problem—judgment is involved as to when expenses are incurred Problem—judgment is involved as to when expenses are incurred Potential exists for deferring expense recognition (back-end loading of expenses) Potential exists for deferring expense recognition (back-end loading of expenses) Defenses—careful analysis and evaluation of current information Defenses—careful analysis and evaluation of current information

AUDIT OPINIONS Independent expression of the fairness of financial statements in accordance with generally accepted accounting principles Independent expression of the fairness of financial statements in accordance with generally accepted accounting principles

AUDIT OPINIONS (CONT.) Types of audit reports Types of audit reports Standard unqualified report—provides greater assurance to the analyst than the other types of opinions; also known as a clean opinion Standard unqualified report—provides greater assurance to the analyst than the other types of opinions; also known as a clean opinion Qualified report, due to a departure from GAAP Qualified report, due to a departure from GAAP Adverse report—lack of conformity with GAAP (gross GAAP departures) Adverse report—lack of conformity with GAAP (gross GAAP departures)

AUDIT OPINIONS (CONT.) Types of audit reports (cont.) Types of audit reports (cont.) Qualified report, due to a limitation or audit procedures (scope) Qualified report, due to a limitation or audit procedures (scope) Disclaimer of report—inability to render an opinion because sufficient evidence could not be obtained (gross scope limitations) Disclaimer of report—inability to render an opinion because sufficient evidence could not be obtained (gross scope limitations)

AUDIT OPINIONS (CONT.) Other audit considerations: Other audit considerations: Explanatory language—describes the circumstances why an unqualified opinion was not rendered Explanatory language—describes the circumstances why an unqualified opinion was not rendered Going concern issue—auditor questions whether an entity can continue in the normal course of business, regardless of the type of audit opinion they issue Going concern issue—auditor questions whether an entity can continue in the normal course of business, regardless of the type of audit opinion they issue

APPLE COMPUTER AND THE PC INDUSTRY PC companies reported economic events on a comparable and consistent basis PC companies reported economic events on a comparable and consistent basis Inventory reductions reduced potential issues related to cost considerations Inventory reductions reduced potential issues related to cost considerations

APPLE COMPUTER AND THE PC INDUSTRY (CONT.) Research and development costs are significant in the industry, but they are immediately expensed in accordance with GAAP; the analyst should monitor R&D spending and impact on income Research and development costs are significant in the industry, but they are immediately expensed in accordance with GAAP; the analyst should monitor R&D spending and impact on income Entities received unqualified audit opinions during the period analyzed Entities received unqualified audit opinions during the period analyzed