© 2005 Accounting 1/e, Terrell/Terrell External Reporting for Public Companies Chapter 13

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 1 Determine the role of ethics in business reporting and the implications of the Sarbanes-Oxley Act of 2002.

© 2005 Accounting 1/e, Terrell/Terrell Reporting Scandals Since trade began, some business people have used unethical business practices. Enron’s gas futures contracts created future liabilities that might cause significant future losses. When the gas markets dropped dramatically, Enron incurred all possible losses.

© 2005 Accounting 1/e, Terrell/Terrell Reporting Scandals WorldCom decided to increase assets and reduce expenses in order to inflate its net income. The Enron and WorldCom cases illustrate the need for accountants and auditors to adhere to their strict code of conduct.

© 2005 Accounting 1/e, Terrell/Terrell The Sarbanes-Oxley Act This act increased the responsibility of management for the representational faithfulness of the financial statements of public companies. The CEO and CFO of the company must certify each 10K and 10Q form. The act makes it illegal for any officer or director to mislead, coerce, influence, or manipulate an auditor of the financial statements.

© 2005 Accounting 1/e, Terrell/Terrell Increased Ethics The Sarbanes-Oxley Act assigns direct responsibility to the officers and directors of public companies for honesty in financial reporting. The Act requires companies to adopt a code of ethics for the CFO, controller, and chief accountant. It requires that the audit committee contains at least one member who is a financial expert.

© 2005 Accounting 1/e, Terrell/Terrell Code of Professional Conduct Responsibilities Public interest Integrity Objectivity Independence They set forth the conduct that conforms with and breaches those principles.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objectives 2 and 3 Understand the information found in a typical annual report and required on Form 10-K. Gather information about a company and obtain an annual report.

© 2005 Accounting 1/e, Terrell/Terrell Format of Annual Reports No two annual reports are exactly alike. The Sarbanes-Oxley Act added a requirement for a management report on internal control.

© 2005 Accounting 1/e, Terrell/Terrell Sample of Annual Report Common Contents Five-year selected financial data Management discussion and analysis (MD&A) Industry and geographical segments Disclosures about risk

© 2005 Accounting 1/e, Terrell/Terrell Disclosures about Risk Nature of operations Use of estimates in financial statements Use of significant estimates Concentrations of risk

© 2005 Accounting 1/e, Terrell/Terrell Obtaining Information Information about publicly traded companies can be found on the Internet, in the library, or from news sources.

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 4 Decipher items found on balance sheets and in the notes to financial statements of large or complex companies.

© 2005 Accounting 1/e, Terrell/Terrell Accounting Elements Found on Complex Corporations’ Financial Statements Public companies frequently engage in complex transactions which create accounts not usually found in smaller firms.

© 2005 Accounting 1/e, Terrell/Terrell Balance Sheet Accounts Current investments Tradingsecurities Available-for-salesecurities

© 2005 Accounting 1/e, Terrell/Terrell Balance Sheet Accounts Noncurrent investments Consolidated financial statements Minority interest in consolidated subsidiaries Controlling investment Held-to-maturity Influential investment

© 2005 Accounting 1/e, Terrell/Terrell Balance Sheet Accounts Operating lease Capital lease

© 2005 Accounting 1/e, Terrell/Terrell Balance Sheet Accounts Goodwill represents the excess paid for the assets of another entity over and above the fair market value of those assets.

© 2005 Accounting 1/e, Terrell/Terrell Balance Sheet Accounts They represent either an asset or a liability to the organization. Deferred income taxes arise because the tax laws in effect for any year often differ from the generally accepted accounting principles.

© 2005 Accounting 1/e, Terrell/Terrell Balance Sheet Accounts Defined contribution pension plan Postretirement benefits plan Defined benefit pension plan

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 5 Explain why recurring and nonrecurring items are presented separately on the income statement.

© 2005 Accounting 1/e, Terrell/Terrell Income Statement GAAP identifies special items and three kinds of nonrecurring events that receive different treatment on an income statement. Special items report events that are either unusual or not likely to recur and are disclosed separately in the operating expenses on the income statement.

© 2005 Accounting 1/e, Terrell/Terrell Income Statement A nonrecurring event is an event that is both unusual in nature and is not expected to recur. Events are separated from continuing income: 1.Discontinued operations 2.Extraordinary items 3.Cumulative effect of changes in accounting principles

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 6 Interpret the net of tax disclosure of extraordinary items, discontinued operations, and accounting changes on the income statement.

© 2005 Accounting 1/e, Terrell/Terrell Income Tax Disclosure The income tax amount shown in the income from continuing operations section is the amount of tax expense associated with the ongoing, recurring operation of the business. How should a company disclose the income tax effect of the nonrecurring items shown on the income statement?

© 2005 Accounting 1/e, Terrell/Terrell Income Tax Disclosure The portion of the business being eliminated is considered a business component provided that its assets, results of operations, and activities can be clearly distinguished from the other assets, results of operations, and activities of the entity. Gains or losses are reported net of tax.

© 2005 Accounting 1/e, Terrell/Terrell Income Tax Disclosure Extraordinary items are reported net of tax. A cumulative effect of a change in an accounting principle is also reported net of tax.

© 2005 Accounting 1/e, Terrell/Terrell Diluted Earnings per Share ConvertiblesecuritiesOptions

© 2005 Accounting 1/e, Terrell/Terrell Diluted Earnings per Share EPS= Net income Common stock outstanding shares BasicEPS= Net income – Preferred dividend requirements Weighted average common stock outstanding DilutedEPS= Net income – Preferred dividend requirements Common stock outstanding assuming dilution

© 2005 Accounting 1/e, Terrell/Terrell Example of Weighted- Average Shares On January 1 Carter-Abshire Company had 100,000 common shares outstanding. On April 1 and August 1 the company issues 20,000 new shares. What is the weighted-average shares?

© 2005 Accounting 1/e, Terrell/Terrell Example of Weighted- Average Shares January 1 April 1 August 1 100,000120,000140,0003/124/125/1225,00040,00058,333 Date(A)Number of shares outstanding(B)Periodoftime (A) × (B)

© 2005 Accounting 1/e, Terrell/Terrell Learning Objective 7 Discuss the importance of skepticism in using financial information.

© 2005 Accounting 1/e, Terrell/Terrell Be a Skeptical User of Financial Information Read the auditor’s report for any explanatory paragraphs, adverse opinion, or refusal to express an opinion. Analyze the financial statements, referring to notes to the statements for clarification. Look at the five-year (or longer) sales trends of the company and the industry in which it operates.

© 2005 Accounting 1/e, Terrell/Terrell Be a Skeptical User of Financial Information Look at the operating cash flows for the past five to ten years. Compute the ratios for the company and compare them to the industry averages.

© 2005 Accounting 1/e, Terrell/Terrell Be a Skeptical User of Financial Information Users of financial statements should be skeptical of financial information. Any information that appears to be contradictory or unbelievable should be carefully investigated using financial analysis tools.

© 2005 Accounting 1/e, Terrell/Terrell End of Chapter 13