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Financial Reporting



                               Accounting 518 Teaching Notes
                                    Financial Reporting
I.     Introduction
       A. The readings indicate many sources of useful accounting information
           1) MD&A
           2) Income
           3) Cash flow
       B. In this class, we will focus on the usefulness of income
           1) All -inclusive versus current operating earnings approach
           2) Concern over how to handle unusual items
           3) Combination with MD&A and footnote disclosure
           4) New statement on comprehensive income (SFAS 130)

II.    All inclusive versus current operating approach
       A. Define
       B. Which do we follow?
           (In general, all-inclusive with some deviations--give examples)

III.   Lecture/problem example on SFAS 130

IV.    Review Standards
       A. PPA's: SFAS 16:
          1) Review standard
          2) Explain income tax accounting exception
          3) Comment on interim reporting
       B. APBO20 - cover problem
       C. APBO30
          Give definitions of extraordinary items and format from bottom of income statement

V.     Debate all-inclusive versus current operating earnings

                                            1 of 18

                                          APBO 9

I.    Defines all-inclusive versus current operating approach

II.   ¶20-25 are superseded by APB30—purpose of reading:
      A. to understand the development/resolution of this issue
      B. to show the development of the definition of a prior period adjustment

                                           2 of 18

                                APBO 20: Accounting Changes

I.    Definitions

      A.) A change in accounting principle results from adoption of a generally accepted
          accounting principle (GAAP) different from the one used previously for reporting
          purposes; this includes not only accounting principles and practices but also the
          methods of applying them.
              Excludes: - initial adoption
                         - changes stemming from changes in the nature of transactions

      B.) Changes in estimates are revisions of factors considered as part of the estimation
          process typically used in financial statement presentations. (a good definition is not given)
              1) A change in estimates effected by a change in accounting principle.
                      Example: Switching to immediate expensing of an asset from deferral
                      and amortization because costs are no longer deemed to provide future

      C.) Change in the Reporting Entity
             1) This is a special type of change in accounting principle which results in
                 financial statements which report on a different entity
                      Example: Business combination accounted for by pooling of interest

      D.) Correction of an Error
          This is distinguishable from a change in estimate.

II.   Opinion

      A.) (¶18) "Most" changes in accounting principle should be recognized by including in
          net income of the period of the change the cumulative effect, based on a retroactive
          computation, of changing to a new accounting principle.
                Why? To instill confidence in financial statement issues, but that a few
                  specific changes in accounting principles should be reported by restating
                  prior periods' financial statements
                Why? See ―special changes requiring restatement,‖ below.
      B.) For most changes in accounting principle:
          1) Present financial statements of prior periods as previously reported
          2) Include cumulative effect in net income, N.O.T.
          3) Clearly disclose the effect of the change
          4) Present pro formas
          5) Note: Illustration in text

      C.) Cumulative effect
          It is different between (a) beginning retained earnings as reported and
                                  (b) beginning retained earnings that would have been reported
                                      had the newly adopted principle been applied all along.
                Recognizing only the direct effect of the change and related tax effects

                                               3 of 18

III.   Special Changes Requiring Restatement of Prior Period

       A.) (¶27) A change from LIFO to another
       B.) A change in accounting for long term construction contracts
       C.) A change to or from ―full cost‖ method in extractive industries
       D.) (SFAS 73) A change from RRB accounting to depreciation in accounting for railroad
           track structures.
       E.) Change from FIFO to LIFO.
            Just begin with the FIFO inventory at beginning of year of change because
               cannot determine the cumulative effect of the change
            Treatment: just disclose the effect of the change on the results of operations of
               the period of the change (including per share data) and explain the reason for
               omitting the cumulative effect and the pro forma amounts
       F.) Disclosures of above
           1) Nature of justification for change
           2) Effect of the changes on:
               (a) Income before extraordinary items,
               (b) Net income, and
               (c) Related per share amounts.

       G.) ¶29: One wouldn't want to initially read financial statements with a change treatment
                in it, because of lack of comparability, but think of bankers reaction to different
                Example in standard

IV.    Change in Accounting Estimates

       A.) Account for in the period of change or in current and future periods---do not restate
       B.) A change in estimate effected in whole or part by a change in principle should be
           reported as a change in estimate.
       C.) Disclosure: effect on income before extraordinary items, net income, and related per
           share amounts should be disclosed for:
           1) Required: A change in estimate that affects several periods
           2) Recommended: for material changes that affect only the current period

V.     Change in reporting entity restate all prior period presented
       Example: Mediplex Group

       A.) Disclosure
           1) Nature of change and reason for it
           2) Effect of change on income before extraordinary items, net income, and related
               per share amounts
       B.) Subsequent financial statements need not repeat

VI.    Relationship to SARs:
               Consider ¶ 39: should be prepared in the same way as the primary financial
       statements, including pro-formas

                                             4 of 18

                                        APBO 30
                            Reporting Results of Operations:
                        Segment Disposals and Extraordinary Items

I.     Introduction
       Undertaken because
       1) "Interpreting the criteria for extraordinary items has been difficult and;
       2) Significant differences of opinion exist about provisions in APB 9‖

II.    Standard corers extraordinary items requirements
       A. Requirements
           1) Unusual in nature
           2) Infrequently occurring

       B. Specifically excludes:
          1) Asset write-downs
          2) Foreign exchange gains and losses
          3) Segment disposals
          4) Other asset sales or disposals
          5) Long-term Contract accrual adjustments

III.   Reporting Format

       A. Defines the all-inclusive approach verses the current operating performance approach
           Board uses all-inclusive approach but embraces current operating performance
             theory in requiring continuing operations

       B. Present form of Income Statement:
          Income from continuing operations before taxes
              Income tax expense
          Income from continuing operations
          Discontinued operations
              Income/Loss from operations prior to discontinuation (N.O.T.)
              Loss of Disposal (N.O.T.)
          Income before extraordinary items and cumulative effect of changes in accounting
              Extraordinary items (N.O.T.)
              Cumulative Effect of Change in Accounting Principles (N.O.T.)
          Net Income

VII.   Extraordinary Items

       Must be...
       A. Unusual in nature - not just in dollar amount

       B. Infrequently occurring - not just in dollar amount

       C. If one or the other, but not both, then disclose separately

                                             5 of 18

VIII.    Accounting for the Disposal of a Segment

         A. The financial statements of current and prior periods that include the results of
            operations of disposed segments prior to the measurement date should disclose the
            results of those operations separately, net of tax, as part of Income before
            Extraordinary Items

       B. Gain or loss on actual disposal
            1) Loss: recognize expected loss at measurement date
            2) Gain: recognize when realized (generally at disposal)
            3) Procedure:
                (1) estimate expected gain or loss on disposal on operations
                (2) (a+b) estimate expected profit or loss from measurement date to disposal date
                (2a time period results are known by the financial statement date—perhaps even
                quite a bit of the 2b time period has passed as well by the time the financial
                statements are produced)
 if loss add to estimate of loss on disposal
 if profit, may offset against estimated loss, then recognize remainder when realized
  (1)               (1)                     (2a)                           (2b)                (3)

        Prior year end         Measurement date*             Financial Statement date   Expected disposal date

                    *    Date on which management commits itself to a formal plan of disposal,
                         whether by sale or abandonment-- plan should be carried out within one year
IX.      Format of Income Statement

         Cost of Goods Sold
         Gross Profit
Operating Expenses
Operating Income
Other Income and Expenses
Income Before Taxes
Income Tax Expense
Income from Continuing Operations
Discontinued Operations
Income Before Extraordinary Items and Cumulative Effect of a Change in Accounting Principle
         Extraordinary Items
         Cumulative Effect of a Change in Accounting Principle
Net Income

                      Discontinued Operations in Comparative Financial Statements
                                                                    Current Year         Prior Year
Discontinued Operations
        Income (Loss) from Operations (Net of taxes)                     (1)                 (1)
        Loss on disposal (Including provision of $ 2b               (2a)+(2b)+3              ----
          for operating losses during phase-out period

                                                   6 of 18

X.        Determining Gain or Loss on Disposal

      Includes adjustments costs and expenses which

      A. Are a direct result of the decision to dispose
         1) Severance pay
         2) Additional pension costs
         3) Employer relocation costs
         4) Future rentals on long-term leases, offset by sub-rentals


      B. Are clearly not items that should have been recognized on a going concern basis prior to
         the measurement date

XI.       Disclosure

      A. Identity of the segment
      B. Expected disposal date
      C. Expected manner of disposal
      D. A description of the remaining assets and liabilities at the balance sheet date
      E. Income or loss from operations and proceeds from disposal during the period from the
          measurement date to the balance sheet date

                                                7 of 18

                                             SFAS 16
                                     Prior Period Adjustment

I.      General rule: virtually used only for corrections of errors

A. ¶16 When these items are handled as PPA's, they must be shown as adjustments to beginning

       Retained earnings January 1, 19x1, as previously exported         XXX
       PPA: correction of error ...                                           X
       Retained earnings, January 1, 19x1, as adjusted                     XX
B. Original standard allowed for PPA treatment for ―adjustments that result from realization of
       income tax benefits of pre-acquisition operating loss carry-forwards of purchased
       subsidiaries. PPA treatment for this item is no longer allowed—see notes on Accounting
       for NOL Carry-forwards Acquired in a Business Combination, below.

II.      Interim financial information: (we will review also next class)
More lax for what is included because of the greater difficulty in preparing quarterly information.
‗An adjustment related to prior interim periods of the current fiscal year‘ is an adjustment or
settlement of litigation or similar claims, of income taxes, of renegotiation proceedings, or of
utility revenue under rate-making processes provided that the adjustment or settlement meets each
of the following:
A. The effect…is material in relation to income from continuing operations of the current fiscal
     year or in relation to the trend of income from continuing operations or by other appropriate
     criteria, and
B. All or part of the adjustment…can be specifically identified with and is directly related to
     business activities of specific prior interim periods of the current fiscal year, and
C. The amount…could not be reasonably estimated prior to the current interim period but
     becomes reasonably estimable in the current interim period.

B. If occurs after Q1,

a) The portion of the adjustment that relates to current period shall be included in the
   determination of net income
b) The portion that relates to prior interim periods of this year shall be handled by restating prior
c) The portion that relates to prior years shall be included in Q1 (i.e., don‘t restate prior periods)

1) Effect on income from continuing operations and net income and related per share amounts
    for each prior interim period
2) The effect on these amounts of any restatement

                                               8 of 18

                               Accounting for NOL Carryforwards
                                Acquired in a business combination

FAS 109: P135

I. On the date of acquisition, if meet criteria for recording a deferred tax benefit, then do so:
    Deferred tax benefit - NOL carryforward              XX
 Record as one of the assets in the business combination
 This equals "including in accounting for the business combo:"

II. If do not meet criteria as of the date of acquisition, but then do meet the criteria in subsequent
1) Do not look a PPA for the time from the date of acquisition to the date that recognition of the
     tax benefit becomes appropriate. Instead, recognize in the year that the transaction meets the
     recognition criteria
2) Record the debit to Deferred Tax Benefit or Income Tax Receivable (?)
3) Credit 3 items in the following order:
     a) Reduce GW from the combo to zero
     b) Reduce other non-current intangible assets from the combo to zero
     c) Reduce current year tax expense

                                                9 of 18

                   SFAS3: Reporting Accounting Changes in Interim Periods

I.      Cumulative effect, type changes
        A. If occurs in first interim period, then include in the net income of the first interim
            period the cumulative effect on RE at the beginning of the year
        B. If occurs in other than the first interim period, then restate the prior interim periods
            and treat the first period as under A above
        C. Disclosures
            1) Nature of and justification for change
            2) Effect on principal income numbers
     3) Pro forma effects on current period and interim periods of preceding years for

                                               10 of 18

                       FASB Statement 130: Reporting Comprehensive Income

I. Purpose: To report a measure of overall enterprise performance by displaying all changes in equity that
result from recognized transactions and other economic events of the period other than transactions with
owners in their capacity as owners. ―As a first step in implementing the concept of comprehensive income,
this Statement requires that all items that meet the definition of components of comprehensive income be
reported in a financial statement...that is displayed as prominently as other financial statements.‖
          A. Should help investors and creditors assess the timing and magnitude of future cash flows.
          B. Users (financial statement analysts) have expressed concern about the increasing number of
items that bypass the income statement and the effort that is required to analyze them. They have urged the
Board to develop and implement the concept of comprehensive income to show the changes in items--such
as unrealized gains and losses on available-for-sale securities, pension liability adjustments, and foreign
currency translation adjustments--which currently are taken directly to the equity section of the balance
          C. Information about components of comprehensive income is expected to be more informative
than the total amount of comprehensive income.

II. Definition of comprehensive income (from SFAC6) and other terms

A. Comprehensive income is the change in equity (net assets) of a business enterprise during a period from
transactions and other events and circumstances from non-owner sources. It includes all changes in equity
during a period except those resulting from investments by and distributions to owners.

B. Comprehensive income refers to the total of all components of comprehensive income, including net
income. Other comprehensive income refers to items included in comprehensive income but not net

C. SFAC5 recommends showing comprehensive income as part of a full set of articulated financial
statement, along with: 1) financial position at the end of a period, 2) earnings (net income is what is now
presented; SFAC5 defines earnings as excluding cumulative effects of changes in accounting principles); 3)
cash flows; and 4) investments by and distributed to owners.

III. Standard
A. Specifies how to report and display; does not specify when to recognize or how to measure constituent
items; existing and future accounting standards will provide guidance and items that are to be included in
comprehensive income and its components.

                                                 11 of 18

B. Classifications within comprehensive income
          1) Net Income: Net Income still includes cumulative effects of changes in accounting principle.
The FASB decided on this treatment more for practical reasons--to get this statement out--than based on
technical merit. Leaving cumulative effect-type adjustments in the income statement limits the scope of
this new statement to display issues, as stated in A above.
          2) Other Comprehensive Income: Items included are classified according to their nature (e.g.,
unrealized gains and losses on securities held available for sale are described as such.)
          3) Reclassification Adjustments
Items such as unrealized gains and losses on investments may eventually be included in net income. When
they are, they also must be backed out of comprehensive income in that period to avoid double-counting
the item in Cumulative Comprehensive Income. Reclassification adjustments are the amounts included in
the calculation of comprehensive income which offset the items included in the current year‘s net income.
          Companies must determine the amount of reclassification adjustments for all items of
comprehensive income except minimum pension liability adjustments. They may be displayed on the face
of the statement or disclosed in the notes:
                   a. gross display: shows reclassification adjustments deducted from comprehensive
                   b. net display: show reclassification adjustments separately in the footnotes.
          4) Income tax treatments: income tax effects from the items in comprehensive income must be
reported for each item of comprehensive income. These tax effects may be presented in the statement of
comprehensive income either
          a)       as one item of income tax expense/benefits (gross amount); or,
          b)       netted against each individual item (net of tax).
This tax treatment facilitates comparison to components of net income (gross amount) and to changes in
equity (net of tax).

C. Title for stockholders‘ equity account: ―Cumulative Other Comprehensive Income‖

D. Amendments to existing pronouncements
The standard amends current pronouncements for items which were taken directly to stockholders‘ equity
but which now go to comprehensive income
        a)      SFAS52: foreign currency translation adjustments
        b)      SFAS80: Futures contracts: gains and losses (deferred due to hedging)
        c)      SFAS115: Unrealized holding gains and losses on securities available for

IV. Presentation Formats: alternatives are possible. See attached examples

V. Effective for years beginning after December 15, 1997.

                                                12 of 18

       Chapter 11 Outline of Intro: Accounting Changes and Earnings Quality

I.     In general, this topic is covered in ACC681, however, we will focus now on All-Inclusive
       v. Current Operating Approach to the income statement.

II.    Discretionary Accounting Changes are not well understood

       A.) No mandatory tax-related cash flow implications
       B.) Income manipulation
           1) GM would have reported a decrease without a depreciation accounting change
                to increase useful lives
                change amount was approximately 1/3 of net income
           2) Pincus & Wasley, smoothing tendency found
           3) Wall Street Journal reported, "most execs would back earnings by "depositing"
               them in good years and "withdrawing" them in bad."
       C.) Three classes of changes for income smoothing or big bath
           1) Accounting methods changes
           2) Changes in discretionary accruals
           3) Changes in timing of transactions

III.   Relation to accounting standards
       A. APBO 20
           1) Changes in principle versus changes in estimated designation ignores the fact that
               firms might use either for manipulation
           2) Summary of standards
               a) Changes in principle:
                    i) with few exceptions, these are applied retroactively with prior period‘s
                        income effect shown in current income statement
                    ii) lead to auditor‘s report explanatory paragraph
               b) Changes in estimation
                    i) Applied prospectively
                    ii) Not flagged by auditor
           3) Difficulty in understanding standards relates to compromises
           4) GM – after the year of the change, there is insufficient information to assess
               earnings impact – requiring further disclosure will help quality of earnings
       B. Need coherent policy for implementing mandated accounting changes

                                           13 of 18

Softer Numbers: As IBM’s Woes Grew, it’s Accounting Tactics Got Less Conservative

I.      IBM‘s apparent rapid fall into trouble may have been delayed through aggressive
        accounting practices
        A. Revenue when right of return exists – relate to standard; can stem from changes in
            marketing approaches
        B. Leasing: booked as Sales Type leases; but lessees booked as operating types–
            accomplished through Merill Leynch

Managing Profits: How GE Damps Fluctuations in its Annual Earnings

I.      GE‘s two major businesses are electrical equipment and financial services. ―GE is
        followed by electrical equipment analysts, most of whom have a loose grasp of financial
II.     Techniques
        A. Offset one-time gains from big asset sales with restructuring changes (which are
            quite loosely defined); keeps earnings from being too high so they can‘t be topped
        B. Time sales of equity stakes and acquisitions (to ―buy earnings‖ in financial services is
            a particular concern: acquisitions become riskier in order to continue to acquire
        C. Follow conservative accounting practices which ―occasionally annoyed managers
            who believed the company was trying to bury profits that were racked up in a stellar

Perceptions of Earnings Reality: What Managers Need to Know

Just defines various earnings management techniques

Argues that companies should be careful to avoid looking like they manage earnings in order to
avoid being perceived as having earnings of low quality.

Low quality earnings:    Lower PE ratios
                         Lower capitalization of new earnings developments

I am not sure about these arguments, it doesn‘t look like GE suffers from these problems!

                                             14 of 18

         Dhaion and Lev: The Valuation Consequence of Accounting Changes:
                           A Multiple-Year Examination

I.    Comments on Table 2, descriptive stets for examined variables

      A. In general, they have calculated:

          Earnings            (i.e. a return measure, 6.88% is the first)
          Ply stock price

      B. AC = E – AE
      C. For income increasing firms
         d E t-1 : - 0.0191 change in earnings from t-2 to t-2
         d E t : -0.061 change in reported earnings form t-1 to t
         d AE t : -0.264 change in reported earnings form t-1 to t if they had not manipulated

II.   Earnings Valuation
      A. Should use assessment of actual announcements
      B. Explain market model

                                             15 of 18

                 Bierman “Extending the Usefulness of Accrual Accounting”

Gives a simple example comparing earnings to cash flow amounts and shows that cash both
provide equivalent answers when analyzing a single investment through NPV calculations.

Is everyone clear on how to prepare an NPV calculation? Discuss general use of cash flow.

Problems with using accrual accounting do arise as one considers individual years performance,
but Bierman argues that more exasperating difficulties arise when using yearly returns based on
cash flows.

Growth in a firm (in investment) gives rise to further difficulties if yearly cash flow rates of
return grow more unrealistic in these circumstances.

Discuss extrapolating these analysis techniques to large firms.

                                               16 of 18

                                       Unreal Accounting
                                     Suhrata N. Chanravarty

Time sold American Television Communications Corporation and took the gain into income and
included as operating earnings.

But what‘s the flip-side: don‘t want to let management be able to hide losses... so want an all
inclusive approach to earnings.

What is the focus here? On very limited, single number analysis.

                                        Periodic Earnings
                                      Income? Or Indicator?
                                         Osear S. Gellein

Discusses all-inclusive approach (where earnings = a portion of lifetime value changes)
Current operating performance

Concludes with guidelines on presentation methods to help usefulness of f/s:
 Separating discontinued operations helps
 Extraordinary item concept is problematic – use a different method focusing on non-
 Avoid direct inclusion of items in equity – due to eroding confidence in reporting

                                              17 of 18

                                      Spotlight on MD&A
                                       Dietert Sandefers

Discuss approach to complying with SEC's MD&A requirements. Look who were the individuals
cited when sanctions were undertaken due to problems with filings' compliance with MD&A
requirement -- Accountants!

Look at required expertise: ―It‘s also helpful in complying…to do a top-down analysis of
economic trends, demands, uncertainties, and so forth." Start with economy as a whole, then
industry, then company specific.

Consider the expertise you need in your profession.

                                   Summary Annual Report
                                      Is Shorter Better

                                        Rezau and Parter

Contrasts sharply with detailed requirements for segment reporting.

              The Value Added Statement: An Innovation for US Companies?
                                      Muk Gray

Sources of income - expenses + investment income = value added

Disposal of value added:
 To employers
 Investments
 Capital providers
 Reinvestment in business

This discussion clearly demonstrates the different presentations that can be derived based on
users' desires.

                                             18 of 18

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