Intermediate
Financial Accounting I

1. Study the content of an income statement .
2. Study the reporting of comprehensive income.
3. Prepare a retained earnings statement.
4. Discuss the quality of earnings, earnings management and limitations of the income statement.
5. Study the content of a statement of cash flows.
2

a. Capital Maintenance Approach
Income = Net assets changes adjusting for additional investments from owners and dividends.
b. Accounting Measurement of Income
(transaction approach)
= Revenues- Expenses + Gains - Losses
3

.
1.Revenues: inflows or increases of assets or decreases of liabilities from activities related to the major operation of a business entity; will eventually increase stockholders’ equity (i.e., sales revenue).
4


Revenue is recognized when it is earned and realized or realizable (SFAC 5, par. 83).

Earned : the entity has substantially accomplished what it must do to be entitled to compensation.

Realized : goods are exchanged for cash or claims.

Realizable : assets received as compensation are readily convertible into cash or claims to cash.


In general, these conditions are met at time of sale
(delivery) or when services are rendered
(SFAC 5, par. 84).
Income Measurement And Profit Analysis
.
5


Other conditions for revenue recognition (Staff Accounting Bulletin
No. 101(1999)):

Persuasive evidence of a sale.

Price is fixed or determinable.

Collectibility is reasonably assured.

Delivery has occurred or services have been rendered.
6

2. Expenses: outflows or decreases of assets or increases of liabilities of a business entity from activities related to the major operation of a business entity; will eventually decrease stockholders’ equity.
 Recognition Principle: Expense recognition (or matching) principle.
7


If revenues are recognized in a period, all related expenses should be recognized in the same period regardless whether expenses are paid or not .

The related expenses include traceable costs (e.g. product costs), period costs, (e.g. interest and rent expenses) and estimated expenses (e.g. depreciation expense and bad debt expense).
Accrual Accounting and the Financial Statements 8

3. Gains: increase in assets from incidental transactions (not related to the major operation of a business entity).
4. Losses: decrease in assets from incidental transactions.
(i.e., Losses from sale of equipment, inventory write-off, unrealized losses of marketable security valuation)
9


Two concepts

Items under debate
10

a. Current Operating Performance Concept:
 I/S should only include normal, ordinary, recurring results of operations from the current period.
b. All-Inclusive Concept:
 All transactions should be reported in
I/S (except for dividends distribution and capital transactions).
11

1. Results from Discontinued Operations.
2. Extraordinary Items.
3. Unusual Gains or Losses (i.e., losses from inventory write-off, losses or gains from disposal of PPE, foreign currency translation gains or losses etc.).
4. Corrections of errors of prior years (Prior
Period Adjustments).
5. Accounting Changes (i.e., changes in estimates and changes in accounting principles).
12

Numbers of Irregular Items Reported in
Recent Years by 500 Large Companies
(Source: Kieso, etc., 14 th e, illustration 4-5)
13

 APB opinion No. 9 (effective 12/31/66) adopts the all inclusive concept except for the prior period adjustment , dividends and capital adjustments (thus, a modified all inclusive concept).
 SFAS No. 154 further excludes the reporting of the cumulated effect from changes of accounting principles from the income statement.
14

Exhibit 4-1 Multiple-Step Income Statement
BANNER CORPORATION
Income Statement
For Year Ended December 31, 20x2
Sales revenue
Less: Sales returns and allow.
$4,000
Sales discounts taken
Net sales
Cost of goods sold (Note A)
Gross profit
Operating expenses
Selling expenses (Note B)
General and administrative exp. (Note C)
Depreciation expense
$2,300
$10,200
16,000
7,800
$150,000
(6,300)
$143,700
(86,000)
$57,700

Exhibit 4-1 (contd.)
Depreciation expense
Total operating expenses
Operating income
Other revenues and expenses
7,800
(34,000)
$23,700
Interest revenue
Dividend revenue
$1,800
600
Interest expense (2,100)
Loss on sale of equipment (4,000) (3,700)
Pretax income from continuing operations
Income tax expense
Income from continuing operations
$20,000
(6,000)
$14,000

Exhibit 4-1 (contd.)
Income from continuing operations $14,000
Results from discontinued operations
Income from operations of discontinued component A
(net of $1,950 I/T) $4,550
Loss on disposal of component A
(net of $3,150 I/T credit) (7,350) (2,800)
Income bef. extraordinary items
Extraordinary loss from explosion
(net of $750 I/T credit)
$11,200
(1,750)
Net income $9,450

Exhibit 4-1 (contd.)
Components of Income
Income from continuing operations
Results from discontinued operations
Extraordinary loss from explosion
Earnings
Per Share *
(5,000 shares)
$2.80
(0.56)
(0.35)
Net income
* Basic and Diluted EPS
$1.89

Inventory, 1/1/x2
Purchases $120,000
Less: Purchase discounts (5,000)
Freight-In 10,000
$40,000
Net purchases
Total inv. available for sale
Less: inventory, 12/31/x2
Cost of goods sold
125,000
165,000
(79,000)
$86,000
19

Sales salaries and commissions
Sales office salaries
Travel and entertainment
Advertising expenses
Freight-out
Shipping supplies and expenses
$3,000
2,000
1,000
1,000
800
1,700
Postage and stationery 400
Telephone & telegraph expenses $10,200
20

General and Administrative Expenses
Offices’ salaries
Legal and professional services
Utility expense
Insurance expense
Stationery, supplies and postage
Miscellaneous office expense
$10,000
2,000
2,000
1,000
500
500
$16,000
21

Exhibit 4-2 Single-Step Income Statement
BANNER CORPORATION
Income Statement
For Year Ended December 31, 20x2
Revenues
Sales rev. (net of $2,300 discounts and $4,000 returns and allow.)
Interest revenue
Dividend revenue
Total revenues
$143,700
1,800
600
Expenses
Cost of goods sold (Note A) $86,000
Selling expenses (Note B)
General and administrative expenses. (Note C)
10,200
16,000
$146,100

Exhibit 4-2 (contd.)
General and administrative expenses. (Note C)
Depreciation expense
Loss on sale of equipment
Interest expense
Income tax expense
Total expenses
Income from continuing operations
16,000
7,800
4,000
2,100
6,000
(132,100)
$14,000
Results form discontinued operations
Income from operations of discontinued component A
(net of $1,950 I/T) $4,550
Loss on disposal of component A
(net of $3,150 I/T credit) (7,350) (2,800)

Exhibit 4-2 (contd.)
Loss on disposal of component A
(net of $3,150 I/T credit) (7,350) (2,800)
$11,200 Income bef. extraordinary items
Extraordinary loss from explosion
(net of $750 I/T credit)
Net income
(1,750)
$9,450

Exhibit 4-2 (contd.)
Components of Income
Income from continuing operations
Results from discontinued operations
Extraordinary loss from explosion
Earnings
Per Share *
(5,000 shares)
$2.80
(0.56)
(0.35)
Net income
* Basic and Diluted EPS
$1.89

Another Example of An Income S tatement(Kieso, etc.,illustration 4-17) ssss
26

I. Income from continuing operations.
a. Net sales.
b. CGS.
c. Operating expenses d. Other revenue and expenses (including unusual gains & losses).
e. Income taxes for the continuing operations.
27

II. Results from discontinued operations
(net of I/T).
a. Income (Losses) from operations of discontinued components.
b. Gains (Losses) from disposal of discontinued components.
III. Extraordinary items (net of I/T).
28

IV. Earnings per share (by components).
* Prior period adjustments are reported in the statement of retained earnings at the net of
I/T effect.
29

Income From Continuing Operations – Details a. Net sales =
Sales -Sales R&A - sales Discounts b. C.G.S.: (see Note A)
Perpetual Inventory system.
Periodic Inventory system.
CGS = Beginning Inventory + Net
Purchases - Ending Inventory
Net Purchases = Purchases - Purchases
R&A - Purchases Discounts +
Freight-In
30

c. Operating expenses (see Ciena Corp. annual report of 2008): Cost incurred to generate operations including
 Research and Development
 Selling Expense (see Note B)
 Administrative Expense (see Note C)
 Depreciation and amortization Exp.
 Restructuring costs
 Goodwill and long-lived asset impairments
31

d . Other revenues and expenses (including unusual gains and losses) :
 Revenues and expenses of recurring items that are not related to major operations (i.e. interest revenue and expense, etc.)
 Gains and losses that are unusual but not infrequent : loss from inventory write-off, gains or losses from disposals of PPE or sale of investments, gains or losses from foreign currency translation.
32

e. Income taxes related to continuing operations (an example of an intraperiod income tax allocation).
33


Restructuring Costs : costs associated with reorganization (i.e., closing down facilities) of operations.

Examples: relocation costs, severance pays (due to facility closings), loss from assets writedown, etc.
34



Potential benefits from restructuring: greater operational efficiency in the future.
Accounting treatments of restructuring costs:
 Prior to SFAS 146: estimated the costs and recognized them in the period in which the reorg. decision was made.
35


Problems associated with this treatment:
 Premature restructuring expense/liability recognition.
 Violating the matching principle.
 Subject to income manipulation.
36




SFAS 146 : managers can only recognize restructuring costs (i.e., expense/liability) when a liability actually has happened.
SFAS 146 alleviates the income manipulation problem associated with the recognition of restructuring costs.
SFAS 146 promotes the matching principle.
37


Format of income from continuing operations:
 Single-step ( Exhibit 4-2 )
 Multiple-step ( Exhibit 4-1 ):
Subdivide the continuing operations results into subgroups based on the characteristics of operating revenues and expenses (i.e., sustainable vs. transitory such as restructuring costs, impairment charges ).
38

(source: Spiceland, etc.)

The relevance of a historical financial statement hinges on its predictive value.

Earnings quality is referred to the ability of reported earnings to predict a company’s future earnings.


To enhance the earnings quality, transitory earnings should be separated from the permanent earnings.
The multi-step format can enhance the earnings quality.
39

Nonoperating Income and Earnings Quality
(source: Spiceland, etc.)
 Items such as interest revenues, gains and losses from disposal of PPE or investments are referred to nonoperating items.
 For some companies, these nonoperating items may contribute significantly to their earnings (i.e.,
Intel- gains from investments contribute 24.8% to its 2000 pre-tax income, etc.).
40

Pro Forma Earnings (Source: Spiceland, etc.)
 Companies often voluntarily report pro-forma earnings to present managers’ view of permanent earnings.
 Sun Microsystems, Inc. reported $67 million earnings for the quarter ended
April 1, 2007 but reported pro forma earnings of more than twice of its
GAAP income .
41

Pro Forma Earnings (Source: Spiceland, etc.)
 Sun Microsystems’ pro forma earnings exclude stock-based compensation, restructuring and impairment charges, intangible asset amortization charges, gains from sale of equity investment and litigation settlement income
.
 The Sarbanes-Oxley Act requires the reporting of pro forma earnings to provide a reconciliation with GAAP earnings .
42

Pro Forma Earnings versus
Earnings from Operations (Kieso, etc. 14 th e, p158)
43


What Constitutes an Operation?

APB No. 30 defines an operation as a segment of a business (i.e., a separate line of business or a separate class of customer).

SFAS 144 (issued in 2001) replaced the term “segment of a business” with
“ component of an entity”.
44


“A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes , from the rest of the entity”
(SFAS 144 , pa. 41).

Examples of a component (SFAS 144, pa41)
: a reportable segment, an operating segment, a reporting unit, a subsidiary or an asset group.
45


If a component of a business has either been disposed of or classified as held for sale , the results of the component should be reported separately in discontinued operations if two conditions are met:
1. The operations and cash flows of the component have been (or will be) eliminated from the ongoing operations of the entity, and
2. The entity will not have significant continuing involvement in the operations of the component after the disposal transaction.
46


An operating segment: a component
 engages in business activities which generating revenues and incurring expenses,
 with discrete financial information available and
 managers regularly review its operating results to make decisions (SFAS 131, pa.
10).
47


(contd.) (Skip)
A reporting unit:
 an operating segment or a level below it as long as discrete financial information is available and managers regularly review the information (SFAS 142, pa. 30)

An asset group:
 a group of assets represents the lowest level for which the cash flows are largely independent of the cash flows of other groups
(SFAS 144, pa. 4).
48

Reporting Elements of the Results of
Discontinued Operations (SFAS 144)

Case I : Disposal date is on or before the fiscal year end (FYE) date:

The reporting elements include
 operating income (or loss) of the discontinued component from the beginning of the reporting period to the disposal date
(net of tax), and
 disposal gain (or loss) on the disposal of the component (net of tax).
49


Case II : Expected disposal date is after the
FYE date:

The reporting elements include:
 Operating income (or loss) of the discontinued component from the beginning of the reporting period to the
FYE date(net of tax),
 An impairment loss if the fair value
(minus costs to sell) of the assets of the component is less than the book value .
50


These two elements can be combined or reported separated.

If combined, the disposal gain or loss must be disclosed.
51

1/1/x3
Measurement date Disposal date
7/1/x3 11/30/x3 12/31/x3
Phase-out period
Realized pretax op. income (1/1/x3 -7/1/x3) $8,000
Realized pretax op. income (7/1/x3 - 11/30/x3) 2,000
Realized disposal loss (7/1/x3 - 11/30/x3) (12,000)
A division has been disposed of and the information pertaining this disposal is provided above. The operations and cash flows of this division can be clearly distinguished from the rest of the entity.
The Income Statement and Statement of Cash Flows 52

Results from discontinued operations:
* Income from operations of discontinued component X, less applicable I/T of $3,000 $7,000
Loss on disposal of component X, less applicable I/T savings of $3,600 $(8,400)
$(1,400)
* Assume a 30% tax rate.
53

Disclosure:
1. The identity of the component of business that has been or will be discontinued.
2. The major classes of assets and liabilities of the component.
3. The expected manner of disposition.
4. The reason of discontinuance.
54

Measurement Date FYE Expected Disposal Date
1/1/x3 8/1/x3 12/31/x3 5/1/x4
Phase-out period
Realized operating income
(1/1/x3 -12/31/x3) = $25,000
Impairment loss on assets = $(22,000 )
Note1: Assets book value on 12/31/x3,$70,000; assets fair value on 12/31/x3 minus expected costs to sell,$48,000.
Note 2: Any realized disposal gains or losses should also be recognized and reported.
55

Results from discontinued operations:
* Income from operation of component X, net of applicable I/T of $7,500 $17,500
Impairment loss of component X , net of I/T savings $6,600 $(15,400)
$2,100
* Assume a 30% tax rate.
56


Reporting the held for sale asset of the discontinued component on the balance sheet:
 The asset should be reported at the lower of the book value or the fair value minus costs to sell.
 The asset is reported under other assets and is not subjected to depreciation or amortization.
57


Must meet three criteria (APB opinion 30):
1. Unusual in nature.
2. Infrequent in occurrence.
3. Material in amount.
Note: iGAAP prohibits extraordinary item reporting (Source: KWW Convergence
Corner, p155).
58


Direct result of a major casualty (i.e., flood, earthquake….).

Expropriation by a foreign government.

Prohibition under a newly enacted law.
59


Not extraordinary Items:
1. Write-off of A/R, N/R, inventories, equipment.
2. Gains or losses from foreign currency exchanges.
3. Gains or losses from disposal of a component.
4. Gains or losses form sale of P.P.E. used in operation.
5. Effects of strikes.
6. Adjustments of accruals on long-term construction contract.
60

Not Extraordinary Items:
 Selling a block of shares from investment portfolio.
 Selling a piece of land (occurred a few times before).
 Frost damage on citrus in Florida.
 Hurricane loss for business in the Gulf
Coast.
61

Continuing operations
Discontinued operations
Extraordinary Items
Total
Basic Diluted
EPS * EPS xx xx xx xx
* EPS = Net Income - Preferred Dividends
Weighted Average of Common Share Outstanding xx xx xx xx
62

IFRS (
S ource: KWW IFRS Insights, 14 th edition)



IFRS does not mention single or multiple-step format.
IFRS prohibits the reporting of extraordinary items.
IFRS and GAAP follows the same presentation guidelines for discontinued operations but differ in defining a discontinued operations.
63

IFRS (
S ource: KWW IFRS Insights, 14 th edition)


IFRS requires company to indicate the amount of net income attributable to non-controlling interest.
IFRS allows the revaluation of land, buildings and intangibles. The unrealized losses/gains are reported as comprehensive income items in the equity section of the B/S.
64

 Changes in Accounting Estimates:
Revision of an estimate due to new information or new experience.
 Changes in Accounting Principle:
Change from one GAAP method to another GAAP method.
 Changes in Reporting Entity: Reporting financial statements for an entity other than the entity existed in the previous period .
65

Accounting treatments for accounting changes(SFAS 154):
1. Changes in Accounting Estimatesprospective treatment.
2. Changes in Accounting Principleretrospective treatment.
3. Changes in Reporting Entityrestating financial statements of all prior periods of the new reporting entity.
66

Examples:
 Changes in the estimated life of property, plant and equipment.
 Change in the bad debt estimation.
 Depreciation method change is now considered as an estimate change under SFAS 154.
67

Changes in Accounting Estimates(cont.)-
Prospective Approach
 Accounting Treatment: Prospective approach.
 Do not restate prior statements using the new estimates. Simply apply the new estimates to the current and subsequent years.
 Footnote disclosure required.
68


A. Change the bad debt exp. estimation from 2% to 4% of the net sale in 20x6. The net sale of 20x6 amounts to $50,000.
12/31/x6 Bad debt exp.
Allow. for bad debt
2,000
2,000

Note: Due to the accounting estimate change, the bad debt expense is increased from $1,000
(at 2%) to $2,000 (at 4%). The net impact (net of income tax credit) from this change is a
$700 decrease in net income of 20x6.
69

(skip p71-75)

B. Machine costing $15,000 was purchased on
1/1/x4 with estimated life of 5 years and zero residual value. The straight-line method was used for depreciation. On 1/1/x6, the estimated life of the machine had been changed to 6 years and the residual value had been changed to
$1,000 due to new information available.
 Book value of the machine on 1/1/x6:
(15,000-6000) =9,000
 Depreciation expense for 20x6, 20x7,20x8, and 20x9:
($9,000 -$1,000) / (6-2) = $2,000
70

12/31/x6
Depr. Exp.
Acc. Depr.
2,000
2,000
 Note: Due to the accounting estimate changes on the estimated life and the salvage value of machine purchased on 1/1/x6, the depreciation expense of 20x6 is decreased by $1,000. The net of income tax effect is a $700 increase in net income of 20x6.
71

Example C: Depreciation Method Change Is Treated as an Estimate Change under SFAS 154

The Gate Inc. decided to change from the straight-line depreciation method to the sumof-theyears’-digits method at the beginning of year x5 for a plant asset. This plant asset was purchased at the beginning of x2 at a cost of $15,000, with an estimated life of 5 years and no salvage value.
The new depre. Expense is :
20x5 => ($15,000-$9,000)=$6,000
$6,000x2/3 =$4,000 ; and
20x6=> 6,000x1/3 = $2,000.
72

 2005 Note: Due to the accounting method changes from the straight-line depreciation method to the sum-of-theyears’-digits method at the beginning of year x5, the depreciation expense of
20x5 is increased by $1,000. The net of income tax effect is a $700 decrease in net income of 20x5.
73

a. Current Period Approach (APB 20, Old ):
Reporting the cumulative effect (net of income taxes) as a separate item following extraordinary items in the I/S
(not allowed under SFAS 154) .
74

 b. Retrospective Approach (SFAS
154): Restate financial statements of the prior periods presented as if the new accounting method were applied, and

Report the cumulative effect of those years not restated in the statement of retained earnings.
75

 SFAS 154 requires voluntary accounting changes be accounted for retrospectively unless the retrospective application is impracticable.
 For a newly issued standard , the provisions of the standard shall be followed.
76

 If no specific transition provisions were prescribed, a retrospective approach should be applied.
 The elimination of the current period approach in SFAS 154 is to improve the comparability and to be convergent with the IAS.
77

(skip)
 Retrospective application of the new standard is Impracticable when:
1) The effects of the retro. application are not determinable.
2) The application requires assumptions regarding manager’s intent in a prior period.
3) The application requires sig. estimates of a prior period and it is not clear whether information to develop those estimates would have been available in prior periods.
78


An example of voluntary accounting method change (i.e., change from LIFO to FIFO or from the percentage-ofcompletion method to completedcontract method for a long-term construction project) using the retrospective approach will be illustrated in chapter 22.
79


Restate the financial statements of all prior years presented to show financial information for the new reporting entity for all periods.
80

1. Condensed Income Statement (Example:
I/S of an annual report).
2. Interim Reports: quarterly reports are required by the SEC for publicly traded companies (10-Q report). Reporting guidelines are provided in APB 28.
3.
 Segment Reporting (SFAS 131).
 Foreign operations and export sales reporting.
 Major customers.
81

4. Related Party Transactions (FASB No.
57). (sales, transfer of properties, purchases, services, …)
5. Accounting procedures (APB 22).
 Inventory cost flow assumption.
 Depreciation, amortization method.
 Revenue recognition principle.
 Interest capitalization.
82


The change in equity excluding owner related transactions such as investments from owners and dividends distribution.
83


Components of comprehensive income: a. Net income (as reported in the I/S) b. Other comprehensive income items * :
*These gains and losses are not
reported in the I/S, but in the stockholders’ section of a B/S. They bypass the I/S but affect stockholders’ equity.
84


Other comprehensive income items:
 Unrealized gains (losses) from valuation of investments,
 Deferred gains(losses) from derivatives,
 Gains (losses) of foreign currency translation adjustments , and
 Gains (losses) from amendments to pension plans. iGAAP allows revaluations of land, buildings and intangible assets. This practice results in more comprehensive income items (Source: KWW,
IFRS Insights)
85


Comprehensive Income Items Presentation format:
A. The two income statement format.
B. Combined income statement format.
C. Statement of stockholders’ equity format
(Eliminated by ASU 2011-05) .
 IFRS allows formats A and B, not C.
 Accounting Trends and Techniques 2010 survey indicates that 492 of the 500 companies surveyed report comprehensive income.
 400 of the 492 companies use format C.
86

Presentation of Net Income and Other
Comprehensive Income Items – An Example

Example: Assuming Avon Corp. reports net sales of $1,000,000 CGS of
$500,000, operating expenses of
$100,000 and an unrealized loss on available-for-sale securities of $40,000
(net of tax) for year 20x1.
87

Avon Corp.
Income Statement
For the Year Ended 12/31/x1
Sales Revenue (Net)
CGS
$1,000,000
500,000
Gross Profit
Operating Expenses
Net Income
500,000
100,000
$400,000
88

Avon Corp.
Comprehensive Income Statement
For the Year Ended 12/31/x1
Net Income $400,000
Other Comprehensive Income Items
Unrealized Loss, net of tax
Comprehensive Income
40,000
$360,000
89

Avon Corp.
Combined Statement of Comprehensive Income
For the Year Ended 12/31/x1
Sales Revenue $1,000,000
CGS
Gross Profit
500,000
500,000
Operating Expenses
Net Income
Unrealized Loss, net of tax
Comprehensive Income
$100,000
$400,000
40,000
$360,000
90

C. Statement of Stockholders’ Equity Format
(most commonly used format in the US; eliminated by
ASU 2011-05, effective date is for fiscal years beginning after
12/15/2011 with early adoption permitted)

Other information available for the statement:
Beginning balance of common stock,
$500,000, retained earnings,
$600,000 and accumulated other comprehensive income, $150,000.
No changes in the common stock account during 20x1. A statement of stockholders’ equity is as follows:
91

Accum.
Other
Comprehensive Retained Compre. Comm.
Income Earnings Income Stock Total
Beg. Balance
Compre. Income
Net Income
Other Compre.
$0 600,000 150,000 500,0001,250,000
$400,000 400,000
Income:
Unrealized Loss ($40,000)
Compre. Income $360,000
(40,000)
400,000
(40,000)
Ending Balance 1,000,000 110,000 500,0001,610,000
92

Avon Corp.
Balance Sheet Statement as of 12/31/x1
(Stockholders’ Equity Section)
Stockholders’ Equity
Common Stock
Retained Earnings
Acc. Other Compre. Income
Total Stockholders’ Equity
500,000
1,000,000
110,000
1,610,000
93


Reporting Items:
 N/I
 Dividends (cash + stock)
 Prior-period adjustment (Net of I/T)
94

(Kieso, etc., 14 th edition, illustration
4-18)
Justin Rose, Inc.
Retained Earnings Statement
For the Year Ended December 31, 2012
Balance, January 1, as reported $1,050,000
Correction for understatement of net income in prior period-inventory error (net of tax)
Balance, January 1, as adjusted
Add: Net income
50,000
1,100,000
360,000
1,460,000
Less: Cash dividends
Stock dividends
$100,000
200,000 300,000
Balance, December 31 $1,160,000
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 Predictive value is a component of the relevance, a primary quality of accounting information.
 Earnings quality refers to the ability of reported earnings to predict future earnings.
 Earnings management reduces earnings quality.
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
Transitory versus Permanent Earnings
 Transitory earnings (with lower earnings quality than permanent earnings): results from transactions or events that are not likely to occur again in the foreseeable future or are likely to have a different impact on the earnings in the future.
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 Examples of results of transitory transactions or events:
 Restructuring costs.
 One-time charges other than restructuring costs.
 Gains from sale of investments or PPE.
 Results from the discontinued operations.
 Extraordinary gains or losses.
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 “The practice by which earnings reported reflect the desires of management rather than the underlying financial performance of the firm.”
(Arthur Levitt, the former SEC chairman); or
 “The planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings.”
(KWW, p161)
 Example: Prematurely recognized sales revenue to increase earnings at the expense of income in future years (KWW, p161)
99

 Determining when revenue has been earned (critical event) and is realized
(measurability) —the two revenue recognition conditions —often requires management judgment .
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 Managers can sometimes exploit the flexibility in GAAP(i.e. the choice of accounting methods and estimates) to manipulate reported earnings in ways that mask the company’s underlying performance.
 Some managers have achieved earnings management by financial frauds (that’s illegal
).
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 “Big bath ” of restructuring charges:
Excessive restructuring write-offs that overstate estimated charges for future expenditures (curtailed by SFAS 146).
 Creative acquisition accounting :
Abuses linked to purchased “in-process
R&D” that SFAS No. 2 requires to be expensed at the date of acquisition.
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 Miscellaneous “ cookie jar reserves ” for bad debts, loan losses, warranties and other accruals: A convenient income smoothing device.
 Intentional errors deemed to be
“immaterial” and intentional bias in estimates.
103

 Income shifting including:
 Premature or aggressive revenue recognition (i.e., Delphi, General
Mills, and Lucent Technology)
 Delay recognition of expenses
(i.e., WorldCom and AOL).
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 Delphi
(WSJ, 3/7/2005
): 1) Prematurely recognized revenue for tech contracts; 2) boosted cash flows and earnings by selling assets and inventory with buy back agreements.
 General Mills
(WSJ 2/18/04):
Parking transactions.
 Lucent Technology
(Spiceland, etc. 5 th edition)
:
Improperly recognized sales of $1.15 billion in 2000 with false documents..
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
Bristal-Myers Squibb (WSJ 6/6/2005):

Sales was inflated by $2.5 billion from
1999-2001.

Wholesalers of Bristal-Myers Squibb were offered incentive to buy more products than needed at the end of fiscal quarters
(this practice is referred as parking transaction ).
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
Traceable costs: cannot be managed easily except in the adoption of different cost flow assumptions.

Period costs may be subject to earnings management or frauds .

AOL delayed recognition of advertising expenses in 1995, 1996 and WorldCom’s improper capitalization of its line costs of
$3.8 billion in 2000-01.
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Earnings Management of Allocation Costs

Allocation Costs (i.e., depreciation expense):
 May be subject to earnings management due to GAAP’s flexibility in allocation methods.
 The estimation of expenses is subject to managers’ discretion.
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SAB No. 104 examples
SEC SAB No.104 illustrates troublesome areas of revenue recognition.:
1.Goods shipped on consignment :
No revenue can be recognized at delivery.
2. Sales with delayed delivery:
Seller cannot recognize revenue until delivery.
3. Goods sold on layaway:
Postpone revenue recognition until merchandise is delivered to customer.
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SAB No. 104 examples
4. Non refundable up-front fees :
Earned as services are delivered over the full term of service engagement.
5. Gross vs. net basis for internet resellers: Revenue should be recognized on a “ net” basis as commission revenue.
6. Capacity swaps:
Revenue should be recognized over time as the capacity is bought on line and used by customers .
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The Importance of Reporting Transparency and the Understanding of Events Reported
 With the flexibility in reporting, the transparency in reporting is essential to the understanding of the information reported.
 In order to predict earnings, one must understand the events reported in the income statement and their relationship with future earnings (i.e., sustainable or transitory) (Spiceland, etc.).
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1. Nature of Accounting Policies.
2. Discretionary Costs.
3. Degree of Certainty of Accounting
Estimates.
4. Maintenance of Capital.
5. Stability of Earnings.
6. Off-balance Sheet Liabilities.
112

th
 Evaluation the past performances of the company
 Provide a basis for predicting future performance
 Help assess the risk or uncertainty of achieving future cash flows
113

1.
Income measurement is based on principles such as historical cost principle: a ssets are mostly reported at cost, thus, the unrealized gains or losses on assets are not recognized.
2.
For investments reported at market value, the unrealized gains/losses of some are reported only in the balance sheet statement.
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3.
Income is based on many estimates which are discretionary and require judgments.
4.
Income is affected by the choice of accounting methods .
5.
Income can be manipulated by managers .
6.
Off balance sheet liability (thus, off I/S expense).
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Statement of Cash Flows:
 Providing uses and sources of cash and operating, financing and investing information of a business entity.
116

Three Sections:
1. Cash flows from operating activities
 N/I ± Adjustments (i.e., depreciation, amortization),
 + any increase in current liabilities,
 + any decrease in current assets (except cash and notes receivable),
 - any decrease in C.L.,
 - any increase in C.A. (except cash and notes receivable).
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2. Cash flows from investing activities
(inflows and outflows).
3. Cash flows from financing activities
(inflows & outflows).
118

GREEN Company
Statement of Cash Flows
For the Year Ended December 31, 2012
Net cash flows from operating activities:
Net Income
Adj. To reconcile net income to net
$8,400 cash provided by operating activities:
Add: Depreciation Expense
Decrease in A/P
3,400
800
Increase in S/P 400
Less: Increase in Inventory (1,600)
Decrease in A/P (1,900)
Gain on sale of Equipment (600)
Net cash provided by oper. activities $8,900
119

GREEN Company
Statement of Cash Flows (contd.)
Cash flows from investing activities:
Payments for purchase of equip.
(15,200)
Proceeds from sale of equipment 2,100
Net cash used by investing activities (13,100)
Cash flows from financing activities:
Proceeds from issuance of bonds 8,000
Payments of dividends (1,800)
Net cash provided by financing activities
Net increase in cash
6,200
$2,000
Cash, Jan 1, 20x2
Cash, Dec 31, 20x2
$3,500
$5,500
1
120

GREEN Company
Statement of Cash Flows (contd.)
Schedule 1: Investing & financing activities not affecting cash flows:
Investing activities:
Acquisition of land by Issuance of common stock ($4,000)
Financing Activities:
Issuance of common stock for land $4,000

(Using the direct method in preparing the operating activities section of a cash flow statement.
Information as provided in the previous example)
Cash flows from Operating Activities:
Cash inflows:
Collections from customers $80,800 1
Cash inflows from operating activities $80,800
1. 80,000 + 800 = 80,800.
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Cash outflows:
Payments to suppliers $(52,100) 1
Payments of interest (700)
Other operating payments (15,500) 2
Payments of income tax (3,600)
Cash outflows from operating activities (71,900)
1. 48,600 + 1600 + 1900 = 52,100.
2. 15,900 - 400 = 15,500.
123

Net cash inflow from operating activities $8,900
* A reconciliation of net income and cash flows using indirect method must also be presented.
124

Another Example of A Cash Flow Statement: illustration 5-23 (Kieso,etc.,14e) eso, etc., 14e)
125



A company with high net income but negative cash from operating activities may experience cash shortage (i.e., fail to pay liabilities when due).
Illustration 5-24 (Kieso, etc.
14e)
126


Hu Inc. could experience cash crunch because it has its cash tied up in receivables and inventory.

If Hu encounters problems in collecting receivables or in selling its inventory, it may not be able to pay its debts on time.

Investors can use the following ratios to assess financial flexibility of companies:
127

Financial Flexibility Ratios and Free Cash Flow
(Kieso, etc., illustrations 5-24, 26 and 27)
128

Free Cash Flow Example (Source: Kieso, etc., 14e)
 As seen in illustration 5-23, Nestor used its free cash flow to redeem bonds.
 Companies with strong financial flexibility can take advantage of investment opportunities without risking dividend cuts or reducing capital expenditures.
129