Financial Statement Anlysis 10e Subramanyam Wild_Chapter 6

Chapter 06 - Analyzing Operating Activities Activities

Chapter 6 Analyzing Analyzing Operating Operating Activities Activities REVIEW Income is the residual of revenues and gains less expenses and losses !et income is measur measured ed using using the accrual accrual "asis "asis of account accountin ing g Accrual ccrual account accounting ing recogn recognize izes s revenues and gains #hen earned$ and recognizes expenses and losses #hen incurred %he income statement &also referred to as statement of operations or earnings' reports net income during a period of time %his statement also reports income components(( revenu revenues$ es$ expense expenses$ s$ gains$ gains$ and losse losses s We analy analyze ze incom income e and its componen components ts to evaluate company performance, assess risk exposures, exposures, and predict amounts, timing, While e )"ot )"otto tom m line line)) net net inco income me fram frames es ou our r and uncert uncertain ainty ty of future future cash cash flows flows Whil analysis$ income components provide provide pieces of a mosaic revealing the economic portrait of a comp compan any y %h %his is chap chapte terr exami examine nes s the the anal analys ysis is and and inte interp rpret retat atio ion n of inco income me components We consider current reporting re*uirements and their implications for our analysis of income components We descri"e ho# #e might usefully apply analytical ad+ustments to income components and related disclosures to "etter our analysis We direct special attention to revenue recognition and the recording of ma+or expenses and costs ,urther use and analysis is made of income components in -art %hree of the "oo.

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O/%0I!E •

Income 1easurement Concept of Income 1easuring Accounting Income Alternative Alternative Classification and Income 1easures

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!on(recurring !on(recurring items Extraordinary Items 2iscontinued 2iscontinued Operations Accounting Accounting Changes 3pecial Items

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Revenue and 4ain Recognition 4uidelines for Revenue Recognition /ncertainty in Revenue Collection Collection Revenue When Right of Return Exists ,ranchise Revenues -roduct ,inancing Arrangements Arrangements Revenue under Contracts Analysis Implications of Revenue Recognition

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2eferred Charges Research and 2evelopment Computer 3oft#are Expenses Exploration and 2evelopment Costs in Extractive Industries 3upplementary Employee 5enefits Employee 3toc. Options Interest Costs Income %axes

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Appendix 6A Earnings per 3hare Computation and Analysis Appendix Appendix 65 Economics of Employee 3toc. Options

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A!A07 A!A073I3 O58EC%IVE3 O58EC%IVE3 •

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Explain the concepts of income measurement and their implications implications for analysis of operating activities a ctivities 2escri"e and analyze the impact of non(recurring items ( including including extraordinary items$ discontinued discontinued segments$ accounting changes$ and restructuring charges and #rite(offs Analyze Analyze revenue and expense recognition and its ris.s for financial analysis Analyze Analyze deferred charges$ including including expenditures for research$ development$ and exploration Explain supplementary employee "enefits and analyze disclosures disclosures for employee stoc. options &E3Os'

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2escri"e and interpret interest costs and the accounting for income taxes

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Analyze Analyze and interpret earnings per share data &Appendix 6A'

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/nderstand the economics of employee stoc. options &appendix 65'

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9/E3%IO!3 : %he income income statement statement portrays portrays the the net results results of operation operations s of an enterprise enterprise 3ince 3ince results are #hat enterprises are esta"lished to achieve and since their value is$ in large measure$ determined "y the size and *uality of these results$ it follo#s that the analyst attaches great importance to the income statement ; Income Income summariz summarizes es in financia financiall terms the the operating operating activiti activities es of a company company Income Income is the amount of revenues and gains for the period in excess of expenses and losses$ all computed under accrual accounting Income provides provides a measure of the the change in shareholder #ealth for a period and an indication of a companyic.sia >ic.sian n concept of income$ income$ considers considers income for the period to "e the amount that can "e #ithdra#n from the company in a period #ithout #ithout changing the net #ealth of the company >ic.sian income income e*uals cash flo# plus the change in the fair value of net assets ? Accou Accounti nting ng income income is the excess of revenues revenues and gains gains over expenses expenses and losses losses measured using accrual accounting accounting As such$ revenues &and gains' are recognized #hen earned and expenses &losses' are matched against the revenues &and gains' @ !et !et inco income me is the exce excess ss of the the reve revenu nues es and and gain gains s of the the comp compan any y over over the the expenses and losses of the company company !et income often is is called the "ottom "ottom line$B although that is a misnomer "ecause certain unrealized holding gains and losses are charged directly to e*uity and "ypass net income Comprehensive Comprehensive income includes all changes in e*uity that result from non(o#ner transactions &excluding items such as dividends dividends and stoc. issuances' issuances' Items creating differences "et#een net income income and comprehensive income include unrealized gains and losses on availa"le for sale securit securities ies$$ forei foreign gn curren currency cy trans translat latio ion n ad+ust ad+ustmen ments$ ts$ mini minimu mum m pensio pension n lia"i lia"ili lity ty ad+ust ad+ustmen ments$ ts$ and unreal unrealiz ized ed hol holdin ding g gains gains or losses losses on deriva derivativ tive e instr instrume uments nts Comprehen Comprehensive sive income income is the ultimate ultimate "ottom "ottom lineB lineB income income num"er num"er Continuin Continuing g income is a measure of net income earned "y ongoing segments of the company Continuing income differs from net income "ecause continuing income excludes the income or loss of segments of the company that are to "e discontinued or sold &it also also excl exclud udes es extr extraor aordi dina nary ry item items s and and effe effects cts from from chan change ges s in accou account ntin ing g principles' 6 2eta 2etail ils s rega regard rdin ing g comp compre rehe hens nsiv ive e inco income me are are repo reporte rted d "y the the vast vast ma+o ma+ori rity ty of companies in the statement of stoc.holders< e*uity rather than the income statement  Core Core income income is a measur measure e of income income that excludes excludes all non(rec non(recurr urring ing items items that are reported as separate items on the income statement

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D Opera Operati ting ng inco income me is a meas measur ure e of firm firm perf perfor orma manc nce e from from op oper erat atin ing g acti activi viti ties es Examples of operating income include product sales$ cost of product sales$ and selli selling ng$$ genera general$ l$ and admin administ istrat rative ive costs costs !on(o !on(oper perati ating ng income income inclu includes des all all components of income not not included in operating operating income Examples of non(operating income include interest revenue and interest expense  Operati Operating ng versus versus non(oper non(operati ating ng and recurr recurring ing versus versus non non(rec (recurr urring ing are distin distinct ct dimensions dimensions of classifying classifying income While there is overlap across selected items$ these dimensions dimensions reflect different characteristics of "usiness "usiness activities ,or example$ the interest income and interest expense of most companies recur in net incomeF hence$ they are included included in recurring recurring income >o#ever >o#ever$$ these items are non(operatin non(operating g in nature 3imilarly$ non(recurring items such as restructuring charge are operating in nature :G Accounti Accounting ng standards standards & APB 30 ' restricted the use of the )extraordinary) category "y re*uir re*uiring ing that an extraord extraordina inary ry item item "e both unusual unusual in nature and infre*uen infre*uentt in occurrence %hese attri"utes are defined as follo#s follo#s a /nusu /nusual al nature nature of the underlyi underlying ng event event or transact transaction ion shoul should d possess possess a high high degree of a"normality and "e of a type clearly unrelated to$ or only incidentally related to$ the ordinary and typical activities of the entity$ ta.ing into account the environment in #hich the entity operates " Infre*uen Infre*uency cy of occurrence occurrence of the underlyin underlying g event or transactio transaction n should should "e of a type that #ould not reasona"ly "e expected to recur in the foreseea"le future$ ta.ing into account the environment in #hich the entity operates %hree examples of extraordinary items are 1a+or casualty losses from an event such as a n earth*ua.e$ flood$ or fire A gain or loss from expropriation of property A gain or loss from condemnation of land "y eminent domain • • •

:: :: %o *ualify *ualify as discon discontin tinued ued operat operation ions$ s$ the assets assets and "u "usin siness ess activ activiti ities es of the divested divested segment must "e clearly clearly disting distinguish uisha"le a"le from the assets and "usiness "usiness activi activitie ties s of the remain remaining ing entity entity Account ccountin ing g and report reporting ing for disco discont ntinu inued ed operations is t#o(fold t#o(fold ,irst$ the income income statement for the current and prior t#o years years are restated restated after excluding excluding the effects of the disconti discontinued nued operations operations from the line line items that determine determine continuing continuing income 3econd$ gains or losses losses pertaining to the discontinued discontinued operations are reported separately$ net of related tax effects An analyst should separate and ignore discontinued operations in predicting future performance and financial condition :; :; %o *u *ual alif ify y as a prio priorr peri period od ad+u ad+ust stme ment nt$$ an item item mu must st meet meet the the foll follo o#ing #ing re*uirements 1aterial in amount 3pecifically identifia"le identifia"le #ith the "usiness activities of specific prior periods !ot attri"uta"le to economic events occurring su"se*uent to the prior period 2ependent primarily on determinations "y persons other than management !ot reasona"ly estima"le prior to such determination • • • • •

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:= := 2ist 2istor orti tion ons s in reve revenu nues es &gai &gains ns'' and and expe expens nses es &los &losse ses' s' can aris arise e from from seve severa rall accounting accounting sources sources %hese include include choices in the timing timing of transactions transactions &such &such as revenue recognition and expense matching'$ selections from the variety of generally accepted accepted princi principle ples s and method methods s availa availa"le "le$$ the intro introduc ductio tion n of conser conservat vativ ive e or aggr aggres essi sive ve esti estima mate tes s and and assu assump mpti tion ons$ s$ and and choi choices ces in ho ho# # reve revenu nues es$$ gain gains$ s$ expenses$ and losses are classified classified and presented in financial statements statements 4enerally$ a company #ishing to increase current income at the expense of future income #ill engage in one or more of the follo#ing practices &a' It #ill choose inventory methods methods that allo# for maximum maximum inventory inventory carrying values and minimum current charges to cost of goods or services sold &"' It #ill choose depreciation methods and useful lives lives of property that #ill #ill result in minimum minimum current charges as depreciation expense &c' It #ill defer defer all managed costs costs to the future future such as$ for example example pre(operating pre(operating$$ moving moving$$ rearra rearrange ngement ment and start(u start(up p costs$ costs$ and mar.et mar.eting ing costs costs 3uch 3uch costs costs #ould "e carried as deferred charges or included #ith the costs of other assets such as property$ property$ plant$ and e*uipment &d' It #il #illl amorti amortize ze assets assets and defer defer costs costs over over the larges largestt possi" possi"le le period period 3uch 3uch assets include good#ill$ leasehold improvements$ patents$ and copyrights copyrights &e' &e' It #il #ill elec electt the the meth method od re*u re*uir irin ing g the the lo#e lo#est st po poss ssi" i"le le pens pensio ion n and and othe other r employment compensation cost accruals &f' It #ill #ill inventory rather than expense administrativ administrative e costs$ taxes$ and similar similar items items &g' It #ill choose the most accelerated methods of income income recognition such as in the areas of leasing$ franchising$ real estate sales$ and contracting &h' &h' It imme immedi diat atel ely y #ill #ill recogn recogniz ize e as reve revenu nue$ e$ rath rather er than than defe deferr the the ta.in ta.ing g up of "enefits$ items such as investment tax credits &i' Companies Companies that that #ish to manage manageB B the size of accounting accounting income income can regulate regulate the flo# of income and expense "y means of reserves for future costs and losses :? :? &:' 2epr 2epreci eciat atio ion n Straight ine %h a Straight %his is is calculat calculated ed "y ta.ing the salvag salvage e value value &3' from the original cost &C' and dividing "y the useful life of the asset in *uestionF that is$ &C(3'H&/seful life' Sum!of!"ears#!$igits  %his depreciatio depreciation n formula formula is &C(3' x &H7'F #here C and 3 are the same as a"ove$  is the remaining years years &that is$ if item is "eing depreciated over @ years and this is the first year$ then J@'$ and 7 e*uals the )sum(of(yearsK(digits) )sum(of(yearsK(digits) &that is$ for a @(year asset$ 7J@L?L=L;L:J:@' 7J@L?L=L;L: J:@' " 3traight 3traight line line is easily understo understood od and provides provides level depreciat depreciation ion and earnings earnings effects %he sum(of(the(yearsK(digits sum(of(the(yearsK(digits gives gives heavier #eight to earlier years and causes higher depreciation and lo#er earnings in the early years and lo#er depreciation and higher earnings to#ard the end of the assetKs life &;' Inve Invent ntor ory y a %&' &last( &last(in$ in$ first first(ou (out' t' method method %he 0I,O 0I,O method method assume assumes s the inven inventor tory y employed are those most recently ac*uired &%&' &first(in$ &first(in$ first(out' method %he ,I,O method assumes the first inventory items ac*uired are used first " %he effect on earning earnings s depends depends on #hether #hether the economy economy is in an inflat inflationa ionary ry or deflat deflation ionary ary period period In times times of inflat inflatio ion n &the &the more more usual usual case'$ case'$ 0I,O 0I,O inventory accounting #ould result in lo#er earnings "eing reported than t han #ould "e the case had ,I,O "een employed

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c &=' Install Installment ment sales sales a Accrual method  Assum ssumes es inco income me is reco recogn gniz ized ed #h #hen en the the sale sale is made made &earned' %nstallment %nstallment method  Assumes income is recognized only #hen cash is received as the various installments come in " %he installme installment nt method method is commonl commonly y used for tax purposes purposes #hile #hile the accrual accrual method is employed in financial statements statements %he accrual method #ould result in a higher earnings ear nings figure "eing reported than the installment installment method :@ %hree different types of accounting changes include include &a' Changes Changes in accountin accounting g principl principle e &"' Changes Changes in accounting accounting estimate estimate &c' Changes Changes in reportin reporting g entity entity :6 3pecial items items refer to transaction transactions s and events that are unusual unusual or infre*uent$ infre*uent$ not "oth %hese items are reported as separate line items on the income statement "efore contin continui uing ng income income Exampl Examples es of specia speciall items items inclu include de restru restructu cturin ring g charge charges$ s$ impairments of long(lived long(lived assets$ and asset #rite(offs : 3pecial &one(time' &one(time' charges usually usually receive receive less attention attention "y investo investors rs "ecause it often is "elieved that such charges #ill not recur in the future As a result$ result$ companies often include as much operating expense and loss as possi"le in special charges hoping hoping that investor investors s #il #illl focus on income income "efore "efore special special charges charges that excludes these expenses expenses and losses losses If investors investors do focus on income income "efore these charges$ charges$ company value may "e erroneously perceived to "e higher than is supported "y the fundamentals :D 1any 1any specia speciall charge charges s shoul should d "e vie#ed vie#ed as operat operating ing expenses expenses that that need need to "e reflec reflected ted in perman permanent ent incom income e Essent Essential ially ly$$ many special special charge charges s are either either correct correction ions s of und unders erstat tated ed past past expense expenses s or inves investme tments nts for for impr improve oved d future future profita"ility profita"ility As such$ such$ analysts should ad+ust their income measurements to include special charges in operating income : %he follo#i follo#ing ng criteria criteria exemplify the rules that have "een esta"lis esta"lished hed to prevent prevent the premature anticipation of revenue Realization is deemed to ta.e place only after the follo#ing follo#ing conditions have "een met &a' %he earning activities activities underta.en underta.en to create revenue revenue are su"stantial su"stantially ly completeF completeF for example$ no significant effort is necessary to complete the transaction &"' In the case of a sale$ the ris. of o#nership o#nership has effectively passed to the "uyer "uyer &c' %he revenue$ revenue$ as #ell as the associate associated d expenses$ can "e measured or estimated estimated #ith su"stantial accuracy &d' &d' %h %he e reve revenu nue e reco recogn gniz ized ed shou should ld no norm rmal ally ly resu result lt in an incr increa ease se in cash cash$$ receiva"les$ or mar.eta"le securities and$ under certain conditions$ in an increase in inventories or other assets$ or a decrease decre ase in a lia"ility lia"ility &e' %he "usiness transactions transactions giving rise to the income should should "e at armKs(length #ith #ith independent parties &that is$ not #ith # ith controlled parties' &f' %he transaction transactions s should should not "e su"+ect su"+ect to revocation$ revocation$ for example$ example$ carrying carrying the right of return of merchandise sold ;G S&AS () &)Revenue &)Revenue Recognition When Right of Return Exists)' specifies that revenue from sales transactions in #hich the "uyer has a right to return the product should "e recognized at the time of sale only if all of the follo#ing conditions conditions are met At the date of sale$ the price is su"stantially fixed or determina"le •

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%he "uyer has paid the seller$ or is o"ligated to pay the seller ¬ contingent on resale of the product' In the event of theft or physical damage to the product$ the "uyerKs o"ligation o"ligation to the seller #ould not "e changed %he "uyer ac*uiring the product for resale has economic su"stance apart from that provided "y the seller seller %he seller does not have significant o"ligations o"ligations for future performance to directly "ring a"out resale of the product -roduct returns can "e reasona"ly estimated If these conditions are not met$ revenue recognition is postponedF if they are met$ sales revenue and cost of sales should "e reduced to reflect estimated returns and expected costs or losses should "e accrued *ote %he 3tatement does not apply to accounting for revenue in &a' service industries if part or all of the service revenue may "e returned under cancellation privileges granted to the "uyer$ &"' transactions involving real estate or leases$ or &c' sales transactions in #hich a customer may return defective goods such as under #arranty # arranty provisions provisions

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;: 3ome 3ome of the factors factors that that might might impai impairr the a"ili a"ility ty to predic predictt return returns s &#hen &#hen right right of return return exists exists in transaction transactions' s' are &:' suscepti" suscepti"ili ility ty to signif significant icant external factors$ factors$ such as technological o"solescence or s#ings in mar.et demand$ &;' long return privilege privilege periods$ and &=' a"sence of appropriate historical return experience ;; S&AS (+ &)Accounting for -roduct ,inancing Arrangements)' is concerned #ith the issue issue of #hether #hether revenue has "een earned A product product financing financing arrangement arrangement is an agreement involving the transfer or sponsored ac*uisition of inventory that$ although it resem"les a sale$ is in su"stance a means of financing inventory through a second party party ,o ,orr exampl example$ e$ if a compan company y transf transfers ers inven inventor tory y to anothe anotherr compa company ny in an apparent sale$ and in a related transaction agrees to repurchase the inventory at a later date$ the arrangement may "e a product financing arrangement rather than a sale sale and su"se*u su"se*uent ent purchas purchase e of invento inventory ry If the party "earing "earing the ris.s and re#ards of o#nership transfers inventory to a purchaser$ and in a related transaction agrees to repurchase the product at a specified price$ or guarantees some specified resale price for sales of the product to outside part partie ies$ s$ the the arra arrang ngem emen entt is a prod produc uctt fina financ ncin ing g arra arrang ngem emen entt and and shou should ld "e accounted for as such ;= %he percentage!of! completion method is prefe preferr rred ed #h #hen en esti estima mate tes s of cost costs s to complete along #ith estimates of progress to#ard completion of the contract can "e made #ith # ith reasona"le dependa"ility A common "asis of profit estimation is to record that part of the estimated total profit that corresponds to the ratio that costs incurred to date "ears to expected total costs Other methods of estimation of completion can "e "ased "ased on uni units ts compl completed eted or on *uali *ualifie fied d engine engineeri ering ng estima estimates tes or on un units its delivered %he completed!contract method of of accounting is prefera"le #here the conditions inherent in the contract present ris.s and uncertainties that result in an ina"ility to ma.e reason reasona"l a"le e estima estimates tes of costs costs and compl completi etion on time time -ro"l -ro"lems ems und under er this this method concern the point at #hich completion of the contract is deemed to have occu occurr rred ed as #e #ell ll as the the .ind .ind of expe expens nses es to "e defe deferr rred ed ,o ,orr exam exampl ple$ e$ some some comp compan anie ies s defe deferr all all cost costs s to the the comp comple leti tion on date date$$ incl inclu udin ding gene genera rall and and admini administr strati ative ve overhe overhead ad #hi #hile le others others consid consider er such such costs costs as period period costs costs to "e expensed as they are incurred 6-8


/nde /nderr eith either er of the the t#o t#o cont contrac ractt accou account ntin ing g meth method ods$ s$ loss losses es &pre &prese sent nt or anticipated' must "e fully provided for in the period in #hich the loss first "ecomes apparent

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;? %he recording of revenue is the first step in the the process of income determination determination and is a step for #hich the recognition of any and all revenue depends %he analyst should "e particularly in*uisitive a"out revenue recognition policies and procedures 3ome specific aspects include the follo#ing follo#ing &:' One element that casts dou"t on the validity of revenue is uncertainty a"out the a"ility of the seller to collect the resulting receiva"le 3pecial collection pro"lems exist #ith respect to installment sales$ real estate sales$ and franchise sales -ro"lems of collection exist$ ho#ever$ ho#ever$ in the case of all sales and the analyst analyst must "e alert alert to them &;' %he analyst analyst must also "e alert to the pro"lems related to the timing of revenue recognition %he present rules generally do not allo# for recognition of profit in advance of saleMsuch as #ith increases in mar.et mar.et value value of proper property ty such such as land land or e*uipm e*uipment ent$$ the accretion accretion of values values in gro#ing tim"er$ or the increase in the value of inventories are not recognized in the accounts As a conse*uence$ income #ill not "e recorded "efore sale and the timing of sales is a matter that lies #ithin the discretion of management %hat$ in turn$ gives management a certain degree of discretion in the timing of profit recognition &=' In the area of contract accounting$ the analyst should recognize that the use of the completed contract method is +ustified only in cases #here reasona"le estimates of costs and the degree of completion are not possi"le 7et$ some companies consider the choice of method a matter of discretion &?' Other alternative methods of ta.ing up revenue$ as in the case of lessors or finance companies$ must "e fully understood "y the analyst "efore an evaluation of a companyKs earnings or a comparison among companies in the same industry is underta.en ;@ S&AS  &)Accounting &)Accounting for Research and 2evelopment Costs)' offers a simple solution to the complex pro"lem pro"lem of accounting for for research and development costs !amely$ !amely$ it re*uires that RN2 costs "e charged to expense #hen incurred It defines research and development activities as follo#s &a' -esearch activities are aimed at discovery of ne# .no#ledge for the development of a ne# product or process or in "ringing a"out a significant improvement to an existing product or process &"' $evelopment activities translate the research findings into a plan or design for a ne# product or process or a significant improvement to an existing product or process RN2 specifically excludes routine or periodic alterations to ongoing operations and mar.et research and testing activities %he 5oard recommended the follo#ing accounting accounting treatment for RN2 costs &a' %he ma+ority ma+ority of expenditur expenditures es incurred in research and development development activitie activities s as defined a"ove constitutes the costs of that activity and should "e charged to expense #hen incurred &"' Costs Costs of materials materials$$ e*uipment$ e*uipment$ and facilitie facilities s that have alternative alternative future uses &in researc research h and develo developme pment nt pro+ec pro+ects ts or other# other#ise ise'' shoul should d "e capita capitali lized zed as tangi"le assets &c' Intangi" Intangi"les les purchased purchased from an external party for RN2 use that have alternativ alternative e future uses should also "e capitalized &d' Indirect costs involved involved in ac*uiring patents should should "e capitalized capitalized as #ell

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Elements of costs that should "e identified #ith RN2 activities activities are &a' Costs of materials$ materials$ e*uipment$ e*uipment$ and facilities facilities that are ac*uired or constructed for a particular research and development pro+ect and purchased intangi"les$ that have no alternative future uses &in research and development pro+ects or other#ise' &"' &"' Cost Costs s of mate materi rial als s cons consum umed ed in rese researc arch h and and deve develo lopm pmen entt acti activi viti ties es$$ the the depreciation of e*uipment or facilities$ and the amortization of intangi"le assets used in research and development activities that have alternative future uses &c' 3alaries and other related costs of personnel personnel engaged in RN2 activities activities &d' Costs of services services performed "y others others &e' A reasona"le reasona"le allocation allocation of indirect indirect costs 4eneral and administra administrative tive costs that are not clearly related to RN2 activities should "e excluded %he specific disclosure re*uirements as stipulated "y 3,A3 3,A3 ; are &:' for each income statement presented$ the total RN2 costs charged to expense is to "e disclosed$ and &;' government(regulated companies that defer RN2 costs in accordance #ith the addendum to 3,A3 ; must ma.e certain cert ain additional disclosures disclosures to that effect ;6 ,or an analyst to form a relia"le opinion opinion on the *uality *uality and the future potential value value of research outlays$ the analyst needs to .no# a great deal more than the totals of periodic research and development outlays outlays %he analyst needs information information on &:' the types of research performed$ &;' the outlays "y category$ &=' the technical feasi"ility$ commercial via"ility$ via"ility$ and future potential of each pro+ect assessed and reevaluated at the time of each periodic report$ and &?' information on a companyKs success(failure experie experience nce in its severa severall areas areas of researc research h activ activity ity to date date Of course course$$ presen presentt disclosure re*uirements #ill not give the analyst a nalyst such information and it appears that$ except except in cases of volun voluntar tary y discl disclosu osure$ re$ onl only y the the invest investor or or the lender lender #ith #ith the the necessary clout #ill "e a"le to o"tain such information information In general$ one can assume that the outright expensing of all research and development outlays #ill result in more conservative "alance sheets and fe#er "ad(ne#s surprises stemming from the #holesale #holesale #rite(off #rite(offs s of previous previously ly capitaliz capitalized ed research research and developme development nt outlays outlays >o#ever$ the analyst must realize that along #ith a lac. of .no#ledge a"out future potent potential ial sHhe may also "e una#are una#are of the po poten tentia tiall disast disasters ers that can "efall "efall an enterprise tempted or forced to sin. ever greater amounts of funds into research and development pro+ects #hose promise #as great "ut #hose failure is nevertheless inevita"le ; One of the most common solutions solutions applied "y analysts analysts to the complex pro"lem of the analysis of good#ill is to simply ignore ignore it %hat is$ they ignore the asset sho#n on the "alance "alance sheet /nfortu /nfortunatel nately$ y$ "y ignorin ignoring g good good#ill #ill$$ analysts analysts ign ignore ore investme investments nts of very su"stantial resources in #hat may often "e a companyKs most important asset Ignoring the impact of good#ill impairment losses on reported periodic income is no solution to the analysis of this complex cost Even considering the limited amount of information availa"le to the analyst$ it is far "etter that the analyst understand the effects of accounting practices in this area on accounting income rather than dismiss them altogether

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;D 4ood#ill is measured "y the excess of cost over the fair mar.et value of tangi"le net assets ac*uired in a transaction transaction accounted for as a purchase %hat is the theory theory of it %he financial analyst must "e alert to the ma.eup and the method of valuation of the 4ood#ill account as #ell as to the method of its ultimate disposition One #ay of disposing of the 4ood#ill account$ fre*uently chosen "y management$ is to #rite it off at a time #hen it #ould have the least serious impact on the mar.etKs +udgment of the companyKs companyKs earnings$ earnings$ for example$ at a time of loss loss or reduced earnings earnings /nder /nder normal circumstances$ good#ill is not indestructi"le "ut is rather an asset #ith a limited useful life 3till$ #hatever #hatever the advantages of location$ mar.et mar.et dominance and competitive stance$ sales s.ill$ product acceptance$ or other "enefits are$ they cannot "e unaffected "y the passing of time and "y changes in the "usiness environment %hus$ the analyst must assess the carrying amount of good#ill "y reference to such eviden evidence ce of contin continui uing ng value value as the profit profita"i a"ili lity ty of un units its for #hi #hich ch the goo good#i d#ill ll consideration #as originally paid ; %he inter interest est cost to a compan company y is the no nomin minal al rate paid paid inclu includi ding$ ng$ in the case of "onds$ "ond s$ the amortiza amortization tion of any "ond discount discount or premium premium A compli complicatio cation n arises #hen #hen compan companies ies issu issue e conver converti" ti"le le de"t de"t or de"t de"t #ith #ith #arran #arrants$ ts$ thus thus achiev achieving ing a nominal de"t coupon cost that is "elo# the cost of similar de"t not carrying these features After After trial pronouncements pronouncements on the the su"+ect and much controversy$ controversy$ APB .( conclu concluded ded in the case case of conver converti" ti"le le de"t de"t that that the the insep insepara ara"il "ility ity of the de"t de"t and e*uity features is such that no portion of the proceeds from the issuance should "e accounted accounted for as attri"uta"le attri"uta"le to the conversion conversion feature feature In the case of de"t issued #ith stoc. #arrants attached$ the proceeds of the de"t attri"uta"le to the #arrants should "e accounted for as paid(in capital %he corresponding charge is to a de"t disc discou ount nt accou account nt that that mu must st "e amor amorti tize zed d over over the the life life of the the de"t de"t issu issue e thus thus increasing the effective interest cost =G =G a S&AS 3( &)Capitalization of Interest Cost)' re*uires capitalization of interest cost as part part of the the hist histor oric ical al cost cost of )ass )asset ets s that that are are cons constr truc ucted ted or othe other# r#is ise e produced for an enterpriseKs o#n use &including assets constructed or produced for the enterprise "y others for #hich deposits or progress payments have "een made') made') Inventor Inventory y items that are routinely routinely manufactured manufactured or produced produced in large large *uanti *uantitie ties s on a repeti repetitiv tive e "asis "asis do no nott *uali *ualify fy for inter interest est capita capitaliz lizat ation ion %he o"+ectives of interest capitalization$ according to the ,A35$ are &:' to measure more mo re accur accurate ately ly the the ac*u ac*uis isit itio ion n cost cost of an asse asset$ t$ and and &;' &;' to amor amorti tize ze that that ac*uisition cost cost against revenues generated "y the asset " %he amount of interes interestt to "e capitalized capitalized is "ased "ased on the entityKs entityKs actual "orro#i "orro#ings ngs and interest payments %he rate to "e used for capitalization may "e ascertained in this order &:' the rate of specific "orro#ings associated #ith the assets and &;' if "o "orr rro# o#in ings gs are are no nott spec specif ific ic for for the the asse asset$ t$ or the the asse assett exceed exceeds s spec specif ific ic "orro#ings therefore$ a #eighted average of rates applica"le to other appropriate "orro#ings may "e used Alternatively$ a company may use a #eighted average of rates of all appropriate "orro#ings regardless of specific "orro#ings incurred to finance the asset

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c Interest Interest capitaliz capitalizatio ation n is not permitt permitted ed to exceed total interest interest costs costs for any period$ period$ nor is imputing interest cost to e*uity funds permitted A company #ithout de"t #ill have no interest to capitalize %he capitalization period "egins #hen three conditions are present &:' expenditures for the asset have "een made "y the entity$ &;' #or. on the asset is in progress$ and &=' interest cost is "eing incurred Interest capitalization capitalization ceases #hen the asset is ready for f or its intended use =: %he intrin intrinsic sic value value of an option option is the amoun amountt "y #hich #hich the mar.et mar.et value value of the underlying security exceeds the option exercise price at the time of measurement %he fair value of an option is the amount that mar.et participants #ould "e #illing to pay today to purchase the option =; %he fair value of an option option is affected "y the exercise price$ the current mar.et price$ the ris.(free rate of interest$ the expected life of the option$ the expected volatility of the stoc. price$ and the expected expe cted dividend yield yield == S&AS re*uires res that that the company company amort amortize ize the fair fair value value of emplo employee yee stoc. stoc. S&AS .3 re*ui options &estimated using various option pricing models' at the grant date over the expected expected life of the option option %he cumula cumulati tive ve amorti amortiza zatio tion n of all employ employee ee stoc. stoc. options granted in the past is collectively called the option compensation expense /ntil recently$ option compensation expense #as not charged to income >o#ever$ a recent revision revision of the standard$ S&AS .3- $ re*uires that the option compensation expense "e charged to income Compensation expense may "e included in various expense categories such as cost of goods sold$ 34NA$ 34NA$ RN2 etc "ased on #hich area of the company the respective employee #or.s for =? %he econom economic ic cost cost of issu issuing ing optio options ns at the prevaili prevailing ng mar.et mar.et price price are &:' the interest cost$ #hich is that the employee is a"le to pay for the stoc. purchase many years years later later using using the current current stoc. stoc. priceF priceF and &;' cost cost of provi providi ding ng an op optio tion n to exercise$ #hich arises "ecause the employee can share in the potential upside "ut is protected from sharing in the potential do#nside do#nside ris. =@ Option overhang refers to the intrinsic intrinsic value of outstanding outstanding options options &"oth exercisa"le and other#ise' as a proportion of the company
6-13


&"' &c' Certai Certain n deduct deduction ions s are not allo#e allo#edMf dMfor or example example$$ penalt penalties ies for filin filing g certai certain n returns$ government fines$ and officer life insurance premiums dividend exclusion on dividends dividends &d' 3pecial deductions granted "y la#Mfor example$ dividend from from uncons unconsol olida idated ted su"sid su"sidiar iaries ies and from from divid dividend ends s receive received d from from other other domestic corporations =6 %he effective tax rate paid "y a corporation on its income #ill vary from the statutory rate "ecause %he "asis of carrying property for accounting purposes may differ from that for tax purposes from reorganizations$ "usiness com"inations$ com"inations$ or other transactions !on*ualified !on*ualified and *ualified stoc.(option plans may result in "oo.(tax differences Certain industries$ such as savings and loan associations$ shipping lines$ and insurance companies en+oy special tax ta x privileges /p to :GG$GGG of corporate income is taxed at lo#er tax rates Certain credits may apply$ such as RN2 credits and foreign tax credits 3tate and local income taxes$ net of federal tax "enefit$ are included in total tax expenses What ma.es these differences and factors permanent is the fact that they do not have any future repercussions on a companyKs taxa"le income %hus$ they must "e ta.en into account #hen reconciling a companyKs actual &effective' tax rate to the statutory rate •

• •

• • •

S&AS .0+ &)Accoun = S&AS &)Accounting ting for Income Income %axes)' %axes)' esta"lish esta"lishes es financia financiall accounting accounting and reporting standards for the effects of income taxes that result from an enterpriseKs activities during the current and preceding years$ and re*uires an asset and lia"ility approach S&AS .0+ re*uires that deferred taxes should "e determined separately for each tax(pay tax(paying ing compo componen nentt &an indiv individ idual ual entity entity or group group of entiti entities es that that is consolidated for tax purposes' in each tax +urisdiction %he determination includes the follo f ollo#ing #ing procedures Identify the types and amounts of existing temporary differences and the nature and amount of each type of operating loss and tax credit cre dit carry for#ard$ plus the remaining length of the carry for#ard period 1easure the total deferred tax ta x lia"ility for for taxa"le temporary differences$ using the applica"le tax rate 1easure the total deferred tax asset for deducti"le temporary differences and operating loss carry for#ards$ using the applica"le tax rate 1easure deferred tax assets for each type of tax credit carry for#ard Reduce deferred tax assets "y a valuation allo#ance if "ased on the #eight of availa"le evidence It is more li.ely than not &a li.elihood of more than @G perce nt' that some portion or all of the deferred tax t ax assets #ill not "e realized %he valuation allo#ance allo#ance should "e sufficient to reduce the deferred tax asset to the amount that is more li.ely than not to "e realized 2eferred tax assets and lia"ilities should "e ad+usted for the effect of a change in tax la#s or rates %he effect should "e included in income from continuing operations for the period that includes the enactment date •

•

•

• •

6-14


=D &a' Revenues Revenues or gains are include included d in taxa"le income income later later than they are included included in pretax accounting income &"' Expenses Expenses or losses losses are deducted deducted in determining determining taxa"le taxa"le income later than they are deducted in determining pretax accounting income &c' Revenues or gains are included in taxa"le income earlier than they they are included in pretax accounting income &d' Expenses Expenses or losses losses are deducted deducted in determining determining taxa"le income earlier earlier than they are deducted in determining pretax accounting income = %he components of the net deferred tax lia"ility or net deferred tax asset recognized in a companyKs "alance sheet should "e disclosed %hese include the %otal of all deferred tax lia"ilities %otal %o tal of all deferred tax assets %otal %o tal valuation allo#ance recognized for deferred tax assets Additional disclosures include the significant components of income tax expense attri"uta" attri"uta"le le to continui continuing ng operation operations s for each year presented presented #hich include$ include$ for example Current tax expense or "enefit 2eferred tax expense or "enefit &exclusive of the effects of other components' Investment tax credits 4ove 4o vern rnme ment nt gran grants ts &to &to the the exten extentt recog recogni nize zed d as a redu reducti ction on of inco income me tax expense' %he "enefits of operating loss carry for#ards %ax %ax expense that results results from allocatin allocating g certain certain tax "enefits "enefits either directly to contri"uted capital or to reduce good#ill or other noncurrent intangi"le assets of an ac*uired entity entity Ad+ustments of a deferred tax lia"ility or asset for enacted changes in tax la#s or rates or a change in the tax status of the enterprise Ad+ustments Ad+ustments of the "eginning(of(year "alance of a valuation allo#ance "ecause of a chan change ge in circ circum umst stan ance ces s that that caus causes es a chan change ge in +udg +udgme ment nt a"ou a"outt the the realiza"ility of the related deferred tax asset in future years Also to "e disclosed is a reconciliation "et#een the effective income tax rate and the statutory federal income tax rate In addition$ the amounts and expiration dates of operating loss and tax credit carry for#ards for tax purposes must "e disclosed • • •

• • • •

• •

•

•

?G &:' One of the fla#s remaining in tax allocation procedures is that no recognition is given to the fact that a future o"ligation$ or loss of "enefits$ should "e discounted rather than sho#n at its entire amount as todayKs tax deferred accounts actually are %he ,A35 has revie#ed the issue and decided not to address it "ecause of the conceptual and implementation issues involved &;' Another fla# is that the 5oard allo#e allo#ed d parent parent compan companies ies to avoid avoid provi providi ding ng taxes taxes on unremi unremitte tted d earning earnings s of su"sidiaries and other specialized exceptions to the re*uirements of deferred tax accounting ?: A %he determination of the earnings level of an enterprise$ #hich is relevant to the purpose purpose of the analyst$ is a complex complex analytica analyticall process process %he earnings earnings figure figure can "e conver converted ted into into a per(sha per(share re amount amount that is useful useful in evaluati evaluating ng the price price of the common stoc.$ its dividend coverage$ and the potential effects of dilution As #ith any measure$ there are strengths and #ea.nesses associated #ith its computation %hus$ the analyst must have a thorough understanding of the principles that govern 6-15


the computation of earnings per share to effectively analyze it and use it in decision ma.ing

6-16


?; A Earnings per share data are used in ma.ing investment investment decisions decisions %hey are used in evaluating the past operating performance of a company and in forming an opinion as to its future potentia potential l %hey are commonly commonly presented presented in prospectuses prospectuses$$ proxy material$ and reports to stoc.holders$ and is the only financial statement ratio that is audited audited %hey are used in the compilation compilation of "usiness "usiness earnings earnings data for the press$ statistica statisticall services$ services$ and other other pu" pu"licat lication ions s When presented presented #ith formal financia financiall statements$ they assist the investor in #eighing the significance of a corporationKs current net income and of changes in its net income from period to period in relation to the shares an analyst holds or may ac*uire Current 4AA- regarding E-3 conforms to international standards %he analyst must "e a#are that "asic E-3 does not ta.e into account securities that$ although not common stoc.$ are in su"stance e*uivalent to common stoc. %he analyst must ta.e care to focus on diluted E-3$ #hich intends to sho# the maximum extent of potential dilution dilution of current earnings that conversions of securities could create ?= A 2iluted earnings per share is the amount of current earnings per share reflecting the maxim maximum um dilu diluti tion on that that #o #oul uld d resu result lt from from conv conver ersi sion ons$ s$ exerci exercise ses$ s$ and and othe other r contingent issuances that individually individually #ould decreased earnings e arnings per share and in the aggregate yield a dilutive effect All such issuances are assumed to have ta.en place at the "eginning of the period &or at the time the contingency arose$ if later' ?? A %he amount of any dividends on preferred stoc. that have "een paid &declared' for the year should "e deducted from net income "efore computing earnings per share ?@ A 7es$ if #arrants or options are present$ an increase in the mar.et price of the common stoc. can increase the num"er of common e*uivalent shares "y decreasing the num"er of shares repurchasa"le under the treasury stoc. method ?6 A S&AS .) has has a num"er of fla#s and inconsistencies that the analyst must consider in interpreting E-3 data &a' %he computati computation on of "asic "asic E-3 completely completely ignores the potentially potentially diluti dilutive ve effects of options and #arrants &"' %here is a "asic "asic inconsistenc inconsistency y in treating certain certain securities securities as the e*uivalent e*uivalent of common stoc. for purposes of computing E-3 #hile not considering them as part of the stoc.holdersK e*uity in the "alance sheet Conse*uently$ the analyst #ill have have diffi difficul culty ty in inter interrel relati ating ng report reported ed E-3 #ith #ith the de"t(lev de"t(leverag erage e po posit sition ion pertaining to the same earnings &c' 4enerally 4enerally$$ E-3 are considere considered d to "e a factor influencin influencing g stoc. prices Whether Whether options and #arrants are dilutive or not depends on the price of the common stoc. %hus #e can get a circular effect in that the reporting of E-3 may influence the mar.et price price #hich$ #hich$ in turn$ turn$ influence influences s E-3 /nder these rules rules earnings earnings may depend on mar.et prices of the stoc. rather than only on economic factors #ithin the enterprise In the extreme$ this suggests that the pro+ection of future E-3 re*uires not only the pro+ection of earnings levels "ut also the pro+ection of future mar.et prices ? A &a' Earning Earnings s per per share share data data are used used in ma.ing ma.ing inves investme tment nt deci decisio sions ns %hey %hey are used in evaluating the past operating performance of a company and in forming an op opin inio ion n as to its its futu future re po pote tent ntia ial l %hey hey are are comm common only ly pres presen ente ted d in prospectuses$ proxy material$ and reports to stoc.holders %hey are used in the compilation compilation of "usiness earnings data for the press$ statistical services$ and other pu"lications pu"lications When 6-17


presented presented #ith formal financial financial statements statements$$ they assist the investor investor in #eighin #eighing g the signi signific ficanc ance e of a corpo corporat ration ionKs Ks curren currentt net income income and of change changes s in its its net income from period to period in relation to the shares an analyst holds or may ac*uire &"' Earnings Earnings per common share share are not fully fully relevant relevant to the valuation valuation of preferred preferred stoc. ,or purposes of preferred stoc. evaluation$ the earnings coverage ratio of preferred stoc. is among the most relevant It measures the num"er of times preferred dividends have "een earned and$ thus$ is a measure of the safety of the dividend as #ell as the safety of the preferred issue

6-18


EERCI3E3 Exercise 6(: &;@ minutes' a Cash xxx 4ain on dispositionP !et assets of discontinued operations P &A loss on disposition #ould "e recorded as a de"it'

xxx xxx

" Income Income &expense &expense'' related related to discont discontinu inued ed operations operations include include the operating operating profit &loss' recorded prior to sale and the gain &loss' on sale %hese are reported net of applica"le tax c When When esti estima mati ting ng futu future re earn earnin ing g po po#e #err$ the the resu result lts s from from disc discon onti tinu nued ed operat operatio ions ns shou should ld no nott "e treated treated as recu recurr rrin ing g %h %his is is importa important nt for an assessment of the permanent income of a company d 3eparat 3eparately ely reportin reporting g discont discontinu inued ed operations operations allo#s the analyst analyst to vie# the results results of operations operations #ithou #ithoutt the segment segment that #ill not "e ongoing ongoing As a result$ the analyst can "etter assess the permanent permanent component of income$ for #hich results of discontinuing operations #ill "e excluded Exercise 6(; &=G minutes' a 5y the use use of reserv reserves$ es$ a compa company ny can alloca allocate te costs costs in excess excess of actual actual experience experience in the current current period$ "ased on estimates of additional costs in the future$ or even "ased on the simple possi"ility of further costs in the future %hen$ in later periods$ actual costs can "e #ritten off against the reserve rather rather than reported reported as expenses expenses in the company companyKs Ks income income statemen statementt for those periods %he advantage to the company is that earnings trends can "e )smoothed$) and a cushion for future earnings can "e "uilt up during good economic years for use during leaner periods %o the extent that sta"ility and predicta"ility of earnings are mar.et virtues$ the companyKs common stoc. might "e accorded a higher multiple for these efforts$ in effect lo#ering the cost of capital to the company company %he use of reserves reserves "oth poses pro"lems pro"lems for the analys analystt and and confli conflicts cts #ith #ith some some "asic "asic accou account nting ing princi principle ples s %h %hese ese include &:' /se of reserves contradicts contradicts the matching principle$ "y #hich revenues revenues and related costs should "e recognized in the same period &;' Reserving Reserving for future events &especially &especially contingencies' contingencies' is o"viously o"viously su"+ect to estimate$ and accounting accounting should attempt to record *uantifia"le *uantifia"le value as much as possi"le

6-19


Exercise 6(;Mcontinued &=' %h %he e reser reservi ving ng techn techni* i*ue ue ma.es ma.es repo reporte rted d earn earnin ings gs less less indic indicati ative ve of fundamental trends in the company %he effects of the economic cycle are reduced reduced$$ ma.ing ma.ing correla correlation tion techni* techni*ues ues &such &such as 4!- gro#th gro#th vs vs E-3 gro#th' invalid %hese reported num"ers might mislead the uninformedB investo investor r In contras contrastt to the artificia artificiall smoothin smoothing g referred referred to earlier earlier$$ the companyKs gro#th rate may "e exaggerated$ "y over(reserving for losses in a "ad year$ and su"se*uent #riting off of the reserve It should "e noted that a reserve can "e properly ta.en such as #hen it recognizes a lia"ility that &:' li.ely exists in the relatively near futureMsuch as costs of #inding up a plant shutdo#n #ith the next year or &;' is su"+ect to *uantificationMsuch as the outright expropriation of net assets in a foreign country " If the analyst analyst is a"le a"le to discern the impact impact of reserves$ reserves$ sHhe should should exclude exclude the reservesK impact from accounting income #hen assessing past trends Only operat operatin ing g or no norma rmall earni earning ngs s shou should ld "e compa compared red over over the shor short(ter t(term m >o#ever$ over a longer period of time$ the losses against #hich reserves have "een ta.en ta.en should should "e included included In estimati estimating ng future future earnings$ earnings$ the analyst analyst must carefully consider the impact of reserves and exclude the impact #hen forecast forecasting ing normal normal earnings earnings 5y doing this$ this$ the analyst analyst #ill have a "etter "etter unders und erstand tanding ing of the true operati operations ons of the company company In the valuatio valuation n of common stoc.$ the analyst must focus on the sustaina"le earning po#er of the company %hus$ earnings may have to "e ad+usted up#ard or do#n#ard depending on the degree of a"use of reserves c 3evera 3everall examples examples of reserve reserves s are cited cited in the chapter chapter Also$ studen students ts often "enefit from a revie# of "usiness magazines in attempting to identify such reserves &C,A Adapted' Adapte d'

Exercise 6(= &=@ minutes' a A change change from from the the sum(o sum(of(th f(the(y e(yea earsK rsK(di (digi gits ts meth method od of depre deprecia ciatio tion n to the the straight(line straight(line method for previously previously recorded assets is a change in accounting accounting 5oth the sum(of(the( sum(of(the(yea yearsK(d rsK(digit igits s method and the straig straight(lin ht(line e principle  5oth method are generally accepted A change in accounting principle principle results from adopti adoption on of a gene general rally ly accept accepted ed accou account ntin ing g princ principl iple e diffe differen rentt from from the the gener generall ally y accep accepted ted acco accoun untin ting g prin princip ciple le used used previ previou ously sly for for repo reporti rting ng purposes

6-20


Exercise 6(=Mcontinued " A chang change e in the expecte expected d serv servic ice e life life of an asset asset arisin arising g "ecau "ecause se of mo more re exper experien ience ce #ith the asset asset is a change in accounting estimate  A change in accounting estimate occurs "ecause future events and their effects cannot "e perceiv perceived ed #ith certainty certainty Estimat Estimates es are an inh inhere erent nt part of the account accounting ing process %herefore$ accounting and reporting for certain financial statement element elements s re*uire re*uires s the exercise exercise of +ud +udgmen gment$ t$ su"+ect su"+ect to revisio revision n "ased "ased on experience c : %he %he cumula cumulativ tive e effect effect of a chan change ge in accou account nting ing prin princip ciple le is the differ differen ence ce "et#een &:' the amount of retained earnings at the "eginning of the period of change and &;' the amount of retained earnings that #ould have "een reported at that date if the ne# accounting principle had "een used in prior periods ; ,A35 ;GG@ ;GG@ 3tat 3tatem emen entt Acc Accou ount ntin ing g Chan Change ges s and and Erro Errorr Corr Correc ecti tion onsB sB re*uires that effective in ;GG@$ companies should apply the retrospective approachB to changes changes in accounting principle %hus$ all presented periods must "e restated as if the change #ere in effect during those periods$ and any any cumu cumula lati tiv ve effe effect ct from from peri period ods s "efo "efore re tho hose se pres presen ente ted d is an ad+ustment to "eginning retained earnings of the earliest period presented d Cons Consis iste tent nt use use of acco accoun unti ting ng prin princi cipl ples es from from one one acco accoun unti ting ng peri period od to another another enhanc enhances es the usefuln usefulness ess of financ financial ial statemen statements ts in comparat comparative ive analysis of accounting data across time e If a change change in account accounting ing principle principle occurs$ occurs$ the nature nature and and effect of a change change in in accou account nting ing prin princip ciple le shou should ld "e disclo disclosed sed to avoid avoid misle misleadi ading ng finan financia ciall statement users %here is a presumption that an accounting principle$ once adopted$ should not "e changed in accounting for events and transactions of a similar type f 1and 1andat ato ory acco accou unting ting chan change ges s are are larg largel ely y no non( n(di disc scre reti tion onar ary y %hu %h us$ manager managerial ial discretio discretion n is not present$ present$ or at least is to a lesser lesser degree degree One should examine the motivations for voluntary accounting changes and assess any earnings *uality impact g 1andatory 1andatory accountin accounting g changes changes are largely non(discretiona non(discretionary ry >o#ever$ >o#ever$ there is often a #indo# of time for a company to adopt a mandatory accounting change If a #indo# exists$ management has discretion discretion as to the timing of of the adoption adoption %hu %hus$ s$ the timing of adoption adoption and any accoun accounting ting ramifica ramification tions s shou should ld "e cons conside idered red ,o ,orr exam example ple$$ if a mana manage gerr is goi going ng to adopt adopt an accounting change that includes a large charge$ the manager might choose to adopt in a relatively poor *uarter to attempt to potentially conceal or do#nplay the poor operating performance

6-21


Exercise 6(=Mconcluded h 1andator 1andatory y account accounting ing changes changes often often includ include e the recogniti recognition on of retroactiv retroactive e earni earning ngs s affect affects s ,o ,orr exampl example$ e$ the the rules rules in accou account ntin ing g for for other other post( employ employme ment nt "ene "enefit fits s re*ui re*uire re that that comp compan anies ies esta"l esta"lish ish a lia"il lia"ility ity for for the the accrued "enefits "enefits to date %his results in a large charge charge for many companies companies Of cour course$ se$ the the mar.e mar.ett po poten tentia tially lly vie#s vie#s the the charg charge e as large largely ly the the fault fault of accou account nting ing rule rule ma.e ma.ers rs %h %hus$ us$ mana manage gers rs have have ince incent ntiv ive e to incr increa ease se the the amount of the charge and use the "loated lia"ility to increase future earnings

Exercise 6(? &;G minutes' Comprehensive income computationP a Co Computation :$GGG$GGG ( :GG$GGG L @G$GGG ( ;@$GGG ( :; :;$GGG  :=$GGG

" 5a 5alance sh sheet ac accounts af affected !et income &closed to e*uity' /nrealized holding loss on availa"le for sale securities ,oreign currency translation gain Additional minimum pension lia"ility ad+ustment /nrealized ho holding losses on on derivative in instruments Comprehensive income &component of e*uity'

P %he unexpected unexpected return return on pension pension fund assets assets &?G$G &?G$GGG' GG' does not affect affect net income income or stoc.holders< e*uity in the current period

6-22


Exercise 6(@ &=G minutes' a %he point point of sale is the the most most #id #idely ely used used "asis "asis for the the timin timing g of reve revenu nue e reco recogn gnit itio ion n "eca "ecaus use e in mo most st case cases s it prov provid ides es the the degr degree ee of o" o"+e +ect ctiv ive e eviden evidence ce many many conside considerr necessa necessary ry to measure measure relia"ly relia"ly periodi periodic c "usine "usiness ss income %hat is$ sales transactions transactions #ith outsiders outsiders represent represent the point in the the revenu revenue e genera generating ting process process #hen #hen most of the uncerta uncertainty inty a"out the final final outcome of "usiness activity has "een alleviated alleviated It is also at the point of sale in most cases that su"stantially all of the costs of generating revenues are .no#n$ and they can at this point "e matched #ith the revenues generated to produce a relia"le statement of a firmKs effort and accomplishment for the period Any attempt to measure "usiness income prior to the point of sale #ould$ in the vast ma+ority of cases$ introduce introduce considera"ly considera"ly more su"+ectivity into financial reporting than most accountants are #illing to accept " : %hou %houg gh it is reco recogn gniz ized ed that that rev revenu enue is earn earned ed thro throug ugho hout ut the the enti entire re production process$ generally it is not feasi"le to measure revenue on the "asis of operating activity It is not feasi"le "ecause of the a"sence of suita suita"le "le crite criteria ria for cons consist isten ently tly and and o" o"+ec +ectiv tively ely arriv arrivin ing g at a perio periodi dic c determination of the amount of revenue revenue to ta.e up Also$ in most situations the sale is the most important single step in the earning process -rior to the the sale sale the the amou amount nt of rev revenue enue anti antici cipa pate ted d from from the the proc proces esse ses s of producti production on is merely merely prospec prospectiv tive e revenu revenueF eF its realizat realization ion remains remains to "e validate validated d "y actual actual sales sales %he accumul accumulatio ation n of costs during production production does not alone generate revenueF rather$ revenues are earned "y the entire process including the actual sales %hus$ as a general rule the sale cannot "e regar regarded ded as "eing "eing an un undu duly ly cons conserv ervati ative ve "asis "asis for the the timing timing of rev revenue enue reco recog gniti nitio on Exce Except pt in un unu usual sual circ circum umst stan ance ces$ s$ reven evenue ue recognition prior to sale #ould "e anticipatory in nature and unverifia"le in amount ; %o critici criticize ze the sales "asis as not "eing sufficie sufficientl ntly y conserva conservativ tive e "ecause "ecause accounts receiva"le do not represent disposa"le funds$ it is necessary to assume that collection of receiva"les is the decisive step in the earning process and that periodic revenue measurement and$ therefore$ net income should depend on the amount of cash generated during the period %his assum assumpti ption on disreg disregar ards ds the the fact fact that that the the sale sale usua usually lly repr represe esent nts s the the deci decisi siv ve fact factor or in the the earn earnin ing g proc proces ess s and su" su"stit stitu utes tes for for it the the administrative function of managing and collecting receiva"les %hat is$ the inv investm estmen entt of fund funds s in rece receiv iva" a"le les s shou should ld "e rega regard rded ed as a po poli licy cy designed to increase total revenues$ properly recognized at the point of saleF and the cost of managing receiva"les &eg$ "ad de"ts and collection costs' should "e matched #ith the sales in the proper period %he fact that some revenue ad+ustments &such as sales returns' and some expenses &such as "ad de"ts and collection costs' can occur in a period su"se*uent su"se*uent to the sale does not detract from the overall usefulness of the sales "asis for the timing of revenue recognition 5oth can "e estimated #ith sufficient accuracy so as not to detract from the relia"ility

6-23


Exercise 6(@Mconcluded of reported net income income %hus$ in the vast vast ma+ority of cases cases for #hich the sales sales "asis "asis is used$ used$ estimati estimating ng errors$ errors$ though though unavoid unavoida"le a"le$$ #ill "e too immaterial in amount to #arrant deferring revenue recognition to a later point in time c : $uring production  %his "asis of recognizing revenue is fre*uently used "y companie companies s #ho #hose se ma+or ma+or source source of revenu revenue e are lon long(ter g(term m constr constructi uction on pro+ects ,or these companies companies the point of sale is far less significant significant to the earning process than is production activity "ecause the sale is assured under the contrac ract$ except ept of course #h #he ere perfo rforman mance is not su"stan su"stantial tially ly in accordan accordance ce #ith the contrac contractt terms terms %o defer defer revenu revenue e recognition until the completion of long(term construction pro+ects could impair impair signific significantl antly y the useful usefulnes ness s of the interve intervenin ning g annual annual financ financial ial statements "ecause the volume of completed contracts during a period is li.ely to "ear no relationship to production volume 2uring each year that a pro+ pro+ec ectt is in proc proces ess s a po port rtio ion n of the the cont contra ract ct price rice is ther theref efo ore approp appropria riatel tely y recog recogni nized zed as that that year yearKs Ks reven revenue ue %h %he e amoun amountt of the the cont contrac ractt price price to "e reco recogn gnize ized d shou should ld "e propo proporti rtion onate ate to the the year yearKs Ks production production progress on the pro+ect pro+ect It should "e noted noted that the use of the produ producti ction on "asis "asis in lieu lieu of the the sales sales "asis "asis for for the the timin timing g of reven revenue ue recognition recognition is +ustifia"le +ustifia"le only #hen total profit or loss on the contracts can "e estima estimated ted #ith #ith reaso reasona na"le "le accur accurac acy y and and its ultim ultimate ate reali realizat zatio ion n is reasona"ly assured ; /hen cash is received received  %he most common application of this "asis for the timin timing g of reve revenu nue e recog recognit nition ion is in conn connect ectio ion n #ith #ith inst install allmen mentt sales sales contracts Its use is +ustified on the grounds that$ due to the length of the collection period$ increased ris.s of default$ and higher collection costs$ there is too much uncertainty to #arrant revenue recognition until cash is receive received d %he mere fact that sales sales are made on an installm installment ent contract contract "asis does not +ustify using the cash receipts "asis of revenue recognition %he +ustification for this departure from the sales depends essentially upon an a"sence of a reasona"ly o"+ective "asis for estimating the amount of collection costs and "ad de"ts that #ill "e incurred in later periods If these these expense expenses s can "e estimate estimated d #ith reasona"le reasona"le accuracy accuracy$$ the sales sales "asis should "e used &AIC-A Adapted' Adapted '

6-24


Exercise 6(6 &;@ minutes' a 1ichael 1ichael Compan Company y should should recognize recognize revenu revenue e as it perform performs s the #or. on the contr contract act &the &the perce percenta ntage(o ge(of(c f(comp omplet letion ion metho method' d' given given that that the the right right to revenue is esta"lished and collecti"ility is reasona"ly assured ,urthermore$ the use of the percentage(of(completion method avoids distortion of income from period to period$ and it provides for "etter matching of revenues #ith the related expenses " -rogress -rogress "illings #ould #ould "e accounted for "y "y increasing increasing Accounts Accounts Receiva"l Receiva"le e and increasing -rogress 5illings on Contract$ a contra asset account that is offset against the Construction Costs in -rogress account If the Construction Cost Costs s in -rog -rogre ress ss acco accoun untt exce exceed eds s the the -rog -rogre ress ss 5ill 5illin ings gs on Cont Contra ract ct account$ the t#o accounts #ould "e sho#n in the current assets section of the "alance sheet If the -rogress 5illings on Contract account exceeds the Construction Costs in -rogress account$ the t#o accounts #ould "e sho#n$ in most cases$ in the current lia"ilities section of the "alance sheet c %he income income recogni recognized zed in the second second year year of the four(year four(year contrac contractt #ould "e determined as follo#s ,irst$ the estimated total income from the contract #ould "e determined "y deducting the estimated total costs of the contract &the actual costs to date plus the estimated cost to complete' from the contract price 3econd$ the actual costs to date #ould "e divided "y the estimated total costs of the contract to arrive at a percentage completed$ #hich #ould "e multiplied "y the estimated total income from the contract to arrive at the total income recognized to date %hird$ the total income recognized in the second year of the contract #ould "e determined "y deducting the income recognized in the first year of the contract from the total income recognized to date •

•

•

d Earning Earnings s in the second second year of the four(year four(year contract contract #ould "e higher higher using the perce percent ntage age(of (of(co (compl mpleti etion on metho method d inst instead ead of the the comple completed(c ted(con ontra tract ct method %his is "ecause income #ould "e recognized in the second year of the contract using the percentage(of(completion method$ #hereas no income #ou #o uld "e reco recog gnized in the the seco secon nd year of the contrac tractt using the completed(contract method

6-25


Exercise 6( &:@ minutes' a Crime ime ControlK rolKs s reve evenue reco ecogniti nitio on prac ractic tices$ #h #hiile not the mo most st conservative$ conform to 4AA- %he important issue is #hether lessees #ill$ in fact$ continu continue e for their their eight(yea eight(yearr terms terms 3hould 3hould large large cancella cancellation tions s occur$ occur$ su"stantial portions of the revenue recognized in earlier years might have to "e reversed in su"se*uent years %his #ould result in distortions of earning po#er and earning trends %hus$ a critical issue of this accounting is #hether the company provides ade*uately for contingencies such as cancellations 3hou 3hould ld the the pace pace of ne#ly ne#ly #ritte #ritten n sales(ty sales(type pe lease leases s slo# slo#$$ the the comp compan anyKs yKs earnings gro#th may stop or earnings may even decline " While While the the tax tax acco accoun untin ting g do does es prov provid ide e the the compa company ny #ith sign signifi ifican cantt fund funds s from tax postpone postponement ment$$ it does does not affect reported reported results results "ecause "ecause under 4AA 4A A- the the compa company ny is re*ui re*uired red to provi provide de for defer deferre red d taxes taxes #hi #hich ch it is assumed #ill "e paya"le in the future c While While it is true that that the sale of the receiva"le receiva"les s #ithout #ithout recourse recourse #ould #ould ena"le ena"le the company to "oo. profits in the year the lease originated$ this practice #ould at the same time su"stantially increase the companyKs tax "ill

Exercise 6(D &;G minutes' a %his %his reve revenu nue e recogn recogniti ition on issue issue stirs stirs controv controvers ersy y 1any 1any "elie "elieve ve that that it is reasona"le for "oth companies to record offsetting advertising revenues and adv adverti ertisi sing ng expe expens nses es from from this this cont contra ract ct %his %h is is +ust +ustif ifie ied d in that that the the tran transa sact ctio ion n seem seemin ingl gly y meet meets s the the usua usuall rev revenue enue reco recogn gnit itio ion n crit criter eria ia Opponents of this treatment #orry a"out uncertainty and completeness of the earning process " Rev Revenue enues s and and rev revenue enue gro# gro#th th are are cons consid ider ered ed go good od indi indica cato tors rs of futu future re prospects for 2otCom 2otCom &Internet' &Internet' companies Accordingly$ Internet companies #ant to maximize the amount of reported revenuesF even if those revenues are entirely offset #ith expenses c An analy analyst st should should see. to determine determine the percen percentt of revenu revenues es that come from from advertising advertising in such "arter transactions transactions versus versus revenues revenues from cash(paying cash(paying &or credit credit'' custo customer mers s 3ome 3ome "elie "elieve ve that that "arte "arter(" r("ase ased d reven revenue ues s shou should ld "e segregated and vie#ed in a different light from that of more normal revenues %his might affect revenue multiples in determining stoc. price or decisions in other applications applications that rely on financial financial statements statements Analysts should should ad+ust their their mo model dels s accor accordi ding ng to their their "elief "eliefs s a"ou a"outt the the relat relativ ive e merits merits of such such revenues

6-26


Exercise 6( &=G minutes' a 3ome 3ome costs costs are recog recogni nized zed as expe expens nses es on the the "asis "asis of a presu presumed med direc directt asso associ ciat atio ion n #i #ith th spec specif ific ic rev revenue enue %his his has "een "een iden identi tifi fied ed "o "oth th as )assoc )associat iatin ing g caus cause e and and effec effect) t) and and as the )match )matchin ing g conc concept ept) ) 2irec 2irectt cause(an cause(and(eff d(effect ect relation relations s can seldom seldom "e conclu conclusiv sively ely demonst demonstrate rated$ d$ "ut many costs appear to "e related to particular revenue$ and recognizing them as expenses accompanies recognition of the revenue 4enerally$ the matching concept re*uires that the revenue recognized and the expenses incurred to prod produc uce e the the rev revenue enue "e give given n conc concur urre rent nt peri period odic ic reco recogn gnit itio ion n in the the accounting records Only if effort is properly related to accomplishment #ill the results$ called earnings$ have useful significance concerning the efficient utiliz utilizati ation on of "u "usin sines ess s resou resourc rces es %h %hus us$$ apply applying ing the the match matchin ing g prin princip ciple le recognizes recognizes the cause(and(effect cause(and(effect relationship that exists "et#een expense and revenue revenue Examples Examples of expenses that are usually usually recogniz recognized ed "y associating associating cause and effect are sales commissions$ freight(out on merchandise sold$ and cost of goods sold or services provided "

3ome 3ome costs are assigne assigned d as expens expenses es to the the curr curren entt acco accoun untin ting g perio period d "ecause &:' their incurrence during the period provides no discerni"le future "enefitsF &;' they are measures of assets recorded in previous periods from #hich no future "enefits are expected or can "e discernedF &=' they must "e incurred each accounting year$ and no "uildup of expected future "enefits occursF &?' "y their nature they relate to current revenues even though they cannot "e directly associated #ith any specific revenuesF &@' the amount of cost to "e deferred can "e measured only in an ar"itrary manner or great uncertainty exists regarding the realization of future "enefits$ or "othF and &6' uncert uncertaint ainty y exists exists regardi regarding ng #hethe #hetherr allocati allocating ng them them to curren currentt and future future periods #ill serve any useful purpose %hus$ many costs are called )period costs) and are treated as expenses in the period incurred "ecause neither do they have a direct relationship #ith revenue earned nor can their occurrence "e directly sho#n to give rise to an asset %he application of this principle of expense recognition results in charging many costs to expense in the period in #hich they they are paid or accrued accrued for payment payment Examples Examples of costs treated as period expenses #ould include officersK salaries$ advertising$ research and development$ and auditorsK fees

c A cost cost should should "e capitalized capitalized$$ that is$ treated treated as an asset$ #hen #hen it is expected expected that the asset #ill produce "enefits in future periods %he important concept here is that the incurrence of the cost has resulted in the ac*uisition of an asset$ a future service potential If a cost is incurred that resulted in the ac*ui ac*uisi sitio tion n of an asset asset from from #h #hic ich h "ene "enefit fits s are are no nott expect expected ed "eyo "eyond nd the the curr curren entt peri period od$$ the the cost cost may may "e expe expens nsed ed as a meas measur ure e of the the serv servic ice e potential that expired in producing the current periodKs revenues !ot only should the incurrence of the cost result in the ac*uisition of an asset from #hich future "enefits are expected$ "ut also the cost should "e measura"le #ith #ith a reas reason ona"l a"le e degree degree of o" o"+ec +ectiv tivity ity$$ and and ther there e shou should ld "e reaso reasona na"le "le grounds grounds for associatin associating g it #ith the the asset ac*uired ac*uired Example Examples s of costs that should "e treated as measures of assets are the costs of merchandise 6-27


Exercise 6(Mconcluded on hand at the end of an accounting period$ the costs of insurance coverage rela relati ting ng to futu future re peri period ods$ s$ and and the the cost costs s of self(c self(con onst stru ruct cted ed plan plantt or e*uipment d In the the a"sence a"sence of a direct direct "asis for associating associating asset asset cost #ith revenue$ revenue$ and and if the asset asset provi provides des "ene "enefit fits s for t#o or mo more re accou accounti nting ng perio periods$ ds$ its cost cost should "e allocated to these periods &as an expense' in a systematic and rati ration onal al mann manner er When When it is impr imprac acti tica cal$ l$ or impo imposs ssi" i"le le$$ to find find a clos close e cause(and(effect relationship "et#een revenue and cost$ this relationship is ofte often n assu assume med d to exis exist t %h %her eref efor ore$ e$ the the asse assett cost cost is allo alloca cate ted d to the the account accounting ing periods periods "y some some method method %he allocatio allocation n method method used used should should appe appear ar reas reason ona" a"le le to an un" n"ia iase sed d o" o"se serv rver er and shou should ld "e foll follo# o#ed ed consist consistentl ently y from period to period period Example Examples s of systemati systematic c and rational rational allo alloca cati tion on of asse assett cost cost #o #ou uld incl includ ude e dep depreci reciat atio ion n of fixe fixed d asse assets ts$$ amortization of intangi"les$ and allocation of rent and insurance e A cost cost should should "e treated treated as a loss #hen #hen an unfavor unfavora"le a"le event event results results from from an activ activity ity othe otherr than than a no norma rmall "u "usin sines ess s activ activity ity %h %he e match matchin ing g of losses losses to specific specific revenu revenue e should should not "e attempted attempted "ecause$ "ecause$ "y definiti definition$ on$ they are expired service potentials not related to revenue produced %hat is$ losses resulting from extraneous and exogenous events that are not recurring or anticipated as necessary necessary in the process process of producing producing revenue revenue %here is no simple #ay of identifying a loss$ "ecause ascertaining #hether a cost should "e a loss is often a matter of +udgment %he accounting distinction "et#een an asset$ asset$ expen expense se$$ loss$ loss$ and and prior(p prior(peri eriod od ad+us ad+ustme tment nt is no nott clear clear(cu (cut t ,o ,or r example$ an expense is usually voluntary$ planned$ and expected as necessary in the generation of revenue 5ut a loss is a measure of the service potential expir expired ed that that is cons consid idere ered d a"nor a"normal mal$$ un unne nece cessa ssary ry$$ un unan antic ticipa ipated ted$$ and and possi"ly nonrecurring and is usually not ta.en into direct consideration in planning the size of the revenue stream &AIC-A Adapted' Adapted ' Exercise 6(:G &:@ minutes' a Rese Resear arch ch and and deve develo lopm pmen entt cost costs s are are expe expens nsed ed in the the year year that that they they are incurred %his means RN2 costs impact current income dollar for dollar Also$ to the extent that research and development efforts lead to future revenues$ this is a violation of the matching principle in relating costs to revenues in determining future income " RN2 expend expenditu itures res at ,rontier ,rontier 5iotech 5iotech decreased decreased su"stan su"stantiall tially y in fiscal ;GG6 As a result$ fiscal ;GG6 net income is su"stantially higher >o#ever$ this may nott "e a go no good od signa signall for futur future e profi profita" ta"ili ility ty %o the exten extentt that that on one e has has confidence in the a"ility of the RN2 department at ,rontier 5iotech$ future revenues may "e compromised "y management

Exercise 6(:: &:@ minutes' a %heor %heoreti etical cally ly$$ presen presentat tatio ion n in the "o "ody dy of the the state stateme ment nt or in the the footno footnotes tes shou should ld have have no infl influe uenc nce e on the the anal analys ysis is of the the finan financia ciall state statemen ments ts In practice$ ho#ever$ footnote disclosures are typically insufficient In addition$ information is more difficult to overloo. #hen presented in the "ody of the financial statements " An anal analys ystt #ou #ould ld ad+u ad+ust st the the analy analysis sis of fina financ ncial ial statemen statements ts "y recasti recasting ng expenses and income computations to include the disclosed stoc. option expense In addition$ the analyst #ould recast retained earnings to reflect the stoc. option expense &net of tax' c !umerous ratio tios are aff affect ected "y the accru ccrua al versu rsus non(ac (accru crual of compensation compensation expense expense related to employee employee stoc. options options ,or example$ all all ratios that include operating expense$ net income$ and e*uity are affected$ such as return on e*uity$ return on net operating assets$ net operating profit margin$ and operating expenses as a percent of sales

Exercise 6(:; &?G minutes' a %he %he plan plan #ill #ill "e deeme deemed d to "e comp compen ensa sato tory ry %his %his is "eca "ecaus use e the the stoc stoc. . option plan is only offered to certain employees and the life of the option is not short " IncentCom #ould IncentCom #ould offer such a lucrative plan to its employees to attract and retain retain a talented talented #or. force force >uman >uman capital capital is a .ey asset asset in technolog technology y companies c %he gra grant nt date date is is 8anu 8anuar ary y :$ ;GG? ;GG?FF Vesting sting date date is is 8anu 8anuar ary y :$ ;GG ;GGF F ,irst ,irst exercise date is 8anuary :$ ;GG d !o$ the employee employee stoc. options are are not not in(the(money in(the(moneyB B at the grant grant date date %his is "ecause at the grant date the exercise price is greater than or e*ual to ¬ less than' the mar.et price of the stoc. e %otal compe compens nsati ation on cost cost shou should ld "e measu measured red at the the date date of measu measure reme ment nt %he date of measurement is the earliest date that the num"er of shares and the stoc. option price is .no#nM#hich is 8anuary :$ ;GG?$ in this case

6-29


Exercise 6(:;Mconcluded f %otal comp compen ensat satio ion n cost cost to "e recogn recogniz ized ed #il #illl depe depend nd upon the accoun accountin ting g rules applied /nder APB  $ total compensation cost is GF computed as the intrinsic value of the options times the num"er of shares$ or Q&;G;G' x :GG$ :GG$GG GGG G shar shares esS S /nde /nderr S&AS the D:$@ D:$@=D =D op opti tion ons s &rou &round nded ed up up'' are are S&AS .3$ the expected to vest "ased on the ?T forfeiture forfeiture rate 3pecifically$ 3pecifically$ :GG$GGG x ?T J ?$GGG ?$GGG options options in ;GGGF 6$GGG 6$GGG x ?T J =$D?G options options in ;GG:F ;$:6G ;$:6G x ?T J =$6D6 options in ;GG;F DD$?? x ?T J =$@= options in ;GG=F and D?$=@ x ?T J =$= options in ;GG? Conse*uently$ 6@;$=G? in total compensation expense should "e recognized &D:$@=D options x D fair value per option' g Compens Compensatio ation n cost should should "e allocated allocated over over the service service period$ period$ years ;GG? ;GG? through ;GGD h %he %he empl employ oyee ee stoc stoc. . op opti tion on plan plan tran transf sfer ers s #e #eal alth th from from stoc stoc.h .hol olde ders rs to employees "y granting potential o#nership rights to employees #ith less than full "uy(inB "uy(inB to ac*uire these o#nership o#nership rights rights %hat is$ if existing o#nership o#nership #ere diluted via a normal issuance of shares to investors$ contri"uted capital received from the investors #ould "e much greater than that received from the exercise price of stoc. options

Exercise 6(:= &:@ minutes' a 1anager 1anagers s often often hold$ hold$ or expect expect to hold$ hold$ stoc. stoc. options options As a result$ result$ they they #ill #ill increase their #ealth #hen the mar.et price of the stoc. increasing exceeds the exercise price price of stoc. options they hold hold 5y #ithholding #ithholding good ne#s and and selectively releasing "ad ne#s "efore the date that the option
6-30


Exercise 6(:? &;G minutes' a 3ome 3ome trans transact actio ions ns affec affectt the the determ determin inati ation on of net net inco income me for accou account ntin ing g purposes in one reporting period and the computation of taxa"le income and income taxes paya"le in a different reporting period In accordance #ith the match matchin ing g princ principl iple$ e$ the the appro appropri priate ate inco income me tax expen expense se repres represen ents ts the inco income me tax tax cons conse* e*ue uenc nces es of reve revenu nues es and and expe expens nses es reco recogn gniz ized ed for for accounting purposes in the current period$ #hether those income taxes are paid or paya"le in current$ current$ future$ future$ or past periods Accordingly$ ccordingly$ a deferred income taxes account is setup to reflect such timing differences " When When depre deprecia ciatio tion n expen expense se for machi machine nery ry pu purc rcha hased sed this this year year is repor reported ted using the 1ACR3 for income tax purposes and the straight(line "asis for accounting purposes$ a timing difference arises 5ecause more depreciation expense is reported for income tax purposes than for accounting purposes this this year year$$ pret pretax ax acco accoun unti ting ng inco income me is mo more re than than taxa taxa"l "le e inco income me %h %he e difference creates a credit to deferred income taxes e*ual to the difference in depreciation multiplied "y the appropriate income tax rate When rent revenues received in advance this year are included in this yearKs taxa"le income "ut as unearned revenues &a current lia"ility' for accounting purposes$ a timing difference arises 5ecause rent revenues are reported this year year for inco income me tax pu purp rpose oses s "u "utt no nott for for accou account nting ing pu purp rpose oses$ s$ preta pretax x accounting accounting income is less than taxa"le income %he difference creates a de"it to deferred income taxes e*ual to the difference in rent revenues multiplied "y the appropriate income tax rate c %he income income tax effect effect of the depreci depreciatio ation n &timing &timing difference' difference' is classifie classified d on the "alance sheet as a noncurrent lia"ility "ecause the asset to #hich it is related is noncurrent %he income tax effect of the rent revenues received in advance &timing difference' is classified on the "alance sheet as a current asset "ecause the lia"ility to #hich it is related is current %he noncurrent lia"ility and the current asset should not "e netted on the "alance sheet "ecause one is current and one is noncurrent On the income statement$ the income tax effect of the depreciation &timing differenc difference' e' and the rent rent revenu revenues es receiv received ed in advanc advance e &timing &timing differen difference' ce' shou should ld "e nett netted ed %h %his is amoun amountt is class classifi ified ed as a defer deferred red compo compone nent nt of income tax expense

6-31


Exercise 6(:@ &:@ minutes' %here are at least t#o earnings targets that are typically relevant for managers and investo investors rs %he first is the consensu consensus s earnings earnings expectatio expectation n of the analyst analyst community %he second is the earnings in the same *uarter of the previous fiscal year &A third might "e an earnings forecast previously released "y management' 5eating these targets "y even a penny is typically vie#ed as a sign of sustained profit profit gro#th and s.illed s.illed leadership leadership %his means means that companies companies near these these targets #ill use earnings management to meet or exceed these targets$ even if only onl y "y a penny penny Accordingl ccordingly y$ earning earnings s increas increases es of GG: GG: can "e significa significant nt #hen the change pushes earnings e*ual to or a"ove relevant earnings targets Of course$ a magnitude or scale issue can "e relevant as #ell A GG: change in an earnings earnings per share figure that is approximately GG@ per share in total can "e *uite relevant$ #hereas a GG: change for an earnings per share figure that is approximately :GGG per share can "e su"stantially less relevant

Exercise 6(:6 &;G minutes' a %he effects effects of diluti dilutive ve stoc. stoc. op optio tions ns and #arran #arrants ts are not inclu include ded d in the computation of the num"er of shares for "asic earnings per share %hey are$ ho#ever$ included in diluted earnings per share computations " %he %he effe effect cts s of dilu diluti tiv ve con converti erti" "le secu securi riti ties es are not incl inclu uded ded in the the computation of the num"er of shares for "asic earnings per share %hey are$ ho#ever$ included in diluted earnings per share computations c Antidi Antidiluti lutive ve securitie securities s are exclude excluded d from from "oth "asic and diluted diluted earning earnings s per share

6-32


Exercise 6(: &;G minutes' a 5asic 5asic earnings earnings per share share is the amount amount of earning earnings s attri"uta" attri"uta"le le to common common shareh shareholde olders rs &that &that is$ net income less less preferr preferred ed dividen dividends' ds' divided divided "y the #eighted average num"er of common shares outstanding for that period " 2iluted 2iluted earning earnings s per share share is the amount amount of current current earning earnings s per share that reflects the maximum dilution that #ould result from the conversion of all conv convert erti" i"le le secu securi ritie ties s and and the the exerc exercise ise of all all #a #arra rrant nts s and and op optio tions ns %h %he e conversion of these securities individually #ould decrease earnings per share and in the aggregate #ould have a dilutive effect %he computation of diluted earnings per share should "e "ased upon the assumption that all such issued and issua"le shares are outstanding outstanding from the "eginning of the period$ or from their inception inception if after the "eginning "eginning of the period period %o summari summarize$ ze$ #hereas #hereas "asic "asic earn earnin ings gs per per shar share e do does es no nott reflec reflectt any any secur securiti ities es conv convert erti"l i"le e or exercisa"le exercisa"le into common shares$ diluted earnings per share includes all such securities and considers their dilutive effect upon earnings per share$ ta.ing into account necessary ad+ustments to income resulting from the conversion process &C,A Adapted' Adapte d'

Exercise 6(:D &:@ minutes' : " 3hares outstan tanding after fter the stoc toc. div dividen dend are ; mil millio lion shares outstanding outstanding entire year L :GT of ; million shares outstanding outstanding for H:; of year$ year$ OR ; mill L ; mill&@' J ;$:@G$GGG shares ; a &poten &potentia tiall lly y dilutiv dilutive e secur securit ities ies are not not cons conside idered red in "asic "asic earnin earnings gs per share' = a &#arrants &#arrants are are antidilutiv antidilutive e "ecause "ecause more more shares shares are assumed "ought "ac. at the average mar.et price #ith the proceeds than #ere issued'

6-33


-RO50E13 -ro"lem 6(: &=G minutes' %he income statements of 2isposo Corp should "e sho#n as follo#s 7ear 7ear D 7ear  3ale 3ales s                                       @ @ 6GG 6GG Costs sts an and ex expen penses                      &6@ &6@' &@6' @6' -retax tax inco income me                    ::D ;? %ax expe expens nse e                                 &@' &@' &:;' &:;' Income from continuing operations   @  :; 2iscontinued operations Operations &net of tax' QaS &=' D 2isposal &net of 6 tax' Q"S S & 6' !et Income me                       

 @G

 ;G

QaS Represe Represents nts net income income &loss' &loss' from from operat operation ions s for for 7ear ear  and for 7ear 7ear D un until til August :@ Q"S Represe Represents nts 0oss 0o ss from from op oper erat atio ions ns Augu gust st :@ to 2ece 2ecem" m"er er =: =:            &:' &:' 0oss 0o ss on sale sale of asse assets ts &aft &after er @ tax' tax'                     &@ ' %otal %o tal                                  &6' %he :G loss and related tax "enefit of @ #ould still "e recorded &anticipated' at 2ecem"er =:$ 7ear D &the asset #ould "e reduced "y :G to mar.et value'

-ro"lem 6(; &=G minutes' : a ; " &?GT &?GT of of revenu revenues es and and costs costs are recogn recognized ized'' = a ? d @ a 6 c  d Q&:;G$ Q&:;G$GGGH GGGH=GT =GT'' L &??G$GG &??G$GGGH?G GH?GT'S T'S

6-34


-ro"lem 6(= &;@ minutes' a &:' &ailing to timely record returned credit card purchases and membership cancellations  An accounts receiva"le analysis #ould "e the focal point to identifying identifying this pro"lem We #ould examine examine for either continual continual gro#th in account accounts s receiv receiva"le a"le or un unusu usual al &unexp &unexplain lained' ed' #rite(of #rite(offs fs of receiva receiva"les "les Ratios or techni*ues that compare cash collections to accounts receiva"le also could potentially identify a pro"lem area or fraudulent "ehavior &;' %mproperly capitali1ing and amorti1ing expenses related to attracting new %his is "ehavi "ehavior or #ould #ould "e difficu difficult lt to un unco cove ver r %h %he e .ey .ey is to members %h understand understand the gro#th in reported intangi"le assets and deferred charges$ and to assess its reasona"leness /nusual increases should "e vie#ed as a potential red flag &=' -ecording .ey to uncov uncoverin ering g fictitious fictitious sales sales is to -ecording fictitious fictitious sales One .ey monitor the +oint "ehavior of sales and accounts receiva"le$ simultan simultaneou eously sly Increa Increasin sing g sales sales should should not necessa necessarily rily lead lead to slo#er slo#er accou account nts s recei receiva va"le "le turn turnov over er Incr Increa eases ses in the the accou account nts s rece receiv iva"l a"le e turn turnov over er ratio ratio shou should ld "e inve investi stigat gated ed "ecau "ecause se this this can can "e caus caused ed "y$ "y$ among other factors$ the recognition of fictitious or uncollecti"le sales " %he externa externall auditor auditor must condu conduct ct the audit audit according according to generall generally y accepted accepted auditing standards %he culpa"ility of auditors in a fraud situation varies on a case "y case "asis It is often difficult difficult to detect a fraud if .ey client personnel are colluding and conspiring to cover up >o#ever$ in this case the fraud #as so #idespr #idespread ead that that audi auditor tor neglig negligen ence ce is part part of the the pro" pro"lem lem ,rom ,rom an economic perspective$ this *uestion #ill ultimately "e ans#ered via litigation

6-35


-ro"lem 6(? &?@ minutes' a Estimati Estimation on of 2epreci 2epreciatio ation n on %ax %ax Return Returns s ..

.0

+

2epreciation expense Q:6;AS S

:?@

:D?:

:@

2ii 2epreciation timing difference Q:;DS

@

:D6

::

2iii Excess depreciation ÷ tax difference "y statutory tax rate 42ii53(67 

:?

@?

=@G

2epreciation on tax return 42i82iii ' 7 7 

;::

;=DD

;:G

2i

&com"ining federal$ state and foreign taxes'  " Identif Identificat ication ion of Amoun Amounts ts N 3ources 3ources &com"ining

..

: ; = ? @

Earnings "ef "efo ore in income ta taxes Q; Q;6S S Expect Expected ed inc incom ome e tax tax U =?T =?T &confirmed "y Q:=?S'  %otal income tax expense Q;S %otal in income tax due P %otal income tax due and not yet paid Q??S

66? ;;6 ;6@ ;=G? 6

.0

+

:? 6:G :@G ::: ?6?

:G6@ 6@ =6; =? :6:; =G:

PIncludes items Q:;;S$ Q:;=S$ and Q:;?S

c 2ifferences 2ifferences "et#een "et#een Effective Effective %ax %ax Rate and 3tatutory 3tatutory Rate &=?T'P &=?T'P ..

6

.0

6

+

6

%ax %ax at statut statutory ory rate rate        ;;6 ;;6 =?G =6; =6;               =?G =?G 3tat 3tate e tax tax &net &net of fed fed "enef enefit it' '          ;G ;GG =G =G =D =D                =6 =6 !ondeducti"le !ondeducti"le divestitures$ divestitures$ re( structuring and unusual charges M M : G : ? @ 6 @ Q:=S !ondeducti"le !ondeducti"le amortization of intangi"les ?G G 6 : 6 G   Q:=DS ,oreign earnings not taxed or taxed at other than statutory rate &;G' &G=' ;  ; : ; Q:= Q:=SS Oth Other er                        :6 ;@ ;; :;

@ : 

? D 

: ;

: :

G ; G:

G ; G:

=?

D

Q:=?S Q:=?S =?G Q:=@ Q:=@SS = Q:=6S

%otals tals                            ;6 ;6@ @6

=D :@ :@G @

P!um"ers are computed "y multiplying E5I% Q;6S "y applica"le percent as given

d Camp"ell Camp"ell can pro"a" pro"a"ly ly deduct deduct for tax purposes purposes only only cash actually actually spent spent in 7ear 7ear :G for these charges If this is so$ an estimate of cash spent is &see item Q:G@S' ==: ( =G:6 J =@F =@ H =?T J ::G million

6-36


-ro"lem 6(@ &?@ minutes' 5I4(2EA0 CO!3%R/C%IO! CO

a

"

$am "ear .

"ear 

"ear 3

5oo. income

: ;? $ GG G

  ; $G G G

 ; ? $ GG G

5oo. income

;

=  $ DG G

@ $ 6G G

 :;$6GG

5oo. income

=

: @ $G G G

? @ $G G G

 @ $G G G

 :@$GGG

:@ :@G$GGG

 :; ? $ DG G

 :? ? $ 6 GG

 D  $6 G G

 : @ $G G G

 =  6 $G G G

%otal "oo. income

%axa"le income

:

%axa"le income

;

%axa"le income

=

"ear 

: ; 6 $G G G

 : ; G $G G G :;6$GGG

 :; G $ G GG ;? $ GG G

 :; ? $ DG G

 ;? ;?$6GG

Incr in def tax &cr' :;$GGG

 6; 6;$?GG

 : ; $= G G

2ecr in def tax &dr'

:; 6 $ G GG

: ; 6 $G G G :@G$GGG

: @ G $G G G

 : @ G $G G G

 =  6 $G G G

&=D$?GG' &:=@$GGG '

 :  $; G G

6-37

9otal

 : ; G $G G G

:;G$GGG

%otal taxa"le Inc 0ine ? less 0ine D

c

;? $ GG G

"ear (

 6  $@ G G


-ro"lem 6(6 &?@ minutes' 3%EA2 COR-ORA%IO! 7ear 7ear ?

7ear 7ear @

7ear 7ear 6

:G$GGG $GGG :G$GGG $GGG

:G$GGG $GGG

& in thousands'

a Inco Income me 3ta 3tate teme ment nt 3ales es                    Expenses P Incom come "efo efore tax tax              

$GGG

$GGG

 :$GGG GGG  :$GGG 

:G$?GG &?GG' GG'

%ax expense Current PP

M

=GG

@GG

2efer 2eferred red                  

@GG

;GG

&GG' &GG'

%otal tax expense e



@GG 

@GG 

&;GG'

!et inco income me &los &loss' s'             



@GG @GG 

@GG 

&;GG' GG'

P Includes unusual expense of :$?GG in 7ear 6 PP%axa"le income &loss' 5efore lo loss ca carryfor#ard After deducting loss carryfor#ard %ax due &at @GT'

 &? &?GG' M M

 :$ :$GGG 6GG =GG

 :$ :$GGG M @GG

*ote  %he timing difference regarding deferred preoperating costs is :$?GG in 7ear ? >o#ever$ only :$GGG of this amount results in a reduction of 7ear ? taxa"le income &the remaining ?GG "ecomes a loss carryfor#ard and reduces taxa"le income in 7ear @' %he tax effect &at @G percent' of these differences is @GG in 7ear ? and ;GG in 7ear @ %he entire timing difference d ifference reverses in 7ear 6

" 5ala 5alanc nce e 3he 3heet et Curren Currentt tax paya"le paya"le         2eferred 2eferred tax paya"le paya"le 

6-38



M

 =GG

 @GG

@GG

GG

M


-ro"lem 6( &6G minutes' Income 3tatement 7ears 7ears

:

;

=

?

@

3ales @G DG :;G :GG Cost of sales ;G =G @G =GG 4eneral and administrative :G

:@

!et income "efore tax ;G =@

;G

6



;GG ?GG @G :;G

:GG

;G

=G

@G &=GG' :=G ;@G

D @GG 6GG ;GG ;@G ?G

@G

;6G =GG

%ax expense &refund'P Current provision :G

:@

;@

Refun Refund d from from carry carry"a "ac. c.     

;@ :=G &@;@' &@;@'

%ax effect of loss carryfor#ard

6@

=;@

%otal ta tax ex expense :G :@ ;@ &@;@' 6@ :;@ Income "efore extraordinary items  :G

:@G

:@

;@ &;?@'

Extraordinary gain &reduction' of taxes due to carryfor#ard   

6@ 6@

:;@

:=G :@G :=G

:@G

=;@

!et !et inco income me &PP' &PP'           :G : :@ ;@ ;@ &;? &;?@' :=G :=G :@ :@@ :=G :=G :@G :@G

P %axa"le income e  ;G %ax due at @GT rate :G

=@ @G :@ ;@

&=GG' &6@'" :D@c ;6G &@;@' a G ;@ :=G

=GG :@G

a

Operating loss of =GG carried "ac. to eliminate all taxa"le income for 7ear :$ 7ear ; and 7ear = and secure refund of @;@ for total taxes paid during those years " Income for 7ear @ of :=G less loss carryfor#ard of :@ c Income for 7ear 6 of ;@G less loss carryfor#ard of 6@

PP 2isclosure %ax loss carryfor#ards are :@ at end of 7ear ? and 6@ at end of 7ear @ Accounting effects 4:ournal entries entries $r; 2
6-39


-ro"lem 6(D &=G minutes' : c &6$@GG &6$@GG$GGG $GGG net net inco income me H ;$@GG ;$@GG$GGG $GGG shar shares es J ;6G' ;6G' ; " 2iluted E-3 J

Ad+usted net income #td avg of L #td avg num"er com commo mon n st stoc. oc. of co common mmon shares ares outstanding issua"le fr from op options and converti"les

3ince 3ince average average mar.et mar.et price price of stoc. stoc. exceeds exceeds exercis exercise e price price of option options$ s$ the options are dilutive /sing treasury stoc. method for options #e o"tain i ;GG$GGG ;GG$GGG shares shares  :@ J =$GGG$G =$GGG$GGG GG proceed proceeds s ii =$GGG$GGG H ;G average price price J :@G$GGG shares purchased purchased in open open mar.et mar.et %hus$ @G$GGG additional shares #ould "e issued issued Are the converti"le "onds dilutive !o Assuming conversion of "onds$ :GG$GGG additional shares #ould "e issued %he net income ad+ustment #ould "e Intere Interest st expense expense related related to "on "onds ds        @GG$GGG @GG$GGG 0ess 0ess taxes taxes                      &;GG$GGG' &;GG$GGG' Increa Increase se in in net net inco income me             =GG$GGG =GG$GGG Conse*uently E-3 J &6$@GG$GGGL=GG$GGG'H& &6$@GG$GGGL=GG$GGG'H&;$@GG$GGGL:GG$GG ;$@GG$GGGL:GG$GGG' G' J ;6; 2iluted E-3 J 6$@GG$GGGH&;$@GG$GGGL@G$GGG' J ;@@

-ro"lem 6( &?G minutes' a 5asic 5asic E-3 E-3 Compu Computat tation ions s 5asic E-3 J ?$GGG$GGG H =$GGG$GGG shares J :== 2iluted E-3 Computations 3ince average mar.et price of stoc. exceeds exercise price of options and #arrants$ the options and #arrants are dilutive /sing treasury stoc. method i :$GGG$GG :$GGG$GGG G shares shares  :@ J :@$GGG :@$GGG$GGG $GGG proce proceeds eds ii :@$GGG$GGG :@$GGG$GGG H ;G J @G$GGG shares purchased purchased in open mar.et mar.et %hus$ ;@G$GGG additional shares #ould "e issued 2iluted E-3 J ?$GGG$GGG H =$;@G$GGG shares J :;= " 5asic 5asic E-3 E-3 Compu Computat tation ions s 5asic E-3 J =$GGG$GGG H =$GGG$GGG shares J :GG 2iluted E-3 Computations 3ince average mar.et price of stoc. exceeds exercise price of options and #arrants$ the options and #arrants are dilutive /sing treasury stoc. method i :$GGG$GG :$GGG$GGG G shares shares  :@ J :@$GGG :@$GGG$GGG $GGG proce proceeds eds ii :@$GGG$GGG :@$GGG$GGG H :D J D==$=== shares purchased purchased in open mar.et mar.et %hus$ :66$66 additional shares #ould "e issued 2iluted E-3 J =$GGG$GGG H =$:66$66 shares J G@

6-40


CA3E3 Case 6(: &@G minutes' a 5alance 3heets 3heets and and Income 3tatement 3tatements s #ith Alternativ Alternative e Revenue Revenue Recognition Recognition 3hipment

Collection

-roduction

"

5alance 3heet Cash  Receiva"les Inventory$ at cost Inventory$ at mar.et %otal assets

:$6G :$DGG GG (( ?$:G

:$6G :$DGG GG (( ?$:G

:$6G :$DGG (( GG ?$=G

:$6G :$DGG (( G c ?$;6G

Accrued shipping cost Accrued sales commission 2eferred income Invested capital Retained earnings %otal lia"ilities and e*uity

((  :DG (( =$GGG G ?$:G

( (  ;G  :DG ;G :DG a (( =$GGG =$GGG D:G :$GDG ?$:G ?$=G

((  :DG (( =$GGG :$GDG ?$;6G

Income 3tatement 3ales $GG Costs and expenses Cost of goods sold 3elling expense 3hipping expense !et income

D$:GG :G$DGG $GG G ;;G  G

$GG

6$=GG D$?GG D:G :$GDG :DG ;?G  D:G  :$GDG

$6:G d G ;;G :$GDG

*otes

a 2eferr 2eferred ed inco income me 3ales 3ales is :$D :$DGG GG less costs of &:$?GG L :DG L ?G' J :DG " %ime %ime of produ producti ction on ,igu ,igures res can can "e reflec reflected ted gross as in left colum column n or net as as in right column c Inventory Inventory$$ at net realiz realiza"le a"le value value G G J GG less less ;G less less G G d Cost of goods sold sold is a )to("alance) )to("alance) figure figure "ased "ased on inventory inventory &for example$ example$ 5eg 5eg G plus purchases D$?GG less End G J CO43 $6:G'

6-41


Case 6(:Mcontinued " %he installme installment nt method method delays delays the reporting reporting of revenues revenues and there"y there"y delays delays the time for payment of taxes %he time value of money is a ma+or motivation for delaying cash payments for taxes c 5alan 5alance ce 3hee 3heet t 3ome 3ome analy analysts sts prefe preferr the install installmen mentt metho method d "ecau "ecause se it is more more cons conser erva vativ tive e >o#ev >o#ever er$$ the the insta installm llmen entt meth method od attemp attempts ts to valu value e receiva"les &less deferred income' at the historical cost of the inventory It #ould #ou ld appear appear that that the credi creditt analy analyst st shou should ld "e futu future(o re(orie riente nted d and and vie# vie# receiva"les at the expected future cash inflo# Income 3tatement 3ome analysts prefer the installment method "ecause it is more conservative >o#ever$ this method has t#o critical #ea.nesses &i' Reve Revenu nues es and and profi profits ts are are no nott reco recogn gnize ized d #hen #hen perfo performa rmanc nce e &earni &earning' ng' occursF instead$ recognition is delayed until cash is collected &ii' 3elling 3elling costs are mismatche mismatched d &this is most most dramati dramatic c in a period period of rapid rapid gro#th or decline in sales' %he installment method does not sho# economic reality

6-42


Case 6(; &6G minutes' a Computation Computation of earnings earnings component components s as a percent percent of sales sales 7ear 7ear :: :: 7ear 7ear :G 3ale ales s                             :GGT :GGT GGT

7ear 7ear  :GGT

Cost of pr products cts sold sold                

66GT GT

6D6T 6T

G G@T

1ar 1ar.et .eting ing and sellin ling expe xpenses es           

:@?T ?T

:@DT DT

:? :??T

Administrative ex expenses

?T

?T

??T

Research an and de development ex expenses

GT

GT

GDT

Interest expense

:T

:DT

:T

Interes rest in income e                    

(G (G?T

(G= (G=T T

(G (GT

,oreign exchange losses$ net t

GGT

G:T

G=T

Other expense

G?T

G;T

G6T

2ivestitures$ restructuring and unusual charges   

GGT

@@T

6GT

Cost Cost of prod produc ucts ts &goo &goods ds'' sold sold has has decl declin ined ed in each each of the the = year years s as a percentage of sales %his has accounted for most of the change in pre(tax profits as all other expense categories have remained fairly constant aside from restructuring costs$ #hich #ere not present in 7ear :: " 3ales 3ales and cost cost of goo goods ds sold sold are are typic typicall ally y the the most most high highly ly persist persisten ent$ t$ and and reductions on CO43 as a percentage of sales such as #e see in this example are rare rare 34NA 34NA costs costs are also also typicall typically y highly highly persi persisten stent t >o#eve >o#ever$ r$ the company may "e a"le to find #ays to cut some of these through operating efficien efficiencies cies %he RN2 RN2 costs costs are are also also reason reasona"ly a"ly persist persistent ent Again$ gain$ the company can choose to increase or decrease these$ "ut such a decision can have have severe severe ramifica ramification tions s for future future profita" profita"ility ility Restru Restructu cturin ring g costs costs are generally vie#ed as transitory c -rovision -rovision for taxes as a percent percent of earnings earnings "efore income income taxes taxes 7ear 7ear :: :: J ;6@H66 ;6@H66? ? J =DT 7ear 7ear :G J :@GH:? :@GH:? J @T 7ear 7ear  J =?H:G6@ =?H:G6@ J DT 2eviations from the statutory percentage of =@T commonly arise as a result of expenses that are recognized for financial reporting purposes that are not deducti"le for tax purposes An example is a restructuring charge that must "e recognized #hen incurred for financial reporting purposes$ "ut cannot "e deducted for tax purposes until paid

6-43


Case 6(;Mconcluded d Camp mp" "ell repo porrts ==: : millio llion n and =?=G =G millio lion in dives ivesti tittures$ es$ rest restru ruct ctu uring ring and and un unu usual sual char charg ges in 7ears ars :G and $ resp respec ecti tiv vely ely Restructuring Restructuring costs typically include include asset #rite(do#ns and severance severance costs Asset #rite(do#ns are non(cash charges that typically relate to reduced cash flo#s flo#s of those those assets assets that that li.el li.ely y have have occu occurre rred d over over sever several al prio priorr year years s 3everance costs typically relate to accruals of costs that #ill not "e paid until some future period e Remo mov val of costs sts rel relati ating to depr eprecia" cia"le le asset sets #i #illl red reduce future depreciation expense A cost is$ therefore$ recognized in the current period that #ould have "een recognized in future periods$ thus shifting income from the present into the future 3imilarly$ 3imilarly$ severance severance costs include the accrual of a lia"ility for future costs %his lia"ility is reduced in future periods instead of recording an expense$ thus increasing future periods< profita"ility

6-44


Case 6(= &?@ minutes' : 5REAX(2OW! O, RE3%R/C%/RI!4 A!2 O%>ER C>AR4E3 Charge Classific -re( -ost( /tilized 2escription ation %ax %ax %ax %ax -re(%ax

5alance -re(%ax

0ease Commitments Commitments Restruc

D:

G

D:

3everanceHC 3everanceHClosing losing Costs Restruc

;

?

;@

--NE Write(2o#n Restruc

:@@

:@@

G

Other Other    Restruc

;

@

;?

:6?

:=G

%otal Re Restructuring

;?

;66

Change in acctg estimateHlegal 34NA provision

=

=

=rd party claimsH,%C claimsH,%C 34NA

;G

:=

;G

%O%A0

=@=

;

:D?

:6

1ar.do#n(Clear Excess Inventory C43

;@=

:

?

1ar.do#n(3tore Closedo#ns C43

;

;

;

Inventory 3ystems RefineHChange C43 in estimates

6=

@

6

%O%A0

=?@

;;

;=D

:G

4RA!2 %O%A0 

6D

@GD

?;;

;6

6-45


Case 6(=Mcontinued ; RECA3% I!CO1E 3%A%E1E!% A,%ER RE1OVI!4 C>AR4E : :D Reported Recast Reported  T  T  T !et 3ales 3ales     :::G :GGT GGT :::G

:GGT GGT

::G=D G=D

:GGT

Cost of goods sold sold  D:: ==T

D?6

G;T

:G

6DT

4ross -rofit ; ;6T

==;?

;DT

==;D

=G;T

3elling$ general N administrative ;??= ;:T

;=D?

;:=T

;;=:

;G;T

2epreciation ;@@ ;=T

;@@

; ;=T

;@=

;=T

Restructurin Restructuring g Charge Charge   ;? ;6T

G

GGT

G

GGT

Interest Expense less Income = GDT

=

G GDT

;

GT

Earnings "efore tax &:G6' (GT

@;

@ @=T

;

GT

%ax -rovision ;6 G;T

;:6

: :T

;D;

;6T

Earnings after tax &:=;' (:;T

=6

= =?T

?G

??T

%otal %o tal Charge Charge                

@GD

?@T ?@T

EA% after charge &:=;' (:;T

&:=;'

(:;T

?G

??T

Cost of goods sold is increasing$ increasing$ resulting resulting in decreasing decreasing gross profit 3elling$ 3elling$ general and administrative expense and interest expense are also increasing$ resulting in a decrease in earnings "efore tax and a :T drop in net profit margin on sales

6-46


Case 6(=Mcontinued = Elements of Restructuring -lan and Expected Economic Effects Element 3tore Closing

-

-

C= -lan( 3tore Reformatti ng etc

Consolidati on of distri"ution centers and admin offices 0egal Contingenc ies %O%A0

-

-

-

-

2escription Close @G international and  %oys RB /s stores that do not meet strategic profita"ility o"+ectives Close =: /3 Xids RB /s stores and convert ;D near"y %oys RB /s stores into com"o stores

Cost 0eases 3everance etc --E Write do#n 1ar.do#n Acctg change N legal settlements %otal

Expected Economic Effects D: 3ales reduction  =;; ; 11$ operating loss :@@ saving  @ 11 pa ; ;6GG employees terminated & :GG(:@G = 11 pa saving' === Closings Eliminate loss ma.ing storesHfocus on more profita"le opportunities Com"o 3tores Release #or.ing capital$ lo#er operating costs$ increase productivity

Reformat stores$ expand product lines 3upply chain reengineering

1ar.do#n 3ystems Refined %otal

Consolidate distri"ution centersH#arehou ses Consolidate 6 admin offices ,%C related = rd party claim

Other

;

=rd party claims

;G

;@= 6= =:6

6D

6-47

 @DG &;?T' reduction in stores inventory Enhanced customer experience >igher productivityHlo#er inventoryHlo#er costHheightened flexi"ility Improve 34NA efficiencies ,latten management and increase customer responsiveness

Expected savings   11 pa


Case 6(=Mcontinued ? %he restructurin restructuring g lia"ility can "e purposefull purposefully y overstated overstated to create create a hidden hidden reserve reserve %his hidden reserve reserve can can "e used to manage manage earnings earnings in at least t#o #ays #ays ,irst$ ,irst$ the compan company y can char charge ge some some operatin operating g expense expenses s of future future periods periods to the restru restructu cturin ring g lia"ility lia"ility 3econd$ 3econd$ the company company can reverse a portion of the charge to create net income in the period of the reversal In the case of %oys R /s it is unli.ely that it is managing its earnings /sing charges to manage earnings is a form of classificatory earnings managementB &see Chapter ;' >o#ever$ "y "urying various elements of the charge in different line items the very purpose of the charge$ ie$ inducing users to ignore the entire charge is lost %herefore it is not li.ely that the purpose of the restructuring charge #as earnings management @ %he %he follo# follo#in ing g ad+u ad+ustm stmen ents ts #o #oul uld d "e made made to the the fina financ ncia iall statem statemen ents ts to recast recast the restructur restructuring ing charge as an investm investment ent to create create future future cost cost savings savings ,irst$ the charge charge is recorded recorded as an asset and and amortized over over :G years 3econd$ ;GxD income is increased "y reversing the charge Income in fiscal ;Gx and the next :G years #ill then "e reduced "y a pro(rata amount of the investmentB 6 %he relative relative success success of restructu restructurin ring g activities activities can and must "e assessed assessed %he company should report higher return on assets and higher return on e*uity Also$ the company should report su"stantially lo#er costs such as selling and and administrative administrative costs costs %hese costs should should also decrease decrease as a percentage of sales Case 6(? &6G minutes' a 5asic 5asic Earning Earnings s -er 3hare 3hare Comput Computatio ations ns 5asic E-3 J :$@GG$GGG H GG$GGG shares J :6 2iluted Earnings -er 3hare Computations %he #arrants are dilutive since the average mar.et price of common stoc. &:=' exceeds the exercise price of the #arrants &:G' i GG$GGG GG$GGG share shares s x :G J $GGG $GGG$GGG $GGG proce proceeds eds ii $GGG$GGG H := J 6;$=G shares shares purchased purchased in open mar.et mar.et %hus$ ;G$6= additional shares #ould "e issued As ifB E-3 J :$@GG$GGGH&GG$GGGL;G$6=' J :=@ Are the su"o su"ordi rdina nated ted conv convert erti"l i"le e de"en de"entu tures res dilut dilutiv ive e 7es Assumi ssuming ng conver conversion sion$$ a total of @GG$GGG @GG$GGG &$GGG$ &$GGG$GGGH GGGH:D' :D' addition additional al common common shares shares #ould "e issued at 8une =G$ 7ear : %he net income ad+ustment #ould "e Interest expense for de"e e"entures s ;G$GGG 0ess ess taxes es                     &:=@$ =@$GGG' GGG' Increase in net income income   :=@$GGG

6-48


As ifB E-3 J &:$@GG$GGGL:=@$GGG'H&GG$GGGL;@G$GGG' J :?; Conse*uently 2iluted E-3 J &:$@GG$GGGL:=@$GGG'H&GG$GGGL;G$6=L;@G$GGG' J :;G " Intere Interest st expen expense se &7 &7ear ear ;' ;' 2e"e e"entures res & &$GGG GGG$GG $GGG x 6T 6T' '        %erm %erm loan loan &=$GGG$ &=$GGG$GGG GGG x T'H; T'H;     &;$@ &;$@GG GG$GG $GGG G x T'H T'H; ;         Inte Intere rest st exp expen ense se                         

@?G$ ?G$GGG GGG :G@$GGG :G@$GGG D$@G D$@GG G =; =;$@ $@GG GG

Earnings "efore interest and taxes &7ear ;' !et !et inco income me                              %axes xes &@GT &@GT' '                             Inte Intere rest st expe expens nse e                         Earn Earnin ing gs "ef "efor ore e inte intere rest st and and taxe taxes s         

:$@ :$@GG GG$G $GGG GG :$@G :$@GG$ G$GG GGG G @GG$ @GG$GG GGG G =$G =$GGG GG$G $GGG GG

%imes interest earned J =$@GG$GGGH=;$@GG J ?D Case 6(@ &?@ minutes' I a 5asic 5asic E-3 E-3 J Q;D@$GG Q;D@$GGG( G( &;?G &;?G x :G$GGG :G$GGG shares shares'S 'S H G$GG G$GGG G shares shares J ;G " 2iluted E-3 Are the conve converti" rti"le le "on "onds ds dilutiv dilutive e 7es es Assuming ssuming conve conversio rsion$ n$ the net income ad+ustment #ould "e Inte Intere rest st expe expen nse for for de"e de"ent ntu ures res                   0ess 0ess taxe taxes s                                     Incr Increa ease se in in net net inco income me                          

DG$ DG$GG GGG G &?G$ &?G$GG GGG' G' ?G$ ?G$GG GGG G

As ifB E-3 J &;D@$GGGL?G$GGG'H&G$GGGL=G$GGG' J ;: Is the converti"le preferred dilutive 7es Assuming conversion As ifB E-3 J ;D@$GGGH&G$GGGL;G$GGG' J ;@ 2iluted E-3 J &;D@$GGGL?G$GGG'H&G$GGGL=G$GGGL;G$GGG shares' J ;=; II Computa Computation tion of 5asic 5asic Earni Earnings ngs -er -er 3hare 3hare Weighted average shares outstanding during 7ear 6 8an 8anuary uary : :                      :G$G :G$GGG GG sh sh 8uly 8uly : :                         ;$GG ;$GGG G sh sh

: yr :H; :H; yr yr

5asic E-3 J &:G$GGG ( :$GGG' H ::$GGG shares J GD;

6-49

:G$G :G$GGG GG sh :$GG :$GGG G sh sh ::$GGG sh

Financial Statement Anlysis 10e Subramanyam Wild_Chapter 6

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