Chapter Fifteen: Financial Reporting and Concepts
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The accounting profession uses an “all inclusive” approach to measuring income. Virtually all transactions, other than shareholder related transactions like issuing stock and paying dividends, are eventually channeled through the income statement. However, there are certain situations where the accounting rules have evolved in sophistication to provide special disclosures. The reason for the added disclosure is to make it easier for users of financial statements to sort out the effects that are related to ongoing operations versus those that are somehow unique. The following discussion will highlight the correct handling of special situations.
Errors consist of mathematical mistakes, incorrect reporting, omissions, oversights, and other things that were simply handled wrong in a previous accounting period. Once an error is discovered, it must be corrected.
The temptation is to simply force the books into balance by making a compensating error in the current period. For example, assume that a company failed to depreciate an asset in 20X4, and this fact is discovered in 20X5. Why not just catch up by “double depreciating” the asset in 20X5, and then everything will be fine, right? Wrong! While it is true that accumulated depreciation in the balance sheet would be back on track at the end of 20X5, income for 20X4 and 20X5 would now both be wrong. It is not technically correct to handle errors this way.
Instead, U.S. generally accepted accounting principles dictate that error corrections (if material) must be handled by prior period adjustment. This means that the financial statements of prior periods must be subjected to a restatement to make them correct. In essence, the financial statements of prior periods are redone to reflect the correct amounts. Global GAAP follows a similar approach but provides an exception for adjustments that are impractical to determine.
The following 20X5 entry reveals the method of adjusting the general ledger for failure to record depreciation of $50,000 in 20X4. The debit to Retained Earnings reflects the expense that would have been recorded and closed to Retained Earnings in the prior year, while the credit to Accumulated Depreciation provides a catch-up adjustment to reflect the account’s correct balance.
Importantly, if comparative financial statements (i.e., side-by-side financial statements, for two or more years) are presented for 20X4 and 20X5, depreciation would be reported at the correct amounts in each years’ statements (along with a note indicating that the prior years’ data have been revised for an error correction). If an error related to prior periods for which comparative data are not presented, then the statement of retained earnings would be amended as follows:
A company may decide to exit a unit of operation by sale to some other company, or by outright abandonment. For example, a computer maker may sell its personal computer manufacturing unit to a more efficient competitor and instead focus on its server and service business. Or, a chemical company may decide to close a unit that has been producing a specialty product that has become an environmental liability.
When an entity disposes of a complete business component, it will invoke the unique reporting rules related to discontinued operations. To trigger these rules requires that the disposed business component have operations that are clearly distinguishable operationally and for reporting purposes. This would typically relate to a separate business segment, unit, subsidiary, or group of assets.
Following is an illustrative income statement for Bail Out Corporation. Bail Out distributes farming implements and sporting goods. During 20X7, Bail Out sold its sporting equipment business and began to focus only on farm implements.
In examining this illustration, be aware that revenues and expenses only relate to the continuing farming equipment operations. All amounts relating to operations of the sporting equipment business, along with the loss on the sale of assets used in that business, are removed from the upper portion of the income statement and placed in a separate category below income from continuing operations. If material, a company may separate the operating gain/loss from the gain/loss on the actual disposal of assets within this section.
If a company disposes of a facility or some other set of assets that is not a separate business component, then discontinued operations reporting is not invoked. Suppose Sail Out sold its facility in Georgia, but continued to distribute the same products at other locations. This would not constitute a discontinued operation because the company will continue to operate in the same line of business. The income statement might include a separate line item for the gain or loss on the sale of the location, but it would not constitute a discontinued operation:
Look again at Bail Out and note that income taxes were “split” between continuing operations and discontinued operations. This method of showing tax effects for discontinued operations is mandatory and is called intraperiod tax allocation. Intraperiod tax allocation is applicable to other items reported below continuing operations (and some prior period and selected equity adjustments), but only one income tax number is attributed to income from continuing operations.
A business may experience a gain or loss that results from an event that is both unusual in nature and infrequent in occurrence. When these two conditions are both met, the item is deemed to be an extraordinary item. Under U.S. GAAP, it is reported net of tax in a separate category below income from continuing operations:
What type of event is both unusual in nature and infrequent in occurrence? UFO Corporation was hit by a meteorite. It is rare for a meteor to hit a specific business. It is unlikely that UFO would sustain this type of loss again. On the other hand, flood losses for businesses located along a river, earthquakes for businesses in the Pacific Rim, and the like can give rise to losses that are not unusual in nature and/or may be expected to reoccur. Accounting requires professional judgment; and, there is sometimes room for debate and perhaps more than one possible solution. International accounting standards do not provide for a separate extraordinary item category.
The Long-term Investments chapter introduced other comprehensive income. OCI arose from changes in the fair value of investments classified as “available for sale.” OCI can also result from certain pension plan accounting adjustments and translation of the financial statements of foreign subsidiaries. OCI does not enter into the determination of net income or retained earnings, but it does enter into the determination of a broader concept of income. When OCI is present, it may be presented as a separate component in a statement of comprehensive income. Alternatively, a company may present a reconciliation of net income to total comprehensive income.
It is highly unlikely that a company would experience all of the previously discussed items within the same year. However, were that the case, its statement of comprehensive income might expand to look something like the following:
Take note that net income or earnings is income from continuing operations plus/minus discontinued operations and extraordinary items. Comprehensive income is net income plus other comprehensive income. OCI is closed to the Accumulated Other Comprehensive Income account that is presented within stockholders' equity (similar to, but separate from, retained earnings).
A company may adopt an alternative accounting principle. Such accounting changes relate to changes from one acceptable method to another. For instance, a company may conclude that it wishes to adopt FIFO instead of average cost. Such changes should only occur for good cause (not just to improve income), and flip-flopping is not permitted. When a change is made, the company must make a retrospective adjustment. This means that the financial statements of prior accounting periods should be reworked as if the new principle had always been used.
Disclosures that must accompany a change in accounting principle are extensive. Notes must indicate why the newly adopted method is preferable. In addition, a substantial presentation is required showing amounts that were previously presented versus the newly derived numbers, with a clear delineation of all changes. And, the cumulative effect of the change that relates to all years prior to the earliest financial data presented must be disclosed.
Do not confuse a change in accounting method with a change in accounting estimate. Changes in estimate are handled prospectively. This type of change was illustrated in the Property, Plant, and Equipment chapter. If a change in principle cannot be separated from a change in estimate, the adjustment would be handled as a change in estimate. Similar treatment is required for any change in depreciation method.
Investors may discuss a company’s “earnings before interest and taxes” (EBIT) and “earnings before interest, taxes, depreciation, and amortization” (EBITDA). These numbers can be calculated from information available in the statements. Some argue that EBIT (pronounced with a long “E” sound and “bit”) and EBITDA (pronounced with a long “E” sound and “bit” and “dah”) are important and relevant to decision making, because they reveal the core performance before considering financing costs and taxes (and noncash charges like depreciation and amortization).
These numbers are sometimes used in evaluating the intrinsic value of a firm, in that they reveal how much the business is producing in earnings without regard to how the business is financed and taxed. These numbers should be used with great care, as they can provide an overly simplistic view of business performance.
How is one to meaningfully compare the net income of a large corporation that has millions of shares outstanding to smaller companies that may have less than even one million shares? The larger company is probably expected to produce a greater amount of income. But, the smaller company might be doing better per unit of ownership. To adjust for differences in size, public companies must supplement their income reports with a number that represents earnings on a per common share basis.
Earnings per share, or EPS, is a widely followed performance measure. Corporate communications and news stories will typically focus on EPS, but care should be taken in drawing any definitive conclusions. Nonrecurring transactions and events can positively or negatively impact income. Companies that present an income statement that segregates income from continuing operations from other components of income must also subdivide per share data (e.g., EPS from continuing operations, discontinued operations, etc.).
Basic EPS may be thought of as a fraction with income in the numerator and the number of common shares in the denominator. Expanding this thought, consider that income is for a period of time (e.g., a quarter or year), and during that period of time, the number of shares might have changed because of share issuances or treasury stock transactions. Therefore, a more correct characterization is income divided by the weighted-average number of common shares outstanding.
Further, consider that some companies have both common and preferred shares. Dividends on common and preferred stock are not expenses and do not reduce income. However, preferred dividends do lay claim to a portion of the corporate income stream. Therefore, one more modification is needed to correctly portray the basic EPS fraction:
Basic EPS = Income Available to Common / Weighted-Average Number of Common Shares Outstanding
The basic EPS calculation entails a reduction of income by the amount of preferred dividends for the period. To illustrate, assume that Kooyul Corporation began 20X4 with 1,000,000 shares of common stock outstanding. On April 1, 20X4, Kooyul issued 200,000 additional shares of common stock, and 120,000 shares of common stock were reacquired on November 1. Kooyul reported net income of $2,760,000 for the year ending December 31, 20X4. Kooyul also had 50,000 shares of preferred stock on which $500,000 in dividends were rightfully declared and paid during 20X4. Kooyul paid $270,000 in dividends to common shareholders. Therefore, Kooyul’s basic EPS is $2 per share ($2,260,000/1,130,000), as discussed in the following paragraph.
Income available to Kooyul’s common shareholders is $2,260,000. This amount is calculated as the net income ($2,760,000) minus the preferred dividends ($500,000). Dividends on common stock do not impact the EPS calculation. Weighted-average common shares outstanding during 20X4 are 1,130,000. The following table illustrates this calculation:
Some companies must report an additional diluted EPS number. The diluted EPS is applicable to companies that have complex capital structures. Examples include companies that have issued stock options and warrants that entitle their holders to buy additional shares of common stock from the company, and convertible bonds and preferred stocks that are exchangeable for common shares. These financial instruments represent the possibility that more shares of common stock will be issued and are potentially “dilutive” to existing common shareholders.
Companies with dilutive securities take the potential effect of dilution into consideration in calculating diluted EPS. These calculations require a series of assumptions about dilutive securities being converted into common stock.
The hypothetical calculations are imaginative; even providing guidelines about how assumed money generated from assumed exercises of options and warrants is assumed to be “reinvested.” Diluted EPS provides existing shareholders a measure of how the company’s income is potentially to be shared with other interests.
Price Earnings Ratio = Market Price Per Share / Earnings Per Share
For example, a stock selling at $15 per share with $1 of EPS would have a P/E of 15. Other companies may have a P/E of 5 or 25. Wouldn’t investors always be drawn to companies that have the lowest ratios since they may represent the best earnings generation per dollar of required investment? Perhaps not, as the “E” in P/E is past earnings. New companies may have a bright future, even if current earnings are not great. Other companies may have great current earnings, but no room to grow.
Another ratio is the “PEG” ratio that relates P/E to the earnings “growth” rate, with growth expressed as a whole number. For example, a company with a P/E of 20 that is experiencing average annual increases in income of 20% would have a PEG of 1 (20 divided by 20). If the same company instead had annual earnings increases of 10%, then the PEG would be 2 (20 divided by 10). Lower PEG numbers sometimes help identify more attractive investments.
Another per share amount that analysts frequently calculate is the book value per share. This refers to the amount of reported stockholders’ equity for each share of common stock. Book value is not the same thing as market value or fair value. Book value is based on reported amounts within the balance sheet.
Many items included in the balance sheet are based on historical costs which can be well below fair value. On the other hand, do not automatically conclude that a company is worth more than its book value, as some balance sheets include significant intangibles that cannot be easily converted to value.
For a corporation the has only common stock outstanding, the calculation of book value per share is simple. Total stockholders’ equity is divided by common shares outstanding at the end of the accounting period.
To illustrate, assume that Fuller Corporation has the following stockholders’ equity, which results in a $24 book value per share ($12,000,000/500,000 shares):
A company with preferred stock must allocate total equity between the common and preferred shares. The amount of equity attributable to preferred shares is generally considered to be the call price (i.e., redemption or liquidation price) plus any dividends that are due. The remaining amount of “common” equity (total equity minus equity attributable to preferred stock) is divided by the number of common shares to calculate book value per common share:
Book Value Per Share = "Common" Equity / Common Shares Outstanding
Assume that Muller Corporation has the following stockholders’ equity:
Mike Kreinhop is a financial analyst for an investment fund, and is evaluating the merits of Muller Corporation. Pursuant to this task, he has diligently combed through the notes to the financial statements and found that the preferred dividends were not paid in the current or prior year. He notes that the annual dividend is $600,000 (6% X $10,000,000) and the preferred stock is cumulative in nature. Although Muller has sufficient retained earnings to support a dividend, it is presently cash constrained due to reinvestment of all free cash flow in a new building and expansion of inventory. Kreinhop correctly prepared the following book value per share calculation:
Many companies do not pay dividends. One explanation is that the company is not making any money. Hopefully, the better explanation is that the company needs the cash it is generating from operations to reinvest in expanding a successful concept. On the other hand, some profitable and mature businesses can easily manage their growth and still have plenty of cash left to pay a reasonable dividend to shareholders. In evaluating the dividends of a company, analysts calculate the dividend rate (also known as yield).
The dividend rate is the annual dividend divided by the stock price:
Dividend Rate = Annual Cash Dividend / Market Price Per Share
If Pustejovsky Company pays dividends of $1 per share each year, and its stock is selling at $20 per share, it is yielding 5% ($1/$20). Analysts may be interested in evaluating whether a company is capable of sustaining its dividends and will compare the dividends to the earnings:
Dividend Payout Ratio = Annual Cash Dividend / Earnings Per Share
If Pustejovsky earned $3 per share, its payout ratio is .333 ($1/$3). On the other hand, if the earnings were only $0.50, giving rise to a dividend payout ratio of 2 ($1/$0.50), one would begin to question the “safety” of the dividend.
Some financial statement analysts will compare income to assets, in an attempt to assess how effectively assets are being utilized to generate profits. The specific income measure that is used in the return on assets ratio varies with the analyst, but one calculation is:
Return on Assets Ratio = (Net Income + Interest Expense) / Average Assets
These calculations of “ROA” attempt to focus on income (excluding financing costs) in relation to assets. The point is to demonstrate how much operating income is generated by the deployed assets of the business. This can prove useful in comparing profitability and efficiency for companies in similar industries.
Return on Equity Ratio = (Net Income - Preferred Dividends) / Average Common Equity
“ROE” enables comparison of the effectiveness of capital utilization among firms. What it does not do is evaluate risk. Sometimes, firms with the best ROE also took the greatest gambles. For example, a high ROE firm may rely heavily on debt to finance the business, thereby exposing the business to greater risk of failure when things don’t work out. Analysts may compare ROE to the rate of interest on borrowed funds. This can help them assess how effective the firm is in utilizing borrowed funds (“leverage”).
Of what value is accounting? Why is so much time and money spent on the development of accounting information? To fairly answer these questions, one must think broadly. Investors and creditors have limited resources and seek to place those resources where they will generate the best returns. Accounting information is the nexus of this capital allocation decision process. Without good information, misallocation of capital would occur and result in inefficient production and shortages.
Most organizations devote a fair amount of time and effort to considering their goals and objectives. The accounting profession is no different. Foremost among the objectives of accounting and reporting is to provide useful information for investors, creditors, analysts, governments, and others.
Accounting information is general purpose and should be designed to serve the information needs of all types of interested parties. To be useful, information should be helpful in assessing an entity's economic resources, claims against resources, and what causes changes in resources and claims. Such assessments are generally benefited by accrual accounting, coupled with consideration of cash flows. Care must be taken to differentiate between resource changes resulting from economic performance and other factors (e.g., earnings vs. issuing additional shares of stock). The following qualities help to make accounting useful.
Be aware of the growing complaint that accounting has become too complex. Many persons within and outside the profession protest the ever growing number of rules and their level of detail. The debate is generally couched under the heading “principles versus rules.” Advocates of a principles-based approach argue that general concepts should guide the judgment of individual accountants. Others argue that the world is quite complex, and accounting must necessarily be rules-based. They believe that reliance on individual judgment may lead to wide disparities in reports that could render meaningful comparisons impossible.
Generally accepted accounting principles, or GAAP, encompass the rules, practices, and procedures that define the proper execution of accounting. It is important to note that this definition is quite broad, taking in more than just the specific rules issued by standard setters. It encompasses the long-standing methodologies and assumptions that have become engrained within the profession through years of thought and development. Collectively, GAAP form the foundation of accounting by providing comprehensive guidance and a framework for addressing most accounting issues.
The Financial Accounting Standards Board (FASB) has been the primary U.S. accounting rule maker since the early 1970s. Its many rulings are available via an online codification of standards (at FASB.org). Prior to its creation, rules were set by the Accounting Principles Board (APB). The APB was created in 1959 by the American Institute of Certified Public Accountants (AICPA). The AICPA is a large association of professional accountants who seek to advance the practice of accounting. Before 1959, the duty of standard development fell on the shoulders of an AICPA committee known as the Committee on Accounting Procedure (CAP).
The International Accounting Standards Board (IASB) is the global counterpart to the FASB. The standards of the IASB are oftentimes referred to as IFRS (International Financial Reporting Standards). The FASB and IASB are working harmoniously to converge toward a single set of accounting standards. This project is receiving considerable interest from financial institutions, investors, and governmental units around the world. Convergence of accounting standards is seen as an important tool in the facilitation and coordination of international commerce and the global economy.
In a 1930s-era effort to bring credibility to capital markets, the U.S. Congress created the Securities and Exchange Commission (SEC). The SEC was charged with the administration of laws that regulate the reporting practices of companies with publicly traded stock. Today, U.S. public companies must register and report to the SEC on a continuing basis. Although the SEC has ultimate authority to set accounting rules, it has elected to operate under a tradition of cooperation and largely defers to the private sector for most specific accounting rules.
To provide a measure of integrity, financial reports of public companies are required to be audited by independent CPAs. Auditors evaluate the systems and data that lead to the reported financial statements. The auditor will usually issue an opinion letter on the fairness of the reports. This letter is rather brief and to the point and includes a paragraph similar to the following:
Note that the auditor is expressing an opinion about the conformity of the financial statements with generally accepted accounting principles. Thus, conformity with GAAP is the key to obtaining the desired audit opinion. Being alert to the detection of potential fraud is important, but it is not the primary mission of a financial statement audit.
The U.S. Congress created the Sarbanes-Oxley Act of 2002 (SOX). It imposed stringent financial statement certification requirements on corporate officers, raised the fiduciary duty of corporate boards, imposed systematic ethics awareness, and placed a greater burden on auditors.
In addition, Section 404 of the Act requires public companies to implement a robust system of internal control; an independent auditor must issue a separate report on the effectiveness of this control system. The Act also created the Public Company Accounting Oversight Board (PCAOB). The PCAOB is a private-sector, non-profit corporation, charged with overseeing the auditors of public companies.
Accounting information should be presented for specific and distinct reporting units. In other words, the entity assumption requires that separate transactions of owners and others not be commingled with the reporting of economic activity for a particular business. On one hand, an individual may prepare separate financial statements for a business he or she owns even if it is not a separate legal entity. On the other hand, consolidated financial statements may be prepared for a group of entities that are economically commingled but are technically separate legal units.
In the absence of contrary evidence, accountants base measurement and reporting on the going-concern assumption. This means that accountants are not constantly assessing the liquidation value of a company in determining what to report, unless of course liquidation looks like a possibility. This allows for allocation of long-term costs and revenues based on a presumption that the business will continue to operate into the future. Accountants are typically conservative (when in doubt, select the lower asset/revenue measurement choice and the higher liability/expense measurement choice) but not to the point of introducing bias based on an unfounded fear for the future.
Accountants assume they can divide time into specific measurement intervals (i.e., months, quarters, years). This periodicity assumption is necessitated by the regular and continuing information needs of financial statement users. More precision could be achieved if accountants had the luxury of waiting many years to report final results, but users need timely information. For instance, a health club may sell lifetime memberships for a flat fee, not really knowing how long its customers will utilize the club. But, the club cannot wait years and years for their customers to die before reporting any financial results. Instead, methods are employed to attribute portions of revenue to each reporting period. This is justified by the periodicity assumption.
The monetary unit assumption means that accounting measures transactions and events in units of money. This assumption overcomes the problems that would arise by mixing measures in the financial statements (e.g., imagine the confusion of combining acres of land with cash). The monetary unit assumption is core and essential to the double-entry, self-balancing accounting model.
Inflation can wreak havoc on the usefulness of financial data. For example, suppose a power plant that was constructed in 1970 is still in operation. Accounting reports may show a profit by matching currently generated revenues with depreciation of old (“cheap”) construction costs. A different picture might appear if one reconsidered the “value” of the power plant that is being “used up” in generating the current revenue stream. Inflation can distort performance measurement. Inflation also has the potential to limit the usefulness of the balance sheet by reporting amounts at costs that differ greatly from current value. Accountants have struggled with this issue for many years, and even experimented with supplemental reporting requirements. However, accounting generally operates under the stable currency assumption, going along as though costs and revenues incurred in different time periods need not be adjusted for changes in the value of the monetary unit over time.
Understand that international trade no longer simply means importing and exporting. Companies have added subsidiaries in many countries, formed cooperative alliances, listed shares on multiple stock exchanges around the globe, engaged in global cross-border debt financing, and set up service centers that utilize technology to provide seamless customer support around the world. Companies engaging in global business face some specific reporting challenges. Two of those challenges are (1) how to consolidate global subsidiaries and (2) how to account for global transactions denominated in alternative currencies.
When a parent corporation has a subsidiary outside of its home country, the financial statements of that subsidiary may be prepared in the “local” currency of the country in which it operates. But, the parent’s financials are prepared in the “reporting” currency of the country in which it is domiciled. Thus, to consolidate the parent and sub first requires converting the sub’s financial information into the reporting currency. Facts and circumstances will dictate whether the conversion process occurs by a process known as the functional currency translation approach or an alternative approach known as remeasurement.
Many firms buy goods from foreign suppliers and/or sell goods to foreign customers. The terms of the transaction will stipulate how payment is to occur and the currency for making settlement. If the currency is “foreign,” then some additional thought must be given to the bookkeeping. Suppose Bentley’s Bike Shop purchases bicycles from GiroCycle of Switzerland. On July 1, 20X6, Bentley purchased bicycles, agreeing to pay 20,000 Swiss francs within 60 days. Bentley is in Cleveland, Ohio, and the U.S. dollar is its primary currency. On July 1, Bentley will record the purchase by debiting Inventory and crediting Accounts Payable. But, what amount should be debited and credited? If 20,000 were used, the accounts would cease to be logical. The total Inventory balance would be illogical since it would include this item, and all other transactions in other currencies. Total Accounts Payable would become unintelligible as well. Therefore, Bentley needs to measure the transaction in dollars. On July 1, assume that the current exchange rate (i.e., the “spot rate”) is 0.90 U.S. dollars to acquire 1 Swiss franc. The correct entry would be:
By the August 29 settlement date, assume that the dollar has weakened and the spot rate is $0.95. Bentley will have to pay $19,000 (20,000 X $0.95) to buy the 20,000 francs needed to settle the obligation. The following entry shows that the difference between the initially recorded payable ($18,000) and the cash settlement amount ($19,000) is to be recorded as a foreign currency transaction loss:
If the exchange rate had gone the other way, a foreign currency transaction gain (credit) would have been needed to balance the payable and required cash disbursement.
It is important to know that foreign currency payables and receivables that exist at the close of an accounting period must also be adjusted to reflect the spot rate on the balance sheet date. Suppose Vigeland Corporation sold goods to a customer in England, agreeing to accept payment of 100,000 British pounds in 90 days. On the date of sale, December 1, 20X1, the spot rate for the pound was $1.75. Vigeland prepared financial statements at its year end on December 31, 20X1, at which time the spot rate for the pound was $1.90. The foreign currency receivable was collected on February 28, 20X2, and Vigeland immediately converted the 100,000 pounds to dollars at the then current exchange rate of $1.70. The following illustrates Vigeland’s sale, year-end adjustment, and subsequent collection:
Some companies may wish to avoid foreign currency exchange risks like those just illustrated. The simplest way is to convince a trading partner to make or take payment in the home currency. In the alternative, various financial agreements can be structured with banks or others to hedge this risk.