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Intermediate Accounting O ctober 12 th , 2010

Intermediate Accounting O ctober 12 th , 2010. General Course Questions Review & Discuss Income Statement, Acctg. Changes & Errors A. Chapter 4 and Questions 3,4,6,7,17,23,24, BE 7 & 8 Exercises 4,5,8,13, CE 4-1 & 4-2 B. Chapter 17 BE 5 & 6, Exercise 6 & 7

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Intermediate Accounting O ctober 12 th , 2010

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  1. Intermediate AccountingOctober 12th, 2010 • General Course Questions • Review & Discuss Income Statement, Acctg. Changes & Errors A. Chapter 4 and Questions 3,4,6,7,17,23,24, BE 7 & 8 Exercises 4,5,8,13, CE 4-1 & 4-2 B. Chapter 17 BE 5 & 6, Exercise 6 & 7 C. Chapter 22 Questions 1,2,3,4,6,8,12,15,18, BE 4,5,7-10 Exercises 2 & 8 • Assignments for Thursday, October 14th: A. Chapter 4 questions 15,16, E 15, Problem 3, CA 4-7 B. DQ for Levitt and Brennan 4. Return & Discuss Quiz Chapters 1-3

  2. Chapter 4, 17, 22 Learning Objectives • Understand the Income Statement uses & limitations • Understand Income Statement Options (Single step vs. Multiple Step) and Explain Required Reporting for: A. Non-recurring items B. Intra period Tax Allocation C. EPS • Distinguish between Changes in Accounting Estimates, Error Corrections, Changes in Accounting Principles and how to handle and/or report for each • Learn how to prepare a Statement of RE & Stockholders’ Equity • Learn three Reporting options for “Other Comprehensive Income” and items causing it

  3. Usefulness of the Income Statement Relevant Information has Feedback or Predictive Value • Evaluate past performance. • Predicting future performance. • Help assess the risk or uncertainty of achieving future cash flows.

  4. Limitations of the Income Statement Limitations • Do not report items that cannot be measured reliably. (ch 4 ?3) • Reported Income is affected by the accounting choices made. (Ch 4 ?4) • Income measurement involves management judgment and can lead to Earnings Management (Ch 4 ?s 6 & 7)

  5. Lists the following for a firm over a period of time: Operating (Ongoing) Activities : Revenues & Expenses Non-Operating (Incidental or Peripheral) Activities: Gains &/or Losses Non-recurring Items (Irregular Items): Resulting from Discontinued Operations &/or Extraordinary Items Net Income = (Revenues + Gains) – (Expenses + Losses) US GAAP vs. IFRS: IFRS requires at least one year of comparative data on income statement (IAS 7) US GAAP has no specific requirement (however, SEC rules require firms to report 3 years of income statement data) Income Statement Information

  6. Single-Step Income Statement The single-step statement consists of just two groupings: Revenues Expenses Net Income Single- Step No distinction between Operating and Non-operating categories. Ch 4 ex 4

  7. Multi-Step Income Statement The presentation divides information into major sections. 1. Operating Section 2. Nonoperating Section 3. Income tax

  8. I. Operating Section: Information about the businesses operating activity Used as basis for extrapolating into the future May include unusual gains and losses II. Non-operating or “Other” Section: Interest expense and revenue Other gains and losses (sale of fixed assets, etc.) May include unusual gains and losses III. Income Tax Section (on above items) IV. Non- recurring (Irregular) Items Section: presented “Net of Tax” Discontinued operations (net of tax) Extraordinary items (net of tax) Multi-Step Income Statement Presentation

  9. Material gains or losses that are generally unusual orinfrequent, but not both. The company must consider the environment in which it operates. Do not qualify as “extraordinary” Reported in Continuing Operations (above the line) in either the operating or non-operating section. Managers exercise discretion in presentation above the line. Examples: A. Restructuring charges B. Write downs or write off of Inventory, Receivables or Intangible items C. Effects of a strike D. Gains or Losses on Sale or Abandonment of PP&E Reporting Unusual and Non-Operating Gains or Losses

  10. Non-recurring Items require separate disclosure on the Income Statement • Non-recurring items that occur during an accounting period must be disclosed separately on an income statement because they should not be used to predict future performance. • Recurring items could happen again. • Nonrecurring items are not expected to happen again; but need to be reported in the year they happen. GAAP limits “nonrecurring” to: • Discontinued Operations – when a business disposes of a major segment of business • Extraordinary Items Gains or losses that are BOTH unusual and infrequent

  11. Income Tax Disclosure • Recurring items – income tax expense is shown as a separate line item. Typically the last expense before calculating “income from continuing operations.” • Nonrecurring items – the income tax effect of a nonrecurring gain or loss is included in the calculation of the gain or loss. The gain or loss is shown “net of tax.”

  12. Taxes Always Reduce the Nonrecurring Item Assume a company with a 25% tax rate has as a: • Nonrecurring gain of $100,000. The gain would add to the company’s taxable income and cause them to pay $25,000 in taxes on the gain. The gain is thus, $_________ net of tax: $100,000 – (25% x $100,000). • Nonrecurring loss of $100,000. The loss would lower the company’s taxable income. The reduction in taxes caused by the loss results in a smaller loss. The loss would be $_________ net of tax. $100,000 – (25% x $100,000).

  13. Non- recurring or Irregular Items Reporting when both Discontinued Operations and Extraordinary Items are present. Previously labeled as “Net Income”. Discontinued Operations Extraordinary Item Ch 4 Ex 5

  14. Extraordinary items must meet BOTH of the following criteria: Event/transaction must be unusual in nature. Event/transaction must occur infrequently. Items are reported “net of tax” (i.e. “below the line”). Items that are NOT Extraordinary Items under GAAP: Losses from write-down or write-off of receivables, inventories, etc. Gains and losses from: Exchange or translation of foreign currency Disposal of a segment of a business Abandonment of property used in business Effects of strike Adjustments or accruals on long term contracts Extraordinary Item classification not allowed under IFRS Reporting Extraordinary Items

  15. Income Statement with Recurring & Non-Recurring Items 1. Operating Section 2. Other or Non-operating Section 3. Income tax (on recurring items) 4. Non-recurring Section, net of tax Ch 4 ?17 ex 4,5,8,

  16. Earnings Per Share • An important business indicator measuring the dollars earned by each share of Common Stock • Firms required to disclose both Basic and Fully Diluted EPS on the Income Statement • Basic EPS • Diluted EPS (when stock equivalents and convertible securities are outstanding, i.e. options, warrants, convertible P.S. or debt)

  17. Earnings Per Share Computed as: Net Income less Preferred Dividends Weighted Average of Common Shares Outstanding Disclosed on the I/S for all the major sections: • Income from continuing operations • Discontinued operations loss, net of tax • Income before extraordinary item • Extraordinary item, net of tax • Net income

  18. Earnings Per Share Divide by weighted-average shares outstanding EPS

  19. Earnings Per Share Example: • Assume Net Income of $5K • Preferred Stock Dividends = $1K • 12/31/10 year-end • Outstanding common shares as follows: • 1/1/10: 100 shares • 4/1/10: 200 shares • 7/1/10: 250 shares Weighted Average Calculation: Ch 4 ? 23, 24 & BE 8

  20. Earnings Per Share Example: At 12/31/06 Shi Corp. had the following stock outstanding: 10% cumulative preferred stock, $100 par, 107,500 shares $10,750,000 Common stock, $5 par, 4,000,000 shares 20,000,000 During 2007, Shi Corp. did not issue any additional common stock. The following also occurred during 2007: Income from continuing operations before taxes $23,650,000 Discontinued operations (loss before taxes) $ 3,225,000 Preferred dividends declared $ 1,075,000 Common dividends declared $ 2,200,000 Effective tax rate 35% Compute EPS as it should appear on the 2007 f/s.

  21. Categories of Accounting Changes: Change in Accounting Estimate Accounting Errors in Financial Statements Change in Accounting Principle Accounting Changes

  22. What possible ways can we handle these changes? 1. 2. 3. Accounting Changes

  23. Application of certain accounting concepts requires estimates: Matching concept requires an estimate of the life of long-lived assets Examples: uncollectible accounts, warranty liabilities, depreciation. Estimates updated as new information becomes available. Reporting: Reported prospectively. Change reported in current and future periods No effect on prior periods (not considered an error) Reported in the affected accounts, NOT “below the line” (not considered an extraordinary item) Change in Accounting Estimate

  24. Example of prospective treatment: Purchase machine on 1/1/09 for $110,000 with an estimated useful life of 10 years and a salvage value of $10,000. Due to technological changes in 2010, it is estimated that the machine will have zero salvage value and will only have a useful life of 4 years beyond 2010. Annual depreciation for 2010 and beyond will be: Change in Accounting Estimate

  25. Includes: Change from an accounting principle that is not GAAP to GAAP or mistake in application of an accounting principle Mathematical mistakes Changes in estimate that occurs because estimates not prepared in good faith or facts used in error Oversights (ex: failure to accrue or defer expenses and revenues at end of period) Reporting: Reported retrospectively as a “restatement” Correct error in year(s) originally made by a direct entry to the affected line item(s). In following years the effect flows through beginning R/E. If error prior to years presented, adjust beginning R/E. Errors from previous periods do not flow through current period income. Accounting Errors andPrior Period Adjustments

  26. Example: ABC company’s auditor found the following errors during the 12/31/10 audit. What is the impact of each error? Assume ABC is public. At the end of 2009, sales salaries of $45,000 were not accrued. In 2010, the company wrote off $87,000 of inventory considered to be obsolete; this loss was charged directly to Retained Earnings and credited to inventory. 2007 depreciation was understated by $100,000. Subsequent years’ depreciation was correctly recorded Accounting Errors andPrior Period Adjustments

  27. Company adopts different accounting principle from the one previously used Change from one acceptable method to another OR change in accounting standards. Examples? If among acceptable methods, must demonstrate that newly adopted principle is preferable to the old one since such changes mean consistency across periods is lost. Reporting since 5/15/05: SFAS154 adopts retroactive approach unless it is impracticable to do so. Prior years’ statements presented in the financial statements are recast on a basis consistent with the newly adopted principle. Adjust beginning retained earnings for the earliest year presented to reflect any cumulative effect on periods prior to those presented. Note no cumulative effect is reported on the Income Statement Change in Accounting Principle

  28. Example: (ch 4 ex 13) Zehms Co. began operations in 2008 and adopted weighted average pricing for inventory. In 2010, Zehms changed to FIFO pricing. The pretax income data is: Year Weighted Ave. FIFO 2008 370,000 395,000 2009 390,000 420,000 2010 410,000 460,000 Assume a 35% tax rate in all years. a) What is NI in 2010? b) Compute the cumulative effect of the change in accounting principle from weighted average to FIFO pricing. c) Show comparative income statements for Zehms Co., beginning with income before income tax, as presented on the 2010 income statement. Change in Accounting Principle

  29. Retained Earnings Statement • Increased by net income and decreased by net loss and dividends for the year. • Prior period adjustments to beginning balance • Corrections of errors in prior period financial statements • cumulative impact of changes in accounting principles • Any part of retained earnings appropriated for a specific purpose is shown as restricted earnings. • So dividends can’t be paid out from restricted R/E (can be part of a debt covenant) Ch 4 ex 8

  30. Retained Earnings Statement Increased by: Decreased by: Net income Cumulative Affect of a Change in accounting principle Error corrections (Prior Period Adj.) Net loss Dividends Cumulative Affect of a Change in accounting principles Error corrections (Prior Period Adj) Restricted Retained Earnings Disclosed in the Notes and Financial Statements as Appropriated Retained Earnings not available for Dividends.

  31. Comprehensive Income Overview What is comprehensive income? • All changes in equity during a period, except those resulting from investments by or distributions to owners. • Includes “regular” net income • PLUS “other comprehensive income”: (Results from unrealized change in Fair Mkt Value) • unrealized gains or losses on available for sale securities (Ch17) • unrealized gains or losses on foreign currency translation • unrealized gains or losses on pension obligations • unrealized gains or losses from incomplete hedging transactions

  32. Unrealized Holding Gains/Losses on Securities • Why do companies invest in debt and equity securities? • < 20% interest assume little or no influence over investee • Report debt intending to hold at “held to maturity” • Record investment at amortized cost • Record interest as income • Report equity & other debt investment using fair value method • Mark investment to “market” on B/S. • Recognize unrealized gain or loss. Where depends upon classification • Trading  Income Statement • Available-for-Sale  Other comprehensive income • Other issues • Can calculate gain or loss at the portfolio level • Potential for earnings management here?

  33. Reporting Comprehensive Income Companies are required to report total comprehensive income in one of three ways: • On the face of its Income Statement (combined statements) • In a separate Statement of Comprehensive Income, or 3. In the Statement of Stockholders’ Equity (most companies choose this option)

  34. Reporting Comprehensive Income on the Income Statement Regular Income Statement “Other Comprehensive Income”

  35. Reporting Comprehensive Income on a second Statement

  36. Reporting Comprehensive Income in a Statement of Stockholders’ Equity

  37. Unrealized Gains/Losses Example: on 1/1/09 Big bought shares of Little for $100,000. The shares were < 20% of the total outstanding stock of Little Company. On 12/31/09 the shares had a fair value of $125,000. Little paid dividends of $1000 to Big. How is this accounted for at 1/1/09 and 12/31/09? • If classified as Trading Securities? • If classified as Available for Sale Securities?

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